ODBCM – 303T: Financial Management

Guru Nanak Dev University, Amritsar

 ODBCM – 303T: Financial Management

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Name of Authors:
Dr. Manjinder Singh

Guru Nanak Dev University, Amritsar

ODBCM – 303T: Financial Management

Guru Nanak Dev University, Amritsar

ODBCM – 303T: Financial Management

Guru Nanak Dev University, Amritsar

ODBCM – 303T: Financial Management

Guru Nanak Dev University, Amritsar

 ODBCM – 303T: Financial Management

INDEX
Title
Unit Page No.

1 Section - A 1-38

2 Section - B 39-56

3 Section - C 57-97

4 Section - D 98-189

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Section-A Time Value of Money

Structure
Unit Objectives
1. Introduction
2. Time value of money
3. Compounding and Discounting Techniques
4. Risk - return relationship
5. Sources of Finance and Cost of Capital
6. Questions and Exercises
7. Let sum up

1. UNIT OBJECTIVES

After studying this module, you will be able to:

 Understand the concept of time value of money
 Understand the concept of discounting and compounding
 Calculate present value and future value of sum
 Understand the concept of Annuity and Perpetuity
 Calculate value of annuity under different circumstances

2. INTRODUCTION

The time value of money is the idea that there is greater benefit
to receiving a sum of money now rather than an identical sum later. It is
founded on time preference.

The time value of money is the reason why interest is paid or earned:
interest, whether it is on a bank deposit or debt, compensates the
depositor or lender for the time value of money.

It also underlies investment. Investors are willing to forgo spending their

money now only if they expect a favorable return on their investment in
the future, such that the increased value to be available later is
sufficiently high to offset the preference to spending money now; see
required rate of return.

History

The Talmud (500 CE) recognizes the time value of money. Talmud
discusses a case where witnesses falsely claimed that the term of a loan
was 30 days when it was actually 10 years. The false witnesses must pay
the difference of the value of the loan "in a situation where he would be
required to give the money back (within) thirty days..., and that same
sum in a situation where he would be required to give the money back
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(within) 10 years...The difference is the sum that the testimony of the
(false) witnesses sought to have the borrower lose; therefore, it is the
sum that they must pay."

The notion was later described by Martín de Azpilcueta (1491–1586) of

the School of Salamanca.

3. COMPOUNDING AND DISCOUNTING

Time value of money problems involves the net value of cash flows at
different points in time.

In a typical case, the variables might be: a balance (the real or nominal
value of a debt or a financial asset in terms of monetary units), a periodic
rate of interest, the number of periods, and a series of cash flows. (In the
case of a debt, cash flows are payments against principal and interest; in
the case of a financial asset, these are contributions to or withdrawals
from the balance.) More generally, the cash flows may not be periodic
but may be specified individually. Any of these variables may be the
independent variable (the sought-for answer) in a given problem. For
example, one may know that: the interest is 0.5% per period (per month,
say); the number of periods is 60 (months); the initial balance (of the
debt, in this case) is 25,000 units; and the final balance is 0 units. The
unknown variable may be the monthly payment that the borrower must
pay.

For example, ₹100 invested for one year, earning 5% interest, will be
worth ₹105 after one year; therefore, ₹100 paid now and ₹105 paid
exactly one year later both have the same value to a recipient who
expects 5% interest assuming that inflation would be zero percent. That
is, ₹100 invested for one year at 5% interest has a future value of ₹105
under the assumption that inflation would be zero percent.

This principle allows for the valuation of a likely stream of income in the
future, in such a way that annual incomes are discounted and then added
together, thus providing a lump-sum "present value" of the entire income
stream; all of the standard calculations for time value of money derive
from the most basic algebraic expression for the present value of a future
sum, "discounted" to the present by an amount equal to the time value of
money. For example, the future value sum to be received in one year is
discounted at the rate of interest to give the present value sum.

Some standard calculations based on the time value of money are:

 Present value: The current worth of a future sum of money or

stream of cash flows, given a specified rate of return. Future cash
flows are "discounted" at the discount rate; the higher the
discount rate, the lower the present value of the future cash flows.
Determining the appropriate discount rate is the key to valuing
future cash flows properly, whether they be earnings or
obligations.

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 Present value of an annuity: An annuity is a series of equal
payments or receipts that occur at evenly spaced intervals. Leases
and rental payments are examples. The payments or receipts
occur at the end of each period for an ordinary annuity while they
occur at the beginning of each period for an annuity due.
 Present value of a perpetuity is an infinite and constant stream of
identical cash flows.
 Future value: The value of an asset or cash at a specified date in
the future, based on the value of that asset in the present.
 Future value of an annuity (FVA): The future value of a stream
of payments (annuity), assuming the payments are invested at a
given rate of interest.

There are several basic equations that represent the equalities listed
above. The solutions may be found using (in most cases) the formulas, a
financial calculator or a spreadsheet. The formulas are programmed into
most financial calculators and several spreadsheet functions (such as PV,
FV, RATE, NPER, and PMT).

For any of the equations below, the formula may also be rearranged to
determine one of the other unknowns. In the case of the standard annuity
formula, there is no closed-form algebraic solution for the interest rate
(although financial calculators and spreadsheet programs can readily
determine solutions through rapid trial and error algorithms).

These equations are frequently combined for particular uses. For

example, bonds can be readily priced using these equations. A typical
coupon bond is composed of two types of payments: a stream of coupon
payments similar to an annuity, and a lump-sum return of capital at the
end of the bond's maturity—that is, a future payment. The two formulas
can be combined to determine the present value of the bond.

An important note is that the interest rate i is the interest rate for the
relevant period. For an annuity that makes one payment per year, i will
be the annual interest rate. For an income or payment stream with a
different payment schedule, the interest rate must be converted into the
relevant periodic interest rate. For example, a monthly rate for a
mortgage with monthly payments requires that the interest rate be
divided by 12. See compound interest for details on converting between
different periodic interest rates.

The rate of return in the calculations can be either the variable solved for,
or a predefined variable that measures a discount rate, interest, inflation,
rate of return, cost of equity, cost of debt or any number of other
analogous concepts. The choice of the appropriate rate is critical to the
exercise, and the use of an incorrect discount rate will make the results
meaningless.

For calculations involving annuities, it must be decided whether the

payments are made at the end of each period (known as an ordinary
annuity), or at the beginning of each period (known as an annuity due).
When using a financial calculator or a spreadsheet, it can usually be set
for either calculation. The following formulas are for an ordinary annuity.
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For the answer for the present value of an annuity due, the PV of an
ordinary annuity can be multiplied by (1 + i).

What does the “Time Value of Money” mean or capture?

Most students agree that what ₹10, today, will buy will be more than
what ₹10 will buy in 5 years in the future. Similarly, they also agree
₹10 would have got them a lot more 5 years ago than what it will get
them today. Since they agree that this is true, I tell them that they have
understood the time value of money concept! This is exactly what the
time value of money concept in finance is trying to show. As time flows
the value of money declines.

Why does the Value of Money Decline?

The value of money declines due to the combined impact of the

following:

1. Inflation in the economy;

2. Risks involved in delayed receipts of cash or financial
transactions; and
3. Opportunity cost of capital delayed.

While each of these forces alone can cause the value of money to decline
individually, all the three usually act with different degrees of impact to
cause a decline in the value of money as time flows.

The Present Value Formula

The present value formula quantifies how fast the value of money
declines. This formula shows you how much once single cash payment
(FV) received in a future time period (t) is worth in today’s terms (PV).

FVt
PV=
(1+r)t

t is the time period in which the future value or cash is received.

Present Value (PV) stands for the value of the money in today’s terms.
Future Value (FV) stands for the amount of cash received in the future.
r is the discount rate or the speed at which the decline in value is
happening (covered in detail later).

Computing the Time Value of Money

If a sum is invested today, it will earn interest and increase in value over
time. The value that the sum grows to is known as its future
value. Computing the future value of a sum is known as compounding.

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The present value of a sum is the amount that would need to be invested
today in order to be worth that sum in the future. Computing the present
value of a sum is known as discounting.

The Future Value of a Sum

The future value of a sum depends on the interest rate and the interval of
time over which the sum is invested. This is shown with the following
formula:

FVt = PV*(1+r)t

where:

FVt = future value of a sum invested for t periods

r = periodic interest rate

PV = present value

t = number of periods until the sum is received

Each period may be a year, a month, a week, etc. The terms in the
formula must be consistent with each other; for example, if it is
measured in months, then r must be a monthly rate of interest.

As an example, suppose that a sum of ₹1,000 is invested for four years at

an annual rate of interest of 3%. What is the future value of this
sum? In this case, t = 4, r = 3% and PV = ₹1,000.

FVt = PV(1+r)t

FV4 = 1,000(1+.03)4

FV4 = 1,000(1.12551)

FV4 = ₹1,125.51

The Present Value of a Sum

The formula for computing the present value of a sum is:

FVt
PV=
(1+r)t

Note that the present value is simply the inverse of the future value.

As an example, how much must be deposited in a bank account that pays

5% interest per year in order to be worth ₹1,000 in three years? In this
case, t = 3, r = 5% and FV3 = ₹1,000.
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Present Value Or What must be deposited to get ₹1,000 = 1,000/(1.1576)
= ₹863.84

Interest Rates and Compounding Frequencies

Compounding refers to the frequency with which interest rates are

charged or paid during a given year. In practice, interest rates can be
compounded anywhere from once per year to once per day; the
theoretical limiting case is known as continuous compounding, in which
rates are compounded at every instant in time. Compounding frequency
is one of the most important determinants of the future value and the
present value of a sum.

For example, if a bank offers a 4% rate of interest with annual

compounding, an investor who holds ₹1,000 in the bank for one year will
have a balance of: ₹1,000(1 + 0.04) = ₹1,040 at the end of the year. In
other words, the future value of this sum is ₹1,040.

If the interest is compounded semi-annually, then the investor will

receive half of the annual rate twice per year; i.e., 2% every six months
during the year. At the end of six months, the investor will have a
balance of: ₹1,000(1 + 0.02) = ₹1,020 at the end of the year, the investor
will have a balance of: ₹1,020(1 + 0.02) = ₹1,000(1 + 0.02)(1 + 0.02) =
₹1,000(1 + 0.02)2 = ₹1,040.40

In this case, since the principal is ₹1,000, the total interest is ₹40.40. Of
this:

₹40 is simple interest (interest on principal)

₹0.40 is compound interest (interest on interest)

In this case, the investor received an interest payment of ₹1,000(0.02) =

₹20 at the end of six months, for a balance of ₹1,020. The interest
payment at the end of the year was based on the principal (₹1,000) and
the interest (₹20) in the account. The interest paid on the principal was
₹1,000(0.02) = ₹20 and the interest paid on the interest was ₹20(0.02) =
₹0.40. Combined with the ₹20 interest paid at the end of six months, the
total interest paid during the year was ₹20 + ₹20 + ₹0.40 = ₹40.40. Of
this, the ₹40 was based on the principal; this is the simple interest. The
remaining ₹0.40 was based on the interest earned during the year; this is
the compound interest.

As the compounding frequency increases, the simple interest earned

during a given period remains fixed, but the compound interest increases.
For example, with quarterly compounding, the investor in the previous
example will receive 1% every three months; at the end of the year the
investor will have a balance of:

₹1,000(1 + 0.01)(1 + 0.01) (1 + 0.01)(1 + 0.01)

= ₹1,000(1 + 0.01)4 = ₹1,040.60

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In this case, the total interest is ₹40.60. Of this:

₹40 is simple interest (interest on principal)

₹0.60 is compound interest (interest on interest)

This demonstrates an important result: as the compounding frequency

increases, the future value of a sum increases.

As another example, suppose that a sum of ₹1,000 is invested for two

years at an annual rate of interest of 8%. What is the future value of this
sum based on the following compounding frequencies?

 Annual compounding
 Semi-annual compounding
 Monthly compounding

With annual compounding, t = 2, r = 8% and PV = ₹1,000.

FVt = PV*(1+r)^t

FV2 = 1,000*(1+.08)^2

FV2 = 1,000*(1.16640)

FV2 = ₹1,166.40

With semi-annual compounding, t = 4, r = 4% and PV = ₹1,000. The

time frame is now 4 semi-annual periods, and the rate of interest is 4%
per semi-annual period.

FVt = PV*(1+r)^t

FV4 = 1,000*(1+.04)^4

FV4 = 1,000*(1.16986)

FV4 = ₹1,169.86

With monthly compounding, t = 24, r = 0.6667% and PV = ₹1,000.

FVt = PV*(1+r)^t

FV24 = 1,000*(1+.006667)^24

FV24 = 1,000*(1.17289)

FV24 = ₹1,172.89

These results show that the future value of a sum continues to increase as
the compounding frequency increases.

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For the present value, a higher compounding frequency reduces the
present value. This is because more compound interest is earned, which
reduces the amount that must be saved today to be worth a specified sum
in the future.

As an example, suppose that an investor has a target of ₹100,000 in five

years, and can invest in a bank account that pays an annual rate of
interest of 6%. How much must the investor save today in order to reach
this goal based on the following compounding frequencies?

 Annual compounding
 Semi-annual compounding
 Monthly compounding

With annual compounding, t = 5, r = 6% and FV5 = ₹100,000.

PV = FVt / (1+r)^t

PV = 100,000 / (1+.06)^5

PV = 100,000 / 1.33823

PV = ₹74,725.82

With semi-annual compounding, t = 10, r = 3% and FV10 = ₹100,000.

PV = FVt / (1+r)^t

PV = 100,000 / (1+.03)^10

PV = 100,000 / 1.34392

PV = ₹74,409.39

With monthly compounding, t = 60, r = 0.5% and FV60 = ₹100,000.

PV = FVt / (1+r)^t

PV = 100,000 / (1+.005)^60

PV = 100,000 / 1.34885

PV = ₹74,137.22

4. ANNUITIES

An annuity is a periodic stream of equally-sized payments. The word

annuity is derived from the Latin word annum (yearly). In spite of this,
any stream of periodic payments of equal size can be treated as an

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annuity. As an example, mortgage payments are made monthly and are
of equal size, and so can be thought of as a type of annuity.

The two basic types of annuities are:

 Ordinary annuity
 Annuity due

Ordinary Annuities

With an ordinary annuity, the first payment takes place one period in the
future. Most annuities are ordinary; some examples are:

 Coupons paid by a bond

 Dividend payments by a share of preferred stock
 Car loan payments
 Mortgage payments
 Student loan payments
 Social security payments

The Future Value of an Ordinary Annuity

The formula for computing the future value of an ordinary annuity is:

where:

FVAt = future value of a t-period annuity

C = the periodic cash flow

r = periodic interest rate

t = number of periods until the sum is received

As an example, suppose that a sum of ₹1,000 is invested each year for

four years, starting next year, at an annual rate of interest of 3%. Since
the cash flows start next year, this is an ordinary annuity. What is its
future value? In this case, t = 4, r = 3% and C = ₹1,000.

Alternatively, the future value of each individual cash flow can be

computed and then combined as follows:

The first cash flow is invested for three years (from year one to year
four):

FV3 = PV(1+r)t

FV3 = 1,000(1+.03)3
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FV3 = 1,000(1.09273)

FV3 = ₹1,092.73

The second cash flow is invested for two years (from year two to year
four):

FV2 = PV(1+r)t

FV2 = 1,000(1+.03)2

FV2 = 1,000(1.06090)

FV2 = ₹1,060.90

The third cash flow is invested for one year (from year three to year
four):

FV1 = PV(1+r)t

FV1 = 1,000(1+.03)1

FV1 = 1,000(1.03)

FV1 = ₹1,030.00

The fourth and final cash flow does not earn any interest since it is not
deposited into the bank until year four. The future value is therefore
₹1,000.

The sum of these future values is:

₹1,092.73 + ₹1,060.90 + ₹1,030.00 + ₹1,000.00 = ₹4,183.63

The Present Value of an Ordinary Annuity

The formula for computing the present value of an ordinary annuity is:

where:

PV At = present value of a t-period ordinary annuity

C = the value of the periodic cash flow

As an example, how much must be invested today in a bank account that

pays 5% interest per year in order to generate a stream of payments of
₹1,000 in each of the following three years? In this case, t = 3, r = 5%
and C = ₹1,000.

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Alternatively, the present value of each individual cash flow can be
computed and then combined as follows:

The present value of the first cash flow (paid in one year) is:

PV = FVt / (1+r)t

PV = 1,000 / (1+.05)1

PV = 1,000 / 1.05

PV = ₹952.38

The present value of the second cash flow (paid in two years) is:

PV = FVt / (1+r)t

PV = 1,000 / (1+.05)2

PV = 1,000 / 1.10250

PV = ₹907.03

The present value of the third cash flow (paid in three years) is:

PV = FVt / (1+r)t

PV = 1,000 / (1+.05)3

PV = 1,000 / 1.15763

PV = ₹863.84

The sum of these present values is:

₹952.38 + ₹907.03 + ₹863.84 = ₹2,723.25

Annuities Due

With an annuity due, the first payment takes place immediately. This is a
less common type of annuity than the ordinary annuity. An example of
this would be a lease agreement or a loan where the first payment is due
immediately.

Due to the timing of the cash flows, the present value and future value of
an annuity will be affected by whether the annuity is an ordinary annuity
or an annuity due.

The Future Value of an Annuity Due

The future value of an annuity due is computed as follows:

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FVA due = FVA ordinary * (1+r)

This shows that the future value of an annuity due is greater than the
future value of an ordinary annuity. This is because each cash flow of an
annuity due is invested for one additional year.

Referring to the previous example, the future value of an annuity due

would be: 4,183.63(1+.03) = ₹4,309.14

This can be confirmed by computing the future value of each cash flow
individually. Each cash flow will be invested for one additional year
compared with the ordinary annuity.

The first cash flow is invested for four years (from today to year four):

FV4 = PV(1+r)t

FV4 = 1,000(1+.03)4

FV4 = 1,000(1.12551)

FV4 = ₹1,125.51

The second cash flow is invested for three years (from year one to year
four):

FV3 = PV(1+r)t

FV3 = 1,000(1+.03)3

FV3 = 1,000(1.09273)

FV3 = ₹1,092.73

The third cash flow is invested for two years (from year two to year
four):

FV2 = PV(1+r)t

FV2 = 1,000(1+.03)2

FV2 = 1,000(1.06090)

FV2 = ₹1,060.90

The fourth cash flow is invested for one year (from year three to year
four):

FV3 = PV(1+r)t

FV3 = 1,000(1+.03)1

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FV3 = 1,000(1.03)

FV3 = ₹1,030.00

The sum of these future values is:

₹1,125.51 + ₹1,092.73 + ₹1,060.90 + ₹1,030.00 = ₹4,309.14

The Present Value of an Annuity Due

The present value of an annuity due is computed as follows:

PVA due = PVA ordinary * (1+r)

This shows that the present value of an annuity due is greater than the
present value of an ordinary annuity. This is because each cash flow of
an annuity due is paid one year sooner, so that the invested principal
earns less interest. As a result, a larger sum must be invested in order to
generate the appropriate cash flows.

Referring to the previous example, the present value of an annuity due

would be: 2,723.25(1+.05) = ₹2,859.41

Alternatively, the present value of each individual cash flow can be

computed and then combined as follows:

The first cash flow is withdrawn immediately, so the present value equals
₹1,000.

The present value of the second cash flow (paid in one year) is:

PV = FVt / (1+r)t

PV = 1,000 / (1+.05)1

PV = 1,000 / 1.05

PV = ₹952.38

The present value of the third cash flow (paid in two years) is:

PV = FVt / (1+r)t

PV = 1,000 / (1+.05)2

PV = 1,000 / 1.10250

PV = ₹907.03

The sum of these present values is:

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₹1,000 + ₹952.38 + ₹907.03 = ₹2,859.41

5. PERPETUITIES

A perpetuity is an investment in which interest payments are made

forever, but principal is not repaid. As an example, a stock that pays a
regular stream of constant dividends can be thought of as a perpetuity.
This is because the same cash flows are paid each year, and the stock has
an infinite lifetime. Another example is a consol, which is a bond that
makes interest payments forever but does not repay the principal.

The Present Value of a Perpetuity

The present value of a perpetuity that pays an annual cash flow of ₹C per
period is:

PV = C/r

As an example, suppose that a perpetuity pays ₹100 per year; assume

that the appropriate rate of interest is 5% per year. The present value of
the perpetuity is ₹100/0.05 = ₹2,000.

The Present Value of a Growing Perpetuity

Suppose that the cash flows provided by a perpetuity grow at a fixed rate
each year. The present value formula is adjusted as follows:

PV = C/(r – g)

where:

g = annual growth rate of the perpetuity

As an example, suppose that a perpetuity currently pays ₹50 per year;

assume that the appropriate rate of interest is 7% per year, and that the
cash flow paid by the perpetuity is estimated to grow at a rate of 3% per
year. The present value of the perpetuity is: ₹50/(0.07 – 0.03) =
₹1,250.

Interest Rate Conventions

Interest rates for loans, bank accounts, etc. can be quoted in two basic
ways:

1. Annual percentage rate (APR)

2. Effective annual rate (EAR)

The annual percentage rate reflects the simple interest of a loan or an

investment, while the effective annual rate reflects both the simple and
compound interest.

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Converting APR to EAR

In order to compare interest rates with different compounding

frequencies, they can be converted into an effective annual rate (EAR);
this reflects the true cost of borrowing (or the return to lending) when
interest is compounded more than once per year. EAR is computed from
APR as follows:

where:

m = the number of compounding periods per year

As an example, suppose that a bank charges an APR of 6% per year,

compounded quarterly for a loan, what is the effective annual rate? This
can be determined as follows:

This indicates that the borrower is actually paying 6.136% per year for
this loan.

Converting EAR to APR

An effective annual rate may be converted to an annual percentage rate

by inverting the previous formula:

As an example, if a bank charges an EAR of 5.25% per year,

compounded monthly for a loan, what is the annual percentage rate? This
can be determined as follows:

Continuous Compounding

Continuous compounding is the limit of compounding frequency.

Continuous compounding indicates that interest rates are being
compounded at every instant in time, which implies that interest is
compounded an infinite number of times. A compounding frequency
which is not continuous is said to be discrete. For example, annual
compounding, monthly compounding, daily compounding, etc. are all
examples of discrete compounding.

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Using continuous compounding requires a new set of formulas for
computing the future value of a sum, the present value of a sum, EAR
and APR.

Computing the Future Value of a Sum with Continuous

Compounding

If interest rates are compounded continuously, the future value of a sum

is:

FVt = PV*(e^rt)

where: e is a constant that is approximately equal to 2.71828

As an example, suppose that a bank offers a rate of interest of 6%,

compounded continuously. An investor who deposits ₹1,000 in this bank
for two years will have an ending balance of: FVt = 1,000(e(0.06)(2)) =
₹1,127.50

Computing the Present Value of a Sum with Continuous

Compounding
The present value of a sum with continuous compounding is:
PV = FVt*(e^-rt)
As an example, suppose that a bank offers a rate of interest of 8%,
compounded continuously. An investor who needs to have ₹10,000 in
three years will have to save the following amount today in order to
reach this goal: PV = 10,000(e^-(0.08)(3)) = ₹7,866.28
Computing EAR with Continuous Compounding
If interest rates are compounded continuously, EAR is computed as
follows:
EAR = eAPR – 1
As an example, if a bank charges an APR of 4% per year, what is the
EAR with continuous compounding?
EAR = e^APR – 1
= e^0.04 – 1
= 1.04081 – 1
= 0.04081 = 4.081%
Computing APR with Continuous Compounding
If interest rates are compounded continuously, APR is computed as
follows:

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APR = ln*(1 + EAR)
As an example, if a bank charges an EAR of 3.5% per year with
continuous compounding, what is the APR?
APR = ln*(1 + EAR)
= ln(1.035)
= 0.03440
= 3.440%
6. SELF ASSESSMENT

1. Adams Company bought a piece of land in1981 for ₹200,000. By

2005, its value had increased to ₹1 million. Find the annual rate
of appreciation during this period. (6.936%)
2. Ahsan Co bought a piece of land in 1991 for ₹160,000 which
appreciated in value at the rate of 3% per year for the first three
years and then at the rate of 4% for the next four years. Find its
value after 7 years. (₹204,534)
3. Your employer has promised to give you a ₹5,000 bonus after
you have been working for him for 5 years. What is the present
value of this bonus if the proper discount rate is 8%?
(₹3402.92)
4. The U.S. government fixed the price of gold at ₹35 an oz in 1934.
In 2005, the price of the yellow metal was ₹480 an oz. Calculate
the price appreciation of gold as percent per year, compounded
annually. (3.757%)
5. You expect to receive ₹10,000 as a bonus after 6 years. You have
calculated the present value of this bonus and the answer is
₹7000. What interest rate did you use in your calculation?
(6.125%)
6. A downtown bank is advertising that if you deposit ₹1,000 with
them, and leave it there for 65 months, you can get ₹2,000 back
at the end of this period. Assuming monthly compounding, what
is the monthly rate of interest paid by the bank?
(1.072%)
7. You decide to put ₹10,000 in a money market fund that pays
interest at the annual rate of 7.2%, compounding it monthly. You
plan to take the money out after one year and pay the income tax
on the interest earned. You are in the 25% tax bracket. Find the
total amount available to you after taxes.
(₹10,558.18)
8. Suppose you have decided to put ₹200 at the beginning of every
month in a savings account that credits interest at the annual rate
of 6%, but compounds it monthly. Find the amount in this
account after 30 years. (₹201,907.52)
9. Antioch Company is adding ₹25,000 per month to a pension fund.
The fund will earn interest at the rate of 6%per year, compounded
monthly. Find the amount available in this fund after 20 years.
(₹11.609 million)
10. Cincinnati Company has decided to put ₹30,000 per quarter in a
pension fund. The fund will earn interest at the rate of 6% per
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year, compounded quarterly. Find the amount available in this
fund after 10 years. (₹1,652,457)
11. Suppose you put ₹250 at the beginning of every month in a
savings account that credits interest at the annual rate of 6%, but
compounds it monthly. Find the amount in this account after 25
years. (₹174,114.73)
12. .Suppose you deposit ₹125 on the first of every month for 240
months, and the bank credits interest at the end of every month at
the annual rate of 6%. How much money do you have in your
account at the end of 20 years?
(₹58,043.89)
13. You have decided to put ₹130 in a savings account at the end of
each month. The savings account credits interest monthly, at the
annual rate of 6%. How much money is in your account after 6
years? (₹11,233.15)
14. Fred Abbott has just opened an IRA in which he plans to deposit
₹150 at the end of every month. The account will compound
interest monthly at the annual rate of 9%. How much money will
Fred have after 25 years in this account?
(₹168,168.29)
15. You have started a job with an annual salary of ₹48,000. You will
get the paycheck at the end of each month, and your deductions
for taxes will be 34%. Using a discount rate of 0.8% per month,
find the present value of the take home pay for the whole year.
(₹30,092.34)
16. Suppose you want to accumulate ₹10,000 for a down payment for
a house. You will deposit ₹400 at the beginning of every month
in an account that credits interest monthly at the rate of 0.6% per
month. How long will it take you to achieve your goal?
(24 months)
17. James Earl has decided to save a million dollars by depositing
₹50,000 at the beginning of each year in an account that pays
interest at the rate of 10%, compounded annually. How long will
it take him to reach his objective? (11 years)
18. Suppose you want to accumulate ₹25,000 as down payment on a
house and the best you can do is to put aside ₹200 a month. If
you deposit this amount at the beginning of each month in an
account that credits 0.75% interest monthly, how long will it take
you to attain your goal?
(88 months)
19. Suppose you deposit ₹300 at the beginning of each month in a
savings account that pays interest at the rate of 6% per year, with
monthly compounding. How long will it take you to accumulate
₹25,000 in this account? (5 years, 10 months)
20. Suppose you deposit ₹70.97 at the beginning of every month in
an account that pays 9% interest per year, compounding it
monthly. You would like to accumulate ₹10,000 in this account.
How long do you have to wait before you reach your goal? (8
years)
21. Suppose you are a property owner and you are collecting rent for
an apartment. The tenant has signed a one-year lease with ₹600 a
month rent, payable in advance. Find the present value of the
lease contract if the discount rate is 12% per year. (₹6820.58)
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22. Republic of Zimbabwe has borrowed ₹50 million from the World
Bank at an interest rate of 3% per year. Zimbabwe will repay the
loan over the next 30 years in equal annual payments. Find the
annual installment. (₹2.551 million)
23. West Bank gives consumer loans at the annual interest rate of
8.25%. Suppose you take out a ₹5,200 loan for 36 months, what
will your monthly payment be?
(₹163.55)
24. Easton Bank gives 6% annual interest, compounded monthly, on
its savings deposits. Suppose you deposit ₹100 on the first of
every month in the bank, how long will it take you to accumulate
₹10,000? (81 months)
25. You want to buy a ₹120,000 house, and you apply for a mortgage
loan. The bank requires a 20% down payment. It will give you a
25-year loan at 8.75% annual interest rate, payable in monthly
installments. How much is your monthly payment?
(₹789.26)
26. Adana Corporation is interested in buying a building for
₹500,000 in cash, or it may pay for it in 50 monthly installments
of ₹12,000 each. If the proper discount rate for Adana is 9%,
which method should it use? PV(installments) =
(₹498,797.36, better)

27. Alhambra Corporation borrowed ₹1 million from Anaheim Bank

with the understanding that Alhambra will pay the loan back in 6
monthly installments of ₹175,000 each. Find the annual rate of
interest charged by the bank.

(16.9
4%)
28. Akron Corporation has borrowed ₹1 million from Canton Bank
with the understanding that Akron will pay the loan back in 12
monthly installments of ₹90,000 each. Find the annual rate of
interest charged by the bank. (14.45%)
29. Armes Corporation has the opportunity to receive ₹20,000 right
now, or, ₹3254.91 per year for the next ten years. The first
payment will be available after one year. For what rate of interest
would the two options be of equal value?
(10% )
30. Auckland Corporation has borrowed ₹700,000 from a bank.
Auckland will repay the loan in ten annual installments of
₹100,000 each. The first installment will be paid a year from now.
Find the rate of interest charged by the bank.
(7.07% )
31. Suppose you buy a machine and you have the option of paying
the full price, ₹40,000, now; or ₹10,000 at the end of each of the
next five years. What is the cost of capital, or the implied interest
rate, for the two methods to be equivalent? (7.93% )
32. You have bought a car. The car dealer offers two payment plans:
(A) Make 48 monthly payments of ₹130 each, or (B) Make 36
payments of ₹165 each. If the time value of money is 12% per
year, which plan is cheaper for you? (A) by about ₹31)

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33. Bennington Company has borrowed a certain amount from the
bank that it will repay in 24 monthly installments. The bank
charges 6% interest annually on this loan and the monthly
payment is ₹6000. Find the amount of loan.
(₹135,377.20)
34. You want to buy a piece of land and the owner would sell it to
you for ₹20,000 cash. Alternatively, he would let you pay for it
with five annual installments of₹5,000 each, the first one due
right now. What is the implied interest rate here?
(12.59%)
35. Karl has borrowed ₹400 from his friend Bill and he will pay him
back in four monthly installments of ₹105 each. Find the monthly
rate of interest charged by Bill.
(1.98%)
36. Dickens Corp wants to buy a 100-acre tract of land. The owner
will sell it for a cash price of ₹175,000, but Dickens offered to
pay for the land in five annual installments of ₹40,000 each, the
first one is due at the end of one year. Find the cost of capital for
Dickens the two prices to be equivalent.
(4.62% )
37. Edinburgh Corporation has the choice of paying for a piece of
land ₹5 million in cash now. Or, after making a down payment of
₹1 million, it may pay the balance may in 6 equal annual
payments of ₹1 million. Find the implied rate of interest in the
second option.
(12.98% )
38. Allegheny Company has borrowed ₹100,000 from a bank with
the understanding that the company will pay ₹2,000 per month to
repay the loan. The bank will charge .75% interest per month on
the unpaid balance. How long will it take Allegheny to amortize
the loan? (63
months)
39. Ames Corporation has borrowed ₹5 million from a bank with the
understanding that it will pay the loan in monthly installments of
₹100,000 each. The bank charges interest at the rate of 0.8% per
month. Find the time required to pay the loan. (65
months)

7. SUMMARY
 The first rule of finance is that money today is worth more than
tomorrow.
 The value that the sum grows to is known as its future value.
 Computing the future value of a sum is known as compounding.
 The present value of a sum is the amount that would need to be
invested today in order to be worth that sum in the future.
 Computing the present value of a sum is known as discounting.
 An annuity is a periodic stream of equally-sized payments.
 Ordinary annuity refers to annuity in which the payments are
made at regular intervals at the end of each period.

