Financial Management

FINANCIAL MANAGEMENT
CHAPTER 1
OVERVIEW OF FINANCE FUNCTION
Learning Objectives
After reading this unit, you will be able to:
Understand the nature and scope and significance of finance
function
State the importance of agency cost
Understand the role of finance manger
Structure
1.1 Introduction
1.2 Nature and scope of Finance Function
1.3 Goal of Finance Function
1.4 Significance of Finance Function
1.5 Agency Cost Theory
1.6 Role of Modern Finance Manager
1.7 Summary
1.1 Introduction
Finance is the backbone of every business. No activity in the business can be

carried out as per expectations of management without proper support of
finance function. This unit makes you to understand the meaning, significance,
objective and role of finance function in any organization.
1.2 Nature And Scope Of Finance Function
(A) Nature:
1. Business is exchange of goods and services for profit. Profit is a function of
revenue and expenses. Business earns revenue only when goods and
services are delivered to customer where, when and how he wants. Thus
unless expenses are incurred first by business it cannot earn profits. Finance
function deals with organizing funds required for these expenses.
2. Finance function permeates throughout the organization. No activity in

business can be effectively and efficiently carried out without proper support of
finance function.
3. Even for non-profit making organizations, it is a necessary function.
4. Thus, finance function is fundamental to every business and is foundation of

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any commercial activity. It is necessary for survival and success of any

business.
5. Finance is a service function and it must give proper support to all functions
in an organization in terms of M.I.S., which is useful for decision-making and
control throughout the organization.
(B) Scope :
Scope of finance function extends to following three areas:
(a) Procurement of funds (Financing decisions)
1) Prime responsibility of finance management is to ensure that sufficient

amount of funds is made available to all business activities all the times.
2) The quantum of funds required by business depends upon goal of business
and plans of management to achieve this goal.
3) Finance management has to assess volume of funds required, when they
are required and locate sources from which these funds can be procured.
4) Company has following sources available for procuring funds:
Ÿ Share Capital
Ÿ Debenture Capital
Ÿ Loan Capital
5) Funds are required for two main purposes. Long-term funds are required for
creating infrastructure and building production capacity as well as for
developing sales network required to achieve the desired goal. Short-term
funds are required for meeting day-to-day fund requirements of the
organization.
6) Long-term requirements are met by issuing share capital, debenture capital
or by taking long-term loan. Short-term requirements can be met by taking
short-term loans known as working capital loans from banks or financial
institutions.
7) While deciding a particular source of finance following factors need
consideration
Ÿ Cost of funds, i.e. interest and other costs
Ÿ Convenience of organization
Ÿ Risks involved
8) Interest charged by banks depends on percentage of Cash Reserve Ratio(
C.R.R) and Statutory Liquidity Ratio (S.L.R) to be maintained by banks.
Banks have been given powers to negotiate interest rates within certain limits.
Finance manager must keep in mind the changes in C.R.R. and S.L.R. and try
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to negotiate with banks for lower rate of interest.

9) Funds are also available at cheaper rates from many foreign sources.
Finance manager must take advantage of these opportunities so that interest
cost would come down and it would be useful for reducing product cost, which
is very much essential for competitive advantage of the firm.
(b) Utilization of funds (Investment decisions)

Funds procured are to be properly deployed in the business and finance
manager has to ensure that funds deployed in various areas of business are
properly utilized. For this, he should initiate following actions:
1) Assess exact finance requirements of various divisions.
2) Deploy funds only which are required and only when they are
required.
3) Ensure that funds are utilized for the purposes as desired by Board of
Directors .
4) Employ various techniques such as budgets, standards, plans, MIS,
cost reduction etc. to ensure that funds are efficiently used by all
divisions of company.
5) Analyse financial performance of organization and periodically
perform top management regarding utility of funds and profitability of
various divisions and organization on a whole.
6) Initiate various actions to correct the situations wherever there is
deviation from predetermined level of fund utilization and analyze its
effect.
7) Finance manager has to ensure top management that required
Returns on Investment (R.O.I) would be available to shareholders of
company.
(c) Distribution of Funds (Dividend Decisions)
Providers of equity funds expect returns on their investments and providers of
loan funds expect repayment of their interest and principal. Following points
are therefore worth noting:
1) Earning Before Interest and Tax (EBIT) should be sufficient to pay
interest burden of organization. This can be achieved by better
operational profits through improved operational efficiency and better
fund management.
2) Earnings After Tax (EAT) should be sufficient to pay dividend to
preference shareholders.
3) Amount remaining after payment of preference dividend is available to
equity shareholders and this decides Earning Per Share (EPS).
4) Of the total amount available to equity shareholders, certain
percentage is retained by management as retained earnings.
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Remaining amount is distributed as divided on equity shares.

5) Finance manager has to assist Board of Directors for taking decision on
dividend percentage and percentage of earnings to be retained.For this,
following factors need consideration:
Ÿ Future growth and expansion plan of organization
Ÿ Future financial needs of organization
Ÿ Expectations of equity Shareholders
Ÿ Goodwill and image of organization
Ÿ Stability of dividend
Ÿ Attitude of management
Ÿ Legal requirements
Ÿ Effect on market value of company's shares
Ÿ Effect on liquidity of firm
Ÿ Cash dividends versus bonus shares
1.3 Goal Of Finance Function
A) Goal of Wealth Maximization:

Financial management has principal goal as maximizing wealth of current
shareholders. This goal has been defended on following grounds:
(i) In a market-based economy, social responsibility of business is to create
value.
(ii) Increasing company's value is a concern of everyone who has a stake in
company including shareholders of company.
(iii) It calls for more effective deployment and most productive use of scarce
resources available with organization.
(iv) It ensures faster economic growth and improvement in standard of living
of the society.
(v) It reflects financial power of the organization.
This goal has been criticized on following grounds:

(I) Many times, stock markets do not reflect correct prices of securities as
they are dominated by many other forces.
(ii) Shareholders can also be rewarded in following ways.
a) Maximizing Company's market share.
b) Enhancing customer satisfaction by offering products at
competitive price, giving desired Quality products and
maintaining delivery schedule desired by customer.
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c) Giving products with zero defects.

(iii) There are interests of various groups in organization who are having
their stakes in company and these interests must be properly dealt
with, for example,
Ÿ Customers require products of desired quality at reasonable price.
Ÿ Employees expect reasonable returns for the services rendered
by them.
Ÿ Shareholders require maximum R.O.I. on their investment.
Ÿ Suppliers require reasonable price and continued business for the
goods supplies by them.
Ÿ Society at large expect goods and services which will enhance
their standard of living.
(iv) Firm should not concentrate on maximization of wealth of shareholders
but try to achieve balance between the interests of these groups.
(v) Firm must consider itself as a socially responsible entity and should try
to discharge its responsibilities towards society because firm
operates with the franchise given to it by the society.
B) Goal of Profit Maximization:

Besides the goal of wealth maximization other suggested goals of financial
management in terms of profit maximization are:
Ÿ Maximization of profits
Ÿ Maximization of Earning Per Share (E.P.S.)
Ÿ Maximization of return on equity
Maximization of profit is not as inclusive a goal as maximization of wealth of
shareholders. It suffers from following limitations:
a) Profit in absolute terms is not a proper guide to decision-making. It
should be expressed either on per share basis or in relation to
investment.
b) Moreover, which profits are to be maximized remains a problem, i.e.
P.B.T. or P.A.T. This limitation does not apply to maximization of E.P.S. or
return on equity.
c) All the above 3 goals suffer from following limitations :
Ÿ They do not consider time value of money. Profits earned at
different points of time cannot be compared because their
present values are different.
Ÿ They ignore risk factor e.g. there is no discrimination between
investment project that generates a certain profit of Rs.50,000
and one that has a variable profit outcome with an expected
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value of Rs.50,000.
C) Conclusion:
Ÿ Thus, maximization of wealth of equity shareholders as reflected in
market value of equity appears to be most appropriate goal for
financial decision-making.
Ÿ Businesses often pursue several goals such as :
I. High rate of growth
ii. Increased market share
iii. Attain market leadership
iv. Attain technological superiority
v. Promote employee welfare
vi. Increased customer satisfaction and so on
Some of these goals are in line with the goal of wealth maximization and some
conflict with it. It is important to know cost of pursuing these goals and
trade-off must be understood.
Ÿ Maximization of wealth of equity shareholders constitutes the principal
guarantee for efficient allocation of resources in economy and hence is
to be regarded as the normative goal from financial point of view.
Ÿ Many Indian companies have started according greater importance to
the goal of wealth maximization. Some of the reasons for this are:
I) Many business families take higher education abroad and hence they
have realized importance of shareholder value more.
ii) With liberalization, companies require more funds and their dependence
of capital markets have increased. This has induced companies to
become more shareholder-friendly.
iii) Companies are relying more on mutual funds, financial institutions and
foreign institutional investors for raising equity capital. They compel
companies to pursue shareholder friendly policies.
iv) With abolition of wealth tax on equity shares and other financial assets,
there is now an incentive to enhance share prices.
1.4 Significance Of Finance Function

Finance is backbone of every business. Every activity requires interaction and
support of finance department.
(A) General
In general, it is useful to organization as a whole on the following aspects:
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(i) To know utilization of funds employed in business.

(ii) To assess fund requirements for future growth and expansion.
(iii) To provide periodical information on profitability of firm.
(iv) To highlight areas of financial inefficiency.
(v) To judge efficacy of management efforts.
(vi) To understand operational efficiency of the organization.
(vii) To assess liquidity and solvency of firm.
(viii) Economic Value Added reporting is now-a-days part of financial
reporting for many blue chips companies, e.g. Coca-Cola.
(ix) To evaluate interest burden of organization.
(x) To design appropriate capital structure of company.
(B) Top management

There is constant interaction of top management with finance department of
organization. In particular, it is useful to top management on following
aspects:
(i) To assess effect of various strategies on financial position of
company.
(ii) To express goals of organization in financial terms.
(iii) To formulate financial policies of company.
(iv) To make financial plans of company.
(v) Finance manager gives periodical profitability reports to top
management which show division wise profits, overall profits and
Return on Investment of company.
(vi) Top management takes many vital decisions such as finalizing
capital budgeting proposals, designing capital structure of
company or restructuring of organization through mergers and
acquisitions. Finance manager provides useful information for
taking these decisions.
(vii) Board of directors declares dividend only after consulting finance
manager.
(C) Research & Development (R&D)

I. Formulating R & D budgets of company.
ii. Project wise allocation of funds.
iii. Controlling utilization of funds allocated to various projects.
iv. Comparing R & D budgets of company with R & D budgets of
competitors.
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v. Cost-benefit analysis of various R & D projects.
(D) Materials Management

I. Formulating vendor development budget of company.
ii. Participate in negotiations with suppliers along with purchase
executives.
iii. Preparing purchase budget of company.
iv. Designing inventory policy of company with reference to funds
requirement.
v. Set inventory valuation norms.
(E) Production management

I. Formulating production budget.
ii. Monitor and control production costs through these budgets with
close interaction with production management.
iii. Preparing material and labour expense budgets.
iv. Make the required funds available for day to day production
activities.
v. Appraisal of capital expenditure proposals forwarded by production
management.
(F) Sales and marketing

I. Preparing sales budget.
ii. Preparing budget for advertisement.
iii. Monitor expenses on Sales and marketing activities.
iv. Decide credit and collection policy of company.
(G) Human Resource Management

I. Prepare Employee cost budget for entire organization through
close interaction with personnel manager.
ii. Making funds available for voluntary retirement scheme
iii. Prepare training and development budget
iv. Involve in mass bargaining negotiations with employee
representatives.
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1.5 Agency Cost Theory
a) Meaning of agency problem

Ÿ One of the important features of corporate enterprise is the
separation between ownership and management.
Ÿ Shareholders of company are scattered and not organized. They
hardly have control on management of company. Therefore,
management of company may act in their own interests rather than
interests of owner.
Ÿ Management enjoys substantial autonomy in regard to affairs of
company.
Ÿ Management would achieve minimum acceptable level of
performance to satisfy goals of shareholders. They would neglect
maximizing shareholder's wealth and focus on their own personal
goals.
Ÿ Thus conflict between personal goal of management and maximizing
shareholders wealth gives rise to agency problem.
b) Remedies on agency problem

Agency problem can be prevented or minimized by two measures.
(A) Act of market forces

Market forces act in two ways:
(i) Behavior of security market participants
Ÿ Shareholders in general and large institutional investors such as
mutual funds, Insurance companies and Financial Institutions hold
large block of shares. They actively participate in management.
Ÿ To ensure competent management and minimize agency problems
they actively exercise their voting rights to replace competent
management in place of underperforming management.
Ÿ Large institutional investors communicate from time to time and exert
pressure on corporate management to perform or face replacement.
(ii) Hostile takeovers

There can be acquisition of inefficient firm by another firm. Such
acquisition may be at low value as the target firm is undervalued due
to poor management. Constant threat of a takeover would motivate
management to act in the best interests of the owners.
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(B) Agency costs

To minimize agency problems and for maximization of shareholders
wealth, shareholders (owners) have to incur four types of costs.
I. Monitoring Expenses
These expenses relate to payment for audit and control monitoring
activities of management through agents.
ii. Bonding Expenses
These are payment by owners to protect themselves against the
potential consequences of dishonest act by management.
iii. Opportunity Costs.
iv. Due to organizational structures, decision hierarchy and control
mechanism, management may face difficulties in seizing upon
profitable investment opportunities quickly.
v. Structuring Expenditures
They relate to structuring managerial compensation in line with share
price maximization. Incentive package in the form of stock options at
concessional price or compensation related to growth in E.P.S. and
other ratios related to returns may be offered to managers so they act
in best interests of shareholders.
1.6 Role Of Modern Finance Manager
In modern enterprise, finance manager occupies key position:

a) He is one of the members of top management team.
b) His role day-by-day is becoming more pervasive, intensive and
significant in solving complex managerial problems.
c) He is no more a score keeper maintaining records, preparing reports and
raising funds as and which needed or a staff officer acting in a passive
role of an advisor.
d) His job is vastly changed. Earlier finance was a supporting function.
Now it is a mainline function.
e) In many organizations finance itself is considered as profit centre.
f) In his new role, he needs to have a broader and far sighted outlook and
must ensure that funds of organization are utilized in most efficient
manner.
In last few years, Indian economic and financial environment has undergone
sea changes, important ones being:
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a) Industrial licensing considerably relaxed.

b) MRTP Act has been virtually abolished.
c) Foreign Exchange Regulation Act (FERA) has been liberalized and
replaced by Foreign Exchange Management Act (FEMA).
d) Considerable freedom given to companies in pricing their equity shares.
e) Foreign investment is liberalized.
f) Interest rates have been considerably brought down.
g) Rupee is made fully convertible on current account.
h) Dependence on capital market has increased.
These changes have made job of finance manager more important, complex
and demanding.
The key challenges for finance manager in new competitive environment are:
I) Locate the sources of funds nationally and internationally which are cost
effective and convenient to the firm.
ii) Invest funds in projects, which would add value to company so that effective
and efficient utilization of funds is ensured.
iii) In his new role of using funds wisely he must address following three
Questions:
a) What should be size of an enterprise and how far should it grow?
b) In what form should it hold its assets?
c) How the required funds be raised?
These questions relate to three broad decision areas viz. investment,
financing and dividend decisions. Modern finance manager has to help
management making these decisions in most rational way.
iv) Profit planning which refers to operating decisions in the areas of pricing,
costs, volume of output and firm's selection of product lines.
v) Develop M.I.S. such that every business decision maker and managers at
operating level gets information at the earliest so that decision-making
becomes qualitative and fast and also proper control is ensured throughout
the organization.
vi) Continuously update management with risk-return analysis of various
projects.
vii) Implement effective cost reduction programme on continuous basis.
viii) Evaluate financial impact of proposed corporate restructuring.
ix) Design capital structure, which will give minimum overall cost of capital and
help improving wealth of shareholders through increased market value of
shares.
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OPERATIONS MANAGEMENT
CHAPTER 1
PRODUCTION OPERATIONS BASICS
Learning Objectives
After going through this unit, you will be able to:
Arrange for the operations process
Calculate the efficiency of the process
Evaluate the effectiveness of the process
Establish relationship between economic growth and productivity
Structure
1.1 Introduction to Production concept
1.2 Production Relationship
1.3 Economic growth and productivity
1.4 Main processes of a company
1.5 Operations management
1.6 Efficiency & Effectiveness
1.7 Summary
1.8 Key Words
1.1 Introduction to Production concept

Production' refers to the economic process of converting of inputs into outputs.
Production uses resources to create a good or service that is suitable for use,
gift-giving in a gift economy, or exchange in a market economy. This can
include manufacturing, storing, shipping, and packaging. Some economists
define production broadly as all economic activity other than consumption.
They see every commercial activity other than the final purchase as some form
of production.
Production is a process, and as such it occurs through time and space.
Because it is a flow concept, production is measured as a “rate of output per
period of time”. There are three aspects to production processes:
1. the quantity of the good or service produced,
2. the form of the good or service created,
3. The temporal and spatial distribution of the good or service produced.
A production process can be defined as any activity that increases the
similarity between the pattern of demand for goods and services, and the
quantity, form, shape, size, length and distribution of these goods and services
available to the market place.
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Factors of production
The inputs or resources used in the production process are called factors of
production by economists. The myriad of possible inputs are usually grouped
into five categories. These factors are:
Materials
Machinery
Manpower
Money
Minutes ( Time )
In the “long run”, all of these factors of production can be adjusted by
management. The “short run”, however, is defined as a period in which at least
one of the factors of production is fixed.
A fixed factor of production is one whose quantity cannot readily be changed.
Examples include major pieces of equipment, suitable factory space, and key
managerial personnel.
A variable factor of production is one whose usage rate can be changed easily.
Examples include electrical power consumption, transportation services, and
most raw material inputs. In the short run, a firm's “scale of operations”
determines the maximum number of outputs that can be produced. In the long
run, there are no scale limitations.
Total, average, and marginal product

period of time
Output per
A
Qm
Units of input
used per period
of time
Total Product Curve
The total product (or total physical product) of a variable factor of production
identifies what outputs are possible using various levels of the variable input.
This can be displayed in either a chart that lists the output level corresponding
to various levels of input, or a graph that summarizes the data into a “total
product curve”. The diagram shows a typical total product curve. In this
example, output increases as more inputs are employed up until point A. The
maximum output possible with this production process is Qm. (If there are
other inputs used in the process, they are assumed to be fixed.)
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The average physical product is the total production divided by the number of
units of variable input employed. It is the output of each unit of input. If there are
10 employees working on a production process that manufactures 50 units per
day, then the average product of variable labour input is 5 units per day.
APP and MPP
APP
Units of inputs
used per period
of time
MPP
Average and Marginal Physical Product Curves
The average product typically varies as more of the input is employed, so this
relationship can also be expressed as a chart or as a graph. A typical average
physical product curve is shown (APP). It can be obtained by drawing a vector
from the origin to various points on the total product curve and plotting the
slopes of these vectors.
The marginal physical product of a variable input is the change in total output
due to a one unit change in the variable input (called the discrete marginal
product) or alternatively the rate of change in total output due to an
infinitesimally small change in the variable input (called the continuous
marginal product). The discrete marginal product of capital is the additional
output resulting from the use of an additional unit of capital (assuming all other
factors are fixed). The continuous marginal product of a variable input can be
calculated as the derivative of quantity produced with respect to variable input
employed. The marginal physical product curve is shown (MPP). It can be
obtained from the slope of the total product curve.
Because the marginal product drives changes in the average product, we
know that when the average physical product is falling, the marginal physical
product must be less than the average. Likewise, when the average physical
product is rising, it must be due to a marginal physical product greater than the
average. For this reason, the marginal physical product curve must intersect
the maximum point on the average physical product curve.
Notes: MPP keeps increasing until it reaches its maximum. Up until this point
every additional unit has been adding more value to the total product than the
previous one. From this point onwards, every additional unit adds less to the
total product compared to the previous one – MPP is decreasing. But the
average product is still increasing till MPP touches APP. At this point, an
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additional unit is adding the same value as the average product. From this
point onwards, APP starts to reduce because every additional unit is adding
less to APP than the average product. But the total product is still increasing
because every additional unit is still contributing positively. Therefore, during
this period, both, the average as well as marginal products, are decreasing, but
the total product is still increasing. Finally we reach a point when MPP crosses
the x-axis. At this point every additional unit starts to diminish the product of
previous units, possibly by getting into their way. Therefore the total product
starts to decrease at this point. This is point A on the total product curve.
(Courtesy: Dr. Shehzad Inayat Ali).
1.2 Production Relationship

Diminishing returns Concept
Diminishing returns can be divided into three categories:
1. Diminishing Total returns, which implies reduction in total product with
every additional unit of input. This occurs after point A in the graph.
2. Diminishing Average returns, which refers to the portion of the APP curve
after its intersection with MPP curve.
3. Diminishing Marginal returns, refers to the point where the MPP curve
starts to slope down and travels all the way down to the x-axis and beyond.
Putting it in a chronological order, at first the marginal returns start to diminish,
then the average returns, followed finally by the total returns.
Diminishing marginal returns

These curves illustrate the principle of diminishing marginal returns to a
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variable input (not to be confused with diseconomies of scale which is a long

term phenomenon in which all factors are allowed to change). This states that
as you add more and more of a variable input, you will reach a point beyond
which the resulting increase in output starts to diminish. This point is illustrated
as the maximum point on the marginal physical product curve. It assumes that
other factor inputs (if they are used in the process) are held constant. An
example is the employment of labour in the use of trucks to transport goods.
Assuming the number of available trucks (capital) is fixed, then the amount of
the variable input labour could be varied and the resultant efficiency
determined. At least one labourer (the driver) is necessary. Additional workers
per vehicle could be productive in loading, unloading, navigation, or around the
clock continuous driving. But at some point the returns to investment in labour
will start to diminish and efficiency will decrease. The most efficient distribution
of labour per piece of equipment will likely be one driver plus an additional
worker for other tasks (2 workers per truck would be more efficient than 5 per
truck).
Resource allocations and distributive efficiencies in the mix of capital and
labour investment will vary per industry and according to available technology.
Trains are able to transport much more in the way of goods with fewer "drivers"
but at the cost of greater investment in infrastructure. With the advent of mass
production of motorized vehicles, the economic niche occupied by trains
(compared with transport trucks) has become more specialized and limited to
long haul delivery.
P.S.: There is an argument that if the theory is holding everything constant, the
production method should not be changed, i.e., division of labour should not be
practiced. However, the rise in marginal product means that the workers use
other means of production method, such as in loading, unloading, navigation,
or around the clock continuous driving. For this reason, some economists think
that the “keeping other things constant” should not be used in this theory.
Expressing the production relationship

The total, average, and marginal physical product curves mentioned above
are just one way of showing production relationships. They express the
quantity of output relative to the amount of variable input employed while
holding fixed inputs constant. Because they depict a short run relationship,
they are sometimes called short run production functions. If all inputs are
allowed to be varied, then the diagram would express outputs relative to total
inputs, and the function would be a long run production function. If the mix of
inputs is held constant, then output would be expressed relative to inputs of a
fixed composition, and the function would indicate long run economies of scale
Rather than comparing inputs to outputs, it is also possible to assess the mix of
inputs employed in production. An isoquant (see below) relates the quantities
of one input to the quantities of another input. It indicates all possible
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combinations of inputs that are capable of producing a given level of output.

Rather than looking at the inputs used in production, it is possible to look at the
mix of outputs that are possible for any given production process. This is done
with a production possibilities frontier. It indicates what combinations of
outputs are possible given the available factor endowment and the prevailing
production technology.
Isoquants
K
0
O = 100,000
0
L L
0
Isoquant Curve/Isocost Curve
Two Isoquants (Interior and Corner Solutions)
An isoquant represents those combinations of inputs, which will be capable of

producing an equal quantity of output; the producer would be indifferent
between them. The isoquants are thus contour lines, which trace the loci of
equal outputs. As the production remains the same on any point of this line, it is
also called equal product curve. Let, Q0 = f(L,K) is a production factor. Where,
Q0 = A fixed level of production.
L = Labour
K = Capital
If three combinations of labour and capital A, B and C produces 10 units of
product, than the isoquant will be like Figure 1.
Here we see that the combination of L1 labour and K3 capital can produce 10
units of product, which is A on the isoquant. Now to increase the labour keeping
the production same the organization have to decrease capital. IN Figure 1 B is
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the point where capital decreases to K2, while labour increases to L2.
Similarly, 10 units of product may produce at point C on the isoquant with
capital K1 and labour L3. Each of the factor combinations A, B and C produces
the same level of output, 10 units.
The marginal rate of technical substitution
Marginal Rate of Technical Substitution
Isoquants are typically convex to the origin reflecting the fact that the two
factors are substitutable for each other at varying rates. This rate of
substitutability is called the “marginal rate of technical substitution” (MRTS) or
occasionally the “marginal rate of substitution in production”. It measures the
reduction in one input per unit increase in the other input that is just sufficient to
maintain a constant level of production. For example, the marginal rate of
substitution of labour for capital gives the amount of capital that can be
replaced by one unit of labour while keeping output unchanged.
To move from point A to point B in the diagram, the amount of capital is reduced
from Ka to Kb while the amount of labour is increased only from La to Lb. To
move from point C to point D, the amount of capital is reduced from Kc to Kd
while the amount of labour is increased from Lc to Ld. The marginal rate of
technical substitution of labour for capital is equivalent to the absolute slope of
the isoquant at that point (change in capital divided by change in labour). It is
equal to 0 where the isoquant becomes horizontal, and equal to infinity where it
becomes vertical.
The opposite is true when going in the other direction (from D to C to B to A). In
this case we are looking at the marginal rate of technical substitution capital for
labour (which is the reciprocal of the marginal rate of technical substitution
labour for capital).
It can also be shown that the marginal rate of substitution labour for capital is
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equal to the marginal physical product of labour divided by the marginal

physical product of capital.
In the unusual case of two inputs that are perfect substitutes for each other in
production, the isoquant would be linear (linear in the sense of a function y = a
− bx). If, on the other hand, there is only one production process available,
factor proportions would be fixed, and these zero-substitutability isoquants
would be shown as horizontal or vertical lines.
1.3 Economic growth and productivity
Components of economic growth (Saari 2006)
Production is a process of combining various material inputs and immaterial

inputs (plans, know-how) in order to make something for consumption (the
output). The methods of combining the inputs of production in the process of
making output are called technology. Technology can be depicted
mathematically by the production function which describes the relation
between input and output. The production function can be used as a measure
of relative performance when comparing technologies.
The production function is a simple description of the mechanism of economic
growth. Economic growth is defined as any production increase of a business
or nation (whatever you are measuring). It is usually expressed as an annual
growth percentage depicting growth of the company output (per entity) or the
national product (per nation). Real economic growth (as opposed to inflation)
consists of two components. These components are an increase in production
input and an increase in productivity.
The figure illustrates an economic growth process (exaggerated for clarity).
The Value T2 (value at time 2) represents the growth in output from Value T1
(value at time 1). Each time of measurement has its own graph of the
production function for that time (the straight lines). The output measured at
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time 2 is greater than the output measured at time one for both of the
components of growth: an increase of inputs and an increase of productivity.
The portion of growth caused by the increase in inputs is shown on line 1 and
does not change the relation between inputs and outputs. The portion of
growth caused by an increase in productivity is shown on line 2 with a steeper
slope. So increased productivity represents greater output per unit of input.
Accordingly, an increase in productivity is characterised by a shift of the
production function (steepening slope) and a consequent change to the
output/input relation. The formula of total productivity is normally written as
follows:
Total productivity = Output quantity / Input quantity
According to this formula, changes in input and output have to be measured
inclusive of both quantitative and qualitative changes. In practice, quantitative
and qualitative changes take place when relative quantities and relative prices
of different input and output factors alter. In order to accentuate qualitative
changes in output and input, the formula of total productivity shall be written as
follows:
Total productivity = Output quality and quantity / Input quality and
quantity
Activity A: Visit any nearby manufacturing unit and list down the different
factors of production used by them.
1.4 Main processes of a company
Main processes of a company (Saari 2006)
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A company can be divided into sub-processes in different ways; yet, the

following five are identified as main processes, each with a logic, objectives,
theory and key figures of its own. It is important to examine each of them
individually, yet, as a part of the whole, in order to be able to measure and
understand them. The main processes of a company are as follows
real process
income distribution process
production process
monetary process
market value process
Productivity is created in the real process, productivity gains are distributed in
the income distribution process and these two processes constitute the
production process. The production process and its sub-processes, the real
process and income distribution process occur simultaneously, and only the
production process is identifiable and measurable by the traditional
accounting practices. The real process and income distribution process can be
identified and measured by extra calculation, and this is why they need to be
analysed separately in order to understand the logic of production
performance.
Real process generates the production output from input, and it can be
described by means of the production function. It refers to a series of events in
production in which production inputs of different quality and quantity are
combined into products of different quality and quantity. Products can be
physical goods, immaterial services and most often combinations of both. The
characteristics created into the product by the manufacturer imply surplus
value to the consumer, and on the basis of the price this value is shared by the
consumer and the producer in the marketplace. This is the mechanism through
which surplus value originates to the consumer and the producer likewise.
Surplus value to the producer is a result of the real process, real income, and
measured proportionally it means productivity. Income distribution process of
the production refers to a series of events in which the unit prices of constant-
quality products and inputs alter causing a change in income distribution
among those participating in the exchange. The magnitude of the change in
income distribution is directly proportionate to the change in prices of the
output and inputs and to their quantities. Productivity gains are distributed, for
example, to customers as lower product sales prices or to staff as higher
income pay. Davis has deliberated the phenomenon of productivity,
measurement of productivity, distribution of productivity gains, and how to
measure such gains. He refers to an article suggesting that the measurement
of productivity shall be developed so that it ”will indicate increases or
decreases in the productivity of the company and also the distribution of the
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distribution of the 'fruits of production' among all parties at interest”. According

to David, the price system is a mechanism through which productivity gains are
distributed, and besides the business enterprise, receiving parties may consist
of its customers, staff and the suppliers of production inputs. In this article, the
concept of ”distribution of the fruits of production” by Davis is simply referred to
as production income distribution or shorter still as distribution.
The production process consists of the real process and the income
distribution process. A result and a criterion of success of the production
process is profitability. The profitability of production is the share of the real
process result the producer has been able to keep to himself in the income
distribution process. Factors describing the production process are the
components of profitability, i.e., returns and costs. They differ from the factors
of the real process in that the components of profitability are given at nominal
prices whereas in the real process the factors are at periodically fixed prices.
Monetary process refers to events related to financing the business. Market
value process refers to a series of events in which investors determine the
market value of the company in the investment markets.
Surplus value as a measure of production profitability
Profitability of production measured by surplus value (Saari 2006)
The scale of success run by a going concern is manifold, and there are no
criteria that might be universally applicable to success. Nevertheless, there is
one criterion by which we can generalise the rate of success in production.
This criterion is the ability to produce surplus value. As a criterion of
profitability, surplus value refers to the difference between returns and costs,
taking into consideration the costs of equity in addition to the costs included in
the profit and loss statement as usual. Surplus value indicates that the output
has more value than the sacrifice made for it, in other words, the output value is
higher than the value (production costs) of the used inputs. If the surplus value
is positive, the owner's profit expectation has been surpassed.
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The table presents a surplus value calculation. This basic example is a

simplified profitability calculation used for illustration and modelling. Even as
reduced, it comprises all phenomena of a real measuring situation and most
importantly the change in the output-input mix between two periods. Hence,
the basic example works as an illustrative “scale model” of production without
any features of a real measuring situation being lost. In practice, there may be
hundreds of products and inputs but the logic of measuring does not differ from
that presented in the basic example.
Both the absolute and relative surplus value has been calculated in the
example. Absolute value is the difference of the output and input values and
the relative value is their relation, respectively. The surplus value calculation in
the example is at a nominal price, calculated at the market price of each period.
1.5 Operations management

