Financial Management Unit 1

Unit 1 Financial Management

Structure:
1.1 Introduction
Objectives
1.2 Meaning and Definition of Financial Management
1.3 Goals of Financial Management
Profit maximisation
Wealth maximisation
Wealth maximisation vs. profit maximisation
1.4 Finance Functions
Financing decisions
Investment decisions
Dividend decisions
Liquidity decisions
1.5 Organisation of Finance function
1.6 Interface between Finance and Other Business Functions
Relation between Finance and accounting
Finance and marketing
Finance and production (operations)
Finance and HR
1.7 Summary
1.8 Glossary
1.9 Terminal Questions
1.10 Answers
1.11 Case Study

1.1 Introduction
Financial management of a firm is concerned with procurement and
effective utilisation of funds for the benefit of its shareholders. It embraces
all those managerial activities that are required to procure funds at the least
cost and their effective deployment.
Reliance and Infosys are examples of admired Indian companies that
employ effective financial management skills to their businesses. They have
been rated well by the financial analysts on many crucial aspects that
enabled them to create value for their shareholders. They employ the best

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technology, produce good quality goods or render services at the least cost,
and continuously contribute to the shareholder’s wealth.
The three core elements of financial management are:
a. Financial planning
Financial planning is done to ensure the availability of capital
investments to acquire the real assets. Real assets are lands, buildings,
plants and equipments. Capital investments are required for establishing
and running the business smoothly.
b. Financial decisions
 Decisions need to be taken on the sources from which the funds
required for the capital investments could be obtained.
 There are two sources of funds - debt and equity. In what proportion
the funds are to be obtained from these sources is to be decided for
formulating the financing plan.
c. Financial control
Financial control involves managing the costs and expenses of a
business. For example, it includes taking decisions on the routine
aspects of day-to-day management of collecting money which is due
from the firm’s customers and making payments to the suppliers of
various resources.
In this unit, you will learn about these core elements of financial
management.
Objectives:
After studying this unit, you should be able to:
 analyse the meaning of financial management
 describe the goals of financial management
 discuss the functions of finance
 explain the interface between finance and other managerial functions of a
firm

1.2 Meaning and Definition of Financial Management

Financial management is the art and science of managing money.
Regulatory and economic environments have undergone drastic changes
due to liberalisation and globalisation of Indian economy. These have
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changed the profile of Indian finance managers. Indian finance managers

have transformed themselves from License Raj managers to well-informed,
dynamic, proactive managers capable of taking decisions of complex
nature.
Traditionally, financial management was considered as a branch of
knowledge that focused on the procurement of funds. Formation, merger
and restructuring of firms and legal and institutional frame work, instruments
of finance occupied the prime place in this traditional approach.
The modern approach transformed the field of study from the traditional,
narrow approach to a dynamic and extensive approach. The core of modern
approach evolved around the procurement of the least cost funds and its
effective utilisation for maximisation of shareholder’s wealth.

Self Assessment Questions

1. What has changed the profile of Indian finance managers?
2. Finance management is considered as a branch of knowledge with
focus on the __________.

1.3 Goals of Financial Management

Financial management means maximisation of economic welfare of its
shareholders. Maximisation of economic welfare means maximisation of
wealth of its shareholders. Shareholder’s wealth maximisation is reflected in
the market value of the firm’s shares. Experts believe that, the goal of
financial management is attained when it maximises the market value of
shares. There are two versions of the goals of financial management of the
firm – Profit Maximisation and Wealth Maximisation.
Let us now discuss the goals of financial management in detail.
1.3.1 Profit maximisation
Profit maximisation is based on the cardinal rule of efficiency. Its goal is to
maximise the returns with the best output and price levels. A firm’s
performance is evaluated in terms of profitability. Profit maximisation is the
traditional and narrow approach, which aims at maximising the profit of the
concern. Allocation of resources and investor’s perception of the company’s
performance can be traced to the goal of profit maximisation. Profit
maximisation has been criticised on many accounts:

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 The concept of profit lacks clarity. What does profit mean?

o Is it profit after tax or before tax?
o Is it operating profit or net profit available to shareholders?
 In this sense, profit is neither defined precisely nor correctly. It creates
unnecessary conflicts regarding the earning habits of the business
concern. Differences in interpretation of the concept of profit thus expose
the weakness of profit maximisation.
 Profit maximisation neither considers the time value of money nor the net
present value of the cash inflow. It does not differentiate between profits
of current year with the profits to be earned in later years.
 The concept of profit maximisation fails to consider the fluctuations in
profits earned from year to year. Fluctuations may be attributed to the
business risk of the firm. Risks may be internal or external which will
affect the overall operation of the business concern.
 The concept of profit maximisation apprehends to be either accounting
profit or economic normal profit or economic supernormal profit.
Profit maximisation as a concept, even though has the above-mentioned
drawbacks, is still given importance as profits do matter for any kind of
business. Ensuring continued profits ensure maximisation of
shareholder’s wealth.
Figure 1.1 depicts the two goals of financial management.

Figure 1.1: Goals of Financial Management

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1.3.2 Wealth maximisation

The term wealth means shareholder’s wealth or the wealth of the persons
those who are involved in the business concern. Wealth maximisation is
also known as value maximisation or net present worth maximisation. This
objective is an universally accepted concept in the field of business.
Wealth maximisation is possible only when the company pursues policies
that would increase the market value of shares of the company. It has been
accepted by the finance managers as it overcomes the limitations of profit
maximisation.
The following arguments are in support of the superiority of wealth
maximisation over profit maximisation:
 Wealth maximisation is based on the concept of cash flows. Cash flows
are a reality and not based on any subjective interpretation. On the other
hand, profit maximisation is based on accounting profit and it also
contains many subjective elements.
 Wealth maximisation considers time value of money. Time value of
money translates cash flow occurring at different periods into a
comparable value at zero period. In this process, the quality of cash flow
is considered critical in all decisions as it incorporates the risk associated
with the cash flow stream. It finally crystallises into the rate of return that
will motivate investors to part with their hard earned savings. Maximising
the wealth of the shareholders means positive net present value of the
decisions implemented.
Let us now look at some of the key definitions.
 Positive net present value can be defined as the excess of present value
of cash inflows of any decision implemented over the present value of
cash out flow.
 Time value factor is known as the time preference rate; that is, the sum
of risk free rate and risk premium.
 Risk free rate is the rate that an investor can earn on any government
security for the duration under consideration.
 Risk premium is the consideration for the risk perceived by the investor
in investing in that asset or security.
 Required rate of return is the return that the investors want for making
investment in that sector.

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Caselet:
X Ltd is a listed company engaged in the business of FMCG (Fast
Moving Consumer Goods). ‘Listed’ implies that the company’s shares are
allowed to be traded officially on the portals of the stock exchange. The
Board of Directors of X Ltd took a decision in one of its board meetings to
enter into the business of power generation. When the company
informed the stock exchange at the conclusion of the meeting about the
decision taken, the stock market reacted unfavourably. The result was
that the next day’s closing of quotation was 30% less than that of the
previous day. Why did the market react unfavourably?
Investors in FMCG company might have thought that the risk profile of
the new business that the company wants to take up is higher compared
to the risk profile of the existing FMCG business of X Ltd, expecting a
higher return. Then, the market value of the company’s shares started
declining.
Therefore, the risk profile of the company gets translated into a time
value factor. The time value factor so translated becomes the required
rate of return.

1.3.3 Wealth maximisation vs. profit maximisation

Let us now see how wealth maximisation is superior to profit maximisation.
 Wealth maximisation is based on cash flow. It is not based on the
accounting profit as in the case of profit maximisation.
 Through the process of discounting, wealth maximisation takes care of
the quality of cash flow. Converting uncertain distant cash flow into
comparable values at base period facilitates better comparison of
projects. The risks that are associated with cash flow are adequately
reflected when present values are taken to arrive at the net present
value of any project.
 Corporates play a key role in today’s competitive business scenario. In
an organisation, shareholders typically own the company, but the
management of the company rests with the board of directors. Directors
are elected by shareholders. Company management procures funds for
expansion and diversification of capital markets.

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In the liberalised set up, society expects corporates to tap the capital
markets effectively for their capital requirements. Therefore, to keep the
investors happy throughout the performance of value of shares in the
market, management of the company must meet the wealth maximisation
criterion.
 When a firm follows wealth maximisation goal, it achieves maximisation
of market value of share. A firm can practise wealth maximisation goal
only when it produces quality goods at low cost. On this account, society
gains because of the societal welfare. Maximisation of wealth demands
on the part of corporates to develop new products or render new
services in the most effective and efficient manner. This helps the
consumers, as it brings to the market the products and services that a
consumer needs.
 Another notable feature of the firms that are committed to the
maximisation of wealth is that, to achieve this goal they are forced to
render efficient service to their customers with courtesy. This enhances
consumer welfare and benefit to the society.
 From the point of evaluation of performance of listed firms, the most
remarkable measure is that of performance of the company in the share
market. Every corporate action finds its reflection on the market value of
shares of the company. Therefore, shareholder’s wealth maximisation
could be considered as a superior goal compared to profit maximisation.
 Since listing ensures liquidity to the shares held by the investors,
shareholders can reap the benefits arising from the performance of
company only when they sell their shares. Therefore, it is clear that
maximisation of market value of shares will lead to maximisation of the
net wealth of shareholders.
Therefore, we can conclude that maximisation of wealth is probably the
more appropriate goal of financial management in today’s context. Though
this cannot be a goal in isolation, it is important to understand that profit
maximisation as a goal, in a way, leads to wealth maximisation.

Self Assessment Questions

3. _______ is based on cash flows.
4. ________ considers time value of money

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1.4 Finance Functions

Finance functions deal with the functions performed by the finance
manager. They are closely related to financial decisions. In the course of
performing these functions, finance manager takes several decisions and
performs various important functions:
 Financing decisions
 Investment decisions
 Liquidity decisions
 Dividend decisions
Figure 1.2 depicts the functions of the finance manager.

Figure 1.2: Finance Manager’s Decisions

Let us now discuss these points in detail.
1.4.1 Financing decisions
Financing decisions relate to the composition of relative proportion of
various sources of finance. The sources could be:
(a) Shareholder’s Fund: Equity Share Capital, Preference Share Capital,
Accumulated Profits.
(b) Borrowing from outside agencies: Debentures, Loans from Financial
Institutions.
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Financial management weighs the merits and demerits of different sources

of finance while taking financing decision. Irrespective of the choice of
source, be it singular or a combination of both, there is a cost involved. The
cost of equity is the minimum return the shareholders would have received if
they had invested elsewhere. Borrowed funds cost involves interest
payment.
Both types of funds, thus, incur cost, and this is the cost of capital to the
company. Hence, it can be said that the cost of capital is the minimum
return expected by the company.
Financing decisions relate to the acquisition of such funds at the least cost.
In order to calculate the specific cost of each type of capital, recognition
should be given to two dimensions of cost:
 Explicit Cost
 Implicit Cost
A firm's explicit costs are the actual cash payments it makes to those who
provide resources. Explicit costs are rent paid on land hired, wages paid to
the employees, and interest paid on capital. In addition to this, a firm also
pays insurance premium and taxes and sets aside depreciation charges.
Explicit cost of any source of capital may be defined as the discount rate
that equates the present value of funds received by the firm net of
underwriting costs, with the present value of expected cash outflows. These
outflows may be interest payments, repayment of principal, or dividend. It
can also be stated as the Internal Rate of Return a firm pays for financing.
Implicit costs are the opportunity costs of using resources owned by the firm
or provided by the firm's owners. To the firm, the implicit costs mean the
money payments that self-employed resources could have earned in their
best alternative uses.
Implicit cost is the rate of return associated with the best investment
opportunity for the firm and its shareholders that will be foregone if the
project presently under consideration by the firm was accepted. Opportunity
costs are technically referred to as implicit cost of capital.
Implicit cost is not a visible cost but it may seriously affect the company’s
operations, especially when it is exposed to business and financial risk.

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The distinction between implicit and explicit cost is important from the point
of view of the computation of cost of capital.
In India, if a company is unable to pay its debts, creditors of the company
may use legal means to sue the company for winding up and is normally
known as risk of insolvency. A company which employs debt as a means of
financing generally faces this risk especially when its operations are
exposed to high degree of business risk.
In all financing decisions, a firm has to determine the capital structure, i.e.
composition of debt and equity.
Debt is cheap because interest payable on loan is allowed as deduction in
computing taxable income on which the company is liable to pay income tax
to the Government of India.
Whenever funds are to be raised to finance investments, capital structure
decision is involved. A demand for raising funds generates a new capital
structure since a decision has to be made as to the quantity and forms of
financing.
Capital structure refers to the mix of a firm’s capitalisation (i.e. mix of long
term sources of funds for meeting capital requirement.) Capital structure
decision refers to deciding the forms of financing (which sources to be
tapped), their actual requirements (amount to be funded), and their relative
proportions in total capitalisation.
Normally, a finance manager tries to choose a pattern of capital structure
which minimises the cost of capital and maximises the owner’s return. We
will learn more on capital structure and related aspects in Unit 7.

Note
The interest rate on loan taken is 12%, tax rate applicable to the company
is 50%, and then when the company pays Rs.12 as interest to the lender,
taxable income of the company will be reduced by Rs.12.
In other words, when the actual cost is 12% with a tax rate of 50%, the
effective cost becomes 6%. Therefore, the debt is cheap. But, every
instalment of debt brings along with it corresponding insolvency risk.
Another thing notable in connection to this is that the firm cannot avoid its
obligation to pay interests and loan instalments to its lenders and
debentures.

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An investor in a company’s shares has two objectives for investing:

 Income from capital appreciation (capital gains on sale of shares at
market price)
 Income from dividends
The ability of the company to offer both these incomes to its shareholders
determines the market price of the company’s shares.
The most important goal of financial management is maximisation of net
wealth of the shareholders. Therefore, management of every company
should strive hard to ensure that its shareholders enjoy both dividend
income and capital gains as per the expectation of the market.
Therefore, to declare a dividend of 12%, a company has to earn a pre-tax
profit of 19%. On the other hand, to pay an interest of 12%, the company
has to earn only 8.4%. This leads to the conclusion that for every Rs.100
procured through debt, it costs 8.4%, whereas the same amount procured in
the form of equity (share capital) costs 19%. This confirms the established
theory that equity is costly but debt is cheap and risky source of funds to the
corporate.
Financing decision involves the consideration of managerial control,
flexibility and legal aspects, and regulatory and managerial elements.

Solved Problem – 1
Dividend = 12% on paid up value
Tax rate applicable to the company = 30%
Dividend tax = 10%
Compute the profit that the company must earn before tax, when a
company pays Rs.12 on paid up capital of Rs.100 as dividend.
Solution
Since payment of dividend by an Indian company attracts dividend tax, the
company when it pays Rs.12 to shareholders, must pay to the Govt of
India
10% of Rs.12 = Rs.1.2 as dividend tax.
Therefore dividend and dividend tax sum up to Rs.12 + Rs.1.2 = Rs.13.2.
Since this is paid out of the post tax profit, in this question, the company
must earn:

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Post  tax dividend paid

 pretax profit required to declare and pay the dividend
1  Tax rate
13.2 13.2
=   Rs.19 (approximat e)
1  0.3 0.7

1.4.2 Investment decisions

To survive and grow, all organisations have to be innovative. Innovation
demands managerial proactive actions. Proactive organisations
continuously search for innovative ways of performing the activities of the
organisation. Innovation is wider in nature. It could be:
 Expanding by entering into new markets.
 Adding new products to its product mix.
 Performing value added activities to enhance customer satisfaction.
 Adopting new technology that would drastically reduce the cost of
production.
 Rendering services or mass production at low cost or restructuring the
organisation to improve productivity.
These innovations change the profile of an organisation. These decisions
are strategic because they are risky. However, if executed successfully with
a clear plan of action, investment decisions generate super normal growth to
the organisation.
A firm may become bankrupt if the management fails to execute the
decisions taken. Therefore, such decisions have to be taken after taking into
account all the facts affecting the decisions and their execution.
There are two critical issues to be considered in these decisions. They are:
 Evaluation of expected profitability of the new investments.
 Rate of return required on the project.
The Rate of Return required by an investor is normally known as the hurdle
rate or the cut off rate or the opportunity cost of capital.
Investments in buildings and machineries are to be conceived and executed
by a firm to enter into any business or to expand its business. The process
involved is called Capital Budgeting. Capital Budgeting decisions demand
considerable time, attention, and energy of the management. They are
strategic in nature as the success or failure of an organisation is directly
attributable to the execution of Capital Budgeting decisions taken.
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Investment decisions are also known as Capital Budgeting decisions and

hence lead to investments in real assets.
The key function of the financial management is the selection of the most
profitable assortment of capital investment. It is also one of the most
important area of decision making for the financial manager because any
action taken by the manager in this area affects the working and the
profitability of the firm in future.

The impact of long-term capital investment decisions is far reaching. It

protects the interests of the shareholders and of the enterprise because it
avoids over-investment and under-investment in fixed assets. By selecting
the most profitable projects, the management facilitates the wealth
maximisation of equity shareholders. We will take a detailed look at Capital
Budgeting in Unit 8.

1.4.3 Dividend decisions

Dividends are payouts to shareholders. Dividends are paid to keep the
shareholders happy. Dividend decision is a major decision made by the
finance manager.

Dividend is that portion of profits of a company which is distributed among

its shareholders according to the resolution passed in the meeting of the
Board of Directors. This may be paid as a fixed percentage on the share
capital contributed by them or at a fixed amount per share. The dividend
decision is always a problem before the top management or the Board of
Directors as they have to decide how much profits should be transferred to
reserve funds to meet any unforeseen contingencies and how much should
be distributed to the shareholders.

Payment of dividend is always desirable since it affects the goodwill of the

concern in the market on the one hand, and on the other, shareholders
invest their funds in the company in a hope of getting a reasonable return.
Retained earnings are the sources of internal finance for financing of
corporate’s future projects but payment of dividend constitute an outflow of
cash to shareholders. Although both - expansion and payment of dividend -
are desirable, these two are in conflicting tasks. It is, therefore, one of the
important functions of the financial management to constitute a dividend
policy which can balance these two contradictory view points and allocate

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the reasonable amount of profits after tax between retained earnings and
dividend. All of this is based on formulation of a good dividend policy.

Since the goal of financial management is maximisation of wealth of

shareholders, dividend policy formulation demands the managerial attention
on the impact of its policy on dividend and on the market value of its shares.
Optimum dividend policy requires decision on dividend payment rates so as
to maximise the market value of shares. The payout ratio means what
portion of earnings per share is given to the shareholders in the form of cash
dividend. In the formulation of dividend policy, the management of a
company will have to consider the relevance of its policy on bonus shares.

Dividend policy influences the dividend yield on shares. Dividend yield is an

important determinant of an investor’s attitude towards the security (stock) in
his portfolio management decisions.

The following issues need adequate consideration in deciding on dividend

policy:
 Preferences of shareholders – Do they want cash dividend or capital
gains?
 Current financial requirements of the company.
 Legal constraints on paying dividends.
 Striking an optimum balance between desire of shareholders and the
company’s funds requirements.

Companies attempt to maintain a stable dividend policy whereby a stable

rate of dividend is maintained. This also ensures that the company’s market
value of shares stays higher. The main reasons why a stable dividend is
preferred are:
(a) A regular and stable dividend payment may serve to resolve uncertainty
in the minds of shareholders, and it creates confidence among
shareholders.
(b) Many investors are income conscious and favour a stable dividend.
(c) Other things being in balance, the market price invariably vary with the
rate of dividend declared by the company on its equity shares. The value
of shares of a company that has a stable dividend policy does not

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fluctuate as much, even if the earnings of the company fluctuate now and
then.
(d) A stable dividend policy encourages investments from institutional
investors.
In this way, stability and regularity of dividends not only affects the market
price of shares but also increases the general credit of the company that
pays the company in the long run. Dividend decisions are thus highly
significant.
1.4.4 Liquidity decisions
The liquidity decision is concerned with the management of the current
assets, which is a pre-requisite to long-term success of any business firm.
This is also called as working capital decision. The main objective of the
current assets management is the trade-off between profitability and
liquidity, and there is a conflict between these two concepts. If a firm does
not have adequate working capital, it may become illiquid and consequently
fail to meet its current obligations thus inviting the risk of bankruptcy. On the
contrary, if the current assets are too enormous, the profitability is adversely
affected. Hence, the major objective of the liquidity decision is to ensure a
trade-off between profitability and liquidity. Besides, the funds should be
invested optimally in the individual current assets to avoid inadequacy or
excessive locking up of funds. Thus, the liquidity decision should balance
the basic two ingredients, i.e. working capital management and the efficient
allocation of funds on the individual current assets.
In other terms, liquidity decisions deal with working capital management. It
is concerned with the day-to-day financial operations that involve current
assets and current liabilities.
The important elements of liquidity decisions are:
 Formulation of inventory policy
 Policies on receivable management
 Formulation of cash management strategies
 Policies on utilisation of spontaneous finance effectively
We will look at these elements individually, in detail, over the course of this
book.

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1.5 Organisation of finance function

Financial decisions and functions are strategic in character and therefore,
an efficient organisational structure is required to administer the same.
The organisation of finance functions implies the division and classification
of functions relating to finance because financial decisions are of utmost
significance to firms. Finance is like blood that flows throughout the
organisation. In all organisations, CFOs play an important role in ensuring
proper reporting based on the substance of the shareholders of the
company.
Although in case of companies, the main responsibility to perform
finance function rests with the top management. Yet the top management
(Board of Directors), for convenience, can delegate its powers to any
subordinate executive who is known as Director of Finance, Chief Financial
Controller/Officer, Financial Manager, or Vice President of Finance.
Moreover, it is finally the duty of the Board of Directors to perform
the finance functions. There are various reasons behind it to assign the
responsibility to them. Financing decisions are quite important for the
survival of the firm. The growth and expansion of business is always
affected by financing policies. The loan paying capacity of the business
depends upon the financial operations.
For the survival of the firm, there is a need to ensure both long-term and
short-term financial solvency.
Weak functional performance by financial department will weaken
production, marketing, and HR activities of the company. The result would
be the organisation becoming anaemic. Once anaemic, unless crucial and
effective remedial measures are taken up, it will pave way for corporate
bankruptcy. Under the CFO, normally two senior officers manage the
treasurer and controller functions.

Activity 1
List out the functions of Chief Financial Officer that can make or mar the
company’s success.
Hint: All the finance functions are to be discussed.

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A Treasurer performs the following functions:

 Obtaining finance and utilising funds
 Liaison with term lending and other financial institutions
 Managing working capital
 Managing investment in real assets
A Controller performs the following functions:
 Accounting and auditing
 Management control systems
 Taxation and insurance
 Budgeting and performance evaluation
 Maintaining assets intact to ensure higher productivity of operating
capital employed in the organisation
In India, CFOs have a legal obligation under various regulatory provisions to
certify the correctness of various financial statements and information
reported to the shareholders in the annual report. Listing norms, regulations
on corporate governance, and other notifications of Government of India
have adequately recognised the role of finance function in the corporate
setup in India.

Self Assessment Questions

5. ________ leads to investment in real assets.
6. ____ relate to the acquisition of funds at the least cost.
7. Formulation of inventory policy is an important element of _______.
8. Obtaining finance is an important function of _________.
9. What are the two critical issues to be considered under investment
decisions?
10. Define rate of return.
11. One of the most important decisions made by a finance manager
dealing with maximisation of shareholder’s wealth is ________.

1.6 Interface between Finance and Other Business Functions

1.6.1 Relation between Finance and accounting
In the hierarchy of the finance function of an organisation, the controller
reports to the CFO. Accounting is one of the functions that a controller

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discharges. Accounting is a part of Finance. For computation of return on

investment, earnings per share and for various ratios of financial analysis,
the data base will be accounting information. Without a proper accounting
system, an organisation cannot administer the effective function of financial
management.
The purpose of accounting is to report the financial performance of the
business for the period under consideration. All the financial decisions are
futuristic based on cash flow analysis. All the financial decisions consider
quality of cash flow as an important element of decisions. Since financial
decisions are futuristic, they are taken and put into effect under conditions of
uncertainty. Assuming the condition of uncertainty and incorporating the
effect on decision making results in use of various statistical models. In the
selection of the statistical models, element of subjectivity creeps in.
The relationship between finance and accounting has two dimensions:
(a) They are closely associated to the extent that accounting is an
important input in financial decision making
(b) There are definite differences between them
Accounting is a necessary input for the finance function as it generates
information through the financial statements. The data contained in these
financial statements assists the financial managers in assessing the past
performance and providing future directions to the firm and in meeting
certain legal obligations. Thus accounting and finance are functionally
inseparable.
The key differences between finance and accounting related to the
treatment of funds and decision making are discussed below:
(a) Treatment of funds: The measurement of funds in accounting is always
based on the accrual concept, whereas, in case of finance, the
treatment of funds is based on cash flow. That means, here the
revenue is recognised only when cash is actually received or actually
paid.
(b) Decision making: The purpose of accounting is collection and
presentation of financial data. The financial manager uses this data for
financial decision making. It does not mean that accountants never
make decisions or financial managers never collect data. But the
primary focus of the function of accountants is collection and
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presentation of data in financial statements while the financial

manager's major responsibility relates to financial planning, con-
trolling, and decision making. Thus, we can say that the role of finance
begins where accounting ends.
1.6.2 Finance and marketing
Marketing decisions, generally, have financial implications. Pricing, product
promotion and advertisement, choice of product mix, distribution policy,
selections of channels of distribution, deciding on advertisement policy,
remunerating the salesmen, etc. all have financial implications. In fact, the
recent behaviour of rupee against US dollar (appreciation of rupee against
US dollar), affected the cash flow positions of export-oriented textile units,
BPOs and other software companies.
It is generally believed that the currency in which marketing manager
invoices the exports decides the cash flow consequences of the
organisation if the company is mainly dependent on exports. Marketing cost
analysis, a function of finance manager, is the best example of application of
principles of finance on the performance of marketing functions by a
business unit. Formulation of policy on credit management cannot be done
unless the integration of marketing with finance is achieved. Deciding on
credit terms to achieve a particular level of sales has financial implications
because sanctioning liberal credit may result in huge and bad debt. On the
other hand, conservative credit terms may depress the sales.
Relation between inventory and sales:
Co-ordination of stores administration with that of marketing management is
required to ensure customer satisfaction and good will. But investment in
inventory requires the financial clearance because funds are locked in, and
the funds so blocked have opportunity cost of capital.
1.6.3 Finance and production (operations)
Finance and operations management are closely related. Decisions on plant
layout, technology selection, productions or operations, process plant size,
removing imbalance in the flow of input material in the production or
operation process and batch size are all operation management decisions.
Their formulation and execution cannot be done unless they are evaluated
from the financial angle. The capital budgeting decisions are closely related
to production and operation management. These decisions make or mar a

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business unit. Failure to understand the implications of the latest

technological trend on capacity expansions has cost even blue chip
companies.
Many textile units in India became sick because they did not provide
sufficient finance for modernisation of plant and machinery. Inventory
management is crucial to successful operation management. But
management of inventory involves a number of financial variables.
In any manufacturing firm, the Production Manager controls a major part of
the investment in the form of equipment, materials, and men. He should
organise his department in such a way that the equipments under his or her
control are used most productively, the inventory of work-in-process or
unfinished goods, stores and spares are optimised, and the idle time and
work stoppages are minimised. If the production manager can achieve this,
he or she would be holding the cost of output under control and thereby help
in maximising profits. He or she has to appreciate the fact that while the
price at which the output can be sold is largely determined by external
factors such as competition, market, government regulations, etc., the cost
of production is more amenable to his or her control. Similarly, he or she
would have to make decisions regarding make or buy, buy or lease, etc., for
which he or she has to evaluate the financial implications before arriving at a
decision.
1.6.4 Finance and HR
Financial management is also related to human resource department as it
provides manpower to all the functional areas of the management. Financial
manager should carefully evaluate the requirement of manpower to each
department and then allocate the required finance to the human resource
department as wages, salary, remuneration, commission, bonus, pension,
and other monetary benefits to the human resource department.
Attracting and retaining the best manpower in the industry cannot be done
unless they are paid salary at competitive rates. If an organisation
formulates and implements a policy for attracting competent manpower, it
has to pay the most competitive salary packages to them. However, by
attracting competent manpower, capital and productivity of an organisation
improves. Hence, financial management is closely associated with human
resource management.

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Caselet:
Infosys does not have physical assets similar to that of Indian Railways.
But if both were to come to capital market with a public issue of equity,
Infosys would command better investor’s acceptance than the Indian
Railways. This is because the value of human resource plays an
important role in valuing a firm.
The better the quality of man power in an organisation, the higher the
value of the human capital and consequently the higher the productivity
of the organisation. Indian Software and IT enabled services have been
globally acclaimed only because of the manpower they possess. But it
has a cost factor - the best remuneration to the staff.

1.7 Summary
Let us recapitulate the important concepts discussed in this unit:
 Financial Management is concerned with the procurement of the least
cost funds, and its effective utilisation for maximisation of the net wealth
of the firm.
 There exists a close relation between the maximisation of net wealth of
shareholders and the maximisation of the net wealth of the company.
 The broad areas of decision are Financing decisions, Investment
decisions, Dividend decisions, and Liquidity decisions.

1.8 Glossary
Dividend: Portion of profits of a company which is distributed among its
shareholder.
Explicit costs: The actual cash payments it makes to those who provide
resources.
Financial management: Concerned with procurement and effective
utilisation of funds.
Implicit costs: The opportunity costs of using resources owned by the firm
or provided by the firm's owners.
Opportunity cost of capital: The Rate of Return required by an investor is
normally known as the hurdle rate or the cut-off rate.
Wealth: Shareholder wealth.
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Financial Management Unit 1

1.9 Terminal Questions

1. What are the goals of financial management?

2. How does a finance manager arrive at an optimal capital structure?
3. Examine the relationship of financial management with other functional
areas of a firm.
4. Examine the relationship between finance and accounting.
5. Examine the relationship between finance and marketing.

1.10 Answers

Self Assessment Questions

1. Liberalisation and globalisation of Indian economy
2. Procurement of funds
3. Wealth maximisation
4. Wealth maximisation
5. Investment decisions
6. Financing decisions
7. Liquidity decisions
8. Treasurers
9. The two critical issues are:
 Evaluation of expected profitability of the new investment
 Rate of return required on the project
10. Rate of return is normally defined as the hurdle rate or cutoff rate or
opportunity cost of the capital.
11. Dividend decision

Terminal Questions
1. Financial management means maximisation of economic welfare of its
shareholders. The two goals of financial management are 1) profit
maximisation and 2) wealth maximisation. Refer 1.3
2. Financing decisions relate to the composition of relative proportion of
various sources of finance. Whenever funds are to be raised to finance
investments, capital structure decision is involved. Refer 1.4.1
3. The relationship between financial management and other areas of a
firm can be explained by the. Refer 1.6
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Financial Management Unit 1

4. Accounting is a necessary input for the finance function as it generates

information through the financial statements. Refer 1.6.1
5. Marketing decisions, generally, have financial implications. Refer 1.6.2

1.11 Case Study: Hindustan Unilever Limited

Introduction:
Hindustan Unilever Limited (HUL) is India's largest Fast Moving Consumer
Goods Company with a heritage of over 75 years in India and touches the
lives of two out of three Indians.
With over 35 brands spanning 20 distinct categories such as soaps,
detergents, shampoos, skin care, toothpastes, deodorants, cosmetics, tea,
coffee, packaged foods, ice cream, and water purifiers, the Company is a
part of the everyday life of millions of consumers across India. Its portfolio
includes leading household brands such as Lux, Lifebuoy, Surf Excel, Rin,
Wheel, Fair & Lovely, Pond’s, Vaseline, Lakmé, Dove, Clinic Plus, Sunsilk,
Pepsodent, Closeup, Axe, Brooke Bond, Bru, Knorr, Kissan, Kwality Wall’s,
and Pureit.
The Company has over 16,000 employees and has an annual turnover of
around Rs.19,401 crore (financial year 2010 - 2011). HUL is a subsidiary of
Unilever, one of the world’s leading suppliers of fast moving consumer
goods with strong local roots in more than 100 countries across the globe
with annual sales of about €44 billion in 2011. Unilever has about 52%
shareholding in HUL.
Unilever has a long history in sustainability and the use of marketing and
market research to promote behaviour change. In November 2011, for the
first time, it published its own model of effective behaviour change. For
those who are interested, the details of this model can be seen at
http://www.hul.co.in/mediacentre/news/2011/inspiring-sustainable-
living.aspx
History of the Company:
In the summer of 1888, visitors to the Kolkata harbour noticed crates full of
Sunlight soap bars, embossed with the words "Made in England by Lever
Brothers". With it began an era of marketing branded Fast Moving
Consumer Goods (FMCG).

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Soon after followed Lifebuoy in 1895, and other famous brands like Pears,
Lux, and Vim. Vanaspati was launched in 1918 and the famous Dalda brand
came to the market in 1937. In 1931, Unilever set up its first Indian
subsidiary, Hindustan Vanaspati Manufacturing Company, followed by Lever
Brothers India Limited (1933) and United Traders Limited (1935). These
three companies merged to form HUL in November 1956; HUL offered 10%
of its equity to the Indian public, being the first among the foreign
subsidiaries to do so. Unilever now holds 52.10% equity in the company.
The rest of the shareholding is distributed among about 360,675 individual
shareholders and financial institutions.
The erstwhile Brooke Bond's presence in India dates back to 1900. By
1903, the company had launched Red Label tea in the country. In 1912,
Brooke Bond & Co. India Limited was formed. Brooke Bond joined the
Unilever fold in 1984 through an international acquisition. The erstwhile
Lipton's links with India were forged in 1898. Unilever acquired Lipton in
1972 and in 1977 Lipton Tea (India) Limited was incorporated.
Pond's (India) Limited had been present in India since 1947. It joined the
Unilever fold through an international acquisition of Chesebrough Pond's
USA in 1986.
Since the very early years, HUL has vigorously responded to the stimulus of
economic growth. The growth process has been accompanied by judicious
diversification, always in line with Indian opinions and aspirations.
The liberalisation of the Indian economy, started in 1991, clearly marked an
inflexion in HULs and the Group's growth curve. Removal of the regulatory
framework allowed the company to explore every single product and
opportunity segment, without any constraints on production capacity.
Simultaneously, deregulation permitted alliances, acquisitions, and mergers.
In one of the most visible and talked about events of India's corporate
history, the erstwhile Tata Oil Mills Company (TOMCO) merged with HUL,
effective from April 1, 1993. In 1996, HUL and yet another Tata company,
Lakme Limited, formed a 50:50 joint venture, Lakme Unilever Limited, to
market Lakme's market-leading cosmetics and other appropriate products of
both the companies. Subsequently in 1998, Lakme Limited sold its brands to
HUL and divested its 50% stake in the joint venture to the company.

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HUL formed a 50:50 joint venture with the US-based Kimberly Clark
Corporation in 1994. Kimberly-Clark Lever Ltd, which markets Huggies
Diapers and Kotex Sanitary Pads. HUL has also set up a subsidiary in
Nepal, Unilever Nepal Limited (UNL), and its factory represents the largest
manufacturing investment in the Himalayan kingdom. The UNL factory
manufactures HULs products like soaps, detergents, and personal products
both for the domestic market and exports to India.
The 1990s also witnessed a string of crucial mergers, acquisitions, and
alliances on the Foods and Beverages front. In 1992, the erstwhile Brooke
Bond acquired Kothari General Foods, with significant interests in Instant
Coffee. In 1993, it acquired the Kissan business from the UB Group and the
Dollops Ice cream business from Cadbury India.
As a measure of backward integration, Tea Estates and Doom Dooma, two
plantation companies of Unilever, were merged with Brooke Bond. Then in
1994, Brooke Bond India and Lipton India merged to form Brooke Bond
Lipton India Limited (BBLIL), enabling greater focus and ensuring synergy in
the traditional Beverages business. 1994 witnessed BBLIL launching the
Wall's range of Frozen Desserts. By the end of the year, the company
entered into a strategic alliance with the Kwality Ice cream Group families
and in 1995 the Milk food 100% Ice cream marketing and distribution rights
too were acquired.
Finally, BBLIL merged with HUL, with effect from January 1, 1996. The
internal restructuring culminated in the merger of Pond's (India) Limited
(PIL) with HUL in 1998. The two companies had significant overlaps in
personal products, speciality chemicals and exports businesses, besides a
common distribution system since 1993 for personal products. The two also
had a common management pool and a technology base. The
amalgamation was done to ensure for the Group, benefits from scale
economies both in domestic and export markets and enable it to fund
investments required for aggressively building new categories.
In January 2000, in a historic step, the government decided to award 74
percent equity in Modern Foods to HUL, thereby beginning the divestment
of government equity in public sector undertakings (PSU) to private sector
partners. HULs entry into bread is a strategic extension of the company's

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wheat business. In 2002, HUL acquired the government's remaining stake in

Modern Foods.
In 2003, HUL acquired the cooked shrimp and pasteurised crabmeat
business of the Amalgam Group of Companies, a leader in value added
marine products exports.
HUL launched a slew of new business initiatives in the early part of 2000s.
Project Shakti was started in 2001. It is a rural initiative that targets small
villages populated by less than 5000 individuals. It is a unique win-win
initiative that catalyses rural affluence even as it benefits business.
Currently, there are over 45,000 Shakti entrepreneurs covering over
100,000 villages across 15 states and reaching to over 3 million homes.
In 2002, HUL made its foray into Ayurvedic health and beauty centre
category with the Ayush product range and Ayush Therapy Centres.
Hindustan Unilever Network, Direct to home business was launched in 2003
and this was followed by the launch of ‘Pureit’ water purifier in 2004.
In 2007, the Company name was formally changed to Hindustan Unilever
Limited after receiving the approval of share holders during the 74th AGM
on 18 May, 2007. Brooke Bond and Surf Excel breached the Rs 1,000 crore
sales mark the same year followed by Wheel which crossed the Rs.2, 000
crore sales milestone in 2008.
On 17th October, 2008, HUL completed 75 years of corporate existence in
India.

Following are excerpts from the company’s Annual Report 2010 –

2011:
Financial Highlights:
Net Sales: Rs. 19,401 crore
Net Profit: Rs.2, 306 crore
EPS (Basic): Rs.10.58
EVA: Rs.1, 750 crore

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Financial Management Unit 1

Total expenditure:

1% 5%
6%
Ma teria ls
6%
Advertising Costs
6%
Sta ff Costs

Ca rria ge a nd
16% Freight
60% Utilities, Rent,
Repa irs etc.
Deprecia tion

Other
Financial Performance – 10 year track record (Rs. Crores)
Expenditure
P&L 2008-09
account 2001 2002 2003 2004 2005 2006 2007 (15 2009-10 2010-11
months)
Gross 11,781.30 10,951.61 11,096.02 10,888.38 11,975.53 13,035.06 14,715.10 21,649.51 18,220.27 20,305.54
Sales*
Other 381.79 384.54 459.83 318.83 304.79 354.51 431.53 589.72 349.64 586.04
Income
Interest (7.74) (9.18) (66.76) (129.98) (19.19) (10.73) (25.50) (25.32) (6.98) (0.24)
Profit 1,943.37 2,197.12 2,244.95 1,505.32 1,604.47 1,861.68 2,146.33 3,025.12 2,707.07 2,730.18
Before
Taxation
@

Profit 1,540.95 1,731.32 1,804.34 1,199.28 1,354.51 1,539.67 1,743.12 2,500.71 2,102.68 2,153.25
After
Taxation
@
Earnings 7.46 8.04 8.05 5.44 6.40 8.41 8.73 11.46 10.10 10.58
Per
Share of
Re. 1#
Dividend 5.00 5.16 5.50 5.00 5.00 6.00 9.00 7.50 6.50 6.50
Per
Share of
Re. 1#

* Sales before Excise Duty Charge @ Before Exceptional/Extraordinary items #

Adjusted for bonus

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Financial Management Unit 1

2008-09
Balance
2001 2002 2003 2004 2005 2006 2007 (15 2009-10 2010-11
Sheet
months)
Fixed Assets 1,320.06 1,322.34 1,369.47 1,517.56 1,483.53 1,511.01 1,708.14 2,078.84 2,436.07 2,468.24
Investments 1,635.93 2,364.74 2,574.93 2,229.56 2,014.20 2,413.93 1,440.80 332.62 1,264.08 1,260.68
Net Deferred 246.48 269.92 267.44 226.00 220.14 224.55 212.39 254.83 248.82 209.66
Tax
Net Current (75.04) (239.83) (368.81) (409.30) (1,355.31) (1,353.40) (1,833.57) (182.84) (1,365.45) (1,304.6
Assets 6)
3,127.43 3,717.17 3,843.03 3,563.82 2,362.56 2,796.09 1,527.76 2,483.45 2,583.52 2,633.92
Share Capital 220.12 220.12 220.12 220.12 220.12 220.68 217.74 217.99 218.17 215.95
Reserves & 2,823.57 3,438.75 1,918.60 1,872.59 2,085.50 2,502.81 1,221.49 1,843.52 2,365.35 2,417.97
Surplus
Loan Funds 83.74 58.30 1,704.31 1,471.11 56.94 72.60 88.53 421.94 – –
3,127.43 3,717.17 3,843.03 3,563.82 2,362.56 2,796.09 1,527.76 2,483.45 2,583.52 2,633.92
Others
HUL Share 223.65 181.75 204.70 143.50 197.25 216.55 213.90 237.50 238.70 284.60
Price on BSE
(Rs. Per
Share of Re.
1)*
Market 49,231 40,008 45,059 31,587 43,419 47,788 46,575 51,770 52,077 61,459
Capitali-
sation
(Rs. Crores)

* Based on year-end closing prices quoted in the Bombay Stock Exchange,

adjusted for bonus shares.

Excerpts from the report on Human Resources:

“…Your Company’s Human Resource agenda for the year focused on
strengthening four key areas: building a robust talent pipeline,
enhancing individual and organisational capabilities for future-readiness,
driving greater employee engagement and strengthening employee
relations further through progressive people practices at the shop
floor…”
“…In the first half of 2010, a comprehensive Talent and Organisation
Assessment was undertaken to understand their readiness to partner
the business ambition in the medium term and a holistic people strategy
was drawn up, which was the basis of the work done in the key areas
mentioned above. This Human Resource agenda not only looks at the
current needs of the business, but also enhances the Company’s
preparedness for the future…”
“…The Company participates in a Global People Survey every 2 years,
which is a leading indicator of employee morale and motivation, with
Employee Engagement being one of the key dimensions measured. For
the current year, the employee participation rate for this survey was over
99% (with an employee base of approximately 15000) and your

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Financial Management Unit 1

Company were ranked among the top performing companies across

Unilever globally in all dimensions. This was on account of a number of
proactive and innovative initiatives to engage our employees, the most
significant being continuous and consistent business linked
engagement, a vision for the future of the business and clarity and
transparency to individuals on their own careers…”
Discussion Questions:
1. Do you think that HUL has preferred the profit maximisation approach
over the wealth maximisation approach? Justify your answer.
(Hint: Refer to wealth maximisation)
2. How do you think an effective interaction between the HR and finance
department of a firm helps in achieving its goals? You may draw
instances from the case provided above.
(Hint: Refer to Finance & HR))
3. Study the pattern of total expenditure as given in the annual report.
Which core element of financial management is this based on?
(Hint: Refer to Financing decisions)
4. HUL is known for its marketing power. Wide bouquets of brands are
handled under their purview, as we have seen above. What is the
correlation between finance and marketing management? How is their
relationship significant to the achievement of final goals of the company?
(Hint: Refer to Finance and Marketing)
(Source: HUL Annual Report 2010 – 2011, www.hul.co.in)

References:
 Khan, M. Y. and Jain P. K. (2007). Financial Management, Text,
Problems & Cases, 5th Edition, Tata McGraw Hill Company, New Delhi.
 Maheshwari, S.N.(2009)., Financial Management – Principles & Practice,
13th Edition, Sultan Chand & Sons.
 Van Horne, James, C (2002), Principles of Financial Management,
Pearson Education.
 Prasanna, Chandra (2007), Financial Management: Theory and Practice,
7th Edition, Tata McGraw Hill.
E-Reference:
 HUL Annual Report 2010 – 2011, www.hul.co.in retrieved on
10/12/ 2011
Manipal University Jaipur B1628 Page No. 29
Financial Management Unit 2

Unit 2 Financial Planning

Structure:
2.1 Introduction
Objectives
Objectives of financial planning
Benefits of financial planning
Guidelines for financial planning
2.2 Steps in Financial Planning
Forecast of income statement
Forecast of balance sheet
Computerised financial planning system
2.3 Factors Affecting Financial Planning
2.4 Estimation of Financial Requirements of a Firm
2.5 Capitalisation
Cost theory
Earnings theory
Over-capitalisation
Under-capitalisation
2.6 Summary
2.7 Glossary
2.8 Terminal Questions
2.9 Answers
2.10 Case Study

2.1 Introduction
In the previous unit, you have learnt about the meaning and definition of
financial management, goals of financial management, functions of finance,
and the interface between finance and other business functions. In this unit,
we will discuss the steps in financial planning, factors affecting financial
planning, estimation of financial requirements of a firm, and the concept of
capitalisation.
Liberalisation and globalisation policies initiated by the government have
changed the dimension of business environment. Therefore, for survival and
growth, a firm has to execute planned strategies systematically. To execute

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Financial Management Unit 2

any strategic plan, resources are required. Resources may be manpower,

plant and machinery, building, technology, or any intangible asset.
To acquire all these assets, financial resources are essentially required.
Therefore, the finance manager of a company must have both long-range
and short-range financial plans. Integration of both these plans is required
for the effective utilisation of all the resources of the firm.
The long-range plans must include:
 Funds required for executing the planned course of action
 Funds available at the disposal of the company
 Determination of funds to be procured from outside sources
Objectives:
After studying this unit, you should be able to:
 explain the steps involved in financial planning
 analyse the factors affecting financial planning
 estimate the financial requirements of a Firm
 explain the effects of capitalisation
2.1.1 Objectives of financial planning
Financial planning is a process by which funds required for each course of
action is decided.
Financial planning means deciding in advance the financial activities to be
carried on to achieve the basic objective of the firm. The basic objective of
the firm is to get maximum profit with minimum losses or risk.
So, the basic purpose of the financial planning is to make sure that
adequate funds are raised at the minimum cost (optimal financing) and that
they are used wisely. Thus planners of financial policies must see that
adequate finance is available with the concern, because an inadequate
supply of funds will hamper operations and lead to crisis. Too much capital,
on the other hand, means lower earnings to the unit holders. A proper
planning is therefore necessary.
A financial plan has to consider capital structure, capital expenditure, and
cash flow. Decisions on the composition of debt and equity must be taken.
Highest earnings can be assured only through sound financial plans. A
faulty financial plan may ruin the business completely. So, sound financial

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Financial Management Unit 2

planning is necessary to achieve the long-term and the short-term objectives

of the firm and to protect the interest of all parties concerned, i.e., the firm,
the creditors, the shareholders, and the public.
Financial planning or financial plan indicates:
 The quantum of funds required to execute business plans
 Composition of debt and equity, keeping in view the risk profile of the
existing business, new business to be taken up, and the dynamics of
capital market conditions
 Formulation of policies, giving effect to the financial plans under
consideration

2.1.2 Benefits of financial planning

Financial planning also helps firms in the following ways:
 A financial plan is at the core of value creation process. A successful
value creation process can effectively meet the benchmarks of investor’s
expectations.
 Financial planning ensures effective utilisation of the funds. To manage
shortage of funds, planning helps the firms to obtain funds at the right
time, in the right quantity, and at the least cost as per the requirements
of finance emerging opportunities. Surplus is deployed through well-
planned treasury management. Ultimately, the productivity of assets is
enhanced.
 Effective financial planning provides firms the flexibility to change the
composition of funds that constitute its capital structure in accordance
with the changing conditions of the capital market.
 Financial planning helps in formulation of policies and instituting
procedures for elimination of wastages in the process of execution of
strategic plans.
 Financial planning helps in reducing the operating capital of a firm.
Operating capital refers to the ratio of capital employed to the sales
generated. Maintaining the operating capability of the firm through the
evolution of scientific replacement schemes for plant and machinery and
other fixed assets will help the firm in reducing its operating capital.
Along with fixed assets such as plant and equipment, working capital is
considered a part of operating capital.

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Financial Management Unit 2

Operating capital = Capital employed/Sales generated

Activity-1:
Review the annual report of Dell computers for the year 2008 and 2009.
Find out how does it minimize the operating capital to support sales
Hint: A study of annual reports of Dell computers will throw light on how
Dell strategically minimised the operating capital required to support
sales. Such companies are admired by investing community.

2.1.3 Guidelines for financial planning

The following are the guidelines of a financial plan:
 Never ignore the cardinal principle that fixed asset requirements must be
met from the long-term sources.
 Make maximum use of spontaneous source of finance to achieve highest
productivity of resources.
 Maintain the operating capital intact by providing adequately out of the
current periods earnings. Give due attention to the physical capital
maintenance or operating capability.
 Never ignore the need for financial capital maintenance in units of
constant purchasing power.
 Employ current cost principle wherever required.
 Give due weightage to cost and risk in using debt and equity.
 Keeping the need of finance for expansion of business, formulate plough
back policy of earnings.
 Exercise thorough control over overheads.
 Seasonal peak requirements to be met from short-term borrowings from
banks.
A strategic financial plan of a firm spells out its corporate purpose,
scope, objectives, and strategies. As a financial manager, one must:
 Sensitise the strategic planning group to the financial implications of
various choices
 Ensure that the chosen strategic plan is financially feasible
 Translate the plan that is finally adopted into a long-range financial
plan
 Coordinate the development of the budget
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Financial Management Unit 2

2.2 Steps in Financial Planning

There are six steps involved in financial planning. Figure 2.1 depicts the
steps involved in financial planning.

Figure 2.1: Steps in Financial Planning

Let us now study the steps in detail.
 Establish corporate objectives – The first step in financial planning is
to establish corporate objectives. Corporate objectives can be grouped
into two:
o Qualitative and quantitative objectives
o Short-term, medium-term, and long-term objectives
For example, a company’s mission statement may specify “create
economic – value added.” However this qualitative statement has to be
stated in quantitative terms such as a 25% ROE or a 12% earnings
growth rates. Since business enterprises operate in a dynamic
environment, there is a need to formulate both short-term and long-term
objectives.
 Formulate strategies – The next stage in financial planning is to
formulate strategies for attaining the defined objectives. Operating plans
help to achieve the purpose. Operating plans are framed with a time
horizon. It can be a five-year plan or a ten-year plan.
 Assign responsibilities – Once the plans are formulated, responsibility
for achieving sales target, operating targets, cost management
benchmarks, and profit targets are to be fixed on respective executives.

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Financial Management Unit 2

 Forecast financial variables – The next step is to forecast the various

financial variables such as sales, assets required, flow of funds, and
costs to be incurred. These variables are to be translated into financial
statements.
Financial statements help the finance manager to monitor the deviations
of actual from the forecasts and take effective remedial measures. This
ensures that the defined targets are achieved without any overrun of
time and cost.
 Develop plans – This step involves developing a detailed plan of funds
required for the plan period under various heads of expenditure. From
the plan, a forecast of funds that can be obtained from internal as well as
external sources during the time horizon is developed. Legal constraints
in obtaining funds on the basis of covenants of borrowings are given due
weightage. There is also a need to collaborate the firm’s business risk
with risk implications of a particular source of funds. A control
mechanism for allocation of funds and their effective use is also
developed in this stage.
 Create flexible economic environment – While formulating the plans,
certain assumptions are made about the economic environment. The
environment, however, keeps changing with the implementation of plans.
To manage such situations, there is a need to incorporate an in-built
mechanism which would scale up or scale down the operations
accordingly.
Forecasting of financial statements:
Following are some basic points that would help you to understand the
importance of financial forecasting before we study the methods of
forecasting and income statement/balance sheet.
 Financial forecasting is the process of estimating future business
performance (sales, costs, earnings).
 Corporations and companies employ forecasting to do financial planning
which includes an assessment of their future financial needs.
Forecasting is also important for production planning, human resource
planning, etc.
 Forecasting is also used by outsiders to value companies and their
securities.

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Financial planning is enabled by creating pro forma income statements and

balance sheets. These are forecasted financial statements. As we have
discussed, financial planning is a continuous process of directing and
allocating financial resources to meet strategic goals and objectives. The
output from financial planning takes the form of budgets. The most widely
used form of budgets is pro forma or budgeted financial statements.

The pro forma statements help to have a comprehensive look at the likely
future financial performance. While the pro forma income statement
represents the operational plan for the whole organisation, the pro forma
balance sheet reflects the cumulative impact of anticipated future decisions.
Budgets include:
 Cash budget
 Operating budget
 Sales budget
 Production budget
 Sales and distribution expenses budget
 Administrative overheads budget

2.2.1 Forecast of income statement

There are three methods of forecasting income statement:
 Percent of sales method or constant ratio method
 Expense method
 Combination of the above two
Percent of sales method
This is the most basic method of forecasting a financial statement. It
assumes that certain expenses, assets, and liabilities maintain a constant
relationship to the level of sales.
Basically, this method assumes that future relationship between various
elements of cost to sales will be similar to their historical relationships.
These cost ratios are generally based on the average of previous two or
three years. For example, cost of goods sold may be expressed as a
percentage of sales.
Therefore, the key driver of this method is the sales forecast and based on
this, pro forma financial statements (i.e., forecasted) can be constructed and
the firm’s needs for external financing can be identified.

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Since sales have a significant effect on the financial needs of a business,

different items of assets, liabilities, revenue, and expenses can be
expressed as a percentage of sales.
The first step is to express the income statement accounts which vary
directly with sales as percentages of sales. This is calculated by dividing the
balance for these accounts for the current year by sales revenue for the
current year.
The accounts which generally vary closely with sales are cash accounts,
receivable, inventory, and accounts payable.
On the income statement, costs are expressed as a percentage of sales.
Since we are assuming that all costs remain at a fixed percentage of sales,
net income can be expressed as a percentage of sales. This indicates the
profit margin.

Caselet:
Raw material cost is 40% of sales revenue for the year ended 31.03.2007.
However, this method assumes that the ratio of raw material cost to sales
will continue to be the same in 2008 also. Such an assumption may not
look good in most of the situations.
If in case, raw material cost increases by 10% in 2008 but selling price of
finished goods increases only by 5%. In this case raw material cost will be
44/105 of the sales revenue in 2008. This can be solved to some extent by
taking the average for the same representative years. However, inflation,
change in government policies, wage agreements, and technological
innovation totally invalidate this approach on a long run basis.

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Illustration:
The Profit and Loss statement of Biotech Ltd. for the years 2000 and 2001
are given below. If the sales for the year 2002 are estimated at
Rs. 22,00,000, prepare a pro forma income statement for the year 2002
using the percent of sales method.
(Rs. ‘000) 2000 2001
Total sales 1,200 1,800
Cost of goods sold 700 1,100
Gross profit 500 700
Selling and administration expenses 180 220
Depreciation 50 80
Operating profit 270 400
Non-operating surplus 40 80
EBIT 310 480
Interest 160 160
Tax 60 100
Profit after tax 90 220
Dividends 30 60
Retained earnings 60 160

Solution:
Average Pro forma income
percent of statement for 2002
sales (in Rs. ’000)
Net sales 100 2,200
Cost of goods sold 60 1,320
Gross profit 40 880
Selling and administration expenses 13.33 293
Depreciation 4.3 95
Operating profit 22.36 492
Non-operating surplus 4 88
EBIT 26.4 580
Interest 10.67 235
Tax 5.3 117
Profit after tax 10.33 228
Dividends 3 66
Retained earnings 7.33 162

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Working notes:
Total cost of goods sold for 2000 and 2001 = Rs 18,00,000.
Total sales for the year 2000 and 2001 = Rs. 30,00,000.
Hence, percentage of total cost of goods sold relative to sales = 18,00,000 /
30,00,000 X 100 = 60
The other items are also computed in a similar manner.
Budgeted expense method
Expenses for the planning period are budgeted on the basis of anticipated
behaviour of various items of cost and revenue.
The value of each item is estimated on the basis of expected developments
in the future period for which the pro forma P&L account is being prepared.
It calls for greater effort on the part of management since they have to
define the likely happenings. This also demands effective database for
reasonable budgeting expenses.
Combination of both these methods
The combination of both these methods is used because some expenses
can be budgeted by the management. This is done taking into account the
expected business environment while some other expenses could be based
on their relationship with the sales revenue expected to be earned.
The budgeted income statement will pull together all revenue and expense
estimates from previously prepared detail budgets. Once this statement is
prepared, the budgeted balance sheet can be prepared.
2.2.2 Forecast of balance sheet
The following steps discuss the forecasting of the balance sheet:
 Compute the sales revenue, having a close relationship with the items of
certain assets and liabilities, based on the forecast of sales and the
historical database of their relationship.
 Determine the equity and debt mix on the basis of funds requirements
and the company’s policy on capital structure.
Projections for Balance sheet can be made as listed below:
 Employ percent of sales method to project items on the asset side,
except “Investments” and “Miscellaneous Expenses and Losses”.

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 Expected values for “Investments” and “Miscellaneous Expenses and

Losses” can be estimated using specific information.
 Use percent of sales method to project values of current liabilities and
provisions. (also referred to as ‘spontaneous liabilities’).
 Projected values of reserves and surplus can be obtained by adding
projected retained earnings from P&L pro forma statement.
 Projected value for equity and preferential capital can be set tentatively
equal to their previous values.
 Projected values for loan funds will be tentatively equal to their previous
level, less repayments or retirements.
 Compare the total of asset side with that of liabilities side and determine
the balancing figure. (If assets exceed liabilities, the balancing figure
represents external funding requirement. If liabilities exceed assets, the
balancing item represents surplus available funds).
The budgeted balance sheet will provide an estimate of how much external
financing is required to support estimated sales.
The main link between the income statement and the balance sheet is
retained earnings. Therefore, preparation of the budgeted balance sheet
starts with an estimate of the ending balance for retained earnings. In order
to estimate ending retained earnings, one has to project future dividends
based on current dividend policies and what management expects to pay in
the next planning period.
Once the budgeted balance sheet is prepared, it will show either a surplus
(excess financing over assets) or a deficit (additional financing needed to
cover assets). This difference is derived from the accounting equation:
Assets = Liabilities + Equity.
We can also calculate External Financing Required (EFR) based on the
relationships between assets, liabilities, and sales.

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Caselet
The following details have been extracted from the books of X Ltd.
Table 2.1 and table 2.2 depict the income statement and balance sheet
respectively.
Table 2.1: Income Statement
2006 2007
Sales less returns 1000 1300
Gross profit 300 520
Selling expenses 100 120
Administration 40 45
Deprecation 60 75
Operating profit 100 280
Non-operating income 20 40
EBIT (Earnings Before Interest and Tax) 120 320
Interest 15 18
Profit before tax 105 302
Tax 30 100
Profit after tax 75 202
Dividend 38 100
Retained earnings 37 102

Table 2.2: Balance Sheet

Liabilities 2006 2007 Assets 2006 2007
Shareholder’s fund Fixed assets 400 510
Share capital Less depreciation 100 120
Equity 120 120 300 390
Preference 50 50 Investments 50 50
Reserves and 122 224
surplus
Secured loans 100 120 Current assets,
loans, and
advances
Unsecured loans 50 60 Cash at bank 10 12
Receivables 80 128

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Current liabilities Inventories 200 300

Trade creditors 210 250 Loans and 50 80
advances
Provisions Miscellaneous 10 24
expenditure
Tax 10 60
Proposed dividend 38 100
700 984 700 984

Forecast the income statement and balance sheet for the year 2008 based on
the following assumptions:
 Sales for the year 2008 will increase by 30% over the sales value for 2007
 Use percent of sales method to forecast the values for various items of
income statement using the percentage for the year 2007
 Depreciation is charged at 25% of fixed assets
 Fixed assets will increase by Rs. 100 million
 Investments will increase by Rs. 100 million
 Current assets and current liabilities are to be decided based on their
relationship with the sales in the year 2007
 Miscellaneous expenditure will increase by Rs. 19 million
 Secured loans in 2008 will be based on its relationship with the sales in the
year 2007
 Additional funds required, if any, will be met by bank borrowings
 Tax rates will be 30%
 Dividends will be 50% of the profit after tax
 Non-operating income will increase by 10%
 There will be no change in the total amount of administration expenses to
be spent in the year 2008
 There is no change in equity and preference capital in 2008
 Interest for 2008 will maintain the same ratio as it has in 2007 with the
sales of 2007
Table 2.3 and table 2.4 depict the forecast of the income statement and the
balance sheet for the year 2008 respectively.

Table 2.3: Income Statement

Particulars Basis Working Amount (Rs.)
Sales Increase by 30% 1300 x 1.3 1690
Cost of sales Increase by 30% 780 x 1.3 1014
Gross profit Sales-cost of sales 1690-1014 676

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Selling expenses 30% increase 120 x 1.3 156

Administration No change 45
Depreciation % given 390  100 123
(Rounded off)
4
Operating profit C - (D + E + F) 352
Non-operating income Increase by 10% 1.1 x 40 44
Earnings Before 396
Interest and Taxes
(EBIT)
Interest 18 18  1690 23
of Sales (Decimal
1300 1300
ignored)
Profit before tax 373
Tax 112
Profit after tax 261
Dividends 130
Retained earnings 131

Table 2.4: Balance Sheet

Particulars Basis Working Amount (Rs.)

Assets
Fixed assets Given 510
Add: Addition 100
610
Depreciation 120 + 123 243
1. Net fixed assets 367
2. Investments 150
3. Current assets, loans,
and advances
Cash at bank 12 12  1690 16
1300 1300 (Rounded off)
Receivables 128 128  1690
166
1300 1300

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Inventories 300 300  1690

390
1300 1300
Loans and advances 80 80  1690
104
1300 1300
4. Miscellaneous
Given 24 + 19 43
Expenditure
Total 1236

Liabilities
1. Share capital
Equity 120
Preference 50
2. Reserves and surplus Increase by
current year’s
355
retained
earnings
3. Secured loan 60 60  1690
78
1300 1300
Bank borrowings 40
(Difference –
Balancing
figure)
4. Unsecured loan 60 60
5. Current liabilities and
provision
Trade creditors 250 250  1690 325
1300 1300
Provision for tax 60 60  1690 78
1300 1300
Proposed dividend Current year 130
given
Total liabilities 1236

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2.2.3 Computerised financial planning system

All corporate forecasts use computerised forecasting models. Additional
funds required to finance the increase in sales could be ascertained using a
mathematical relationship based on the following:
Additional Funds Required = Required Increase in Assets – Spontaneous
Increase in Liabilities – Increase in Retained Earnings
(This formula has been recommended by Eugene F. Brigham and Michael
C. Earnhardt in the book Financial Management – Theory and Practice)
Prof. Prasanna Chandra, in his book Financial Management, (6th edition -
Manohar Publishers and Distributors) has given a comprehensive formula
for ascertaining the external financial requirements.

A ( s) L ( s)
EFR =  – MS1 (1-d) – (1m + SR)
S S

Here
A
  (ΔΔs= Expected increase in assets, both fixed assets and current
S
assets required for the expected increase in sales in the next year.
L
  (ΔΔs= Expected spontaneous finance available for the expected
S
increase in sales.
 MS1 (1-d) = It is the product of profit margin, expected sales for the next
year, and the retention ratio.
 Retention ratio = 1 – payout ratio.
 Payout ratio refers to the ratio of the dividend paid to the earnings per
share.
 1m = Expected change in the level of investments and miscellaneous
expenditure.
 SR = It is the firm’s repayment liability on term loans and debenture for
the next year.
The formula described above has certain features:
 Ratios of assets and spontaneous liabilities to sales remain constant
over the planning period.

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 Dividend payout and profit margin for the next year can be reasonably
planned in advance.
 Since external funds requirements involve borrowings from financial
institution, the formula rightly incorporates the management’s liability on
repayments.

Solved Problem
X Ltd. has given the following forecasts: “Sales in 2008 will increase from
Rs. 1000 to Rs. 2000 in 2007”. Table 2.5 depicts the balance sheet of the
company as on December 31, 2007.

Table 2.5: Balance Sheet

Liabilities Rs. Assets Rs.
Share capital Net fixed assets 500
Equity (Shares of Rs.10 100 Inventories 200
each)
Reserves and surplus 250 Cash 100
Long term loan 400 Bills receivable 200
Creditors for expenses 50
outstanding
Trade creditors 50
Bills payable 150
1000 1000

Taking into account the following information, the external funds

requirements for the year 2008 has to be ascertained:
The company’s utilisation of fixed assets in 2007 was 50% of capacity but
its current assets were at their proper levels.
Current assets increase at the same rate as sales.
Company’s after-tax profit margin is expected to be 5%, and its payout
ratio will be 60%.
Creditors for expenses are closely related to sales.
(Adapted from IGNOU MBA).

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Solution:
Preliminary workings:
A = Current assets = Cash + Bills receivables + Inventories
= 100 + 200 +200 = 500
A 500
 ( s)   1000  Rs. 500
S 1000
L = Trade creditors + Bills payable + Expenses outstanding
= 50 + 150 + 50 = Rs. 250
L 250
 ( s)   1000  Rs. 250
S 1000
M (Profit margin) = 5 / 100 = 0.05
S1 = Rs.2000
1-d = 1 – 0.6 = 0.4 or 40 %
1m = NIL
SR = NIL

A ( s) L
Therefore: EFR    s - ms1 (1-d) – (1m + SR)
S S
= 500 – 250 – (0.05 x 2000 x 0.4) – (0 + 0)
= 500 – 250 – 40 - (0 + 0)
= Rs. 210
Therefore, external fund requirements for 2008 will be Rs. 210. This
additional fund requirement will be procured by the firm based on its
policy on capital structure.

Self Assessment Questions

1. Corporate objectives could be grouped into ___ and ___.
2. Control mechanism is developed for _____ and their effective use.

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Financial Management Unit 2

3. Seasonal peak requirements to be met from __________________

from banks.

2.3 Factors Affecting Financial Planning

Figure 2.2 depicts the various factors affecting financial plan.

Figure 2.2: Factors Affecting Financial Plan

Let us now discuss these factors in detail.

 Nature of the industry – The first factor affecting the financial plan is
the nature of the industry. Here, we must check whether the industry is a
capital-intensive or labour-intensive industry. This will have a major
impact on the total assets that a firm owns.
 Size of the company – The size of the company greatly influences the
availability of funds from different sources. A small company normally
finds it difficult to raise funds from long-term sources at competitive
terms.
On the other hand, large companies like Reliance enjoy the privilege of
obtaining funds both short-term and long-term at attractive rates.
 Status of the company in the industry – A well-established company
enjoys a good market share, because its products normally command

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investor’s confidence. Such a company can tap the capital market for
raising funds in competitive terms for implementing new projects to
exploit the new opportunities emerging from changing business
environment.
 Sources of finance available – Sources of finance could be grouped
into debt and equity. Debt is cheap but risky whereas equity is costly. A
firm should aim at optimum capital structure that would achieve the least
cost capital structure. A large firm with a diversified product mix may
manage higher quantum of debt because the firm may manage higher
financial risk with a lower business risk. Selection of sources of finance is
closely linked to the firm’s capability to manage the risk exposure.
 The capital structure of a company – The capital structure of a
company is influenced by the desire of the existing management
(promoters) of the company to retain control over the affairs of the
company. The promoters who do not like to lose their grip over the
affairs of the company normally obtain extra funds for growth by issuing
preference shares and debentures to outsiders.
 Matching the sources with utilisation – The prudent policy of any
good financial plan is to match the term of the source with the term of the
investment. To finance fluctuating working capital needs, the firm resorts
to short-term finance. All fixed-asset investments are to be financed by
long-term sources which is a cardinal principle of financial planning.
 Flexibility – The financial plan of a company should possess flexibility
so as to effect changes in the composition of capital structure whenever
the need arises. If the capital structure of a company is flexible, there will
not be any difficulty in changing the sources of funds. This factor has
become a significant one today because of the globalisation of capital
market.
 Government policy – SEBI guidelines, finance ministry circulars,
various clauses of Standard Listing Agreement and regulatory
mechanism imposed by FEMA, and Department of Corporate Affairs
(government of India) influence the financial plans of corporates today.
Management of public issues of shares demands the compliances with
many statutes in India. They are to be complied with a time constraint.

