FINANCIAL MANAGEMENT

COURSE CODE
YEAR 1:2

Course Aim/s
 To give an overview of the problems facing a financial manager in the commercial world.
 It will introduce the concepts and theories of corporate finance that underlie the
techniques that are offered as aids for the understanding, evaluation and resolution of
financial manager’s problems.
Learning Outcome/s:
 Provides support for decision making.
 It enables to monitor their decisions for any potential financial implications and for
 Lessons to be learned from experience and to adapt or react as needed.
 To demonstrate ability to manage working capital
 Information. FM helps in understanding the use of resources efficiently, effectively and
economically.
Module description
Unit-I: The Finance Function Introduction to Finance, Nature and Scope, Finance Function It’s
Role in the Contemporary Scenario, Goals of Finance Function.

Unit-II: Value for money: time preference for money, present value for money, future value for
money, sinking fund.

Unit-III: the Investment Decision nature of investment, importance, capital budgeting process,
Capital Budgeting Techniques: PBP&NPV, risk and uncertainty in investment.

Unit IV: the financing decision. Sources of short term and long term finance cost of capital.

Unit v: working capital management. Meaning, importance of working capital, determination,

financing working capital, management of cash, inventory and accounts receivable.

Unit VI: dividend decision. Importance, types and forms, determinants, modes of paying.

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Unit vii: financial planning. Importance, financial ratio analysis.

UNIT 1
MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It includes financial service
and financial instruments.
Finance also is referred as the provision of money at the time when it is needed. Finance function
is the procurement of funds and their effective utilization in business concerns.
Definition:
According to GUTHMANN and DOUGALL, business finance may be broadly defined as “the
activity concerned with the planning, raising, controlling and administering the funds used in the
business.”
Financial decisions refer to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm maker in pursuit of maximizing
shareholders wealth, viz., kind of assets to be acquired, pattern of capitalization, distribution of
firms income etc. We can classify these decisions into these major groups:
 Investment decisions
 Financing decision.
 Dividend decisions.
 Working capital decisions.

NATURE OF FINANCE FUNCTION:

 In most of the organizations, financial operations are centralized. This results in
economies.

 Finance functions are performed in all business firms, irrespective of their sizes / legal
form of organization.

 They contribute to the survival and growth of the firm.

 Finance function is primarily involved with the data analysis for use in decision making.

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  Finance functions are concerned with the basic business activities of a firm, in addition to
external environmental factors which affect basic business activities, namely, production
and marketing.

 VI. Finance functions comprise control functions also

SCOPE OF FINANCIAL MANAGEMENT:

The main objective of financial management is to arrange sufficient finance for meeting short
term and long term needs. A financial manager will have to concentrate on the following areas of
finance function.
1. Estimating financial requirements:
The first task of a financial manager is to estimate short term and long term financial
requirements of his business. The amount required for purchasing fixed assets as well as needs
for working capital will have to be ascertained.
2. Deciding capital structure:
Capital structure refers to kind and proportion of different securities for raising funds. After
deciding the quantum of funds required it should be decided which type of securities should be
raised. A decision about various sources for funds should be linked to the cost of raising funds.
3. Selecting a source of finance: An appropriate source of finance is selected after preparing a
capital structure which includes share capital, debentures, financial institutions, public deposits
etc. If finance is needed for short term periods then banks, public deposits and financial
institutions may be the appropriate. On the other hand, if long term finance is required then share
capital and debentures may be the useful.

4. Selecting a pattern of investment: When funds have been procured then a decision about
investment pattern is to be taken. A decision will have to be taken as to which assets are to be
purchased? The funds will have to be spent first on fixed assets and then an appropriate portion
will be retained for working capital and for other requirements.

5. Proper cash management: Cash management is an important task of finance manager. He

has to assess various cash needs at different times and then make arrangements for arranging
cash. Cash may be required to purchase of raw materials, make payments to creditors, meet wage

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bills and meet day to day expenses. The idle cash with the business will mean that it is not
properly used.

6. Implementing financial controls: An efficient system of financial management necessitates

the use of various control devices. They are ROI, break even analysis, cost control, ratio analysis,
cost and internal audit. ROI is the best control device in order to evaluate the performance of
various financial policies.

7. Proper use of surpluses: The utilization of profits or surpluses is also an important factor in
financial management. A judicious use of surpluses is essential for expansion and diversification
plans and also in protecting the interests of share holders. A balance should be struck in using
funds for paying dividend and retaining earnings for financing expansion plans.

EVOLUTION OF FINANCE FUNCTION:

Financial management came into existence as a separate field of study from finance function in
the early stages of 20th century. The evolution of financial management can be separated into
three stages:
1. Traditional stage (Finance up to 1940): The traditional stage of financial management
continued till four decades. Some of the important characteristics of this stage are:

 In this stage, financial management mainly focuses on specific events like formation
expansion, merger and liquidation of the firm.
 The techniques and methods used in financial management are mainly illustrated and in
an organized manner.
 The essence of financial management was based on principles and policies used in capital
market, equipments of financing and lawful matters of financial events.
 Financial management was observed mainly from the prospective of investment bankers,
lenders and others.

2. Transactional stage (After 1940): The transactional stage started in the beginning years of
1940‟s and continued till the beginning of 1950‟s. The features of this stage were similar to the

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traditional stage. But this stage mainly focused on the routine problems of financial managers in
the field of funds analysis, planning and control. In this stage, the essence of financial
management was transferred to working capital management.

3. Modern stage (After 1950): The modern stage started in the middle of 1950‟s and observed
tremendous change in the development of financial management with the ideas from economic
theory and implementation of quantitative methods of analysis. Some unique characteristics of
modern stage are:
 The main focus of financial management was on proper utilization of funds so that wealth
of current share holders can be maximized.
 The techniques and methods used in modern stage of financial management were
analytical and quantitative.

Since the starting of modern stage of financial management many important developments took
place. Some of them are in the fields of capital budgeting, valuation models, dividend policy,
option pricing theory, behavioral finance etc.

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GOALS/ OBJECTIVES OF FINANCE FUNCTION Effective procurement and efficient use
of finance lead to proper utilization of the finance by the business concern. It is the essential part
of the financial manager. Hence, the financial manager must determine the basic objectives of
the financial management as discussed below.

 Profit Maximization
The main aim of any kind of economic activity is earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern. Profit maximization is also the
traditional and narrow approach, which aims at, maximizing the profit of the concern. Profit
maximization consists of the following important features.
 Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.
 Ultimate aim of the business concern is earning profit; hence, it considers all the possible
ways to increase the profitability of the concern.
 Profit is the parameter of measuring the efficiency of the business concern. So it shows
the entire position of the business concern.
 Profit maximization objectives help to reduce the risk of the business.

Unfavorable Arguments against Profit Maximization

The following important points are against the objectives of profit maximization:
 Profit maximization leads to exploiting workers and consumers.
 Profit maximization creates immoral practices such as corrupt practice, unfair trade
practice, etc.
 Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.

 Wealth Maximization
Wealth maximization is one of the modern approaches. The term wealth means shareholder
wealth or the wealth of the persons who are involved in the business concern. Wealth
maximization is also known as value maximization or net present worth maximization. This

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objective is universally accepted concept in the field of business. Stockholders current wealth in
a firm = (Number of shares owned) x (Current Stock Price share)

Favorable Arguments for Wealth Maximization

 Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.
 Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business
operation.
 Wealth maximization considers both time and risk of the business concern.
 Wealth maximization provides efficient allocation of resources.
 It ensures the economic interest of the society.

Unfavorable Arguments for Wealth Maximization

 Wealth maximization creates ownership-management controversy.
 Management alone enjoys certain benefits.
 The ultimate aim of the wealth maximization objectives is to maximize the profit.
 Wealth maximization can be activated only with the help of the profitable position of the
business concern.

 Productivity
 Growth
 Profitability
 Market share
 Increased revenue
 Survival
 Innovation
 Cash flow etc.