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 With an annuity due, the first payment takes place immediately.
An example of this would be a lease agreement or a loan where
the first payment is due immediately.
 Future value of an annuity due is greater than the future value of
an ordinary annuity
 The present value of an annuity due is also greater than the
present value of an ordinary annuity, because each cash flow of
an annuity due is paid one year sooner, so that the invested
principal earns less interest.
 A perpetuity is an investment in which interest payments are
made forever, but principal is not repaid.
 A stock that pays a regular stream of constant dividends can be
thought of as a perpetuity.

7.1 SUMMARY OF FORMULAE

FVt
 PV=
(1+r)t

 FVt = PV*(1+r)t
(1 i)n 1
 FV of annuity=
i
1
1-
(1+r)t
 PV of annuity =C
r
 FVA due = FVA ordinary * (1+r)
 PVA due = PVA ordinary * (1+r)
 PV of a perpetuity = C/r
 PV of a Growing Perpetuity = C/(r – g)
 FVt of a Sum with Continuous Compounding = PV*(e^rt)
 PV of a Sum with Continuous Compounding = FVt*(e^-rt)
 EAR, if interest rates are compounded continuously = e^APR – 1

8. SUGGESTED READINGS

 I M Pandey, “Financial Management”, 2010, Vikas.

 Horne, Van “Financial Management and Policy”, 2002, Pearson.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008,
Pearson.
 Banerjee, B, “Financial Policy and Management Accounting”,
2005, PHI.
 Chandra, P., “Financial Management”, 2015, TMH.
 Srivastava, R.M., “Financial Management”, 2017, HPH.

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 http://swayam.gov.in
 http://edx.org

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1. UNIT OBJECTIVES

After studying this module, you will be familiar with:

 Concept of financing
 Different sources of financing
 Short term financing sources
 Long term sources of financing

2. INTRODUCTION

Concept
Finance is considered as lifeblood of an organization. It is not
only required to set up an organization, but also to run it, perform day-to-
day operations and further expand the organization. Depending upon the
requirements of the company, whether finance is required for meeting
working capital(short-term) needs or for creation of production
capacities(long term), there are a wider number of options available to
the companies. Under the short term or working capital financing, as the
name denotes, a company has to repay the borrowed funds within a time
period of one year. On the other hand, in long-term financing, as the
finance is raised to create production facilities that are expected to yield
returns to the company over a period of time in future, the repaying
period extends to more than a year. Figure 1 illustrates the different
sources (short-term and long-term) of financing available to a firm:

Figure 1: Sources of Finance

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3. SOURCES OF FINANCE
A. Short-Term Sources of finance: In order to carry out normal
business operations, various types of expenses are incurred by the
businesses. A business must have enough funds available at all times to
keep the business moving. The short term requirements(working capital)
of the funds are met by the companies using short term sources of
finance. Short-term mainly refers to period up to one year. Thus, the
funds raised by the companies using short term finance options, have to
be repaid within a period of one year. Following are some of the
different sources, from which short-term finance can be raised by the
company:

1. Bank Credit: Bank credit constitutes most important source for

financing the working capital requirements. Primarily, the credit is often
by the banks in the forms of :
(i) Cash credits or overdraft: Both cash credit and overdraft, offers
borrower with a pre-defined limit of borrowing, to withdraw more than
the balance in the account. The borrower can withdraw the funds as and
when required, provided the withdrawal does not exceed the sanctioned
limit. The borrower is charged interest only on the running balance of the
account and not on the whole limit sanctioned.
(ii) Loans: When a lump-sum amount is paid to the borrower against the
some security, it is termed as a loan. A company can meet its short term
requirements of finance, by taking short term loan from the bank also.
The amount is normally credited to the bank account of the borrower.
The amount of loan is payable periodically in installments. The interest is
charged on the whole amount credited to the account, irrespective of the
amount withdrawn by the borrower.
(iii) Discounting of bills: It is another important form of credit offered
by the banks. A bill may be clean bill or documentary bill, accompanied
by the documents of title to receipt. The seller of goods draws a bill on
the buyer, which may be payable on demand or after an usance period.
The seller can go to the bank in order to collect the amount whenever he
wants the required money. For this, the seller bank discounts the bill( pay
the amount of bill after deducting some portion as a fee) to the seller

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and then on the due date the bill is presented by the bank to the buyer for
getting the payment.
(iv) Letter of credit: A letter of credit is an arrangement in which a bank
undertakes a guarantee for the payment of credit taken by its customer
from his supplier, in case of his inability to do so. In other words, here
the bank helps its customer to get the credit from supplier’s easy terms.
For example, a bank issues a letter of credit in favor of M, for the
purchases to be made by him from N. Now, M may wanted to make
purchases on credit, but N may not be ready to give credit except based
on some previous record about the credibility of the customer. So, in this
case, letter of credit will help M to purchase goods on credit from N,
because it will now assure N that in case of non-payment of purchases by
M, the bank will meet the obligation. It is to be noted that while finance
is being provided by the supplier, the risk has been assumed by the bank.
Thus, letter of credit is an indirect form of short term financing for the
firms.

2. Trade Credit: Trade credit refers to the credit offered by the supplier
of goods and services. It is an important form of arrangement of credit by
the firms on short term basis. For example, a firm purchased inputs of Rs.
10,000 from its supplier. If it is short of funds or want to invest funds
elsewhere, then it can avail trade credit from its supplier. This will allow
the firm to carry on its operations as usual, without incurring any
immediate cash outflows regarding payment of inputs.
The credibility and goodwill of the customer(firm) acts as a
benchmark for the supplier while offering credit. Thus the confidence of
the supplier on his customer is a yardstick for granting short term finance.
The following aspects are generally considered by the suppliers while
offering trade credit:
(i) Good earning record: If a firm has a good earning record over a
period of time, then it is considered favorable by the suppliers.
(ii) Liquidity position of the firm: As the short term finance has to
repaid within a period of one year, thus suppliers gives more importance
to the liquidity factor of the firm. Liquidity refers to ability of the firm to
meet its short term obligations out of the available current funds. It is

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generally estimated by calculating the current assets to current liabilities
ratio of the firm.
(iii) Payment history: A supplier will also confirm the credibility of the
customer, by searching and contacting other suppliers from whom the
same customer would have taken the credit earlier.

3. Accruals: Accruals refers to amounts due from the company’s side

but not paid by the company or not received to the parties to whom it
was due. In other words, accruals act as liability for the firm for the
services it has already availed but not paid for it. The major accrual
items are wages, salaries, interest and taxes. These expenses act as a
good source of short term finance for the companies mainly because of
two reasons:
(i) they are paid periodically, i.e. only after a period of time after the
services have been received or profit earned.
(ii) Act as a free source of finance, as no interest is payable on the
accruals.
While accruals may be easy source of meeting the short term
requirements, but they are not open to control for by the management.
This is because the payment period for wages and salaries is generally
decided according to the practices of the industry , while the tax payment
period is decided by the provisions of the law.

4. Commercial Paper: Commercial papers represent short-term

unsecured promissory notes. These are issued by large corporations and
firms having higher credit rating, in order to meet their short term
requirements of funds. In India, it was introduced by RBI on the
recommendations of Vaghul committee, as short term instrument of
money market. No separate amount of interest is payable on this
instrument. A commercial paper is issued at discount and is redeemable
on face value. Thus, the difference between the discounted value and the
redeemable value can be regarded as an implicit interest amount for the
investors. Since it is an unsecured form of instrument, Reserve Bank of
India has stipulated certain conditions, in order to ensure that only high
net worth companies and high credit companies can raise finance through

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this instrument. The important features of commercial paper are as
follows:
(i) The maturity period of commercial paper ranges from 7 days to 1
year.
(ii) Commercial paper is issued at discount and are redeemed at their face
value. Thus, the difference between issue value and redeemable value
denotes the implicit interest for investors of the instrument.
(iii) High net worth companies and companies having high credit rating
are allowed to raise short term finance by issuing commercial paper.

5. Factoring: A factor is a financial institution that offers services

related to management and financing of debts arising out of credit sales.
There are three parties to a factoring arrangement, i.e. factor,
client(seller/company who transfer its receivables to factor) and the
debtor( to whom goods or services have been provided by seller on
credit). Besides providing the basic bill discounting facility offered by
commercial banks, a complete range of services related to administration
of credit sales, including maintenance of sales ledger, collection of
accounts receivables, credit control, and rendering of advisory services to
clients, are offered to the clients.
Factoring may be recourse basis or on non-recourse basis.
Under recourse basis of factoring, the credit risk(bad debts) is borne by
the client, while in non-recourse factoring, the credit risk is borne by the
factor. Sometimes, factoring and bill discounting are considered as same,
but there are significant difference between the two concept. Table 1
summarises the points of difference between bill discounting and
factoring:
S.No. Basis Bill discounting Factoring
1. Meaning It involves provision Factoring includes a
of funds against the range of various
bills to the seller of services such as
goods for sales made administration of sales
on credit. ledger, collection of
receivables, providing
advisory services, in
addition to provision
of funds against the
bill to the
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client(seller).
2. Recourse and Bill discounting is Factoring can be on
Non-recourse always done on recourse or
basis recourse basis, i.e. the non-recourse basis.
risk of non-payment Under non-recourse
of bill on the due date basis, the risk of non-
by the drawee(buyer) payment of the debt
is borne by the is borne by the
drawer(client). factor only.
3. Transactions Bill discounting Under factoring all the
involves individual receivables are
acceptance of bills by transferred to factor,
the banks for in return of which,
discounting. normally an upfront
payment is made by
the factor to the client.
4. Treatment in Bill discounting is a Factoring is an off
balance sheet balance sheet balance sheet item.
financing. In other
words it is shown in
the balance sheet.
5. Parties to Drawer, drawee and Factor, client and
transaction payee debtor.
6. Collection of The drawer takes the In factoring, factor
debts responsibility for assumes the
collection of responsibility for
receivables from the collection of debts
buyer and remitting it from the debtors.
to the financing
agency (bank).

Functions of a factor:
 Financing trade debts: It is a unique feature offered in factoring,
where the factor assumes the trade receivables from the factor
and agrees to finance the receivables up to 80 percent of the
receivables.
 Administration of sales ledger: The factor not only assumes the
responsibility of financing the trade debts, but also maintains the
sales ledger related to all the credit sales made by the client.
 Collection facility: On assuming the trade debts of the client, the
factor also thereby assumes the responsibility for the collection of

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debts from the customers of the client. This unique service
offered by the factor, relieves the client from the botheration
involved in the collection process, involving, sending timely
reminders, making followup of the client activities or business.
 Cost of services: Factor provides a variety of services including
advisory services such as updating client regarding the emerging
marketing strategies, emerging trends and so on, at a charge. This
charge is taken normally taken upfront only, as a percentage of
assumed trade debts by the factor.

6. Public Deposits: In order to meet the working capital requirements,

companies also resort to raising of finance from public in the form of
unsecured deposits. These deposits are regulated under section 73 of the
Companies Act, 2013, that provides for the requirements to be fulfilled
by the companies for acceptance of deposits from the public.

7. Advances from Customers: This is another method of financing the

short term requirements of funds. Some companies get the amount of
order from their customers in advance only, before fulfilling the orders.

8. Deferred Income: It refers to income received in advance, before the

provision of goods and services. This source of finance helps the
companies to meet the short term liquidity needs. But, only the firms
having good image in the market, can resort to this type of financing.

B. LONG TERM FINANCE SOURCES OF FINANCE: Long term

normally indicates a period of more than one year. Thus, Long term
sources of finance, includes those sources, whose maturity exceeds one
year. Like the short term financing needs are met through short term
sources of finance, likewise the long term investment needs (like
purchase of fixed assets, that are expected to yield over a number of
years in future), are met through long term sources of finance. This
satisfies the concept of matching principle of accounting also. The
various sources of financing available to a firm, in order to meet their

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long term finance requirements, are equity shares, preference shares,
debentures, bonds and term loans.

1. Issue of Share Capital: Share capital refers to the capital of the

company raised from the issue of shares. The whole capital of the
company is divided into denominations of smaller units. Each unit is
referred to as a share. For example, if the total capital of the company is
10 lakhs, and if such capital is divided into 1000 units of Rs. 100 each,
then this unit of Rs. 100 is the share of the company. The maximum
capital that a company can issue during its lifetime ( according to
memorandum) is known as authorized capital of the company. Part of the
total capital issued for subscription to the public is called as issued
capital. The part of the issued capital subscribed by the public is known
as subscribed capital of the company. And the part of the subscribed
capital of the paid by the shareholders is known as paid up share capital
of the company. Section 43 of the Companies Act stipulates that a
company can broadly issue two types of share capital:
a. Equity share capital
b. Preference share capital
a. Equity Share Capital: Equity share capital represents ownership
capital. In other words, the holder of equity shares are the owners of the
company. They have control over the working and management of the
company. This is due to the voting right given to the them, which is in
proportion to their contribution in the capital of the company.
Features of equity shares:
 Claim on income and assets: Equity shareholders have a residual
claim over the income of the company. This implies that the operating
profits of the company are firstly used for meeting all expenses, interest
charges, taxes and preference dividends. Then, the remaining portion is
distributed to the equity shareholders as dividend.
 Claim on assets: Equity shareholders have a residual claim over the
assets of the company. At the time of liquidation of the company, when
the assets are sold and money is realized, then firstly all the expenses,
claims of debt holders and preference share holders are met, then equity
shareholders can claim from the amount, if any left.

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 Voting rights: Equity shareholders have a right to vote at the
meetings of the company. As owners of the company, the equity
shareholders elect the board of directors of the company.
 Pre-emptive right: Pre-emptive right refers to the first right. In other
words, when the companies have to raise additional capital by issuing
more equity shares, then a company is required by law, to give first right
to the existing shareholders to subscribe to those shares in a given
proportion of their(shareholder’s) existing shares.
Demerits of equity shares
 Cost: Companies have to bear comparatively higher cost for issue of
equity shares. This is because the floatation costs involved in issue of
equity shares is high and moreover the dividends payable to equity
shareholders do not provide any tax benefit to the company, like
interest on debt.
 Risk: As equity shareholders have a residual claim on the income
and assets of the company, so they have to bear higher risk regarding
non-payment of dividends or enjoy capital gains.
 Dilution of control: The equity shareholders have a risk regarding
their dilution of control in the management of the company. While
the existing shareholders are given a pre-emptive right to subscribe
the new shares, but they may be short of funds to subscribe the issue
of shares. Thus, the issue of new shares may dilute their existing
ownership.

b. Preference share capital: The raising of required amount of funds

through the issue of preference shares, is a hybrid termed as hybrid
financing. This is because it has some characteristics of equity form of
financing and some features of debt form of financing.
 Like equity financing, it has following characteristics: (i) there is
no legal binding regarding their dividend payments. (ii) dividend
is payable to preference shareholders out of distributable
profits.(iii) the dividend payment is not tax-deductible.
 Like debentures, preference shareholders holds following
characteristics: (i) the dividend payment to preference
shareholders is fixed, as there are cumulative preferences on

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which the unpaid dividends gets cumulated and are paid when the
company has enough distributable profits. (ii) the preference
shareholders have a claim on the income(dividend) before equity
shareholders. (iii) preference shares generally do not enjoy voting
rights except for matters related to them. (iv) There are
redeemable preference shareholders(that are to be repaid during
the life time of the company).
Features of equity shares
 Maturity: There are redeemable and irredeemable preference
shares. The redeemable preference shares have to be repaid
during the lifetime of the company. On the other hand, the
irredeemable preference shares are repaid at the time of
liquidation or winding up of the company.
 Claim on income: Preference shareholders, as the name denotes
are given preference/priority. If the company has to make
dividend payments, then firstly dividend is dividend is distributed
to the preference shareholders, then left over portion is distributed
to equity shareholders. At the time of liquidation or winding up of
the company, they have a prior claim over the income (profits left
after tax payment) of the company, before equity shareholders.
 Claim on the assets: The preference shareholders also have a
claim on the assets of the company. They get their claim on the
assets of the company before equity shareholders.
 Tax deductibility: Unlike interest on debt, the dividend payable
to the preference shareholders is not tax deductible. The dividend
is distributed to the preference shareholders after deducting tax
from the operating profits of the company.
 Control over management: Ordinarily, preference share holders
do not have control over the management of the company. But,
section 47 of the Companies Act, 2013 provides for the voting
right of the preference share holders regarding the matters
directly affecting them.
Demerits of Preference shares
 Limited voting rights: Preference shareholders do not enjoy full
voting rights like equity shareholders. Preference shareholders are

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given the right of voting for the matters directly affecting their
interest.
 No tax advantage: Unlike interest on debt, the dividend
payable to the preference shareholders is not tax deductible. Thus,
these are costlier for the companies than the issue of debentures.
 Cumulative dividends: Though the companies are under no
legal obligation regarding payment of dividend to preference
shareholders, but in case of cumulative preference shares, the
unpaid dividend payments gets cumulated, and are payable in
future.

2. ISSUE OF DEBT: A company can raise the debt capital of the

company, either through debentures, bonds or term loans. A company a
raise long term finance by issuing bonds and debentures to the public, or
it can directly raise finance from the banks and financial institutions
through term loans.
a. Issue of Bonds and Debentures: Debentures are promissory notes
that are issued by the companies for raising long term finance. The
debenture holders of the company are the creditors of the company. The
company promises to pay interest and principal after a stipulated period
of time. Debentures may be secured or unsecured. Bonds and debentures
differ on following aspects;
 While debenture is a secured bond and bonds are usually
unsecured, hence bonds are issued at relatively high rate of
interest than the debentures.
 Debentures carry a fixed rate of interest while interest on bonds
may be fixed or fluctuating.
 Bonds can also be issued without explicit payment of interest,
known as deep discount bonds.
Characteristics of Debentures and Bonds
 Maturity: Bonds and debentures may be redeemable or
irredeemable. Redeemable denotes those debenture holders
whose repayment has to be made during the lifetime of the
company. While irredeemable debentures are those that are
repaid at the time of winding up of the company. But as per Rule

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18(1)(a) of the Companies Act, 2013, the companies can issue
debentures having redeemable period of not more than 10 years
from the date of issue.
 Fixed interest rate: The interest payment on debentures is fixed.
The companies are under legal obligation to pay interest on
debentures regardless of their profitability position.
 Security: Debentures may be secured or unsecured. A secured
debenture provides security of the company’s assets to the
debenture holders. In other words, it is assured that in case of the
inability of the company to repay the stipulated amounts, then the
payment will be made from the realization of the assets. While,
unsecured debentures are not backed by the assets of the
company.
 Claim on assets and income: Debenture holders a prior claim on
the assets and income of the company. In other words, the interest
payment to the debenture holders is made before the payment of
dividend to preference shareholders and equity shareholders.
 Tax benefit: The interest payable on the debentures is a tax
deductible expense. The companies can save a considerable
amount of its profit. Hence it is regarded a cheaper source of
financing as compared to equity shares or preference shares.
Demerits of debentures
 Burden on company: Since the Interest charges and principal
amount has to be paid after a fixed interval, irrespective of the
distributable profits available to a firm, so it act as burden on the
companies.
 Controlling interest: The debenture holders of the company do
not having voting rights, so they cannot exercise control over the
management of the company.
 Difficulty in raising loans: In case a company wants to raise
loan from a financial institution, it cannot raise loan on the
security of the assets already mortgaged to the debenture holders.

b. Term Loans: Term loans represents debt (loan) raise by the

company from banks and financial institutions. These loans have a

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maturity period exceeding one year and up to 10 years. The purpose
of term loans is mostly to meet the capital expenditures(such as
acquisition of fixed assets) of the companies. These loans differ from
short term loans, due to the purpose of raising loan. Short term loans
are raised to meet the working capital requirements of the company.
Features of term loan:
 Maturity: The term loans are generally offered by the banks and
financial institutions to the companies for a period ranging from 6
to 10 years. More time may be granted depending upon the
discretion of the banks and financial institutions.
 Definite obligations: The payment of interest and principal
payments on the term loan are definite obligations for the
companies. In case a company has been unable to pay the
installments, then it will have to bear higher (penalty) interest
charged by the banks and financial institutions.
 Security: Term loans are generally granted on secured terms. In
other words, banks generally demand some form of security from
its borrowers (companies), while granting loans, in order to cover
uncertainty regarding non-payment of loan by the borrower in
future.
 Tax deductibility: The interest paid on the term loans is a tax-
deductible expense. Thus, it is considered as cheaper on these
terms over raising of finance through issue of shares.
Demerits of term loans
 Risk of bankruptcy: The payment of fixed interest and
principal amount is an obligation for the bank. The continuous
inability of the borrower to make the repayments may lead to
financial distress for the company and may even lead to bankruptcy
of a firm.
 Increase in cost of equity: Increased used of debt may result in
increase in cost of equity. The equity shareholders will fear
regarding the financial burden put on the company due to increased
use of debt. In turn, in order to cover the increased risk(loss), the
equity shareholders will demand more return on their investments.

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 Restricted covenants: A longer repayment period brings more
uncertainty about the future prospects of the companies or
businesses. Thus, in order to cover the future uncertainty or
expected loss due to inability of the borrower to repay the amount
borrowed, banks and financial institutions normally impose
restrictive covenants on the companies, such as maintenance of
minimum asset base; restrictions on incurring additional liability,
competent management etc. This puts extra burden on the
companies.

4. COMPARITIVE VIEW OF LONG TERM SOURCES OF

FINANCE
Sources Cost of issue Dilution of Risk
Control involved in
repayment
Equity share High Yes Nil
capital
Preference share High No Negligible
capital
Debentures Low No High
Term loans Low No High

5. SUMMARY

 The basic short-term sources of finance available to a firm are bank

credit, trade credit, commercial paper, factoring, bill discounting,
public deposits, deferred income, accruals and customer advances.
 Short term financing sources have maturity period upto one year.
 Bank credit denotes credit taken from banks, whereas trade credit
denotes credit given by the trader to the buying organization.
 Commercial papers are unsecured promissory notes issued by
companies fulfilling guidelines issued by RBI.
 Bill discounting involves provision of funds to the drawer or the seller
of the goods against bills receivable, while factoring involves a range
of range of services such as administration of sales ledger, collection of
trade debts, provision of advisory services and other services related to

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management of receivables , in addition to provision of funds against
the book debts transferred to factor.
 Public deposits are the deposits raised by the companies from the
public.
 Accruals financing involves meeting short time requirements of
finance from the expenses, for which goods and services have been
received by the companies, but have not been paid for.
 Deferred income refers to income received in advance, before the
provision of goods and services.
 In order to correct short term mismatches of funds, some companies
get the amount of order from their customers in advance only, before
fulfilling the orders
 Funds required to meet the capital expenditures is termed as long term
finance.
 Long term finance has ranging from normally five years to 10 years.
 The long term finance can be raised by the companies through issue of
equity shares, preference shares, debentures, bonds or through raising
term loans.
 Equity share capital represents the ownership capital. The equity
shareholders are considered as the real owners of the company. They
have a control over the management of the company.
 Equity shareholders have a residual claim over the assets and income
of the company.
 Preference shareholders enjoy the priority of claims over the equity
shareholders.
 At time of payment of dividend or winding up of the company,
preference shareholders are paid prior to equity shareholders.
 A company can offer bonds and debentures to the public for
subscription.
 The company has a fixed obligation for payment of interest on
debentures.
 Debenture holders are the creditors of the company.
 Debt offers an exclusive benefit of tax deductibility. Interest payable
on debt by the company is a tax deductible expense.
 Term loans generally have a maturity period of 5 to 10 years.
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 Term loans can be raised by the companies from the banks and
specialized financial institutions.

6. SUGGESTED READINGS

 Khan and Jain, “Financial Management”, 2011, MH.

 I M Pandey, “Financial Management”, 2010, Vikas.
 Srivastava, R.M., “Financial Management”, 2017, HPH.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008, Pearson.
 Banerjee, B, “Financial Policy and Management Accounting”, 2005,
PHI.
 Chandra, P., “Financial Management”, 2015, TMH.
 http://swayam.gov.in
 http://edx.org

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Section-B Cost of Capital

Structure
Unit Objectives
1. Introduction
2. Cost of capital
3. Relevance of Cost
4. Specific Cost
5. Marginal cost
6. Questions and Exercises
7. Let sum up

1. UNIT OBJECTIVES

After studying this module, you will be able to:

 Understand the concept of cost of capital
 Understand Relevance of Cost of capital
 Discuss Specific costs and Weighted average cost of capital
 Discuss the concept of Marginal cost of capital

2. INTRODUCTION

Concept of Cost of Capital

Every company needs funds, not only to carry out its day-to-day
business operations, but also to make investments in new projects, that
yield returns to a company over a period of time. While taking long term
investment decision, the cost and profitability of the project is analysed.
After estimating the cost involved in the project, different sources for
financing the projects are evaluated. A firm can raise the required funds
from equity source of finance, preference shares, debt and retained
earnings. But the choice of financing will depend upon relative cost of
each source of finance. Thus, cost of capital refers to the cost involved in
raising the required funds from particular source(s). The cost of capital(k)
is compared with the return(s) generated from the project. If returns
generated by the projected are more than the cost of the project, then the
project is considered as profitable(r>k). So, if a company is able to
maximize the return on the investment made, then it will lead to wealth
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maximization( appreciation in the amount of investment made by the
shareholders). In other words, the return on the amount of investment,
expected by the investors or givers of money to the company, is termed
as cost of capital to the company. For instance, in return for raising funds
from equity shares, it will have to pay dividend to shareholders and
interest to on debt. Thus, the cost of capital reflects the minimum rate of
return that a company must earn on its investments, in order to cover the
costs involved in raising the finance and meet the expectations of the
shareholders.

3. RELEVANCE OF COST OF CAPITAL

The concept of cost of capital holds extreme importance while

making important financial decisions, capital structure decisions and
capital budgeting decisions of a firm. It is considered as a benchmark for
taking important decisions as follows:
a) Evaluation of investment decisions: The main objective for
calculating the cost of capital of a firm is to use it as a standard while
making capital expenditure decisions. Under the Net present value
method for taking capital expenditure decisions, a project is accepted (or
an investment is made in the project), if its net present value is equal to
or more than the cost of capital. Net present value is calculated by
discounting the expected returns from the project by the cost of capital.

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b) Deciding optimal capital structure of firm: While deciding an
appropriate mix of difference sources of finance in capital structure, cost
of capital holds extreme importance. An optimal capital structure aims at
maximizing the value of the firm while minimizing the overall cost of
capital of the firm.
c) Performance appraisal: The concept of cost of capital is also useful
in evaluating the performance of the management. The performance of
the management can be measured by comparing the actual
profitability(return) from the investment made in the projects with the
actual costs incurred to raise the funds required for the investment.
d) Other decisions: The cost of capital also plays a useful role in
making other decisions like choosing among methods of financing,
dividend decisions, rights issue decisions etc.

4. FACTORS AFFECTING COST OF CAPITAL

Following are the main factors that affects the determination of cost of
capital:
1. Risk-free rate of interest: Risk free rate of interest is defined as the
minimum interest rate that an investor has to pay on risk free securities.
It is considered by the companies as a benchmark for deciding their own
cost of funds. When the risk free rate of interest rises, the overall cost of
funds rises in the economy and vice versa.
2. Business risk: Business risk represents the risk that arises due to
fluctuations in the revenue and expenses components of a company. In
other words, it is related to the company’s ability to generate enough
revenue in order to cover its expenses.
3. Financial risk: Financial risk arises due to the presence of debt
component in the capital structure of the company. Higher the debt,
higher will the financial risk, resulting in higher insolvency risk. Higher
insolvency risk, in turn, leads to higher cost of capital because investors
will demand higher return for undertaking higher risk.
4. Other factors: Other factors like liquidity and profitability too affects
the cost of capital. If the securities of the company are marketable i.e.
can easily be bought and sold in market, then the company will be able to
raise capital at a relative lower cost and vice versa. On the other hand,

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profitability also affects the cost of capital. If the company is highly
profitable, then it will be able to raise capital with less floatation costs
and vice versa.

4. SPECIFIC COSTS AND WEIGHTED AVERAGE COSTS

Specific costs refers to the individual costs of various sources of

capital used by a firm. For example, if a company is using debt and
equity in its capital structure, then specific costs indicates the cost of debt
and cost of equity. On the other hand, weighted average costs denotes the
weights assigned to different types of costs involved in raising funds
from different sources, including equity shares, preference shares, debt
and retained earnings. The weighted average cost of capital(WACC),
also known as overall cost of capital , is calculated according to the ratio
of each source of finance in the overall capital of the company, as
follows:
n
ko=  ktwt
t1
where ko is the weighted average cost of capital and wt is the cost of ith
source of capital.

 Computation of Cost of Capital

The calculation of overall cost of capital includes:

A) Computation of cost of specific source of finance
B) Computation of Weighted average cost of capital

A) Computation of Cost of specific source of finance

1. COST OF DEBT: Primarily, debt includes debentures, bonds and

term loans. The cost of debt is the rate of interest that the firm has to pay
on the amount of debt holders, from whom the debt has been raised. The
rate of interest paid on debt is a tax deductible expense. Hence, the cost
of debt is calculated after considering(deducting) the tax. A company can
issue debenture or bond at par, premium or discount. The cost of debt
can be discussed under two categories:

a) Cost of irredeemable debt: It is calculated as:-

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I
Before tax cost of debt, Kdb=
NP
I
After tax cost of debt, Kda= (1-t)
NP
where Kdb = Before-tax cost of debt Kda= After-tax cost of debt ; I=
Interest; NP= Net Proceeds ; t= Rate of tax

Example 1: Compute the cost of debt capital:

(i) A company issues Rs. 1,00,000 10% debentures at par. The tax rate
applicable to the company is 50 percent.
I
Solution: Kda= (1-t)
NP
Kda = 10䉰000 (1-0.50)
1䉰00䉰000
= 1 (1-0.50)
10
Kda= 5%

(ii) A company issues Rs. 1,00,000 10% debentures at a discount of 5%.

The tax rate applicable to the company is 50 percent.

10䉰000
Kda = (1-0.50)
9ǡ䉰000
10
= (1-0.50)
9ǡ
Kda= 5.26%

(iii) A company issues Rs. 1, 00,000 10% debentures at a premium of 5%.

The tax rate applicable to the company is 50 percent. Compute the cost
of debt capital.

Kda = 10䉰000 (1-0.50)

1䉰0ǡ䉰000

10
= (1-0.50)
9ǡ
Kda= 4.76 %

b) Cost of Redeemable debt: It is the debt payable after a certain period

during the life span of a company. It is calculated as:-

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

where I is the annual interest, n is the number of years in which the debt
will be redeemed; RV is the redeemable value of debt ; NP is the net
proceeds of the debentures.

Example 2: A company issued Rs. 1,00,000 10% redeemable debentures

at a discount of 5% . The debentures are redeemable after 4 years.
Calculate the cost of debt if tax rate is 25%.

1
50(1-0.5)+ (500  240)
Solution: Kda = 10
1
(500+240)
2
7ǡ00+12ǡ0
=
9䉰7ǡ䉰00

Kda = 8.97%

Example 3: Compute the after tax cost of debt, a company pays tax at
50% rate:
(i) a perpetual bond sold at par, coupon rate of interest being 5%.
(ii) a 10 year, 10% Rs. 500 per bond sold at Rs. 250 less 4%
underwriting commission.

Solution: (i) Cost of a perpetual bond

𝐼
Kda= (1-t)
NP
ǡ
= (1-0.50)
100
Kda= 2.5 %

(ii) Cost of a redeemable debt

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

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1
50(1-0.5)+ (500  240)
= 10
1
(500+240)
2
2ǡ+26
=
370
Kda = 13.78%

2. COST OF EQUITY SHARE CAPITAL: The cost of equity refers to

the rate of return expected by the shareholders on their amount invested
in the firm. The rate of return depends upon two elements namely a)
dividend and (b) capital gain. The dividend payments depends upon the
firm specific policies but the capital gain depends upon a number of
factors of market and the perception of the investors about the company.
The equity shareholders are paid dividend out of the profits of the
company. It is not a legal binding for the company to pay dividend to the
equity shareholders. Normally, the equity shareholders are interested in
the capital appreciation. Thus, if some better opportunity of investment is
available in the market, then the company can take decision regarding
non-payment of dividends and invest the retained amount in that
profitable avenue of investment. But, still, while making investment, as
equity shareholders expects a company to make sufficient return on their
investment, enough to cover the market risk. A number of approaches are
used to compute cost of equity, to ensure sufficient return to the equity
shareholders, as follows:
a) Dividend Yield method: Under this method, cost of equity capital is
computed with the rate of return required by the equity shareholders,
which is equal to the present value of the expected dividends discounted
at the rate of return required by the equity shareholders.

