FACULTY OF COMMERCE

B. COM. 2023 - 24

SEMESTER 4

SUBJECT: FINANCIAL MANAGEMENT

UNIT 1: INTRODUCTION TO FINANCIAL

MANAGEMENT

COMPILED BY
DR.KRUPA BHATT DR. SHIMONI TRIVEDI

STUDY MATERIAL FOR REFERENCE

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 UNIT- 1 INTRODUCTION TO FINANCIAL MANAGEMENT

Finance is the application of economic principles and concepts to business decision

making and problem solving. The field of finance broadly consists of three
categories: Financial Management, Investments and Financial Institutions.
i) Financial Management: This area is concerned with financial decision making
within a business entity. Financial management decisions, include maintaining
optimum cash balance, extending credit, mergers and acquisitions,raising of funds
and the instruments to be used for raising funds and the instruments to be used for
raising funds etc.
ii) Investments: This area of finance focuses on the behaviour of financial markets
and pricing of financial instruments.
iii) Financial Institutions: This area of finance deals with banks and other financial
institutions that specializes in bringing supplier of funds together withthe users of
funds. There are three categories of financial institutions which act as an
intermediary between savers and users of funds, viz., banks, developmental
financial institution and capital markets.
Financial management is broadly concerned with the acquisition and use of funds
bya business firm. The scope of financial management has grown in recent years,
but traditionally it is concerned with the following:
 How large should a firm be and how fast should it grow?
 What should be the composition of the firm’s assets?
 What should be the mix of the firm’s financing?
 How should the firm analyses, plan and control its financial affairs?
The past two decades have witnessed several rapid changes on the economic and
corporate front which have an important bearing on how firms are run and
managed. On the one hand we have witnessed economies of several countries
opening up thereby throwing new opportunities and on the other hand we have also
witnessed that the growth rate of developed countries are stagnating or even
declining. The impact of these changes is that the firms have to move out of the
saturated marketsand explore new markets.

EVOLUTION OF FINANCIAL MANAGEMENT

The evolution of financial management may be divided into three broad phases:
i) The traditional phase
ii) The transitional phase
iii) The modern phase.

In the traditional phase the focus of financial management was on certain events

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 which required funds e.g., major expansion, merger, reorganization etc. The
traditional phase was also characterized by heavy emphasis on legal and procedural
aspects as at that point of time the functioning of companies was regulated by a
plethora of legislation. Another striking characteristic of the traditional phase was
that, a financial management was designed and practiced from the outsiders’ point
ofview mainly those of investment bankers, lenders, regulatory agencies and other
outside interests.

During the transitional phase the nature of financial management was the same but
more emphasis was laid on problems faced by finance managers in the areas of
fundanalysis planning and control.

The modern phase is characterized by the application of economic theories and the
application of quantitative methods of analysis. The distinctive features of the
modern phase are:
Changes in macro-economic situation that has broadened the scope of financial
management. The core focus is how on the rational matching of funds to their uses
in the light of the decision criteria.
The advances in mathematics and statistics have been applied to financial
management specially in the areas of financial modeling, demand forecasting and
risk analysis.

SCOPE OF FINANCIAL MANAGEMENT

The broad scope of financial management includes the following areas:

1) Investment Decision
2) Financing Decision
3) Dividend Decision
4) Liquidity Decision

1. Investment Decision
The firm has scarce resources that must be allocated among competing uses. On
the one hand the funds may be used to create additional capacity which in turn
generates additional revenue and profits and on the other hand some investments
results in lower costs. In financial management the returns, from a proposed
investment are compared to a minimum acceptable hurdle rate in order to accept
or reject a project. The hurdle rate is the minimum rate of return below which no
investment proposal would be accepted. In financial management we measure
(estimate) the return on a proposed investment and compare it to minimum
acceptable hurdle rate in order to decide whether or not the project is acceptable.
The hurdle rate is a function of riskiness of the project, riskier the project higher
the hurdle rate. There is a broad argument that the correct hurdle rate is the
opportunity cost of capital. The opportunity cost of capital is the rate of return that

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an investor could earn by investingin financial assets of equivalent risk.

2. Financing Decision
Another important area where financial management plays an important role is in
deciding when, where, from and how to acquire funds to meet the firm’s investment
needs. These aspects of financial management have acquired greater importance in
recent times due to the multiple avenues from which funds can be raised. Some of
thewidely used instruments for raising finds are ADRs, GDRs, ECBs Equity Bonds
and Debentures etc. The core issue in financing decision is to maintain the optimum
capital structure of the firm that is in other words, to have a right mix of debt and
equity in the firm’s capital structure. In case of pure equity firm (Zero debt firms)
theshareholders returns should be equal to the firm’s returns. The use of debt
affects the risk and return of shareholders. In case, cost of debt is used the firm’s
rate of return the shareholder’s return is going to increase and vice versa. The
change in shareholders return caused by change in profit due to use of debt is called
the financial deaverage.

3. Dividend Decision
Dividend decisions is the third major financial decision. The share price of a firm
is afunction of the cash flows associated with the share. The share price at a given
point of time is the present value of future cash flows associated with the holding
of share. These cash flows are dividends. The finance manager has to decide what
proportion of profits has to be distributed to the shareholders. The proportion of
profits distributed as dividends is called the dividend payout ratio and the retained
proportion of profits is known as retention ratio. The dividend policy must be
designed in a way, that it maximizes the market value of the firm’s share. The
retention ratio depends upon a host of factors the main factor being the existence
ofinvestment opportunities. The investors would be indifferent to dividends if the
firm is able to earn a rate or return which is higher than the cost of the capital.
Dividends are generally paid in cash, but a firm may also issue bonus shares. Bonus
share are shares issued to the existing shareholders without any charge. As far as
dividend decisions are concerned the finance manager has to decide on the question
of dividend stability, bonus shares, retention ratio and cash dividend.

4. Liquidity Decision
A firm must be able to fulfill its financial commitments at all points of time. In
orderto ensure this the firm should maintain sufficient amount of liquid assets.
Liquidity decisions are concerned with satisfying both long and short-term
financial commitments. The finance manager should try to synchronize the cash
inflows with cash outflows. An investment in current assets affect the firm’s
profitability and liquidity. A conflict exists between profitability and liquidity
while managing currentassets. In case, the firm has insufficient current assets it
may default on its financial obligations. On the other hand, excess funds result in
foregoing of alternative investment opportunities.