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Self Assessment Questions

4. ______ has a major impact on the total assets that the firm owns.
5. Sources of finance could be grouped into ______ and _____.
6. ___________ of any good financial plan is to match the term of the
source with the term of the investment.
7. _____ refers to the ability to _____ whenever needed.

2.4 Estimation of Financial Requirements of a Firm

A company should be properly capitalised and the actual capital should be
neither more nor less than the amount which is needed and which can be
gainfully employed. It is, therefore, necessary for a concern to estimate its
requirements of funds properly. The financial requirements of a company
may be outlined under the following heads:
 Cost of fixed assets including land and buildings, plant and machinery,
furniture, etc. The amount invested in these items is called fixed capital.
 Cost of current assets including cash, stock of goods (also called
inventory of merchandise), book debts, bills, etc.
 Cost of promotion including the expenses on preliminary investigation in
case of a new company, accounting, marketing, legal advice, etc.
 Cost of establishing the business, i.e., the operating losses which have
generally to be sustained in the initial periods of a company.
 Cost of financing including brokerage on securities, commission on
underwriting, etc.
 Cost of intangible assets like goodwill, patents, etc.
Of the various items of financial requirements listed above, the first two
deserve special consideration as the successes of any concern will depend
largely on them.
The estimation of capital requirements of a firm involves a complex process.
Even with expertise, managements of successful firms could not arrive at
the optimum capital composition in terms of the quantum and the sources.
As indicated above, capital requirements of a firm could be grouped into
fixed capital and working capital.

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The long-term requirements such as investments in fixed assets will have to

be met out of funds obtained on long-term basis.

Fixed capital of an industrial concern is invested in fixed assets like plant

and machinery, land, buildings, furniture, etc. These assets are not fixed in
value. In fact, their value may record an increase or decrease in course of
time.
Variable working capital requirements which fluctuate from season to
season will have to be financed only by short-term sources.
The working capital is required for the purchase of raw materials and for
meeting the day-to-day expenditure on salaries, wages, rents, advertising,
etc.
Any departure from this well-accepted norm causes negative impact on the
firm’s finances. We will look at assessing these requirements in detail in the
upcoming pages.

Activity 2
Select 2 companies each from FMCG, Software and Manufacturing on the
mission statement. What is your observation on financial requirements?
Hint: All the finance requirements are to be discussed.

Self Assessment Questions

4.8. Capital requirement of a firm could be grouped into ____ and _____.
5.9. Variable working capital will have to be financed only by _______.

2.5 Capitalisation
Capitalisation of a firm refers to the composition of its long-term funds and
its capital structure. It has two components – Debt and Equity.
After estimating the financial requirements of a firm, the next decision that
the management has to take is to arrive at the value at which the company
has to be capitalised.
There are two theories of capitalisation for the new companies:
 Cost theory
 Earnings theory

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Figure 2.3 depicts the two theories of capitalisation.

Figure 2.3: Theories of Capitalisation

Let us now discuss these theories in detail.

2.5.1 Cost theory

Under this theory, the total amount of capitalisation for a new company is
the sum of:
 Cost of fixed assets
 Cost of establishing the business
 Amount of working capital required
Merits of cost approach
 It helps promoters to estimate the amount of capital required for
incorporation of company, conducting market surveys, preparing detailed
project report, procuring funds, procuring assets both fixed and current,
running a trial production, and successfully producing, positioning, and
marketing its products or rendering of services.
 If done systematically, it will lay the foundation for successful initiation of
the working of the firm.
Demerits of cost approach
 If the firm establishes its production facilities at inflated prices, the
productivity of the firm will become less than that of the industry.
 Net worth of a company is decided by the investors and the earnings of a
company. Earning capacity based on net worth helps a firm to arrive at
the total capital in terms of industry-specified yardstick (operating capital
based on benchmarks in that industry). Cost theory fails in this respect.

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2.5.2 Earnings theory

Earnings are forecasted and capitalised at a rate of return, which actually is
the representative of the industry. Earnings theory involves two steps. They
are:
 Estimation of the average annual future earnings.
 Estimation of the normal earning rate of the industry to which the
company belongs.

Merits of earnings theory

 Earnings theory is superior to cost theory because of its lesser chances
of being either under or over capitalisation.
 Comparison of earnings approach to that of cost approach will make the
management to be cautious in negotiating the technology and the cost of
procuring and establishing the new business.

Demerits of earnings theory

 The major challenge that a new firm faces is deciding on capitalisation
and its division thereof into various procurement sources.
 Arriving at the capitalisation rate is equally a formidable task because the
investor’s perception of established companies cannot be really unique
of what the investor’s perceive from the earning power of the new
company.
Due to this problem, most of the new companies are forced to adopt the
cost theory of capitalisation. Ideally, every company should have normal
capitalisation, which is a utopian way of thinking.
Changing business environment, role of international forces, and dynamics
of capital market conditions force us to think in terms of ‘what is optimal
today need not to be so tomorrow’.
Even with these constraints, management of every firm should continuously
monitor its capital structure to ensure and avoid the bad consequences of
over and under capitalisation.
2.5.3 Over-capitalisation
A company is said to be over-capitalised when its total capital (both equity
and debt) exceeds the true value of its assets.

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It is wrong to identify over-capitalisation with excess of capital because most

of the over-capitalised firms suffer from the problems of liquidity. The correct
indicator of over-capitalisation is the earnings capacity of the firm.
If the earnings of the firm are less than that of the market expectation, it will
not be in a position to pay dividends to its shareholders as per their
expectations. This is a sign of over-capitalisation. It is also possible that a
company has more funds than its requirements based on current operation
levels and yet have low earnings.
Over-capitalisation may be considered on the account of:
 Acquiring assets at inflated rates
 Acquiring unproductive assets
 High initial cost of establishing the firm
 Companies which establish their new business during boom condition
are forced to pay more for acquiring assets, causing a situation of over-
capitalisation once the boom conditions subside
 Total funds requirements have been over estimated
 Unpredictable circumstances (like change in import/export policy,
change in market rates of interest, and changes in international
economic and political environment) reduce substantially the earning
capacity of the firm. For example, rupee appreciation against US dollar
has affected the earning capacity of the firms engaged mainly in the
export business because they invoice their sales in US dollar
 Inadequate provision of depreciation adversely affects the earning
capacity of the company leading to over-capitalisation of the firm
 Existence of idle funds

Effects of over-capitalisation
 Decline in earnings of the company
 Fall in dividend rates
 Loss of goodwill
 Market value of the company’s share falls, and the company loses
investors’ confidence
 Company may collapse at any time because of anaemic financial
conditions which affect its employees, society, consumers, and
shareholders. Employees will lose jobs. If the company is engaged in the

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production and marketing of certain essential goods and services to the

society, the collapse of the company will cause social damage

Remedies of over-capitalisation
Over-capitalisation often results in a company becoming sick. Restructuring
the firm helps to avoid such a situation. Some of the other remedies of over-
capitalisation are:
 Reduction of debt burden
 Negotiation with term lending institutions for reduction in interest
obligation
 Redemption of preference shares through a scheme of capital reduction
 Reducing the face value and paid-up value of equity shares
 Initiating merger with well–managed, profit-making companies interested
in taking over ailing company

2.5.4 Under-capitalisation
Under-capitalisation is just the reverse of over-capitalisation. A company is
considered to be under-capitalised when its actual capitalisation is lower
than the proper capitalisation as warranted by the earning capacity.

Symptoms of under-capitalisation
The following points describe the symptoms of under-capitalisation:
 Actual capitalisation is less than the warranted earning capacity
 Rate of earnings is exceptionally high in relation to the return enjoyed by
similar situated companies in the same industry
Causes of under-capitalisation
The following points describe the causes of under-capitalisation:
 Under estimation of the future earnings at the time of the promotion of
the company
 Abnormal increase in earnings from the new economic and business
environments
 Under estimation of total funds requirement
 Maintaining very high efficiency through improved means of production
of goods or rendering of services
 Companies which are set up during the recession period will start
making higher earning capacity as soon as the recession is over
 Purchase of assets at exceptionally low prices during recession
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Effects of under-capitalisation
The following points describe some of the effects of under-capitalisation:
 Under-capitalisation encourages competition by creating a feeling that
the line of business is lucrative
 It encourages the management of the company to manipulate the
company’s share prices
 High profits will attract higher amount of taxes
 High profits will make the workers demand higher wages. Such a feeling
on the part of the employees leads to labour unrest
 High margin of profit may create an impression among the consumers
that the company is charging high prices for its products
 High margin of profits and the consequent dissatisfaction among its
employees and consumer may invite governmental enquiry into the
pricing mechanism of the company
Remedies
The following points describe the remedies of under-capitalisation:
 Splitting up of the shares, which will reduce the dividend per share
 Issue of bonus shares, which will reduce both the dividend per share and
the earnings per share
Both over-capitalisation and under-capitalisation are detrimental to the
interests of the society.

Self Assessment Questions

10. _____ of a firm refers to the composition of its long-term funds.
11. Two theories of capitalisation for new companies are ______ and
earnings theory.
12. A company is said to be ________, when its total capital exceeds the
true value of its assets.
10.13. A company is considered to be _______, when its actual
capitalisation is lower than its proper capitalisation as warranted by its
earning capacity.

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2.6 Summary
Let us recapitulate the important concepts discussed in this unit:
 Financial planning deals with the planning, the execution, and the
monitoring of procurement and utilisation of funds. Financial planning
process gives birth to financial plan. It could be thought of as a blueprint
explaining the proposed strategy and its execution.
 There are many financial planning models. All these models forecast the
future operations and then translate them to income statements and
balance sheets. It will also help the finance managers to ascertain the
funds to be procured from the outside sources. The essence of all these
is to achieve a least cost capital structure which would match with the
risk exposure of the company.
 Failure to follow the principle of financial planning may lead a new firm to
over or under-capitalisation when the economic environment undergoes
a change.
 Ideally, every firm should aim at optimum capitalisation or it might lead to
a situation of over or under-capitalisation. Both are detrimental to the
interests of the society. There are two theories of capitalisation - cost
theory and earnings theory.

2.7 Glossary
Accounting equation: Assets = Liabilities + Equity.
Capitalisation of a firm: Refers to the composition of its long-term funds
and its capital structure. It has two components – Debt and Equity.
Financial planning: Process by which funds required for each course of
action is decided.

2.8 Terminal Questions

1. Explain the steps involved in Financial Planning.
2. Explain the factors affecting Financial Plan.
3. List out the causes of over-capitalisation.
4. Explain the effects of under-capitalisation.

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2.9 Answers

Self Assessment Questions

1. Qualitative, Quantitative
2. Allocation of funds
3. Short-term borrowings
4. Nature of the industry
5. Debt, equity
6. The prudent policy
7. Flexibility in capital structure, effect changes in the composites of
capital structure
8. Fixed capital, working capital
9. Short-term sources
10. Capitalisation
11. Cost theory
12. Over-capitalised
12.13. Under-capitalised

Terminal Questions
1. There are six steps involved in financial planning. Refer to 2.2
2. There are various factors affecting financial plan. Refer to 2.3
3. A company is said to be over-capitalised when its total capital (both
equity and debt) exceeds the true value of its assets. Refer to 2.5.3
4. A company is considered to be under-capitalised when its actual
capitalisation is lower than the proper capitalisation as warranted by the
earning capacity. Refer to 2.5.4

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2.10 Case Study: Financial Planning

Firms need to plan their future activities keeping in view the expected
changes in the economic, social, technical, and competitive environment.
The top and middle-level managers plan their business activities in terms of
financial projections keeping in view the various factors that will affect the
business.
Financial planning is enabled by creating pro forma income statements and
balance sheets. These are forecasted financial statements. As we have
discussed in the unit, financial planning is a continuous process of directing
and allocating financial resources to meet strategic goals and objectives. he
output from financial planning takes the form of budgets. The most widely
used form of budgets is pro forma or budgeted financial statements.
Given below is the profit and loss account statement and balance sheet
synopsis of Reliance Industries for the last five years. Study the statements
in detail.
Profit and Loss Account (Rs. in Crores)
Mar '11 Mar '10 Mar '09 Mar '08 Mar ‘07

Income
Sales Turnover 2,58,651.15 2,00,399.79 1,46,328.07 1,39,269.46 1,18,353.71
Excise Duty 10,515.09 8,307.92 4,369.07 5,463.68 6,654.68
Net Sales 2,48,136.06 1,92,091.87 1,41,959.00 1,33,805.78 1,11,699.03
Other Income 3,358.61 3,088.05 1,264.03 6,595.66 236.89
Stock Adjustments 3,243.05 3,947.89 427.56 -1,867.16 654.60
Total Income 2,54,737.72 1,99,127.81 1,43,650.59 1,38,534.28 1,12,590.52

Expenditure
Raw Materials 1,98,076.21 1,53,689.01 1,09,284.34 98,832.14 80,791.65
Power and Fuel Cost 2,255.07 2,706.71 3,355.98 2,052.84 2,261.69
Employee Cost 2,621.59 2,330.82 2,397.50 2,119.33 2,094.09
Other Manufacuring
Expenses 2,915.44 2,153.67 1,162.98 715.19 1,112.17
Selling and Admin
Expenses 7,207.83 5,756.44 4,736.60 5,549.40 5,478.10
Miscellaneous Expenses 500.52 651.96 562.42 412.66 321.23
Preoperative Exp
Capitalised -30.26 -1,217.92 -3,265.65 -175.46 -111.21
Total Expenses 2,13,546.40 1,66,070.69 1,18,234.17 1,09,506.10 91,947.72

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Operating Profit 37,832.71 29,969.07 24,152.39 22,432.52 20,405.91

PBDIT 41,191.32 33,057.12 25,416.42 29,028.18 20,642.80
Interest 2,328.30 1,999.95 1,774.47 1,162.90 1,298.90
PBDT 38,863.02 31,057.17 23,641.95 27,865.28 19,343.90
Depreciation 13,607.58 10,496.53 5,195.29 4,847.14 4,815.15
Other Written Off 0.00 0.00 0.00 0.00 0.00
Profit Before Tax 25,255.44 20,560.64 18,446.66 23,018.14 14,528.75
Extra-ordinary items 0.00 0.00 0.00 48.10 0.51
PBT (Post-Extra-ord items) 25,255.44 20,560.64 18,446.66 23,066.24 14,529.26
Tax 4,969.14 4,324.97 3,137.34 3,559.85 2,585.35
Reported Net Profit 20,286.30 16,235.67 15,309.32 19,458.29 11,943.40

Balance Sheet (Rs. in Crores)

Mar ‘11 Mar ‘10 Mar ‘09 Mar ‘08 Mar ‘07
Sources of Funds
Total Share Capital 3,273.37 3,270.37 1,573.53 1,453.39 1,393.21
Equity Share Capital 3,273.37 3,270.37 1,573.53 1,453.39 1,393.21
Share Application Money 0.00 0.00 69.25 1,682.40 60.14
Preference Share Capital 0.00 0.00 0.00 0.00 0.00
Reserves 1,42,799.95 1,25,095.97 1,12,945.44 77,441.55 59,861.81
Revaluation Reserves 5,467.00 8,804.27 11,784.75 871.26 2,651.97
Networth 1,51,540.32 1,37,170.61 1,26,372.97 81,448.60 63,967.13
Secured Loans 10,571.21 11,670.50 10,697.92 6,600.17 9,569.12
Unsecured Loans 56,825.47 50,824.19 63,206.56 29,879.51 18,256.61
Total Debt 67,396.68 62,494.69 73,904.48 36,479.68 27,825.73
Total Liabilities 2,18,937.00 1,99,665.30 2,00,277.45 1,17,928.28 91,792.86

Application of Funds
Gross Block 2,21,251.97 2,15,864.71 1,49,628.70 1,04,229.10 99,532.77
Less: Accum.
Depreciation 78,545.50 62,604.82 49,285.64 42,345.47 35,872.31
Net Block 1,42,706.47 1,53,259.89 1,00,343.06 61,883.63 63,660.46
Capital work-in-
progress 12,819.56 12,138.82 69,043.83 23,005.84 7,528.13
Investments 33,019.27 19,255.35 20,268.18 20,516.11 16,251.34
Inventories 29,825.38 26,981.62 14,836.72 14,247.54 12,136.51
Sundry Debtors 17,441.94 11,660.21 4,571.38 6,227.58 3,732.42
Cash and Bank
Balance 604.57 362.36 500.13 217.79 308.35
Total Current Assets 47,871.89 39,004.19 19,908.23 20,692.91 16,177.28
Loans and Advances 17,320.60 10,517.57 13,375.15 18,441.20 12,506.71
Fixed Deposits 31,162.56 17,073.56 23,014.71 5,609.75 1,527.00
Total CA, Loans and
Advances 96,355.05 66,595.32 56,298.09 44,743.86 30,210.99
Deferred Credit 0.00 0.00 0.00 0.00 0.00

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Current Liabilities 61,399.87 48,018.65 42,664.81 29,228.54 24,145.19

Provisions 4,563.48 3,565.43 3,010.90 2,992.62 1,712.87
Total CL and
Provisions 65,963.35 51,584.08 45,675.71 32,221.16 25,858.06
Net Current Assets 30,391.70 15,011.24 10,622.38 12,522.70 4,352.93
Miscellaneous
Expenses 0.00 0.00 0.00 0.00 0.00
Total Assets 2,18,937.
00 1,99,665.30 2,00,277.45 1,17,928.28 91,792.86
Contingent Liabilities 41,825.13 25,531.21 36,432.69 37,157.61 46,767.18
Book Value (Rs.) 446.25 392.51 727.66 542.74 439.57

Discussion Questions:
Prepare pro forma financial statements for the year 2012 with the following
considerations:
1. The sales for the year 2012 are to be increased by 30% over the value of
sales for the year 2011.
2. Use percent of sales method to forecast the values for various items of
income statement using the percentage for the year 2011.
3. Secured loans in 2012 will be based on its relationship with the sales in
the year 2011.
4. Additional funds required, if any, will be met by bank borrowings.
5. Selling and administration expenses expected to increase by 5%.
(Hint: Refer proforma financial statements)
(Source: http://www.moneycontrol.com/financials

References:
 Prasanna Chandra, Financial Management, 6th edition - Manohar
Publishers and Distributors
 Brigham. Eugene F. and Houston. Joel F.(2007). Fundamentals of
Financial Management, 11th Edition, Cengage Learning

E-References:
 http://www.moneycontrol.com/financials) retrieved on 10/12/ 2011

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Financial Management Unit 3

Unit 3 Time Value of Money

Structure:
3.1 Introduction
Objectives
Rationale
3.2 Time Preference for Money
Time preference rate and required rate of return
Compounding technique
Discounting technique
3.3 Future value
Doubling period
Increased frequency of compounding
Effective vs. nominal rate of interest
Future value of series of cash flows
Future value of annuity
Sinking fund
3.4 Present Value
Present value of a single flow
Present value of even series of cash flows
Present value of perpetuity
Present value of an uneven periodic sum
Capital recovery factor
3.5 Summary
3.6 Glossary
3.7 Solved problems
3.8 Terminal Questions
3.9 Answers
3.10 Case Study

3.1 Introduction
In the previous unit, you have learnt about the steps in financial planning,
factors affecting financial planning, estimation of financial requirements of a
firm, and the concept of capitalisation. In the earlier units, you have also
learnt that wealth maximisation is far more superior to profit maximisation.

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Wealth maximisation considers time value of money which translates cash

flow occurring at different periods into a comparable value at zero period.
For example, a firm investing in fixed assets will reap the benefits of such
investment for a number of years. However, if such assets are procured
through bank borrowings or term loans from financial institutions, there is an
obligation to pay interest and return of principal.
Decisions, therefore, are made by comparing the cash inflows
(benefits/returns) and cash outflows (outlays). Since these two components
occur at different time periods, there should be a comparison between the
two.
In order to have a logical and a meaningful comparison between cash flow
occurring over different intervals of time, it is necessary to convert the
amounts to a common point of time. This unit is devoted to a discussion of
the time value of money.
Objectives:
After studying this unit, you should be able to:
 explain the time value of money
 compute the future values of lump sums and annuity flows
 calculate the present values of lump sums and annuity flows
3.1.1 Rationale
“Time value of money” is the value of a unit of money at different time
intervals. The value of the money received today is more than its value
received at a later date. In other words, the value of money changes over a
period of time. Since a rupee received today has always more value,
rational investors would prefer current receipts over future receipts. That is
why this phenomenon is referred to as “time preference of money”.
Consider this – we intuitively know that Rs.100 in hand now is more
valuable than Rs. 100 receivable after a year. In other words, we will not
part with Rs. 100 now in return for a firm assurance that the same sum will
be repaid after a year. But we might part with the same Rs. 100 now if we
are assured that something more than Rs. 100 will be paid at the end of first
year. This additional compensation required for parting with Rs. 100 now is
called the ‘interest’ or the time value of money.

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Some important factors contributing to this nature are:

 Investment opportunities
 Preference for consumption
 Risk
These factors remind us of the famous English saying, “A bird in hand is
worth two in the bush”. The question now is: why should money have time
value?
Some of the reasons are:
 Productivity – Money can be employed productively to generate real
returns. For example, if we spend Rs. 500 on materials, Rs. 300 on
labour, and Rs. 200 on other expenses and the finished product is sold
for Rs. 1100, we can say that the investment of Rs. 1000 has fetched us
a return of 10%.
 Inflation – During periods of inflation, a rupee has higher purchasing
power than a rupee in the future.
 Risk and uncertainty – We all live under conditions of risk and
uncertainty. As the future is characterised by uncertainty, individuals
prefer current consumption over future consumption. Most people have
subjective preference for present consumption either because of their
current preferences or because of inflationary pressures.

3.2 Time Preference for Money

3.2.1 Time preference rate and required rate of return
The time preference for money is generally expressed by an interest rate
which remains positive even in the absence of any risk. It is called the risk-
free rate.
For example, if an individual’s time preference is 8%, it implies that he or
she is willing to forego Rs. 100 today to receive Rs. 108 after a period of
one year. Thus he or she considers Rs. 100 and Rs. 108 as equivalent in
value. In reality though, this is not the only factor he or she considers. He or
she requires another rate for compensating him or her for the amount of risk
involved in such an investment. This rate is called the risk premium.

Required rate of return = Risk-free rate + Risk premium

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There are two methods by which the time value of money can be calculated:
 Compounding technique
 Discounting technique
3.2.1.1 Compounding technique
In the compounding technique, the future values of all cash inflow at the end
of the time horizon at a particular rate of interest are calculated. The amount
earned on an initial deposit becomes part of the principal at the end of the
first compounding period.
The compounding of interest can be calculated by the following equation:

n
.

Where, A = Amount at the end of the period

P = Principal at the end of the year
i = Rate of interest
n = Number of years

Example
Mr. A invests Rs. 1,000 in a bank which offers him 5% interest
compounded annually. Table 3.1 depicts the values arrived at by
substituting the actual figures for the investment or Rs. 1000 in the
n
formula .
Table 3.1: Interest Compounded Annually

Year 1 2 3
Beginning amount Rs.1000 Rs.1050 Rs.1102.50
Interest rate 5% 5% 5%
Amount of interest 50 52.50 55.13
Beginning principal Rs.1000 Rs.1050 Rs.1102.50
Ending principal Rs.1050 Rs.1102.50 Rs.1157.63

As seen from table 3.1, Mr. A has Rs. 1050 in his account at the end of
the first year. The total of the interest and principal amount
Rs. 1050 constitutes the principal for the next year. He thus earns
Rs. 1102.50 for the second year. This becomes the principal for the third

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Financial Management Unit 3

year. This compounding procedure will continue for an indefinite number

of years.
Let us now see how the values in table 3.1 are arrived at.
Amount at the end of year 1 = Rs. 1000 (1+0.05) = Rs. 1050
Amount at the end of year 2 = Rs. 1050 (1+0.05) = Rs. 1102.50
Amount at the end of year 3 = Rs. 1102.50 (1+0.05) = Rs. 1157.63
The amount at the end of the second year can be ascertained by
substituting Rs.1000 (1+0.05) for Rs.1050, that is,
Rs.1000 (1+0.05) (1+0.05) = Rs.1102.50
Similarly, the amount at the end of the third year can be ascertained by
substituting Rs.1000 (1+0.05) for Rs.1102.50, that is,
Rs.1000 (1+0.05) (1+0.05) (1+0.05) = Rs.1157.63

3.2.1.2 Discounting technique

In the discounting technique, the present value of the future amount is
determined. Time value of money at time zero on the time line is calculated.
This technique is in contrast to the compounding approach where we
convert the present amounts into future amounts.

Solved Problem – 1
Mr. A requires Rs. 1050 at the end of the first year. Given the rate of
interest as 5%, find out how much Mr. A would invest today to earn this
amount.
Solution:
If P is the unknown amount, then
P (1+0.05) = 1050
P = 1050/(1+0.05)
= Rs.1000
Thus, Rs. 1000 would be the required principal investment to have
Rs. 1050 at the end of the first year at 5% interest rate. The present
value of the money is the reciprocal of the compounding value.
Mathematically, we have

 1 
P=A  n 
 (1  i) 

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Where P is the present value for the future sum to be received,

A is the sum to be received in future,
i is the interest rate, and
n is the number of years.

3.3 Future value

The process of calculating future value will become very cumbersome if it
has to be calculated over long maturity periods of 10 or 20 years. A
generalised procedure of calculating the future value of a single cash flow
compounded annually is as follows:

FVn = PV(1+i)n

Where, FVn = future value of the initial flow in n years hence,

PV = initial cash flow
i = annual rate of interest
n = life of investment

The expression ( 1  i)n represents the future value of the initial investment
of Re. 1 at the end of n number of years at a rate of interest ‘i’ referred to as
the Future Value Interest Factor (FVIF). To help ease the calculations, this
expression has been evaluated for various combinations of “i” and “n” and
these values are presented in table 3.1. To calculate the future value of any
investment, the corresponding value of (1  i)n from table 3.1 is multiplied
with the initial investment.

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Solved Problem – 2
Table 3.2 depicts the interest rates offered by the fixed deposit scheme
of a bank.
Table 3.2: Fixed Deposit Scheme of a Bank
Period of deposit Rate per annum
<45 days 9%
46 days to 179 days 10%
180 days to 365 days 10.5%
365 days and above 11%

What will be the status of Rs. 10,000 after three years if it is invested at
this point of time?
Solution:
FVn = PV(1+i)n or PV*FVIF (11%, 3y)
= 10000*1.368 (from the tables)
= Rs.13, 680
The status of Rs. 10,000 after three years, if it is invested at this point of
time, would be Rs.13,680.

3.3.1 Doubling period

A very common question arising in the minds of an investor is “how long will
it take for the amount invested to double for a given rate of interest”. There
are 2 ways of answering this question:
1. One way is to answer it by a rule known as ‘rule of 72’. This rule states
that the period within which the amount doubles is obtained by dividing
72 by the rate of interest. Though it is a crude way of calculating, this
rule is followed by most.
For instance, if the given rate of interest is 10%, the doubling period is
72/10, that is, 7.2 years.
2. A much accurate way of calculating doubling period is by using the rule
known as ‘rule of 69’. By this method,
Doubling Period = 0.35+69/Interest rate
Going by the same example given above, we get the number of years as
7.25 years {(0.35 + 69/10) or (0.35 +6.9)}.

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Growth rate:
The compound rate of growth for a given series for a period of time can be
calculated by employing the FVIF. Consider the following example.

Years 1 2 3 4 5 6
Profits (in Lakh) 75 90 105 140 160 180

How is the compound rate of growth for the above series determined? This
can be done in two steps:
1. The ratio of profits for year 6 to year 1 is to be determined, i.e., 180/75 =
2.4.
2. The FVIF table is to be looked at. Look at the value that is close to 2.4
for the row of 5 years.

The value close to 2.4 is 2.386, and the interest rate corresponding to this is
19%. Therefore, the compound rate of growth is 19%.

3.3.2 Increased frequency of compounding

So far, we have seen the calculation of the time value of money. It has been
assumed that the compounding is done annually.
Let us now see the effect on interest earned when compounding is done
more frequently - half-yearly or quarterly.

Example
Table 3.3 depicts the interest earned if we have deposited Rs.10,000 in a bank
which offers 10% interest per annum compounded semi-annually.
Table 3.3: Interest Earned
Amount invested Rs.10,000
Interest earned for first 6 months
10000*10%*1/2 (for 6 months) Rs.500
Amount at the end of 6 months Rs.10,500
Interest earned for second 6 months
105000*10%*1/2 Rs.525
Amount at the end of the year Rs.11,025

If in the above case, compounding is done only once in a year the interest
earned will be 10000*10% which is equal to Rs. 1000, and we will have
Rs. 11000 at the end of first year.

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Going by the calculations, we see that one gets more interest if

compounding is done on a more frequent basis. The generalised formula for
shorter compounding periods is:
mXn
 i 
FV n  PV 1  
 m

Where, FVn= future value after n years

PV = cash flow today
i = nominal interest rate per annum
m = number of times compounding is done during a year
n = number of years for which compounding is done

Solved Problem – 3
Under the ABC Bank’s Cash Multiplier Scheme, deposits can be made
for periods ranging from 3 months to 5 years and for every quarter,
interest is added to the principal. The applicable rate of interest is 9%
for deposits less than 23 months and 10% for periods more than 24
months. What will be the amount of Rs. 1000 after 2 years?
Solution:
mXn
 i 
FV n  PV 1  m 
m = 12/3 = 4 (quarterly compounding)
1000 (1+0.10/4)4*2
1000 (1+0.10/4)8
Rs. 1218
The amount of Rs. 1000 after 2 years would be Rs. 1218.

3.3.3 Effective vs. nominal rate of interest

We have just learnt that interest accumulation under half-yearly/quarterly
compounding is much more than in the case of annual compounding. This
means that the rate of interest given to us in the example, i.e., 10% is the
nominal rate of interest per annum.
If the compounding is done more frequently, say semi-annually, the principal
amount grows at 10.25% per annum. This 10.25% is known as the
“effective rate of interest” which is the rate of interest per annum under

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the annual compounding that produces the same effect as that produced by
an interest rate of 10% under semi-annual compounding.
The general relationship between the effective and nominal rates of interest
is as follows:

 i m
r = (1  ( ) ) 1
 m 
Where,
r = Effective rate of interest
i = Nominal rate of interest
m = Frequency of compounding per year

Solved Problem – 4
Calculate the effective rate of interest if the nominal rate of interest is
12% and interest is compounded quarterly.
Solution:
 i 
r = (1  ( )m )  1
 m 
M = 12/3 = 4 (quarterly compounding)
r = {(1+0.12/4)4}-1
r = 0.126 or 12.6% p.a. effective rate of interest is 12.6% p.a.

3.3.4 Future value of series of cash flows

An investor may be interested in investing money in instalments and wish to
know the value of his or her savings after n years.
Let us understand the calculation of the same with the help of a solved
problem.

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Solved Problem – 5
Mr. Madan invests Rs. 500, Rs. 1000, Rs. 1500, Rs.2000, and Rs. 2500
at the end of each year for 5 years. Calculate the value at the end of 5
years compounded annually if the rate of interest is 5% p.a.
Solution:
Table 3.4 depicts the value at the end of 5 years, compounded annually
at a rate of interest of 5% per annum
Table 3.4: Future Value of Series of Cash Flow
Amount Number of Compounded
End of invested years interest factors FV in Rs.
year
(Rs.) compounded from tables

1 500 4 1.216 608

2 1000 3 1.158 1158

3 1500 2 1.103 1654

4 2000 1 1.050 2100

5 2500 0 1.000 2500

Amount at the end of the fifth year Rs.8020

The value at the end of the fifth year is Rs. 8020

Thus, to ascertain the accumulation of a series of unequal flows as at the

end of a specified time horizon, we have to find out the accumulations of
each of these flows using the appropriate FVIF and sum up these
accumulations.
This process tends to get tedious if we have to determine the accumulation
of a series of flows over a long period of time, for example, the accumulation
of a recurring bank deposit of Rs. 100 per month for 60 months at a rate of
1 percent per month. In such cases, an easier method can be employed
provided the flows are of equal amounts. This method is discussed in the
following sub-section.

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3.3.5 Future value of an annuity

Annuity refers to the periodic flows of equal amounts. These flows can be
either receipts or payments.

Example
If you have subscribed to the recurring deposit scheme of a bank
requiring you to pay Rs. 5000 annually for 10 years, this stream of
payouts can be called “annuities”. Annuities require calculations based
on regular periodic contribution of a fixed sum of money.

The future value of a regular annuity for a period of n years at “i” rate of
interest can be summed up as follows:

 (1  i ) n  1
FVAn = A  
 i 
Where, FVAn = Accumulation at the end of n years
i = Rate of interest
n = Time horizon or number of years
A = Amount invested at the end of every year for n years

The expression [(1  i ) n  1] / i ) is called the Future Value Interest Factor

for Annuity (FVIFA). This represents the accumulation of Re.1 invested at
the end of every year for n number of years at “i” rate of interest.

As in the case of FVIFA, this expression has also been evaluated for
different combinations of ‘i’ and ‘n’. Table 3.4 and table 3.5 depict these
tabulations respectively. We just have to multiply the relevant value from
the table with ‘A’ (i.e. Amount invested at the end of every year for n years)
and get the accumulation in the formula given above.

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Solved Problem – 6
Mr. Ram Kumar deposits Rs. 3000 at the end of every year for five years
into his account. Interest is being compounded annually at a rate of 5%.
Determine the amount of money he will have at the end of the fifth year.

Solution:
Table 3.5 depicts the amount of money Mr. Ram Kumar will have at the
end of the fifth year.

Table 3.5: Computation of Future Value of Annuity

End Amount Number of years Compounded FV in Rs.
of invested compounded interest factors
year (Rs) from tables

1 2000 4 1.216 2432

2 2000 3 1.158 2316
3 2000 2 1.103 2206
4 2000 1 1.050 2100
5 2000 0 1.000 2000
Amount at the end of the fifth year 11054

Or Refer FVIFA table to compute the value at the end of 5th year:
= 2000 * FVIFA (5%, 5y)
= 2000*5.526
= Rs. 11052

We notice that we can get the accumulations at the end of n period using
the tables. Calculations for a long time horizon are easily done with the help
of reference tables. Annuity tables are widely used in the field of investment
banking as ready beckoners.

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Solved Problem – 7
Calculate the value of an annuity flow of Rs. 5000 done on a yearly
basis of five years, yielding at an interest of 8% p.a.
Solution:
= 5000 FVIFA (8%, 5y)
= 5000* 5.867
= Rs. 29335
The value of annuity flow is Rs. 29,335.

If the payments/investments are made at the beginning of every year, then

the value of such an annuity, called ‘annuity due’, is ascertained by
modifying the formula for annuity (regular):
FVAn(due) = A ( 1+ i ) FVIFAi,n

Activity 1
If you are investing in State Bank of India Recurring deposit scheme that
requires you to pay Rs 1000 annually for 10 years how would you
calculate the contribution?
Hint: Future value of an Annuity

3.3.6 Sinking fund

Sinking fund is a fund which is created out of fixed payments each period to
accumulate for a future sum after a specified period.
It can be said that it is a fund created for a specified purpose by way of
sequence of periodic payments over a time period at a specified interest
rate.
The sinking fund factor is useful in determining the annual amount to be put
in a fund, to repay bonds or debentures, or to purchase a fixed asset or a
property at the end of a specified period.
 i 
A = FV  
 (1  i)  1
n

i /[(1  i ) n 1] is called the sinking fund factor.

Example: Manas Ltd. has an obligation to redeem Rs. 50,00,000 debentures
for 6 years. How much should the company deposit annually in the sinking

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fund account yielding 14 percent interest to cumulate Rs. 50,00,000 six

years from now?
Solution: n=6 years, r= 14%, Accumulated sum = 50,00,000
Annual sinking fund deposit should be:
A= 50,00,000
FVIFA (14%, 6yrs)
Referring FVIFA table the factor is 8.536
50,00,000
=  Rs. 5,85,754
8.536

Self Assessment Questions

1. The important factors contributing to time value of money are
__________, ________________ and _______.
2. During periods of inflation, a rupee has a ___than a rupee in future.
3. As future is characterised by uncertainty, individuals prefer _________
consumption to __________ consumption.
4. There are two methods by which time value of money can be calculated
by _________ and _________ techniques.

3.4 Present Value

Given the interest rate, compounding technique can be used to compare the
cash flows separated by more than one time period. With this technique, the
amount of present cash can be converted into an amount of cash of
equivalent value in future.
Likewise, we may be interested in converting the future cash flow into their
present values. ‘Present value’ can be simply defined as ‘the current value
of a future sum’. It can also be defined as the amount to be invested today
(present value) at a given rate of interest over a specified period to equal the
‘future’ sum.
If we reverse the flow by saying that we expect a fixed amount after ‘n’
number of years and we also know the present prevailing interest rate, then

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by discounting the future amount at the given interest rate, we will get the
present value of investment to be made.
The present value of a sum to be received at a future date is determined by
discounting the future value at the interest rate that the money could earn
over the period. This process is known as discounting.
3.4.1 Present value of a single flow
Ascertaining Present Value (PV) is simply the reverse of finding Future
Value (FV). Hence, the formula for FV can be simply transformed into the
PV formula. Thus, we can determine the PV of a future cash flow or a
stream of future cash flows using the formula:

Where, PV = Present Value

FVn = Amount (Future value after ‘n’ years)
i = Interest rate
n = Number of years for which discounting is done

Solved Problem – 8
If Ms. Sapna expects to have an amount of Rs. 1000 after one year what
should be the amount she has to invest today if the bank is offering 10%
interest rate?

FV n
Solution: PV 
(1  i) n
= 1000/(1+0.10)1
= Rs. 909.09
The same can be calculated with the help of tables.
= 1000*PVIF (10%, 1y)
= 1000*0.909
= Rs. 909
The amount to be invested today to have an amount of Rs, 1000 after
one year is Rs. 909.

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Solved Problem – 9
An investor wants to find out the value of an amount of Rs.10,000 to be
received after 15 years. The interest offered by bank is 9%. Calculate the
PV of this amount.
Solution:
FV n
PV  or 10000 PVIF(9%, 15y)
(1  i) n
= 10000*0.275
= Rs. 2750
The PV of Rs. 10, 000 is Rs. 2750.

Activity-2
If you are an investor and are interested in finding out the value of an
amount of Rs 1000 to be received after 15 years, how would you
calculate?
Hint: calculate Present value

3.4.2 Present value of even series of cash flows

In a business scenario, the businessman will receive periodic amounts
(annuity) for a certain number of years. An investment done today will fetch
him returns spread over a period of time. He would like to know if it is
worthwhile to invest a certain sum now in anticipation of returns he expects
after a certain number of years. He should, therefore, equate the anticipated
future returns to the present sum he is willing to forego. The PV of a series
of cash flows can be represented by the following formula:

A A A A
PVAn     ... 
(1  i) 1
(1  i) 2
(1  i) 3
(1  i) n
The above formula or the equation reduces to:
 (1  i ) n  1
PVAn= A  n 
 i (1  i ) 
The expression {(1 i)n  1/ i (1  i)n } is known as Present Value Interest
Factor Annuity (PVIFA). It represents the present value of a regular annuity
of Re. 1 for the given values of i and n. Table 3.6 depicts the values of

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PVIFA (i, n) for different combinations of ‘I’ and ‘n’. It should be noted that
these values are true only if the cash flows are equal and the flows occur at
the end of every year.
It must also be noted that PVIFA (i,n) is NOT the inverse of FVIFA (i,n),
although PVIF (i,n) is the inverse of FVIF (i,n).

Solved Problem – 10
Calculate the PV of an annuity of Rs. 500 received annually for four years
when discounting factor is 10%.
Solution:
Table 3.6 depicts the calculated present value of annuity:
Table 3.6: Computation of PV of Annuity
End of year Cash inflows PV factor PV in Rs.
1 Rs.500 0.909 454.5
2 Rs.500 0.827 413.5
3 Rs.500 0.751 375.5
4 Rs.500 0.683 341.5
3.170 1585.0

Present value of an annuity is Rs. 1585.

or
By directly looking at the table we can calculate:
= 500*PVIFA (10%, 4y)
= 500*3.170
= Rs. 1585
The present value of annuity is Rs. 1585.

Solved Problem – 11
Find out the present value of an annuity of Rs. 10000 over 3 years when
discounted at 5%.
Solution:
Present value of annuity
= 10000*PVIFA(5%, 3y)
= 10000*2.7232
= Rs. 27232
Hence, the present value of annuity is Rs. 27232.

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3.4.3 Present value of perpetuity

An annuity for an infinite time period is perpetuity. It occurs indefinitely. A
person may like to find out the present value of his investment assuming he
will receive a constant return year after year.
The present values of perpetuity can be expressed as follows:

Where, = Present value of perpetuity

A = constant annual payment
= Present value interest factor for a perpetuity

Therefore, the value of is

It can be said that PVIF of perpetuity is simply one divided by interest rate
expressed in decimal form. Hence, PV of perpetuity is simply equal to the
constant annual payment divided by the interest rate. This can be expressed
as follows:

Solved Problem – 12
The principal of a college wants to institute a scholarship of Rs. 5000 for
a meritorious student every year. Find out the PV of investment which
would yield Rs. 5000 in perpetuity, discounted at 10%.
Solution:

= 5000/0.10
= Rs. 50000
This means he should invest Rs. 50000 to get an annual return of
Rs. 5000.

3.4.4 Present value of an uneven periodic sum

In some investment decisions of a firm, the returns may not be constant. In
such cases, the PV is calculated as follows:

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A1 A2 A3 An
P    ... 
(1  i) 1
(1  i) 2
(1  i) 3
(1  i) n
or
PV= A1 PVIF (i, 1) + A2 PVIF (i, 2) + A3 PVIF (i, 3) + A4 PVIF (i, 4)
+……………..…. + An PVIF (i, n)

Solved Problem – 13
An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000, and
Rs. 4000 respectively at the end of every five years. Find out the
present value of this stream of uneven cash flows, if the investors
interest rate is 8%.
Solution:
PV=10000/ (1+0.08) +15000/ (1+0.08)2+8000/ (1+0.08)3+11000/
(1+0.08)4+4000/ (1+0.08)5
=Rs.39276
Or by referring table we can compute
PV=10000 PVIF(8%,1yr)+15000 PVIF(8%,2yrs)+ 8000 PVIF(8%,3yrs)+
11000 PVIF(8%,4yrs)+4000 PVIF(8%,5yrs)
= 10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681
=9260+ 12855 + 6352 +8085 + 2724 =Rs.39,276
The present value of this stream of uneven cash flows is Rs. 39,276

3.4.5 Capital recovery factor

Capital recovery factor is the annuity of an investment for a specified time at
a given rate of interest.
The reciprocal of the present value annuity factor is called capital recovery
factor.

 i (1  i ) n 
A = PVAn  n 1 
 (1  i ) 

 i (1  i ) n 
 n 1 
is known as the Capital Recovery Factor.
 (1  i ) 

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Solved Problem – 14
A loan of Rs. 100000 is to be repaid in 5 equal annual instalments. If the
loan carries a rate of 14% p.a, what is the amount of each instalment?
Solution:
Instalment*PVIFA(14%, 5) = 100000
Instalment=100000/3.433 = Rs. 29128.
The amount of each instalment has been calculated.

Self Assessment Questions

5. _________________ is created out of fixed payments each period to
accumulate for a future sum after a specified period.
6. The ________________of a future cash flow is the amount of the
current cash that is equivalent to the investor.
7. An annuity for an infinite time period is called ______________.
8. The reciprocal of the present value annuity factor is called __________.

3.5 Summary
Let us recapitulate the important concepts discussed in this unit:
 Money has time preference.
 A rupee in hand today is more valuable than a rupee a year later.
Individuals prefer possession of cash now rather than at a future point of
time. Therefore cash flow occurring at different points in time cannot be
compared.
 Interest rate gives money its value and facilitates comparison of cash
flow occurring at different periods of time.
 Compounding and discounting are two methods used to calculate the
time value of money.

3.6 Glossary
Annuity: Refers to the periodic flows of equal amounts.
Capital recovery factor: Annuity of an investment for a specified time at a
given rate of interest.
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Perpetuity: An annuity for an infinite time period.

Required rate of return: Risk free rate + Risk premium.
Rule of 72: The period within which the amount doubles is obtained by
dividing 72 by the rate of interest.
Sinking fund: Fund which is created out of fixed payments each period to
accumulate for a future sum after a specified period.
Time value of money: Value of a unit of money at different time intervals.

3.7 Solved Problems

15. What is the future value of a regular annuity of Re. 1.00 earning a rate
of 12% interest p.a. for 5 years?

Solution: FVAn = A * FVIFA (12%,5yrs)

= 1*FVIFA (12%, 5y) = 1*6.353 = Rs. 6.353

16. If a borrower promises to pay Rs. 20,000 eight years from now in return
for a loan of Rs. 12,550 today, what is the annual interest being
offered?

Solution: PV = A * PVIF(r%,8 yrs)

12550 = 20000*PVIF (r%, 8yrs)
12550/20000 = PVIF (r%, 8yrs)
0.627 = PVIF (r%, 8yrs)
Refer PVIF table and search for 0.627 in the 8th year row. You can
identify this number under the 6% column.
Hence the annual interest (r) = 6%

17. A loan of Rs. 500000 is to be repaid in 10 equal instalments. If the loan

carries 12% interest p.a., what is the value of one instalment?

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Solution:
PV = A*PVIFA (12%, 10y)
500000 = A *5.650
500000/5.650= A
Rs. 88492 = A (instalment amount)

18. A person deposits Rs. 25,000 in a bank that pays 6% interest half-
yearly. Calculate the amount at the end of 3 years

Solution:
mXn
: FV n  PV 1  i 
 m
I/m = 6%; m = 2 ; n = 3 yrs
25000*(1+0.06)3*2 = 25000*1.14185 = Rs. 35462

19. Find the present value of Rs. 100000 receivable after 10 years if 10%
is the time preference for money.

Solution:
FV n
PV 
1  i n
Refer PVIF table (10%,10yrs)
PV =100000*(0.386)
= Rs. 38600

3.8 Terminal Questions

1. If you deposit Rs. 10000 today in a bank that offers 8% interest, how
many years will the amount take to double?
2. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of
each year for 20 years. What is the amount he or she will accumulate in
his or her PF at the end of 20 years if the rate of interest given by PF
authorities is 9%?

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3. A person can save _____________ annually to accumulate Rs. 400000

by the end of 10 years if the saving earns 12%.
4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the
present value of the annuity assuming he or she can earn interest on his
or her investment at 10% per annum.
5. Aparna invests Rs. 5000 at the end of each year at 10% interest p.a.
What is the amount she will receive after 4 years?

3.9 Answers

Self Assessment Questions

1. Investment opportunities, preference for consumption, risk
2. Higher purchasing power
3. Current and future
4. Compounding and discounting
5. Sinking fund
6. Present Value
7. Perpetuity
8. Capital Recovery Factor

Terminal Questions
1. 9 years (using rule of 72); 8.975 years (using rule of 69)
2. 30000*FVIFA(9%, 20Y) = 30000*51.160 = Rs. 1534800
3. A*FVIFA(12%, 10y) = 400000 which is 400000/17.549 = Rs.22795
4. 20000*PVIFA(105, 5y)=20000*3.791 = Rs. 75820
5. 5000*FVIFA(10%, 4y) = 5000*6.105 = Rs. 23205

3.10 Case Study: Multiple Investment Avenues

In India, multiple investment avenues are available to meet the varied
interests and backgrounds of the public. These include savings bank
accounts, money market or liquid funds, and fixed deposits with banks.
These are mostly short-term investments avenues. There are also some
financial instruments which offer a long-term horizon for investment. These
include post office savings, public provident fund (PPF), company fixed
deposits, bonds, and mutual funds.

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Small savings schemes in India are framed and enacted by the central
government under the Government Savings Bank Act, 1873, and
Government Savings Certificate Act, 1959. Small savings schemes came
into existence after independence with the objective of providing safe and
simple investment opportunities to the lower and middle income groups.
These schemes were channelised and administered by government
institutions, such as post offices and nationalised banks. With the same
objective, the PPF was established in 1968 for individuals to save for their
investments.
There are various schemes offered by the Government of India (GoI)
through post offices across the country. These schemes include the post-
office Savings Account, the post-office Recurring Deposit Account, the post-
office Time Deposit Account, the post-office Monthly Income Account, the
post-office Public Provident Fund Account, the Kisan Vikas Patra, the
National Savings Certificate, and the Senior Citizens Savings Scheme. The
maturity period of these schemes varies from very short as in the case of a
savings deposit to over 15 years as in the case of PPF. However, all these
investment options come under the same risk class as all of them have fixed
returns and are guaranteed by the GoI. The returns vary between the
schemes based on their features and maturity period.
The responsibility of promoting and mobilising small savings schemes rests
with the National Savings Institute (NSI), a division of the ministry of finance.
The NSI markets the small savings schemes on a nationwide basis and
provides the government with feedback from customers.
The small savings scheme programme aims at promoting the savings habit
and providing safe investment avenues to people with limited income and
savings potential. These schemes are operated through about 1,60,000 post
offices across the country. The PPF scheme is also operated through more
than 8000 branches of public sector banks.
Post Office Savings Schemes in India
The main financial services offered by the Department of Posts are the Post
Office Savings Bank. It is the largest and oldest banking service institution in
the country. The Department of Posts operates the Post Office Savings
Scheme function on behalf of the Ministry of Finance, Government of India.
Under this scheme, more than 20.50 crores savings accounts are operated.

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These accounts are operated through more than 1,54,000 post offices
across the country.
The Post offices provide a number of savings schemes like the Savings
Account Schemes, Recurring Deposit Schemes, Time Deposit Schemes,
Public Provident Fund Schemes, Monthly Income Schemes, National
Savings Certificates, Kisan Vikas Patras, and Senior Citizens
Savings Scheme. A brief of the various schemes is as follows:

Investment
Interest Denominati
Scheme Tenure Salient Features Tax rebate
Rates ons and
limits
Post 3.5% p.a. On No Min: Rs. 50  Cheque facility Interest is
Office individual specific Max: Rs. 1 available tax-free u/s
Savings and joint or fix lakh for 80L
Account account tenure individual
and 2 lakhs
for joint
account
5-Year 7.5% 5 years. Min: Rs. 10  One withdrawal up to No tax rebate
Post compounded Can be per month 50% of
Office quarterly renewed or multiples the balance is
Recurring for of Rs. 5 allowed after one
Deposit another Max: No year.
Account 5 years limit  Full maturity value
allowed on R.D.
 6 and 12 months
advance deposits
earn rebate.
Post 6.25% 1 year Min: Rs. 200  Long-term accounts Investment
Office and its could be closed after qualifies for
6.50% 2 years
Time multiple 1 year for discounted deduction u/s
Deposit 7.25% 3 years thereof Max: interest. 80C. Interest
Account No limit  Accounts could be is tax-free u/s
closed after 6 80L
months but before a
7.50% 5 years year for no interest.
 Interest is calculated
quarterly but payable
yearly.
Post 8% p.a. 6 years Min: Rs.  Account if closed Interest is
Office 1500 per after 1 year but tax-free u/s
Monthly month or before 3 years will 80L
Income multiples of suffer a deduction of
Account it. Max: Rs. 2% of the deposit.
4.5 lakhs for  Account if closed

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individual after 3 years will

account and suffer a deduction of
Rs. 9 lakhs 1% of the deposit.
for joint  On maturity, bonus
account of 5% on principal
amount is admissible
15-year 8% p.a. 15 years Min: Rs. 500  Withdrawal can be Investment
Public compounded tenure in 1 year made every year qualifies for
Provident yearly Max: Rs. after the 7th financial deduction u/s
Fund 70000 in 1 year. 80C. Interest
Account year  From the 3rd is tax-free u/s
Deposits financial year, loan 80L
can be can be availed
made in against PPF.
lump-sum or  No attachment under
12 court decree order.
instalments
Kinas 8.4% --- No limits.  A single holder No tax
Vikas compounded Investment certificate can be benefits
Patra yearly. denominatio purchased by an
Money ns available adult.
doubles in 8 are of  A certificate can also
years and 7 Rs. 100, be purchased jointly
months Rs. 500, by two adults.
Rs. 1000,
Rs. 5000,
Rs. 10,000,
in all Post
Offices and
Rs. 50,000
in all Head
Post
Offices.
National 8% p.a. 6 years Min:  A single holder Investment
Savings compounded Rs. 100. certificate can be as well as the
Certificate half-yearly Also purchased by an interest
(VIII issue) but payable available in adult. deemed to
after maturity denominatio be re-
ns of Rs. invested
100/-, 500/-, qualifies for
1000/-, 5000 deduction u/s
and Rs. 80C.
10,000/-.
Max: no limit
Senior 9% p.a. 5 years Only 1  Age should be above Investment
Citizens deposit 60 years or 55 years qualifies for
Savings allowed in above if retired under deduction u/s
Scheme multiple of superannuation. 80C.
Rs. 1000.  Account if closed
Max is after 1 year will

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Rs. 15 lakhs suffer a deduction of

1.5% interest and
after 2 years will
suffer a deduction of
1% interest.
 TDS is made on
interest if it exceeds
Rs. 10000 p.a.

Mr. Sreedhar is looking for some simple investment options. Mr. Sreedhar
works in a local textile factory. His annual income is Rs. 5,30,000. His
monthly net pay is approx. Rs. 37,000. The break-up of his salary income is
as below:

Salary Components Monthly Annual

Basic 15,900 1,90,800

Allowances /FBP 21,179 2,54,146

Sub-total(A) 37,079 4,44,946

PF 1,908 22,896

Gratuity 763 9,158

Retirals Total(B) 2,671 32,054

Performance Based
53,000
Pay
Variable Pay(C)

Total(A+B) 39,750 5,30,000

FBP - Flexible Benefit Plan (Consists of various options in the
menu from which one can choose what he wants to take. These
are basically allowances/reimbursements which attracts Fringe
Benefit Tax). The unclaimed amount is paid as Special Allowance
and taxed fully as per the tax bracket.

Mr. Sreedhar has decided to invest Rs.1,00,000 per annum in a balanced

proportion of short (<5 years ) and long term (7–15 yrs) instruments of
investments. He is looking at the same as an avenue to avail tax benefits.
He would appreciate a portion of returns to come to him in a series of even
flows through the tenure of the investment to meet some of his monthly
commitments.

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He is rather conservative and wants to invest in the Post Office savings

schemes, as he believes they are simple and safe.
Discussion Questions:
1. Help Mr. Sreedhar choose a good mix of instruments and thus plan his
investments.
(Hint: Do keep in mind to take care of his requirements of proportions,
returns, and tenure of investments. Justify your suggestion with details of
returns and how the selected scheme is most profitable.)
2. Mr. Sreedhar is further considering two finance schemes to purchase a
motorbike. His income details are as available above. The price of the
motorbike of his choice is Rs.24,000. Prime Finance Ltd. is offering
100% finance on the bike for a period up to 2 years. For a two-year
finance scheme, Mr. Sreedhar has to pay monthly instalments of
Rs.1,200. Another finance scheme under consideration is offered by a
mercantile bank. But the bank wants Mr. Sreedhar to bring in a margin of
Rs.5,000 and pay equated monthly instalment of Rs.940 for two years.
Mr. Sreedhar is confident that he can raise the amount of margin
payment from a friend and repay it in semi-annual instalments of
Rs1,500 each in two years. He would like to find the effective rate of
interest under both the alternatives and opt for the alternative which has
lower interest rate. Help him in choosing the more profitable alternative.
(Hint: Find the effective rate of interest under both the alternatives and
opt for the alternative which has lower interest rate.)
(Source: www.finmin.nic.in retrieved on 10/12/2011)

References:
 Keown, Arthur J. (2005). Financial Management. Principles and
Applications, 10th Edition.
 "Time Value of Money", (2008) Finance for Engineers,
E-References:
 www.ideaindia.org retrieved on 10/12/2011
 www.finmin.nic.in retrieved on 10/12/2011

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Financial Management Unit 4

Unit 4 Valuation of Bonds and Shares

Structure:
4.1 Introduction
Objectives
Concept of intrinsic value
Concept of book value
4.2 Valuation of Bonds
Irredeemable bonds or perpetual bonds
Redeemable bonds
Bonds with annual interest payments
Bond values with semi-annual interest payments
Zero coupon bonds
Bond yield measures
Current yield
Yield to Maturity (YTM)
Bond value theorems
4.3 Valuation of Shares
Valuation of preference shares
Valuation of ordinary shares
Dividend capitalisation model
Types of dividends
Other approaches to equity valuation
Price earnings ratio
4.4 Summary
4.5 Glossary
4.6 Solved Problems
4.7 Terminal Questions
4.8 Answers
4.9 Case Study

4.1 Introduction
In the previous unit, we discussed about the future value and present value
of money. In this unit, we will learn about the valuation of bonds and shares.
Valuation is the process of linking risk with returns to determine the worth of

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an asset. Assets can be real or financial; securities are called financial

assets, physical assets are real assets.
The value of an asset depends on the cash flow it is expected to provide
over the holding period. The fact is, till date, there is no method by which
prices of shares and bonds can be accurately predicted. This fact should be
kept in mind by an investor before he/she decides to take an investment
decision, which we discussed in the previous units.
Ordinary shares are riskier than bonds or debentures, and some shares are
more risky than others. The investor would therefore commit funds on a
share only if he/she is convinced about the rate of return being
commensurate with risk.
The present unit will help us to know why some securities are priced higher
than others. We can design our investment structure by exploiting the
variables to maximise our returns.
Objectives:
After studying this unit, you should be able to:
 define value in terms of finance theory
 recall the procedure for calculating the value of bonds
 recognise the mechanics of valuation of equity shares
4.1.1 Concept of intrinsic value
A security can be evaluated by the series of dividends or interest payments
receivable over a period of time. In other words, a security can be defined
as the present value of the future cash streams. The intrinsic value of an
asset is equal to the present value of the benefits associated with it. The
expected returns (cash inflows) are discounted using the required return
commensurate with the risk. Mathematically, intrinsic value can be
represented by:

C1 C2 Cn
V0=   .... 
(1  i ) (1  i )
1 2
(1  i ) n

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Financial Management Unit 4

Where V0= value of the asset at time zero (t=0)

Ct= expected cash flow at the end of period t.
i = discount rate or the required rate of return on cash flows
n = expected life of an asset

Solved Problem – 1
Determine the value of assets of two projects, A and B, with a discount
rate of 10% and with a cash flow of Rs. 20000 and Rs. 10000. Table 4.1
depicts the cash flow of projects A and B.
Table 4.1: Cash Flow of Projects A and B

Year Cash flows of A (Rs.) Cash flows of B (Rs.)

1 20000 10000
2 20000 20000

3 20000 30000

Solution:
Value of asset A
= 20000*PVIFA (10%, 3y)
= 20000*2.487
= Rs.49470
Value of asset B
= 10000 PVIF(10%, 1) + 20000 PVIF (10%, 2) +
30000 PVIF (10%, 3)
= 10000*0.909 + 20000*0.826 + 30000*0.751
= 9090+16520+22530
= Rs.48140

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Solved Problem – 2
Calculate the value of an asset if the annual cash inflow is Rs. 5000 per
year for the next 6 years and the discount rate is 16%.
Solution:
Value of an asset

Cn
(1  i ) n

= 5000/ (1+0.16)6
= Rs.18425
or
= 5000 PVIFA (16%, 6y) = 5000*3.685
= Rs. 18425

4.1.2 Concept of book value

Book value is an accounting concept. Value is what an asset is worth today
in terms of its potential benefits. Assets are recorded at historical cost and
these are depreciated over years. Book value may include intangible assets
at acquisition cost minus amortised value. The book value of a debt is stated
at an outstanding amount. Book value of a share is calculated by dividing
the net worth by the number of outstanding shares.
Shareholders net worth = Assets – Liabilities
Net worth = Paid-up capital + Reserves + Surplus
The following factors explain the concept of book value:
 Replacement value is the amount a company is required to spend if it
were to replace its existing assets in the present condition. It is difficult
to find the cost of assets presently used by the company.
 Liquidation value is the amount a company can realise if it sold the
assets after winding up its business. It will not include the value of
intangibles as the operations of the company will cease to exist.
Liquidation value is generally the minimum value a company might
accept if it sold its business.

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 Going concern value is the amount a company can realise if it sells its
business as an operating one. This value is higher than the liquidation
value.
 Market value is the current price at which the asset or security is being
sold or bought into the market. Market value per share is generally
higher than the book value per share for profitable and growing firms.

Key Points
Book value of a share is calculated by dividing the net worth by the number
of outstanding shares.
Book value may include intangible assets at acquisition cost minus
amortised value.

4.2 Valuation of Bonds

Bonds are long-term debt instruments/fixed income (debt) instruments
issued by government agencies or big corporate houses to raise large sums
of money. They can also be referred as negotiable promissory notes that
can be used by individuals, business firms, governments, or government
agencies. Bonds issued by government agencies or public sector
companies are generally secured and those issued by private sector
companies may be secured or unsecured. The rate of interest on bonds is
fixed, and they are redeemable after a specific period. The expected cash
flow consists of annual interest payments plus repayment of principal.
Let us look at some important terms in bond valuation:
 Coupon rate is the specified rate of interest in the bond. The interest
payable at regular intervals is the product of the par value and the
coupon rate broken down to the relevant time horizon. Interest paid on a
bond is tax deductible.
 Maturity period refers to the number of years after which the par value
becomes payable to the bondholder. Generally, corporate bonds have a
maturity period of 7-10 years and government bonds, 20-25 years.
 Face value, also known as par value, is the value stated on the face of
the bond. It represents the amount that the unit borrows, which is to be
repaid at the time of maturity, after a certain period of time. A bond is
generally issued at values such as Rs. 100 or Rs. 1000.
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 Market value is the price at which the bond is traded in the stock
exchange. Market price is the price at which the bonds can be bought
and sold, and this price may be different from par value and redemption
value.
 Redemption value is the amount the bondholder gets on maturity. A
bond may be redeemed at par, at a premium (bondholder gets more
than the par value of the bond), or at a discount (bondholder gets less
than the par value of the bond.
Types of bonds
Bonds are of three types – Irredeemable bonds, redeemable bonds and
zero coupon bonds. Figure 4.1 depicts the three types of bonds.

Figure 4.1: Types of Bonds

Let us now discuss the three types of bonds in detail.

4.2.1 Irredeemable bonds or perpetual bonds
Bonds which will never mature are known as irredeemable or perpetual
bonds. Indian Companies Act restricts the issue of such bonds and
therefore, these are very rarely issued by corporates these days. In case of
these bonds, the terminal value or maturity value does not exist because
they are not redeemable. The face value is known, and the interest received
on such bonds is constant and received at regular intervals and hence, the
interest receipt resembles perpetuity. The present value is calculated as:

Where Vo is the present value; ‘I’ is the annual interest payable on the bond
and ‘’ is the required rate of interest.
If a company offers to pay Rs. 70 as interest on a bond of Rs. 1000 per
value and the current yield is 8%, the value of the bond is 70/0.08 which is
equal to Rs. 875.

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4.2.2 Redeemable bonds

Redeemable bonds are of two types, one with annual interest payments and
the other one with semi-annual interest payments.
4.2.2.1 Bonds with annual interest payments
The holder of a bond receives a fixed annual interest for a specified number
of years and a fixed principal repayment at the time of maturity. The intrinsic
value or the present value of bond can be expressed as:
V0 or P0=∑nt=1 I/(I+ Kd)n +F/(I+ Kd)n
The above expression can also be stated as:
V0 = I*PVIFA(Kd, n) + F*PVIF(Kd, n)
Where V0 = Intrinsic value of the bond
P0 = Present value of the bond
I = Annual interest payable on the bond
F = Principal amount (par value) repayable at the maturity time
n= Maturity period of the bond
Kd= Required rate of return

Solved Problem – 3
A bond whose face value is Rs. 100 has a coupon rate of 12% and a
maturity of 5 years. The required rate of interest is 10%. What is the
value of the bond?
Solution:
Interest payable = 100*12% = Rs. 12
Principal repayment is Rs. 100
Required rate of return is 10%.
V0=I*PVIFA(kd, n) + F*PVIF(kd, n)
Therefore,
Value of the bond
= 12*PVIFA (10%, 5yrs) + 100*PVIF (10%, 5yrs)
= 12*3.791 + 100*0.621
= 45.49 + 62.1
= Rs.107.59

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Solved Problem – 4
Mr. Anant purchases a bond whose face value is Rs. 1000 and which has
a nominal interest rate of 8%. The maturity period is 5 years. The
required rate of return is 10%. What is the price he should be willing to
pay now to purchase the bond?
Solution:
Interest payable = 1000*8% = Rs. 80
Principal repayment is Rs. 1000
Required rate of return is 10%
V0=I*PVIFA(Kd, n) + F*PVIF(Kd, n)
Value of the bond
= 80*PVIFA (10%, 5y) + 1000*PVIF (10%, 5y)
= 80*3.791 + 1000*0.621
= 303.28 + 621
= Rs. 924.28

This implies that the company is offering the bond at Rs. 1000 but its worth
is Rs. 924.28 at the required rate of return of 10%. The investor should not
pay more than Rs. 924.28 for the bond today.
4.2.2.2 Bond values with semi-annual interest payments
In reality, it is quite common to pay interest on bonds semi-annually. With
the effect of compounding, the value of bonds with semi-annual interest is
much more than the ones with annual interest payments. Hence, the bond
valuation equation can be modified as:
V0 or P0=∑2nt=1 I/2/(I+Kd/2)n +F/(I+Kd/2)2n
Where V0 = Intrinsic value of the bond
P0 = Present value of the bond
I/2 = Semi-annual interest payable on the bond
F = Principal amount (par value) repayable at the maturity time
2n = Maturity period of the bond expressed in half-yearly periods
kd/2 = Required rate of return semi-annually.

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Solved Problem – 5
A bond of Rs. 1000 value carries a coupon rate of 10%, maturity period
of 6 years. Interest is payable semi-annually. If the required rate of
return is 12%, calculate the value of the bond.
Solution:
V0 or P0 = ∑2nt=1 (I/2)/(I+kd/2)n +F/(I+kd/2)2n
= (100/2)/(1+0.12/2)6 + 1000/(1+0.12/2)6
= 50*PVIFA (6%, 12y) + 1000*PVIFA (6%, 12y)
= 50*8.384 + 1000*0.497
= 419.2 + 497
= Rs. 916.20
It is to be kept in mind that the required rate of return is halved (12%/2)
and the period doubled (6y*2) as the interest is paid semi-annually.

4.2.3 Zero coupon bonds

In India, zero coupon bonds are alternatively known as Deep Discount
Bonds (DDBs). These bonds became very popular in India for over a
decade because of issuance of such bonds at regular intervals by IDBI and
ICICI.
Zero coupon bonds have no coupon rate, that is, there is no interest to
be paid out. Instead, these bonds are issued at a discount to their face
value, and the face value is the amount payable to the holder of the
instrument on maturity. Thus, no interest or any other type of payment is
available to the holder before maturity. Since there is no intermediate
payment between the date of issue and the maturity date, these DDBs are
also called zero coupon bonds. The valuation of DDBs is similar to the
ordinary bonds valuation. Since DDB at the time of maturity generates only
one future cash flow, the value of this may be taken as equal to the present
value of this future cash flow discounted at the required rate of return of the
investor for the number of years of the life of DDBs. The value of DDB is
calculated as:

Value of the DDB

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FV= Face value of DDB payable at maturity

r= The required rate of return
n= Life of the DDB

Effective interest earned = Discounted issue price – Face value

They are called deep discount bonds because these bonds are long-term
bonds whose maturity some time extends up to 25 to 30 years. Reading the
compound value (FVIF) table, horizontally along the 25-year line, we find ‘r’
equals 8%. Therefore, the bond gives an effective return of 8% per annum.