D D
Ke= or
NP MP

Ke= Cost of equity capital; D= Expected Dividend per share; NP= Net
Proceeds per share; MP= Market Price

Example 4: A company issues 5000 equity shares of Rs. 500 each. The
company has been paying 20% dividend to equity shareholders for the
past five years and expects to maintain the same in future also. Compute
the cost of equity capital.
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D
Solution: Ke=
NP
20
= ×100
ǡ00

Ke = 4%

Example 5 : A company issues 10000 equity shares of Rs. 100 each at a

premium of 10%. The company has also been paying 10% dividend to
the equity shareholders for the past 4 years and expects to maintain the
same in future also. Compute the cost of equity capital.
𝐷
Solution: Ke=
𝑁𝑃
10
= ×100
110

Ke = 9.09%

b) Dividend Yield plus Growth in Dividend Method: The basic

computation of this method is same as dividend yield method, the only
difference is that, this method is used when the dividends are expected to
grow at a constant rate and dividend-pay-out ratio is constant.
D1 (n  m)P1  (I  E) + G or D1 + G
Solution: Ke= +G=
NP (1 k) MP

Ke= Cost of equity capital ; D= Expected Dividend per share ; NP= Net
Proceeds per share ; MP= Market Price ; G= Rate of growth in dividends;
D0= Previous year’s dividend

Example 6: A company issues 5000 equity shares of Rs. 500 each. The
company pays a dividend of Rs.20 per share initially and the growth in
dividends is expected to be 5%. Compute the cost of equity capital.
Do
Solution: Ke= +G
NP
20
= +5
ǡ00
= 4%+5%

Ke = 9%

Example 7: The cost of equity capital is 15.5%. The company had paid
dividend of Rs.4 per share last year. Investors expected growth in the rate
of dividend of 7 per cent per year. Calculate the market price per share.

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D0 (1 g)
Solution: Ke= G
MP

4(1 0.07)
15.5% =  7%
MP
4෸2⺂
15.5% - 7%=
MP
MP = Rs. 50.35

b) Earning Yield Method: Under this method, cost of equity capital is

computed with the rate of return required by the equity shareholders, that
equates the present value of expected future earnings per share with the
net proceeds.

EPS EPS
Ke= or
NP MP
where, EPS is the earning per share, NP= Net Proceeds, MP= Market
Price

Example 8: A firm is considering an expenditure of Rs. 40 lakhs for

expanding its existing business operations. The related information is
given as follows:

Rs.
Number of existing equity shares 10 lakhs
Market value of existing share 20
Net earnings 50 lakhs
Compute the cost of equity share capital.
Net earnings ǡ0䉰00䉰000
Solution: EPS =
No෸ of existing equity shares
= 10䉰00000
= Rs. 5

EPS
Ke=
NP
ǡ
Ke = ×100
20
Ke= 25%

d) Capital Asset Pricing Model: It is the most commonly used method

for computation of cost of equity. This method considers a linear relation
with risk and return characteristics of securities. If an investor wants to
earn higher return on securities, then he will have to bear more risk, and
vice-versa. Under this method three variables are included in the
computation of cost of equity:
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(i) Rf is the risk free rate on securities such as government securities.
(ii) β is the beta coefficient that represents the systematic risk of the
equity stock in relation to the market.
(iii) Rm is the rate earned in the market, such as on NSE Nifty index.
The formula for determining cost of equity under CAPM is given by:

Ke= Rf + β (Rm - Rf )
where Ke is the rate of return of security; Rf is the risk free rate; β is
the beta of the security, sensitivity of a security to change in market
movements; Rm is the rate of return on the market portfolio.

Example 9: Z Ltd. has issued equity shares with β of 1.30. The estimated
market return is 10% and the risk free rate based on government
securities is 5.5%. Calculate cost of equity capital based on CAPM
model.

Solution: Ke= Rf + β (Rm - Rf )

Ke=5.5% + 1.30( 10%-5.5%)

Ke= 11.35%

3. COST OF PREFERENCE SHARES: The cost of preference shares

is the fixed rate of dividend payment to preference shareholders. They
can be discussed under two categories:

a) Irredeemable Preference shares: The cost of irredeemable

preference shares is:
D
KP =
NP
Example 10: A company issues 20,000 10% preference shares of Rs.
100 each. Calculate cost of preference share capital, if these shares are
issued at (i) par (ii) at premium of 5% (iii) at a discount of 10%
𝐷
Solution: Cost of Preference share capital, KP=
𝑁𝑃
2䉰00䉰000
(i) KP = ×100
20䉰000䉰00

KP = 10Ⰲ
2䉰00䉰000
(ii) KP = ×100
20䉰000䉰00+1䉰00䉰000

KP = 9෸ǡ2Ⰲ
2䉰00䉰000
(iiI) KP = ×100
20䉰000䉰00−2䉰00䉰000

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KP = 11෸11Ⰲ

b) Redeemable Preference shares: The cost of redeemable preference

shares is:

MV-NP
D+
KP = n
1
(MV+NP)
2

KP = Cost of Preference share capital; D= Dividend ; MV= Maturity

value of preference shares ; NP= Net Proceeds ; n= number of years to
maturity.

Example 11: Almora company ltd. has preference shares having face
value of Rs. 150 per share. The dividend rate is 10% p.a. The shares are
redeemable after 10 years at par. The net amount realized per share is Rs.
90. Determine the cost of preference capital.

MV-NP
D+
Solution: KP = n
1
(MV+NP)
2

150-90
10+
= 1 10
(150+90)
2
10+6
=
120
KP = 13.33%

4. COST OF RETAINED EARNINGS: Cost of retained earnings is

similar to cost of equity because retained earnings belong to shareholders
only. It is the amount of profits not distributed to shareholders, when
they agree to forego it to allow the company to invest the profits in some
profitable investment avenues. In other words, it is the opportunity cost
of dividends foregone by the shareholders.

Kr = Ke (1-t) (1-b)

Kr = Cost of retained earnings; t= tax rate ; b= cost of purchasing new

securities for shareholders.

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Example 12: The cost of equity capital of a firm is 10%, the average tax
rate of the shareholders is 40% and it has been expected that while
investing in alternative securities, shareholders will have to bear 1.5 %
brokerage cost . Compute cost of retained earnings.
Solution: Kr = Ke (1-t) (1-b)

Kr = 10 (1-0.4) (1-0.015)

Kr = 10 (1-0.4) (1-0.015)

Kr = 5.91%

B. COMPUTATION OF WEGHTED AVERAGE COST OF

CAPITAL(WACC)

As discussed above, under WACC, assigns weights to

different sources from where capital has been raised by the company.
The weights are assigned according to the proportion of a specific source
in the total capital of the company. It is calculated as follows:

WACC= wEkE + wPkP + wDkD (1-tC) + wrkr

Where WACC is the weighted average cost of capital; wE is the

proportion of equity ; rE is the proportion of equity; wP is the
proportion of preference, rP is the cost of preference; wD is the proportion
of debt; rD is the cost of debt, and t C is the corporate tax rate; wr is the
proportion of retained earnings; kr is the cost of retained earnings.

The following example illustrates the calculation of WACC of B Limited

Company:

Example 13: The different sources of finance, their amount and cost of
raising from particular sources are given below:
Source of Capital Amount Cost
Equity 1,20,000 16.0%
Preference 10,000 14.0%
Debt 70,000 8.4%
Total amount =
2,00,000

Compute the weighted average cost of capital.

Solution:
Computation of Weighted Average Cost of Capital
(1) (2)= (1) / (3) (4) = (2)
Total X (3)

amount
Source of Amount Proportion(W) Cost Weighted
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Capital Cost
Equity 1,20,000 0.60 16.0% 9.60%
Preference 10,000 0.05 14.0% 0.70%
Debt 70,000 0.35 8.4% 2.94%
Total
amount =
2,00,000
WACC=
13.24%

Relevance of After tax Weighted Average Cost of Capital: The

interest paid on debt is a tax-deductible expense. So, debt is is
considered as a cheaper cost of debt. Accordingly, it should reduce the
weighted average cost of capital. But it does not happen. This is because,
as the proportion of debt is increased, the risk for equity shareholders
increases, thereby resulting in increase in cost of equity, which nullifies
the benefit of cheaper source of debt.

5. MARGINAL COST OF CAPITAL:

 Marginal Cost refers to the additional or incremental cost of new
capital raised by a firm. The overall marginal cost of additional
funds is calculated on the basis of market value weights because
the new funds are to be raised at the market values. A capital
structure based upon the market value weights indicates that the
amount of debt and equity and debt are constantly adjusted for
the change in the value of the firm. The cost of capital calculated
on the basis of market value weights reflects true economic
values , but because due to rapid fluctuations in the market
prices of the securities, it becomes difficult to use market value
weights.

6. SELF ASSESSMENT TEST

1. A limited company issues 5000 8% debentures of Rs. 100 each at a
premium of 10%. The tax rate applicable to the company is 50%.
(Ans. Kda= 4%)

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2. A company raised preference share capital of Rs. 1,00,000 by the issue
of 12% preference share of Rs. 100 each. Find out the cost of preference
share capital, issued (a) 12% premium and (b) 12% discount
(Ans. a. KP = 10.7% b. KP = 13.63% )

3. The following table shows the capital structure of B limited company.

Determine the weighted average cost of capital.
Source of Finance Amount(Rs) Cost (%)
Preference shares 2,00,000 12%
Equity share capital 3,00,000 15
Retained Earnings 1,50,000 15
Debentures 3,50,000 10
( Ans. WACC= 12.65%)

4. Dividend per share of a firm is Rs. 10. The cost of equity is expected
to grow at 5% per annum. Calculate the cost of equity capital, assuming
the market price per share as Rs. 25.
(Ans. Ke= 45%)
5. Y Ltd. has issued equity shares with β of 1.25. The estimated market
return is 11% and the risk free rate based on government securities is
15%. Calculate cost of equity capital based on CAPM model.
(Ans. Ke= 16%)

6. A limited company issues 14% debentures of Rs. 100 each. Cost of

issue is Rs. 5 per share. Calculate cost of preference share capital if the
shares are issued at discount of 5%.
(Ans. 15.55%)

7. Compute the after tax cost of debt, a company pays tax at 50% rate:
(i) a perpetual bond sold at par, coupon rate of interest being 10%.
(ii) a 10 year, 10% Rs. 750 per bond sold at Rs. 500 less 4%
underwriting commission.
(Ans. i. 5% , ii. 12.5% )

8. A company issues 5000 equity shares of Rs. 100 each at a premium of

5%. The company has also been paying 10% dividend to the equity
shareholders for the past 4 years and expects to maintain the same in
future also. Compute the cost of equity capital.
(Ans. 9.52% )

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9. The cost of equity capital is 10%. The company had paid dividend of
Rs.1 per share last year. Investors expected growth in the rate of dividend
of 6 per cent per year. Calculate the market price per share.
(Ans. Rs. 25)

10. The cost of equity capital of a firm is 15%, the average tax rate of the
shareholders is 40% and it has been expected that while investing in
alternative securities, shareholders will have to bear 1% brokerage cost.
Compute cost of retained earnings.
(Ans. 8.91%)
11. A firm is considering an expenditure of Rs. 60 lakhs for expanding
its existing business operations. The related information is given as
follows:
Rs.
Number of existing equity shares 15 lakhs
Market value of existing share 40
Net earnings 70 lakhs
Compute the cost of equity share capital.
(Ans. 11.67%)

12. From the following information, calculate the weighted average cost
of capital of the company:
Source of fund Cost(%) Weight
Preference shares 12 20
Equity 15 30
Retained earnings 15 15
Debentures 10 35
(Ans. 12.65%)

13. From the following information, calculate the cost of capital for each
source of capital and also the weighted average cost of capital of the
company:
Source of fund Book Value(Rs.)
9% Preference shares @ 100 each 2,00,000
Equity Shares @100 each 8,00,000
Retained earnings 4,00,000
11% Debentures 6,00,000
(Ans. Ke=18.12 % , Kd= 7.7% , Kp=9% , Kr= 14.5 and Ko= 13.36%)

14. The dividend per share of a firm is expected to be Rs. 1 per share
next year and is expected to grow at 6% per year annually. Determine the
cost of equity capital, assuming the market price per share to be Rs. 25.
(Ans. Ke=10%)

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15. A company has 15% perpetual debt of Rs. 1,00,000. The tax rate is
50%. Determine the after-tax cost of capital assuming the debt is issued
(i) at par (ii) 10% discount (iii) 10% premium.
(Ans. (i) at par: Kdb= 15% , Kda= 7.5% ; (ii) at discount: Kdb= 16.7% ,
Kda= 8.3% ; (iii) at premium: Kdb= 13.6% ,
Kda= 6.8% )

7. SUMMARY
 The cost of capital of a firm is the minimum expected rate of
return that the investors or lenders of money want to earn for the
time and risk accepted by them.
 The concept of cost of capital is of vital importance for a)
evaluation of investment proposals. (b) for appraisal of
performance of management. (c) for deciding optimal capital
structure of the firm.
 The cost of each source of capital is termed as specific cost of
capital.
 The overall cost of capital is also known as weighted average cost
of capital(WACC).
 In weighted average cost of capital, each source of capital is
assigned a weight according to its proportion in the total capital
of the company.
WACC= wEkE + wPkP + wDkD (1-tC) + wRkR , where WACC
is the weighted average cost of capital; wE is the proportion of
equity ; rE is the proportion of equity; wP is the proportion of
preference, rP is the cost of preference; wD is the proportion of
debt; rD is the cost of debt, and t C is the corporate tax rate; wR is
the proportion of retained earnings; kRis the cost of retained
earnings.

 The cost of debt is the interest payable on borrowings.

 The cost of debt is calculated after making adjustment for the tax.
This is because interest on debt is a tax deductible expense.
Kda = Kdb(1-t) , where Kda is the cost of debt after tax, Kdb is
cost of debt before tax, t is the corporate tax rate.

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 The cost of equity is the dividend payable to the shareholders.
Normally, shareholders wants a growth in their dividend
D (1 g)
payments. It is calculated as: 0 G
NP
where, Ke= Cost of equity capital ; NP= Net Proceeds
per share ; MP= Market Price ;
g = Rate of growth in dividends; D0= Previous year’s
dividend

 Another method to compute cost of equity is CAPM. This is

considered as more objective method, as it considers three key
variables in computation of cost of equity: risk free rate, market
risk and market return.
Ke= Rf + β (Rm - Rf ), where Ke is the rate of return of
security; Rf is the risk free rate; β is the beta of the security,
sensitivity of a security to change in market movements; Rm
is the rate of return on the market portfolio.

 The cost of preference share capital is the agreed rate of dividend

payable to preference shareholders.
 The cost of retained earning is same as cost of equity, except for
adjustments related to tax on dividend income and brokerage
costs on purchase of new securities, if paid by investors, are done.
 The marginal cost of capital is the additional or incremental cost
of new capital raised by a firm.
 Marginal cost of capital is calculated on the basis of market value
weights.

8. SUGGESTED READINGS

 Khan and Jain, “Financial Management”, 2011, MH.

 I M Pandey, “Financial Management”, 2010, Vikas.
 Srivastava, R.M., “Financial Management”, 2017, HPH.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008,
Pearson.
 Banerjee, B, “Financial Policy and Management Accounting”,
2005, PHI.
 Chandra, P., “Financial Management”, 2015, TMH.
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 http://swayam.gov.in
 http://edx.org

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Section-C Leverage and Capital Structure

Structure
Unit Objectives
1. Introduction
2. Business Risk
3. Trading on Equity
4. Capital Structure Decisions
5. Various capital structure theories
6. Questions and Exercises
7. Let sum up

1. UNIT OBJECTIVES

 Understand the concept of leverage

 Discuss different types of leverages
 Understand the concept of financial leverage and degree of
financial leverage
 Understand the concept of operating leverage and degree of
operating leverage
 Study the risks associated with operating leverage and financial
leverage

2. INTRODUCTION

A firm has to undertake a number of financing and investment

decisions, keeping in mind its two key objectives of profit maximization
and wealth maximization. It may easily evaluate the profitability of the
project but that same project will be considered as worth if it will be able
to maximize the wealth of the shareholders. The shareholders wealth is
maximized when there is increase in the market value of the firm. It
reflects that while taking any investment decision, financing decision is
involved. Financing decision involves deciding the sources of financing
options for making investment. As number of financing alternative are
available like financing through issue of equity shares, preference shares,
debt and retained earnings. So, the company will make choice of

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financing decision depending upon its effect on the market value of the
firm.

Concept of leverage
The term ‘leverage’ has been derived from the French word
‘lever’ which means ‘to lift’ or to ‘raise’. Technically, lever is used to
magnify the force to help lift up heavy objects. In the same terms, lever
in ‘finance’ is used to magnify the shareholder’s earnings. In the field of
finance, fixed costs i.e. fixed operating costs and fixed financing costs
acts as lever and are used to magnify the earnings of the shareholders. In
other words, leverage can be categorized into financial leverage and
operating leverage. Leverage concerned with the financing activities of a
firm is known as financial leverage, while leverage concerned with
acquisition activities of a firm is termed as operating leverage. Financial
leverage and operating leverage together makes up ‘total leverage’. The
following section covers discussion on different types of leverages:

3. FINANCIAL LEVERAGE

While making investment decisions, a number of financing

options are available to a firm. It can finance its activities using equity
shares, preference shares or debt. Equity shareholders holds residual
claim on the income and assets of the firm. While the preference
shareholders and debt carry fixed rates of payment by a firm. Though,
there is no legal binding on the firm for payment of dividend to
preference shareholders, but otherwise preference shareholders get fixed
amount of dividend when the firm earns profits. But, the interest payable
on debt is not only fixed but is also an obligatory payment for a firm.
When the firm uses sources of funds having fixed-charges (preference
share capital and debt) with the owner’s equity, it is termed as financial
leverage.
Financial leverage is considered as a double edged sword. From
one side, it can magnify the earnings of the shareholder, but from other
side, it can also result in shrinkage in the earnings of the equity
shareholders. For example, if a company borrows Rs. 10 lakhs at 10
percent rate of interest and further invest that amount, from where it is

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expected to earn 15 percent rate of return. The excess rate of return
earned on investment after considering the interest amount, pertains to
equity shareholders. But on the other hand, if a firm is not able to earn
more than the cost of the investment, it will result in decline in the
earnings of the shareholders.

The concept of financial leverage is also termed as trading on

equity. This is because it is the equity that is traded upon. In other words,
equity is used as a basis for raising of debt by the company, which gives
some surety to the lenders, regarding the repayment of debt by the
company.

 Degree of Financial leverage

The degree of financial leverage reflects the percentage change in
profit after taxes or earnings per share of the company, due to change in
the operating profit (earnings before interest and taxes) of the company.
Ⰲchange in EPS EBIT
Degree of Financial Leverage(DFL) = or
Ⰲchange in EBIT EBT
EBIT
or
EBT−I−(PD/1−t)

EPS is calculated as:

Profit after tax
Earnings per share (EPS) =
Number of shares

Where, EPS= Earnings per share; EBIT= Earnings before interest and
taxes; EBT= Earnings before tax; PD= Preference dividend; I=
Interest on debt; t = corporate tax rate.

Example 1: Ramesh and Sons has a sales worth Rs. 10,00,000 and its
total operating cost consists of Rs.8,00,000 as variable costs and Rs.
40,000 as fixed costs. Interest payable on debt is Rs.2,000 annually. The
preference dividends of Rs. 1000 are to be paid every year. The tax rate
applicable to the company is 20%. Calculate degree of financial leverage.
Solution:
Sales Rs. 10,00,000
Less: Variable costs Rs. 8,00,000
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Less: Fixed Costs Rs. 40,000
EBIT Rs. 1,60,000

EBIT
Degree of Financial leverage(DFL) =
EBT−I−(PD/1−t)

1䉰60䉰000
=
1䉰60䉰000−2000−(1000/1−0෸2)

1䉰60䉰000
=
1䉰60䉰000−2000−12ǡ0

1䉰60䉰000
=
1䉰ǡ6䉰7ǡ0

1䉰60䉰000
=
1䉰ǡ6䉰7ǡ0
DFL=
1.02
Example 2: EBIT is 4000, interest payment is 1000, dividend to be paid
to preference shareholders is 900 and number of shares are 5000. Tax
rate is 50%. Compute Degree of financial leverage.
Solution:
EBIT 4000
Interest 1000
EBT(Earnings before taxes) 3000
Taxes 1500
Profit after taxes(PAT) 1500
EBIT
Degree of Financial leverage(DFL) =
EBT−I−(PD/1−t)

4䉰000
=
4䉰000−1䉰000−(900/1−0෸ǡ)

4䉰000
=
4䉰000−1䉰000−1䉰⺂00

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4䉰000
=
1䉰200

4䉰000
=
1䉰200
DFL=
3.33
4. OPERATING LEVERAGE

Operating leverage implies change in the operating profits(EBIT)

of the company, due to presence of fixed operating costs. Here, fixed
operating costs acts as a lever, in magnifying the profits of the firm. The
higher the proportion of fixed costs to the total costs, the higher will be
the operating leverage of the firm. Table 1 illustrates the relationship of
degree of operating leverage with the selling price, variable costs and
fixed costs.
Table 1: Relationship of degree of operating leverage with the selling
price, variable costs and fixed costs
DOL Selling Price Variable Cost Fixed Cost
Increases Decreases Increases Increases
Decreases Increases Decreases Decreases

Thus, while financial leverage has an effect on earning per share

or profit after taxes of the company. On the other hand, operating
leverage affects the firm’s operating profit(earnings before interest and
taxes).

 Degree of operating leverage

The degree of operating leverage is defined as the percentage
change in the operating income (EBIT) of the firm, with a given
percentage change in sales.

Ⰲchange in EBIT
Degree of Operating Leverage (DOL) = or
Ⰲchange in Sales
Contribution EBIT+FC
or
EBIT EBIT

where, EBIT= Earnings before interest and taxes ; FC= Fixed Costs

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Interpretation for operating leverage: The degree of operating
leverage indicates by what percentage the EBIT will change, as a result
of percentage change in sales.

Example 3. A firm has an expected sales volume of 1,50,000 units, sale

price per unit is Rs.7, variable cost per unit is Rs. 3 and fixed costs of a
firm are equal to Rs.2,80,000. Compute Degree of operating leverage.

Sales(1,50,000 @ Rs. 7) Rs. 10,50,000

Less: Variable costs( 1,00,000 @ Rs. 3,00,000
Rs.3)
Contribution 7,00,000
Less: Fixed Costs Rs. 2,80,000
EBIT Rs. 4,70,000
Contribution
Degree of Operating Leverage (DOL) =
EBIT

7䉰00䉰000
=
4䉰70䉰000
DOL

= 1.48

Example 4 A company as sales worth Rs. 7,00,000 and its total

operating costs includes variable costs of Rs. 400,000 and fixed costs of
Rs. 50,000. Calculate DOL.

Sales(1,50,000 @ Rs. 7) Rs. 7,00,000

Less: Variable costs( 1,00,000 @ Rs. 4,00,000
Rs.3)
Contribution 3,00,000
Less: Fixed Costs Rs. 50,000
EBIT Rs. 2,50,000

Contribution
Degree of Operating Leverage (DOL) =
EBIT

3䉰00䉰000
=
2䉰ǡ0䉰000

DOL = 1.2

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Example 4 A company has sales volume of 6,00,000 units, sale price per
unit is Rs.8, variable cost per unit is Rs. 2 and fixed costs of a firm are
equal to Rs.1,00,000. Compute Degree of operating leverage.

Solution:
Sales(6,00,000 @ Rs. 8) Rs. 48,00,000
Less: Variable costs( 6,00,000 @ Rs. 12,00,000
Rs.2)
Contribution 36,00,000
Less: Fixed Costs Rs. 1,00,000
EBIT Rs. 35,00,000

Contribution
Degree of Operating Leverage (DOL) =
EBIT

36䉰00䉰000
=
3ǡ䉰00䉰000

DOL
= 1.02

5. COMBINED LEVERAGE

Financial leverage and operating leverage together comprise the

combined leverage or the total leverage (TL). The financial and
operating and financial leverages in combination results in higher
variation in earning per share of the company, for a given level of change
in the sales of the company. The higher the operating and financial
leverages, the higher will be the effect on the EPS.
Degree of combined leverage(DCL) : The degree of combined leverage
is given by the following equation:
Degree of combined leverage(DCL) = DFL × DOL

Ⰲchange in EBIT Ⰲchange in EPS

= ×
Ⰲchange in sales Ⰲchange in EBIT
Ⰲchange in EPS
Degree of combined leverage(DCL) = Ⰲchange in sales
or
Contribution
EBT

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DCL( in units) =
Q(S−V)
Q S−V −FC−I

where, Q is the quantity produced, S is the selling price per unit, V is the
variable cost per unit, I is the interest paid on debt, FC is the fixed costs,
EBT is the earnings before taxes.

Example 5 A company has sales of Rs. 25,00,000 and variable costs of

Rs. 13,00,000. The fixed costs are Rs. 3,00,000. The debt of the firm is
Rs. 9,00,000 at 10%. Determine:
a. Financial leverage
b. Operating leverage
c. Combined leverage

Solution:
Sales Rs. 25,00,000
Less: Variable costs Rs. 13,00,000
Contribution 12,00,000
Less: Fixed Costs Rs. 3,00,000
EBIT Rs. 9,00,000
Less: Interest 90000
EBT 8,10,000

EBIT
(a) Degree of financial leverage(DFL) =
EBT

9䉰00䉰000
=
⺂䉰10䉰000

DFL = 1.11
Contribution
(b) Degree of operating leverage(DOL) =
EBIT

12䉰00䉰000
=
9䉰00䉰000

DOL = 1.33

(c) Degree of combined leverage(DCL) = DFL × DOL

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= 1.11 × 1.33

DCL= 1.48

Example 6 A firm has debt of Rs. 5,00,000 raised at 10% rate of interest.
Selling price per unit is Rs. 45 per unit. The fixed costs of the company
are Rs. 1,00,000 and the number of equity shares are 15,000. Determine
the degree of combined leverage at 10,000 units of production . The
variable cost is Rs. 20 per unit and the tax rate is 50.
Q(S−V)
Degree of combined leverage(DCL)=
Q S−V −FC−I

= 10䉰000(4ǡ−20)

10䉰000 4ǡ−20 −1䉰00䉰000−ǡ0䉰000

2䉰ǡ0䉰000
=
2䉰ǡ0䉰000−1䉰00䉰000−ǡ0䉰000
DCL = 2.5

Example 7 Considering the following information , calculate different

types of leverages:
Rs. (in lakhs)
EBIT 1500
PBT 350
Fixed Cost 900

Solution:
Contribution
a) Degree of Operating Leverage (DOL) =
EBIT

EBIT+FC
=
EBIT

1ǡ00+900
=
1ǡ00

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DOL = 1.6
EBIT
b) Degree of financial leverage(DFL) =
EBT

1ǡ00
=
3ǡ0

DFL = 4.2
(c) Degree of combined leverage (DCL) = DFL × DOL

= 1.6 × 4.2

DCL= 6.72

Example 8 From the following information, calculate degree of

operating leverage, financial leverage and combined leverage of the
company:
Rs.
Sales 7,00,000
Variable Cost 2,50,000
EBIT 4,00,000
Interest 1,50,000
Earnings before taxes 2,50,000
Taxes @ 50% 1,25,000
Net earnings 1,25,000

Contribution
Solution (i)Degree of operating leverage (DOL) =
EBIT

Sales−Variable Cost
=
EBIT

7䉰00䉰000−2䉰ǡ0䉰000
=
4䉰00䉰000

DOL=1.12
EBIT
(ii) Degree of Financial Leverage (DFL) =
EBT

4䉰00䉰000
=
2䉰ǡ0䉰000

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DFL= 1.6
(iii) Degree of combined leverage (DCL) = DFL × DOL

= 1.6 × 4.2

DCL = 6.72
Example 9 Calculate operating leverage and financial leverage from the
information given in the following table:
Sales(units) 45,000
Selling price per unit 20
Variable cost per unit 15
Fixed cost Rs. 60,000
Interest 15,000
Tax(%) 50
Number of equity shares 10,000

Solution:
Sales(45,000 X 20) 9,00,000
Variable cost(45000 X 15) 6,75,000
Contribution(S-VC) 22,5,000
Fixed cost 60,000
EBIT 1,65,000
Interest 15,000
EBT 1,50,000
Tax( 50 %) 75,000
Profit after tax 75,000

Contribution
(i) Degree of operating leverage (DOL) =
EBIT

22䉰ǡ000
=
1䉰6ǡ䉰000

DOL=1.36
EBIT
(ii) Degree of Financial Leverage (DFL) =
EBT

1䉰6ǡ䉰000
=
1䉰ǡ0䉰000

DFL= 1.1

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6. RISKS ASSOCIATED WITH LEVERAGE

There are mainly two types of risks that are associated with operating
leverage and financial leverage of a firm:
a) Business Risk
b) Financial risk

a) OPERATING LEVERAGE AND BUSINESS RISK:

The risk that arises due to fluctuations in the operating profits of
the company as a result of change in the sales of the company, is termed
as business risk. The higher the operating leverage of the firm, the
higher will be the business risk. Thus, operating leverage is a double
edged weapon for the company. On one side, it helps the companies to
magnify the profits of the company but the presence of higher fixed costs
may also cause larger fluctuations in the operating profits of the
company.
Business risk may arise due to internal or external factors. The
operating profit(EBIT) component of a firm has two elements:
i. Variability of sales
ii. Variability of expenses
i. Variability of Sales: It is the main determinant for determining
the business risk. The sales of the company may fluctuate due to changes
in business cycle, general economic conditions, shifts in consumer
preferences, change in the management of the company, strike in the
company, etc.
ii. Variability of expenses: Given the change in sales, the EBIT
of the company is also affected due to the proportion of fixed and
variable expenses. The higher the proportion of fixed expenses in
comparison to variable expenses, higher will be the operating leverage.
In turn, higher operating leverage will cause variations in EBIT, when
sales rise. But, when sales of the company are falling, higher operating
leverage causes more variations in the EBIT than the level of change in
the sales.

b) FINANCIAL LEVERAGE AND FINANCIAL RISK:

Financial risk denotes the risk of the inability of the firm to meet its
fixed obligations on specified time. While the business risk may not be
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avoidable by a firm, due to the presence of factors that are not in the
control of the firm. But financial risk can be avoided by a firm. It mainly
arises due to presence of debt component in the capital structure of the
firm. The variability caused in the EPS as a result of variations in EBIT,
is termed as financial risk.
Financial leverage also acts a double edged sword for the firm. When
the firm increases debt proportion in its capital structure, it will result in
increased interest payments for the firm. As interest paid on debt is a tax-
deductible expense, so increased amount of interest will reduce the
taxable profits of the company. Thus, with the use of debt, a company
can save higher payment of taxes.
But on the other hand, higher interest payments may cause financial
distress in the company. This occurs when there is decline in the
operating profits of the company, from which the interest payments are
made by the company. Higher interest payments and lower paying
capacity due to lower operating profits, gives rise to insolvency risk of a
firm and thereby bankruptcy of the firm. Thus, the fixed charges
component on one hand magnify the earning per share of the firm, but
higher fixed charges with lower EBIT may cause higher variability in
EPS. This is known as financial risk.
Hence, financial and operating leverage, no doubt, helps in
magnifying the earning per share of the company and earnings before
interest and taxes, but on the other hand may result in their higher
variability if the company will not be able to generate enough sales and
operating profits, which gives arise to financial and business risks for the
companies.