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 KEY ACTIVITIES OF FINANCIAL MANAGEMENT

The Financial Management main role is to plan, organise and govern all the
financial activities of a company. It applies management ethics to the financial
resources of a company. This practice controls all the economic operations of an
enterprise like utilisation of funds, procurement of funds, payment, accounting, risk
assessment and everything related to the cash.
Financial management governs all the financial activities of a company. A few key
activities are mentioned below:
 Accounting & Book-keeping Process: It is essential to identify, take appropriate
measures and record all the financial details of a company. Whatever funds are
debited or credited from a company’s account; the financial management efficient
accounting system gives an overview. Also, the bookkeeping records the everyday
transaction of a company and forms a base for the accounting system.
 Reporting of Financial Statements: Most of the stakeholders depend on the
organization’s financial statement before making any decision. The finance team
shares a financial report to its shareholders regularly. Depending on the report, the
shareholder forecast on when to buy or sell the stock. So, the accuracy of the
financial data is essential to make a decision.
 Liquidity of Company: Managing what your company owes to the vendors, and
what the customer owes to the company is essential. It gives a clear view of how
much liquid cash a company should have in all time.
 Opportunities for Investment: The Financial report gives the opportunity to
invest in the right stock and at the right time. Only after seeing the financial status,
an organisation can leverage the correct openings.

 Minimizing the risk: A robust financial management system is mandatory to

maximize the profit and minimize the risk and liabilities. An efficient financial
team should incorporate sufficient insurance to all the essential elements of a
company.

ROLE OF FINANCIAL MANAGER

The task and responsibilities of finance managers vary from organisation to

organisation depending upon the nature and size of the business, but in spite of
thesevariations the main tasks and responsibilities of finance manager can be
classified asfollows:
a) Compliance with policy and procedures laid by the Board of Directors.
b) Compliance with various rules and procedures as laid by law.

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c) Information generation for various stakeholders.
d) Effective and efficient utilization of funds.
The main tasks and responsibilities of a financial manager are discussed below:

1. Financial Planning and Forecasting: Financial manager is also concernedwith

planning and forecasting of production, sales and level of inventory. In addition to
this, he has also to plan and forecast the requirement of funds andthe sources from
which the funds are to be raised.

2. Financial Management: Fund management is the primary responsibility of the

finance manager. Fund management includes effective and efficient acquisition,
allocation and utilization of funds. The fund management includes the following:
 Acquisition of funds: The finance manager has to ensure that adequate funds are
available from the right sources at the right cost at the right time. The finance
manager will have to decide the mode of raising fund, whetherit is to be through
the issue of securities or lending from the bank.
 Allocation of funds: Once funds are acquired the funds have to be allocated to
various projects and services as per the priority fixed by theBoard of Directors.
 Utilization of funds: The objective of business finance is to earn profiles,which on
a very large extent depend upon how effectively and efficientlyallocated funds are
utilized. Proper utilization of funds is based on sound investment decisions, proper
control and asset management policies and efficient management of working
capital.

3. Disposal of Profits: Finance manager has to decide the quantum of dividend

which the company wants to declare. The amount of dividend will depend upon
mainly the future requirement of funds for expansion and the prevailing tax policy.

4. Maximization of Shareholder’s Wealth: The objective of any business is to

maximize and create wealth for the investors, which is measured by the price ofthe
share of the company. The price of the share of any company is a function of its
present and expected future earnings. The finance managers should pursue policies
which maximizes earnings.

5. Interpretation and Reporting: Interpretation of financial data requires skills.

The finance manager should analyses financial data and find out the reasons for
variance from standards and report the same to the management. He should also
assess the likely financial impact of these variances.

6. Legal Obligations: All the companies are governed by specific laws of the land.
These laws relate to payment of taxes, salaries, pension, corporate governance,
preparation of accounts etc. The finance manager should ensurethat a true and
correct picture of the state of affairs should be reflected in thestatement of accounts.

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 He should also ensure that the tax returns and variousother information should be
submitted on time.

CONCEPT OF PROFIT AND WEALTH MAXIMISATION

The firm has to take investment and financing decisions on a continuous basis. To
make optimum and wise decisions, a clear understanding of the objectives is a
must. There are two widely-discussed approaches regarding objectives of financial
management.
(A) Profit Maximization Approach
(B) Wealth Maximization Approach
The objective is used in the sense of a goal or decision criterion for the decisions
involved in financial management.
(A) Profit Maximization Approach:
Economists have held for a very long time the belief that the main purpose of any
corporate organisation should be to maximise profits, because doing so will also
lead to the most efficient use of available resources. The company will engage in
activities that have the potential to boost its earnings while avoiding those that
could have the opposite effect. Therefore, in terms of economic theory, the
maximization of profits is essentially a criterion for determining whether or not an
economy is efficient. According to what Soloman and Pringle have stated, "There
is also broad agreement that under perfect completion, where all prices accurately
reflect true values and consumes are well informed, profit maximising behaviour
by firms leads to an efficient allocation of resources and maximum social welfare"

The goal of maximising profits can be understood by looking at the logic behind it.
A corporation is an organisation that exists for the purpose of generating profits.

 Profit is a test of economic efficiency.

 It is assumed to lead to efficient allocation of resources.
 It ensures maximum social welfare.

LIMITATIONS OF PROFIT MAXIMIZATION OBJECTIVE

(1) The Concept of profit is vague: The definition of the term profit is vague and
ambiguous. Does it refer to gross profit or profit after tax? Total profit or profit per
share? Profit is interpreted by different persons in different ways.

(2) It ignores time value of money: ‘The fact that a rupee received today is of more
value than a rupee received later’. This concept is ignored leading to mistakes in

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 decision making.

(3) It ignores risk: ‘The future benefits may possess different degrees of certainty.
The more certain the expected return, the higher is its value or conversely the more
uncertain is the expected return, the lower is its value’. This concept is also totally
ignored. It ranks the two proposals involving different degrees of risk equally.

(4) Soloman and Pringle stated, A system based on private ownership and profit
maximisation might be efficient, but it leads to serious inequality of income and
wealth among different groups. Of course, the counter argument is that society as
a whole is clearly better off, as it leads to optimum allocation of society's resources.