Operations management is an area of management concerned with
overseeing, designing, and redesigning business operations in the production
of goods and/or services. It involves the responsibility of ensuring that
business operations are efficient in terms of using as little resources as
needed, and effective in terms of meeting customer requirements. It is
concerned with managing the process that converts inputs (in the forms of
materials, labor, and energy) into outputs (in the form of goods and/or
services). The relationship of operations management to senior management
in commercial contexts can be compared to the relationship of line officers to
the highest-level senior officers in military science. The highest-level officers
shape the strategy and revise it over time, while the line officers make tactical
decisions in support of carrying out the strategy. In business as in military
affairs, the boundaries between levels are not always distinct; tactical
information dynamically informs strategy, and individual people often move
between roles over time.
According to the U.S. Department of Education, operations management is
the field concerned with managing and directing the physical and/or technical
functions of a firm or organization, particularly those relating to development,
production, and manufacturing. Operations management programs typically
include instruction in principles of general management, manufacturing and
production systems, plant management, equipment maintenance
management, production control, industrial labor relations and skilled trades
supervision, strategic manufacturing policy, systems analysis, productivity
analysis and cost control, and materials planning. Management, including
operations management, is like engineering in that it blends art with applied
science. People skills, creativity, rational analysis, and knowledge of
technology are all required for success.
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The origins of operations management can be traced back through cultural

changes of the 18th, 19th, and 20th centuries, including the Industrial
Revolution, the development of interchangeable manufacture, the Waltham-
Lowell system, the American system of manufacturing, Fayolism, scientific
management,[3] the development of assembly line practice and mass
production, industrial engineering, system engineering, manufacturing
engineering, operations research, the Toyota Production System, lean
manufacturing, and six Sigma. Combined, these ideas allow for the
standardization of best practices balanced with room for further innovation
ithrough continuous improvement of production processes. Key features of
these production systems are the departure from craft production to a more
thorough division of labor and the transfer of knowledge from within the minds
of skilled, experienced workers into the systems of equipment, documentation,
and semiskilled workers, often with an average of less tenure and less
experience. The disciplines of organizational studies industrial and
organizational psychology, program management, project management and
management information systems all ideally inform optimal operations
management, although most smart people who work in the corporate world
can empirically observe that the reality often falls far short of the ideal in ways
that the market nevertheless rewards, based mostly on the fact that in markets,
"good-enough-to-scrape-by" methods tend to defeat "proper" ones on cost.
There is a strong tradition of recruiting operations managers simply by
promoting the most effective workers, which does work, although its main
systemic flaw is the Peter Principle. One of the reasons why competition
doesn't kill businesses that operate this way is that few operate in any more
ideal way. Typically the Peter Principle is so pervasive throughout an industry
that similarly afflicted businesses face a field of competitors who are more or
less equally hobbled by it (the "same circus, different clowns" problem).
There are scores of people who can be viewed as thought leaders whose life's
work laid the foundations for operations management (only some of which
have name recognition among the general population). A very cursory list
would include (in approximate chronological order) Adam Smith, Jean-
Baptiste Vaquette de Gribeauval, Louis de Tousard, Honore Blanc, Eli
Whitney, John H. Hall, Simeon North, Henri Fayol, Frederick Winslow Taylor,
Henry Gantt, Henry Ford, Sakichi Toyoda,Alfred P. Salon and Bill Knudsen of
GM, Frank and Lillian Gilbreth, Tex Thornton and his Whiz Kidsteam, and W.
Edwards Deming and the developers of the Toyota Production System(Taiichi
Ohno, Shigeo Shingo, Eiji Toyoda, Kiichiro Toyoda, and others). Whereas
some influences place primary importance on the equipment and too often
viewed people as recalcitrant impediments to systems (e.g., Taylor and Ford),
over time the need to view production operations as sociotechnical systems,
duly considering both humans and machines, was increasingly appreciated
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and addressed.
Historically, the body of knowledge stemming from industrial engineering
formed the basis of the first MBA programs, and is central to operations
management as used across diverse business sectors, industry, consulting
and non-profit organizations.
Business operations
Business operations are those ongoing recurring (cyclic) activities involved
in the running of a business for the purpose of producing value for the
stakeholders. They are contrasted with project management (business
change managers are responsible for bridging the gap between the projects
and business operations), and consist of business processes.
The outcome of business operations is the harvesting of value from assets
owned by a business. Assets can be either physical or intangible. An example
of value derived from a physical asset like a building is rent. An example of
value derived from an intangible asset like an idea is a royalty. The effort
involved in "harvesting" this value is what constitutes business operations
cycles.
Business operations encompasses three fundamental management
imperatives that collectively aim to maximize value harvested from business
assets (this has often been referred to as "sweating the assets"):
1. Generate recurring income
2. Increase the value of the business assets
3. Secure the income and value of the business
The three imperatives are interdependent. The following basic tenets illustrate
this interdependency:
The more recurring income an asset generates, the more valuable it
becomes. For example, the products that sell at the highest volumes and
prices are usually considered to be the most valuable products in a
business's product portfolio.
The more valuable a product becomes the more recurring income it
generates. For example, a luxury car can be leased out at a higher rate
than a normal car.
The intrinsic value and income-generating potential of an asset cannot be
realized without a way to secure it. For example, petroleum deposits are
worthless unless processes and equipment are developed and employed
to extract, refine, and distribute it profitably.
The business model of a business describes the means by which the three
management imperatives are achieved. In this sense, business operations is
the execution of the business model.
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Business operations concepts
A. Generating recurring income

This is the most straightforward and well-understood management imperative
of business operations. The primary goal of this imperative is to implement a
sustained delivery of goods and services to the business's customers at a cost
that is less than the funds acquired in exchange for said goods and services-in
short, making a profit. The funds directly acquired by the business in exchange
for the goods and services it delivers is the business's revenue.
The cost of developing, producing, and delivering these goods and services is
the business's expenses.
A business whose revenues are sufficiently greater than its expenses makes
profit or income. Such a business is profitable. As such, generating recurring
"revenue" is not the focus of operations management; what counts is
management of the relationship between the cost of goods sold and the
revenue derived from their sale. Efficient processes that reduce costs even
while prices remain the same expand the gap between revenue and expenses
and derive higher profitability.
A. Increasing the value of the business

The more profitable a business is, the more valuable it is. A business's
profitability is measured on the following basis:
· How much income it generates for the amount of assets its business
operations employ—its business return.
How much income it generates for the amount of revenue it
realizes—its business margin.
B. Securing the income and value of the business

· Desirability or demand for its goods and services
· Ability of its customers to pay for its goods and services
· Uniqueness and competitiveness of its business model
· Control exerted over the quality and efficiency of production activities
· Public regard for the business as a member of the community
A business that can harvest a significant amount of value from its assets but
cannot demonstrate an ability to sustain this effort cannot be considered a
viable business.
Business process
A business process or business method is a collection of related, structured
activities or tasks that produce a specific service or product (serve a particular
goal) for a particular customer or customers. It often can be visualized with a
flowchart as a sequence of activities.
There are three types of business processes:
1. Management process, the processes that govern the operation of a
system. Typical
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management processes include "Corporate Governance” and "Strategic

Management".
2. Operational Processes, processes that constitute the core business and
create the primary value stream. Typical operational processes and
Purchasing, Manufacturing, Advertising and Marketing and Sales.
3. Supporting processes, which support the core processes. Examples include
Accounting, Recruitment, Call center, Technical support.
A business process begins with a mission objective and ends with

achievement of the business objective. Process-oriented organizations break
down the barriers of structural departments and try to avoid functional silos.
A business process can be decomposed into several sub-processes, which

have their own attributes, but also contribute to achieving the goal of the super-
process. The analysis of business processes typically includes the mapping of
processes and sub-processes down to activity level.
Business Processes are designed to add value for the customer and should
not include unnecessary activities. The outcome of a well designed business
process is increased effectiveness (value for the customer) and increased
efficiency (less costs for the company).
Business Processes can be modeled through a large number of methods and
techniques. For instance, the Business Process Modeling Notation is a
Business Process Modeling technique that can be used for drawing business
processes in a workflow.
Activity B: Visit any nearby service organization and list down the different
parameters considered by them for measuring productivity.
Operations Management History
Adam Smith
One of the first people to describe processes was Adam Smith in his famous
(1776) example of a pin factory. Inspired by an article in Diderot’s
Encyclopedie, Smith described the production of a pin in the following way:
”One man draws out the wire, another straights it, a third cuts it, a fourth points
it, a fifth grinds it at the top for receiving the head: to make the head requires
two or three distinct operations: to put it on is a particular business, to whiten
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the pins is another ... and the important business of making a pin is, in this
manner, divided into about eighteen distinct operations, which in some
manufactories are all performed by distinct hands, though in others the same
man will sometime perform two or three of them.”
Smith also first recognized how the output could be increased through the use
of labor division. Previously, in a society where production was dominated by
handcrafted goods, one man would perform all the activities required during
the production process, while Smith described how the work was divided into a
set of simple tasks, which would be performed by specialized workers. The
result of labor division in Smith's example resulted in productivity increasing by
24,000 percent (sic), i.e. that the same number of workers made 240 times as
many pins as they had been producing before the introduction of labor division.
It is worth noting that Smith did not advocate labor division at any price and per
se. The appropriate level of task division was defined through experimental
design of the production process. In contrast to Smith's view which was limited
to the same functional domain and comprised activities that are in direct
sequence in the manufacturing process, today's process concept includes
cross-functionality as an important characteristic. Following his ideas the
division of labor was adopted widely, while the integration of tasks into a
functional, or cross-functional, process was not considered as an alternative
option until much later.
Other definitions
In the early 1990s, US corporations, and subsequently companies all over the
world, started to adopt the concept of reengineering in an attempt to re-achieve
the competitiveness that they had lost during the previous decade. A key
characteristic of Business Process Reengineering (BPR) is the focus on
business processes. Davenport (1993) defines a (business) process as
”a structured, measured set of activities designed to produce a specific output
for a particular customer or market. It implies a strong emphasis on how work is
done within an organization, in contrast to a product focus's emphasis on what.
A process is thus a specific ordering of work activities across time and space,
with a beginning and an end, and clearly defined inputs and outputs: a
structure for action. ... Taking a process approach implies adopting the
customer's point of view. Processes are the structure by which an organization
does what is necessary to produce value for its customers.”
This definition contains certain characteristics a process must possess. These
characteristics are achieved by a focus on the business logic of the process
(how work is done), instead of taking a product perspective (what is done).
Following Davenport's definition of a process we can conclude that a process
must have clearly defined boundaries, input and output, that it consists of
smaller parts, activities, which are ordered in time and space, that there must
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be a receiver of the process outcome- a customer - and that the transformation

taking place within the process must add customer value.
Hammer & Champy's (1993) definition can be considered as a subset of

Davenport's. They define a process as ”a collection of activities that takes one
or more kinds of input and creates an output that is of value to the customer.”
As we can note, Hammer & Champy have a more transformation oriented
perception, and put less emphasis on the structural component – process
boundaries and the order of activities in time and space.
Rummler & Brache (1995) use a definition that clearly encompasses a focus
on the organization's external customers, when stating that
”a business process is a series of steps designed to produce a product or
service. Most processes (...) are cross-functional, spanning the 'white space'
between the boxes on the organization chart. Some processes result in a
product or service that is received by an organization's external customer. We
call these primary processes. Other processes produce products that are
invisible to the external customer but essential to the effective management of
the business. We call these support processes.”
The above definition distinguishes two types of processes, primary and
support processes, depending on whether a process is directly involved in the
creation of customer value, or concerned with the organization's internal
activities. In this sense, Rummler and Brache's definition follows Porter's value
chain model, which also builds on a division of primary and secondary
activities. According to Rummler and Brache, a typical characteristic of a
successful process-based organization is the absence of secondary activities
in the primary value flow that is created in the customer oriented primary
processes. The characteristic of processes as spanning the white space on
the organization chart indicates that processes are embedded in some form of
organizational structure. Also, a process can be cross-functional, i.e. it ranges
over several business functions.
Finally, let us consider the process definition of Johansson et al. (1993). They
define a process as ”a set of linked activities that take an input and transform it
to create an output. Ideally, the transformation that occurs in the process
should add value to the input and create an output that is more useful and
effective to the recipient either upstream or downstream.”
This definition also emphasizes the constitution of links between activities and
the transformation that takes place within the process. Johansson et al. also
include the upstream part of the value chain as a possible recipient of the
process output. Summarizing the four definitions above, we can compile the
following list of characteristics for a business process.
1. Defin ability : It must have clearly defined boundaries, input and output.
2. Order : It must consist of activities that are ordered according to their
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position in time and space.

3. Customer: There must be a recipient of the process' outcome, a
customer.
4. Value-adding : The transformation taking place within the process must
add value to the recipient, either upstream or downstream.
5. Embeddedness: A process cannot exist in itself, it must be embedded
in an organizational structure.
6. Cross-functionality : A process regularly can, but not necessarily must,
span several functions.
Frequently, a process owner, i.e. a person being responsible for the
performance and continuous improvement of the process, is also considered
as a prerequisite...
Importance of the Process Chain
Business processes comprise a set of sequential sub-processes or tasks, with
alternative paths depending on certain conditions as applicable, performed to
achieve a given objective or produce given outputs. Each process has one or
more needed inputs. The inputs and outputs may be received from, or sent to
other business processes, other organizational units, or internal or external
stakeholders.
Business processes are designed to be operated by one or more business
functional units, and emphasize the importance of the “process chain” rather
than the individual units.
In general, the various tasks of a business process can be performed in one of
two ways – 1) manually and 2) by means of business data processing systems
such as ERP systems. Typically, some process tasks will be manual, while
some will be computer-based, and these tasks may be sequenced in many
ways. In other words, the data and information that are being handled through
the process may pass through manual or computer tasks in any given order.
The Four Major Process Improvement Areas

The point to note here is that, irrespective of the class of the task - whether
manual or computerised - it is important that each task - and hence the process
as a whole – is designed and periodically reviewed, improved, or substituted
by another task, with a view to continuous improvement in four major areas:
1. Effectiveness
2. Efficiency
3. Internal control
4. Compliance to carious statutes and policies
These areas are explained by highlighting typical deficiencies in each of them,
as under:
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Effectiveness
The overall effectiveness of a process is the extent to which the outputs
expected from the process are being obtained at all, and is therefore a first
measure of the basic adequacy of the process and its capability to fulfill the
logical and reasonable expectations of process uses and operators.
For example, consider the material procurement process. One of its important
tasks is the sub-process for supplier follow-up to ensure timely deliveries of
materials. Such a task is considerably less effective if it does not provide
accurate and timely purchase order status reports for use of the purchase
department staff responsible for follow-up.
Efficiency
Supposing it has been observed that the average time taken to prepare and
send out a purchase order after receipt of a properly prepared intent from the
end-user is unacceptably high, leading to delayed customer deliveries and
consequent customer complaints.
The process of “converting” the end-user's intent to a purchase order is
effective because a purchase order is being somehow generated, but its
efficiency is very low since it takes an inordinate amount of time and costs
considerably more in terms of the cost to the company of the salaries of staff
members involved.
Internal Control
In a scenario where quantities of major raw materials are regularly ordered and
consumed, rates are fixed with selected, reliable, approved vendors for an
extended period – commonly a year. Moreover, let us say that the rate contract
does not contain a price escalation clause. This safeguards the organisation
from unanticipated price escalation during the period. The rate contract data
are stored in the ERP system's database. Whenever materials are to be
ordered (with or without a delivery schedule), purchase orders are generated
mentioning the rate finalised in the rate contract. An internal control exists to
keep the purchase rate constant throughout the year.
Suppose, however, it is found that the rate on a purchase order based on a
current rate contract is changed to a different value, and the purchase order
then sent out to the supplier. This is a serious lapse in internal control, since a
change to a higher rate exposes the company to a higher financial liability.
Moreover, the editability of the rate in such a purchase order completely
nullifies the internal controls provided by having a rate contract in the first place
and including a no-escalation clause in it. There would be a further breach of
internal control if it were found that such a PO amendment is actually
authorised before sending the purchase order to the supplier.
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Compliance to various statutes and policies

There are certain situations where payments made to consultants or service
contractors must be statutorily made after deducting tax at source (T.D.S.),
and such T.D.S. amounts must be deposited in government treasury accounts
with banks on or before a specified date in the month following the month in
which the payments are made.
In such cases, if a business process does not provide for deduction of T.D.S.
and/or fails to ensure deposition into government accounts by the specified
date, then this is a statutory compliance issue that makes the concerned
executives liable to civil / criminal legal action.
Policies, Processes and Procedures

The above improvement areas are equally applicable to policies, processes
and detailed procedures (sub-processes/tasks). There is a cascading effect of
improvements made at a higher level on those made at a lower level.
For instance, if a recommendation to replace a given policy with a better one is
made with proper justification and accepted in principle by business process
owners, then corresponding changes in the consequent processes and
procedures will follow naturally in order to enable implementation of the
policies
Manual / Administrative vs. Computer System-Based Internal Controls

Internal controls can be built into manual / administrative process steps and / or
computer system procedures.
It is advisable to build in as many system controls as possible, since these
controls, being automatic, will always be exercised since they are built into the
design of the business system software. For instance, an error message
preventing an entry of a received raw material quantity exceeding the
purchase order quantity by greater than the permissible tolerance percentage
will always be displayed and will prevent the system user from entering such a
quantity.
However, for various reasons such as practicality, the need to be “flexible”
(whatever that may signify), lack of business domain knowledge and
experience, difficulties in designing/writing software, cost of software
development/modification, the incapability of a computerised system to
provide controls, etc., all internal controls otherwise considered to be
necessary are often not built into business systems and software.
In such a scenario, the manual, administrative process controls outside the
computer system should be clearly documented, enforced and regularly
exercised. For instance, while entering data to create a new record in a
material system database's item master table, the only internal control that the
system can provide over the item description field is not to allow the user to
leave the description blank – in other words, configure item description as a
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mandatory field. The system obviously cannot alert the user that the
description is wrongly spelt, inappropriate, nonsensical, etc.
In the absence of such a system-based internal control, the item creation

process must include a suitable administrative control through the detailed
checking, by a responsible officer, of all fields entered for the new item, by
comparing a print-out taken from the system with the item data entry sheet,
and ensuring that any corrections in the item description (and other similar
fields where no system control is possible) are promptly carried out. Last but
not least, the introduction of effective manual, administrative controls usually
requires an overriding periodic check by a higher authority to ensure that such
controls are exercised in the first place.
Information Reports as an Essential Base for Executing Business

Processes
Business processes must include up-to-date and accurate Information reports
to ensure effective action. An example of this is the availability of purchase
order status reports for supplier delivery follow-up as described in the section
on effectiveness above. There are numerous examples of this in every
possible business process.
Another example from production is the process of analysis of line rejections
occurring on the shop floor. This process should include systematic periodical
analysis of rejections by reason, and present the results in a suitable
information report that pinpoints the major reasons, and trends in these
reasons, for management to take corrective actions to control rejections and
keep them within acceptable limits. Such a process of analysis and
summarisation of line rejection events is clearly superior to a process which
merely inquires into each individual rejection as it occurs.
Business process owners and operatives should realise that process
improvement often occurs with introduction of appropriate transaction,
operational, highlight, exception or M.I.S. reports, provided these are
consciously used for day-to-day or periodical decision-making. With this
understanding would hopefully come the willingness to invest time and other
resources in business process improvement by introduction of useful and
relevant reporting systems.
Supporting theories and concepts

Frederick Winslow Taylor developed the concept of scientific management.
The concept contains aspects on the division of labor being relevant to the
theory and practice around business processes. The business process related
aspects of Taylor's scientific management concept are discussed in the article
on Business Process Reengineering.
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Span of control
The span of control is the number of sub-ordinates a supervisor manages
within a structural organization. Introducing a business process concept has a
considerable impact on the structural elements of the organization and thus
also on the span of control.
Large organizations that are not organized as markets need to be organized in
smaller units - departments - which can be defined according to different
principles.
Information management concepts

Information Management and the organization design strategies being related
to it, are a theoretical cornerstone of the business process concept.
1.6 Efficiency & Effectiveness
Efficiency in general describes the extent to which time or effort is well used
for the intended task or purpose. It is often used with the specific purpose of
relaying the capability of a specific application of effort to produce a specific
outcome effectively with a minimum amount or quantity of waste, expense, or
unnecessary effort. "Efficiency" has widely varying meanings in different
disciplines.
The term "efficient" is very much confused and misused with the term
"effective". In general, efficiency is a measurable concept, quantitatively
determined by the ratio of output to input. "Effectiveness", is a relatively
vague, non-quantitative concept, mainly concerned with achieving objectives.
In several of these cases, efficiency can be expressed as a result as
percentage of what ideally could be expected, hence with 100% as ideal case.
This does not always apply, not even in all cases where efficiency can be
assigned a numerical value, e.g. not for specific impulse.
A slightly broader model of efficiency that nevertheless remains consistent
with the "percentage" definition in many cases is to say that efficiency
corresponds to the ratio r=P/C of the amount P of some valuable resource
produced, per amount C of valuable resources consumed. This may
correspond to a percentage if products and consumables are quantified in
compatible units, and if consumables are transformed into products via a
conservative process. For example, in the analysis of the energy conversion
efficiency of heat engines heat engines in thermodynamics, the product P may
be the amount of useful work output, while the consumable C is the amount of
high-temperature heat input. Due to the conservation of energy, P can never
be greater than C, and so the efficiency r is never greater than 100% (and in
fact must be even less at finite temperatures).
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In science and technology
In physics
Efficient energy use, useful work per quantity of energy, mechanical

advantage over ideal mechanical advantage, often denoted by the Greek
lowercase letter η (Eta)
In thermodynamics:
Energy efficiency, measure of second law thermodynamic loss
Thermal efficiency useful work per the higher heating value of the fuel
Radiation efficiency, ratio of radiated power to power absorbed at the
terminals of an antenna
Volumetric efficiency, in internal combustion engine design for the RAF
Lift-to-drag ratio
Faraday Efficiency, electrolysis
Quantum efficiency, a measure of sensitivity of a photosensitive device
Grating efficiency, a generalization of the reflectance of a mirror,
extended to a diffraction grating
In economics
Economic efficiency , a general term, capturing the amount of waste or
other undesirable features
Financial market efficiency, how efficient is the trading going on the
financial markets
Pareto efficiency, making one individual better off, without making any
other individual worse off
Kaldor-Hicks efficiency, like a less stringent Pareto efficiency
Allocative efficiency, an optimal distribution of goods Efficiency wages,
paying workers more than the market rate for increased productivity
Business efficiency, expenses as a percentage of revenue, etc.
Efficiency Movement, of the Progressive Era (1890–1932), advocated
efficiency in the economy, society and government
In other sciences
In computing:
Algorithmic efficiency, optimizing the speed and memory requirements of
a computer program
Storage efficiency, effectiveness of computer data storage
Efficiency factor, in data communications
Efficiency (statistics), a count of desirability of an estimator
Material Efficiency, compares material requirements between
construction projects or physical processes
Administrative efficiency, increasing transparency within public
authorities and simplification of rules and procedures for citizens and
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businesses
Effectiveness
Effectiveness (noun) is defined as the capability of producing a desired effect.
When something is deemed effective (adjective), it means it has an intended or
expected outcome, or produces a deep, vivid impression.
“The effectiveness of the advertisement was determined by a survey of

potential customers.”
“This assignment will be graded on its effectiveness in appealing to a broad
audience.”
The root word for effectiveness is effective. The origin of the word effective
stems from the Latin word effectīvus, which means creative, productive or
effective. It surfaced in Middle English between 1300-1400 A.D.
Use in Various Disciplines

In mathematics, effective is sometimes used as a synonym of algorithmically
computable.
In physics, an effective theory is, similar to a phenomenological theory, a
framework intended to explain certain (observed) effects without the claim that
the theory correctly models the underlying (unobserved) processes.
In heat transfer, effectiveness is a measure of the performance of a heat
exchanger when using the NTU method.
In medicine, effectiveness relates to how well a treatment works in practice, as
opposed to efficacy, which measures how well it works in clinical trials or
laboratory studies.
In management, effectiveness relates to getting the right things done. Peter

Drucker reminds us that effectiveness can and must be learned.”
In- humancomputer interaction, effectiveness is defined as “the accuracy and
completeness of users' tasks while using a system”
1.7 Summary
Production is defined by some economists as all economic activity other than

consumption. They see every commercial activity other than the final purchase
as some form of production.
Production is a process, and as such it occurs through time and space.
Because it is a flow concept, flow concept, production is measured as a “rate of
output per period of time”. There are three aspects to production processes:
1. the quantity of the good or service produced,
2. the form of the good or service created,
3. the temporal and spatial distribution of the good or service produced.
Factors of production are classified as Materials, Machinery, Manpower,
Money, Land and minutes
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Diminishing returns can be divided into three categories:

1. Diminishing Total returns, which implies reduction in total product with
every additional unit of input. This occurs after point A in the graph.
2. Diminishing Average returns, which refers to the portion of the APP curve
after its intersection with MPP curve.
3. Diminishing Marginal returns, refers to the point where the MPP curve
starts to slope down and travels all the way down to the x-axis and beyond.
Putting it in a chronological order, at first the marginal returns start to diminish,
then the average returns, followed finally by the total returns.
An isoquant represents those combinations of inputs, which will be capable of
producing an equal quantity of output; the producer would be indifferent
between them. The isoquants are thus contour lines, which trace the loci of
equal outputs. As the production remains the same on any point of this line, it is
also called equal product curve
The production function is a simple description of the mechanism of economic
growth. Economic growth is defined as any production increase of a business
or nation (whatever you are measuring). It is usually expressed as an annual
growth percentage depicting growth of the company output (per entity) or the
national product (per nation). Real economic growth (as opposed to inflation)
consists of two components. These components are an increase in production
input and an increase in productivity.
Total productivity is defined as ratio of Output quality and quantity to Input
quality and quantity
A company can be divided into sub-processes in different ways; yet, the
following five are identified as main processes, each with a logic, objectives,
and theory and key figures of its Total productivity is defined as ratio of Output
quality and quantity to Input quality and quantity A company can be divided into
sub-processes in different ways; yet, the following five are identified as main
processes, each with a logic, objectives, and theory and key figures of its own
as: real process, income distribution process, production process, monetary
process, and market value process
Operations management is an area of management concerned with
overseeing, designing, and redesigning business operations in the production
of goods and/or services. It involves the responsibility of ensuring that
business operations are efficient in terms of using as little resources as
needed, and effictive in terms of meeting customer requirements. It is
concerned with managing the process that converts inputs (in the forms of
materials, labor, and energy) into outputs (in the form of goods and/or
services).
Operations management is mainly concerned with managing business
processes. There are three types of business processes:
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Management process, the processes that govern the operation of a

system.
Operational process, processes that constitute the core business and
create the primary value stream.
Supporting processes, which support the core processes.
A business process begins with a mission objective and ends with

achievement of the business objective. Process-oriented organizations break
down the barriers of structural departments and try to avoid functional
silos.The Four Major Process Improvement Areas: Effectiveness, Efficiency,
Internal contol, Compliance to various statutes and policies Business
operations encompasses three fundamental management imperatives that
collectively aim to maximize value harvested from business assets as:
Generate recurring income, Increase the value of the business assets, Secure
the income and value of the business
1.8 Keywords
Production - Production' refers to the economic process of converting of

inputs into outputs. Production uses resources to create a good or service that
is suitable for use, gift-giving in a gift economy, or exchange in a market
economy. This can include manufacturing, storing, shipping , and packaging.
The total product - The total product (or total physical product) of a variable
factor of production identifies what outputs are possible using various levels of
the variable input.
The average physical product - The average physical product is the total
production divided by the number of units of variable input employed. It is the
output of each unit of input.
The marginal physical product - The marginal physical product of a variable
input is the change in total output due to a one unit change in the variable input
(called the discrete marginal product) or alternatively the rate of change in total
output due to an infinitesimally small change in the variable input (called the
continuous marginal product).
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Business operations - Business operations are those ongoing recurring

(cyclic) activities involved in the running of a business for the purpose of
producing value for the stakeholders.
Business process - A business process or business method is a collection of
related, structured activities or tasks that produce a specific service or product
(serve a particular goal) for a particular customer or customers.
Efficiency – Efficiency in general describes the extent to which time or effort is
well used for the intended task or purpose.
Effectiveness - Effectiveness is defined as the capability of producing a
desired effect.
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Notes
CHAPTER 2
FINANCIAL SYSTEM
Learning Objectives
State the meaning and significance of financial system
Explain the meaning and significance of financial assets and market
Enumerate the components of financial market
Define the regulatory framework within which financial system
operates
Structure
2.1 Introduction
2.2 Meaning and significance of Financial System
2.3 Meaning and significance of Financial Assets
2.4 Meaning and significance of Financial Market
2.5 S.E.B.I. (Securities Exchange Board Of India)
2.6 Stock Exchange
2.7 Summary
2.8 Self-Assessment Questions
2.9 Model Answers
2.1 Introduction
Every finance manager is required to procure funds, use them wisely and give
appropriate returns to the stakeholders in business. Financial system provides
safety and security of funds both to the corporate, who procure funds and to
those who provide funds to corporate investment community.
This unit deals with understanding of financial system, its importance and
regulatory bodies and norms, which govern the operation of this system.
2.2 Meaning And Significance Of Financial System
Meaning:
Financial system is a set of- Financial Institutions, Financial Markets, Financial
Services and Instruments and Regulatory Frame Work. Comprises of Indian
Financial System.
Financial Institutions:
Ÿ Insurance Companies
Ÿ Credit rating agencies
Ÿ Merchant bankers
Ÿ Non Banking Financial Companies (NBFCs)
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Notes Financial Markets :

Ÿ Money market
Ÿ Capital market
Ÿ Foreign exchange market
Financial services and instruments :

Ÿ Mutual Funds
Ÿ Depositories
Ÿ Leasing
Ÿ Venture capital
Ÿ Factoring
Regulatory Framework :
Ÿ SEBI
Ÿ RBI
Ÿ Stock Exchange
Significance :
Financial system performs following functions
Ÿ It provides payment system for exchange of goods and services e.g.
banks and credit cards.
Ÿ Modern business enterprise requires large investments.
Mechanisms like financial markets. and financial intermediaries
facilitate pooling of household savings for financing business.
Ÿ It facilitates transfer of economic resources for most productive use in
the business sector.
Ÿ It offers variety of instruments that provide opportunities for risk
pooling and risk sharing for household and business, e.g. hedging,
diversification and insurance.
Ÿ It provides information that helps in coordinating and decision-
making of household as well as corporate sector.
Ÿ Financial intermediaries transmit complete information to all the
parties related to transaction, which is useful for developing healthy
financial market.
2.3 Meaning And Significance Of Financial Assets
Ÿ An asset is any right or property, which has a value in exchange.