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ROLE OF FINANCIAL MANAGER IN CONTEMPORARY SCENARIO
 Estimate the required capital
 Determine the capital structure looking at the forms of financial sources putting in mind
the debt structure of the company
 Evaluate and select the source of capital
 Allocate and control finances
 Distribute profits and surpluses
 Monitor financial activities.

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Topic: 3 Sources of business Finance

When you’re looking to start or expand a business, there is always one major barrier: MONEY.

But the high business failure rate is partly caused by either too much ill-planned finance,
insufficient or inappropriate finance. The good news is, there is no ideal amount of money
required to start a business. So the question is, how do you raise the finance needed to fund your
business?

It is perhaps the toughest part of all the entrepreneur’s efforts. Choosing the right source and the
right mix of finance is a key challenge for every entrepreneur. The process of selecting the right
source of finance involves in-depth analysis of each and every source of fund.

On the basis of a time period, sources are classified as long-term, medium term, and short term.

(i) Long-term financing means capital requirements for a period of more than 5 years to
10, 15, and 20 years or maybe more depending on other factors. For analyzing and
comparing the sources, it needs the understanding of all the characteristics of the
financing sources.
(ii) Medium term financing means financing for a period of 3 to 5 years.
(iii) Short term financing means financing for a period of less than 1 year.

In terms of ownership and control: classify sources of finance into owned (internal) and
borrowed capital (external) which are the two major sources of generating capital.

(ii) An external source of finance is the capital generated from outside the business. Apart from
the internal sources of funds, all the sources are external sources.

(i) The internal source of capital is the one which is generated internally by the business. For
example: Retained profits (profits put back), Reduction or controlling of working capital, Sale of
assets etc. The main advantage of the internal sourcing of capital is that the business grows by
itself and does not depend on outside parties.

All the sources have different characteristics to suit different types of requirements. The usage of
the wrong source increases the cost of funds which in turn would have a direct impact on the

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feasibility of the project under concern. Also Improper match of the type of capital with business
requirements may go against the smooth functioning of the business.

It is essential to be knowledgeable about all of the options and to weigh the pros and cons of
each before making a decision.

Listed below are the common eight (8) common sources of funding, a brief explanation of
each:

 Grants this refers to money, equipment, assets, gifts that you are given for use in the
business but you don’t have to pay back.
 Supplier’s Credit these are goods, items or services given to you to use or sell and you
pay later. Here cash is not immediately paid and the delay of payment represents a source
of finance.
 Equity this refers to the initial contribution from the entrepreneur or owner(s) of the
business. It can come from many sources; for example, personal savings, an
entrepreneur's friends and family, investors, sale of shares.
 Re-invested Profits this refers to profits which the business makes and are reinvested
(put back) to increase the business’ capital. Your capital will grow organically when you
put back profits
 Disposal of underutilized or non-essential fixed assets. Here you sell some of your old
household items, personal or business assets to raise working capital for business instead
of getting a loan.
 Venture Capital Funding (VC) many entrepreneurs think that VC Funding is the key to
their success. Venture capitalists are investors who are willing to put forward a large sum
of money in exchange for equity (ownership of the business), but only get their money
out once the business either is bought by another company or goes public. VC normally
look for investments that can give up to 6X return on their investment, so you better be
prepared to go big!

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  Bank Loans bank loans are the most frequently sought after source of financing and can
be pursued at your nearest lending institution. Bank financing can be very tricky as there
are many different types of financing options and interest rates along with them. It is
imperative that you first educate yourself about the process of getting bank loans and
your options before applying for a loan.
 Pre-financed Services and products Customers give you or pay a deposit for goods or
services to be supplied later. E.g. making doors, windows, beds, dresses, furniture, etc.
You do not have to get working from expensive sources because customers give enough
to buy all the raw materials you need.

Other sources of money

Love money

This is money loaned by a spouse, parents, family or friends. A banker considers this as "patient
capital", which is money that will be repaid later as your business profits increase.

When borrowing love money, you should be aware that:

 family and friends rarely have much capital

 they may want to have equity/ ownership in your business
 a business relationship with family or friends should never be taken lightly

Angels

Angels are generally wealthy individuals or retired company executives who invest directly in
small firms owned by others. They are often leaders in their own field who not only contribute
their experience and network of contacts but also their technical and/or management knowledge.

In return for risking their money, they reserve the right to supervise the company's management
practices

Crowd funding

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Is a form of fundraising where a business asks the public for a contribution, usually in exchange
for equity in the company?

It usually entails a private company asking large numbers of people for small contributions. This
differs from the more conventional practice of raising money through angel investors or venture
capitalists, where a handful of actors inject larger sums into your business.

THE CAPITAL MARKET

The capital market is a financial market where buyers and sellers trade long-term financial assets.
Such financial assets either may not have a specific maturity period or have a long maturity period, at
least more than a year.

The capital market enables the government, financial institutions, companies, etc., to raise the required
long-term funds by issuing capital market instruments like shares, bonds, debentures, etc. Investors in
return get moderate to high returns.

The capital market is the market for medium and long term funds. Capital Market plays a
significant role in the growth of a country’s economy as it provides a platform for mobilizing the
funds.

The nature of the capital market is risky markets. Therefore, it is not used for short-term funds
investment.

The capital market is a type of financial market where financial products like stocks (a share in
the ownership of the company), bonds (issued by government to raise finance), debentures
(unsecured long term debt security used by companies) are traded for a long time. They serve the
purpose of long-term financing and long-term capital requirement. The capital market is a dealer
and an auction market and consists of two categories:

Primary market

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The primary market is a marketplace where securities are first issued. For instance, if a company
comes with an initial public offering (IPO).

Secondary market

The secondary market is where the already existing securities are traded among the investors. For
instance, if you buy any stock from another investor through the stock exchange, that transaction is
said to have occurred in the secondary market.

Capital markets also consists of:

 Stock markets, which provide financing through the issuance of shares or common stock, and
enable the subsequent trading there of. The stock market trades shares of ownership of public
companies. Each share comes with a price, and investors make money with the stocks when
they perform well in the market. It is easy to buy stocks. The real challenge is in choosing the
right stocks that will earn money for the investor. When stocks are bought at a cheaper price
and are sold at a higher price, the investor earns from the sale.
 Bond markets, which provide financing through the issuance of bonds, and enable the
subsequent trading there of. The bond market offers opportunities for companies and the
government to secure money to finance a project or investment. In a bond market, investors
buy bonds from a company, and the company returns the amount of the bonds within an
agreed period, plus interest.

Features of Capital Market

Important features of the capital market are:

 Unites entrepreneurial borrowers and investors

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  Deals with long-term investments.

 Agents are required.

 It is controlled by government rules and regulations.

 Foreign Investors.

 Minimizes transaction cost and time.

 Investment opportunities

Capital Market Examples

The capital market circulates the capital in the economy among the user and the suppliers of
money.
The maturity period is more than one year or sometimes it is incurable (no maturity).
 Stocks
 Bonds
 Debentures
 Euro issues

Capital Market Instruments

Here are the types of capital market instruments.

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Equity securities

Equity securities represent partial ownership in an issuing company. A common shareholder can have
voting rights. On the other hand, a preference shareholder may get preferred over equity shareholders
in terms of dividend payment and assets in the event of bankruptcy.

Debt securities

Bonds and debentures are those financial instruments by which companies, governments or other
financial institutions borrow money from investors for a specific period at the end of that period; they
repay the amount to the borrowers.

Other types of financial markets

 Commodity markets, The commodity market is a market that trades in the

primary economic sector rather than manufactured products, Soft commodities is
a term generally referred as to commodities that are grown, rather than mined
such as crops (corn, wheat, soybean, fruit and vegetable), livestock, cocoa, coffee
and sugar and Hard commodities is a term generally referred as to commodities
 Futures markets, which provide standardized forward contracts for trading
products at some future date; see also forward market.
 Derivatives Market, They get their value from an underlying asset. Individuals
and firms can trade in futures, options, forward contracts, and such trades can be
entered either via over-the-counter to manage the financial risk.