Wealth Maximization or Net Worth Maximization: It means maximization of net

worth of the shareholders. It is also known as Maximization approach. When a
financial decision is to be taken to invest money in some project, the project must
be so selected that the present value of cash flow received from it exceeds the
present value of cash outflow to be invested. Thus Net present worth of a course of
action is the difference between the present value of all cash inflows and the present
value of all cash outflows. A course of action means some action taken in which
funds are invested e.g. a new machine is installed to replace manual labour. This is
a course of action or a project in which money is invested. If the project gives more
cash flow than cash invested, then it can be said that it increases net worth of
shareholders. It increases value of shares of the company. As Prof. I. M. Pandey
has written, "The wealth maximization principle implies that the fundamental
objective of a firm should be to maximize the market value of its shares. The value
of the company's shares is represented by their market price, which in turn, is a
reflection of the firm's financial decisions. The market price serves as the firm's
performance indicator." A decision which maximizes net present worth also
maximizes shareholders' wealth. A decision which results into negative net present
worth will reduce shareholders' wealth and so such decisions are not to be accepted.
This objective of maximization of shareholders' wealth also takes care all the three
limitations of profit maximization objective.
 It is clear: Since cash flows and not profits are taken for finding out net present
worth, there is no confusion in using the term cash flow, as it is in case of profit.
 It considers time value of money by discounting appropriately the future cashflows.
Here, present value of cash inflows and present value of cash outflows are taken
into account.
 It considers risk element for evaluation: The future cash flows are discounted by a
rate higher or lower depending upon the uncertainty associated with it. Hence, Net
Present Value of cash flows with more uncertainty will automatically be reduced
when discounting is done at rate higher or lower according to the degree of risk
involved.

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 FACTORS AFFECTING FINANCIAL PLANNING
The management's arbitrary judgments and subjective views cannot be allowed to
guide the creation of the capital plan. When deciding on the company's capital
strategy, some specific considerations must be made. These are what they are:

(1) Money Market Conditions: Investors will purchase equity shares during a boom
time in anticipation of substantial dividends. They will, however, prioritise safety
over income during a depression and be more ready to invest in debentures than in
stock shares. Therefore, it makes sense to issue ordinary shares during a boom and
debentures and preference shares during a downturn. Therefore, the management
should consider the state of the money market when creating a financial plan.

(2) Retaining Control: The existing management will issue fewer equity shares and
raise more money through preference shares and debentures if they wish to
maintain control. Due to the lack of voting privileges in preference shares and
debentures, more money can be raised through their issuance while yet allowing
the current management to maintain control of the business.

(3) The Nature of the Company's Assets: When the management creates a financial
strategy, they should consider the types of assets and their market prices. A
corporation cannot issue debentures if it does not have high-value fixed assets since
it cannot mortgage those assets. It will also not be wise to issue debentures if a
company's asset value is vulnerable to significant changes. The business must rely
on equity shares.

(4) Capital Needs: The company's overall capital needs should be taken into
consideration when deciding what kind of securities to issue.

Only one sort of asset, such as equity shares, can be issued when a modest amount
of money is required. But it will be necessary to issue various kinds of securities if
a significant amount of financing is needed.

(5) Stability of Earnings: The choice of the securities to be issued should be made in
light of the company's earnings. Preference shares and debentures may be issued if
earnings are consistent and reliable. For precisely this reason, public utilities
typically raise money through fixed interest-bearing securities like bonds and
debentures. However, because the earnings of businesses in the consumer products
sector are unpredictable, they must rely heavily on equity share capital.

(6) Firm Nature: The capital structure pattern can be significantly influenced by the
nature of the business. Debentures and preference shares, which demand the regular
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 payment of fixed interest and dividends, can be relied upon reliably by a company
with predictable and consistent income. However, ordinary shares should be
depended upon if the firm is dangerous and its income is inconsistent because they
are not required to pay dividends on a regular basis.

(7) Financing Cost: The cost of financing varies depending on the security. If funding
is raised by issuing stock shares, it is fairly high. because it calls for extensive
advertising, the payment of underwriting commission and brokerage fees, etc.
Conversely, because debentures are thought of as safe investments, issuing them
calls for reduced costs. The law also mandates that holders of debentures pay a
relatively small underwriting commission (The Companies Act does not allow to
pay more than 5 per cent underwriting commission on shares and more than 2.5 per
cent on debentures).

(8) Legal Restrictions: With regard to the issuance of various securities, the companies
must abide by legal requirements. For instance, SEBI approval is required by law
in India for businesses. Any public corporation is not permitted to issue delayed
shares under the Companies Act of 1956.

(9) Investor Attitudes: There is a wide range of investor attitudes. Some investors
prioritise safety above high returns. Debentures and preference shares should be
issued to fulfil their needs. Some investors favour huge returns over security.
Equity shares should be issued in order to suit their needs. As a result, it is
preferable to issue a variety of securities to attract investors with a range of attitudes
and preferences. Additionally, it will guarantee a broad distribution of securities.

(10). The government's tax policy: Since debentures are viewed as debts and the interest
on them is deductible under the income tax law, companies prefer to issue them
when the tax rate on their profits is particularly high. Therefore, businesses can
lower their tax burden and give shareholders a high rate of dividend by issuing
debentures. Companies prefer to raise money through debentures rather than shares
if dividends are taxed. Currently, tax savings on interest expenses is one reason
why Indian corporations are issuing debentures on a huge scale.

(11) General Level of Interest Rates: When choosing the categories of securities to be
issued, interest rates should be taken into consideration. It is preferable to issue
common shares when interest rates are high. Debentures should be issued if interest
rates are low.

TYPES OF FINANCIAL PLAN

On the basis of duration of time, the financial plan can be grouped into two
categories:
(1) Short term Financial Plan
(2) Long term Financial Plan
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(1) Short-term Financial Plan: A short-term financial plan is one that is generally
established for a maximum of one year. According to some experts, a financial plan
that covers a time frame of a year and a half must be considered a short term
financial plan.
The aim of a short-term plan is to plan for collecting these money and estimate the
working capital needed for daily operations. Creating a capital plan for assets and
liabilities is another aspect of it. It entails the creation of numerous budgets,
including cash and sales budgets as well as funds flow and cash flow statements.
Thus, it calculates the ideal cash balance, the amount of money that will likely be
held in inventories and accounts receivable, etc.

