FINANCIAL MANAGEMENT

Module 1

1.1 Introduction

Financial management "is the operational activity of a business that is responsible for obtaining
and effectively utilising the funds necessary for efficient operations".

Financial management is concerned with three key activities namely:

Anticipating financial needs
Acquiring financial resources
Allocating funds in business

Traditionally, financial management was considered as a branch of knowledge with focus on

the procurement of funds. Instruments of financing, formation, merger and restructuring of
firms, legal and institutional framework involved etc. occupied the prime place in this
approach.

Modern phase has shown the commendable development with combination of ideas from
economic and statistics that led the financial management more analytical and quantitative. The
key work area of this approach is rational matching of funds to their uses, which leads to the
maximisation of shareholders' wealth.

1.2 Scope of Financial Management or Functions of financial management / Broad

areas of financial decision making / Types of financial decisions

Financial management as an academic discipline has undergone fundamental changes with

regard to its scope and coverage. In the earlier years, it was treated synonymously with the
raising of funds. In the later years, its broader scope, included in addition to the procurement
of funds, efficient use of resources.
Financial management provides a conceptual and analytical framework for financial decision
making. The finance function covers both acquisition of funds as well as their allocations. Thus,
apart from the issues involved in acquiring external funds, the main concern of financial
management is the efficient and wise allocation of funds to various uses. The principal contents
of the modern approach to financial management can be said to be: (i) How large should an
enterprise be, and how fast should it grow? (ii) In what form should it hold assets? and (iii)
What should be the composition of its liabilities? The three questions posed above cover the
major financial problems of a firm.
In other words, the financial management, according to the new approach, is concerned with
the solution of three major problems relating to the financial operations of a firm, corresponding
to the three questions of investment, financing and dividend decisions. Thus, financial
management, in the modern sense of the term, can be broken down into three major decisions
as functions of finance: (i) The investment decision, (ii) The financing decision, and (iii) The
dividend policy decision.

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Investment decisions
It begins with a determination of the total amount of assets needed to be held by the firm. It
relates to the selection of assets, on which a firm will invest funds. The required assets fall into
two groups namely: Long term assets and short term assets.
Long-term assets: This involves huge investment and yield a return over a period of time in
future. It is also termed as 'Capital budgeting' and can be defined as the firm's decision to
invest its current funds most efficiently in fixed assets with an expected flow of benefits
over a series of years.
Capital budgeting is probably the most crucial financial decision of a firm. It relates to the
selection of an asset or investment proposal or course of action whose benefits are likely to be
available in future over the lifetime of the project. The long-term assets can be either new
or old/existing ones. The first aspect of the capital budgeting decision relates to the choice of
the new asset out of the alternatives available or the reallocation of capital when an existing
asset fails to justify the funds committed. The second element of the capital budgeting decision
is the analysis of risk and uncertainty. Since the benefits from the investment proposals extend
into the future, their accrual is uncertain. They have to be estimated under various assumptions
of the physical volume of sale and the level of prices. Finally, the evaluation of the worth of a
long-term project implies a certain norm or standard against which the benefits are to be
judged. The requisite norm is known by different names such as cut-off rate, hurdle rate,
required rate, minimum rate of return and so on. This standard is broadly expressed in terms of
the cost of capital. The concept and measurement of the cost of capital is, thus, another major
aspect of capital budgeting decision. In brief, the main elements of capital budgeting decisions
are: (i) the long-term assets and their composition, (ii) the business risk complexion of the firm,
and (iii) the concept and measurement of the cost of capital.

Short-term assets: These are the current assets that can be converted into cash within a financial
year without diminution in value. Investment in current assets is termed as 'Working capital
management'.
Working capital management is concerned with the management of current assets. It is an
important and integral part of financial management as short-term survival is a prerequisite for
long-term success. One aspect of working capital management is the trade-off between
profitability and risk (liquidity). There is a conflict between profitability and liquidity. If a firm
does not have adequate working capital, that is, it does not invest sufficient funds in current
assets, it may become illiquid and consequently may not have the ability to meet its current
obligations and, thus, invite the risk of bankruptcy. If the current assets are too large,
profitability is adversely affected. The key strategies and considerations in ensuring a trade- off
between profitability and liquidity is one major dimension of working capital management. In
addition, the individual current assets should be efficiently managed so that neither
inadequate nor unnecessary funds are locked up. Thus, the management of working capital has
two basic ingredients: (1) an overview of working capital management as a whole, and (2)
efficient management of the individual current assets such as cash, receivables and inventory.

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Financing decisions
The second major decision involved in financial management is the financing decision. The
investment decision is broadly concerned with the asset-mix or the composition of the assets
of a firm. The concern of the financing decision is with the financing-mix or capital structure
or leverage. The term capital structure refers to the proportion of debt (fixed- interest sources
of financing) and equity capital (variable-dividend securities/source of funds). The financing
decision of a firm relates to the choice of the proportion of these sources to finance the
investment requirements. Financing decisions also relate to theacquisition of funds at the least
cost.

Dividend Decision
This is the third financial decision, which relates to dividend policy. Dividend is a part of profits
that are available for distribution, to equity shareholders. Payment of dividends should be
analyzed in relation to the financial decision of a firm. There are two options available in
dealing with the net profits of a firm, viz., distribution of profits as dividends to the ordinary
shareholders’ or they can be retained in the firm itself if they require, for financing of any
business activity. But distribution of dividends or retaining should be determined in terms of
its impact on the shareholders’ wealth. The Financial manager should determine optimum
dividend policy, which maximizes market value of the share thereby market value of the firm.
Considering the factors to be considered while determining dividends is another aspect of
dividend policy.

1.3 Goals or Objectives of Financial Management—Profit Maximization vs. Wealth

Maximization

Traditional Approach—Profit Maximization

It has been traditionally argued that the objective of a company is to earn profit. This means
that the finance manager has to make decision in a manner that the profit is maximised. Each
alternative, therefore, is to be seen as from the stand point of its ability to maximise profit for
the firm.
(Firm refers to any business entity that is engaged in selling goods and services)

Points in favor of profit maximization

Profit is a barometer through which performance of a business unit can bemeasured.
Profit ensures maximum welfare to the shareholders, employees and prompts payment
to creditors of a company.
Profit maximization attracts the investors to invest their savings in securities.
Profit indicates the efficient use of funds for different requirements
Profit max increases the confidence of management in expansion

Profit maximization objective gives rise to a number of problems as below:

1. Profit maximization concept should be considered in relation to risks involved. There
is a direct relationship between risk and profit. Many risky propositions yield high

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 profit. Higher the risk, higher is the possibility of profits. If profit maximization is the
only goal, then risk factor is altogether ignored.
2. Profit maximization, as an objective does not take into account time value of returns.
Example: Proposal A may give a higher amount of profits compared to proposal B,
yet if the returns begin to flow say, 10 years later, proposal B may be preferred, which
may have lower overall profits but the returns flow is earlier and quicker.
3. Profit maximization, as an objective is too narrow. It fails to take into account the other
obligations of the business to various factors such as - interests of workers, consumers,
society as well as ethical trade practices. Further, most business leaders believe that
adoption of ethical standards strengthen their competitive positions.
4. Profits do not necessarily result in cash flows available to the stockholder. Shareholders
receive cash flow in the form of either cash dividend paid to them or proceeds from
selling their shares for a higher price than paid initially.

Modern Approach—Wealth Maximization

Wealth maximisation refers to maximising the net wealth of the company's shareholders.
Wealth maximisation is means company aims to pursue such policies that would increase
the market value of shares of the company. This is also known as Value Maximization. Wealth
or Value is represented by the market price of the company’s equity shares. Prices in the share
market at a given point of time, are the result of many factors like general economic outlook,
particularly if the companies are under consideration, technical factors and even mass
psychology. However, taken on a long-term basis, the share market prices of a company’s
shares do reflect the value, which the various parties put on a company.

If the company earns a higher rate of earning per share through risky operations or risky
financing pattern, the investors will not look upon its shares with favour. To that extent, the
market value of the shares of such a company will be impacted. However, if a company invests
its fund in risky ventures, the investors will put in their money if they get higher return as
compared to that from a low risk share.

Role of Stakeholders
Stakeholders are groups such as employees, customers, suppliers, creditors, owners and others
who have a direct economic link with the firm. A firm with a stakeholder focus, consciously
avoids actions that would prove detrimental to stakeholders. The goal is not to maximize
stakeholder well-being but to preserve it. It is expected to provide long-run benefit to
shareholders by maintaining positive stakeholder relationships. Such relationship should
minimize stakeholder turnover, conflicts and litigation. Clearly, the firm can better achieve its
goal of shareholder wealth maximization by maintaining cooperation with other stakeholders
rather than having conflict with them.

The Role of Ethics

Ethics is standards of conduct or moral judgment. Today, the business community in general
and the financial community in particular are developing and enforcing ethical standards,
purpose being to motivate business and market participants to adhere to both the letter and the
spirit of laws and regulations concerned with business and professional practice. An effective
ethics programme is believed to enhance corporate value. An ethics programme can reduce
potential litigation and judgment costs, maintain a positive corporate image, and

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build shareholders’ confidence, and gain the loyalty, commitment and respect of the firm’s
stakeholders. Such actions, by maintaining and enhancing cash flow and reducing perceived
risk, can positively affect the firm’s share prices. Ethical behaviour is, therefore, viewed as
necessary for achieving the firm’s goal of owner wealth maximization.

Agency Problem
In a joint stock company, owners are different from the person who is managing the day to day
affairs of the company. The separation of the “ownership” (principal) and the “control” (agent)
in principle-agent relationships create the grounds for potential conflict of interests between
the two parties. This is known as agency problem since Managers are the agents appointed by
the owners (shareholders). When the objectives of shareholders and managers are not in
tandem, there arises a conflict of interest known as ‘agency problem’. Manager may focus on
taking such decisions which can bring quick results to the company in terms of higher profits
or move up market price of the stock in the short term. However, in this process, they may take
up certain risky proposals / business decisions which may hamper the growth of the company
in the long run if things do not go as planned.

1.4 Place of Finance Function in the Organizational Structure

The finance function is almost the same in most enterprises. The details may differ but the
important features are universal in nature. The finance function occupies such a major place
that it cannot be the sole responsibility of the executive. The important aspects of the finance
function have to be carried on by the top management i.e., the Managing Director and the Board
of Directors. It is the Board of Directors, which makes all the material final decisions involving
finance.
Financial management in many ways is an integral part of the jobs of managers who are
involved in planning, allocation of resources and control. The responsibilities for financial
management are disposed throughout the organization.

Example:
1. The engineer, who proposes a new plant, shapes the investment policy of the firm.
2. The marketing analyst provides inputs in the process of forecasting and planning.
3. The purchase manager influences the level of investment in inventories.
4. The sales manager has a say in the determination of receivable policy.
5. Departmental managers, in general, are important links in the financial control system of
the firm.

The Chief Financial Officer (CFO) is basically to assist the top management. He has an
important role to contribute to good decision-making on issues that involve all the functional
areas of the business. He must clearly bring out financial implications of all decisions and make
them understood.
CFO (his designation varies from company to company) works directly under the President
or the Managing Director of the company. Besides routine work, he keeps the Board of
Directors informed about all the phases of business activity, including economic, social and
political developments affecting the business behaviour. He also furnishes information about
the financial status of the company by reviewing from time-to-time. The CFO may have
different officers under him to carry out his functions ; Treasury function (headed by

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financial manager) is commonly responsible for handling financial activities, such as financial
planning and fund raising, making capital expenditures decisions, managing cash, managing
credit activities, managing the pension fund and managing foreign exchange. The control
function (headed by Chief Accountant/Financial Controller) typically handles the accounting
activities such as corporate accounting, tax management, financial accounting and cost
accounting.

Org. Structure of Finance Function

1.5 Relationship of Finance with other disciplines / functional areas

Relation to Economics
The field of finance is closely related to economics. Financial managers must be able to use
economic theories as guidance for efficient business operation. Example: supply-demand
analysis, profit-maximizing strategies, and price theory.
The primary economic principle used in managerial function is marginal analysis, the principle
that financial decisions should be made and actions taken only when the added benefits exceed
the added costs. Nearly all financial decisions ultimately come down to an

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assessment of their marginal benefits and marginal costs. Financial managers must understand
the economic framework and be alert to the consequences of varying levels of economic
activity and changes in economic policy.

Relation to Accounting
The firm’s finance (treasurer) and accounting (controller) activities are closely related and
generally overlapped. Normally, managerial finance and accounting are not often easily
distinguishable. In small firms, the controller often carries out the finance function and in large
firms many accountants are also involved in various finance activities. There are two basic
differences between finance and accounting:
1. Emphasis on cash flows: The accountant’s primary function is to develop and report data for
measuring the performance of the firm, assuming its financial position and paying taxes using
certain standardized and generally accepted principles. The accountant prepares financial
statements based on accrual basis. The financial manager places primary emphasis on cash
flows, the inflow and outflow of cash.
2. Use of decision-making: Accountants devote most of their operation to the collection and
presentation of financial data. The primary activities of the financial manager in addition to
ongoing involvement in financial analysis and planning are making investment decisions and
making financing decisions. Investment decisions determine both the mix and the type of assets
held by the firm. Financing decisions determine both the mix and the type of financing used
by the firm. However, the decisions are actually made on the basis of cash flow effects on the
overall value of the firm.
In short, accounting provides input required for financial decision making.

Relation to Marketing, Production and Statistics

Apart from economics and accounting, finance also draws—for its day-to-day decisions—on
supportive disciplines such as marketing, production and quantitative methods. For instance,
financial managers should consider the impact of new product development and promotion
plans made in marketing area since their plans will require capital outlays and have an impact
on the projected cash flows. Similarly, changes in the production process may necessitate
capital expenditures which the financial managers must evaluate and finance. And, finally, the
tools of analysis developed in the quantitative methods area are helpful in analysing complex
financial management problems. The marketing, production and quantitative methods are, thus,
only indirectly related to day to-day decision making by financial managers and are supportive
in nature while economics and accounting are the primary disciplines on which the financial
manager draws substantially.

1.6 Changing role of financial manager

Modern financial management has come a long way from the traditional corporate finance. The
finance manager is working in a challenging environment, which changes continuously. As the
economy is opening up and global resources are being tapped, the opportunities available to
finance manager have no limits. At the same time, one must understand the risk in the decisions.
Financial management is passing through an era of experimentation and excitement, as a large
part of the finance activities carried out today were not heard of a few years ago.

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A few instances are enumerated below:
1. Interest rates have been deregulated. Further, interest rates are fluctuating, and minimum
cost of capital necessitates anticipating interest rate movements.
2. The rupee has become freely convertible in current account.
3. Optimum debt equity mix is possible. Firms have to take advantage of the financial leverage
to increase the shareholders wealth. However, financial leverage entails financial risk. Hence
a correct trade-off between risk and improved rate of return to shareholders is a challenging
task.
4. With free pricing of issues, the optimum price of new issue is a challenging task, as
overpricing results in under subscription and loss of investor confidence, whereas under-
pricing leads to unwarranted increase in a number of shares and also reduction of earnings per
share.
5. Maintaining share prices is crucial. In the liberalized scenario, the capital markets are the
important avenue of funds for business. The dividend and bonus policies framed have a direct
bearing on the share prices.
6. Ensuring management control is vital, especially in the light of foreign participation in
equity (which is backed by huge resources) making the firm an easy takeover target. Existing
managements may lose control in the eventuality of being unable to take up the share
entitlements. Financial strategies to prevent this are vital to the present management.