7. SELF ASSESSMENT

1. Hamir and brothers has sales worth Rs. 7,00,000 and its total operating
cost consists of Rs.6,50,000 as variable costs and Rs. 20,000 as fixed
costs. Interest payable on debt is Rs.2,000 annually. The preference
dividends of Rs. 1000 are to be paid every year. The tax rate applicable
to the company is 20%. Calculate degree of financial leverage.
(Ans. DFL= 1.3)

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2. EBIT is 6000, interest payment is 2000, dividend to be paid to
preference shareholders is 700 and number of shares are 3000. Tax rate
is 50%. Compute Degree of financial leverage.
(Ans. DFL= 2.3)
3. A firm has an expected sales volume of 4,50,000 units, sale price per
unit is Rs.10, variable cost per unit is Rs. 7 and fixed costs of a firm are
equal to Rs.2,80,000. Compute Degree of operating leverage.
(Ans. DOL= 1.26)
4. A company as sales worth Rs. 10, 00,000 and its total operating costs
includes variable costs of Rs. 6, 00,000 and fixed costs of Rs. 30,000.
Calculate DOL.
(Ans. DOL= 1.08)
5. A company has sales volume of 15,00,000 units, sale price per unit is
Rs.9, variable cost per unit is Rs. 5 and fixed costs of a firm are equal to
Rs.2,50,000. Compute Degree of operating leverage.
(Ans. DOL= 1.04)
6. A company has sales of Rs. 20,00,000 and variable costs of Rs.
14,00,000. The fixed costs are Rs. 4,00,000. The debt of the firm is Rs.
10,00,000 at 10% rate of interest. Determine:
a. financial leverage
b. operating leverage
c. combined leverage
(Ans. DCL= 6)
7. A firm has debt of Rs. 7,00,000 raised at 5% rate of interest. Selling
price per unit is Rs. 40 per unit. The fixed costs of the company are Rs.
1,50,000 and the number of equity shares are 10,000. Determine the
degree of combined leverage at 20,000 units of production . The variable
cost is Rs. 10 per unit and the tax rate is 40.
(Ans. DCL= 1.44)
8. Calculate operating, financial and combined leverage for the firm X:
Amount (in millions)
Sales 100
Variable costs 25
Contribution 75
Fixed Costs 35
EBIT 40
Interest 10

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Profit 30
(Ans. DFL= 1.33; DOL= 1.87 and DCL= 2.5)

9. A firm sells its products for Rs. 50 per unit. It has fixed costs of Rs.
2,00,000 per year and variable costs of Rs.20 per unit. Its current level of
sales is 5000 units. Ascertain the degree of operating leverage.
(Ans. DOL=3)
10. Calculate degree of operating leverage of firm J and K:
Sales(Rs.) Variable Fixed costs(Rs.)
costs(Rs.)
Firm J 2000 450 900
Firm K 3000 550 200
(Ans. Firm J: DOL= 2.38 ; Firm K: DOL=1.08)
11. Calculate operating leverage:
Rs.(in lakhs)
EBIT 2000
PBT 500
Fixed cost 700
(Ans. DOL=1.35)

12. From the following information, calculate degree of operating

leverage, financial leverage and combined leverage of the company:
Sales Rs. 5,00,000
Variable Cost Rs. 1,50,000
EBIT Rs. 3,00,000
Interest Rs. 1,20,000
Earnings before taxes Rs. 1,80,000
Taxes @ 50% 90,000
Net earnings Rs. 90,000
(Ans. DOL= 1.17 ; DFL= 1.67 ; DCL= 1.95 )

13. Calculate operating leverage and financial leverage from the

information given in the following table:
Sales(units) 50,000
Selling price per unit 20
Variable cost per unit 15
Fixed cost Rs. 40,000
Interest 20,000
Tax(%) 40
Number of equity shares 15,000
(Ans. OL= 1.19 ; FL= 1.10)

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14. A firm sells its products for Rs. 20 per unit. It has fixed costs of Rs.
80,000 per year and variable costs of Rs.6 per unit. Its current level of
sales is 5000 units. Ascertain the degree of operating leverage.
(Ans. DOL=7)

15. The sales of a company are Rs.6,00,000, variable costs are 0% of

sales, fixed costs equal to Rs. 1,00,000 and interest cost is Rs. 8,000.
Compute degree of financial leverage.
(Ans. DFL=1.032)

8. SUMMARY
 Leverage, in financial terms, refers to use of fixed charges to
magnify the earnings of the shareholders.
 In the field of finance, fixed costs i.e. fixed operating costs and
fixed financing costs acts as lever.
 Use of fixed interest bearing component in the capital structure of
the company is known as financial leverage.
 Financial leverage is also termed as trading on equity.
 Financial leverage reflects the sensitivity o the relationship
between EBIT and EPS of the firm, due to the presence of fixed
financing costs in the capital structure of the compnay.
 If a firm is not able to earn more than the cost of the investment,
then presence of debt in the capital structure of the company will
result in decline in the earnings of the shareholders.
 The degree of financial leverage indicates the percentage change
in profit after taxes or earnings per share of the company, due to
change in the operating profit (earnings before interest and taxes)
of the company.
 The percentage change in the EPS due to a given percentage
change in EBIT is called as degree of financial leverage.
Ⰲchange in EPS
Degree of Financial Leverage(DFL) =
Ⰲchange in EBIT

 Operating leverage implies change in the operating profits(EBIT)

of the company, due to presence of fixed operating costs.
 The higher the proportion of fixed costs to the total costs, the
higher will be the operating leverage of the firm.
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 Operating leverage comprises relationship between the sales and
earnings before interest and taxes(EBIT) of a firm.
 The percentage change in the EBIT due to a given percentage
change in the sales is called as degree of operating leverage.
Ⰲchange in EBIT
Degree of Operating Leverage (DOL) =
Ⰲchange in Sales
 Financial leverage and operating leverage together comprise the
combined leverage
 The higher the operating and financial leverages, the higher will
be the effect on the EPS.

Degree of combined leverage(DCL) = DFL × DOL

Ⰲchange in EPS
DCL =
Ⰲchange in sales

 There are two types of risks that are associated with operating
leverage and financial leverage of a firm: business risk and
financial risk.
 The risk that arises due to fluctuations in the operating profits of
the company as a result of change in the sales of the company, is
termed as business risk.
 Variability of sale and variability of earnings are the main
components of business risk.
 The higher the operating leverage of the firm, the higher will be
the business risk.
 Operating leverage helps the companies to magnify the profits of
the company.
 The presence of higher fixed costs can cause larger fluctuations in
the operating profits of the company.
 The financial risk arises due to the presence of debt component in
the capital structure of the firm.
 The variability caused in the EPS as a result of variations in EBIT,
is termed as financial risk.

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 The fixed charges component on one hand magnify the earning
per share of the firm, but higher fixed charges with lower EBIT
may cause higher variability in EPS. It is known as financial risk.

9. SUGGESTED READINGS

 Khan and Jain, “Financial Management”, 2011, MH.

 I M Pandey, “Financial Management”, 2010, Vikas.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008,
Pearson.
 Banerjee, B, “Financial Policy and Management Accounting”,
2005, PHI.
 Srivastava, R.M., “Financial Management”, 2017, HPH.
 http://swayam.gov.in
 http://edx.org

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1. UNIT OBJECTIVES

 Understand the concept of capital structure and optimum capital

structure
 Explain the relevant theories of capital structure
 Understand valuation of firm under Net Income approach and
Traditional View
 Discuss irrelevant approach of capital structure theories
 Understand valuation of firm under Net Operating Income
approach and MM approach.

2. INTRODUCTION

A company can finance its assets using different short term and
long term sources of finance. The various means through which
companies finance their assets constitutes the financial structure of the
companies. While the composition of debt and equity used by the
companies constitutes their capital structure. Thus,

Short-term + Long-term sources of finance = Financial Structure

(liabilities + equity)

Long-term sources of finance = Capital

structure

The decision regarding appropriate mix of debt and equity

constitutes an important decision for the management of the firm. The
proportion of various long term sources of finance mainly depends upon
their specific costs and the extent of requirement of funds by the firm. As
studied under leverages that the use of fixed charge funds with equity
acts as double edged sword for the firm. If the firm continues to increase
debt in its capital structure, it may result in financial distress for the
company. Thus, an appropriate mix of both debt and equity should be
used in the capital structure. It is considered that optimum capital
structure of the firm helps in maximizing the value of the firm. A number
of theories have been given in this context, whether capital structure
influences the value of the firm or not.

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3. CAPITAL STRUCTURE PATTERNS

Capital structure patterns denote the various options available for

a firm to design its capital structure. A firm can use only equity, debt or
preference shares or a combination of all the patterns depending upon its
resultant earning per share. This is because; it has been seen under
financial leverage concept, that, an inappropriate use of debt could cause
high variability in the EPS of the company. Thus, it is important to
discuss the patterns and study its impact on the earnings per share of the
firm. This will be discussed with the help of following example:

Example 1 The capital structure of a company consists of 20,000 equity

shares of Rs.100 each. The management of the company is planning to
raise further capital of Rs. 40 lakhs to finance a major project in order to
expand its operations. The following alternatives are available to a
company:
(i) To issue 40,000 equity shares of Rs. 100each.
(ii) To issue 40,000, 10% debentures of Rs. 100 each.
(iii) To issue 40,000, 10% preference shares of Rs.100 each.
It has been expected that operating profits(EBIT) of the company will be
Rs.14 lakhs. Assuming a corporate tax rate of 50%, determine the EPS
under each alternative and suggest the best alternative to the company
with the reason for it.
Solution:

(Rs. in lakhs)
Plan I Plan II Plan III
Equity Debt Preference
Financing Financing shares
financing
Earnings before
interest and 14 14 14
taxes(EBIT)
Less: interest - 4 -
Earnings after
interest but before 14 10 14
taxes
Less: tax 7 5 7
Earnings after
7 5 7
tax(EAT)
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Less: Preference
- - 4
dividend
Earnings available
to equity 7 5 3
shareholders
Number of Equity 60,000
20,000 20,000
shares
Earnings per share 11.67
(Earnings
available to equity
25 15
shareholders /
Number of Equity
shares)

Comments: It can be inferred from the above table that earnings per
share is highest in Plan II, i.e. where the company has used debt with
equity. Thus, as the use of debt has helped the company to magnify the
earnings of the shareholders, the company should issue 40,000, 10%
debentures of Rs. 100 each, in order to expand its business operations.
Thus, the pattern of capital structure can influence the value of the firm
through leverage.

4. OPTIMAL CAPITAL STRUCTURE

An optimal capital structure is defined as the capital structure or that

composition of debt and equity in the total capital of the firm that results
in minimization of the overall cost of capital of firm and maximization of
the value of the firm. For this, the companies will have to trade-off
between risks and return arising out of use of debt or no use of debt at all.
If a company will use debt, then it will be able to enjoy the tax shield
provided by the interest on debt, but higher user may result in financial
distress for the company. However, if it will not use debt, then it will not
be able to take benefit of interest tax shield and also has to bear the high
floatation costs for raising funds through equity financing. The following
figure depicts the optimal capital structure and risk arising out of
inclusion or non-inclusion of debt in capital structure of the company.

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Figure 1: Optimal capital Structure

5. CAPITAL STRUCTURE THEORIES

A number of theories have been propounded by different authors

explaining the relationship between the capital structure and the value of
the firm. Based on the effect of capital structure on the value of a firm,
these theories can be categorized as shown below:

5.1. THEORIES RELATED TO RELEVANCE OF CAPITAL STRUCTURE

The relevant view of capital structure theories holds that capital
structure decision is important for the firms. The optimal capital structure
will help the firm to reduce its overall cost of capital and increase the
value of the firm.

5.1.1 The Net Income approach: This approach holds that capital
structure of the firm affects the value of the firm. It states that as
company will increase debt proportion in its capital structure, the
weighted average cost of the firm will decrease and the value of the firm
will be maximized.
This approach is based on the following assumptions:
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(i) The cost of debt (Kd) is less than cost of equity (Ke).
(ii) There are no taxes.
(iii) Firm has an infinite life.
(iv) The cost of debt and cost of equity remains constant,
(v) The overall cost of capital decline with more use of debt.
Based on these assumptions, the overall cost of capital of the firm
will decline and the value of the firm will increase with the more use of
debt in the capital structure. This is because debt is considered as less
costlier source of financing for the firm due to the tax shield available on
the interest payable on the debt. This is shown in the figure 2:

Figure 2: Effect of debt on cost of capital

 Valuation under Net Income approach:

 Value of a firm
The value of the firm can be can be calculated as :
EBIT
V= or V=S+D
ko
where, V is the value of the firm ; S is the market value of equity ; D is
the market value of debt.
 Overall cost of capital
The overall cost of capital under net income approach can be
calculated as follows:
Ko =
EBIT
V
where, EBIT is the earnings before interest and taxes ; Ko = cost of
capital

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 Calculation of Value of firm using Net Income (NI) approach
The working of net income approach can be well understood with the
help of following example:

Example 1: M Ltd. is expecting EBIT of Rs. 2 lakhs. The company has

Rs.5 lakhs, 10% debentures. The cost of equity capital is 12%. Calculate
the total value of the firm using Net Income Approach.
Solution:
Calculation of Value of Firm
EBIT Rs. 2,00,000
Interest
Rs.50000
Earnings available to equity Rs.1,50,000
shareholders
Cost of Equity(ko) 12%
Market Value of Equity (S) Rs.12,50,000
Market Value of Debt (D) 5,00,000
Value of Firm(V = S+D) 17,50,000

Thus, the value of the firm(V) according to Net Income approach =

17,50,000

5.1.2 The Traditional View: This view has emerged as trade-off to the
concept given by the net income approach. According to this view, a firm
can reduce its overall cost of capital and increase the value of firm, with
an appropriate mix of debt and equity in the total capital of the firm. In
other words, the presence of debt in the capital structure of the firm will
result in reduction of overall cost of capital of firm only up to a certain
extent. As the level of debt will be increased, the increased use of debt
will increase the cost of equity because the equity shareholders will
demand more return to cover the risk of increased debt. Thus, with
increased use of debt the overall cost of capital will begin to rise and the
overall cost of capital will also start increasing. This is depicted in Figure
3:

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Figure 3: The cost of capital curve

The traditional view can be discussed in three different stages:

1. First stage: In the first stage, with the use of debt, the cost of equity
rises slightly. This is because in the initial stage the equity shareholders
have optimistic view regarding the use of debt. Thus, the overall cost of
capital will decrease and value of firm will increase.
2. Second Stage: Once a firm has used debt upto a certain extent, any
further use of debt will have negligible impact on the overall cost of
capital of the firm and thus, on the value of the firm also. This is shown
in the above figure, which depicts that at stage two, there is a point where
overall cost of capital is at its minimum level. This happens because the
low cost debt offsets the increased cost of equity.
3. Third stage: The use of debt beyond an acceptable limit (optimal
structure, as shown in figure), will increase the overall cost of capital of
the firm and cause a decline in the value of firm. This is because further
use of debt will increase financial distress of the company and hence the
shareholders will demand high return to cover the financial risk.
It can be briefed that, use of debt upto certain level is accepted by
the shareholders, but use of debt beyond an appropriate and acceptable
level, leads to rise in the overall cost of capital of the firm and a decline
in the value of the firm.

 Calculation of Value of firm using Traditional View

The working of traditional approach can be understood with the help of
following example:
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Example 2: Compute the value of the firm and the cost of capital from
the following information:
Calculation of Value of Firm
Net Operating Income Rs.4,00,000
Total Investment Rs.12,00,000
Equity capitalization rate
a) If the firm uses no debt 12%
b) If the firm uses Rs. 6,00,000 13%
debentures
c) If the firm uses Rs. 8,00,000 14%
debentures
A firm can raise Rs. 6,00,000 debentures at 4% rate of interest, whereas
Rs. 8,00,000 can be raised at 5%.
Solution :
Calculation of Value of Firm and Cost of capital
(a) No debt (b) 4% debt (c) 5%
Net Operating Income(EBIT) 4,00,000 4,00,000 4,00,000
Less: Interest - 24,000 40,000
Earnings available for equity Rs. Rs. 3,76,000 Rs.
shareholders 4,00,000 3,60,000
Equity Capitalisation Rate 12% 13% 15%
Market value of shares(S) 33,33,333 28,92,308 24,00,000
Market value of debt(D) - 6,00,000 8,00,000
Market 33,33,333 34,92,308 32,00,000
value of firm (V= S+D)
Cost of Capital(EBIT/V) 12% 11.4% 12.5%

It is evident from the calculation that, with the inclusion of debt

(use of debt) in the capital structure of the firm, the firm is able to reduce
its cost of capital, but with the further use of debt, there is an increase in
the overall cost of capital of the firm and hence a fall in the market value
of firm also.
Thus, the above example illustrated the traditional view clearly that
only a judicious use of debt and upto an acceptable level only, the overall
cost of capital of the company will decline and the value of the firm will
increase.

Criticism of Traditional view

The authors of traditional view holds that use of debt up to a
certain level is accepted by the equity shareholders , but use of debt
beyond an optimum level leads to increase in cost of capital of firm and
fall in the value of the firm. But, there does not exist any sufficient

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justification regarding the acceptance of debt at different levels by the
shareholders.

5.2. THEORIES RELATED TO IRRELEVANCE OF CAPITAL STRUCTUR

Irrelevant theories of capital structure have given a contrasting

view. According to irrelevant approach, the capital structure of the firm
does not have any effect on the cost of capital of the firm and the value
of the firm. The main theories holding this view are explained below:
5.2.1 Net Operating Income approach: The net operating income
approach states that the overall cost of capital and the value of the firm
are not affected by the capital structure of the firm. David Durand
explained the irrelevance of capital structure for the firm. He viewed
operating income and business risk, as two main aspects, affecting the
value of the firm.
The Net operating income approach is based on the following
assumptions:
(i) The overall cost of capital ( ko ) remains constant at all levels of debt
employed by the firm.
(ii) The capital markets are efficient and the firm operates under zero-tax
environment.
(ii) The value of the firm is independent of the use of debt.
Thus, the main assumption of this operates is that the market
value of the firm is not affected by the composition of debt and equity in
the capital structure. This is justified on the ground that, as the firm
increases the proportion of debt, there is increase in the cost of equity
because the shareholders demand more return in the form of dividend
from the company, to cover the financial risk due to increased debt. This
offsets the benefit provided by debt. Thus the overall cost of capital
remains constant irrespective of amount of debt employed in the capital
structure of the firm (Figure 4).

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Figure 4: Leverage and Cost of Capital

 Valuation under Net Operating Income Approach:

 Value of a firm
EBIT
V=
ko
 Cost of Equity
Cost of Equity (Ke) =
Earnings after Interest and Taxes
Market value of firm−Market Value of Debt
EBIT−I
=
V−D
where, V is the total market value of firm ; D is the Market value of
debt ;

 Calculation of Value of firm using Net Operating Income

Approach
The working of net operating income approach can be understood with
the help of following example:

Example 3: A company expects a net income of Rs. 1,00,000. It has Rs.

1,00,000 10% debentures. The equity capitalization rate is 10%.
Compute the value of a firm and overall cost of capital under Net
Operating Income approach.

Solution:
Calculation of Value of Firm
EBIT 1,00,000
Interest 10000
Earnings available to equity 90,000

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shareholders
Cost of Equity(ko) 10%
Market Value of Firm (V) 9,00,000
Market Value of Debt (D) 1,00,000
Market value of Equity(S = V-D) Rs. 8,00,000

Cost of Equity (Ke) =

Earnings after Interest and Taxes
Market value of firm−Market Value of Debt

EBIT−I
=
V−D

90䉰000
=⺂䉰00䉰000 X 100

Ke = 11.25

5.2.2 Modigliani-Miller(MM) Theory

Franco Modigliani and Merton Miller were the first authors to
make a thorough analysis regarding the decision concerning the capital
structure of a firm. The theory developed by Modigliani and Miller
supported the assumptions of net operating income approach. While, in
1958, M-M approach considered the independence of value of firm from
capital structure in the absence of corporate taxes(MM without taxes). It
was propounded that the earnings of the firm and business risk affects the
value of firm and not by the capital structure of the firm. But in 1963, it
was updated to include the impact of corporate taxes also (MM with
taxes).

5.2.2.1 Irrelevance of Capital Structure: MM Hypothesis without

Taxes
The MM hypothesis can be understood in terms of two set of
propositions:

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1. Propositions I: Irrelevance of Capital Structure
The first set of proposition given by Modigliani and Miller stated
that the market value of the firms belonging to same risk class is not
affected by the proportion of debt and equity in the capital structure.
Proposition I is based on a set of following assumptions:
1. There is perfect capital market.
2. There are no transaction costs.
3. The decisions are taken by the investors rationally.
4. The firm operates in a zero-tax environment.
5. The firms operating under same business conditions have similar risk
classes.

 Value of Firm under Proposition I: The basic assumption of

proposition I is that firms operating under same industry have
homogenous risks and their value is independent of financial
leverage. In other words, the use of debt and equity does not
affect the value(net operating income) of the firm. Thus, the
proposition states that firms having same operating income and
same level of business risks, will have same market value. Hence
the value of levered firm(using debt) will be equal to the value of
unlevered firm (not using debt) and value of firms is given by
capitalizing the operating income by the firm’s opportunity cost
of capital.
Value of levered firm (Vl)
= Value of Unlevered firm (Vu)
Net Operating Income
Value of firm(V) =
Opportunity Cost of Capital
Net Operating Income
Thus, V= Vl = Vu=
Opportunity Cost of Capital
In the absence of corporate taxes, this assumption is similar to net
operating income approach. The net operating income(EBIT) of a firm
and value of the firm are not affected by the use of debt and
equity(financial leverage) in the capital structure. Thus, the overall cost
of capital will also remain constant irrespective of financial leverage.

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 Arbitrage Process: The justification for the MM hypothesis is
given through arbitrage process. Arbitrage refers to an act of
buying an asset or a security in one market at low prices, then
selling that in another market at higher price. It is basically a
balancing mechanism, which implies that two assets cannot be
sold at different prices. The first proposition of MM hypothesis
states that firms belonging to same risk classes have identical
assets, irrespective of how the assets have been financed by the
firms, cannot have different market values. This is because even
if the firms will be having different market values, then the
investors will engage in the arbitrage process and create personal
leverage, thus neutralizing the difference between the market
values of two firms. This can be understood with the help of
following example:
Example 4 There are two companies A and B, which are identical in
all respects except for their capital structure. Both the companies have
earnings of Rs. 60,000. Company B is 28% leveraged and the cost of
debt is 5% per annum per annum. Company B is unlevered. The
following information is given:
A B
EBIT Rs.60,000 Rs.60,000
Interest - 9,000
Earnings available to Rs.60,000 Rs.51,000
equity shareholders
Cost of Equity(ko) 10% 11%
Market Value of Equity Rs.6,00,000 Rs.4,63,636
Market Value of Debt - Rs.1,80,000
(D)
Market value of Firm Rs. 6,00,000 Rs. 6,43,636
What will be the cost of capital for both the firms?
Operating Income(EBIT)
Solution: ko =
Market value of firm(V)
Operating Income(EBIT) 60䉰000
For Firm A, Ko =
Market value of firm(V)
= 6䉰00䉰000
= 10%
Operating Income(EBIT) 60䉰000
For Firm B, Ko = = = 9.32%
Market value of firm(V) 6䉰43䉰636
The above example illustrates that the value of a levered firm(A)
is more than unlevered firm(B), as viewed by the authors giving
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argument for relevance of capital structure for having an effect on the
value of firm. But Modigliani and Miller took their views forward and
argued that two identical firms except for their difference in capital
structures cannot have different market values. Even if the market value
is found different (as in above example) the investors will engage in
arbitrage process and hence the values of both the firms will become
identical.

2. Proposition II: Relevance of Capital Structure

The first proposition of the MM approach stated that the value
of the firm is not affected by financial leverage. But in the presence of
corporate taxes, financial leverage has an impact on the shareholder’s
returns. Proposition 2 states that when the company will use debt with
equity in its capital structure, the financial risk of the shareholders will
increase, thereby causing variability in the earning per share of the firm.
Due to increased financial risk, shareholders will demand more return on
their investment. As a result, the cost of equity for the firm will increase,
neutralizing the benefit of using debt. Further, when the firm will employ
more debt its capital structure, the cost of equity will start falling,
because due to increase in the amount of interest, lesser share will be left
for shareholders, hence the cost of equity (ke) declines. This is shown in
figure 5. On the other hand, due to excessive use of debt financial risk of
the firm will increase, for which the debt holders will demand more
return (interest) to cover the default risk of the firm, but the overall cost
of capital will remain same. Thus, as a result of financial leverage, only
the cost of debt will increase, cost of equity will fall as a result of transfer
of financial risk to debt holders, while, the cost of capital will remain
same.

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Figure 5: Cost of capital under MM approach

 Proposition II and Valuation: The Proposition II states that

financial leverage affects the shareholders returns. The cost of equity for
an unlevered firm will be equal to its overall cost of capital because of
the absence of debt component in the capital structure (K0=Ke). While,
for a levered firm, the overall cost of capital will remain constant but the
cost of equity will increase, to meet the shareholder’s demand of
premium(compensation) for increased financial risk. Thus, the cost of
equity for a levered firm will be higher than the overall cost of
capital(Ke> K0). As the overall cost of capital will be equal to the sum
of cost of equity and cost of debt, so the overall cost of capital for a
levered firm can be calculated as:
E
Ko = Ke ×
E+D

E
+ Kd ×
E+D

and , with the help of above formula Cost of Equity can be calculated as,
D
Ke= Ko + (Ko-Kd)
E
Example 5: H Limited is an all equity financed company. It has 20,000
outstanding shares. The market value of these shares is 2,20,000. The
expected EBIT is 40,000.
(i) Compute EPS and cost of equity for an unlevered firm.

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(ii) Compute EPS and cost of equity for levered firm if it raises debt of
Rs. 1,00,000 at 6% rate of interest and the company is buying back
equity of Rs. 10,000 with market value of Rs. 1,00,000.
Solution: (i) EPS and cost of equity for an unlevered firm
Earnings available for equity shareholders 40䉰000
EPS= = =
No෸ of equity shares 20000
Rs. 2
As H Ltd. is an unlevered firm, so the cost of equity will be equal to the
overall cost of capital of the firm.
Expected NOI
Ko = Ke =
Market value of debt and equity
40䉰000
=
220000
40䉰000
=
220000
Ke = 0.18 or 18.18%
Thus, for an unlevered firm cost of equity comes out to be 18.18%.
(ii) EPS and cost of equity for levered firm:
Earnings available for equity shareholders 40䉰000−6000
EPS= =
No෸ of equity shares 10000
= Rs. 3.4
The EPS of the H Ltd. has increased by 70 per cent due to presence of
financial leverage. If there is fluctuation in the net operating company of
the company, then more variability will be caused in the EPS of the
company. But, as the net operating income of the company has not
changed, so the overall cost of capital of H Ltd. will not change and will
remain at 18.18%. But, the cost of equity will rise as a result of increased
financial risk. It can be calculated as follows:
Ke=
D
Ko + (Ko - Kd)
E

= 0.18 + (0.18 – 0.06) 1䉰00䉰000

1䉰00䉰000

= 0.3 or 30%

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Thus, the overall cost of capital has remained constant, but the cost of
equity has increased to 30% , due to use of financial leverage.
Criticism of MM Hypothesis:
1. All the firms cannot borrow at same rates of interest.
2. The arbitrage strategy does not work due to the presence of transaction
costs.
3. There are restrictions for institutional investors to engage in arbitrage.
4. Due to the presence of corporate taxes, the value of levered firm and
its net operating income will be more than unlevered firm

5.2.2.2 Relevance of Capital Structure: MM Hypothesis with Taxes

MM hypothesis states that the value of the firm is independent of
its capital structure is based on the assumption of absence of corporate
taxes. But in real world, corporate taxes exists and the firm gets
advantage of the interest paid on debt, as debt is a tax deductible expense.
Thus, MM hypothesis holds that the value of the firm will increase with
the use of debt in the capital structure of the firm and the value of the
levered firm will be more than the unlevered firm.
 Value of Firm
 Value of Unlevered firm: Unlevered firm is an all equity
financing firm i.e. that does not employ debt in its capital
structure. So, due to absence of the after-tax income of unlevered
firm will be equal to its after-tax net operating income. The value
of a unlevered firm can be calculated as follows:
Value of unlevered
After tax net operating income
firm=
Unlevered firm's cost of capital
 Value of levered firm: In case of a levered firm, the after-tax
income includes the after-tax non-operating income and the
interest tax shield. Thus, the value of a levered firm will be equal
to the sum of after tax net operating income of unlevered firm
discounted at its opportunity cost of capital(value of unlevered
firm) and the present value of interest tax shield.

Value of Levered firm= Value of Unlevered

firm + Present value of tax shield

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where, Present value of tax shield=
Corporate tax rate ×interest
Cost of debt
Example 6 There are two firms L and U which are identical in all
respects except that L is a levered firm and U is an unlevered firm. U
firm is all equity financed firm while L firm employs equity and debt of
Rs. 10,000 at 10%. Both the firms have EBIT of Rs. 4000, pay corporate
tax rate of 50 percent and has 100 percent dividend payout ratio. The
overall cost of capital for unlevered firm is 12.5%. Calculate value of
levered and unlevered firm.
Solution
Income of Firm U and L under Corporate Taxes
U L
EBIT Rs.4000 Rs.4,000
Interest - 1,000
Earnings available to Rs.4,000 Rs.3,000
equity shareholders
Tax @ 50% 2,000 1,500
Income after tax Rs.2,000 Rs.1,500
Net Income for 2,000 1,500
investors after corporate
tax
Interest payment to debt - 1,000
holders
Net income for Rs.2,000 Rs.2,500
investors
Interest tax shield - 500
Relative tax advantage - 1.25

 Value of Firm
 Value of Unlevered
After tax net operating income
firm=
Unlevered firm's cost of capital
=
2䉰000
0෸12ǡ
Vu = Rs.
16,000

 Value of Levered Firm :

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Present value of tax shield=
Corporate tax rate ×interest
Cost of debt
=
0෸ǡ0×(0෸10×10000)
C

ǡ00
=
0෸10
Present value of tax shield = Rs.5000
Value of Levered Firm = Value of Unlevered firm +
Present value of tax shield
=
16,000 + 5,000
=
Rs.21,000
Thus, when a firm employs debt in its capital structure, then its
value(levered firm) will be more than the unlevered firm. It is
depicted in Figure 6:

Figure
6: Value of a levered firm

6. SELF ASSESMENT

1. X Ltd. is expecting EBIT of Rs. 4 lakhs. The company has Rs.7 lakhs,
10% debentures. The cost of equity capital is 10%. Calculate the total
value of the firm using Net Income Approach.
(Ans. Value of firm = 40, 00,000)
2. Compute the value of the firm and the cost of capital from the
following information:
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Net Operating Income 2,00,000
Total Investment 10,00,000
Equity capitalization rate
a) If the firm uses no debt 10%
b) If the firm uses Rs. 6,00,000 11%
debentures
c) If the firm uses Rs. 8,00,000 13%
debentures
A firm can raise 4,00,000 debentures at 5% rate of interest, whereas Rs.
6,00,000 can be raised at 6%.
Ans. When no debt is used: Value of
firm= Rs. 2, 00,000, Cost of capital 10%
When 4,00,000 debentures issued = Value of firm= Rs.
20,36,363, Cost of capital 9.8%
When 6,00,000 debentures issued = Value of firm= Rs.
18,61,538, Cost of capital 10.7%
3. A company expects a net income of Rs. 70,000. It has Rs. 50,000 10%
debentures. The equity capitalization rate is 10%. Compute the market
value of firm and cost of equity under Net Operating Income approach.
(Ans. V= Rs. 6,50,000 , S = Rs. 6,00,000 ; Ke = 10.83)

4. M Limited is an all equity financed company. It has 15,000

outstanding shares. The market value of these shares is 2,00,000. The
expected EBIT is 30,000.
(i) Compute EPS and cost of equity for an unlevered firm.
(ii) Compute EPS and cost of equity for levered firm if it raises debt of
Rs. 50,000 at 5% rate of interest and the company is buying back equity
of Rs. 5,000 with market value of Rs. 50,000.
(Ans. (i) EPS= Rs.2 , Cost of equity=15% ; (ii) EPS= Rs.5.5 , Cost of
equity=25%)

5. Company A and Company B are identical in all aspects except their

capital structure. Company A is a levered firm, using debt while
company Y is an unlevered firm, that does not use debt. Company A has
Rs. 9,00,000 debentures, carrying 10% rate of interest. Both the
companies have an EBIT at 20% of the total assets of Rs. 15 lakhs.
Assuming tax rate of 50% and the capitalization rate of 15% for B
company, compute the value of company A and company B using Net
Income approach.
(Ans. Value of levered firm: Rs. 16, 00,000 and Value of unlevered firm:
Rs. 10, 00,000)

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6. A company is having current EBIT of Es. 4 lakhs. The firm has Rs.10
lakhs of 10% debt outstanding. Its cost of equity capital is estimated to
be 15%.. Determine the value of firm and overall cost of capital or
capitalisation rate using traditional valuation approach.
(Ans. Value of firm: Rs. 30,00,000 and Overall cost of capital= 13.33%)

7. There are two companies X and Y, which are similar in every respect,
except their capital structure. Company X is an unlevered firm, while
company Y is a levered firm. Company Y has Rs. 20 lakhs of 8%
outstanding debentures. The tax rate applicable to the company is 50%.
EBIT is Rs. 6 lakhs and equity capitalization rate for company X is 10%.
Assuming that all the MM assumptions are met, calculate the value of
firm X and firm Y, using MM approach.
(Ans. Value of firm X= Rs. 30, 00,000 and Value of firm Y= 40,
00,000)

8. The following information is given for company X and company Y,

which are having similar risk classes:
X Y
EBIT 25,000 25,000
Interest 5,000 -
Earnings available to equity 20,000 25,000
shareholders
Cost of Equity(ko) 12.5% 12.5%
Market Value of Firm 2,00,000 2,00,000
Market Value of Debt (D) 1,00,000 -
Market value of Equity 1,00,000 2,00,000
Cost of equity(Ke) 20% 12.5%
Determine the value of X and Y companies under the traditional
approach assuming the cost of capital for X and Y companies to be 14%
and 11% respectively.
(Ans. Firm X, V= Rs. 2,42,857 ; Firm Y, V=Rs.2,27,272)

9. A company’s expected annual net operating income(EBIT) is Rs.

50,000. The company has Rs. 2,00,000, 10% debentures. The equity
capitalization rate(Ke) of the company is 12.5%. Calculate the value of
the firm according to Net Income Approach.
(Ans. V= Rs. 4,40,000)
10. Assuming a firm having no taxes and the interest rate to be 10%,
calculate total market value for each firm from the additional information
given below :
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EBIT Interest Ke
amount
X 2,00,000 20,000 12%
Y 3,00,000 60,000 16%
Z 5,00,000 2,00,000 15%
W 6,00,000 2,40,000 18%
Also determine weighted average cost of capital.
(Ans. Value of firms and weighted average cost of capital : X= Rs.
17,00,000 and 11.76%, Y= Rs.21,00,000 and 14.29%, Z= Rs.
40,00,000 and 12.5%, W= Rs.44,00,000 and 13.63%)

7. SUMMARY

 The various long term sources of finance used by firm to finance its
assets constitute the capital structure of the company.