Solved Problems – 6
IDBI issued deep discount bonds in 1996 which have a face value of
Rs. 200000 and a maturity period of 25 years. The bond was issued at
Rs. 5300. What is the realised yield of this zero coupon bond?
Solution:
5300 = 200000
(1+r) 25
25
(1+r) = 37.7358
1+r = (37.7358)1/25 = 1.1563
r = 15.63%

Solved Problem – 7
If a zero coupon bond is issued with a maturity value of Rs. 100000 and
is issued for a price of Rs. 2500 maturing after 20 years, then realised
yield is

Solution: 2500 = 1,00,000

(1+r)20
20
(1+r) = 1,00,000 /2500 = 40
(1+r) =[ 40]1/20
= 1.2025 or
r = 20.25%

4.2.4 Bond yield measures

The bond yield measures are categorised into two parts – current yield and
the yield to maturity.

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4.2.4.1 Current yield

Current yield measures the rate of return earned on a bond if it is purchased
at its current market price and the coupon interest that is received.

Current Yield (“CY”) = Coupon Interest/Current Market Price

Coupon rate and current yield are two different measures. Coupon rate and
current yield will be equal if the bond’s market price equals its face value.

Solved Problem – 8
Continuing with the same problem, calculate the CY if the current market
price is Rs. 920
Solution:
CY=Coupon Interest/Current Market Price
= 80/920 = 8.7%

4.2.4.2 Yield To Maturity (YTM)

Yield To Maturity (YTM) is the rate of return earned by an investor who
purchases a bond and holds it till its maturity.
The YTM is the discount rate equalling the present values of cash flow to
the current market price/purchase price.
The rate of return (Kd), which makes the discounted values of these cash
flow equal to the bond’s market value, is known as the YTM of the bond. So,
a bond’s YTM may be defined as the Internal Rate of Return (IRR) for a
given level of risk.
In other words, YTM is the IRR for the investor who buys the bond.
Calculation of YTM assumes that the bond is held till maturity. It may be
noted that like in the case of coupon yield, the YTM will equal the coupon
rate only if the bond is trading at par. The YTM of a bond is not constant
over its lifetime, and it changes as the bond price changes.
While finding out the YTM, an implied assumption is that all interest received
are reinvested at a rate of return equal to the bond’s YTM.
Discounting is the process used in bond markets to find the price of a bond.
We have already discussed this concept in the earlier chapter. We add the

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Present Values (PV) of all future cash flow to arrive at the price of the bond.
The ‘i' is substituted by the YTM while calculating the PV of bond’s future
cash flow.
YTM is an important factor in bond pricing. This is the rate applied to the
future cash flow (coupon payment) to arrive at its present value. If the YTM
increases, the present value of the cash flow will go down. This is obvious
as the YTM appears in the denominator of the formula, and we know as the
denominator increases, the value of the ratio goes down. So here as well,
as the YTM increases, the present value falls.

Solved Problem – 9
A bond has a face value of Rs. 1000 with a 5-year maturity period. Its
current market price is Rs. 883.40. It carries an interest rate of 6%. What
shall be the rate of return on this bond if it is held till its maturity?
Solution:
V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n)
883.4 = 60*PVIFA(Kd, 5yrs) + 1000*PVIF(Kd, 5yrs)
By trial and error method let us take Kd = 10%
= 60*PVIFA(10%,5yrs) +1000* PVIF (10%,5yrs)
= 60*3.791 +1000*.621
= 227.46 + 621 = 848.46 (We need to equate this value with
the current market price of Rs.883.40 by reducing the Kd rate)
Let us try Kd = 9%
= 60*3.890 + 1000*.650
= 233.40 + 650 = 883.40 = current market price. Hence YTM is 9%

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Solved Problem – 10
A bond has a face value of Rs. 1000 with a 9-year maturity period. Its
current market price is Rs. 850. It carries an interest rate of 8%. What
shall be the rate of return on this bond if it is held till its maturity?
Solution:
V0 or P0=∑nt=1 I/(I+kd)n +F/(I+kd)n
OR
V0 = I*PVIFA (kd, n) + F*PVIF (kd, n)
= 80*PVIFA (Kd%, 9) + 1000*PVIF (Kd%, 9)
= 850 (current market price)
To find out the value of Kd, trial and error method is to be followed. Let
us therefore start the value of Kd to be 12%.
The equation now looks like this:
80*PVIFA (12%, 9yrs) + 1000*PVIF(12%, 9yrs) = 850
Let us now see if LHS equals RHS at this rate of 12%. Looking at the
tables, we get LHS as:
80*5.328 + 1000*0.361 = Rs. 787.24
Since this value is less than the value required on the RHS, we take a
lesser discount rate of 10%.
At 10%, the equation is:
80*PVIFA (10%, 9yrs) + 1000*PVIF (10%, 9yrs) = 850
Let us now see if LHS equals RHS at this rate of 11%. Looking at the
tables, we get LHS as:
80*5.759 + 1000*0.424 = Rs. 884.72
We now understand that Kd clearly lies between 10% and 12%. We shall
interpolate to find out the true value of Kd.
10% + {(884.72-850)/(884.72-787.24)}*(12%-10%)
10% + (34.72/97.48)*2
10% + 0.71
Therefore Kd = 10.71%

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YTM approximation method

The trial and error method to obtain the rate of return (Kd) is a very tedious
procedure and requires lots of time. The following formula can be used as a
ready reference formula.
 F  P
I  
YTM =
 n 
F  P
 
 2 
Where YTM = Yield to Maturity
I = Annual interest payment
F = Face value or redemption value of the bond
P = Current market price of the bond
n = Number of years to maturity

Solved Problem – 11
A company issues a bond with a face value of Rs. 5000. It is currently
trading at Rs. 4500. The interest rate offered by the company is 12%,
and the bond has a maturity period of 8 years. What is the YTM?
Solution:
 F  P
I  
YTM =
 n 
F  P
 
 2 
= 600 + {(5000-4500)/8} / {(5000+4500)/2}
= {600 + 62.5} / 4750
= 13.94%

4.2.5 Bond value theorems

The following factors affect the bond value theorems:
 Relationship between the required rate of return (Kd) and the coupon
rate
 Number of years to maturity
 Yield To Maturity (YTM)
We will look at the theorems under each circumstance, as mentioned above.
A. Following are the theorems which show the effect on the bond values
influenced by the relationship between required rate of return (Kd) and
coupon rate.

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a. When the required rate of return is equal to the coupon rate, the
value of the bond is equal to its par value.
i.e., If Kd = Coupon rate; then Bond value = Par value
b. When the required rate of return (Kd) is greater than the coupon
rate, the value of the bond is less than its par value.
i.e., If Kd > Coupon rate; then, Bond value < Par Value

Solved Problem – 12
Sugam Industries wishes to issue bonds with Rs. 100 as par value,
coupon rate of 12%, and YTM of 5 years. What is the value of the bond if
the required rate of return of an investor is 12%, 14%, and 10%?
Solution:
When Kd is equal to the coupon rate, the intrinsic value of the bond is
equal to its face value.
If Kd is 12%,
V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n)
= 12*PVIFA (12%, 5) + 100*PVIF (12%, 5)
= 12*3.605 + 100*0.567
= 43.3 + 56.7
= Rs. 100 (Intrinsic value = Face value)
When Kd is greater than the coupon rate, the intrinsic value of the bond is
less than its face value.
If Kd is 14%,
V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n)
=12*PVIFA (14%, 5) + 100*PVIF (14%, 5)
=12*3.433 + 100*0.519
= 41.20 + 51.9
= Rs. 93.1 (Intrinsic value <Face value)
When Kd is lesser than the coupon rate, the intrinsic value of the bond is
greater than its face value.
If Kdis 10%,
V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n)
=12*PVIFA (10%, 5) + 100*PVIF (10%, 5)
=12*3.791 + 100*0.621
= 45.49 + 62.1
= Rs. 107.59 (Intrinsic value > Face value)

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B. Number of years of maturity

a. When Kd is greater than the coupon rate, the discount on the bond
declines as maturity approaches.

Solved Problem – 13
To show the effect of the above, consider a case of a bond whose face
value is Rs. 100 with a coupon rate of 11% and a maturity of 7 years.
If Kd is 13%, then,
V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n)
= 11*PVIFA (13%, 7) + 100*PVIF (13%, 7)
= 11*4.423 + 100*0.425
= 48.65 + 42.50
= Rs.91.15
After 1 year, the maturity period is 6 years, the value of the bond is
V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n)
= 11*PVIFA (13%, 6) + 100*PVIF (13%, 6)
= 11* 3.998 + 100*0.480
= 43.98 + 48
= Rs. 91.98.
The value of the bond increases with the passage of time (one year
later) as “Kd” is higher than the coupon rate (13%>11%).

b. When Kd is less than the coupon rate, the premium on the bond
declines as the maturity approaches.

Solved Problem – 14
Consider a case of a bond whose face value is Rs. 100 with a coupon
rate of 11% and a maturity of 7 years. Let us see the effect on the
bond value if the required rate is 8%. (Kd = 8%)
Kd is less than coupon rate (8% < 11%)

Solution:
If Kd is 8%,
V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n)
= 11*PVIFA (8%, 7) + 100*PVIF (8%, 7)
= 11*5.206 + 100*0.583

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= 57.27 + 58.3
= Rs. 115.57
One year later, with Kd at 8%,
V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n)
= 11*PVIFA (8%, 6) + 100*PVIF (8%, 6)
= 11*4.623 + 100* 0.630
= 50.85 + 63
= Rs. 113.85
For a required rate of return of 8%, the bond value decreases with
passage of time and premium on bond declines as maturity
approaches.

C. Yield to Maturity
a. A bond’s price varies inversely with yield. This is because as the
required yield increases, the present value of the cash flow decrease
and hence the price decreases. [Refer Solved Problem No.12]
Price –Yield Relationship

b. For a given difference between YTM and coupon rate of the bonds,
the longer the term of maturity, the greater will be the change in price
with change in YTM. Thus, long-term bonds are more variable to
changes in interest rates than the short-term bonds.
c. Given the maturity, the change in price of the bond will be greater
with a decrease in the bond’s YTM than the change in price of bond
with an equal increase in the bond’s YTM.
d. For any given change in YTM, the percentage price change in case
of bonds of high coupon rate will be smaller than in the case of
bonds of low coupon rate, other things being constant.

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e. A change in YTM affects the bonds with a higher YTM more than it
does to bonds with a lower YTM.

4.3 Valuation of Shares

A company’s shares can be categorised into:
 Ordinary or equity shares
 Preference shares
The returns the shareholders receive in return are called dividends.
Preference shareholders get a preferential treatment as to the payment of
dividend and repayment of capital in the event of winding up. Such holders
are eligible for a fixed rate of dividends.
The following are some important features of preference and equity shares:
 Dividends – Rate is fixed for preference shareholders. They can be
given cumulative rights, that is, the dividend can be paid off after
accumulation. The dividend rate is not fixed for equity shareholders.
They change with an increase or decrease in profits. During the years of
big profits, the management may declare a high dividend. The dividends
are not cumulative for equity shareholders, that is, they cannot be
accumulated and distributed in the later years. Dividends are not
taxable.
 Claims – In the event of the business closing down, the preference
shareholders have a prior claim on the assets of the company. Their
claims shall be settled first and the balance, if any, will be paid off to
equity shareholders. Equity shareholders are residual claimants to the
company’s income and assets.
 Redemption – Preference shares have a maturity date on which the
company pays off the face value of the shares to the holders.
Preference shares can be of two types – redeemable and irredeemable.
Irredeemable preference shares are perpetual. Equity shareholders
have no maturity date.
 Conversion – A company can issue convertible preference shares.
After a particular period, as mentioned in the share certificate, the
preference shares can be converted into ordinary shares.

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4.3.1 Valuation of preference shares

Preference shares like bonds carry a fixed rate of dividend or return.
Symbolically, this can be expressed as:
P0= Dp/{1+Kp)n } + Pn/{(1+Kp)n}
or
P0 = Dp*PVIFA (Kp, n) + Pn *PVIF (Kp, n)
Where P0= Price of the share
Dp= Dividend on preference share
Kp= Required rate of return on preference share
n= Number of years to maturity
4.3.2 Valuation of ordinary shares
People hold common stocks:
 to obtain dividends in a timely manner
 to get a higher amount when sold
Generally, shares are not held in perpetuity. An investor buys the shares,
holds them for some time during which he gets dividends, and finally sells it
off to get capital gains. The value of a share which an investor is willing to
pay is linked with the cash inflows expected and risks associated with these
inflows.
Intrinsic value can be referred to as the value of a stock which is justified by
assets, earnings, dividends, definite prospects, and the factor of the
management of the issuing company.
Intrinsic value of a share is associated with the earnings (past) and
profitability (future) of the company. Dividends pay and expect the future
definite prospects of the company. Intrinsic value of the share is the
economic value of a company considering its characteristics, nature of
business, and investment environment.

Activity 1
Investors prefer safe, stable, fixed return income. Debt plays a safer bet.
Discuss
Hint: The rate of interest on bonds is fixed, and they are redeemable
after a specific period.

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4.3.2.1 Dividend capitalisation model

When a shareholder buys a share, he is actually buying the stream of future
dividends. Therefore, the value of an ordinary share is determined by
capitalising the future dividend stream at an appropriate rate of interest. So
under the dividend capitalisation approach, the value of an equity share is
the discounted present value of dividends received plus the present value of
the resale price expected when the share is disposed. Two assumptions are
made to apply this approach. They are:
 Dividends are paid annually.
 First payment of dividend is made after one year from the day that the
equity share is bought.
A. Single period valuation model
This model holds well when an investor holds an equity share for one year.
The price of such a share will be:
D1 P1
P0  
( 1 Ke ) ( 1 Ke )
Where P0 = Current market price of the share
D1 = Expected dividend after one year
P1 = Expected price of the share after one year
Ke = Required rate of return on the equity share

Solved Problem – 15
XYZ India Ltd’s share is expected to touch Rs. 450 one year from now.
The company is expected to declare a dividend of Rs. 25 per share.
What is the price at which an investor would be willing to buy if his or her
required rate of return is 15%?
Solution:
P0 = D1/(1+Ke) + P1/(1+Ke)
= {25/(1+0.15)} + {450/(1+0.15)}
= 21.74 + 391.30
= Rs. 413.04
An investor would be willing to buy the share at Rs. 413.04

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B. Multi period valuation model

An equity share can be held at an indefinite period as it has no maturity
date. The value of an equity share of infinite duration is equal to the
discounted value of the flow of dividend of infinite period.
P0 = D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +………..+ D∞/(1+Ke)n = ∞
Or
n
P0 = ∑ t=1 Dt/ (1+Ke)t
Where P0 = Current market price of the share
D1 = Expected dividend after one year
P1 = Expected price of the share after one year
D∞ = Expected dividend at infinite duration
Ke= Required rate of return on the equity share.
The above equation can also be modified to find the value of an equity
share for a finite period.
P0 = D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +……..+ (Dn+ Pn)/(1+Ke)n
P0=∑nt=1 Dt/(1+Ke)t + Pn/(1+Ke)n

4.3.2.2 Types of dividends

We can come across three types of dividends in companies. They are:
 Constant dividends
 Constant growth of dividends
 Changing growth rates of dividends
A. Valuation with constant dividends
If constant dividends are paid year after year, then:
P0 = D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +………..+ D∞/(1+Ke)
Simplifying this we get:
P = D/Ke
B. Valuation with constant growth in dividends
Here, we assume that dividends tend to increase with time as and when
businesses grow over time. If the increase in dividend is at a constant
compound rate, then
Po = D1 / (Ke – g)
Where, g stands for constant compound growth rate.

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Solved Problem – 16
Sagar Automobiles Ltd’s share is traded at Rs. 180. The company is
expected to grow at 8% per annum and the dividend expected to be
paid off is Rs. 8. If the rate of return is expected to be 12%, what is the
price of the share one would be expected to pay today?
Solution:
Po = D1 / (Ke – g)
= 8/0.12-0.08
= Rs. 200
The price of one share today would be Rs. 200.

Solved Problem – 17
Monica Labs are expected to pay Rs. 4 as dividend per share next year.
The dividends are expected to grow perpetually at 8%. Calculate the
share price today if the market capitalisation is 12%.
Solution:
Po = D1 / (Ke – g)
P0 = 4/(0.12-0.08)
= Rs. 100
The share price today would be Rs. 100.

C. Valuation with changing growth in dividends

Some firms may not have a constant growth rate of dividends indefinitely.
There are periods during which the dividends may grow super normally, that
is, the growth rate is very high when the demand for the company’s products
is very high. After a certain period of time, the growth rate may fall to normal
levels when the returns fall due to fall in demand for products (with
competition setting in or due to availability of substitutes).
The price of the equity share of such a firm is determined in the following
manner:
1. Expected dividend flows during periods of supernormal growth is to
be considered and present value of this is to be computed with the
following equation:
a. P0=∑nt=1 Dn/(1+Ke)n

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2. Value of the share at the end of the initial growth period is calculated
as:
a. Pn=(Dn+1)/ (Ke-gn ) (constant growth model)
b. This is discounted to the present value and we get:
c. [(Dn+1)/ (Ke- gn)] * [1 / (1+Ke)n ]
3. Add both the present value composites to find the value P0 of the
share, that is,
P0=∑nt=1 Dn/(1+Ke)n + (Dn+1)/(Ke-gn)* [1/(1+Ke)n]
Where,
P0 = Price of equity share
Dn = D1(1+ge)n-1
D1 = expected dividend a year hence
ga = super normal growth rate of dividends
gn = normal growth rate of dividends

Solved Problem – 18
Souparnika Pharma’s current dividend is Rs. 5. It expects to have a
supernormal growth period running to 5 years during which the growth
rate would be 25%. The company expects normal growth rate of 8% after
the period of supernormal growth period. The investor’s required rate of
return is 15%. Calculate what the value of one share of this company is
worth.
Solution:
D0 = 5, n = 5y, ga (supernormal growth) = 25%, gn (normal growth) = 8%,
Ke = 14%

Step I:
P0 = ∑nt=1 Dn/(1+Ke)n
D1 = 5 (1.25)1
D2 = 5 (1.25)2
D3 = 5 (1.25)3
D4 = 5 (1.25)4
D5 = 5 (1.25)5

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The present value of this flow of dividends will be:

= 5(1.25)/(1.15) + 5(1.25)2/(1.15)2 + 5(1.25)3/(1.15)3 + 5(1.25)4/(1.15)4 +
5(1.25)5/(1.15)5
= 5.43+ 5.92 + 6.42 + 6.98 + 7.63 = 32.38
Step II:
Pn= (Dn+1)/(Ke-g)
P5 = D6/Ke-gn
= D5(1+gn)/Ke-gn
= {5(1.25)5(1+0.08)} / (0.15-0.08)
= 15.26(1.08) / 0.07
= 16.48 / 0.07
= 235.42
The discounted value of this price is 235.42/(1.15)5 = Rs. 117.12
Step III:
P0 = ∑nt=1 Dn/(1+Ke)n + (Dn+1)/(Ke-gn)*1/(1+Ke)n
The value of the share is Rs. 32.38 + Rs. 117.12 = Rs.149.50

4.3.2.3 Other approaches to equity valuation

In addition to the dividend valuation approaches discussed in the previous
section, there are other approaches to valuation of shares based on “ratio
approach”.
Book value approach:
The Book Value Per Share (BVPS) is the net worth of the company divided
by the number of outstanding equity shares.
Net worth is represented by the total sum of paid-up equity shares,
reserves, and surplus. Alternatively, this can also be calculated as the
amount per share on the sale of the assets of the company at their exact
book value minus all liabilities including preference shares.

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Solved Problem – 19
One Ltd. has total assets worth Rs. 500 crore, liabilities worth Rs. 300
crore, and preference shares worth Rs. 50 crore, and equity shares
numbering 10 lakh. Calculate BVPS.
Solution:
The BVPS is Rs. 150 crore/10 lakh = Rs. 150.
BVPS does not give a true investment picture. This relies on historical
book values than the company’s earning potential.

Liquidation value
The liquidation value per share is calculated as:
{(Value realised by liquidating all assets) – (Amount to be paid to all the
credit and preference shares)} divided by number of outstanding shares.
In the above example, if the assets can be liquidated at Rs. 450 crore., the
liquidation value per share is (450 crore-350 crore)/10 lakh shares which is
equal to Rs. 1000 per share.
4.3.3 Price earnings ratio
The price earnings ratio reflects the amount investors are willing to pay for
each rupee of earnings.
Expected earnings per share = (Expected PAT) – (Preference
dividend)/Number of outstanding shares.
Expected PAT is dependent on a number of factors like sales, gross profit
margin, depreciation, and interest and tax rate. The price earnings ratio has
to consider factors like growth rate, stability of earnings, company size,
company management team, and dividend payout ratio.

Where, 1-b is dividend payout ratio

r is required rate of return
ROE*b is expected growth rate

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Self Assessment Questions

1. ___________ is the minimum value the company accepts if it sold its
business.
2. ___________ per share is generally higher than the book value per
share for profitable and growing firms.
3. Bonds issued by ____________ are secured and those issued by
private sector companies may be _________ or ___________.
4. ___________ is the rate earned by an investor who purchases a bond
and holds it till its maturity.
5. When Kd is lesser than the coupon rate, the value of the bond is
_________ than its face value.
6. ___________of a share is associated with the earnings (past) and
profitability (future) of the company, dividends paid and expected, and
future definite prospects of the company.
7. The _______________ is the net worth of the company divided by the
number of outstanding equity shares

4.4 Summary
Let us recapitulate the important concepts discussed in this unit:
 Valuation is the process which links the risk and return to establish the
asset worth. The value of a bond or a share is the discounted value of all
their future cash inflows (interest/dividend) over a period of time. The
discount rate is the rate of return which the investors expect from the
securities.
 In case of bonds, the stream of cash flows consists of annual interest
payment and repayment of principal (which may take place at par, at a
premium, or at a discount). The cash flows which occur in each year are
a fixed amount. Cash flows for preference share are also a fixed
amount, and these shares may be redeemed at par, at a premium, or at
a discount.
 The equity shareholders do not have a fixed rate of return. Their
dividend fluctuates with profits. Therefore, the risk of holding an equity
share is higher than holding a preference share or a bond. Equity share
valuation is usually done using the dividend capitalisation method. The
valuation is based on the flow of dividends.
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4.5 Glossary
Book value per share (BVPS): The net worth of the company divided by
the number of outstanding equity shares.
Net worth: Total sum of paid up equity shares, reserves, and surplus.
Yield to maturity: The rate of return earned by an investor who purchases
a bond and holds it till its maturity.

4.6 Solved Problems

Solved Problem – 20
The current price of an Ashok Leyland share is Rs. 30. The company is
expected to pay a dividend of Rs. 2.50 per share which goes up
annually at 6%. If an investor’s required rate of return is 11%, should he
or she buy this share or not?
Solution:
P = D1 (1+g) / Ke-g = 2.5(1+0.06) / 0.11-0.06 = Rs. 53
The investor should certainly buy this share at the current price of Rs. 30
as the valuation model says the share is worth Rs. 53.

Solved Problem – 21
A bond with a face value of Rs. 100 provides an annual return of 8%
and pays Rs. 125 at the time of maturity, which is 10 years from now. If
the investor’s required rate of return is 12%, what should be the price of
the bond?
Solution:
P = Int*PVIFA (12%, 10y) + Redemption value*PVIF (12%, 10y)
= 8*PVIFA (12%, 10y) + 125*PVIF (12%, 10y)
= 8*5.65 + 125*0.322
= 45.2 + 40.25 = Rs. 85.45
The price of the bond should be Rs. 85.45.

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Solved Problem – 22
The bond of Silicon Enterprises with a par value of Rs. 500 is currently
trading at Rs. 435. The coupon rate is 12% with a maturity period of 7
years. What will be the yield to maturity?
Solution:
r = I + {(F-P)/n} / (F+P)/2
= 60 + {(500-435)/7} / (500+435)/2
= 15.03%
The yield to maturity will be 15.03%

Solved Problem – 23
The share of Megha Ltd. is sold at Rs. 500 a share. The dividend likely
to be declared by the company after one year is Rs. 25 per share.
Hence, the price after one year is expected to be Rs. 550. What is the
return at the end of the year on the basis of likely dividend and price per
share?
Solution:
Holding period return = (D1 + Price gain/loss) / purchase price
= (25 + 50) / 500 = 15%
The return at the end of the year will be 15%.

Solved Problem – 24
A bond of face value of Rs. 1000 and a maturity of 3 years pays 15%
interest annually. What is the market price of the bond if YTM is also
15%?
Solution:
P = Int*PVIFA (15%, 3y) + Redemption value*PVIF (15%, 3y)
P = 150*2.283 + 1000*0.658
P = 342.45 + 658 = Rs. 1000.45
The market price of the bond is Rs. 1000.45.

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4.7 Terminal Questions

1. What should be the price of a bond which has a par value of Rs. 1000
carrying a coupon rate of 8% and having a maturity period of 9 years?
The required rate of return of the investor is 12%.
2. A bond of Rs. 1000 value carries a coupon rate of 10% and has a
maturity period of 6 years. Interest is payable semi-annually. If the
required rate of return is 12%, calculate the value of the bond.
3. A bond whose par value is Rs. 500 bearing a coupon rate of 10% and
has a maturity of 3 years. The required rate of return is 8%. What should
be the price of the bond?
4. If the current year’s dividend is Rs. 24, growth rate of a company is 10%,
and the required return on the stock is 16%, what is the intrinsic value of
the stock?
5. If a stock is purchased for Rs. 120 and held for one year during which
time Rs. 15 dividend per share is paid and the price decreases to
Rs. 115, what is the nominal return on the share?

4.8 Answers

Self Assessment Questions

1. Liquidation value
2. Market value
3. Government agencies, secured or unsecured
4. Yield To Maturity
5. Greater
6. Intrinsic value
7. Book Value Per Share (BVPS)

Terminal Questions
1. P = Int*PVIFA (12%, 9y) + Redemption Price*PVIF (12%, 10y)
= 80*PVIFA (12%, 9) + 1000*PVIF (12%, 9y)
= 80*5.328 + 1000*0.361
= 426.24 + 361 = Rs. 787.24

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2. P = 50*PVIFA (6% + 12y) + 1000*PVIF (6% + 12y)

= 50*8.384 + 1000*0.497
= Rs. 916.2
3. P = Int*PVIFA (8%, 3y) + Redemption Price*PVIF (8%, 3y)
= 50*2.577 + 500*0.794
= 128.85 + 397 = Rs. 525.85
4. Intrinsic value = 24 {(1+0.1)} / 0.16-0.1 = Rs. 440
5. Holding period return = (D1 + Price gain/loss) / purchase price
{15 + (-5)} / 120 = 8.33%

4.9 Case Study: Dividend Decision

ABG Limited is a public company, under the Companies Act 1956,
incorporated on January 19th, 1989 with its registered office at Lucknow,
Uttar Pradesh. The company obtained certificate for commencement of
business on April 10th, 1990.The company was promoted by Mr. P. Garg
who is the Chairman and Managing Director of the Company.
The company manufactures hydrogenated vegetable oil (Vanaspati Ghee)
and refined oils. Though the company, when started, was a modest one, it is
now among the largest manufacturing company of hydrogenated vegetable
oil in the country. The products of the company are marketed under the
brand name of ‘Sunshine’ which has been well accepted in the market.
In October 2011, the company declared dividend at Rs. 0.20 per share of
Rs. 1/- each on equity shares for the year ended March 31, 2011. The
market value of the share is presently Rs.14 per share.
They have recently announced signing of MOUs for collaboration on new
technology and other ventures. Their company was recently awarded the
ISO 9001-2000 accreditation.

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Financial Management Unit 4

Balance Sheet (Rs. in crore)

Mar 2011 Mar 2010 Mar 2009 Mar 2008 Mar 2007

Sources of Funds

Total Share Capital 12.84 12.84 25.11 12.30 7.50

Equity Share Capital 12.84 12.84 7.50 7.50 7.50

Share Application Money 19.00 0.00 0.00 0.00 0.00

Preference Share Capital 0.00 0.00 17.61 4.80 0.00

Reserves 210.21 163.19 97.82 71.16 49.24

Revaluation Reserves 0.00 0.00 0.00 0.00 0.00

Networth 242.05 176.03 122.93 83.46 56.74

Secured Loans 130.55 295.38 206.51 61.26 105.65

Unsecured Loans 18.01 45.00 25.00 9.00 20.00

Total Debt 148.56 340.38 231.51 70.26 125.65

Total Liabilities 390.61 516.41 354.44 153.72 182.39

Application of Funds

Gross Block 192.61 162.66 128.47 69.60 53.59

Less: Accum. Depreciation 34.23 25.72 19.21 15.30 12.15

Net Block 158.38 136.94 109.26 54.30 41.44

Capital Work in Progress 10.39 1.54 1.54 0.01 4.05

Investments 19.72 9.09 8.20 32.01 2.36

Inventories 311.59 223.93 135.03 206.61 138.77

Sundry Debtors 120.80 99.40 73.50 77.46 19.28

Cash and Bank Balance 50.66 30.68 125.34 25.37 8.34

Total Current Assets 483.05 354.01 333.87 309.44 166.39

Loans and Advances 96.66 95.97 58.17 44.37 22.39

Fixed Deposits 282.11 267.20 129.44 61.27 117.43

Total CA, Loans and

861.82 717.18 521.48 415.08 306.21
Advances

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Financial Management Unit 4

Deferred Credit 0.00 0.00 0.00 0.00 0.00

Current Liabilities 640.26 329.36 273.80 339.57 166.61

Provisions 19.44 18.98 12.24 8.11 5.05

Total CL and Provisions 659.70 348.34 286.04 347.68 171.66

Net Current Assets 202.12 368.84 235.44 67.40 134.55

Miscellaneous Expenses 0.00 0.00 0.00 0.00 0.00

Total Assets 390.61 516.41 354.44 153.72 182.40

Contingent Liabilities 1.16 0.94 0.71 0.71 0.97

Book Value (Rs) 17.37 137.05 140.43 104.88 75.65

Discussion Questions:
1. The dividend per share paid by the company is expected to grow at a
rate of 25% for the next three years. After that, the growth rate is
expected to drop to a stable level, which will continue forever.
(Hint: Refer to valuation of shares)
2. If the required rate of return on this company’s stock is 20%,
determine the expected growth rate of the dividends after three
years.
(Hint: Refer to valuation of shares)
3. Suppose, the dividend history of the company is as follows:
Year 1 2 3
Dividend per share (Rs.) 1.00 1.50 1.80
Dividend yield (%) 2.3 6.0 8.2

If the dividends are expected to grow at the same rate as during the
period given above, compute the price at the end of year 3 as well as
the required rate of return of the equity investors of the company.
State the variations in market price between years 1 and 3.

(Hint: Refer to valuation of shares)

Source: www.moneycontrol.com

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References:
 Keown, Arthur J. (2005). Financial Management. Principles and
Applications, 10th Edition.
 "Time Value of Money", (2008) Finance for Engineers,
E-References:
 www.ideaindia.org retrieved on 11-12-2011
 www.finmin.nic.in retrieved on 11-12-2011
 www.moneycontrol.com 11-12-2011

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Financial Management Unit 5

Unit 5 Cost of Capital

Structure:
5.1 Introduction
Objectives
5.2 Meaning of Cost of Capital
5.3 Cost of Different Sources of Finance
Cost of debentures
Cost of term loans
Cost of preference capital
Cost of equity capital
Dividend forecast approach
Capital Asset Pricing Model approach
Earnings price ratio approach
Cost of retained earnings
5.4 Weighted Average Cost of Capital
Assignment of weights
5.5 Summary
5.6 Glossary
5.7 Solved Problems
5.8 Terminal Questions
5.9 Answers
5.10 Case Study

5.1 Introduction
In the last unit, we discussed about the valuation of bonds and shares. In
this unit, we will learn about the meaning of cost of capital, cost of different
sources of finance, and weighted average cost of capital. Capital structure
is the mix of long-term sources of funds like debentures, loans, preference
shares, equity shares, and retained earnings in different ratios.
It is always advisable for companies to plan their capital structure. We have
discussed in the previous units that all the financial decisions taken by not
assessing things in a correct manner may jeopardise the very existence of
the company. Firms may prosper in the short run by not indulging in proper
planning but ultimately may face problems in the future. With unplanned

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Financial Management Unit 5

capital structure, they may also fail to economise the use of their funds and
adapt to the changing conditions.
Objectives:
After studying this unit, you should be able to:
 define cost of capital
 explain how cost of different source of finance is determined
 compute weighted average cost of capital

5.2 Meaning of Cost of Capital

Capital, like any other factor of production, involves a cost. The cost of
capital is a significant element in capital expenditure management. The cost
of capital of a company is the average cost of different components of
capital of all long-term sources of finance. Understanding the cost of capital
concept is very helpful in making investment and financing decision. A
combination of debt and equity is used to fund the activities of a company.
What should be the proportion of debt and equity? This depends on the
costs associated with raising various sources of funds.
The cost of capital is the minimum rate of return of a company which it must
earn to meet the expenses of the various categories of investors who have
made investment in the form of loans, debentures, equity, and preference
shares.
A company being able to meet these demands may face the risk of
investors taking back their investments thus leading to bankruptcy.
Loans and debentures come with a predetermined interest rate. Preference
shares also have a fixed rate of dividend while equity holders expect a
minimum return of dividend based on their risk perception and the
company’s past performance in terms of payout dividends.

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Figure 5.1 depicts the risk-return relationship of various securities.

Equity
share
Required rate of return

Preference
share

Debt

Govt bonds

Risk free
security

Risk-Return relationship of various securities

Figure 5.1: Risk-Return Relationship

The concept of cost of capital is a very important concept in financial

management decision making. Any efficient management team will take
cost of capital into consideration while taking any financial decisions. This
concept is rather relevant in the following managerial decisions:
 Capital budgeting decision
 Designing the capital/ financial structure of the firm
 Ascertaining the best method/mode of financing
 Performance of top management
 Other areas include dividend decisions, working capital policy, etc.

5.3 Cost of Different Sources of Finance

In making investment decisions, cost of different types of capital is
measured and compared. The source, which is the cheapest, is chosen and
capital is raised.
The area to be focussed on is how to measure the cost of different sources
of capital. It is based largely on forecasts and is subject to various margins
of error. While computing the cost of capital, care should be taken for factors
like needs and requirements of the company, the conditions under which it

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is raising its capital, corporate policy constraints, and level of expectations of

investors.
A company raises funds from different sources, and therefore, composite
cost of capital can be determined after specific cost of each type of fund has
been obtained. It is, therefore, necessary to determine the specific cost of
each source in order to determine the minimum obligation of a company,
i.e., composite cost of raising capital.
In order to determine the composite cost of capital, the specific costs of
different sources of raising funds are calculated. The weighted arithmetic
average of the cost of different financial resources that a company uses is
termed as its cost of capital.
The various sources of finance and their costs are explained in this section.
5.3.1 Cost of debentures
The cost of debenture is the discount rate which equates the net proceeds
from issue of debentures to the expected cash outflows.
The expected cash outflows relate to the interest and principal repayments.
I (1  T )  F  P  / n
Kd=
(F  P ) / 2

Where Kd is post tax cost of debenture capital

I is the annual interest payment per unit of debenture
T is the corporate tax rate
F is the redemption price per debenture
P is the net amount realised per debenture
n is maturity period

Solved Problem – 1
Lakshmi Enterprise wants to have an issue of non-convertible
debentures (NCD) for Rs. 10 crore. Each debenture is of a par value of
Rs. 100 having an interest rate of 15%. Interest is payable annually and
they are redeemable after 8 years at a premium of 5%. The company is
planning to issue the NCD at a discount of 3% to help in quick
subscription. If the corporate tax rate is 50%, what is the cost of
debenture to the company?

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Solution:
I(1 T )  ( F  P ) / n
Kd 
(F  P ) / 2
15 (1 0.5 )  (105  97 ) / 8

(105  97 ) / 2
7 .5  1

101
 0.084 0 r 8.4%

5.3.2 Cost of term loans

Term loans are loans taken from banks or financial institutions for a
specified number of years at a predetermined interest rate. The cost of term
loans is equal to the interest rate multiplied by (1-tax rate).
The interest is multiplied by (1-tax rate) as interest on term loans is also tax
deductible.
Kt = I (1—T)
Where I is interest rate,
T is tax rate

Solved Problem – 2
Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9%
interest. What is the cost of term loan if the tax rate is 40%?
Solution:
Kt = I (1—T) = 9(1—0.4) = 5.4%
The cost of term loan is 5.4%

5.3.3 Cost of preference capital

The cost of preference share Kp is the discount rate which equates the
proceeds from preference capital issue to the dividend and principal
repayments. It is expressed as:
Kp= (D + {(F – P) / n} / ((F + P) / 2)

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Where Kp is the cost of preference capital

D is the preference dividend per share payable
F is the redemption price
P is the net proceeds per share
n is the maturity period

Solved Problem – 3
C2C Ltd. has recently come out with a preference share issue to the tune
of Rs. 100 lakh. Each preference share has a face value of 100 and a
dividend of 12% payable. The shares are redeemable after 10 years at a
premium of Rs. 4 per share. The company hopes to realise Rs. 98 per
share now. Calculate the cost of preference capital.
Solution:
D  ( F  P ) / n
Kp 
(F  P ) / 2

12  (104  98 ) / 10 12.6
 
(104  98 ) / 2 101

Kp = 0.1247 or 12.47%
The cost of preference capital now will be 12.47%

5.3.4 Cost of equity capital

Equity shareholders, unlike preference shareholders, do not have a fixed
rate of return on their investment. There is no binding legal requirement
(unlike in the case of loans or debentures where the rates are governed by
the deed) to pay regular dividends to them. Measuring the rate of return to
equity holders is always a difficult and complex exercise.
There are many approaches for estimating return – the dividend forecast
approach, capital asset pricing approach, realised yield approach,
earnings – price ratio approach, and bond yield plus risk premium approach.
We will have a brief look at some of these models in the following pages.
5.3.4.1 Dividend forecast approach
According to dividend forecast approach, the intrinsic value of an equity
share is the sum of present values of dividends associated with it.

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Dividends cannot be accurately forecasted as they may sometimes be nil or

have a constant growth or sometimes have supernormal growth periods.
Hence, it is not possible to arrive at the price per equity share on the basis
of forecast of future streams of dividends.
The following is a simplified equation that arrives at the rate of return
required by the equity shareholders.
Ke = (D1/Pe) + g
This equation is modified from the equation, Pe= {D1/Ke-g}. This equation is
arrived at with the assumption that there is a constant growth in dividends.
If the current market price of the share is given (Pe), and the values of
D1 and ‘g’ are known, the equation is then rewritten as Ke = (D1/Pe) + g
5.3.4.2 Capital asset pricing model approach
This model establishes a relationship between the required rate of return of
a security and its systematic risks expressed as “β”. According to this model,
Ke = Rf + β (Rm – Rf)
Where Ke is the rate of return on share
Rf is the risk free rate of return
β is the beta of security
Rm is rate of return on market portfolio
Beta (β) of a security is a measure of a stock's volatility in relation to the
market. By definition, the market has a beta of 1.0, and individual stocks are
ranked according to how much they deviate from the market. A stock that
swings more than the market over time has a beta above 1.0. If a stock
moves less than the market, the stock's beta is less than 1.0. High-beta
stocks are supposed to be riskier but provide a potential for higher returns.
Low-beta stocks pose less risk but also lower returns.
Beta is a key component for the Capital Asset Pricing Model (CAPM), which
is used to calculate cost of equity. We know that the cost of
capital represents the discount rate used to arrive at the present value of a
company's future cash flows. All things being equal, the higher a company's
beta, the higher its cost of capital discount rate. The higher the discount
rate, the lower the present value placed on the company's future cash flows.
In short, beta can impact a company's share valuation.

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The CAPM model is based on some assumptions, some of which are:

 Investors are risk-averse.
 Investors make their investment decisions on a single-period horizon.
 Transaction costs are low and therefore can be ignored. This translates
to assets being bought and sold in any quantity desired. The only
considerations that matter are the price and amount of money at the
investor’s disposal.
 All investors agree on the nature of return and risk associated with each
investment.

Solved Problem – 4
What is the rate of return for a company if its β is 1.5, risk free rate of
return is 8%, and the market rate or return is 20%?
Solution:
Ke = Rf + β (Rm — Rf)
= 0.08 + 1.5(0.2-0.08)
= 0.08 + 0.18
= 0.26 or 26%
The rate of return is 26%

5.3.4.3 Earnings price ratio approach

Under the case of earnings price ratio approach, the cost of equity can be
calculated as:
Ke = E1/P
Where E1 = expected EPS for the next year
P = current market price per share
E1 is calculated by multiplying the present EPS with (1 + Growth rate).
This ratio assumes that the EPS will remain constant from the next year
onwards.
Is equity capital free of cost?
Some people are of the opinion that equity capital is free of cost as a
company is not legally bound to pay dividends and also as the rate of equity
dividend is not fixed like preference dividends. This is not a correct view as
equity shareholders buy shares with the expectation of dividends and capital

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appreciation. Dividends enhance the market value of shares and therefore,

equity capital is not free of cost.

Solved Problem – 5
Suraj Metals are expected to declare a dividend of Rs. 5 per share and the
growth rate in dividends is expected to grow @ 10% p.a. The price of one
share is currently at Rs. 110 in the market. What is the cost of equity
capital to the company?
Solution:
Ke = (D1/Pe) + g
= (5/110) + 0.10
= 0.1454 or 14.54%

Cost of equity capital is 14.54%

5.3.5 Cost of retained earnings

A company’s earnings can be reinvested in full to fuel the ever-increasing
demand of company’s fund requirements or they may be paid off to equity
holders in full or they may be partly held back and invested and partly paid
off. These decisions are taken keeping in mind the company’s growth
stages.
High-growth companies may reinvest the entire earnings to grow more,
companies with no growth opportunities and return the funds earned to their
owners. Companies with constant growth invest a little and return the rest.
Shareholders of companies with high-growth prospects utilising funds for
reinvestment activities have to be compensated for parting with their
earnings.
Therefore, the cost of retained earnings is the same as the cost of
shareholder’s expected return from the firm’s ordinary shares. So,
Kr = Ke
The cost of retained earnings is always less than the cost of new issue of
ordinary shares due to absence of floating costs.
Some regard that cost of retained earnings is nil but it is not so. Retained
earnings also have opportunity cost which can be computed.

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If the entire earning is not distributed and the firm retains a part, then these
retained earnings are available within the firm. Companies are not required
to pay any dividend on retained earnings. It is generally observed that this
source of finance is cost free, but it is not true. If earnings were not retained,
they would have been paid out to the ordinary shareholders as dividend.
This dividend forgone by the equity shareholders is opportunity cost. The
firm is required to earn on retained earnings, at least equal to the rate that
would have been earned by the shareholders, if they were distributed to
them. So the cost of retained earnings may be defined as opportunity cost in
terms of dividends forgone by withholding from the equity shareholders.
This can be expressed as:

Where, Kr = Cost of retained earnings

Ti = Marginal income tax rate applicable to an individual
T0 = Capital gain tax
D = Dividends per share
P = Price of share
Cost of retained earnings and cost of external equity
As we have just learnt that if retained earnings are reinvested in business
for growth activities, the shareholders expect the same amount of returns
and therefore
Ke=Kr
However, it should be borne in mind by the policy makers that floating of a
new issue and people subscribing to the new issue will involve huge
amounts of money towards floating costs. This need not be incurred if
retained earnings are utilised towards funding activities.
Cost of external equity comes into picture when the floatation costs arise in
the process of raising equity from the market. It is the rate of return that the
company must earn on the net funds raised in order to satisfy the equity
holder’s demand for return.

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From the dividend capitalisation model, the following model can be used for
calculating cost of external equity.
Ke = {D1/P0(1—f)} + g
Where, Ke is the cost of external equity
D1 is the dividend expected at the end of year 1
P0 is the current market price per share
g is the constant growth rate of dividends
f is the floatation costs as a percentage of current market price
The following formula can be used as an approximation:
Ke = Ke/(1—f)
Where Ke is the cost of external equity
Ke is the rate of return required by equity holders
f is the floatation cost
This formula can be used for all other approaches for which there is no
particular method for accounting for the floatation costs.

Solved Problem – 6
Alpha Ltd. requires Rs. 400 crore to expand its activities in the southern
zone of India. The company’s CFO is planning to get Rs. 250 crore
through a fresh issue of equity shares to the general public and for the
balance amount; he proposes to use ½ of the reserves which are
currently to the tune of Rs. 300 crore. The equity investor’s expectations
of returns are 16%. The cost of procuring external equity is 4%. What is
the cost of external equity?
Solution:
We know that Ke= Kr, that is Kr is 16%
Cost of external equity is
Ke = Ke/(1—f)
0.16/(1– 0.04) = 0.1667 or 16.67%
Hence, cost of external equity is 16.67%

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Key Point
Dividends cannot be accurately forecasted as they might sometimes
become nil or have a constant growth or sometimes have supernormal
growth periods.

Activity 1:
Make a list of companies which have declared dividends and/or bonus
shares in the last 3 years.
Refer: websites

5.4 Weighted Average Cost of Capital

In the previous section, we have calculated the cost of each component in
the overall capital of the company. The term, cost of capital, refers to the
overall composite cost of capital or the weighted average cost of each
specific type of fund. The purpose of using weighted average is to consider
each component in proportion to their contribution to the total fund available.
Use of weighted average is preferable to simple average method for the
reason that firms do not procure funds equally from various sources and
therefore simple average method is not used. The following steps are
involved to calculate the WACC:
Step I: Calculate the cost of each specific source of fund, that of debt,
equity, preference capital, and term loans.
Step II: Determine the weights associated with each source.
Step III: Multiply the cost of each source by the appropriate weights.
Step IV: Add these weighted costs, as calculated in Step III, to determine
the WACC as given below:
WACC = W e Ke + W r Kr + W p Kp + W d Kd + W t Kt
Assignment of weights
Weights can be assigned based on any of the following methods:
 The book value of the sources of the funds in capital structure
 Present market value of funds in the capital structure
 Adoption of finance planned for capital budget for the next period

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As per the book value approach, weights assigned would be equal to each
source’s proportion in the overall funds. The book value method is
preferable. The market value approach uses the market values of each
source, and the disadvantage in this method is that these values change
very frequently.

Solved Problem – 7
Table 5.1 depicts the capital structure of Prakash Packers Ltd.
Table 5.1: Capital Structure in Lakhs

Equity capital (Rs. 10 par value) 200

14% preference share capital Rs. 100 each 100
Retained earnings 100
12% debentures (Rs. 100 each) 300
11% term loan from ICICI bank 50
Total 750

The market price per equity share is Rs. 32. The company is expected to
declare a dividend per share of Rs. 2 per share, and there will be a
growth of 10% in the dividends for the next 5 years. The preference
shares are redeemable at a premium of Rs. 5 per share after 8 years and
are currently traded at Rs. 84 in the market. Debenture redemption will
take place after 7 years at a premium of Rs. 5 per debenture and their
current market price Rs. 90 per unit. The corporate tax rate is 40%.
Calculate the WACC.

Solution:
Step I: Determine the cost of each component.
Ke = ( D1/P0) + g
= (2/32) + 0.1
= 0.1625 or 16.25%
Kp = [D + {(F—P)/n}] / {F+P)/2}
= [14 + (105—84)/8] / (105+84)/2
=16.625/94.5
= 0.1759 or 17.59%

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Kr = Ke which is 16.25%
Kd = [I(1—T) + {(F–P)/n}] / {F+P)/2}
= [12(1—0.4) + (105—90)/7] / (105+90)/2
= [7.2 + 2.14] / 97.5
= 0.096 or 9.6%
Kt = I(1–T)
= 0.11(1–0.4)
= 0.066 or 6.6%
Step II: Calculate the weights of each source.
We= 200/750 = 0.267
Wp = 100/750 = 0.133
Wr= 100/750 = 0.133
Wd = 300/750 = 0.4
Wt= 50/750 = 0.06
Step III: Multiply the costs of various sources of finance with
corresponding weights, and WACC is calculated by adding all these
components
WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt
= (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) +
(0.06*0.066)
= 0.043 + 0.023 + 0.022 + 0.0384 + 0.004
= 0.1304 or 13.04%
The value of WACC is 13.04%

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Solved Problem – 8
Johnson Cool Air Ltd. would like to know the WACC. The following
information is made available to you in this regard.
The after tax cost of capital are:
 Cost of debt 9%
 Cost of preference shares 15%
 Cost of equity funds 18%
The capital structure is as follows:
 Debt Rs. 6,00,000
 Preference capital Rs. 4,00,000
 Equity capital Rs. 10,00,000
Solution:
Table 5.2 depicts the calculated WACC.
Table 5.2: WACC
Fund source Amount Ratio Cost Weighted cost
Debt Rs. 600000 0.3 0.09 0.027
Preference capital Rs. 400000 0.2 0.15 0.030
Equity capital Rs. 1000000 0.5 0.18 0.090
Total Rs. 2000000 1.0 0.147

WACC is 14.7%.

Solved Problem – 9
Manikyam Plastics Ltd. wants to enter into the arena of plastic moulds
next year for which it requires Rs. 20 crore to purchase new equipment.
The CFO has made available the following details based on which you are
required to compute the weighted marginal cost of capital.
 The amount required will be raised in equal proportions by way of debt
and equity (new issue and retained earnings put together account for
50%)
 The company expects to earn Rs. 4 crore as profits by the end of the
year after which it will retain 50% and payoff rest to the shareholders.
 The debt will be raised equally from two sources - loans from IOB
costing 14% and from the IDBI costing 15%.

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 The current market price per equity share is Rs. 24 and hence the
dividend payout one year will be Rs. 2.40. Tax rate is 50%
Solution:
Ke = (D1/P0)
= (2.40 / 24) = 0.1 or 10%
Cost of equity Ke = cost of retained earnings
Kt = I(1 – T) [14% loan from IOB]
= 0.14(1 – 0.5) = 0.07 or 7%
Kt = I(1 – T) [15% IDBI loan]
= 0.15(1 – 0.5) = 0.075 or 7.5%

Table 5.3 depicts the computation of weighted marginal cost of capital.

Table 5.3 Weighted Cost of Capital
Source of funds Weights After tax cost Weighted cost
Equity capital 0.4 0.1 0.040
Retained earnings 0.1 0.1 0.010
14% loan from IOB 0.25 0.07 0.0175
15% IDBI loan 0.25 0.075 0.0188
Total 0.0863
Weighted average cost of capital 8.63%

Solved Problem – 10
Canara Paints has paid a dividend of 40% on its share of Rs. 10 in the
current year. The dividends are growing at 6% p.a. The cost of equity
capital is 16%. The company’s top Finance Managers of various zones
recently met to take stock of the competitor’s growth and dividend policies
and came out with the following suggestions to maximise the wealth of the
shareholders. As the CFO of the company, you are required to analyse
each suggestion and take a suitable course keeping the shareholder’s
interests in mind.
Alternative 1: Increase the dividend growth rate to 7% and lower
Ke to 15%

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Alternative 2: Increase the dividend growth rate to 7% and increase

Ke to 17%
Alternative 3: Lower the dividend growth rate to 4% and lower Ke to 15%
Alternative 4: Lower the dividend growth rate to 4% and increase
Ke to 17%
Alternative 5: Increase the dividend growth rate to 7% and lower Ke to14%
Solution:
We all know that
P0 = D1/(Ke – g)
Present case = 4/(0.16-0.06) = Rs 40
Alternative 1 = 4.28/(0.15 – 0.07) = Rs. 53.5
Alternative 2 = 4.28/(0.17 – 0.07) = Rs. 42.8
Alternative 3 = 4.16/(0.15 – 0.04) = Rs. 37.8
Alternative 4 = 4.16/(0.17 – 0.04) = Rs. 32
Alternative 5 = 4.28/(0.14 – 0.07) = Rs. 61.14
Recommendation
The last alternative is likely to fetch the maximum price per equity share
thereby increasing the wealth.

Self Assessment Questions

1. ________ is the mix of long-term sources of funds like debentures,
loans, preference shares, equity shares, and retained earnings in
different ratios.
2. The capital structure of the company should generate _______ to the
shareholders.
3. The capital structure of the company should be within the _____.
4. An ideal capital structure should involve _____ to the company.
5. _______ do not have a fixed rate of return on their investment.
6. According to dividend forecast approach, the intrinsic value of an equity
share is the sum of ______ associated with it.

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5.5 Summary
Let us recapitulate the important concepts discussed in this unit:
 Any organisation requires funds to run its business. These funds may be
acquired from short-term or long-term sources. Long-term funds are
raised from two important sources – capital (owner’s funds) and debt.
Each of these two has a cost factor, merits, and demerits.
 Having excess debt is not desirable as debt holders attach many
conditions which may not be possible for the companies to adhere to. It
is therefore desirable to have a combination of both debt and equity
which is called the ‘optimum capital structure’. Optimum capital structure
refers to the mix of different sources of long-term funds in the total
capital of the company.
 Cost of capital is the minimum required rate of return needed to justify
the use of capital. A company obtains resources from various sources –
issue of debentures, availing term loans from banks and financial
institutions, issue of preference and equity shares, or it may even
withhold a portion or complete profits earned to be utilised for further
activities.
 Retained earnings are the only internal source to fund the company’s
future plans. Weighted average cost of capital is the overall cost of all
sources of finance. The debentures carry a fixed rate of interest. Interest
qualifies for tax deduction in determining tax liability. Therefore, the
effective cost of debt is less than the actual interest payment made by
the firm.
 The cost of term loan is computed keeping in mind the tax liability. The
cost of preference share is similar to debenture interest. Unlike
debenture interest, dividends do not qualify for tax deductions.
 The calculation of cost of equity is slightly different as the returns to
equity are not constant. The cost of retained earnings is the same as the
cost of equity funds.

5.6 Glossary
Cost of debenture: The discount rate which equates the net proceeds from
issue of debentures to the expected cash outflows.

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Term loans: Loans taken from banks or financial institutions for a specified
number of years at a predetermined interest rate.

5.7 Solved Problems

11. Deepak Steel has issued non-convertible debentures for Rs. 5 crore.
Each debenture is of a par value of Rs. 100 carrying a coupon rate of
14%. Interest is payable annually and they are redeemable after
7 years at a premium of 5%. The company issued the NCD at a
discount of 3%. What is the cost of debenture to the company? Tax
rate is 40%.

Solution:
I(1 T )  ( F  P ) / n
Kd 
(F  P ) / 2
14 (1 0.4 )  (105  97 ) / 7 8.4  1.14
 = 0.094 or 9.4%
(105  97 ) / 2 101
12. Supersonic industries Ltd. has entered into an agreement with Indian
Overseas Bank for a loan of Rs. 10 crore with an interest rate of 10%.
What is the cost of the loan if the tax rate is 45%?
Solution:
Kt=I(1 – T) = 10(1 – 0.45) = 5.5%
13. Prime group issued preference shares with a maturity premium of 10%
and a coupon rate of 9%. The shares have a face value of
Rs. 100 and are redeemable after 8 years. The company is planning to
issue these shares at a discount of 3% now. Calculate the cost of
preference capital.
Solution:
D  ( F  P ) / n
Kp 
(F  P ) / 2
(110  97 ) / 8  9  .1.625
9   10.27%
(110  97 ) / 2 103.5

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5.8 Terminal Questions

1. The following data is available in respect of a XYZ company. The market
value of Equity is Rs. 10 lakh and the cost of equity is 18%. The market
value of debt is Rs. 5 lakh and cost of debt is 13%. Calculate the
weighted average cost of funds as weights assuming tax rate as 40%.
2. Table 5.4 depicts the capital structure of Bharat chemicals.
Table 5.4: Capital Structure

Rs. 10 face value equity shares Rs. 400000

Term loan at 13% Rs.150000
9% Preference shares of Rs. 100, currently traded at Rs. Rs. 100000
95 with 6 years maturity period
Total Rs. 650000
The company is expected to declare a dividend of Rs. 5 next year and
the growth rate of dividends is expected to be 8%. Equity shares are
currently traded at Rs. 27 in the market. Assume tax rate of 50%. What
is WACC?
3. The market value of debt of a firm is Rs. 30 lakh and equity is Rs. 60
lakh. The cost of equity and debt are 15% and 12%. What is the WACC
if the tax rate is 50%?
4. A company has 3 divisions – X, Y, and Z. Each division has a capital
structure with debt, preference shares, and equity shares in the ratio
3:4:3 respectively. The company is planning to raise debt, preference
shares, and equity for all the 3 divisions together. Further, it is planning
to take a bank loan at the rate of 12% interest. The preference shares
have a face value of Rs. 100, dividend at the rate of 12%, 6 years
maturity, and currently priced at Rs. 88. Calculate the cost of preference
shares and debt if taxes applicable are 45%.
5. Tanishk Industries issues partially convertible debentures with face value
of Rs. 100 each and retains Rs. 96 per share. The debentures are
redeemable after 9 years at a premium of 4% and taxes applicable are
40%. What is the cost of debt if the coupon interest is 12%?

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5.9 Answers

Self Assessment Questions

1. Capital structure
2. Maximum returns
3. Debt capacity
4. Minimum risk of loss of control
5. Equity shareholders
6. Present values of dividends

Terminal Questions
1. Hint: Use the equation
WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt
Ans. = 14.57%
2. Hint: Use the equation
WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt
3. Hint: Use the equation
WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt
Ans. = 8.97%

4. Hint: Apply the formula Kp  D 

( F  P ) / n
F P ) / 2

I (1  T )  ( F  P) / n
5. Hint: Apply the formula Kd 
( F  P) / 2
Ans. = 8.09%

5.10 Case Study: Sources of Finance

Sources of Finance
KARE Ltd. is a healthcare concern that was established in 1993. It was
founded with the aim of manufacturing life-saving immuno-biologicals which
were in shortage in the country and imported at high prices. Thereafter,
several life-saving biologicals were manufactured in abundance at prices
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Financial Management Unit 5

affordable to common man. As a result, the country was made self-sufficient

for Tetanus, Anti-toxin, and Anti-snake Venom serum followed by DTP
(Diphtheria, Tetanus, and Pertussis) group of Vaccines and then later on
MMR (Measles, Mumps, and Rubella) group of vaccines.

The company has recently set up KARE Park in Special Economic Zone
(SEZ). The Park is adjoining the company’s existing manufacturing unit and
is a sector-specific SEZ meant for biotechnology and pharmaceutical
products. The SEZ will allow the company to avail various tax benefits such
as income tax, import duty on capital goods, etc. This has encouraged a lot
of foreign companies to partner with KARE to avail and share these
benefits.

The company’s financial data is given below:

Sources of Funds:
Shareholder’s funds:
Fully paid-up equity share capital 300
Reserves and Surplus 600 900
Loan funds:
Secured Loans:
12% non-convertible debentures 400
14% term loan from IDBI 528
Working Capital loan from IOB 150 1,078
Unsecured Loans:
Fixed Deposits 50 50
2,028
Application of Funds:
Fixed Assets (net) 1,250
Investments 250
Current assets – loans and advances 750
(-) current liabilities and provisions 350 400
Miscellaneous expenditures and losses 128
2,028

The following information is also provided:

1. The equity share capital consists of 30 lakh equity shares with par value
Rs. 10. The market value of the equity capital is Rs. 450 lakh. Hence, the

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Financial Management Unit 5

dividend per share expected a year is Rs. 1.50 per share. The dividends
are expected to grow at a rate of 5% per annum.
2. 12% non-convertible debentures consist of 4 lakh debentures which
were issued at par (Rs.100). The issue cost was Rs.28 lakh. The
difference between the redemption price and the net amount realised
after issue will be written off evenly over the life of the debentures; it is
assumed that the amount so written off will be a tax-deductible expense.
The debentures will be redeemed after 10 years at a premium of 3%.
The market value of the debenture capital is Rs. 384 lakh.
3. The market value of the term loan can be considered equal to its book
value.
4. The tax rate of the company is 35%.
Discussion Questions:
1. Is equity capital free of cost? What is your view on that? Draw references
from the above example.
(Hint: Refer to cost of capital)
2 Calculate the cost of different long-term sources of finance employed by
KARE Ltd.
(Hint: Refer to cost of sources of finance)
3. Calculate the WACC using the market values of the long-term sources of
finance as weights.
(Hint: Refer to WACC)
4. Which factors, according to you, affect the WACC?
(Hint: Refer to WACC)
5. What is the use of calculating WACC? Explain and justify your answer.
You may draw inference from the example case above.
(Hint: Refer to WACC)
Source: www.moneycontrol.com

Reference:
 Pandey I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition
E-Reference:
 www.moneycontrol.com retrieved on 12/12/2011

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Financial Management Unit 6

Unit 6 Leverage
Structure:
6.1 Introduction
Objectives
6.2 Operating Leverage
Application of operating leverage
6.3 Financial Leverage
Use of financial leverage
6.4 Total or Combined Leverage
Uses of Degree of Total Leverage (DTL)
6.5 Summary
6.6 Glossary
6.7 Solved Problems
6.8 Terminal Questions
6.9 Answers
6.10 Case Study

6.1 Introduction
In the previous unit, you have learnt about the meaning of cost of capital,
cost of different sources of finance, and Weighted Average Cost of Capital
(WACC). In this unit, we will discuss the concepts of operating leverage,
financial leverage, and total or combined leverage.
A company uses different sources of financing to fund its activities. These
sources can be classified as those which carry a fixed rate of return and
those whose returns vary. These were discussed in the earlier units. The
fixed sources of finance have a bearing on the return on shareholders.
Borrowing funds as loans have an impact on the return on shareholders,
and this is greatly affected by the magnitude of borrowing in the capital
structure of a firm.
‘Leverage’ means ‘effectiveness’ or ‘power’. The use of an asset or source
of funds for which the company has to pay a fixed cost or fixed return is
termed as leverage. Leverage studies how the dependent variable responds
to a particular change in the independent variable.

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Figure 6.1 depicts the three types of leverages – operating, financial, and
combined.

Figure 6.1: Types of Leverage

Operating leverage is associated with the asset purchase activities, while

financial leverage is associated with the financial activities. However,
combined leverage is the combination of operating leverage and the
financial leverage.
Thus, the term leverage refers to an increased means of accomplishing
some purpose. With leverage, it is possible to lift objects which are
otherwise impossible. The term refers, generally, to circumstances which
bring about an increase in income volatility. In business, leverage is the
means of increasing profits. It may be favourable or unfavourable. The
former reduces profit, while the latter increases it. The leverage of a firm is
essentially related to a measure which may be a return on investment or on
earnings before taxes. It is an important tool of financial planning because it
is related to profits.
Objectives:
After studying this unit, you should be able to:
 explain operating leverage
 explain the Financial leverage
 explain the Combined Leverage

6.2 Operating Leverage

Operating leverage arises due to the presence of fixed operating expenses
in the firm’s income flows. It has a close relationship to business risk.
Operating leverage affects business risk factors, which can be viewed as
the uncertainty inherent in estimates of future operating income.

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The operating leverage takes place when a change in revenue produces a

greater change in Earnings Before Interest and Taxes (EBIT). It indicates
the impact of changes in sales on operating income. A firm with a high
operating leverage has a relatively greater effect on EBIT for small changes
in sales. A small rise in sales may enhance profits considerably, while a
small decline in sales may reduce and even wipe out the EBIT.
Figure 6.2 depicts the three categories of a company’s operating costs.

Figure 6.2: Classification of Operating Costs

Let us now discuss these three categories in detail.

 Fixed costs – Fixed costs are those which do not vary with an increase
in production or sales activities for a particular period of time. These are
incurred irrespective of the income and value of sales and generally
cannot be reduced.
For example, consider that a firm named XYZ Enterprises is planning to
start a new business. The main aspects that the firm should concentrate
on are salaries to the employees, rents, insurance of the firm, and the
accountancy costs. All these aspects are referred to as “fixed costs”.
 Variable costs – Variable costs are those which vary in direct proportion
to output and sales. An increase or decrease in production or sales
activities will have a direct effect on such types of costs incurred.
For example, we have discussed about fixed costs in the above context.
Now, the firm has to concentrate on some other features like cost of
labour, amount of raw materials, and the administrative expenses. All
these features relate to or are referred to as “Variable costs”, as these
costs are not fixed and keep changing depending upon the conditions.
 Semi-variable costs – Semi-variable costs are those which are partly
fixed and partly variable in nature. These costs are typically of fixed

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Financial Management Unit 6

nature up to a certain level beyond which they vary with the firm’s
activities.
For example, after considering both the fixed costs and the variable
costs, the firm should concentrate on some other features like production
cost and the wages paid to the workers. At some point in time, these will
act as fixed costs and can also shift to variable costs. These features
relate to or are referred to as “Semi-variable costs”.
The operating leverage refers to the degree to which a firm has built-in
fixed costs due to its particular or unique production process.
The extent of the operating leverage at any single sales volume is
calculated as follows:
 Marginal contribution/EBIT)
 (Revenue – Variable costs)/(Revenue – Variable costs – Fixed costs)
In most cases, a firm would be in a position to exercise a degree of control
on the choice of its technology and the related production processes. The
production processes which are accompanied by high fixed costs but low
variable costs are generally the highly mechanised and automated
processes. With such processes, the degree of operating leverage is
generally high, the break-even point is relatively higher, and thus changes in
the sales level have a magnified (or “leveraged” ) effect on profits. Break-
even sales volume goes up with operating leverage (i.e., fixed costs), thus,
greater the impact on profits for a given change in sales volume.
Thus, the operating leverage is the firm’s ability to use fixed operating costs
to increase the effects of changes in sales on its EBIT. Operating leverage
occurs any time if a firm has fixed costs. The percentage of change in profits
with a change in volume of sales is more than the percentage of change in
volume. The higher the fixed costs, the greater the leverage and the more
frequent the changes in the rate of profit (or loss) with alternations in the
volume of activity.

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Solved Problem – 1
A firm sells a product for Rs. 10 per unit. Its variable costs are Rs. 5 per
unit and fixed expenses amount to Rs. 5000 p.a. Show the various levels
of EBIT that result from sale of 1000 units, 2000 units, and 3000 units.
Solution:
Table 6.1 depicts the various levels of EBIT that result from the sale of
1000 units, 2000 units, and 3000 units.
Table 6.1: Various Levels of EBIT
Sales in units 1000 2000 3000
Sales revenue Rs. 10000 20000 30000
Variable cost 5000 10000 15000
Contribution 5000 10000 15000
Fixed cost 5000 5000 5000
EBIT 000 5000 10000

If we take 2000 units as the normal course of sales, the results can be
summed as:
 A 50% increase in sales from 2000 units to 3000 units results in a
100% increase in EBIT.
 A 50% decrease in sales from 2000 units to 1000 units results in a
100% decrease in EBIT.

The illustration clearly tells us that when a firm has fixed operating
expenses, an increase in sales results in a more proportionate increase in
EBIT and vice versa. The former is a favourable operating leverage and the
latter is unfavourable.
Another way of explaining this phenomenon is examining the effect of the
Degree of Operating Leverage (DOL). The DOL is a more precise
measurement.
DOL measures the effect of change in volume on net operating income or
earnings before interest and taxes. It examines the effect of the change in
the quantity produced on EBIT.