 Forex Market; The foreign exchange (Forex) market helps conduct foreign
currency exchange trade. These markets are operated through financial
institutions and are used to determine foreign exchange prices for every money.

Distinctions between money markets and capital markets

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 Basis for
Money Market Capital Market
Comparison

Capital market is part of the

It is the part of financial market where
financial market where lending
Definition lending and borrowing takes place for
and borrowing takes place for the
short-term up to one year
medium-term and long-term

Money markets generally deal

Types of Capital market deals in equity
in promissory notes, bills of exchange,
instruments shares, debentures,
commercial paper, T bills, call money,
involved bonds, preference shares etc.
etc.

It involves stockbrokers,
Institutions The money market contains financial
individual investors, commercial
involved/types of banks, the central bank, commercial
banks, stock exchanges, Insurance
investors banks, financial companies, etc.
Companies

Nature of Market Money markets are informal Capital markets are more formal

Liquidity of the Capital Markets are comparatively

Money markets are liquid
market less liquid

The maturity of capital markets

The maturity of financial instruments is
Maturity period instruments is longer and they do
generally up to 1 year
not have stipulated time frame

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 Basis for
Money Market Capital Market
Comparison

Since the market is liquid and the Due to less liquid nature and long
Risk factor maturity is less than one year, Risk maturity, the risk is comparatively
involved is low high

The capital market fulfills the

The market fulfills the short-term credit
Purpose long-term credit needs of the
needs of the business
business

The money markets increase the The capital market stabilizes the
Functional merit
liquidity of funds in the economy economy due to long-term savings

Return on The return in money markets are usually The returns in capital markets are
investment low high because of higher duration

Relevance to the Brings and boosts liquidity in the Mobilize savings and convert
economy economy. them into productive investments.

Capital markets are well

Organization Money markets are not that organized.
organized,

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 Unit: 3 Investment decision
Definition:
The term "investment" can be used to refer to any mechanism used for the purpose of generating
future income. In the financial sense, this includes the purchase of bonds, stocks or real estate
property. Additionally, the constructed building or other facility used to produce goods can be
seen as an investment.

Capital Definition:
The word Capital refers to be the total investment of company money in, tangible and intangible
assets
Or
Investment decision is the process of making investment decisions in capital expenditure.

A capital expenditure may be defined as an expenditure whose benefits are expected to be

received over period of time exceeding one year. The main characteristic of a capital expenditure
is that the expenditure is incurred at one point of time whereas benefits of the expenditure are
realized at different points of time in future.

Capital Budgeting
The process through which different projects are evaluated is known as capital budgeting.
Capital budgeting is defined “as the firm’s formal process for the acquisition and investment of
capital. It involves firm’s decisions to invest its current funds for addition, disposition,
modification and replacement of fixed assets”.
By definition
Capital budgeting (investment decision) as, “is a long term planning for making and financing
proposed capital outlays.” Charles T.Horngreen

NEED AND IMPORTANCE OF CAPITAL BUDGETING

 Huge investments: Capital budgeting requires huge investments of funds, but the
available funds are limited, therefore the firm before investing projects, plan are control
its capital expenditure.
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  Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore
financial risks involved in the investment decision are more. If higher risks are involved,
it needs careful planning of capital budgeting.

 Irreversible: The capital investment decisions are irreversible, are not changed back.
Once the decision is taken for purchasing a permanent asset, it is very difficult to dispose
of those assets without involving huge losses.

 Long-term effect: Capital budgeting not only reduces the cost but also increases the
revenue in long-term and will bring significant changes in the profit of the company by
avoiding over or more investment or under investment. Over investments leads to be
unable to utilize assets or over utilization of fixed assets. Therefore before making the
investment, it is required carefully planning and analysis of the project thoroughly.

CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process as it involves decisions relating to the investment of
current funds for the benefit to the achieved in future and the future is always uncertain.
However the following procedure may be adopted in the process of capital budgeting:
 Identification of various investments
 Screening or matching the available resources
 Evaluation of proposals
 Fixing property
 Final Approval
 Implementation

PROJECT GENERATION
 Identification of Investment Proposals:
The proposal or the idea about potential investment opportunities may originate from the top
management or may come from the rank and file worker of any department or from any officer
of the organization.
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  Screening the Proposals:
The expenditure planning committee screens the various proposals received from different
departments. The committee views these proposals from various angels to ensure that these are
in accordance with the corporate strategies or selection criterions of the firm and also do not lead
to departmental imbalances.
PROJECT EVALUATION
 Evaluation of Various Proposals:

The next step in the capital budgeting process is to evaluate the profitability of various proposals.
There are many methods which may be used for this purpose such as payback period method,
rate of return method, net present value method, internal rate of return method etc.
PROJECT SELECTION
 Fixing Priorities:

After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected
straight ways. But it may not be possible for the firm to invest immediately in all the acceptable
proposals due to limitation of funds. Hence, it is very essential to rank the various proposals and
to establish priorities after considering urgency, risk and profitability involved therein.
 Final Approval and Preparation of Capital Expenditure Budget:
Proposals meeting the evaluation and other criteria are finally approved to be included in the
Capital expenditure budget.
PROJECT EXECUTION
 Implementing Proposal:

Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the

budget does not itself authorize to go ahead with the implementation of the project. A request for
authority to spend the amount should further be made to the Capital Expenditure Committee.
Further, while implementing the project, it is better to assign responsibilities for completing the
project within the given time frame and cost limit so as to avoid unnecessary delays and cost
over runs by applying Network techniques PERT and CPM.
 Performance Review:
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The last stage in the process of capital budgeting is the evaluation of the performance of the
project. The evaluation is made through post completion audit by way of comparison of actual
expenditure of the project with the budgeted one, and also by comparing the actual return from
the investment with the anticipated return. The unfavorable variances, if any should be looked
into and the causes of the same are identified so that corrective action may be taken in future.

PROJECT EVALUATION TECHNIQUES (OR) CAPITAL BUDGETING

TECHNIQUES
There are many methods of evaluating profitability of capital investment proposals. The various
commonly used methods are as follows:
(A) Traditional methods:
 Pay-back Period Method or Pay out or Pay off Method.
 Accounting or Average Rate of Return Method.

(B) Time-adjusted method or discounted methods:

 Net Present Value Method.
 Internal Rate of Return Method.
 Profitability Index Method.
Under our study we shall basically focus on the pay back period and net present value
techniques of appraising investment proposals as below:

(A) Traditional methods

1. PAY-BACK PERIOD ETHOD The pay back sometimes called as pay out or pay off period
method represents the period in which the total investment in permanent assets pays back itself.
This method is based on the principle that every capital expenditure pays itself back within a
certain period out of the additional earnings generated from the capital assets.

ACCEPT /REJECT CRITERIA

Under this method, various investments are ranked according to the length of their payback
period in such a manner that the investment within a shorter payback period is preferred to the
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one which has longer pay back period. (It is one of the non-discounted cash flow methods of
capital budgeting).
Therefore pay back period = initial investment / annual cash inflows

MERITS
 It is easy to calculate and simple to understand.
 Pay-back method provides further improvement over the accounting rate return.
 Pay-back method reduces the possibility of loss on account of obsolescence.

DEMERITS
 It ignores the time value of money.
 It ignores all cash inflows after the pay-back period.
 It is one of the misleading evaluations of capital budgeting.

2. AVERAGE RATE OF RETURN:

This method takes into account the earnings expected from the investment over their whole life.
It is known as accounting rate of return method for the reason that under this method, the
Accounting concept of profit (net profit after tax and depreciation) is used rather than cash
inflows. ARR = (Average Annual profits)/ (Net investment in the project) x 100

Accept /reject criteria

According to this method, various projects are ranked in order of the rate of earnings or rate of
return. The project with the higher rate of return is selected as compared to the one with lower
rate of return.
This method can also be used to make decision as to accepting or rejecting a proposal. Average
rate of return means the average rate of return or profit taken for considering.

Merits
 It is easy to calculate and simple to understand.

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  It is based on the accounting information rather than cash inflow.
 It considers the total benefits associated with the project.