(2) Long-term Financial Plan: A long-term financial plan is one that has been
established for a period of at least five years. According to one author, the long-
term goal of long-term planning is to maximise wealth by using capital in a way
that will ultimately raise the productivity of the remaining factors of production.
The management must weigh different investment options, evaluate their returns,
and choose the most lucrative one. The long-term strategy will then take into
account how much money will be needed and how it will be raised. So there are
three steps involved. Starting the business, keeping it operational, and developing
a capital plan are all important steps. The firm would continue operating smoothly
if the long-term plan had been created by the management skillfully and with
sufficient foresight.

(3) Overall Financial Plan: The preparation of an overall plan and the supervision of
its execution are the primary responsibilities of financial management.

When the opportunity to advertise and launch a new business presents itself, a
financial plan is created that addresses all possible financial needs. The task of
identifying all financial management programmes in advance and integrating and
coordinating them with other business operations is known as overall financial
planning. Plans are also made for a functioning business overall. Maintaining
balance between total financial requirements and available money is important
when growth and development are occurring, production or selling capacity is
being enhanced, or when business is rapidly dropping owing to a depression or the
effects of the trade cycle. The following four considerations must be made in such
circumstances:

(1) How much assets are required?

(2) When would there be need for raising funds?
(3) For how long funds would be needed?
(4) What would be the sources of funds that would be required?

When the aforementioned four issues are resolved, the overall strategy will be
finished.
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 (1) An estimated total asset value: The overall amount of assets necessary relies on the
business's ability to raise money and whether it will expand or decline. The
financial manager is crucial in this process since the senior management must
estimate the entire assets that would be needed. The senior management should
have a true understanding of the worth of these assets while preparing a financial
plan. This would lead to either undercapitalization or overcapitalization if there
were an underestimate or exaggeration in this regard. It is important to keep in mind
that when evaluating the total assets needed, there should be a fair balance between
the return anticipated from them and the overall amount invested in them.
(2) Establishing the Timings of Obtaining Money: If funds are to be used
effectively and not sit idle for an extended period of time, they must be raised
during the moment of need. It would be expensive if they were to be raised before
they were needed. As a result, choosing the right time to acquire funds is crucial to
a financial plan.
(3) Duration of the need for the funds: Funds may be needed for a short-term
or long-term period of time. The business needs money to buy current assets as
well as fixed assets. It is necessary to raise the long-term financing needed for fixed
assets by issuing equity shares or long-term debentures. You can obtain the short-
term finances you need through a bank loan or overdraft.
(4) Establishing the Ideal Capital Structure: The capital structure has a
significant role in determining whether a corporation succeeds or fails. A flawed
and improperly planned financial structure would impede business growth and
ultimately cause the company to go out of business. The capital structure has an
impact on a company's liquidity, dividend yield, and ability to raise money in the
future. A financial structure that ensures capital raising at the lowest possible cost
is the ideal one. Therefore, it is accurate to state that the company's capital structure
is its beating heart.

 Case studies of business crisis due to on poor financial

management

Kingfisher Airlines: The premium and world-class airline was based in Bangalore and
founded by the infamous Vijay Mallya. The airline carried out around 400 flights every
day. However, the brand couldn’t keep up with customer satisfaction. Lack of deputation,
misbehaviour and lack of attention to the customer. Eventually, the increasing complaints
from the customers and lack of attention from the owner, kingfisher airlines got
completely shut down.

2. Chevrolet: In the year 2017, Chevrolet shut all its operations in India. Even after delivering
really good automobiles, Chevrolet was unable to compete with the pre-existing sharks like
Maruti Suzuki, Honda, etc. Moreover, they faced heavy losses and couldn’t make a comeback
with any new automobile model in the Indian market.

3. Bisleri Pop: Bisleri is one such brand which has today become a synonym for water. We can
see Bisleri water bottles everywhere. However, Biselri was highly unsuccessful when it tried to
introduce other beverages into the market like Pina Colada, Fonzo, Spice and Limonata. The
newly launched product completely failed to grab the audience’s attention. This forced Bisleri to
withdraw them from the market.
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4. TATA Nano: The name TATA itself reminds us how gigantic the organisation is. But, even
such a massive and powerful company failed when it tried to launch Nano into the automobile
market. Initially, Nano grabbed a lot of attention for its shape, size and cost-effective factors.
However, the same reason for the shape and size turned out to be the downfall of the TATA
Nano.

5. Bloomberg TV: In the year 2016, the management of Bloomberg TV decided not to renew the
channel license and suspended all its broadcasting operations. Bloomberg TV was an English
news channel which was started by Business Broadcast News Private Limited. The company
decided to shut down because of intense loss and very low TRP.

6. Taxi4Sure: Launched by India’s largest taxi aggregator OLA, In the year 2011 got shut down
due to its poor market conditions. However, this wasn’t just the only reason for the company’s
downfall. The organisation raised about 250 crores and was burning hard cash to acquire more
customers and drivers. In these proceedings, they made a loss of rupees 200 on every ride.

7. Volkswagen Bettle: Just like Tata Nano, Volkswagen failed miserably with its beetle. The car
had an authentic vintage design and was available in pop colours as well. What went wrong for
them was the expensive price tag. The high-priced Beetle was unsuccessful to rule the customer’s
hearts like its other cars.

8. Kodak: Kodak was the market leader once in the photographic film industry. Every other
family-owned a Kodak in the ’90s and early 20’s. One of the major reasons for Kodak to fall was
the lack of following the trend and staying updated and ahead of competitors marketing
campaigns and strategies. It was other brands that took a massive growth putting Kodak behind
and in huge loss.

9. Onida: The iconic devil mascot with horns of Onida was cherished by everyone. Onida was
one of the strong players in the appliances industry. However, the major reason for its downfall
was the constant change in the advertising agencies. It was more like the ownership of the brand
and its strategies were owned by agencies and not the company.

10. Nokia: There was a time when Nokia was a market leader in the phone industry. Every
second person had a Nokia with them. However, with time Nokia started experiencing its rapid
downfall. The primary reason for the doom was not shifting to android as well as overestimating
the brand value. Sticking to the same software, made it easier for other brands to take over.