Ÿ Assets are classified as tangible or intangible. Tangible assets can be
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Ÿ shown physically whereas intangible assets have no physical existence. Notes

Ÿ Financial assets have following features:
i) They are intangible assets
ii) They have claim on future benefit
iii) They are also known as financial instruments
Ÿ The person or entity who has promised to make future cash payments is
known as issuer of financial asset and the owner of financial asset is known
as investor, e.g. Rajesh has purchased 400 shares of Reliance Industries
Ltd. In this case, Reliance Industries Ltd. is an issuer. Rajesh is an investor.
400 shares is a financial asset.
Ÿ Examples of financial assets
i) Loans given by SBI to borrower to buy a house
ii) Bonds issued by Government of India
iii) Bonds issued by IDBI
iv) Shares of Tata Motors Ltd.
Ÿ Claim on financial asset may be fixed or variable.

Ÿ When claim is fixed, asset is called debt security and the claim is in the form
of fixed interest at a specific interval of time.
Returns on debt = Interest Amount x 100
Purchase price
For example, debenture having face value Rs. 100 is issued by the company
for Rs. 120. Coupon rate (i.e. interest rate) is 12%. Then,
Return on debt = Interest Amount x 100

Purchase Price
= 12 x 100
120
= 10%
Note: Interest is paid on face value and not on purchase price
Ÿ When claim is variable, it is known as equity security. Claim is in the form
of dividend, which is not fixed.
There are two components of returns :
- Dividend received at the end of year.
- Capital gain i.e. profit on sale of equity shares.
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Notes Returns on Equity= [Cash Dividend + End Price - Beginning Price] x 100
Beginning Price
For example, 200 shares with face value Rs. 10 of Hero Honda Ltd. purchased
@ Rs. 200 each. Dividend received is 20%. Shares sold for @ Rs. 250 each
then
Return on equity = [Cash dividend + End price - Beginning price]x 100

Beginning Price
Cash dividend = 2 x 200 = Rs. 400 [20% on face value Rs.10 each]
Beginning Price = 200 x 200 = Rs. 40,000
End Price = 250 x 200 = Rs. 50,000
Note: dividend is paid on face value and not on market value.
Return on Equity = [400 + 50,000 - 40,000] x 100

[40,000]
= 10,400 x 100
40,000
= 26%
Ÿ Financial assets have two economic functions :

i) To transfer funds from those having surplus funds to those who need funds
to invest in tangible assets.
ii) To reduce risk of both issuers and investors.
Ÿ Three types of risks are associated for investing funds in financial assets :
i) Purchasing power of expected cash flows is known as purchasing power
or inflation risk.
ii) Issuer may default on making payment to investor is known as default
risk.
iii) If financial assets are involving cash flow in foreign currency, then there is
a risk that exchange rate will change adversely; it is known as foreign
exchange risk.
2.4 Meaning And Significance Of Financial Market
It is a market for creation and exchange of financial assets. It is a channel
through which funds flow from one market participant to another. It plays
following three important functions
Ÿ Continuous interaction between numerous buyers and sellers help in
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Ÿ establishing prices of financial assets Notes

Ÿ It provides liquidity to financial assets. Individual can sell andbuy the
financial assets through mechanism of financial markets
Ÿ It is useful to reduce transaction costs.
Ÿ Two major costs associated with transacting are search costs and
information costs. Both these costs are reduced due to financial markets
Ÿ Following are the participants of financial market:
1. Ultimate Investors
2. Ultimate borrowers
3. Intermediaries such as - Brokers, Banks, F.Is, NBFCs, Insurance Cos., Unit
trusts.
Following are the two important segments of financial market:
(I) Money Market :

·It is a market where short term securities for a period one year or less are
traded.
Ÿ Money and highly liquid securities are bought and sold in this market.
Ÿ Main function of this market is to bridge gap of liquidity of different
companies.
Ÿ Volume of funds traded is very large (in crore).
Ÿ Controlled by R.B.I.
Following are money market instruments:
(I) T- bill:
These are the treasury bills issued by Govt. for duration 14 to 364 days.
(ii) Central Government Securities or Gilt edged Securities:

Securities issued by central Government.
(iii) Call or notice money market:

In this market, money can be borrowed or lent for period of 1day to 14 days.
When it is borrowed or lent for 1 day, it is called as call money.
When it is borrowed or lent for 2days to 14 days, it is called notice money.
(iv) Commercial paper:

It is a Usance Promissory Note issued by companies who fulfill norms set by
R.B.I. at discount. It is issued for minimum 15 days and maximum one year in
denomination of 5 lacs and multiples thereof.
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Notes Ÿ (v) Certificate of Deposit:

It is issued by any scheduled bank or co-op. bank for minimum 3 months and
maximum one year in the form of promissory note at a discount. They are
negotiable. There is lock-in period for 15 days. Minimum size of deposit is Rs. 1
lac and multiple thereof to single investor.
(vi) Repos (Repurchase of securities):

One party sells a security to another party with an agreement to buy it back at
specified time and price.
(II) Capital market :

Ÿ Market for long term funds (More than one year)
Ÿ It has two components : stock market and debt market
Ÿ In stock market, two instruments are traded viz.
(a) Equity shares
(b) Preference shares
Ÿ In debt market, debt instruments are bought and sold
This market is divided into two markets :
Ÿ Primary Market: securities are directly sold by company to investors
Ÿ Secondary Market: securities are sold by one investor to another investor
through stock exchange.
2.5 S.e.b.i. (securities Exchange Board Of India)
(A) Objectives of SEBI :

i. To protect interests of investors in securities
ii. To promote development of securities market
iii. To regulate securities market
(B) Functions of SEBI :

i) Regulate business in stock exchange and any other security market
ii) Register and regulate working of :
Ÿ Stock brokers
Ÿ Sub brokers
Ÿ Share transfer agents
Ÿ Bankers to issue
Ÿ Trustees of trust deeds
Ÿ Registrars to an issue
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Ÿ Merchant bankers Notes

Ÿ Underwriters
Ÿ Portfolio managers
Ÿ Investment advisors
Ÿ Any other intermediaries
i) Register and regulate working of collective investment schemes

including mutual funds.
ii) Promote and regulate self-regulatory organizations.
iii) Prohibit fraudulent and unfair trade practices in the securities market.
iv)Promote investors education and training of intermediaries in
securities market.
v) Prohibit insiders trading in securities.
vi)Regulate substantial acquisition of shares and takeover of
companies.
vii)Calling information, undertaking inspection.
viii) Conducting enquiries and audits of stock exchanges.
ix) Intermediaries and self-regulatory organizations in securities market.
(C) Role of SEBI in primary market :
SEBI has issued guidelines to tighten the entry norms for companies
assessing capital market, important norms are :
Ÿ Co. must have track record of dividend payment for minimum 3 years
preceding the issue.
Ÿ Co. making public issue must have at least 5 public shareholders for
every one lac of net capital offer made to the public.
Ÿ Promoters contribution should be 20% of issued capital and entire
contribution should be received before public issue.
Ÿ The draft prospectus filed with SEBI is made as a public document to
enhance transparency.
Ÿ Book building has been accepted as one of the modes of public issue
and SEBI has issued specific guidelines for book building process.
Ÿ Minimum application for shares is 200 shares
Ÿ Shares must be allotted on proportionate basis.
Ÿ Of the total issue, 50% should be offered to small investors (who have
applied for 100 or less shares.)
Ÿ Company must complete allotment process within 30 days of closure of
public issue.
Ÿ According to SEBI guidelines, merchant banker is one who handles
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Notes public issue and manages them.

Ÿ Merchant banker must have net worth of Rs. 5 crore.
(D) Role of SEBI in secondary market :

Ÿ Governing body of stock exchanges is constituted as per SEBI's
directives
Ÿ Infrastructure of stock exchanges and computer set up for screen based
trading must be as per directives of SEBI and must be approved by them.
Ÿ Settlement and cleaning of securities must as per norms set by SEBI
Ÿ SEBI has made it mandatory for all debts instruments to be rated from
any one of the authorized credit rating company.
Ÿ SEBI has asked stock exchanges to monitor the prices of newly listed
permitted scrips from the first day of trading.
Ÿ SEBI has issued strict guidelines for de-listing of securities from stock
exchanges.
Ÿ Every broker and sub-broker must be registered with SEBI and must
follow code of conduct laid down by SEBI.
Ÿ Insider trading is prohibited and SEBI is empowered to investigate cases
of insider trading.
2.6 Stock Exchange
Ÿ It is an organized market place where securities are traded.

Ÿ It is called as secondary market.
Ÿ Securities issued by Govt., Semi–Govt. Public sector undertaking and
limited Companies are traded in this market.
Ÿ As per Securities Contract (Regulations) Act 1956, trading insecurities is
regulated by Central Govt.
Ÿ Out of total transactions 80 to 90% are traded in BSE/NSE.
Ÿ Trading in approved contracts can only be done and through registered
members of stock exchange.
Ÿ Trading must be in normal trading hours (10 A.M. to 4 P.M.).
Ÿ In BSE Screen based trading called BOLT (BSES – on-line Trading) has
been introduced. At present BOLT is a nationwide network. Securities
traded in BSE are classified in various groups viz.
Group A: Specified shares i.e. Cos. with large outstanding shares, good track
record and large volume of business in the secondary market.
Group B1: Relatively liquid securities
Group B2: Remaining shares
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Group F: Debt securities Notes

Group Z: Companies not complying with listing requirements and not
responding to investors complaints.
Ÿ There is a separate surveillance department in the stock exchange to

ensure free and fair market.
Ÿ NSE was established in 1994. It has following main objectives :
- To establish nation-wide trading facilities for equities, debt
instruments and hybrids.
- To ensure equal access to investors all over the country through
appropriate communication network.
- To provide fair, efficient and transparent securities market to
investors using.
Ÿ Electronic communication network :
- To enable shorter settlement cycle.
- To meet current international standards of securities market.
Ÿ NSE ensures wider accessibility the satellite linked trading facility.
Computers terminals and links with VSAT help the traders to contact
their counterparts in other parts of the country quickly. The quick trading
system ensures better pricing.
Ÿ After establishing its operations in Mumbai. NSE had expanded its
operations to other cities.
Objective Stock Exchange :
I) To safeguard the interest of investing public having dealings on the

exchange.
ii) To establish and promote honorable and just practices in securities
transactions
iii) To promote, develop and maintain well-regulated market for dealing in
securities.
iv) To promote industrial development in the country through efficient
resource mobilization by way of investment in corporate securities.
2.7 Summary
Ÿ Every finance manager has to raise funds for his company. He must be
aware of meaning and significance of financial system, financial market
and financial assets.
23 | Page
Notes Ÿ Financial system provides statutory framework for raising funds by

company and gives safety and security to investors.
Ÿ Financial assets are intangible assets, which have future claims. When
claim is fixed, it is called debt security and when variable it is called equity
security.
Ÿ Financial market provides liquidity and price fixing for financial assets.
Two main arms of this market are money market where funds required for
period less than one year can be procured by company. Other arm is
capital market. When funds are required for more than one year,
company approaches this market.
Ÿ S.E.B.I. is an apex regulatory authority, which controls financial market
and protects the interest of investors.
Ÿ Stock exchange is a place where financial assets are bought or sold.
Norms provided by stock exchange ensures that dealings in financial
assets are fair.
2.8 Self Assessment Questions
[A] Fill in the blanks.
1. When claim on financial asset is ________________________it is called

equity.
2. Financial market is a market for ___________and ______________of

financial assets.
3. T- bills have duration _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ t o

________________________days.
4. Money market is controlled by ________________________.
5. Stock exchange is called as ________________________ .
[B] Select the Correct Alternative

1. Financial system comprises of:
a. Financial Institutions and Financial Markets
b. Financial Institutions, Financial Market, Financial Instruments
and Regulators
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CHAPTER 3
FINANCIAL ANALYSIS
Learning Objectives
Enlist various tools of financial analysis
Explain managerial reporting of such analysis
Draw conclusions for managerial decision-making and control
Structure
3.1 Introduction
3.2 Comparative Statements Analysis
3 . 3 Common Size Statements
Analysis 3.4 Trend Analysis
3.5 Ratio Analysis
3.6 Cash Flow Analysis
3.7 Summary
3.1 Introduction
Ÿ Financial statements exhibit income earned by company during specific

period and give assets and liabilities available with company at a
particular point of time.
Ÿ Financial analysis gives trend pattern of revenues, expenses, assets
and liabilities. Many conclusions can be drawn from financial analysis,
which can be used by management for improving their performance and
control the business.
Ÿ This unit takes you through five types of analysis :
i. Comparative statements analysis is useful for year to year
comparison of financial performance of same company.
ii.Common size statements analysis is useful for comparing
competitor's performance with our company.
iii. Trend Analysis is useful for knowing trend of various financial
parameters.
iv.Ratio analysis is useful to know liquidity, Profitability, solvency and
efficiency of company.
v. Finally, cash flow analysis is useful to know the sources of cash in
27 | Page
business and the ways this cash has been utilized.
3.2 Comparative Statements Analysis
Ÿ It is also known as horizontal analysis or dynamic analysis.

Ÿ In this analysis, figures of two or more periods are shown side by side to
facilitate comparison.
This analysis shows :
i) Absolute figures in terms of money for each period
ii) Changes (+/-) in absolute figures
iii) Changes (+/-) in terms of percentage
iv) Percentage of totals
v) Comparison of period-to-period percentages
Ÿ Comparative financial statements are prepared both for income
statement and balance sheet.
Ÿ Presenting comparative financial statements in annual report increases
usefulness of the report and brings out trend of current changes, which
affect the enterprise.
Ÿ Analysis gives considerable insight into strengths and weakness of
various areas.
Illustration 1
Comparative Income Stateent for year 2015 and 2016 [Rs. in lacs.]
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30 | Page
Report to Management:
Ÿ There is an increase in sales by 5%.
Ÿ Gross profit has increased by 28.6%, which indicates that direct
expenses are under control.
Ÿ There is sharp rise in administrative expenses by 30%, in selling
expenses by 46.7% and in depreciation by 50%. This has resulted in
operating expenses to go up which means operating efficiency of the
business has gone down.
Ÿ There is rise in interest payment by 35% where as loan funds have
gone down by 20%. This means the interest rate on loans has
considerably increased.
Ÿ All above changes have resulted in increasing E.A.T. only by 6.7%
despite of increase in G/P by 28.6%.
Ÿ Company has policy of transferring same amount to reserves every
year that is why dividend payout is not constant.
Ÿ Shareholders equity has increased by 150%. This is mainly due to new
issue of equity and transfer to reserve. Former has increased by
250%and latter by 100%. Company has also issued preference
capital.
Ÿ Capital has increased by 150%.
Ÿ Company has repaid Rs. 100 lacs of secured loans.
Ÿ In 2015, company was more dependent on loan funds. In 2016 there is
more dependence on own funds and less on external debt.
Ÿ Net fixed assets have increased by 66.7%, which means company has
made new investments in fixed assets- a sign of growth.
Ÿ The working capital of company has also increased by 35.7%.
3.3 Common Size Statements Analysis
Ÿ Also termed as vertical analysis

Ÿ It is useful to study quantitative relationship of items of financial
statement on a particular date.
Ÿ In this analysis comparison is made between :
a. Different division of same company or
b. Same division of different companies
e.g. comparison of soap division and furniture division of Godrej or comparison

31 | Page
of soap division of Godrej and soap division of Hindustan Lever.

Ÿ This analysis can be done on monthly or yearly basis.
Ÿ In common size income statement, net sales figure is assumed to be 100
and all other items are expressed as a percentage of net sales. This
statement is useful to assess operating efficiency of the business.
Ÿ Common size balance sheet is prepared by assuming total assets to be 100
and total sources to be 100 and all other items are expressed as percentage
of these two variables.
32 | Page
33 | Page
Report to Management.
Ÿ Sales have increased by 12.5% in 2016 satisfactory performance of
marketing division.
Ÿ In 2015, gross profit was 50%, which has come down to 40% in 2016.
Purchase and Manufacturing departments are accountable for increase
in C.O.G.S.
Ÿ Operating expenses, i.e. administration, selling, and depreciation have
by and large remained same. This means operating efficiency remains
same in 2016 as in 2015.
Ÿ E.B.I.T. was 37.5% in 2015, which has come down to 26% in 2016. This is
mainly due to drop in G/P. Same drop is observed in E.B.T. and E.A.T.
Ÿ Dividend payout by and large remains constant
[For 2015, 5/9 = 56% and for 2016: 4/7 = 57%]
This means company is following constant dividend policy.
Ÿ In 2015, shareholders' funds are 75% and loan funds are 25%, which has
become 87% and 13% respectively in 2016. This means company is
more dependent on internal funds in 2016 as compared to 2015.
Ÿ Company has invested 50% of funds in fixed assets and 47.5% funds in
working capital, in 2015. This has charged to around 35% and 63%
respectively i.e. company's investment policy has charged in 2016.
Ÿ In conclusion, we can say that top line, i.e. net sales is improving where
as bottom line i.e. E.A.T. is decreasing. This may affect market price of
company's shares.
Ÿ Company investing equal funds in fixed assets and working capital in
2015. This policy has changed in 2016 with more investment in working
capital and less in fixed assets.
3.4 Trend Analysis

Ÿ This involves calculating index ratios of various items in financial
statements for a number of accounting periods.
Ÿ Following steps are involved :
Ÿ i) Select a base year
Ÿ ii) Every item of financial statements for base year is taken as 100
Ÿ Figure for subsequent years is calculated as:
Absolute figure of year x 100

Absolute figure of base year
34 | Page
This analysis is useful to know the trend of various financial parameters and
from this trend company's progress can be assessed.
35 | Page
Ÿ There is continuous growth in net sales of company, which has doubled in

last three years.
Ÿ G/P has increased by 180%, E.B.I.T. has increased by 150%, E.B.I. has
increased by 150% and E.A.T. by 140%. These are the indicators of
improving operational efficiency
Ÿ Dividend distributed has doubled in three years and retained earnings by
167%. Both these would result in company's share price to go up.
Ÿ Shareholders equity has increased by 86% in last three years. This
means management is creating value to shareholders.
Ÿ Loan funds have doubled in last three years, which means company is
also taking loan for expansion and growth.
Ÿ Company's investment in fixed assets has doubled and in working capital
by 167% in last three years which is required for supporting similar growth
in sales.
3.5 Ratio Analysis
a) Meaning:
Ratio is a relationship expressed in mathematical terms between two figures or
group of figures connected with each other in some logical manner. Ratios are
expressed as pure ratio, i.e. say 4:1 or as no. of times e.g.3 times or as % say
25%
Ratio analysis is 3 step processes:
- Calculate ratio
- Compare it with standard ratio
- Find conclusion that is useful for decision-making and control
Ratio analysis can take any of the following forms:
1) Cross sectional analysis:

- Comparison of ratios of our company with other company of same
industry (generally competitors).
- Comparison of ratios of our company and of leader in the industry.
This is useful for bench marking.

2) Time series analysis:
- Comparing performance of our company over a period of time.
- Trends are studied.
36 | Page
- Useful for future planning.

- Company can assess whether it is achieving long-term goals or
not.
3) Combined analysis:
- Both A and B are combined
- Trend of ratio is compared with some standard over a period
Ÿ Ratio analysis should be undertaken only after following precautions:

- Period for comparison must be same
- Accounting policies must be same of companies whose ratio are
being compared
- Group of ratios is preferred to single ratio
- Figures used to calculate ratios must be related to each other
b) Significance:
Ÿ Liquidity
It is the ability of company to pay its current obligations and is reflected by
liquidity ratios such as current ratio and liquid ratio. These two ratios give
amount of inventory, debtors and cash balance with company. High level of
ratio indicate that funds of company are blocked in its current assets which
may reduce profits as company may have to pay interest on these funds. Low
level of ratios indicate excess current liabilities and it indicates that company is
unable to pay its short-term liabilities.
Ÿ Long term solvency

It is the ability of co to pay its long-term liabilities and is of concern to long-term
creditors and present and potential investors of company. This aspect is
reflected by capital structure or leverage ratios. Debt-Equity is the main ratio in
this group. High ratio means more debt and this may endanger long-term
solvency of the business and low ratio means less dependence on external
funds, but dilution of control as firm has employed more equity capital as
compared to debt capital.
Ÿ Management Efficiency
Ratio analysis throws light on degree of management efficiency and utilization
of its assets. Various activity ratios measure operational efficiency by reflecting
use of assets of company to generate sales revenue.
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Ÿ Overall profitability of concern

Ratios such as N/P ratio or Return on capital employed (ROCE) reflect ability of
the firm to provide reasonable returns to its owners and ensure optimum
utilization of assets of company.
Ÿ Intra firm and inter firm comparison

Intra firm and inter firm comparison is possible with ratios. Company ratios are
compared with those of competitors. Ratios of two or more divisions of same
company can be compared to assess their performance.
Ÿ Trend analysis
Ratio analysis shows whether financial position of company is improving or
deteriorating over the years. Treads can be compared with respect to industry
standards.
c) Classification of ratios
I) Liquidity Ratios
Ÿ Liquidity refers to the maintenance of cash, bank balances and those
assets, which are easily convertible into cash in order to meet liabilities as
and when they arise.
Ÿ Liquidity ratios provide a quick measure of liquidity of the firm by establishing
relationship between its current assets and current liabilities. If firm does not
have sufficient liquidity, it may not be in a position to meet its commitments
and thereby may lose its creditworthiness.
Ÿ Liquidity ratios are also called as balance sheet ratios because information
required for the calculation of these ratios is available in balance sheet only.
1) Current Ratio
Formula: Current assets
Current liabilities
Current Assets = Inventory + Debtors + B/R+ Pre-paid exp.+ Marketable
Securities+ Cash+ Bank
Current Liabilities = Creditors + B/P+ Short Term Loans+ Bank over draft
+ outstanding expenses + Provision for tax + Proposed dividend
Significance:
I) Throws light on the firm's ability to pay its current assets
38 | Page
Generally ratio 2:1 is considered to be satisfactory

(i) Standard Current Ratio may vary from one industry to other
(ii) Gives margin by which the value of current assets may go down
without creating any payment problems.
2) Quick Ratio
Ÿ Also called as acid test or liquid ratio.
Ÿ Establishes relationship between quick or liquid assets and liquid
liabilities.
Ÿ A current asset is considered liquid if it is convertible into cash without
loss of time and value.
Ÿ Inventory is kept out because it may become obsolete, unstable or
out of fashion and always inventories have a tendency to fluctuate in
value.
Ÿ Another item, which is generally kept out, is pre-paid expenses
because by nature they are not realized into cash.
Formula:
Quick Ratio=Quick or liquid assets
Quick liabilities
= C.A.- (Inventory and prepaid expenses)
C.L. – (Bank Overdraft)
Significance:
(i) Better test of liquid than the current ratio
(ii) Ratio 1:1 is considered satisfactory
(iii) Quick ratio is itself not a conclusive test of liquidity because-
Ÿ Inventories which have been ignored may not always be so illiquid
Ÿ Receivables and marketable securities, which are considered
liquid, may not be so liquid.
Therefore, firms having quick ratio 1:1 or even higher may still face problems
in meeting its commitments if the liquid assets consist of slow paying or
defaulting customers.
II) Solvency or Leverage or Capital Structure Ratios :
These ratios decide long-term solvency of the company. Their value is decided
by debt-equity mix in the capital structure. When debt component is more,
there is excess dependence on external funds. Long-term survival and
39 | Page
success of organization is reflected by these ratios.

1. Debt-Equity Ratio :
Formula:
D/E Ratio=Long term debts
Shareholders' Equity
OR
D/E Ratio= Total debts
Shareholders' Equity
Total debts= Long term debts + Current Liabilities
Shareholders Equity = Equity Capital + Preference Capital + Reserves and

Surplus
The use of particular formula depends on requirements of user.
Significance:
I. Ratio, indicates proportion of owners' stake in the business.
ii. Excess debts tend to cause insolvency.
iii. Ratio indicates the extent to which firm depends upon outsiders for
its existence.
iv. It tells the owners, the extent to which they can gain benefits or
maintain control with limited investment.
2. Proprietary Ratio Formula:
Proprietary Ratio= Shareholders' funds
Total Tangible Assets
= Equity and Preference capital + Reserve and Surplus

Total Tangible Assets
Significance:
i. It focuses attention on the general financial strength of business.
ii. High ratio means more portion of business assets is financed by
shareholders. This situation is preferred by creditors of company. For
example, if ratio= 0.70 and assets = 100 crore. This means assets worth
Rs.70 crore are financed by shareholders.In case of winding up of Co. more
money would be available for creditors.
40 | Page
iii. Low ratio indicates greater risk to creditors, e.g. if in above case ratio is
0.3, then only 30cr. would be available to creditors on winding up of the
company.
3) Capital Gearing Ratio:
Formula:
Capital gearing Ratio= Long term debts + Preference Capital
Equity Capital + Reserves and surplus
Significance:
I. Business is highly geared when ratio is more than 1.
This situation is preferred when business is having boom and profits are
stable or increasing.
ii. Business is low geared when ratio is less than 1.This situation is preferred
when business is having slack and profits are decreasing.
1) Interest Coverage Ratio:

Formula:
I.C.R.= Profit before depreciation, interest and tax (PBDIT or EBDIT
Interest payment
Significance:
i. Shows capabilities of the firm to pay interest
ii. Banks and financial institutes look for this ratio
iii. Higher the ratio, more is the assurance to banks and F.I.s for interest
recovery.
2) Debt Service Coverage Ratio:
Formula:
D.S.C.R= Profit After Tax (PAT) +Interest + Depreciation
Interest on term loan + periodic repayment
Significance:
I. Financial Institutions calculate average D.S.C.R. for period during which
term loan is repayable.
ii. Normally they consider D.S.C.R. 1.5 to 2 to be satisfactory.
6) Activity Ratio
Ÿ sAlso called turnover or performance ratios.
Ÿ Measure of movement and thus indicates as to how frequently an account
has moved/ turned over during a period.
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Ÿ Shows how effectively and efficiently assets of the firm are being utilized.
Ÿ Measure effectiveness with which the firm uses its resources.
Ÿ Calculated with reference to sales/ cost of goods sold.
Ÿ Expressed in terms of rate or times.
Following are activity ratios:

1. Inventory Turnover Ratio:
Ratio = Sales or cost of goods sold
Average Inventory
= Sales or (sales – G/P)

(Op. stock+Cl. Stock)
2
Higher the ratio, better is the efficiency with which the inventory is used. It also
indicates that inventory level for given sales level is low.
2. Receivables or debtors turnover ratio:
Ratio = Annual Net credit sales
Average Receivables
i) More ratio means less receivables.

ii) Lower ratio mean high receivables.
iii) Ratio reflects efficiency of credit and collection department and also
indicates credit policy of the firm.
3. Payables or creditors turnover ratio:

Ratio =Annual net credit purchases
Avg. Payables
I) More ratio means less payables.