Methods and Tools of Financial Management

• In the area of financing, funds are procured from long-term sources as well as short-
term sources. Long-term funds may be made available by owners, i.e., shareholders,
lenders through issue of debentures/bonds, from financial institutions, banks and public
at large. Short-term funds may be procured from commercial banks, suppliers of goods,
public deposits etc. The finance manager has to decide on optimum capital structure
with a view to maximize shareholder’s wealth. Financial leverage or trading on equity
is an important method by which return to shareholders can be increased.
• For evaluating capital expenditure (investment) decisions, a finance manager uses
various methods such as average rate of return, payback, internal rate of return, net
present value and profitability index.
• In the area of working capital management, there are various methods for efficient
utilization of current resources at the disposal of the firm, thus increasing profitability.
• The centralized method of cash management is considered a better method ofmanaging
liquid resources of the firm.
• In the area of dividend decision, a firm is faced with the problem of declaring dividend
or postponing dividend declaration, a problem of internal financing. There are tools to
tackle such situation.
• For the evaluation of a firm’s performance, there are different methods. Example: Ratio
analysis is a popular technique to evaluate different aspects of a firm.
• The main concern of the finance manager is to provide adequate funds from the best
possible source, at the right time and the minimum cost and to ensure that the funds so
acquired are put to best possible use through various methods/techniques are used to
determine that funds have been procured from the best possible available

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 services and the funds have been used in the best possible way. Funds flow and cash
flow statements and projected financial statements help a lot in this regard.
Time Value of Money

Introduction

This unit is concerned with interest rates and their effects on the value of money. Interest rates
have widespread influence over decisions made by businesses and by us in personal lives.
Corporations pay lakhs of rupees in interest each year for the use of money they have borrowed.
We earn money on sums we have invested in savings accounts, certificate of deposit, and
money market funds. We also pay for the use of money that we have borrowed for education
loans, vehicle loans, home loans, or credit card purchases. We will first examine the nature of
interest and its computation. Then, we will discuss several investment solutions and
computations related to each.

Time value of money

Money available at present is more valuable than money value in future.

Interest - The compensation for waiting is the time value of money is called interest. Interest is
a fee that is paid for having the use of money.

Example: Interest on mortgages (home loans) for having the use of bank’s money. Similarly,
the bank pays us interest on money invested in savings accounts or certificates of deposit
because it has temporary access to our money. The amount of money that is lent or invested is
called principal. Interest is usually paid in proportion and the period of time over which the
money is used. The interest rate is typically stated as a percentage of the principal per period of
time.
Example: 18 per cent per year or 1.5 per cent per month.

Simple Interest - Interest that is paid solely on the amount of the principal is called simple
interest. Simple interest is usually associated with loans or investments that are very short-
term in nature. The computation of simple interest is based on the following formula: Simple
interest = Principal × Interest rate per time period × Number of time period

Compound Interest: Compound Interest occurs when interest earned during the previous
period itself earns interest in the next and subsequent periods.

If 1000 is placed into savings account paying 6% interest per year, interest accumulates as
follows:

Principal invested in the first year 1000.00

Interest for first year ( 1000 × 0.06 × 1) 60.00

Amount available at end of first year 1060.00

Interest for second year ( 1060 × 0.06 × 1) 63.60

Amount available at end of second year 1123.60

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The interest earned in the second year is greater than 60 because it is earned on the principal
plus the first year’s interest.

If the savings account pays 6% interest compounded quarterly, 1.5% interest is added to the
account each quarter, as follows:

Principal invested in the first year 1000.00

Interest for first quarter ( 1000 × 0.06 × 1 × 1/4) 15.00
Amount available at end of first quarter 1015.00

Interest for second quarter ( 1015 × 0.06 × 1 × 1/4) 15.23

Amount available at end of second quarter 1030.23
Interest for third quarter ( 1030.23 × 0.06 × 1 × 1/4) 15.45
Amount available at end of third quarter 1045.68

Interest for fourth quarter ( 1045.68 × 0.06 × 1 × 1/4) 15.69

Amount available at end of first year 1061.37

With quarterly compounding, the initial investment of 1000 earned 1.37 more interest
inthe first year than with annual compounding.

2.1 Future Value of single cash flow (one-time payment/receipt)

A sum of money invested today at compound interest accumulates to a larger sum called the
amount or future value. The future value of 1000 invested at 6% compounded annually for 2
years is 1123.60. The future value includes the original principal and the accumulated interest.
The future value varies in accordance with the interest rate, the compounding frequency and the
number of periods.

For example, at 8% interest per period, a principal investment of Re. 1 accumulates as

follows:

Future value of 1 at 8% for 1 period = 1.00000 × 1.08 = 1.08000

Future value of 1 at 8% for 2 periods = 1.08000 × 1.08 = 1.16640
Future value of 1 at 8% for 3 periods = 1.16640 × 1.08 = 1.25971

The general formula for the future value of any amount is -

FV= PV (1+ r)n

PV – Present value
FV – Future value after ‘n’ period
n - the number of compounding period r
- rate of interest

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Using this formula, future values can be calculated for any interest rate and any number of
time periods.

Future value can also be computed using the appropriate factor from the Future Value table
(FVIF table).

FV = PV (FVIF r,n)

2.2 Intra-year compounding or discounting (frequency is less than one year)

If the frequency of cash flow is less than one year – half-yearly, quarterly, monthly or weekly,
the compounding/discounting happens at the end of every period.

In this case, the ‘n’ will be the number years multiplied with frequency per year;

Half-yearly or bi-annually – ‘n’ to be multiplied by 2

Quarterly – ‘n’ to be multiplied by 4
Monthly – ‘n’ to be multiplied by 12

Rate of interest or compounding rate will be divided by the number of frequency per year.
E.g. if the rate of interest per year is 10% but the compounding cycle is half-yearly, then ‘r’
will be 5% for each period (10% divided by 2)

2.3 Nominal and effective interest rate

If interest rate is paid on an annual basis (compounded annually) it is known as nominal interest
rate; If compounding is done more than once a year, the actual annualised rate of interest would
be higher than the nominal interest rate and it is known as effective interest rate

Effective interest rate = (1 + r/m ) m -1

r = annual interest rate m

= frequency per year

2.4 Present Value of single cash flow or lupmsum

If 1 can be invested at 8% today to become 1.08 in the future, then 1 is the present value of the
future amount of 1.08. The present value of future receipts of money is important in business
decision-making. It is necessary to decide how much future receipts are worth todayin order to
determine whether an investment should be made or how much should be invested. Finding the
present value of future receipts involves discounting the future value to the present. Discounting
is the opposite of compounding. It involves finding the present value of some future amount of
money that is assumed to include interest accumulations.

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For example, assuming 8% interest per period, present values of Re. 1 can be constructed as
follows:

Present value of 1 discounted for 1 period at 8% = 1.0/1.08 = 0.92593 Present

value of 1 discounted for 2 periods at 8% = 0.92593/1.08 = 0.85734 Present
value of 1 discounted for 3 periods at 8% = 0.85734/1.08 = 0.79383

Formula for computing present value of any amount is -

PV = 1
FV (1+r)
n

Present value can also be computed using the appropriate factor from the PV table (PVIF table)

PV = FV (PVIF r,n)

2.7 Annuities

An annuity is a series of equal payments made at equal time intervals, with compounding or
discounting taking place at the time of each payment. Loan installment purchases (EMI),
Recurring deposits, Contribution to sinking fund, pension plans and any such recurring
expenses or incomes are examples of annuities.

Hint – Any expense or income incurred more than once on a regular or periodic basis
and each cash flow amount is even (uniform), it should be considered as an annuity and
apply the annuity formula;

If the expense or income is one-time, apply the lump-sum formula for

it.2.8 Future Value of Annuity (Uniform cash flows)

Or

Alternatively, it can also be computed by referring to the future value interest factor for annuity
table -

FVA = A (FVIFA r, n)
FVA = Future Value of
Annuity A = Annuity
FVIFA = Future value interest factor for annuities (table)

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2.9 Present value of annuity (Uniform cash flows)

PVA =

Or

Alternatively, it can also be computed by referring to the present value interest factor
for annuity table -

PVA = A (PVIFA r,n)

PVA = Present value of annuity

FVIFA = Present value interest factor for annuities (table)

2.10 Loan Amortization

Loan is an amount raised from outsiders at an interest and repayable at a specified

period. Payment of loan in the form of installment is known as amortization.
Installment amount needs to be first computed using the present value of annuity
formula, as installment is a form of annuity.

PVA = A (PVIFA)

PVA = Annuity or Installment

amount PVIFA
Once the installment is found out, amortization schedule is to be prepared in a tabular
format like below; At end the end of the last year/month, the outstanding balance
should be Nil.

Amortization schedule format

Year/ Beginnin Annual/ Interest Principal Outstandin

Month gloan Monthly Amoun Repaymen g loan
amount Installmen t(Rs.) t(Rs.) balance
(Rs.) t(Rs.) (Rs.)

2.10 Present value of perpetuity

Perpetuity is an annuity (either expense or income) of infinite duration – incurred

continuously/ forever/ perpetually.

Present value of a perpetuity = Perpetual Annuity Amount

Interest rate
PV of a perpetuity = A / r

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Important Theory Questions:
1. What are the three functions of financial management?
2. Explain the goals of Financial Management
3. How is Financial Management related to other functional areas?
4. Differentiate between Simple Interest and Compound Interest.
5. Why is Wealth Maximization preferred more than Profit Maximization?
6. Analyze the changing role of Finance Manager.
7. Explain the Organisation structure of Finance function.
8. ‘A rupee today is more valuable than a rupee tomorrow’, Elucidate with reasons.
9. What do you mean by Perpetuity? How do we compute the present value of a
perpetuity?
10. Differentiate between Effective and Nominal Interest rate.

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 Module 2: Cost of Capital

Sources of Long-term Financing

1. Equity Shares (Ordinary shares)

A share in the ownership capital of a business ; Each shareholder share the reward and risks
associated with the ownership of a business enterprise

Features of equity shares

• Residual claim to income – Entitled to the remaining income / profits (residual) of the
company after all outside claims are met
• Residual claim on assets - in the event of liquidation of the company
• Voting rights - Each shareholder is entitled to one vote for each share held ; Legal right
to elect board of directors and participation in the decision making by way of voting
• Pre-emptive rights – is a legal right of existing shareholders to be offered by the
company in the first opportunity to purchase additional equity shares in proportion to
their current holdings
• Liability is limited to the extent of their investment

2. Term loans
It’s a long-term loan given by a bank or financial institution to a business having an initial
maturity period of more than one year; Also known as project finance

Features of term loans

• Security – all terms loans are secured; secured loan means it has specific assets pledged
as collateral; Collateral involves the items used by a borrower to back up a loan or any
asset against which a lender has a legal claim if the borrower defaults on some
provisions of the loan agreement
• Maturity – ranges between 5 to 10 years
• Negotiated – terms of the loans are negotiated between the borrowers and the lenders
(customised)
• Restrictive covenants – contractual clauses in loan agreements that place certain
operating and financial constraints on the borrower

3. Debentures

A debt instrument indicating that a company has borrowed certain sum of money and
promises to repay it in future under clearly defined terms
Features
• Interest – The debenture carry a fixed rate of interest, the payment of which is
legally binding and enforceable
• Maturity – Length of time for redemption (usually 7-10 years)
 • Trust indenture – A trustee is appointed through an indenture or trust deed; It’s a legal
agreement between issuing company and trustee (usually a FI/bank/law firm) stating
the conditions under which debenture has been issued
• Debenture redemption reserve (sinking fund)– has to be created for all debentures
before commencement of redemption
• Claim on income and assets - higher priority as compared to equity / preference
shareholders
• Credit rating – by credit rating agencies (CRISIL, ICRA, CARE) is mandatory
• Security – can be secured against present or future immovable assets
• Convertibility – Some debentures can also be converted into equity shares at the option
of debentures holders (debentures without this feature called as Non Convertible
Debentures)
• Call provision – Provides an option to the issuing company to redeem the debentures
at a specified price before the maturity
Put provision – Provides an option to the debenture holder to seek redemption at
specified time at predetermined price

4. Hybrid Financing Instruments

Hybrid source of financing has characteristics of both debt and equity. They are – Preference
shares; Convertible bonds/debentures

4.1 Preference Shares

Preference shares has a preferential claim over equity shares both on income and assets of the
company. It combines some features of equity as well as debentures. It is also called as a fixed
income security

Features
• It carries a fixed rate of dividend
• Prior claim on income and assets – Dividends to preference shareholders must be
paid in full before any dividend on equity shares; In the event of liquidation, the
whole of preference capital must be paid before anything is paid to equity
shareholders (but after repaying debenture holders)
• No voting rights
• Redeemable - Preference capital has a fixed maturity (unlike equity) after which it
must be retired
• Convertibility – Can be convertible partly or fully into equity shares at a certain ratio
during a specified period
• Dividend on preference capital is paid out of Profit After Tax and hence not tax-
deductible
• Dividend can be carried forward and paid later (cumulative dividend)
• Do not require any charge against any asset
4.2 Convertible Debentures / Bonds

‘Convertible’ means – right or option to convert a finance instrument; Convertible debentures

give the debenture holders right or option to convert them into equity shares on certain terms.
Holders are entitled to a fixed income till the conversion option is exercised and would share
the benefits associated with equity shares after the conversion; Conversion ratio – ratio at
which a convertible debenture can be exchanged for shares Conversion price – is the per share
price paid for the equity shares at the time of conversion Conversion time – period from the
date of allotment after which the option can be exercised.

Features
• A company may issue Compulsorily Convertible Debentures (CCD) or
Optionally Convertible debentures
• It can be Fully Convertible (FCD) or Partly Convertible (PCD)
• All details about the conversion terms are specified in the offer document or
prospectus
• Credit rating is mandatory for fully convertible debentures

5. Warrants

A warrant entitles its holders to subscribe to the equity capital of a company during a specified
period at a certain price; The holder has only the right but no obligation to buy the equity shares.
They are generally issued in conjunction to debentures or bonds.
• Exercise price – It is the price at which holders of warrant can purchase a specified
number of shares
• Expiry date – Date after which the option to buy shares can not be exercised (life of a
warrant); Usually 5 to 10 years
• Detachable and Non-detachable – A detachable warrant can be sold separately which
means the holder can continue to retain the instrument without holding the warrant;
these are listed independently in the stock exchanges trading.
• Exercise of warrant infuses new capital unlike convertibles

6. Lease financing
Leasing is a process by which a firm can obtain the use of a certain fixed asset for which it
must make a series of contractual, periodic, tax-deductible payments / rentals. At the end of
the lease period, the lease could either be
- Terminated and asset reverts to the lessor
- Lease is renewed for X period
- Asset is transferred from lessor to lessee

Features/ Elements
• Parties to the contract - Lessor is the owner of the assets that are being leased;
Lessee is the receiver of the services of the assets
• Ownership separated from user – ownership of assets vests with the lessor and only the
use of asset is allowed to the lessee
 • Assets – Could be property, equipment, automobile, machinery and so on
• Lease rentals – Consideration that the lessee pays to the lessor
• Term of lease – it is the period for which the agreement of lease payments is in
operation

Classification

Finance lease
• lessee has the option to select the asset as per his requirement
• the duration or term of the lease is for major part of the useful life of the
asset;
• responsibility of maintenance of the asset rests with the lessee (insurance,
servicing etc.)
• risk and reward incidental to the ownership of the asset is transferred to the
lessee
• Lease agreement transfers the ownership to the lessee before the lease
expires; Examples – Aircraft

Operating
lease • are for a duration or term shorter than the useful life of the asset
• as the duration of lease is short, lessor leases the asset to multiple
users/lessees over life of the asset
• responsibility of maintenance of asset is on the lessor;
• Risk and rewards incidental to the ownership of the asset rests with
the lessor ; Examples – computers, office equipment etc.

7. Venture capital (VC)

• Venture capital is equity finance in relatively new businesses when it is too early to
go to the capital market to raise funds. It is a financial intermediary between investors
looking for high potential returns and entrepreneurs who need institutional capital;
Financing at early stage of the business venture include – financing the seed capital
(pre start-up), start-up stage, second round financing
• VCs are categorized as Alternate Investment Fund (AIF) and regulated by SEBI
Alternate Investment Fund Regulations, 2012 (Category 1); An AIF is a privately
pooled investment vehicle which collects funds from investors whether Indian or
foreign for investing in accordance with a defined investment policy
• Venture capital Fund (or institution) (VPI/VCF) - invests primarily in unlisted
securities of start-up, emerging/early-stage ventures, technology/IP right based
activities, new business model;
• Business venture which receives such capital is called venture capital undertaking
(VCU) ; it is a company not listed on a stock exchange at the time of investment
Features of VC in India
• Governed by SEBI Venture Capital Fund Regulations, 1996
• They are authorized to raise money from Indian, Foreign and NRI investors
• VC fund can not invest more than 25% corpus of the fund in one VCU
• It should invest at least 66.67% of the investible funds in unlisted equity shares or
equity linked instruments of VCU

Angel Investing
• Angel investing is also meant for investing in start-up or early stage business
ventures or social ventures; It pools in funds by way of issue of units to angel
investors
• Angel investor refers to
• an individual investor who has net tangible assets of at least 2 crore rupees
excluding the value of his residence and who has experience as – serial
entrepreneur or early-stage investment experience or senior management
professional with 10 year’s experience
• a company with a net worth of at least 10 crore rupees
• A minimum investment of INR 25 lacs from each investor to the investment fund and
minimum corpus of at least INR 5 crores
• It can be established in the form of a company or trust or limited liability partnership
(LLP)
• It is also categorized as AIF category 1 as per SEBI regulations; Both VC and
Angel investment are privately pooled investment vehicle.