Demerits
 It ignores the time value of money.
 It ignores the reinvestment potential of a project.
 Different methods are used for accounting profit. So, it leads to some difficulties in the
calculation of the project.

(B) TIME – ADJUSTED OR DISCOUNTED CASH FLOW METHODS: or MODERN

METHOD

1. NET PRESENT VALUE

Net present value method is one of the modern methods for evaluating the project proposals. In
this method cash inflows are considered with the time value of the money. Net present value
describes as the summation of the present value of cash inflow and present value of cash
outflow. Net present value is the difference between the total present values of future cash
inflows and the total present value of future cash outflows.

Accept/Reject criteria
If the present value of cash inflows is more than the present value of cash outflows, it would be
accepted. If not, it would be rejected.
Merits
 It recognizes the time value of money.
 It considers the total benefits arising out of the proposal.
 It is the best method for the selection of mutually exclusive projects.
 It helps to achieve the maximization of shareholders‟ wealth.

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Demerits
 It is difficult to understand and calculate.
 It needs the discount factors for calculation of present values.
 It is not suitable for the projects having different effective lives.

2. INTERNAL RATE OF RETURN METHOD

This method is popularly known as time adjusted rate of return method/discounted rate of return
method also. The internal rate of return is defined as the interest rate that equates the present
value of expected future receipts to the cost of the investment outlay. This internal rate of return
is found by trial and error.
First we compute the present value of the cash-flows from an investment, using an arbitrarily
elected interest rate. Then we compare the present value so obtained with the investment cost. If
the present value is higher than the cost figure, we try a higher rate of interest and go through the
procedure again. Conversely, if the present value is lower than the cost, lower the interest rate
and repeat the process.
The interest rate that brings about this equality is defined as the internal rate of return. In other
words it is a rate at which discount cash flows to zero. This rate of return is compared to the cost
of capital and the project having higher difference, if they are mutually exclusive, is adopted and
other one is rejected. As the determination of internal rate of return involves a number of
attempts to make the present value of earnings equal to the investment, this approach is also
called the Trial and Error Method. Internal rate of return is time adjusted technique and covers
the disadvantages of the Traditional techniques.

Merits
 It considers the time value of money.
 It takes into account the total cash inflow and outflow.
 It does not use the concept of the required rate of return.
 It gives the approximate/nearest rate of return.

Demerits

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  It involves complicated computational method.
 It produces multiple rates which may be confusing for taking decisions.
 It is assume that all intermediate cash flows are reinvested at the internal rate of return.

NPV vs. IRR Methods

Key differences between the most popular methods, the NPV (Net Present Value) Method and
IRR (Internal Rate of Return) Method, include:

 NPV is calculated in terms of currency while IRR is expressed in terms of the percentage
return a firm expects the capital project to return;

 Academic evidence suggests that the NPV Method is preferred over other methods
since it calculates additional wealth and the IRR Method does not;

 The IRR Method cannot be used to evaluate projects where there are changing cash
flows (e.g. an initial outflow followed by in-flows and a later out-flow, such as may be
required in the case of land reclamation by a mining firm);

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  However, the IRR Method does have one significant advantage -- managers tend to
better understand the concept of returns stated in percentages and find it easy to compare
to the required cost of capital; and, finally,

Risk and uncertainty in investment: (assignment)

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Capital structure
Funds are the basic need of every firm to fulfill long term and working capital requirement.
Enterprise raises these funds from long term and short term sources. In this context, capital
structure and financial structure are often used. Capital Structure covers only the long term
sources of funds, whereas financial structure implies the way assets of the company are
financed, i.e. it represents the whole liabilities side of the Position statement, i.e. Balance Sheet.

Definition of Capital Structure

This is the combination of long-term sources of funds, i.e. equity capital, preference capital,
retained earnings and debentures in the firm’s capital is known as Capital Structure. It focuses on
choosing such a proposal which will minimize the cost of capital and maximize the earnings per
share. For this purpose a company can opt for the following capital structure mix:
 Equity capital only
 Preference capital only
 Debt only
 A mix of equity and debt capital.
 A mix of debt and preference capital.
 A mix of equity and preference capital.
 A mix of equity, preference and debt capital in different proportions.

There are certain factors which are preferred while choosing the capital structure like, the pattern
opted for capital structure should reduce the cost of capital and increase the returns, the capital
structure mix should contain more of equity capital and less of debt to avoid the financial risk, it
should provide liberty to the business and management to adapt itself according to the changes
and so on.

Definition of Financial Structure

The mix of long term and short term funds employed by the company to procure the assets which
are required for day to day business activities is known as Financial Structure. Trend Analysis
and Ratio Analysis are the two tools used to analyze the financial structure of the company.
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The composition of the financial structure represents the whole equity and liabilities side of the
Balance Sheet, i.e. it includes equity capital, preference capital, retained earnings, debentures,
short-term borrowings, account payable, deposits provisions, etc.

The following factors are considered at the time of designing the financial structure:

Leverage: this refers to using debt or borrowed capital to finance investments.

Types of leverage
 Financial leverage this is where a firm borrows money to invest.
 Operational leverage this is increasing production to spread fixed cost.
 Intellectual leverage using knowledge and expertise to amplify results.
Benefits
 Increased potential returns
 Amplified efficiency
 Enhanced competitiveness
Risk
 Debt obligation
 Interest payments
 Potential losses
Examples
 Buying a house with a mortgage
 Scaling business production by increasing output while controlling cost, efficiency and
quality
Leverage can be either positive or negative, i.e. a modest rise in the EBIT will give a high rise to
the EPS but simultaneously increases the financial risk.
Cost of Capital: The financial structure should focus on decreasing the cost of capital. Debt and
preference share capital are cheaper sources of finance as compared to equity share capital.

Control: The risk of loss and dilution of control of the company should be low.

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Flexibility: Any firm cannot survive if it has a rigid financial composition. So the financial
structure should be such that when the business environment changes structure should also be
adjusted to cope up with the expected or unexpected changes.

Solvency: The financial structure should be such that there should be no risk of getting
insolvent.

Basis for Comparison Capital Structure Financial Structure

Meaning The combination of long term The combination of long term
sources of funds, which are and short financing represents
raised by the business, is the financial structure the
known as Capital Structure. company.
Appears on Balance Sheet Under the head Shareholders The whole equities and
fund and Non-current liabilities side.
liabilities.
Includes Equity capital, preference Equity capital, preference
capital, retained earnings, capital, earnings, debentures,
debentures, long term long term borrowing, account
borrowings etc. payable, short term borrowing
One in another The capital structure is a Financial structure includes
section of financial structure. capital structure.

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Capitalization
Capitalization‟ refers to total amount of capital employed in a business; it’s therefore the process
of determining the quantum of funds that a firm would require to run its business. It’s only the
par value (i.e., face value indicated on the security itself) of the long-term securities (shares and
debentures) plus by any reserves which are meant to be used for meeting long-term and
permanent needs of a company.
Share capital refers only to the paid-up value of shares issued.

The term capital refers to the total investment of a company in money, tangible assets like
goodwill. It is in a way the total wealth of a company.

Capital structure is a broad term and it deals with qualitative aspect of finance. While
capitalization is a narrow term and it deals with the quantitative aspect. Capitalization is
generally found to be of following types-
 Normal
 Over
 Under

Overcapitalization
Overcapitalization is a situation in which actual profits of a company are not sufficient enough to
pay interest on debentures, on loans and pay dividends on shares over a period of time. This
situation arises when the company raises more capital than required. A part of capital always
remains idle. With a result, the rate of return shows a declining trend. The causes can be

 High promotion cost- When a company goes for high promotional expenditure, i.e.,
making contracts, canvassing, underwriting commission, drafting of documents, etc. and
the actual returns are not adequate in proportion to high expenses, the company is over-
capitalized in such cases.

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  Purchase of assets at higher prices- When a company purchases assets at an inflated
rate, the result is that the book value of assets is more than the actual returns. This
situation gives rise to over-capitalization of company.