As we can see that even the most well known and popular brands can face failure because of the
lack of correct marketing, and brand strategy and not changing & innovating with time. Thus, a
company needs to adapt and apply the right marketing & branding strategies. Also, they must be
aware of the changing trends and growing interests of the desired consumers.

Background:

The scam broke in 2009 when founder-chairman of Satyam Computers Ramalinga Raju
confessed that the company’s accounts were tampered with. He disclosed a Rs.7,000-crore
accounting fraud in the balance sheets. On January 7, 2009, Ramalinga Raju sent off an email to
Sebi and stock exchanges, wherein he admitted and confessed to inflating the cash and bank
balances of the company.
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What happened:

Raju also manipulated the books by non-inclusion of certain receipts and payments, resulting in
an overall misstatement to the tune of Rs 12,318 crore, shows an analysis of findings of Sebi’s
probe. As many as 7,561 fake bills which were even detected in the company’s internal audit
reports and were furnished by one single executive.

Merely through these fake invoices, the company’s revenue got over-stated by Rs 4,783 crore
over a period of 5-6 years. The probe itself continued for almost six years and found that
fictitious invoices were created to show fake debtors on the Satyam books to the tune of up to Rs
500 crore.

Weeks before the scam began to unravel with his famous statement that he was riding a tiger and
did not know how to get off without being eaten. Raju had said in an interview that Satyam, the
fourth-largest IT company, had a cash balance of Rs 4,000 crore and could leverage it further to
raise another Rs 15,000-20,000 crore.

Ramalinga Raju was convicted with 10 other members on 9 April 2015. The 10 people found
guilty in the case are: B Ramalinga Raju; his brother and Satyam’s former managing director B
Rama Raju; former chief financial officer Vadlamani Srinivas; former PwC auditors Subramani
Gopalakrishnan and T Srinivas; Raju’s another brother B Suryanarayana Raju; former employees
G Ramakrishna, D Venkatpathi Raju and Ch Srisailam; and Satyam’s former internal chief
auditor V S Prabhakar Gupta. Ramalinga Raju and three others given six months jail term by
SFIO on 8 December 2014.

What was the action taken and the result:

After the fraud came to light, the government had ordered an auction for sale of the company in
the interest of investors and over 50,000 employees of Satyam Computers. It was acquired by
Tech Mahindra, and was then renamed as Mahindra Satyam, and was eventually merged into
Tech Mahindra. The Satyam saga eventually turned out to be a case of financial misstatements to
the tune of approximately Rs 12,320 crore, as per Sebi’s probe then.

Section: A Long Questions

Answer the following in brief:
1. Explain the concept of profit and wealth maximization in detail.
2. What is financial planning? Explain factors affecting financial planning.
3. Discuss in brief about the types of financial plan.
4. Discuss in brief about the evolution of Financial Management
5. Explain about the role of Financial Manager
6. Explain in detail about the scope of Financial Management
7. Discuss in brief about the key activities of Financial Management

14
 Section: B Short Questions
1. What is financial planning?
2. State any 2 limitations of profit maximization.
3. Give the objectives of wealth maximization.
4. What is Financial Management? How does a modern financial management
differ from traditional financial management?
5. “The importance of financial management has increased in modern times”.
Elucidate
6. “Sound Financial Management is a key to the progress for corporation.”Explain.
7. “Without adequate finance no business can survive and without efficient financial
management, no business can prosper and grow.” Comment on this statement
bringing out the role of financial management.

Section: C Multiple Choice Questions

1. The ______ approach of financial management provides analytical framework for financial
problems.
A. Classical B. Traditional C. Modern D. Empirical

2. The ______approach of financial management fully ignores the internal decision-making.

A. Business financeB. Traditional C. ModerN D. two sided

3. _______ is the main goal of financial management.

A. profit maximization B. fund transfer C. maximum returnsD. wealth maximization

4. The main objective of financial management of an enterprise is to _________.

A. maximize the business expenses B. maximize the profit
C. maintain bill and payments D. maximise the production costs

5. For maximizing the profit, production is to be ________.

A. minimized B. ignored
C. maximized D. downsized

6. The concept of financial management is mainly related to ______

A. arrangement of funds for the company
B. procurement & utilization of funds for company operations
C. profit maximization for the organization
D. accounting of profit and loss on yearly basis

7. For maximizing the profit, the costs should be ______.

A. minimized B. ignored C. maximized D. upgraded

8. The finance manager has to decide what proportion of profits has to be distributed to the
shareholders. What kind of decision is this?
A. Investment decision B. Financing decision
C. Liquidity decision D. Dividend decision

9. ______________ is the primary responsibility of the finance manager.

15
A. Fund Management B. Policy Making
C. Decision Making D. Procurement of Funds

10. During the ________ the nature of financial management was the same but more
emphasis was laid on problems faced by finance managers in the areas of fund analysis
planning and control.
A. Traditional phase B. Transitional phase
C. Modern phase D. None of the above

11, Financial Management is mainly concerned with:

A Arrangement of funds
B All aspects of acquiring and utilizing financial resources activities
C Efficient management of every business
D Decision making

12, Financial Management helps in:

A.the estimation of total requirement of funds and monitoring effective deployment of funds in
fixed assets and working capital
B. long-term planning of company’s activities
C. profit planning for the organisation
D both (a)& (b)

13, In his traditional role the finance manager is responsible for:

A. arrangement and efficient utilisation of funds
B. arrangement of financial resources
C acquiring capital assets for the organisation
D maximum utilization of resources

14, As per modern approach to finance function the following decisions are taken:
A.Investment Decision , Financing Decision
B. Financing Decision , Dividend Decision
C. Dividend Decision , Investment Decision
D. Dividend Decision , Financing Decision , Investment Decision

15, “Financial plan is the act of deciding in advance the quantum of capital requirements and its
forms”, this statement is given by:
A R. M. Shrivastava B R. S. Davis
C Bouneville D R. S Rathi

16, Financial planning act is:

A. Estimation of required capital
B Selection of various sources of capital acquirement of financial policies
C. Determination
D Acquiring

17, Financial planning is:

A Short-term , long term ,medium term B Medium-term, long term
C. Long-term , short term D short term , medium term