8. Private Equity (PE)

• It is categorized as Category 2 Alternate Investment Fund (AIF) as per SEBI
Regulations. PE fund invests primarily in equity and equity linked instruments
according to the stated objective of the fund
• PE firm can have a maximum of 1000 investors and with a minimum deposit of INR
1 crore per investor. It should not undertake leverage or borrowing other than for its
working capital needs
• PE firms mostly buy established companies with an intention of owning 100% of the
shares. They usually prefer to concentrate on a single company which has proven its
worth in the market. They may also invest in unsubscribed portion of IPO through the
underwriter.
Examples – Kotak Private Equity, ICICI Venture Fund, Bain Capital, Baring
PrivateEquity, The Carlyle Group

1. COST OF CAPITAL-MEANING

When a business entity procures finances or funds, it has to pay some additional amount of
money besides the principal amount. The additional money paid is said to be the cost of using
the capital and it is called as ‘cost of capital’. Cost of capital of a company is the average cost
of the various capital components employed by it. Put differently, it is the average rate of return
required by the investors who provide capital to the company. Cost of capital is the return
expected by the providers of capital (lenders, shareholders, debt- holders) to the business as a
compensation of their contribution to the total capital.
Considering the firm’s main goal of maximizing the wealth of shareholders, company should
earn a rate of return on its investments which is more than the its cost of capital. Hence, Cost
1
of capital is also known as ‘cut off rate’ or ‘hurdle rate’ or ‘minimum rate of return’

Significance of Cost of capital

• Maximization of the Value of the Firm: For the purpose of maximization of value of
the firm, a firm tries to minimize the average cost of capital. There should be judicious
mix of debt and equity in the capital structure of a firm so that the business does not to
bear undue financial risk.
• Capital Budgeting Decisions: Proper estimate of cost of capital is important for a firm
in taking capital budgeting decisions. Generally, cost of capital is the discount rate used
in evaluating the desirability of the investment project. In the internal rate of return
method, the project will be accepted if it has a rate of return greater than the cost of
capital
• Decisions Regarding Leasing: Estimation of cost of capital is necessary in taking
leasing decisions of business concern.
• Management of Working Capital: In management of working capital the cost of
capital may be used to calculate the cost of carrying investment in receivables and to
evaluate alternative policies regarding receivables. It is also used in inventory
management also.
• Dividend Decisions: Cost of capital is significant factor in taking dividend decisions.
The dividend policy of a firm should be formulated according to the nature of the firm—
whether it is a growth firm, normal firm or declining firm. However, the nature of the
firm is determined by comparing the internal rate of return (r) and the cost of capital (k)
i.e., r > k, r = k, or r < k which indicate growth firm, normal firm and decline firm,
respectively.
• Determination of Capital Structure: Cost of capital influences the capital structure
of a firm. In designing optimum capital structure that is the proportion of debt and
equity, due importance is given to the overall or weighted average cost of capital of the
firm. The objective of the firm should be to choose such a mix of debt and equity so
that the overall cost of capital is minimized.
• Evaluation of Financial Performance: The concept of cost of capital can be used to

2
 evaluate the financial performance of top management. This can be done by comparing
the actual profitability of the investment project undertaken by the firm with the overall
cost of capital.

• Making Investment Decision: Cost of capital is used as discount factor in determining

the net present value. Similarly, the actual rate of return of a project is compared with
the cost of capital of the firm. Thus, the cost of capital has a significant role in making
investment decisions.
• Evaluating the Performance: Cost of capital is the benchmark of evaluating the
performance of different departments. The department is considered the best which can
provide the highest positive net present value to the firm. The activities of different
departments are expanded or dropped out on the basis of their performance.

Factors Affecting Cost of Capital

The cost of capital is affected by several factors, some beyond the control of the firm and others
dependent on the investment and financing policies of the firm.

Factors Outside a Firm's Control

The three most important factors, outside a firm's direct control, that have a bearing on the cost
of capital are the level of interest rates, the market risk premium, and the tax rate.

The Level of Interest Rates If interest rates in the economy rise, the cost of debt to firms
increases and vice versa. Interest rates also have a similar bearing on the cost of preference and
cost of equity. Remember that the risk-free rate of interest is an important component of the
CAPM, a model widely used for estimating the cost of equity.

Market Risk Premium The market risk premium reflects the perceived riskiness of equity
stocks and investor aversion to risk. A factor beyond the control of individual firms, the market
risk premium affects the cost of equity directly and the cost of debt indirectly (through a
substitution effect).

Tax Rates The tax policy of the government has a bearing on cost of capital. The corporate tax
rate has a direct impact on the cost of debt as used in the weighted average cost of capital. The
capital gains tax rate relative to the rate on ordinary income has an indirect effect on the cost
of equity relative to the cost of debt.

Factors Within a Firm's Control

The cost of capital of a firm is affected by its investment policy, capital structure policy, and
dividend policy.

Investment Policy - To estimate the cost of capital, we start with the rates of return required
on the outstanding equity and debt of the firm. These rates reflect how risky the firm's existing
assets are. If a firm plans to invest in assets similar to those currently used, then its marginal
cost of capital would be more or less the same as its current cost of capital. On the other hand,
if the riskiness of its proposed investments is likely to be very different

3
from the riskiness of its existing investments, its marginal cost of capital should reflect the
riskiness of the proposed investments.

Capital Structure Policy - To calculate the WACC we assumed a given target capital
structure. Of course, a firm can change its capital structure and such a change is likely to affect
the cost of capital because the post-tax cost of debt is lower than the cost of equity and equity
beta, an input for calculating the cost of equity is a function of financial leverage.

Dividend Policy - The dividend policy of a firm may affect its cost of equity.

Problems/Challenges in determining cost of capital

1. Disagreement regarding the dependence of cost of capital upon the method and level
of financing:
There is a, major controversy whether or not the cost of capital dependent upon the method
and level of financing by the company. According to some scholars, the cost of capital of a
firm depends upon the method and level of financing. On the other hand, the modern scholars
such as Modigliani and Miller the firm’s total cost of capital argue that is independent of the
method and level of financing.
2. Computation of Cost of Equity: The determination of the cost of equity capital is another
problem. In theory, the cost of equity capital may be defined as the minimum rate of return that
accompany must earn on that portion of its capital employed, which is financed by equity
capital so that the market price of the shares of the company remains unchanged.
3. Computation of Cost of Retained Earnings and Depreciation Funds: The cost of capital
rose through retained earnings and depreciation funds will depend upon the approach adopted
for computing the cost of equity capital. Since there are different views, therefore, a finance
manager has to face difficult task in subscribing and selecting an appropriate approach.
4. Future Costs versus Historical Costs: It is argued that for decision-making purposes, the
historical cost is not relevant. The future costs should be considered. It, therefore, creates
another problem whether to consider marginal cost of capital, i.e., cost of additional fundsor
the average cost of capital, i.e., the cost of total funds.
5. Problem in assigning weights: The assignment of weights to each type of funds is a
complex issue. The finance manager has to make a choice between the risk value of each source
of funds and the market value of each source of funds. The results would be different in each
case.

4
2. COMPUTATION OF SPECIFIC COST OF CAPITAL

A firm obtains capital from various sources. As explained earlier, because of the risk
differences and the contractual agreements between the firm and investors, the cost of capital
of each source of capital differs. The cost of capital of each source of capital is known as
component, or specific, cost of capital. The combined cost of all sources of capital is called
overall, or average cost of capital. The component costs are combined according to the weight
of each component capital to obtain the average costs of capital. Thus, the overall cost is called
the weighted average cost of capital (WACC)

The mix of debt and equity is called the firm’s capital structure. Because of the connection
between the sources of capital and the firm’s desire to have a target capital structure in the long
run, it is generally agreed that the cost of capital should be used in the composite, overall sense-
in terms of weighted average cost of capital.
The overall cost of capital is the weighted average cost of the various sources of capital.

Suppose a firm has the cost of equity of 11 per cent and cost of debt of 6 per cent.
If the long-run proportions of debt and equity in the above-mentioned example respectively are
60 per cent and 40 per cent, then the WACC or the combined cost of capital is: 0.06 ×
0.60 + 0.11 × 0.40 = 0.8 or 8 per cent. Thus, both Projects A and B should be accepted since
each of them is expected to yield a rate of return higher than the overall cost of capital.
Accepting both Projects A and B will maximize the shareholders’ wealth

Cost of Debt

A company may raise debt in a variety of ways. It may borrow funds from financial institutions
or public either in the form of public deposits or debentures (bonds) for a specified period of
time at a certain rate of interest. A debenture or bond may be issued at par or at a discount or
premium as compared to its face value. The contractual rate of interest or the coupon rate forms
the basis for calculating the cost of debt.

2.1 Cost of Term loan

Kd = r (1-t) OR I (1-t)
P
r = Rate of interest
I = Amount of Interest payment
P = Principal amount
t = tax rate applicable

2.2 Cost of debentures

Key terms related to debentures

Par value – Face value of bond or debenture as specified in the document / certificate Coupon
rate – Rate of interest on bond or debenture as mentioned in the document/ certificate

5
Maturity period – Number of years after which the par value is payable to thedebenture/bond
holder
Market value – Price at which the bond or debenture is traded in secondary market; It can be
more or less than the face value
Premium on issue – Amount by which a debenture is issued higher than its face value Discount
on issue - Amount by which a debenture is issued lower than its face value Premium on
redemption – Amount higher than the face value at the time of repayment to debenture holder

Formula of cost of debentures

Kd = I (1-t) + (RV-NP)
n
(RV + NP) / 2

Kd = Cost of debenture/debt
I = Annual interest payment on debentures (Rupee value) t
= Tax rate applicable for the company
n = Term of the debenture or maturity period
RV = Redemption value per debenture (debenture value during repayment at the end ofterm)
NP = Net Proceeds of issue per debentures or Current market value of debentures NP
in case of issue at par = Face value – floatation cost, if any
NP in case of discount on issue = Face value- discount on issue – floatation cost NP
in case of premium on issue = Face value + premium on issue – floatation cost

When Maturity period is not provided (Irredeemable

debt)

Kd = I (1-t)
NP

2.3 Cost of Preference capital

In the case of debt, there is a binding legal obligation on the firm to pay interest, and the interest
constitutes the basis to calculate the cost of debt. However, in the case of preference capital,
payment of dividends is not legally binding on the firm and even if the dividends are paid, it is
not a business expense; rather it is a distribution or appropriation of earnings to preference
shareholders. Hence, cost of preference capital is a function of the dividend expected by
investors.

The concept behind calculating cost of preference shares is similar to that of debentures
with two exceptions
- Dividend is paid instead of interest
- Preference shares dividends are not tax deductible ; Hence, no adjustment for income tax

6
Kp = D + (RV-NP)
n
(RV + NP) /
2

D = Dividend per share (rupee value)

N = Term of preference shares
RV = Redemption value per preference shares
NP = Net Proceeds of issue per preference share or market price of preference shares

NP in case of issue at par = Face value – floatation cost

NP in case of discount on issue = Face value- discount on issue – floatation cost NP
in case of premium on issue = Face value + premium on issue – floatation cost

2.4 Cost of Equity

Equity finance may be obtained in two ways: (i) retention of earnings, and (ii) issue of
additional equity. The cost of equity or the return required by equity shareholders is the same
in both the cases. Note that when a firm decides to retain earnings, an opportunity cost is
involved. Shareholders could have received the earnings as dividends and invested the same in
alternative investments of comparable risk to earn a return. So, irrespective of whether a firm
raises equity finance by retaining earnings or issuing additional equity shares, the cost of equity
is the same.

Cost of equity can be defined as the minimum rate of return that a company must earn on the
equity financed portion of an investment or project in order to have no negative impact on the
market price of its shares

While the cost of debt and preference can be determined fairly easily, the cost of equity is rather
difficult to estimate. This difficulty stems from the fact that there is no definite commitment on
the part of the firm to pay dividends. Because of this, scholars have suggested various models
to come up with reasonably good estimates of the cost of equity by employing some basic
principles.

Dividend Growth Model

Under this approach, the cost of equity capital is defined as ‘the discount rate that equals the
present value of all expected future dividends per share with the current value of the shares’.
Myron J Gordon was the one who proposed it first and hence this approach is known as Gordon
Model.

Calculation of cost of equity on the basis of dividend approach has the following
components –
i) Net proceeds from the sale of share or current market price of share
ii) Dividend paid or expected dividend
iii) Expected future growth rate of dividends

7
Cost of Equity (Ke) as per Dividend Approach

Ke = D1 +g
Po

D1 = Expected dividend per share

Po = Net proceeds per share after deducting flotation cost and discount on issue, if any OR Current
Market Price of the share
g = Growth rate in expected dividends

Capital Asset Pricing Model (CAPM)

It is a model used to determine a theoretically appropriate required rate of return for equity
shares. It describes the relationship between the required return (cost of equity capital) and the
non-diversifiable risk of a firm.
CAPM shows that expected return on an equity share is equal to the risk-free return plus a risk
premium.
This theory was introduced by William F Sharpe building on the earlier work of Harry
Markowitz on modern portfolio theory. They jointly won Nobel prize in Economics for their
contribution.

The model considers the following aspects

Risk – Is measured as fluctuations in the market price of shares (volatility of returns) in relation
to the fluctuations of overall market; It is denoted as Beta

Diversifiable risk / unsystematic risk- Risk resulting from factors specific to the company
; this risk can be reduced by way of diversification

Non-diversifiable risk / systematic risk - Risk resulting from external market forces which
are common to all companies ; this risk cannot be diversified as it affects all the companies

Beta – Measure of fluctuations in market price of shares of a particular company incomparison

to the fluctuations in the overall stock market ;

Beta = Correlation between Standard deviation of returns of share Standard

specific share & overall market deviation of returns of market

Beta of more than 1 means share of a company’s share price has more fluctuations than the
overall market movement ; Beta of less than 1 means company’s share price movements less
fluctuating than the overall market ; Overall market has a beta of 1. The beta of the stock may
be calculated by regressing the monthly returns on the stock over the monthly returns on the
market index over the past 60 months or more

8
Risk-free return – Returns without any volatility / fluctuations or returns from a risk-free asset
(e.g., government bonds) The yields on the government Treasury securities with a maturity
period of less than a year are used as the risk-free rate. Since investments are long- term
decisions, few analysts prefer to use yields on long-term government bonds (say, 10 or 15-year
government bonds) as the risk-free rate. We should always use the current risk-free rate rather
than the historical average.

The market risk premium may be estimated as the difference between the average return on
the market portfolio and the average risk-free rate over the past 10 to 15 years - the longer the
period, the better it is.

CAPM Formula

Ke = Rf + b (Rm – Rf)

Ke = Cost of equity
Rf = Risk free rate of return
Rm = Required rate of return on a market portfolio / index (overall market) b
= Beta coefficient
Km- Rf = Risk premium

Suppose in the year 2013 the risk-free rate is 6 per cent, the market risk premium is 9 per
cent and beta of L&T’s share is 1.54.
The cost of equity for L&T is:
Ke for L and T = 0.06 + 0.09 × 1.54 = 0.1986 = 20 %

The CAPM is based on the following assumptions:

• Investors are risk averse.
• Security returns are normally distributed.
• The utility function of investors is quadratic.
• Investors have homogeneous expectations -they have identical subjective estimates of
the means, variances, and covariances among returns.
• Investors can borrow and lend freely at a riskless rate of interest.
• The market is perfect: there are no taxes; there are no transactions costs; securities are
completely divisible; the market is competitive.
• The quantity of risky securities in the market is given

Advantages of the CAPM

Systematic Risk - The CAPM takes into account systematic risk (beta), which is left out of
other return models, such as the dividend discount model (DDM). Systematic or market risk is
an important variable because it is unforeseen and, for that reason, often cannot be completely
mitigated

Diversified Portfolio -The assumption that investors hold a diversified portfolio, similar to the
market portfolio, eliminates unsystematic (specific) risk.

9
Risk Premium - CAPM allows investors to take the risk premium of an investment into
consideration and use it for further decision-making. Risk premium is the expected return on
an investment in excess of the risk-free rate of return. The risk premium of investment allows
investors or companies to determine the value of return for the risk they are taking. The risk
premium will be high for startup companies and relatively lower for established companies.