 A company’s floatation n boom period- At times company has to secure its solvency
and thereby float in boom periods. That is the time when rate of returns are less as
compared to capital employed. This results in actual earnings lowering down and
earnings per share declining.

 Inadequate provision for depreciation- If the finance manager is unable to provide an

adequate rate of depreciation, the result is that inadequate funds are available when the
assets have to be replaced or when they become obsolete. New assets have to be
purchased at high prices which prove to be expensive.

 Liberal dividend policy- When the directors of a company liberally divide the dividends
into the shareholders, the result is inadequate retained profits which are very essential for
high earnings of the company. The result is deficiency in company. To fill up the
deficiency, fresh capital is raised which proves to be a costlier affair and leaves the
company to be over- capitalized.

 Over-estimation of earnings- When the promoters of the company overestimate the

earnings due to inadequate financial planning, the result is that company goes for
borrowings which cannot be easily met and capital is not profitably invested. This results
in consequent decrease in earnings per share.

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Effects of Overcapitalization

On Shareholders- The over capitalized companies have following disadvantages to

shareholders:
 Since the profitability decreases, the rate of earning of shareholders also decreases.
 The market price of shares goes down because of low profitability.
 The profitability going down has an effect on the shareholders. Their earnings become
uncertain.
 With the decline in goodwill of the company, share prices decline. As a result shares
cannot be marketed in capital market.

On Company-
 Because of low profitability, reputation of company is lowered.
 The company’s shares cannot be easily marketed.
 With the decline of earnings of company, goodwill of the company declines and the
result is fresh borrowings are difficult to be made because of loss of credibility.
 In order to retain the company’s image, the company indulges in malpractices like
manipulation of accounts to show high earnings.
 The company cuts down it’s expenditure on maintenance, replacement of assets, adequate
depreciation, etc.

On Public- An overcapitalized company has got many adverse effects on the public:
 In order to cover up their earning capacity, the management indulges in tactics like
increase in prices or decrease in quality.
 Return on capital employed is low. This gives an impression to the public that their
financial resources are not utilized properly.
 Low earnings of the company affects the credibility of the company as the company is
not able to pay it’s creditors on time.
 It also has an effect on working conditions and payment of wages and salaries also lessen.

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Undercapitalization
An undercapitalized company is one which incurs exceptionally high profits as compared to
industry. An undercapitalized company situation arises when the estimated earnings are very low
as compared to actual profits. This gives rise to additional funds, additional profits, high
goodwill, high earnings and thus the return on capital shows an increasing trend. The causes can
be-
 Low promotion costs
 Purchase of assets at deflated rates

 Conservative dividend policy

 Floatation of company in depression stage

 High efficiency of directors

 Adequate provision of depreciation

 Large secret reserves are maintained.

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Effects of Under Capitalization
1. on Shareholders
 Company’s profitability increases. As a result, rate of earnings go up.
 Market value of share rises.
 Financial reputation also increases.
 Shareholders can expect a high dividend.

2. on company
 With greater earnings, reputation becomes strong.
 Higher rate of earnings attract competition in market.
 Demand of workers may rise because of high profits.
 The high profitability situation affects consumer interest as they think that the company is
overcharging on products.

3. on Society
 With high earnings, high profitability, high market price of shares, there can be unhealthy
speculation in stock market.
 Restlessness in general public is developed as they link high profits with high prices of
product.
 Secret reserves are maintained by the company which can result in paying lower taxes to
government.
 The general public inculcates high expectations of these companies as these companies
can import innovations, high technology and thereby best quality of product.

Bases of Capitalization:
The major problem faced by the financial manager is determination of value at which a firm
should be capitalized because it has to raise funds accordingly. there are two theories that contain
guidelines with which the amount of capitalization can be summarized;
 Cost Theory of Capitalization

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According to this theory capitalization of a firm is regarded as the sun of cost actually incurred in
setting of the business. A film needs funds to acquire fixed assets, to defray promotional and
organizational expenses and to meet current asset requirements of the enterprise sum of the costs
of the above asset gives the amount of capitalization of the firm, acquiring fixed assets and to
provide with necessary working capital and to cover possible initial losses, it will capitalized
under this method more emphasis is laid on current investments. They are static in nature and do
not have any direct relationship with the future earning capacity. This approach is given as the
value of capital only at a particular point of time which would not reflect the future changes.

 Earning Theory of Capitalization

According to this theory, firm should be capitalized on the basis of its expected earning A firm is
profit is seeking entity and hence its value is determiner according to What it earns. The probable
earning are forecast and them they are capitalized at a normal representative rate of return.

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Capitalization of a company as per the earning theory can thus be determined with help
following formula.
Capitalization = Annual Net Earnings X Capitalization Rate
Thus for the purpose of determining amount of Capitalization in an enterprise the financial
manager has to fist estimate of annual net earnings of the enterprise where after he will have to
determine the capitalization rate. The future earning cannot be forecast exactly and depend to a
large extent on such external factors which are beyond the control of management.

LEVERAGES
Financial and Operating Leverage is common term in financial management which entails the
ability to amplify results at a comparatively low cost. In business, company's managers make
decisions about leverage that affect profitability.
According to James Horne, leverage is, "the employment of an asset or fund for which the firm
pays a fixed cost or fixed return". When they evaluate whether they can increase production
profitably, they address operating leverage. If they are expecting taking on additional debt, they
have entered the field of financial leverage.
Operating leverage and financial leverage both heighten the changes that occur to earnings due to
fixed costs in a company's capital structures. Fundamentally, leverage refers to debt or to the
borrowing of funds to finance the purchase of a company's assets. Business proprietors can use
either debt or equity to finance or buy the company's assets. Use of debt, or leverage, increases
the company's risk of bankruptcy. It also upsurges the company's returns, specifically its return
on equity. It is a fact because, if debt financing is used rather than equity financing, then the
owner's equity is not diluted by issuing more shares of stock. Investors in a business like for the
business to use debt financing but only up to a point. Investors get nervous about too much debt
financing as it drives up the company's default risk.

Types of leverage
There are many types of leverage. The company may use finance leverage or operating leverage,
to increase the EBIT and EPS.
Financial Leverage

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The ability of a firm to use fixed financial charges to magnify the effect of changes in
EBIT/Operating profits, on the levels of EPS is knows as Financial Leverage. Financial leverage
measures the extent to which the fixed financing costs arise out of the use of debt capital A firm
with high financial leverage will have relatively high fixed financing costs.
Formula for Degree of Financial Leverage Financial Leverage Formula example is given
below: Degree of financial leverage= % Change in EPS/ % Change in EBIT (OR) EBIT/ EBT
Why financial leverage important?
 It provides a framework for financial decisions.
 It helps in choosing the best mixture of source of funds and helps to maintain a desirable
capital structure for the firm. The structure of the funds influences the shareholder‟s in
terms of return and risk.
 In order to quantify the risk-return relationship of various alternative capital structures,
firms use financial leverages.
 Financial Leverages help in making prudent investment decisions by providing an upper
limit of risk and by balancing the return on investment against charges of debt.

Limitations of Financial Leverages

In view of the limitations given below, financial decisions should not be solely based on
financial leverages. It should rather be used to support or supplement those decisions. Given
below are financial leverage limitations examples:
Financial leverages do not take into account implicit costs of debt. It implies that as long as
the future earnings of the firm are greater than the interest payable on debt i.e. explicit cost, the
firm should rely on debt to raise additional funds. However, that may not always help maximize
the wealth of shareholders because it results in a decline in the market price of the common stock
as a result of increased financial risk.
Financial Leverages are based on certain unrealistic assumptions. Financial leverages
assume that costs of debt remain constant irrespective of the degree of leverage of the firm. That
is an unrealistic assumption because as the amount of debt increases, the firm is exposed to
greater risk and therefore, the interest rate charged to the firm also increases simultaneously.
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Operating Leverage
Definition of Operating Leverage
It measures the extent of the fixed operating costs of a firm. If the operating leverage of a firm is
high, it implies that it has high fixed costs in comparison to a firm with a low operating leverage.
It measures the effect of change in sales on the level of EBIT.
Degree of operating leverage refers to a firm‟s ability to use fixed operating costs to magnify
effects of changes in sales on its earnings before interest and taxes.