Lower ratio means more payables.
ii) Ratio indicates credit period availed by company from suppliers.
4. Working capital turnover ratio:

Ratio = Annual Net Sales
Avg. Working Capital
Higher ratio means lower investment in working capital, i.e. better working
capital management.
42 | Page
5. Total asset turnover ratio:

Ratio = Net Sales
Avg. tangible assets
I) Indicates how efficiently assets have been used by company for
generating sale.
ii) The higher the ratio, better is the efficiency.
6. Fixed Assets Turnover Ratio:

Ratio = Net Sales__
Avg. fixed assets
It indicates efficiency of management of using fixed assets. Higher the
ratio more is efficiency.
7. Capital Turnover Ratio:

Ratio = Net Sales_____
Capital employed
Ratio indicates greater sales made for each rupee of capital employed
and hence higher profits. It shows efficiency of using capital.
IV) Profitability Ratios

1. Gross Profit Ratio (G/P Ratio):
Ratio = Gross Profit x 100
Sales
= (Sales- Cost of goods sold) x100
Sales
Ratio reflects efficiency of purchase and production departments.
2. Operating Profit Ratio:
Ratio = Operating profits x 100 = E.B.I.T. x 100

Sales Sales
i) Ratio measures the efficiency with which the firm not only
manufactures/ purchases goods but also sells goods.
ii) It shows operating efficiency of the firm.
3. Net Profit Ratio (N/P Ratio):

Ratio = P.A.T. x 100 or =P.B.T. x 100
Sales Sales
43 | Page
I) Ratio indicates overall efficiency in manufacturing, administration, selling

and distribution.
ii) Shows proportion of sales revenue available to the owners of company.
4.Operating Ratio:
Ratio = Total operating cost x 100
Net Sales
Operating ratio and operating profit ratio are complementary to each other. If
operating ratio is 85%, then operating profit ratio is 15%.
5. Return on investment (ROI) or return on capital employed (ROCE):
ROI or ROCE = Profit After Tax (PAT) x 100 or = EBIT x 100

Capital employed Capital employed
I) It shows whether amount of capital employed has been effectively used

or not.
ii) It is an index to the operational efficiency of the business as well as an
indicator of profitability. The higher the ratio, the better it is.
iii)Factors that affect ROI can be represented by a chart known as Du
Pont Chart.
This chart was first introduced by Du Pont Company of U.S.A.in annual
report.
Du Pont Chart
ROI = Net Profit
Capital
= Net Profit x Sales
Sales x Capital
= N/P Ratio x Capital Turnover Ratio
N/P= [Sales]- [C.O.G.S. + Admin. Exp. + Selling Exp.+ Income Tax]
Capital= Shareholders Equity +Long Term Funds or
= Fixed Assets + Current Assets – Current Liabilities
6. Return on Equity :
Ratio = [Profit After Tax (PAT)- preference dividend] x 100
Equity
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Equity = Equity Capital + Reserves

Significance:
I) This is the single most ratio to judge whether firm has earned
satisfactory returns for its equity holders or not.
ii) This ratio is compared with that of competitors or with industry
average.
V. Invisibility Ratio :
Ÿ Investors who are interested to invest in the shares of a Co. would be
keen to know the investment potential of a company before taking
final decision.
Ÿ Analysis of Invisibility ratio helps the investors to know the invisibility
of a Co.
Following are the ratios:
1. Earning per share (E.P.S)

E.P.S = PAT – PREF dividend
No. of equity shares
Cash E.P.S = PBT + Depreciation

Ratio indicates:
i) Earning Capacity of the company
ii) Amount available to shareholders
iii) Efficiency of management
iv) Market value of share
v) Amount of cash generated from equity share employed in business
2. Price Earning Ratio (P/E):

P/E= Market Price
E.P.S
I) Ratio indicates market price fluctuations of Co's share
ii) Capitalization Rate = 1 = E. P. S
P/E Market Price
For example, if P/E = 10, then capitalization rate = 1/10 = 10%
3. Dividend per share (D.P.S.):
D.P.S = Total profit distributed
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This reflects dividend policy of the firm
E.P.S – D.P.S = Reserve created per share

e.g. E.P.S = Rs. 5 and D.P.S = Rs. 3
No. of shares = 1 lakh
Reserves created by Co. = 1 lakh (5-3) = 2 lakh
4. Dividend payout ratio (D/P ratio)
D/P = D.P.S x 100
E.P.S
(1 – D/P ) = Retention ratio
ROE x (1 – D/P) = rate of growth of shareholders' funds
ROE = PAT - Preference Dividend x 100
Equity shareholders funds
5. Dividend Yield:
Ratio = D.P.S. x 100 _
Mkt.Price Per Share
Ratio is useful for investor to find returns on shares when purchased from
market.
Illustration 1:
Particulars Amt. (Rs.)
Stock 40,000
Sundry debtors 50,000
Prepaid expenses 10,000
Bank balance 20,000
Cash Balance 15,000
Sundry Creditors 50,000
Bank Overdraft 30,000
Proposed Dividend 5,000
Provision for tax 15,000
Calculate: (a) Current Ratio (b) Liquid Ratio.
Solution:
(a) Current Ratio = Current Assets
Current Liabilities
= Stock + Sundry debtors+ P.P. Expenses + Bank + Cash
S/Crs + Bank overdraft + Proposed dividend + Prov. For tax
= 40,000 + 50,000 + 10,000 + 20,000 + 15,000
50,000 + 30,000 + 5,000 + 15,000
46 | Page
= 1,35,000
1,10,000
= 1.23
(b) Liquid Ratio = Liquid Assets

Liquid Liabilities
=(Current Assets) - [Stock and Prepaid expenses]

(Current Liabilities) - [Bank overdraft]
= (1, 35,000) - ( 40,000 + 10,000)

( 1,10,000 ) - ( 30,000 )
= 85,000
80,000
= 1.06
Illustration 2:
Current Ratio is 2
Liquid Ratio is 1.2
Working Capital is Rs. 2,40,000
There is no overdraft and prepaid expenses
Decide (a) Current Assets (b) Current Liabilities (c) Stock
Solution:
Working Capital = 2,40,000
i.e. [Current Assets] (-) [Current liabilities]= 2,40,000----------(1)
Current Ratio = 2 = Current Assets
Current Liabilities
i..e. Current Assets =2 x Current Liabilities --------------------------(2)

From (1) and (2)
2 [Current Liabilities] - Current Liabilities] = Rs. 2,40,000
i.e. Current Liabilities = Rs. 2,40,000
Putting this value in equation (2)
Current Assets = 2 x 2,40,000 = Rs. 4,80,000
Now, Liquid Ratio=(Current Assets) - (Stock and prepaid Expenses)
(Current Liabilities) - (Bank Overdraft)
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i.e. 1.2 = (4,80,000) – (Stock)[Since there are no prepaid Exp.

2,40,000 and Bank overdraft ]
Stock = (4,80,000) - 1.2 ( 2,40,000)
= Rs. 1,92,000
Ans.: Current Assets Rs. 4,80,000
Current Liabilities Rs. 2,40,000
Stock Rs. 1,92,000
Illustration 3:
Total capital of company is Rs. 400 Crs. Collected from following sources:
Equity Capital Rs. 220 Crore.
Preference Capital Rs. 10 Crore.
Reserves Rs. 40 Crore.
Debentures ( 12% ) Rs. 100 Crore.
Secured Loans ( 13% ) Rs. 30 Crore.
Decide: (a) Debt Equity Ratio (b) Capital Gearing Ratio
Solution:
(a) Debt – Equity = Long Term Debt
Shareholders equity
= Debentures + Secured Loans
Equity + Reserves + Pref. Capital
= 100 + 30
220 + 40 + 10
= 130
270
= 0.48
(b)Capital Gearing Ratio =Debenture + Secured Loan+ Pref. Capital
Equity + Reserves
= 100 + 30 + 10
220 + 40
= 140
260
= 0.54
46 | Page
Illustration 4:
Capital Structure of company has following sources:
Equity Capital Rs. 100 Crore
Reserves Rs. 50 Crore
Debentures Rs. 200 Crore
Secured Loans ( 12 % ) Rs. 50 Crore.
Net Sales are Rs. 800 Crore.
Operating expenses are Rs. 600 Crore.
Which includes depreciation Rs. 100 Crore.
Tax rate is 35%.
Secured loan and debentures are to be repaid in 5 equal installments
Decide: (a)Interest Coverage Ratio (I.C.R.) (b) Debt Service Coverage
Ratio (D.S.C.R.)
Solution:
E.B.I.T. = (Net Sales ) - (Operating Expenses )
= ( 800 ) - ( 600 )
= Rs. 200 Crore.
E.B.T. = (EBIT) - ( Interest )

Interest = (Interest on debentures) + ( Interest on loans )
= (10% of 200 ) + ( 12% on 50 )
= 20 + 6
= 26
E.B.T. = 200 - 26
= 174
E.A.T. = (E.B.T.) - Tax
= 174 - 35% of 174
= 174 - 60.9
= 113.10
(a) Interest Coverage Ratio (I.C.R.) = E.B.I.T._____
Interest Payable
= 200
26
= 7.7
(b) Debt Service Coverage Ratio (D.S.C.R.)
=E.A.T.+Interest+ Depreciation
Principal + Interest
47 | Page
=113.10 + 26 + 100
50 + 26
[Total Loan = Rs. 250 Cr. Principal repayment = 250 x 1 = Rs. 50 Crore. ]
Debt Service Coverage Ratio (D.S.C.R.) = 239.10
76
= 3.15
Illustration 5:
You have been given following income statement
Particulars Rs. ( in Crore.)
Net Sales 3,000
(-) C.O.G.S. 2,000
=G / P 1,000
(-) Admin. Exp. 50
Selling Exp. 150
Depreciation 80
= E.B.I.T. 720
(-) Interest 120
= E.B.T. 600
=Tax 210
=E.A.T 390
(-) Pref. Dividend 40
(-) Equity Dividend [ 20% on 150 Crore. Capital)30
=Retained Earnings 320
Accumulated Reserves are Rs. 480 Crore.
Required:
a) Gross Profit Ratio
b) Operating Profit Ratio
c) Operating Ratio
d) Net Profit Ratio
e) Returns on Equity
f) Earning Per share.
Solution:
(a)G / P Ratio = G / P x 100 = 1,000 x 100= 33.33%
Sales 3,000
(b)Operating Profit Ratio = E.B.I.T. x 100 = 720 x 100 =24%
Sales 3,000
(c)Operating Ratio =C.O.G.S + Admin. + Selling + Depreciation x 100
Sales
48 | Page
= 2,000 + 50 + 150 + 80 x 100

3,000
= 2,280 x 100
3,000
= 76%
(d)N / P Ratio =E.A.T. x 100 = 390 x 100 = 13%

Sales 3,000
(e) Returns on Equity = E.A.T - Pref. Dividend

Equity + Reserve
= 390 - 40
150 + 480
= 350 x 100
630
= 55.6%
(f) E.P.S. = E.A.T - Pref. Dividend

No. of Equity Shares
= (350 - 40 )lacks
15 lakhs
= Rs. 23.33
Note: Equity Capital is Rs. 150 CroreEach Equity Share is of Rs. 10 hence
no. of Equity Shares are 150/ 10 = 15 Crore.
Illustration 6: Amt. ( Rs. Lakh. )

Annual Sales 2,100
Equity 200
Reserves 100
Debentures ( 10% ) 100
Loans (12 %) 100
Represented by:
Net Fixed Assets 300
Current Assets 300
Current Liabilities 100
49 | Page
Note: Current assets include: 150 (Inventory), 100 (Debtors), 50 (Other

current assets)
Decide: a) Current Ratio
b) Inventory Turnover
c) Working Capital Turnover
d) Fixed Assets Turnover
e) Capital Turnover
Solution:
(a) Current Ratio = Current Assets_= 300 =3

Current Liabilities 100
(b) Inventory Turnover = Net Sales = 2,100 = 14
Inventory 150
(c) W.C. Turnover = __Net Sales_ _ = __2,100_ = 10.5
Working Capital (300 – 100)
(d) Fixed Assets Turnover = Net Sales = 2,100 =7.0

Net Fixed Assets 300
(e) Capital Turnover = ___Net Sales _ _

Capital Employed
= Net Sales = 2,100 = 4.2

Equity + Reserves 500
+ Debentures + Loans
Illustration 7:
Company is capitalized as follows:
7% Preference Shares ( Re. 1 each ) 6,00,000
Equity shares ( Re. 1 each ) 16,00,000
Market Price per Equity Share 4
Dividend 20 %
P.A.T. 5,42,000
Calculate:
a) Dividend yield
b) Dividend payout
50 | Page
c) P/E Ratio
d) Earnings Yield
Solution:
(a) Dividend Yield = Dividend x 100 = 0.20 x 100 = 5%
Market Price per Share 4
(b) Dividend Payout= D.P.S.= 0.20 x 100= 64%

E.P.S. 0.3125
E.P.S. = P.A.T. - Pref. Dividend = 5,42,000 - 42,000 = Rs. 0.3125

No. of Equity Shares. 16,00,000
(c)P / E = Market Price Per Share= 4=12.80

E.P.S. 0.3125
(d) Earnings Yield = E.PS.x 100= 0.3125 x 100 = 7.8%

Market Price 4
Illustration 8:
Financial statement are provided to you for year 2015 and 2016.Caluclate
following ratios and write report to management based on these ratios
(i) G/P (ii) Operating Profit (iii) Operating Expenses
(iv) N/P (v) Return On Equity (vi) R.O.I.
(vii) Current (viii) Liquid (ix) Debt Equity
(x) Capital Gearing. (xi).C.R. (xii) D.S.C.R.
(xiii)Inventory Turnover (xiv) Debtors Turnover
(xv)Fixed Assets Turnover (xvi)Working Capital Turnover
(xvii)Total Assets Turnover (xviii)Capital Turnover
(xix)E.P.S. (xx) D.P.S.
(xxi) D / P (xxii) P / E
(xxiii) Dividend Yield (xiv) Earning Yield
(xv) Return on Net Worth
51 | Page
İ ŎPMÕĬ ŎÞǾŃÑŒĂĖ Å 500 600
Net Fixed Assets (I) 250 300
52 | Page
Solution:
2015 2016
i)G / P Ratio= G / P x 100 435 x 100 = 31.41% 480 x 100 = 30.38%
Sales 1,385 1,580
Ÿ Ratio has slightly come down. Direct Manufacturing expenses are under
control.
2015 2016
ii) Operating = EBITx100 310x100=22.38% 335 x 100= 21.20%
Profit Ratio Sales 1385 1580
53 | Page
Ÿ Ratio shows slight downward trend. Operating expenses are under

control.
iii)Operating Exp. Ratio = C.O.G.S.+Adm. Exp.+Selling Exp.+Deprn. x 100

Sales
2015 2016
950+35+60+30x100 = 77.62% 1100+40+ 65 40 x 100 = 78.8%
1,385 1,580
Ÿ Ratio by and large remains at same level operating expenses are under
control.
iv) N / P Ratio = PAT x 100

Sales
2015 2016
184 x 100 =13.3% 197x100= 12.47%
1,385 1,580
Ÿ Overall profitability has slightly come down. Management should try to

maintain this ratio in line with industry average or with competitor's ratio.
v) Return on Equity =E.A.T. -Preference Dividend x 100

Equity + Reserves
2015 2016
(184 - 4) x 100 =120 % (197- 4) x 100 = 96.5 %
150 200
·Ratio has come down which indicates that returns to shareholders have
gone down. Actions are required to improve this ratio. However very good
returns to shareholders.
vi) R.O.I. = E.A.T.
Capital Employed
2015 2016
184 x100=36.8% 197x 100= 32.83%
500 600
54 | Page
·ROI has dropped down by nearly 4%. Management should try to regain
position of year 2015. Also study ROI of competitors and realign target
ROI accordingly.
vii) Current Ratio = _Current Assets_

Current Liabilities
2015 2016
650=1.63 800=1.60
400 500
Ÿ No change in ratio. Working capital is managed properly. Ratio 1.6 can

be considered as reasonably good one.
viii) Liquid Ratio = [C.A.] - [ Prepaid expenses and Inventory ]

[C.L.] - [Bank overdraft]
2015 2016
650 - 330 - 35 = 0.80 800 - 460 - 15= 0.68
400 - 40 500 - 20
Ÿ Ideal ratio is 1:1. As ratio in 2015 is 0.80 and it has further gone down in
2016 to 0.68, this means company has liquidity problems.
ix)Debt – Equity Ratio = Long Term loan + Debts_

Equity + Reserves + Pref.
2015 2016
200 + 100_ = 1.5 200 + 150_ = 1.4
60 + 90 + 50 80 + 120 + 50
Ÿ Ratio remains by and large same. This means equity and debt slightly
increased to maintain same ratio.
x) Capital Gearing Ratio = Long term debts + Preference

Equity + Reserves
2015 2016
300 + 50 = 2.33 350 + 50 = 2.0
150 200
55 | Page
Ÿ
·As ratio is more than 1, company is highly geared.
xi) Interest Coverage Ratio (I.C.R.) = E.B.I.T.

Interest
2015 2016
Interest I.C.R.
200 (10%)+100(12%)=32 20(10%)+150(12%) = 38
310 = 9.69 335 = 8.82
32 38
Ÿ I.C.R. is very high in both years. Banks and FIs would give preference to
company for extending loan.
xii)Debt Service Coverage Ratio(D.S.C.R.)=PAT+ Interest +Depreciation

Principal + Interest
2015 2016
Interest 32 38
Principal 60(300/5) 70 (350 / 5)
D.S.C.R. 184+32+30=2.67 197+38+40 =2.55
60+32 70+38
Ÿ Generally 1.5 to 2 D.S.C.R. is considered satisfactory. Hence D.S.C.R.

very good in both the years.
xiii) Inventory Turnover = Sales

Closing stock
2015 2016
1,385 =4.20 1,580= 3.43
330 460
Ÿ Higher the ratio lower is the inventory level. This means company is
maintain higher stocks in 2016 as compared to 2015.
xiv) Debtors Turnover = Credit Sales
2015 2016
Debtors 1,385 = 6.3 1,580 = 6.5
220 240
56 | Page
Debtors in months = 12 12 =1.90 12 = 1.82

D.T.R. 6.3 6.58
Ÿ Company is having credit policy of around 2 months.
xv) Fixed Asset Turnover = ____Sales______

Net Fixed Assets
2015 2016
1,385=5.5 1,580= 5.25
250 300
Ÿ Efficiency of using fixed assets is constant and is very high.
xvi) Working capital Turnover = Sales

Working Capital
2015 2016
1,385 = 5.5 1,580 = 5.25
250 300
( Note: Working Capital means net current assets )
·Efficiency of using working capital is constant and is quite satisfactory

xvii) Total Asses Turnover = __ Sales__
Fixed Assets + Current Assets
2015 2016
1,385 = 1.54 1,580 = 1.44
250 + 650 300 + 800
Ÿ Ratio seems to be inadequate and more efficiency is required in using
fixed and current assets.
xviii) Capital Turnover = Sales
F.A. + C.A. – C.L.
2015 2016
1,385=2.77 1,580= 2.63
500 600
xix) E.P.S. = EAT - Pref. dividend

No. of Eq. Shares
2015 2016
184-4 = 30 197 - 4= 24.12
6 8
57 | Page
·E.P.S. has come down in 2016. This may affect share price.
xx) D.P.S. = Total Amt. Distributed

2015 2016
90 = 15 163 =
20.37
6 8
xxi) D / P = D.P.S. x 100

E.P.S.
2015 2016
15 x 100 = 50% 20.37 x 100= 84.5%
30 24.12
·Company has changed its dividend policy. In 2016 more dividends have
been distributed. Company should try to follow constant dividend policy
xxii) P / E = M.V.P.S.
E.P.S.
2015 2016
55 = 1.83 60 = 2.49
30 24.12
Ÿ P / E ratio increase means market price of shares is going up.
xxiii) Dividend Yield = D.P.S. x 100
M.V.P.S.
2015 2016
15 x 100 = 27.3% 20.37 x 100= 34%
55 60
·Ratio is increasing investors can get good returns on investment good
share to invest.
xxiv) Earning Yield = E.P.S.

M.V.P.S.
2015 2016
30 x100 = 54.5% 24.12 x 100 = 40.2
55 60
58 | Page
Ÿ Ratio is decreasing as EPS has come down and market price has
increased.
xxv) Return on Net Worth = E.AT._____

Equity + Reserves
2015 2016
184 x 100= 123% 197 x 100 = 98.5%
150 200
Ÿ Returns are decreasing less returns to shareholders
3.6 Cash Flow Analysis
Ÿ Every limited company listed on recognized stock exchange must

incorporate cash flow statement in Annual Report of company
Ÿ Cash flow statement must be prepared as per Accounting Standard no. 3
issued by Institute of chartered Accountants of India.
Ÿ Cash flow statement indicates cash flows during a particular period
under following three heads:
i) Cash generated from operating activities.
ii) Cash generated from investing activities.
iii) Cash generated from financing activities.
Ÿ Amount of cash flows arising from operating activities gives idea
whether organization has generated sufficient cash flows:
- To maintain operating capability of organization
- To pay dividends
- To repay loans
- To make new investments
Without external sources of finance,
Ÿ Separate disclosure of cash generated from investing activities
indicates the investments made by business to generate future cash
flows.
Ÿ Disclosure of cash flows from financing activities is useful to predict
claims on future cash flows by providers of funds to the business.
Ÿ Format of cash flow statement
Ÿ (A) Cash flows from operating activities:
Net profit before tax 3,350
+
59 | Page
+ 450
+ 400
+foreign exchange loss 40
Interest income [To be taken under investment activities] 300
Dividend income [To be taken under investment activities] 200
= Operating profit before working capital changes 3,740
-Increase in Current assets 500
+Decrease in Current assets 1,050
-Decrease in Current liabilities 2,340
+Increase in Current liabilities 600
= Cash before Tax 2 550
- Tax 860
= Cash flow before Extraordinary items 1,690
+ Extraordinary item 180
= CASH FROM OPERATING ACTIVITIES (A 1,870
(B) Cash flows from investment activities:

Purchase of plant 350
Sale of plant 20
Interest Received 300
Dividend Received 200
CASH FROM INVESTMENT ACTIVITIES (B) 170
(C) Cash flows from financing activities:

Issue of share capital 250
Issue of Debentures 250
Dividend paid (1,320)
Interest paid (400)
CASH FROM FINANCING ACTIVITIES ( C ) (1,220)
Increase in cash during year (A+B+C) 820
Opening balance 160
Cash balance at end 980
Illustration 1:
From following particulars, prepare cash flow statement for year 2015–
2016 and write report to management.
Particulars Amt. (Rs. Lakh)
------------------------------------------------------------------------------------
E.B.T. 2,520
Tax Paid 820
Interest Paid 600
60 | Page
Depreciation 350
Loss due to exchange rate fluctuation 80
Interest received 150
Dividend received 230
Extraordinary gain 50
Plant purchased 230
Investment sold 85
Plant sold 105
Investment Purchased 70
Dividend Paid 280
Share Capital issued 300
8% Debentures redeemed 50
10% Pref. Capital issued 50
Openings balance of cash and near cash items. 360
Opening Balance Closing Balance

Inventory 380 270
Debtors 148 268
Creditors 386 126
Outstanding Expenses 88 108
Solution: Amt. (Rs. Lakh)

(A) Cash Flow from operating activities:
E.B.T 2,520
+Depreciation 350
+Interest paid (To be considered under financing activities) 600
+Loss on foreign (Non-operating loss) 80
-Interest Recd. (To be considered under investing activities) 150
-Dividend Recd. (To be considered under investing activities) 230
=Operating profit before working capital changes 3,170
+Decrease in inventory 110
+Increase in outstanding expenses 20
-Increase in debtors 120
-Decrease in creditors 260
=Cash before extraordinary item 2,920
+Extraordinary gain 50
=Cash before tax 2,970
-Tax paid 820
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=Cash from Operating Activities (A) 2,150

(B) Cash from Investment Activities:
Investment Sold + 85
Plant Sold + 105
Plant Purchased 230
Investment Purchased 70
Interest Received + 150
Dividend Received + 230
=Cash from Investment Activities (B) 270
(C) Cash from Financing Activities:

Issue of Equity Capital 300
Issue of (10%) Preference Capital + 50
Redemption of (8%) Debentures - 50
Interest Paid - 600
Dividend Paid - 280
=Cash from Financing Activities ( C ) (-) 580
Increase in cash and near cash items during year (A+B+C)1,840
+Opening cash and near cash items 360
= Cash and near cash items balance in end 2,200
Ÿ Total cash generated during is Rs. 1,840 lakh.