Limitations CAPM
• Historical returns are considered for computing market returns and it may not be
representative of future market returns
• Beta coefficient is subject to change varying from period to period ; this unstable
nature of beta may not be reflective of the true risk involved
• Investors may not hold diversified portfolios as assumed by CAPM model

Cost of Equity - CAPM vs Dividend Growth model

The dividend-growth approach has limited application in practice because of, it assumes
that the dividend per share will grow at a constant rate, g, forever. This assumption imply that
the dividend-growth approach cannot be applied to those companies, which are not paying any
dividends, or whose dividend policies are highly volatile. The dividend-growth approach also
fails to deal with risk directly. In contrast, the CAPM has a wider application although it is
based on restrictive assumptions. The only condition for its use is that the company’s share is
quoted on the stock exchange. Also, all variables in the CAPM are market determined and
except the company specific share price data, they are common to all companies. The value of
beta is determined in an objective manner by using sound statistical methods. One practical
problem with the use of beta, however, is that it does not normally remain stable over time.

2.5 Cost of Retained Earnings (Kr)

In brief, the cost of retained earnings represents an opportunity cost in terms of the return on
their investment in another enterprise by the firm whose cost of retained earnings is being
considered. Cost of retained earnings is the same as the cost of an equivalent fully subscribed
issue of additional shares, which is measured by the cost of equity capital.
The opportunity cost given by the external yield criterion which can be consistently applied
can be said to measure the Kr , which is likely to be equal to the Ke . Therefore, Ke should be
used as Kr. However, the latter could be lower than the former due to differences in flotation
cost.

3. COMPUTATION OF OVERALL COST OF CAPITAL

The computation of the overall cost of capital (represented symbolically by ko) involves the
following steps: 1. Assigning weights to specific costs. 2. Multiplying the cost of each of the
sources by the appropriate weights. 3. Dividing the total weighted cost by the total weights.
The crucial part of the exercise is the decision regarding appropriate weights and the related
aspects

10
Assignment of Weights

The weights to specific funds may be assigned, based on the following:

1. Book Values: Book value weights are based on the values found on the balance
sheet. The weight applicable to a given source of fund is simply the book value of the
source of fund divided by the book value of the total funds.

2. Market Value Weights: Under this method, assigned weights to a particular

component of capital structure is equal to the market value of the component of capital
divided by the market value of all components of capital and capital employed by the
firm.

In the absence of any information in the question, we should consider market value
for assigning weights since market value method is considered as more appropriate.

4. MARGINAL COST OF CAPITAL

Companies may raise additional funds for expansion. Here, a financial manager may
be required to calculate the cost of additional funds to be raised. The cost of additional
funds is called marginal cost of capital. For example, a firm at present has 1,00,00,000
capital with WACC of 12 per cent, but it plans to raise 5,00,000 for expansion, such
as additional funds, the cost that is related to this 5 lakhs is marginal cost of capital.
The weighted average cost of new or incremental, capital is known as the marginal
cost of capital. The marginal cost of capital is the weighted average cost of new capital
using the marginal weights. The marginal weights represent the proportion of various
sources of funds to be employed in raising additional funds.

Important Theory Questions

• What do you mean by cost of capital?

• Name the factors affecting cost of capital
• What do you mean by Warrant? / Warrants and convertibles?
• What is meant by CAPM? Outline its different assumptions / assumptions
of CAPM model / Explain CAPM in detail / merits and demerits of CAPM
approach of cost of equity
• What is hybrid financing?
• What is venture capital? Venture capital financing?
• Explain the sources of finance / discuss various sources of long-term funds
• State the differences between angel investing and private equity
• Discuss the cost and benefits of going public to raise long term finance
• What are floatation costs
• Differentiate between debenture and equity
• What are cumulative preference shares
• What is the conservative approach to financing a firm’s funds requirements?
• What is lease financing; explain its types
• What is seed capital ?

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 MODULE 3- CAPITAL BUDGETING

MEANING

The investment decisions of a firm are generally known as the capital budgeting,
or capital expenditure decisions. A capital budgeting decision may be defined as
the firm’s decision to invest its current funds most efficiently in the long-term
assets in anticipation of an expected flow of benefits over a series of years. The
long-term assets are those that affect the firm’s operations beyond the one-year
period.

The firm’s investment decisions would generally include expansion, acquisition,

modernization and replacement of the long-term assets.
It is important to note that investment in the long-term assets invariably requires
large funds to be tied up in the current assets such as inventories and receivables.
As such, investment in fixed and current assets is one single activity.

The following are the features of investment decisions:

• The exchange of current funds for future benefits
• The funds are invested in long-term assets
• The future benefits will occur to the firm over a series of years

It is significant to emphasize that expenditures and benefits of an investment

should be measured in cash. In the investment analysis, it is cash flow, which is
important, and not the accounting profit. Theoretically, two alternative criteria are
available to quantify the benefits:

(i) accounting profit and (ii) cash flows

The basic difference between them is primarily due to the inclusion of certain
non-cash expenses in the profit and loss account, for instance, depreciation.
Therefore, the accounting profit is to be adjusted for non-cash expenditures to
determine the actual cash inflow. The cash flow approach of measuring future
benefits of a project is superior to the accounting approach as cash flows are
theoretically better measures of the net economic benefits of costs associated with
a proposed project.

It may also be pointed out that investment decisions affect the firm’s value. The
firm’s value will increase if investments are profitable and add to the
shareholders’ wealth. Thus, investments should be evaluated on the basis of a
criterion, which is compatible with the objective of Shareholder Wealth
Maximization. An investment will add to the shareholders’ wealth if it yields
benefits in excess of the minimum benefits, as per the opportunity cost of capital.
1
Importance of Capital Budgeting

Investment decisions require special attention because of the following reasons:

• They influence the firm’s growth in the long run
• They affect the risk of the firm
• They involve commitment of large amount of funds

2
 • They are irreversible, or reversible at substantial loss
• They are among the most difficult decisions to make

Growth The effects of investment decisions extend into the future and have to be
endured for a longer period than the consequences of the current operating
expenditure. A firm’s decision to invest in long-term assets has a decisive
influence on the rate and direction of its growth. A wrong decision can prove
disastrous for the continued survival of the firm; unwanted or unprofitable
expansion of assets will result in heavy operating costs to the firm. On the other
hand, inadequate investment in assets would make it difficult for the firm to
compete successfully and maintain its market share.

Risk A long-term commitment of funds may also change the risk complexity of
the firm. If the adoption of an investment increases average gain but causes
frequent fluctuations in its earnings, the firm will become more risky. Thus,
investment decisions shape the basic character of a firm.

Funding Investment decisions generally involve large amount of funds, which

make it imperative for the firm to plan its investment programmes very carefully
and make an advance arrangement for procuring finances internally or externally.

Irreversibility Most investment decisions are irreversible. It is difficult to find a

market for such capital items once they have been acquired. The firm will incur
heavy losses if such assets are scrapped.

Complexity Investment decisions are among the firm’s most difficult decisions.
They are an assessment of future events, which are difficult to predict.

CAPITAL BUDGETING PROCESS (Steps in capital budgeting)

Capital budgeting is a complex process which may be divided into the following
phases:
■ Identification of potential investment opportunities
■ Assembling of proposed investments
■ Decision making
■ Preparation of capital budget and appropriations
■ Implementation
■ Performance review

Identification of Potential Investment Opportunities The capital budgeting

process begins with the identification of potential investment opportunities.
Typically, the planning body (it may be an individual or a committee organised
formally or informally) develops estimates of future sales which serve as the basis
3
for setting production targets. This information, in turn, is helpful in identifying
required investments in plant and equipment, research and development,
distribution, and so on.
For imaginative identification of investment ideas- it is helpful to (i) monitor
external environment regularly to scout investment opportunities, (ii) formulate
a well-defined corporate strategy based on a thorough analysis of strengths,
weaknesses, opportunities, and threats, (iii) share corporate strategy and
perspectives with persons who are involved in the

4
process of capital budgeting, and (iv) motivate employees to make suggestions.

Assembling of Investment Proposals Investment proposals identified by the

production department and other departments are usually submitted in a
standardised capital investment proposal firm. Generally, most of the proposals,
before they reach the capital budgeting committee or somebody which assembles
them, are routed through several persons. The purpose of routing a proposal
through several persons is primarily to ensure that the proposal is viewed from
different angles. It also helps in creating a climate for bringing about co-
ordination of interrelated activities.

Investment proposals are usually classified into various categories for

facilitating decision making, budgeting, and control. An illustrative classification
is given below.
1. Replacement investments
2. Expansion investments
3. New product investments
4. R&D investments
5. Obligatory and welfare investments

Decision Making A system of rupee gateways usually characterises capital

investment decision making. Under this system, executives are vested with the
power to okay investment proposals up to certain limits. For example, in one
company the plant superintendent can okay investment outlays up to Rs.200,000,
the works manager up to Rs.500,000, and the managing director up to Rs.
2,000,000. Investments requiring higher outlays need the approval of the board
of directors.

Preparation of Capital Budget and Appropriations Projects involving smaller

outlays and which can be decided by executives at lower levels are often covered
by a blanket appropriation for expeditious action. Projects involving larger
outlays are included in the capital budget after necessary approvals. Before
undertaking such projects an appropriation order is usually required. The purpose
of this check is mainly to ensure that the funds position of the firm is satisfactory
at the time of implementation. Further, it provides an opportunity to review the
project at the time of implementation.

Implementation Translating an investment proposal into a concrete project is a

complex, time-consuming, and risk-fraught task. Delays in implementation,
which are common, can lead to substantial cost-overruns. For expeditious
implementation at a reasonable cost, the following are helpful. Adequate
formulation of projects The major reason for delay is inadequate formulation of
projects.
Put differently, if necessary homework in terms of preliminary studies and
5
comprehensive and detailed formulation of the project is not done, many surprises
and shocks are likely to spring on the way. Hence, the need for adequate
formulation of the project cannot be over- emphasised. Use of the principle of
responsibility accounting Assigning specific responsibilities to project managers
for completing the project within the defined time-frame and cost limits is helpful
for expeditious execution and cost control.

Use of network techniques For project planning and control several network
techniques like PERT (Programme Evaluation Review Technique) and CPM
(Critical Path Method) are

6
available. With the help of these techniques, monitoring becomes easier.

Performance Review Performance review, or post-completion audit, is a

feedback device. It is a means for comparing actual performance with projected
performance. It may be conducted, most appropriately, when the operations of the
project have stabilised.
It is useful in several ways:
(i) it throws light on how realistic were the assumptions underlying the project;
(ii) it provides a documented log of experience that is highly valuable for decision-
making;
(iii) it helps in uncovering judgmental biases; and (iv) it induces a desired
caution among project sponsors.

TYPES OF INVESTMENT DECISIONS

Project analysis entails time and effort. The costs incurred in this exercise must be
justified by the benefits from it. Certain projects, given their complexity and
magnitude, may warrant a detailed analysis; others may call for a relatively simple
analysis. Hence firms normally classify projects into different categories. Each
category is then analysed somewhat differently. Following are the main types of
investment decisions.

Mandatory Investments These are expenditures required to comply with

statutory requirements. Examples of such investments are pollution control
equipment, medical dispensary, fire fighting equipment, creche in factory
premises, and so on. These are often non-revenue producing investments. In
analysing such investments the focus is mainly on finding the most cost-effective
way of fulfilling a given statutory need.

Replacement Projects Firms routinely invest in equipments meant to replace

obsolete and inefficient equipments, even though they may be in a serviceable
condition. The objective of such investments is to reduce costs (of labour, raw
material, and power), increase yield, and improve quality. Replacement projects
can be evaluated in a fairly straightforward manner, though at times the analysis
may be quite detailed.

Expansion Projects These investments are meant to increase capacity and/or

widen the distribution network. Such investments call for an explicit forecast of
growth. Since this can be risky and complex, expansion projects normally warrant
more careful analysis than replacement projects. Decisions relating to such
projects are taken by the top management.

7
Diversification Projects These investments are aimed at producing new products
or services or entering into entirely new geographical areas. Often diversification
projects entail substantial risks, involve large outlays, and require considerable
managerial effort and attention. Given their strategic importance, such projects
call for a very thorough evaluation, both quantitative and qualitative. Further, they
require a significant involvement of the board of directors.

Research and Development Projects Traditionally, R&D projects absorbed a

very small proportion of capital budget in most Indian companies. Things,
however, are changing. Companies are now allocating more funds to R&D
projects, more so in knowledge-intensive

8
industries. R&D projects are characterised by numerous uncertainties and
typically involve sequential decision making. Hence the standard discounted cash
flow analysis is not applicable to them. Such projects are decided on the basis of
managerial judgment. Firms which rely more on quantitative methods use
decision tree analysis and option analysis to evaluate R&D projects.

Miscellaneous Projects This is a catch-all category that includes items like

interior decoration, recreational facilities, executive aircrafts, landscaped gardens,
and so on.
Corporate social responsibility (CSR) projects or contributions, which are now
assuming greater significance , may also be included here. There is no standard
approach for evaluating these projects and decisions regarding them are based on
personal preferences of top management.

EVALUATION TECHNIQUES/METHODS OF CAPITAL BUDGETING

A. Traditional Techniques of Evaluation

Payback Period

Sometimes called the pay out method i.e., a computationally simple project
evaluation approach
that has been used for many years. The procedure is to determine how long
it takes a project to
return the cost of the original investment.

The project with a lower payback period will be preferred. Sometimes, the
management lays
down policy guidelines regarding payback period.

Payback period = Initial

Investment
Annual cash
flow

Example – An investment of Rs. 40,000 in a machine is expected to produce cash

flow of Rs. 8,000 for 10 years; Payback period would be = 40,000/8,000 = 5 years

Merits
1. This method is quite simple and easy to understand; it has the advantage of
making it clear that there is no profit of any project unless the payback is over.
When funds are limited, it is always better to select projects having shorter
9
payback periods. This method is suitable to industries where the risks of
obsolescence are very high.
2. The payback period can be compared to a break-even point, the point at which
costs are fully recovered, but profits are yet to commence.
3. The risk associated with a project arises due to uncertainty associated with the
cash inflows. A shorter payback period means less uncertainty towards risk.

10
Limitations
1. The method does not give any considerations to time value of money. Cash
flows occurring at all points of time are simply added.
2. This method becomes a very inadequate measure of evaluating two projects
where cash inflows are uneven.
3. It stresses capital recovery rather than profitability. It does not take into account
the returns from a project after its payback period. Therefore, this method may
not be a good measure to evaluate where the comparison is between two projects
one involving a long gestation period and other yielding quick results only for a
short period.

Accounting Rate of Return (ARR)

The accounting rate of return (ARR) method of evaluating capital budgeting

projects is so named because it parallels traditional accounting concepts of
income and investment. A project
is evaluated by computing a rate of return on the investment, using accounting
measures of net
income. The formula for the accounting rate of return is:

ARR = Average Annual Profit X

100 Average Investment

• Average annual profit is calculated by adding up all the projected PAT over
the entire life of the project and then dividing by the life of the project
• Average book value of the investment over the entire life of the project
• Alternatively, only Initial Investment instead of average cost of
investment can be used

Merits: This method is quite simple and popular because it is easy to understand
and includes income from the project throughout its life.
Limitations:
1. This method ignores the timing of cash flows, the duration of cash flows and the
time value of money.
2. It is based upon a crude average of profits of the future years. It ignores the
effect of fluctuations in profits from year to year.

Conclusion: The traditional techniques of appraising capital investment decision

have two major
drawbacks:
1. They do not consider total benefits throughout the life of the project and
2. timing of cash inflows is not considered.
11
B. Discounted Cash Flow Methods

Discounted cash flow refers to the fact that all projected cash inflows and
outflows for a capital
budgeting project are discounted to their present value using an approximate interest
rate.

All discounted cash flow methods are based on the time value of money, which
means that an
amount of money received now is worth more than an equal amount of money
received in future. Money in hand can be invested to earn a return.

1. Net Present Value (NPV)

Under this method, all cash inflows and outflow are discounted at a minimum
acceptable rate of
return, usually the firm’s cost of capital. If the present value of the cash inflows is
greater than the present value of the cash outflows, the project is acceptable i.e.,
NPV > 0, accept and NPV
< 0, reject. In other words, a positive NPV means the project earns a rate of return
higher than the firm’s cost of capital.