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DOL = % change in EBIT / % change in output

To put in a different way,
(ΔEBIT/EBIT) / (ΔQ/Q)
EBIT is Q(S—V)—F
Where Q is quantity
S is sales
V is variable cost
F is fixed cost
Substituting this we get,
{Q(S—V)} / {Q(S—V)—F}
DOL will be calculated for a firm when it moves over from one level of sales
(volume or value) to another.

Solved Problem – 2
Calculate the DOL of Guptha Enterprises. Table 6.2 depicts the
information of Guptha Enterprises.
Table 6.2: Information of Guptha Enterprises

Quality produced and sold 1000 units

Variable cost Rs. 200 per unit
Selling price per unit Rs. 300 per unit
Fixed expenses Rs. 20, 000
Solution:
DOL = {Q(S–V)} / {Q(S–V)–F}
= {1000(300–200)}/{1000(300–200)–20000}
= 100000/80000
DOL = 1.25
The DOL of Guptha enterprises is 1.25.
If the company does not incur any fixed operating costs, there is no
operating leverage.

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Solved Problem – 3
Calculate the DOL of Utopia Enterprises. Table 6.3 depicts the
information of Utopia Enterprises.
Table 6.3: Information of Utopia Enterprises

Quality produced and sold 2000 units

Variable cost Rs.300 per unit
Selling price per unit Rs. 400 per unit
Fixed expenses Rs.25, 000
Solution:
DOL = {Q(S–V)} / {Q(S–V)–F}
= {2000(400–300)}/{2000(400–300)–25000}
= 200000/175000
DOL = 1.14
The DOL of Utopia Enterprises is 1.14.

Solved Problem – 4
Table 6.4 depicts the statistics of a firm and its sales requirements.
Compute the DOL according to the values given in the table.
Table 6.4: Statistics of a Firm

Sales in units 1000

Sales revenue Rs. 10000

Variable cost 5000

Contribution 5000

Fixed cost 0

EBIT 5000
Solution:
DOL= {Q(S—V)} / {Q(S—V)—F}
{1000(5000)} / {1000(5000) – 0}
= 5000000/5000000
= DOL=1
The DOL according to the values given in the table is 1.

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Solved Problem – 5
Table 6.5 depicts the statistics of a firm and its sales requirements.
Compute the DOL according to the values given in the table.
Table 6.5: Statistics of a Firm
Sales in units 2000
Sales revenue Rs. 20000
Variable cost 10000
Contribution 6000
Fixed cost 0
EBIT 6000
Solution:
DOL= {Q(S—V)} / {Q(S—V)—F}
{2000(10000)} / {2000(10000) – 0}
= 2000000/2000000
= DOL=1
The DOL according to the values given in the table is 1.
As operating leverage can be favourable or unfavourable, high risks are
attached to higher degrees of leverage. As DOL considers fixed expenses, a
larger amount of these expenses increases the operating risks of the
company and hence, a higher DOL. Higher operating risks can be taken
when income levels of companies are rising and should not be ventured into
when revenues move southwards.
Thus, the higher the DOL, the greater will be the fluctuations in profits in
response to changes in volume. And this relationship works both ways, i.e.,
when volume increases as well as when it declines.
6.2.1 Application of operating leverage
The applications of operating leverage are as follows:
 Business risk measurement
 Production planning
 Measurement of business risk
Risk refers to the uncertain conditions in which a company performs. A
business risk is measured using the DOL and the formula of DOL is:
DOL = {Q(S–V)} / {Q(S–V)–F}

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Financial Management Unit 6

The greater the DOL, the more sensitive will be the EBIT to a given change
in unit sales. A high DOL is a measure of high business risk and vice versa.
 Production planning
A change in production method increases or decreases DOL. A firm can
change its cost structure by mechanising its operations, thereby, reducing
its variable costs and increasing its fixed costs. This will have a positive
impact on DOL. This situation can be justified only if the company is
confident of achieving a higher amount of sales thereby increasing its
earnings.

6.3 Financial Leverage

Financial leverage relates to the financing activities of a firm and measures
the effect of EBIT on Earnings Per Share (EPS) of the company.
A company’s sources of funds fall under two categories:
 Those which carry fixed financial charges like debentures, bonds, and
preference shares
 Those which do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest and are to be paid off
irrespective of the firm’s revenues. The dividends are not contractual
obligations, but the dividend on preference shares is a fixed charge and
should be paid off before equity shareholders. The equity holders are
entitled to only the residual income of the firm after all prior obligations are
met.
Financial leverage refers to a firm's use of fixed-charge securities like
debentures and preference shares (though the latter is not always included
in debt) in its plan of financing the assets.
The concept of financial leverage is a significant one because it has direct
relation with capital structure management. It determines the relationship
that could exist between the debt and equity securities. A firm which does
not issue fixed-charge securities has an equity capital structure and does
not have any financial leverage. However, it is common for firms to issue
some debt securities, in which case, the leverage is either favourable or
unfavourable. Financial leverage is a process of using debt capital to
increase the rate of return on equity. For this reason, it is also referred to as
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Financial Management Unit 6

trading on equity. Borrowing is done by a company because of the financial

advantage that is expected from it. The use of borrowings for the purpose of
such advantage for residual shareholders is also called ‘trading on equity’ or
‘leverage’.
Thus, financial leverage refers to the mix of debt and equity in the capital
structure of the firm. This results from the presence of fixed financial
charges in the company’s income stream. Such expenses have nothing to
do with the firm’s performance and earnings and should be paid off
regardless of the amount of EBIT.
It is the firm’s ability to use fixed financial charges to increase the effects of
changes in EBIT on the EPS. It is the use of funds obtained at fixed costs
which increase the returns on shareholders.
A company earning more by the use of assets funded by fixed sources is
said to be having a favourable or positive leverage. Unfavourable leverage
occurs when the firm is not earning sufficiently to cover the cost of funds.
Financial leverage is also referred to as “trading on equity”.
Thus, the effect of financial leverage is also measured through another
variable, viz, EPS. This is done in the case of joint stock companies which
have raised their proprietary capital by selling units of such capital known as
equity shares.
EPS is obtained by dividing earnings (after interest and taxes) by total
equity. If a company has preference shares also on its capital structure, net
equity earnings will be arrived at after deducting interest, taxes, and
preference dividends.
Capital structure refers to the permanent long-term financing of a company
represented by a mix of long-term debt, preference shares, and net worth
(which included paid-up capital, reserves, and surplus).
Financial leverage and its effects are a crucial consideration in planning and
designing capital structures.

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Financial Management Unit 6

Solved Problem – 6
The EBIT of a firm is expected to be Rs. 10000. The firm has to pay
interest at a rate of 5% on debentures of worth Rs. 25000. It also has
preference shares worth Rs. 15000 carrying a dividend of 8%. How does
EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may be taken
as 40% and number of outstanding shares as 1000.
Solution:
Table 6.6 depicts the various changes of EPS if EBIT is Rs. 15,000,
Rs. 10,000, and Rs. 5,000.
Table 6.6: Various Changes of EPS

EBIT 5000 10000 15000

Interest on debt 1250 1250 1250
EBT 3750 8750 13750
Tax 40% 1500 3500 5500
EAT 2250 5250 8250
Preference div. 1200 1200 1200
Earnings available 1050 4050 7050
to equity holders
EPS 1.05 4.05 7.05

Interpretation
 A 50% increase in EBIT from Rs. 10,000 to Rs. 15,000 results in 74%
increase in EPS
 A 50% decrease in EBIT from Rs. 10,000 to Rs. 5,000 results in 74%
decrease in EPS

This example shows that the presence of fixed interest source funds leads
to a value more than that occurs due to proportional change in EPS. The
presence of such fixed sources implies the presence of financial leverage.
This can be expressed in a different way. The Degree of Financial Leverage
(DFL) is a more precise measurement. It examines the effect of the fixed
sources of funds on EPS.

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Financial Management Unit 6

DFL = %change in EPS

%change in EBIT

DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}
Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}
I is Interest, Dp is dividend on preference shares, T is tax rate.

Solved Problem – 7
Kusuma Cements Ltd. has an EBIT of Rs. 5,00,000 at 5000 units of
production and sales. Table 6.7 briefly depicts the capital structure of the
company.
Table 6.7: Capital Structure of the Company
Capital structure Amount
Rs.
Paid up capital 500000 equity shares of 5000000
Rs. 10 each
12% Debentures 400000
10% Preference shares of Rs. 100 each 400000
Total 5800000
Corporate tax rate may be taken at 40%
Solution:
EBIT 500000
Less Interest on debentures 48000
EBIT 452000
DFL= EBIT ÷ {EBIT—I—{Dp/(1-T)}}
500000/(500000—48000—{40000/(1—0.40)}
DFL=1.30
The degree of financial leverage of Kusuma Cements Ltd. is found to be
1.30.

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Financial Management Unit 6

Solved Problem – 8
XYZ Enterprises Ltd. has an EBIT of Rs. 2,00,000 at 4000 units of
production and sales. Table 6.8 briefly depicts the capital structure of the
company.
Table 6.8: Capital Structure

Capital structure Amount

Rs.
Paid-up capital 200000 equity shares of 2000000
Rs. 10 each
10% Debentures 500000
5% Preference shares of Rs. 100 each 500000
Total 3000000

Corporate tax rate may be taken at 50%

Solution:
EBIT 200000
Less Interest on debentures 50000
EBIT 150000

DFL= EBIT ÷ {EBIT—I—{Dp/(1-T)}}

200000/(200000—50000—{25000/(1—0.50)}
DFL=2.0
The degree of financial leverage of XYZ Enterprises is found to be 2.0.

6.3.1 Use of financial leverage

Studying the DFL at various levels makes financial decision making on the
use of fixed sources of funds for funding activities easy. One can assess the
impact of change in EBIT on EPS.
Like operating leverage, the risks are high at high DFL. High financial costs
are associated with high DFL. An increase in financial costs implies higher
level of EBIT to meet the necessary financial commitments.

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Financial Management Unit 6

A firm which is not capable of honouring its financial commitments may be

forced to go into liquidation by the lenders of funds. The existence of the
firm is shaky under these circumstances.
On one side, the trading on equity improves considerably by the use of
borrowed funds, and on the other hand, the firm has to constantly work
towards higher EBIT to stay alive in the business. All these factors should
be considered while formulating the firm’s mix of sources of funds.
One main goal of financial planning is to devise a capital structure in order
to provide a high return to equity holders. But at the same time, this should
not be done with heavy debt financing which drives the company on to the
brink of winding up.
Impact of financial leverage
Highly leveraged firms are considered very risky and lenders and creditors
may refuse to lend them further to fuel their expansion activities. On being
forced to continue lending, they may do so with their own conditions like
earning a minimum of X% EBIT or stipulating higher interest rates than the
market rates or no further mortgage of securities.
Financial leverage is considered to be favourable till such time that the rate
of return exceeds the rate of return obtained when no debt is used.

Activity:
Coverage R Ltd V Ltd
DOL 2.1 1.5
DFL 1.0 2.2
Comment or leverage of the firms
Hint: R Ltd has more fixed operating costs than V ltd, so its DOL is more.
V Ltd has more fixed financial costs than R ltd, so its DFL is more.

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Solved Problem – 9
Table 6.9 depicts the balance sheets of two firms – firm A and firm B.
Table 6.9: Balance Sheets of Firms A and B
Balance sheet of A Balance sheet of B
Equity 100000 Assets 100000 Equity 40000 Assets 100000
capital capital
Debt @ 60000
15%
Total 100000 Total 100000 Total 100000 Total 100000

Both the companies earn an income before interest and tax of

Rs. 40000. Calculate the DFL and interpret the results thereof.
Solution:
EBIT
DFL = {EBIT  I  {Dp /(1  T )}}

40000
Company A = 1
40000  0  0
40000
Company B =  1.29
40000  9000  0
The degree of financial leverage of the companies A and B are 1 and
1.29 respectively.
The company, not using debt to finance its assets, has a higher DFL
compared to that of a company using it. Financial leverage does not exist
when there is no fixed charge financing.

6.4 Total or Combined Leverage

The combination of operating and financial leverage is called combined
leverage. Operating leverage affects the firm’s operating profit EBIT and
financial leverage affects PAT or the EPS. These cause wide fluctuations in
EPS. A company having a high level of operating or financial leverage will
find a drastic change in its EPS even for a small change in sales volume.
Companies whose products are seasonal in nature have fluctuating EPS,
but the amount of changes in EPS due to leverages is more pronounced.

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The combined effect is quite significant for the earnings available to ordinary
shareholders. Combined leverage is the product of DOL and DFL.
Q(S  V )
DTL = Q(S  V )  F  I  {Dp /(1  T )}

Where DTL = Degree of Total Leverage

Solved Problem – 10
Calculate the DTL of Pooja Enterprises Ltd. Table 6.10 depicts the
information regarding the expenses, shares, and sales of the company.
Table 6.10: Details of Pooja Enterprises Ltd.
Quantity sold 10,000 units
Variable cost per unit Rs. 100 per unit
Selling price per unit Rs. 500 per unit
Fixed expenses Rs. 10,00,000
Number of equity shares 1,00,000
Debt Rs. 10,00,000 @ 20% interest
Preference shares dividend 10,000 shares of Rs.100 each @ 10%
Tax rate 50%

Solution:
Q(S  V )
DTL = Q(S  V )  F  I  {Dp /(1  T )}

10000 (500  100 )

10000 (500  100 )  1000000  200000  {100000 / 0.5}

DTL=1.53
Cross verification:
{Q(S  V )}
DOL = {Q(S  V )  F}

10000(500  100 )

10000(500  100 )  1000000

DOL=1.33

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Financial Management Unit 6

EBIT = [Q(S-V)-F}

EBIT
DFL= EBIT  I  {Dp /(1  T )}}

3000000
3000000  200000  {100000 / 0.5}
DFL=1.15
DTL=DOL*DFL
1.53 =1.33*1.15
Hence the DTL of Pooja Enterprises Ltd. is 1.54.

Solved Problem – 11
Calculate the DTL of Utopia Enterprises Ltd. Table 6.11 depicts
information regarding the expenses, shares, and sales of the company.
Table 6.11: Details of Utopia Enterprises Ltd.

Quantity sold 20,000 units

Variable cost per unit Rs. 200 per unit
Selling price per unit Rs. 600 per unit
Fixed expenses Rs. 20,00,000
Number of equity shares 1,50,000
Debt Rs. 20,00,000 @ 20% interest
Preference shares dividend 20,000 shares of Rs.200 each
@ 10%
Tax rate 40%

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Solution:
Q(S  V )
DTL = Q(S  V )  F  I  {Dp /(1  T )}

20000 (600  200)

20000 (600  200)  2000000  400000  {400000 / 0.6}
DTL=1.62
Cross verification:
{Q(S  V )}
DOL= {Q(S  V )  F}
20000(600  200)

20000(600  200)  2000000

DOL = 1.33

EBIT
DFL = EBIT  I  {Dp /(1  T )}}
6000000
6000000  400000  {400000 / 0.6}
DFL=1.22
DTL=DOL*DFL
1.62 = 1.33*1.22
Hence the DTL of Utopia enterprises Ltd. is 1.60

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Solved Problem – 12
Calculate the DTL of CMA Enterprises Ltd. Table 6.12 depicts
information regarding the expenses, shares, and sales of the company.
Table 6.12: Details of CMA Enterprises Ltd.

Quantity sold 30,000 units

Variable cost per unit Rs. 300 per unit
Selling price per unit Rs. 700 per unit
Fixed expenses Rs. 30,00,000
Number of equity shares 2,00,000
Debt Rs. 30,00,000 @ 30% interest
Preference shares dividend 30,000 shares of Rs.200 each @
20%
Tax rate 30%

Solution:
Q(S  V )
DTL = Q(S  V )  F  I  {Dp /(1  T )}

30000 (700  300)

30000 (700  300)  3000000  900000  {1200000 / 0.7}

DTL=1.88
Cross verification:
{Q(S  V )}
DOL = {Q(S  V )  F}

30000(700  300)

30000(700  300)  3000000
DOL=1.33

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EBIT
DFL = EBIT  I  {Dp /(1  T )}}

6000000
6000000  900000  {1200000 / 0.7}
DFL=1.77
DTL=DOL*DFL
1.33*1.77=2.35
Hence the DTL of CMA enterprises Ltd. is 2.35

6.4.1 Uses of Degree of Total Leverage (DTL)

 DTL measures the total risk of the company as DTL is a combined
measure of both operating and financial risk
 DTL measures the variability of EPS

Self Assessment Questions

1. __________ arises due to the presence of fixed operating expenses in
the firm’s income flows.
2. EBIT is calculated as _______.
3. Higher operating risks can be taken when ______ of companies are
rising.
4. Dividend on _________ is a fixed charge.
5. Financial leverage is also referred to as ___________.
6. Costs are categorised into _____, ____, and _______.
7. The three types of leverage a company faces are ______, ________,
and __________.

6.5 Summary
Let us recapitulate the important concepts discussed in this unit:
 Leverage is the use of influence to attain something else. The advantage
a company has with the current status of the leverage can be used to
gain other benefits.

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 There are three measures of leverage – operating leverage, financial

leverage, and total or combined leverage.
 Operating leverage examines the effect of change in quantity produced
upon EBIT and is useful to measure business risk and production
planning. Financial leverage measures the effect of change in EBIT on
the EPS of the company. It also refers to the debt-equity mix of a firm.
 Total leverage is the combination of operating and financial leverages.

6.6 Glossary
Capital structure: The permanent, long-term financing of a company
represented by a mix of long-term debt, preference shares, and net-worth.
Combined leverage: The combination of operating and financial leverage.
Financial leverage: A firm's use of fixed-charge securities like debentures
and preference shares in its plan of financing the assets.
Fixed costs: The costs which do not vary with an increase in production or
sales activities for a particular period of time.
Leverage: The use of an asset or source of funds for which the company
has to pay a fixed cost or fixed return.
Operating leverage: The degree to which a firm has built-in fixed costs
due to its particular or unique production process.
Semi-variable costs: Costs which are partly fixed and partly variable in
nature.
Variable costs: Costs which vary in direct proportion to output and sales.

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6.7 Solved Problems

13. Table 6.13 depicts the information which has been collected from
the annual report of Garden Silks. What is the degree of financial
leverage?
Table 6.13: Annual Report of Garden Silks

Total sales Rs. 14,00,000

Contribution ratio 25%
Fixed expenses Rs. 1,50,000
Outstanding bank loan Rs. 4,00,000 @ 12.5%
Applicable tax rate 40%

Solution:
DFL = EBIT / (EBIT-I) = 200000/200000-50000 = 1.33
EBIT = Sales*25% less fixed expenses
1400000*25% = 350000-150000 = 200000
14. Suppose X and Y have provided the information regarding the sales
and the cost of their expense. Table 6.14 depicts the information.
Which firm do you consider to be risky?
Table 6.14: Information of X and Y
X Ltd. Y Ltd.
Sales in units 40000 40000
Price per unit 60 60
Variable cost p.a. 20 25
Fixed financing cost Rs. 100000 Rs. 50000
Fixed financing cost Rs. 300000 Rs. 200000

Solution:
DOL = Q(S-V) / Q(S-V)-F
Company X: 40000(60-20) / 40000(60-20)-400000
1600000/1200000 = 1.33
Company Y: 40000(60-25) / 40000(60-25)-250000
1400000/1150000= 1.22

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15. Calculate EPS. Table 6.15 depicts the information of a firm.

Table 6.15: Information of a Firm
EBIT Rs. 11,80,000
Interest Rs. 2,20,000
No. of outstanding shares 40,000
Tax rate applicable 40%

Solution:
Table 6.16 depicts the calculated earnings per share.
Table 6.16 Earnings Per Share
EBIT Rs. 11,80,000
Less interest Rs. 2,20,000
EBT 9.60,000
Tax @ 40% Rs. 3,84,000
EAT Rs. 5,76,000

EPS = EAT/no of shares outstanding

576000/40000 = Rs. 14.4
16. Table 6.17 depicts the leverages of three firms. Which one of the
combinations should be chosen for the combined leverage to be the
maximum and what are the inferences?
Table 6.17: Leverages of Three Firms

A B C
Operating leverage 1.14 1.23 1.33
Financial leverage 1.27 1.3 1.33

Solution:
We should calculate the combined leverage to draw inferences.
Combined leverage of A is 1.14*1.27 = 1.45,
Combined leverage of B is 1.23*1.3 = 1.60,
Combined leverage of C is 1.33*1.33 = 1.77
We find that the combined leverage is highest for firm C and this suggests
that this firm is working under very high risky situation.

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6.8 Terminal Questions

1. Table 6.18 depicts the information provided by Mishra Ltd. What is the
degree of operating leverage?
Table 6.18: Details of Mishra Ltd.

Output 25,000 units

Fixed costs Rs. 15,000
Variable cost per unit Rs. 0.50
Interests on borrowed funds Rs. 15,000
Selling price per unit Rs. 1.50

2. Table 6.19 depicts the information provided by X Ltd. What is the degree
of financial leverage?
Table 6.19: Details of X Ltd.

Output 25,000 units

Fixed costs Rs. 25,000
Variable cost Rs. 2.50 per unit
Interest on borrowed funds Rs. 15,000
Selling price Rs. 8 per unit
3. Table 6.20 depicts the sales, costs, and interests of two firms. Comment
on their relative performance through leverage?
Table 6.20: Sales and Costs of Two Firms A and B

A Ltd. (Rs. In lakhs) B Ltd. (Rs. In lakhs)

Sales 1000 1500
Variable cost 300 600
Fixed cost 250 400
EBIT 450 500
Interest 50 100

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4. Table 6.21 depicts the information provided by ABC Ltd. regarding the
cost, sales, interests, and selling prices. Calculate the DFL.
Table 6.21: Details of ABC Ltd.

Output 20,000 units

Fixed costs Rs. 3,500
Variable cost Rs. 0.05 per unit
Interest on borrowed funds Nil
Selling price per unit 0.20

6.9 Answers

Self Assessment Questions

1. Operating leverage
2. Q(S—V)—F
3. Income levels
4. Preference shares
5. Trading on Equity
6. Fixed costs, variable costs, and semi-variable costs.
7. Operating leverage, financial leverage, and combined leverage.

Terminal Questions
{Q(S  V )}
1. Hint DOL =
{Q(S  V )  F}
EBIT
2. Hint DFL = {EBIT  I  {Dp /(1  T )}}

3. Hint calculate DFL

EBIT
4. Hint calculate DFL =
EBIT  I  {Dp /(1  T )}}

6.10 Case Study: Leverage

Financial Leverage is something you need to watch carefully. As with any
kind of debt, a judicious amount can boost returns, but too much can lead to
disaster. Look at the kind of business a firm is in. If it's fairly steady, a

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company can probably take on large amounts of debt without too much risk
because there's only a small chance of the business falling off a cliff and the
company being caught short when bondholders demand their interest
payments. On the flip side, be very wary of a high financial leverage ratio if a
company's business is cyclical or volatile. Because interest payments are
fixed, the company has to pay them whether business is good or bad.
Following is an excerpt from the stock analysis of Opto Circuits. The entire
analysis is available on
Opto Circuits is a small company in medical electronics industry with focus
in the niche areas of invasive (coronary stents) and non-invasive (sensors,
patient monitors) segments. Prior to '2002, Opto's revenues were less than
Rs. 50 crore. Today revenues stand at Rs. 468 crore with exports
accounting for more than 95% of revenues. Opto Circuits is based in
Bangalore, India and operates out of offices established in the USA, Europe,
South-East Asia, Latin America, and the Middle East and boasts of a strong
international distribution network present in over 70 countries.
Opto Circuits Profitability Snapshot

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As one can see from above, net profit margins are healthy (over 28%), great
return on equity and solid return on invested capital ratios (over 45%).
Financial health has been steadily improving over the years with
comfortable financial leverage (1.34) and Debt to equity (0.31), with solid
current and quick ratios. However, Opto Circuits still has a long way to go
before it can show loads of excess cash in its books due to its aggressive
business expansion. Free cash flow as a percentage of sales is ~6%. It has
consistently increased dividends per share and has a unique track record of
rewarding shareholders with bonus shares every year for the 7th straight
year.
There are these 3 levers that can boost Return on Equity (ROE) - net
margins, asset turnover, and financial leverage. (Because ROE = Net
Margin x Asset Turnover x Financial Leverage).
Opto Circuits has shown steady improvements on net margin front but
recorded a quantum jump from ~16% in FY05 to over 27% in FY06. It has
since maintained net margins at around 27-29%. While asset turnover has
dipped in recent years before recovering somewhat in FY08, high net
margins have compensated for return on assets steadily improving from
around 14% in FY 2002 to almost 30%.
Opto Circuits has done even better with respect to the efficiency of using
shareholder’s equity with ROE improving from about 20% in FY02 to 40%.
What has boosted ROE in the last few years is consistent net margin
improvements and decent use of financial leverage.
Can we dig deeper to see what else we can understand about how Opto
Circuits makes money? A good way is to look at the common size profit and
loss statement. Common size statements are great tools for evaluating
companies because they put every line item in context by looking at each of
them as a percentage of Sales.

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The numbers show some consistent trends. Gross Margins have improved
over the years from over 33% in FY02 to over 40% in FY 08. Spending on
overheads - selling and operating expenses - after rising in the initial years
is now showing signs of increasing efficiencies – perhaps due to increasing
synergies and rationalisation in Opto’s distribution network - declining to
about 12% in FY08 from about 18% in FY05.
Overall, we see a company that is achieving increasing control over cost of
goods sold and showing signs of becoming more efficient in terms of
overhead spending.
Once we have figured out how fast (and why) a company has grown and
how profitable it is, we need to look at its financial health.
Opto Circuits Financial Health Snapshot

Performance of Opto Circuits

A review of the last 7 years with respect to Opto Circuits Management
performance is heartening. Return on assets has improved from around
14% in FY02 to almost 30% in FY08. ROE in FY08 is 40% - the highest
ROEs in the medical electronics industry - from 20% in FY02. The fact that
this has been achieved, at Opto Circuits’ scorching pace of growth, without
resorting to excessive financial leverage is commendable.
(Source : www.stock-picks-focus.com)
Discussion Questions:
1. Explain how you think the company has used its financial leverage?
(Hint Refer to financial leverage)
2. A company considered too highly leveraged may find its freedom of
action restricted. Do you agree?
(Hint Refer to financial leverage)
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Financial Management Unit 6

3. What do you think is the association of leverage with business risk?

(Hint Refer to leverage)
4. The result of the analysis of the stock in this case is positive. How much
credit in this regard would you attribute to the company’s use of financial
leverage?
(Hint Refer to financial leverage)
5. What is your understanding on the relationship between financial
leverage and Return on Equity?
(Hint Refer to combined leverage)
(Source: http://www.stock-picks-focus.com/opto-circuits.html#Profitability-
Snapshot)

References:
1. Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition
2. Prasanna, Chandra (2007), Financial Management: Theory and Practice,
7th Edition, Tata McGraw Hill.
E-Reference:
 http://www.stock-picks-focus.com/opto-circuits.html#Profitability-
Snapshot retrieved on 11-12-2011.

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Financial Management Unit 7

Unit 7 Capital Structure

Structure:
7.1 Introduction
Objectives
7.2 Features of an Ideal Capital Structure
7.3 Factors Affecting Capital Structure
7.4 Theories of Capital Structure
Net income approach
Net operating income approach
Traditional approach
Miller and Modigliani approach
Basic propositions
Criticisms of MM proposition
7.5 Summary
7.6 Glossary
7.7 Terminal Questions
7.8 Answers
7.9 Case Study

7.1 Introduction
In the previous unit, you have learnt about operating leverage, financial
leverage, and total or combined leverage. In this unit, we will discuss the
features of ideal capital structure, factors affecting capital structure, and
theories of capital structure.
Finance is an important input for any type of business and is needed for
working capital and for permanent investment. The total funds employed in
a business are obtained from various sources as we have already seen in
the earlier units. A part of the funds are brought in by the owners and the
rest is borrowed from others – both individuals and institutions. While some
of the funds are permanently held in business, such as share capital and
reserves (owned funds), some others are held for a long period such as
long-term borrowings or debentures, and still some other funds are in the
nature of short-term borrowings. The entire composition of these funds
constitutes the overall financial structure of the firm.

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A firm needs to have such sources in the right proportion. Short-term funds
keep varying and hence, their proportions cannot be laid down in a rigid
manner. However, a more definite policy is required for the composition of
the long-term funds. This forms the capital structure of the firm.
Thus, the capital structure of a company refers to the mix of long-term
finances used by the firm. In short, it is the financing plan of the company.
More important areas of the policy are the debt-equity ratio and the dividend
decision. The latter affects the building up of retained earnings which is an
important component of long-term owned funds. Since the permanent or
long-term funds often occupy a large portion of total funds and involve long-
term policy decision, the term financial structure is often used to mean the
capital structure of the firm.
With the objective of maximising the value of the equity shares, the choice
should be that pattern of using of debt and equity in a proportion which will
lead towards achievement of the firm’s objective. The capital structure
should add value to the firm. Financing mix decisions are investment
decisions and have no impact on the operating earnings of the firm. Such
decisions influence the firm’s value through the earnings available to the
shareholders.
The value of a firm is dependent on its expected future earnings and the
required rate of return. The objective of any company is to have an ideal mix
of permanent sources of funds in a manner that it will maximise the
company’s market price. The proper mix of funds is referred to as optimal
capital structure. The capital structure decisions include debt-equity mix and
dividend decisions. Both these have an effect on the Earnings Per Share
(EPS).
Objectives:
After studying this unit, you should be able to:
 explain the features of an ideal capital structure
 name the factors affecting the capital structure
 discuss the various theories of capital structure

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7.2 Features of an Ideal Capital Structure

How do you choose a particular type of capital structure? The decision
regarding what type of capital structure a company should have is of critical
importance because of its potential impact on profitability and solvency.
Capital structure of the company should be such that the company derives
maximum benefits from it and is able to adjust it easily to changing
conditions. Companies aim to find an appropriate proportion of different
types of capital which will minimise the cost of capital and maximise the
market value.
Optimum or balanced capital structure means an ideal combination of
borrowed and owned capital that may attain the marginal goal, i.e.,
maximisation of market value per share or minimisation of cost of capital.
The market value will be maximised or the cost of capital will be minimised
when the real cost of each source of funds is the same. It is a formidable
task for the financial manager to determine the combination of the various
sources of long-term finance.
Thus, capital structure is usually planned keeping in view the interests of the
ordinary shareholders. The ordinary shareholders are the ultimate owners of
the company and have the right to elect the directors. While developing an
appropriate capital structure for his or her company, the financial manager
should aim at maximising the long-term market price of equity shares.
Figure 7.1 depicts the features of an ideal capital structure – profitability,
flexibility, control, and solvency.

Figure 7.1: Features of an Ideal Capital Structure

Let us now discuss these features in detail.

Profitability
The firm should make maximum use of leverage at a minimum cost.

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Flexibility
An ideal capital structure should be flexible enough to adapt to changing
conditions. It should be in a position to raise funds at the shortest possible
time and also repay the money it borrowed, if they appear to be expensive.
This is possible only if the company’s lenders have not put forth any
conditions like restricting the company from taking further loans, restricting
the usage of assets, or restricting early repayments. In other words, the
finance authorities should have the power to take decisions as
circumstances warrant.
Control
The structure should have minimum dilution of control.
Solvency
Use of excessive debt threatens the very existence of the company.
Additional debt involves huge repayments. Loans with high interest rates
must be avoided even if some investment proposals look attractive. Some
companies who resort to issue of equity shares to repay their debt for equity
holders do not have a fixed rate of dividend.

7.3 Factors Affecting Capital Structure

Capital structure should be planned at the time a company is promoted.
The initial capital structure should be designed very carefully. The
management of the company should set a target capital structure, and the
subsequent financing decisions should be made with a view to achieve the
target capital structure.
Every time the funds have to be procured, the financial manager weighs the
pros and cons of various sources of finance and selects the most
advantageous sources keeping in view the target capital structure. Thus, the
capital structure decision is a continuous one and has to be taken whenever
a firm needs additional finance.
The major factor affecting the capital structure is leverage. There are also a
few other factors affecting them. All the factors are explained briefly here.

Leverage
The use of sources of funds that have a fixed cost attached to them, such as
preference shares, loans from banks and financial institutions, and
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Financial Management Unit 7

debentures in the capital structure, is known as “trading on equity” or

“financial leverage”.
If the assets financed by debt yield a return greater than the cost of the debt,
the EPS will increase without an increase in the owner’s investment.
Similarly, the EPS will also increase if preference share capital is used to
acquire assets. But the leverage impact is felt more in case of debt because
of the following reasons:
 The cost of debt is usually lower than the cost of preference share
capital
 The interest paid on debt is a deductible charge from profits for
calculating the taxable income while dividend on preference shares is
not
The companies with high level of Earnings Before Interest and Taxes (EBIT)
can make profitable use of the high degree of leverage to increase return on
the shareholder’s equity.
Debt-equity ratio is another parameter that comes into play here. Debt-
equity ratio is an indicator of the relative contribution of creditors and
owners. The debt component includes both long-term and short-term debt,
and this is represented as debt/equity.
Creditors insist on a debt-equity ratio of 2:1 for medium-sized and large-
sized companies, while they insist on 3:1 ratio for Small Scale Industries
(SSI).
A debt-equity ratio of 2:1 indicates that for every 1 unit of equity, the
company can raise 2 units of debt. By normal standards, 2:1 is considered
as a healthy ratio, but it is not always a hard and fast rule that this standard
is insisted upon. A ratio of 5:1 is considered good for a manufacturing
company while a ratio of 3:1 is good for heavy engineering companies.
Generally, in debt-equity ratio, the lower the ratio, the higher is the element
of uncertainty in the minds of lenders. Increased use of leverage increases
commitments of the company (the outflows being in the nature of higher
interest and principal repayments), thereby increasing the risk of the equity
shareholders.

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The other factors to be considered before deciding on an ideal capital

structure are:
 Cost of capital – High cost funds should be avoided. However attractive
an investment proposition may look like, the profits earned may be eaten
away by interest repayments.
 Cash flow projections of the company – Decisions should be taken in
the light of cash flow projected for the next 3-5 years. The company
officials should not get carried away at the immediate results expected.
Consistent lesser profits are any way preferable than high profits in the
beginning and not being able to get any profits after 2 years.
 Dilution of control – The top management should have the flexibility to
take appropriate decisions at the right time. Fear of having to share
control and thus being interfered by others often delays the decision of
the closely held companies to go public. To avoid the risk of loss of
control, the companies may issue preference shares or raise debt
capital. An excessive amount of debt may also cause bankruptcy, which
means a complete loss of control. The capital structure planned should
be one in this direction.
 Floatation costs – Floatation costs are incurred when the funds are
raised. Generally, the cost of floating a debt is less than the cost of
floating an equity issue. A company desiring to increase its capital by
way of debt or equity will definitely incur floatation costs. Effectively, the
amount of money raised by any issue will be lower than the amount
expected because of the presence of floatation costs. Such costs should
be compared with the profits and right decisions should be taken.

Activity: List the possible sources of capital that a company might use.
Hint:
 Issue of equity shares in the domestic capital market.
 Issue of equity (depository shares) in the international capital market.
 Equity financing from financial institutions
 Private equity
 Issue of debentures in the domestic capital market.
 Issue of debentures to financial institutions

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 Long term loans from financial institutions

 Mortgage loans from financial institutions
 External Commercial borrowings/ Syndicated loans (i.e., debt capital
from international capital market)
 Issue of preference shares in the domestic capital market.
 Issue of preference shares to financial institutions

7.4 Theories of Capital Structure

As we are aware, equity and debt are the two important sources of long-
term sources of finance of a firm. The proportion of debt and equity in a
firm’s capital structure has to be independently decided case to case.
A proposal, though not being favourable to lenders, may be taken up if they
are convinced with the earning potential and long-term benefits.
What proportion of equity and debt should be taken up in the capital
structure of a firm? The answer is tricky and is based on the understanding
and interpretation of the relationship between the financial leverage and firm
valuation or financial leverage and cost of capital. Many theories have been
propounded to understand the relationship between financial leverage and
firm value.

Assumptions
The following are some common assumptions made:
 The firm has only two sources of funds, debt and ordinary shares
 There are no taxes, both corporate and personal
 The firm’s dividend payout ratio is 100%, that is, the firm pays off the
entire earnings to its equity holders and retained earnings are zero
 The investment decisions of a company are constant, that is, the firm
does not invest any further in its assets
 The operating profits/EBIT are not expected to increase or decrease
 All investors shall have identical subjective probability distribution of the
future expected EBIT
 A firm can change its capital structure at a short notice without the
incurrence of transaction costs
 The life of the firm is indefinite

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Based on the assumptions regarding the capital structure, we derive the

following formulae:
Cost of Debt
 Debt capital being constant, Kd is the cost of debt which is the discount
rate at which the discounted future constant interest payments are equal
to the market value of debt, that is,
Kd = I/B
where, I refers to total interest payments and B is the total market value
of debt.
Therefore value of the debt B = I/Kd
Cost of Equity
As mentioned above, it is assumed that there is a 100% dividend payout
and constant earnings. Such being the case, the cost of equity is the
discount rate at which the discounted future dividend/earnings are equal to
the market value of equity.
 Cost of equity capital Ke = (D1/P0) + g
where D1 is dividend after one year, P0 is the current market price and
g is the expected growth rate.
 Retained earnings being zero, g = br where r is the rate of return on
equity shares and b is the retention rate, therefore g is zero. Now we
know Ke = E1/P0 + g and g being zero, so Ke = NI/S where NI is the net
income to equity holders and S is market value of equity shares.
Firm Value
 The net operating income being constant, overall cost of capital is
represented as K0 = W1 K1 + W2 K2.
 That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the
debt, S is the market value of equity and V is the total market value of
the firm and can be given as (B+S).
The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1
being the debt component and Ke being the equity component) which
can be expressed as:
K0 = I + NI/V or EBIT/V
or in other words, net operating income/market value of firm.

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In the following pages we will understand what happens when the financial
leverage changes and its impact on Kd, Ke, and K0.
7.4.1 Net income approach
Net Income (NI) approach is suggested by Durand. He is of the view that
capital structure decision is relevant to the valuation of the firm. Any change
in the financial leverage will have a corresponding change in the overall cost
of capital and also the total value of the firm. As the ratio of debt to equity
increases, the Weighted Average Cost of Capital (WACC) declines and
market value of firm increases. According to this approach, a firm can
minimise the overall WACC and maximise the value of a firm by increasing
the proportion of debt in its capital structure.
The NI approach is based on 3 assumptions. They are:
 no taxes
 the cost of debt is less than the cost of equity and remains constant
 use of debt does not change the risk perception of investors
We know that,
K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
Where, B is the market value of Debt and S, the market value of equity.
The following graphical representation of NI approach may help us
understand this better. Figure 7.2 depicts the NI approach.

Figure 7.2: Net Income Approach

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Financial Management Unit 7

It can be understood from the given graphical representation that as the

market value of debt-to-equity ratio (B/S) increases, K0 decreases. This is
because the proportion of debt, the cheaper source of finance, increases in
the capital structure.

Solved Problem – 1
Given below are two firms, A and B, which are identical in all aspects
except the degree of leverage employed by them. What is the average cost
of capital of both firms? Table 7.1 depicts the details of firms A and B.
Table 7.1: Details of Firms A and B
Firm A Firm B
Net operating income EBIT Rs. 1, 00, 000 Rs. 1, 00, 000
Interest on debentures I Nil Rs. 25, 000
Equity earnings E Rs. 1, 00, 000 Rs. 75, 000
Cost of equity Ke 15% 15%
Cost of debentures Kd 10% 10%
Market value of equity S = E/Ke Rs. 6, 66, 667 Rs. 5,00, 000
Market value of debt B Nil Rs. 2, 50, 000
Total value of firm V Rs. 6, 66, 667 Rs. 7, 50, 000

Solution:
Average cost of capital of firm A is:
10% * 0/Rs. 666667 + 15% * 666667/666667 = 0 + 15 = 15%
Average cost of capital of firm B is:
10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10 = 13.4%
Interpretation:
The use of debt has caused the total value of the firm to increase and the
overall cost of capital to decrease.

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Solved Problem – 2
The net income approach may be illustrated with a numerical example.
There are two firms, A and B, similar in all aspects except in the degree of
leverage employed by them. Financial data for these firms are given
below: Calculate average cost of capital for both the firms.
Net Income approach
Amount (in Rs.) Firm A Firm B
Net operating income 10,000 10,000
Interest on debt 0 3,000
Equity earnings 10,000 7,000
Cost of equity capital 10% 10%
Cost of debt capital 6% 6%
Market value of equity 100,000 70,000
Market value of debt 0 50,000
Total value of firm 100,000 120,000
Average cost of capital for Firm A:
6% * 0/100,000 + 10% * 100,000/100,000 = 10%
Average cost of capital for firm B:
6% * 50,000/120,000 + 10% * 70,000/100,000 = 8.33%

7.4.2 Net operating income approach

Net Operating Income (NOI) approach is also propounded by Durand and is
totally opposite to the NI approach. Durand says that any change in
leverage will not lead to any change in the total value of the firm, market
price of shares, and overall cost of capital. The overall capitalisation rate
and the cost of debt is the same for all degrees of leverage.
We know that:
K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
As per the NOI approach, the overall capitalisation rate remains constant for
all degrees of leverage. The market values the firm as a whole and the split
in the capitalisation rates between debt and equity is not very significant.
The increase in the ratio of debt in the capital structure increases the
financial risk of equity shareholders and to compensate this, they expect a
higher return on their investments. Thus, K0 and Kd remaining constant for
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all degrees of leverage, the cost of equity is:

Ke = K0 +[ (K0 – Kd)(B/S)].

Cost of debt
The cost of debt has two parts. Figure 7.3 depicts the two parts of cost of
debt.

Figure 7.3: Cost of Debt

Let us now discuss these two parts in brief.

Explicit cost can be considered as the given rate of interest. The firm is
assumed to borrow irrespective of the degree of leverage. This can result to
a conclusion that the increasing proportion of debt does not affect the
financial risk of lenders, and they do not charge higher interest.
Implicit cost is the increase in Ke attributable to Kd. Thus the advantage of
use of debt is completely neutralised by the implicit cost resulting in Ke and
Kd being the same.
Figure 7.4 depicts the behaviour of Kd, Ke and K0, in response to changes in
B/S.

Figure 7.4: Graphical Representation of Debts

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Solved Problem – 3
Table 7.3 depicts the figures of two firms, X and Y, which are similar in all
aspects except the degree of leverage employed. Calculate the equity
capitalisation rates of the firms.
Table 7.3: Details of Firms X and Y
Firm X Firm Y
Net operating income EBIT Rs. 10000 Rs. 10000
Overall capitalisation rate K0 18% 18%
Total market value 55555 55555
V = EBIT/K0
Interest on debt I Rs. 1000 Rs. 2000
Debt capitalisation rate Kd 11% 11%
Market value of debt B= I/Kd Rs. 9091 Rs. 18181
Market value of equity S=V—B Rs. 46464 Rs. 37374
Leverage B/S 0.1956 0.2140

Solution:
The equity capitalisation rates are:
Ke = K0 +[ (K0 – Kd)(B/S)]
Firm X = 0.18 + [(0.18 – 0.11)(0.1956)] = 19.36%
Firm Y= 0.18 + [(0.18 – 0.11)(0.4865)] = 21.40%

Solved Problem – 4
Consider two firms, MA and CMA, which are similar in all aspects other
than the degree of leverage employed by them. Table 7.4 depicts the
financial data of both these firms. Calculate the equity capitalisation rates
of the firms.
Table 7.4: Details of Firms MA and CMA
Firms MA Firms CMA
Net operating income EBIT Rs. 20, 000 Rs. 20, 000
Overall capitalisation rate K0 19% 19%
Total market value 66, 666 66, 666
V = EBIT/K0
Interest on debt i Rs. 1, 500 Rs. 3, 000

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Debt capitalisation rate Kd 13% 13%

Market value of debt B = i/Kd Rs. 11, 538 Rs. 23, 077
Market value of equity S = V-B Rs. 55, 128 Rs. 43, 589
Leverage B/S 0.21 0.53

Solution:
The equity capitalisation rates are:
Ke = K0 +[ (K0 – Kd)(B/S)]
Firm MA = 0.19 + [(0.19 – 0.13)(0.21)] = 0.2026 = 20.26%
Firm CMA = 0.19 + [(0.19 – 0.13)(0.53)] = 0.2218 = 22.18%

7.4.3 Traditional approach

The traditional approach has the following propositions:
 Kd remains constant until a certain degree of leverage and thereafter
rises at an increasing rate
 Ke remains constant or rises gradually until a certain degree of leverage
and thereafter rises very sharply
 As a sequence to the above 2 propositions, K0 decreases till a certain
level, remains constant for moderate increases in leverage thereafter
and rises beyond a certain point
Figure 7.5 depicts the graphical representation based on the propositions
made on the traditional approach.

Figure 7.5: Propositions of Traditional Approach

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The approach primarily implies that the cost of capital is dependant on the
capital structure, and there is an optimal capital structure which minimises
the cost of capital. At this optimal capital structure, the real marginal cost of
debt and equity is the same. Before this point is reached, the real marginal
cost of debt is less than the real marginal cost of equity. After this point, the
real marginal cost of debt is more than the real marginal cost of equity.
7.4.4 Miller and Modigliani approach
Miller and Modigliani criticise traditional approach that the cost of equity
remains unaffected by leverage up to a reasonable limit and K0 remains
constant at all degrees of leverage. They state that the relationship between
leverage and cost of capital is elucidated as in NOI approach.
Table 7.6 depicts the assumptions regarding Miller and Modigliani (MM)
approach: perfect capital markets, rational behaviour, homogeneity, taxes,
and dividend payout.

Figure 7.6: Analysis of Miller and Modigliani Approach

Let us now discuss these assumptions in detail.

 Perfect capital markets – Securities can be freely traded, that is,
investors are free to buy and sell securities (both shares and debt
instruments), no hindrances on the borrowings, no presence of
transaction costs, securities are infinitely divisible, and availability of all
required information at all times.

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 Investors behave rationally – They choose the combination of risk and

return which is most advantageous to them.
 Homogeneity of investor’s risk perception – All investors have the
same perception of business risk and returns.
 Taxes – There is no corporate or personal income tax.
 Dividend payout is 100% – The firms do not retain earnings for future
activities.
7.4.4.1 Basic propositions
Three propositions can be derived based on the assumptions made on MM
approach:
Proposition I: The total market value of the firm, which is equal to the total
market value of equity and total market value of debt, is independent of the
degree of leverage. Therefore, the market value of the firm can be
expressed as:

Expected NOI/discount rate appropriate to its risk class

i.e., expected overall capitalisation rate

V = (S+B)

which is equal to O/k0

which is equal to NOI/k0

V = (S+B) = O/k0 = NOI/k0

Where V is the market value of the firm,

S is the market value of the firm’s equity,
B is the market value of the debt,
O is the net operating income,
k0 is the capitalisation rate of the risk class of the firm, i.e., the
discount rate applicable.

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Figure 7.7 depicts the graphical representation of proposition 1.

Figure 7.7: Representation of Proposition 1

The basic argument for proposition I is that equilibrium is restored in the

market by the arbitrage mechanism.
Arbitrage is the process of buying a security at lower price in one market
and selling it in another market at a higher price bringing about equilibrium.
This is a balancing act.
Miller and Modigliani perceive that the investors of a firm whose value is
higher will sell their shares and in return, buy shares of the firm whose value
is lower. They will earn the same return at lower outlay and lower perceived
risk. The MM hypothesis thus states that the total value of homogeneous
firms that differ only in leverage will not be different due to the arbitrage
operation.
Such behaviours are expected to increase the share prices whose shares
are being purchased and lowering the share prices of those share which are
being sold. This switching operation will continue till the market prices of
identical firms become equal or identical. Thus, the arbitrage process drives
the value of two homogeneous companies to equality that differs only in
leverage.
Proposition II: The expected yield on equity (ke) is equal to the discount
rate (capitalisation rate) applicable (k0) plus a premium. This premium is
equal to the debt-equity ratio times the difference between k0 and the yield
on debt, r.
This can be represented as below:
ke = k0 + [ (k0 – r) (B/S)]
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Proposition III: This proposition states the implication of the earlier

propositions for investment decision making.
It states that the average cost of capital is not affected by the financing
decisions as investment and financing decisions are independent.
7.4.4.2 Criticisms of MM proposition
There were many criticisms, on various grounds, over MM propositions.
Figure 7.8 depicts the criticisms of MM proposition.

Figure 7.8: Criticisms of MM Proposition

Let us now discuss these criticisms in detail.
Risk perception
The assumption that risks are similar is wrong. The risk perceptions of
investors/personal leverage and corporate leverage is different. The
presence of limited liability of firms in contrast to unlimited liability of
individuals puts firms and investors on a different footing.
All investors lose if a leveraged firm becomes bankrupt, but an investor
loses not only his or her shares in a company but would also be liable to
repay the money he or she borrowed.
Arbitrage process is one way of reducing risks. It is more risky to create
personal leverage and invest in unlevered firm than investing in levered
firms.
Convenience
Investors find personal leverage inconvenient. This is so because it is the
firm’s responsibility to observe corporate formalities and procedures
whereas it is the investor’s responsibility to take care of personal leverage.
Investors prefer the former rather than taking on the responsibility and thus
the perfect substitutability is subjected to question.
Transaction costs
Another cost that interferes in the system of balancing with arbitrage
process is the presence of transaction costs. Due to the presence of such
costs in buying and selling securities, it is necessary to invest a higher
amount to earn the same amount of return.

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Taxes
When personal taxes are considered along with corporate taxes, the MM
approach fails to explain the financing decision and the firm’s value.
Agency costs
A firm requiring loan approaches creditors and creditors may sometimes
impose protective covenants to protect their positions. Such restriction may
be in the nature of obtaining prior approval of creditors for further loans,
appointment of key persons, restriction on dividend payouts, limiting further
issue of capital, limiting new investments or expansion schemes, etc.

Taxation and other imperfections cast a shadow on the leverage irrelevance

theorem of MM and imply that the cost of capital is affected by financial
leverage. The effect of taxation is to reduce the cost of capital as financial
leverage increases. Alternatively, it implies that the value of the firm
increases with financial leverage.
Bankruptcy and agency costs, however, tend to increase the cost of capital
as financial leverage increases. In other words, these imperfections detract
from the value of the firm as financial leverage increases.

Self Assessment Questions

1. Financing decisions are ________ and have no impact on the
_______ of the firm.
2. The value of the firm is dependent on its _____ and the ________.
3. ______ and _________ are two important sources of long-term
sources of finance of a firm.
4. As the ratio of debt-to-equity increases, the ________ declines and
______ of the firm increases.
5. As per the NOI approach, the ___________ remains constant for all
degrees of leverage.
6. ___ is the process of buying a security at a lower price in one market
and selling it in another market at a higher price bringing about ____.
7. The criticisms over Miller and Modigliani approach are ______,
__________, _________, _________, and_________.
8. Define Arbitrage.
9. The features of an ideal capital structure are _______, __________,
________, and __________.
10. The Miller and Modigliani approach fails to explain ______ decisions
and _____ value.
7.5 Summary
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Let us recapitulate the important concepts discussed in this unit:

 The capital structure of a company refers to the mix of long-term
finances used by the firm. In short, it is the financing plan of the
company.
 The proportion of equity and debt in the capital structure of a firm is
based on the understanding and interpretation of the relationship
between the financial leverage and firm valuation or financial leverage
and cost of capital.
 Many theories have been propounded to understand the relationship
between financial leverage and firm value.
 NI approach indicates that any change in the financial leverage will have
a corresponding change in the overall cost of capital and also the total
value of the firm.
 NOI approach states that any change in leverage will not lead to any
change in the total value of the firm, market price of shares, and overall
cost of capital. The overall capitalisation rate and the cost of debt is the
same for all degrees of leverage.
 Traditional approach implies that the cost of capital is dependant on the
capital structure, and there is an optimal capital structure which
minimises the cost of capital.
 MM approach states that the financial leverage does not have any
impact on the value of the firm.

7.6 Glossary
Arbitrage: The process of buying a security at a lower price in one market
and selling it in another market at a higher price bringing about equilibrium.

7.7 Terminal Questions

1. What are the assumptions of MM approach?
2. The following data is available with respect to 2 firms. What is the
average cost of capital? Table 7.5 depicts the data of a company.
Table 7.5: Data of a Company

Firm A Firm B
Net operating income Rs. 5,00,000 Rs. 5,00,000

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Interest on debt Nil Rs. 50,000

Equity earnings Rs. 5,00,000 Rs. 4,50,000
Cost of equity capital 15% 15%
Cost of debt Nil 10%
Market value of equity shares Rs. 20,00,000 Rs. 14,00,000
Market value of debt Nil Rs. 4,00,000
Total value of firm Rs. 20,00,000 Rs. 18,00,000

3. Two companies are identical in all aspects except in the debt-equity

profile. Company X has 14% debentures worth Rs. 25,00,000 whereas
company Y does not have any debt. Both companies earn 20% before
interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax
rate of 40% and cost of equity capital to be 22%, find out the value of the
companies X and Y using NOI approach?
4. The market values of debt and equity of a firm are Rs. 10 crore and Rs.
20 crore respectively, and their respective costs are 12% and 14%. The
overall capital is 13.33%. Assuming that the company has a 100%
dividend payout ratio and there are no taxes, calculate the net operating
income of the firm.
5. If a company has equity worth Rs. 300 lakh, debentures worth Rs. 400
lakh, and term loan worth Rs. 50 lakh, calculate the WACC.

7.8 Answers

Self Assessment Questions

1. Investment decisions, operating earnings
2. Expected future earnings, required rate of return
3. Equity debt
4. WACC, market value
5. Overall capitalisation rate
6. Arbitrage, equilibrium
7. Risk perception, convenience, transaction costs, taxes and agency
costs.
8. Arbitrage is the process of buying a security at lower price in one
market and selling it in another market at a higher price bringing about
equilibrium. Thus arbitrage process is a balancing act.
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9. Profitability, flexibility, control, and solvency.

10. Financing, firm’s

Terminal Questions
1. Assumptions of Miller and Modigliani (MM) approach: perfect capital
markets, rational behaviour, homogeneity, taxes, and dividend payout.
Refer to 7.4.4
2. Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
3. Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
4. Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
5. WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt
Hint : we =0.4; W d = 0.533; wt = 0.067

7.9 Case Study: “Capital Structure of Indian Corporate:

Changing Trends
In the review article, “Capital Structure of Indian Corporate:
Changing Trends” in ASIAN Journal of Management Research,
Mr. Ashok Kumar Panigrahi, examines the changing trend of the capital
structure financing pattern of Indian companies during pre and post
liberalised era as well as in the recent past. Following are excerpts from the
publishing. Interested students can read the entire article on
http://ipublishing.co.in/ajmrvol1no1/EIJMRS1023.pdf
Introduction
Capital structure is the combination of debt and equity that funds an
organisation's strategic plan. The "right" capital structure supports strategic
financial goals while optimising flexibility and minimising cost. Capital
structure management can be approached by answering the question,
what is the appropriate amount, mix, structure, and cost of debt and
equity to support the organisation's strategic financial goals? The proper
and strategic management of capital structure ensures access to the capital
needed to fund future growth and enhance financial performance. The key
benefits of effective capital structure management are increased capital
access, added flexibility, and lower overall cost of capital.

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A company considered too highly leveraged (too much debt versus equity)
may find its freedom of action restricted by its creditors and/or may have its
profitability hurt as a result of paying high interest costs.
Theoretically, the financial manager should plan an optimum capital
structure for his/her company. The optimum capital structure is obtained
when the market value per share is at maximum. Since a number of factors
influence the capital structure decision of a company, the judgment of
the person making the capital structure decision plays a crucial part.
Two similar companies can have different capital structures if the decision
makers differ in their judgment of the significance of various factors.
Liberalisation of economy
The government of India started the economic liberalisation policy in 1991.
Even though the power at the centre has changed hands, the pace of
the reforms has never slackened till date. Before 1991, changes
within the industrial sector in the country were modest to say the least. Post
1991, a major restructuring has taken place with the emergence of more
technologically advanced segments among industrial companies.
Nowadays, more small-scale and medium-scale enterprises contribute
significantly to the economy.
By the mid 90s, the private capital had surpassed the public capital.
The management system had shifted from the traditional family based
system to a system of qualified and professional managers. One of the most
significant effects of the liberalisation era has been the emergence of
a strong, affluent, and buoyant middle class with significant purchasing
power, and this has been the engine that has driven the economy since.
Capital structure of Indian corporate before liberalisation
Studies on capital structure of Indian industries are inconclusive and often
conflicting. A study by Sharma and Rao (1968) on 30 engineering firms for 3
years concludes that debt due to its tax deductibility is a prominent
determinant of the cost of capital. A study by I. M. Pandey (1981) on cotton
textiles, chemicals, and engineering and electricity generations lends
support to the traditional approach. Bhatt (1980) in his paper concludes
that the leverage ratio is very much influenced by business risks measured
in terms of variability in earnings, profitability, debt service capacity, and
dividend payout ratio. I. M. Pandey (1984) in another study found

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that during 1973-81 about 80% of the assets of the companies sampled
were financed by external debt and current liabilities. Large-sized
companies were more levered though a large number of small firms also
courted more debt capital. Leverage did not exhibit a definite relationship
with growth and profitability, although all the three variables moved in the
same direction. He also found that a majority of the profitability and growth-
oriented companies were within the narrow bands of leverage.
Before 1980s, Indian financial managers courted debt due to its low cost,
tax advantages, and the complicated procedures to be observed in
garnering equity capital. The substitutability of short-term debt for long-term
loan was another attraction. However, with the waves of liberalisation,
privatisation, and globalisation sweeping the capital market in recent years,
the corporate world has started wooing equity capital in a big way. The
arrival of a matrix of new financial instruments such as commercial papers,
asset securitisation, factoring and forfeiting services, and the market related
interest rate structure and their stringent conditions for lending, force
modern enterprises to court equity finance.
Of different sources, bank credit has been working since long as a major
source of working capital in India and abroad. Long-term borrowings like
debenture, institutional loan, and government loan have also contributed to
working capital financing, since a part of current assets is usually
covered by long-term funds. Another viable source of working capital is
trade credit, which is considered to be a formality free, security free,
and interest free source of finance.
Impact of liberalisation on capital structure of Indian corporate
Until the early nineties, corporate financial management in India was
a relatively drab and placid activity. There were not many important financial
decisions to be made for the simple reason that firms were given very
little freedom in the choice of key financial policies. The government
regulated the price at which firms could issue equity, the rate of interest
which they could offer on their bonds, and the debt-equity ratio that was
permissible in different industries. Moreover, most of the debt and
a significant part of the equity were provided by public sector institutions.
The liberalisation changed all of this. The corporate sector was exposed to
international competition and subsidised finance gave way to a regime of

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high real interest rates. Consequently, the post-liberalised era has started
observing the following changes in the sources of Industrial finance:
 Domestic capital formation – It was envisioned that increased capital
formation would contribute for more industrial output and a 'virtuous
circle' of growth. Gross Capital Formation (GCF) is estimated across
three types of assets, viz, construction, machinery, and equipment.
The GCF, adjusted for errors and omissions, is termed as aggregate
investment or Gross Domestic Capital Formation (GDCF). A
positive association is hypothesised between the capital formation
and the industrial production.
 Foreign direct investment – A few decades ago, many countries
considered FDI as the source of economic imperialism, but things are
quite different now. The argument is that FDI contribute to the growth of
host economies in many ways. For example, physical capital formation,
technology transfer, human formation, stimulation of productivity,
augmentation of output, promotion of foreign trade, and improvement of
competitiveness of indigenous entrepreneurs.
As part of the economic reforms introduced in 1991, in the wake of
a sharp external payments crisis, policies relating to foreign investment
and foreign technology agreements were radically changed.
 Primary issues in the capital market - With the liberalisation of the
Indian economy since 1991, the government has provided a number of
additional fiscal and other incentives to foster capital market
development. The magnitude of growth has been rapid and vivid in terms
of fund mobilised, the amount of market capitalisation, and the
expansion of investor population. The Indian market was opened up for
investment by the Foreign Institutional Investors (FIIs) in September
1992, and the Indian companies were allowed to raise resources abroad
through Global Depository Receipts (GDR) and Foreign Currency
Convertible Bonds (FCCB).
 Bank credit – Banks are the dominant financial intermediaries in
developing countries including India. Bank credit is considered as an
important source of industrial finance. The dependence on bank for
finance could vary according to the size of the companies. The small-
scale industrial units have increased their dependence on banks for
loans because they have virtually no access to the capital markets.

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The financial sector reforms, based on working committee reports were

mainly aimed to provide credit to the industrial sector by reducing
the cash reserve ratio and statutory liquidity ratio. The liberalisation
policy also called for increased efficiency of commercial banks by
encouraging them to compete in the market. The public sector banks
were given autonomy to frame their policies including interest rate
fixation. It may be noted that the bank credit to the industrial sector has
not increased during the post-reform period in spite of the various
attempts.
Capital structure of Indian corporate after liberalisation
Capital structure management has been impacted by a number of
developments discussed above. Some of the important implications of
these changes for short-term financial management in the Indian corporate
sector are:
a) Creditworthiness – The abolition of the notion of maximum permissible
bank finance has given banks greater freedom and responsibility for
assessing credit needs and creditworthiness.
b) Choice – Top notch corporate borrowers are seeing a plethora of
choices. The disintegration of the consortium system, the entry of term
lending institutions into working capital finance, and the emergence of
money market borrowing options gives them the opportunity to
shop around for the best possible deal.
c) Maturity profile – The greater concern for interest rate risk makes
choice of debt maturity more important than before. Short-term
borrowings expose borrowers to rollover risk and interest rate risk.
d) Cash management – Companies now have to decide on the optimal
amount of cash or near-cash that they need to hold and also on how
to deploy the cash. Deployment, in turn, involves decisions
about maturity, credit risk, and liquidity.

Capital structure of Indian companies in the recent past

 Indian corporate employs substantial amount of debt in their capital
structure in terms of the debt-equity ratio as well as total debt to total
assets ratio.

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 The corporate enterprises in India seem to prefer long-term borrowings

over short-term borrowings.
 As a result of debt-dominated capital structure, the Indian corporate
is exposed to a very high degree of total risk. It is reflected in high
degree of operating leverage and financial leverage. Consequently, it is
subject to a high cost of financial distress which includes a broad
spectrum of problems ranging from relatively minor liquidity shortages to
extreme cases of bankruptcy.
 Retained earnings are the most favoured source of finance.
 Loan from financial institutions and private placement of debt are the
next most widely used sources of finance.
 The hybrid securities are the least popular source of finance amongst
corporates in India.
 Equity capital as a source of fund is not preferred across the board.
 To sum up, nature of the industry to which the firm belongs to, its size,
age, and location plays a major role in the determination of the capital
structure of the private sector firms of Indian corporate.
[Source: ASIAN JOURNAL OF MANAGEMENT RESEARCH,
Online Open Access publishing platform for Management Research –
Capital Structure of Indian Corporate: Changing Trends by
Ashok Kumar Panigrahi
Discussion Questions:
1. How do you think the trend of capital structures across the Indian
corporates affect the economy as a whole?
(Hint: factors affecting capital structure)
2. The author, in his study, has found that corporates are increasingly going
in for debt-dominant structures. Why do you think that is?
(Hint: debt is cheap)
3. There are various approaches that examine the relationship between
financial leverage and a firm’s value. We have seen the important ones,
the NI approach, the NOI approach, the traditional approach, and the
MM approach. If you were to argue in support of any one of these in the
background of the Indian scenario, which one would you pick and why?
(Hint: Theories of Capital Structure)

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(http://ipublishing.co.in/ajmrvol1no1/EIJMRS1023.pdf)]

Reference:
 Prasanna, Chandra (2007), Financial Management: Theory and Practice,
7th Edition, Tata McGraw Hill.
 Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition

E-Reference:
 http://ipublishing.co.in/ajmrvol1no1/EIJMRS1023.pdf retrieved on
11/12/2011
 Egyankosh.ac.in
 Igidr.ac.in

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Financial Management Unit 8

Unit 8 Capital Budgeting

Structure:
8.1 Introduction
Objectives
8.2 Importance of Capital Budgeting
8.3 Complexities Involved in Capital Budgeting Decisions
8.4 Phases of Capital Expenditure Decisions
8.5 Identification of Investment Opportunities
8.6 Rationale of Capital Budgeting Proposals
8.7 Capital Budgeting Process
Technical appraisal
Economic appraisal
Financial appraisal
8.8 Investment Evaluation
Estimation of cash flows
Estimation of incremental cash flows
8.9 Appraisal Criteria
Traditional techniques
Pay back method
Accounting rate of return
Discounted pay-back period
Discounted cash flow method
8.10 Summary
8.11 Glossary
8.12 Terminal Questions
8.13 Answers
8.14 Case Study

8.1 Introduction
In the previous unit, we have discussed about features of ideal capital
structure, factors affecting capital structure, and theories of capital structure.
In this unit we will discuss about capital budgeting. Indian economy is
growing at 9% per annum. New lines of business such as retailing
investment, investment advisory services and private banking are emerging.
We have already discussed in the previous units that businesses involve
investment decisions.
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In this unit, we will discuss the capital budgeting. The investment decisions
taken by corporates are known as capital budgeting decisions. Such
decisions help corporates reap the benefits arising out of the emerging
business opportunities.
The capital budgeting decisions involve evaluation of specific investment
proposals. Here, the word “capital” refers to the operating assets used in
production of goods or rendering of services. The word budgeting involves
formulating a plan of the expected cash flows during the future period.
Capital budgeting is a blue-print of planned investments in operating assets.
Thus, capital budgeting is the process of evaluating the profitability of the
projects under consideration and deciding on the proposal to be included in
the capital budget for implementation.
Capital budgeting decisions involve investment of current funds in
anticipation of cash flows occurring over a series of years in future. All these
strategic decisions can change the profile of the organisations.
Successful organisations have created wealth for their shareholders through
capital budgeting decisions. Investment of current funds in long term assets
for generation of cash flows in future over a series of years characterises
the nature of capital budgeting decisions.
HDFC bank takes over Centurion Bank of Punjab. ICICI bank took over
Bank of Madurai. The motive behind all these mergers is to grow, because
in this era of globalisation, the need of the hour is to grow as big as
possible. In all these, one could observe the desire of the management to
create value for shareholders as a motivating force.
Another way of growing involves branch expansion, product mix expansion
and cost reduction through improved technology for deeper penetration into
the market.

Example 1
A bank, which is urban based, takes over a bank with rural network for
expansion, because urban based bank can open more urban branches
only when it meets the Reserve Bank of India guideline of having a
minimum number of rural branches. This is the motive of the merger of
urban based bank of ICICI with the rural based Bank of Madurai.

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Investment of current funds in long-term assets for generation of cash flows

in future, over a series of years characterises the nature of capital budgeting
decisions.
Objectives:
After studying this unit, you should be able to:
• explain the concept of capital budgeting
• recall the importance of capital budgeting
• examine the complexity of capital budgeting procedures
• analyse the various techniques of appraisal methods
• evaluate the capital budgeting decision

8.2 Importance of Capital Budgeting

In this section, we will discuss the importance of capital budgeting. Capital
budgeting decisions are the most important decisions in corporate financial
management. These decisions make or mar a business organisation. These
decisions commit a firm to invest its current funds in the operating assets
(i.e. long-term assets) with the hope of employing those most efficiently to
generate a series of cash flows in future. These decisions could be grouped
as:
• Decision to replace the equipments for maintenance of current level of
business or decisions aiming at cost reductions, known as replacement
decisions
• Decisions expansion through improved network of distribution or on
expenditure for increasing the present operating level
• Decisions for production of new goods or rendering of new services
• Decisions on penetrating into new geographical area
• Decisions to comply with the regulatory structure affecting the operations
of the company, like investments in assets to comply with the conditions
imposed by Environmental Protection Act
• Decisions on investment to build township for providing residential
accommodation to employees working in a manufacturing plant
The reasons that make the capital budgeting decisions most crucial for
finance managers are as follows:
• These decisions involve large outlay of funds in anticipation of cash
flows in future, for example, investment in plant and machinery. The
economic life of such assets has long periods. The anticipated
projections of cash flows involve forecasts of many financial variables of
which the most crucial variable is the sales forecast.