Formula for Degree of Operating Leverage

Sales- variable Cost/EBIT

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Unit V: WORKING CAPITAL MANAGEMENT:
CONTENT
1. Introduction
2. Definition of Working Capital
3. Concept of Working Capital Management
4. Types of Working Capital
5. Factors Determining Working Capital
6. Operating Cycle
7. Management of cash, inventory and accounts receivables.

INTRODUCTION
It has been often observed that the shortage of working capital leads to the failure of a business.
The proper management of working capital may bring about the success of a business firm. The
management of working capital includes the management of current assets and current liabilities.
A number of companies for the past few years have been finding it difficult to solve the
increasing problems of adopting seriously the management of working capital.
A firm may exist without making profits but cannot survive without liquidity.

The function of working capital management in an organization is similar to that of the heart in
a human body. The financial manager must determine the satisfactory level of working capital
funds and also the optimum mix of current assets and current liabilities. He must ensure that the
appropriate sources of funds are used to finance working capital and should also see that short
term obligation of the business are met well in time.
By definition
“Working Capital is the excess of Current Assets over current liabilities.”
Concept of working capital management

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There are two concepts of working capital viz .quantitative and qualitative. Some people also
define the two concepts as gross concept and net concept.
According to quantitative concept, the amount of working capital refers to ‘total of current
assets’. Current assets are considered to be gross working capital of the firm.
The qualitative concept gives an idea regarding source of financing capital. According to
qualitative concept the amount of working capital refers to “excess of current assets over current
liabilities.” L.J. Guthmann defined working capital as “the portion of a firm’s current assets
which are financed from long–term funds.”
The excess of current assets over current liabilities is termed as ‘Net working capital’. In this
concept “Net working capital” represents the amount of current assets which would remain if all
current liabilities were paid.
Current assets – It is rightly observed that “Current assets have a short life span. These types of
assets are engaged in current operation of a business and normally used for short term operations
of the firm during an accounting period i.e. within twelve months.
The two important characteristics of such assets are,
 short life span, and
 Swift transformation into other form of assets. Cash balance may be held idle for a week
or two; account receivable may have a life span of 30 to 60 days, and inventories may be
held for 30 to 100 days.

Current liabilities – The firm creates a Current Liability towards creditors (sellers) from whom
it has purchased raw materials on credit. This liability is also known as accounts payable and
shown in the balance sheet till the payment has been made to the creditors. The claims or
obligations which are normally expected to mature for payment within an accounting cycle (1
year) are known as current liabilities.
These can be defined as “those liabilities where liquidation is reasonably expected to require the
use of existing resources properly classifiable as current assets, or the creation of other current
assets, or the creation of other current liabilities.”

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TYPES OF WORKING CAPITAL
According to the needs of business, the working capital may be classified into the following two
bases:
1) On the basis of periodicity
2) On the basis of concept
On the basis of periodicity:
The requirements of working capital are continuous. More working capital is required in a
particular season or the peck period of business activity. On the basis of periodicity working
capital can be divided under two categories as under:
1. Permanent working capital
2. Variable working capital
(a) Permanent working capital: This type of working capital is known as Fixed Working
Capital. Permanent working capital means the part of working capital which is permanently
locked up in the current assets to carry out the business smoothly. The minimum amount of
current assets which is required to conduct the business smoothly during the year is called
permanent working capital.
The amount of permanent working capital depends upon the size and growth of company. Fixed
working capital can further be divided into two categories as under:
 Regular Working capital:
Minimum amount of working capital required to keep the primary circulation. Some amount of
cash is necessary for the payment of wages, salaries etc.
 Reserve Margin Working capital:
Additional working capital may also be required for contingencies that may arise any time. The
reserve working capital is the excess of capital over the needs of the regular working capital is
kept aside as reserve for contingencies, such as strike, business depression etc.
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(b) Variable or Temporary Working Capital:

The term variable working capital refers to that level of working capital which is temporary and
fluctuating. Variable working capital may change from one assets to another and changes with
the increase or decrease in the volume of business.
The variable working capital may also be subdivided into following two sub-groups.
 Seasonal Variable Working capital:

Seasonal working capital is the additional amount which is required during the active business
seasons of the year. Raw materials like raw-cotton or sugarcane are purchased in particular
season. The industry has to borrow funds for short period. In short, seasonal working capital is
required to meet the seasonal liquidity of the business.
 Special variable working capital:

Additional working capital may also be needed to provide additional current assets to meet the
unexpected events or special operations such as extensive marketing campaigns or carrying of
special job etc.

FACTORS DETERMINING WORKING CAPITAL

The following factors determine the amount of working capital requirement for firms.

 Nature of Companies:
The composition of an asset is a function of the size of a business and the companies to which it
belongs. Small companies have smaller proportions of cash, receivables and inventory than large
corporation.

 Demand of Creditors:
Creditors are interested in the security of loans. They want their obligations to be sufficiently
covered. They want the amount of security in assets which are greater than the liability.

 Cash Requirements:
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Cash is one of the current assets which are essential for the successful operations of the
production cycle. A minimum level of cash is always required to keep the operations going.
Adequate cash is also required to maintain good credit relation.

 Nature and Size of Business:

The working capital requirements of a firm are basically influenced by the nature of its business.
Trading and financial firms have a very less investment in fixed assets, but require a large sum of
money to be invested in working capital. Retail stores, for example, must carry large stocks of a
variety of goods to satisfy the varied and continues demand of their customers. Some
manufacturing business, such as tobacco manufacturing and construction firms also have to
invest substantially in working capital and a nominal amount in the fixed assets.

 Time:
The level of working capital depends upon the time required to manufacturing goods. If the time
is longer, the size of working capital is great. Moreover, the amount of working capital depends
upon inventory turnover and the unit cost of the goods that are sold. The greater this cost, the
bigger is the amount of working capital.

 Volume of Sales:
This is the most important factor affecting the size and components of working capital. A firm
maintains current assets because they are needed to support the operational activities which
result in sales. The volume of sales and the size of the working capital are directly related to each
other. As the volume of sales increase, there is an increase in the investment of working capital-
in the cost of operations, in inventories and receivables.

 Terms of Purchases and Sales:

If the credit terms of purchases are more favorable and those of sales liberal, less cash will be
invested in inventory. With more favorable credit terms, working capital requirements can be
reduced. A firm gets more time for payment to creditors or suppliers. A firm which enjoys
greater credit with banks needs less working capital.
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  Business Cycle:
Business expands during periods of prosperity and declines during the period of depression.
Consequently, more working capital required during periods of prosperity and less during the
periods of depression.

 Production Cycle:
The time taken to convert raw materials into finished products is referred to as the production
cycle or operating cycle. The longer the production cycle, the greater is the requirements of the
working capital. An utmost care should be taken to shorten the period of the production cycle in
order to minimize working capital requirements.

 Liquidity and Profitability:

If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of its working
capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of
its working capital. However, this policy is likely to result in a reduction of the sales volume, and
therefore, of profitability. A firm, therefore, should choose between liquidity and profitability
and decide about its working capital requirements accordingly.

 Seasonal Fluctuations:
Seasonal fluctuations in sales affect the level of variable working capital. Often, the demand for
products may be of a seasonal nature. Yet inventories have got to be purchased during certain
seasons only. The size of the working capital in one period may, therefore, be bigger than that in
another.

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OPERATING CYCLE
The duration of time required to complete the sequence of events right from purchase of raw
material / goods for cash to the realization of sales in cash is called the operating cycle, working
capital cycle or cash cycle.
Operating Cycle of Manufacturing Cycle:

The above operating cycle relates to a manufacturing firm where cash is needed to purchase raw
materials and convert raw materials into work-in-process is converted into finished goods.
Finished goods will be sold for cash or credit and ultimately debtors will be realized.