NPV = Sum of PV of all future cash inflows – Initial investment or PV of cash

outflows

Steps to calculate net present values -

1. Determine the net cash inflow in each year of the investment
2. Select the desired rate of return or discounting rate or WACC
3. Find the discount factor for each year based on the desired rate of return selected
4. Determine the present values of the net cash flows by multiplying the cash
flows by respective discount factors of respective period
5. Add the amounts of PV of all cash flows

The net present value relies on the time value of money and the timings of cash
flows in evaluating projects. All cash flows are discounted at the cost of capital
and NPV assumes that all cash inflows from projects are re-invested at the cost of
capital.

As a decision criterion, this method can be used to make a choice between

mutually exclusive projects. The project with the highest NPV would be assigned
the first rank, followed by others in the descending order.

12
Merits:
1. It recognises the time value of money.
2. The whole stream of cash flows throughout the project life is considered.
3. A changing discount rate can be built into the NPV calculations by altering the
denominator.
4. NPV can be seen as the addition to the wealth of shareholders. The criterion of
NPV is, thus, in conformity with basic financial objectives.
5. This method is useful for selection of mutually exclusive projects.

13
6. An NPV uses the discounted cash flows i.e., expresses cash flows in terms of
current rupees. The NPV’s of different projects therefore, can be added/compared.
This is called the value additive principle, implying that NPV’s of separate
projects can be added. It implies that each project can be evaluated independent of
others on its own merit.

Limitations:
1. It is difficult to calculate as well as understand and use in comparison with
the payback method or even the ARR method.
2. The calculation of discount rate presents serious problems. In fact, there is
difference of opinion even regarding the exact method of calculating it.
3. PV method is an absolute measure. Prima facie between the two projects, this
method will favour the project, which has Higher Present Value (or NPV). But it
is likely that this.
Project may also involve a larger initial outlay. Thus, in case of projects involving
different outlays, the present value method may not give dependable results.
4. This method may not give satisfactory results in case of projects having
different effective Lives.

2. Desirability Factor/Profitability Index (PI) / Benefit Cost Ratio

NPV of a project is a function of the discount rate, the timings of the cash flow and
the size of the
cash flows. Other things being equal, large investment proposals yield larger
net present values.

Logic tells, cash flows of the larger machine are merely a multiple of cash flows
of the smaller machines. To adjust, the size of the cash flows, we can calculate a
profitability index, which is the ratio of the present value of cash inflows to the
present value of the cash outflows. Thus, profitability index-

PI = Sum of P.V. of cash inflows

P.V. of cash outflow or Initial investment

The higher the PI, the more desirable the project in terms of return per rupees of
investment. A PI is the cut-off point for accepting projects and is equivalent to
being NPV positive. A PI of less than 1.0 indicates negative net present value for
the project.

3. Internal Rate of Return (IRR)

14
Internal rate of return is the interest rate that discounts an investment’s future cash
flows to the present so that the present value of cash inflows exactly equals the
present value of the cash outflows i.e., at that interest rate the net present value
equals zero. The discount rate i.e., cost of capital is considered in determination of
the net present value while in the internal rate of return calculation, the net present
value is set equal to zero and the discount rate which satisfies this condition is
determined and is called Internal Rate of Return. Any

15
investment that yields a rate of return greater than the cost of capital should be
accepted because the project will increase the value of the firm.

The following steps are taken in determining IRR for an annuity (equal cash flows):
1. Determine the payback period of the proposed investment or Find out the
present value of interest factor for annuity with the help of cash flow and
investment values
2. From the table of Present value of Annuity, look for year that is equal to or
closer to the life of the project.
3. From the year column, find two Present Value or discount factors closest
to payback period, one larger and other smaller than it.
4. From the top row of the table note, the two interest rates corresponding to these
Present values as in (3) above.
5. Determine IRR by interpolation

When cash flows are not uniform, an interest rate cannot be found using annuity
tables. Instead, trial and error methods or a computer can be used to find the
IRR. If the IRR is computed manually, the first step is to select an interest rate
that seems reasonable (this can be done by calculating average annual cash flows
by the annuity method as mentioned earlier) and then compute the present value
of the individual cash flows using that rate.

In case of unequal or uneven future cash flows

• Trial and error method has to be used to find out the IRR
• Calculate the average annual cash inflows to get an ‘approximate’ annuity
• Find out the ‘approximate’ rate of return by repeating the same steps used in
case of
annuity
• Try out different rates until the present value of future cash flows equals
the initial investment

If the net present value is positive, then the interest rate used is low, i.e., IRR is
higher than the interest rate selected. A higher interest rate is then chosen and the
present value of the cash flows
is computed again. If the new interest rates yield a negative net present value,
then a lower interest rate is to be selected. The process is repeated until the present
value of cash inflow is equal to the present value of the cash outflows. Finding
the rate of return using trial and error methods can be tedious, but a computer can
accomplish the task quite easily.

Advantages

16
1. It possesses the advantages, which are offered by the NPV criterion such as it
considers time value of money and takes into account the total cash inflows and
outflows.
2. IRR is easier to understand. Business executives and non-technical people
understand the concept of IRR much more readily that they understand the
concepts of NPV.
3. It does not use the concept of the required cost of return (or the cost of capital).
It itself provides a rate of return which is indicative of the profitability of the
proposal. The cost of capital enters the calculation, later on.

17
4. It is consistent with the overall objective of maximizing shareholders wealth
since the acceptance or otherwise of a project is based on comparison of the IRR
with the required rate of return.

Limitations
1. It involves tedious calculations.
2. It produces multiple rates, which can be confusing.
3. In evaluating mutually exclusive proposals, the project with the highest IRR
would be picked up to the exclusion of all others. However, in practice, it may not
turn out to be one that is the most profitable and consistent with the objectives of
the firm i.e., maximization of the wealth of the shareholders.
4. Under IRR method, it is assumed that, all intermediate cash flows are reinvested
at the IRR rate. It is not logical to think that the same firm has the ability to re-
invest, the cash flows at different rates. In order to have correct and reliable results
it is obvious, therefore, that they should be based on realistic estimates of the
interest rate at which the income will be re- invested.
5. The IRR rule requires comparing the projects IRR with the opportunity cost of
capital. But, sometimes, there is an opportunity cost of capital for 1 year cash
flows, a different cost of capital for 2-year cash flows and so on. In these cases,
there is no simple yardstick for evaluating the IRR of a project.

Reinvestment rate assumption

In the case of mutually exclusive projects, the NPV and IRR methods would rank
projects differently where (a) the projects have different cash outlays initially, (b)
the pattern of cash inflows is different, and (c) the service lives of the projects are
unequal. It has also been found that the ranking given by the NPV method in such
cases is theoretically more correct. The conflict between these two methods is
mainly due to different assumptions with regard to the reinvestment rate on funds
released from the proposal.
The assumption underlying the IRR method seems to be incorrect and deficient.
The IRR criteria implicitly assumes that the cash flow generated by the projects
will be reinvested at the internal rate
of return, that is, the same rate as the proposal itself offers. With the NPV method,
the assumption
is that the funds released can be reinvested at a rate equal to the cost of capital,
that is, the required
rate of return. The crucial factor is which assumption is correct? The assumption
of the NPV method is considered to be superior theoretically because it has the
virtue of having a rate which can consistently be applied to all investment
proposals. Moreover, the rate of return
(k) represents an opportunity rate of investment. In contrast to the NPV method,
the IRR method assumes a high reinvestment rate for investment proposals
18
having a high IRR and a low investment rate for investment proposals having a
low IRR. The implicit reinvestment rate will differ depending upon the
cash flow stream for each investment proposal. Obviously, under the IRR method,
there can be as many rates of reinvestment as there are investment proposals to
be evaluated unless some investment proposals turn out to have an IRR which is
equal to that of some other project(s).

19
 4. Modified Internal Rate of Return (MIRR)

There a percentage measure that overcomes the shortcomings of the regular IRR
and it is called the modified IRR or MIRR. Since investment at the cost of capital
is generally more realistic, the modified IRR (MIRR) is a better indicator of a
project’s true profitability. The MIRR also solves the problem of multiple IRRs.

The procedure to calculate MIRR is as follows:

Step 1: Calculate the present value of the costs associated with the project, using
the cost of capital (r) as the discount rate
Step 2: Find out the future value of all expected cash flows (terminal value)
Step 3: Find out the rate of return between initial investment and the future value
of cash flows.

Evaluation

MIRR is superior to the regular IRR in two ways. First, MIRR assumes that
project cash flows are reinvested at the cost of capital, whereas the regular IRR
assumes that project cash flows are reinvested at the project's own IRR. Since
reinvestment at cost of capital (or some other explicit rate) is more realistic than
reinvestment at IRR, MIRR reflects better the true profitability of a project.
Second, the problem of multiple rates does not exist with MIRR.

Thus, MIRR is a distinct improvement over the regular IRR. However, We should
note the following -

■ If the mutually exclusive projects are of the same size, NPV and MIRR lead
to the same decision irrespective of variations in life.
■ If the mutually exclusive projects differ in size there is a possibility of conflict.

Therefore, MIRR is better than the regular IRR in measuring the true rate of return.
However, for choosing among mutually exclusive projects of different size, NPV
is a better alternative in measuring the contribution of each project to the value of
the firm.

ESTIMATION OF CASH FLOWS

To evaluate a project, you must determine the relevant cash flows, which are the
incremental after-tax cash flows associated with the project. The cash flow stream
of a conventional project - a project which involves cash outflows followed by
cash inflows - comprises of three basic components: (i) initial investment, (ii)
operating cash inflows, and (iii) terminal cash inflow. The initial investment is

20
the after-tax cash outlay on capital expenditure and net working capital when the
project is set up. The operating cash inflows are the after-tax cash inflows
resulting from the operations of the project during its economic life. The terminal
cash inflow is the after-tax cash flow resulting from the liquidation of the project
at the end of its economic life.

21
Factors to be considered for Cash Flow Estimation

Incremental Principle – For the purpose of estimating cash flows, only those cash
flows which are directly attributable to the investment project are considered.
Incremental cash flows are the additional cash flows expected to result from a
proposed project (Inflow as well as outflow)
• Fixed and Variable overhead costs are considered only if it is
related to the project being proposed (incremental over-head costs)
• Sunk costs are to be ignored – Costs that have already been
incurred irrespective of whether the project is being accepted or
rejected
• Effect on other projects – Identify changes in cash flows in existing
projects as a result of undertaking the new project
• Working capital effects – Increased net working capital requirement
due to the new project is to be considered

Post tax principle – Cash flow should be measured on after –tax basis ; Effect of
depreciation also needs to be considered as it is a deductible expense in
determining taxable income; The depreciation rates allowed as per Income Tax
Act depends on the type of asset.

Illustration

Naveen Enterprises is considering a capital project about which the following

information is available: The investment outlay on the project will be Rs.100
million for plant and machinery. The entire outlay will be incurred at the beginning
of the project. The project will be financed with Rs.45 million of equity capital,
Rs.5 million of preference capital, and Rs. 50 million of debt capital. Preference
capital will carry a dividend rate of 15 percent; debt capital will carry an interest
rate of 15 percent. The life of the project is expected to be 5 years. At the end of
5 years, fixed assets will fetch a netsalvage value of Rs.30 million. Project is
expected to increase the revenues of the firm by Rs.120 million per year. The
increase in costs on account of the project is expected to be Rs.80 million per year
(This includes all items of cost other than depreciation, interest, and tax). The
effective tax rate will be 30 percent. Plant and machinery will be depreciated at
the rate of 25 percent per year as per the written down value method. Hence, the
depreciation charges will be: First year : Rs.20.00 million Second year : Rs.15.00
million Third year : Rs.11.25 million Fourth year : Rs.8.44 million Fifth year :
Rs.6.33 million Given the above details, the project cash flows are to be shown as
follows-

22
Cash flow projection (Rs. In millions)

Particulars Year Zero Year 1 Year 2 Year 3 Year 4

Fixed Assets (100)
Revenues 120 120 120 120
Costs 80 80 80 80
Depreciation 20 15 11.25 8.44
Profit before tax 20 25 28.75 31.56
Tax (30 % of 6 7.5 8.62 9.46
PBT)
Profit After Tax 14 17.5 20.13 22.1
Salvage value - - - 30
Operating Cash 34 32.5 31.38 30.54
Flows (PAT +
Depreciation)
Net Cash Flow (100) 34 32.5 31.38 60.54
(PAT
+Depreciatio
n+ Salvage
value)

CAPITAL RATIONING

The process of selecting the more desirable projects among many profitable
investments is called capital rationing. Like any rationing it is designed to
maximize the benefit available from using scarce resources. In this case the scarce
resources are funds available for capital investments and the benefits are returns
on the investments. The objective is to select the combination of projects, which
would give maximization of the total NPV.

The project selection under capital rationing involves two stages:

1. The identification of the acceptable projects,
2. To select the combination, of projects. The acceptability of projects can be
based either on profitability/present value index or IRR.

There are various ways of resorting to capital rationing. For instance, a firm may
effect capital rationing through budgets. Capital rationing may also be exercised
23
by following the concept of “responsibility accounting”, whereby management
may introduce capital rationing by authorizing a particular department to make
investment only up to a specified limit, beyond which the investment decisions
are to be taken up by higher-ups. In capital rationing, it may also be more
desirable to accept small investment proposals than a few large investment
proposals so that there may be full utilization of budgeted amount. This may result
in accepting relatively less profitable investment proposals if full utilization
of budget is a

24
primary consideration. Similarly, capital rationing may also mean that the firm
foregoes the next most profitable investment following after the budget ceiling,
even though it is estimated to yield a rate of return much higher than the required
rate of return. Thus, capital rationing does not always lead to optimum results.

RISK ANALYSIS IN CAPITAL BUDGETING

Risk is inherent in almost every business decision. More so in capital budgeting

decisions as they involve costs and benefits extending over a long period of time
during which many things can change in unanticipated ways. It has been assumed
so far that all investments being considered for inclusion in the capital budget had
the same risk as those of the existing investments of the firm. Hence the average
cost of capital was used for evaluating every project. Investment proposals,
however, differ in risk. A research and development project may be more risky
than an expansion project and the latter tends to be more risky than a replacement
project. In view of such differences, variations in risk need to be evaluated
explicitly in capital investment appraisal.

Risk analysis is one of the most complex and slippery aspects of capital
budgeting. Many different techniques have been suggested and no single
technique can be deemed as best in all situations. The variety of techniques
suggested to handle risk in capital budgeting fall into two broad categories: (i)
Approaches that consider the stand-alone risk of a project, (ii) Approaches that
consider the risk of a project in the context of the firm or in the context of the
market.

Sources of Risk
There are several sources of risk in a project. The important ones are project-
specific risk, competitive risk, industry-specific risk, market risk, and
international risk.

Project-specific risk The earnings and cash flows of the project may be lower
than expected because of estimation error or some factors specific to the project
like the quality of management.

Competitive risk The earnings and cash flows of the project may be affected by
unanticipated actions of competitors.

Industry-specific risk Unexpected technological developments and regulatory

changes, that are specific to the industry to which the project belongs will have
an impact on the earnings and cash flows of the project as well.

Market risk Unanticipated changes in macroeconomic factors like the GDP

25
growth rate, interest rate, and inflation have an impact on all projects, albeit in
varying degrees.

International risk In the case of a foreign project, the earnings and cash flows may
be different than expected due to exchange rate risk or political risk.

********

26
 Important Theoretical Questions

• What is capital budgeting? Explain the importance of capital budgeting

process.
• Describe the important steps involved in the capital budgeting process
• What is capital budgeting decision? Explain various techniques
of capital budgeting and its limitations
• What are the types of cashflows?
• What is capital rationing? Explain the steps in capital rationing
• What do you mean by payback period? Enumerate its limitations
• What is internal rate of return?
• What is MIRR? how is it computed?
• Write any two features of pay-back period

27
 MODULE 4
CAPITAL STRUCTURE AND DIVIDEND
DECISIONS

Capital Structure

Organizations have need of funds to run and maintain its business. The requisite funds may be raised
from short-term sources or long-term sources or a combination both the sources of funds, so as to equip
itself with an appropriate combination of fixed assets and current assets. Current assets to a considerable
extent, are financed with the help of short-term sources. Normally, firms are expected to follow a
prudent financial policy, as revealed in the maintenance of net current assets. This net positive current
asset must be financed by long-term sources. Hence, long-term sources of funds are required to finance
for both (a) long-term assets (fixed assets) and (b) networking capital (positive current assets). The long-
term financial strength as well as profitability of a firm is influenced by its financial structure. The term
‘Financial Structure’ refers to the left-hand side of the balance sheet as represented by “total liabilities”
consisting of current liabilities, long-term debt, preference share and equity share capital. The financial
structure, therefore, includes both short-term and long-term sources of funds.