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For example, Metal Box spent large sums of money on expansion of its
production facilities based on its own sales forecast. During this period,
huge investments in R & D of packaging industry brought about new
packaging medium that totally replaced metal as an important component of
packing boxes. At the end of the expansion, Metal Box Ltd found that the
market for its metal boxes has declined drastically.
The end result was that Metal Box became a sick company from the position
it enjoyed prior to the execution of expansion as a blue chip. Employees lost
their jobs. It affected the standard of living and cash flow position of its
employees. This highlights the element of risk involved in these types of
decisions.
Equally, we have empirical evidence of companies which took decisions on
expansion through the addition of new products and adoption of the latest
technology, creating wealth for share-holders. The best example is the
Reliance Group.
In case there is any serious error in forecasting sales, the amount of capital
expenditure can significantly affect the firm. An upward bias might lead to a
situation of the firm creating idle capacity.
Any downward bias in forecasting might lead the firm to a situation of losing
its market to its competitors.
• Sometimes, long time investments of the funds may change the risk
profile of the firm.

Example 2
A FMCG company decides to enter into a new business of power
generation. This decision will totally alter the risk profile of the company
business. Investor’s perception of risk of the new business to be taken up
by the company will change its required rate of return to invest in the
company.
In this connection it should be noted that the power pricing is a politically
sensitive area, affecting the profitability of the organisation. Therefore,
capital budgeting decisions change the risk dimensions of the company
and hence, the required rate of return that the investors want.

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• Most of the capital budgeting decisions involve huge outlay. The funds
required during the phase of execution must be synchronised with the
flow of funds. Failure to achieve the required coordination between the
inflow and outflow may cause time over-run and cost over-run.
These two problems of time overrun and cost overrun have to be
prevented from occurring in the beginning of execution of the project.
Quite a lot of empirical examples are there in public sector in India in
support of this argument that cost overrun and time overrun can make a
company’s operation unproductive.
• Capital budgeting decisions involve assessment of market for company’s
product and services, deciding on the scale of operations, selection of
relevant technology and finally procurement of costly equipment.
If a firm were to realise after committing itself to considerable sums of
money in the process of implementing the capital budgeting decisions
taken that the decision to diversify or expand would become a wealth
destroyer to the company, then the firm would have experienced a
situation of inability to sell the equipments bought. Loss incurred by the
firm would be heavy if the firm were to scrap the equipments bought
specifically for implementing the decision taken. Sometimes these
equipments will be specialised costly equipments. Therefore, capital
budgeting decisions are irreversible. All capital budgeting decisions
involve three elements. These three elements are:
o cost
o quality
o timing
Decisions must be taken at the right time which would enable the firm to
procure the assets at the least cost for producing products of required
quality for the customer. Any lapse on the part of the firm in
understanding the effect of these elements on implementation of capital
expenditure, will strategically affect the firm’s profitability.
• Liberalisation and globalisation gave birth to economic institutions like
world trade organisations. General Electrical can expand its market into
India snatching away the share that was enjoyed by firms like Bajaj
Electricals or Kirloskar Electric Company. Ability of GE to sell its
products in India at a rate lesser than the rate, at which Indian
companies sell, cannot be ignored.
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Therefore, the growth and survival of any firm in today’s business

environment demands it to be pro-active. Pro-active firms cannot avoid
the risk of taking challenging decisions of capital budgeting for growth.
• The social, political, economic and technological forces generate high
level of uncertainty in future cash flow streams associated with capital
budgeting decisions. These factors make these decisions highly
complex.
• Capital budgeting decisions are very expensive. To implement these
decisions, firms will have to tap the capital market for funds. The
composition of debt and equity must be optimal keeping in view the
expectations of investors and risk profile of the selected project.
Therefore, capital budgeting decisions for growth have become an essential
characteristic of successful firms today.

Self Assessment Questions

1. ____________make or mar a business.
2. _________decisions involve large outlay of funds in anticipation of cash inflows
in future.
3. Social, political, economical and technological forces make capital budgeting
decisions.

8.3 Complexities Involved in Capital Budgeting Decisions

Let us discuss the complexities involved in capital budgeting decisions.
Capital expenditure decision involves forecasting of future operating cash
flows. Forecasting the future cash flows demands certain assumptions
about the behaviour of costs and revenues in future.

Example 3
The arrival of mobile revolution made the pager technology obsolete. The
firms which invested in pagers faced the problem of pagers losing its
relevance as a means of communication. The firms with the ability to
adapt the new know-how in mobile technology could survive the effect of
this phase of technological obsolescence. Others who could not manage
the effect of change in technology had a natural death and so most
capital expenditure decisions are irreversible.

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However, there are complexities involved in capital budgeting decisions.

They are as follows:
• Estimation of future cash flows
• Commitment of funds on long-term basis
• Problem of irreversibility of decisions

Self Assessment Questions

4. __________________commit a firm to invest its current funds in the operating
assets (i.e. long-term assets) with the hope of employing those most efficiently
to generate a series of cash flows in future.
5. Capital expenditure decisions are_________ .
6. Forecasting of future operating cash flows from because the future is
________

8.4 Phases of Capital Expenditure Decisions

In this section, we will discuss the phases of capital expenditure decisions.
There are various phases involved in capital budgeting decisions such as:
• Identification of investment opportunities
• Evaluation of each investment proposal
• Examination of the investments required for each investment proposal
• Preparation of the statements of costs and benefits of investment
proposals
• Estimation and comparison of the net present values of the investment
proposals that have been cleared by the management on the basis of
screening criteria
• Examination of the government policies and regulatory guidelines, for
execution of each investment proposal screened and cleared based on
the criteria stipulated by the management
• Budgeting for capital expenditure for approval by the management
• Implementation
• Post-completion audit

Self Assessment Questions

7. Post-completion audit is________ in the phases of capital budgeting decisions.
8. Identification of investment opportunities is the _______in the phases of capital
budgeting decisions.

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8.5 Identification of Investment Opportunities

In this section, we will discuss the identification of investment opportunities.
A firm is in a position to identify investment proposal only when it is
responsive to the ideas of capital projects emerging from various levels of
the organisation. The proposal may be to:
• Add new products to the company’s product line
• Expand capacity to meet the emerging market demand for company’s
products
• Add new technology based process of manufacture that will reduce the
cost of production

Caselet 1
A sales manager may come with a proposal to produce a new product as
per the requirements of company’s consumers. Marketing manager,
based on the sales manager’s proposal, may conduct a market survey to
determine the expected demand for the new product under consideration.
Once the marketing manager is convinced of the market potential for
proposed new product, the proposal goes to the engineers to examine it
with all aspects of production process. Then the proposal goes to the cost
accountant to translate the entire gamut of the proposal into costs and
revenues in terms of incremental cash flows, both outflows and inflows.
The cost-benefit statement generated by cost accountant shall include all
incremental costs and benefits that the firm will incur and derive on
commercialisation of the proposal under consideration.

Therefore, generation of ideas with the feasibility to convert them into

investment proposals occupies a crucial place in the capital budgeting
decisions. Proactive organisations encourage a continuous flow of
investment proposals from all levels in the organisation.
In this connection following points deserve to be considered:
• Analysing the demand and supply conditions of the market for the
company’s product could be a fertile source of potential investment
proposals.
• Market surveys on customer’s perception of company’s product could be
a potential investment proposal to redefine the company’s products in
terms of customer’s expectations.

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• Companies which invest in research and development constantly get

exposure to the benefit of adapting the new relevant technology to keep
the firm competitive in the most dynamic business environment. Reports
emerging from R&D section could be a potential source of investment
proposal.
• Economic growth of the country and the emerging middle class endowed
with purchasing power could generate new business opportunities in
existing firms. These new business opportunities could be potential
investment ideas.
• Public awareness of their rights compels many firms to initiate projects
from environmental protection angle. If ignored, the firm may have to
face the public wrath through PILs entertained at the Supreme Court and
High Courts.
Therefore, project ideas that would improve the competitiveness of the firm
by constantly improving the production process with the sole objective of
cost reduction and customer welfare, are accepted by well managed firms.
Self Assessment Questions
9. Analysing the demand and supply conditions of the market for the company’s
products could be_______ of potential investment proposal.
10. Generation of ideas for capital budgets and screening the same can be
considered_________of capital budgetary decisions.

8.6 Rationale of Capital Budgeting Proposals

The investors and the stake-holders expect a firm to function efficiently to
satisfy their expectations. The stake-holders’ expectation and the
performance of the company may clash among themselves, the one that
touches all these stake-holders’ expectation could be visualised in terms of
firm’s obligation to reduce the operating costs on a continuous basis and to
increase its revenues.
Therefore, capital budgeting decisions could be grouped into two categories:
• Decisions on cost reduction programmes
• Decisions on revenue generation through expansion of installed capacity

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Self Assessment Questions

11. _______decisions could be grouped into two categories.
12. _______and revenue generation are the two important categories of capital
budgeting.

8.7 Capital Budgeting Process

In this section, we will discuss the capital budgeting process. After the
screening of proposals for potential involvement is over, the company
should take up the following aspects of capital budgeting process:
• A proposal should be commercially viable. The following aspects are
examined to ascertain the commercial viability of any investment
proposal:
o Market for the product
o Availability of raw materials
o Sources of raw materials
o The elements that influence the location of a plant, i.e., the factors to
be considered in the site selection
• Infrastructural facilities such as roads, communication facilities, financial
services such as banking and public transport services
Ascertaining the demand for the product or services is crucial. It is done by
market appraisal. In appraisal of market for the new product, the following
details are compiled and analysed:
• Consumption trends
• Competition and players in the market
• Availability of substitutes
• Purchasing power of consumers
• Regulations stipulated by government on pricing the proposed products
or services
• Production constraints
Relevant forecasting technologies are employed to get a realistic picture of
the potential demand for the proposed product or service. Many projects fail
to achieve the planned targets on profitability and cash flows, if the firm
could not succeed in forecasting the demand for the product on a realistic
basis. Capital budgeting process involves three steps – Financial appraisal,

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Technical appraisal and Economic appraisal. Figure 8.1 depicts the capital
budgeting process.

Figure 8.1: Capital Budgeting Process

8.7.1 Technical appraisal

The technical appraisal deals with the technical aspects of the project. The
technical aspects of a project are:
• Selection of process know-how
• Decision on determination of plant capacity
• Selection of plant, equipment and scale of operation
• Plant design and layout
• General layout and material flow
• Construction schedule
Technical appraisal ensures implementation of all the technical aspects of
the project.
8.7.2 Economic appraisal
The economic appraisal deals with economic and social impacts of a
project. It examines the impact of the project on the following:
• Environment
• Income distribution in the society
• Fulfilment of certain social objective like generation of employment and
attainment of self sufficiency
• Materially altering the level of savings and investment in the society
Economic appraisal examines the project from the social point of view.
Hence, is referred to as social cost benefit analysis.
8.7.3 Financial appraisal
Financial appraisal is to examine the financial viability of the project.
Financial appraisal technique examines:
• Cost of the project
• Investment outlay
• Means of financing and the cost of capital
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• Expected profitability
• Expected incremental cash flows from the project
• Break-even point
• Cash break-even point
• Risk dimensions of the project
• Project potential to materially alter the risk profile of the company
• If the project is financed by debt, expected “Debt Service Coverage
Ratio”
• Tax holiday benefits, if any
Under this appraisal, the risk and returns at various stages of project
execution are assessed. Besides, it examines whether the risk adjusted
return from the project exceeds the cost of financing the project.

Self Assessment Questions

13. _______examines the project from the social point of view.
14. All technical aspects of the implementation of the project are considered
in______.
15. _______of a project is examined by financial appraisal.
16. Among the elements that are to be examined under commercial appraisal, the
most crucial one is the_________.

8.8 Investment Evaluation

In this section, we will discuss the investment evaluation. Steps involved in
the evaluation of any investment proposal are:
• Estimation of cash flows both inflows and outflows occurring at different
stages of project life cycle
• Examination of the risk profile of the project to be taken up and arriving
at the required rate of return
• Formulation of the decision criteria
Now, let us discuss each of the steps in details.
8.8.1 Estimation of cash flows
Estimating the cash flows associated with the project under consideration is
the most difficult and crucial step in the evaluation of an investment
proposal. Estimation is the result of the team work of many professionals in
an organisation.

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• Capital outlays are estimated by engineering departments after

examining all aspects of production process
• Marketing department on the basis of market survey forecasts the
expected sales revenue during the period of accrual of benefits from
project executions
• Operating costs are estimated by cost accountants and production
engineers
• Incremental cash flows and cash out flow statement is prepared by the
cost accountant on the basis of the details generated in the above steps
The ability of the firm to forecast the cash flows with reasonable accuracy
lies at the root of the success of the implementation of any capital
expenditure decision.
8.8.2 Estimation of incremental cash flows
Investment (capital budgeting) decision requires the estimation of
incremental cash flow stream over the life of the investment. Incremental
cash flows are estimated on tax basis.
Incremental cash flows stream of a capital expenditure decision has three
components.
• Initial cash outlay (Initial investment)
Initial cash outlay to be incurred is determined after considering any post
tax cash inflows. In replacement decisions, existing old machinery is
disposed of and new machinery incorporating the latest technology is
installed in its place.
On disposal of existing old machinery the firm has a cash inflow. This
cash inflow has to be computed on post tax basis. Therefore, the net
cash out flow (total cash required for investment in capital assets minus
post tax cash inflow on disposal of the old machinery being replaced by
a new one) is the incremental cash outflow. Additional net working
capital required on implementation of new project is to be added to initial
investment.
• Operating cash inflows
Operating cash inflows are estimated for the entire economic life of
investment (project). Operating cash inflows constitute a stream of
inflows and outflows over the life of the project. Here, incremental inflows

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and outflows attributable to operating activities are also considered. Any

savings in cost on installation of new machinery in the place of the old
machinery will have to be accounted on post tax basis. In this connection
incremental cash flows refer to the change in cash flows on
implementation of a new proposal over the existing positions.
• Terminal cash inflows
At the end of the economic life of the project, the operating assets
installed will be disposed off. It is normally known as salvage value of
equipments. The terminal cash inflows are computed on post tax basis.
Prof. Prasanna Chandra in his book, Financial Management has identified
certain basic principles of cash flow estimation. The knowledge of these
principles will help a student in understanding the basics of computing
incremental cash flows.
The basic principles of cash flow estimation, by Prof. Prasanna Chandra,
are – Separation principle, Increment principle, Post-tax principle and
Consistency principle. Figure 8.2 depicts the principles of cash flow
estimation.

Separation Incremental
principle principle
Figure 8.2: Principles of Cash Flow Estimation

Separation principle
The essence of this principle is the necessity to treat investment element of
the project separately (i.e. independently) from that of financing element.
The financing cost is computed by the cost of capital. Cost of capital is the
cut off rate and rate of return expected on implementation of the project.
Therefore, we separately compute cost of funds for execution of project
through the financing mode. The rate of return expected on implementation
if the project is arrived at, by the investment profile of the projects.
Therefore, interest on debt is ignored while arriving at operating cash
inflows.

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The following formula is used to calculate profit after tax

Incremental PAT = Incremental EBIT ( 1-t )

(Incremental) (Incremental)

EBIT = earnings (profit) before interest and taxes

t = tax rate
Incremental principle
Incremental principle says that the cash flows of a project are to be
considered in incremental terms. Incremental cash flows are the changes in
the firm’s total cash flows arising directly from the implementation of the
project. While determining incremental cash flows, keep the following things
in mind:
• Ignore sunk costs - Sunk costs are costs that cannot be recovered after
they have been incurred. Therefore, sunk costs are ignored when the
decision on project under consideration is to be taken.
• Opportunity costs - If the firm already owns an asset or a resource,
which could be used in the execution of the project under consideration,
then the asset or the resource has an opportunity cost. The opportunity
cost of such resources will have to be taken into account in the
evaluation of the project for acceptance or rejection.

Caselet 2
A firm wants to open a branch in Chennai for expansion of its market in
Tamil Nadu. The firm already owns a building in Chennai. The building in
Chennai is let out to some other firm on an annual rent of Rs. 1 crore. For
opening the branch at Chennai the firm uses its own building by
sacrificing the rental income which it has been receiving. The opportunity
cost of the building at Chennai is Rs. 1 crore. This will have to be
considered in arriving at the operating cash flows associated with the
decision to open a branch at Chennai.

• Need to take into account all incident effect - Effects of a project on

the working of other parts of a firm, also known as externalities, must be
taken into account.

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Caselet 3
Expansion or establishment of a branch at a new place may increase the
profitability of existing branches because the branch at the new place has
a complementary relationship with the other existing branches or it may
reduce the profitability of existing branches because the branch at the new
place competes with the business of other existing branches or takes
away some business activities from the existing branches.
• Cannibalisation – Another problem that a firm faces on introduction of a
new product is the reduction in the sale of an existing product. This is
called cannibalisation. The most challenging task is handling the
problems of cannibalisation. Depending on the company’s position with
that of the competitors in the market, appropriate strategy has to be
followed. Correspondingly, the cost of cannibalisation will have to be
treated as either relevant cost of the decision or ignored.
Product cannibalisation will affect the company’s sales if the firm is
marketing its products in a market characterised by severe competition,
without any entry barriers. In this case, costs are not relevant for
decision.
However, if the firm’s sales are not affected by competitor’s activities due to
certain unique protection that it enjoys on account of brand positioning or
patent protection, the costs of cannibalisation cannot be ignored in taking
decisions.
Post tax principle
All cash flows should be computed on post tax basis.
Consistency principle
Cash flows and discount rates used in project evaluation need to be
consistent with the investor group and inflation.

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Solved Problem – 1
A firm is considering replacement of its existing machine by a new
machine. The new machine will cost Rs. 1,60,000 and have a life of five
years. The new machine will yield annual cash revenue of Rs. 2,50,000
and incur annual cash expenses of Rs. 1,30,000. The estimated salvage
of the new machine at the end of its economic life is Rs. 8,000. The
existing machine has a book value of Rs 40,000 and can be sold for
Rs. 20,000. The existing machine, if used for the next five years is
expected to generate annual cash revenue of Rs. 2,00,000 and involves
annual cash expenses of Rs. 1,40,000. If sold after five years, the
salvage value of the existing machine will be negligible.
The company pays tax at 30%. It writes off depreciation at 25% on the
written down value. The company’s cost of capital is 20%. Compute the
incremental cash flows of replacement decisions.
Solution
Table 8.1 gives the initial investments and annual cash flows from
projects.
Table 8.1: Initial Investments and Annual Cash Flows
Initial investment
Gross investment for new machine (1, 60, 000)
Less: cash received from the sale of existing machine 20, 000
Net cash outlay (1, 40, 000)
Annual cash flows from operations
Incremental cash flows from revenue 50, 000
Incremental decrease in expenditure 10, 000

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Table 8.2 shows the incremental depreciation schedule:

Table 8.2: Incremental Depreciation Schedule
Year Depreciation Depreciation Incremental
(new machine) (old machine) depreciation (Rs.)
1 45, 000 10,000 (35,000)
2 33, 750 7,500 (26,250)
3 25, 312 5,625 (19,687)
4 18, 984 4,219 (14,765)
5 14, 238 3,164 (11,074)

Table 8.3 shows the calculation of depreciation:

Table 8.3: Calculation of Depreciation
Book value 40, 000
Add: cost of new machine 1, 60, 000
2, 00, 000
Less: sale proceeds of old machine 20, 000
1, 80, 000
Depreciation for 1 year 25% 45, 000
1, 35, 000
Depreciation for 2 year 25% 33, 750
1, 01, 250
Depreciation for 3 year 25% 25, 312
75, 938
Depreciation for 4 year 25% 18, 894
56, 954
Depreciation for 5 year 25% 14, 238
Book value after 5 years 42, 716

The computation of the incremental cash flows of replacement decisions

is briefly described in table 8.4.

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Table 8.4: Statement of Incremental Cash Flows

Particulars Year
0 1 2 3 4 5
1. Investment in new (1,60,000)
machine
2. After tax salvage 20,000
value of old
machine
3. Net Cash Out lay (1,40,000)
4. Increase in revenue 50,000 50,000 50,000 50,000 50,000
5. Decrease in 10,000 10,000 10,000 10,000 10,000
expenses
6. Increase in (35,000) (26,250) (19,687) (14,765) (11,074)
depreciation
7. Increase in EBIT 25,000 33,750 40,313 45,235 48,926
(4+5 -6)
8. EBIT (1 – T) 17,500 23,625 28,219 31,665 34,248
(1-.30)
9. Incremental Cash 52,500 49,875 47,906 46,430 45,322
flows from operation
(8 + 6)
EAT + Depreciation
10. Salvage value of 8,000
new machine
11. Incremental Cash (1,40,000) 52,500 49,875 47,906 46,430 53,322
flows from operation negative
(8 + 6)
EAT + Depreciation

Activity-1
Complete the following table
Particulars Rs.
Sales
Less: Cost of goods sold
Less: Cost of goods sold

Less: Operating expenses excluding depreciation

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Less: Depreciation

Less: interest

Less: Tax

Add:
CFAT (Cash Flow After Tax)
Hint
Particulars Rs.
Sales
Less: Cost of goods sold
Gross profit
Less: operating expenses excluding depreciation
EBDIT (Earnings before depreciation, interest and tax)
Less: Depreciation
EBIT (Earnings before interest and tax)
Less: interest
EBT (Earnings before tax)
Less: Tax
PAT (Profit after tax)
Add: depreciation
CFAT (Cash Flow After Tax)

Self Assessment Questions

17. ________is the third step in the evaluation of investment proposal.
18. A_______ is not a relevant cost for the project decision.
19. Effect of a project on the working of other parts of a firm is known as______
20. The essence of separation principle is the necessity to treat______ of a project
separately from that of__________.
21. Pay-back period _________time value of money.
22. IRR gives a rate of return that reflects the _______ the project.

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8.9 Appraisal Criteria

The methods of appraising an investment proposal can be grouped into:
• Traditional methods
• Modern methods
Let us discuss both the methods in detail.
8.9.1 Traditional techniques
Traditional methods are of two types – payback method and accounting rate
of return.
8.9.1.1 Payback method
Payback period is defined as the length of time required to recover the initial
cash out lay.

Solved Problem – 2
Table 8.5 gives details on the cash flows of two projects A and B.
Table 8.5: Cash Flows of A and B
Year Project A cash flows (Rs.) Project B cash flows (Rs.)
0 (4,00,000) (5,00,000)
1 2,00,000 1,00,000
2 1,75,000 2,00,000
3 25,000 3,00,000
4 2,00,000 4,00,000
5 1,50,000 2,00,000
Compute pay-back period for A and B.

Solution
Table 8.6 shows the cash flows and the cumulative cash flows of the
projects A and B.
Table 8.6 Cash Flows and Cumulative Cash Flows of A and B
Year Project A Project B
Cash flows Cumulative Cash flows Cumulative
(Rs.) Cash flows (Rs.) Cash flows
1 2,00,000 2,00,000 1,00,000 1,00,000
2 1,75,000 3,75,000 2,00,000 3,00,000
3 25,000 4,00,000 3,00,000 6,00,000
4 2,00,000 6,00,000 4,00,000 10,00,000
5 1,50,000 7,50,000 2,00,000 12,00,000

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From the cumulative cash flows column, project A recovers the initial
cash outlay of Rs 4,00,000 at the end of the third year. Therefore,
payback period of project A is 3 years.
From the cumulative cash flow column the initial cash outlay of
Rs. 5,00,000 lies between 2nd year and 3rd year in case of project B.
Therefore, payback period for project B is:
5,00,000 − 3,00,000
2+
3,00,000
= 2.67 years
Pay-back period for project B is 2.67 years

Evaluation of payback period

Let us discuss the merits and demerits of the payback period.
Merits of payback period
• It is simple in concept and application.
• Emphasis is on recovery of initial cash outlay. Pay-back period is the
best method for evaluation of projects with very high uncertainty.
• With respect to accept or reject criterion, pay back method favours a
project which is less than or equal to the standard pay back set by the
management. In this process, early cash flows get due recognition than
later cash flows. Therefore, pay-back period could be used as a tool to
deal with the ranking of projects on the basis of risk criterion.
• For firms with short-age funds, this method is preferred, because it
measures liquidity of the project.
Demerits of payback period
• Pay-back period ignores time value of money.
• It does not consider the cash flows that occur after the pay-back period.
• It does not measure the profitability of the project.
• It does not throw any light on the firm’s liquidity position but just tells
about the ability of the project to return the cash out lay originally made.
• Project selected on the basis of pay back criterion may be in conflict with
the wealth maximisation goal of the firm.

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Accept or reject criteria

If projects are mutually exclusive, select the project which has the least pay-
back period.
With respect to other projects, select the project which has pay-back period
less than or equal to the standard pay back stipulated by the management.
Illustration
Pay-back period:
Project A = 3 years
Project B = 2.5 years
Standard set up by management = 3 years
If projects are mutually exclusive, accept project B which has the least pay-
back period.
If projects are not mutually exclusive, accept both the projects, because
both have pay-back period less than or equal to the standard pay-back
period set by the management.
Pay-back formula

Year prior to full recovery + Balance of initial out lay to be recovered

Of initial out lay at the beginning of the year in which full
Re covery takes place
Cash in flow of the year in w hichfull recovery takes place

8.9.1.2 Accounting rate of return

Accounting rate of return (ARR) measures the profitability of investment
(project) using information taken from financial statements.

ARR = Average income / Average investment

ARR = Average of post tax operating profit / Average investment

Average investment =
Book Value of theinvestment + Book value of investment at the end of
in thebeginning thelife of theproject or investment
2

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Solved Problem – 3
Table 8.7 gives the particulars of two projects:

Table 8.7: Particulars of Two Projects

X Y
Cost 40,000 60,000
Estimated life 5 years 5 years
Salvage value Rs. 3,000 Rs. 3,000
Table 8.8 gives an estimate income after tax.
Table 8.8: After Tax

X (Rs.) Y (Rs.)
1 3,000 10,000
2 4,000 8,000
3 7,000 2,000
4 6,000 6,000
5 8,000 5,000
Total 28,000 31,000
Average 5,600 6,200
21,500 31,500
Average
investment

5,600
ARR X = = 26%
21,500
6,200
ARR Y= = 19.7%
31,500

Let us discuss the merits and demerits of accounting the rate of return.
Merits of accounting rate of return
• It is based on accounting information
• Simple to understand
• It considers the profits of entire economic life of the project
• Because it is based on accounting information, the business executives
familiar with the accounting information, understand it

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Demerits of accounting rate of return

• ARR is based on accounting income not on cash flows, as the cash flow
approach is considered superior to accounting information based
approach
• ARR does not consider the time value of money
• Different investment proposals which require different amounts of
investment may have the same accounting rate of return. The ARR fails
to differentiate projects on the basis of the amount required for
investment
• ARR is based on the investment required for the project. There are many
approaches for the calculation of denominator of average investment.
Existence of more than one basis for arriving at the denominator of
average investment may result in adoption of many arbitrary bases
Due to this the reliability of ARR as a technique of appraisal is reduced
when two projects with the same ARR but with differing investment amounts
are to be evaluated.
Accept or reject criteria
In any project which has an excess ARR, the minimum rate fixed by the
management is accepted.
If actual ARR is less than the cut-off rate (minimum rate specified by the
management) then that project is rejected.
When projects are to be ranked for deciding on the allocation of capital on
account of the need for capital rationing, project with higher ARR are
preferred to the ones with lower ARR.
8.9.2 Discounted pay-back period
The length in years required to recover the initial cash out lay on the present
value basis is called the discounted pay-back period. The opportunity cost of
capital is used for calculating present values of the cash inflows. Discounted
pay-back period for a project will be always higher than simple pay-back
period because the calculation of discounted pay-back period is based on
discounted cash flows.

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Solved Problem – 4
Table 8.9 shows the cash flows of project A for different years at a rate of
10% p.a.
Table 8.9: Cash Flows of Project A
Cumulative
Project A PV of Cash
Year PV factor at 10% positive
Cash flows flows
Cash flows
0 (4,00,000) 1 (4,00,000) –
1 2,00,000 0.909 1,81,800 1,81,800
2 1,75,000 0.826 1,44,550 3,26,350
3 25,000 0.751 18,775 3,45,125
4 2,00,000 0.683 1,36,600 4,81,725
5 1,50,000 0.621 93,150 5,74,875
Discounted pay-back period
4,00,000 −3,45,125
3+ = 3.4 years
1,36,600

8.9.3 Discounted cash flow method

Discounted cash flow method or time adjusted technique is an improvement
over the traditional techniques. In evaluation of the projects, the need to give
significance to the timing of return is effectively considered in all DCF
methods. DCF methods are cash flow based and take the cognisance of
both the interest factors and cash flow after the pay-back period.
DCF technique involves:
• Estimation of cash flows, both inflows and outflows of a project over the
entire life of the project
• Discounting the cash flows by an appropriate interest factor (discount
factor)
• Deducting the sum of the present value of cash outflows from the sum
of present value of cash inflows to arrive at net present value of cash
flows
The most popular techniques of DCF methods are:
• The net present value
• The internal rate of return
• Profitability index

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Let us discuss each of the DCF techniques in detail.

• Net present value
Net present value (NPV) method recognises the time value of money. It
correctly admits that cash flows occurring at different time periods differ in
value. Therefore, there is the need to find out the present values of all cash
flows. NPV method is the most widely used technique among the DCF
methods.
Steps involved in NPV method are:
• Forecasting the cash flows, both inflows and outflows of the projects to
be taken up for execution.
• Decisions on discount factor or interest factor. The appropriate discount
rate is the firm’s cost of capital or required rate of return expected by the
investors.
• Computation of the present value of cash inflows and outflows using the
discount factor selected.
• Calculation of NPV by subtracting the PV of cash outflows from the
present value of cash inflows.
Accept or reject criteria
If NPV is positive, the project should be accepted. If NPV is negative the
project should be rejected.
Accept or reject criterion can be summarised as given below:
• NPV > Zero = accept
• NPV < Zero = reject
NPV method can be used to select between mutually exclusive projects by
examining whether incremental investment generates a positive net present
value.
Let us discuss the merits and demerits of NPV method.
Merits of NPV method
• It takes into account the time value of money.
• It considers cash flows occurring over the entire life of the project.
• NPV method is consistent with the goal of maximising the net wealth of
the company.
• It analyses the merits of relative capital investments.

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• As the cost of capital of the firm is the hurdle rate, the NPV ensures that
the project generates profits from the investment made for it.
Demerits of NPV method
• Forecasting of cash flows is difficult as it involves dealing with the effect
of elements of uncertainties on operating activities of the firm.
• For deciding the discounting factor, there is the need to assess the
investor’s required rate of return, but it is not possible to compute the
discount rate precisely.
• There are practical problems associated with the evaluation of projects
with unequal lives or under funds’ constraints.
For ranking of projects under NPV approach, the project with the highest
positive NPV is preferred to that with a lower NPV.

Solved Problem 5
A project costs Rs.25000 and is expected to generate cash inflows.
Table 8.10 shows the cash inflows.
Table 8.10: Cash Inflows
Year Cash inflows
1 10,000
2 8,000
3 9,000
4 6,000
5 7,000

The cost of capital is 12%. Table 8.11 shows the present value factors.
Table 8.11: Present Value Factors
Year PV factor at 12%
1 0.893
2 0.797
3 0.712
4 0.636
5 0.567
Compute the NPV of the project

Solution
The present value of the cash flows are computed based on the

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information given in tables 8.8 and 8.9, at a rate of interest of 12% per
annum. Table 8.12 shows the PV of cash flows.
Table 8.12: PV of Cash Flows
PV factor at
Year Cash flows PV of cash flows
12%
1 10,000 0.893 8,930
2 8,000 0.797 6,376
3 9,000 0.712 6,408
4 6,000 0.636 3,816
5 7,000 0.567 3,969
Total 29,499

Sum of the present value of the cash outflows = 25,000

NPV = 4,499
The project generates a positive NPV of Rs. 4,499. Therefore, project
should be accepted.

Solved Problem – 6
A company is evaluating two alternatives for distribution within the plant.
The two alternatives are as follows:
• C system with a high initial cost but low annual operating costs.
• F system which costs less but have considerably higher operating
costs.
The decision to construct the plant has already been made, and the
choice here will have no effect on the overall revenues of the project. The
cost of capital of the plant is 12% and the projects expected net cash
costs are listed in table 8.13.
Table 8.13: Expected Net Cash
Expected net cash costs
Year
C systems F systems
0 (3,00,000) (1,20,000)
1 (66,000) (96,000)
2 (66,000) (96,000)
3 (66,000) (96,000)
4 (66,000) (96,000)
5 (66,000) (96,000)
What is the present value of costs of each alternative?
Which method should be chosen?
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Solution
Computation of present value is done in table 8.14
Table 8.14: Computation of PV
Year C systems F systems Incremental
1 (66,000) (96,000) 30,000
2 (66,000) (96,000) 30,000
3 (66,000) (96,000) 30,000
4 (66,000) (96,000) 30,000
5 (66,000) (96,000) 30,000

Present value of incremental savings =

30,000 x PV IFA (12%, 5) = 30,000 x 3.605 = 1,08,150
Initial cash outlay [C system – F system] = 3,00,000 – 1,20,000 = 1,80,000
Incremental cash outlay = 1,80,000 – 108150 =71850
Since the present value of incremental net cash inflows of C system over
F system is negative. C system is not recommended.
Therefore, F system is recommended.
Properties of the NPV
• NPVs are additive. If two projects A and B have NPV (A) and NPV (B)
then by additive rule the net present value of the combined investment is
NPV (A + B).
• Intermediate cash inflows are reinvested at a rate of return equal to the
cost of capital.

Activity 2
Why NPV leads to better investment decisions than other criteria?
Refer: NPV
• Internal rate of return (IRR)
Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the
NPV of any project equal to zero. IRR is the rate of interest which equates
the PV of cash inflows with the PV of cash outflows.
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IRR is also called as yield on investment, managerial efficiency of capital,

marginal productivity of capital, rate of return and time adjusted rate of
return. IRR is the rate of return that a project earns.
Let us discuss the merits and demerits of IRR.
Merits of IRR
• IRR takes into account the time value of money.
• IRR calculates the rate of return of the project, taking into account the
cash flows over the entire life of the project.
• It gives a rate of return that reflects the profitability of the project.
• It is consistent with the goal of financial management i.e. maximisation of
net wealth of share holders.
• IRR can be compared with the firm’s cost of capital.
• To calculate the NPV the discount rate normally used is cost of capital.
But to calculate IRR, there is no need to calculate and employ the cost of
capital for discounting because the project is evaluated at the rate of
return generated by the project. The rate of return is internal to the
project.
Demerits of IRR
• IRR does not satisfy the additive principle.
• Multiple rate of returns or absence of a unique rate of return in certain
projects will affect the utility of this technique as a tool of decision making
in project evaluation.
• In project evaluation, the projects with the highest IRR are given
preference to the ones with low internal rates.
• Application of this criterion to mutually exclusive projects may lead under
certain situations to acceptance of projects of low profitability at the cost
of high profitability projects.
• IRR computation is quite tedious.
Accept or reject criteria
If the project’s internal rate of return is greater than the firm’s cost of capital,
accept the proposal, otherwise reject the proposal.

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IRR can be determined by solving the following equation for

Ct
r = CF 0 =  where t = 1 to n
(1+r ) t
CF0 = Investment

Sum of the present values of cash inflows at the rate of interest of r is

Ct
CF0 = 
(1+r ) t where t = 1 to n

Solved Problem-7
A project requires an initial outlay of Rs. 1,00,000. It is expected to
generate the cash inflows shown in table 8.15
Table 8.15: Cash Inflows
Year Cash inflows
1 50,000
2 50,000
3 30,000
4 40,000

What is the IRR of the project?

Solution
Step 1
The average of annual cash inflows is computed as shown in table 8.16.
Table 8.16: Average of Cash Inflows
Year Cash inflows
1 50,000
2 50,000
3 30,000
4 40,000
Total 1,70,000
1,70,000
Average = = Rs. 42,500
4

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Step 2
Divide the initial investment by the average of annual cash inflows
1,00,000
= = 2.35
42,500
Step 3
From the PVIFA table for 4 years, the annuity factor very near 2.35 is
25%. Therefore, the first initial rate is 25% as shown in table 8.17
Table 8.17: Trial Rate at 25%
Year Cash flows PV factor at 25 % PV of Cash flows
1 50,000 0.800 40,000
2 50,000 0.640 32,000
3 30,000 0.512 15,360
4 40,000 0.410 16,400
Total 1,03,760

As the initial investment of Rs.1,00,000 is less than the computed value

at 25% of Rs.1,03,760, the next trial rate is 26%.
Hence the changes in the calculations are as shown in table 8.18
Table 8.18: Trial Rate at 26%
Year Cash flows PV factor at 26 % PV of Cash flows
1 50,000 0.7937 39,685
2 50,000 0.6299 31,495
3 30,000 0.4999 14,997
4 40,000 0.3968 15,872
Total 1,02,049

The next trial rate is 27%, the changes are as shown in table 8.19.
Table 8.19: Trial Rate at 27%
Year Cash flows PV factor at 27 % PV of Cash flows
1 50,000 0.7874 39,370
2 50,000 0.6200 31,000
3 30,000 0.4882 14,646
4 40,000 0.3844 15,376
Total 1,00,392

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The next trial rate is 28%, the changes are as shown in

table 8.20
Table 8.20: Trial Rate at 28%

Year Cash flows PV factor at 26 % PV of Cash flows

1 50,000 0.7813 39,065
2 50,000 0.6104 30,520
3 30,000 0.4768 14,3047
4 40,000 0.3725 14,900
Total 98,789

Because, initial investment of Rs.1,00,000 lies between 98789 (28 %)

and 1,00,392 (27%), the IRR by interpolation is equal to:
1,00,392−1,00,000
27+ 1
1,00,392−98,789
392
27 + 1
1603
= 27 + 0.2445
= 27.2445 = 27.24 %

Modified internal rate of return (MIRR)

Modified internal rate of return (MIRR) is a distinct improvement over the
IRR. Managers find IRR intuitively more appealing than the rupees of NPV
because IRR is expressed on a percentage rate of return. MIRR modifies
IRR. MIRR is a better indicator of relative profitability of the projects. MIRR
is defined as
PV of Costs = PV of terminal value
n
C0
PVC = 
t =1 (1+ r)t
n

TV =  C t (1 + r)
t

t =1

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PVC = PV of costs
To calculate PVC, the discount rate used is the cost of capital. To calculate
the terminal value, the future value factor is based on the cost of capital
MIRR is obtained on solving the following equation.

PV of costs = TV/ (1 + MIRR)n

Superiority of MIRR over IRR

• MIRR assumes that cash flows from the project are reinvested at the
cost of capital. The IRR assumes that the cash flows from the project are
reinvested at the projects own IRR. Since reinvestment at the cost of
capital is considered realistic and correct, the MIRR measures the
project’s true profitability.
• MIRR does not have the problem of multiple rates which we come
across in IRR.

Solved Problem – 8
Table 8.21 shows the cash flows for respective years at a cost of capital of
12%.
Table 8.21: Cost of Capital
Year 0 1 2 3 4 5 6
Cash flows (Rs. in millions) (100) (100) 30 60 90 120 130
100
Present value of cost = 100 + 1.12
= 100 + 89.29 = 189.29
Terminal value of cash flows:

1 = 0 cash inflow (1+r)

n
TV = n-t

Where r = 0.12, n= 6 , t=2 for the 2nd year, t=3 for 3rd year, t=4 for 4th year
and so on.
= 30 (1.12)4 + 60 (1.12)3 + 90 (1.12)2 + 120 (1.12) + 130
= 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130
= 47.205 + 84.294 + 112.896 + 134.4 + 130
= 508.80

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MIRR is obtained on solving the following equation:

508.80
189.29 =
(1+ MIRR)6

508.80
(1+ MIRR)6 =
189.29
(1 + MIRR)6 = 2.6879
MIRR = 17.9 %
Modified internal rate of return = 17.9%

Profitability index
Profitability index (PI) is also known as benefit cost ratio. Profitability index is
the ratio of the present value of cash inflows to initial cash outlay. The
discount factor based on the required rate of return is used to discount the
cash inflows.

PI = Present value of cash inflows / initial cash outlay

Accept or reject criteria

• Accept the project if PI is greater than 1
• Reject the project if PI is less than 1
If profitability index is 1 then the management may accept the project
because the sum of the present value of cash inflows is equal to the sum of
present value of cash outflows. It neither adds nor reduces the existing
wealth of the company.
Let us discuss the merits and demerits of PI.
Merits of PI
• It takes into account the time value of money
• It is consistent with the principle of maximisation of share holders wealth
• It measures the relative profitability

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Demerits of PI
• Estimation of cash flows and discount rate cannot be done accurately
with certainty.
A conflict may arise between NPV and profitability index if a choice between
mutually exclusive project has to be made.

Solved Problem – 9
A firm is considering an investment proposal which requires an initial
cash outlay of Rs 8 lakhs now and Rs 2 lakhs at the end of the third year.
It is expected to generate cash flows as shown in table 8.22.
Table 8.22 Cash Inflows
Year Cash inflows
1 3,50,000
2 8,00,000
3 2,50,000
Apply the discount rate of 12% and calculate profitability index

Solution-10
Table 8.23 shows the present value of cash outflows.
Table 8.23: Present Value of Cash Outflows
Year PV factor at 12 % Cash out flows PV of Cash flows
1 Rs.8lakhs Rs.8lakhs
2
3 0.712 2lakhs 1.424lakhs
Total 9.424lakhs

Table 8.24 shows the present value of cash inflows.

Table 8.24: Present Value of Cash Inflows
Year PVIF (12%) Cash inflows PV of Cash flows
1 0.893 3,50,000 3.1255 lakhs
2 0.797 8,00,000 6.376 lakhs
4 0.636 2,50,000 1.5900 lakhs
Total 11.0915 lakhs

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Total of present value of cashinf lows

PI=
Total of present value of cash outflows
11.0915
= =1.177
9.424
For every Re.1 invested the project is expected to give a cash inflow of
Rs. 1.177 i.e. for every rupee invested a profit of Rs.0.177 is obtained.

8.10 Summary
Let us recapitulate the important concepts discussed in this unit:
• Capital investment proposals involve current outlay of funds in the
expectation of a stream of cash inflow in future.
• Various techniques are available for evaluating investment projects.
They are grouped into traditional and modern techniques.
• The major traditional techniques are payback period and accounting rate
of return.
• The important discounting criteria are net present value, internal rate of
return and profitability index.
• A major deficiency of payback period is that it does not take into account
the time value of money.
• DCF techniques overcome this limitation. Each method has both positive
and negative aspects.
• The most popular method for large project is the internal rate of return.
Payback period and accounting rate of return are popular for evaluating
small projects.

8.11 Glossary
Cannibalisation: The introduction of a new product, the reduction in the
sale of an existing product.

8.12 Terminal Questions

1. Examine the importance of capital budgeting.

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2. Briefly examine the significance of identification of investment

opportunities in capital budgeting process.
3. Critically examine the pay-back period as a technique of approval of
projects.
4. Summarise the features of DCF techniques.

8.13 Answers

Self Assessment Questions

1. Capital budgeting
2. Capital budgeting
3. Highly complex
4. Capital budgeting decisions
5. Irreversible
6. Uncertainty, highly uncertain.
7. Final step
8. First step
9. A fertile source
10. The most crucial phase
11. Capital budgeting
12. Cost reduction
13. Economic appraisal
14. Technical appraisal
15. Financial viability
16. Demand for the product or service.
17. Decision criteria
18. Sunk cost
19. Externalities
20. Investment element; Financing element
21. Ignores
22. Profitability of

Terminal Questions
1. Capital budgeting decisions are the most important decisions in
corporate financial management. Refer to 8.2

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2. A firm is in a position to identify investment proposal only when it is

responsive to the ideas of capital projects emerging from various levels
of the organisation. Refer to 8.5
3. Payback period is defined as the length of time required to recover the
initial cash out lay. Refer to 8.9.1
4. The length in years required to recover the initial cash out lay on the
present value basis is called the discounted pay-back period. Refer to
8.9.3.

8.14 Case Study: HPCL Revamps Ways of Capital Budgeting

Getting into the Fortune 500 isn't easy, but living up to it is even more
difficult. Ask Hindustan Petroleum (HPCL). Established in 1952, the
company operates from 500 different locations, including refineries,
terminals, LPG plants, aviation service facilities, etc.
"Each year, over 2,000 budget proposals originate from these locations
requesting for capital budgets for various purposes like expanding
operations, replacement of assets, etcetera," explains Nishi Vasudeva,
executive director-IS, HPCL.
These proposals, along with supporting documents were being couriered to
regional, zonal or head offices for review and approval. During reviews,
clarifications are often sought and the paper flows back to the originator,
and a new loop is formed.
This manual process not only involved huge amounts of paper flow, but had
other inherent issues. There was a complete lack of discipline in meeting
timelines to complete the budgeting process and activities subsequent to it.
Monitoring the budgeting process was hampered because there was no
ready access to facts and figures by various monitoring agencies at different
levels within the organisation. "The need, clearly, was to eliminate paper
flows and ensure that the information was readily available for review and
decision-making," says Vasudeva.
So, she developed a Lotus Notes workflow tool and deployed it across the
organisation. "Now, any capital investment proposal from any operating
location in the country can be routed to relevant reviewers and approving
authorities," says Vasudeva.

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Financial Management Unit 8

The implementation of the new online system entailed a paradigm shift from
the way the entire capital budgeting process was being carried out. So,
change management was an issue. But extensive end-user training and
feedback mechanisms helped Vasudeva fix these problems.
Today, the system provides the means to justify the investment, mention the
estimated timelines for completion and the estimated ROI. Proposals can be
enabled online and even be converted into capital budgets with necessary
controls and validations built into the system. This system has also brought
in high level of discipline and adherence to the timelines. "The total cost
savings as a result of reduced man-hours amounts to about Rs 25 lakh per
annum," says Vasudeva.
Discussion Questions:
1. Explain the importance of capital budgeting process and how timelines
are of significance in taking capital budgeting decisions.
(Hint: Refer importance of capital budgeting decisions)
2. What do you think would have been the complexities involved in
implementing this new project at HPCL?
(Hint: Refer capital budgeting process)
3. What are the various phases in the capital budgeting process? To what
extent do you believe that automation can ease out the process?
(Hint: Refer phases in capital budgeting decisions)

(Source: http://www.computerworld.in/articles/ )

References :

• Prasanna, Chandra (2007), Financial Management: Theory and Practice,

7th Edition, Tata McGraw Hill.
• Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition
E-References :
• http://www.computerworld.in/articles/retrieved on 10/11/2011

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Unit 9 Risk Analysis in Capital Budgeting

Structure:
9.1 Introduction
Objectives
Definition of risk
9.2 Types and Sources of Risk in Capital Budgeting
Sources of risk
Techniques for incorporation of risk factor in capital budgeting
9.3 Risk Adjusted Discount Rate
Evaluation of risk adjusted discount rate
9.4 Certainty Equivalent Approach
Evaluation of certainty equivalent
9.5 Probability Distribution Approach
9.6 Sensitivity Analysis
Evaluation of sensitivity analysis
9.7 Simulation Analysis
Evaluation of simulation analysis
9.8 Decision Tree Approach
Evaluation of decision tree approach
9.9 Summary
9.10 Glossary
9.11 Terminal Questions
9.12 Answers
9.13 Case Study

9.1 Introduction
In the previous units, we discussed that capital budgeting decisions typically
involve forecasting the future operating cash flows. Forecasting involves
making certain assumptions about the future behaviour of costs and
revenues.
However, such forecasting, suffers from uncertainty because the future is
highly uncertain. Assumptions made about the future behaviour of costs and
revenues may change and can significantly alter the fortunes of a company.

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Thereby, the process is inherently risky. In this unit, we will discuss about
the risk analysis in capital budgeting.
In other words, the financial analyst determines the upfront cost of a project,
as well as the periodic future cash flows resulting from the project. Those
cash flows are then used to calculate either the net present value (NPV) of
the project - using the firm's weighted-average cost-of-capital (WACC) as a
discount rate, or the internal rate of return (IRR) for the project. If the NPV is
positive, or if the IRR exceeds the WACC, the firm undertakes the project;
otherwise it doesn't.
The difficulty in making proper capital budgeting decisions arises as a
consequence of the difficulty in determining the upfront costs, the periodic
cash flows, even the proper WACC. All of these quantities must be
estimated, and all of the ensuing estimates will contain some degree of
uncertainty; the process is inherently risky.
“To understand uncertainty and risk is to understand the key business
problem, and the key business opportunity” – David. B. Hertz, 1972. Thus,
analysing the risks to reduce the element of uncertainty has therefore
become an essential aspect of today’s corporate project management.
This unit will help you understand the various types of risks involved in
capital budgeting decisions. You will also study how sensitivity analysis is
used to determine the most critical uncertainties in the estimation and the
pitfalls of using uncertain single-point estimates for the cash flows
associated with the project.
This unit will help the capital budget decision-makers to avoid costly
mistakes.
Objectives:
After studying this unit, you should be able to:
 define risk in capital budgeting
 examine the importance of risk analysis in capital budgeting
 determine the methods of incorporating the risk factor in capital
budgeting decision
 analyse the types and sources of risk in capital budgeting decision

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9.1.1 Definition of risk

Before we start to discuss about risk analysis in capital budgeting, let us first
understand the meaning of risk and its relevance in capital budgeting
decisions.
There are several definitions for the term ‘risk’. It may vary depending on the
situation, context and application. Risk may be termed as a degree of
uncertainty. It may be defined as the possibility that the actual result from an
investment will differ from the expected result. Risk in capital budgeting may
be defined as the variation of actual cash flows from the expected cash
flows.
Every business decision involves risk. Risk exists on account of the inability
of a firm to make perfect forecasts of cash flows. The inability can be
attributed to factors that affect forecasts of investment, cost and revenue.
Some of these are as follows:
 The business is affected by changes in political situations, taxation,
interest rates, monetary policies of the central bank of the country for
lending by banks.
 Industry specific factors influence the demand for the products of the
industry to which the firm belongs.
 Company specific factors like change in management, wage negotiations
with the workers, and also strikes or lockouts affect company’s cost and
revenue.
Let us see a caselet explaining why making a perfect forecast of cash flows
is difficult.

Caselet 1
A company wants to produce and market a new product to their
prospective customers and the demand is affected by the general
economic conditions. Demand may be very high if the country
experiences higher economic growth. On the other hand economic
events like weakening of US dollar and sub-prime crises may trigger
economic slow-down. This may create a pessimistic demand drastically
bringing down the estimate of cash flows.

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9.2 Types and Sources of Risk in Capital Budgeting

In this section, we discuss the types and sources of risk in capital budgeting.
Having understood what risk in capital budgeting means, let us now
understand the types of risk and their sources.
Capital budgeting involves four types of risks in a project: stand-alone risk,
portfolio risk, market risk and corporate risk. Figure 9.1 depicts the risks
involved in a project.

Figure 9.1: Types of Risks

Stand-alone risk
Stand alone risk of a project is considered when the project is in isolation.
Stand-alone risk is measured by the variability of expected returns of the
project.
Portfolio risk
A firm can be viewed as portfolio of projects having a certain degree of risk.
When new project is added to the existing portfolio of project, the risk profile
of the firm will alter. The degree of the change in the risk depends on the
following:
 The co-variance of return from the new project
 The return from the existing portfolio of the projects
If the return from the new project is negatively correlated with the return
from portfolio, the risk of the firm will be further diversified.

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Market risk
Market risk is defined as the measure of the unpredictability of a given stock
value. However, market risk is also referred to as systematic risk. The
market risk has a direct influence on stock prices. Market risk is measured
by the effect of the project on the beta of the firm. The market risk for a
project is difficult to estimate, as it includes a wide range of external factors
like recessions, wars, political issues, etc.
Corporate risk
Corporate risk focuses on the analysis of the risk that might influence the
project in terms of entire cash flow of the firms. Corporate risk is the
projects’ risks of the firm.
9.2.1 Sources of risk
The five different sources of risk are:
 Project-specific risk
 Competitive or competition risk
 Industry-specific risk
 International risk
 Market risk
Let us discuss the sources of risk in detail.
Project-specific risk
Project-specific risk could be traced to something quite specific to the
project. Managerial deficiencies or error in estimation of cash flows or
discount rate may lead to a situation of actual cash flows realised being less
than the projected cash flow.
Competitive or competition risk
Unanticipated actions of a firm’s competitors will materially affect the cash
flows expected from a project. As a result of this, the actual cash flows from
a project will be less than that of the forecast.
Industry-specific risk
Industry-specific risks are those that affect all the firms in the particular
industry. Industry-specific risk could be again grouped into technological
risk, commodity risk and legal risk. Let us discuss the groups in industry-
specific risks, as follows:

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 Technological risk – The changes in technology affect all the firms not
capable of adapting themselves in emerging into a new technology.

Example
The best example is the case of firms manufacturing motor cycles with
two stroke engines. When technological innovations replaced the two
stroke engines by the four stroke engines, those firms which could not
adapt to new technology had to shut down their operations.

 Commodity risk – It is the risk arising from the effect of price-changes

on goods produced and marketed.
 Legal risk – It arises from changes in laws and regulations applicable to
the industry to which the firm belongs.

Example
The imposition of service tax on apartments by the government of
India, when the total number of apartments built by a firm engaged in
that industry exceeds a prescribed limit. Similarly, changes in import-
export policy of the government of India have led to either closure of
some firms or sickness of some firms.

All these risks will affect the earnings and cash flows of the project.
International risk
These types of risks are faced by firms whose business consists mainly of
exports or those who procure their main raw material from international
markets.
The firms facing such kind of risks are as follows:
 The rupee-dollar crisis affected the software and BPOs, because it
drastically reduced their profitability.
 Another example is that of the textile units in Tirupur in Tamil Nadu,
which exports the major part of the garments produced. Strengthening of
rupee and weakening of dollar, reduced their competitiveness in the
global markets.
 The surging crude oil prices coupled with the governments delay in
taking decision on pricing of petro products eroded the profitability of oil
marketing companies in public sector like Hindustan Petroleum
Corporation Limited.

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 Another example is the impact of US sub-prime crisis on certain

segments of Indian economy.
The changes in international political scenario also affected the operations
of certain firms.
Market risk
Factors like inflation, changes in interest rates, and changing general
economic conditions affect all firms and all industries. Firms cannot diversify
this risk in the normal course of business.
There are many techniques of incorporation of risk perceived in the
evaluation of capital budgeting proposals. They differ in their approach and
methodology as far as incorporation of risk in the evaluation process is
concerned.

Activity 1
List the various risks that Tata Nano as a project faced/is facing.
Hint: legal risk, competition, increase in prices of inputs, technology
failure, political risk (no support from government) etc.

9.2.2 Techniques for incorporation of risk factor in capital budgeting

The techniques for incorporation of risk factor in capital budgeting decisions
could be grouped into conventional and statistical techniques.
The conventional technique usually put to use is the pay-back period
concept.
Pay-back period
The oldest and the most commonly used method of recognising risk
associated with a capital budgeting proposal is pay-back period. Pay-back
period is defined as the length of time required to recover the initial cash
out-lay. Pay-back period ignores time value of money (cash flows).
Pay-back period prefers projects of short-term pay backs to that of long-term
pay backs. The emphasis is on the liquidity of the firm through recovery of
capital. Traditionally, Indian business community employed this technique in
evaluating projects with very high level of uncertainty.

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The changing trends in fashion, makes the fashion business risky and
therefore, pay-back period has been endorsed as a tradition in India to take
decisions on whether to accept or reject such projects.
The usual risk in business is more concerned with the forecast of cash
flows. It is the down-side risk of lower cash flows arising from lower sales
and higher costs of operation that matters in formulating standards of pay-
back.

Caselet 2
Table 9.1 gives the details related to two projects.
Table 9.1: Details of Two Projects
Particulars Project A (Rs.) Project B (Rs.)
Initial cash outlay 10lakhs 10 lakhs
Cash flows
Year 1 5 lakhs 2 lakhs
Year 2 3 lakhs 2 lakhs
Year 3 1 lakh 3 lakhs
Year 4 1 lakh 3 lakhs

Both the projects have a pay-back period of 4 years. The project B is

more risky than the Project A, because Project A recovers 80% of initial
cash outlay in the first two years of its operation; whereas Project B
generates higher cash inflows only in the latter half of the pay-back
period. This undermines the utility of pay-back period as a technique of
incorporating risk in project evaluation.

This method considers only time related risks and ignores all other risks of
the project under consideration.
The other techniques used in decision making as regards capital
expenditures and risks involved are:
(a) Risk adjusted discount rate
(b) Certainty equivalent approach
(c) Sensitivity analysis
(d) Probability distribution
(e) Decision tree model

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We will now take a brief look at each of these models in the following
sections.

Self Assessment Questions

1. ___is measured by the variability of expected returns of the project.
2. Market risk is measured by the effect of the project on the ____ of the
firm.
3. Firms cannot ____ market risk in the normal course of business.
4. Impact of U.S sub-prime crisis on certain segments of Indian economy
is the example of _______________________.

9.3 Risk Adjusted Discount Rate

In this section, we will discuss the model of risk adjusted discount rate
(RADR). The basic principle of risk adjusted discount rate is that there
should be adequate reward in the form of return to the firms which decide to
execute risky business projects. Man by nature is risk-averse and tries to
avoid risk.
To motivate firms to take up risky projects, returns expected from the project
shall have to be adequate, keeping in view the expectations of the investors.
Therefore risk premium needs to be incorporated in discount rate during the
evaluation of risky project proposals.
This method of risk analysis adjusts the cost of capital upward as projects
become more risky. Greater the risk, higher the adjusted discount rate, and
therefore lower the project’s risk-adjusted NPV.
Risk adjusted discount rate is more briefly described as:

Risk Adjusted Discount rate = Risk free rate + Risk premium

 Risk free rate is computed based on the returns on government

securities.
 Risk premium is the additional returns that the investors require for
assuming the additional risk associated with the project to be taken up
for execution.
If the uncertainty in the returns of the project is more, then the risk involved
is higher. Higher the risk, greater is the premium.
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Solved Problem – 1
An investment will have an initial outlay of Rs 100,000. It is expected to
generate cash inflows. Table 9.2 highlights the cash inflow for four years.

Table 9.2: Cash inflow

Year Cash inflow

1 40000
2 50000
3 15000
4 30000

If the risk free rate and the risk premium is 10%,

a) Compute the NPV using the risk free rate
b) Compute NPV using risk-adjusted discount rate

Solution
a) NPV can be computed using risk free rate. Table 9.3 shows NPV
calculation using the risk free rate.

Table 9.3: PV Using Risk Free Rate

Year Cash flows (inflows) PV factor at PV of cash flows

Rs. 10% (inflows)
1 40000 0.909 36,360
2 50000 0.826 41,300
3 15000 0.751 11,265
4 30000 0.683 20,490
PV of cash inflows 1,09,415
PV of cash outflows (1,00,000)
NPV 9,415

b) NPV can be computed using risk-adjusted discount. Table 9.4 shows

NPV calculation using the risk-adjusted discount.

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Table 9.4: NPV Using Risk-adjusted Discount Rate

Year Cash inflows Rs. PV factor at 20% PV of cash inflows

1 40000 0.833 33,320
2 50000 0.694 34,700
3 15000 0.579 8,685
4 30000 0.482 14,460
PV of Cash in flows 91,165
PV of cash outflows (100, 000)
NPV (8, 835)

The project would be acceptable when no allowance is made for risk.

However, it will not be acceptable if risk premium is added to the risk free
rate. By doing so, it moves from positive NPV to negative NPV. If the firm
were to use the internal rate of return (IRR), then the project would be
accepted, when IRR is greater than the risk-adjusted discount rate.

9.3.1 Evaluation of risk-adjusted discount rate

The advantages and limitations occurring during the evaluation of risk-
adjusted discount rate are listed as follows:
Merits of risk adjusted discount rate
 Risk adjusted discount rate is simple and easy to understand
 Risk premium takes care of the risk element in future cash flows
 Risk adjusted discount rate satisfies the businessmen who are risk-
averse
Demerits of risk adjusted discount rate
 There are no objective bases of arriving at the risk premium. In this
process, the computed premium rates become arbitrary.
 The assumption that investors are risk-averse may not be true in respect
of certain investors who are willing to take risks. For such investors, as
the level of risk increases, the discount rate would be reduced.
 Cash flows are not adapted to incorporate the risk adjustment for net
cash inflows.

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Self Assessment Questions

5. Risk premium is the __________________ that the investors require as
compensation for assumption of additional risks of project.
6. RADR is the sum of ______________ and ______________.
7. Higher the risk __________________ the premium.

Activity-2
Find the Expected Value of CFAT of the two projects A and B.
Project A Project B
CFAT (Rs.) Probability CFAT Probability (Rs.)
15,000 .2 20,000 .1
25,000 .6 40,000 .7
45,000 .2 60,000 .2

Hint:
Project A: Rs. 27,000, Project B Rs. 42,000

9.4 Certainty Equivalent Approach

In this section, we will discuss the model of certainty equivalent approach.
Under the method of certainty equivalent, unexpected future cash flows are
converted into cash flows with certainty. Here, we multiply uncertain future
cash flows by the certainty-equivalent coefficient to convert uncertain cash
flows into certain cash flows.
The certainty equivalent coefficient is also known as the risk-adjustment
factor. Risk adjustment factor is normally denoted by α (Alpha). Risk
adjustment factor is the ratio of certain net cash flow to risky net cash flow.

Certain Cash flow

Certainty equivalent =
Uncertain Cash flow

The discount factor to be used is the risk-free rate of interest. Certainty

equivalent coefficient is between 0 and 1. This risk-adjustment factor varies
inversely with risk. If risk is high, a lower value is used for risk adjustment. If
risk is low, a higher coefficient of certainty equivalent is used.

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Solved Problem – 2
A project costs Rs. 50,000. It is expected to generate cash inflows as
shown in table 9.5.
Table 9.5: Generation of cash inflows

Year Cash inflows Certainty equivalent

1 32000 0.9
2 27000 0.6
3 20000 0.5
4 10000 0.3

If the risk free rate is 10%, compute NPV.

Solution
Table 9.6 shows the computation of NPV.
Table 9.6: Computation of NPV

Certain PV PV of
Uncertain
Year CE cash factor certain cash
cash inflows
flows at 10% inflows
1 32000 0.9 28800 0.909 26179
2 27000 0.6 16200 0.826 13381
3 20000 0.5 10000 0.751 7510
4 10000 0.3 3000 0.683 2049
PV of certain
49119
cash inflows
Initial cash
(50000)
out-lay
NPV (881)

The project has negative NPV, therefore it is rejected.

If internal rate of return (IRR) is used, the rate of discount at which NPV is
equal to zero is computed and then compared with the minimum (required)
risk free rate. If IRR is greater than specified minimum risk-free rate, the
project is accepted, otherwise rejected.

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9.4.1 Evaluation of certainty equivalent

Evaluation of certainty equivalent recognises risk. Recognition of risk by
risk-adjustment factor facilitates the conversion of risky cash flows into
certain cash flows. However, there are chances of inconsistency in the
procedure employed from one project to another.
When forecasts pass through many layers of management, original
forecasts may become highly conservative. Due to high conservation in this
process, good projects are likely to be cleared when this method is
employed.
Certainty-equivalent approach is considered to be theoretically superior to
the risk-adjusted discount rate.

Self Assessment Questions

8. CE coefficient is the _______.
9. Discount factor to be used under CE approach is _________.
10. Because of high ______________ CE clears only good projects.
11. ___________ is considered to be superior to RADR.

9.5 Probability Distribution Approach

In this section, we will discuss the model of probability distribution approach.
Net present value becomes more reliable when we incorporate the chances
of occurrences of various economic environments. The chances of
occurrences are expressed in the form of probability.
Probability is the likelihood of occurrence of a particular economic
environment. After assigning probabilities to future cash flows, expected net
present value is computed.
If the cash flows are independent over time, i.e., cash flow of one year is
independent of cash flow of the other year, probability distribution approach
is considered for estimating the risk.
Following four steps are involved in the process:
(a) Calculation of expected NPV of project
(b) Standard deviations for various periods

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(c) Standard deviation for project as a whole (This is also referred as the
standard deviation of the present value distribution.)
(d) Determining probability of positive NPV using normal distribution
Measures of risk
As discussed risk refers to variability, of which there are several measures,
the important ones being –
 Range
 Mean absolute deviation
 Standard deviation
 Coefficient of variation
 Semi-variance
In order to measure the expected value and dispersion of a variable, its
probability distribution is required. In some cases the probability distribution
can be defined with a fairly high degree of objectivity on the basis of past
evidence. In most of the real life cases, the probability distribution is highly
subjective.
When the selection of a project is considered, to arrive at the risk profile, the
probability distribution of net present value, an absolute measure, is
transformed into the probability distribution of probability index, a relative
measure. After this is done, the dispersion of the profitability index of the
project is compared with the maximum risk profile acceptable to the
management, for the expected profitability index of the project. Thus, the
decision on project selection is arrived at. If the profitability index is high, the
probability that the NPV is negative is negligible, even if the dispersion is
wide.

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Solved Problem – 3
A company has identified a project with an initial cash outlay of
Rs. 50, 000. Table 9.7 shows the distribution of cash flow in the life of the
project for three years.
Table 9.7: Life of the Project for Three Years
Year 1 Year 2 Year 3
Cash Cash Cash
Probability Probability Probability
inflow inflow inflow
15, 000 0.2 20, 000 0.3 25, 000 0.4
18, 000 0.1 15, 000 0.2 20, 000 0.3
35, 000 0.4 15, 000 0.2 20, 000 0.3
32, 000 0.3 30, 000 0.2 45, 000 0.1

Discount rate is 10%

Year 1
= 15,000 x 0.2 + 18,000 x 0.1 + 35,000 x 0.4 + 32,000 x 0.300
= 3,000 + 1,800 + 14,000 + 9,600
= 28,400
Year 2
= 20,000 x 0.3 + 15,000 x 0.2 + 30,000 x 0.3 + 30,000 x 0.2
= 6,000 + 3,000 + 9,000 + 6,000
= 24,000
Year 3
= 25,000 x 0.4 + 20,000 x 0.3 + 40,000 x 0.2 + 5,000 x 0.1 =
=10,000 + 6,000 + 8,000 + 4,500
= 28,500
Table 9.8 gives the complete illustration of the entire procedure
Table 9.8: Illustration of Entire Procedure
PV factor at PV of expected
Year Expected cash inflows
10% cash inflows
1 28,400 0.909 25,816
2 24,00 0.826 19,824
3 28,500 0.751 21,403
PV of expected cash inflows 67,043
PV of initial cash out-lay (50,000)
Expected NPV 17,043

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Variance
A study of dispersion of cash flows of projects will help the management in
assessing the risk associated with the investment proposal.
Dispersion is computed by variance or standard deviation.
Variance measures the deviation of each possible cash flow from the
expected.
Square root of variance is standard deviation.

Solved Problem – 4
Table 9.9 shows details related to a project that requires an initial cost of
Rs. 500 thousand.
Table 9.9: Details of a Project (in’000)
Year Economic conditions Cash flows Probability
1 High growth 200 0.3
Average growth 150 0.6
No growth 40 0.1
2 High growth 300 0.3
Average growth 200 0.5
No growth 500 0.2
3 High growth 400 0.2
Average growth 250 0.6
No growth 30 0.2
Discount rate is 10%
Determine the NPV and the standard deviation for the respective years.
Solution
Table 9.10 shows the NPV for the first year.
Table 9.10: NPV for the First Year (in’000)
Economic Cash Expected value of
Probability
condition inflow cash inflow
High growth 200 0.3 60
Average growth 150 0.6 90
No growth 40 0.1 4
Expected value 154

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Table 9.11 shows the NPV for the second year.