Ÿ Major cash is generated from operating activities which indicates good
operating efficiency
Ÿ Company has sold plant for Rs. 105 lakh and purchased plant worth Rs.
70 lakh. This means asset base of company is reduced No. growth plans.
Ÿ Company has received dividend Rs. 230 lakh and interest Rs. 150 lakh,
which shows that company is investing excess funds in good companies.
Ÿ Company has issued equity capital of Rs. 300 lakh. This means equity
base is enlarged. This would be useful for raising loans for expansnion
and growth
Ÿ Company has issued (8%) Preference capital to redeem (10%)
debentures. This would release the charge on assets created for
debentures issued.
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Illustration 2:
You have been given following cash flow statement. Study this
statement and give report to management.
(Rs. in Crore)
E.B.T. 135
+ Depreciation 35
+ Interest paid 20
+ Loss on sale of assets 30
- Interest Received 10
- Dividend Received 20
= Operating Profit Before Working Capital Changes 190
+ Decrease in Debtors 20
+ Increase in Creditors 10
Increase in Inventory 15
Decrease in Bills Payable 5
=Cash before tax 200
-Tax paid 40
=Cash Flow From Operating Activities ( A ) 160
Investment Sold 20
Plant Sold 80
Interest Received +10
Dividend Received +20
=Cash Flow from Investment Activities ( B ) 130
Issue of (10%) Debenture + 20

Receipt of (13%) Loans + 90
Interest Paid - 20
Dividend Paid - 15
=Cash Flow from Financing Activities ( C ) 75
Increase in cash and near cash items 365
During year (A + B + C) +Opening Cash and near cash items 85
=Closing cash and near cash items 450
Solution:
Ÿ Company is having huge cash balance. No new investments have been
made. This means management is conservative and do not want to grow
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Ÿ business.
Ÿ Plant has been sold for Rs. 80 Crore but not replaced. This has reduced
asset base a good sign for long-term survival.
Ÿ Company has unnecessarily taken huge loans, as this amount has not been
utilized for making any new investments.
Ÿ Company has generated Rs. 160 Crore from operation. This indicates
operational efficiency. Management should make use of this strength by
investing funds in new plants and other assets and achieve good growth in
business.
Ÿ Company has E.B.T. of Rs. 135 crore and Rs. 40 crore taxes paid. This
leaves Rs. 95 crore available to equity shareholders. However, dividend
paid is only Rs. 15 crore. This shows conservative approach of
management.
3.7 Summary
Ÿ Many conclusions can be drawn from financial analysis, which can be

used by management for improving business performance and for
SWOT analysis of business. It is also useful for managerial control.
Ÿ Comparative statements are prepared to get insight into strengths and
weakness of various areas.
Ÿ Common size statements are useful for assessing efficiency of different
divisions of same company or same divisions of different companies.
This analysis is useful for competitive analysis.
Ÿ Trend analysis gives idea about trends on company performance over
no. of years.
Ÿ Ratio analysis a powerful tool used for assessing liquidity, solvency,
profitability and for knowing efficiency of using available resources and
highlights various ratios useful to investor for deciding whether to invert
funds in a company or not.
Ÿ Cash flow analysis highlights cash generated from operations,
investments and from financing activities.
64 | Page
CHAPTER 4
VALUATION
Learning Objectives
Discuss the concept of present value of money
Explain the concept of future value of money
State the meaning of annuity and its present and future value
Use these concepts in business application
Structure
4.1 Introduction
4.2 Time Value of Money
4.3 Future Value Concept
4.4 Present Value Concept
4.5 Annuity Concept
4.6 Business Applications Of Time Value Of Money (T.M.V.)
4.7 Valuation of Financial Assets
4.8 Summary
4.1 Introduction
Ÿ Decision-making is the important management function. Any decision

involves incurring cost today and benefit tomorrow
Ÿ Time value of money is useful to bring costs and benefits at same point of
time so that decisions can be taken if costs are more than benefits.
Ÿ Many times business wants to make provisions for liabilities going to
occur in future. To make exact assessment of provision time value of
money is useful.
4.2 Time Value Of Money
i. Value of unit of money is different in different times. Sum of money

received today has more value than sum of money received after some
time.
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ii. Time value of money is also referred to as time preference for money.
iii. There are three reasons for time preference for money :
a) Risk and uncertainty: Individual is not certain about future receipts.
b) Preference for consumption: money is means by which individuals
acquires goods and services. Most of them prefer present
consumption to future consumption because due to illness, death or
inflation they may not be able to enjoy future consumption.
c) Investment opportunities: With present available cash. They are in a
position to avail investment opportunities to earn additional cash.
iv) Time preference is generally expressed by an interest rate. This rate is
available even in absence of risk and it is called risk free rate. However,
in real life situation, risk is always involved. It is therefore necessary to
add risk premium. Thus,
Required rate of return = Risk free rate + Risk Premium
It is also called as opportunity cost of capital of comparable risk, as
investors could invest money in assets or securities of equivalent risk.
v) Basic objective of financial management is wealth maximization, which
is future oriented. Therefore, time value of money has great importance in
financial decision-making. In order to evaluate decisions costs and benefits
are to be compared at same point of time. Costs are incurred today and
benefits are derived in future, which must be brought to level of today. This is
done with the help of present value of money.
4.3 Future Value Concept
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This factor is given in compounded value tables, which are readily available.
In case r is in fraction and / or n is also in fraction then these tables are not
useful and one has to use computer for calculating future value.
Illustration 1:
Rs. 20,000 deposited in bank for 3 years. Rate of interest is 10%. What will
be maturity value of deposit, if compounding is done yearly?
Illustration 2:
In problem 1, if rate of interest is 12% and compounding is done 6 monthly,

what is maturity value?
74 | Page
Illustration 3:
Anil wants to deposit Rs. 1,00,000. Interest rate is 12% and compounding is
done quarterly. What will be the maturity value?
75 | Page
Illustration 4
Asmita received scholarship of Rs. 2,00,000. This amount she will use for
payment of MBA fees after 12 months. Till such time, she has deposited
amount in bank. Rate of interest is 12% and compounding is done monthly.
How much amount will be available to her?
Illustration 5:
Company wants to pay off liability Rs. 5,00,000 after 6 months. How much
amount should be kept aside today?
76 | Page
Illustration 6:
Rate of interest is 12% P.A. What is effective rate of interest if
(a) Compounding is done twice a year (b) 4 times a year (c) 12 times a
year
4.4 Present Value Concept
77 | Page
Illustration 1:
What is the P.V. of amount Rs. 3,00,00 which is to be received after 3 years
Compounding is done yearly and Rate of interest is 12%.
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Illustration 2:
Company is considering the buying of a machine for Rs. 70,00,000. It
will give benefits for 5 years as follows :
Year Benefit
1 10,00,000
2 15,00,000
3 20,00,000
4 25,00,000
5 30,00,000
Rate of interest applicable is 12%.
Should company buy the machine?
Illustration 3:
Company has been offered a contract which has following terms:
An immediate cash outlay of Rs. 15,000 followed by cash inflow of Rs. 17,900
after 3 years. What is company's rate of return on this contract.
79 | Page
4.5 Annuity Concept
Annuity is a finite series of equal cash flows made at regular intervals. In

business many payments are made or received at regular interval. Finding
present and future value of annuity becomes essential for many business
decisions or investment decisions by investors.
[PVAF]r,n is a present value annuity factor. This factor is given in annuity

tables for particulars r and n. If r is in fraction one has to use computer to
calculate (P.V.) annuity.
80 | Page
Illustration 1:
A 4 year annuity of Rs. 3,000 P.A. is deposited in bank account which pays
9% interest compounded annually. What is future value of annuity?
[Given: ( CVAF) = 4.573 ]
Illustration 2:
Recurring deposit is opened in bank for 12 months. Amount deposited every
month is Rs. 5,000. If rate of interest is 12% how much amount would be
available on maturity of recurring deposit.
Illustration 3:
Interest is to be received at the end of each year for the next 5 years Rs.
10,000. What is the present value of this amount if rate of interest is 10%
p.a.[PVAF)10%,5 = 3.7907]
Solution:
This is an annuity of Rs. 10,00n0
81 | Page
Illustration 4:
Find P.V. of investment which is expected to give a return of Rs. 2,500 P.A. and
Rs. 2,500 P.M. perpetually. Rate of interest is 12%.
4.6 Business Applications Of Time Value Of Money (t.m.v.)
a) Finding out Implicit Rate of Interest:

Financial institutes issue deep discount bond where investor is required to pay
a specific amount at the time of issue and receives larger amount at the end of
specified period. TMV is useful to find out rate of interest.
Illustration 1:
Deep Discount Bond is issued for Rs. 5,000 today and will mature after 5
years for Rs. 10,000 what is rate of interest Offered.
82 | Page
Illustration 2:
A company offers a scheme under which a deposit of Rs. 15,000 will entitle the
depositor to receive Rs. 4,000 per year at the end of each of next 5 years.
Should the scheme be accepted ? (PVAF)r,5 = 3.75 for 10.57%.
Investor should accept scheme if normal rate of interest is less than

this.
b) Calculating no. of periods for repaying certain amount

Many times, equal installment including principal and interest is to be paid to
bank or other lender. Management is interested to know how many payments
would be required to clear off the loan.
Illustration 1:
A loan of Rs. 50,000 is to be repaid in equal annual installments of Rs. 14,000.
The loan carries 6% interest rate. How many payments are required to repay
this loan?
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c) Sinking Fund:
A finance manager may be interested to accumulate a target amount in order
to replace an asset or in order to repay liability at the end of a specified period.
Illustration: 1
An amount of Rs. 1,00,000 is required after 5 years to repay a liability. How
much amount should be accumulated every year.
d) Capital Recovery:
Sometimes one may be interested to find out equal annual amount paid in
order to repay a loan of specified amount over a specified period together
with interest.
Illustration 1
Amount borrowed = Rs. 1,00,000
Repayment = 5 Equal yearly installments
Rate of Interest = 10% P.A. and PVAF = 3.791
84 | Page
e) Deferred Payments:
Sometimes repayment of loan may not start immediately. In such case
management is interested to know installment amount which would include
principal and interest.
Illustration 1:
Loan of Rs. 1,00,000 is taken on which interest is payable @ 10%. Repayment
is to start at the end of third year from now. What should be annual payment if
total loan and interest is to be repaid in 6 installments PVA F 10%, 6 =
4.355
Ĭ ŎÕÞPÒŎŌÈ
ĂHÅ Find amount due at end of 2nd year i.e. At he beginning of 3rd year, from now
F.V. = PV ( 1 + r)n
= 1,00,000 ( 1 + 0.1)2
= 1,21,000
(II) 1,21,000 is the PV of annuity of 6 years. @ 10%.

PV = (Annuity Amount) x PVAF 10%, 6
1,21,000 = Annuity x 4.355
Annuity = 1,21,000
4.355
= Rs. 27,784
4.7 Valuation Of Financial Assets
(a) Concept of Valuation:

· Financial assets refer to the financial claims such as Bonds,
Preference Shares, Equity Shares etc.
· Every financial manager and investor must understand how to
value: financial assets, to judge whether they are good to buy or not.
85 | Page
· Book Value (BV) of an asset:

- Accounting concept
- Based on historical data given in balance sheet
- Book value of debenture is the face value itself and is stated in balance
sheet.
- Book value of Equity Shares = Net worth of co.____
Ÿ Market Value (MV) of an assets:
- Price at which asset can be sold
- Market value of financial asset is the price of financial asset prevailing in
stock exchange
Ÿ Liquidating Value (LV):
- Refers to net difference between the realizable value of all assets and the
sum of all liabilities.
- This net difference is available to the owners.
Ÿ Capitalized Value (CV):

- Sum of present value of cash flows expected to be received in future
- For finding PV required rate of return is the discounting rate.
- In valuation of financial assets, the capitalized value is the most relevant
concept of valuation.
(b) Required Rate of Return:
Ÿ Required rate of return may be defined as minimum rate of return
necessary to induce an investor to hold or to buy a security.
Ÿ It is a function of following :
I) The risk free rate (Rf )
ii) Risk perception of investor
iii) Risk premium i.e. compensation required for bearing risk
(Rp )
86 | Page
Ħ = Rf + Rp K = Required rate of return.
Rate of
Return K
Rp
----------------------------------------------
Risk
Free Rf
Rate
Risk.
c) Basic Valuation Model:
Ÿ Assumptions:
I. Estimated future cash flows is a single figure and not a series of
expected figures.
ii. Every investor has a subjective assessment of the risk associated with
financial assets and its expected cash flows. He incorporates this risk
in valuation procedure through discount factor. Thus, no standard rate
of discount can be applied to all the investors and to all the securities.
Higher the risk greater would be the discount factor.
PV of security Vo = (CF)1 + (CF)2+ -----------(CF)n

(1+k)1 (1 +k)2 (1 + k)n
= ? n(CF)i
i=1 (1+k)i
Where Vo = Value of the security at present

(CF)i = Cash flow expected at the end of year i
k = Discount rate
n = Expected life of an asset
Example:
An investment is expected to provide an annual cash flow of Rs. 5,000 for next
5 years and discount rate is 15% then,
87 | Page
(d) Bond Valuation:

Ÿ Bond or Debenture is a debt security issued by company and subscribed by
investor.
Ÿ It is used for long term financing by firm.
Ÿ When bonds are issued and subscribed by an investor following conditions
are implied:
i) Company will pay interest regularly say monthly, quarterly etc.
ii) Company will repay principal amount after certain period say 5,7,10
years.
iii) Rate of interest is specified in the terms of issue.
iv) Any other conditions are also stated.
Ÿ Following terms are important
i) Par Value :
- This is also called as face value or nominal value of a bond.
- Principal amount of bond
- Stated on face of bond
- May be Rs. 100, Rs. 1,000 etc.
- Bond can be issued at discount i.e. 100 Rs. bond issued for Rs. 95
- Bond can be issued at premium i.e. 100 Rs. bond issued for Rs. 105
ii) Coupon Rate:
- Interest rate on par value
- Generally described as %
- Applied on par value to calculate periodic interest payable on bond
iii) Maturity:
- Period from date of issue
- On maturity firm must repay bond par value to investor.
Ÿ Basic assumption in bond valuation is that first payment will become due
for payment after one year from date of issue.
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Illustration:
A bond of Rs. 1,000 having coupon rate 12% is redeemable at par in 10 years
find out the value of bond if
a) Required rate of return is 12%, 10%, 14%.
Conclusion:
i) Coupon rate = Required rate
Bond should be purchased at its face value (Rs. 1,000)
ii) Coupon rate < Required rate
Bond should be purchased at price.
89 | Page
Situation Decision
i) Required Rate = Coupon Rate Purchase bond at its face value( Rs. 1,000)
ii) Required Rate >Coupon Rate Purchase bond at price below face value
(Rs.895.92)
iii)Required Rate < Coupon Rate Purchase bond at price above face value
(Rs.1123.40)
Illustration 2:
A bond of Rs. 10,000 bearing coupon rate 12%andredeemable in 8 years at
par is being traded at Rs. 10,600. Find out YTM of bond.
90 | Page
Illustration:
DDB has maturity 10 years. Par value 25,000 required rate 15%
Solution:
Bo (DDB) = 25,000 (PVF 15%, 10 years.)
= 25,000 x 0.247
= Rs. 6,175
Ñ) Valuation of Preference shares

Valuation of redeemable preference shares is similar to bond valuation
Po = ?n Di + Rv .
i=1
(1 + kp)I ( 1 + kp )n
Po = Value of Preference Shares
Di = Annual Fixed Dividend
Rv = Redemption Value
n = Life of Preference Shares.
Kp = Required Rate of Return by Preference Shareholders.
f) Valuation of Equity Shares:

I) Based on Accounting Information
A) Book Value:
·Value of firm's ownership based on balance sheet values for each equity
share.
·BV = Equity Share Capital + Reserves
· Assumption is that all assets are expected to realize an amount which is
stated in balance sheet.
· Easy to calculate.
· Ignores profitability of firm.
· Considers historical Figures and therefore fails to give realistic valuation of
equity shares.
B) Liquidation Value:
Ÿ All the assets of company are sold.
Ÿ All the liabilities including preference shares are paid.
Ÿ Remaining amount is distributed to equity shareholders.
Ÿ Based on current realizable values.
Ignores profitability of firm.
Ÿ
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II) Based on Dividends

A) Constant Dividend
Ÿ Dividend amount remains constant over years.
Ÿ Dividend stream is therefore a long term annuity or perpetuity.
Ÿ Po = D Po = Value of equity shares
Ke D = Constant dividend
Ke = Rate of return expected by equity
shareholder.
Ÿ Model requires no. estimation of future dividends and only
dividend expected at the end of year 1 is required.
Ÿ Constant dividend is unrealistic assumption.
Illustration:
Firm pays a dividend of 20% on equity shares of face value of Rs. 100.
Dividend is expected to remain constant and rate of return of investor is 15%.
Solution:
Po = D
Ke
= 20
15%
= Rs. 133.33
92 | Page
III) Valuation Based on Earnings

A) Gordon Model:
Ÿ As per this approach, earnings of the firm are assumed to be either
distributed to shareholders or reinvested in business.
Ÿ Growth in dividend in future would depend upon the profits retained 7
rate of return on these retained profits.
Ÿ Model is based on following assumptions :
- Retention ratio is constant
- Rate of return on reinvested profits is constant
Ÿ As per model
Po = EPS1 ( 1 – b) Po = Price of a share
Ke - br (EPS)1 = EPS at year end 1
b = Retention ratio
ke = Reqd. Rate of return.
r = I.R.R.
93 | Page
Thus difference of Rs. 48 (108 – 60) is one which investor is ready to pay for
growth opportunities or investors are willing to forgo present dividends for
higher future earnings and dividends.
Further is r = 10% which is less than required rate i.e. 15% then firm is
considered as no growth firm and investor will not be ready to pay a higher
price even if firm retains. The earning and value of equity share is
Po = 9 ( 1 - 0.4 )___
0.15 - 0.4 x 0.1
= Rs. 49.10
B) Based on P /E Ratio:
Ÿ P/E ratio is the ratio between the price of a share and its EPS
Ÿ Value = EPS x P/E
Ÿ For forecasting P/E ratio
94 | Page
Following factors are to be considered.

- Find P/E of similar companies or industry
- Risk involved in business is to be assessed
- Evaluate growth prospectus of a company
- Stability of earnings
- Quality of management
- Dividend payout ratio
- Accounting policies
- EBIT of company
- Interest burden
- I / Tax rate
- Pref. capital and dividend
- Capital structure of firm
Illustration:
EBIT of company is Rs. 60 Crore. Interest paid Rs. 10 Crore. Tax rate 40%.
Company has Rs. 20 Crore equity capital (Rs. 10 each) and preference capital
(10%) Rs. 5 Crore. P/E ratio is 8. What is the value of company's share.
Solution:
E.B.I.T. = 60 Cr.
-Interest = 10 Cr.
= E.B.T. = 50 Cr.
- Tax(40%) = 20 Cr.
= E.A.T. = 30 Cr.
E.P.S. = E.A.T. - Preference Dividend
= [30 - 0.5] Cr. = Rs. 14.75
2 Cr.
Value = EPS x P/E
= 14.75 x 8 = Rs. 118
4.8 Summary
Ÿ In business decisions, knowing present and future value of any cash

outlay is essential.
Ÿ Present value gives value of benefits today, which are going to be
received in future. Management can compare today's cost and benefits
of today and them it is possible to take appropriate decision.
Ÿ Future value is useful to know amount to be kept aside today so that
95 | Page
Ÿ desired amount at future point of time can be made available.

Ÿ Annuity is series of receipts or payments made at regular interval. This is
useful to collect desired level of funds for future liabilities to be paid.
Ÿ Time value of money is useful to business for taking many vital
decisions, such as finding implicit rate of interest, no. of periods
necessary to pay certain amount, amount to be transferred to particular
fund for paying future liability or replacing an asset, capital recovery and
so on.
Ÿ Financial assets have different types of value. Book value is one, which
is shown by books of accounts. Market value is price at which asset is
sold or bought in financial market.
Ÿ Capitalized value is the present value of future cash flows and this value
is important in finding value of financial assets.
Ÿ Different methods are used to find out the value of financial assets i.e.
equity shares, preference shares and debentures.
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CHAPTER 5
LONG-TERM SOURCES OF FINANCE
Learning Objectives
Name different sources of finance available to company.
State the features of each source of finance.
Explain the legal obligations of company associated with different
sources.
Structure
5.1 Introduction
5.2 Equity Share Capital
5.3 Preference Share Capital
5.4 Debentures
5.5 Term Loans
5.6 Lease Finance
5.7 Hire Purchase
5.8 Venture Capital
5.9 Summary
5.1 Introduction
Every company requires two types of capital.

Long-term capital is required for buying assets and creating infrastructure of
company. Short-term capital is required for day-to-day activities of business.
This is known as Working capital of company. This unit deals with various long-
term sources used by company, their cost and their features.
5.2 Equity Share Capital
This is a permanent capital available to company. Once equity capital is

collected from public, it is returned only when company is liquidated or wound
up.
Features of equity share capital:
(1) Authorized share capital is the maximum amount of capital which
company can collect from public.
(2) Issued share capital is the portion of authorized capital, which has been
offered by company to public to subscribe.
(3) Subscribed share capital represents that part of issued capital that
public has agreed to subscribe.
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(4) Paid-up share capital is the amount of subscribed capital actually paid up
by public to company.
(5) Equity shareholders have two residual claims:
Ÿ On income of company:
Income available after paying expenses, taxes and preference dividend
is divided into two components:
-Dividend is paid to shareholders
-Reserves are kept by company for future expansion and growth.
Ÿ On assets of company:
When company is liquidated, the amount realized from assets is used for
settling the claims in following order:
-Creditors and debt holders
-Preference Shareholders
-Remaining balance to equity shareholders
(6) Paying dividend is the decision of Board of Directors. There may be profits
to company, but directors may not declare any dividend. There is no legal
obligation to pay any dividend. Thus, dividend to be received on equity
shares is a variable income. Therefore, it is known as variable income
security.
(7) Directors of company who look after day-to-day management of company
are appointed by equity shareholders and if Board fails to protect the
interests of shareholders, they can remove Board.
(8) Equity shareholders have pre-emptive right to maintain their proportionate
share of ownership in company. Thus, if shareholder has one percent of
company's shares then he has pre-emptive right to buy 1% of new shares
issued by company. This is known as rights issue and its price is less than
market price.
(9) At Annual General Meeting (A.G.M.), only equity shareholders can vote, as
they are the owners of company.
(10) Liability of equity shareholders is limited to the amount of their investment
in shares.
(11) Equity capital increases financial base of company and thus borrowing
limits. When new equity shares are issued ownership and control of
existing shareholders is diluted.
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5.3 Preference Share Capital
1) It is a hybrid security that consists of features of both equity shares and

debentures.
2) It is called fixed income security because it provides constant income
to investor
3) Most of the preference shares carry feature of cumulative dividend and
they are called cumulative preference shares. Thus, if in any year
preference dividend is not paid due to inadequacy of profits the same is
accumulated and all past unpaid preference dividend must be paid
before any equity dividend is paid.
4) Preference dividend is paid at fixed rate from income after paying
income tax.
5) Preference shareholders have claims on income and assets before
equity shareholders.
6) Preference shareholders have no voting right at A.G.M.
7) Nonpayment of preference dividend does not force company into
liquidation.
8) Preference shares provide some financial flexibility to company as
payment of preference dividend can be postponed
9) It provides financial leverage/advantage because preference dividend
is fixed obligation of company.
10) It is costlier than debentures since dividend on preference shares is not
deductible for income tax.
5.4 Debentures
1) It is a long-term secured loan raised by company from public at large.

2) It is a promise by company to pay interest and repay principle as per
terms of issue of debentures.
3) It is a long-term fixed income security.
4) Debenture holders are creditors of company.
5) Interest rate on debentures is fixed and company must pay interest
whether company makes profits or losses.
6) Interest paid by company is allowed as deduction for income tax but it is
taxable in the hands of investors.
7) Debenture is a secured loan. If company fails to pay interest or
principal debenture holders can bring action through court and
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company has to sell its assets and make payment. In many cases,
company is forced to liquidate its business.
8) In India, companies issuing debentures get credit rating of company
and debentures from authorized credit rating agencies such as
CRISIL, CARE, ICRA etc. This gives confidence to investors who want
to invest in Debentures of company.
9) Debenture holders are not the owners of company and they cannot
vote at A.G.M.
10) Debentures can be used as financial leverage. After paying fixed
interest remaining amount is available to equity shareholders. Thus,
income of shareholders is magnified.
11) Debentures generally mature after 5 to 7 years after which company
repurchases debentures. This is known as redemption of debentures.
12) Three types of debentures can be issued by company :
Ÿ Non Convertible Debentures (NCDs), which cannot be converted
into Equity shares of company.
Ÿ Partly Convertible Debentures (PCDs), which can be partially
converted into Equity shares of company.
Ÿ Fully Convertible Debentures (FCDs), which can be fully converted
into Equity shares of company.
5.5 Term Loans

(1) It is a source of long-term debt. Term loan is generally taken by
company for expansion, diversification or modernization. Therefore, it
is also known as project financing.
(2) Banks and Financial Institutions (FIs) provide term loans to
companies.
(3) They are granted for long period between 5 to 10 years.
(4) In some cases, initial grace period or moratorium of 1 to 2 years is
granted during which company does not have to make any repayment
of loan.
(5) Raising term loan costs less to company as it is directly negotiated with
banks or Financial Institution.
(6) These loans are secured by the assets acquired using term loan.
(7) Bank or F.I. may put covenants or restrictions such as:
Ÿ Company must maintain minimum asset base
Ÿ Company must maintain minimum working capital
Ÿ Company cannot sell assets without permission of lender
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Ÿ Purchasing additional assets require concurrence of lender.

Ÿ Company cannot pay dividend before paying principal amount
Ÿ Lender may nominate director on Board of company.
Ÿ Loan may be converted into equity at the option of lender.
(8) Repayment schedule specifies time schedule for paying interest and
principal. There are two methods of payment :
Ÿ Equal principal amount: In this method, principal is paid in equal
installments and interest goes on reducing
Ÿ Equal [ principal + interest ]: In this method, equal installment is paid
every month
5.6 Lease Finance
(1) It is a contract between two parties-lessor, who is the owner of the

asset and lessee, is the user of the asset.
(2) For using asset, lessee pays rent to lessor for an agreed period. This is
called as Lease rental.
(3) At the end of lease period, asset is given back to lessor by lessee.
(4) As legal owner of the asset, lessor can claim depreciation for income
tax purpose.
(5) After lease period, asset reverts to lessor and he can recover salvage
value if any.
(6) For lessee, lease rental is expense, which qualifies for tax deduction.
(7) There are three types of lease:
Ÿ Operating Lease:
- It is a short-term cancelable lease.
E.g. Computers, Car on rent, office equipment
- Lessor is responsible for maintenance and insurance.
- Lessee has option to cancel lease.
- Risk of obsolescence lies with lessor.
- Lease rental is higher.
Ÿ Financial Lease
- Long-term non- cancelable lease.
- E.g.: Plant, Machinery, Buildings, Aircrafts
- Cost of asset is amortized over term of lease.
- Maintenance and insurance is borne by lessee.
- Lessor buys asset identified by lessee from manufacturer and
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- signs a Lease Contract with lessee.
Ÿ Sale and Lease back:

- Existing user of asset sells asset to lessor.
- Lessor then leases him the same asset.
- Thus, funds of user of asset are released.
5.7 Hire Purchase
(1) It is a contract in which one party is allowed to take possession of goods

belonging to another party. The party that is allowed to take possession
pays initial margin money, followed by no. of installments for specified
period.
(2) Goods do not become legal property of acquirer until final installment
has been paid.
(3) Price of the goods includes cost of an asset as well as interest payable
for making payment over long period in installments.
(4) Hire purchaser can claim depreciation as well as interest payable for tax
benefit.
(5) Hire Purchase Vs. Lease Finance :

Hire Purchase Lease Finance
5.8 Venture Capital

(1) It is an early stage financing of new and young enterprises seeking to
grow rapidly.
(2) Venture financing is equity participation through direct purchase of
shares or convertible securities.
(3) The objective of Venture Capital Firm (VCF) is to make capital gain by
selling off the investment in the company to whom finance has been
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provided by VCF once the enterprise becomes profitable.

(4) VCF has to wait for a long period say 5 to 10 years to make large profits.
(5) More than finance, VCF provides marketing, technology, planning and
management skills to new firm.
(6) VCF combines qualities of banker, investor and entrepreneur in one.
(7) Stages in venture capital financing:
Early stage financing:
Ÿ Seed financing to support concept and idea.
Ÿ R & D financing for product development.
Ÿ Start financing for initial production and marketing.
Ÿ First stage financing for full scale production and marketing.
Expansion stage financing:
Ÿ Second stage financing for initial expansion and working capital.
Ÿ Development financing for facilitating public issue.
Bridge financing:
Ÿ For facilitating public issue.
Growth stage financing:
Ÿ Acquisition financing to acquire another firm.
Ÿ Turnaround financing for turning around sick unit.
5.9 Summary
Company requires two types of capital- long-term capital and working capital.
Long-term sources include:
Ÿ Equity capital is a permanent capital of company. Equity shareholders

are owners of company and they have residual claim on income in form
of dividend and on assets when company is liquidated.
Ÿ Preference share capital is a long-term capital. Preference
shareholders have preference over equity shareholders for residual
claim on income i.e. dividend and repayment of capital on liquidation of
company.
Ÿ Debenture is a secured loan taken from public at large. Paying interest
on debentures and repayment of debentures amount after specific
period is obligatory to company, whether company makes profits or
loss.
Ÿ A term loan is a secured loan taken from bankers or financial
institutions. It is generally for 5 to 10 years. Repayment is through EMI,
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which includes both principal and interest.