The basic objective of financial management is to maximize the shareholders wealth. Therefore, all
financial decisions in any firm should be taken in the light of this objective. Whenever a company is
required to raise long-term funds the finance manager is required to select such a mix of sources of
finance that overall cost of capital is minimum (i.e., value of the firm/wealth of shareholders is
maximum). Mix of long-term sources of finance is referred as “Capital structure”.

Optimum Capital Structure

The capital structure is said to be optimum when the firm has selected such a combination of equity and
debt so that the wealth of firm (shareholder) is maximum. At this capital structure, the cost of capital is
minimum and market price per share is maximum. It is very difficult to find out optimum debt and
equity mix where capital structure would be optimum because it is difficult to measure a fallin the market
value of an equity shares on account of Increase in risk due to high debt content in capital structure.
Hence, in practice, the expression ‘appropriate capital structure’ is more realistic expression than
‘optimum capital structure’.

Features of an Appropriate Capital Structure

1. Profitability: The most profitable capital structure is one that tends to minimize cost of financing
and maximize earning per equity share.
2. Flexibility: The capital structure should be such that company can raise funds whenever needed.
3. Conservation: The debt content in the capital structure should not exceed the limit, which the
company can bear.
4. Solvency: The capital structure should be such that firm does not run the risk of becoming
insolvent.
5. Control: The capital structure should be so devised that it involves minimum risk of loss of control
of the company.

Factors influencing capital structure decisions

ln planning the capital structure, one should keep in mind that there is no one definite model that can be
suggested/used as an ideal for all business undertakings. This is because of varying circumstances of
business undertakings. It is, therefore important to understand that different financing mix or

1
capital structure would be required for different types of business undertakings. Finance manager should
take into consideration following factors while planning the capital structure. The key factors governing
the capital structure decisions are as follows -

• Nature of industry
• Profitability aspect
• Liquidity aspect
• Leverage ratios in the industry
• Management control
• Company characteristics
• Consultation with investment bankers or lenders
• Timing
• Tax planning

Nature of industry
If an industry’s sales are subject to wide fluctuations, over a business cycle, the firm should have a low
degree of financial leverage. Industries which are not subject to wide fluctuations in sales can afford to
have higher debt proportions in capital structure as they don’t run the risk of being unable to meet their
commitments. If there is less intra-industry competition, the sales are more stable and predictable and
firms can use more debt. If the industry is in its infancy stage, probability of failure may be high and
more emphasis needs to be placed on equity capital.

Profitability aspect
A capital structure needs to be designed considering the profitability aspect from the point of view of
shareholders. EBIT-EPS analysis is a good way to measure the profitability considering the primary
objective of maximizing the market value of the firm. EPS is a measure of a firm’s performance – larger
the EPS, lager would be the value of a firm’s shares. EBIT-EPS analysis is an approach for selecting
capital structure that maximizes earnings per share (EPS) over the expected range of earnings before
interest and taxes. The firm should determine the probability of critical levels of EBIT which has an
impact on the EPS. Depending on the level of EBIT, the appropriate financing mix needs to be chosen.
The ability of the firm to use debt, from the standpoint of profitability can also be judged in terms of
coverage ratio. Coverage ratio measures the size of interest payments relative to the EBIT. The higher
the coverage ratio, the greater is the certainty that the firm would be in a position to meet its obligations
of interest payment. The coverage ratio can be calculated at various levels of EBIT. This would provide
a better picture of the firm’s most likely EBIT to meet specific commitments.

Liquidity Aspect
A firm needs to assess its ability to service fixed charges over a period time. It may be possible that the
company’s EBIT is adequate to cover its specific commitments, arising out of debt obligations, but the
firm may not have sufficient cash to pay as its funds would have been blocked in working capital in the
form of higher inventory, receivables etc. Hence, analysis of the cash flows is an important exercise to
be carried out in capital structure planning in addition to profitability analysis.
Cash flow analysis evaluates the risk of financial distress and should be recognized as a good
supporting supplement to the profitability analysis in framing the firm’s capital structure.
Ratio of fixed charges to net cash inflows measures the coverage of fixed financial charges (interest and
repayment of principle) to net cash inflows. Greater the coverage ratio, greater is the amount of debt that
a firm can use. Another measure to analyze the cash flow is to prepare a cash budget to determine
whether the expected cash flows are sufficient to cover the fixed obligations. It is prepared for a range of
possible cash inflows with a probability attached to each of them.

2
Leverage ratios in the industry
Comparisons are made with other firms belonging to the same industry having similar business risk.
The rationale of the use of industry standards is that debt equity ratios appropriate for other firms in
similar business should be suitable for the firm also. Looking at industry standards while deciding on
capital structure is helpful as it acts as a bench mark and indicates whether the firm is in line with the
industry.

Control
Lenders may place certain restrictions in the loan agreement on the management’s activities but they do
not have any direct voice in the policy decisions of the company. Likewise, preference shareholders too
do not have the right to vote. The power to choose the management in most cases rests with the equity
shareholders. If the main objective of the management is to maintain control, they prefer to have a
greater weightage for debt and preference shares in additional capital requirements as it does not result
in dilution of control. This scenario is applicable more to closely held companies than widely held
companies as shares of widely held companies are dispersed with large number of shareholders.

Company characteristics
Size of the company and its credit standing also play a vital role in determining the share of debt and
equity in capital structure. The management may not have choice in case of small sized companies and
may have to rely on owner’s funds for their financing. As investors consider these firms more risky,
such firms do not have ready access to different types of funds from various sources. Firms enjoying a
high credit standing among investors/lenders in the capital market are in a better position to get funds
from the sources of their choice. If the credit standing is poor, the firm’s choice of obtaining funds is
rather limited.

Consultation with investment bankers and lenders

Seeking the opinion of investment analysts, institutional investors, investment bankers and lenders.
They would have the expertise and access to information regarding the capital market and are in a better
position to assess the financial plan of a firm.

Timing
Proper timing of a security issue often brings substantial savings because of the dynamic nature of the
capital market. A prudent management tries to anticipate the climate in capital market with a view to
minimize the cost of raising funds and also to minimize the dilution resulting from an issue of new
ordinary shares. An expected decline in interest rates may encourage the firms to postpone borrowings
and remain in flexible position which helps to take advantage of lower interest rates in the future.

Tax planning
Interest on debt is a tax-deductible expense. Hence, if a firm is in higher tax bracket, there is greater
incentive to use debt. However, dividend on shares is not tax deductible from the operating profits ofthe
company. Hence, corporate taxation too is an important determinant of the choice between different
sources of financing. However, the choice of going for debt financing involves a trade-off between tax
benefits and the risk of financial distress. Going too far in exploiting the debt can be riskyin the long run.

3
Methods used in deciding the capital structure

Leverage Analysis

The term ‘leverage’ in general refers to using something to maximum advantage. In finance, leverage
results from the use of fixed costs to magnify returns to the firm’s owners. Generally, increases in
leverage results in increased returns and risk; and decreases in leverage results in decrease in returnsand
risk. The amount of leverage in the firm’s capital structure (the mix of long-term debt and equity) can
significantly affect its value by affecting returns and risks.

Relationship between Sales, Profit and EPS

Particulars Amount
Revenue from sales XX
Less : Variable costs XX
Contribution XX
Less : Fixed operating costs XX
Earnings before interest and tax (EBIT or PBIT) / Operating income XX
Less: Interest on debt (fixed finance cost) XX
Earnings before tax (or PBT) XX
Less : Income tax XX
Earnings After Tax (or PAT) XX
Less : Preference share dividend XX
Earnings available for equity shareholders XX
Earnings per share = PAT – Preference Dividend
Number of equity shares XX

Types of leverages

Operating leverage arises from the firm's fixed operating costs such as salaries, rent, depreciation,
insurance, property taxes, and advertising outlays. It is concerned with the relationship between the
firm’s sales revenue and its earnings before interest and taxes, or EBIT (also called as operating
income/profits).

Financial leverage arises from the firm's fixed financing costs such as interest on debt. It is concerned
with the relationship between the firms EBIT and earnings available to equity shareholders measuredon
a per share basis - which is known as Earnings Per Share (EPS). It is defined as the firm’s ability to use
fixed financial charges to magnify the effects of charge in EBIT/operating profit on firm’s earnings per
share.

Total leverage is concerned with the relationship between the firm’s sales revenue and EPS.

Operating Leverage

Operating leverage is present any time in a firm when it has operating (fixed) costs regardless of the
level of production. The operating costs of a firm fall into two categories:
- Fixed costs, which may be defined as those do not vary with sales volume, are a function of
time and are typically contractual; they must be paid regardless of the amount of revenue
available with sales volume.
- Variable costs, which vary directly.

4
 Some costs are semi-variable or semi-fixed in nature, which are partly fixed and partly variable. They
are fixed over a certain higher sales volumes. Operating leverage results from the existence of the fixed
operating expenses in the firm’s income stream. With fixed costs, the percentage change in profit
accompanying a change in volume is greater than the percentage change in volume. Therefore, operating
leverage is defined as the firm’s ability to use fixed operating costs to magnify effects of change in sales
on its EBIT or operating profit. The degree of operating leverage may be defined as the change in the
percentage of operating income (EBIT), for a given change in % of sales revenue. Hence,

Degree of Operating Leverage (DOL) = % Change in EBIT

% change in Sales

It can also be computed by the following formula when % change is not given:

Operating leverage = Contribution

EBIT

Operating leverage helps in knowing how operating profits would change with a given change in units
produced. It is also helpful in measuring business risk.

Financial Leverage

Financial manager job is to raise funds for long-term activities with different composition of sources.
The required funds may be raised by two sources: equity and debt. The use of fixed charge sources of
funds such as debt and preference share capital along with the equity share capital in capital structure is
described as financial leverage. In other words, financial leverage is defined as the ability of a firm to
use fixed financial charges to magnify the effects in EBIT/operating profits, on the firm’s earning per
share.

The two fixed financial cost that may be found in the firm’s income statement are:
1. Interest on debt and
2. Dividends on preferred shares.
These charges must be paid regardless of the amount of EBIT available to pay them.

The financial leverage is favourable when the firm earns more on the investments/ assets financed by the
sources having fixed charges. It is obvious that shareholders gain in a situation where a company earns
a higher rate of return and pays a low rate to the supplier of long-term funds.

The degree of financial leverage is the measure of the firms’ financial leverage and is calculated as:

Degree of Financial leverage (DFL) = Percentage change in EPS

Percentage change in EBIT

Or

Financial Leverage = EBIT

EBT-(PD/1-t)

The effect of financial leverage is such that an increase in the firm’s EBIT results in a more than
proportional increase in the firms earnings per share, whereas a decrease in the firms EBIT results in a
more than proportional decrease in EPS.

5
Significance of Financial Leverage
Financial leverage is a double-edged sword. On the one hand, it increases earnings per share, and on the
other hand it increases financial risk. A high financial leverage means high fixed financial cost and high
financial risks. That means when the debt component in capital structure increases, the financialleverage
increases and at the same time the financial risk also increases (risk of insolvency). Therefore, finance
manager is required to trade–off between the risk of leverage and the return for determining the
appropriate amount of debt in the capital structure of a firm.

Trading on Equity
When the firm uses financial leverage to boost the return of the shareholders, that process is known as
Trading on Equity. Trading on Equity occurs when a company takes new debt, in the form of bonds,
preferred stock, or loans etc. to increase gain for the equity shareholders. The company uses those funds
to acquire assets to generate a return greater than the interest cost of new debt. The term owes its name
also to the fact that the creditors are willing to advance funds on the strength of the equity supplied by
the owners. Trading feature here is simply one of taking advantage of the permanent stockinvestment to
borrow funds on reasonable basis.

Combined Leverage

The operating leverage has its effects on operating risk and is measured by the % change in EBIT due
to the % change in sales. The financing leverage has its effects on financial risk and is measured by the
% change in EPS due to the % change in EBIT. Since, both these leverages are closely related with the
ascertainment of the firm's ability to cover fixed charges, the sum of them gives us the total leverage or
combined leverage and the risk associated with combined leverage is known as total risk.

Hence, combined leverage or total leverage can be defined as potential use of fixed costs, both operating
and financial, to magnify the effect of changes in sales on the firm’s earnings per share.

The degree of combined leverage may be defined as the % change in EPS due to the % change in sales.

Degree of Combined leverage = % Change in EPS

% Change in Sales

Or

Combined leverage = Operating leverage × Financial leverage

Or

Combined leverage = Contribution

EBT- (PD/1-t)

Significance of Combined Leverage

A high operating leverage and a high financial leverage combination is very risky. If the company is
producing and selling at a high level, leverage will make extremely high profit for its shareholders. But,
even a small fall in the level of operations would result in tremendous fall in earnings per share. A
company must, therefore, maintain a proper balance between these two leverages. A combination ofhigh
operating level and a low financial leverage indicates that the management is careful since the higher
amount of risk involved in high operating leverage has been sought to be balanced by low financial
leverage. However, a more preferable option would be to have a low operating leverage and a high
financial leverage. A low operating leverage implies that the company reaches its breakeven

6
point at a low level of sales. Therefore, risk is diminished. A highly cautious and conservative manager
will keep both its operating and financial leverage at a very low level, but the approach may, however,
mean that the company is losing profitable opportunities.

EBIT -EPS Analysis

This is another way to analyze the impact of leverages on the return available to shareholders. Given a
particular level of EBIT, what will be the level of return available to shareholders under various
combinations and conditions of financing ? It is possible that firms which are operating under similar
conditions and having same level of EBIT and are alike in all respects except the pattern of financing.
Will these firms have same return for the shareholders ? This analysis of the effect of different patterns of
financing or the financial leverage on the level of returns available to the shareholders, under different
assumptions of EBIT is known as EBIT – EPS analysis.
Given a level of EBIT, a particular combination of different sources of finance will result in a particular
EPS and therefore, for different financing pattern, there would be different levels of EPS. An interaction
between the varying level of EBIT and the financing patterns can affect the EPS in more than one ways.
These implications of the financing patterns can be studied as EBIT – EPS analysis under two cases as
follows :

• Constant EBIT and change in financing patterns

• Varying EBIT with different financing patterns
The relationship between EBIT and EPS is as follows :
EPS = Earnings available to equity shareholders
Number of equity shares

EBIT = (EPS X Number of equity shares) + PD + 1

(I-t)

ROI and ROE analysis

In this method, relationship between Return on investment (ROI) and the return on equity (ROI) is analyzed
for different level of financial leverage (debt)
The relationship between ROI and ROE is summarized as follows -
i) When the ROI is less than the cost of debt,
the ROE of the capital structure which does not contain any debt, will be more than the capital
structure which has debt component
ii) When ROI is equal to the cost of debt,
There will not be any difference ROE of capital structure which contains debt and which does not
contain debt

7
 iii) Where ROI is more than the cost of debt,
ROE of capital structure which contains debt, will be more than the capital structure which does not
have any debt
The influence of ROI and financial leverage on ROE is represented mathematically as below :
ROE = (ROI + (ROI – r) D/E ratio) (1-t)
r = rate of interest on debt ; D/E ratio = Debt Equity ratio
The above formula is derivation of the ROE original formula = PAT - PD / Equity Shareholder’s funds.
ROI = EBIT / Total Assets or net capital employed

Dividend Decisions
Dividends refer to that portion of a firm’s net earnings which are paid out to the shareholders. A major
decision of financial management is the dividend decision in the sense that the firm has to choose
between distributing the profits to the shareholders and ploughing them back into the business. The
choice would obviously hinge on the effect of the decision on the maximisation of shareholders’ wealth.
Given the objective of financial management of maximising present values, the firm should be guided by
the consideration as to which alternative use is consistent with the goal of wealth maximisation. That
is, the firm would be well advised to use the net profits for paying dividends to the shareholders if the
payment will lead to the maximisation of wealth of the owners. If not, the firm should rather retain them
to finance investment pro-grammes. The relationship
between dividends and value of the firm should, therefore, be the decision criterion. Dividend policy
involves decision to pay out earnings or to retain them for re-investment.