 Capital structure patterns denote the various options available and

used by a firm to design its capital structure.
 An optimal capital structure is defined as the capital structure of the
firm that results in minimization of the overall cost of capital of firm
and maximization of the value of the firm.
 The Net Income approach and Traditional View theories have
propounded that capital structure of a firm have an effect on the
value of firm and its overall cost of capital.
 The Net Income approach at one extreme agrees on relevance of
capital structure for having its impact on value of firm.
 The Net Operating approach at another extreme viewed the
irrelevance of capital structure for having an effect on the overall
cost of capital and value of firm.
 The traditional view at striking a balance between two extreme
views given by net income approach and net operating income
approach.
 The net income approach holds an extreme view that the use of debt
in the capital structure of a firm, results in reduction of the overall
cost of capital of firm and increase in the value of firm.
 As per traditional approach, the capital structure should be based on
the tradeoff for risk-return characteristics of debt.
 The traditional view holds that the presence of debt in the capital
structure of the firm will result in reduction of overall cost of capital
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of firm only up to a certain extent. After that, as the level of debt
will be increased, the increased use of debt will increase the cost of
equity.
 Modigliani Miller (MM) hypotheses (without taxes) , viewed that
the value of a firm is affected by its investment decisions and not
financing decisions.
 MM proposition I states that the value of firm and overall cost of
capital are not affected by the capital structure of the firm(in absence
of taxes).
 MM Proposition II states that use of debt in the capital structure has
an impact on the cost of equity of the firm, but does not impact the
overall cost of capital of the firm.
 MM hypothesis under corporate taxes holds that the value of the
firm will increase with the use of debt in the capital structure of the
firm and the value of the levered firm will be more than the
unlevered firm.
8. SUGGESTED READINGS

 Khan and Jain, “Financial Management”, 2011, MH.

 I M Pandey, “Financial Management”, 2010, Vikas.
 Horne, Van “Financial Management and Policy”, 2002, Pearson.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008,
Pearson.
 Banerjee, B, “Financial Policy and Management Accounting”,
2005, PHI.
 Chandra, P., “Financial Management”, 2015, TMH.
 Srivastava, R.M., “Financial Management”, 2017, HPH.
 http://swayam.gov.in
 http://edx.org

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Section-D Working Capital Management

Structure
Unit Objectives
1. Introduction
2. Working Capital Management
3. Bank Financing
4. Capital Expenditure Decisions
5. Dividend Decisions
6. Questions and Exercises
7. Let sum up

1. UNIT OBJECTIVES

After studying this module, you will be able to:

 Understand the concept of working capital.
 Discuss the objectives of working capital management.
 Explain approaches of working capital.
 Understand operating cycle.

2. INTRODUCTION

The working capital is the amount revolving capital to meet the day
today requirements of the firm. The other facets of the working capital is
circulating capital, floating capital and moving capital which are required
to meet the immediate requirements of the firm. The "working capital"
means the funds available for day today operations of the enterprise. It
also represents the excess of current assets over the current liabilities
which include the short-term loans. Accounting standards Board, The
institute of Chartered Accountant of India note the
ASB has used the term “working capital” and not “Net working capital”.
Objectives of Working Capital Management
1. Estimating the working capital requirements: The working
capital requirements are normally estimated to the tune of
production policies, nature of the business, length of
manufacturing process, credit policy and so on.
2. Sources of the working capital: The requirement of the working
capital should be met with the help of long term and shot term
resources. The permanent and temporary working capital
requirements should be met out of long term and short term
financial resource respectively.
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Approaches of Working Capital
The approaches of the working capital are classified into two categories
viz the hedging approach and conservative approach:
1. The hedging approach: Under this approach, the maturity of the
financial resources is matched with the nature of assets to be
financed. Permanent working capital is financed by the long-term
financial resources and the seasonal working capital requirements
are met out through short term financial resources.
2. The conservative approach: Acc to this approach, all
requirements of the funds should met out long-term sources. The
short-term resources should be only for emergency requirements.

3. DETERMINANTS OF WORKING CAPITAL

Following are the major determinants of the working capital:
General nature of Business: The nature of the business should be
considered for the determination of working capital only to the tune of i)
cash nature of business ii) sale of services rather than commodities:
These are things considered only on the basis of stock , book volume of
debts and so on.
Production cycle: The need of the working capital is determined on the
basis of duration of the production cycle. The time duration taken by the
manufacturing process should be considered from the stage of raw
materials to the stage of finished goods. If the duration is lengthier may
require the firm to keep more amount of working capital to meet out the
requirements and vice versa.
Business cycle: The cycle of the business should be relatively considered
for the need of working capital. The upswing of the business cycle
requires the business venture to invest more amount of working capital
due more volume of sales, results out of huge volume of stock, book
debts and so on. During the downswing of the business require the
business to have only lesser volume of working capital due lesser volume
of business and so on.
Production policy: The working capital requirement is determined on the
basis of production policy of the firm. Normally the production policy of
the firm is classified on the basis of two methodologies:
(i) The firm produces the goods then and there to the tune of immediate
needs of the market. This may require the firm to meet adversities due to
lack of working capital to meet out, due to in adequate planning. During
the peak season, it requires enormous working capital which may disturb
working conditions of the business venture.
(ii) The steady production policy by considering the futuristic demands,
which will not disturb the long-term prospects of the business venture
due to effective planning.
Credit Policy: The credit policy of the firm is another determinant for
the determination of the working capital. There are two different credit
policies viz liberal and stringent credit policies
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(i) Liberal credit policy: The liberal credit policy may lead to have
greater volume of book debts, greater credit period, huge amount
required for the built of stock; require the firm to have greater amount of
working capital
(ii) Stringent credit policy: Would not require that much of working
capital like the earlier segment.
Growth and Expansion: The growth and expansion prospects of the firm
should be appropriately determined in order to identify the volume of
working capital required during the future, unless otherwise that will
badly affect the future development of the firm.
Acute shortage of the raw materials supply: If the shortage of raw
materials is acute, the firm is required to keep sufficient volume of
working capital to have smooth flow of production process without any
interruptions. In such cases the firm should have additional volume of
working capital not only to avoid interruptions during the production
process due lack of supply of raw materials, but also to enjoy greater
trade discounts during the Working Capital Management bulk purchase
in order to bring down the purchase cost of the raw materials.
Net profit: It is one of the major sources of working capital and
practically speaking it is one of the sources of cash from operations. To
maintain the liquidity, the net profit earning capacity should be
maintained forever.
Dividend policy: The cash dividend payment leads to greater amount of
cash outflows which are more essential to the value of the firm to be
maintained. The value of the firm could also be alternately maintained by
either through the declaration of bond dividend or stock dividend or
property dividend. The later specified methodologies facilitate the firm to
postpone the cash out flow which normally evade the immediate cash
requirement.
Depreciation policy: The depreciation policy of the firm not only
facilitates to bring down the taxable liability but also brings down the
profit which enhances the liquidity of the firm on the other side.
Price level changes: The price level changes require the firm to keep
more amount of working capital to go hand in hand with the price
changes which normally affect the firm's liquidity position. During the
periods of inflation, the firm is required to anticipate the price level
changes which drastically affect the working capital position of the firm.

4. POSITIVE AND NEGATIVE WORKING CAPITAL

Positive working capital generally indicates whether a company is able to

quickly pay off its short-term liabilities. Negative working capital
generally indicates that a company is unable to do so.

This is why analysts are sensitive to decreases in working capital and

may suggest that a company is becoming overleveraged, struggling to
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maintain/grow sales, paying bills too quickly, or collecting receivables
too slowly. Increases in working capital, on the other hand, suggest the
opposite.

The working capital formula (current assets - current liabilities)

demonstrates that if a company has positive working capital, it will be
able to repay its payables and other short-term debt, even if business
were to suddenly dry up.

Companies with positive working capital may face a problem if they

have only enough cash to pay for "day-to-day" operations and not
enough cash for further expenses. If this occurs, it might mean that the
company is:

 having trouble moving its inventory

 collecting receivables from customers too slowly, or
 paying its vendor's payables too quickly.

If the company has little cash available and is unable to perform well in
those three situations, it may run into problems paying bills and vendors.

5. WORKING CAPITAL POLICIES

The working capital has to be adequately managed by the firm , neither

more nor less than its requirement to meet out the needs. If the working
capital is more than the requirement means that the firm is expected to
unnecessarily keep short-term assets idle in state and vice versa. The
maintaining of the working capital management is mainly depending
upon three major influences of the organizations
i) Profitability
ii) Liquidity and
iii) Structural health of the organisation

Why the study of Management of working capital is required ?

If the working capital is less than the requirement means that the volume
of current assets are inadequate to meet the short term obligations of the
firm on time, which may lead to disrepute the name and fame of the
organisation.
Contradictorily to the above, if the firm keeps more working capital that
means more volume of current assets are maintained in the investment
structure to meet out the short term obligations of the firm which poses
more liquidity but on the other hand it hurdles the righteous opportunity
to invest in the fixed assets to earn more income. The excessive volume
of current assets drastically affects the profitability of the firm due to
excess liquidity out of more amount of current assets.

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As a firm should always maintain the righteous volume of working
capital not only to maintain the liquidity of the firm but also to earn
adequately from the investment volume of fixed assets.
The working capital management policies are studied in the following
context viz
i) Concerned with profitability, liquidity and risk of the firm
ii) Concerned with the composition of the current assets
iii) Concerned with the composition of the current liabilities

There are two major types of working capital policies:

1. Conservative policy of working capital: Under this policy, the
firm minimizes risk by maintaining a higher level of current
assets in meeting the liquidity of the firm.
2. Aggressive policy of working capital: Under this policy , the firm
enhances the risk by way of reducing the working capital in order
to earn more and more profits.

6. ESTIMATION OF WORKING CAPITAL REQUIREMENT

The following is the proforma of the working capital requirement
Statement of working capital required
Current Assets:
i) Cash XXXX
ii) Debtors XXXX
iii) Stocks XXXX
iv) Advanced payments XXXX
v) Others XXXX
Less: Current liabilities
i) Creditors XXXX
ii) Lag in payment of expenses XXXX
iii) Outstanding expenses if any XXXX
Working capital (Current assets-Current liabilities) XXXX
Add: Provision for contingencies XXXX
Net working capital required XXXX

Prepare an estimate of working capital requirement from the following

data of the XYZ Ltd.
a) Projected annual sales volume 2,00,000 units
b) Selling price Rs.10 per unit
c) % of net profit on sales 25%
d) Average credit period allowed to customers 8 weeks
e) Average credit period allowed by suppliers 4 weeks
f) Average holding period of the inventories 12 weeks
g) Allow 10% for contingencies
Statement of working capital requirements
Current Assets Rs
Debtors (8 weeks) Rs.15,00,000 × 8/52(At cost) 2,30,769.23
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Stock (12 weeks) Rs.15,00,000 × 12/52 3,46,153.38
Less Current liabilities
Creditors (4 weeks) Rs15,00,000 × 4/52 1,15,384.61
Net working capital 4,61,538.0
Add: 10% contingencies 46,153.8
Working capital required 5,07,691.8

7. CASH MANAGEMENT
The management of cash resources should not be only in a position to
afford liquidity but also it should not require the firm to keep the cash
resources simply idle; which should be invested in the marketable
securities to earn some rate of return whenever the firm feel excessive
holding of cash resources.

1. Motives of holding cash

Transaction Motive: If the cash outflows are more than that of the cash
inflows, the firms are expected to maintain the cash resources.
Precautionary Motive: Some times the firm may be required to meet out
the contingent needs which could not be foreseen during its life span;
warrants the adequate maintenance of working capital.
Speculative Motive: It is a motive holding the cash resources by the firm
to exploit the opportunities available in the market. If the vendor of raw
materials announces that there is a greater discount towards the bulky
purchase of raw materials, may lead the firm to bring down the cost of
purchase. For which, the cash resources are required and made use of to
the tune of announcements.
Compensation motive: Banks provide certain services to the firms only
on the basis of the certain amount of balances in the accounts. That is the
motive holding cash resources to avail services from the banker viz
compensation motive.

2 Objectives of Cash Management

(i) Meeting the cash requirement: Meeting of cash requirements on time
which normally involves in the maintenance of the goodwill of the firm.
The firm should keep the adequate cash balances to meet the requirement
which are greater in importance.
(ii) Minimising the funds locked up in the cash balances: The funds
locked up in the form of cash resources should be more, but it should
only to the tune of the requirement.

3 Basic Problems of Cash Management

(i) Controlling level of cash
(a) Preparing the cash budget: Through the preparation of the budget,
the cash requirement could be identified which would normally facilitate
the firm to trim off the excessive cash in holding.
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(b) Providing room for unpredictable discrepancies: The separate
amount should be maintained for the purpose to meet out the
discrepancies which are not easily foreseen.
(ii) Controlling of inflows of cash
(a) Concentration banking: The amount of collection from the local
branches are normally deposited in a particular account of the firm, as
soon as the deposit has reached the certain limit , the amount in the
respective branch account will be transferred to the account at where the
firm maintains in the head office. This process of transfer is normally
taking place only through telegraphic transfer during the early days but
on now a days the anywhere banking is facilitated to transfer the amount
of deposit instantaneously.
(b) Lock box system: The process of collection is carried out with the
help of local post offices only in order to avoid the postal delays in the
transit . This system enhances the speed of the collection at rapid and
finally the local branch messenger collects the cheques from the parties
through specified post box allocated for the process of collection.
(iii) Controlling of cash outflows
(a) Centralizing of disbursing the payments: The centralizing the
process of payment may facilitate the enterprise to take advantage of
time in settling the payments i.e., reduces the need of immediate cash
requirements.
(b) Stretching payment schedule: It is another methodology to avail the
maximum possible credit period to postpone the payment by making use
of the cash resources most effectively.
(iv) Investing the excessive cash surplus
(a) Determine the need of the surplus cash: Identify the excessive cash
resources which are kept simply idle more than the requirement.
(b) Determination of the various avenues of investment: After
identifying the various investment opportunities , the excessive cash
resources should be invested to earn appropriate rate of return during the
slack season at when the firm does not require greater volume of working
capital and vice versa.

8. MANAGEMENT OF INVENTORIES

1 Meaning of Inventory
The inventory includes the following :
l Stock of raw materials: It means that the value of the raw materials
stored for the purpose of production in the storage yard. The stock of raw
materials can be classified normally into two categories viz opening
stock and closing stock of raw Working Capital Management materials.
l Stock of work in progress: During the production process, the firm
usually stores the semi finished goods which are neither a raw materials
nor finished goods. The purpose of the storage of work in progress in
order to shorten the time duration to manufacture the finished goods. The
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value of the semi finished / work in progress stored in the storage house
may be classified into two categories viz opening stock and closing stock.
The finalizing the value of the stock of the work in progress is inevitable
process in transfer pricing. The value of the work in progress normally
expressed in two different ways viz on the basis of prime cost and works
cost.
l. Stock of finished goods: This is the stage at which the goods are
readily available for selling in the market. The value of the stock of the
goods is computed on the basis of cost of production.
2. Why inventory is to be controlled ?
The ultimate purpose of controlling the inventory arises only due to the
conflicting and heterogeneous objectives of the various functional
departments of the organizations. How inventory influences the various
department of the organization ? Normally, the inventory influences on
the following departments viz Production Purchase,Finance and Sales
department How it influences the various departments at a time
together.
On/of the Production department: The manager production frequently
insists the organisation to maintain the continuous and uninterrupted
supply to have smooth flow production. This requires the production
manager to build ample stock of raw materials. This is routed through the
purchase requisition by the manager production to the purchase manager.
Less the stock of raw materials and accessories - Risk of Lock out
due to insufficient quantities and vice versa
On/of the Purchase department: Due to the influence from the
production manager, the purchase department is demanded to procure the
requirements. As per the requisition of the production department,
meeting the requirements is not tough task but the department should
know about the financial intricacies of the organisation through the
finance department which is especially meant for the purpose. Lesser
the quantum of purchase will lead to lesser financial commitment but
expected to loose the benefits out of the bulk procurement. Not advisable
for the materials which are in scarcity.
Lesser the quantum of purchase - Greater will be cost of
procurement and lesser will the economic benefits and vice versa
Inventory

Raw materials Work in progress Finished goods

On/of the Sales department: Due to the market pressure/greater demand
of the products require the sales department to supply the goods in time
as well as to meet the needs and demands of the intermediaries and
consumers. To supply them in time, the sales manager need not wait for
the production cycle to be completed to produce the finished goods. To
save time, the sales manager must be given ample facility to store the
finished goods in the depot not only to meet the needs but also traps and
drags the existing customers and consumers.
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More the stock of the finished goods - Better the position for the firm
to meet the needs of the biz environment and more the cost of
storage and investment on the current assets and vice versa
On/of the Finance department : Due to influence from the department of
the production, purchase and sales departments, the finance department
is required to concentrate on the various angles. It is the only department
bearing a difference of opinion in maintaining more volume of inventory
in the firm; which certainly slashes the earning capacity of the firm due
to least volume of assets deploy on the productive purpose.
Lesser the inventory - Higher the risk in meeting the needs of
production, purchase and sales - but better the return of the firm.
For e.g. The famous MNC Jindal Corporation Ltd. has wound up its
operations at industrial site in Bangalore due to the cost of raw materials
cost. The transportation cost, acquisition cost of copper ore gone up due
to escalated cost in the biz market. They were neither to store nor to
transport more and more which led to the winding up of operations of the
enterprise at Bangalore.
Inventory control: Inventory control means that maintenance of desired
level of inventory by way of taking into the economic interest of the firm.
The economic interest of the firm differs from one functional dept. to
another due to the heterogeneous objectives. The economic desired
benefits of the dept. are illustrated to the tune of the preceding illustrated
diagrams.
Production department: Benefits towards less production cost through
mass production.
Purchase department: Benefits towards discounts, carrying cost and so
on.
Sales department: Timely supply of the goods to the requirements,
facilitates the firm to earn greater volume of earning. To reduce the
operating cycle in duration in order to realize the economic benefits as
early as possible.
Finance department: Benefits towards the carrying cost, storage cost of
the entire inventory.

3. Major Benefits of Inventory Control

1. It leads to effective utilization of funds only through an
appropriate investment on inventory
2. It facilitates to obtain the economic supply of raw materials
3. It possess the firm comfortably to meet the needs and wants of
the consumers in time
4. It neither allows the firm to undergo the practices of overstocking
nor understocking.
5. It leads to effectiveness in the material handing which reduces the
wastage, pilferage and so on.

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Before discussing the methods of inventory control, every one must
obviously understand the organization of the stores department. The
stores department is the only department which applies all the techniques
of inventory control.
The organization of the inventory control are various in dimensions . The
organization of differs from one industry to another industry, one firm to
another within the same industry, from one nature to another, from
volume to another. They are as follows:
a) Centralised stores
b) Decentralised stores
c) Central and Sub stores
a) Centralised Stores
Under this type, the materials are received by and issued at one central
place by the department to the requirements of the other functional
departments. The following diagram will facilitate to understand the
organisation structure of the centralized stores of the manufacturing
department. The materials are continuously received by the stores dept.
through the purchase department and the received material are
distributed to the various assisting departments. This type of organization
of stores control has its own advantages and disadvantages in application
The major advantages are following:
1. It requires less space
2. It facilitates to minimize the stock investment
3. The centralization leads to lower administrative and maintenance
cost of stores
In addition to the advantages, the present organization suffers with its
own limitation while in applications; which are following:
1. The centralization of stores leads to enhance the cost of
transportation as well as handling cost of materials.
2. The centralized system leads to lot of inconvenience and delay to
other department due to distance.
3. There is a greater risk of calamity loss of materials which are
stored under one roof.
4. The success is subject to the effectiveness of the transportation.
b) Decentralised Stores
Under this method, the separate stores are maintained by the departments
on their own
as well as run by the exclusive store keeper. It ensures the smooth flow
material to the
tune of requirements and reduces the time involved in the transit of
materials from the
stores to the respective departments. The following diagram will
facilitate to have an
insight on the organization of the stores.

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Central stores and Sub stores
This is a method which attempts to discard the bottlenecks of the above
mentioned as well as brings forth unique organization of stores. Under
this method, each department is given separate sub store which is within
easier access and shorter in distance to supply the material requirements
through the store keeper. The sub store keeper should have to make
requisition to central stores where all the materials are centrally procured
and supplied then and there to the tune of the individual departments.
The role of the store keeper is most inevitable in controlling the stores.
While controlling the stores, the store keeper should neither disturb the
production process nor undergo the practices of overstocking. By
earmarking the above enlisted objectives, every store keeper is led by the
various methods of inventory valuation in addition to various methods of
requisitioning of material.

Reordering Level
This is the level at which the firm should go for fresh purchase
requisition of material through the store keeper to meet the requirements.
The reordering level which takes into consideration of minimum level of
consumption of raw material during the course of production process as
well as the amount material required by the firm during period of
purchase and goods in transit immediately after the order.
Reordering level=Minimum level of stock for uninterrupted flow of
production process +
Amount of materials required during the periods of consumption Or Lead
time stock level

Alternate method is available by using the maximum consumption and

maximum reorder period
Re ordering level= Maximum consumption × Maximum Re- order period
This method registers the maximum consumption of the firm during the
production as well as the maximum time period required for the supply
of required materials.
Under this alternate approach, the firm at any moment will not face any
difficulties due to short supply or insufficient amount of materials.

Minimum Level/Safety level

The firm should at always maintain minimum amount of material in its
hands to facilitate the flow of production process as unaffected .due to
short fall in the quantum of materials. The following points are most
important in designing the minimum level of stock:
Lead time should be predominantly considered to determine the time lag
in between the materials ordered and received. The firm should find out
the practical difficulty of the vendor in supplying the material for the
determination for minimum level of stock.

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Minimum stock level=Reordering level- (Normal level consumption ×
Normal Reorder
Minimum level = Reorder level + (Average level of consumption ×
Average Reorder period)
Average and normal level of consumption are synonymous with each
other. If normal or average consumption is not given, the formula is as
follows
Minimum Level Amount of materials required during the periods of
consumption
Reordering Level
Average consumption = Minimum level consumption + Maximum level
consumption
Maximum Level
This is the level at which the firm holds maximum quantity of materials
as stock during the process. The ultimate aim of fixing the level of
maximum level is that to avoid the overstocking. If the stock level of the
firm exceeds the maximum level already fixed is known as overstocking
level of the firm, more than the requirement.
Why over stocking is considered not advisable ?
1. It leads to excessive investment on inventory more than the
requirement
2. It leads to unnecessary wastage of the materials due to excessive
stock
3. The excessive storage of materials may certainly affect the price
of the product
Maximum stock level= Reordering level+ Reordering quantity -
(Minimum consumption × Minimum Reordering period)
Danger level
At this level, the firm should not further issue any materials to the
various functional departments .At the danger level, the purchase
department is vested with greater responsibility to immediately arrange
the supply of raw materials in order to maintain the flow of production as
uninterrupted.
The consumption level of the materials is getting varied from one time
period to another. During the specified period , there may be maximum
consumption and minimum consumption, which should be averaged to
find the mid point in between the two, in order to either fulfill the
minimum consumption or maximum consumption to the extent possible.

Why the maximum reorder period is taken into consideration?

The purpose of considering is that the greater period taken by the
supplier to supply the required materials
Danger Level= Average consumption × Maximum reorder period

Average Stock Level

Average stock level =Minimum stock level + ½ of the reorder quantity
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Economic Ordering Quantity

The ordering of materials usually tagged with three different component
of costs viz:
1. Acquisition cost of materials
2. Ordering cost of materials
3. Carrying cost of materials
The ordering quantity of materials may be either larger or meager in
volume, which carries its own advantages and disadvantages.
If the quantity ordered is larger in volume, the following are some of the
important advantages:
1. The bulk purchase order reduces the ordering cost of the
materials. The greater the size of the order which leads to reduce
the number of the orders in procuring the materials.
Quantity discounts: The discount can be classified into two categories
viz Trade discount and Cash discount.
l What is trade discount ?
Trade discount is the discount granted by the supplier to the buyer of
materials at the Working Capital Management moment of bulk purchase.
This % of discount is greatly possible only during the periods of greater
volume of purchase; which reduces the over all cost of the acquisition. If
the quantity is procured in meager volume, the following are construed
as advantages:
1. The carrying cost will come down in the case of lesser
inventories
2. The cost of storage is lesser as far as the meager quantities of
materials
3. Loss due to deterioration, obsolescence, wastage will be
minimum
4. Insurance cost is less due to meager volume of materials

Example:1
Demand for the Child Cycle at Best Buy is 500 units per month. Best
Buy incurs a fixed order placement, transportation, and receiving cost of
Rs. 4,000 each time an order is placed. Each cycle costs Rs. 500 and the
retailer has a holding cost of 20 percent. Evaluate the number of
computers that the store manager should order in each replenishment lot?

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In the stores control, there are two important documents viz Bin card
system and stores ledger.

Example-2
ABC Ltd. uses EOQ logic to determine the order quantity for its various
components and is planning its orders. The Annual consumption is
80,000 units, Cost to place one order is Rs. 1,200, Cost per unit is Rs. 50
and carrying cost is 6% of Unit cost. Find EOQ, No. of order per year,
Ordering Cost and Carrying Cost and Total Cost of Inventory.

Example-3:
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Midwest Precision Control Corporation is trying to decide between two
alternate Order Plans for its inventory of a certain item. Irrespective of
the plan to be followed, demand for the item is expected to be 1,000 units
annually. Under Plan 1st, Midwest would use a teletype for ordering;
order costs would be Rs. 40 per order. Inventory holding costs (carrying
cost) would be Rs. 100 per unit per annum. Under Plan 2 nd order costs
would be Rs. 30 per order. And holding costs would 20% and unit Cost
is Rs. 480. Find out EOQ and Total Inventory Cost than decide which
Plan would result in the lowest total inventory cost?

Example-4

A local TV repairs shop uses 36,000 units of a part each year (A

maximum consumption of 100 units per working day). It costs Rs. 20 to
place and receive an order. The shop orders in lots of 400 units. It cost
Rs. 4 to carry one unit per year of inventory.

Requirements:

(1) Calculate total annual ordering cost

(2) Calculate total annual carrying cost

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(3) Calculate total annual inventory cost
(4) Calculate the Economic Order Quantity
(5) Calculate the total annual cost inventory cost using EOQ inventory
Policy
(6) How much save using EOQ
(7) Compute ordering point assuming the lead time is 3 days

Bin Card: Bin card is a record prepared by the store keeper at the
moment of issuing and receiving the materials. It is maintained by the
store keeper for physical verification with accuracy and effectiveness.
The inventory control can be accessed through physical verification then
and there, whenever the situation warrants.
The bin card system is adopted by many firms for their inventory control
either in the form of bin tag or stock card hanging outside the rack in
order to portray the information. The bin card system is available in two
major categories viz:
Two Bin card system: Under this system two different bins are used. As
soon as the goods or materials received by the store keeper, that should
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be recorded in terms of quantities. One among the two should be
maintained for Re order level and minimum level another for Maximum
stock level.
To alarm the firm neither to store more than the maximum level nor to
issue less than the minimum level of the stock. If the firm once reaches
the maximum level, it should immediately caution the implications due
to the overstocking. The same firm, if reaches the minimum level of
stock, it should not go for further issue of materials to functional
department or otherwise, the firm's production may be disturbed due to
the poor stocking.
Three Bin Card system: It is an extension of the early method, which
incorporates the lead time stock level in addition to the other level viz
Maximum, Reorder and Minimum level of the stock. Among the three ,
two cards are exclusively used by the firm in order to maintain the
appropriate stock level, i.e., for maximum stock level and minimum
stock level. The firm should neither to store beyond the maximum level
nor to issue less than the Minimum level. In between, a separate bin card
is used only for the Reorder level and Lead time stock level at which the
firm should go for the placement of an order to get fresh delivery of
materials and facilitate the firm to undergo production without any
interruption by considering the time taken by the supplier to supply the
ordered materials.

INVENTORY LEVELS

Minimum level

The minimum level of stock refers to the minimum quantity of inventory

that should be always maintained within the business premises. It is also
termed as safety level or precautionary level of inventory as this quantity
is must to be maintained always to keep the organization functioning. If
the stock level falls below this point, then the organization will stop
working due to a shortage of materials.

It can be calculated using the formula:-

Minimum level of inventory = (Maximum usage × Maximum lead

time) – (Average usage × Average lead time)

OR

Minimum Level of inventory = Re-order level – (Average usage ×

Average lead time)

Maximum level

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The maximum level of stock refers to the maximum quantity of
inventory a firm can hold and cannot exceed this level. Any quantity of
stock beyond this level will be termed as overstocking which will have
adverse effects on firm and results in high material cost. The maximum
level is decided considering various factors like availability of capital
and storage facilities, rate of consumption of materials, availability of
materials, fluctuations in material price, the possibility of fashion change,
etc.

It can be calculated using the formula:-

The maximum level of inventory = Reordering Level + Reordering

Quantity – (Minimum Consumption x Minimum Reordering period)

Average stock level

The average stock level refers to the average quantity of stock held by
companies for a given period of time. It offers a balanced solution and
therefore is calculated and maintained by many firms. The average stock
level is a level that is above the minimum level and below the maximum
level.

It can be calculated using the formula:-

Average Stock Level = Minimum stock Level + 1/2 of Reorder

Quantity.

Danger level

Danger stock level is one where the issue of material is temporarily

stopped. It is an alarming situation for the organization and should
always be avoided. If a stock level approaches danger level which is
below a minimum level, management should take immediate action to
acquire the required materials in less time.

It can be calculated using the formula:-

Danger Level of inventory = Average Consumption x Maximum

reorder period for emergency purchases.

Re-ordering level

The re-ordering level is a point at which the company should start a new
manufacturing run or place a new order with the supplier to procure
materials. In simple words it is a level at which purchase order is place. It
is a level that is fixed in between the minimum and maximum levels of
inventory. Identifying the right reorder level is a must to avoid any
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understocking or overstocking. A purchase order is put before the stock
reaches the minimum stock level.

It can be calculated using the formula:-

Reorder level or Ordering level = Maximum rate of consumption ×

Maximum reorder period.