Ÿ Lease finance involves payment of lease rental by lessee on regular
basis for using assets owned by party called lessor.
Ÿ In Hire Purchase, company can take possession of assets
belonging to other party and pays the purchase price in
installments. When all the installments are paid, ownership is
transferred to company.
Ÿ Venture capital is an early stage financing of new and young
enterprises sacking to grow rapidly.
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CHAPTER 6
COST OF CAPITAL
Learning Objectives
·State the meaning of cost of capital.
·Specify the significance of cost of capital.
·Calculate cost of equity preference debenture loan capital and
weighted average cost of capital (WACC).
Structure
6.1 Introduction
6.2 Meaning of Cost of Capital
6.3 Significance of Cost of Capital
6.4 Cost of Equity Shares
6.5 Cost of Preference Shares
6.6 Cost of Debenture
6.7 Cost Of Long Term Loans (KL)
6.8 Weighted Average Cost Of Capital (W.A.C.C.)
6.9 Summary
6.1 Introduction
Business procures funds from different sources. Every source has different
cost either in the form of dividend or in the form of interest. Business must earn
returns, which are sufficient to pay the cost of the funds.
Cost of capital is the minimum returns, which must be earned by business from
funds invested in business, which is weighted average cost of capital (WACC)
of various sources of funds used in business.
6.2 Meaning Of Cost Of Capital
It is the minimum rate of return that company must try to earn on the funds
invested in various projects of the company.
Minimum rate consists of risk free rate of return + premium for risk associated
with particular business.
Risk free rate of return is available on government securities where there is no
risk of default.
Premium is added for two types of risks associated with business viz. Business
Risk that arises when there is volatility in earnings of a company due to
changes in demand, supply, economic environment, business conditions etc.
Financial risk arises when firm depends on debt funds, since payment of
principal and interest must be made as per loan obligation.
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6.3 Significance Of Cost Of Capital
Management must invest funds in those projects, which would bring returns
more than cost of capital; then only share holders are benefited. Cost of capital
is the weighted average cost of capital (WACC) of various sources of funds
used in capital structure. Thus, returns from the project must be more than
WACC. In capital budgeting, decision methods used for evaluation of project
are based on WACC of project. While locating various sources of finance and
designing capital structure, management must ensure that WACC is kept at
minimum.
6.4 Cost Of Equity Shares
Cost of Equity Capital (Ke)
(1) Dividend-Yield Method
Formula:
Ke = D/ P
D= Dividend per share
P= Market price per share
Features:
(i) Future expected dividend is assumed to be constant.
(ii) Does not allow for any growth rate
(iii) In re ality, shareholders expect growth.
Illustration 1:
ABC Ltd. has declared dividend of 15% on share of Rs. 10, which will remain
constant. What is cost of equity if market price of share is Rs. 30?
Solution: Ke = D x 100
P
Ke = 1.5 x 100
30
= 5%
D = 15% = Rs. 1.50
P = Rs. 30
(2) Dividend-growth Method
Formula : Ke = (D1/ P) + g
D 1= Do (1+g)
g = Growth rate of dividend
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Features:
(I) Based on assumption that shareholders expect dividend to grow year after
year.
(ii) Allowance for future growth in dividend is added to current dividend
yield.
(iii) It is recognized that current market price of a share reflects expected future
dividends.
Illustration 2:
Company has declared dividend of 20% last year, which is expected to
increase at a constant rate of 6%.What is cost of equity if market price share is
Rs. 18?
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Features:
(i) Based on assumption that investors capitalize the stream of future earnings
of the share
(ii) Even if earnings are not distributed and kept as retained earnings, it causes
further growth in earnings of company and market price of share
Illustration 3:
Aditya Ind. Ltd. has just paid dividend of 35%, which is expected to grow at a
constant rate of 5%. What is cost of equity if market price of share is Rs. 30?
Solution:
Ke = D1 + g D1 = Rs. 3.50
P P = Rs. 30
g =5%
= 3.5 + 5%
30
= 11.67%+ 5%
= 16.67%.
Illustration 4:
EBIT of company is Rs. 28 Crore. Interest paid by company is Rs. 3 crore. Tax
rate is 40%. Preference capital (10%) is Rs. 10 crore and equity capital (Rs. 5)
is Rs. 30 Crore. Debentures (10%) Rs. 50 Crore and Loan (12%) Rs. 25 Crore.
Decide cost of equity if market price of share is Rs. 20.
Solution:
Ke = ___________E.P.S.______________
Market Value per Share (M.V.P.S.)
Now EPS = EBIT - Int. – Tax – Pref. Dividend
No. of Equity Shares.
EBIT = Rs. 28 crore
Int. = Rs. 3 crore
Tax. = 40% [28 – 3] = Rs. 10 crore
Pref. Div. = 10% [10] = Rs. 1 crore
No. of equity shares = Equity Capital = 30 Cr. = 6 Cr. Shares
Price per share 5
Hence,
E.P.S. = 28 - 3 - 10 - 1
6
= 14
6
and Ke= 2.33 x 100
20 = 11.65%
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(4) Capital Asset Pricing Model (CAPM) Method

Formula: Ke = Rf +β (Rm - Rf )
Rf = Risk free rate of return Risk free rate
Rm=Market return
Β=Beta of investment
Features:
(i) CAPM divides cost of capital in two components Risk free rate of return and
risk premium for a particular investment, which depends on market returns
and risk factor β.
Illustration 5:
Returns available on Govt. T-bills is 3%. Returns available in market are 18%.
Beta for the share is 1.2. Decide cost of equity using C.A.P.M. method.
Solution:
Ke = Rs + β [Rm - Rf]
Rf= 3%Rm = 18%β = 1.2
Hence,
Ke = 3% + 1.2 [18% - 3%]
= 3% + 18%
6.5 Cost Of Preference Shares

Cost of Redeemable Pref. Shares (Kp)
The cost of redeemable preference share can be calculated by
using the following formula:
Where, DP = Preference dividend,
n = Period of preference share,
RV= Redeemable value of preference share, and
NP = Net proceeds from issue of preference shares.
Example 4.3:
Baibhav Ltd., issued 10,000, 12% preference shares of Rs 100 each at a
premium of 6%); the floatation cost being 2.5% on issue price. The shares are
to be redeemed after 5 years at a premium of 5%. Compute the cost of
preference share capital.
Solution:
We know that the cost of preference shares may be calculated as
Where I= Interest =2,00,000 x 12/100 =Rs 24,000
NP = Net proceeds = Rs. 2,00,000
T =Tax Rate = 30% i.e 0.3
Kd = 24,000 (1-0.3) = 0.84 or 8.4 %
2,00,000
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6.6 Cost Of Debenture

Cost of Redeemable Debentures (Kd) For redeemable debentures, the
maturity date is fixed initially. so we take the averages of sale value and
redeemable value while calculating the cost of redeemable debentures.
1. Cost of redeemable debt, before tax : Cost of redeemable debt, a before
tax issued at par can be expressed as follows:
Kd = I + (P- NP)/n
(P+ NP)/2
Where,
Kd = Cost of debt
I = Interest /Fixed charge per annum
P/RV = Face value of debenture/ Redeemable value
NP = Net proceed /Price at which the debenture or the bond is sold
T = Tax rate
n= No of years
Illustration 1:
A firm issues debentures of Rs 1,00,000 and realizes Rs 98000 after allowing
2% commission to brokers.The debenture carry an interest rate of 10% . The
debenture are due for maturity at the end of the 10th year. You are required to
calculate the effective cost of debt before tax.
Solution:
Kd = I + (P- NP)/n
(P+ NP)/2
10,000 + (1,00,000 -98,000)/10
(1,00,000 +98000)/2
= 10, 000 + 200
99,000
=.103 or 10.30%
2. Cost of redeemable Debt,after
A debenture or a bond may be issued at a discount tax or a premium.It is
redeemable after the expiry of a given period(n).Its price differs from its face
value .The cost of redeemable debt issued at a discount or premium is
calculated as follows:
Kd = [I + 1/n (P- NP)](1-t)
1/2 (P+ NP)
Kd = cost of debt
I = Fixed charge per annum
P/RV = Face value of debenture /redeemable value
NP= price at which the debenture or the bond is sold/net proceed
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T = tax rate
n = No. of years
Illustration 2
MV Ltd issues 10 years debentures of the face value of Rs 100 at a discount of
10% . The coupon rate of interest is 8% .Assuming 50% tax rate, calculate
after-tax cost of the debt.
Solution:
The after –tax cost of debt will be:
Kd = [I + 1/n (P- NP)](1-t)
1/2 (P+ NP)
[Rs8 + 1/10 (Rs 100-90)] (1- 0.50)
½ (100+90)
= 0.0474 or 4.74
6.7 Cost Of Long Term Loans (kL)
KL= Interest (1-t)
Loan
Illustration 1:
Company took loan = 100 processing charges = 2%. Rate of interest 13%.
Tax rate 35%What is cost by Loan?
Solution:
KL = Interest ( 1 – t ) x 100
Net loan proceed
= 13 Cr. ( 1 – 0.35) x 100
( 100 - 2 ) Cr.
= 8.2 %
6.8 Weighted Average Cost Of Capital (w.a.c.c.)
Weighted Average Cost of Capital (WACC):
WACC is the weighted average of cost of various sources of finance, weight
being book value or market value of each source.
Capital available for any project of company is coming from various sources.
Hence cost of capital is WACC.
For proper evaluation of project, WACC is considered as minimum rate of
return required from project. The relative worth of a project is determined using
this rate as discounting rate.
W.A.C.C. Ke x Equity Kp x Pref. cap Kd x Debenture KL x Loan
= ---------------- + ---------------- + ------------------- + -------------
Total capital Total capital Total capital Total capital
Kdand KL are post tax costs
Total capital = Equity +Pref. + Debentures + Loan taken
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Illustration 1:
Total capital of Co. = Rs. 150 crore
Composition is as under
Source Amount ( Rs. crore) Cost
Equity 20 18%
Preference shares 10 8%
Debentures 100 7% (Post – Tax )
Loan 20 8.5% (Post – Tax )
What is W.A.C.C.?
Solution:
WACC = E x Ke + P x Kp+ D Kd__ + L x Kl_

E+P+D+L E+P+D+L E + P + D +L E+P+D+L
Given : E = 20, P = 10, D = 100, L = 20
Ke = 18% Kp = 8% Kd = 7% KL = 8.5%
Hence WACC = 20 x 18% + 10 x8% + 100 x 7% + 20 x 8.5%

150 150 150 150
= 1 [ 20 x 18 + 10 x 8 + 100 x 7 + 20 x 8.5 ] %
150
= 8.73%
Illustration 2:
Company has total capital Rs. 100 Cr. With following composition ( tax rate
= 40%)
Source Amt. (Rs. Crore.) Cost
Equity 10 20%
Preference 20 8%
Debentures 60 12% ( Pre - tax )
Loan 10 14% ( Pre - tax )
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Solution:
WACC = E Ke + P Kp+ D Kd_(1-E)_+ L x KL ( 1- t)
E+P+D+L E+P+D+L E + P + D +L E+P+D+L
E = 10, P = 20, D = 60, L = 10
Ke = 20% Kp = 8% Kd = 12% KL = 14%
Hence WACC = 10 x 20% + 20 x 8% + 60 x 12%(1-0.4) + 10 x 14% (1-

0.4)
100 100 100 100
= 1 [10 x 20 + 20 x 8 + 60 x 12 x 0.6 + 10 x 14 x 0.6 ] %

100
= 8.76%
6.9 Summary
· Cost of capital is the minimum rate of return that must be earned by business
on the funds invested in business.
· Shareholders are benefited when management invests funds in projects,
which bring returns more than cost of capital.
· There are different formulae and methods to find out cost of equity shares,
preference shares, debentures, and loans.
· WACC is the weighted average of cost of various sources of finance.
Generally, cost of capital of company is WACC.
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CHAPTER 7
CAPITAL STRUCTURE
Learning Objectives
·State the meaning of capital structure
·Explain significance of capital structure
·Identify the importance and factors of optimum capital structure
·Specify the effect of capital structure on profitability and liquidity of firm
Structure
7.1 Introduction
7.2 Meaning of Capital Structure
7.3 Significance of Capital Structure
7.4 Optimum Capital Structure
7.5 Various Aspects Of Capital Structure
7.6 Summary
7.1 Introduction
Every company collects funds from different sources. Right mix of various
sources of long-term funds is necessary to keep cost of funds to minimum and
at the same time, company should be able to make maximum use of funds.
Capital structure is the mix of long-term sources of funds. This unit deals with
various aspects of capital structure.
7.2 Meaning Of Capital Structure
. It refers to the mix of long term finances used by company.

. Capital structure may be the combination of equity and one or more of the
following in different proportion :
– Debentures
– Preference shares
– Long term loans
. Capital structure is different from financial structure of company. While
former is a mix of long funds, later is a mix of long-term funds and current
liabilities of company.
. Company should plan its capital structure to maximize use of funds and to
be able to adapt more quickly to changing business conditions.
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7.3 Significance Of Capital Structure
Having proper capital structure is important for following reasons:

· Optimum capital structure is useful for maximizing Earning Per Share (E.P.S.)
and Market Value Per Share (M.V.P.S.).
· Liquidity and profitability of company is affected by capital structure decision.
· Control over the company is defined by its capital structure.
· Capital budgeting and capital structure decision are closely related to each
other.
· Capital structure decision is taken at the time of formation of company or at
the time of expansion and diversification of business.
7.4 Optimum Capital Structure
Company always likes to have optimum capital structure because at this point.
- E.P.S. is maximum.
- Cost of capital is minimum.
Following factors are to be considered while designing optimum capital
structure for company:
(1) Maximization of profitability
· Capital structure should be most profitable for equity shareholders.
· Within given constraints maximum debt financing should be adopted to
increase the returns available to equity shareholders.
· E.P.S. should be maximized.
(2) Minimization of risk
Capital structure must be consistent with business risk and financial risk.
Business Risk:
a) It is the relationship between revenue and E.B.I.T. of company.
b) Business risk is high when:
- E.B.I.T. changes (up or down) as compared to sales of company
- Company has more fixed costs
- Costs and revenues are not stable.
Financial Risk :
a) This risk arises when company uses debt capital and preference capital in
capital structure.
Capital structure may be called as sound if it keeps the total risk of the
company [i.e. Business Risk + Financial Risk] to minimum level.
Excessive use of debt affects long-term solvency and financial risk and this
must be assessed for a given capital structure.
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(3) Flexibility
It refers to ability of company to raise additional capital funds whenever
needed to finance profitable and viable investment opportunities.
Flexibility implies that a capital structure should always have an untapped
borrowing capacity, which can be used any time in future.
(4) Capacity
The capital structure should be determined within debt raising capacity of the
company.
The debt capacity of company depends on its ability to generate future cash
flows.
Company should have enough cash to pay fixed charges and principal sum of
creditors.
(5) Control
Control is the most important aspect of corporate management. Ultimate
control of company affairs is in the hands of equity shareholders. For dealing
with controlling aspects while deciding capital structure, following points must
be kept in mind:
· Capital structure should reflect the philosophy of control of management.
· While redeemable debentures do not result in dilution of control, convertible
debentures result in dilution of control when converted in equity shares.
· Convertible preference shares and convertible loans from banks or financial
institutions result in dilution of control.
· Preference capital and debt financing do not dilute controlling powers of
management.
(6) Simplicity
Capital structure must be simple to operate and easy to understand.
Administrative convenience must be maximum.
Rights attached with each type of security must be clearly spelt.
(7) Economy
Capital structure should be economical from point of view of:
· Floatation cost i.e. cost of floating capital.
· Operation cost, i.e. servicing equity, preference and debenture holders, to be
paid to underwriters and brokers.
· Commissions and brokerage.
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7.5 Various Aspects Of Capital Structure
A] Profitability and Capital Structure: [EBIT-EPS analysis]

Finance manager must study various alternative financial leverages and find
their effect on E.P.S. of Co. When rate of return on assets employed in
business is more than cost of their financing EPS increases and it is favorable
financial leverage. When rate of return on assets employed in business is less
than cost of their financing EPS decreases and it is unfavorable financial
leverage.
Fixed financial charge financing must be analyzed with reference to choice
between debt and preference shares. Generally, rate of interest payable to
debt instruments or loans is lower than dividend payable on preference
shares. Interest payable on debt is tax deductible whereas dividend on
preference shares is paid from P.A.T. When various options are available to
company, the action that gives maximum E.P.S. should be selected. Risk
attached with leverage may be incorporated in analysis. Find indifferent level
of EBIT, i.e. level of EBIT for which EPS is same for different capital structure by
formula:
( EBIT - I1 ) ( 1 – T ) = (EBIT - I2 ) ( 1 – T )
E1 E2
EBIT = Earnings before interest and tax
I1 = Interest charges in alternative 1
I2 = Interest charges in alternative 2
E1 = No. of Equity shares in alternative 1
E2 = No. of Equity shares in alternative 2
Compare expected EBIT with indifference level.
a) When expected EBIT is more than indifferent EBIT debt financing is
advantageous.
b) When expected EBIT is less than indifferent EBIT debt financing is risky.
Greater the difference between the two more the advantageous or risky is the
debt financing. In EBIT –EPS analysis debt capacity of the firm for debt service
and interest service and effect on liquidity of company must be incorporated.
B] Liquidity and Capital Structure (Cash flow analysis)
Company though earning sufficient profits may not be generating large
enough cash surplus perhaps due to needs to reinvest heavily in working
capital. Such a firm finds it difficult to service fixed interest and preference
dividend. In such case, company may resort to equity finance where dividends
can be paid based on cash position.
Companies, which can generate large cash surplus from their operations, will
tend to opt, for large debt financing.
122 | Page
Finance manager, while evaluating different capital structures, should ensure

liquidity for:
I) Interest on debt
ii) Repayment of debt
iii) Dividend on Preference capital
iv) Redemption of Preference capital
Liquidity can be ascertained from:
I) Debt service coverage ratio (DSCR)
DSCR = P.A.T. + DEP. + Interest + Non-Cash Expenses __
Preference dividend + Interest + Repayment obligation
This ratio helps in assessing the extent to which cash profits of the firm covers
the cash payments of revenue and capital nature. Higher DSCR better is the
liquidity of company.
II) From projected cash flow analysis:
If cash inflows are comfortably higher than cash outflows then company can
proceed with debt financing. Cash inflows and outflows should be assessed
under varying operating conditions along with their probabilities.
Illustration 1:
Company is in the process of undertaking new project worth Rs. 2,000 crore.
Four alternatives are available to company. [Amt. Rs. Crore]
Alternative Equity Preference (8%) Debenture (10%) Loan (12%)
I 300 100 800 800
II 400 200 700 700
III 600 300 600 500
IV 800 400 500 300
Company expects E.B.I.T. of 15% on capital employed. Tax applicable to
company is 40%. Which alternative should be selected on basis of E.P.S.
Solution:
E.B.I.T. expected = 15% of Rs. 2,000 crore = Rs. 300 crore
Company should select the alternative that gives maximum E.P.S. It is
therefore necessary to calculate E.P.S. under all four alternatives.
123 | Page
[Amt. Rs. Crore]

Alternative I II III IV
-------------------------------------------------------------------------------------------------
Equity Capital 300 400 600 800
Preference Capital (8%) 100 200 300 400
Debentures (10%) 800 700 600 500
Loan (12%) 800 700 500 300
Total 2,000 2,000 2,000 2,000
E.B.IT. 300 300 300 300
(-)Interest on debentures 80 70 60 50
Interest on loan 96 84 60 36
=E.B.T. 124 146 180 214
(-)Tax (40%) 49.60 58.40 72 85.60
=E.A.T. 74.40 87.60 108 128.40
(-)Pref. Dividend 8 16 24 32
=Amount available
to equity shareholders (a) 66.40 71.60 84 96.40
No. of equity shares (b) 30 40 60 80
(In crore)
E.P.S. = a 2.21 1.79 1.40 1.21
Note:
When nothing is mentioned, it is to be assumed that each equity share is of
Rs. 10.
Interest is paid by company on debentures and loan before tax is paid.
Dividend is paid on preference capital after tax is paid.
Since E.P.S. is maximum for alternative number 1, company should select this
alternative.
Equity capital Rs. 300 crore
Preference Capital (8%) Rs. 100 crore
Debentures (10%) Rs. 800 crore
Loan (12%) Rs. 800 crore
Illustration 2
Company has two alternatives of capital structure for its expansion plan, which
require Rs. 150 crore.
Alternative A: Rs.60 crore Equity, Rs. 40 crore Debentures (12%) and
remaining by loan.
Alternative B: Rs.80 crore Equity, Rs. 50 crore Debentures (12%) and
remaining by loan.
124 | Page
Interest on loan is as under:

Up to Rs. 5 crore - 10%
5 crore to 20 crore - 11%
More than 20 crore - 13%
Expected E.B.I.T. is Rs. 35 crore. Tax is 40%. Company has corporate
objective of maximizing company's wealth. P/E ratio expected is 8 for
alternative A and 9 for alternative B.
Advice the company on appropriate capital structure.
Solution:
[Amt. Rs. in Crore]

Alternative A B
Equity Capital 60 80
Debentures (12%) 40 50
Loan 100 70
Total 200 200
E.B.I.T. 35 35
(-)Interest 12.55 8.65
=E.B.T. 22.45 26.35
(-) Tax (40%) 8.98 10.54

=E.A.T. 13.47
(-) Pref. Dividend NIL NIL

=Amt. to Equity shareholders 13.47 15.81
(a)
No. of equity shares (b) 6 8
(in crore.)
E.P.S.=[a/b] 2.25 1.98
P/E 8 9
M.V.P.S. = E.P.S. x P/E 18 17.82
Market capitalization 108 142.56
= M.V.P.S. x No. of equity shares
125 | Page
Notes:
1) Calculation of Interest
For alternative A:
First – Rs. 5 Crs. @ 10% = Rs. 0.5 Crs.
Next Rs. 15 Crs. @ 11% = Rs. 1.65 Crs.
Next Rs. 80 Crs. @ 13% = Rs. 10.40 Crs.
Total Rs. 12.55 Crs.
For alternative B:
First Rs. 5 Crs. @ 10% = Rs. 0.5 Crs.
Next Rs. 15 Crs. @ 11% = Rs. 1.65 Crs.
Next Rs. 50 Crs. @ 13% = Rs. 6.50 Crs.
Total = Rs. 8.65 Crs.
2) Market Value per Share (M.V.P.S.)= (P/E) x (E.P.S.)
3) Wealth of company is nothing but market capitalization.
Hence, the alternative that maximizes market capitalization should be
selected.
4) Each equity share is of Rs. 10 unless otherwise stated.
5) If wealth of shareholders is to be maximized then select alternative with
maximum M.V.P.S.
Ans.: Management should select alternative B, since market capitalization is
maximum.
Management should select alternative A if wealth of shareholders is to be
maximized.
7.6 Summary
· Capital structure is composition of company's long-term capital.
· Optimum capital structure ensures maximum profitability, minimizing risk,
flexibility, control and at the same time keeps capital structure to be simple
and debt raising capacity to be intact.
· Profitability and liquidity of company is affected by capital structure
decision.
126 | Page
CHAPTER 8
LEVERAGE ANALYSIS
Learning Objectives
Explain the meaning of different leverages
Calculate various leverages
State the effect of these leverages
Structure
8.1 Introduction
8.2 Meaning of Leverage
8.3 Types of Leverage
8.4 Effect of Leverage
8.5 Summary
8.1 Introduction
Management is faced with two problems relating to procurement of capital and

its use in business. Operating leverage deals with use of funds in business and
financial leverage deals with borrowing of funds. This unit deals with borrowing
of funds, use of funds and their combined effect on profitability of the business.
8.2 Meaning Of Leverage
The term leverage refers to relationship between two interrelated variables.

These variables may be Cost, Output, Sales, EBIT, EPS.
Leverage = % change in dependent variable_
% change in independent variable
Example: Firm increase sales promotion expenses from Rs. 5,000 to 6,000
This has resulted in no. of units sold to increase from 200 to 300
Leverage = % change in units sold_______
% change in sales promotion expenses
= 50%
20%
= 2.5
This means if sales promotion expenses increase by 20%, units sold will
increase by 50%.
129 | Page
8.3 Types Of Leverage
a) Operating Leverage (O.L.)

It is the % change in EBIT as a result of % change in sales
O.L. = % change in EBIT
% change in Sales
Or
= Contribution
EBIT
Or
= Contribution_ ___
Contribution (-) Fixed cost
High O.L. means:
Ø High fixed cost by way of depreciation and other costs
Ø Higher risk to company
Ø EBIT increases faster in response to increase in sales
a) Financial Leverage (F.L.)

It is % change in EPS as a result of % change in EBIT
F.L. = % change in EPS

% change in EBIT
Or
= EBIT
EBT
Or
= E.B.I.T. ( 1 – t )___
(EBIT. – I ) ( 1 – t ) – Dp
Where t = Tax Rate
I = Interest
Dp = Preference Dividend
High F.L. means:
Ÿ Higher level of borrowings and high interest cost
Ÿ Higher risk to company
Ÿ EPS increases faster in response to increase in EBIT
130 | Page
a) Combined Leverage (C.L.)

It is a % change in EPS as a result of % change in sales
C.L. = O.L. x F.L.
b) Calculating Leverages
Sales
(-) Variable Cost
= Contribution (A)
(-) Fixed Cost
= EBIT (B)
(-) Interest
= EBT (C)
O.L. = A / B
F.L. = B / C
C.L. = O.L. x F.L.
8.4 Effect Of Leverage
O.L. F.L. Comments

High High (I) High fixed cost and high borrowings
(ii) Highest risk
(iii) Expansion on external borrowings
(iv) High interest outflow
High Low (i) High fixed cost and less borrowings

(ii) Risk is reduced due to low borrowings
(iii) Company is expanding but less dependent on external funds
(iv) Low interest outflow
Low High (i) Low fixed cost and high borrowings

(ii) Borrowings are used mainly for variable costs which are in
line with increase in sales
(iii) Risk is further reduced due to low fixed cost
(iv) Ideal situation for profit maximization
Low Low (i) Low fixed cost and low borrowings

(ii) Management is over cautious
(iii) No expansion plans
(iv) Minimum interest outflow
131 | Page
Illustration 1:
Sales = Rs. 20,000
Variable cost = Rs. 14,000
Fixed cost = Rs. 4,000
What is operating leverage of company. How you will interpret it?
Solution:
Sales = Rs. 20,000
- Variable cost = Rs. 14,000
= Contribution = Rs. 6,000 (a)
- Fixed cost = Rs. 4,000
= E.B.I.T. = Rs. 2,000 (b)
Operating Leverage = a/b
= 6,000
2,000
= 3
Interpretation: If sales of company ↑ 100%, EBIT will ↑ 300%
If sales of company ↓ 100%, EBIT will ↓ 300%
Illustration 2:
Sales Rs. 8,00,000
P/V 20%
Fixed cost Rs. 40,000
Interest Rs. 20,000
Decide: (i) Operating leverage (ii) Financial leverage
(iii) Combined leverage
Give your interpretation.
Solution: Amt. ( Rs. )
Sales 8,00,000
P/V 20%
Contribution 1,60,000 (a) [ P/V = C i.e. sales x P/V
= Contribution ] S
(-) Fixed cost 40,000
= E.B.I.T. 1,20,000 (b)
(-) Interest 20,000
= EBT 1,00,000 (c)
O.L. (a/b) 1.33
F.L. (a/c) 1.20
C.L. = O.L. x F.L. 1.60
132 | Page
Interpretation:
1. When sales ↑ or ↓ by 100% E.B.I.T. ↑ or ↓ by 133.3%
2. When EBIT ↑ or ↓ by 100% E.P.S. ↑ or ↓ by 120%
3. When sales ↑ or ↓ by 100% E.P.S. ↑ or ↓ by 160%
Illustration 3:
Operating leverage is 2 and financial leverage is 1.5. Interest paid by company
is Rs. 2 lakh and fixed cost is Rs. 3 lakh. Prepare income statement of
company if tax rate is 40% and P/V ratio for company is 30%.
Solution:
F.L.= E.B.I.T.
E.B.T.
= E.B.I.T. __
E.B.I.T. – Interest
1.5 = E.B.I.T.__
E.B.I.T. – 2
1.5 (EBIT) – 3 = E.B.I.T.
1.5 (E.B.I.T.) – E.B.I.T. = 3

0.5 (EBIT) = 3
E.B.I.T. = 3 = 6
0.5
O.L. = __C__
E.B.I.T.
C = O.L. x EBIT
= 2 x 6
= 12
Now C = P/V
S
Hence C = S
P/V
_12_ = 40
30%
133 | Page
Income Statement Rs. in Lakh.
Sales 40
P/V 30%
= Contribution 12
(-) Fixed Cost 6
= E.B.I.T. 6
(-) Interest 2
= E.B.T. 4
(-) Tax ( 40%) 1.60
= E.A.T. 2.40
Illustration: 4
Net Sales = 10 Crore.
EBIT = 20% of sales
Tax rate = 40%
Equity capital Rs. 2 crore
Preference capital (10%) Rs. 3 crore
Debentures (12%) Rs. 5 crore
Calculate: (a) E.P.S. (b) Percentage change in EPS. If E.B.I.T. increases
by 10% (c) Calculate financial leverage.
Solution:
a) E.P.S. = (E.B.I.T. – Interest) ( 1 – t) – Dp
N
t = Tax rate = 40%
Dp = Preference dividend = 10% of Rs. 3 Crs. = Rs. 0.3 Crs.
Interest = 12% of Rs. 5 Crs. = Rs. 0.6 Cr.
N = No. of equity shares in Crs. = 0.2 Cr.
EBIT = 20% of 10 = 2 Crore
Hence,
a) (E.P.S.)1 = [ 2 – 0.6 ] ( 1-0.4) - 0.3
0.2
= (1.4) (0.6) - 0.3
0.2
= 0.84 - 0.30
0.2
= 0.54
0.2
= Rs. 2.70
134 | Page
b) (E.P.S.)2 = (New E.B.I.T. - Interest ) ( 1 – t) – Dp

N
New E.B.I.T.= 1.1 x E.B.I.T.
= 1.1 x 2 Cr.
= 2.2 Crs.
(EPS)2 = (2.2 – 0.6) ( 1 – 0.4) – 0.3
0.2
= (1.6) ( 0.6) - 0.3
0.2
= 0.96 - 0.3
0.2
= 0.66
2
= Rs. 3.3
c) F.L. = % Change in E.P.S.
% Change in EBIT.
% Change in E.P.S. = [(EPS)2 - (EPS.)1] x 100
(E.P.S.)1
= [(3.3) - ( 2.70)] x 100
2.70
= 22.22%
Hence F.L. = 22.22%
10%
= 2.22
Illustration 5:
The following figures relate to two companies: [Rs. lakh.]
Particulars P Ltd. Q Ltd.
Sales 500 1,000
Variable costs 200 300
Contribution 300 700
Fixed Cost 150 400
150 300
Interest 50 100
Profit before Tax (PBT) 100 200
You are required to calculate –
(a) Operating financial and combined leverages of the two companies and
(b) Comment on the relative position of the companies in respect of the risk.
135 | Page
Solution:
[Rs. in lakh]
Particulars P Ltd Q Ltd.
Operating leverage Contribution 300 = 2 700 = 2.33
EBIT 150 300
Financial leverage EBIT 150 = 1.5 300 = 1.5
EBT 100 200
Combined leverage Contribution 300 = 3 700 = 3.5
EBT 100 200
Comment:
Ÿ The operating leverage is higher for Q Ltd. and therefore it is subject to
greater degree of business risk than P Ltd. The EBIT will tend to vary more
with sales in Q Ltd.
Ÿ The financial leverage of both the companies stand at 1.5 times. It conveys
that interest burden is proportionately same and also financial risk is similar
both the companies.
Ÿ The combined leverage of Q Ltd. is higher and its overall risk is more as
compared to P Ltd.
Illustration 6:
A firm has sales of Rs. 75,00,000 variable cost of Rs. 42,00,000 and fixed cost
of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and equity of Rs.
55,00,000.
i) What is the firm's ROI?
ii) Does it have favorable financial leverage ?
iii) If the firm belongs to an industry whose asset turnover is 3, does it have a
high or low asset leverage?
iv) What are the operating, financial and combined leverages of the firm?
v) If the sales drop to Rs. 50,00,000. What will be the new EBIT ?
vi) At what level the EBT of the firm will be equal to zero?
Solution:
Calculation of EBIT and EBT Rs.
Sales 75,00,000
Less: Variable cost 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: Interest on debt (@ 9% on Rs. 45 lakh.) 4,05,000
EBT 22,95,000
136 | Page
i) ROI = _EBIT x 100_

Capital employed
= EBIT x 100
Equity + Debt.
= 27,00,000 x 100__
55,00,000 + 45,00,000
= 27%
ii) The return on investment of Firm is 27% where as the firm is only paying 9%
rate of interest on its debt and hence the firm is enjoying favorable financial
leverage.
iii) Asset Turnover = Net Sales
Total Assets
Or = Net sales_
Total Investment
= 75,00,000
1,00,00,000
= 0.75
As compared to the industry's normal asset turnover of 3 times, the firm's asset
turnover ratio is only 0.75 and the investment level of the firm is highly
abnormal.
iv) Calculation of operating, financial and combined leverages
a) Operating Leverage =Contribution =33,00,000 = 1.22

EBIT 27,00,000
b) Financial Leverage =EBIT =27,00,000 = 1.18

EBT 22,95,000
c) Combined Leverage =Contribution =33,00,000 = 1.44

EBT = 22.95,000
Or = Operating Leverage x Financial Leverage = 1.22 x 1.18= 1.44
137 | Page
v) New EBIT when sales drop to Rs. 50,00,000 Rs.
New Sales (After 33.33% drop) 50,00,000
Less: Variable cost (Rs. 42 lakh 33.33%) 28,00,000
Less: Fixed Cost 6,00,000
New EBIT 16,00,000
vi) Sales level at which EBT of the firm will be equal to zero. Since the
combined leverage is 1.44, sales have to drop by 100 / 1.44 i.e. 69.44%
New sales = 75,00,000 x (1 – 0.6944)
= Rs. 22,92,000 (approx)
New Sales (After 33.33% drop) 50,00,000

Less: Variable cost (Rs. 42 lakh 33.33%) 28,00,000
Less: Fixed Cost 6,00,000
New EBIT 16,00,000
vi) Sales level at which EBT of the firm will be equal to zero. Since the
combined leverage is 1.44, sales have to drop by 100 / 1.44 i.e. 69.44%
New sales = 75,00,000 x (1 – 0.6944)
= Rs. 22,92,000 (approx)
Illustration 7:
The following financial data have been furnished by A Ltd. and B Ltd. for the
year ended31-3-2016.
Particulars A Ltd. B Ltd.