Factors affecting dividend policy

The factors determining the dividend policy of a firm may, for purpose of exposition, be classified into:
(a) Dividend payout (D/P) ratio, (b) Stability of dividends, (c) Legal, contractual and internal constraints
and restrictions, (d) Owner’s considerations, (e) Capital market considerations (f) Inflation (g) clientele
effect

Dividend payout ratio

D/P (dividend payout) ratio indicates the percentage earnings distributed to shareholders in cash,
calculated by dividing the cash dividend per share by its earnings per share. The optimum dividend
policy should strike the balance between current dividends and future growth which maximises the price
of the firm’s shares. The D/P ratio of a firm should be determined with reference to two basic
objectives—maximising the wealth of the firm’s owners and providing sufficient funds to finance
growth. These objectives are not mutually exclusive, but interrelated. Given the objective of wealth
maximisation, the firm’s dividend policy (D/P ratio) should be one
which can maximise the wealth of its owners in the ‘long run’. In theory, it can be expected that the
shareholders take into account the long-run effects of D/P ratio, that is, if the firm is paying low
dividends and having high retentions, they recognise the element of growth in the level of future
earnings of the firm. However, in practice, they have a clear cut preference for dividends because of
uncertainty and imperfect capital markets. The payment of dividends can, therefore, be expected to
affect the price of shares: a low D/P ratio may cause a decline in share prices, while a high ratio may
lead to a rise in the market price of the shares.

8
Stability of Dividends

The second major aspect of the dividend policy of a firm is the stability of dividends. The investors
favour a stable dividend as much as they favour the payment of dividends (D/P ratio). The term dividend
stability refers to the consistency or lack of variability in the stream of dividends. In more precise terms,
it means that a certain minimum amount of dividend is paid out regularly. The stability of dividends can
take any of the following three forms: (i) constant/stable dividend per share, (ii) constant/stable D/P
ratio, and (iii) constant dividend per share plus extra dividend.

Constant / stable dividend per share policy is a policy of paying a certain fixed amount per share as
dividend. For instance, on a share of face value of Rs 100, a firm may pay a fixed amount of, say Rs 15
as dividend. This amount would be paid year after year, irrespective of the level of earnings. In other
words, fluctuations in earnings would not affect the dividend payments. In fact, when a company
follows such a dividend policy, it will pay dividends to the shareholder even when it suffers losses. A
stable dividend policy in terms of a fixed amount of dividend per share does not, however, mean thatthe
amount of dividend is fixed for all times to come. The dividends per share are increased over the years
when the earnings of the firm increase and it is expected that the new level of earnings can be
maintained.

Constant/Stable payout ratio is a policy to pay a constant percentage of net earnings as dividend to
shareholders in each dividend period. In other words, a stable dividend payout ratio implies that the
percentage of earnings paid out each year is fixed. Accordingly, dividends would fluctuate
proportionately with earnings and are likely to be highly volatile in the wake of wide fluctuations in the
earnings of the company. As a result, when the earnings of a firm decline substantially or there is a loss
in a given period, the dividends, according to the target payout ratio, would be low or nil. To illustrate,
if a firm has a policy of 50 per cent target payout ratios, its dividends will range between Rs 5 and zero
per share on the assumption that the earnings per share are Rs 10 and zero respectively.

Stable rupee plus extra dividend – Under this policy, a firm usually pays a fixed dividend to the
shareholders and in years of marked prosperity additional or extra dividend is paid over and above the
regular dividend. As soon as normal conditions return, the firm cuts the extra dividend and pays the
normal dividend per share.

Desire for Current Income A factor favouring a stable policy is the desire for current income by some
investors. Investors such as retired persons and widows, for example, view dividends as a source of
funds to meet their current living expenses. Such expenses are fairly constant from period to period.
Therefore, a fall in dividend will necessitate selling shares to obtain funds to meet current expenses and,
conversely, reinvestment of some of the dividend income if dividends rise significantly. For one thing,
many of the income-conscious investors may not like to ‘dip into their principal’ for current
consumption. Moreover, either of the alternatives involves, inconvenience apart, transaction costs in
terms of brokerage, and other expenses. These costs are avoided if the dividend stream is stable and
predictable.

Informational Contents Another reason for pursuing a stable dividend policy is that investors are
thought to use dividends and changes in dividends as a source of information about the firm’s
profitability. If investors know that the firm will change dividends only if the management foresees a
permanent earnings change, then the level of dividends informs investors about the company’s expected
earnings. Accordingly, the market views the changes in the dividends of such a company as of a semi-
permanent nature. A cut in dividend implies poor earnings expectation; no change, implies earnings
stability; and a dividend increase, signifies the management’s optimism about earnings. On

9
the other hand, a company that pursues an erratic dividend payout policy does not provide any such
information, thereby increasing the risk associated with the shares. Stability of dividends, where such
dividends are based upon long-run earning power of the company, is, therefore, a means of reducing
share-riskiness and consequently increasing share value to investors.

Requirements of Institutional Investors A third factor encouraging stable dividend policy is the
requirement of institutional investors like life insurance companies, general insurance companies,
mutual funds and so on, to invest in companies which have a record of continuous and stable dividend.
These financial institutions owing to the large size of their investible funds, represent a significant force
in the financial markets and their demand for the company’s securities can have an enhancing effect on
its price and, thereby, on the shareholder’s wealth. A stable dividend policy is a prerequisite to attract
the investible funds of these institutions.

Legal, Contractual, and Internal Constraints and Restrictions

The dividend decision is also affected by certain legal, contractual, and internal requirements and
constraints. The legal factors stem from certain statutory requirements, the contractual restrictions arise
from certain loan covenants and the internal constraints are the result of the firm’s liquidity position.
Legal Requirements Legal stipulations do not require a dividend declaration but they specify the
conditions under which dividends must be paid.

Contractual Requirements

Important restrictions on the payment of dividend may be accepted by a company when obtaining
external capital either by a loan agreement, a debenture indenture, a preference share agreement, or a
lease contract. Such restrictions may cause the firm to restrict the payment of cash dividends until a
certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or
percentage of earnings. Since the payment of dividend involves a cash outflow, firms are forced to
reinvest the retained earnings within the firm. The restriction on dividends may take three forms. In the
first place, firms may be prohibited from paying dividends in excess of a certain percentage, say, 12 per
cent. Alternatively, a ceiling in terms of the maximum amount of profits that may be used for dividend
payment may be laid down, say not more than 60 per cent of the net profits, or a given absolute amount
of such profits can be paid as dividends.

Internal Constraints

Such factors are unique to a firm and include (i) liquid assets, (ii) growth prospects, (iii) financial
requirements, (iv) availability of funds, (v) earnings stability and (iv) control

Liquid Assets Once the payment of dividend is permissible on legal and contractual grounds, the next
step is to ascertain whether the firm has sufficient cash funds to pay cash dividends. It may well be
possible that the firm’s earnings are substantial, but the firm may be short of funds. This situation is
common for (a) growing companies; (b) companies which have to retire past loans as their maturity
year has come; and (c) companies whose preference shares are to be redeemed.

Growth Prospects Another set of factors that can influence dividend policy relates to the firm’s growth
prospects. The firm is required to make plans for financing its expansion programmes. In this context,
the availability of external funds and its associated cost together with the need for investment funds
would have a significant bearing on the firm’s dividend policy.

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Financial Requirements Financial requirements of a firm are directly related to its investment needs.
The firm should formulate its dividends policy on the basis of its foreseeable investment needs. If a firm
has abundant investment opportunities, it should prefer a low payout ratio, as it can usually reinvest
earnings at a higher rate than the shareholders can. Such firms, designated as ‘growth’ companies, are
constantly in need of funds. Their financial requirements may be characterised as large and immediate.

Availability of Funds The dividend policy is also constrained by the availability of funds and the need
for additional investment. In evaluating its financial position, the firm should consider not only its
ability to raise funds but also the cost involved in it and the promptness with which financing can be
obtained. In general, large, mature firms have greater access to new sources for raising funds than firms
which are growing rapidly.

Earnings Stability The stability of earnings also has a significant bearing on the dividend decision of
a firm. Generally, the more stable the income stream, the higher is the dividend payout ratio. Such firms
are more confident of maintaining a higher payout ratio. Public utility companies are classic examples
of firms that have relatively stable earnings pattern and high dividend payout ratio.

Control Dividend policy may also be strongly influenced by the shareholders’ or the management’s
control objectives. That is to say, sometimes management employs dividend policy as an effective
instrument to maintain its position of command and control. The management, in order to retain control
of the company in its own hands, may be reluctant to pay substantial dividends and would prefer a
smaller dividend payout ratio. This will particularly hold good for companies which require funds to
finance profitable investment opportunities when an outside group is seeking to gain controlof the firm.

Owner ’s Considerations

The dividend policy is also likely to be affected by the owner’s considerations of (a) the tax status of
the shareholders, (b) their opportunities of investment, and (c) the dilution of ownership. It is well- nigh
impossible to establish a policy that will maximise each owner’s wealth. The firm must aim at a dividend
policy which has a beneficial effect on the wealth of the majority of the shareholders.

Taxes The dividend policy of a firm may be dictated by the income tax status of its shareholders. If a
firm has a large percentage of owners who are in high tax brackets, its dividend policy should seek to
have higher retentions. Such a policy will provide its owners with income in the form of capital gains
as against dividends. Since capital gains are taxed at a lower rate than dividends, they are worth more,
after taxes, to the individuals in a high tax bracket. On the other hand, if a firm has a majority of low
income shareholders who are in a lower tax bracket, they would probably favour a higher payout of
earnings because of the need for current income and the greater certainty associated with receiving the
dividend now, instead of the less certain prospects of capital gains.

Opportunities The firm should not retain funds if the rate of return earned by it would be less than one
which could have been earned by the investors themselves from external investments of funds. Such a
policy would obviously be detrimental to the interests of shareholders. It is difficult to ascertain the
alternative investment opportunities of each of its shareholders and, therefore, the alternative investment
opportunity rate later.

Dilution of Ownership The financial manager should recognise that a high D/P ratio may result in the
dilution of both control and earnings for the existing equity holders. The control aspect has already been
discussed. Dilution in earnings results because low retentions may necessitate the issue of new

11
equity shares in the future, causing an increase in the number of equity shares outstanding and
ultimately lowering earnings per share and their price in the market. By retaining a high
percentage of its earnings, the firm can minimise the possibility of dilution of earnings.

Capital Market Considerations

Yet another set of factors that can strongly affect dividend policy is the extent to which the
firm has access to the capital markets. In case the firm has easy access to the capital market,
either because it is financially strong or large in size, it can follow a liberal dividend policy.
However, if the firm has only limited access to capital markets, it is likely to adopt low
dividend payout ratios. Such firms are likely to rely more heavily on retained earnings as a
source of financing their investments. Firms which lean heavily on financial institutions for
procuring funds, declare a minimum dividend so that they can remain on the ‘eligible’ list of
these institutions. It is because, in general, most financial institutions are prohibited by their
charter from buying shares in companies which pay no dividends. A company should be
paying dividends at a certain minimum rate for at least some specified number of year (say,5
years). Since such institutions are significant buyers of corporate securities, some firms that
would otherwise have not paid any amount of dividend, would pay some dividend so that they
remain on the eligible list.

Inflation

Finally, inflation is another factor which affects the firm’s dividend decision. With rising
prices, funds generated from depreciation may be inadequate to replace obsolete equipments.
These firms have to rely upon retained earnings as a source of funds to make up the shortfall.
This aspect becomes all the more important if the assets are to be replaced in the near future.
Consequently, their dividend payout tends to be low during periods of inflation.

Clientele Effect
Investors have diverse preferences. Some want more dividend income; others want more
capital gains; still others want a balanced mix of dividend income and capital gains. Over a
period of time, investors naturally migrate to firms which have a dividend policy that matches
their preferences. The concentration of investors in companies with dividend policies that are
matched to their preferences is called the clientele effect. The existence of a clientele effect
implies that (a) firms get the investors they deserve and (b) it will be difficult for a firm to
change an established dividend policy.

Important theoretical questions

• Differentiate between operating leverage and financial leverage

• What is EBIT-EPS analysis? What is the significance of point of indifference in
this analysis?
• What is trading on equity ?
• What is optimal capital structure?
• What is capital structure ?
• Explain the factors influencing capital structure decisions
• Discuss factors which are relevant for determining dividend payout ratio
• What is stable dividend policy ?
• What is dividend policy? Briefly explain different factors affecting dividend policy
/ Explain any 7 factors affecting dividend policy of an organization

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 MODULE 5
WORKING CAPITAL MANAGEMENT

Working capital management refers to managing the current assets, current liabilities and the
interrelationships that exist between them; The goal of working capital management is to
manage the firm’s current assets and liabilities in such a way that a satisfactory level of working
capital is maintained. Working capital refers to the funds invested in current assets, i.e.,
investment in sundry debtors, cash and other current assets. Current assets are essential to
utilize facilities provided by plant and machinery, land and buildings. In case of the
manufacturing organization, a machine cannot be used without raw material. The investment
in the purchase of raw materials is identified as working capital. It is obvious that a certain
amount of funds are tied up in raw material inventories, work in progress, finished goods,
consumable stores, sundry debtors and day-to-day cash requirements. However, the
organization also enjoys credit facilities from its suppliers by way of credit. Similarly, the
organization need not pay immediately for various expenses, etc. the workers are paid only
periodically. Therefore, a certain amount of funds automatically become available to finance
the current assets requirement. However, the requirement of current assets is usually greater
than the amount of funds provided through current liabilities. The goal of working capital
management is to manage the firm’s current assets and current liabilities in such a way that a
satisfactory level of working capital is maintained.

Working capital, can be used in two different ways:

1. Gross working capital: The gross working capital refers to investment in all the current
assets taken together. The total of investments in all current assets is known as gross working
capital.
2. Net working capital: Net working capital refers to the excess of total current assets over total
current liabilities. Current liabilities are those liabilities that are intended to be paid in the
ordinary course of business within a year, out of the current assets or earnings of the concern.

From the point of view of time, the term working capital can be divided into two categories:
1. Permanent: It is the minimum level of investment in the current assets that is carried by the
business at all times to carry out maximum level of its activities. It is usually financed by long-
term sources.

2. Temporary working capital: It refers to that part of working capital, which is required by
the business over and above permanent working capital. It is also called variable working
capital. Since the quantum of temporary working capital keeps on fluctuating from time to-
time depending on the business activities, at may be financed from short-term sources.

Factors affecting/influencing working capital requirements

The main objective of a firm’s working capital management is to ensure that the firm has
adequate working capital for its operation, neither too much nor too little working capital. There
is no set of rules or formulae to determine the working capital requirements of a firm. The total
working capital requirement is determined by a wide variety of factors. However, theimpact of
these factors are different for different companies.

1. General nature of business - In some organizations, the sales are mostly in cash basis and
theoperating cycle (explained) later is also short. In these concerns, the working capital

1
requirement is comparatively low. Mostly, service companies come under this category. In
manufacturing companies, usually the operating cycle is very long and a firm is also required
to give credit to customers to boost sales. In such cases, working capital requirement is high.
Similarly, a trading concern requires lower working capital than a manufacturing concern.

2. Business cycle – Business fluctuations lead to cyclical and seasonal changes which cause
change in the working capital position, especially the temporary working capital
requirements. During boom period, the need for working capital may grow due to the
increased demand for products. On the other hand, the need for working capital may decline
in times of recession due to fall in sales.

3. Production policy – A firm can confine their production only to periods when goods are
purchased or they can follow a steady production policy throughout the year. In case of the
former, a firm needs to maintain their work force and production facilities without adequate
production. During peak period, firms have to operate in full capacity to meet the demand.
Hence, the need for working capital fluctuates throughout the year. Under a steady
productionpolicy, the working capital requirements may be high because of accumulation
of unsold finished goods. However, working capital needs will not fluctuate much in this
kind of production policy and hence can be estimated more accurately.

4. Credit policy of the company and of its suppliers – A company, which allows liberal
creditto its customers, may have higher sales, but consequently will have larger amount of
funds tied up in sundry debtors. Similarly, a company, which has very efficient debt
collection machineryand offers strict credit terms, may require lesser amount of working
capital that the one wheredebt collection system is not so efficient where the credit terms
are liberal.
On the other hand, if liberal credit terms are available from the suppliers of the goods, the need
for working capital is less. Terms and conditions related to the credit policy are generally
governed by prevailing trade practices and by changing economic conditions.

5. Growth and expansion – A growing firm may need funds to invest in fixed assets in order
tosustain its growing production and sales. This will, in turn, increase investment in current
assets to support increased scale of operations. Hence, a growing firm needs additional
working capital which needs to be planned well in advance.