Example: From the following information, calculate minimum stock

level, maximum stock level and re-ordering level:

(i) Maximum Consumption = 200 units per day

(ii) Minimum Consumption = 120 units per day

(ii) Normal Consumption =160 units per day

(iv) Reorder period = 10-15 days

(v) Reorder quantity = 1,600 units

(vi) Normal reorder period = 10 days.

Solution:

Reordering Level = Maximum Consumption x Maximum Reorder

period

= 200 units X 15 = 3,000 units Minimum Stock Value = Reordering

Level – (Normal Consumption x Nominal Reordering Period)

= 3,000 – (160 X 10) = 3,000 – 1,600 = 1,400 units

Maximum Stock Level = Reordering Level + Reorder Quantity –

(Minimum Consumption x Reorder period) = 3,000 + 1,600 – (120 X
10) = 3,000 + 1,600 – 1,200 = 2,400 units.

Some other methods of the inventory control Working Capital

Management There are few models exercise the inventory control ,
which facilitates the firm to avoid either under or over stocking.

ABC Analysis
In materials management, ABC analysis is an inventory categorization
technique. ABC analysis divides an inventory into three categories—"A
items" with very tight control and accurate records, "B items" with less
tightly controlled and good records, and "C items" with the simplest
controls possible and minimal records.

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The ABC analysis provides a mechanism for identifying items that will
have a significant impact on overall inventory cost,[1] while also
providing a mechanism for identifying different categories of stock that
will require different management and controls.

The ABC analysis suggests that inventories of an organization are not of

equal value.[2] Thus, the inventory is grouped into three categories (A, B,
and C) in order of their estimated importance.

'A' items are very important for an organization. Because of the high
value of these 'A' items, frequent value analysis is required. In addition to
that, an organization needs to choose an appropriate order pattern (e.g.
'just-in-time') to avoid excess capacity. 'B' items are important, but of
course less important than 'A' items and more important than 'C' items.
Therefore, 'B' items are intergroup items. 'C' items are marginally
important.

ABC analysis categories

There are no fixed thresholds for each class, and different proportions
can be applied based on objectives and criteria. ABC Analysis is similar
to the Pareto principle in that the 'A' items will typically account for a
large proportion of the overall value, but a small percentage of the
number of items.
Examples of ABC class are:

 'A' items – 20% of the items accounts for 70% of the annual
consumption value of the items
 'B' items – 30% of the items accounts for 25% of the annual
consumption value of the items
 'C' items – 50% of the items accounts for 5% of the annual
consumption value of the items

Another recommended breakdown of ABC classes:

1. "A" approximately 10% of items or 66.6% of value

2. "B" approximately 20% of items or 23.3% of value
3. "C" approximately 70% of items or 10.1% of value

The Unique features of the ABC analysis:

Advantages
(1) It guides the management to exercise the control based on the value
of goods to the total composition.
(2) Systematic inventory control can be exercised through this analysis
on the basis of value of the materials. The high value materials of Group
A are rigidly controlled which finally led to lesser investments.

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(3) Scientific system facilitates to lessen the storage cost of the
inventory.

VED Analysis, SDE Analysis and FSN Analysis

VED stands for vital, essential and desirable. This analysis relates to the
classification of maintenance spare parts and denotes the essentiality of
stocking spares.

The spares are split into three categories in order of importance. From
the view-points of functional utility, the effects of non-availability at the
time of requirement or the operation, process, production, plant or
equipment and the urgency of replacement in case of breakdown.

Some spares are so important that their non-availability renders the

equipment or a number of equipment in a process line completely
inoperative, or even causes extreme damage to plant, equipment or
human life.

On the other hand some spares are non-functional, serving relatively

unimportant purposes and their replacement can be postponed or
alternative methods of repair found. All these factors will have direct
effects on the stocks of spares to be maintained.

Therefore, it is necessary to classify the spares in the following

categories:

V: Vital items which render the equipment or the whole line operation in
a process totally and immediately inoperative or unsafe; and if these
items go out of stock or are not readily available, there is loss of
production for the whole period.

E: Essential items which reduce the equipment’s performance but do not

render it inoperative or unsafe; non-availability of these items may result
in temporary loss of production or dislocation of production work;
replacement can be delayed without affecting the equipment’s
performance seriously; temporary repairs are sometimes possible.

D: Desirable items which are mostly non-functional and do not affect the
performance of the equipment.

As the common saying goes “Vital Few — trivial many”, the number of
vital spares in a plant or a particular equipment will only be a few while
most of the spares will fall in ‘the desirable and essential’ category.

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However, the decision regarding the stock of spares to be maintained will
depend not only on how critical the spares are from the functional point
of view (VED analysis) but also on the annual consumption (user) cost of
spares (ABC-analysis) and, therefore, for control of spare parts both
VED and ABC analyses are to be combined.

SDE Analysis

The criterion for this analysis is the availability of the materials in the
market. In industrial situations where certain materials are scarce
(specially in a developing country like India) this analysis is very useful
and gives proper guideline for deciding the inventory policies.

The characteristics of the three categories – SD and E – are:

S: Refers to scarce items, items which are in short supply. Usually these
are raw materials, spare parts and imported items.

D: Stands for difficult items, items which are not readily available in
local markets and have to be procured from faraway places, or items for
which there are a limited number of suppliers; or items for which quality
suppliers are difficult to get.

E: Refer to items which are easily available in the local markets.

FSN Analysis

Here the items are classified into fast-moving (F), slow-moving (S) and
Non-moving (N) items on the basis of quantity and rate of consumption.
The non-moving items (usually, not consumed over a period of two years)
are of great importance. It is found that many companies maintain huge
stocks of non-moving items blocking quite a lot of capital.

Moreover, there are thousands of such items. Scrutiny of these items is

made to determine whether they could be used or to be disposed off. The
classification of fast and slow moving items helps in arrangement of
stocks in stores and their distribution and handling methods.

9. RECEIVABLES MANAGEMENT
Concept of Receivables Management
The receivables are normally arising out of the credit sales of the firm.
What is meant by the accounts receivable?
It is an asset owed to the firm by the buyer out of the credit sales with the
terms and conditions of repayment on an agreed time period.
Meaning of the receivables management: The receivables out of the
credit sales crunch the availability of the resources to meet the day today
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requirements. The acute competition requires the firm to sustain among
the other competitors through more volume of credit sales and in the
intention of retaining the existing customers. This requires the firm to
sell more through credit sales only in order to encourage the buyers to
grab the opportunities unlike the other competitors they offer in the
market.
Objectives of Accounts Receivables
i) Achieving the growth in the volume of sales
ii) Increasing the volume of profits
iii) Meeting the acute competition
Cost of Maintaining the Accounts Receivables
Capital cost: Due to in sufficient amount of working capital with
reference to more volume of credit sales which drastically affects the
existence of the working capital of the firm. The firm may be required to
borrow which may lead to pay certain amount of interest on the
borrowings . The interest which is paid by the firm due to the borrowings
in order to meet the shortage of working capital is known as capital cost
of receivables.
Administrative cost: Cost of maintaining the receivables.
Collection cost: Whatever the cost incurred for the collection of the
receivables are known as collection cost.
Defaulting cost: This may arise due to defaulters and the cost is in other
words as cost of bad debts and so on.
Factors Affecting the Accounts Receivables
i) Level of sales: The volume of sales is the best indicator of accounts
receivables. It differs from one firm to another.
ii) Credit policies: The credit policies are another major force of
determinant in deciding the size of the accounts receivable. There are
two types of credit policies viz lenient and stringent credit policies.
Lenient credit policy: Enhances the volume of the accounts receivable
due to liberal terms of the trade which normally encourage the buyers to
buy more and more.
Stringent credit policy: It curtails the motive buying the goods on credit
due stiff terms of the trade put forth by the supplier unlike the earlier.
iii) Terms of trade: The terms of the trade are normally bifurcated into
two categories viz credit period and cash discount
Credit period: Higher the credit period will lead to more volume of
receivables, on the other side that will lead to greater volume of debts
from the side of buyers.
Cash discount: If the discount on sales is more, that will enhance the
volume of sales on the other hand that will affect the income of the
enterprise.

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MANAGEMENT OF ACCOUNTS PAYABLE/FINANCING THE
RESOURCES
It is more important at par with the management of receivable, in order to
avail the short term resources for the smooth conduct of the firm.
Accounts payable and its management is vital for the smooth functioning
process of any business entity. It is important for any business because:

1. It primarily takes charge of paying the entity’s bills on a timely

basis. This is important so that strong credit and long-term
relationship with the vendors can be maintained.
2. Only when invoices are paid on time, vendors will ensure an
uninterrupted flow of supplies and services; which in turn will
help in the systematic flow of business.
3. A good accounts payable process ensures there are no overdue
charges, penalty or late fees to be paid for the dues.
4. The organized accounts payable process ensures all that the
invoices due are tracked and paid properly. This will help avoid
missing payments and making a payment twice.
5. It also enables business entities to manage better cash flows (i.e.
making payments only when due, using the credit facility
provided by the vendor, etc.)
6. Frauds and thefts can be avoided to a greater extent by following
a stringent accounts payable process.

10. VARIOUS COMMITTEE REPORTS ON WORKING CAPITAL

The following committees were especially appointed for the purpose to

administer the working capital
i) Dheja Committee Report 1969
ii) Tandon Committee Report 1975
iii) Chore Committee Report 1980
iv) Marathe Committee Report 1984
The various committee report implications are the following:
1. Dheja Committee Report 1969
"The study carried out on the credit need of the industry and trade and
how that needs inflated and such trends were checked" by the under the
chairmanship of Dheja Committee.
Findings
i) General tendency was found among the firms to avail the bank credit
more than their requirements
ii) Another tendency was among them that the short term credit was
generally made use of by thee for the acquisition of the long term assets
iii) The lending through cash credit should be done on the basis of
security in order to assess the financial position of the firm
Recommendations Working Capital Management

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i) Appraisal should be done by the bankers on the present and future
performance of the firms
ii) The total dealings are segmented into two categories viz core and
short-term needs
iii) The committee suggested the firms to maintain only one account with
the one banker For huge amount of borrowing, consortium was
suggested among the bankers to lend the corporate borrowers

2.Tandon Committee
The next committee was appointed Tandon Committee 1975, in an
intention of granting loans and advances to the industry on the need basis
through the study of the development proceeds only in order to improve
the weaker section of the people.
Findings of the Committee
i) The bank should not reveal this much only to lent to the requirements
of the firm in accordance with lending policy, in spite of that the banks
were expected to lend to the tune of firm's requirement
ii) It should be treated as supplementary source of finance but not as
major source of finance
iii) Loans were lent only in accordance on the basis of the securities
produced by the borrower but not on basis of level of operations
iv) Security compliance wont provide any safety to the banks but the
periodical follow up only should facilitate the banker to get back the
amount of loans and advances lent
Recommendations: It reached the land mark in studying the need of the
industries towards the requirements of the working capital. The
committee has submitted its report on 9th Aug , 1975 by studying the
lending policies.
i) Necessary information about the future operations are to be supplied
ii) The supporting current assets should be shown to the banker at the
moment of borrowing
iii) The bank should understand that the bank credit is only for the
purposes to meet out the needs of the borrower but not for any other.

3. Chore Committee Report 1979

This committee especially constituted only for the purpose to study the
sanctionable limits of the banker and the extent of the loan amount
utilization of the borrower. The another purpose of the committee to
appoint that to provide the alternate ways and means to afford credit
facility to the industries to enhance the productive activities in the
country.
i) Continuance of the existing three system of credits by the banker viz
cash credit,loans and bills
ii) No need to bifurcate the cash credit accounts of the borrower for the
implementation of the differential rate of interest

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iii) According to the specifications of the borrower, the banker should
come to one conclusion which in normal peak level and non peak level
of operations only to the tune of operations
iv) No frequent sanction of ad hoc limits of borrowing from the banker
v) The overdependence on the bank credit should be lessened among the
practices of the industrialists through emphasizing the need of term
finance.

4. Marathe Committee Report 1984

The fourth committee is Marathe committee which was instituted by the
Reserve bank of India and it submitted the report on 1983. The
recommendations were implemented by the Government of India from
April 1,1984.
Recommendations
i) Reasonability of the projection statements are to be studied by the
banks more carefully
ii) Current assets and liabilities are to be classified in accordance with the
norms issued by the Reserve bank of India
iii) Maintenance of the current assets ratio 1.33:1
iv) Timely supply the information stipulated by the bankers
v) Apt supply of annual accounting information

11. OPERATING CYCLE

Cash, accounts receivable, inventories and accounts payable are often
discussed together because they represent the moving parts involved in a
company’s operating cycle (a fancy term that describes the time it takes,
from start to finish, of buying or producing inventory, selling it, and
collecting cash for it).

For example, if it takes an appliance retailer 35 days on average to sell

inventory and another 28 days on average to collect the cash post-sale,
the operating cycle is 63 days.

In other words, there are 63 days between when cash was invested in the
process and when cash was returned to the company. Conceptually, the
operating cycle is the amount of days that it takes between when a
company initially puts up cash to get (or make) stuff and getting the cash
back out after you sold the stuff.

Since companies often purchase inventory on credit, a related concept is

net operating cycle (or cash conversion cycle), which factors in credit
purchases. In our example, if the retailer purchased the inventory on
credit with 30-day terms, it had to put up the cash 33 days before it
collected. Here, the cash conversion cycle is 35 days + 28 days – 30 days
= 33 days. Pretty straight forward.
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Below is a summary of the formulas required to calculate the operating
cycle described above:

Working Capital Management

For many firms, the analysis and management of the operating cycle is
the key to healthy operations. For example, imagine the appliance retailer
ordered too much inventory – its cash will be tied up and unavailable for
spending on other things (such as fixed assets and salaries). Moreover, it
will need larger warehouses, will have to pay for unnecessary storage,
and will have no space to house other inventory.

Imagine that in addition to buying too much inventory, the retailer is

lenient with payment terms to its own customers (perhaps to stand out
from the competition). This extends the amount of time cash is tied up
and adds a layer of uncertainty and risk around collection.

Now imagine our appliance retailer mitigates these issues by paying for
the inventory on credit (often necessary as the retailer only gets cash
once it sells the inventory). Cash is no longer tied up, but effective
working capital management is even more important since the retailer
may be forced to discount more aggressively (lowering margins or even
taking a loss) to move inventory in order to meet vendor payments and
escape facing penalties.

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Taken together, this process represents the operating cycle (also called
the cash conversion cycle). Companies with significant working capital
considerations must carefully and actively manage working capital to
avoid inefficiencies and possible liquidity problems. In our example, a
perfect storm could look like this:

1. Retailer bought a lot of inventory on credit with short repayment

terms
2. Economy is slow, customers aren’t paying as fast as was
expected
3. Demand for the retailer's product offerings change and some
inventory flies off the shelves while other inventory isn't selling

In this perfect storm, the retailer doesn’t have the funds to replenish the
inventory that’s flying off the shelves because it hasn’t collected enough
cash from customers. The suppliers, who haven’t yet been paid, are
unwilling to provide additional credit, or demand even less favorable
terms. In this case, the retailer may draw on their revolver, tap other debt,
or even be forced to liquidate assets. The risk is that when working
capital is sufficiently mismanaged, seeking last-minute sources of
liquidity may be costly, deleterious to the business, or in the worst-case
scenario, undoable.

What Causes Working Capital Changes

The most common factors that can positively and negatively impact a
company’s working capital are listed below:
1. Credit Policy: If a company tightens its credit policy,
outstanding accounts receivables will shrink since customers are
required to pay more quickly. This will increase the amount of
cash the company is bringing in. However, customers may buy
less as a result. Conversely, if a company grants customers more
time to pay, cash will come in more slowly, but customers may
be encouraged to buy more goods on credit.
2. Inventory Planning: In anticipation of sales growth, a company
may increase its inventory levels. Increasing inventory will use
cash, and shrinking inventory will free up cash.
3. Purchasing: In an effort to reduce unit costs, a company may
reduce its costs by purchasing materials in greater volumes.
While the initial outlay may be attributed more to larger volume,
more cash would be available over the long term due to cost
savings.
4. Accounts Payable: A company may decide to change the way it
pays vendors. Switching from 30 day net (where bills are paid
monthly) to a 45 day net policy to free up cash.

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12. SUMMARY

 The working capital is the amount revolving capital to meet the

day today requirements of the firm.
 Working capital represents the excess of current assets over the
current liabilities which include the short-term loans.
 The requirement of the working capital should be met with the
help of long term and shot term resources.
 The permanent and temporary working capital requirements
should be met out of long term and short term financial resource
respectively.
 Under hedging approach, the maturity of the financial resources
is matched with the nature of assets to be financed.
 According to conservative approach, all requirements of the
funds should met out long-term sources.
 Positive working capital generally indicates whether a company
is able to quickly pay off its short-term liabilities.
 Negative working capital generally indicates that a company is
unable to do so.
 The working capital has to be adequately managed by the firm ,
neither more nor less than its requirement to meet out the needs.
 The maintaining of the working capital management is mainly
depending upon three major influences of the organizations
i) Profitability
ii) Liquidity and
iii) Structural health of the organisation
 Operating cycle is the time taken by the firm in converting raw
material into finished goods.
 Since companies often purchase inventory on credit, a related
concept is net operating cycle (or cash conversion cycle), which
factors in credit purchases.
 There are many factors that affect the working capital needs of a
firm such as sales volume, nature of business, technological
changes, etc.
 The investment in current assets involves a trade-off between risk
and return.
 High investment in current assets reduces risk of liquidity, but
low profitability.
 Low investment in current assets leads to high risk of liquidity,
but high profitability.
 Inventory Control leads to effective utilization of funds only
through an appropriate investment on inventory and facilitates to
obtain the economic supply of raw materials
 Bin card is a record prepared by the store keeper at the moment
of issuing and receiving the materials. It is maintained by the
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store keeper for physical verification with accuracy and
effectiveness.
 The minimum level of stock refers to the minimum quantity of
inventory that should be always maintained within the business
premises.
 The maximum level of stock refers to the maximum quantity of
inventory a firm can hold and cannot exceed this level.
 The average stock level refers to the average quantity of stock
held by companies for a given period of time.
 Danger stock level is one where the issue of material is
temporarily stopped.
 The re-ordering level is a point at which the company should start
a new manufacturing run or place a new order with the supplier to
procure materials.

13. SUGGESTED READINGS

 Khan and Jain, “Financial Management”, 2011, MH.

 I M Pandey, “Financial Management”, 2010, Vikas.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008,
Pearson.
 Banerjee, B, “Financial Policy and Management Accounting”,
2005, PHI.
 Chandra, P., “Financial Management”, 2015, TMH.
 Srivastava, R.M., “Financial Management”, 2017, HPH.
 http://swayam.gov.in
 http://edx.org

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1. UNIT OBJECTIVES

After studying this module, you will be familiar with:

 Concept of Bank Financing
 Regulation of Bank Credit
 Recommendations of Tandon Committee
 Recommendations of Chore Committee

2. INTRODUCTION

India has a diversified financial sector undergoing rapid expansion, both

in terms of strong growth of existing financial services firms and new
entities entering the market. The sector comprises commercial banks,
insurance companies, non-banking financial companies, co-operatives,
pension funds, mutual funds and other smaller financial entities. The
banking regulator has allowed new entities such as payment banks to be
created recently, thereby adding to the type of entities operating in the
sector. However, financial sector in India is predominantly a banking
sector with commercial banks accounting for more than 64 per cent of
the total assets held by the financial system.

The Government of India has introduced several reforms to liberalise,

regulate and enhance this industry. The Government and Reserve Bank
of India (RBI) have taken various measures to facilitate easy access to
finance for Micro, Small and Medium Enterprises (MSMEs). These
measures include launching Credit Guarantee Fund Scheme for MSMEs,
issuing guideline to banks regarding collateral requirements and setting
up a Micro Units Development and Refinance Agency (MUDRA). With
a combined push by Government and private sector, India is undoubtedly
one of the world's most vibrant capital markets. In 2017, a new portal
named 'Udyami Mitra' was launched by Small Industries Development
Bank of India (SIDBI) with an aim to improve credit availability to
MSMEs in the country. India has scored a perfect 10 in protecting
shareholders' rights on the back of reforms implemented by Securities
and Exchange Board of India (SEBI).

Sources Of Financing

A firm can exercise its option in using the different sources of firm for
financing its working capital requirements. But the use of any source
depends on its availability, costs, terms and conditions to obtain the
funds etc. The following are the available sources of funds that a firm
can use in order to fulfill its needs for working capital

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a) Trade Credit: Trade credit refers to the credit granted by the
suppliers of goods/services in the normal course of the business. The
customers do not have to pay their dues to the suppliers immediately on
receipt of the delivery of goods. This type of deferral payment
contributes the short term source of fund to the firm to satisfy its need for
working capital. In India, it is an important short term source to finance
the working capital needs and it constitutes about one third of the total
short term financing. As to the small firm, it is very difficult to obtain
bank loan or to use other sources of financing available in the capital
market, hence, such a type of firm has to be dependent mostly on trade
credit for financing its day-to-day operation.

b) Bank Credit: Bank is an important and vital source of both short term
and long term firms to meet the different types of need of the firm. It is
also the main institutional source to finance the working capital needs in
India. Normally, three-fourth of the working capital requirements of any
industry is financed jointly through bank credit and trade credit.

3. REGULATION OF BANK CREDIT

The Banks in India have been providing credit to the industry and trade
based on the security provided by the borrowers. But at present the
supply of bank credit is the subject matter of regulation and control. This
is effective due to providing bank credit with planning priorities and to
ensure the equitable distribution of bank credit to the various industries
of the economy. In view of this, the National Credit Council constituted a
committee in 1968 under the chairmanship of V.T. Dehejia and
subsequently a few number of committees have also been constituted on
the same subject matter.

3.1 TANDON COMMITTEE REPORT

1. To make suggestions for prescribing inventory norms for

different industries both in the private and public sectors and to
indicate the broad criteria for deviating from these norms.
2. To suggest criteria regarding satisfactory capital structure and
sound financial basis in relation to borrowings.
3. To make recommendations as to whether the existing pattern of
financing of working capital requirements by cash credit or
overdrafts requires to be modified, if so, to suggest suitable
modification.
4. To make recommendation on any other related matters, as the
committee may consider necessary to the subject of enquiry or
any other allied matter which may be specified by the Reserve
Bank of India.

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 Observations & Recommendations
The study group submitted its report to the Reserve Bank of
India in August, 1975. The major recommendations of the
committee were; -
a) The borrowers should prepare the operating plan for the ensuing
year and submit it to the bank. On the basis of such plan, the
borrower should indicate the likely demand for credit. In this way,
it will be helpful for the lending bank to evaluate the borrower’s
credit need in realistic manner and to follow up periodically
during the ensuing year.
b) The banker should finance only the genuine production needs of
the borrowers. The borrower should maintain the reasonable level
of inventory and receivables which should be just enough to any
out its desired production. In this way, the efficient management
would be able to eliminate the slow moving and obsolete
inventories.
c) The committee recommended that the bank would finance a
reasonable part of the working capital needs of the borrowers, not
the entire part. The remaining part of the working capital needs
should be financed by the borrowers from their own funds.
d) The bank should ensure the proper end-use of the bank credit. For
this purpose, it should have to keep close contract with the
borrower’s business.
e) For financing working capital needs, the borrower can obtain
bank credit in different forms like cash credit, bills purchased and
discounted; working capital term loan etc.
f) By keeping close contract on the operation of the borrower’s
business, it would be possible for a bank by requiring them to
submit data regarding their business and financial operations for
both the past and future periods at regular intervals.
g) The committee had also recommended the lending norms under
three alterative:
i. Firstly, the borrowers will provide 25% of the working
capital gap and the balance 75% can be financed from the
bank borrowings which will give a minimum current ratio
1:1.
ii. Secondly, the borrower should contribute 25% of the total
current assets and the remaining working capital gap (i.e.,
the working capital gap-borrower’s contribution) can be
collected from the bank borrowings. This alternative will
provide the current ration of 1.3:1.
iii. Thirdly, the borrower will provide 100% of the core
current assets and 25% of the balance current assets. The
remaining working capital gap can be financed from bank

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borrowings. This method will also be helpful to
strengthen the current ratio further.
h) The committee had also suggested the inventory and receivable
norms. The term ‘NORM’ refers to the maximum level of
holding inventories and receivables in each industry. In this
context, the committee suggested the norms for inventories and
receivables for 15 major industries. This covers about one- half of
the industrial advances of the banks. The study group worked out
the .norms for Cotton & Synthetic Textiles, Man-made Fiber, Jute
Textiles, Rubber products. Fertilizers, Pharmaceuticals, Dye and
Dyestuffs, Basic Industrial Chemicals, Vegetables and
Hydrogenated oils. Paper, Cement, Engineering manufacturers
and other Capital equipment suppliers, (other than Heavy
engineering). The group had not suggested the norms for Heavy
engineering and highly seasonal industries. In case of other
industries, the group had suggested that those norms should be
progressively extended to cover more and more industries
including small scale industries.
The group suggested the norms relating to:
(i) Raw materials including spares and other items used in the
process of manufacture,
(ii) Stock in process
(iii)Finished goods
(iv)Receivables.

The norms had been suggested on the basis of time element

which are –
1. Raw materials as so many months’ consumption.
2. Stock in process as so many month’s cost of production.
3. Finished goods and receivables as so many months’ cost of
sales and sales
respectively.
The norms prescribed for the account receivable was related to
the inland sales only on a short term basis. The receivables
arising out of deferred payment of sales and export were excluded.
The group did not suggest the norms for the stock of spares
because this item forms a small part of the operational
expenditure. These norms indicated the maximum level of
holding of inventory and receivables in each industry. The
borrowers are not generally interested to hold more than that. But
if the borrower can manage with the less amount; then they are
allowed to do so. The norms suggested by the study group for
inventory and receivables were not rigidly to apply. Any
deviation from the suggested norms may be permitted where it is
found to be justified.
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3. 2 CHORE COMMITTEE

The Reserve Bank of India constituted another committee in

April, 1979 under the leadership of Mr. K.B Chore. The main
purpose of appointing such committee was to review the
operation of cash credit system in regard to the gap between the
sanctioned credit amount and the extent of their use.
The committee submitted its report in August, 1979. The major
recommendations of the committee were-

1. The borrowers should provide more funds for financing their

working capital requirements. They must take steps to reduce
their dependence on bank credit. In this context, the committee
suggested to adopt the second method of financing as recommend
by the Tandon Committee. If it is not possible for the firm to
provide the sufficient firms as per its requirement immediately,
the firm would be provided loan in the form of working capital
term- loan and this should be repaid in instalments within a
period not exceeding five years. The rate of interest would be
higher in that case than the usual rate under cash credit system.

2. The bank should fix up separate credit limit for the peak and non-
peak level indicating the relevant period also for all the barrowers
in excess of Rs.lO lacs. Adhoc or temporary credit limits should
be generally discouraged by bank. If it is to be sanctioned under
special circumstances, an additional interest of 1% p.a should be
charged on such sanctioned amount.

3. The existing three types of lending system viz. cash credit, loans
and bills should be continuing. On the basis of the prevailing
circumstances, the bank should take steps to replace the existing
cash credit system by loans and bills.

4. The Committee also recommended for implementing the

corrective measures to remove the obstacles in using the bill
system of finance and also to remove the drawbacks observed in
cash credit system.
5. Quarterly statement in the prescribed format should be obtained
by the banks from all the borrowers having working capital credit
limit of Rs.50 lacs and above.

 The group suggested the norms in relation to:

(i) Raw Materials;
(ii) Stock-in-process;
(iii) Finished goods; and
(iv) Receivables and Bills purchased on the basis of time element,
i.e., in terms of
month.

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These norms represent the maximum level for holding inventory
and receivables. The RBI advised the scheduled banks in
regard to the implementation of these norms which are as
under:
1. These norms are applicable in case of both the existing and new
borrowers with immediate effect. All fresh proposals including
those from the existing borrowers seeking enhanced credit
facilities may be regulated by these norms.
2. In case of all existing borrowers whether or not they seek
enhancement in credit limits, if their inventories and receivables
level are excessive on the basis of the suggested norms, the
matter should be discussed with them and a programme for a
phased reduction may be worked out.

3. In case the excess levels of inventories and receivables continue

without justification, the bank must not abruptly stop operations
in the accounts of the borrower since it may upset his normal
functioning. In that case, the bank must consider, after a
reasonable period of time, say about 2 months, whether it should
charge a higher rate of interest on the proportion of the
borrowings which is considered to be excessive.

4. The bank should exercise control with due flexibility and

understanding of the circumstances which may warrant deviation
from the norms for temporary periods. The bank may call for
additional information for this purpose.

5. At the initial stage, all industrial borrowers including small-scale

industries with aggregate limits from the banking system in
excess of Rs. 10 lakhs should be covered. Borrowers with
aggregate limits of Rs. 10 lakhs or less should be covered
progressively as early as possible.

3. 2.1 Approach to Lending:

 Financing Working Capital Cap and Bank Credit

It was the opinion of the Study Group that the borrower should be
expected to hold only a reasonable level of current assists in relation to
the requirements of his production. The Group defined the working
capital gap as, ‘total current assets minus total current liabilities other
than bank borrowings’.
The working capital gap could be bridged partly from the own funds of
the borrower and long-term borrowings and partly through bank
borrowings. The Study Group has also suggested that the bank must
supplement the resource of the borrower in order to enable the latter to
carry an acceptable level of current assets. For this purpose, the Study
Group suggested the following methods in order to work out the
maximum permissible bank borrowing to meet the working capital gap.
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(a) Annual Revenue of Accounts:

Bearing in mind the information that the system of cash credit cannot be
totally replaced by any other lending system, the RBI felt the necessity of
streamlining the system with regular periodical reviews of limits in order
to verify the continued viability of borrowers and for assessing the need-
based character of their limits.

All scheduled banks are required to review accounts of the borrowers

having working capital limits of Rs 10 lakhs and over at least once in a
year. If the borrowers’ limit exceeds by Rs. 50 lakhs and over, they are
required to submit quarterly statement for the purpose.

(b) Bifurcation of Accounts Discontinued:

The RBI withdrew its past directives which were issued to the scheduled
banks requiring them to bifurcate the cash credit accounts into demand
loan, cash credit components and charging differential interest rates. If
the accounts are already bifurcated, the differential rates are to be
abolished as an immediate effect.

The RBI indicated the following four measures that are applicable on all
the borrowers having total working capital limits of Rs. 50 lakhs and
over.

(i) Peak Level and Non-Peak Level Limits:

Banks are to fix separate credit limits for the borrowers according to the
normal peak level and non-peak level as far as possible which are to be
selected on the basis of past performances of the borrowers and the
utilization of such limits. At the same time, the period for which the
borrowings are to be utilized is to be specified.

For agriculture based industries and consumer goods industries, separate

limits are to be fixed since they have seasonal demand of their products
and for others, only one limit is to be fixed by the banks

(ii) Withdrawals of Funds:

After sanctioning the credit limit, the borrower must indicate, before the
commencement of each quarter, his expected requirements of funds in
the said quarter. Such limits are known as operating limit. It is expected
that borrower must withdraw funds from bank within the operating limit
in that particular quarter subject to a tolerance limit of 10% either way.

That is, if a borrower withdraws any amount which is more than or less
than that tolerance limit, the same is considered as irregularity in the
account and as a consequence, bank should take corrective steps in order
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to avoid such repetition of irregularity of funds in future which is
actually the product of defective planning of the borrower.

(iii) Temporary Limits:

Banks must be very careful about the request made by the borrower for
ad hoc/ temporary limits in excess of the sanctioned limits in order to
meet unforeseen contingencies. Such limits should be allowed for pre-
determined short-durations and in the form of a demand loan or ‘non-
operable’ cash credit account for which an additional interest of 1% over
and above the normal rate is to be charged.

But if the borrower is unable to provide corresponding additional

contributions for this purpose, bank will simply refuse.

(iv) Contribution of the Borrowers:

The RBI stressed the need in order to reduce the over-dependence on

bank credit by medium and large borrowers. Borrowers must increase
their contribution towards working capital. Bank must assess the
maximum permissible bank finance by applying the second method of
lending which was recommended by Tandon Committee.

That is, under this method, borrowers must have to contribute from (i)
his owned funds and (ii) term loans an amount which must be at least
25% of total current assets. In short, the contribution of the borrowers
towards working capital should be increased from 25% of the working
capital gap (under 1st Method) to 25% of the total current assets which
result in a current ratio of 1.3: 1 instead of a 1: 1 current ratio.

 Arrangement during Transition Period:

If it is found that the borrower fails to comply with the above

requirements, immediately bank may segregate the excess borrowing and
may treat the same as Working Capital Term Loan (WCTL). This loan
must be repaid by the borrowers in half-yearly installments within a
period not exceeding 5 years.