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Operating Cycle of Non-Manufacturing Firm
The non-manufacturing firms, such as whole sellers and retailers, will not have the
manufacturing phase; they will have rather direct conversion of cash into finished stock, into
accounts receivables and then into cash. The operating cycle of a non-manufacturing firm is
shown as under.

Operating Cycle of Service and Financial Firms

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In addition to this, some service and financial concerns may not have any inventory at all. Such
firms have shorter operating cycle.

Financing working capital:

Cash management
Cash is the most important asset for the operations of the business firms. It is the basic input
needed to keep the business running on a continuous basis and also the ultimate out for the
business operations.
The business firm should always maintain sufficient cash reserves, because the excessive cash
will remain idle, shortage will disrupt the firm operations. Normally, every business firm holds 1
to 3 percent of its assets in the form of cash to enable itself to discharge its routine obligations
such as payment of salaries, bills, day-to-day expenses, repayment of loans, dividends, interest,
etc. The meeting capacity of business transactions depends more on the amount of cash it holds
either in bank or on hand.

Functions of Cash management:

The following are the functions of cash officer of any business concern irrespective of its size,
nature, volume of business, age, etc. The same can also be referred as management of receipts
and payments, which includes:

 Forecasting cash needs;

 Expediting cash collections;
 Disbursing cash to meet firm's obligations and
 Gainful investment of surplus cash;

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 Business

Receipts payments

Diagram showings Receipts and payments

Different levels of cash:

In any business firm, the cash balance may be either shortage or excessive and it is difficult to
maintain exactly the required amount. Either a firm faces cash shortage or cash surplus if not
cash officer controls its cash flows. Normally, in these days of heavy competition, due to the
uncertainties of cash sales and cash collections disbursements tend to be more than the cash
receipts. The function of cash management is to match these two either by borrowing during
times of cash shortage or investing cash in times of surplus so as to ensure that the firm is free
from cash problems. Thus, cash manager invests the excess cash in securities and see that it will
be made available in times of scarcity.
Illustration of the cash cycle

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Objectives of Cash management:
The twin objectives of working capital management such as profitability and liquidity are also
implied to cash management. The cash manager has to arrange right amount of cash at right time
for a right purpose to pay for. It does not mean that he can hold heavy amount at the cost of
interest. In simple, the idle cash causes interest loss and the firm incurs opportunity cost, which
indirectly affects the profitability. Therefore, the cash manager has to hold optimum level of cash
and not a rupee extra or short beyond the optimum level of cash.

IMPORTANCE OF CASH MANAGEMENT:

Cash is unique resource and not comparable with any other component of current asset. If excess
cash is held, it will not generate profits since cash is sterile. It will not be productive directly as
in the case of other assets. Inventory bought excess will be useful even after sometime, without
loss of value and many a time value of inventories tend to increase due to inflation. Hence idle
cash will not generate profit but causes loss of interest. Further, cash shortage causes irreparable
loss to the management, since firms loose not only profitable business opportunities but also
goodwill when they fail to clear the bills timely due to cash shortage.

Motives for holding cash:

Keynes, the famous economist said that the businessmen hold cash for 3 motives, which are as
follows:

Transactions motive:
Cash manager is expected to arrange right amount of cash at right time to pay for a right purpose.
In fact, the cash receipts will never synchronize with cash obligations to pay for. Hence to meet
the expenses timely, a firm has to hold optimum amount of cash and keep the firm comfortable
in its cash transactions. Larger the business transactions more the amount of cash balance to be
maintained and vice - verse.

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Precautionary motive:
Firms at times need cash without prior notice. They need cash under emergency conditions such
as break down of machines, fire, theft t, accidents etc failing which they have to pay heavy
penalties. In such cases cash rich companies can withstand rather than nil less cash companies.
Thus, causalities, accidents, theft, machinery break - down, etc., in organizations generally
demand cash immediately. To meet the said eventualities, the firms have to maintain cash
balances. This cash balance is called precautionary cash balance. Hence they have to raise funds
in very short notice.

Speculative motive:
Of course, not all firms do business with speculative motives. Occasionally, every business firm
comes across speculative conditions such as sudden and heavy fluctuations in prices of raw
materials and rates of interest leading to raise in market for goods. Hence, there is sudden rise in
demand for goods, which warrants availability of cash in very short notice. Thus the speculative
conditions give chance to raise profitable opportunities. Firms, having ability to generate cash in
short notice will take advantage of these speculative conditions of business opportunities.

Factors affecting cash:

The amount of cash requirement of a business firm depends upon the following factors, which
are discussed as under:

Credit position
Firms having goodwill in the market do not require cash balance much. They get services and
goods on credit as they re-pay the bills timely out of the in sale proceeds and have such firms
need not maintain thereby cash balances.

Debtor’s position:
The ability to pay bills depends upon the company's sales policy i.e., whether on credit or cash,
credit for how long. Longer the credit period more the cash balances it should prepare to make its
purchases. Further, a firm extending liberal credit will have its debtors position high and
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consequent of it more bad debts also. And firms with tight credit policy will maintain low
debtors position and less bed debts hence and the firm is able to do the business with less cash
balances.

Nature of market:
It has great influence on cash requirement, in certain markets one has to buy on cash, since credit
facility is not available. In some of the unorganized sectors and small businesses where bank
loans are not extended, the firms have to arrange their own cash.

Inventory levels:
Higher the inventory levels a firm follows, more the 'cash' required. Lower the inventory level
less is the cash balance to be needed. Thus, inventory level certainly influences the cash
requirements of the business.

Technology
The firms, which follow manual methods, need more cash by week ends to pay for wages.
Whereas, the firms whose business activities are more technology based required less amount of
cash for the above said purposes

Efficiently in using cash:

Cash balance depends upon the efficiency of using cash. Professional managements maintain
optimum cash balance and discharge cash obligations.

Management attitude towards cash Management:

Management attitude too will influence the cash requirements of business. Conservative
managements do hold huge cash balance and, clear the bills without reminders, whereas
aggressive management which maintains small cash balances in order to gain more and clears the
bills after several remainders.

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Cash budget practices:
Firms with cash planning and budgeting can avoid sudden and unsaid obligations and run firms
smoothly without cash out problems.

Protection against loss:

Companies have to take necessary measures to prevent theft or burglary by going for insurance.
These protection measures will keep the firm comfortable; of course firms incur extra
expenditure towards insurance premium.

Short costs or cash out problems:

Firms if they do not maintain cash balance, have to face cash out problems thereby incur extra
expenses or lose profitable opportunities. These costs are called short out costs and the firms,
who are unable to get cash, will be ready to incur such costs. So, management has to trade-off
between short-term losses and benefits of adequate cash balances.

Speculation factor and uncertainties:

Firms in speculation business should have excess cash than others. Hence, one should take into
account whether the business is involved in such business and should hold more cash in order to
continue without sales and timely market for its production.

Cooperation from bankers:

Firms, which pay their loans timely, will be in good terms with banks. Such firms can go 'easy' in
times of cash shortage, since bankers will extend cooperation and provide extra credit in times of
need and when market conditions are bright.

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Benefits of adequate cash maintenance:
The following are the benefits to a business firm who maintains adequate cash:

Cash discount
Firms can enjoy cash discounts and get goods / services at considerable prices if they made down
payments. This will increase profits and credibility.

Large scale buying

If firms buy raw materials in large quantities they can get at low prices, which will increase the
overall profitability of the firms? The firms with cash balance are able to order bulk purchases to
get them at lower prices.

Meet contingencies boldly

Firm with adequate cash balance can absorb comfortably the unexpected changes in the market
like technological and demand of the product.

Liquidity
Firms, regular in payments of bills and taxes will be respected by the suppliers and cooperate by
way of supplying required quantity of goods at lower prices. The suppliers can also ensure
supply of goods in times of scarcity.

Profitability
Firms, which bargain at the turn of purchasing inputs and services, will get production at low
cost. This will enhance profit margin of the firms, which in turn will enhance its profitability.

Business opportunities
Profitable opportunities can be had only if the firms maintain adequate cash.
Otherwise, they loose new and bright business chances. New business opportunities will come to
firms with abundant cash. Firms often face cash - out problems do not ensure growth and cannot
under - take new ventures.