Table 9.11: NPV for the Second Year (in’000)
Economic Expected value of
Cash inflow Probability
condition cash inflow
High growth 300 0.3 90
Average growth 2000 0.5 100
No growth 500 0.2 10
Expected value 200

Table 9.12 shows the NPV for the third year.

Table 9.12: NPV for the Third Year (in ‘000)
Economic Expected value of
Cash inflow Profitability
condition cash inflow
High growth 400 0.2 80
Average growth 250 0.6 150
No growth 30 0.2 6
Expected value 236

Expected NPV
154 200 236
   – 500
1.10 1.10 2 1.10 3
= 140 + 165.3 + 177.3 – 500 = (17.4) negative NPV
Table 9.13 shows the standard deviation for the first year.
Table 9.13: Standard Deviation for the First Year (in ‘000)
Cash inflow Expected value 2 2
(C-E) (C-E) × probability
C E
2 2
200 154 (46) (46) × 0.3 = 634.8
2 2
150 154 (- 4) (- 4) × 0.6 = 9.6
2 2
40 154 (-114) (-114) × 0.1 = 1299.6
Variance 1944.0

Variance of cash flows for 1st year = 4538.4

Standard deviation of cash flow for 1st year= √1944 = 44.1

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Table 9.14 shows the standard deviation for the second year.
Table 9.14: Standard Deviation for the Second Year (in’000)
Cash inflow Expected value 2 2
(C-E) (C-E) × probability
C E
2 2
300 200 (100) (100) × 0.3 = 3,000
2 2
200 200 (0) (0) × 0.5 = 0
2 2
50 200 (-150) (-150) × 0.2 = 4,500
Total = 7,500

Variance of cash flows for 2nd year = 7,500

Standard deviation of cash flow for 2nd year = √7500 = 86.6
Table 9.15 shows the standard deviation for the third year.
Table 9.15: Standard Deviation for Third Year (in’000)
Cash inflow Expected value 2 2
(C-E) (C-E) × probability
C E
2 2
400 236 (164) (164) ×0.2 = 5,379.2
2 2
250 236 (14) (14) ×0.6 = 117.6
2 2
30 236 (-206) (-206) ×0.2 = 8487.2
Total 13984.0

Variance of cash flows for the 3rd year = 13984

Standard deviation of cash flows for the third year = 118.25

Self Assessment Questions

12. Probability distribution approach incorporates the probability of
occurrences of various economic environments, to make the NPV
________.
13. _______ is likelihood of occurrence of a particular economic
environment.

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9.6 Sensitivity Analysis

In this section, we will discuss the model of sensitivity analysis. There are
many variables like selling price, sales, cost of sales, cost of capital, amount
of investments and tax rates that affect the NPV and IRR of a project.
Analysing the change in the project’s NPV or IRR on account of a given
change in one of the variables is called Sensitivity Analysis.
Sensitivity analysis is a tool to measure the risk surrounding a capital
expenditure project. Sensitivity analysis measures the sensitivity of NPV of a
project with respect to a change in one or more of the input variables of
NPV.
The reliability of the NPV depends on the reliability of cash flows. If
forecasts go wrong on account of changes in assumed economic
environments, reliability of NPV & IRR is lost. Therefore, forecasts are made
under different economic conditions like pessimistic, expected and
optimistic. NPV is arrived at for all the three assumptions.
Following steps are involved in sensitivity analysis:
 Identification of variables that influence the NPV & IRR of the project.
 Examination and definition of the mathematical relationship between the
variables.
 Analysis of the effect of the change in each of the variables on the NPV
of the project.
Sensitivity analysis is carried out on the projects that are reporting positive
net present values. Thus, it requires the calculation of percentage change in
value of each determinant of the NPV that may reduce the NPV to zero.
These percentages are then put in ascending order. The item corresponding
to minimum change is considered to be most sensitive / risky. There is a
view that this concept indicates that the management should pay maximum
attention to this item, as small adverse change in this item may result in big
unfavourable results. Therefore, sensitivity analysis provides an indication of
why a project might fail and helps the management to take proactive steps
in that regard.
9.6.1 Evaluation of sensitivity analysis
Let us discuss the merits and demerits of sensitivity analysis.

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Merits
 It helps management to identify the underlying variables and their inter-
relationships.
 It indicates how robust or vulnerable a project is to the changes in the
underlying variables.
 It indicates where further work is required. If the NPV or IRR is highly
sensitive to changes in certain variables, it is desirable to gather more
information on them.
Demerits
 It may fail to provide leads. If such analysis merely presents a
complicated set of switching values, it may not highlight the risk
characteristics of the project.
 The study of the impact of variation in one factor at a time, holding other
factors constant, may not be very meaningful, when the underlying
factors are likely to be interrelated.

9.7 Simulation Analysis

In this section, we will discuss the model of simulation analysis. While
sensitivity analysis indicates the sensitivity of the criterion of merit (NPV,
IRR or such other) to variations in basic factors and provides certain
information, it may not be adequate for decision making. The decision
maker would also like to know the likelihood of such occurrences. This
information can be generated by simulation analysis. This may be used for
developing the probability profile of a criterion of merit by randomly
combining values of variables that have a bearing on the chosen criterion.
Simulation analysis is the analysis of cash flows and returns on investments,
when more than one uncertain element is considered (allowing more than
one probability distribution to enter the scenario). It allows the finance
manager to develop probability distribution of possible outcomes, given a
probability distribution for each variable that may change.
This is more realistic than sensitivity analysis, as it introduces uncertainty for
many variables in the analysis.
Simulation is a mathematical technique which is used to predict the
expected outcome when several outcomes are possible.

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The technique is based on random number. (A set of numbers is said to be

random, when the probability of its selection is equal to the probability of
selection of any other number, i.e. a set of number is said to be random
when the probability of selection of all members is equal.)
This model is also referred as the Hertz model. Hertz used this model for
evaluation of risky investment decisions by calculating average of various
possible returns (Hertz’s capital budgeting model). Hertz suggested that
simulation can be used to estimate the return on capital employed on a
proposed project, which is facing various uncertainties.
9.7.1 Evaluation of simulation analysis
Let us discuss the merits and demerits of simulation analysis.
Merits
 It is versatile. It can handle problems characterised by: (a) several
external variables following any kind of distribution; and (b) complex
interrelationships among the various parameters, external variables and
internal factors.
 It forces the decision maker to explicitly consider the interdependencies
and uncertainties lining the project.
Demerits
 It tends to look at a project in isolation, ignoring the diversification effects
of projects and focusing on a single project’s total risk. It further ignores
the effects of diversification for the owners’ personal portfolio.
 It is difficult to model the project and specify the probability distributions
of external variables.
 It tends to be inherently imprecise. It provides a rough approximation of
the probability distribution of NPV.
 A realistic simulation model, which is likely to be complex, would most
probably be constructed in theory, not by the decision maker practically.
A decision maker, lacking in knowledge, may not use it.
 To ascertain the NPV in a simulation run, the risk free discount rate is
used. Thus, the measure of NPV takes a meaning, very different from its
usual one, which is difficult to interpret.

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Solved Problem – 5
A company has two mutually exclusive projects under consideration –
project A and project B.
Each project requires an initial cash outlay of Rs.300000 and has an
effective life of 10 years. The company’s cost of capital is 12%. Table
9.16 shows forecast of cash flows made by the management. What is the
NPV of the project?
Table 9.16: Details of Project A and B

Economic
Project A Project B
Environment Annual cash inflows Annual cash inflows
Pessimistic 65, 000 25, 000
Expected 75, 000 75, 000
Optimistic 90, 000 1, 00, 000

Which project should the management consider?

Given PVIFA = 5.650.
Solution
Table 9.17 shows the NPV of Project A.
Table 9.17: NPV of Project A
PV of cash
Economic Project PVIFA NPV
inflows
At 12% for
Environment Cash inflows
10 years
Pessimistic 65000 5.650 367250 67250
Expected 75000 5.650 423750 123750
Optimistic 90000 5.650 508500 208500

Table 9.18 shows the NPV of project B.

Table 9.18: NPV of Project B
Pessimistic 25000 5.650 141250 (158750)
Expected 75000 5.650 423750 123750
Optimistic 100000 5.650 565000 265000

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Table 9.19 shows the comparison of NPV of project A & project B.

Table 9.19: Comparison of NPV of Project A & Project B
PROJECT A PROJECT B
ACCEPT /
NPV NPV ACCEPT / REJECT
REJECT
(+ ) (-)
Pessimistic
Rs.67,250 ACCEPT Rs.158750 REJECT
(+) ACCEPT (A) (+)
Expected ACCEPT (A) OR (B)
Rs.1,23,750 OR (B) Rs.1,23,750
ACCEPT
(+) (+)
Optimistic (HIGHER
Rs.2,08,500 REJECT Rs.2,65,000
NPV)
Which project is more risky?
Project B is risky compared to Project A, because the NPV range is
large.
Difference between Optimistic and Pessimistic NPV
Project A = 1,41,250
Project B = 4,23,750

Self Assessment Questions

14. .________ analyse the changes in the project NPV on account of a
given change in one of the input variables of the project.
15. Examining and defining the mathematical relation between the variable
of the NPV is _________________________.
16. Forecasts under sensitivity analysis are made under __________.

9.8 Decision Tree Approach

In this section, we will discuss the model of decision tree approach. Many
project decisions are complex investment decisions. Such complex
investment decisions involve a sequence of decisions, over time.
A decision tree is a diagram that exhibits the outcomes of an act under
various events. Acts are those strategies about which we have to take
decision. Acts are also referred as actions, courses of actions, strategies or
alternatives.
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Decision tree is an effective tool for choosing between several courses of

actions. The technique is particularly helpful in situations of complex multi-
stage decision making problems.
Decisions tree can handle the sequential decisions of complex investment
proposals. The decision of taking up an investment project is broken into
different stages. At each stage the proposal is examined to decide whether
to go ahead or not. The multi-stages approach can be handled effectively
with the help of decision trees. A decision tree presents graphically, the
relationship between:
 Present decision and future events
 Future decisions and consequences of such decisions
In capital budgeting, this approach is used for decision making if the cash
flows of a period are dependent upon cash flows of the other period. In this
process, we find various possible NPV estimates by making a decision tree
(The term NPV estimate means event – based NPV i.e. NPV that would be
there if a particular event takes place). We calculate mean and standard
deviations of these NPV estimates.
The key steps in decision tree analysis are as follows:
1. Identification of the problem and alternatives
2. Delineation of the decision tree
3. Specification of probabilities and monetary outcomes
4. Evaluation of various decision alternatives.

Solved Problem 6
R & D section of a company has developed an electric moped. The firm is
ready for pilot production and test marketing. This will cost Rs. 20 million
and takes six months. Management believes that there is a 70% chance
that the pilot production and test marketing will be successful.
In case of success, the company can build a plant costing Rs. 150 million.
The plant will generate annual cash inflow of Rs. 30 million for 20 years if
the demand is high or an annual cash inflow of 20 million if the demand is
low. High demand has a probability of 0.6 and low demand has a
probability of 0.4 with a cost of capital of 12%.
Determine the optimal course of action using decision tree analysis.

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Solution
Working Notes: Start from right hand side (C2) of the decision tree
Step 1: Computation of Expected Monetary Value at point C2. Here EMV
represents expected NPV.

Table 9.20 shows the computation of expected monetary value at

point C2.
Table 9.20: Computation of Expected Monetary Value at Point C2
Cash in flow Probability Expected value of cash inflows
(1) (2) (1) X (2) = (3)
30 [PVIFA( 12%, 20yrs) 0.6 134.4
30 x 7.469 = 224.07
20 [ PVIFA(12%,20 yrs) 0.4 59.8
20 x 7.469 = 49.38
EMV 194.2

Step 2: Arriving at the decision point.

Table 9.21 shows the computation of EMV at decision point D2.
Table 9.21: Computation of EMV at Decision Point D2

Decision taken Consequences The resulting EMV at this level

D 21 Invest Rs150 million 194.2 – 150 = 44.2 million
D 22 Stop 0

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Step 3: Here the decision criterion is “select the EMV with the highest
value”. So select D21 and truncate D22
Step 4: Calculate the EMV at chance point C1
Table 9.22 shows the computation of EMV at point C1.
Table 9.22: Computation of EMV at Point C1

EMV Probability Expected value

44.2 0.7 30.9 million
0 0.3 0

Step 5: Evaluate the EMV of the decision alternatives at D1

Table 9.23 shows the computation of EMV at point D.
Table 9.23: Computation of EMV at Point D

Decision taken Consequences The resulting EMV at this level

D 11 carry out pilot Invest 20
30.9 - 20= Rs.10.9 million
production and market test million
D 12 Do nothing 0 0
(Apply the EMV criterion) i.e. select the EMV with the highest value

Based on the above evaluation, we find that the optimal decision strategy
is as follows:
1. Choose D11 (carry out pilot production and market test) at the
decision point D1 and wait for the outcome at the chance point C1.
2. If the outcome at C1 is C11 (success) invest Rs150 million, else if the
outcome at C1 is C12 (failure) stop.

9.8.1 Evaluation of decision tree approach

The evaluation of decision tree approach leads to the following
assumptions:
 Decision tree approach portrays inter-related, sequential and critical
multi dimensional elements of major project decisions
 Adequate attention is given to the critical aspects of an investment
decision, which spread over a time sequence

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 Complex projects involve huge out lay and hence are risky. There is the
need to define and evaluate scientifically, the complex managerial
problems arising out of the sequence of interrelated decisions with
consequential outcomes of high risk. It is effectively answered by
decision tree approach
 Structuring a complex project decision with many sequential investment
decisions demands effective project risk management. This is possible
only with the help of an analytical tool like decision tree approach
 Ability to eliminate unprofitable outcomes helps in arriving at optimum
decision stages in time sequence.
Self Assessment Questions
17. Decision-tree can handle the __________ of complete investment
proposals.
18. __________ portrays inter-related sequential and critical multi-
dimensional element of major project decisions.
19. Adequate attention is given to the ___________ in an investment
decision under decision-tree approach.
20. ___________ are effectively handled by decision-tree approach.

9.9 Summary
Let us recapitulate the important concepts discussed in this unit:
 Risk in project evaluation arises on account of the inability of the firm to
predict the performance of the firm with certainty.
 Risk in capital budgeting decision may be defined as the variability of
actual returns from the expected.
 There are many factors that affect forecasts of investment, costs and
revenues of a project.
 It is possible to identify three types of risk: any project-stand-alone risk,
corporate risk and market risk. The sources of risks are as follows:
 Project
 Competition
 Industry
 International factors and
 Market
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 The techniques for incorporation of risk factor in capital budgeting

decision could be grouped into conventional techniques and statistical
techniques.

9.10 Glossary
Risk: It is defined as the variation of actual cash flows from the expected
cash flows.

9.11 Terminal Questions

1. Define risk. Examine the need for assessing the risks in a project.
2. Examine the type and sources of risk in capital budgeting.
3. Examine risk adjusted discount rate as a technique of incorporating risk
factor in capital budgeting.
4. Examine the steps involved in sensitivity analysis.
5. Examine the features of decision-tree approaches.

9.12 Answers

Self Assessment Questions

1. Stand-alone risk.
2. Beta
3. Diversify
4. International risk
5. Additional return
6. Risk free rate, risk premium
7. Greater
8. Risk - adjustment factor
9. Risk free rate of interest
10. Conservation
11. CE
12. More reliable
13. Probability
14. Sensitivity analysis
15. One of the steps of sensitivity analysis
16. Different economic conditions
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17. Sequential decisions

18. Decision tree
19. Critical aspects
20. Complex projects

Terminal Questions
1. Risk in capital budgeting may be defined as the variation of actual cash
flows from the expected cash flows Refer to 9.1.1.
2. Capital budgeting involves four types of risks in a project: stand-alone
risk, portfolio risk, market risk and corporate risk. Refer to 9.2.
3. The basic principle of risk adjusted discount rate is that there should be
adequate reward in the form of return to the firms which decide to
execute risky business projects. Refer to 9.3.
4. Analysing the change in the project’s NPV or IRR on account of a given
change in one of the variables is called Sensitivity Analysis. Refer to 9.6
5. A decision tree is a diagram that exhibits the outcomes of an act under
various events. Refer to 9.8.

9.13 Case Study: Net Present Value

A manufacturer of electrical components for the motor vehicle industry is

faced with the problem of building a new plant for the manufacture of
electronic components for vehicles. Estimates of the size of the new plant
to be built have been made and two sizes are selected based on forecast
of future new vehicle demand. A large plant is estimated to cost
Rs. 3 million and a small plant Rs. 1.4 million. Table 9.24 shows the net
cash inflows per annum of each size of plant according to the demand.

Table 9.24: Net Cash Inflows per Annum

Demand
Size of Plant
High (Rs.’000) Low (Rs.’000)
Large 1200 300
Small 500 400

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Based on a manufacturing plant life of six years, the following possible

outcomes are assessed:
1. Demand will be high for the first two years and then it will fall to a low
level. A probability of 20 per cent is given to this outcome.
2. Demand will be high for the first two years and it will remain at a high
level for the final four years. A 40 per cent probability is assigned to
this event.
3. Demand will be low for the first two years and will remain low for the
final four years. This outcome is given a 15 per cent probability.
4. Demand will be low for the first two years, but then it will then recover
to high level for the final four years. This is given a 25 per cent
probability of occurring.
Table 9.25 shows the relevant capital costs and net cash inflows, at
present values are given in the table for the two alternative plant sizes at
the high and low demand levels as discussed earlier.
Table 9.25: Capital Costs and Net Cash Inflows, at Present Values
Net cash inflow at present values
Plant Demand Year 1 and 2 Year 3 to 6
(Rs.’000) (Rs.’000)
High 2082 3143
Large
Low 521 786
High 868 1310
Small
Low 694 1040
The net present values have been calculated, for the two periods covered
by the predictions, at the rate of 10 per cent per annum which is the
expected cost of capital. You are required to do the following:
(a) Draw the decision tree diagram for the above information.
(b) Evaluate the decision tree and advise management which plant, if
either should be built.
Apply each of the criteria separately to achieve the following:
i) Maximise the net present value of the project.
ii) Maximise the rate of return on capital.
Hint: You are not required to calculate predicted rates of return, only to
deduce which would be the higher.
(Source: Pandey, I. M., (2005), Financial Management, Vikas Publishing
th
House 2005, 9 edition)

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References:
 Khan, M. Y. and Jain P. K. (2007). Financial Management, Text,
Problems & Cases, 5th Edition, Tata McGraw Hill Company, New Delhi.
 Maheshwari, S.N.(2009)., Financial Management – Principles & Practice,
13th Edition, Sultan Chand & Sons.
 Prasanna, Chandra (2007), Financial Management: Theory and Practice,
7th Edition, Tata McGraw Hill.

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Financial Management Unit 10

Unit 10 Capital Rationing

Structure:
10.1 Introduction
Objectives
10.2 Meaning of Capital Rationing
10.3 Types of Capital Rationing
10.4 Steps Involved in Capital Rationing
10.5 Various Approaches to Capital Rationing
10.6 Summary
10.7 Glossary
10.8 Example of Capital Rationing
10.9 Terminal Questions
10.10 Answers
10.11 Case Study

10.1 Introduction
In the previous unit, we discussed that capital budgeting decisions involve
huge outlay of funds. Funds available for projects may be limited. Therefore,
a firm has to prioritise the projects on the basis of availability of funds and
economic compulsion of the firm. In this unit we will discuss the concept of
capital rationing.
It is not possible for a company to take up all the projects at a time. There is
a need to rank them on the basis of strategic compulsion and funds
availability. Because companies will have to choose one amongst many
competing investment proposals, the need to develop criteria for capital
rationing cannot be ignored.
The companies may have many profitable and viable proposals but they
cannot execute them because of shortage of funds. Another constraint is
that the firms may not be able to generate additional funds for the execution
of all the projects.
When a firm imposes constraints on the total size of the firm’s capital
budget, it requires capital rationing. When capital is rationed, there is a need
to develop a method of selecting the projects that could be executed with
the company’s resources giving the highest possible net present value.

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Objectives:
After studying this unit, you should be able to:
 describe the meaning of capital rationing
 recognise the need for capital rationing
 explain the process of capital rationing
 describe the various approaches to capital rationing

10.2 Meaning of Capital Rationing

Firms may have to make a choice from among profitable investment
opportunities, because of the limited financial resources. Capital rationing
refers to a situation in which the firm is under a constraint of funds, limiting
its capacity to take up and execute all the profitable projects. Such a
situation may be due to external factors or due to the need to impose
internal constraints, keeping in view of the need to exercise better financial
control.
Capital rationing may be needed due to:
 External factors
 Internal constraints imposed by management
Figure 10.1 depicts reasons for capital rationing.

Figure 10.1: Reasons for Capital Rationing

External capital rationing

External capital rationing occurs due to the imperfections of capital market.
Mainly, the imperfections are caused due to:
 Deficiencies in market information
 Rigidities that hamper the force flow of capital between firms

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When capital markets are not favourable to the company, the firm cannot
tap the capital market for executing new projects even though the projects
have positive net present values. The following reasons attribute to the
external capital rationing:
 The inability of the firm to procure required funds from capital market,
because the firm does not command the required investor’s confidence
 National and international economic factors may make the market highly
volatile and unstable
 Inability of the firm to satisfy the regularity norms for issuing instruments
needed to tap the market for funds
 High cost of issue of securities i.e. high floatation costs. Smaller firms
may have to incur high costs of issue of securities. This discourages
small firms from tapping the capital market for funds

Internal capital rationing

Impositions of restrictions by a firm on the funds allocated for fresh
investment is called internal capital rationing.
This decision may be the result of a conservative policy pursued by a firm.
These are basically self-imposed restrictions by the management.
Restriction may be imposed on divisional heads on the total amount that
they can commit on new projects.
Another internal restriction for capital budgeting decision may be imposed
by a firm based on the need to generate a minimum rate of return. Under
this criterion only those projects that are capable of generating the
management’s expectation on the rate of return, will be cleared.
Generally, internal capital rationing is used by a firm as a means of financial
control.
The various factors related to the internal constraints imposed by the
management are: Private owned company; Divisional constraints; Human
resource limitations; Dilution and Debt constraints.

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Figure 10.2 depicts the factors related to internal constraints.

Figure 10.2: Internal Constraints

Private owned company

Under internal constraint, the management of the firms might decide that
expansion of the company might be a problem and not worth taking. This
kind of condition arises only when the management of a firm fears losing the
control in the company.
Divisional constraints
Another constraint might lead to the allocation of fixed amount for each
division in a firm by the upper management. This procedure can also be
considered as an overall corporate strategy. These situations arise mainly
from the point of view of a department. The cost of capital or the cost
structure of the management, the budget constraints imposed by the senior
officials or decisions coming from the head-office and wholly owned
subsidiary decisions relate to the internal constraints.
Human resource limitations
The management of the firm or the company should see that excessive
labour is being used for the project. Lack of proper man-power can become
an internal constraint.
Dilution
Dilution refers to the dilution of the company. This constraint occurs mainly
when there is reluctance in the issuing of further equity, due to the fear of
management losing the control over the company.

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Debt constraints
Debt constraints also constitute to the internal constraints in capital
rationing. This constraint occurs mainly due to the issue of earlier debt
which prohibits the issue of debts in the firm up-to a certain level.
Now, we will look at the different types of capital rationing in the following
sections.
Self Assessment Questions
1. When a firm imposes constraints on the total size of its capital budget, it
is known as _____________.
2. Internal capital rationing is used by a firm as a ____________________.
3. Rigidities that affect the free flow of capital between firms cause
_________________.
4. Inability of a firm to satisfy the regularity norms for issue of equity shares
for tapping the market for funds causes __________________.
5. The various internal constraints for capital rationing are _____,
________, ______________, ____________ and ________.
6. Lack of ____ will become a huge failure and also an essential effect of
internal constraint.
7. The reasons for capital rationing are _______ and ________.

10.3 Types of Capital Rationing

Now, let us discuss the various types of capital rationing that effects the
management of a firm. There are basically two types of capital rationing:
 Hard capital rationing
 Soft capital rationing
Figure 10.3 depicts the types of capital rationing.

Figure 10.3: Types of Capital Rationing

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Hard capital rationing

Hard capital rationing is defined as the capital rationing that cannot be
violated under any circumstances. Hard capital rationing also refers to the
companies acting external to the firms, which will not supply enough amount
of investment capital, though having positive NPV projects. Hard capital
rationing does not occur under perfect market.
Soft capital rationing
Soft capital rationing is defined as the circumstances under which the
constraints on spending can be violated. Soft capital rationing refers to or
arises with the internal, management-imposed limits on investment
expenditure.

10.4 Steps involved in Capital Rationing

In the previous topic we have discussed about the different types of capital
rationing. Now, let us look at the different steps involved in capital rationing.
Firms draw up their capital budgets under the assumption that the
availability of funds is limited. This limitation, as previously discussed, may
be due to difficulty in obtaining funds externally or it may be due to self-
imposed restrictions by the management.
The objective of capital expenditure decision-making, under conditions of
capital rationing, should be to maximise the NPV of the set of investments
that are selected. To be more precise, the objective should be to maximise
NPV per rupee of capital rather than to maximise NPV. Projects should be
ranked by their profitability index, and top-ranked projects should be
undertaken until funds are exhausted.
Thus, the following are the steps involved in capital:
 Ranking of different investment proposals
 Selection of the most profitable investment proposal

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Figure 10.4 depicts the steps involved in capital rationing.

Figure 10.4: Steps Involved in Capital Rationing

Ranking of different investment proposals

It means that the various investment proposals should be ranked on the
basis of their profitability. Ranking is done on the basis of NPV, profitability
index or IRR in the descending order.
Net present value method
It recognises the time value of money. Net present value correctly admits
that cash flows occurring at different time periods differ in value. Therefore,
there is a need to find out the present values of all the cash flows. NPV can
be represented with the following formula.

Net present value = present value of cash inflows - present value of

cash outflows

Profitability index
Profitability index (PI) is also known as benefit cash ratio. Profitability index
is the ratio of the present value of cash inflows to initial cash outlay. The
discount factor based on the required rate of return is used to discount the
cash inflows.
PI = Present value of cash inflows / initial cash outlay

Internal rate of return (IRR)

Internal rate of return is the rate (i.e. discount rate) which makes the net
present value of any project equal to zero. Internal rate of return is the rate
of interest which equates the present value (PV) of cash inflows with the
present value of cash outflows.
IRR is also called as yield on investment, managerial efficiency of capital,
marginal productivity of capital, rate of return and time adjusted rate of

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return. IRR is the rate of return that a project earns. IRR can be determined
by solving the following equation for

Ct
r = CF0   where t = 1 to n
(1  r ) t
CF0 = Investment

Profitability index as the basis of capital rationing

Let us discuss a problem regarding the concept of profitability index as the
basis of capital rationing. The profitability index is calculated in the following
case study based on the capital rationing factors per annum. The ranking is
given according to the most preferable investment proposal.

Solved Problem – 1
Table 10.1 describes the cash inflows of three projects. Compute the NPV
and profitability index of all the three projects and rank them on the basis
of capital rationing.
Table 10.1: Details of the Projects
Cash Inflows
Project Initial Cash outlay Year 1 Year 2 Year 3
A 1,00,000 60,000 50,000 40,000
B 50,000 20,000 40,000 20,000
C 50,000 20,000 30,000 30,000
Cost of Capital is 15 %
Solution
Table 10.2 shows the NPV computation for project A.
Table 10.2: Computation of NPV for Project A
Year Cash in flows PV factor at 15% PV of Cash in flows
1 60,000 0.870 52,200
2 50,000 0.756 37,800
3 40,000 0.658 26,320
PV of Cash inflow 1,16,320 Formatted Table

Initial Cash out lay (1,00,000)

NPV 16,320

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PV of Cash inf low s

Profitability index =
PV of Cash outflow s
1,16,320
  1.1632
1,00,000

Table 10.3 shows the NPV computation for project B.

Table 10.3: Computation of NPV for Project B
Year Cash in flows PV factor at 15% PV of Cash inflows
1 20,000 0.870 17,400
2 40,000 0.756 30,240
3 20,000 0.658 13,160
PV of cash inflow 60,800
Initial cash out-lay (50,000)
NPV 10,800

60,800
Profitability index =  1.216
50,000
Table 10.4 shows the NPV computation for project C
Table 10.4: Computation of NPV for Project C
Year Cash inflows PV factor at 15% PV of Cash inflows
1 20,000 0.870 17,400
2 30,000 0.756 22,680
3 30,000 0.658 19,740
PV of Cash inflow 59,820
Initial Cash out lay (50,000)
NPV 9,820
59,820
Profitability index =  1.1964
50,000

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Table 10.5 shows the ranking of projects.

Table 10.5: Ranking of Projects
Project NPV Profitability Index
Absolute Rank Absolute Rank
A 16320 1 1.1632 3
B 10800 2 1.216 1
C 9820 3 1.1964 2

If the firm has sufficient funds and no capital rationing restriction, then all
the projects can be accepted because all of them have positive NPVs.

Let us assume that the firm is forced to resort to capital rationing because
the total funds available for execution of project is only Rs. 1,00,000.

In this case on the basis of NPV Criterion, project A will be cleared. It

incurs an initial cash outlay of Rs. 1,00,000. After allocating Rs. 1,00,000
to project A, left over funds is nil. Therefore, on the basis of NPV criterion
other projects i.e. B and C cannot be taken up for execution by the firm. It
will increase the net wealth of the firm by Rs. 16,320.

On the other hand, on the basis of profitability index, project B and C can
be executed with Rs. 1,00,000 because both of them incur individually an
initial cash outlay of Rs. 50,000.

Therefore, with the execution of projects B and C, increase in net wealth of

the firm will be 10800 + 9820 = Rs. 20620.

The objective is to maximise NPV per rupee of capital and the projects
should be ranked on the basis of the profitability index. Funds should be
allocated on the basis of ranks assigned by profitability index.
Let us consider another problem discussing about the profitability index as
the basis of capital rationing.

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Solved Problem – 2
Table 10.6 describes the cash inflows of three projects. Compute the NPV
and profitability index of all the three projects and rank them on the basis
of capital rationing.
Table 10.6: Details of a Firm
Cash Inflows
Project Initial Cash outlay Year 1 Year 2 Year 3
A 1,00,000 50,000 40,000 30,000
B 60,000 30,000 50,000 10,000
C 30,000 10,000 20,000 20,000
Cost of Capital is 15 %
Solution
Table 10.7 shows the computation of NPV.
Table 10.7: Computation of NPV
Year Cash in flows PV factor at 15% PV of Cash in flows
1 70,000 0.870 60,870
2 40,000 0.756 30,250
3 30,000 0.658 19,730
PV of Cash inflow 1,10,850
Initial Cash out lay (1,00,000)
NPV 10,850
PV of Cash inflows
Profitability index =
PV of Cash outflows
1,10,850
  1.1085
1,00,000
Table 10.8: Project B

Year Cash inflows PV factor at 15% PV of Cash inflows

1 30,000 0.870 26,100
2 50,000 0.756 37,800
3 10,000 0.658 6,580
PV of cash inflow 70,480
Initial cash out-lay (60,000)
NPV 10,480

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70,480
Profitability index =  1.175
60,000
Table 10.9: Project C

Year Cash inflows PV factor at 15% PV of Cash inflows

1 10,000 0.870 8,700
2 20,000 0.756 15,120
3 20,000 0.658 13,150
PV of Cash inflow 36,970
Initial Cash out lay (30,000)
NPV 6,970

36,970
Profitability index =  1.232
30,000
Table 10.10: Ranking of Projects

Project NPV Profitability Index

Absolute Rank Absolute Rank
A 10850 1 1.1085 3
B 10480 2 1.175 2
C 6970 3 1.232 1

If the firm has sufficient funds and no capital rationing restriction, then all
the projects can be accepted because all of them have positive NPVs.
Let us assume that the firm is forced to resort to capital rationing because
the total funds available for execution of project is only Rs.1,00,000.
In this case, on the basis of NPV criterion, project A will be cleared. It
incurs an initial cash outlay of Rs. 1,00,000. After allocating Rs. 1,00,000
to project A, left over funds is nil. Therefore, on the basis of NPV criterion
other projects i.e. B and C cannot be taken up for execution by the firm. It
will increase the net wealth of the firm by Rs. 10,850.
On the other hand on the basis of profitability index, project B and C can
be executed with Rs. 1,00,000 because both of them incur individually an
initial cash outlay of Rs. 60,000 and Rs. 30,000.
Therefore, with the execution of projects B and C, increase in net wealth
of the firm will be 10480 + 6970 = Rs. 17450.

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The objective of the previous problem is to maximise NPV per rupee of

capital. Projects should be ranked on the basis of the profitability index.
Funds should be allocated on the basis of ranks assigned by profitability
index.
Selection of the most profitable investment proposal
After ranking the different investment proposals based on their net present
value, profitability index and the internal rate of return, the selection of the
most profitable investment proposal is to be done. Mainly, the selection is
done with a view to select the investment proposal which earns more profits
than the other proposals.
The basic features to be taken under consideration during the selection of
the most profitable investment proposal are:
 The proposal should have the potential of making large anticipated
profits
 The proposal should involve high degree of risk
 The proposal should involve a relatively long time-period between the
initial outlay and the anticipated return
Evaluation of the selection procedure
 PI rule of selecting projects under capital rationing may not yield
satisfactory result because of project indivisibility. When projects
involving high investment is accepted many small projects will have to be
excluded. However, the sum of the NPVs of those small projects may be
higher than the NPV of a single large project.
 Capital rationing also suffers from the multi-period capital constraints.

Activity: List the various steps involved in Capital Rationing

Hint: refer to section 10.4

10.5 Various Approaches to Capital Rationing

There are various approaches to analyse capital rationing, but here, we will
mainly deal with the programming approach.
Programming approach
There are many programming techniques of capital rationing. Among them
are: linear programming and integer programming

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Figure 10.5 depicts two of the programming approaches.

Figure 10.5: Programming Approach

Linear programming
Linear programming (LP) approach to capital rationing, tries to achieve
maximum NPV subject to many constraints. Here the objective function is
maximisation of sum of the NPVs of the projects.
Here, the constraints matrix incorporates all the restrictions associated with
capital rationing imposed by the firm.

Caselet
Let us consider a wine production problem and try to solve it using linear
programming approach. A firm, has decided to produce two types of wine
(X and Y), to sell to the local shops. Now, the firm should know the profit
figures for each type. The firm should know the requirements of each
type of wine in terms of their ingredients, namely, grapes, sugar and
extract. When the firm gets to know the constraints on these ingredients,
it should be in a position to know the best way to proceed. In this way,
the firm should obtain information on how to use the resources to
maximise the profit.
Integer programming
LP may give an optimal mix of projects in which there may be a need to
accept the fraction of a project. Accepting a fraction of a project is not
feasible. Therefore, the optimum may not be attainable. The actual
implementation of projects may be suboptimal. When projects are not
divisible, integer programming can be employed to avoid the chances of
accepting fraction of projects.
Now, let us discuss the merits and demerits of programming approach.

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Merits of programming approach

 Programming approach provides information on dual variables.
 Programming approach also gives information on shadow prices of
budget constraints.
 Dual variables provide information for decision on transfer of funds from
one year to another year.
Demerits of programming approach
 They are costly to use when large, indivisible projects are being
examined.
 They are deterministic models.
 The variables of capital budgeting are subjected to change, making the
assumption of deterministic highly invalid.

Self Assessment Questions

8. The two steps involved in capital rationing are __________ and
__________________.
9. Project indivisibility can lead to sub optimal result when ____________
is used for capital rationing.
10. Objective function under linear programming approach is
___________.
11. When projects are not divisible ______________ can be employed to
avoid the chances of accepting fraction of a project.
12. The programming techniques of capital rationing are ______ and
____________.
13. The selection is done mainly in the view that the selected investment
proposal earns __________ than the other proposals.
14. The proposal should have the potential of making large
____________.

10.6 Summary
Let us recapitulate the important concepts discussed in this unit:
 Often, firms are forced to ration the funds among the eligible projects
that the firm wants to take up.

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 The inability of the firm in finding adequate funds for execution of the
projects could be due to many factors. It may be due to external factors
or internal constraints imposed by the management.
 External capital rationing occurs mainly because of imperfections in
capital markets.
 Internal capital rationing is caused by restrictions imposed by the
management.

10.7 Glossary
Capital rationing:
Impositions of restrictions by a firm on the funds allocated for fresh
investment is called internal capital rationing.

10.8 Example of Capital Rationing

Financing public hospitals

Capital rationing technique is an essential requirement in the case of
public hospitals. Funding public hospitals is essentially required to meet
the requirements of the patients and to provide efficient treatment to the
patients. Funding public hospitals also meets the requirements of
hospitals like getting latest equipments for better treatment of the patients.
Furthermore, the number of alternatives available is small enough that
each alternative can be thoroughly investigated and traditional capital
markets can be used to acquire the necessary requirements or the
resources. Many of these conditions do not apply to the public hospitals.
The government introduces many policies or funds for the development of
public hospitals, but very rarely these policies get implemented. New
projects, when finished, must compete with the existing facilities for a
limited supply of operating funds. So the commission should look for the
technique to screen the proposals submitted by the hospitals get
approved, while the unneeded proposals could be rejected.
Over 8,000,000 residents come under or relate to the public hospitals.
Over 200 active treatment and chronic hospitals of all types (proprietary,
voluntary and religiously affiliated) except long time psychiatric hospitals
fall under its sphere of influence in a manner analogous to a franchise
system. No readily available output measure adequately reflects the
operation of this social welfare system.
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Criteria of capital rationing

We know from various units discussed under finance management that the
rate of return on the intermediate cash flows is equal to the risk-adjusted
discount rate. However, in many situations the two rates are different. In this
unit we have discussed that net present value and the profitability index are
used in ranking of the proposed projects, but this technique is found
incorrect in many situations. Another problem is that in the present business
scenario, finance managers would prefer to use internal rate of return for
ranking the proposed projects, although ranking by net present value is
theoretically superior.
The reason behind the finance manager considering internal rate of return
rather than the net present value, may be that the rate of return gives the
finance manager a clear idea about the proposal than the net present value.
For example, we consider NPV in dollars whereas rate of return in
percentages. The value in percentage gives more clear idea to the finance
manager rather than the value in dollars. Theoretically, a company should
be able to obtain financing for all the acceptable projects (NPV>0).
However, in reality all companies practise capital rationing.
The objective of capital rationing is to maximise NPV per rupee of capital
and projects should be ranked on the basis of the profitability index. Funds
should be allocated on the basis of ranks assigned by profitability index.
Obviously, when one project is allowed by the budget, the NPV criterion is
appropriate. However, when two or more projects are allowed, the NPV
criterion might fail to serve that purpose because it does-not consider the
investment size at the same time.
For example, when the company is in the business of a single line of
products (e.g., computer hardware) and their intention is to expand the
production and sales (in the same market) of the same line of products, then
risk adjusted discount rate (RADR) will always be equal to normal rate of
return (k), as the risks are the same. Thus, the financing of the project and
future projects is consistent with the target capital structure of the company.
The actual rate of return on the project may be different from the risk
adjusted discount rate (RADR), as the expansion of business may be more
efficient or less efficient than the current business. Concerning r and RADR,
r is the actual rate (not required rate) of return on the cash flows.

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Even if the reinvestment has the same risk as the project, r is not
necessarily equal to RADR.
Thus, a finance manager considers all the situations and scenarios and then
depends only on the internal rate of return in ranking the projects.

10.9 Terminal Questions

1. Examine the need for capital rationing.
2. Examine the reasons for external capital rationing.
3. Internal capital rationing is used by firms for exercising financial control.
How does a firm achieve this?
4. Brief explain the process of capital rationing.

10.10 Answers

Self Assessment Questions

1. Capital rationing
2. Means of financial control
3. External capital rationing
4. External capital rationing
5. Private owned company, Divisional constraints, Human resource
limitations, Dilution and Debt constraints
6. Lack of man-power
7. External constraints and internal constraints imposed by the
management
8. Ranking the project, selection of the most profitable investment
proposal
9. Profitability index
10. Maximisation of sum of NPVs of the projects
11. Integer programming
12. Linear programming and integer programming
13. More profits
14. Anticipated profits

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Terminal Questions
1. Capital rationing refers to a situation in which the firm is under a
constraint of funds, limiting its capacity to take up and execute all the
profitable projects. Refer to 10.2
2. External capital rationing occurs due to the imperfections of capital
market Refer to 10.2
3. Impositions of restrictions by a firm on the funds allocated for fresh
investment is called internal capital rationing Refer to 10.2
4. The objective of capital expenditure decision-making, under conditions of
capital rationing, should be to maximise the NPV of the set of
investments that are selected Refer to 10.4

10.11 Case Study: Prakash Tools Ltd.

Prakash Tools Ltd. is a manufacturing concern that designs and
manufactures machine tools that are required for various manufacturing
operations. Originally established in a small village on the outskirts of South
Bangalore, the company was started as a 100 percent export-oriented unit,
which catered to the international markets. The company’s success was
mainly attributed to its comprehensive idea generation and strategic project
selection process.
After its inception, the company performed well in the international markets.
The revenues of the company have been increasing at a rate of 50-65
percent every year. Considering the growth and demand in the domestic
market, the company management started its own wholesale outlets in
some major cities across the country. The response was more than what
was expected.
In its 16th annual board meeting in March 2010, the company management
decided to set up small scale manufacturing units to meet the domestic
market demand. The management allocated Rs. 1.1 crore for this project.
Mr. Alexander, manager, marketing, conducted a market survey close to
Chennai, Bangalore, Kolkata and Delhi as the feasible areas to start new
projects. The survey also revealed the following:
 The investment required for the projects in Chennai, Bangalore, Kolkata
and Delhi was Rs. 50 lakhs, Rs. 55 lakhs, Rs. 65 lakhs and Rs. 1 crore
respectively.

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 The expected life period for each of these projects was 6 years, 4 years,
5 years and 5 years, respectively.
 The likely annual cash inflow generated by each of these projects was
Rs. 13 lakhs, Rs. 18 lakhs, Rs. 19 lakhs and Rs. 28 lakhs, respectively.
 The salvage value of each of these units was estimated as Rs. 2 lakhs,
Rs. 6 lakhs, Rs. 1 lakh and Rs. 7 lakhs, respectively.
Based on the above information, the management committee members, Mr.
Gajendra Shukla and Mr. Rajeev Sharma attempted at evaluating the
projects assuming the cost of capital at 12%. Gajendra used the criterion of
NPV while Rajeev used the criterion of profitability index, to rank the
projects. When they finally compared, they realised that their rankings were
different.
Discussion Questions:
1. What were the rankings arrived at by Mr.Gajendra Shukla as per the
NPV criterion?
2. What were the rankings arrived at by Mr.Rajeev Sharma?
3. What do you think is the final and best option for Prakash Tools Ltd.?
Justify your response.
4. What would your response to the above question be, if it is stated that
(a) The company has no capital constraints.
(b) The company has a constraint and it can spare only Rs. 85 lakhs.
(c) Projects in Chennai and Bangalore are mutually exclusive*.
(Hint: Net Present Value associated with a project = Present value of all
cash flows + Present value of salvage value – Initial outlay.
Hint: * A set of mutually exclusive projects maybe defined as a set if projects
from which only one project may be selected.)

References:

 Khan, M. Y. and Jain P. K. (2007). Financial Management, Text,

Problems & Cases, 5th Edition, Tata McGraw Hill Company, New Delhi.
 Maheshwari, S.N.(2009)., Financial Management – Principles & Practice,
13th Edition, Sultan Chand & Sons.
 Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition,

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Unit 11 Working Capital Management

Structure:
11.1 Introduction
Objectives
11.2 Components of Current Assets and Current Liabilities
11.3 Concepts of Working Capital
Gross working capital
Net working capital
11.4 Objective of Working Capital Management
11.5 Need for Working Capital
11.6 Operating Cycle
11.7 Determinants of Working Capital
11.8 Approaches for Working Capital Management
Conventional approach
Operating cycle approach
11.9 Estimation of Working Capital
Estimation of current assets
Estimation of current liabilities
11.10 Summary
11.11 Glossary
11.12 Terminal Questions
11.13 Answers
11.14 Case Study

11.1 Introduction
In the previous unit, we have discussed the concept of capital rationing. As it
is not possible for a company to take up all the projects at a time, there is a
need to rank them on the basis of strategic compulsion and funds
availability. This ranking is done with the help of capital rationing. In this unit
we will discuss about the management of working capital.
Working capital is the capital required by a business for its day to day
operations. It is that portion of a business asset which is used frequently in
current operations and in the operating cycle of the firm.

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Inadequacy or mismanagement of working capital is the leading cause of

many business failures. Therefore, a financial manager spends a larger part
of his time in managing working capital. The two important elements to be
considered under the working capital management are:
 Decision on the amount of current assets to be held by a firm for efficient
operations of its business
 Decision on financing working capital requirement
The need for proper management of working capital is even more important
in the modern era of information technology. In support of the above
argument, let us consider the performance of Dell computers as reported in
one of the recent Fortune articles. A perusal of the article will give you an
insight of how Dell used the technology for improving the performance of
components of working capital. Dell achieved improved performance of
components of working capital by:
 Using Internet as a tool for reducing costs of linking manufacturer with
their suppliers and dealers
 Outsourcing on operations, if the firm’s competence does not permit the
performance of the operation effectively
 Training the employees to accept change
 Introducing Internet business
 Releasing capital by reduction in investment in inventory for improving
the profitability of operating capital
Objectives:
After studying this unit, you should be able to:
 explain the meaning, definition and various concepts of working capital
 state the objectives of working capital management
 estimate the process of working capital

11.2 Components of Current Assets and Current Liabilities

In this section, we will discuss the components of current assets and current
liabilities. Working capital management is concerned with managing the
different components of current assets and current liabilities as well as the
financing aspect of current assets.
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It can be stated that working capital is the difference between resources in

cash or readily convertible into cash (current assets) and organisational
commitments for which cash will soon be required (current liabilities).
Hence, it is very important to be clear about what constitutes current assets
and liabilities. Following is a brief description on the same.
Some key components of current assets are as follows:
 Inventories
 Sundry debtors
 Bills receivables
 Cash and bank balances
 Short-term investments
 Advances such as advances for purchase of raw materials, components
and consumable stores and pre-paid expenses
Some important components of current liabilities are as follows:
 Sundry creditors
 Bills payable
 Creditors for out-standing expenses
 Secured loans, from banks, for working capital
 Unsecured loans in the form of fixed deposits or any such short term
advances
 Temporary bank overdrafts
 Provisions for taxation and proposed dividends
 Other provisions against the liabilities payable within a period of 12
months
A firm must have adequate working capital, neither excess nor inadequate.
Maintaining adequate working capital is crucial for maintaining the
competitiveness of a firm.
Any lapse of a firm on this account may lead a firm to the state of
insolvency.

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Activity 1
List the key components of current assets and current liabilities
Hint: Refer to section 11.2

Self Assessment Questions

1. Pre-paid expenses are __________.
2. Provision for tax is____________.
3. A firm must have _________ neither excess nor shortage.
4. List any two components of current assets.
5. List any two components of current liabilities.

11.3 Concepts of Working Capital

In this section, we will discuss the concepts of working capital. The four
most important concepts of working capital include gross working capital,
net working capital, temporary working capital and permanent working
capital.
Figure 11.1 depicts the concepts of working capital.

Figure 11.1: Concepts of Working Capital

Gross working capital

Gross working capital refers to the amounts invested in various components
of current assets. It basically refers to the current assets. This concept has
the following practical relevance:
 Management of current assets is the crucial aspect of working capital
management
 Gross working capital helps in the fixation of various areas of financial
responsibility
 Gross working capital is an important component of operating capital.
Therefore, for improving the profitability on its investment, the finance

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manager of a company must give top priority to efficient management of

current assets
 The need to plan and monitor the utilisation of funds of a firm demands
working capital management, as applied to current assets
Gross working capital is often termed as the quantitative aspect of working
capital.
Net working capital
Net working capital is the excess of current assets over current liabilities and
provisions. Net working capital is positive when current assets exceed
current liabilities and negative when current liabilities exceed current assets.
This concept has the following practical relevance:
 Net working capital indicates the ability of the firm to effectively use the
spontaneous finance in managing the firm’s working capital requirements
 A firm’s short term solvency is measured through the net working capital
position, it commands
‘Net working capital’ is a qualitative concept, which indicates the liquidity
position of the firm and the extent to which working capital needs may be
financed by permanent sources of funds.
Permanent working capital
Permanent working capital is the minimum amount of investment required to
be made in current assets at all times to carry on the day-to-day operation of
firm’s business. This minimum level of current assets has been given the
name of core current assets by the Tandon committee.
Permanent working capital is also known as fixed working capital.
Temporary working capital
Temporary working capital is also known as variable working capital or
fluctuating working capital. The firm’s working capital requirements vary
depending upon the seasonal and cyclical changes in demand for a firm’s
products. The extra working capital required as per the changing production
and sales levels of a firm is known as temporary working capital. It is the
amount of investment required to take care of variations/fluctuations in the
business activity.

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Self Assessment Questions

6. _______________ refers to the amounts invested in current assets.
7. To ________________ and monitor the utilisation of funds of a firm
________________________ is to be given top priority.
8. When current assets exceed current liabilities the net working capital is
__________________.
9. Permanent working is called _________________ working capital.

11.4 Objective of Working Capital Management

In this section, we will discuss the objective of working capital management.
The objective of financial management is maximising the net wealth of the
shareholders. A firm must earn sufficient returns from its operations to
ensure the realisation of this objective. There exists a positive co-relation
between sales and firm’s return on its investment. The amount of earnings
that a firm earns depends upon the volume of sales achieved. There is the
need to ensure adequate investment in current assets, keeping pace with
accelerating sales volume.
Firms make sales on credit. There is always a time gap between sale of
goods on credit and the realisation of sales’ earnings from the firm’s
customers. Finance manager of a firm is required to finance the operation
during this time gap.
Therefore, objective of working capital management is to ensure smooth
functioning of the normal business operations of a firm. The firm has to
decide on the amount of working capital to be employed.
The firm may have a conservative policy of holding large quantum of current
assets to ensure larger market share and to prevent the competitors from
snatching any market for their products. However, such a policy will affect
the firm’s returns on its investment. The firm will have returns higher than
the required amount of investment in current assets. This excess funds
locked in current assets will reduce the firm’s profitability on operating
capital.
On the other hand, a firm may have an aggressive policy of depending on
spontaneous finance to the maximum extent. Credit obtained by a firm from
its suppliers is known as spontaneous finance. Here, a firm will try to reduce

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its investments in current assets as much as possible, with a check that it is

not affecting the firm’s ability to meet working capital needs for sales growth
targets. Such a policy will ensure higher return on its investment as the firm
will not be locking in any excess funds in current assets. However, any error
in forecasting can affect the operations of the firm unfavourably, if the error
is fraught with the down-side risk. There is another risk of firm losing on
maintaining its liquidity position.
Objective of working capital management is achieving a trade–off between
liquidity and profitability of operations for the smooth conduct of normal
business operations of the firm. This has to be done while taking into view
the attitude of management towards risk and other constraints imposed by
the suppliers of finance.
Self Assessment Questions
10. Objective of working capital management is achieving a trade-off
between _________ and _____________.
11. Credit obtained by a firm from its suppliers is known as _______.
12. An aggressive policy of working capital management means depending
on _________ to the maximum extent.
13. To prevent the competitors from snatching any market for their products
the firm may have ______ a policy of holding ______ of current assets.

11.5 Need for Working Capital

In this section, we will discuss the need for working capital. The need for
working capital arises on account of two reasons:
 To finance operations during the time gap between sale of goods on
credit and realisation of money from customers of the firm
 To finance investments in current assets for achieving the growth target
in sales
Therefore, to finance the operations in operating cycle of a firm, working
capital is required. Negligence of management on working capital may result
in technical insolvency and even liquidation of a business unit. Inefficient
working capital management may cause either inadequate or excessive
working capital, which is dangerous.

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Following are some adversities that may affect the firm in case of
inadequate working capital:
 Growth may be stunted. It may become difficult for the enterprise to
undertake profitable projects due to non-availability of working capital.
 Implementation of operating plans may become difficult and
consequently the profit goals may not be achieved.
 Cash crisis may emerge due to paucity of working funds.
 Operating inefficiencies may creep in due to difficulties in meeting day to
day commitments.
 Optimum capacity utilisation of fixed assets may not be achieved due to
non-availability of the working capital.
 The business may fail to honour its commitment in time, thereby
adversely affecting its credibility. This situation may lead to business
closure.
 The business may be compelled to buy raw materials on credit and sell
finished goods on cash. In the process it may end up with increasing
cost of purchases and reducing selling prices by offering discounts. Both
these situations would affect profitability adversely.
 Non-availability of stocks due to non-availability of funds may result in
production stoppage.
 Fixed assets may not be efficiently used due to lack of working funds,
thus lowering the rate of return on investments in the process.
While under-assessment of working capital has disastrous implications on
business, over-assessment of working capital also has its own dangers.
Some of the issues that may crop up due to excessive working capital are
as follows:
 Excess of working capital may result in unnecessary accumulation of
inventories.
 It may lead to offer too liberal credit terms to buyers and very poor
recovery system and cash management.
 It may make management complacent leading to its inefficiency.
 Over-investment in working capital makes capital less productive and
may reduce return on investment.

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Thus, the working capital is the lifeline of any business unit. Working capital
is very essential for success of a business and therefore, it needs efficient
management and control. Each of the components of the working capital
needs proper management to optimise profit. When we are trying to
understand the need for working capital, it is also important to identify some
of the significant factors that affect the composition of working capital or
current assets.
Factors that affect working capital are as follows:
 Nature of business/industry
 Size of business/scale of operations
 Growth prospects
 Nature of raw material used
 Business/manufacturing cycle
 Process technology used
 Operating cycle and rapidity of turnover
 Operating efficiency
 Nature of finished goods
 Profit margin and profit appropriation
 Policies on depreciation, taxation and dividends
 Government regulations
We will take a better look at such factors in the upcoming section 11.7. In
the next section, we will proceed to learn about the concept of operating
cycle of a firm and its implications on working capital management.

Self Assessment Questions

14. To finance the operations in _______ of a firm working capital is
required.
15. To finance operations during the time gap between _______ and
________ time gap is required.

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11.6 Operating Cycle

In this section, we will discuss the concept of operating cycle of a firm and
its implications on the working capital. The time gap between acquisition of
resources and collection of cash from customers is known as the operating
cycle. It is also referred to as the working capital cycle.
Operating cycle of a firm involves the following elements:
 Acquisition of resources from suppliers
 Payment disbursements to suppliers
 Conversion of raw materials into finished products
 Sale of finished products to customers
 Collection of cash from customers for the goods sold
Figure 11.2 depicts the phases of an operating cycle.

Figure 11.2: Phases of an Operating Cycle

The five phases of the operating cycle occur on a continuous basis. The
successive events that typically take place in an operating cycle have been
depicted above. On perusal, it can be understood that the funds invested in
operations are recycled back into cash and further operations.

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There is no synchronisation between the activities in the operating cycle.

Cash outflows occur before the occurrences of cash inflows in operating
cycle.
Cash outflows are certain. However, cash inflows are uncertain because of
uncertainties associated with effecting sales as per the sales forecast and
ultimate timely collection of amount due from the customers to whom the
firm has sold its goods.
As cash inflows do not match with cash out flows, firm has to invest in
various current assets to ensure smooth conduct of day to day business
operations. Therefore, the firm has to assess the operating cycle time of its
operation for providing adequately for its working capital requirements. A
standard operating cycle may be for any time period, but it does not
generally exceed a financial year. As one can understand from the
discussion above, the shorter the operating cycle, the larger will be the
turnover of funds invested.
Operating Cycle = IC Period + RC Period
IC Period = Inventory Conversion Period
RC Period = Receivables Conversion Period
Inventory conversion period is the average length of time required to
produce and sell the product.

Average Inventory  365

Inventory Conversion Period =
Annual Cost of Goods Sold

Receivables conversion period is the average length of time required to

convert the firm’s receivables into cash.

Average Accounts Re ceivables  365

Receivables Conversion Period =
Annual Sales

Accounts payables period is also known as payables deferral period.

Average Creditors
Accounts Payables Period =
Purchases per Day

(Payables deferral period)

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Total Purchases for Year

Purchases per Day =
365
Cash conversion cycle is the length of time between the firm’s actual cash
expenditure and its own cash receipt. The cash conversion cycle is the
average length of time for which a rupee is tied up in current assets.
Cash conversion cycle is
CCC = ICP + RCP – PDP
CCC = Cash conversion cycle
ICP = Inventory conversion period
RCP = Receivables conversion period
PDP = Payables deferral period

Solved Problem – 1
Table 11.1 gives the complete details of sales and costs of the goods
produced by XYZ ltd for the year 31.03.08.
Table 11.1: Sales and Costs Produced by XYZ Ltd.
Sales 80,000 Inventory
Cost of goods 56,000 31.03.07 9,000
31.03.08 12,000
Accounts Receivables
31.03.07 12,000
31.03.08 16,000
Accounts Payable
31.03.07 7,000
31.03.08 10,000

What is the length of the operating cycle?

What is the cash cycle?
Assume 365 days in the year
Solution
Operating Cycle = Inventory Conversion Period + Accounts Receivables
Conversion Period
From the above formula we need to first calculate the individual
conversion periods.

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Inventory conversion period

Average Inventory (9000  12000 ) / 2
 365  365
Annual Cost of goods sold 56000

10500 365
 68.4 days
56000
Receivables Conversion Period
Average Accounts Re ceivables
365
= Annual Sales
( 12000 16000 ) / 2365
 63.9 days
80000
Payables Conversion Period
Average Accounts Payables
=  365
Annual Cost of Goods Sold
(7000  10000 ) / 2  365
56000
8500 365
 55.4 days
56000
Operating Cycle = ICP + RCP
= 68.4 + 63.9 = 132.3 days
Cash Conversion Cycle= OC – PDP
= 132.3 – 55.4 = 76.9 days

Activity 2
Indicate whether the operating cycle in the following industries is short
(less than 30 days), medium (less than 6 months) or long (more than 6
months)
Steel, rice, vegetables, fruits, jewelry, processed food, furniture, mining,
flowers and textiles
Hint:
 Short: vegetables, fruits, flowers
 Medium: rice, fruits, processed food,
 Long: Steel, jewelry, furniture, mining, textiles

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The cash conversion cycle shows the time interval over which additional
non-spontaneous sources of working capital financing must be obtained to
carry out firm’s activities. An increase in the length of operating cycle,
without a corresponding increase in payables deferral period, increases the
cash conversion cycle. Any increase in cash conversion cycle leads to
additional working capital needs of the firm.
Self Assessment Questions
16. The time gap between acquisition of resources from suppliers and
collection of cash from customers is known as ______.
17. ___________ is the average length of time required to produce and sell
the product.
18. __________ is the average length of time required to convert the firm’s
receivables into cash.
19. _________ conversion cycle is the length of time between firms’ actual
cash expenditure and its own receipt.

11.7 Determinants of Working Capital

In this section, we will discuss the determinants of working capital. A large
number of factors influence working capital needs of a firm. The basic
objective of a firm’s working capital management is to ensure that the firm
has adequate working capital for its operations, neither too much nor too
little. Figure 11.3 depicts factors that determine the working capital.

Figure 11.3: Factors Determining Working Capital

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The following factors determine a firm’s working capital requirements (see

figure 11.3)
 Nature of business – Working capital requirements are basically
influenced by the nature of business of the firm. Trading organisations
are forced to carry large stocks of finished goods, accounts receivables
and accounts payables. Public utilities require lesser investment in
working capital.
 Size of business operation – Size is measured in terms of the scales
of operations. Normally, a firm with large scale of operation requires
more working capital than a firm with a low scale of operation.
 Manufacturing cycle – Capital intensive industries with longer
manufacturing process will have higher requirements of working capital,
because of the need of running their sophisticated and long production
process.
 Products policy – Production schedule of a firm influences the
investments in inventories. A firm, exposed to seasonal changes in
demand that follows a steady production policy, will have to face the
costs and risks associated with inventory accumulation during the off-
season periods. On the other hand, a firm with a variable production
policy will be facing different dimensions of management of working
capital. Such a firm has to effectively handle the problem of production
planning and control associated with utilisation of installed plant
capacity, under conditions of varying volumes of production of products
of seasonal demand.
 Volume of sales – There is a positive direct correlation between the
volume of sales and the size of working capital of a firm.
 Term of purchase and sales – A firm that allows liberal credit to its
customers will need more working capital than a firm with strict credit
policy. A firm, which enjoys liberal credit facilities from its suppliers
requires lower amount of working capital when compared to a firm,
which does not have such a facility.
 Operating efficiency – The firm with high efficiency in operation can
bring down the total investment in working capital to lower levels. Here,
effective utilisation of resources helps the firm in bringing down the
investment in working capital.
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 Price level changes – Inflation affects the working capital levels in a

firm. To maintain the operating efficiency under an inflationary set up, a
firm should examine the maintenance of working capital position under
constant price level. The financial capital maintenance demands a firm
to maintain higher amount of working capital, keeping pace with rising
price levels. Under inflationary conditions, the same levels of inventory
will require increased investment. The ability of a firm to revise its
products’ price with rising price levels will decide the additional
investment to be made to maintain the working capital intact.
 Business cycle – During boom, sales rise as business expands.
Depression is marked by a decline in sale. During boom, expansion of
business can be achieved only by augmenting investment in various
assets that constitute working capital of a firm. When there is a decline
in business on account of depression in economy, the inventory glut
forces a firm to maintain the working capital at a level far in excess of the
requirements under normal conditions.
 Processing technology – Longer the manufacturing cycle, larger is the
investment in working capital. When raw material passes through
several stages in the production, process work in process inventory will
increase correspondingly.
 Fluctuations in the supply of raw materials – Companies which use
raw materials available only from one or two sources are forced to
maintain buffer stock of raw materials to meet the requirements of
uncertainty in lead time. Such firms normally carry more inventory than it
would have done, had the materials been available in normal market
conditions.
Investing heavily in current assets will drain the firm’s earnings and
inadequate investment in current assets will reduce the firm’s credibility as it
affects the firm’s liquidity. Therefore, the need to strike a balance between
liquidity and profitability cannot be ignored.

Self Assessment Questions

20. Capital intensive industries require _________ amount of working
capital.
21. There is a __________ between volume of sales and the size of the
working capital of a firm.
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22. Under inflationary conditions same level of inventory will require

__________ investment in working capital.
23. Longer the manufacturing cycle, ________ the investment in working
capital.

11.8 Approaches for Working Capital Management

In this section, we will discuss the approaches for the working capital
management. There are generally two approaches followed for the
management of working capital. They are: (a) the conventional approach
and (b) the operating cycle approach.
11.8.1 Conventional approach
This approach advocates managing the individual components of working
capital (i.e., inventory, receivables, payables, etc.) in an effective and
economic manner, in such a way that there are neither idle funds nor
shortage of funds. Various techniques have evolved for the management of
each such component. This approach involves matching of cash inflows and
outflows; but it does not take into account time value of money.
11.8.2 Operating cycle approach
The approach, as the name suggests, is based on the operating or working
capital cycle. We have discussed in detail, the meaning of operating cycle in
the earlier pages.
Under this approach, the working capital is determined on the basis of the
duration of the operating cycle and the operating expenses required for
completing the cycle.
Hitherto, in India, most firms followed the conventional approach for the
working capital management. However, the practice has gradually shifted in
favour of the operating cycle approach. The banks too, usually apply this
approach while granting credit facilities to their clients.

11.9 Estimation of Working Capital

Working capital, as we have seen earlier, comprises of two important
components – current assets and current liabilities.

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Figure 11.4 depicts the components of working capital.

Figure 11.4: Components of Working Capital

Estimation of working capital is based on the assumption that production

and sales occur on a continuous basis and all costs occur accordingly.
Each constituent of working capital retains its form for a certain period and
that holding period is determined by the factors discussed above. So, for
correct assessment of the working capital requirement, the duration at
various stages of the working capital cycle is estimated. Thereafter, proper
value is assigned to the respective current assets, depending on its level of
completion. Table 11.2 gives the basis for assigning value to each
component.
Table 11.2: Valuation of Components
Component Valuation Basis
Stock of raw material Purchase cost of raw material
Stock of work-in-process At cost or market value, whichever is lower
Stock of finished goods Cost of production
Debtors Cost of sales or sales value
Cash Working expenses

The duration of the operating cycle is ascertained for different segments.

They may be segmented and calculated as below:
(a) Raw material storage period (say, p1)
(b) Conversion period (p2)
(c) Finished goods Storage period (p3)
(d) Average collection period (p4)
(e) Average payment period (p5)

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From the above calculations, the gross operating cycle period is obtained as
(p1 + p2 + p3 + p4) days. When the average payment period of p5 is
subtracted from the gross operating cycle period, the resultant figure is the
actual operating cycle period. When the operating cycle is short, it indicates
that the locking up of funds in current assets is for a relatively short period
and the company can obtain greater mileage from each rupee invested in
current assets.
Each constituent of the working capital is valued on the basis of valuation
enumerated in table 11.2 for the holding period estimated, as detailed
above. The total of all such valuation becomes the total estimated working
capital requirement.
11.9.1 Estimation of current assets
Similarly, we can estimate the current assets. Current assets are estimated
as follows:
 Average investment in raw material is estimated
 Average investment in work-in-progress inventory is estimated
 Average investment in finished goods inventory is estimated
 Average investment in receivables (both in debtors and bills receivables)
is estimated based on credit policy that the firm wishes to pursue
 Based on the firm’s attitude towards risk, access to borrowing sources,
past experience and nature of business, firms decide on the policy of
maintaining the minimum cash balances
The investments in the various components of current assets are calculated
on the basis of the operating cycle and holding period, as discussed earlier.
In other words, the operating cycle is applied to estimate the working capital
requirement.
11.9.2 Estimation of current liabilities
Current liabilities are estimated based on the following factors: trade
creditors, direct wages and overheads.

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Figure 11.5 depicts the estimation of current liabilities.

Figure 11.5: Estimation of Current Liabilities

Trade creditors
The average amount of financing available to the firm is estimated based on
the production budget, raw material consumption and the credit period
enjoyed from suppliers.
Direct wages
Estimation is made on total wages, to be paid on average basis, based on
production budget, direct labour cost per unit and average time-lag in
payment of wages.
Overheads
Estimation on an average basis of the outstanding amount to be paid to the
creditors for overhead is estimated based on production budget, overhead
cost per unit and average time-lag in payment of overhead.