6. Supply conditions / Availability of raw material - If prompt and adequate supply of raw
materials, spares, stores, etc., is available it is possible to manage with small investments
in inventory or work on Just-In-Time (JIT) inventory principles. However, if supply is
erratic, scant, seasonal, channelized through government agencies etc. it is essential to keep
larger stocks increasing working capital requirements. There may be some materials, which
cannot be procured easily either because their sources are few or they are irregular. To
sustain smoothproduction, therefore, the form may be compelled to purchase and stock
them far in excess ofgenuine production needs.

7. Level of taxes - The amount of taxes to be paid is determined by the prevailing tax
regulations.Very often taxes have to be paid in advance on the basis of the profit of the
preceding year. Management has no discretion in regard to payment of taxes; in some cases,
non-payment may invite penal action. There is, however, wide scope to reduce the tax
liability through proper tax planning. An adequate provision for tax payments is an
important aspect of working capital planning.

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8. Dividend policy - Payment of dividend utilizes cash available with the firm while retaining
profit acts as a source of working capital. Hence, working capital planning needs to consider
whether the profits are retained or paid out to the shareholders in the form of dividend.

9. Depreciation policy – Depreciation charges do not involve any cash outflows. Depreciation
isa tax- deductible expense. Enhanced rates of depreciation lower the profits and therefor
tax liability and thus results in more cash available. Higher depreciation also means lower
disposable profits and dividend payment can be small. Hence cash is preserved due to the
depreciation which helps in financing the working capital. That is the reason why
depreciationpolicy is relevant to the planning of working capital.

10. Operational efficiency - Operating efficiency relates to the optimum utilisation of a firm’s
resources at minimum costs. The firm with high efficiency in operation can bring down the
total investment in working capital to lower level. Effective utilisation of resources helps
the firm in bringing down the investment in working capital. If a firm successfully controls
operating cost, it will be able to improve net profit margin which, will, in turn, release
greaterfunds for working capital purposes.

The following are the advantages of adequate working capital:

1. Solvency of the Business: Adequate working capital ensures uninterrupted flow of production.
The finished goods can be sold thereby increase in sales turnover and results in the sufficient cash
in hand. In this way, solvency of the business is maintained.

2. Cash Discount: If proper cash balance is maintained, the business can avail of the cash discount
facilities offered to it by the suppliers.

3. Goodwill: Whenever the solvency of the business is maintained, the business concern can make
the payments within the stipulated time very easily. If so, the good will of the business concern is
created and maintained in the days to come.

4. Liquidity: An able businessman can determine the extent of working capital requirements i.e.
adequate working capital. In this context, the liquidity of the business concern is maintained with
the help of adequate working capital.

5. Easy Loan: If a business concern maintains high solvency of business and goodwill banks and
financial institutions are ready to extent credit facility i.e. loan on favorable terms. In this way, the
business concern gets the loan very easily.

6. Meeting unseen Contingencies: It provides funds for unseen emergencies so that a business can
successfully meet the contingencies. The impact of contingencies on the business operation can be
reduced at the maximum.

7. Regular Supply of Raw Materials: Adequate working capital ensures regular supply of raw
material for continuous flow of production.

8. High Morale: The executives cannot use the available funds according to their wishes. If so,
misuse of funds is highlighted through the business operation. The uses of funds increase efficiency
of employees and results in the higher income. In this way, high morale is maintained among the
employees.
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9. Regular Payment of Commitments: The wages and salaries and other day to day operating
expenses should be paid within the stipulated time. It is possible only because of maintaining
adequate working capital. The regular payment of commitments increase the efficiency of
employees and reduces wastage, costs and enhances production and profits.

10. Good Relations with Banks and Financial Institutions: A business concern can repay its loan
with interest within the due date by having adequate working capital. This type of practice ensures
good relations with banks and financial institutions.

11. Exploitation of favorable Market Conditions: Market condition is in such a way that trade
discount and low price are available for bulk purchase. These type of favorable market conditions
can be availed only if adequate working capital is maintained.

12. Increased Fixed Assets Productivity: Generally, fixed assets are acquired for increasing earning
capacity of the business concern. Therefore, the fixed assets should be used properly. The fixed
assets can be used properly for increasing productivity with the help of adequate working capital.

13. Ability to Face Crisis: Adequate working capital enables a business concern to face the crisis
during emergency period such as depression. Most of the business concern have no adequate
working capital during depression period. If one business concern has adequate working capital, the
specified business concern can reap more benefits.

14. Research and Innovation Programme: No research programme, innovation and technical
developments are possible to be undertaken without sufficient amount of working capital.

15. Quick and Regular Return on Investments: Investor would always look for a way to earn quick
bucks. They also expect a regular returns on their investments. A company can pay the dividends to
its shareholders i.e. investors very quickly and regularly by maintaining sufficient amount of
working capital. This type of practice helps in obtaining confidence among the shareholders.

16. Expansion Facilitated: The expansion of any type of business programme requires additional
funds. Adequate working capital facilitates the business concern for the successful implementation
of the expansion programme.

17. Increased Profitability: There should be a right proportion of fixed assets and current assets. The
maintenance of adequate working capital ensures the right proportion of fixed assets and current
assets. If so, there is a chance of being increased profitability of the business concern.

Working Capital Financing Policy

A firm can adopt different financing policies vis-à-vis current assets. Three types of financing
may be distinguished as:
• Long-term financing The sources of long-term financing include ordinary share
capital, preference share capital, debentures, long-term borrowings from financial
institutions and reserves and surplus (retained earnings).
• Short-term financing The short-term financing is obtained for a period less than one
year. It is arranged in advance from banks and other suppliers of short-term finance in
the money market. Short-term finances include working capital funds from banks,
public deposits, commercial paper, factoring of receivables, etc.

4
Depending on the mix of short and long-term financing, the approach followed by a company
may be referred to as:
• Matching approach
• Conservative approach
• Aggressive approach

Matching Principle
The firm can adopt a financial plan which matches the expected life of assets with the expected
life of the source of funds raised to finance assets. Thus, a ten-year loan may be raised to finance
a plant with an expected life of ten years; stock of goods to be sold in thirty days may be
financed with a thirty-day commercial paper or a bank loan. The justification for the exact
matching is that, since the purpose of financing is to pay for assets, the source of financing and
the asset should be relinquished simultaneously. Using long-term financing for short-term
assets is expensive as funds will not be utilized for the full period. Similarly, financing long-
term assets with short-term financing is costly as well as inconvenient, as arrangements for the
new short-term financing will have to be made on a continuing basis. When the firm follows a
matching approach (also known as hedging approach), long-term financing will be used to
finance fixed assets and permanent current assets and short-term financing to finance
temporary or variable current assets. However, it should be realized that exact matching is not
possible because of the uncertainty about the expected lives of assets.

Conservative Approach

A firm in practice may adopt a conservative approach in financing its current and fixed assets.
The financing policy of the firm is said to be conservative when it depends more on long-term
funds for financing needs. Under a conservative plan, the firm finances its permanent assets
and also a part of temporary current assets with long-term financing. In the periods when the
firm has no need for temporary current assets, the idle long-term funds can be invested in the
tradable securities to conserve liquidity. The conservative plan relies heavily on long-term
financing and, therefore, the firm has less risk of facing the
problem of shortage of funds. It can be noted from the below image that when the firm has no
5
temporary current assets [e.g., at (a) and (b)], the released long-term funds can be invested in
marketable securities to build up the liquidity position of the firm.

Aggressive Approach

A firm may be aggressive in financing its assets. An aggressive policy is said to be followed
by the firm when it uses more short-term financing than warranted by the matching plan. Under
an aggressive policy, the firm finances a part of its permanent current assets with short term
financing. Some extremely aggressive firms may even finance a part of their fixed assets with
short-term financing. The relatively large use of short-term financing makes the firm more
risky.

6
Working Capital Financing - Short term sources

Main short-term sources of financing the working capital requirements are as follows –

1. Trade Credit

• Trade credit refers to the credit extended by supplier of goods and services; the time
lag between purchase and payment represents a source of finance for purchase
• The credit period varies depending on the nature of product and practices followed in
that industry
• It can be an informal arrangement between the buyer and the seller or a formal
agreement
• Granting of trade credit by suppliers depends on certain factors such as – past record
of payment, liquidity position of the firm and past earnings record of the firm
• Trade discount may also be present to for making payment to the seller before the
credit period

2. Bank Credit

Working capital finance is provided by banks in the following ways – i) Cash credit /
Overdraft ii) Loans iii) Purchase or discounting of bills iv) letter of credit

Cash credit /Overdraft –

• Under this arrangement, the bank specifies a predetermined borrowing or credit limit.
The borrower can draw up to the stipulated limit. Within the specified limit, any
number of drawings is possible
• Interest is levied on the amount actually utilized by the borrower and not on the total
limit
Loans
• Loans of fixed amount which are credited to the current account of the borrower
• Interest is paid on the entire amount of loan
• Loans are repaid on installments

Purchase or discounting of bills

• A bill is an agreement between buyer and seller for a credit purchase transaction;
• Seller of the goods draws bill on the purchaser of goods, with amount payable on
demand or within a specified period – not more than 90 days
• Once the bill is accepted by the purchaser, the seller offers it to the bank and bank will
release the money to the seller after deducting certain amount; On the due, date bank
recovers the amount from the purchaser
• Banks can rediscount the bills with other banks or RBI

Letter of credit
• It is a letter written by a bank stating that the bank guarantees payment of an invoiced
amount if all the underlying agreements are met
• Purchaser of the goods obtains a letter of credit from the bank; Bank undertakes the
responsibility to make payment to the supplier in case the buyer fails to meet his
obligations.

7
3. Commercial Papers
• A commercial paper is an unsecured money market instrument issued in the
form of a promissory note to investors
• It is governed by the guidelines issued by RBI
• It is issued through Issuing and paying agent (IPA) – which must be a
scheduled bank
• A CP can be issued by a company which meets the specified requirements
mentioned in the guidelines
• CP can be issued for a period between 7 days to 1 year from the date of issue
• Credit rating of CP is mandatory
• It can be issued in denominations of Rs. 5 lakh and multiples thereof
• It will be issued at a discount to the face value and are redeemed at their face
value

4. Factoring

• A ‘factor’ is a financial institution that specializes in purchasing accounts receivables

(debtors) from business firms sales
• Factoring can broadly be defined as an agreement in which receivables arising out of
sale of goods / services are sold by a firm to a ‘factor’; the title of the goods / services
represented by the said receivables passes on to the factor
• Factor functions as an intermediary between the seller and the customer (debtor)
• Factor charges a commission as a percentage of debt amount ; it also charges interest
for the period between the date of advance payment and date of collection from the
debtor
• Factor performs the following functions –
• Purchase of debts of the seller- it grants advances to the seller to the extent of
80% of the debt and remaining amount is paid once amount is collected from
the debtor; In case the debtor does not pay on due date, seller has to refund the
amount to the factor – this is called factor with recourse
• Collection facility – factor undertakes the task of collecting the amount from
the debtors and also maintenance of sales records
• Acceptance of credit risks – in case of factor without recourse, factor assumes
the risk of default in payment by the debtor
• The benefits of factoring are – No need for credit and collection department
results in efficiency; Ensures smooth cash inflows from the credit sales
• Regulated by Factoring Regulation Act, 2011.

Operating Cycle and Cash Cycle

The investment in working capital is influenced by four keys events in the production and
sales cycle of the firm:
Purchase of raw materials
■ Payment for raw materials
■ Sale of finished goods
■ Collection of cash for sales

The below picture depicts these events on the cash flow line. The firm begins with the purchase
of raw materials which are paid for after a delay which represents the accounts payable period.

8
The firm converts the raw materials into finished goods and then sells the same. The time lag
between the purchase of raw materials and the sale of finished goods is the inventory period.
Customers pay their bills sometime after the sales. The period that elapses between the date of
sales and the date of collection of receivables is the accounts payable period (debt period).

The time that elapses between the purchase of raw materials and the collection of cash for sales
is referred to as the operating cycle, whereas the time length between the payment for raw
material purchases and the collection of cash for sales is referred to as the cash cycle. The
operating cycle is the sum of the inventory period and the accounts receivable period, whereas
the cash cycle is equal to the operating cycle less the accounts payable period. From the
financial statements of the firm, we can estimate the inventory period, the accounts receivable
period, and the accounts payable period.

Computation of Operating Cycle and Cash Cycle

Operating Cycle = Raw material holding period + WIP period + FG holding period +
Debtor collection Period

Raw material holding period + WIP period + FG holding period = Inventory Holding
Period

Cash cycle = Operating cycle – Creditor payment period

Raw material holding period =

Average Stock of Raw material X Number of days/months in a year

Cost of raw materials consumed

Work in Progress holding period = Average WIP X Number of days/months in a year

Cost of production

9
 Finished goods holding period =

Average stock of finished goods X Number of days/months in a year

Cost of goods sold or cost of sales

Inventory Period = Average Inventory X Number of days/months in a year

Cost of goods sold

Accounts receivables period = Average Debtors X Number of days in a year

Credit sales

Accounts payable period = Average Creditors X Number of days in a year

Credit purchases

Average balance = Opening balance + Closing balance

2

Estimation of working capital requirements

• Two components of working capital are : Current Assets and Current Liabilities; Cost
of various components under current assets and current liabilities needs to be estimated
• Working capital computed with reference to cash cost : It excludes depreciation and
profit margin

Calculation of working capital is based on the assumption that the production / sales is
carried out evenly throughout the year

Step 1 Estimation of Current Assets

a) Desired cash and bank balances
b) Inventories – Raw material, Work in Progress, Finished Goods
c) Debtors or Accounts receivables
Total Current Assets (a+b+c)

Step 2 Estimation of Current Liabilities

a) Creditors or Accounts payables
b) Wages
c) Overheads
Total Current Liabilities (a+b+c)
Step 3 Net Working Capital = Step 1 - Step 2 (Total Current Assets – Total Current
Liabilities)
Add Margin required for contingency / emergency
Step 4 Net working capital required

10
1. Estimation of Current Assets

Raw material inventory = Cost of raw material X Average inventory holding period
12 or 52 or 365

Work in progress inventory = Cost of WIP X Average time span of WIP

12 or 52 or 365

Cost of WIP = Proportionate share of cost of raw materials and labour and overhead excluding
depreciation; Labour and overhead expenses are known as conversion costs

Finished goods inventory =

Cost of goods produced (excl. depreciation) X Finished goods holding period
12 or 52 of 365

Debtors = Cost of credit sales (excl. depreciation) X Average debt collection period
12 or 52 or 365

Note – Any holding period or payment period or time-lag could be in term of days or weeks
or months; E.g. finished goods holding period can be 1 month or 2 weeks or 21 days

Note – Any advance payment made to creditors will be shown under Current assets ; Same is
applicable for advance payment of wages and overheads (prepaid expenses)

2. Estimation of Current Liabilities

Creditors = Raw material cost X Creditor payment period

12 or 52 or 365

Note - Only credit purchases need to be considered

Direct wages = Direct labour cost X Average time-lag in payment of wages

12 or 52 or 365
Overheads = Overhead costs X Average time-lag in payment of overheads
12 or 52 or 365

Note - The payment period and time-lag for other costs could be in term of days or weeks or
months
Note - Advance received from debtors to be shown under current liabilities

Points to remember
• Check whether the holding period/ time lag is mentioned in terms of
days/weeks/months
• Check whether cost is mentioned in terms of price per unit or total cost
• Check if information on credit sales and credit purchases are given separately
• Check if different completion percentages is given for different elements under work
in progress (Raw material + labour + overheads)
• Check if number of units are mentioned separately for any elements such as – WIP/
Finished goods/ debtors

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• Check if any safety margin to be added for contingencies
• Show working notes / assumptions that you made wherever possible along
with theanswer

Important Theoretical Questions

• Explain the significance of maintaining adequate amount of working capital.

• Define working capital
• Various factors influencing working capital requirements
• Analyse the working capital financing policy.
• Elaborate the sources of short term finance for working capital.
• Hedging approach of financing working capital funds requirements
• What is Operating cycle? What is cash cycle
• Gross operating cycle and net operating cycle
• Distinguish between gross working capital and net working capital
• What is factoring?
• What is letter of credit?
• Dangers of excess working capital and inadequate working capital/ List problems
of excessive working capital
• Discuss the Current asset finance policy (Hedging and Conservative approach)

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