16
18, Which of the following does not include in the long-term financial planning:
A. Quantum of Capitalisation
B. Preparing Capital Structure
C. Management of working capital
D. Estimation of required capital

19, In what Financial Planning is not necessary:

A. For adequate liquidity
B. Expansion and Development of business
C. Adequate return on capital employed
D. Estimation of required capital

20, which is not the Factor affecting financial planning is:

A. Nature of business B. Amount of risk
C. Government Control D. Errors of Forecasting

21, Limitation of financial planning is:

A. Errors of Forecasting B. Lack of Co-operation and co-ordination
C. Attitude of Financial Manager D. All above

22, Financial Planning is related to:

A.Procurement of funds B. Uses of funds
C. Both (a) and (b) D.only (a)

23 .Maximisation of Shareholders Wealth is reflected in

A. Sales Maximization
B. Number of Shareholders
C. Market Price of Equity Shares
D. none of the above

24.What is not a part of Investment decision in financial management ?

A. Dividend Payout decision B. Working Capital Management
C. Capital Budgeting Decisions D. Payable Management

25. Finance function involves:

A. Procurement of finance only
B. Expenditure of funds only
C. Safe custody of funds
D. Procurement and effective utilization of funds

A The objective of wealth maximization takes into consideration:

A. Risk related to uncertainty of returns B. Timing of expected returns
C. Amount of returns expected D. All of the above

27. Which is not the limitation of profit maximization ?

A. Concept of profit is vague B. Ignores time value of money
C. Ignores risk D. Capital Structure

28.Financial management is mainly concerned with _____.

A. all aspects acquiring & utilizing financial resource for firm activities .

17
B. Arrangement of funds
C. Efficient management of every business .
D. Profit maximization

29. Primary goal of financial management is ____.

A. To maximize the return
B. To minimize the risk
C. To maximize the wealth of owners
D. To maximize profit

30. Financial Management function has become _______ and complex .

A. Less demanding B. More demanding
C. Less important D. Out dated

31. The ____ approach of financial management framework for financial problems.
A. Classical B. Traditional
C. Modern D. Empricical

32. For maximizing the profit , production is to be _____.

A. Minimized B. Ignore
C Maximized D. down sized

33. Which is not the limitation of profit maximization?

A. Concept of profit is vague B. Ignores time value of money
C. Ignores risk D. Capital structure

34. Financial management mainly focuses on _____.

A. Efficient management of every business
B. Brand dimension
C. Arrangement of funds
D. All elements of acquiring & using means of financial resources for financial activities.

35. What is the focal point of financial management in a firm?

A. the creation of value for shareholders
B. the number of types of products or services provided by the firm.
C. the dollars profit earned by the firm.
D. investment , financing & assest management.

36. Financial Management is mainly concerned with .

A. acquiring financial resources for firms’ activities
B. Utilizing financial resources for firms’ activities
C. procurement of funds of the enterprise
D. All of the above

37. Select correct option.

A. Profits maximisation can be part of a Wealth maximisation strategy
B. Wealth maximisation can be part of a Profits maximisation strategy
18
C. Profits maximisation and Wealth maximisation strategy are the same
D. Wealth maximisation is completely different from Profits maximisation strategy

38. According to Massie, Financial management is the activity of a business.

A. operational B. marketing
C. human resource management D. sales

39. Financial management process deals with

A. investments B. financing decisions
C. profit maximization D. more assets

40. Financial management mainly focuses on .

A. Arrangement of funds
B. Efficient management of every business
C. Brand dimension
D. All elements of acquiring and using means of financial resources for financial
activities

41. Financial management is an function of any business.

A. organic B. inorganic
C. conventional D. least important

42. ----------- is concerned with the duties of the financial managers in the business
firm.
A. Financial Management B.Accounting Management
B. Personnel Management D.Merger

43. The financial management function has become and complex.

A. Less demanding
B. More demanding
C. Less important
D. Outdated

44. The approach of financial management provides analytical framework for

financial problems.
A. Classical B.Traditional C.Modern D.Empirical

19
 45. The approach of financial management fully ignores the internal decision-making.
A. Business finance B.Traditional
C.Modern D.Ttwo sided

46. _______ is the main goal of financial management.

A. profit maximization B.fund transfer C.maximum returns D.wealth
maximization

47. The main objective of financial management of an enterprise is to .

A. maximize the business expenses
B. maximize the profit
C. maintain bill and payments
D. maximize the production costs

48. For maximizing the profit, production is to be.

A. minimized B.ignored C.maximized D.downsized

49. The concept of Financial management is mainly related to

A. arrangement of funds for the company
B. procurement & utilization of funds for company operations
C. profit maximization for the organization
D. accounting of profit and loss on yearly basis

50. For maximizing the profit, the costs should be .

A. minimized B.ignored C.maximized D.upgraded

51. Objective of financial management is:

A. profit maximization
B. wealth maximization
C. assets maximization
D. Sales maximization

52. What is not a part of Investment decision in financial management?

A. Dividend Payout decision
B. Working Capital Management
C. Capital Budgeting Decisions

20
D. Payable Management

53. The objective of wealth maximization takes into consideration:

A. Risk related to uncertainty of returns
B. Timing of expected returns
C. Amount of returns expected
D. All of the above

54. Financial management came into existence as a separate field of study from…?
A.19th century B 21st century
C 20th century D None of these

55. Financial management is concerned with managerial activities relating to

A Planning
B Procurement and administration of funds
C Optimum utilization of funds
D All of the above

56. Which of the following factors affect financial decision?

A Cost B Risk C Cash flow position D All of the above

57. _________ refers to planning regarding financial needs of the enterprise various sources of
raising funds and their optimum utilization.
A Financial planning B Capital structure
C Financial management D. All of these

58. Which of the following is not a feature of a financial plan?

A Simplicity B Cost
C Flexibility D Foresight

59. ______ is concerned with the duties of the financial managers in the business firm.
A. Financial Management B. Accounting Management
C. Personnel Management D. Merger

60. The financial management function has become _____ and complex.
A. Less demanding B. More demanding
C. Less important D. Outdated

61. Finance function includes:

A. Raising of Funds
B Utilisation of Funds and raising of funds
C Control on Funds , Utilization of funds , Raising of funds
D both (a) and (b)