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Easily overcome contingencies
Firms some times involve in accidents such as fire, theft, break down, change of technology,
need for modernization etc. The cash - rich companies can over come such eventualities easily.

Better Bargain
Firm with adequate cash can bargain and obtain inputs at reasonably low price and reduce cost of
production.

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DIVIDEND POLICY
Once a company makes a profit, it must decide on what to do with those profits. They could
continue to retain the profits within the company, or they could pay out the profits to the owners
of the firm in the form of dividends.
The dividend policy decision involves two questions:
 What fraction of earnings should be paid out, on average, over time? And,
 What type of dividend policy should the firm follow? I.e. issues such as whether it should
maintain steady dividend policy or a policy increasing dividend growth rate etc.
On the other hand Management has to satisfy various stakeholders from the profit. Out of the
Stakeholders priority is to be given to equity share holders as they are being the highest risk.

DIVIDEND - DEFINED
According to the Institute of Chartered Accountants of India, dividend is "a distribution to
shareholders out of profits or reserves available for this purpose.
The term dividend refers to that portion of profit (after tax) which is distributed among the
owners / shareholders of the firm." "Dividend may be defined as the return that a shareholder
gets from the company, out of its profits, on his shareholdings." In other words, dividend is that
part of the net earnings of a corporation that is distributed to its stockholders. It is a payment
made to the equity shareholders for their investment in the company.
As per the section 2(22) of the Income Tax Act, 1961, dividend defined as: - "Any distribution of
accumulated profits whether capitalized or not, if such distribution entails a release of assets or
part thereof". Dividend is a reward to equity shareholders for their investment in the company. It
is a basic right of equity shareholders to get dividend from the earnings of a company. Their
share should be distributed among the members within the limit of an act and with rational
behavior of directors. The word dividend has not been defined in The Indian Companies Act,
1956. It may be described as periodical and cannot be declared from capital gains under
following conditions:
i) Provision in Articles of Association.
ii) Capital gain must be realized. All assets & liabilities must be revalued before distributing
this capital gain.

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DEFINITION: DIVIDEND POLICY
Dividend policy determines the ultimate distribution of the firm's earnings between retention
(that is reinvestment) and cash dividend payments of shareholders." "
Dividend policy means the practice that management follows in making dividend payout
decisions, or in other words, the size and pattern of cash distributions over the time to
shareholders."
In other words, dividend policy is the firm's plan of action to be followed when dividend
decisions are made. A dividend policy decides proportion of dividend and retains earnings.
Retained earnings are an important source of internal finance for long term growth of the
company while dividend reduces the available cash funds of company. "As long as the firm has
investment project whose returns exceed its cost of capital, it will use retained earnings to
finance these projects". There is a reciprocal relationship between retained earnings and dividend
i.e. larger the retained earnings, lesser the dividend and smaller the retained earnings, larger the
dividend. James E. Walter (1963) says "Choice of dividend policy almost affects the value of the
enterprise” The dividend policy of a company reflects how prudent its financial management is.
The future prospects, expansion, diversification mergers are effected by dividing policies and for
a healthy and buoyant capital market, both dividends and retained earnings are important factors.
Most of the company follows some kind of dividend policy. The usual policy of a company is to
retain a position of net earnings and distribute the remaining amount to the shareholders. Many
factors have to be evaluated before forming a long term dividend policy.
TYPES OF DIVIDENDS:
Classifications of dividends are based on the form in which they are paid. Following given below
are the different types of dividends:
 Cash dividend
 Bonus Shares
 Property dividend interim dividend, annual dividend
 Special- dividend, extra dividend etc.
 Regular Cash dividend
 Scrip dividend

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  Liquidating dividend
 Property dividend

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 cash dividend: Companies mostly pay dividends in cash. A Company should have enough
cash in its bank account when cash dividends are declared. If it does not have enough bank
balance, arrangement should be made to borrow funds. When the Company follows a stable
dividend policy, it should prepare a cash budget for the coming period to indicate the
necessary funds, which would be needed to meet the regular dividend payments of the
company. It is relatively difficult to make cash planning in anticipation of dividend needs
when an unstable policy is followed. The cash account and the reserve account of a company
will be reduced when the cash dividend is paid. Thus, both the total assets and net worth of
the company are reduced when the cash dividend is distributed. The market price of the share
drops in most cases by the amount of the cash dividend distributed.

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  Bonus Shares: An issue of bonus share is the distribution of shares free of cost to the
existing shareholders, In India, bonus shares are issued in addition to the cash dividend
and not in lieu of cash dividend. Hence, Companies in India may supplement cash
dividend by bonus issues. Issuing bonus shares increases the number of outstanding
shares of the company. The bonus shares are distributed proportionately to the existing
shareholder. Hence there is no dilution of ownership. The declaration of the bonus shares
will increase the paid-up Share Capital and reduce the reserves and surplus retained
earnings) of the company. The total net-worth (paid up capital plus reserves and surplus)
is not affected by the bonus issue. Infect, a bonus issue represents a recapitalization of
reserves and surplus. It is merely an accounting transfer from reserves and surplus to paid
up capital. The following are advantages of the bonus shares to shareholders:
 Tax benefit: One of the advantages to shareholders in the receipt of bonus shares is the
beneficial treatment of such dividends with regard to income taxes.

 Indication of higher future profits: The issue of bonus shares is normally interpreted by
shareholders as an indication of higher profitability.

 Future dividends may increase: if a Company has been following a policy of paying a
fixed amount of dividend per share and continues it after the declaration of the bonus
issue, the total cash dividend of the shareholders will increase in the future.

 Psychological Value: The declaration of the bonus issue may have a favorable
psychological effect on shareholders. The receipt of bonus shares gives them a chance
sell the shares to make capital gains without impairing their principal investment. They
also associate it with the prosperity of the company.

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Special dividend: In special circumstances Company declares Special dividends. Generally
company declares special dividend in case of abnormal profits.

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Extra- dividend: An extra dividend is an additional non-recurring dividend paid over and above
the regular dividends by the company. Companies with fluctuating earnings payout additional
dividends when their earnings warrant it, rather than fighting to keep a higher quantity of regular
dividends. Annual dividend: When annually company declares and pay dividend is defined as
annual dividend. Interim dividend: During the year any time company declares a dividend, it is
defined as Interim dividend. Regular cash dividends: Regular cash dividends are those the
company exacts to maintain every year. They may be paid quarterly, monthly, semiannually or
annually.

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Scrip dividends: These are promises to make the payment of dividend at a future date: Instead
of paying the dividend now, the firm elects to pay it at some later date. The „scrip‟ issued to
stockholders is merely a special form of promissory note or notes payable Liquidating dividends:
These dividends are those which reduce paid-in capital: It is a pro-rata distribution of cash or
property to stockholders as part of the dissolution of a business Property dividends: These
dividends are payable in assets of the corporation other than cash. For example, a firm may
distribute samples of its own product or shares in another company it owns to its stockholders.

DIVIDENDS AND VALUE OF THE FIRM

The company's Board of Directors makes dividend decisions. They are faced with the decision to
pay out dividends or to reinvest the cash into new projects. The tradeoff between paying
dividends and retaining profits within the company The dividend policy decision is a trade-off
between retaining earnings v/s paying out cash dividends. Dividend policies must always
consider two basic objectives:
 Maximizing owners' wealth
 Providing sufficient financing

FACTORS DETERMINING DIVIDEND POLICY

While determining a firm's dividend policy, management must find a balance between current
income for stockholders (dividends) and future growth of the company (retained earnings). In
applying a rational framework for dividend policy, a firm must consider the following two
issues:
 How much cash is available for paying dividends to equity investors, after meeting all
needs-debt payments, capital expenditures and working capital (i.e. Free Cash Flow to
Equity - FCFE)
 To what extent are good projects available to the firm (i.e. Return on equity - ROE >
Required Return) The potential combinations of FCFE and Project Quality and the
generalizations of the dividend policy to be adapted in each situation are presented
below:

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