Operating leverage 3:1 4:1
Financial leverage 2:1 3:1
Interest charges per annum Rs. 12 lakh Rs. 10 lakh
Corporate tax rate 40% 40%
Variable cost as % of sales 60% 50%
Prepare Income statement of the two companies. Also comment on the

financial position and structure of the two companies.
Solution:
A Ltd. data
a) Calculation of EBIT
Financial leverage (given) = 2
138 | Page
EBIT ___ = 2
EBIT - Interest
EBIT = 2
EBIT - 12
2 EBIT - 24 = EBIT
EBIT = Rs. 24 lakh

b) Calculation of Contribution
Operating leverage (given) = 3
Contribution = 3
EBIT
Contribution = 3
24
Contribution = Rs. 72 lakh
c) Calculation of Fixed Cost

Operating leverage (given) = 3
Contribution = 3
Contribution – FC
___72 = 3
72 - FC
(3 x 72) - 3 FC = 72
3 FC = 216 - 72
FC = 144/3
Fixed cost = Rs. 48 lakh
d) Calculation of sales
Contribution = 40%
Sales
139 | Page
Sales = 72 x 100 / 40
= Rs. 180 lakh
Similarly, following the above procedure, the basic data of B Ltd. can also be
ascertained.
Particulars A Ltd. B Ltd.
Operating leverage (Contribution / EBIT) 3 4
Financial leverage ( EBIT / EBT) 2 3
Combined leverage (Contribution / EBT) 6 12
P.V. Ratio (Contribution / Sales) 40% 50%
Comments:
Ÿ Contribution / Sales ratio is more in case of B Ltd.
Ÿ Operating leverage of B Ltd. is more than that of A Ltd. indicating a
larger proportion of fixed costs in the former. The ratio of fixed costs to
sales is 37.5% for B Ltd. against 26.67% for A Ltd.
Ÿ Finance leverage for B Ltd. is 3 against 2 for A Ltd. This indicates a
higher percentage of debt in the capital structure of B Ltd. although in
absolute terms the interest amount is less. Interest accounts for 81/3%
of sales realization is B Ltd. as against 62/3% only for A Ltd.
Ÿ Although contribution / sales is more for B Ltd., both operating leverage
and financial leverage are higher for the company. As a result
profitability (EAT/sales) is only 2.5% as against 4% for A Ltd.
Illustration 8:
The balance sheet of Alpha Numeric Company is given below:
Liabilities Rs. Assets Rs.
Equity capital (Rs. 10 per share) 90,000 Net fixed assets 2,25,000
10% Long-term debt 1,20,000 Current Assets 75,000
Retained earnings 30,000 Current liabilities 60,000
3,00,000 3,00,000
The Company's total assets turnover ratio is 3, its fixed operating costs is
Rs. 1,50,000 and its variable operating cost ratio is 50%. The income – tax
rate is 50%.
You are required to
(i) Calculate the different type of leverages for the company.
(ii) Determine the likely level of EBIT if EPS is:
140 | Page
(a) Re. 1 (b) Rs. 2 (c) Rs. 0

Solution:
___Sales _ = Sales Turnover Ratio
Total Assets
__Sales__ = 3
3,00,000
Sales = 3 x 3,00,000
= Rs. 9,00,000
i) Calculation of Leverage
Income statement for the year ended Rs.
Sales 9,00,000
Less: Variable cost (50% of sales) 4,50,000
Less: Fixed operating cost 1,50,000
EBIT 3,00,000
Less: Interest (Rs. 1,20,000 x 10 / 100) 12,000
EBT 2,88,000
Less: Tax (@ 50%) 1,44,000
EAT 1,44,000
a) Operating leverage = Contribution
EBIT
= 4,50,000 = 1.50
3,00,000
b) Financial Leverage = EBIT

EBT
= 3,00,000 = 1.04
2,88,000
c) Combined leverage = Operating leverage x Financial
leverage
= 1.50 x 1.04 =1.56
i) Calculation of likely levels of EBIT at different level of EPS
141 | Page
EPS = (EBIT - I ) ( 1 – t )
N
a) Level of EBIT, if EPS is Re. 1

1 = (EBIT – 12,000) ( 1 – 0.50)
9,000
9,000 = (EBIT - 12,000) ( 0.50)
9,000 = 0.50 EBIT - 6,000

0.50 EBIT = 9,000 + 6,000
EBIT = 15,000
0.50
= Rs. 30,000
b) Level of EBIT, If EPS is Rs. 2
2 = (EBIT - 12,000) ( 1 – 0.50)
9,000
9,000 x 2 = (EBIT - 12,000) ( 0.50)
18,000 = 0.50 EBIT - 6,000
0.50 EBIT = 18,000 + 6,000
EBIT = 24,000 / 0.50

= Rs. 48,000
c) Level of EBIT, if EPS is Re. 0

0 =(EBIT – 12,000) ( 1 – 0.50)
9,000
9,000 x 0 = (EBIT – 12,000) ( 0.50)
0.50 EBIT- 6,000 = 0
0.50 EBIT = 6,000
EBIT = 6,000 / 0.50

142 | Page
Illustration 9:
You are a finance manager in Big Pen Ltd. The degree of operating
leverage of your company is 5.0. The degree of financial of your company is
3.0. Your Managing Director has found that the degree of operating
leverage and the degree of financial leverage of your nearest competitor
Small Pen Ltd. are 6.0 and 4.0 respectively. In his opinion, the Small pen
Ltd. is better than of Big Pen Ltd. because of higher value of degree of
leverages. Do you agree with the opinion of your Managing Director? Give
reasons.
Solution:
Particulars Big Pen Ltd. Small Pen Ltd.
1) Operating leverage = Contribution 5 6
EBIT
2) Financial Leverage = EBIT 3 4

EBT
3) Combined leverage = Contribution 15 24

EBT
Ÿ The operating leverage of Big Pen Ltd. is 5 and of small Pen Ltd. is 6.
It means change in the level of sales will have more impact on EBIT of
small Pen Ltd. than that of Big Pen Ltd. The volume of fixed cost may
be higher in case of small Pen Ltd. than that of Big Pen Ltd. The
business risk of small Pen Ltd. is also more as compared to Big. Pen
Ltd.
Ÿ The financial leverage of Big Pen Ltd. is 3 and of small Pen Ltd. is 4. It
means that the interest burden of small Pen Ltd. is higher than Big
Pen Ltd. Financial risk of small Pen Ltd. is higher as compared to Big
Pen Ltd.
Ÿ The degree of combined leverage of Big Pen Ltd. is 15 and that of

small Pen Ltd. is 24 It means any change in sales will show more
impact on EPS in case of small Pen Ltd.
143 | Page
Illustration 10:
From the following information available for four companies, calculate –
(a) EBIT
(b) EPS
(c) Operating leverage
(d) Financial leverage
Particulars P Q R S
Selling price / unit (Rs.) 15 20 25 30

Variable cost/unit (Rs.) 10 15 20 25
Quantity (Nos.) 20,000 25,000 30,000 40,000
Fixed Costs (Rs.) 30,000 40,000 50,000 60,000
Interest (Rs.) 15,000 25,000 35,000 40,000
Tax rate (%)40 40 40 40
No. of equity shares 5,000 9,000 10,000 12,000
Solution:
Company P Q R S
Selling price / unit (Rs.) [a] 15 20 25 30

Variable cost / unit (Rs.) [b] 10 15 20 25
= Contribution / unit (Rs.) [c] 5 5 5 5
Quantity (Nos.)[d] 20,000 25,000 35,000 40,000

Total Contribution (cxd) [e] 1,00,000 1,25,000 1,75,000 2,00,000
Fixed Cost (Rs.) [f] 30,000 40,000 50,000 60,000
= E.B.I.T. (Rs.) [g] 70,000 85,000 1,25,000 1,40,000

- Interest (Rs.) [h] 15,000 25,000 35,000 40,000
= E.B.T. (Rs.) [ i] 60,000 6,000 90,000 1,00,000
- Tax (40%) (Rs.) [j] 24,000 24,000 36,000 40,000
= E.A.T. (Rs.) [k] 36,000 36,000 54,000 60,000
No. of Equity shares [l] 5,000 9,000 10,000 12,000

144 | Page
Operating leverage [e/g] 1.43 1.47 1.40 1.43

Financial Leverage [ g/I] 1.17 1.42 1.39 1.40
E.P.S. [k/l] 7.20 4.0 5.40 5.00
8.5 Summary
Ÿ Leverage refers to ability of business to borrow and employ long-term

funds to increase returns to owners.
Ÿ Operating leverage indicates extent to which fixed costs have been
incurred by company . Higher operating leverage means higher level of fi
xed costs
Ÿ Financial leverage indicates borrowing of company. High financial
leverage means high borrowings.
Ÿ Combined leverage indicates combined effect of above two leverages.
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CHAPTER 9
WORKING CAPITAL MANAGEMENT
Learning Objectives
Explain the meaning of working capital
Identify the factors on which working capital of company depends
Estimate the working capital requirements of company
Determine how to control working capital
Name various sources of working capital
Structure
9.1 Introduction
9.2 Meaning of Working Capital
9.3 Significance of Working Capital
9.4 Determinants of Working Capital
9.5 Working Capital Cycle [Operating Cycle]
9.6 Estimation of Working Capital
9.7 Controlling Working Capital
9.8 Sources Of Working Capital (Short-Term Sources Of Finance)
9.9 Summary
9.1 Introduction
Every company requires capital for infrastructure and for carrying out day-to-
day activities. Capital required for running the business smoothly and
efficiently on day-to-day basis is known as working capital of company.
Understanding meaning, significance, factors and methods of estimation of
working capital is essential for managing working capital efficiently.
For controlling working capital, various ratios can be calculated to know the
effect of working capital management on liquidity and profitability of company.
There are various sources of working capital finance. It is important to know
these sources so that cost of working capital finance can be kept to minimum.
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9.2 Meaning Of Working Capital
J Î Ī ĦHÍ Ġ FĖĨ Hİ ĖI
CURRENT ASSETS (Less) CURRENT LIABILITIES
Converted into cash Payable

within one year within one year
1) Ĭ PŎŃÔ 1) Ĭ ÞŌŇǾŘ ŃǾÑŇÒPŎǾŒ
Ī MR ÖMPÑǾÒMÕ 2) ĘÒÕÕŒŐMŘMNÕÑ ĂĘCĨ Å
J BHBĨ B 3) Ĭ OŎǾP PÑǾÖ ÕŎMŌŒ
ĞÒŌÒŒOÑŇ ŊŎŎŇŒ 4) ĘMŌÔŎverdraft
Ĭ PŎǾÑŒC ŒŐMǾÑŒ 5) ĖŇQMŌŃÑŒǾÑŃÑÒQÑŇ
2) Ĭ ÞŌŇǾŘ ŇÑNPŎǾŒ 6) HCİ MŔ ŐMŘMNÕÑ
3) ĖŇQMŌŃÑŒŐMÒŇ 7) Ĩ ǾŎŐŎŒÑŇ ŇÒQÒŇÑŌŇ
4) İ ÑÖ ŐŎǾMǾŘ ÒŌQÑŒPÖ ÑŌP
5) FMŒO – Bank
6) FMŒO – Hand
7) ĘÒÕÕŒĪ ÑŃÑÒQMNÕÑŒ
8) ĂĘCĪ Å
Gross Net Temporary Permanent
Total of all Total of all Required Minimum level of

current assets current over and current assets
held by assets less above which must be
company at all current permanent maintained by
any given liabilities working company all times
point of time held by capital to also called as fixed
company at support working capital
a point of increased
time activities of
any
business
9.3 Significance Of Working Capital
For every business, capital is required to build up productive capacity and

basic infrastructure. This capital is used for purchase of fixed assets such as
land, building, machinery, furniture, fixtures and other facilities required for
long term. This is called fixed capital of company.
In addition, company needs capital for purchase of raw materials, payment of
wages and salaries and payment of various services and other materials
purchased by company for producing and selling the goods. This capital is
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required for a short period – generally for a period less than a year. This is
called as working capital required by company.
If sufficient working capital is not available then business activities are either
disturbed or come to halt. Thus, adequate working capital is required by every
business for day-to-day functioning.
Further if working capital is in shortage then plant efficiency is affected due to
less use of machinery, as raw material, labor and other services would not be
available in time and in required quantity.
Shortage of working capital results in
Ÿ Loss of production
Ÿ Late distribution of goods
Ÿ Loss of sale and loss of market share
Ÿ Loss of company's goodwill
Ÿ It is thus important for management to allocate funds for working capital
or make proper arrangements so that funds are available for working
capital.
9.4 Determinants Of Working Capital
For estimating working capital, following factors must be considered:

1) Volume of business
When the volume of business is small, working capital requirements are less,
whereas businesses having large volume of activities require higher level of
working capital, e.g. Tata Steel or Tata Motors would require higher level of
working capital.
2) Type of business
Working capital depends on the type of business activities.
There can be three types of businesses:
Ÿ Manufacturing business requires maximum working capital.
Ÿ Trading business requires moderate working capital.
Ÿ Service industries require minimum working capital.
3) Nature of business
A seasonal business such as sugar, ice cream or cold drink requires more
working capital during peak season and less working capital during off-
season.
Non-seasonal businesses such as FMCG companies require mostly same
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working capital throughout the year.
4) Raw material requirements

Companies manufacturing the products containing more raw materials have to
stock these materials in large quantities; this increases working capital
requirements of company.
If raw material is imported, lead-time is more and quantity to be purchased is
more. This makes raw material stocks to go up and increase working capital
requirements.
5) Production activities
If production cycle time is more WIP stocks go up and working capital
increases. Due to peculiar features of production process such as in case of
chemical companies and liquor manufacturing units, production cycle time is
more, which makes these companies to carry higher WIP stocks.
If the production efficiency is low, production cycle time increases and so do

working capital requirements.
6) Sales and distribution activities

Ÿ Company with more distribution time requires more working capital
because working capital cycle becomes longer.
Ÿ When company spends more on sales commission, advertising, sales
promotion and on after sales service working capital requirements go
up.
7) Sale and Purchase Pattern

Working capital requirements go up when:
Ÿ Cash sales are less.
Ÿ Credit period given to customers is more.
Ÿ Cash purchases are more.
Ÿ Credit period given by suppliers is less.
Working capital requirements go down when:

Ÿ Cash sales are more.
Ÿ Credit period given to customers is more.
Ÿ Cash purchases are less.
Ÿ Credit period given by suppliers is more.
8) Other Factors
Ÿ More labour requirements, more working capital
Ÿ Higher machinery means higher level of repairs, maintenance, spares,
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Ÿ consumables and more are requirements of working capital.

Ÿ ·When payments of Excise Duty, Sales Tax, Income Tax and octroi are to be
made working capital requirements would go up.
Ÿ Working capital depends on volume of capital budgeting. More capital
expenditure means expansion of production, which requires higher level
of working capital.
9.5 Working Capital Cycle [ Operating Cycle ]
Operating cycle of a firm is time required to convert cash available with firm
into raw material, W.I.P. finished goods, debtors and back to cash.
Operating cycle can be shown as:
Thus, operating cycle consists of following stages:

i) Procurement of raw materials and services
ii) Conversion of raw materials into W.I.P.
iii) Conversion of W.I.P. into finished goods.
iv) Sale of finished goods on credit.
v) Conversion of receivables into cash.
Operating cycle period is calculated by using following formula:

O.C. (days) =R + W + F + D – C
R = Average Raw material stocks / raw material consumption per day
W = Average W.I. P. stocks / cost of production per day
F = Average Finished goods stocks / cost of sales per day
D = Average Debtors / credit sale per day
C= Average Creditors / credit purchase per day
Illustration 1
Following information is available for ABC ltd. Compute operating cycle in
days.
Period covered 365 days
Av. Debtors outstanding 4,80,000 Rs.
Raw material consumed 44,00,000 Rs.
Total production cost 100,00,000 Rs.
Total cost of sales 105,00,000 Rs.
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Sales of year 160,00,000 Rs.

Credit allowed by supplier 16 days
Value of av. Stocks:
Raw material 3,20,000 Rs.
W.I.P. 3,50,000 Rs.
Finished goods 2,60,000 Rs.
O.C. = R + W + F + D – C
= 27 + 13+ 9 + 11 – 16
= 44 days
Now annual cost of sales is 105,00,000
W.C. reqd. = 105,00,000 / 365 x 44 = Rs. 12,65,753, i.e. 12.66 lakh
Illustration 2
Calculate the operating cycle of a company that gives the following details
relating to its operations:
Rs.
Raw materials consumption per annum 8,42,000
Annual cost of production 14,25,000
Annual cost of sales 15,30,000
Annual sales 19,50,000
Average value of current assets held:
Raw materials 1,24,000
Work-in-progress 72,000
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Finished goods 1,22,000

Debtors 2,60,000
The company gets 30 days credit from its suppliers. All sales made by the firm
are on credit only. You may take one year as equal to 365 days.
Solution:
Calculation of operating cycle
a) Raw Material Conversion Period
Average stock of raw materials x365 = Rs. 1,24,000 x365 = 54 days.
Raw material consumption p.a. Rs. 8,42,000
b) Work-in-progress conversion period
Average stock of WIP x 365 = Rs. 72,000 x365 = 18 days.

Annual cost of production Rs. 14,25,000
c) Finished Goods Conversion Period
Average stock of finished goods x 365 = Rs. 1,22,000x365=29 days.

Annual cost of sales Rs.15,30,000
d) Debtors collection period

Average value of debtorsx365= Rs. 2,60,000 x 365= 49 days.
Annual sales Rs.19,50,000
e) Payment Deferral Period =30 days (given)
Operating cycle = (54 + 18 + 29+49) – 30 = 120 days.
9.6 Estimation Of Working Capital
1) Percentage of sales method

Ÿ traditional and simple method
Ÿ determined on basis of past experience
Ÿ based on relationship between sales and working capital
requirements
Ÿ past figures are adjusted to suit future sales figures and price
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structure of inventories and expenses expected

Illustration 1
Firm is having following details for 2015
Current assets Rs
Inventories 10,00,000
Receivables 11,00,000
Cash and bank 1,00,000
Currentliabilities:Sundry creditors 6,00,000
Provision for taxatio 3,00,000
Turnover 60,00,000
Following changes are expected in year 2016:
i) Raw material prices would go up by 5 %.
ii) Inventories would be 10% more in quantity and included only raw
material.
iii) Selling price would increase by 10 %.
iv) Sales volume would be 1.5 times that of this year.
v) Receivables would be 10 % less in quantity.
vi) Cash balance would be 1.3 times of present level.
vii) Creditors would be 20 % more in quantity.
viii) Tax rates are expected to come down to 35 % and profits are 10 % on
sales.
Estimate requirements of working capital of company for year 2016.
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From above it is clear that even though turnover has increased by 1.5 times
working capital requirements have increased by 1.28 times only. This means
management is envisaging aggressive policy of working capital.
2) Operating cycle method:

Working capital is estimated by following formula:
Estimated Working Capital
=Estimated C.O.G.S. x Days of operating cycle+Desired cash balance
365
Illustration:
ABC Ltd. expects its cost of goods for year 2016 to be Rs. 600 lacs. The
expected operating cycle is 90 days. It wants to maintain cash balance of Rs.
20 Lacs what is expected working capital requirement if no. of days in a year
are 360.
Solution:
Estimated Working Capital.
= [Estimated C.O.G.S. x Days of operating cycle] + Desired cash balance
360
= [600 x90/360] + 20
= Rs. 170 Lacs
3) Regression analysis method:

Ÿ Statistical technique.
Ÿ It helps is making working capital requirement projections after
establishing average relationship between sales and working capital
and its various components in past years. Method of least square is
used.
Ÿ Relationship between sales(X) and working capital (Y) is given by
equation: Y= a+bX.
Ÿ Value of a and b is found from following simultaneous equations :
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a = Fixed component
b = Variable component
n = Number of observations
Illustration:
Following are the figures for ABC Ltd. Estimate working capital for year 2016.
Solution :
9,11,450 = 2540a + 13,85,400 b-------(2)
Solving (1) and (2)

a = (-)2.36 and b= 0.67
y= a + bx, x = 870
y =(-)2.36 +0.67 x 870
= 580.54 lacs
Thus, working capital required by company for year 2016 is Rs. 580.54 Lakh.
4. Individual component approach:

Ÿ Note all items of C.A. and C.L.
Ÿ Add all items of C.A. let it =A
Ÿ Add all items of C.L. let it = B
Ÿ Working Capital = (A– B )
Ÿ Add amount for contingencies as required
Ÿ Raw material stock is valued at raw material purchase price
Ÿ For valuing W.I.P. take :
Raw material (100 %) + labour (% as per stage of completion) +
overhead (% as per stage of completion).
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Ÿ In problems, it is stated that production is carried out evenly throughout

the year in such case take. Raw Material = 100%; Over head =50%;
Labour = 50%
Ÿ When items are required in days, then annual figures/365
Ÿ When items are required in weeks, then annual figures /52
Ÿ When items are required in months, then annual figures /12
Ÿ When items are required in quarterly, then annual figures /4
Illustration 1
The board of XYX Ltd wants to now working capital requirements for activity
level of 1,56,000 units production p.a. Other information is as follows:
Raw material = Rs. 90 per unit
Dir. Labour = Rs. 40 per unit
Overheads = Rs. 75 per unit
Profit = Rs. 60 per unit
Sale 20 % cash and 80% credit
Cash at bank Rs 60,000
Raw material in stock 1 week
WIP in stock 2 weeks
Finished goods st. 1 week
Credit by suppliers 1 week
Credit to debtors 8 weeks [Debtors to be valued at selling price]
Lag in payment of wages 1.5 weeks
Lag in payment of overhead 4 weeks
Add 10 % for contingencies
Solution:
Weekly production = 156,000 / 52 = 3000 units
Current assets:
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Notes:
1) Value of Raw material stock:
Value = Units per week x no. of weeks stock x Raw Material cost per unit
= 3,000 x 4 x 90
= Rs. 10,80,000
2) Value of WIP Stock:

When stage of completion is not mentioned, wages and overheads are to
be taken at 50% and raw material at 100%.
Thus, one unit of WIP will value as:
Raw material (100%) + Labour (50%) + Overheads (50%)
Rs. 90 + 20 + 37.5 = Rs. 147.5
Value = Units per week x no. of weeks stock x cost per unit
= 3,000 x 2 x 147.5 = Rs. 8,85,000
3) Value of finished goods stock:

When finished goods is ready, material, labour and overheads are to be
taken at 100%.
Value = Units per week x No. of weeks stock x Cost per unit
= 3,000 x 4 x [ 90 + 40 + 75 ]
= Rs. 24,60,000
For valuation of finished goods stock, profit is not to be added since goods
are still not sold and are lying in company only.
4) Value of sundry debtors:
Debtors are to be taken only for credit sale. When nothing is mentioned,
valuation is to be done at total cost, i.e. Rs. 205 per unit.
In the given problem, it is mentioned that debtors are to be valued at selling
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price, i.e. Rs. 265 per unit.

Value = [Units per weeks x No. of week credit x Cost per unit] x 80%
= [3,000 x 8 x 265]
= Rs. 50,88,000
(Since 20% sale is against cash and 80% is on credit.)
5) Value of sundry creditors:

Value = Units per week x No. of week credit x Cost per unit
= 3,000 x 4 x 90
= Rs. 10,80,000
6) Outstanding Wages:
Value = Units per week x Outstanding week x Labour rate per unit
=3,000 x 1.5 x 40
=Rs. 1,80,000
7) Outstanding overheads:
Value = Units per week x No. of outstanding weeks x Cost per unit
= 3,000 x 4 x 75
= Rs. 9,00,000
Illustration 2
Estalla Garment Co. Ltd. is a famous manufacturer and exporter of garments
to the European countries. The Finance Manager of the company is preparing
its working capital forecast for the next year. After carefully screening all the
documents, he collected the following information:
Production during the previous year was 15,00,000 units. The same level of
activity is to be maintained during the current year. The expected ratios of cost
to selling price are:
Raw materials 40%
Direct wages 20%
Overheads 20%
The raw materials ordinarily remain in stores for 3 months before production.
Every unit of production remains in the process for 2 months and is assumed to
be consisting of 100% raw material, wages and overheads. Finished goods
remain in warehouse for 3 months. Credit allowed by the creditors is 4 months
from the date of the delivery of raw material and credit given to debtors is 3
months from the date of dispatch.
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Estimated balance of cash to be held Rs. 2,00,000

Lag in payment of wages ½ month
Lag in payment of expenses ½ month
Selling price is Rs. 10 per unit. Both production and sales are in a regular cycle.
You are required to make a provision of 10% for contingency (except cash).
Solution:
Estimation of Working Capital (Rs.)
Current Assets:
Raw materials stock (15,00,000 x 4 x 3/12) 15,00,000

Work-in-process (15,00,000 x 8 x 2/12) 20,00,000
Finished goods stock (15,00,000 x 8 x 3/12) 30,00,000
Debtors (15,00,000 x 8 x 3/12) 30,00,000
(a) 95,00,000
Current Liabilities:
Creditors for raw-material (15,00,000 x 4 x 4/12)20,00,000
Wages outstanding (15,00,000 x 2 x 1/24) 1,25,000
Outstanding expenses (15,00,000 x 2 x 1/24) 1,25,000
(b) 22,50,000
Current Assets less Current Liabilities (a – b) 72,50,000
Add: Contingency (10% of 72,50,000) 7,25,000
79,75,000
Add:Desired Cash Balance 2,00,000
________
Estimated Working Capital 81,75,000
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9.7 Controlling Working Capital
1) Various ratios can be used to judge whether working capital is managed

efficiently or not.
2) These ratios reflect the impact of working capital management on
liquidity and profitability of firm.
3) Ratios can be compared with standard ratios set for a particular industry
or a company or can be compared for one period to another period.
4) While making comparison it should be ensured that accounting policy of
firm does not change and composition of CA and CL remains same.
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9.8 Sources Of Working Capital (short-term Sources Of Finance)
I) Trade Credit:
Ÿ It is a spontaneous source of finance i.e. source arising in normal
course of business.
Ÿ Trade credit is extended to business depending upon custom of
trade, competition in industry and relationship with suppliers.
Ÿ Trade credit is generated when company acquires materials and do
not pay for them immediately.
Ÿ When bill of exchange is accepted by company it is called bills
payable.
Ÿ Trade credit is extended on following terms:
- Maximum credit limit
- Credit period
- Cash discount
- Starting date
ii) Bills discounting:

Bills drawn by company and accepted by customers are purchased by
bankers of company at say 80% of bill value. On maturity, remaining
amount less bank charges are credited to company's account.
iii) Cash credit or Bank Overdraft:

It is an arrangement under which bank sanctions limit up to which cash or
cheques can be drawn by company even if there is no balance in
account. When arrangement is temporary, it is called overdraft and when
it is permanent, it is called cash credit.
iv) Inter corporate deposits or loans:

Business can take loan from other business for short period. It is
generally for 60 to 180 days.
v) Commercial Paper:
It is a short-term debt instrument issued at discount for a period 3 months
up to one year.
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Commercial paper can be issued by companies fulfilling requirements issued

by R.B.I.
vi) Public Deposits:

Important source for well-established companies with huge capital base.
For issuing public deposits, company must follow provisions of sections
58A, 58AA and 58B of Companies Act, 1956 and rules there under.
vii) Factoring:
Ÿ Company sells its debtors to bank or financial institution called as
factor
Ÿ Company sells goods to debtors and sends one copy of invoice to
factor
Ÿ On receiving invoice factor immediately makes 80% payment to
company
Ÿ On due date factor collects bill amount from debtors and after
deducting his charges and interest remits remaining amount to
company
Ÿ Factors performs following functions :
- Debtors accounting
- Debtors collection
- Bears risk of nonpayment by debtors.
Ÿ Depending upon functions performed by factors his charges are

negotiated by company.
9.9 Summary
There are four types of working capital :

o Gross working capital is total of current assets.
o Net working capital is excess of current assets. Over current liabilities.
o Temporary working capital is additional current assets required to
support seasonal fluctuations.
o Permanent working capital is amount of current assets required to be
maintained at all times.
Adequate working capital is required for smooth and efficient day-to-day
working of business.
Working capital required by business depends upon type, nature,and volume
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of business, raw material and labour requirements, production and distribution

efficiency, selling and after sales costs, credit period of suppliers and
customers and other factors.
Operating cycle is the time required to convert cash of business into raw
materials, W.I.P., finished goods, debtors and back to cash. Longer the
operating cycle more are the requirements of working capital.
There are 4 methods to estimate working capital :
o Percentage of sales
o Relationship between sales and working capital
o Operating cycle period
o Estimation of individual working capital component
For controlling working capital, various ratios are used.