Of course, banks may charge a higher rate of interest for this purpose
which must not exceed the ceiling for encouraging early payments. Bank
also may charge a penal rate if there is any default in repayment of the
said loans.

 Additional Credit Limits:

Banks are permitted to grant additional credit limits to the borrowers, if

such limits are necessary for increased production. But Bank must insist
on (i) the incremental current ratio of 1.33: 1 and (ii) WCTL component
must not be increased.

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However, the RBI exempted the following categories of borrowers
from the compliance of this requirement:

1. New companies floated prior to December 8, 1980.

2. Companies showing signs of incipient sickness.
3. Companies having finalized modernization or expansion
programme before the Chore Committee recommendation.
4. Borrowers who have failed to pay the installment/interest due to
term lending institutions, if the efforts to re-schedule the
installments do not succeed.

In the above categories of borrowers, the RBI has advised the scheduled
banks to examine carefully the financial position on the basis of cash
flow/fund flow statements and other relevant information.

If they are satisfied, they may assess the credit requirement of the
borrowers without applying the second method of lending recommended
by Tandon Committee which is permitted only for a period of 3 years
and bank, in these cases, should impress upon the borrowers the
usefulness of changing-over to second method.

The RBI has also clarified that the above measures are not applicable in
those cases that enjoy aggregate working capital limits below Rs. 50
lakhs but exceed this level due to sanctioning additional credit limits for
the temporary periods.

RBI also has advised to adopt a flexible approach in case of exporters

who are unable to bring in additional contribution for additional credit
limits sanctioned for specific export transactions.

If any borrower exports a substantial part of his production and the

WCTL has to be carved out of the existing paking credit limit, bank may
identify the WCTL on a national basis. That is, the amount of excess
borrowings may be identified but not transferred to a separate account
for concessionary rate of interest.

The borrower must contribute the required amount within a period of 5

years.

4. SUMMARY
 Financial sector in India is predominantly a banking sector with
commercial banks.
 A firm can exercise its option in using the different sources of
firm for financing its working capital requirements. But the use of
any source depends on its availability, costs, terms and conditions
to obtain the funds etc.

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 The supply of bank credit is the subject matter of regulation and
control.
 A number of committees have also been constituted on the same
subject matter.
 A number of recommendations were given by Tandon Committee
including that the bank would finance a reasonable part of the
working capital needs of the borrowers, only the genuine
production needs of the borrowers should be financed, bank
should ensure the proper end-use of the bank credit and keeping
close contract on the operation of the borrower’s business
 The Reserve Bank of India constituted another committee in
April, 1979 under the leadership of Mr. K.B Chore.
 The main purpose of Chore committee was to review the
operation of cash credit system in regard to the gap between the
sanctioned credit amount and the extent of their use.
 Chore committee made a number of recommendations including
The borrowers should provide more funds for financing their
working capital requirements, bank should fix up separate credit
limit for the peak and non-peak levels, implementing the
corrective measures to remove the obstacles in using the bill
system of finance and also to remove the drawbacks observed in
cash credit system and obtaining quarterly statement in the
prescribed format from the borrowers.

5. SUGGESTED READINGS

 I M Pandey, “Financial Management”, 2010, Vikas.

 Horne, Van “Financial Management and Policy”, 2002, Pearson.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008,
Pearson.
 Banerjee, B, “Financial Policy and Management Accounting”,
2005, PHI.
 Chandra, P., “Financial Management”, 2015, TMH.
 Srivastava, R.M., “Financial Management”, 2017, HPH.
 http://swayam.gov.in
 http://edx.org

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1. UNIT OBJECTIVES

After studying this module, you will be able to:

 Understand the capital budgeting as a technique of capital
expenditure decision.
 Explore the process involved in evaluation of capital expenditure
projects.
 Understand different types of investment projects.
 Understand traditional and modern methods of capital budgeting.

2. INTRODUCTION

The term Capital Budgeting refers to the long-term planning for

proposed capital outlays or expenditure for the purpose of maximizing
return on investments. The capital expenditure may be :
(1) Cost of mechanization, automation and replacement.
(2) Cost of acquisition of fixed assets. e.g., land, building and
machinery etc.
(3) Investment on research and development.
(4) Cost of development and expansion of existing and new
projects.

Definition of Capital Budgeting

Capital Budget is also known as "Investment Decision Making or Capital
Expenditure Decisions" or "Planning Capital Expenditure" etc. Normally
such decisions where investment of money and expected benefits arising
there from are spread over more than one year, it includes both raising of
long-term funds as well as their utilization. Charles T. Horngnen has
defined capital budgeting as "Capital Budgeting is long term planning for
making and financing proposed capital outlays."
In other words, capital budgeting is the decision making process by
which a firm evaluates the purchase of major fixed assets including
building, machinery and equipment.

According to Hamption, John. .,

"Capital budgeting is concerned with the firm's formal process for the
acquisition and investment of capital."

From the above definitions, it may be concluded that capital budgeting

relates to the evaluation of several alternative capital projects for the
purpose of assessing those which have the highest rate of return on
investment.

Importance of Capital Budgeting

Capital budgeting is important because of the following reasons:

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1. Capital budgeting decisions involve long-term implication for the
firm, and influence its risk complexion.
2. Capital budgeting involves commitment of large amount of
funds.
3. Capital decisions are required to assessment of future events
which are uncertain.
4. Wrong sale forecast ; may lead to over or under investment of
resources.
5. In most cases, capital budgeting decisions are irreversible. This is
because it is very difficult to find a market for the capital goods.
The only alternative available is to scrap the asset, and incur
heavy loss.
6. Capital budgeting ensures the selection of right source of finance
at the right time.
7. Many firms fail, because they have too much or too little capital
equipment.
8. Investment decision taken by individual concern is of national
importance because it determines employment, economic
activities and economic growth.

Objectives of Capital Budgeting

The following are the .important objectives of capital budgeting:
1. To ensure the selection of the possible profitable capital projects.
2. To ensure the effective control of capital expenditure in order to
achieve by forecasting the long-term financial requirements.
3. To make estimation of capital expenditure during the budget
period and to see that the benefits and costs may be measured in
terms of cash flow.
4. Determining the required quantum takes place as per
authorization and sanctions.
5. To facilitate co-ordination of inter-departmental project funds
among the competing capital projects.
6. To ensure maximization of profit by allocating the available
investible.

Principles or Factors of Capital Budgeting Decisions

A decision regarding investment or a capital budgeting decision involves

the following principles or factors:
1. A careful estimate of the amount to be invested.
2. Creative search for profitable opportunities.
3. A careful estimates of revenues to be earned and costs to be
incurred in future in respect of the project under consideration.
4. A listing and consideration of non-monetary factors influencing
the decisions.

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5. Evaluation of various proposals in order of priority having regard
to the amount available for investment.
6. Proposals should be controlled in order to avoid costly delays and
cost over-runs.
7. Evaluation of actual results achieved against those budget.
8. Care should be taken to think all the implication of long range
capital investment and working capital requirements.
9. It should recognize the fact that bigger benefits are preferable to
smaller ones and early benefits are preferable to latter benefits.

Capital Budgeting Process

The following procedure may be considered in the process of capital
budgeting decisions :
1. Identification of profitable investment proposals.
2. Screening and selection of right proposals.
3. Evaluation of measures of investment worth on the basis of
profitability and uncertainty or risk.
4. Establishing priorities, i.e., uneconomical or unprofitable
proposals may be rejected.
5. Final approval and preparation of capital expenditure budget.
6. Implementing proposal, i.e., project execution.
7. Review the performance of projects.

Types of Capital Expenditure

Capital Expenditure can be of two types:

(1) Capital expenditure increases revenue.
(2) Capital expenditure reduces costs.
1. Capital Expenditure Increases Revenue: It is the expenditure
which brings more revenue to the firm either by expanding the
existing production facilities or development of new production
line.
2. Capital Expenditure Reduces Costs: Such a capital expenditure
reduces the cost of present product and thereby increases the
profitability of existing operations. It can be done by replacement
of old machine by a new one.

Types of Capital Budgeting Proposals

A firm may have several investment proposals for its consideration. It
may adopt after considering the merits and demerits of each one of them.
For this purpose capital expenditure proposals may be classified into :
(1) Independent Proposals
(2) Dependent Proposals or Contingent Proposals
(3) Mutually Excusive Proposals

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1. Independent Proposals: These proposals are said be to
economically independent which are accepted or rejected on the
basis of minimum return on investment required. Independent
proposals do not depend upon each other.
2. Dependent Proposals or Contingent Proposals: In this case, when
the acceptance of one proposal is contingent upon the acceptance
of other proposals. it is called as "Dependent or Contingent
Proposals." For example, construction of new building on
account of installation of new plant and machinery.
3. Mutually Exclusive Proposals: Mutually Exclusive Proposals
refer to the acceptance of one proposal results in the automatic
rejection of the other proposal. Then the two investments are
mutually exclusive. In other words, one can be rejected and the
other can be accepted. It is easier for a firm to take capital
budgeting decisions on such projects.

3. METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSALS

There are number of appraisal methods which may be recommended for

evaluating the capital investment proposals. We shall discuss the most
widely accepted methods. These methods can be grouped into the
following categories :
I. Traditional Methods:
Traditional methods are grouped in to the following :
(1) Pay-back period method or Payout method.
(2) Improvement of Traditional Approach to Pay-back Period Method.
(a) Post Pay-back profitability Method.
(b) Discounted Pay-back Period Method.
(c) Reciprocal Pay-back Period Method.
(3) Rate of Return Method or Accounting Rate of Return Method.
II. Time Adjusted Method or Discounted Cash Flow Method
Time Adjusted Method further classified into:
(1) Net Present Value Method.
(2) Internal Rate of Return Method.
(3) Profitability Index Method.

I. Traditional Methods
(1) Pay-back Period Method: Pay-back period is also termed as "Pay-
out period" or Pay-off
period. Payout Period Method is one of the most popular and widely
recognized traditional method of evaluating investment proposals. It is
defined as the number of years required to recover the initial investment
in full with the help of the stream of annual cash flows generated by the
project.

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Calculation of Pay-back Period: Pay-back period can be calculated into
the following two different situations :
(a) In the case of constant annual cash inflows.
(b) In the case of uneven or unequal cash inflows.
(a) In the case of constant annual cash inflows : If the project generates
constant cash flow the Pay-back period can be computed by dividing
cash outlays (original investment) by annual cash inflows.
The following formula can be used to ascertain pay-back period :

Illustration: 1
A project requires initial investment of Rs. 40,000 and it will generate an
annual cash inflows of Rs. 10,000 for 6 years. You are required to find
out pay-back period.

Solution:

(b) In the case of Uneven or Unequal Cash Inflows: In the case of uneven
or unequal cash inflows, the Pay-back period is determined with the help
of cumulative cash inflow. It can be calculated by adding up the cash
inflows until the total is equal to the initial investment.

Illustration: 2
From the following information you are required to calculate pay-back
period :
A project requires initial investment of Rs. 40,000 and generate cash
inflows of Rs. 16,000,
Rs. 14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth
year respectively.

Solution:

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The above table shows that at the end of 4th years the cumulative cash
inflows exceeds the investment of Rs. 40,000. Thus the pay-back period
is as follows :

Illustration : 3
Rahave Ltd. is producing articles mostly by manual labour and is
considering to replace it by a new machine. There are two alternative
models X and Y of the new machine. Prepare a statement of profitability
showing the pay~back period from the following information :
Estimate life of the Machine

Solution:

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Machine X should be preferred because it has a shorter pay-back period.

Illustration: 4
From the following information advise the management as to which
project is preferable based on pay-back period. Two projects X and Y,
each project requires an investment of Rs. 30,000. The standard cut off
period for the company is 5 years.

Solution:

Accept or Reject Criterion

Investment decisions based on pay-back period used by many firms to
accept or reject an investment proposal. Among the mutually exclusive
or alternative projects whose pay-back periods are lower than the cut off
period. The project would be accepted. if not it would be rejected.
Advantages of Pay-back Period Method
(1) It is an important guide to investment policy
(2) It is simple to understand and easy to calculate
(3) It facilitates to determine the liquidity and solvency of a firm
(4) It helps to measure the profitable internal investment opportunities
(5) It enables the firm to select an investment which yields a quick return
on cash funds
(6) It used as a method of ranking competitive projects

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(7) It ensures reduction of cost of capital expenditure.
Disadvantages of Pay-back Period Method
(1) It does not measure the profitability of a project
(2) It does not value projects of different economic lives
(3) This method does not consider income beyond the pay-back period
(4) It does not give proper weight to timing of cash flows
(5) It does not indicate how to maximize value and ignores the relative
profitability of the project
(6) It does not consider cost of capital and interest factor which are very
important factors in taking sound investment decisions.

2. Improvement of Traditional Approach to Pay-back Period

The demerits of the pay-back period method may be eliminated in the
following ways:
(a) Post Pay-back Profitability Method: One of the limitations of the
pay-back period method is that it ignores the post pay-back returns of
project. To rectify the defect, post pay-back period method considers the
amount of profits earned after the pay-back period. This method is also
known as Surplus Life Over Payback Method. According to this method,
pay-back profitability is calculated by annual cash inflows in each of the
year, after the pay-back period. This can be expressed in percentage of
investment.

(b) Discounted Pay-back Method: This method is designed to

overcome the limitation of the payback period method. When savings are
not levelled, it is better to calculate the pay-back period by taking into
consideration the present value of cash inflows. Discounted pay-back
method helps to measure the present value of all cash inflows and
outflows at an appropriate discount rate. The time period at which the
cumulated present value of cash inflows equals the present value of cash
outflows is known as discounted pay-back period.
(c) Reciprocal Pay-back Period Method: This methods helps to
measure the expected rate of return of income generated by a project.
Reciprocal pay-back period method is a close approximation of the Time
Adjusted Rate of Return, if the earnings are levelled and the estimated
life of the project is somewhat more than twice the pay-back period. This
can be calculated by the following formula:

Illustration: 5
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The company is considering investment of Rs. 1,00,000 in a project. The
following are the income forecasts, after depreciation and tax, 1st year
Rs. 10,000, 2nd year Rs. 40,000, 3rd year Rs. 60,000, 4th year Rs. 20,000
and 5th year Rs. Nil.
From the above information you are required to calculate: (1) Pay-back
Period (2) Discounted Pay-back Period at 10% interest factor.
Solution:

From the above table, it is observed that upto the 4th year Rs. 1,00,000 is
recovered. Because the Discounting Cumulative Cash Inflows exceeds
the original cash outlays of Rs. 1,00,000. Thus the Discounted Pay-back
Period is calculated as follows :

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(3) Average Rate of Return Method (ARR) or Accounting Rate of
Return Method: Average Rate of Return Method is also termed as
Accounting Rate of Return Method. This method focuses on the average
net income generated in a project in relation to the project's average
investment outlay. This method involves accounting profits not cash
flows and is similar to the pelformance measure of return on capital
employed. The average rate of returr. can be determined by the following
equation:

Advantages
(1) It considers all the years involved in the life of a project rather than
only pay-back years.
(2) It applies accounting profit as a criterion of measurement and not
cash flow.
Disadvantages
(1) It applies profit as a measure of yardstick not cash flow.
(2) The time value of money is ignored in this method.
(3) Yearly profit determination may be a difficult task.

Illustration: 6
From the following information you are required to find out Average
Rate of Return :

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Solution:

The percentage is compared with those of other projects in order that the
investment yielding the highest rate of return can be selected.
Illustration: 7

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Solution:

Both the project satisfy the minimum required rate of return. The
percentage is compared with those of other project in order that the
investment yielding the highest rate of return can be selected. Project A
will be selected as itsARR is higher than Project B.

Illustration: 8
A project costs Rs. 5,00,000 and has a scrap value of 1,00.000 after 5
years. The net profit before depreciation and taxes for the five years
period are expected to be Rs. 1,00.000. Rs. 1,20,000. Rs. 1.40,000, Rs.
1,60.000 and Rs. 2.00,000. You are required to calculate the Accounting
Rate of Return, assuming 50% rate of tax and depreciation on straight
line method.
Solution:

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The percentage is compared with those of other projects in order that the
investment yielding the highest rate of return can be selected.

Discounted Cash Flow Method (or) Time Adjusted Method: Discount

cash flow is a method of capital investment appraisal which takes into
account both the overall profitability of projects and also the timing of
return. Discounted cash flow method helps to measure the cash inflow
and outflow of a project as if they occurred at a single point in time so
that they can be compared in an appropriate way. This method
recognizes that the use of money has a cost, i.e., interest foregone.
In this method risk can be incorporated into Discounted Cash Flow
computations by adjusting the discount rate or cut off rate.
Disadvantages
The following are some of the limitations of Discounted Pay-back Period
Method:
(1) There may be difficulty in accurately establishing rates of interest
over the cash flow period.
(2) Lack of adequate expertise in order to properly apply the techniques
and interpret results.
(3) These techniques are based on cash flows, whereas reported earnings
are based on profits. The inclusion of Discounted Cash Flow Analysis

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may cause projected earnings to fluctuate considerably and thus have an
adverse on share prices.
Net Present Value Method (NPV) : This is one of the Discounted Cash
Flow technique which explicitly recognizes the time value of money. In
this method all cash inflows and outflows are converted into present
value (i.e., value at the present time) applying an appropriate rate of
interest (usually cost of capital).
In other words, Net Present Value Method discount inflows and outflows
to their present value at the appropriate cost of capital and set the present
value of cash inflow against the present value of outflow to calculate Net
Present Value. Thus, the Net Present Value is obtained by subtracting the
present value of cash outflows from the present value of cash inflows.
Equation for Calculating Net Present Value:
(1) In the case of conventional cash flows. i.e., all cash outflows are
entirely initial and all cash inflows are in
future years, NPV may be represented as follows:
NPV + +

(2)

Rules of Acceptance: If the rate of return from a project is greater than

the return from an equivalent risk investment in securities traded in the
financial market, the Net Present Value will be positive. Alternatively, if
the rate of return is lower, the Net Present Value will be negative.
In other words, if a project has a positive Net Present Value it is
considered to be viable because the present value of the inflows exceeds
the present value of the outflows. If the projects are to be ranked or the
decision is to select one or another. the project with the greatest Net
Present Value should be chosen Symbolically the accept or reject
criterion can be expressed as follows:
Where
NPV > Zero Accept the proposal

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NPV < Zero Reject the Proposal

Advantages of Net Present Value Method

(1) It recognizes the time value of money and is thus scientific in its
approach.
(2) All the cash flows spreadover the entire life of the project are used for
calculations.
(3) It is consistent with the objectives of maximizing the welfare of the
owners as it depicts the positive or otherwise present value of the
proposals.
Disadvantages
(1) This method is comparatively difficult to understand or use.
(2) When the projects in consideration involve different amounts of
investment, the Net Present Value Method may not give satisfactory
results.

Illustration: 9

Calculate the Net Present Value of the following project requiring an

initial cash outlays of Rs. 20,000 and has a no scrap value after 6 years.
The net profits after depreciation and taxes for each year of Rs. 6,000 for
six years. Assume the present value of an annuity of Re.1 for 6 years at
8% p.a. interest is Rs.4.623.
Solution:

I
llustration: 10
A project cost Rs. 25,000 and it generates cash inflows through a period
of five years Rs. 9,000, Rs. 8,000, Rs. 7,000, Rs. 6,000 and Rs. 5,000. the
required rate of return is assumed to be 10%. Find out the Net Present
Value of the project.
Solution:

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Net Present Value of Cash Inflows 27,244

Present Value of Cash Inflows - Value of Cash Outflow
Rs. 27,244 - 25,000 = Rs. 2,244
Now the NPV of the project is positive and it can be accepted for
investment.

Illustration: 11
A project costing Rs. 5.00,000 has a life of 10 years at the end of which
its scrap value is likely to be Rs. 50,000. The firm cut-off rate is 12%.
The project is expected to yield an annual profit after tax of Rs. 1,00,000
depreciation being charged on straight line basis. At 12% P.A. the
present value of the rupee received annually for 10 years is Rs. 5.65 and
the value of one rupee received at the end of 10th year is Re. 0.322.
Ascertain the Net Present Value of the project.
Solution:

Now the Net Present Value of the project is positive and it can be
accepted for investment.

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Illustration: 12
MIs. Pandey Ltd. is contemplating to purchase a machine A and B each
costing of Rs.5,OO,OOO.Profits before depreciation are expected as
follows :

Using a 10% discounted rate indicate which of the machine would be

profitable using the Net Present Value (NPV) method.
Solution:

From the above table, we obsserved that the Net Present Value of
Machine A is higher than that of Machine B. Hence Machine A is
preferable.
(2) Internal Rate of Return Method (IRR) : Internal Rate of Return
Method is also called as "Time Adjusted Rate of Return Method." It is
defined as the rate which equates the present value of each cash inflows
with the present value of cash outflows of an investment. In other words,
it is the rate at which the net present value of the investment is zero.
Horngren and Foster define Internal Rate of Return as the rate of interest
at which the present value of expected cash inflows from a project equals
the present value of expected cash outflows of the project. The Internal
Rate of Return can be found out by Trial and Error Method. First,
compute the present value of the cash flow from an investment, using an
arbitrarily selected interest rate, for example 10%. Then compare the
present value so obtained with the investment cost.
If the present value is higher than the cost of capital, try a higher interest
rate and go through the procedure again. On the other hand if the
calculated present value of the expected cash inflows is lower than the
present value of cash outflows, a lower rate should be tried. This process
will be repeated until and unless the Net Present Value becomes zero.

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The interest rate that brings about this equality is defined as the Internal
Rate of Return.
Alternatively, the internal rate can be obtained by Interpolation Method
when we come across 2 rates. One with positive Net Present Value and
other with negative Net Present Value. The IRR is considered as the
highest rate of interest which a business is able to pay on the funds
borrowed to finance the project out of cash inflows generated by the
project.
The Interpolation formula can be used to measure the Internal Rate of
Return as follows :

Evaluation
A popular discounted cash flow method, the internal rate of return
criterion has several virtues :
(I) It takes into account the time value of money.
(2) It considers the cash flows over the entire life of the project.
(3) It makes more meaningful and acceptable to users because it satisfies
them in terms of the rate of return on capital.
Limitations
(1) The internal rate of return may not be uniquely defined.
(2) The IRR is difficult to understand and involves complicated
computational problems.
(3) The internal rate of return figure cannot distinguish between lending
and borrowings and hence high internal rate of return need not
necessarily be a desirable feature.

Illustration: 13
The cost of a project is Rs. 32,400. It is expected to generate cash
inflows of Rs. 16,000, Rs. 14,000 and Rs. 12,000 through it three year
life period. Calculate the Internal Rate of Return of the Project.
Solution:

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From the above table of Calculation is can be observed that the real rate
lies in between 14% and 16%. Therefore let us select 15% as the internal
rate to ascrtain its applicability.

Thus, the Net Present Value at 15% rate is zero. It indicates that the
present value of cash inflows is equal to the present value of cash
outflows. Thus internal rate of return 15% for the project under review.

Illustration: 14

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Solution:

The conflict in ranking arises because of skewness in cash flows. In case

of project C, cash flows occur later in the life and in case of project D,
cash flows are skewed towards the beginning.
At lower discount rate, project C's NPV will be higher than that of
project D.
As the discount rate increases, project C's NPV will fall at a faster rate,
due to compounding effect. After breakeven discount rate (14%) project
D has higher NPV as well as higher IRR.
(ii) If the opportunity cost of funds is 10%, project C should be accepted
because the firm's wealth will be more by Rs.316 (Rs.4139 - Rs.3823)
The incremental analysis will substantiate this point :
Project Cash Flows (Rs.)
C C1 C2 CJ NVPat 10% IRR 0
C - D 0 - 8,000 + 1,000 + 9,000 Rs.316 12.5%
Thus Project C should be accepted, when opportunity cost of fund is
10%.

(3) Profitability Index Method

Profitability Index is also known as Benefit Cost Ratio. It gives the
present value of future benefits, computed at the required rate of return
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on the initial investment. Profitability Index may either be Gross
Profitability Index or Net Profitability Index. Net Profitability Index is
the Gross Profitability Index minus one. The Profitability Index can be
calculated by the following equation:
Present Value of Cash Inflows

Rule of Acceptance: As per the Benefit Cost Ratio or Profitability Index

a project with Profitability Index greater than one should be accepted as
it will have Positive Net Present Value. Likewise if Profitability Index is
less than one the project is not beneficial and should not be accepted.
Advantages of Profitability Index:
(1) It duly recognizes the time value of money.
(2) For calculations when compared with internal rate of return method it
requires less time.
(3) It helps in ranking the project for investment decisions.
(4) As this method is capable of calculating incremental benefit cost ratio,
it can be used to choose between mutually exclusive projects.

Illustration: 15
A project is in the consideration of a firm. The initial outlay of the
project is Rs. 10,000 and it is expected to generate cash inflows of Rs.
4,000, Rs. 3,000, Rs. 5,000 and Rs. 2,000 in four years to follow.
Assuming 10% rate of discount, calculate the Net Present Value and
Benefit Cost Ratio of the project.
Solution:

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The Profitability Index indicates less than one, the project is not
beneficial and should not be accepted.

Illustration: 16
There are two mutually exclusive projects under active consideration of a
company. Both the projects have a life of 5 years and have initial cash
outlays of Rs. 1,00,000 each. The company pays tax at 50% rate and the
maximum required rate of the company has been given as 10%. The
straight line method of depreciation will be charged on the projects. The
projects are expected to generate a net cash inflow before taxes as
follows :

With the help of the above given information you are required to
calculate:
(a) The Pay-back Period of each project
(b) The Average Rate of Return for each project
(c) The Net Present Value and Profitability Index for each project
(d) The Internal Rate of Return for each project
On the basis of your calculations advise the company which project it
should accept giving reasons.
Solution:

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(a) Calculation of Pay-back Period:

Thus, the pay-back period of project Y will be 3 years 5 months and 4

days.
(b) Calculation of Average Rate of Return (ARR):

From the above analysis it follows that project Y is superior to project X

as it gives 22% average rate of return ItS against only 20% average rate
of return from project X.

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(c) Calculation of Net Present Value (NPV) :

(d) Calculation of Internal Rate of Return (IRR):

IRR is the rate which when applied to discount the cash flow makes the
Net Present Value equal to zero. So IRR of the project X will be :
Project X : There is constant cash inflow of Rs. 30,000 for 5 years. The
nearest discount factor for this flow can be obtained by dividing the cash
outlays of Rs. 1,00,000 by Rs. 30,000 which comes to 3.33 (Le., Rs.
1,00,000 + Rs. 30,000).
Referring to the present value of annuity table in the annexure (Table A -
4). We find that the nearest discount factor on the 5 year row is 3.352
which corresponds to a discount rate of 15%. But since 3.333 is lower
than 3.352, the actual rate should be between 15% and 16%. To obtain
the actual rate of discount, the interpretation will be done as follows:

Project Y : In the case of project Y the cash inflow stream is uneven and
so the trial and error'method wiII be used to find out the actual rate of
discount. Let us begin with 16% rate of discount. The present value will
be
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So the total present value is higher than the cash outlay, therefore to
make it equal to Rs. 1,00,000, higher rate of discount should be used.
Therefore let us calculate the present value at 18% discount rate which
read as follows:

The Internal Rate of Return Project X has been found out to be 15.24%
whereas the IRR of Project Y is 16.79%. Thus, Project Y should be
accepted and project X rejected.
Precisely Project Y is recommended by the IRR method, NPV method,
PI method and IRR method. Project X is recommended by Pay-back
Period Method. However, it should be noted that Pay-back Period
Method is not theoretically sound method.

4. SUMMARY
 Capital Budgeting refers to the long-term planning for proposed
capital outlays or expenditure for the purpose of maximizing
return on investments.
 Capital decisions are required to assessment of future events
which are uncertain.
 Investment decision taken by individual concern is of national
importance because it determines employment, economic
activities and economic growth.
 The process of capital budgeting decisions involves identification
of profitable investment proposals, screening and selection of
right proposals, evaluation of measures of investment worth on
the basis of profitability and uncertainty or risk, establishing
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priorities, i.e., uneconomical or unprofitable proposals may be
rejected, final approval and preparation of capital expenditure
budget, implementing proposal, i.e., project execution and review
the performance of projects.
 Independent Proposals proposals are said be to economically
independent which are accepted or rejected on the basis of
minimum return on investment required.
 In dependent Proposals or Contingent Proposals, the acceptance
of one proposal is contingent upon the acceptance of other
proposals.
 Mutually Exclusive Proposals refer to the acceptance of one
proposal results in the automatic rejection of the other proposal.
 Pay back period is defined as the number of years required to
recover the initial investment in full with the help of the stream of
annual cash flows generated by the project.
 Post pay-back period method considers the amount of profits
earned after the pay-back period.
 Discounted pay-back method helps to measure the present value
of all cash inflows and outflows at an appropriate discount rate.
 Reciprocal pay-back period method is a close approximation of
the Time Adjusted Rate of Return, if the earnings are levelled and
the estimated life of the project is somewhat more than twice the
pay-back period.
 Discounted cash flow method helps to measure the cash inflow
and outflow of a project as if they occurred at a single point in
time so that they can be compared in an appropriate way.
 Net Present Value Method (NPV) is one of the Discounted Cash
Flow technique which explicitly recognizes the time value of
money.
 Internal Rate of Return Method is also called as "Time Adjusted
Rate of Return Method." , is defined as the rate which equates the
present value of each cash inflows with the present value of cash
outflows of an investment.
 Profitability Index is also known as Benefit Cost Ratio. It gives
the present value of future benefits, computed at the required rate
of return on the initial investment.
 Profitability Index may either be Gross Profitability Index or Net
Profitability Index. Net Profitability Index is the Gross
Profitability Index minus one.

5. SELF ASSESSMENT
1. A company is considering a project which will cost Rs. 60,000.
It has a life expectancy of six years and the tax rate is 50%.
Estimated profits after tax are given below:

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Year Profit
1 10,000
2 12,000
3 15,000
4 18,000
5 20,000
6 22,000
Compute Payback period(PB), ARR and IRR.
(Ans. PB = 4.83 years, ARR = 12.3% and IRR = 2%)
2. A company has an investment opportunity costing Rs. 40,000
with the expected cah flow shown below(after tax and before
depreciation):
Year Inflow PVF(10% Year Inflow PVF(10%
n years) n years)
1 7,000 0.909 7 10,000 0.513
2 7,000 0.826 8 15,000 0.467
3 7,000 0.731 9 10,000 0.424
4 7,000 0.653 10 4,000 0.386
5 7,000 0.621
6 8,000 0.564
Determine NPV and PI using 10% as the cost of capital.
(Ans. NPV= 48,611 and PI=1.215)

3. A company invests Rs. 40,000 in a new project with expected

useful life of six years. The cash flows after tax are given below:
Year Profit
1 10,000
2 11,000
3 15,000
4 10,000
5 12,000
6 11,000
Compute Payback period(PB).
(Ans. PB = 3.4 years)
4. The initial cash outlay of a project is Rs. 1,00,000 and it can
generate cash inflow of Rs.40,000, Rs.30,000, Rs.40,000 and Rs.
20,000 in year 1, 2,3 and 4 respectively. Assume 10% rate of
discount and calculate PI for the project.
(Ans. PI=1.05)
4. From the following information, calculate discounted payback
period:

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Year Profit
0 -1,50,000
1 70,000
2 60,000
3 30,000
4 20,000
5 10000
(Ans. DPB = 4.093 years)

5. SUGGESTED READINGS

 Khan and Jain, “Financial Management”, 2011, MH.

 I M Pandey, “Financial Management”, 2010, Vikas.
 Horne, Van “Financial Management and Policy”, 2002, Pearson.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008,
Pearson.
 Banerjee, B, “Financial Policy and Management Accounting”,
2005, PHI.
 Chandra, P., “Financial Management”, 2015, TMH.
 Srivastava, R.M., “Financial Management”, 2017, HPH.
 http://swayam.gov.in
 http://edx.org

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1. UNIT OBJECTIVES

After studying this module, you will be familiar with:

 Understand the concept and nature of dividend.
 Understanding formulation and types of dividend policies.
 Discuss types of dividends.
 Discuss Walter’s model and Gordon’s model related to dividend
relevance.
 Understand calculation of market price under Gordon and
Walter’s model.
 Discuss dividend irrelevancy theories: Residual approach and
Modigliani Miller approach.