Solved Problem – 2
A pro-forma cost sheet of a company provides the details as shown in
table 11.3.
Table 11.3: Pro-forma Sheet
Raw material 52.00
Direct labour 19.50
Overheads 39.00
Total cost 110.50
Profit 19.50
Selling price 130.00

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The following additional information is also available:

 Average raw material in stock: one month
 Average materials in process: half a month
 Credit allowed by Suppliers: one month
 Credit allowed to debtors: two months
 Time lag in payment of wages: one and a half weeks
 Time lag in payment of overheads: one month
 One-fourth of sales on cash basis
 Cash balance expected to be maintained is Rs.1,20,000
You are required to prepare a statement showing the working capital
required to finance a level of activity of 70,000 units of output. You may
assume that production is carried on evenly through-out the year and
wages and overheads occur similarly. Assume 360 days in a year.
Solution
Estimation of working capital
a. Investment in inventory
1. Raw material

RMC 70000  52
 RMCP   30  303333 .33
360 360
2. Work in process inventory

COP 70000  110.5

 WIIPCP   15  322291 .67
360 360
3. Finished goods inventory
COS 70000  110.5  30
 FGCP   644583.33
360 360
b. Investment in debtors

Cost of Credit Sales 52500 110.5

 DCP  60  966875 .00
360 360

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c. Cash balance 120000

d. Total current Asset (A + B + C) 2357083.33
e. Current liabilities
1. Creditors
Purchase of raw materials  PDP
360
52  30
70000   303333 .33
360
2. Wages
19.5  10
70000   37916.67
360
3. Overheads
39  30
70000   227500 .00
360
Total current liabilities = 568750.00
Net working capital (D – E) = 1788958.33

Solved Problem – 3
The annual figures shown in table 11.4, are regarding the sales and the
production of a company, XYZ ltd.
Table 11.4: Annual Figures of XYZ Ltd
Sales (at two months credit) Rs. 36,00,000
Materials consumed (suppliers extend two months credit) Rs. 9,00,000
Wages paid (monthly in arrears) Rs. 7,20,000
Manufacturing expenses outstanding at the end of the Rs. 80,000
year(cash expenses are paid one month in arrears)
Total administrative expenses paid, as above Rs. 2,40,000
Sales promotion expenses, paid quarterly in advance Rs.1,20,000

The company sells its products on gross profit of 25% counting

depreciation as part of the cost of production. It keeps one month’s
stock each of raw materials and finished goods, and a cash balance of
Rs.100 000.

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Assume a 20 percent safety margin. Calculate the working capital

requirements of the company on cash cost basis.
Solution
The computation of manufacturing expenses is as shown in the table
11.5.
Table 11.5: Computation of Manufacturing Expenses
Sales Rs.36,00,000
Less: gross profit at 25% Rs.9,00,000
Total manufacturing cost Rs.27,00,000
Less: materials Rs.9,00,000
Less: wages Rs.7,20,000
Manufacturing expenses Rs.10,80,000
Cash manufacturing expenses Rs.9,60,000

Depreciation
Total manufacturing expenses – Cash manufacturing expenses
10,80,000 – 9,60,000 = Rs.1,20,000
The total cash cost is determined and shown in the following table 11.6
Table 11.6: Total Cash Cost
Total manufacturing cost Rs.27,00,000
Less: depreciation Rs.1,20,000
Cash manufacturing cost Rs.25,80,000
Total manufacturing expenses Rs.2,40,000
Sales promotion expenses Rs.1,20,000
Total cash cost Rs.29,40,000

Statement of working capital required:

Current assets:
Raw materials stock
Material Cost 900000  1
1  75000
12 12

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Finished goods stock

1
Cash manufacturing cost 
12
2580000 / 12 = 215000
Debtors
Total cash cost of sales x 2 /12
= 2940000 x 2 / 12 = 490000
Sales promotion expenses = 120000 x 1/4= 30,000
Cash required = 100000
Total assets = 910000
Current liabilities
Sundry creditors
Material Cost 900000  2
 2   150000
12 12
Wages outstanding = 720000 x 1/12 = 60000
Manufacturing expenses outstanding = 80000
Total administrative expenses:
Outstanding = 240000 / 12 =20000
Total current liabilities = 310000
Working capital
A – B = 600000
Add 20% safety margin = 120000
Working capital required = 720000

Self Assessment Questions

24. ______ is used to estimate working capital requirements of a firm.
25. Operating cycle approach is based on the assumption that production
and sales occur on a ___________.
26. The factors involved in the estimation of the current liabilities are _____,
_________ and _________.

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11.10 Summary
Let us recapitulate the important concepts discussed in this unit:
 All companies are required to maintain a minimum level of current assets
at all point of time. This level is called core or permanent working capital
of the company.
 Working capital management is concerned with the determination of
optimum level of working capital and its effective utilisation.
 To assess the working capital required for a firm to conduct its operations
smoothly, firms use operating cycle concept and compute each
component of working capital.

11.11 Glossary
Gross working capital: It refers to the amounts invested in various
components of current assets.
Net working capital: It is the excess of current assets over current liabilities
and provisions.
Operating cycle: It is the time gap between acquisition of resources and
collection of cash from customers.
Working capital: It is the difference between current assets and current
liabilities.

11.12 Terminal Questions

1. Examine the components of working capital.
2. Explain the concepts of working capital.
3. What are the objectives of working capital management?
4. Briefly explain the various elements of operating cycle.

11.13 Answers

Self Assessment Questions

1. Current assets
2. Current liability
3. Adequate working capital
4. Inventories, sundry debtors

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5. Sundry creditors, bills payable

6. Gross working capital
7. Plan, working capital management as applied.
8. Positive
9. Fixed
10. Liquidity, Profitability
11. Spontaneous finance
12. Spontaneous finance
13. Conservative, Large quantum
14. Operating cycle
15. Sale of goods on credit, realisation of money from customers.
16. Operating cycle
17. Inventory conversion period
18. Receivables conversion period
19. Cash Conversion cycle
20. Higher
21. Positive direct correlation
22. Increased
23. Larger
24. Operating cycle
25. Continuous basis
26. Trade creditors, direct wages and overheads
Terminal Questions
1. Working capital management is concerned with managing the different
components of current assets and current liabilities Refer 11.2
2. The four most important concepts of working capital include gross
working capital, net working capital, temporary working capital and
permanent working capital. Refer 11.3
3. The objective of working capital is to ensure smooth functioning of the
normal business operations of a firm. Refer 11.4
4. The time gap between acquisition of resources and collection of cash
from customers is known as the operating cycle. Refer 11.6.

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11.14 Case Study: Sintex Improves Working Capital Management

The net working capital days have reduced to 103 days in the year ended
31 March from 150 days in the previous year.
Sintex Industries Ltd™ stock gained 3.3% to Rs. 179 in the last two trading
days in reaction to the company’s™ fourth quarter results announcement.
During the same period, the Bombay Stock Exchange™ (BSE) benchmark
Sensex fell 3%.
The company’s results were not only better than the Street estimates, but
also reported a considerable improvement in working capital management.
The net working capital days have reduced to 103 days in the year ended
31 March from 150 days in the previous year, Sintex said in a statement.
On the business front, revenue increased 34% in the three months ended
March from the year ago to Rs. 1,464 crore. The company, whose brand is
synonymous with storage tanks, derived 54% of its revenue from the
building materials business, which performed well and its sales increased by
about 47%.
The building materials business includes the monolithic construction
business (low-cost housing solutions) and prefabs (housing concepts used
to build temporary and permanent residences). The monolithic business
currently has an order book of Rs. 2,900 crore, to be executed over the next
two years, offering revenue visibility to that extent.
Sintex derived 37% of the revenue from its custom moulding business
(which makes plastic moulded products), which increased by about 27%.
The remaining revenue came from the textile business and rose by 36%.
The textile business performed well on account of better capacity utilisation
and improved global luxury spending.
Overall, operating profit margin improved to 21.1% from 17.6% last year.
Operating profit, thus, increased at a much faster pace of 60% to Rs. 310
crore.
The company managed to deliver a strong operating performance despite
higher raw material costs, as employee costs and other expenditure grew at
a slower pace. However, net profit growth was slower at 21% to about
Rs. 170 crore, mainly because of higher tax outgo and a loss under the

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other income head (caused by mark-to-market loss on its foreign currency

convertible bonds).
Since the beginning of this current fiscal, Sintex™’s stock has outperformed
the BSE-200 index. Better working capital management augurs well for its
financial health, but investors are likely to watch that metric closely, to see if
the improvement is sustained in fiscal 2012.
Though in the conference call management guided for marginal tightening of
cycle, we believe working capital cycle will have upward pressure as
monolithic (working capital-intensive business) is expected to be (the)
largest contributor to future growth, analysts from Emkay Global Financial
Services Ltd wrote in their post-earnings note. The recent outperformance in
its share price is likely to keep a check on near-term upsides in the stock.
Discussion Questions:
1. Discuss the importance of working capital management, in the backdrop
of the above cited case.
(Hint : Refer introduction of working capital management)
2. “Companies with the shortest working capital cycles have current ratios
much lower than the firms with longer cycles”. What is your view on this
statement?
(Hint : Refer operating cycle)
3. On reading the above article, what is your understanding on the
relationship between working capital management and market
performance of a company? Do you think the kind of relationship varies
depending on the type of industry?
(Hint: need for working capital)
4. How do you think the operating cycle affects operating profit margins?
(Hint : Refer operating cycle)
5. What is the impact of inefficient working capital management on a
company’s reputation/credibility?
(Hint : Refer operating cycle)
(Source: http://www.livemint.com/2011/05/03225215/Sintex-improves-
working-capita.html)

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Financial Management Unit 11

Reference:
 Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition
 Prasanna, Chandra (2007), Financial Management: Theory and
Practice, 7th Edition, Tata McGraw Hill.
E-Reference :
 http://www.livemint.com/2011/05/03225215/Sintex-improves-working-
capita.html retrieved on 12/12/2011.

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Financial Management Unit 12

Unit 12 Cash Management

Structure:
12.1 Introduction
Objectives
Meaning of cash
12.2 Meaning and Importance of Cash Management
12.3 Motives of Holding Cash
12.4 Objectives of Cash Management
12.5 Models for Determining Optimal Cash Needs
Baumol model
Miller-Orr model
12.6 Cash Planning
12.7 Cash Forecasting and Budgeting
12.8 Summary
12.9 Glossary
12.10 Terminal Questions
12.11 Answers
12.12 Case Study

12.1 Introduction
In the previous unit, we discussed the working capital management, current
assets and liabilities and determinants of working capital. Cash is the most
important current asset for a business operation. It is the energy that drives
business activities and also gives the ultimate output expected by the
owners. It is of vital importance to the daily operations of a business. While
the proportion of assets held in the form of cash is very small, its efficient
management is crucial to the solvency of the business. The firm should
keep sufficient cash at all times. Excessive cash will not contribute to the
firm’s profits and shortage of cash will disrupt its manufacturing operations,
as discussed in the previous unit. Therefore, planning and controlling cash
are very important tasks.
In this unit, we will discuss the meaning of cash, why companies hold cash,
the concept of cash management and basics of cash budgeting as a tool to
efficient cash management.

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Objectives:
After studying this unit, you should be able to:
 explain the meaning and importance of cash management in a firm
 analyse the motives for holding cash
 analyse the objectives of cash management
 elucidate the different models of determining the optimal cash balances
 understand the concept of financial planning
 analyse the techniques for cash forecasting
12.1.1 Meaning of cash
Before getting into various other concepts of cash management, let us first
discuss the meaning of cash and near cash assets. “Cash” can be classified
into or can be used in two senses (see figure 12.1) – Narrow sense and
Broader sense.

Figure 12.1: Classification of Cash

 Narrow sense includes currency and other cash equivalents such as

cheques, drafts and demand deposits in banks.
 Broader sense includes near cash assets such as marketable securities
and time deposits in banks.
The distinguishing nature of this kind of asset is that it can be converted into
cash very quickly. Cash in its own form is an idle asset. Unless employed in
some form or another, it does not earn any revenue.

12.2 Meaning and Importance of Cash Management

Cash management is concerned with the following requirements:
 Management of cash flows in and out of the firm.

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 Cash management within the firm.

 Management of cash balances held by the firm – deficit financing or
investing surplus cash.
Cash, be it in hand or at the bank, is the most liquid of all current assets. By
virtue of being the most liquid asset, cash is extremely suitable for business
purposes. The basic reason behind the need for cash is the same as well.
The need of cash has often been compared to that of blood or oxygen in a
human body. Thus, larger cash and bank balances indicate high liquidity
position of a firm. However, cash lying idle or as balance in current accounts
of banks fetches no return to the firm.
Cash management tries to accomplish at a minimum cost, the various tasks
of cash collection, payment of out-standings and arranging for deficit funding
or surplus investment.
It is very difficult to predict cash flows accurately. Generally, there is no co-
relation between inflows and outflows. At some point of time, cash inflows
may be lower than outflows because of the seasonal nature of product sale
thus prompting the firm to resort to borrowings. And sometimes outflows
may be lesser than inflows resulting in surplus cash.
There is always an element of uncertainty about the inflows and outflows.
The firm should therefore evolve strategies to manage cash in the best
possible way. The management of cash can be categorised into:
 Cash planning – Cash flows should be appropriately planned to avoid
excessive or shortage of cash. Cash budgets can be prepared to aid this
activity.
 Managing cash flows – The flow of cash should be properly managed.
Steps to speed up cash collection and inflows should be implemented
while cash outflows should be slowed down.
 Optimum cash level – The firm should decide on the appropriate level
of cash balance. Balance should be struck between excess cash and
cash deficient stage.
 Investing surplus cash – The surplus cash should be properly invested
to earn profits. Many investment avenues to invest surplus cash are
available in the market such as, bank short term deposits, T-Bills and
inter corporate lending.

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The ideal cash management system will depend on a number of issues

such as firm’s product, competition, collection programme, delay in
payments, availability of cash at low rates of interests and investment
opportunities.
In the context of working capital management, cash management refers to
optimising the benefit and cost associated with holding cash. The objective
of cash management is best achieved by speeding up the working capital
cycle, particularly the collection process and investing surplus cash in short
term assets in most profitable avenues. Before going further into the
objectives of cash management, we should understand why companies hold
cash. Let us now look at the basic motives behind holding cash.

12.3 Motives of Holding Cash

The main motives behind holding cash are:
 Transaction motive
 Precautionary motive
 Speculative motive
 Compensating motive
These are not just motives for holding cash, but also the motive that is
present behind the immense demand for cash, as well as proper cash
management.
Figure 12.2 displays the various motives.

Figure 12.2: Motives of Holding Cash

Transaction motive
Transaction motive refers to a firm holding some cash to meet its routine
expenses that are incurred in the ordinary course of business. A firm will
need finances to meet excess of payments like wages, salaries, rent, selling
expenses, taxes and interests.

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The necessity to hold cash will not arise if there is a perfect co-ordination
between the inflows and the outflows. However, these two never completely
coincide. At times, receipts may exceed outflows and at other times,
payments outrun inflows. For such periods when payments exceed inflows,
the firm should maintain sufficient balances to be able to make the required
payments. For transactions motive, a firm may invest its cash in marketable
securities. Generally, they purchase securities whose maturity will coincide
with the payment obligations.
Precautionary motive
Precautionary motive refers to the need to hold cash to meet some
exigencies which cannot be foreseen. Such unexpected needs may arise
due to sudden slow down in collection of accounts receivable, cancellation
of an order by a customer, sharp increase in prices of raw materials and
skilled labour. The money held to meet such unforeseen fluctuations in cash
flows is called precautionary balances.
The amount of precautionary balance also depends on the firm’s ability to
raise additional money at a short notice. The greater the creditworthiness of
the firm in the market, the lesser is the need for such balances. Generally,
such cash balances are invested in high liquid and low risk marketable
securities.
Speculative motive
Speculative motive relates to holding cash to take advantage of unexpected
changes in business scenarios that are not normal in the usual course of the
firm’s dealings. Speculative motive may also result in investing in profit-
backed opportunities as the firm comes across. The firms often want to
make profits from the movements in market prices of investment options
such as securities. Enough reserves of funds allow the companies, the
flexibility to try out these opportunities.
The firm may hold cash to benefit from a falling price scenario or getting a
quantity discount when paid in cash or delay purchases of raw materials in
anticipation of decline in prices. By and large, business firms do not hold
cash for speculative purposes and even if it is done, it is done only with
small amounts of cash. Speculation may sometimes also backfire, in which
case the firms lose a lot.

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Compensating motive
Compensating motive is yet another motive to hold cash to compensate
banks for providing certain services and loans. Banks provide a variety of
services such as cheque collection, transfer of funds through Demand Draft
and Money Transfer
To avail all these purposes, the customers need to maintain a minimum
balance in their accounts at all times. The balance so maintained cannot be
utilised for any other purpose. Such balances are called compensating
balance.
Compensating balances can restrict to any of the following forms:
 Maintaining an absolute minimum, say for example, a minimum of
Rs. 25000 in current account or
 Maintaining an average minimum balance of Rs. 25000 over the month.
A firm is more affected by the first restriction than the second restriction. Let
us now discuss the objectives of cash management.

12.4 Objectives of Cash Management

The major objectives of cash management in a firm are:
 Meeting payments schedule
 Minimising funds held in the form of cash balances
Meeting payments schedule
In the normal course of functioning, a firm has to make various payments by
cash to its employees, suppliers and infrastructure bills. Firms will also
receive cash through sales of its products and collection of receivables.
Both of these do not occur simultaneously.
The basic objective of cash management is therefore to meet the payment
schedule on time. Timely payments will help the firm to maintain its
creditworthiness in the market and to foster cordial relationships with
creditors and suppliers. Creditors give cash discount if payments are made
in time and the firm can avail this discount as well.
Trade credit refers to the credit extended by the supplier of goods and
services in the normal course of business transactions.

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Generally, cash is not paid immediately for purchases but after an agreed
period of time. This is deferral of payment and is also considered as a
source of finance. Trade credit does not involve explicit interest charges, but
there is an implicit cost involved. If the credit term is for example, 2/10, net
30; it means the company will get a cash discount of 2% for a payment
made within 10 days, or else the entire payment is to be made within 30
days. Since the net amount is due within 30 days, not availing discount
means paying an extra 2% for the 20-day period.
The other advantage of meeting the payments on time is that it prevents
bankruptcy that arises out of the firm’s inability to honour its commitments.
At the same time, care should be taken not to keep large cash reserves as it
involves high cost.
Minimising funds held in the form of cash balances
Trying to achieve the second objective is very difficult. A high level of cash
balance will help the firm to meet its first objective, but keeping excess
reserves is also not desirable as funds in its original form is idle cash and a
non-earning asset. It is not profitable for firms to maintain huge balances.
A low level of cash balance may mean failure to meet the payment
schedule. The aim of cash management is therefore to have an optimal
level of cash by bringing about a proper synchronisation of inflows and
outflows, and to check the spells of cash deficits and cash surpluses.
Seasonal industries are classic examples of mismatches between inflows
and outflows. The efficiency of cash management can be augmented by
controlling a few important factors:
 Prompt billing and mailing
There is a time lag between the dispatch of goods and preparation of
invoice. Reduction of this gap will bring in early remittances.
 Collection of cheques and remittances of cash
Generally, we find a delay in the receipt of cheques and their deposits in
banks. The delay can be reduced by speeding up the process of
collecting and depositing cash or other instruments from customers.
 Float
The concept of ‘float’ helps firms to a certain extent in cash
management. Float arises because of the practice of banks not crediting
the firm’s account in its books when a cheque is deposited by it and not
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debiting the firm’s account in its books when a cheque is issued by it,
until the cheque is cleared and cash is realised or paid respectively.
A firm issues and receives cheques on a regular basis. It can take
advantage of the concept of float. Whenever cheques are deposited in
the bank, credit balance increases in the firm’s books but not in bank’s
books until the cheque is cleared and money is realised. This refers to
‘collection float’, that is, the amount of cheques deposited into a bank
and clearance awaited.
Likewise the firm may take benefit of ‘payment float’.

Net float = Payment float – Collection float

When net float is positive, the balance in the firm’s books is less than the
bank’s books; when net float is negative; the firm’s book balance is higher
than in the bank’s books.
We can, thus, say that the objectives of cash management are
straightforward – (a) meeting payments schedule and (b) maximise the
value of funds while minimising the cost of funds.

12.5 Models for Determining Optimal Cash Needs

In the previous section, we discussed that holding of excessive cash is not a
profitable proposition, as idle cash fetches no return to the firm. Similarly,
shortage of cash may deprive the firm of availing benefits of cash discounts,
and taking advantage of other favourable opportunities. Default in paying
liabilities also leads to a fall in credibility. Hence, every firm, irrespective of
its size or nature, has to ascertain the appropriate or optimum cash balance
that it would need.
One of the prime responsibilities of a finance manager is to maintain an
appropriate balance between cash and marketable securities. The amount
of cash balance will depend on risk-return trade-off. A firm with less cash
balance has a weak liquidity position but earns profits by investing its
surplus cash, while on the other hand it loses profits by holding too much
cash.

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A firm’s cash balance is generally not constant over time. It would therefore
be advisable to ascertain the maximum, minimum and average cash needs
over a designated period of time. We should also understand the
opportunity cost that exists in the maintenance of cash balance:
 Cash can be invested in acquiring assets such as inventory, or for
purchasing securities. Opportunities for such investments may be lost if
a certain minimum cash balance is not held.
 Holding cash can mean that it cannot be used to offset financial risks
from short term debts.
 Excessive dependence on internally generated funds can isolate the firm
from the short term financial market.
A balance has to be maintained between these aspects at all times. So how
much is optimum cash? This section explains the models for determining
the appropriate balance. Two important models which determine the optimal
cash needs are studied here:
 Baumol model
 Miller-Orr model
12.5.1 Baumol model
The Baumol model helps in determining the minimum amount of cash that a
manager can obtain by converting securities into cash. Baumol model is an
approach to establish a firm’s optimum cash balance under certainty. As
such, firms attempt to minimise the sum of the cost of holding cash and the
cost of converting marketable securities to cash. Baumol model of cash
management trades off between opportunity cost or carrying cost or holding
cost and the transaction cost.
The Baumol model is based on the following assumptions:
 The firm is able to forecast its cash requirements in an accurate way.
 The firm’s payouts are uniform over a period of time.
 The opportunity cost of holding cash is known and does not change
with time.
 The firm will incur the same transaction cost for all conversions of
securities into cash.
A company sells securities and realises cash, and this cash is used to make
payments. As the cash balance decreases and reaches a point, the finance

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manager replenishes its cash balance by selling marketable securities

available with it and this pattern continues.
Cash balances are refilled and brought back to normal levels by the sale of
securities. The average cash balance is C/2. The firm buys securities as and
when it has above-normal cash balances. This pattern is explained in figure
12.3.

C
Cash balance

C/2 Average

0 T1 T2 T3

Time

Figure 12.3: Baumol Model

Baumol cut-off model

The total cost associated with cash management has two elements:
 Cost of conversion of marketable securities into cash and
 Opportunity cost
The firm incurs a holding cost for keeping cash balance, which is the
opportunity cost. Opportunity cost is the benefit foregone on the next best
alternative for the current action. Holding cost is k*(C/2).
The firm also incurs a transaction cost whenever it converts its marketable
securities into cash. Total number of transactions during the year will be the
total funds requirement, T, divided by the cash balance, C, i.e., T/C. If per
transaction cost is c, then the total transaction cost is c*(T/C).
The total annual cost of the demand for cash is k*(C/2) + c*(T/C).

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The Baumol Cut-off Model is represented in figure 12.4.

Total cost
Cost

Holding cost

Transaction cost

Cash balance C*

Baumol Cut-off Model

Figure 12.4: Baumol Cut-off Model

The optimum cash balance, C*, is obtained when the total cost is minimum,
which is expressed as:

C* = √2cT/k

where C* is the optimum cash balance,

c is the cost per transaction,
T is the total cash needed during the year and
k is the opportunity cost of holding cash balance.
The optimum cash balance will increase with the increase in per-transaction
cost and total funds required, and decrease with the opportunity cost.
However, there are certain limitations to the Baumol Model:
 It does not provide for fluctuation of cash flows.
 It does not take into account overdraft situations.

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Solved Problem – 1
A firm’s annual cost requirement is Rs. 20000000. The opportunity cost
of capital is 15% per annum. Rs. 150 is the per transaction cost of the
firm when it converts its short-term securities to cash. Find out the
optimum cash balance. What is the annual cost of the demand for the
optimum cash balance?
Solution
C* = √2cT/k = √[2*150*20000000] / 0.15 = Rs. 200000
The annual cost is Rs. 200000
150*(20000000/200000) + 0.15*(200000/2) = Rs. 30000
Annual cost of the demand = Rs. 30000

Solved Problem – 2
Mysore Lamps Ltd. requires Rs. 30 lakhs to meet its quarterly cash
requirements. The annual return on its marketable securities which are of
the tune of Rs. 30 lakhs is 20%. During the conversion of the securities
into cash necessities, a fixed cost of Rs. 3000 per transaction is
maintained. Compute the optimum conversion amount.
Solution
C* = √2cT/k = √[2*3000*3000000] / 0.05 = Rs. 600000
The optimum conversion amount is Rs. 600000
The rate of return is “20%/4” as 20% is the annual return and “4” signifies
that the fund requirement is done on a quarterly basis.

12.5.2 Miller-Orr model

Miller-Orr came out with another model due to the limitation of the Baumol
model as discussed in the previous section. As we have seen, Baumol
model assumes that the cash flow does not fluctuate. In the real world,
rarely do we come across firms which have constant cash needs. Keeping
other factors such as expansion, modernisation and diversification constant,
firms face situations wherein they need additional cash to maintain their
present position because of the effect of inflationary pressures. The firms
therefore cannot forecast their fund requirements accurately.

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The Miller-Orr (MO) model overcomes these shortcomings and considers

daily cash fluctuations. The MO model assumes that cash balances
randomly fluctuate between an upper bound (upper control limit) and a lower
bound (lower control limit). When cash balances hit the upper bound, the
firm has too much cash and it is time to buy enough marketable securities to
bring back to the optimal bound. When cash balances touch zero level, the
level is brought up by selling securities into cash. Return point lies between
the upper and lower bounds. It can be said that, firms buy or sell the
marketable securities only if the cash balance is equal to any one of these
bounds.
In such cases, it is normally assumed that the average value of the
distribution of net cash flows is zero. It is also understood that the
distribution of net cash flows has a standard deviation. The MO model of
cash management also assumes that distribution of cash flows is normal.
Symbolically, this can be expressed as:
Z = 3√3/4*(cσ2/i)
where Z is the optimal cash balance,
c is the transaction cost,
σ2 is the standard deviation of the net cash flows and
i is the interest rate.
MO model also suggests that the optimum upper boundary “b” is three times
the optimal cash balance plus the lower limit, i.e.,
upper limit = lower limit + 3Z and
return point = lower limit + Z.
The explanations are briefly explained using a graphical representation in
figure 12.5.

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Figure 12.5: Miller-Orr Model

Solved Problem – 3
Mehta Industries have a policy of maintaining Rs. 500000 minimum cash
balance. The standard deviation of the company’s daily cash flows is
Rs. 200000. The interest rate is 14%. The company has to spend Rs. 150
per transaction. Calculate the upper and lower limits, and the return point
as per MO model.
Solution
Z = 3√3/4*(cσ2/i)
3√3/4*(150*2000002) / 0.14/365 = Rs. 227226
The upper control limit = lower limit + 3Z
= 500000 + 3*227226 = Rs. 1181678
Return point = lower limit + Z
= 500000 + 227226 = Rs. 727226
Average cash balance = lower limit + 4/3Z
= 500000 + 4/3*227226 = Rs. 802968

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12.6 Cash Planning

We discussed the two models that are used in determining the optimal cash
needs of a firm. Let us now discuss cash planning and its objectives. Cash
planning is a technique to plan and control the use of cash. Cash planning
helps in developing a projected cash statement from the expected inflows
and outflows of cash.
Cash planning has three main objectives:
 Ensure that expenditures are smoothly financed during the year, so as to
minimise borrowing costs.
 Enable the initial budget policy targets, especially the surplus or deficit,
to be met.
 Contribute to the smooth implementation of policies in place.
An effective cash planning and management system should:
 Recognise the time value and the opportunity cost of cash.
 Enable all internal segments/departments to plan the expenditure
effectively.
 Be proactive–anticipating economic developments while accommodating
significant economic/industry-specific changes and minimising the
adverse effects on budget execution.
 Be responsive to the cash needs of all segments/departments.
 Be comprehensive–covering all inflows of cash resources.
 Plan for the liquidation of both short- and long-term cash liabilities.
Even if the budgets prepared are realistic, well-prepared and objective, it
does not necessarily mean that its implementation will be smooth. Timing
issues can be expected between payments coming due and the availability
of cash necessary to discharge them.
An ideal cash plan should include, for example a month ahead, a daily
forecast of cash outflows and cash inflows. A set cash plan can instil
confidence within the firm that they have cash control.
A system can be put in place whereby a continuous monthly updating of the
cash plan takes place. This would help ensure that the initial budget targets
are met. When it is clear from a latest forecast available, that targets may

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not be met in the future or at the end of the year, measures can be taken to
constrain expenditure or to increase revenues. The cash plan can contribute
to the decisions on the size, type and targeting of the measures required.
Forecasts are based on the past performance and future anticipation of
events. Cash planning can be performed on a daily, a weekly or a monthly
basis. Generally, monthly forecasts and cash plans are commonly prepared
by firms.
Let us now understand how cash budgets, as a tool, incorporates estimates
of future inflows and outflows of cash over a projected short period of time.

12.7 Cash Forecasting and Budgeting

Cash budgeting or short-term cash forecasting is a principal tool of cash
management. A cash budget incorporates estimates of future inflows and
outflows of cash over a projected short period of time, which may usually be
a year, a half or a quarter year. Effective cash management is facilitated if
the cash budget is further broken down into monthly, weekly or daily basis.
Cash budget is a device which is used to plan and control cash receipts and
payments. It gives a summary of cash flows over a period of time.
The finance manager can plan the future cash requirements of a firm based
on the cash budgets. The first element of a cash budget is the selection of
the time period, which is referred to as the planning horizon.
Selection of appropriate time period is based on factors that are exclusive to
the firms. Some firms may prefer to prepare weekly budget while others may
prefer to prepare monthly estimates while some others may prepare
quarterly or yearly budgets. Firms should ensure that the period selected
should neither be too long nor too short.
Over a too long period, estimates will not be accurate, whereas a too short
period requires periodic changes. Yearly budgets can be prepared by such
companies whose business is very stable and who do not expect major
changes affecting the company’s cash flow. The second element that has a
bearing on cash budget preparation is the selection of factors that have a
bearing on cash flows. Only cash items are to be selected while non-cash
items such as depreciation and amortisation should be excluded.

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Cash budgets are part of the total budgeting process of a firm, under which
other budgets and statements are also prepared. Various information that
are generated during the preparation of operating budgets, such as sales
forecasts, wages and salaries, manufacturing expenses overheads, etc.,
become useful in the process. While operating budgets are prepared based
on the accrual principle, cash budgets are concerned with cash inflows and
outflows. The main sources for these cash flows are:
Cash Inflows:
 Cash sales
 Cash received from debtors
 Cash received from loans, deposits, etc.
 Cash receipt of other revenue income
 Cash received from sale of investments or assets
Cash Outflows:
 Cash purchases
 Cash payment to creditors
 Cash payment for other revenue expenditure
 Cash payment for assets creation
 Cash payment for withdrawals, taxes
 Repayment of loans, etc.
Cash budgets are prepared based on the following three methods:
 Receipts and Payments method
 Income and Expenditure method
 Balance Sheet method
Short-term cash forecasting is normally prepared under the receipts and
payments method, showing the time and magnitude of expected cash
inflows and outflows. Long term cash forecasting is generally made using
the adjusted net income method. This method of cash forecasting
resembles a funds flow statement and seeks to estimate the firm’s need for
cash at some future date and indicate whether this need can be met from
internal sources or not. In this unit, we will focus on short term forecasting.
A sample (suggestive) format of a cash budget is shown in table 12.1.

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Table 12.1: Format of a Cash Budget

Months
Particulars
Jan Feb March
Estimated cash inflows:
1.
2.
3.
4.
……..
I. Total Cash inflows
Estimated cash outflows:
1.
2.
3.
4.
……..
II. Total Cash outflows
III. Opening cash balance
IV. Add/Deduct Surplus/
Deficit during the month
(I – II)
V. Closing cash balance
VI. Minimum level cash
balance
VII. Estimated excess/
shortfall of cash (V – VI)

Table 12.2 shows the various items of cash receipts and payments, and
their basis of estimation.
Table 12.2: Various Items of Cash Receipts and Payments
Items Basis of estimation
Cash Sales Estimated sales and its division between
cash and credit sales
Collection of accounts receivables Estimated sales, its division between cash
and credit sales, and collection pattern
Interest and dividend receipts Firm’s portfolio of securities and return
expected from the portfolio
Increase in loans/deposits and Financing plan
issue of securities

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Sale of assets Proposed disposal of assets

Cash purchases Estimated purchases, its division between
cash and credit purchase and terms of
credit purchases
Wages and salaries Manpower employed, and wages and
salaries structure
Manufacturing expenses Production plan
General, administration and selling Administration and sales personnel, and
expenses proposed sales promotion and distribution
expenditure
Capital equipment purchases Capital expenditure budget and payment
pattern associated with capital equipment
purchases
Repayment of loans and Financing plan
retirement of securities
(Source: Financial Management – Theory & Practice, Prasanna Chandra)

A worksheet maybe prepared comprising the various items of cash inflows

and outflows, and the resultant net cash flows, as indicated in table 12.2.
The finance manager can get an idea of cash by perusing the pattern and
amount of inflows and outflows over the months, to see whether some of the
items of outflows can either be advanced or postponed so that the outflows
are not clustered during a certain period. Thus, the budget becomes a very
handy tool to effectively manage cash.

Activity: List the typical cash inflows and cash outflows of a

1. Manufacturing firm
2. Service firm
Hint:
Manufacturing firm
 Cash inflows : sales, collection from debtors,
 Cash outflows: purchases of materials for cash, payment to trade
creditors, operating expenses.
Service firm
 Cash inflows: fees collection from clients (sales), collection from A/R
 Cash outflows: operating expenses, payment to creditors for expenses.

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Caselet: The information in table 12.3 gives the cash budget of

M/s. Panduranga Sheet Metals Ltd. for 6 months, ending on 30th June
2007. The company has an opening cash balance of Rs. 60000 on 1 st Jan
2007.
Table 12.3: Cash Budget of Panduranga Sheet Metals

Production Selling
Month Sales Purchases Wages
overheads overheads
Jan 60000 24000 10000 6000 5000
Feb 70000 27000 11000 6300 5500
March 82000 32000 10000 6400 6200
April 85000 35000 10500 6600 6500
May 96000 38800 11000 6400 7200
June 110000 41600 12500 6500 7500

The company has a policy of selling its goods at 50% on cash basis and
the rest on credit terms. Debtors are given a month’s time to pay their
dues. Purchases are to be paid off two months from the date of purchase.
The company has a time lag in the payment of wages of ½ a month and
the overheads are paid after a month. The company is also planning to
invest in a machine which will be useful for packing purposes, the cost
being Rs. 45000, payable in 3 equal instalments starting bi-monthly from
April.
It also expects to apply for loan in a bank for Rs. 50000 and the loan will
be granted in the month of July. The company has to pay advance income
tax of Rs. 20000 in the month of April. Salesmen are eligible for a
commission of 4% on total sales effected by them and this is payable one
month after the date of sale.

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Solution
The cash balances, the cash payments and the closing cash balances of
the company are described clearly in table 12.4 and wages in table 12.5:
Table 12.4: Details of the Company

Jan Feb March April May June

Opening cash balance 60000 85000 126100 153000 118850 150100
Cash receipts:
Cash sales 30000 35000 41000 42500 48000 55000
Credit sales 30000 35000 41000 42500 48000
Total cash available 90000 150000 202100 236500 209350 253100
Cash payments
Materials 24000 27000 32000 35000
Wages 5000 10500 10500 10250 10750 11750
Production overheads 6000 6300 6400 6600 6400
Selling overheads 5000 5500 6200 6500 7200
Sales commission 2400 2800 3280 3400 3840
Purchase of asset 15000 15000
Payment of advance IT 20000
Total cash payments 5000 23900 49100 117650 59250 79190
Closing cash balances 85000 126100 153000 118850 150100 173930

Working note:
The wages are calculated in table 12.5

Table 12.5: Wages

Jan Feb Mar Apr May Jun
10000 11000 10000 10500 11000 12500
5000 5500-feb 5000-mar 5250-apr 5500-may 6250-jun
5000-mar 5500-feb 5000-mar 5250-apr 5500-may
5000 10500 10500 10250 10750 11750 Formatted Table

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Self Assessment Questions

1. Management of cash balances can be done by ____________ and
_________.
2. The four motives for holding cash are ______________________,
____________, ____________ and ____________.
3. The greater the creditworthiness of the firm in the market, lesser is the
need for ___________ balances.
4. __________refers to the credit extended by the supplier of goods and
services in the normal course of business transactions.
5. When cheques are deposited in a bank, credit balance increases in the
firm’s books but not in the bank’s books until the cheque is cleared and
the money realised. This is called as ________________.
6. According to Baumol model, the total cost associated with cash
management has two elements __________ and __________.
7. The MO model assumes that cash balances randomly fluctuate
between a ____________ and a __________________.

12.8 Summary
Let us recapitulate the important concepts discussed in this unit:
 All companies are required to maintain a minimum level of current
assets at all points of time.
 Cash management is concerned with determination of relevant levels of
cash balances, near cash assets and their efficient use.
 The need for holding cash arises due to a variety of motives –
transaction motive, speculation motive, precautionary motive and
compensating motive.
 The objective of cash management is to make short-term forecasts of
cash inflows and outflows, investing surplus cash and finding means to
arrange for cash deficits.
 Cash budgets help the finance manager to forecast the cash
requirements.

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12.9 Glossary
Trade credit: The credit extended by the supplier of goods and services in
the normal course of business transactions.

12.10 Terminal Questions

1. Miraj Engineering Co. has forecasted its sales for 3 months ending on
Dec. as follows:
Oct. - Rs. 500000
Nov. - Rs. 600000
Dec. - Rs. 650000
The goods are sold on cash and credit basis at a rate of 50% each.
Credit sales are realised in the month following the sale. Purchases
amount to 50% of the month’s sales and are paid in the following month.
Wages and administrative expenses per month amount to Rs. 150000
and Rs. 80000 respectively and are paid in the following month. On 1 st
Dec. the company will purchase a testing equipment worth Rs. 20000
payable on 15th Nov. On 31st Dec. a cash deposit with a bank will mature
for Rs. 150000. The opening cash balance on 1st Nov. is Rs. 100000.
What is the closing balance in Nov. and Dec.?
2. Michael Industries Ltd. requests you to help them in preparing a cash
budget for the period ending on Dec. 2007 based on the information
given in table 12.6.
Table 12.6: Cash Budget
Particulars May June July Aug Sep Oct Nov Dec Jan
Sales 15 20 22 3 34 25 25 15 15
Materials 7 20 22 29 15 15 8 8 Nil
Rent – – 0.50 0.5 0.5 0.50 0.5 0.5 –
Salaries – – 1.5 2 2.5 1.5 1 1 –
Misc. – – 0.15 0.2. 0.2 0.4. 0.3. 0.2 –
charges
Taxes – – – – – 4 – – –
Purchase of – – – – – – 10 – –
asset

Credit terms: Customers are allowed one month time.

Suppliers of materials are paid after two months.

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The company pays salaries after a gap of 15 days.

Rent is paid after a gap of one month.
The company has an opening balance of Rs. 200000 on 1st June.
Prepare a cash budget and find out what is the closing cash balance on 31 st
Dec.

12.11 Answers

Self Assessment Questions

1. Deficit financing or investing surplus cash
2. Transaction, speculative, precautionary and compensating
3. Precautionary
4. Trade credit
5. Collection float
6. Cost of conversion of marketable securities into cash and opportunity
cost
7. Upper bound (upper control limit) and lower bound (lower control limit)

Terminal Questions
1. Prepare a cash budget for November and December. For more details,
refer to the example in section 12..7
2. Prepare a cash budget. For more details, refer to the example in section
12.7

12.12 Case Study: Cash Management Services

Cash management is at the heart of working capital management and is a
key driver of efficiency for many corporations. Many corporations are opting
for technologically advanced payment and receivables solutions with
adequate controls. In today's competitive market place, effectively managing
cash flow can make the difference between success and failure.
The fundamental objective of cash management is ‘optimisation of liquidity
through improved flow of funds’. In today’s highly competitive environment,
where time is considered as money, deployment of staff to render basic
routine tasks does not make economic sense. As a sequel, cash
management today is not what it used to be. Electronic banking, which
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began as a passive desktop access to bank balances, is emerging into

complex processes of liquidity management through numerous techniques.
Cash management services offered by banks are used extensively by
corporations throughout the country. The services broadly fall under
collection services, disbursement services, information and control services,
services related to Electronic Data Interchange (EDI), commercial web
banking services, sweep services, fraud detection solutions, global trade
solutions and investment solutions.
Many banks have special branches rendering Cash Management Services
(CMS) to corporate clients, for managing their receivables and payments
across the country. Under CMS, banks offer custom-made collection,
payment and remittance services to their corporate clients allowing them to
reduce the time taken between collections and remittances, thereby
streamlining their cash flows. Cash management products include physical
cheque-based clearing, electronic clearing services, central pooling of
country-wide collections, dividend and interest remittance services and
Internet-based payment products. Such services provide customers with
enhanced liquidity and better cash management.
Following is a brief explanation of the services under CMS:
 Collection Services accelerate the receipt of payments from sales and
quickly turn them into usable cash in accounts.
 Disbursement Services make efficient payments by reducing or
eliminating idle balances in company’s accounts.
 Information and Control Services receive the data and provide the
management capability needed to monitor company cash picture, control
costs, reconcile and audit bank accounts, and reduce exposure to fraud.
 Financial Electronic Data Interchange (EDI) is a computerised exchange
of payments between a company’s business and its customers and
vendors.
 Commercial Web Banking Services give a wide range of services from
any Internet connection, which can help streamline banking process
quickly and efficiently.
 Sweep Services maintain liquidity and increase earnings without having
to actively monitor accounts, and move money in and out of them.
Information reporting solutions assist companies, which need to receive

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account data that is timely, precise, and easy to access and interested in
initiating online transactions.
 Investment solutions help to minimise excess balances and maximise
return on available funds.

Cash Management in India

Products offered by banks under collections (paper and electronic):
 Local cheque collections
 High value (0 Day clearing)
 Magnetic Ink Character Recognition (MICR) (three day clearing of
cheques)
 Outstation cheque collections
 Cheques drawn on branch locations
 Cheques drawn on correspondent bank locations
 Cheques drawn on coordinator locations
 House cheque collections
 Outside network cheque collections
 Cash collections
 ECS-Debit
 Post dated cheque collections
 Invoice collections
 Capital market collections
Products offered by banks under payments (paper and electronic):
 Demand drafts/bankers cheques
 Customer cheques
 Locally payable
 Payable at par
 RTGS/NEFT/ECS
 Cash disbursement
 Payments within bank
 Capital market payments
One of the emerging CMS in India is payment outsourcing. Though cheques
and drafts are a popular mode of payment in India, it is a time consuming
procedure because of the manual processing required. This is an area
where payment outsourcing can help. It allows corporations to reduce their
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overheads and focus on their core competencies and, as a result, benefit

from speed and accuracy. The enhanced security it offers also allows for
tighter fraud control. For Indian payment system to become completely
seamless, there are many variables, such as regulatory and legal issues,
customer behaviour and infrastructure that need to be tackled. As more
corporations and banks have added technology to their processes, the
issues surrounding connectivity security have become more important.
Today, treasurers need to ensure that they are equipped to make the best
decisions. For this, it is imperative that the information they require to
monitor risk and exposure is accurate, reliable and fast. A strong cash
management solution can give corporations a business advantage and it is
very important in executing the financial strategy of a company. The
requirement of an efficient cash management solution in India is to execute
payments, collect receivables and managing liquidity.
Discussion Questions:
1. What in your opinion is the primary advantage arising from the bank
offerings as regards to cash management?
(Hint: Refer Cash management services offered by banks)
2. You are a manufacturer of electrical appliances, having 20 branch offices
across the country. You have an agreement with a nationalised bank for
CMS, whereby the bank will collect the money from your company’s area
office and send it by Telegraphic transfer to your company’s main office
at Mumbai. This, on an average takes 5 days, i.e. for the main account,
to be credited. A private bank, which has a faster collection system,
offers its services, whereby the main account will be credited in just a
day. For this, the bank expects maintenance of a minimum balance of
Rs. 1000000 in the main account. Your firm’s total collection per day is
Rs. 600000 and opportunity cost of funds is 10%.
(a) If the nationalised bank is not charging a fee, would you accept the
private bank’s scheme?
(b) Supposing the private bank is not insisting on such minimum
balance, instead charging an annual fee of Rs. 40000, would you
accept it?
(Hint: Refer cash management)

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References:
 Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition
 Prasanna, Chandra (2007), Financial Management: Theory and Practice,
7th Edition, Tata McGraw Hill.

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Unit 13 Inventory Management

Structure:
13.1 Introduction
Objectives
13.2 Role of Inventory in Working Capital
Characteristics of inventory as current assets
Levels of liquidity
Liquidity lags
13.3 Purpose of Inventory
13.4 Costs Associated with Inventories
13.5 Inventory Management Techniques
Economic order quantity
ABC system
Determination of stock levels
Pricing of inventories
13.6 Importance of Inventory Management Systems
13.7 Summary
13.8 Glossary
13.9 Terminal Questions
13.10 Answers
13.11 Case Study

13.1 Introduction
In the previous unit we studied about the cash management, model for
determining the optimal cash needs and cash planning. In this unit, we will
be studying the role of inventory in working capital. Inventories are the most
significant part of current assets of the manufacturing firms in India. Since
they constitute an important element of the total current assets held by a
firm, the need to manage inventories efficiently and effectively for ensuring
optimal investment in inventory cannot be ignored. Any lapse on the part of
the management of a firm in managing inventories may be the cause in
failure of the firm, as discussed in the previous units. The major objectives
of inventory management are:
 Maximum satisfaction to customer
 Minimum investment in inventory
 Achieving low cost plant operation

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These objectives conflict with each other. Therefore, a scientific approach is

required to arrive at an optimal solution for earning maximum profit on
investment in inventories. Decisions on inventories involve many
departments:
 Raw material policies are decided by purchasing and production
departments.
 Production department plays an important role in work – in – process
inventory policy.
 Finished goods inventory policy is shaped by production and marketing
departments.
But the decisions of these departments have financial implications.
Therefore, as an executive entrusted with the responsibility of managing
finance of the company, the financial manager of the firm has to ensure that
monitoring and controlling inventories of the firm are executed in a scientific
manner for attaining the goal of wealth maximisation of the firm.
Objectives:
After studying this unit, you should be able to:
 elucidate the role of inventory management
 state the purpose of inventory management
 state the costs associated with inventory management
 analyse the techniques of inventory control
 recall the importance of inventory management

13.2 Role of Inventory in Working Capital

Inventories constitute an important component of a firm’s working capital.
The various features of inventory are inventory as current assets, level of
liquidity and liquidity lags, highlight the significance of inventory in working
capital management. Figure 13.1 shows the features of inventory.

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Figure 13.1: Features of Inventory

13.2.1 Characteristics of inventory as current assets

Current assets are those assets which are expected to be realised in cash
or sold or consumed during the normal operating cycle of the business.
Various forms of inventory in any manufacturing unit are:
 Process of production, where the raw materials are to be converted into
finished goods.
 Work – in – process inventories are semi finished products in the
process of being converted into finished good.
 Finished goods inventories are completely manufactured products that
can be sold immediately.
The first two are inventories concerned with production and the third is
meant for smooth performance of marketing function of the firm.
Nature of business influences the levels of inventory that a firm has to
maintain in these three kinds. A manufacturing unit will have to maintain
high levels of inventory in all the three forms. A retail firm will be maintaining
very high level of finished goods inventory only.
The three kinds of inventories listed above are direct inventories. There is
another form of inventories called indirect inventories. These indirect
inventories are those items which are necessary for manufacturing but do
not become part of the finished goods.
The indirect inventories are:
 Lubricants
 Grease
 Oil
 Petrol
 Office maintenance materials

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The inventories are held for the following four reasons:

i) Smooth production
To ensure smooth production as per the requirements of marketing
department, inventories are procured and sold.
ii) Competitive edge
To achieve competitive edge most of the retail and industrial
organisations carry inventory to ensure prompt delivery to customers.
No firm wants to lose its customers on account of its item being out of
stock.
iii) Benefits of buying in large volume
Sometimes buying in large volumes may give the firm quantity
discounts. This quantity discounts may be substantial that the firm will
take the benefit of it. The company may also benefit in terms of
reducing order costs.
iv) Hedge against uncertain lead times
Lead time is the time required to procure fresh supplies of inventory.
Uncertainty due to supplier taking more than the normal lead time will
affect the production schedule and the execution of the orders of
customers as per the orders received from customers. To avoid all
these problems arising from uncertainty in procurement of fresh
supplies of inventories, the firms maintain higher levels of inventories
for certain items of inventory.
13.2.2 Levels of liquidity
Inventories are meant for consumption or sale. Both excess and shortage of
inventory affect the firm’s profitability. They are source of near cash.
Though inventories are called current assets, in calculating absolute liquidity
of a firm these are excluded because it may have slow moving or dormant
items of inventory which cannot be easily disposed of. Therefore level and
composition of inventory significantly influence the quantum of working
capital and hence profitability of the firm.
13.2.3 Liquidity lags
Inventories have three types of liquidity lags which are creation lag, storage
lag and sale lag. Figure 13.2 shows liquidity lags.

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Figure 13.2: Liquidity Lags

Creation lag
Raw materials are purchased on credit and consumed to produce finished
goods. There is always a lag in payment to suppliers from whom raw
materials are procured. This is called spontaneous finance. Spontaneous
finance is that amount of a firm which is capable of enjoying the influences
of the quantum of working capital of the firm.
Storage lag
The goods manufactured or held for sale cannot be converted into cash
immediately. Before dispatching the goods to the customers on sale, there
is always a time lag. During this time lag goods are stored in warehouse.
Many expenses of storage will be recurring in nature and cannot be
avoided. The level of expenditure that a firm incurs on this account is
influenced by the inventory levels of the firm. This influences the working
capital management of a firm.
Sale lag
Firms sell their products on credit. There is some time lag between sale of
finished goods and collection of dues from customers. Firms which are
aggressive in capturing markets for their products maintain high levels of
inventory and allow their customers liberal credit period. This will increase
their investment in receivables. This increase in investment in receivables
will have its effect on working capital of the firms.

13.3 Purpose of Inventory

The purpose of holding inventory is to achieve efficiency through cost
reduction and increased sales volume. Figure 13.3 shows various purposes
involved in holding inventories:

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Figure 13.3: Purpose for Holding Inventory

 Sales
Customers place orders for goods only when they need it. But when
customers approach a firm with orders the firm must have adequate
inventory of finished goods to execute it. This is possible only when the
firm maintains ready stock of finished goods in anticipation of orders
from the customers.
If a firm suffers from constant customer complaints about the product
being out of stock, customers may migrate to other producers. This will
affect the firm’s customer’s base, customer loyalty and market share.
 To avail quantity discounts
Suppliers give discounts for bulk purchases. Such discounts decrease
the cost per unit of inventory purchased. Such cost reduction increase
firm’s profit. A firm may go in for orders of large quantity to avail itself of
the benefit of quantity discounts.
 Reduce risk of production stoppages
Manufacturing firms require a lot of raw materials and spares and tools
for production and maintenance of machines. Non availability of any vital
item can stop the production process. Production stoppage has serious
consequences. Loss of customers on account of the failure to execute
their orders will affect the firm’s profitability. To avoid such situations,
firms maintain inventories as hedge against production stoppages.
 Reducing ordering costs and time
Every time a firm places an order it incurs cost of procuring it. It also
involves a lead time in procurement. In some cases the uncertainty in
supply due to certain administrative problems of the supplier of the
product will affect the production schedules of the organisation.

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Therefore, firms maintain higher levels of inventory to avoid the risks of

lengthening the lead time in procurement.
Therefore, to save on time and costs, firms may place orders for large
quantities.
Therefore, it can be concluded that the motives for holding inventories are:
 Transaction motive – For making available inventories to facilitate
smooth production and sales.
 Precautionary motive – For guarding against the risk of unexpected
changes in demand and supply.
 Speculative motive – To take benefit out of the changes in price, firms
increase or decrease in the inventory levels.

13.4 Costs Associated with Inventories

Figure 13.4 shows the various types of costs associated with the
inventories:

Figure 13.4: Costs Associated with Inventories

Material cost
Material cost is the cost of purchasing goods and related costs such as
transportation and handling costs that are associated with it.

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Ordering cost
The expenses incurred to place orders with suppliers and replenish the
inventory of raw materials are called ordering cost. They include the costs of
the following:
a) Requisitioning
b) Purchase ordering or set-up
c) Transportation
d) Receiving, inspecting and receiving at the ware house.
These costs increase in proportion to the number of orders placed. Firms
maintaining large inventory levels, place a few orders and incur less
ordering costs.
Carrying cost
Costs incurred for maintaining the inventory in warehouses are called
carrying costs. They include interest on capital locked up in inventory,
storage, insurance, taxes, obsolescence, deterioration spoilage, salaries of
warehouse staff and expenses on maintenance of warehouse building. The
greater the inventory held, the higher the carrying costs.
Shortage costs or stock-out costs
These are the costs associated with either a delay in meeting the demand or
inability to meet the demand due to shortage of stock. These costs include:
 Loss of profit on account of sales and loss caused by the stock out
 Loss of future sales as customers migrate to other dealers
 Loss of customer goodwill
 Extra costs associated with urgent replenishment purchases
Measurement of shortage cost attributable to the firm’s failure to meet the
customers’ demand is difficult because it is intangible in nature and it affects
the operation of the firm.
Self Assessment Questions
1. Lead time is the time required to ____________.
2. Both excess and shortage of inventory affect the firms’ _____.
3. Precautionary motive of holding inventory is for guarding against the risk
of _______ and supply.

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4. Cost incurred for maintaining the inventory in warehouse is called

__________.
5. The purposes involved in holding inventory are ___, ____, ___ and ___.

13.5 Inventory Management Techniques

As we have seen in the earlier sections, the importance of effective
inventory management is directly influenced by the size of investment in
inventory. While the total ordering costs can be decreased by increasing the
order size. The carrying cost increases with the increase in order size
indicating the need for proper balancing of these two types of costs
behaving in opposite directions with changes in size of order.
There are many techniques of management of inventory. Some of them are
as shown in the figure 13.5

Figure 13.5: Inventory Management Techniques

13.5.1 Economic order quantity (EOQ)

Economic order quantity (EOQ) refers to the optimal order size that will
result in the lowest ordering and carrying costs for an item of inventory
based on its expected usage, carrying costs and ordering cost.
EOQ model answers the following key quantum of inventory management.
 What should be the quantity ordered for each replenishment of stock?
 How many orders are to be placed in a year to ensure effective inventory
management?
 What order size will minimise the total inventory costs?
EOQ is defined as the order quantity that minimises the total cost
associated with inventory management.
EOQ is based on the following assumptions, as shown in figure 13.6:

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Figure 13.6: Assumptions

 Constant or uniform demand – The demand or usage is even through-

out the period.
 Known demand or usage – Demand or usage for a given period is
known i.e. deterministic.
 Constant unit price – Per unit price of material does not change and is
constant irrespective of the order size.
 Constant carrying costs – The cost of carrying is a fixed percentage of
the average value of inventory.
 Constant ordering cost – Cost per order is constant and is not affected
by the size of the order.
 Inventories can be replenished immediately as the stock level reaches
exactly equal to zero. Constantly there is no shortage of inventory.
We should understand the following before moving onto calculating the
EOQ.
Total inventory cost = Ordering cost + Carrying cost
Total ordering cost = Number of orders X Cost per order = Annual usage X
Fixed cost per order / Quantity ordered
Total carrying cost = Average level of inventory X Price per unit X Carrying
cost (as a percentage)

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Economic order quantity is represented using the following formula:

2 DK
Qx =
Kc

Figure 13.7 shows the economic order quantity.

Figure 13.7: Economic Order Quantity

Where D = Annual usage or demand

Qx = Economic order quantity
K = Ordering cost per order
kc = pc = Price per unit x percent carrying cost = carrying cost of
inventory per unit per annum.

Solved Problem – 1
Annual consumption of raw materials is 40,000 units. Cost per unit is
Rs.16 along with a carrying cost of 15% per annum. The cost of placing
an order is given as Rs.480. Find out the EOQ of the raw materials.
Solution
2 × 40000 × 480
EOQ = = 4000 units
16 × 0.15
EOQ of the raw materials = 4000 units

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Solved Problem – 2
Annual demand of a company is 30,000 units. The ordering cost per
order is Rs. 20(fixed) along with a carrying cost of Rs. 10 per unit per
annum. The purchase cost per unit i.e. price per unit is Rs. 32 per unit.
Determine EOQ, total number of orders in a year and the time-gap
between two orders.
Solution
2 DK
Qx  
Kc

√(2x30000x20) = 346 units

√10
K = Rs.20
Kc = Rs.10
D = 30,000
30,000
The total number of orders in a year =
346
= 87 orders
365
Time gap between two orders = = 4 days
87

13.5.2 ABC system

The inventory of an industrial firm generally comprises thousands of items
with diverse prices, large lead time and procurement problems. It is not
possible to exercise the same degree of control over all these items. Items
of high value require maximum attention while items of low value do not
require same degree of control. The firm has to be selective in its approach
to control its investment in various items of inventory. Such an approach is
known as selective inventory control. ABC system belongs to selective
inventory control.
ABC analysis classifies all the inventory items in an organisation into three
categories.
A. Items are of high value but small in number. They are most costly or the
slowest turning items of inventory. All such items require strict control.

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B. Items of moderate value and size require reasonable attention of the

management.
C. Items represent relatively small value items, large in number and require
simple control.
Thus, the following procedure is followed for categorising inventory in ‘A’, ‘B’
and ‘C’ categories:
 All items of inventory are to be ranked in the descending order of their
annual usage value.
 The cumulative totals of annual usage values of these items along with
their percentages to the total annual usage value are to be noted
alongside.
 The cumulative percentage of items to the total number of items is also
to be recorded in another column.
 An approximate categorisation of items into A, B and C groups can be
made by comparing the cumulative percentage of items with the
cumulative percentage of the corresponding usage values.
Since this method concentrates attention on the basis of the relative
importance of various items of inventory, it is also known as control by
importance and exception. As the items are classified in order of their
relative importance in terms of value, it is also known as proportional value
analysis.
Advantages of ABC analysis
 ABC analysis ensures closer controls on costly elements in which firm’s
greater part of resources are invested
 By maintaining stocks at optimum level it reduces the clerical costs of
inventory control
 Facilitates inventory control over usage of materials, leading to effective
cost control
Limitations
 As a concept, the system analyses items according to their value and not
according to their importance in the production process.
 A never ending problem in inventory management is adequately
handling thousands of low value of C items. ABC analysis fails to answer
this problem.

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 If ABC analysis is not periodically reviewed and updated, it defeats the

basic purpose of ABC approach.

Activity: A jewellery company has the items of following stocks.

Diamonds, Platinum, Gem stones, gold and silver. Classify them as per
ABC principles.
Hint:
A category: Diamonds, Platinum, Gem stones (superior quality)
B category: Gold, Gem stones (moderate/medium quality)
C category: Silver, Gem stones (inferior quality)

13.5.2.1 Determination of stock levels

Most of the industries which are subjected to seasonal fluctuations and
sales during different months of the year are usually different. If, however,
production during every month is geared to sales demand of the month,
facilities have to be installed to cater for the production required to meet the
maximum demand.
During the slack season, a large portion of the installed facilities remains
idle with consequent uneconomic production cost. To remove this
disadvantage, attempt has to be made to obtain a stabilised production
programme throughout the year.
During the slack season, there will be accumulation of finished products
which will be gradually cleared as sales progressively increase. Depending
upon various factors of production, storing and cost, a normal capacity will
be determined. To meet the pressure of sales during the peak season,
however, higher capacity may have to be used for temporary periods.
Similarly, during the slack season, to avoid loss due to excessive
accumulation, capacity usage may have to be scaled down. Accordingly,
there will be a maximum capacity and a minimum capacity consumption of
raw material which will accordingly vary depending upon the capacity usage.
Again, the delivery period or lead time for procuring the materials may
fluctuate. Accordingly, there will be maximum and minimum delivery period
and the average of these two is taken as the normal delivery period.

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Maximum level
Maximum level is that level above which stock of inventory should never
rise.
Maximum level is fixed after taking into account the following factors.
 Requirement and availability of capital
 Availability of storage space and cost of storing
 Keeping the quality of inventory intact
 Price fluctuations
 Risk of obsolescence
 Restrictions, if any, imposed by the government
Maximum Level = Ordering level – (MRC x MDP) + standard ordering
quantity
Where, MRC = minimum rate of consumption
MDP = minimum lead time
Minimum level
Minimum level is that level below which stock of inventory should not
normally fall.
Minimum level = OL – (NRC x NLT)
Where, OL = Ordering level
NRC = Normal rate of consumption
NLT = Normal lead time
Ordering Level
Ordering level is the level at which action for replenishment of inventory is
initiated.
OL = MRC X MLT
Where, MRC = Maximum rate of consumption
MLT = Maximum lead time
Average stock level
Average stock level can be computed in two ways:
1. minimum level  maximum level
2

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2. Minimum level + 1 /2 of re-order quantity

Average stock level indicates the average investment in that item of
inventory. It is quite relevant from the point of view of working capital
management.
Managerial significance of fixation of inventory level
The managerial significance of fixation of inventory level entails the
following:
 Inventory level ensures the smooth productions of the finished goods by
making available the raw material of right quality in right quantity at the
right time.
 Inventory level optimises the investment in inventories. In this process,
management can avoid both overstocking and shortage of each and
every essential and vital item of inventory.
 Inventory level can help the management in identifying the dormant and
slow moving items of inventory. This brings about better co-ordination
between materials manager and production manager on one hand and
between stores manager and marketing manager on the other.
Thus, inventory level helps the management in different ways.
Re-order Point
“When to order” is another aspect of inventory management. This is
answered by re-order point.
The re-order point is that inventory level at which an order should be placed
to replenish the inventory.
To arrive at the re-order point under certainty, details of the two keys
required are:
 Lead time
 Average usage
Lead time refers to the average time required to replenish the inventory after
placing orders for inventory.

Re-order point = Lead time x Average usage

Under certainty, re-order point refers to that inventory level which will meet
the consumption needs during the lead time.
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Safety stock
Since it is difficult to predict usage and lead time accurately, provision is
made for handling the uncertainty in consumption due to changes in usage
rate and lead time. The firm maintains a safety stock to manage the stock –
out arising out of this uncertainty. When safety stock is maintained (When
variation is only in usage rate):

Re – order point = Lead time x Average usage + Safety stock

Safety stock = [(Maximum usage rate) – (Average usage rate)] x Lead
time.
Or
Safety stock when the variation in both lead time and usage rate are to be
incorporated.

Safety stock = (Maximum possible usage) – (Normal usage)

Maximum possible usage = Maximum daily usage x Maximum lead time
Normal usage = Average daily usage x Average lead time

Solved Problem
A manufacturing company has an expected usage of 50,000 units of a
certain product during the next year. The cost of processing an order is Rs
20 and the carrying cost per unit per annum is Rs 0.50. Lead time for an
order is five days and the company will keep a reserve of two days usage.
Calculate EOQ and Re – order point. Assume 250 days in a year.

Solution
2 DK
EOQ  
Kc
= √(2x 50000x20) = √4000000 = 2000 units
√0.50
= 2000 units
Re-order point

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50000
Daily usage =
250
= 200 units
Safety stock = 2 x 200 = 400 units.
Re-order point (lead time x Average usage) + safety stock
(5 x 200) + 400 = 1,400 units

13.5.2.2 Pricing of inventories

There are different ways of pricing inventories used in production. If the
items in inventory are homogenous (identical except for insignificant
differences) it is not necessary to use specific identification method. The
convenient price is in using a cost flow assumption referred to as a flow
assumption.
When flow assumption is used, it means that the firm makes an assumption
as to the sequence in which units are released from the stores to the
production department.
The flow assumptions selected by a company need not correspond to the
actual physical movement of raw materials. When units of raw material are
identical, it does not matter which units are issued from the stores to the
production department.
The method selected should match the costs with the revenue to ensure
that the profits are uncertain in a manner that reflects the conditions actually
prevalent.
 First in, first out (FIFO) – FIFO assumes that the raw materials (goods)
received first are used first. The same sequence is followed in pricing the
material requisitions i.e., the pricing will be based on the cost of material
that was obtained first.
 Last in, first out (LIFO) – The consignment last received is first used
and if this is not sufficient for the requisitions received from production
department then the use is made from the immediate previous
consignment, etc. The requisitions are priced accordingly. The material
issued thus will be priced based on the material that has been purchased
recently. This method is considered to be suitable under inflationary
conditions. Under this method, the cost of production reflects the current

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market trend. The closing inventory of raw material will be valued on a

conservative basis under the inflationary conditions.
 Weighted average – Material issues are priced at the weighted average
of cost of materials in stock. This method considers various
consignments in stock along with their unit’s price for pricing the material
issued from stores. In other words, the pricing will be done on weighted
average basis (weights will be given based on the quantity).
Other methods are:
a. Replacement price method
Replacement price method prices the issues at the value at which it can
be procured from the market.
b. Standard price method
Under the standard price method the materials are priced at standard
price. Standard price is decided based on market conditions and
efficiency parameters. The difference between the purchase price and
the standard price is analysed through variance analysis.
Self Assessment Questions
6. ABC system belongs to ______.
7. ______________ are of high value but small in number.
8. ABC system is known as _____________ because the items are
classified in order of their relative importance in terms of value.
9. _________ is defined as the order quantity that minimises the total
cost of inventory management.
10. Define Re-order point.
11. Define Lead time.

13.6 Importance of Inventory Management Systems

An effective inventory management system must bring together the
following objectives, to ensure that there is continuity between functions.
 Company’s strategic goals
 Sales forecasting

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 Sales and operations planning

 Production and materials requirement planning
The system must be designed to meet the dictates of the market and
support the company’s strategic plan. The changes in the market demand,
new opportunities due to worldwide marketing, global sourcing of materials
and new manufacturing technology mean many companies need to change
their inventory management approach and change the process for inventory
control.
Inventory Management system provides information to efficiently manage
the flow of materials, effectively utilise people and equipment, coordinate
internal activities and communicate with customers. Inventory management
does not make decisions or manage operations but provide information to
managers who make more accurate and timely decisions to manage their
operations.
Despite the changes that companies go through, the basic principles of
inventory management and inventory control remain the same. Some of the
new approaches and techniques are wrapped in new terminology, but
the underlying principles for accomplishing good inventory management and
inventory activities have not changed.
The basic building blocks for the inventory management system, as
indicated above, are:
 Sales forecasting or demand management
 Sales and operations planning
 Production planning
 Material requirements planning
 Inventory reduction
The emphasis on each area will vary depending on the company and how it
operates, and what requirements are placed on it due to market demands.
Each of the areas above will need to be addressed in some form or another
to have a successful programme of inventory management and inventory
control.
Modern day inventory is managed by sophisticated system applications that
are designed to manage complex inventory plans and to a large extent
contain processes that initiate and streamline the operations and inventory
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management. In the wake of improvements in the communication

technology, companies are deploying one single ERP (Enterprise Resource
Planning) system across all factories, offices, departments and locations,
thereby ensuring seamless transactions, visibility and control.
Inventory in the earlier days used to be managed by a system known as
cardex system. Bin cards were printed and kept in every bin location.
Whenever inventory was put into the bin or removed, the card had to be
updated. Apart from the bin cards, books or registers were maintained to
note down the transactions and reports were prepared manually. The
system was basic and did not provide flexibility to manage warehouse
locations as dynamic locations. The operations being manual were time
consuming.
With the ERP system introduction, MM (Material Management) modules are
deployed which work in tandem with procurement and other modules.
Inventory modules contain intelligent applications that manage the
inventory, help in analysis, categorisation and to a large extent initiate
actions and processes based on auto inputs derived from other sources.
ERP systems do contain WMS (Warehouse Management System) modules,
which can be deployed along with the inventory module to manage the
warehouse operations.
Warehouse Management System applications are designed to work like an
extension of the inventory system but are stand alone applications that help
in warehousing, control, direct and manage inventory and operations.
In fact a robust system suite comprising ERP and WMS with interfaces built
in between the two systems can play a major role in managing inventory
efficiencies.
Both the systems need to be robust, strong and built to suit the business
operations requirement as well as logistics operations requirements. While
the inventory management efficiencies depend upon the ERP functioning
and features, the inventory operations management is heavily dependant
upon WMS System.
Thus, ERP inventory management handles everything from ordering,
physical inventory count, scheduling, shipping, receiving, purchasing, and
supply chain planning. Changes in inventory are automatically updated. It no
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longer takes hours (sometimes up to 24) before the change is recorded.