21
62. Financial Management is related to:
A Raising of Funds
B Planning, Organising, Directing and Controlling of financial activities
C.Management of Working Capital
D supervising

63. Financial Management is:

A Administrative Process , Decentralized process
B Analytical Process , Decentralized process
C Centralised Process , Analytical process
D Centralised Process , Analytical process , Administrative process

64. Financial Management is:

A Science B Art
C Both art and science D psychology

65. “Financial Management is the application of the planning control functions of the finance
functions”, this statement is given by:
A Howard and Upton B Weston and Brigham C J. F. Bradley
D J.S. Massic

66.“Financial Management is an area of financial decision making harmonising individual

motives and enterprise goals”, this statement is given by:
A Eravin Friend
B Prof. Soloman
C Weston and Brigham
D J.S. Massic

67.Main objective of Financial Management is:

A Profit Maximisation
B Wealth Maximisation
C Cash Maximisation
D Both (a)&(b)

68.Traditional approach to finance was evolved:

A Before 1920
B Between 1920 and 1930
C In 1950
D None of above

69.Modern approach to finance was evolved:

A. Before 1950 B After 1950
C Before 1920 D None of above

70. Which of the following is not the component of finance function?

A. Investing Decisions B. Financing Decision
C. Decision regarding setting up a business D Dividend Decision

22
REFERENCES:

The above material has been compiled from the below mentioned reference books and official
data from websites.

Financial Engineering and Financial Martand Telsan

Management
Financial Management I.M. Pandey
Financial Management Prasanna Chandra
Financial Management P.K. Jain

******************************

23
 FACULTY OF COMMERCE
2023 – 24

SEMESTER 4

SUBJECT: FINANCIAL MANAGEMENT

UNIT : 2
Time Value of Money & Leverage Analysis

COMPILED BY :
Dr. Bhavna Parwani Prof. Meghavi Thaker

STUDY MATERIAL FOR REFERENCE ONLY

 Financial Management
UNIT-II
Time Value of money and Leverage analysis

Time Value of Money

Introduction:
The concept of time value of money implies that the value of money depends on
the time when it is received. The value of a certain amount of money received
earlier is higher than that of money received after a longer period of time. For
instance the value of Rs. 100 available today is greater than Rs. 100 available
after a year because at 10% rate of interest, today's Rs. 100 will grow to Rs. 110
after one year.
Anybody would accept that if we are given a choice between Rs. 100 today and
Rs. 100 after a year, we will prefer to take Rs. 100 today. This is because Rs.
100 at present has a greater time value than Rs. 100 after a year. If the current
rate of interest is 10 per cent per annum, Rs. 100 will grow to Rs. 110 after one
year. Thus, money also has time-value. The compounded value and discounted
cash flow methods recognise the time value of money.
Formula:
1) A= P ( 1+ R) N
2) Recurring deposit (P) A= P (1+R)N – 1
R
3) Recurring calculation of interest.
For every 6 Months = R/2 = N*2
For every 4 Months = R/3=N*3
For every 3 Months = R/4=N*4
For every month R/12=N*12

1
A= P[ ( 1 + R/K)N*R - 1]
R/K
4) To calculate P When A is given single amount , P= A
(1+R)N
(1+𝑅)𝑛 –1
5) For Recurring amount , P = A ⟦ ⟧
𝑅(1+𝑟) 𝑛

6) For Infinate = P= A
R
The easy way to calculate present value is to use calculator. If the rate of
discount is 10% then put 1 in numerator and 110 in denominator.
Then press the button % in calculator two times and we get present value of Re.
1 for 2 years. If we want to find out P.V. for 5 years, press the % button of
calculator five times.
Readymade tables are available showing present value of a rupee for different
time periods and at different rates of interest. For instance, Rs. 1,000 is
receivable after 5 years. What will be its present value at 8% rate of interest?
The table shows that at 8% rate of interest, present value of a rupee receivable
after 5 years is Rs. 0.681 :
: Rs. 1,000 × 0.681 = Rs. 681.
Thus, at 8% rate of discount, the present value of Rs. 1,000
receivable after 5 years is Rs. 681.
We have seen that an individual will prefer to have money at present than at a
future point of time. It means.
(i) that a person will have to pay in future more for a rupee received today. This
concept is compound value concept.
(ii) A person will accept something less for a rupee today for an amount to be
received in future. This is called present value concept.
We can say clearly that the value of a sum of money received today is more than
value of the same sum received at a later date.

2
In other words, future cash flows are less valuable because of the investment
opportunities of the present cash flows. A rational person always values the
opportunity to receive money now than waiting for one or more years to receive
the same amount.
It is said, "A bird in hand is worth two in bush."
Money has time value due to following reasons :
(1) Individuals generally prefer current consumption.
(2) An investor can profitably employ a rupee received today to give him a
higher value to be received after a certain period.
(3) In an inflationary economy, the money received today has more purchasing
power than the same sum of money to be received in future.
Three reasons may be attributed to the individual's time preference for money :
(1) Risk
(2) Preference for current consumption
(3) Investment opportunities
Future is uncertain. As an individual is not very certain about future cash
receipts, he prefers receiving cash now. What is available at present is preferable
to what may be available in the future. The more distant the future is, the more
uncertain it is likely to be. Most people have subjective preference for present
consumption over future consumption of goods and services because of the risk
of not being in a position to enjoy future consumption that may be caused by
illness or death. The main reason for time preference for money is to be found
in reinvestment opportunities for the funds which are received early. The funds
received earlier can earn a rate of return, which would not be possible if they are
received at a later date.
The time value of money is therefore generally expressed in terms of a rate of
return or more popularly as a discount rate.
TECHNIQUES:
Now it is clear that in order to have logical and meaningful comparisons
between cash flows occurring at different points of time, it is necessary to
convert the sums of money into a common point of time. We hereunder discuss
two most common methods of adjusting cash flows for time value of money :
(A) Compounding or future value determination.