2. INTRODUCTION
Dividend implies part of profits after interest and tax that are
distributed to the shareholders, as a return on investment made by them
in the form of equity of the firm. As preference shareholders get a fixed
rate of dividend, so the dividend decision has to be taken regarding
equity shareholders. Shareholders want return on their investments made
and company on the other hand want to meet its financing needs for
making investment decisions. This is because if the company will not be
able to meet its investment needs out of the profits earned, then it will
have to resort for external financing, which may be costlier for the firm
due to high floatation costs involved. Thus, a company has to make
dividend decision by striking a balance between the retained earnings
and issuing of new shares.

Nature of Dividend decisions

Dividend decision refers to decision regarding distribution of
profits or retention of profits. It constitutes an important part of financial
management decision. As major objective of financial management is
wealth maximization i.e. maximizing the shareholder’s value and the
shareholders value is maximized when the market value of the firm is
maximized. Thus, a firm has to evaluate its decision regarding the
payment or retention of profits in light of maximizing the value of the
firm. There are no promising facts regarding the impact of high payouts
firms having lower market price share or lower payout firms having

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higher market price per share over a period of time. Because, the market
price of the companies are a reflection of a number of factors, thus, there
are conflicting views regarding the impact of dividend decisions on the
value of the firm. One school of thought agrees on the relevance of
dividend decisions for having an impact on the value of the firm, while
another school of thought consider dividend decision as irrelevant for
considering their impact on the value of firm.

3. DIVIDEND POLICY

Dividend policy refers to the policy of determining how much of the

earnings of the firm are to be distributed to the shareholders and the
amount to be ploughed back (retention earnings). The dividend policy of
a firm has its effect on the wealth of the shareholders and long term
financing needs of the firm. Thus, the dividend policy should strike a
balance between meeting the needs of the shareholders for getting
dividends and the need of the company for funds to meet the long term
growth objectives. If a firm has profitable investment opportunities, then
the firm should retain the earnings, otherwise it should distribute the
earnings among the shareholders.

3.1 FORMULATION OF DIVIDEND POLICY

The formulation of dividend policy by companies depends upon a

number of factors. It has to maintain a tradeoff between the expectations
of shareholders and its own need of funds for making investment in
available investment avenues. The following factors mainly guide the
company in framing its dividend policy:
1. Investment Opportunities: If a firm is having profitable investment
opportunities in the market, then it will prefer to retain the profits to
finance the long term growth of the company. Otherwise, it will have to
borrow the funds from market which may involve high floatation costs.
On the other hand, if profitable investment opportunities are not
available, the firm should distribute its earnings.
2. Expectations of Shareholders: Another factor influencing the
dividend policy of a company is the expectation of shareholders. Some
shareholders may want to have current income and others may want to
enjoy capital gains on their investments. Thus, a company should devise
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dividend policy striking a balance between the two extreme needs, in
order to achieve the object of maximization of shareholders wealth.
3. Constraints concerning dividend payments: The decision
concerning the distribution of earnings or retention of earnings depends
upon a number of constraints, as follows:
a) Liquidity: It is one of the constraints faced by the companies.
Liquidity denotes the cash flow position of the company. Thus, if a
company has sound cash position, then it will be able to pay dividends
and vice-a-versa.
b) Legal restrictions: Another constraint on companies restricting its
dividend policy are the legal restrictions. A company has to work as per
the regulations of the regulatory bodies, under whose ambit it is carrying
on its operations. For instance, the Companies Act restricts the
companies for payment of dividends out of profits only. If a company
does not have distributable profits, then it cannot make use of retained
earnings for payment of dividends.
c) Accessibility to capital market: The ease with which a company can
raise funds from the capital market decides its accessibility position. If a
company does not have sound cash position but has profitability track
record, then it will have ease of access to capital markets for raising
funds. But, if a company does not have sound cash position and nor has
profitability record, then it will not be able to raise funds from the capital
market to pay dividends.
d) Dilution of Control: If a company wants to retain the control of
existing management or existing shareholders of the company, then it
may not be able to pay dividends regularly. This is because; payment of
dividends may necessitate the company to borrow funds from market by
issuing more shares. The issue of new shares could result in dilution of
control of existing management and shareholders of a company. So, this
is one of the constraints being faced by the companies while making
decision concerning retention of profits or payment of dividends out of
profits.
e) Inflation: Another constraint restricting a company for payment of
dividends is inflation. Most of the companies follow historical basis of
recording the transactions. As a result, the companies are left with

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insufficient funds for replacement of fixed assets in times of inflation due
to insufficient provision of depreciation provided for on historical basis.

3.2 DIVIDEND POLICIES

There are number of dividend policies that can be adopted by

companies. These are shown in Figure 1 below:

Figure 1: Types of Dividend Policies

1. Regular Dividend Policy: This policy involves payment of dividend

of at regular intervals of time. If a company earns abnormal profits in any
year, then the surplus profits are not distributed to the shareholders but
are retained by the companies. However, if a company incurs loss in any
year, even then the shareholders are paid dividend. So, this type of policy
can be followed by the companies which have been established over a
long period of time and are having stable earnings. This kind of policy
creates confidence in the minds of the shareholders and stabilizes the
market price of shares of such companies.

2. Stable Dividend Policy: Stability refers to consistency in the payment

of dividends. In other words, stability of dividends involves regularity in
payments of certain amount of dividends to the shareholders. This type
of policy can be followed in three forms:
a. Constant dividend per share: According to this policy, payment of
dividend is made at a certain fixed amount per share. For example: for
a share having face value of Rs. 10, a firm may pay fixed amount of, say,

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Rs.3 as dividend. This amount of dividend will be paid by the company
every year irrespective the level of its earnings or losses in any year.
However, when there is increase in the level of earnings, a company can
increase its dividend per share amount. The relationship between
earnings per share (EPS) and dividend per share (DPS) is depicted in
figure 2:

Figure 2: Relationship between EPS and DPS under Constant dividend per
share policy

b. Constant Payout Ratio: Payout ratio reflects the ratio of dividends to

the earnings of a firm. A constant payout ratio implies payment of
dividends of a fixed percentage of net earnings every year. In other
words, a fixed percentage of dividends of the net earnings are paid out
each year. For example: if a firm has a policy of 40% as target payout
ratio, then the range of dividend payments will be between Rs.6 and zero
per share on the assumption that the earnings per share of the company
are Rs.15 per share and zero (or less) per share respectively. The
relationship between earnings per share(EPS) and dividend per
share(DPS) under constant payout ratio is depicted in figure 3:

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Figure 3: Relationship between EPS and DPS under Constant payout

policy

c. Constant Dividend per share plus extra dividend: This policy is

followed by companies which have fluctuating earnings. Such companies
pay a fixed amount of dividend per share and extra dividend is paid over
and above the regular dividend in times of prosperity.

3. Irregular dividend policy: On account of uncertainties such as

uncertainty in the amount of earnings, insufficient liquid resources,
unsuccessful business operations, some companies may follow irregular
dividend policy. Irregularity refers to payment of dividends at irregular
intervals, i.e. a company pays dividends only when it earns profits or is
of the view that that it has sufficient distributable profits.

3.3 TYPES OF DIVIDENDS

Dividends can be distributed by the companies either in the form

of cash or in the form of shares. Dividends distributed in the form of cash
are known as cash dividends, while dividends distributed in the form of
shares is known as bonus issue. The following section explains the types
of dividends:
a. Cash Dividend: Dividend paid in the form of cash is known as cash
dividend. A company paying cash dividends should ensure that it has
sufficient cash balance. Moreover, if a company follows a stable
dividend policy, then it is preferable for it to prepare cash budget to
estimate the amount of funds to ensure regular payments. When dividend
payment is made in the form of cash, it reduces the total assets and net
worth of the company.

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b. Bonus Shares: When dividend is paid in the form of shares, it is
known as bonus issue. In other words, bonus issue involves distributing
shares free of cost to the existing shareholders. These shares are
distributed to the shareholders in the proportion of their existing
shareholding in a company. For example: X, a shareholder owns 150
shares at the time when company made a bonus issue at 10%, so X will
receive 15 additional shares. When bonus issue is made, it increases the
paid up share capital of the company and reduces the reserves and
surplus of the company.

4. DIVIDEND THEORIES

There are two schools of thoughts defining the relationship

between the value of a firm and dividend policy of a firm. These can be
categorized as shown in Figure 4:

Figure 4: Dividend Theories

A. THEORIES CONCERNING DIVIDEND DECISION

RELEVANCE
These are the theories which consider that dividend policy by a
firm has an effect on the value of firm. Dividend relevance theories
consist of the following theories given by Walter and Gordon
respectively:

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a. WALTER’S MODEL: Professor James E. Walter developed a
theoretical model supporting the premises that choice of dividend policy
by a firm has an effect on the valuation of firm. In support of this
premise, the model focused on the importance of relationship between
the return on investments made by a firm(r) and its cost of capital(k). In
other words, to determine optimum dividend policy of a company, it is
important to understand the relationship between r and k. The model is
based on a set of assumptions:
1. 100 percent internal financing: A firm finances all of its investment
through retained earnings only. External sources of finance are not used
by the firms.
2. Return on investment and cost of capital: The business risk is not
changed with the additional investments made by firms . In other words,
r and k remains constant.
3. EPS and DPS remains constant: Initial earnings per share and
dividend per share are assumed to remain constant.
4. Perpetual life: A firm is assumed to have a very long or perpetual life.

 Relationship between r and k as defined under Walter’s model:

Effect of
Dividend Dividend
Relationshi
payout policy on
Firms p between r Profits
ratio(Dividen Market
and k
d policy) value of
firm
Growth Retain all Maximize
a. r>k Nil or Zero
firms earnings d
Distribute
b Declinin Maximize
r<k all 100%
. g firms d
earnings
Earnings
can be No optimum
Normal
c. r=k retained or dividend
firms No Effect
distributio policy
n
Table 1: Relationship between r and k under Walter’s Model

Table 1 shows that under which situation firms should retain or

distribute the earnings and what should the optimum payout ratio for
such firms. Walter’s model has related the distribution of earnings with
the investments opportunities available to a firm, as explained below:
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a. Growth firms: If firms have adequate investment opportunities
available in the market, then they will be able to earn more than the
required rate of return(r > k) by the investors. These firms are called
growth firms, and will be able to maximize their value by retaining
whole earnings for making investments. For such firms, dividend
payout(D/P) ratio will be zero.
b. Declining firms: If a firm does not have adequate investment
opportunities available in the market, then it should distribute its entire
earnings to the shareholders, so as to allow the shareholders to invest
their dividends in the market. These firms are known as declining firms
and for these firms optimum dividend policy will be to have 100 percent
as dividend payout ratio, which will maximize the value of firm.
c. Normal Firms: If firms are not having ample investment
opportunities over a period of time, then after exhausting super
investment opportunities, such firms are able to earn returns just equal to
the cost of capital(r = k). These firms are known as normal firms. For
such firms, there is no optimum payout ratio and the value of the firm
will remain constant for all payout ratios ranging between zero and 100%.
In other words, whether the firm pays 100 % dividend or retains all the
earnings, the value of the firm will not get affected.

 Valuation of Market price per share:

Based on the above assumptions, Walter has derived a formula
for calculation of market price per share of a company. The formula is
based on the share valuation model as follows:
𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀𝑣 𝑘
P= 𝑘 +
𝑘
where, P is the market price per share, Div is dividend per share,
EPS is earnings per share, r is the firm’s rate of return and k is the firm’s
cost of capital.

The above formula has two components, first part (Div / k)

reflects the calculation of present value of all the future dividend
receipts.

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While, the second part reflects the present value of future stream

of capital gains .
Example 1 A firm has Rs. 10 as EPS and pays Rs. 4 as dividend per
share. Its actual capitalization rate(r) is 15% and normal capitalization
rate is 10%. Calculate the value of firm according to Walter’s model.

𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀 𝑘
Solution P = 𝑘 +
𝑘 1ǡⰂ10−4
4 + 10Ⰲ
= 10Ⰲ
10Ⰲ
4 9
= +
10 10
P = Rs. 130
Example 2 A firm has Rs. 10 as EPS and pays Rs. 2.5 as dividend per
share. Its rate of return on investments is 15% and capitalization rate is
10%. Calculate the value of firm according to Walter’s model.
𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀 + 𝑘
Solution P = 𝑘 𝑘
1ǡⰂ 10−2෸ǡ
2෸ǡ 10Ⰲ
= +
10Ⰲ 10Ⰲ
2෸ǡ 11෸2ǡ
= +
10 10
P = Rs. 137.5

Example 3 The following information is given in respect of a firm:

Capitalization rate (ke) = 10%
Earnings per share (EPS) = Rs. 10
Assume rate of return on investment(r) to be (i) 15% and (ii) 8%.
Consider two cases of dividend payout ratio i.e. 0% and 25%.
Show the effect of dividend policy on the value of the firm using
Walter’s model.

Solution (i) when rate of return is 15%

a) r= 15% and D/P ratio is 0%(dividend per share is 0)

𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀𝑣
P= 𝑘
𝑘 +
𝑘

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1ǡⰂ10−0
0 10Ⰲ
= 10Ⰲ +
10Ⰲ
1ǡⰂ10−0
0 10Ⰲ
= +
10Ⰲ
10Ⰲ
0 1ǡ
=10Ⰲ +
10Ⰲ
P = 150

b) r = 15% and D/P ratio is 25%(dividend per share is Rs.2.5)

𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀𝑣 𝑘
P= +
𝑘 𝑘
1ǡⰂ 10−2෸ǡ
2෸ǡ 10Ⰲ
= 10Ⰲ +
10Ⰲ
1ǡⰂ 10−2෸ǡ
2෸ǡ 10Ⰲ
= +
10Ⰲ
10Ⰲ
2෸ǡ 11෸2ǡ
= +
10Ⰲ
10Ⰲ
P = 137.5

(ii) when rate of return is 8%

a) D/P ratio is 0 %(dividend per share is 0)

𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀𝑣 𝑘
P= +
𝑘 𝑘

⺂Ⰲ 10−0
0 10Ⰲ
= 10Ⰲ +
10Ⰲ

0 ⺂Ⰲ 10−0
= 10Ⰲ
10Ⰲ +
0 10Ⰲ
⺂
=10Ⰲ +
10Ⰲ
P = 80
b) D/P ratio is 25 %(dividend per share is Rs.2.5)
𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀𝑣 𝑘
P= +
𝑘 𝑘

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⺂Ⰲ 10−2෸ǡ
2෸ǡ
= 10Ⰲ + 10Ⰲ
10Ⰲ

⺂Ⰲ 10−2෸ǡ
2෸ǡ
= 10Ⰲ
10Ⰲ + 10Ⰲ

2෸ǡ 6
= +
10Ⰲ
10Ⰲ
P = 85
Interpretation: (i) when r>k, i.e. rate of return is 15% and cost of
capital is 10%. This is a case for growth firms. In order to maximize the
value of firm, these firms should retain all the earnings and thus dividend
payout ratio should be zero. This is evident from above example. When
payout ratio was 25% , the firm value was Rs.137.5, but when firm has
payout ratio equal to zero, then its market value is more(Rs. 150). So in
order to maximize the value of firm, when r>k, then dividend payout
ratio should be zero.

(ii) when r<k, i.e. rate of return is 8% and cost of capital is 10%. This is
a case for declining firms. In order to maximize the value of firm, these
firms should distribute all the earnings and thus dividend payout ratio
should be 100%. This is evident from above example. When payout ratio
was 25% then firm value was Rs.85, but when firm has payout ratio
equal to zero, then its market value is less(Rs. 80). So in order to
maximize the value of firm, when r<k, then firm should distribute its
earnings.

Example 4 The following information is given in respect of a firm:

Capitalization rate(ke) = 10%
Earnings per share(EPS) = Rs. 10

Assume rate of return on investment(r) to be 10%

Consider two cases of dividend payout ratio is 0% and 25% .
Show the effect of dividend policy on the value of the firm using
Walter’s model.

Solution (i) when rate of return is 10% and D/P ratio is 0%(dividend
per share is 0)

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𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀𝑣 𝑘
P=
𝑘 +
𝑘

10Ⰲ10−0
0 10Ⰲ
= 10Ⰲ +
10Ⰲ
10Ⰲ10−0
0 10Ⰲ
= +
10Ⰲ 10Ⰲ
0 10
=10Ⰲ +
10Ⰲ
P = 100
(ii) when rate of return is 10% and D/P ratio is 25%(dividend per
share is 2.5)

𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀𝑣
P= 𝑘
𝑘 +
𝑘
10Ⰲ 10−2෸ǡ
2෸ǡ 10Ⰲ
= 10Ⰲ +
10Ⰲ
1ǡⰂ 10−2෸ǡ
2෸ǡ 10Ⰲ
= +
10Ⰲ 10Ⰲ
2෸ǡ 7෸ǡ
= +
10Ⰲ 10Ⰲ
P = 100

Interpretation: In the above example r=k, i.e. r=10% and k=10%, these
firms are known as normal firms. The market value of these firms does
not change with change in the dividend payout ratio. This is evident from
above, whether the firm has dividend payout ratio of 0 or 25%, the
market value in both the cases has remain same (Rs. 100).
 Criticism of Walters Model:
1. 100% Internal Financing: Walter model assumes that for making
investments external financing is not used by the firms; they only utilize
their retained earnings. But in real terms, it is not possible to rely on
internal funds. In order to meet diverse investment needs, firms have to
go for external financing.

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2. Constant return(r): The model assumed that rate of return and cost
of capital remains constant. But in realistic terms, r changes with the
extent of investments made by a firm.
3. Constant k: The model further assumed that k, i.e. cost of capital
remains constant. By assuming this, the effect of risk on the value of firm
has been ignored. This is because, k. changes directly with the firm’s
risk.

b. GORDON’S MODEL: Another theory which asserted that choice of

dividend policy by a firm has an effect on the valuation of firm is given
by Myron Gordon. This theory is based on a set of following
assumptions:
1. All-equity firm: The firm is an all-equity firm. No external financing
is used. The investments are financed using retained earnings only.
2. Constant r and k: The model assumes rate of return and cost of
capital to be constant.
3. Infinite life: It has been assumed that a firm has a perpetual or a long
life.
4. Constant b: The retention ratio, b, is constant. Thus, the growth
rate,(g=br) is also constant.
5. k is more than g: The discount rate is greater than growth rate(k>g).

 Valuation of share under Gordon’s Model

According to Gordon’s Model, the market value of a share is equal to the
present value of future stream of dividends. It is used to study the impact
of dividend policy of a firm on the market value of a firm. It can be
expressed as:
𝐸𝑃𝑆(1−𝑏) D1 Do(1+g)
P= or or
𝑘−𝑏𝑟 K-g K-g

where, P is the price of share, EPS is earnings per share, b is the retention
ratio, 1-b is the percentage of earnings distributed as dividend (D/P ratio),
k is cost of capital, br = g = Growth rate in r (rate of return on investment
of an all equity firm), D is dividend per share, D 1 is expected dividend at
the end of year 1.

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 Relationship between r and k as defined under Gordon’s

model:
Effect of
Dividend
Relationship Dividend
Firms policy on
between r and k policy
Market value
of share
Growth Increase
a. r>k Maximized
firms retention ratio
Declining Increase
b. r<k Maximized
firms Payout ratio
No optimum
Normal
c. r=k dividend
firms No Effect
policy
Table 2 : Relationship between r and k under Gordon’s Model

Table 2 depicts the relationship between rate of return(r) and cost

of capital(k), as defined under Gordon’s model. In case of firms with
growth opportunities, where r>k, the market price of share increases with
the retention ratio of the earnings. While, in case of declining firms,
where r<k, the market price of share increases with increase in payout
ratio of the earnings. On the other hand, in case of normal firms, where r
= k, the market price share of a firm is not affected by the dividend
policy of a firm. But this effect(where r=k) is not applicable in case of
uncertain situations(explained below under The Bird-In-The-Hand
Argument).

 Dividend and Uncertainty: The Bird-In-The-Hand

Argument:
According to Gordon’s model, in case of normal firms, where r=k,
the dividend policy does not have any impact on the market price of
share of a firm. But, this assumption was refined afterwards. It was found
that under conditions of uncertainty, dividend policy has an effect on the
value of share when rate of return is equal to cost of capital(r=k). The
bird in hand argument indicates that a bird in hand is better than the two
in the bush. In other words, what is available at present is better than
what may be available in the future. Based on this argument, Gordon
argued that investors are rational and risk averse, they want to avoid
uncertainty. So they will prefer near dividends to future dividends
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(capital gains). As a result, the discount rate (k) will also not remain
constant. The discount rate will increase with the uncertainty, which in
turn increases with time(Figure 5). Thus, the investors would discount
the future dividends(capital gains) at a higher rate than the near
dividends. This argument related to the effect of dividend policy on the
market value of share is known as bird-in-hand argument.

Figure 5: Discount rate and Retention rate

under conditions of uncertainty

Example 5 The following information is given for a firm:

r = (i) 12% (ii) 10%
k = 11%
EPS = Rs. 20
Determine the value of shares, assuming (a) (1-b) =10% and b=90%
(b) (1-b) =20% and b=80%.

Solution The value of share under Gordon’s model is given by:

𝐸𝑃𝑆(1−𝑏)
P= 𝑘−𝑏𝑟
(i) when r = 12%
a) (1-b) =10% and b=90%
20(10Ⰲ)
P = 11Ⰲ−90Ⰲ×12Ⰲ

P = Rs. 1,000

b) (1-b) =20% and b=80%

20(20Ⰲ)
P=
11Ⰲ−⺂0Ⰲ×12Ⰲ
P = Rs. 285.71
Interpretation: When r>k, the market value of share should increase
with increase in retention ratio. It can be seen that when retention rate is

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80% market value of share is Rs. 285.71, but with increase in the
retention rate to 90%, the market value has also increased to Rs.1000.

(ii) when r = 10%

a) (1-b) =10% and b=90%
20(10Ⰲ)
P = 11Ⰲ−90Ⰲ×10Ⰲ

P = Rs. 100

b) (1-b) =20% and b=80%

20(20Ⰲ)
P=
11Ⰲ−⺂0Ⰲ×10Ⰲ
P = Rs. 133.33
Interpretation: When r<k, the market value of share should increase
with increase in payout ratio. It can be seen that when payout rate of
dividends is 10% , market value of share is Rs. 100, but with increase in
the payout rate to 20%, the market value of share has also increased to
Rs.133.33.

Example 6 A company is expected to pay dividend of Rs. 4 per share

next year. The dividends are expected to increase at 10% annually. What
is the value of share if the required rate of return is 20%?
D1
Solution P=
K-g
4
=
0෸1ǡ−0෸10
P = Rs.80

Example 7 The current share price of a company is Rs. 100. The

company is expected to pay a dividend of Rs. 2 per share next year with
an annual growth rate of 5 percent. If an investor’s required rate of return
is 10%, should he buy the share?
D1
Solution P=
K-g
2
=
0෸10−0෸0ǡ
P = Rs.40

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As the value of the share(Rs.40) is less than the current price of the share
of Rs. 100. The investor should not buy the share.

B. THEORIES CONCERNING DIVIDEND DECISION

IRRELEVANCE
In contrast to Walter’s model and Gordon’s model, there are theories that
consider dividend decision irrelevant for determining the value of a firm.
1. Residual Approach: This approach considers that the dividend
decision has no impact on the value of a firm. It considers dividend
decision as a financing decision. Accordingly, if there is requirement of
funds in the business, the earnings will be retained in the business to
finance the investments, otherwise the earnings will be distributed as
dividends. If there are attractive opportunities available in the market,
then investors would applaud the decision of the firm for retention of
earnings, otherwise the earnings should be distributed as dividends. Thus,
this approach considers dividend decision to be a residual decision.

2. Modigliani And Miller(MM) Approach: According to MM

approach, dividend policy of a firm is irrelevant and hence does not has
an effect on the value of a firm. They propounded that the value of a firm
depends on the earnings resulting from the investment policy of a firm. A
firm can thus, split the earnings of the earnings in any ratio between
dividends and retained earnings. The MM approach is based on
following set of assumptions:
1. There are perfect capital markets.
2. Investors are rational.
3. There is no cost involved in obtaining any information from market.
4. No transaction costs and floatation costs are involved.
4. A firm operates under zero-tax environment.
5. The investment policy of the firm is fixed.
6. There is no risk of uncertainty. Investors can forecast the future value
of firm with certainty.

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 Valuation of Firm under MM approach
Based on the above assumptions, r and k will be equal to each
other and will be same for all the shares. Thus, the price of the share
must adjust so that the rate of return will be equal to the discount rate and
be identical for all the shares. It can be expressed as:
Dividends+Capital gains(or loss)
r=
Share price
Div1 +(P1 -Po )
r=
Po
where Po is the market price per share at time 0, P1 is the market price
per share at time 1, Div1 is dividend per share at time 1.

Under MM approach, the investments of a firm can be financed

from internal funds(retained earnings) as well using external finance. The
value of the firm remain unaffected from the kind of dividend policy
followed by a firm. The value of firm can be calculated from the
following formula:
(n  m)P1  (I  E)
nPo =
(1 k)
where, m is the number of shares to be issued, I is the investment
required, E refers to the total earnings of the firm during the period, P1
is the market price per share at the end of the period, K is the cost of
capital, n is the number of shares outstanding at the beginning of period,
D1 refers to dividend to be paid at the end of the period and nP0 is the
value of the firm.

5. SELF ASSESSMENT TEST

1. The following information is given in respect of a firm:

Capitalization rate (ke) = 10%
Earnings per share(EPS) = Rs. 10
Assume rate of return on investment(r) to be (i) 15% and (ii) 8%.
Consider two cases of dividend payout ratio is 50% and 75% .
Show the effect of dividend policy on the value of the firm using
Walter’s model.

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(Ans. Value of firm when r is 15% and D/P ratio is 0 and 75%, P = 125
and Rs. 112.50 respectively ; when r is 8% and D/P ratio is 0 and 75%,
P = 90 and Rs. 95 respectively).

2. The current share price of a company is Rs. 250. The company is

expected to pay a dividend of Rs. 4 per share next year with an annual
growth rate of 12 percent. If an investor’s required rate of return is 14%,
should he buy the share(Gordon Model)?
(Ans. P= Rs.200)

3. A company is expected to pay dividend of Rs. 2 per share next year.

The dividends are expected to increase at 5% annually. What is the value
of share if the required rate of return is 10% (Gordon Model)?
(Ans. P= Rs.40)

4. A company is expected to pay dividend of Rs. 6 per share next year.

The dividends are expected to increase at 9% annually. What is the value
of share(Gordon Model) if the required rate of return is 15%?
(Ans. P= Rs.100)

5. The following information is given for a firm:

r = (i) 11% (ii) 10%
k = 11%
EPS = Rs. 20
Determine the value of shares, assuming (a) (1-b) =50% and b=50%
(b) (1-b) =70% and b=30%.
(Ans. Value of share when r is 11% and b is 50% and 30%, P = 200 and
Rs. 189.19 respectively; when r is 10% and b is 50% and 30%, P =
166.67 and Rs. 175 respectively).

6. The following information is given in respect of a firm:

Capitalization rate(ke) = 10%
Earnings per share(EPS) = Rs. 10
Assume rate of return on investment(r) to be 10%
Consider two cases of dividend payout ratio is 50 and 75% .
Show the effect of dividend policy on the value of the firm using
Walter’s model.

(Ans. Value of firm in both payout ratio is Rs. 100)

7. A firm has expected return(r) of 14%, cost of capital(k) is 10%, the
earnings per share is Rs. 7 and dividend per share is Rs.0. Based on this
information, calculate the market price of share for firm under Walter’s
model.

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(Ans. P= Rs. 98)

8. The current share price of a company is Rs. 200. The company is

expected to pay a dividend of Rs. 5 per share next year with an annual
growth rate of 10 percent. If an investor’s required rate of return is 12%,
should he buy the share(Gordon Model)?
(Ans. P= Rs.250)

9. A firm has expected return(r) of 14%, cost of capital(k) is 10%, the

earnings per share is Rs. 7 and dividend per share is Rs.3. Based on this
information, calculate the market price of share for firm under Walter’s
model.
(Ans. P=Rs.86)

10. A steel company which earns Rs. 5 per share, is capitalized at 10%
and has a return on investment of 12%. Using Walter’s model determine
the price per share.
(Ans. P=Rs. 60)

11. A company has total investment of Rs. 5,00,000 in asserts and 50,000
outstanding ordinary shares at Rs.10 per share. It earns a rate of 15
percent on its investment, and has a policy of retaining 50 percent of the
earnings. If the discount rate of the firm is 10 percent, determine the
price of its share using Gordon’s Model. What shall happen to the price
of share if the company has payout of 80 percent and 20 per cent?
(Ans. At 50 percent payout, P=Rs.30, At 80 percent payout, P=Rs.17 and
at 20 percent payout, P=Rs.15)

12. A company has earnings per share of Rs. 12 and the rate of
capitalization applicable to company is 10 percent. The company has two
options: (1) adopting a payout ratio of 25%, (2.) adopting a payout of
75%. Using Walter’s formula of dividend payout, calculate the market
value of share, if r is (1)15%, (2) 10% and (3) 5%
Ans. At r=10% and payout of 25% and 75%, P= Rs. 120 and Rs. 120
At r=15% and payout of 25% and 75%, P= Rs. 165 and Rs.
135
At r= 5% and payout of 25% and 75%, P= Rs. 75 and Rs.
105
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6. SUMMARY
 Dividend refers to the portion of earnings distributed to the
shareholders of a company.
 Dividend may be distributed in the form of cash or shares.
 Bonus shares are issued free of cost to the existing shareholders.
 Dividend policy refers to the policy of determining how much of
the earnings of the firm are to be distributed to the shareholders
and the amount to be ploughed back (retention earnings).
 Regular dividend policy involves payment of dividend of at
regular intervals of time.
 Stable dividend policy involves regularity in payments of certain
amount of dividends to the shareholders.
 Constant dividend per share denotes payment of dividend is made
at a certain fixed amount per share.
 A constant payout ratio implies payment of dividends of a fixed
percentage of net earnings every year.
 Constant dividend per share plus extra dividend policy involves
payment of a fixed amount of dividend per share and extra
dividend is paid over and above the regular dividend in times of
prosperity.
 Under irregular dividend policy company pays dividends only
when it earns profits or is of the view that that it has sufficient
distributable profits.
 Theories which consider that dividend policy of a firm has an
effect on the value of firm are known as dividend relevance
theories.
 Dividend relevance theories include Walter’s model and
Gordon’s model.
 Theories which consider that dividend policy of a firm has no
effect on the value of firm are known as dividend irrelevance
theories.
 According to Walter’s model, the value of a firm depends on the
availability of adequate profitable investment opportunities in the
market. If profitable investments are available in the market, then
a firm will retain 100 per cent of its earnings.

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 Walter’s formula for calculation of market price of shares:
𝑟 𝐸𝑃𝑆−𝐷궀𝑣
𝐷궀𝑣 𝑘
P= 𝑘 +
𝑘
 Gordon’s model is also based on the dividend relevance model
and market price of a share can be calculated as:
𝐸𝑃𝑆(1−𝑏)
P=
𝑘−𝑏𝑟
 Gordon found that under conditions of uncertainty, dividend
policy has an effect on the value of share when rate of return is
equal to cost of capital(r=k)
 There are theories that consider dividend decision irrelevant for
determining the value of a firm.
 Residual approach and Modigliani Miller approach consider
irrelevance of dividend policy for having an impact on the value
of firm.
 Residual approach considers dividend decision as a financing
decision. Accordingly, if there is requirement of funds in the
business, the earnings will be retained in the business to finance
the investments; otherwise the earnings will be distributed as
dividends.
 MM model states that dividends are irrelevant.
 According to MM hypothesis, the dividend policy of affirm does
not affect the wealth of the shareholders.
 MM hypothesis holds good only under perfect capital market
conditions.
 MM hypothesis considers that the value of a firm depends on the
earnings resulting from the investment policy of a firm.

7. SUGGESTED READINGS

 Khan and Jain, “Financial Management”, 2011, MH.

 I M Pandey, “Financial Management”, 2010, Vikas.
 Horne, Van “Financial Management and Policy”, 2002, Pearson.
 Kapil, S., “Financial Management”, 2015, Wiley.
 Sharan, “Fundamentals of Financial Management”, 2008,
Pearson.
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 Banerjee, B, “Financial Policy and Management Accounting”,
2005, PHI.
 Chandra, P., “Financial Management”, 2015, TMH.
 Srivastava, R.M., “Financial Management”, 2017, HPH.
 http://swayam.gov.in
 http://edx.org

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