This helps inventory management employees to be able to see if an item is
currently in stock. Faster service means better customer service.
Inventory management using ERP systems has many advantages. The
main advantage for a company is that the ERP system is company-wide and
involves only one software application. Companies that do not use ERP
management will sometimes have several different software applications
that are not compatible with one another.
Some other advantages include:
 Maintains proper communication between different areas.
 Tracks orders from the time the order was received to its delivery.
 Keeps up with the revenue cycle from when the invoice is issued through
when the payment is received.
 Changes in different software systems need not be updated. One system
is tied together.
 Provides a ‘top down’ overview of the workings of a company.
 Reduces the risk of loss of information.
 Sets up a form of security to protect against theft from outside or within a
company.

13.7 Summary
Let us recapitulate the important concepts discussed in this unit:
 Inventories form part of current assets of firm. Objectives of inventory
management are:
 Maximum customer satisfaction
 Optimum investment in inventory
 Operation of the plant at the least cost structure
 Inventories could be grouped into direct inventories as raw materials,
work-in-process inventories and finished goods inventory.
 Indirect inventories are those items which are necessary for
production process but do not become part of the finished goods.

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There are many reasons attributable to holding of inventory by the

management.

13.8 Glossary
Ordering costs: The expenses incurred to place orders with suppliers and
replenish the inventory of raw materials
Carrying costs: Costs incurred for maintaining the inventory in
warehouses.

13.9 Terminal Questions

1. Examine the reasons for holding inventories by a firm.
2. Discuss the techniques of inventory control.
3. Discuss the relevance and factors that influence the determination of
stock level.
4. Explain the various cost of inventory decision.

13.10 Answers

Self Assessment Questions

1. Obtain fresh supplies of inventory
2. Profitability
3. Unexpected changes in demand
4. Carrying costs
5. Smooth production, competitive edge, benefits of buying in large
volume ledge against uncertain lead times.
6. Selective inventory control
7. A items
8. Proportional value analysis
9. Economic order quantity (EOQ)
10. The re-order point is that inventory level at which an order should be
placed to replenish the inventory.
11. Lead time refers to the average time required to replenish the inventory
after placing orders for inventory.

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Terminal Questions
1. Inventories constitute an important component of a firm’s working capital
Refer 13.2
2. There are many techniques of management of inventory. Refer 13.5
3. Most of the industries which are subjected to seasonal fluctuations and
sales during different months of the year are usually different. Refer
13.5.2.1
4. There are various types of costs associated with the inventories. Refer
13.4.

13.11 Case Study: Inventory Management

Introduction:
Just like any investment in business, inventory needs to serve the purpose
of maximising profit. However, in many cases inventory has turned into a
major cash flow constraint thus making it necessary to optimise inventory
using analytical and statistical methods in an integrated approach.
One of the biggest challenges in optimising inventory is the fact that it is
merely an output of many inter-organisational processes. All too often
organisations attempt to lower inventory using non-analytical approaches
with lower service levels.
Although counterintuitive, it in fact is possible to reduce inventory while
improving service levels simultaneously using appropriate inventory
management methodology.
Inventory management methodology should attack inventory from two
directions:
 Optimising inventory levels while viewing the existing order fulfilment
process as a given constraint
 Changing the fundamental order fulfilment process across the entire
system
During the first step cash can be made available quickly and success is
immediately generated. Step two is used to generate breakthrough business
results and provide a robust order fulfilment process that will be able to

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perform at lower inventory levels while providing extraordinary service

levels.
A Case:
M/s. Avinashi Enterprises is a manufacturing concern that deals with steel
bolts. The set-up was started in the year 1998 by Mr. Avinash Malhotra. It is
an SSI unit and has its campus in the outskirts of South Bangalore.
Mr.Avinash suspected a cash problem and set up a committee to analyse
the issue. Further analysis revealed that inventory levels were high and
turnover was below most major competitors. In addition a technology
change and a proliferation of models was amplifying the issue.
The committee, under the guidance of Mr. Avinash set up as a goal, a
reduction of inventory across the order fulfilment process in excess of 50%
with no negative impact on service levels. Customer feedback reveals that a
key to customer satisfaction is on time delivery and any deviation from
promised dates has a negative impact on customer satisfaction.
They decide to first use ABC analysis on their list of inventories, to have a
closer control on them. Following are the list of items:

Item Annual Price per

No.1 Usage (units) unit (Rs.)
1 10,000 0.50
2 200 100.00
3 400 80.00
4 7,000 1.50
5 1,000 1.20
6 1,500 0.80
7 600 50.00
8 1,200 0.40
9 300 0.60
10 70 500.00
11 2,000 2.00
12 5,000 1.50

The responsibility to rank these items and maintain control is handed over to
Mr. Rajeev Sharma and team.

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Simultaneously, a baseline of the existing order fulfilment process is

conducted. It quickly highlights some key leverage points in the order
fulfilment process. Furthermore it becomes apparent that most of the current
inventory is present due to internally generated variation versus customer
driven order variation.
Following the baseline activity various process changes are modelled to
verify their impact on inventory levels and service levels. Real world
constraints are taken into account prior to deciding on the appropriate
changes. Simulations are conducted to verify the appropriateness of the
analytical models using actual process data.
As a result the following changes are made to accomplish the goals.
 Implementation of a pull system for the order fulfilment process. This pull
system spans from supplier through manufacturing, logistics to the
customer. The previous order fulfilment process was managed via an
MRPII system.
 Determination of inventory levels using economic and statistical methods
in an integrated approach.
 Implementation of appropriate inventory management models to
minimise cost given various real world conditions in the supply chain
(flow production, batch production, re-manufactured parts inflow etc.)
 Revision of the planning process to support the order fulfilment process.
 Training of analysts to determine the appropriateness of forecast
models.
 Extensive control on inventory items as analysed and ranked by the ABC
model.
Reduction of internally generated variation through:
o Organisational changes to reduce tampering
o Application of statistical methods
Management of the new process is significantly less resource intensive than
the original process. Changes in volume are easily accomplished due to the
simplicity of the new order fulfilment process. Inventory is reduced and
service levels to customers are improved.

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Discussion Questions:
1. What is your understanding on the relationship between
inventory management and customer service? Explain in detail using
examples.
(Hint: Refer Role of Inventory)
2. What would be the ranking of inventory items listed in the case, as drawn
up by Mr. Rajeev?
(Hint: Refer ABC analysis)
3. Do you think the ABC system is a reliable approach? What in your view
are its advantages and limitations?
(Hint : Refer ABC analysis)
4. What is the importance of technology in inventory management in
present times? Give your response in the background of the case above.
(Hint: Refer Role of Inventory)
5. Supposing, M/s. Avinash Enterprises requires 75,000 units of a certain
item per annum and the cost per unit of the item is Rs.25. The ordering
cost is Rs, 250 per order and the inventory carrying cost is Rs.10 per unit
per annum.
a) Calculate the EOQ.
b) Ascertain what the company should do if the supplier of the item
offers a cash discount of 2% for a minimum order size of 3500 units.
(Hint : Refer EOQ)
(Source: www.sixsigmasystems.com)

References:
 Prasanna, Chandra (2007), Financial Management: Theory and
Practice, 7th Edition, Tata McGraw Hill.
 Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition,
E-Reference:
 www.sixsigmasystems.com retrieved on 12-12-2011

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Financial Management Unit 14

Unit 14 Receivable Management

Structure:
14.1 Introduction
Objectives
14.2 Costs Associated with Maintaining Receivables
14.3 Credit Policy Variables
14.4 Evaluation of Credit Policy
14.5 Summary
14.6 Glossary
14.7 Terminal Questions
14.8 Answers
14.9 Case Study

14.1 Introduction
In the previous unit, we studied about inventory management, role of
inventory in working capital, costs associated with inventories. In this unit,
we will discuss about costs associated with maintaining receivables. Firms
sell goods on credit to increase the volume of sales. In the present era of
intense competition, to improve their sales, business firms offer relaxed
conditions of payment to their customers. When goods are sold on credit,
finished goods get converted into receivables.
Trade credit is a marketing tool that functions as a bridge for the movement
of goods from the firm’s warehouse to its customers. When a firm sells
goods on credit, receivables are created. The receivables arising out of
trade credit have three features:
 Receivables that arise out of trade credit involve an element of risk.
Therefore, before sanctioning credit, careful analysis of the risk involved
needs to be done.
 Receivables out of trade credit are based on economic value. Buyer
gets economic value in goods immediately on sale, while the seller
receives an equivalent value later on.
 Receivables out of trade credit have an element of futurity. The buyer
makes payment in future.

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Amounts due from customers, when goods are sold on credit are called
trade debits or receivables. Receivables form a part of the current assets.
These constitute a significant portion of the total current assets of the
buyers, after inventories.
Receivables are assets – accounts representing amount due to the firm
from sale of goods/services in the ordinary course of business.
The main objective of selling goods on credit is to promote sales, for
increasing the profits of the firms. Customers always prefer buying on credit
rather than buying on cash. They always go to a supplier who gives credit.
Therefore, all firms grant credit to their customers to increase sales, profit
and to sustain competition.
Objectives:
After studying this unit, you should be able to:
 explain the meaning of receivables management
 recognise the costs associated with maintaining receivable
 determine the credit policy variables
 define the process of evaluation of credit policy
Meaning of receivables management
Receivables are a direct result of credit. A firm resorts to credit sales to push
up its sales which in turn, push up the profits earned by the firm. At the
same time, by selling goods on credit the funds of the accounts receivables
are blocked.
Therefore, additional funds are required for the operating needs of the
business, which involve extra costs in terms of interest. Moreover, increase
in receivables also increases the chances of bad debts. Thus, creation of
accounts receivables is beneficial as well as dangerous to the firm.
The financial manager needs to follow a policy of using cash funds
economically to such an extent that it is possible to extend the receivables
to enhance the chances of increasing sales and making more profits.
Management of accounts receivables may, therefore, be defined as the
process of making decision related to the investment of funds in receivables
for maximising the overall return on the investment of the firm.

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Thus, the objective of receivables management is to promote sales and

projects, until the cost involved in further funding of receivables is less than
the cost involved in financing that additional cost. Therefore, the purpose of
receivables can be directly related to the company’s objectives of promoting
credit sales. Those objectives are as follows:
 To increase sales – when a company sells its goods on credit, it will be
able to sell more goods than if it insists on immediate cash payments.
 To increase profits – this is as a result of increase in sales, not just in
terms of volume, but also in terms of profit margins. Firms normally have
a higher profit margin set on credit sales than cash sales.
 To meet increasing competition – company may look at granting
better credit facilities in order to attract more customers.

14.2 Costs Associated with Maintaining Receivables

There are four different varieties of costs associated with maintaining
receivables: capital cost, administration cost, delinquency cost and bad-
debts or default cost. Figure 14.1 depicts the costs associated with
maintaining of receivables.

Figure 14.1: Costs Associated with Maintaining Receivables

Capital cost
When firm sells goods on credit, the good achieves higher sales. Selling
goods on credit has consequences of blocking the firm’s resources in
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receivables, as there is a time lag between a credit sale and cash receipt
from customers.
To the extent the funds are held up in receivables, the firm has to arrange
for additional funds to meet its own obligation of monthly as well as daily
recurring expenditure. Additional funds may have to be raised either out of
profits or from outside.
In both the cases, the firm incurs a cost. In the former case, there is the
opportunity cost of the income the firm could have earned had the same
amount been invested in some other profitable avenue. In the latter case of
obtaining funds from outside, the firm has to pay interest on the loan taken.
Therefore, sanctioning credit to customers for the sale of goods has a
capital cost.
Administration cost
When a firm sells goods on credit it has to incur two types of administration
costs:
 Credit investigation and supervision costs
 Collection costs
Before sanctioning credit to a customer, the firm has to investigate the credit
rating of the customer to ensure that credit given will be recovered on time.
Therefore, administration costs are incurred in this process.
Costs incurred in collecting receivables are administrative in nature. These
include additional expenses on staff for administering the process of
collection of receivables from customers.
Delinquency cost
The firm incurs this cost when the customer fails to pay back the amount on
the expiry of credit period. These costs take the form of sending reminders
and legal charges.
Bad-debts or Default costs
When the firm is unable to recover the due amount from its customers, it
results in bad debts. Defaults occur when a firm relaxes its credit policy, for
customers with relatively low credit rating. In this process, a firm may make
credit sales to customers who do not pay at all.

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Therefore, assessing the effect of a change in credit policy of a firm involves

examination of:
 Opportunity cost of lost contribution
 Credit administration cost
 Collection costs
 Delinquency cost
 Bad-debt losses

Self Assessment Questions

1. Costs of maintaining receivables are _____________, _________ cost
and _______.
2. A period of “Net 30” means that it allows its customers, 30 days of
credit with ____ for ___________.
3. Selling goods on credit has consequences of blocking the firm’s
resources in receivables as there is a time lag between
_____________ and ____________.
4. When a firm sells goods on credit it has to incur two types of
administration cost: _____ and _________________.
5. The four different varieties of costs associated with maintaining
receivables are _________, ________, _____ and ____.
6. Define receivable management.
7. Define receivables.

14.3 Credit Policy Variables

The credit policy of a firm can be termed as a trade-off between increased
credit sales leading to increase in profit and the cost of having larger amount
of cash locked up in the form of receivables along with the loss due to the
incidence of bad debts.
The term ‘credit policy’ comprises the policy of a company with respect to
the credit standards adopted; the period over which the credit is extended to
customers; any incentive in the form of cash discount offered; as also the
period over which the discount can be used by the customers; and the
collection effort made by the company.
Thus, the four aspects of credit policy are as follows (see figure 14.2):
 Credit standards

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 Credit period
 Cash discounts and
 Collection programme
These variables are related and have a bearing on the level of sales, bad
debt loss, discounts taken by customers, and collection expenses. Figure
14.2 depicts the credit policy variables.

Figure 14.2: Credit Policy Variables

Credit standards
The term credit standards refer to the criteria for extending credit to
customers. The basis for setting credit standards are:
o Credit ratings
o References
o Average payment period
o Ratio analysis
There is always a benefit to the company with the extension of credit to its
customers, but with the associated risks of delayed payments or non-
payment and of getting funds blocked in receivables.
The firm may have light credit standards. The firm may sell goods on cash
basis and extend credit only to financially strong customers.
Such strict credit standards will bring down bad-debt losses and reduce the
cost of credit administration.
However, the firm will not be able to increase its sales. The profit on lost
sales may be more than the costs saved by the firm. The firm should
evaluate the trade-off between cost and benefit of any credit standards.
Credit period
Credit period refers to the length of time allowed by a firm, for its customers
to make payment, for their purchases. Credit period is generally expressed
in days like 15 days or 20 days. Generally, firms give cash discount if
payments are made within the specified period.
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If a firm follows a credit period of ‘net 20’ it means that it allows its
customers 20 days of credit with no inducement for early payments.
Increasing the credit period will bring in additional sales from existing
customers and new sales from new customers.
Reducing the credit period lowers sales, decreases investments in
receivables and reduces the bad-debt loss. Increasing the credit period
increases sales, increases investment in receivables and increases the
incidence of bad debt loss.
The effects of increasing the credit period on the profits of the firms are
similar to that of relaxing the credit standards.
Cash discount
Firms offer cash discounts to induce their customers to make prompt
payments. Cash discounts have implications on sales volume, average
collection period, investment in receivables, incidence of bad debts and
profits.
A cash discount of 2/10 net 20 means that a cash discount of 2% is offered
if the payment is made by the tenth day; otherwise full payment will have to
be made by 20th day.
Collection programme
The success of a collection programme depends on the collection policy
pursued by the firm. The objective of a collection policy is to achieve a
timely collection of receivables. Releasing funds locked in receivables and
minimising the incidence of bad debts are the other objectives of the
collection policy. The collection programmes consists of the following:
o Monitoring the receivables
o Reminding customers about due date of payment
o Interacting on-line through electronic media with customers about the
payments due, around the due date
o Initiating legal action to recover the amount from overdue customers as
the last resort to recover the dues from defaulted customers
o Formulating collection policy such that, it should not lead to bad
relationship with the customers

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Self Assessment Questions

8. Credit period is a ______________.
9. _______ refer to the criteria for extending credit to customers.
10. _________ refers to the length of time allowed by a firm for its
customers to make payment for their purchase.
11. A cash discount of 2/10 net 20 means that a ____________ is offered
if the payment is made __________________.
12. The four varieties of credit policy variables are ____, ______, _____
and _____.

14.4 Evaluation of Credit Policy

Credit policy of every company is largely influenced by two conflicting
objectives, irrespective of the native and type of company. They are liquidity
and profitability. Liquidity can be directly linked to book debts. Liquidity
position of a firm can be easily improved without affecting profitability by
reducing the duration of the period for which the credit is granted and further
by collecting the realised value of receivables as soon as they fail due. To
improve profitability one can resort to lenient credit policy as a booster of
sales, but the implications are:
 Chances of extending credit to those with week credit rating.
 Unduly lenient credit terms.
 Tendency to expand credit to suit customer's needs.
 Lack of attention to over dues accounts.
Optimum credit policy is one which would maximise the value of the firm.
Value of a firm is maximised when the incremental rate of return on an
investment is equal to the incremental cost of funds used to finance the
investment.
Therefore, credit policy of a firm can be regarded as:
 Trade-off between higher profits from increased sales and
 The incremental cost of having large investment in receivables
The credit policy to be adopted by a firm is influenced by the strategies
pursued by its competitors. If competitors are granting 15 days credit and if
the firm decides to extend the credit period to 30 days, the firm will be
flooded with customers’ demand for company’s products.

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To summarise, in order to achieve the goal of maximising the value of the

firm the evaluation of investment in receivables accounts should involve the
following four steps:
1. Estimation of incremental operating profit.
2. Estimation of incremental investment in accounts receivables.
3. Estimation of the incremental rate of return of investment.
4. Comparison of incremental rate of return with the required rate of return
In reality, it is rather a different task to establish an optimum credit policy as
the best combination of variables of credit policy is quite difficult to obtain.
The important variables of credit policy should be identified before
establishing an optimum credit policy and then they should be evaluated.
We have learnt about the important credit policy variables in the earlier
pages.
Individual evaluation of all the four credit policy variables of a firm is as
shown:
Credit standard
The effect of relaxing the credit standards on profit can be estimated as
under:
P = S (1-V) - k I - bn S
P = Change in profit
S = Increase in sales
Contribution to sales ratio = c = 1 – V
Where V = Variable cost to sales ratio
bn = bad debts loss ratio on new sales
k = post tax cost of capital
I = Increase in receivables investment= S/360 X Average collection period
(ACP) X V
Therefore,

Change in profit = (Additional contribution on increase in sales – Bad

Debts on new sales) (1 – tax rate) – Cost of incremental investment.
= (1 – tax rate) – cost of capital x Incremental investment in receivables.
= Increase in profit i.e. change in profit = [Incremental contribution – Bad

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Solved Problem – 1
The details shown in table 14.1 are regarding the statistics of the
company X Ltd.
Table 14.1: Statistics of X Ltd
Current sales Rs.100 million
Increase in sales Rs.15 million
Bad-debt losses 10%
Contribution margin ratio 20%
Average collection period 40 days
Post-tax cost of funds 10%
Tax-rate 30%
Examine the effect of relaxing the credit policy on the profitability of the
organisation. (MBA) adopted.
Solution
Incremental contribution = 15 x 0.20 = Rs 3 million
Bad debts on new sales = 15 x 0.10 = Rs 1.5 million
Cost of capital is 10%
Incremental investment in receivables =
Increase in Sales
 Average Collection period  Variable cos t to Sales ratio
No. of days in the year
 [15 / 360]  40  0.8  Rs.1.33million
10
Cost of incremental investment   1.33 = 0.133
100
Therefore, change in profit is calculated using the information in table
14.2
Table 14.2: Change in Profit ( in millions)
Incremental contribution 3.00
Less: bad-debts on new sales 1.50
Less: Income tax at 30% .45
1.05
Less: Opportunity cost of incremental 0.13
investment in receivables
Increase in profit 0.92

Because the impact of change in credit standards on profit is positive, the

change in credit standards may be considered.
debts on new sales]

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Credit period
Credit period refers to the length of time allowed to customers to pay for
their purchases. It generally varies from 15 to 60 days. If a firm allows, 45
days of credit with no discount to induce early payment, its credit terms are
stated as ‘net 45’.
Lengthening the credit period pushes sales up by inducing existing
customers to purchase more and attracting additional customers, at the
same time increasing receivables investment and incidence of bad debts.
The effect of changing the credit period on profits of the firm can be
computed as shown:

Change in profit = (Incremental contribution – Bad debts on new sales) Formatted: Font color: Auto

(1 – tax rate) – cost of incremental investment in receivables. Formatted: Font color: Auto
Formatted: Font color: Auto
The components of the formula are the same as discussed in the earlier
section, i.e.
P = S (1-V) - k I - bn S
Except for one thing that here I = increase in investment is defined as
below:
I = (ACPn – ACPo) (So/360) + V (ACPn) (S/360)
Where, ACPn = new average credit period (after increasing credit period)
ACPo = old average credit period
V = variable cost to sales ratio
S = increase in sales
So = Sales before liberalising

Solved Problem – 2
A company is currently allowing its customers, 30 days of credit. Its
present sales are Rs 100 million. The firm’s cost of capital is 10% and the
ratio of variables cost to sales is 0.80. The company is considering
extending its credit period to 60 days. Such an extension will increase the
sales of the firm by Rs 100 million. Bad debts on additional sales would be
8%. Tax rate is 30%. Assume 360 days in a year. Examine the effect of
relaxing the credit policy on the profitability of the organisation
(MBA) adopted.

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Solution
Incremental contribution = 10,000,000 x 0.2 = Rs 2,000,000
Bad debts on new sales = 10,000,000 x 0.8 = Rs 8,000,000
Existing investment in receivables =
30
1,00,000,000   Rs.8,333,333
360
Expected investment in receivables after increasing the credit period to
60 days:
Expected investment in receivables on current sales =
1,00,000,000
  60  Rs.16,666,667
360
60
1,00,000,000   0.80  Rs.13,33,333
360
Additional investment in receivable on new sales = Rs. 13,33,333
Expected total investment in receivables on increasing the period of
credit = 1,80,00,000
Incremental investment in receivables = 18000000 – 8333333 =
Rs. 9666667
Opportunity cost of incremental investment in receivables =
0.10 x 9666667 = Rs.966667
Table 14.3 depicts the statement showing the effect of increasing the
credit period from 30 days to 60 days as firm’s project.
Table 14.3: Effect of Increase in Credit Period
Incremental contribution 20,00,000
Less: Bad debts on new sales 8,00,000
12,00,000
Less: Income tax at 30% 3,60,000
8,40,000
Less: Opportunity cost of incremental in
receivables 9,66,667
Change in profit (1,26,667)

Because the impact of increasing the credit period on profits of the firm is
negative, the proposed change in credit period is not desirable.

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Cash discount
Firms usually offer cash discounts to induce prompt payments. Credit terms
reflect the percentage of discount and the period during which it is available.
For instance, credit terms of 1/20, net 30 mean discount of 1 percent is
offered if the payment is made by the 20th day, otherwise the full payment is
due by the 30th day.
For assessing the effect of cash discount the following formula can be used.

Change in profit = (Incremental contribution – Increase in discount cost)

(1 - t) + Opportunity cost of savings in receivables investment
P = S (1 – V) + kI – DIS
Where P = change in profit
S = increase in sales
V = variable cost to sales ratio
k = cost of capital
I = savings in receivables management =
(ACPo – ACPn) (So/360) - V (ACPn) (S/360)

DIS = Increase in discount cost = pn(So + S)dn - poSodo

Where, pn = proportion of discount sales after liberalising
So = sales before liberalising
S = increase in sales
dn = new discount percentage
po = proportion of discount sales before liberalising
do = old discount percentage
Collection policy
The collection programme ideally comprises the following:
 Monitoring the state of receivables
 Despatching letters to customers whose due date is approaching
 Sending telegraphic/telephonic/SMS/email advice to customers around
due date
 Demonstrating threat of legal action to overdue accounts
 Taking legal action against overdue accounts

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Computation of the effect of new collection programme can be evaluated

with the help of the following formula.
Change in profit = (Incremental contribution – Increase in bad debts) (1 –
tax rate) – cost of increase in investment in receivables.

Formatted: Font color: Auto

P = S (1 – V) – k I – BD – C
Where,
P = change in profits
S = increase in sales
V = variable costs to sales ratio
k = cost of capital
BD = increase in bad debts cost = b n(So + S) - boSo
I = increase in investment in receivables =
(So/360)(ACPn – ACPo) + (S/360)(ACPn) V
Where, ACPn = new average credit period (after increasing credit period)
ACPo = old average credit period
V = variable cost to sales ratio
S = increase in sales
So = Sales before liberalising
bn = bad debts loss ratio on new sales
bo = bad debts before changes

Solved Problem – 3
A company is considering relaxing its collection effort. Its present sales
are Rs 50 million, ACP = 20 days, variable cost to sales ratio = 0.8, cost
of capital 10%. The company’s bad debt ratio is 0.05. The relaxation in
collection programme is expected to increase sales by Rs 5 million,
increase ACP to 40 days and bad debts ratio to 0.56. Tax rate is 30%.
Examine the effect of change in collection programme on firm’s profits.
Assume 360 days in a year. (MBA adopted and also ACS
Solution
Increase in Contribution = 5, 000, 000 x 0.2 = Rs.1, 000, 000
Increase in bad debts
Bad debts on existing sales = 50, 000, 000 x 0.05 = 25, 00, 000
Bad debts on total sales after increase in sales =

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55, 000, 000 x 0.56 = 33, 00, 000

Increase in bad debts = Rs.8, 00, 000
Incremental investment in receivables
50,000,000( 40  20) 5,000,000  40  0.8
 
360 360
= 2777778 + 444444 = Rs.3222222
Opportunity cost of incremental investment in receivables
= 0.1x 3222222 = Rs.322222

Table 14.4 depicts the statement showing the impact of new collection
programme on profits of the organisation.
Table 14.4: Impact of New Collection
Incremental contribution 1,00,000
Less: increase in bad debts 8,00,000
2,00,000
Less: Income tax at 30% 60,000
1,40,000
Less: opportunity cost of increase in investment in 3,22,222
receivables
Profit/loss (1,82,222)
negative
Since the change will lead to decrease in profit (a loss of Rs.182222) it is
not desirable to relax the collection programme of the firm.

Activity:
Indicate by a (+), (-) or (0) whether each of the following events would
probably cause A/R, Sales, and profits to increase, decrease or no
change.
A/R Sales Profits
1. The firm tightens credit
standards
2. The credit manager gets
tough with past due
accounts
Hint: Decrease, decrease, decrease
Decrease, decrease, increase
Reference: Fundamentals of Financial Management, Brigham and Houston

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Self Assessment Questions

13. Credit policy of a firm can be regarded as a trade-off between
___________ and _______.
14. Optimum credit policy maximises the __________.
15. Value of a firm is maximised when the incremental rate of return on
investment in receivable is ________________ to the incremental cost
of funds used to finance that investment.
16. Credit policy to be adopted by a firm is influenced by strategies
pursued by its competitors. (True/False)

14.5 Summary
 Receivables are a direct result of credit sales.
 Management of accounts receivables is the process of making decision
related to investment of funds in receivable which will result in
maximising the overall return on the investment of the firm.
 Cost of maintaining receivables are of three types - capital costs,
administration costs and delinquency costs.
 Credit policy variables are credit standards, credit period, cash discounts
and collection programme. Optimum credit policy is that which
maximises the value of the firm.

14.6 Glossary
Credit period: Refers to the length of time allowed to customers to pay for
their purchases.

14.7 Terminal Questions

1. Examine the meaning of receivable management.
2. Examine the costs of maintaining receivables.
3. Examine the variables of credit policy.
4. What are the features of optimum credit policy?

14.8 Answers
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Self Assessment Questions

1. Capital costs, administration, delinquency costs
2. No inducement for early payments
3. Credit sale, cash receipt from customers
4. Credit investigation and supervision cost, collection costs
5. Capital cost, administration cost, delinquency cost and bad-debts or
default cost
6. Management of accounts receivables may be defined as the process
of making decision relating to the investment of funds in receivables
that will result in maximising the overall return on the firm’s investment
7. Receivables are asset-accounts representing amounts owing to the
firm as a result of sale of goods/services
8. Credit policy variable
9. Credit standards
10. Credit period
11. Cash discount of 2%, on the tenth day
12. Credit standards, credit periods, cash discounts and collection
programme.
13. Higher profits from increased sales, incremental cost of having large
investment in receivable.
14. Value of the firm.
15. Equal
16. True

Terminal Questions
1. Receivables are a direct result of credit. Refer to 14.1.
2. There are four different varieties of costs associated with maintaining
receivables. Refer to 14.2.
3. The term ‘credit policy’ comprises the policy of a company with respect
to the credit standards adopted; the period over which the credit is
extended to customers; any incentive in the form of cash discount
offered; as also the period over which the discount can be used by the
customers; and the collection effort made by the company. Refer to
14.3.

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4. Optimum credit policy is one which would maximise the value of the firm.
Refer to 14.4.

14.9 Case Study: Credit Policy

Jubilee Chemicals Ltd. are manufacturer and exporter of industrial
chemicals and fine chemicals such as chlorinated paraffin oil,
monochlorobenzene, paradichlorobenzene, orthodichlorobenzene,
orthonitrochlorobenzene, orthonitroaniline, paranitrochlorobenzene and
ortho nitrotolune.
They are among the leading International Marketing companies in India.
They market chemicals, petrochemicals and commodities to their principals
abroad. They further provide a unique platform to their overseas principals
for developing market of their products in India. The company facilitates
export of the above mentioned products and guaranties international quality,
timely delivery and competitive prices.
The company currently provides a credit period of 30 days to its clients. 25%
of the clients pay on the 15 th day while 50% of the clients pay on the 30 th
day and the rest of the clients pay on the 85 th day.
For the year that ended on March 31, 2011, the company recorded sales of
Rs.10 crores, out of which the credit sales are 80%. Its variable cost to sales
ratio is 80%. The company financed its receivables using bank finance at an
interest rate of 18% p.a. and with a margin requirement of 40%.
Mr. Jadhav, the marketing manager of the company, proposed to change
the credit terms from net 30 to 1/10 net 45. He expects that this change
would improve the credit sales by Rs. 2 crores and also change the
payment pattern of the customers.
If the credit policy is introduced, as per his market survey, 75% of clients
pay on the 10th day, 10% of the clients will pay on the 45 th day and the rest
15% of the clients will pay on the 120th day. He believes that these 15%
clients are also long standing customers and hence need not be
discouraged. The bank will provide finance as per the existing terms for the
additional credit sales, also.
Out of the additional sales of Rs. 2 crores, however there is a risk of bad
debts to the extent of 5%.
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The cost of capital of the company is 16% and the tax rate applicable to it is
35%.

Discussion Questions:
1. Analyse the details and suggest whether the change in credit terms is
advisable.
(Hint: Refer credit variables)
2. Explain how a credit policy affects the sales and reputation of a firm.
(Hint: Refer credit policy)

References:

 Prasanna, Chandra (2007), Financial Management: Theory and Practice,

7th Edition, Tata McGraw Hill.
 Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition

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Financial Management Unit 15

Unit 15 Dividend Decisions

Structure:
15.1 Introduction
Objectives
15.2 Traditional Approach
15.3 Dividend Relevance Model
Walter model
Gordon’s dividend capitalisation model
15.4 Miller and Modigliani Model
15.5 Stability of Dividends
15.6 Forms of Dividends
15.7 Stock Split
15.8 Summary
15.9 Glossary
15.10 Terminal Questions
15.11 Answers
15.12 Case Study

15.1 Introduction
In the previous section, we discussed about receivables management.
Managing the receivables, a direct result of credit sales, involves decision
making related to investment of funds in receivable for maximising the
overall return on the investment of the firm.
In this unit, we will discuss the significance and the various attributes of
dividend. Dividends are that portion of a firm’s net earnings which are paid
to the shareholders. Preference shareholders are entitled to a fixed rate of
dividend irrespective of the firm’s earnings. Equity holders’ dividends
fluctuate year after year. Dividend decisions depend on what portion of
earnings is to be retained by the firm and what portion is to be paid off.
As dividends are distributed out of net profits, the firm’s decisions on
retained earnings have a bearing on the amount to be distributed. Retained
earnings constitute an important source of financing investment
requirements of a firm. However, such opportunities should have enough
growth potential and sufficient profitability.

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There is an inverse relationship between these two – larger the retentions,

lesser the dividends and vice versa. The constituents of net profits –
dividends and retentions, are always competitive and conflicting.
Dividend policy has a direct influence on the two components of
shareholders’ return – dividends and capital gains. A low payout and high
retention may have the effect of accelerating the earnings growth.
Investors of growth companies realise their money in the form of capital
gains. Dividend pay-out ratio will be low for such companies. The influence
of dividend policy on future capital gains happens in distant future and
therefore, by all means it is uncertain.
Dividend policy of a firm is a residual decision. In true sense, it means that a
firm with sufficient investment opportunities will retain the entire earnings to
fund its growth avenues. Conversely, if no such avenues are forthcoming,
the firm will pay-out its entire earnings. So there exists a relationship
between return on investments “r” and the cost of capital “k”. So, as long as
r exceeds k, a firm shall have good investment opportunities.
That is, if the firm can earn a return “r” higher than its cost of capital “k”, it
will retain its entire earnings. If this source is not sufficient, it will go in for
additional sources in the form of additional financing like equity issue,
debenture issue or term loans. Thus, the dividend decision is a trade-off
between retained earnings and financing decisions.
Different theories have been given by various people on dividend policy. We
have the traditional theory and new sets of theories based on the
relationship between dividend policy and firm value.
The modern theories can be grouped as:
 Theories that consider dividend decision as an active variable in
determining the value of the firm and
 Theories that do not consider dividend decision as an active variable in
determining the value of the firm
While the modern theories are gaining momentum, the traditional
theories are still in use.

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Objectives:
After studying this unit, you should be able to:
 explain the importance of dividends to investors
 analyse the effect of declaring dividends on share prices
 describe the advantages of a stable dividend policy
 list out the various forms of dividend
 elucidate reasons for stock split

15.2 Traditional Approach

Traditional approach is given by B. Graham and D. L. Dodd. They clearly
emphasise the relationship between the dividends and the stock market.
According to them, the stock value responds positively to high dividends and
negatively to low dividends, that is, the share values of those companies
which pay high dividends, rises considerably and the prices fall in the event
of low dividends paid.
Symbolically, P = [m (D+E/3)]
Where P is the market price,
m is the multiplier,
D is dividend per share,
E is earnings per share.
Drawbacks of traditional approach
As per this approach, there is a direct relationship between P/E ratios and
dividend pay-out ratio. High dividend pay-out ratio will increase the P/E ratio
and low dividend pay-out ratio will decrease the P/E ratio. This may not
always be true. A company’s share prices may rise in spite of low dividends
due to other factors.

15.3 Dividend Relevance Model

Dividend relevance models support the view that the dividend policy of the
firm has a bearing on share valuation.
Under this section we examine two theories:
 Walter Model
 Gordon Model

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Walter model
Prof. James E. Walter considers that dividend pay-outs are relevant and
have a bearing on the share prices of the firm. He further states that
investment policies of a firm cannot be separated from its dividend policy
and both are inter-linked. The choice of an appropriate dividend policy
affects the value of the firm.
Walter model clearly establishes a relationship between the firm’s rate of
return “r” and its cost of capital “k” to give a dividend policy that maximises
shareholders’ wealth. The firm would have the optimum dividend policy that
enhances the value of the firm.
Walter model can be studied with the relationship between r and k.
 If r>k, the firm’s earnings can be retained, as the firm has better and
profitable investment opportunities and the firm can earn more than what
the shareholders could earn by re-investing, if earnings are distributed.
Firms which have r>k are called ‘growth firms’ and such firms should
have a zero pay-out ratio.
 If r<k, the firm should have a 100% pay-out ratio as the investors have
better investment opportunities than the firm. Such a policy will maximise
the firm value.
 If r = k, the firm’s dividend policy will have no impact on the firm’s value.
The dividend pay-outs can range between zero and 100% and the firm
value will remain constant in all cases. Such firms are called ‘normal
firms’.
Figure 15.1 depicts the assumptions on which the Walter’s model is based.

Figure 15.1: Assumptions Regarding Walter’s Model

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Financial Management Unit 15

The following are the assumptions on which the Walter’s model is based:
 Financing – All financing is done through retained earnings. Retained
earning is the only source of finance, available and the firm does not use
any external source of funds like debt or equity.
 Constant rate of return and cost of capital – The firm’s “r” and “k”
remain constant and any additional investment made by the firm will not
change the risk and return profile.
 100% pay-out or retention – All earnings are either completely
distributed or immediately re-invested.
 Constant EPS and DPS – The earnings and dividends do not change
and are assumed to be constant forever.
 Life – The firm has a perpetual life.
According to this approach, the market price of the share is taken as the
sum of the present value of the future cash dividends and capital gains.
Walter’s formula to determine the market price is as follows:
Market price per share of the firm is given as:
P = D / (Ke – g)
Implies, Ke = D/P + g , where g = ∆P / P
Thus, Ke = D/P + ∆P / P
But since, ∆P = [r / Ke( E  D)] , we get

D [ r / Ke ( E  D )]
P= 
Ke Ke
Where P is the market price per share
D is the dividend per share
Ke is the cost of capital
g is the growth rate of earnings
E is Earnings per share
r is IRR
∆P is change in price

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Caselet: The following information relates to Alpha Ltd. Show the effect
of the dividend policy on the market price of its shares using the Walter’s
Model.
Equity capitalisation rate Ke is 11%
Earnings per share is given as Rs. 10
ROI (r) may be assumed as follows: 15%, 11% and 8%
Show the effect of the dividend policies on the share value of the firm for
three different levels of r, taking the DP ratios as zero, 25%, 50%, 75%
and 100%.
Solution
Ke 11%, EPS 10, r 15%, DPS=0
D [ r / Ke ( E D )]
P= 
Ke Ke
Case I r >k (r = 15%, Ke = 11%)
0  [0.15 / 0.11(10  0)]
a. DP = 0 = 13.64/0.11 = Rs. 123.97
0.11
2.5  [ 0.15 / 0.11(10  2.5 )]
b. DP = 25% = 12.73/0.11 = Rs. 115.73
0.11
5  [0.15 / 0.11(10  5)]
c. DP = 50% = 11.82/0.11 = Rs. 107.44
0.11
7.5  [ 0.15 / 0.11(10  7.5 )]
d. DP = 75% = 10.91/0.11 = Rs. 99.17
0.11

10  [0.15 / 0.11(10  10)]

e. DP = 100% = 10/0.11 = Rs. 90.91
0.11
Case II r = k (r = 11%, Ke = 11%)

0  [0.11/ 0.11(10  0)]

a. DP = 0 = 10/0.11 = Rs. 90.91
0.11
2.5  [0.11/ 0.11(10  2.5)]
b. DP = 25% = 10/0.11 = Rs. 90.91
0.11

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5  [ 0.11/ 0.11(10  5 )]
c. DP = 50% = 10/0.11 = Rs. 90.91
0.11

7.5  [0.11/ 0.11(10  7.5)]

d. DP = 75% = 10/0.11 = Rs. 90.91
0.11
10  [0.11/ 0.11(10  10)]
e. DP = 100% = 10/0.11 = Rs. 90.91
0.11
Case III r<k (r = 8%, K = 11%)

0  [0.11/ 0.08 (10  0)]

a. DP = 0 = 13.75/0.08 = Rs. 171.88
0.08
2.5  [0.11/ 0.08 (10  2.5)]
b. DP = 25% = 12.81/0.08 = Rs. 160.13
0.08
5  [0.11/ 0.08 (10  5)]
c. DP = 50% = 11.88/0.08 = Rs. 107.95
0.08
7.5  [0.11/ 0.08 (10  7.5)]
d. DP = 75% = 10.94/0.08 = Rs. 99.43
0.08
10  [0.11/ 0.08 (10  10)]
e. DP= 100% = 10/0.08 = Rs. 90.91
0.08
Interpretation
The above workings can be summarised as follows:
 When r>k, that is, in growth firms, the value of shares is inversely
related to dividend policy (DP) ratio, as the DP increases, market
value of shares decline. Market value of share is highest when DP is
zero and is least when DP is 100%.
 When r=k, the market value of share is constant irrespective of the
DP ratio. The market value of the share is not affected, though the
firm retains the profits or distributes them.
 In the third situation, when r<k, in declining firms, the market price of
a share increases as the DP increases. There is a positive
correlation between the two.

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Limitations of Walter’s Model

 Walter has assumed that investments are exclusively financed by
retained earnings and no external financing is used.
 Walter’s model is applicable only to all-equity firms. Also, “r” is assumed
to be constant, which again is not a realistic assumption.
 Finally, Ke is also assumed to be constant and this ignores the business
risk of the firm which has a direct impact on the firm value.
Other than in hypothetical cases of r = k, in other cases where r>k and r<k,
according to the Walter model, the dividend policy of a firm is relevant for
maximising the share price of the firm.
Gordon’s Dividend Capitalisation Model
Myron Gordon also contends that dividends are relevant to the share prices
of a firm. Gordon uses the dividend capitalisation model to study the effect
of the firm’s dividend policy on the stock price.
Some assumptions regarding Gordon’s dividend capitalisation model are as
follows:
 The firm is an all-equity firm with no debt
 No external financing is used and only retained earnings are used to
finance any expansion schemes
 Constant return “r”
 Constant cost of capital “Ke”
 The life of the firm is indefinite
 The retention ratio “g = br” is constant forever
 Cost of capital is greater than br, that is, Ke > br
Gordon’s model assumes investors are rational and risk-averse. Investors
prefer certain returns to uncertain returns and therefore, they give premium
to the constant returns and discount to uncertain returns. Therefore, the
shareholders prefer current dividends to avoid risk. In other words, they
discount future dividends. Retained earnings are evaluated by the
shareholders as risky and therefore, the market price of the shares would be
adversely affected.
Gordon explains his theory with preference to the current income. Investors
prefer to pay higher price for stocks which fetch them current dividend
income. Gordon’s model can be symbolically expressed as:

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Where P is the price of the share,

E is earnings per share,
b is retention ratio,
(1 – b) is dividend payout ratio,
Ke is cost of equity capital,
br is growth rate (g) in the rate of return on investment

Caselet: Given Ke as 11%, E as Rs. 10, calculate the stock value of

Mahindra Tech. for (a) r=12%, (b) r=11% and (c) r=10% for various
levels of DP ratios given in table 15.1.
Table 15.1: Various Levels of DP Ratio
DP ratio (1 – b) Retention ratio
A 10% 90%
B 20% 80%
C 30% 70%
D 40% 60%
E 50% 50%

Solution
Case I r >k (r = 12%, K = 11%)
E ( 1 b )
P=
Ke  br
a. DP 10%, b 90%
10 (1 0.9 )
equals 1/.002 = Rs. 500
0.11 ( 0.9 * 0.12 )

b. DP 20%, b 80%
10 (1 0.8 )
equals 2/.014 = Rs. 142.86
0.11 ( 0.8 * 0.12 )

c. DP 30%, b 70%
10 (1  0.7 )
equals 3/.026 = Rs. 115.38
0.11  (0.7 * 0.12

d. DP 40%, b 60%
10 (1  0.6)
equals 4/.038 = Rs. 105.26
0.11  (0.6 * 0.12)

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e. DP 50%, b 50%
10 ( 1 0.5 )
equals 5/.05 = Rs. 100
0.11 ( 0.5 * 0.12 )

Case II r = k ( r = 11%, K = 11%)

E (1  b)
P=
Ke  br

a. DP 10%, b 90%

10 (1  0.8 )
equals 1/.011 = Rs. 90.91
0.11  (0.9 * 0.11)

b. DP 20%, b 80%
10 ( 1 0.8 )
equals 2/.022 = Rs. 90.91
0.11  ( 0.8 * 0.11)

c. DP 30%, b 70%
10 ( 1  0.7 )
equals 3/.033 = Rs. 90.91
0.11  ( 0.7 * 0.11)

d. DP 40%, b 60%
10 ( 1 0.6 )
equals 4/.044 = Rs. 90.91
0.11 ( 0.6 * 0.11)

e. DP 50%, b 50%

10 (1  0.5 )
equals 5/.55 = Rs. 90.91
0.11  (0.5 * 0.11)

Case III r<k ( r=10%, K=11%)

E (1  b)
P=
Ke  br

a. DP 10%, b 90%
10 (1  0.9)
equals 1/.02 = Rs. 50
0.11  (0.9 * 0.1)

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b. DP 20%, b 80%
10 (1 0.8 )
equals 2/.03 = Rs. 66.67
0.11 ( 0.8 * 0.1)

c. DP 30%, b 70%
10 (1  0.7)
equals 3/.04 = Rs. 75
0.11  (0.7 * 0.1)

d. DP 40%, b 60%
10 (1 0.6 )
equals 4/.05 = Rs. 80
0.11 ( 0.6 * 0.1)

e. DP 50%, b 50%
10 (1  0.5)
equals 5/.06 = Rs. 83.33
0.11  (0.5 * 0.1)

Interpretation
Gordon is of the opinion that dividend decision does have a bearing on
the market price of the share.
 When r > k, the firm’s value decreases with an increase in pay-out
ratio. Market value of share is highest when dividend policy (DP) is
least and retention highest.
 When r = k, the market value of share is constant irrespective of the
DP ratio. It is not affected whether the firm retains the profits or
distributes them.
 When r < k, market value of share increases with an increase in DP
ratio.

15.4 Miller and Modigliani Model

The Miller and Modigliani (MM) hypothesis seeks to explain that a firm’s
dividend policy is irrelevant and has no effect on the share prices of the firm.
This model advocates that it is the investment policy through which the firm
can increase its share value and hence, this should be given more
importance.

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Certain assumptions regarding Miller and Modigliani model are as follows:

 Existence of perfect capital markets – All investors are rational and
have access to all information, free of cost. There are no floatation or
transaction costs, securities are infinitely divisible and no single investor
is large enough to influence the share value.
 No taxes – There are no taxes, implying there is no difference between
capital gains and dividends.
 Constant investment policy – The investment policy of the company
does not change. The implication is that there is no change in the
business risk position and the rate of return.
 Certainty about future investments – The dividends and the profits of
the firm have no risk. This assumption was, however, dropped at a later
stage.
Based on the above assumptions, Miller and Modigliani have explained the
irrelevance of dividend as the crux of the arbitrage argument.
The arbitrage process refers to setting off or balancing two transactions
which are entered into investment programmes, simultaneously.
The two transactions which the arbitrate process refers to are:
 paying out dividends and
 raising external funds to finance additional investment programmes
If the firm pays out dividend, it will have to raise capital by selling new
shares for financing activities.
The arbitrage process will neutralise the increase in share value (due to
dividends) with the issue of new shares. This makes the investor indifferent
to dividend earnings and capital gains as the share value is more dependent
on the future earnings of the firm than on its current dividend policy.
Symbolically, the model is given as
Step I: The market price of a share in the beginning is equal to the PV of
dividends paid and market price at the end of the period.
1
P0 = * (D1 + P1)
(1 Ke)

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Where P0 is the current market price

P1 is market price at the end of period 1
D1 is dividends to be paid at the end of period 1
Ke is the cost of equity capital
Step II: Assuming there is no external financing, the value of the firm is:

1
nP0 = * (nD1 + nP1)
(1 Ke )

Where n is number of out-standing shares

Step III: If the firm’s internal sources of financing its investment
opportunities fall short of funds required, new shares are issued at the end
of year 1 at price P1. The capitalised value of the dividends to be received
during the period plus the value of the number of shares outstanding is less
than the value of new shares.

1
nP0 = * (nD1 + (n + n1)P1 – n1 P1)
(1 + Ke)

Firms will have to raise additional capital to fund their investment

requirements after utilising their retained earnings, that is,
n1 P1 = I – (E – nD1) which can be written as n1 P1 = I – E + nD1
Where I is total investment required,
nD1 is total dividends paid,
E is earnings during the period,
(E – n D1) is retained earnings.
Step IV: The value of share is thus:

1
nP0 = * (nD1 + (n + n1) P1 – I + E – nD1)
(1  Ke)

Or,

1
nP0 = * ((n + n1) P1 – I + E
(1  Ke)

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Thus, according to the MM Model, the market value of the share is not
affected by the dividend policy and this is explicitly shown in the final
equation as above. (Dividend does not figure in this equation used to
calculate the share price)

Caselet: A company has a capitalisation rate of 10%. Currently it has

outstanding shares worth Rs. 25,000, selling currently at Rs. 100 each.
The firm expects to have a net income of Rs. 400000 for the current
financial year and it is contemplating to pay a dividend of Rs. 4 per
share. The company also requires Rs. 600000 to fund its investment
requirement. Show that under MM model, the dividend payment does
not affect the value of the firm.

Solution:
Case I: When dividends are paid:
Step I:
1
P0 = * (D1 + P1)
(1  Ke)

100 = 1/(1+0.1) * (4 + P1)

P1 = Rs. 106

Step II:
n1 P1 = I – (E – nD1), nD1 is 25000*4
n1 P1 = 600000 – (400000 – 100000) = Rs. 300000

Step III: Number of additional shares to be issued

300000/106 = 2831 shares
Step IV: The firm value
(n  n1) P1 - I  E
nP0 = =
(1 Ke)

(25000  1819 ) *110  600000  400000

equals Rs. 2500000
(1 .10 )

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Case II: When dividends are not paid:

Step I:
1
P0 = * (D1 + P1)
(1  Ke)

100 = 1/(1+0.1) * (0 + P1)

P1 = Rs. 110

Step II:
n1P1 = I – (E – nD1), nD1 is 25000*4
n1P1 = 600000 – (400000 – 0) = Rs. 200000

Step III: Number of additional shares to be issued

200000/110 = 1819 shares

Step IV: The firm value

(n  n1)P1 - I  E
nP0 = =
(1  Ke)

(25000  1819 ) *110  600000  400000

equals Rs. 2500000
(1 0.1)

Thus, the value of the firm remains the same in both the cases whether
dividends are declared or dividends are not declared.

Critical Analysis of MM Hypothesis

The analysis of MM hypothesis considers the following costs (see
figure 15.2): transaction cost, floatation cost, under-pricing of shares.
Figure 15.2 depicts the analysis of MM hypothesis.

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Figure 15.2: Analysis of MM Hypothesis

Floatation cost
Miller and Modigliani have assumed the absence of floatation costs.
Floatation costs refer to the cost involved in raising capital from the market,
that is, the costs incurred towards underwriting commission, brokerage and
other costs.
Floatation costs ordinarily account for around 10%-15% of the total issue
and they cannot be ignored given the enormity of these costs. The presence
of these costs affects the balancing nature of retained earnings and external
financing.
External financing is definitely costlier than retained earnings. For instance,
if a share is issued worth Rs. 100 and floatation costs are 12%, then the net
proceeds are only Rs. 88.
Transaction cost
This is another assumption made by MM which implies that there are no
transaction costs like brokerage involved in capital market. These are the
costs associated with sale of securities by investors.
This theory implies that if the company does not pay dividends, the investors
desirous of current income sell part of their holdings without any cost
incurred. This is very unrealistic as the sale of securities involves cost;
investors wishing to get current income should sell higher number of shares
to get the income they are supposed to receive.

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Under-pricing of shares
If the company has to raise funds from the market, it should sell shares at a
price lesser than the prevailing market price to attract new shareholders.
This follows that at lower prices, the firm should sell more shares to replace
the dividend amount.
Market conditions
If the market conditions are bad and the firm has some lucrative
opportunities, it is not worth-approaching new investors at this juncture,
given the presence of floatation costs. In such cases, the firms should
depend on retained earnings and low pay-out ratio to fuel such
opportunities.

15.5 Stability of Dividends

Stability of dividends is the consistency in the stream of dividend payments.
This method relates to the payment of certain amount of minimum dividend
to the shareholders.
The steadiness is a sign of good health of the firm and may take any of the
following forms:
 constant dividend per share
 constant DP ratio
 constant dividend per share plus extra dividend
Constant dividend per share
As per this form of dividend policy, a firm pays a fixed amount of dividend
per share, year after year.

Example:
A firm may have a policy of paying 25% dividend per share on its paid-up
capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year
irrespective of its earnings. Generally, a firm following such a policy will
continue payments even if it incurs losses.
In such years, when there is a loss, the amount accumulated in the
dividend equalisation reserve is utilised. As and when, the firm starts
earning a higher amount of revenue, it will consider payment of higher
dividends and in future it is expected to maintain the higher level.

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Constant DP ratio
With this type of DP policy, the firm pays a constant percentage of net
earnings to the shareholders.
For example, if the firm fixes its DP ratio as 25% of its earnings, it implies
that shareholders get 25% of earnings as dividend, year after year. In such
years, when profits are high, they get higher amount.
Constant dividend per share plus extra dividend
Under this policy, a firm usually pays a fixed dividend ordinarily and in years
of good profits, additional or extra dividend is paid over and above the
regular dividend.
The stability of dividends is desirable due to the following advantages:
 Building confidence amongst investors – A stable dividend policy
helps to build confidence and remove uncertainty in investors. A
constant dividend policy will not have any fluctuations, thereby
suggesting the investors that the firm’s future is bright. In contrast,
shareholders of a firm having an unstable DP will not be certain about
their future in such a firm.
 Investors desire for current income – A firm has different categories of
investors –
o old and retired persons
o pensioners
o youngsters
o salaried class
o housewives
Of these, people like retired persons prefer current income. Their living
expenses are fairly stable from one period to another. Sharp changes in
current income, that is, dividends, may necessitate sale of shares. Stable
dividend policy avoids sale of securities and inconvenience to investors.
 Information about firms profitability – Investors use dividend policy as
a measure of evaluating the firm’s profitability. Dividend decision is a
sign of firm’s prosperity and hence a firm should have a stable DP.
 Institutional investors’ requirements – Institutional investors like LIC,
GIC and MF prefer to invest in companies with a record of stable DP. A
company having erratic DP is not preferred by these institutions. Thus, to

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attract these organisations which have large quantities of investible

funds, firms follow a stable DP.
 Raise additional finance – Shares of a company with stable and
regular dividend payments appear as quality investment rather than a
speculation. Investors of such companies are known for their loyalty and
whenever the firm comes with new issues, they are more responsive and
receptive. Thus, raising additional funds becomes easy.
 Stability in market – The market price of shares varies with the stability
in dividend rates. Such shares will not have wide fluctuations in the
market prices which is good for investors.
On account of the advantages discussed, the policy of constant dividend per
share plus extra dividend is preferred amongst investors.

Self Assessment Questions

1. ____________ constitutes an important source of financing
investment requirements of a firm.
2. Dividend policy has a direct influence on the two components of
shareholders’ return __________ and ____________.
3. ______________ considers that dividend pay-outs are relevant and
have a bearing on the share prices of the firm.
4. The __________ process refers to setting off or balancing two
transactions which are entered into simultaneously.
5. ______ costs refer to the cost involved in raising capital from the
market.
6. ______ are the costs associated with sale of securities by investors.

15.6 Forms of Dividends

Dividends are portions of earnings available to the shareholders. Generally,
dividends are distributed in cash, but sometimes they may also declare
dividends in other forms, as depicted in figure 15.3.

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Figure 15.3: Forms of Dividend

The forms of dividend are listed as follows:

 Cash dividend – Most companies pay dividends in cash. The investors
also, especially the old and retired investors, depend on this form of
payment for want of current income.
 Scrip dividend – In this form of dividends, equity shareholders are
issued transferable promissory notes with shorter maturity periods, which
may or may not bear interest. This form is adopted if the firm has earned
profits and it will take some time to convert its assets into cash (having
more of current sales than cash sales). Payment of dividend in this form
is done only if the firm is suffering from weak liquidity position.
 Bond dividend – Scrip and bond dividend are the same, except that
they differ in terms of maturity. Bond dividends carry longer maturity
periods and bear interest, whereas scrip dividends carry shorter maturity
periods and they may or may not carry interest.
 Stock dividend (bonus shares) – Stock dividend, as known in USA or
bonus shares, as known in India, is the distribution of additional shares
to the shareholders at no additional cost. This has the effect of
increasing the number of outstanding shares of the firm. The reserves
and surplus (retained earnings) are capitalised to give effect to bonus
issue. This decision has the effect of recapitalisation, that is, transfer
from reserves to share capital and not changing the total net worth. The

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investors are allotted shares in proportion to their present shareholding.

Declaration of bonus shares has a favourable psychological effect on
investors. They associate it with prosperity.
In this sub-section, we have discussed the four forms of dividends.

15.7 Stock Split

Before going into the concept of stock split, let us start with its definition.
A stock split is a method to increase the number of outstanding shares by
proportionately reducing the face value of a share.
The reasons for splitting shares are as follows:
 To make shares attractive – The prime reason for affecting a stock split
is to reduce the market price of a share to make it more attractive to
investors. Shares of some companies enter into higher trading zone
making it out-of-reach to small investors. Splitting the shares will place
them in more popular trading range thus providing marketability and
motivating small investors to buy them.
 Indication of higher future profits – Share split is generally considered
a method of management communication to investors, that the company
is expecting high profits in future.
 Higher dividend to shareholders – When shares are split, the
company does not resort to reducing the cash dividends. If the company
follows a system of stable dividend per share, the investors would surely
get higher dividends with stock split.
A stock split affects only the par value and does not have any effect on the
total outstanding amount in share capital.

Activity:
Obtain the Annual Reports of any two public limited companies and read
their policy regarding dividend.
Hint: visit web sites of any two public limited companies and down load the
Annual Reports.

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15.8 Summary
Let us recapitulate the important concepts discussed in this unit:
 Dividends are the earnings of the company distributed to shareholders.
Payment of dividend is not mandatory, but most companies see to it that
dividends are paid on a regular basis to maintain the image of the
company.
 As payment of dividend is not compulsory, the question which arises in
the minds of policy makers is “Should dividends be paid, if yes, what
should be the quantum of payment?”
 Various theories have come out with various suggestions on the
payment of dividend. B. Graham and D. L. Dodd are of the view that
there is a close relationship between the dividends and the stock market.
The stock value responds positively to high dividends and vice versa.
 Prof. James E. Walter considers dividend pay-outs are necessary but if
the firm’s ROI (rate of interest) is high, earnings can be retained as the
firm has better and profitable investment opportunities.
 Gordon also contends that dividends are significant to determine the
share prices of a firm. Shareholders prefer certain returns (current) to
uncertain returns (future) and therefore, they give premium to the
constant returns and discount to uncertain returns.
 Miller and Modigliani explain that a firm’s dividend policy is irrelevant and
has no effect on the share prices of the firm. They are of the view, that it
is the investment policy through which the firm can increase its share
value and hence this should be given more importance.
 Dividends can be paid out in various forms such as cash dividend, scrip
dividend, bond dividend and bonus shares.

15.9 Glossary
Stock split: A method to increase the number of outstanding shares by
proportionately reducing the face value of a share.

15.10 Terminal Questions

1. Write a short note on the different types of dividend.
2. What is stock split? What are its advantages?

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3. The following information (as shown in table 15.1) is available with

respect to a company. Calculate the price of the share as per Walter
model.
Table 15.1: Information of a Company

Equity capitalisation 15%

Earnings per share Rs.25
Dividend pay-out ratio 25%
Rate of interest (ROI) 12%

4. Considering the following information, what is the price of the share as

per Gordon’s Model?
Table 15.2: Details of the Company
Net sales Rs.120 lakhs
Net profit margin 12.5%
Outstanding preference shares Rs.50 lakhs@ 12% dividend
No. of equity shares 25, 000
Cost of equity shares 12%
Retention ratio 40%
Rate of interest (ROI) 16%

5. If the EPS is Rs.5, dividend pay-out ratio is 50%, cost of equity is 20%
and growth rate in the ROI is 15%. What is the value of the stock as per
Gordon’s Dividend Equalisation Model?
6. Nile Ltd. makes the following information available. What is the value of
the stock as per Gordon Model?
Ke 14%, EPS Rs. 20, D/P ratio 35% Retention ratio 65%, ROI 16%
7. What is the stock price as per Gordon Model, if DP ratio is 60% in the
above case?

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15.11 Answers

Self Assessment Questions

1. Retained earnings
2. Dividends and capital gains
3. Prof. James E. Walter
4. Arbitrage
5. Floatation costs
6. Transaction costs

Terminal Questions
1. Dividends are portions of earnings available to the shareholders.
Generally, dividends are distributed in cash, but sometimes they may
also declare dividends in other forms Refer to 15.6.
2. A stock split is a method to increase the number of outstanding shares
by proportionately reducing the face value of a share. Refer to 15.7.
3. Hint: Apply the formula – Walter’s formula to determine the market price
D [r(E - D) / Ke]
P = +
Ke Ke
E (1 - b)
4. Hint: Apply the Gordon formula of P = .
Ke - br
E (1 - b)
5. Hint: Apply the Gordon formula of P = .
Ke - br
E (1 - b)
6. Hint: Apply the Gordon formula of P = .
Ke - br
E (1 - b)
7. Hint: Apply the Gordon formula of P = .
Ke - br

15.12 Case Study: Maruti Suzuki India Limited

As you are aware, Maruti Suzuki India Limited (MSIL, formerly known as
Maruti Udyog Limited) is a subsidiary of Suzuki Motor Corporation, Japan.
MSIL has been the leader of the Indian car market for over two and a half
decades. The company has two manufacturing facilities located at Gurgaon
and Manesar, south of New Delhi, India. Both the facilities have a combined
capability to produce over a 1.2 million (1,200,000) vehicles annually.

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The company plans to expand its manufacturing capacity to 1.75 million by

2013.
The company offers a wide range of cars across different segments. It offers
15 brands and over 150 variants - Maruti 800, people movers, Omni and
Eeco, international brands Alto, Alto-K10, A-star, WagonR, Swift, Ritz and
Estilo, off-roader Gypsy, SUV Grand Vitara, sedans SX4, Swift DZire and
Kizashi. In an environment friendly initiative, in August 2010 Maruti Suzuki
introduced factory fitted CNG option on 5 models across vehicle segments.
These include Eeco, Alto, Estilo, WagonR and SX4.
In fiscal 2009-10, Maruti Suzuki became the only Indian company to
manufacture and sell One Million cars in a year.
Maruti Suzuki has employee strength over 8,500 (as at end March 2011).
In 2010-11, the company sold over 1.27 million vehicles including 1,38,266
units of exports. With this, at the end of March 2011, Maruti Suzuki had a
market share of 44.9 per cent of the Indian passenger car market.
The company is listed on Bombay Stock Exchange and National Stock
Exchange.
The following data provides information on various ratios as regards
profitability, EPS and liquidity of the company.
Maruti Suzuki India Ltd.
Ratios
Mar ' 11 Mar ' 10 Mar ' 09 Mar ' 08 Mar ' 07

Per share ratios

Adjusted EPS (Rs) 77.21 83.15 42.81 55.94 53.69

Adjusted cash EPS (Rs) 112.29 111.70 67.26 75.61 63.09

Reported EPS (Rs) 79.21 86.45 42.18 59.91 54.07

Reported cash EPS (Rs) 114.30 115.00 66.64 79.57 63.46

Dividend per share 7.50 6.00 3.50 5.00 4.50

Operating profit per share (Rs) 115.72 129.38 65.89 88.31 76.30

Book value (excl rev res) per

share (Rs) 479.99 409.65 323.45 291.28 237.23

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Book value (incl rev res) per

share (Rs.) 479.99 409.65 323.45 291.28 237.23

Net operating income per share

(Rs) 1,265.50 1,014.77 717.50 625.34 512.49

Free reserves per share (Rs) 474.32 403.82 318.45 286.28 231.89

Profitability ratios

Operating margin (%) 9.14 12.74 9.18 14.12 14.88

Gross profit margin (%) 6.37 9.93 5.77 10.97 13.05

Net profit margin (%) 6.13 8.34 5.72 9.34 10.29

Adjusted cash margin (%) 8.69 10.78 9.13 11.79 12.01

Adjusted return on net worth

(%) 16.08 20.29 13.23 19.20 22.63

Reported return on net worth

(%) 16.50 21.10 13.04 20.56 22.78

Return on long term funds (%) 21.74 28.80 17.48 27.35 30.74

Leverage ratios

Long term debt / Equity 0.02 0.03 0.06 0.05 0.08

Total debt/equity 0.02 0.06 0.07 0.10 0.09

Owners fund as % of total

source 97.81 93.51 93.04 90.33 91.57

Fixed assets turnover ratio 3.13 2.82 2.38 2.48 2.41

Liquidity ratios

Current ratio 1.49 1.02 1.53 1.03 1.42

Current ratio (inc. st loans) 1.47 0.91 1.51 0.91 1.40

Quick ratio 1.14 0.67 1.26 0.66 1.13

Inventory turnover ratio 33.33 30.47 30.46 22.93 28.76

Payout ratios

Dividend payout ratio

(net profit) 11.00 8.09 9.70 9.78 9.72

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Financial Management Unit 15

Dividend payout ratio

(cash profit) 7.62 6.08 6.14 7.36 8.28

Earning retention ratio 88.72 91.59 90.44 89.53 90.21

Cash earnings retention ratio 92.24 93.74 93.92 92.25 91.67

Coverage ratios

Adjusted cash flow time total

debt 0.09 0.25 0.35 0.41 0.34

Financial charges coverage

ratio 167.58 130.02 48.06 50.46 68.23

Fin. charges cov.ratio

(post tax) 136.33 100.18 38.75 39.57 49.76

Component ratios

Material cost component

(% earnings) 78.99 77.21 77.10 77.25 73.36

Selling cost Component 2.62 3.12 3.56 3.10 3.37

Exports as percent of total sales 9.56 15.49 7.24 4.10 3.90

Import comp. in raw mat.

consumed 11.99 12.89 11.70 10.84 12.62

Long term assets / total Assets 0.65 0.76 0.59 0.74 0.61

Bonus component in equity

capital (%) – – – – –

Dividend
Year Month Dividend (%)
2011 Apr 150
2010 Apr 120
2009 Apr 70
2008 Apr 100
2007 Apr 90
2006 Jul 70
2005 May 40
2004 May 30

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Discussion Questions:
1. On studying the data given above, do you find relevance between the
dividend policy /pay-out ratio and the EPS? Explain your stand.
(Hint: Refer Gorden Model)
2. What is the MM stand, regarding the relevance of dividends on the value
of the firm?
(Hint: Refer M & M Model)
3. Dividend pay outs convey information about the company. In this case,
what in your view is the management of Maruti Suzuki trying to convey
by declaring such dividends?
(Hint: Refer to significance of dividends)
(Source: http://www.marutisuzuki.com/about-us.aspx and
http://money.rediff.com )

References:
 Khan, Jain, (2005), Financial Management, 4th edition
 Pandey, I. M., (2005), Financial Management, 9th edition,
 Chandra Prasanna, (2005), Financial Management,6th edition
 Gupta, Shashi, & Gupta, Neeti, (2008), Financial Management, 2nd
edition
 Rustogi, (2010), Financial Management, 1st edition,.
 B. Graham and D. L. Dodd 3rd edition, McGraw Hill, New York, 1951

E-References
 Source: http://www.marutisuzuki.com/about-us.aspx and
http://money.rediff.com ) retrieved on 12/12/2011.

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