Sources of working capital includes: Trade credit, discounting of bills raised on
customers, bank overdraft, cash credit, inter corporate loans, commercial
paper public deposits and factoring.
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CHAPTER 10
CAPITAL BUDGETING
Learning Objectives
State the meaning of capital budgeting
Explain the significance of capital budgeting
Enumerate the steps involved in capital budgeting process
Structure
10.1 Introduction
10.2 Meaning of Capital Budgeting
10.3 Significance of Capital Budgeting
10.4 Steps in Capital Budgeting Process
10.5 Cash Flows in Capital Budgeting
10.6 Evaluation Of Capital Expenditure Proposals
10.7 Summary
10.1 Introduction
Every company requires long-term assets for creating infrastructure and

capacity and for long-term survival and success of business. Capital budgeting
is one of the important managerial decisions. It is therefore important to know
factors and dimensions involved in this decision. Decision should increase
profits and in turn value of the firm.
10.2 Meaning Of Capital Budgeting
Decision to invest current funds most efficiently in long-term assets in

anticipation of an expected flow of benefits over a series of years.
Long-term assets are those, which affect operations of the firm beyond one
year.
Capital budgeting decision affects value of a firm. Value of a firm will increase if
investments are profitable and shareholders wealth is enhanced.
10.3 Significance Of Capital Budgeting
Capital budgeting is important for the following reasons:
Ÿ Cost today benefits tomorrow

When company purchases a plant, machinery or any other asset, payment is
to be made immediately but benefits are available in future. When
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10.4 Steps In Capital Budgeting Process
Step 1:
To identify investment opportunities potential sources of opportunities are:
Ÿ Study of supply/ demand conditions of different industries
Ÿ Study of end and by-products
Ÿ Analysis of input requirements
Ÿ Important substitutes
Ÿ Social and economic trends
Ÿ Sick unit to be turned into profitable unit
Ÿ Backward and forward integration
Ÿ Government policy
Step 2:
Available opportunities should be screened with reference to:
Ÿ Compatibility with promoters
Ÿ Compatibility with government
Ÿ Availability of raw materials and utilities
Ÿ Size of potential market
Ÿ Costs and risks involved
Step 3:
Appraisal of screened opportunities
i) Market appraisal
Ÿ Market size
Ÿ Company's share expected
Ÿ Composition
Ÿ Demand and supply analysis
Ÿ Consumer requirements
Ÿ Production constraints
ii) Technical appraisal
Ÿ Proposed Vs available technology
Ÿ Availability of raw material and other inputs
Ÿ Optimization
Ÿ Plant layout and design
iii) Economic appraisal

Ÿ Impact on savings and investment in society
Ÿ Job potential
Ÿ Contribution to social objectives
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Impact on foreign exchange reserves

iv) Financial appraisal
This involves two steps
Ÿ Step 1:Assessing cash flows during life of a project
Ÿ Step 2: Evaluating different proposals based on cash flows
generated in step no. 1.
10.5 Cash Flows In Capital Budgeting
Three cash flows are involved:

INITIAL CASH FLOWS (AT THE TIME OF BUYING NEW ASSET)
= Cost of new asset
(+) Installation Expenses
(+) Other capital expenditure
(+) Additional working capital
(+) Tax burden on sale of old asset
(- ) Salvage value of old asset
These are cash outflows at the time of buying an asset
SUBSEQUENT CASH FLOWS (EVERY YEAR DURING LIFE OF ASSET)
= EBIT (1-t) + Depreciation – Additional capital expenditure
Where t = Tax Rate
TERMINAL CASH FLOWS (IN THE LAST YEAR OF LIFE OF ASSET)
Yearly cash flows, i.e. EBIT (1 – t) + Depreciation
(+) Working capital released
(+) Scrap value of new asset
While ascertaining cash flows of a proposal, financial cash inflows and

outflows such as issue of capital or debt or repayment of debt, interest and
dividend are ignored because interest and dividend are considered in
calculating W.A.C.C., which is used to discount future cash inflows.
10.6 Evaluation Of Capital Expenditure Proposals
Expected cash flows estimated as above are used for deciding whether
proposal /s under consideration should be accepted or not. Following
methods are used:
1 Payback Period (PB) Method :

(i) Payback period (PB) is the number of years required to cover initial
investment.
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(ii) PB less than PB expected by management, then project is accepted.

PB more than PB expected by management, then project is rejected
(iii) When two or more projects are having accepted payback period, then
project with minimum payback gets top priority.
(iv) Yearly cash flows are considered and not the profits.
(v) Merits:
Ÿ Easy to understand and compute
Ÿ Inexpensive
Ÿ Uses cash flow information
Ÿ Easy but crude way to cope with risk
(vi) Demerits:
Ÿ Ignores time value of money
Ÿ Ignores cash flows after payback period
Ÿ Standard payback period cannot be determined
Ÿ Not in line with wealth maximization principle
2. Accounting Rate of Return (ARR) Method :

(I) ARR is calculated by following formula:
ARR = AV. EBIT (! -t) x100 [or] Av. P.A.T. x 100
AV. INVESTMENTAv. Investment
AV. EBIT (1– t) =(EBIT)1(1- t) + (EBIT)2 (1 – t ) + -----(EBIT)n (1- t)
N
n = No. of years
= Corporate tax rate
AV. Investment =Original Investment + Scrap Value
2
(ii) If ARR more than expected by management, Project is accepted.
If ARR less than expected by management, Project is rejected
(iii)If two or more projects have accepted ARR, then project with highest
ARR gets top priority.
(iv)Yearly profits are considered and not the cash flows.
(v) Merits:
Ÿ Uses accounting data
Ÿ Gives more weightage to future receipts
(vi) Demerits:
Ÿ Ignores the time value of money
Ÿ Does not use cash flows
174 | Page
Ÿ Minimum ARR required cannot be decided

3. NPV method :
(i) Net Present Value (NPV) = ( ∑ P.V. of all cash flow) – ( ∑P.V. of all cash
outflow)
(ii) If N.P.V. > 0 (accepted project) or PI >1
N.P.V < 0 (reject project) or PI < 1
(ii) When two or more projects are having positive NPV then project with
maximum NPV gets priority.
iv) Features of Net Present Value (NPV) Method:
- NPV of an investment proposal may be defined as sum of present
values of cash inflow-less sum of present values of all cash
outflows associated with a proposal.
- A rate of discount must be specified and applied to both inflows
and outflows in order to find out their present values (Pvs).
- When present value of all inflows and outflows are added, the
resultant figure is denoted as net present value (NPV). NPV is
positive or negative.
- When NPV is positive project is acceptable because cash inflows
are more than cash outflows on the other hand if cash outflows
are more than cash inflows then NPV is negative and project is
rejected.
- From economic point of view, rate of discount is the overall cost
of capital, which takes into account expectations of
shareholders, business risk and leverage used.
- In case of mutually exclusive proposals with highest NPV ranks
first and that with lowest NPV ranks last.
(iv) Merits:
Ÿ It recognizes time value of money.
Ÿ Considers the entire cash flow streams during life of project.
Ÿ Based on cash flow and thus helps in analyzing the effect of the
proposal on the wealth on shareholders in a better way.
Ÿ Discount rate can be adjusted to take care of risk involved in the
project.
Ÿ NPV represents the net contribution on a proposal towards wealth of
the firm and is therefore is in full conformity with the objective of
wealth maximization of shareholders.
NPVs of different projects can be added.
Ÿ
175 | Page
4. Profitability Index Method (P.I.Method):

i) PI = [ ∑P.V. of all cash inflows]
∑ P.V. of all cash outflows]
ii) If PI > 1 Project accepted

PI < 1 Project rejected
iii) When two or more projects have PI > 1, then project with highest PI
gets priority.
iv) Merits and Demerits: Same as for N.P.V. method
5. Internal Rate of Return (IRR) Method:

I) IRR of a proposal is the discount rate, which produces zero NPV.
ii) Also known as marginal or break-even rate or return.
iii) Future cash inflows are discounted in such a way their PV is just equal to PV
cash outflows.
iv) Discounting rate is arrived at by trial and error method.
v) Decision rule:
First firm has to decide its own required rate or return this is known as “cut
off rate” (k)
If IRR > k – Accept proposal
If IRR < k – Reject proposal
In case of mutually exclusive proposals,
Proposal with highest IRR ranks first.
Proposal with lowest IRR ranks last.
vi) Method of calculating IRR:
Step II:
Decide factor 'F' to be located in PV annuity tables.
F = Original investment (I)
AV. Cash inflow per year (c)
This factor is located in PV table on line representing no. of years

corresponding to estimated useful life of the asset. This gives expected rate of
return to be applied for discounting cash inflows or IRR.
4. Profitability Index Method (P.I.Method):

i) PI = [ ∑P.V. of all cash inflows]
∑ P.V. of all cash outflows]
176 | Page
ii) If PI > 1 Project accepted

PI < 1 Project rejected
iii) When two or more projects have PI > 1, then project with highest PI gets
priority.
iv) Merits and Demerits: Same as for N.P.V. method
5. Internal Rate of Return (IRR) Method:

I) IRR of a proposal is the discount rate, which produces zero NPV.
ii) Also known as marginal or break-even rate or return.
iii) Future cash inflows are discounted in such a way their PV is just equal to PV
cash outflows.
iv) Discounting rate is arrived at by trial and error method.
v) Decision rule:
First firm has to decide its own required rate or return this is known as “cut off
rate” (k)
If IRR > k – Accept proposal
If IRR < k – Reject proposal
In case of mutually exclusive proposals,
Proposal with highest IRR ranks first.
Proposal with lowest IRR ranks last.
vi) Method of calculating IRR:

Step I:
Decide factor 'F' to be located in PV annuity tables.
F = Original investment (I)

AV. Cash inflow per year ©
This factor is located in PV table on line representing no. of years

corresponding to estimated useful life of the asset. This gives expected rate
of return to be applied for discounting cash inflows or IRR.
Step II:
Find NPV of project using IRR as decided in Step I.
If NPV = 0, then selected rate is correct IRR.
If NPV is + ve, then try higher rate for discounting.
If NPV is - ve, then try lower rate for discounting.
(Generally, choose next higher rate by 2%. )
177 | Page
Step III:
To find IRR,
Let b = NPV at lower rate
c = NPV at higher rate
Actual IRR = [Lower rate of discount] + [(b) x Diff. in rate]
(b-c)
Example:
A company has to select one of the following two projects using IRR method
cash flow.
Year A B
0 (11,000) (10,000)
1 6,000 1,000
2 2,000 1,000
3 1,000 2,000
4 5,000 10,000
Solution:
F =11,000 10,000
3,500 3,500
=3.14 2.86
Discount Rate
(From Tables) 10% 15%
Project A:
Year Cash inflow Discounting Factor (10%) P.V.
0 (11,000) 1.000 (11,000)
1 6,000 0.909 5,454
2 2,000 0.826 1,652
3 1,000 0.751 751
4 5,000 0.683 3,415
Total P.V. = 11,272 and NPV = + 272

As PV is more than required, PV of Rs. 11,000 or NPV is + ve.
Choose next higher rate, i.e. 12%; then
Year Cash flow Discount factor (12%) PV.
0 (11,000) 1.000 (11,000)
1 6,000 0.893 5,358
2 2,000 0.797 1,594
178 | Page
3 1,000 0.712 712

4 5,000 0.636 3,180
As NPV for 10% = + 272 (b)
and NPV for 12% = - 156 (c
For some rate between 10% and 12%, NPV must be zero.
Required IRR = 10 + [b] x [2]
[b – c]
= 10 + [272] x 2_
272- (- 156 )
= 11.27%
Project B:
Year Cash flow Discount factor (15%) PV.
0 (10,000) 1.000 (10,000)
1 1,000 0.870 870
2 1,000 0.756 756
3 2,000 0.658 1,316
4 10,000 0.572 5,720
NPV. = (-)1.338
Since NPV is -ve, we try next lower level of rate, i.e. 13%
Year Cash flow PVF. (13%) PV.

0 (10,000) 1.000 (10,000)
1 1,000 0.885 885
2 1,000 0.783 783
3 2,000 0.693 1,386
4 10,000 0.613 6,130
NPV. = (-) 816
Since NPV is – ve, we try next lower level of rate, i.e. 11%.
Year Cash flow PVF. (11%) PV.
0 (10,000) 1.000 (10,000)
1 1,000 0.900 900
2 1,000 0.812 812
3 2,000 0.731 1,462
4 10,000 0.659 6,590
NPV. = (-) 236
179 | Page
Since NPV is – ve, we try next lower level of rate, i.e. 9%.
Year Cash flow PVF (9%) PV
0 (10,000) 1.000 (10,000)
1 1,000 0.917 917
2 1,000 0.842 842
3 2,000 0.772 1,542
4 10,000 0.708 7,080
NPV. = (+) 381
As NPV is now +ve, IRR must be between 9% and 11%.
Actual IRR = 9 + 381 x 2
381 –(-236)
= 9 + 381 x 2
617
= 9 + 1.24
= 10.24%
IRR of project B = 10.24%
IRR of project A = 11.27%
As IRR of project A is more, project A should be accepted by
management.
Superiority of NPV over IRR:
I) NPV shows expected increase in wealth of shareholders.
ii) NPV gives clear-cut accept – reject decision rule while IRR may give
multiple results.
iii) NPV of different projects can be added but IRR cannot be so added.
iv) NPV gives better ranking as compared to IRR.
Illustration 1
Company wants to purchase new machine, details of which are as under:
Cost of machine is Rs. 65 lakh.
Installation charges are Rs. 3 lakh.
Additional machine to support smooth functioning of this machine would cost
Rs. 7 lakh. New machine will increase production by 25% and to support the
production activities additional working capital of Rs. 8 lakh would be required.
Old machine will be sold for Rs. 13 lakh and will be replaced by this machine.
Decide initial cash outflow (ignore tax effects).
Solution: Amt. (Rs. lakh)
Cost of new machine 65
+Installation charges 3
+Additional machine cost 7
180 | Page
+ Additional working capital required 8

- Sale of old machine 14
= Initial Cash Outflow 70
Illustration 2
Cost of new plant is Rs. 120 lakh. Additional working capital required is Rs. 10
lakh. Installation charges Rs. 2 lakh; old plant is sold for Rs. 30 lakh, on which
tax burden is Rs. 6 lakh. What is initial cash outflow?
Solution: Amt. (Rs. lakh)

Cost of new plant 120
+Installation charges 2
+ Addition working capital 10
+Tax burden 6
-Sale of old plant 30
= Initial cash outflow 108
Illustration 3
Cost of plant is Rs. 10,00,000. Life of plant is 5 years and scrap value is nil.
EBDIT expected for 5 years is as:
Year : 1 2 3 4 5
EBDIT (Rs.): 2,20,000 2,50,000 3,00,000 4,00,000 3,00,000
Corporate tax rate is 35%. Decide cash flows.
Company uses S.L.M. for depreciation.
Solution:
Amt. (in Rs.)
Year EBDIT DEPREN. EBIT EBIT(1-t) Cash flow
(a) (b) (a-b) = c (d) (b + d)
0 - - - - (-)10,00,000
1 2,20,000 2,00,000 20,000 13,000 2,13,000
2 2,50,000 2,00,000 50,000 32,500 2,32,500
3 3,00,000 2,00,000 1,00,000 65,000 2,65,000
4 4,00,000 2,00,000 2,00,000 1,30,000 3,30,000
5 3,00,000 2,00,000 1,00,000 65,000 2,65,000
Note: t =tax rate = 35%; hence (1- t) = 0.65
EBIT (1- t) = 20,000 x 0.65
= 13,000 and so on
Illustration 4
Company is planning to replace its old plant.
Old plant will be sold for Rs. 3 crore and no income tax burden on this sale. New
181 | Page
plant will cost company Rs. 20 crore. Installation cost would be Rs. one crore
and additional working capital of Rs. 5 crore would be required. Estimated life
of plant is 5 years with scrap value of Rs. 5 crore. Company follows straight-line
method (SLM) of depreciation and tax rate applicable to company is 35%.
Decide cash flows for 5 years.
Expected EBIT for 5 years is:
Year : 1 2 3 4 5
EBIT (Rs.) : 2.5 3.2 4 5.5 5
Solution:
Initial cash outflow: (year 0) Rs. Cr.
Purchase price of new plant 19
+Installation cost 1
+ Additional working capital required 5
-Scrap value of old plant 3
= Initial cash outflow 22
Subsequent cash inflows (year 1 to 4):
[Amt. Rs. Crore]
Year EBIT EBIT(1-t) Depreciation Cash flow = EBIT (1-t) + Depre.
1 2.5 1.625 3.00 4.625
2 3.2 2.080 3.00 5.080
3 4 2.600 3.00 5.600
4 5.5 3.575 3.00 6.575
Terminal cash flow (year 5)
Cash flow=[EBIT(1-t) + Depreciation] + [working capital released] + [Scrap
value of new asset]
= [5 ( 1 – 0.35 ) + 3] + [5] + [5]
= 6.25 + 5 + 5
= 16. 25
Cash flow statement (Amt. Rs. Crore)
Year Cash Flow
0 ( - ) 22
2 4.625
2 5.080
3 5.600
4 6.575
5 16.250
Note: 1) Depreciation = Initial cost of plant - Scrap value
Life of plant
182 | Page
= ( 19 + 1) - 5
5
= Rs 3crore
2) While calculating depreciation, installation charges are to be added to cost
of plant to get initial cost of plant.
Illustration 5
Ram Engineering works wants to replace their old plant. Following details are
available:
Cost of new plant is Rs. 70 Crore.
Old plant would be sold for Rs. 18 crore on which tax burden is Rs. 2 crore.
Additional working capital required is Rs. 12 crore.
Installation of new plant would cost Rs. 2 crore.
Expected life of new plant is 6 years.
Corporate tax rate is 40%.
Depreciation is to be charged on S.L.M.
New plant would fetch Rs. 12 crore at the end of 6 years as scrap value.
Expected EBIT is Rs. 2 crore in year one, Rs. 8 crore in year 2 and 3, Rs. 18
crore year 4 and 5.
Decide cash flows during life of asset.
Solution:
Initial cash outflow (Year zero) (Amt. Rs. Crore)
Cost of new plant 70
+ Installation cost 2
+Additional working capital 12
+Tax burden 2
-Sale of old plant 8__
= Initial Cash outflow 78
Subsequent cash flow: [year 1 to 5] [Amt. Rs. Crore]
Year EBIT (a) EBIT (1-t)(b) Depreciation(c) Cash flow (b+c)
1 2 1.20 10 11.20
2 8 4.80 10 14.80
3 8 4.80 10 14.80
4 18 10.80 10 20.80
5 18 10.80 10 20.80
183 | Page
Depreciation = ( 70 + 2 ) - 12 = 10
6
Terminal cash flows (year 6)
Cash flow = [EBIT (1-t) + Deprn.] + [Scrap value]+ [Working capital released]
= [25 (1 – 0.4) + 10] + [12 Crore] + [12]
= 25 + 12 + 12
= 49
Cash Flow Statement
Year Cash flow (Amt. Rs. Crore)
0 (-) 78
1 11.20
2 14.80
3 14.80
4 20.80
5 20.80
6 49.00
Illustration 6
Following cash flows are expected from two machines. Calculate payback
period for both machines. Maximum payback expected by management is 4
years. Which machine should be purchased by company?
(Rs. lakh)
Year Machine I Machine II
0 (-) 70 80
1 10 15
2 20 20
3 20 35
4 30 25
5 20 20
Solution:
Payback period of machine I
In first 3 years cash flow = 10 + 20 + 20 = Rs. 50 lakh
Amount to be recovered in year 4 = Rs. 20 lakh
th
Total cash flow in 4 year = Rs. 30 lakh
Hence no. of months required to cover 20 lakh = 20 x 12 = 8 months
30
Payback period =3 years and 8 months
Payback period of machine II
184 | Page
In first 3 years cash flow = 15 + 20 + 35 = Rs. 70 lakh

th
Amount to be recovered in 4 year = Rs. 10 lakh
th
Total cash flow in 4 year = Rs. 25 lakh
Hence no. of months required to cover Rs. 10 lakh = 10 x 12 = 4.8
months
25
Payback period = 3 years and 4.8 months
Decision: Both machines are having payback period less than target payback
period of 4 years. Both machines can be purchased. Priority should be given
to machine II because it has lower payback period.
Illustration 7
Following details are available for a two machines [Rs. in lakh]
Machine 1 Machine 2
Initial investment 140 160
Scrap value 20 30
EBIT expected:
Year: 1 30 30
2 40 50
3 40 50
4 30 40
5 20 25
Tax rate of company is 40%.
Management expects A.R.R. to be minimum 20%.
Decide A.R.R. of both machines and suggest management on selection of
machine.
Solution:
A.R.R. = A.V. EBIT ( 1 – t ) x 100
Av. Investment
Av. Investment = Initial Investment + Scrap Value
2
Av. EBIT (Machine I) = 30 + 40 + 40 + 30 + 20
5
= Rs. 32 lakh
Av. Investment (Machine I) = 140 + 20
2
= Rs. 80 lakh
185 | Page
A.R.R. (Machine I) = 32 ( 1 – 0.4 ) x 100

80
= 24%
Av. EBIT (Machine II) = 30 + 50 + 50 + 40 + 25
5
= Rs. 39 lakh
Av. Investment (Machine II) = 160 + 30
2
= Rs. 95 lakh.
A.R.R. (Machine II) = 39 ( 1 – 0.4 ) x 100
95
= 24.63%
Decision:
Both machines are acceptable, as both are having A.R.R. more than 20%,
which is an expectation of management.Machine II is having slightly more
A.R.R. Hence this machine can be given priority.
Illustration 8
Two projects are under consideration of management.
Their cash flows and discounting rate applicable are:
[Amt. Rs. Crore]
Year Machine A Machine B
0 (-) 100 (-) 120
1 20 25
2 25 30
3 25 35
4 30 40
5 20 20
Discounting rate 12% 12%
Calculate: (i) NPV of both machines
(ii) P.I. of both machines
(iii) I.R.R. of both machines
Solution:
Year Cash flow (A) Cash Flow(B) Pvf. (12%) PV (A) PV (B)
(1)(2) (3) (1 x 3) (2 x 3)
0 (-) 100 (-) 120 1.000 (-)100 (-) 120
1 20 25 0.893 17.86 22.33
2 35 40 0.797 27.90 31.88
3 35 45 0.712 24.92 32.04
186 | Page
P.I. 1.01 1.03 B

I.R.R. (%) 12.45 13.3 B
Note:
When priority differs among different methods, priority given by N.P.V. is given
first choice.
Illustration 9
ITC Ltd. has decided to purchase a machine to augment the company's
installed capacity to meet the growing demand for its products. There are three
machines under consideration of the management. The relevant details
including estimated yearly expenditure and sales are given below:
All sales are on cash. Corporate income-tax rate is 40%. Interest on capital
may be assumed 10%.
(Rs.)
Particulars Machine 1 Machine 2 Machine3
Initial investment required 3,00,000 3,00,000 3,00,000
Estimated annual sales 5,00,000 4,00,000 4,50,000
Cost of production (estimated)
Direct Materials 40,000 50,000 48,000
Direct Labour 50,000 30,000 36,000
Factory overheads 60,000 50,000 58,000
Administration costs 20,000 10,000 15,000
Selling and distribution costs10,000 10,000 10,000
The economic life of Machine 1 is 2 years, while it is 3 years for the other two.
The scrap values are Rs. 40,000, Rs. 25,000 and Rs. 30,000 respectively. You
are required to find out the most profitable investment based on 'Pay Back
Method'.
187 | Page
Analysis – Machine I has low Pay Back Period; hence, it is preferred to the
other two machines.
Illustration 10
National Electronics Ltd., an electronic goods manufacturing company,
produces a large range of electronic goods. It has under consideration two
projects X and Y, each costing Rs. 120 lakh.
The projects are mutually exclusive and the company is considering the
question of selecting one of the two. EBDIT have been worked out for both the
projects and the details are given below. X has life of 8 years and Y has a life of
6 years. Both will have zero salvage value at the end of their operational lives.
The company is already making profits and its tax rate is 50%. The cost of
capital of the company is 15%.
188 | Page
(Rs. lakh.)
At the end of EBDIT Present value of
the year Project X Project Y Rupee at 15%
1 25 40 0.870
2 35 60 0.756
3 45 80 0.685
4 65 50 0.572
5 65 30 0.497
6 55 20 0.432
7 35 -
The company follows straight-line method of depreciating assets. Advise the
company regarding the selection of the project.
Solution: Calculation of Net Present Value of the Project X and Project

Y
Project X ( Rs. in lakh)
End of EBDIT Depn. EBIT EBIT(1-t) NetC.F. Discount P.V.
Year (a) (b) (c) (d) e=b+d factor(f) g=exf
------------------------------------------------------------------------------------------------------
1 25 15 10 5 20 0.870 17.40
2 35 15 20 10 25 0.756 18.90
3 45 15 30 15 30 0.658 19.74
4 65 15 50 25 40 0.572 22.88
5 65 15 50 25 40 0.497 19.88
6 55 15 40 20 35 0.432 15.12
7 35 15 20 10 25 0.376 9.40
8 15 15 - - 15 0.327 491
__________________________________________________________
PV of Cash Inflows 128.23
Less: Initial Investment 120.00
Net Present Value 8.23
Project Y ( Rs. in lakh)
_________________________________________________________
End of EBDIT Depn. EBIT EBIT(1-t) Net C.F. Discount P.V.
Yr (a) (b) (c) (d) e = b + d factor(f) g =exf
_________________________________________________________
1 40 20 20 10 30 0.870 26.10
2 60 20 40 20 40 0.756 0.24
189 | Page
80 20 60 30 50 0.658 32.90
50 20 30 15 35 0.572 20.02
30 20 10 5 25 0.497 12.43
20 20 0 0 20 0.432 8.64
____________________________________________________________
PV of Cash Inflows 130.33
Less: Initial Investment 120.00
Net Present Value 10.33
10.7 Summary
Ÿ Capital budgeting is the process of investing funds of company in fixed

assets to get benefits over long period.
Ÿ Capital budgeting decision affects value of firm as it brings more profits
to company.
Ÿ Capital budgeting process involves three important steps:
I Locating opportunities
II Screening opportunities that are beneficial and convenient to
III Appraisal of screened opportunities to decide whether project/s
should be undertaken.
Ÿ Important methods used for appraisal of capital expenditure proposals
are Payback Period Accounting Rate of Return, NPV. Profitability Index
Internal Rate of Return. Before selecting a particular method, it is
essential to study merits and demerits of the method and its utility to
business.
Ÿ Financial appraisal is the most important aspect of capital budgeting
decision which involves:
a) Estimating cash flows from project
b) Applying different methods for evaluation of project on basis of
estimated cash flow
190 | Page

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FINANCIAL MANAGEMENT

OVERVIEW OF FINANCE FUNCTION

Finance is the backbone of every business. No activity in the business can be

1.2 Nature And Scope Of Finance Function

2. Finance function permeates throughout the organization. No activity in

3. Even for non-proﬁt making organizations, it is a necessary function.

4. Thus, ﬁnance function is fundamental to every business and is foundation of

any commercial activity. It is necessary for survival and success of any

(a) Procurement of funds (Financing decisions)

1) Prime responsibility of ﬁnance management is to ensure that sufﬁcient

to negotiate with banks for lower rate of interest.

(b) Utilization of funds (Investment decisions)

Remaining amount is distributed as divided on equity shares.

1.3 Goal Of Finance Function

A) Goal of Wealth Maximization:

This goal has been criticized on following grounds:

c) Giving products with zero defects.

B) Goal of Proﬁt Maximization:

1.4 Signiﬁcance Of Finance Function

(i) To know utilization of funds employed in business.

(B) Top management

(C) Research & Development (R&D)

v. Cost-beneﬁt analysis of various R & D projects.

(D) Materials Management

(E) Production management

(F) Sales and marketing

(G) Human Resource Management

1.5 Agency Cost Theory

a) Meaning of agency problem

b) Remedies on agency problem

(A) Act of market forces

(ii) Hostile takeovers

(B) Agency costs

1.6 Role Of Modern Finance Manager

In modern enterprise, ﬁnance manager occupies key position:

a) Industrial licensing considerably relaxed.

PRODUCTION OPERATIONS BASICS

1.1 Introduction to Production concept

Total, average, and marginal product

Total Product Curve

APP and MPP

Average and Marginal Physical Product Curves

1.2 Production Relationship

Diminishing marginal returns

variable input (not to be confused with diseconomies of scale which is a long

Expressing the production relationship

combinations of inputs that are capable of producing a given level of output.

Isoquant Curve/Isocost Curve

Two Isoquants (Interior and Corner Solutions)

An isoquant represents those combinations of inputs, which will be capable of

Marginal Rate of Technical Substitution

equal to the marginal physical product of labour divided by the marginal

1.3 Economic growth and productivity

Components of economic growth (Saari 2006)

Production is a process of combining various material inputs and immaterial

1.4 Main processes of a company

Main processes of a company (Saari 2006)

A company can be divided into sub-processes in different ways; yet, the

distribution of the 'fruits of production' among all parties at interest”. According