3
(B) Discounting or present value determination.
DISCOUNTING TECHNIQUES:
Suppose, a person wants to invest Rs. 1,000 for one year at 10% p.a.
Here, he will get interest of Rs. 100 and principal of Rs. 1,000 at the end of first
year. So here the aggregate (A) amount is Rs. 1,100. If Rs. 1,000 is given at
present and Rs. 1,100 at the end of one year the value of both will be the same.
It can be said that Rs. 1,100 received at the end of 1St year at 10% interest p.a.
is equivalent to Rs. 1,000 received today. It means Rs. 1,000 is the present value
of Rs. 1,100 to be received at the end of the year at 10% interest.
With the compounding technique, the amount of present cash can be converted
into an amount of cash equivalent in future. But in discounting, the amount of
future cash flows are translated into their present values. The present value of a
future cash flow is the amount of current cash that is of equivalent value to the
decision-maker. In the compounding approach, money invested now appreciates
in value because compound interest is added; whereas in the discounting
approach, money is received at some future date and will be worth less because
the interest for the period is lost.
ILLUSTRATION:
1. A has a recurring bank account in which he pays Rs. 15,000 p.a. on which the
bank pays interest at 10% p.a. compounded annually.
Calculate the amount that he will get at the end of 8 years.
Solution :
Let us calculate the amount receivable at the end of 8 years, using the above
formula.
(1+𝑅)𝑛 –1
A=P⟦ 𝑅
⟧
(1+0.1)8−1
= 15,000
0.1

= 15,000 * 11.436
= Rs. 1,71,540
2. If a person deposits Rs. 10,000 every six months for 15 years at 8% p.a.
compounded semi-annually, what would he get in aggregate at the end of 15th
year?
Solution:
4
 (1+𝑅)𝑛 –1
A=P⟦ ⟧
𝑅

Here r = 8/2 = 4 for 6 months

Period n = 15 * 2 = 30 periods of 6 months
(1+0.04)30 –1
A = 10,000 ⟦ 0.04
⟧
(1.04)30 –1
10,000 ⟦ 0.04
⟧
3.2433975–1
10,000 ⟦ ⟧
0.04
2.2433975
10,000 ⟦ 0.04
⟧

10,000( 56.084937)
= 560840
3. What would be the present value of a sum of Rs. 80,000 deposited in a bank
for a period of 6 years at 10% rate of interest.
We use following formula P = A
(1+r)n
80,000 = A
(1+0.1)6
80,000 = A
(1.7716)
A = 80,000 * 1.7716
A= 1,41,728
4. A Ltd. had taken a freehold land on lease enjoyable in perpetuity. If the rent is
Rs. 60,000p.a. and the rate of interest is 8% p.a.
Find out the present value of freehold land.

Here, P = A
r/100
A= Annual rent
R= 8% or 0.08
P = 60,000/0,08
P= 7,50,000

5
CLASSWORK:

1. What sum will amount to Rs. 1,000 in 3 years at 12% pa, if

(a) Compounding is done annually
(b) Compounding is done semi-annually
(c) Compounding is done quarterly

2. Find in how many years, Rs. 300 will become Rs. 600 at
5% compound interest.

3. Compute the present value of Rs. 100 received every year upto 5th year and
Rs. 200 from 6th year onwards forever.
Assume discounting rate of 10%.

4. Find the amount that Rs. 100 will become after 20 years at compound interest
at 5% calculated annually.

5. What sum of money invested at 4% compound interest for 18 years will

amount to Rs. 10,000 ?

6 Determine the present value of Rs. 1000 paid at the end of each of the next six
years. Assume 8% rate of interest.

7. An investor deposits Rs. 100 every quarter in a bank account for 5 years at
24% per annum. Find the amount which he gets at the end of 5 years.

8. If the investor deposits Rs. 100 every month in a bank account for 2 years at
24% per annum, find the amount that he gets at the end of 2 years.

9. If Mr. A invests Rs. 100 each year from the end of 7 th year to the end of 10th
year, what is the amount received by him, if the rate of interest is 10% p.a.

HOMEWORK:

1. Find in how many years Rs. 30,000 will become Rs. 60,000 at 5
% compound interest.

2. 3. What sum of money invested at 4% p.a. compound interest for

18 years will amount to Rs. 50,000 ?

6
3. Find the amount that Rs. 10,000 will become after 20 years at compound
interest at 5% calculated annually.

4. Compute the present value of Rs. 100 a perpetuity of per year to be received
from the end of third year, if the discount rate, is 10%.

MULTIPLE CHOICE QUESTION

1. What does the time value of money (TVM) concept imply?

a) Money grows with time c) Money has different
values at different
points in
b) Money has the same value over time d) Money is constant
regardless of time

2. Which of the following factors is NOT considered in the time value of money
calculations?
a) Interest rate c) Future value
b) Present value d) Currency denomination
3. If you deposit Rs.1,000 in a bank account that pays 5% interest annually,
how much will you have in the account after two years?
a) Rs.1,050 c) Rs.1,102
b) Rs.1,102.50 d) Rs.950
4. Which formula is used to calculate the future value of a sum of money?
a) Present Value = Future Value / (1 + Interest Rate)
b) Future Value = Present Value x (1 + Interest Rate)
c) Future Value = Present Value / (1 + Interest Rate)
d) Present Value = Future Value x (1 + Interest Rate)
5. What happens to the present value of a future sum if the discount rate
increases?
a) Present value increases c) Present value remains the same
b) Present value decreases d) Present value becomes negative

6. If you receive Rs.500 one year from now and the discount rate is 10%, what
is the present value of that amount?
a) Rs.454.55 c) Rs.500
b) Rs.454.55 d) Rs.550
7. How does compounding frequency affect the future value of an investment?
a) Higher compounding frequency increases future value
b) Lower compounding frequency increases future value
c) Compounding frequency has no effect on future value
d) Compounding frequency decreases future value
7
8. What is the relationship between the time to maturity and the present value of
a bond?
a) Inverse relationship c) No relationship
b) Direct relationship d) Random relationship
9. If the interest rate is 8%, what is the present value of Rs.1,000 due in three
years?
a) Rs.793.83 c) Rs.857.34
b) Rs.747.26 d) Rs.925.93
10. Annuities involve a series of equal payments made at regular intervals.
Which of the following statements is true about the present value of an annuity?
a) Present value of an annuity decreases with an increase in the interest rate
b) Present value of an annuity increases with an increase in the interest rate
c) Present value of an annuity is not affected by the interest rate
d) Present value of an annuity is always zero
11. Compound interest is calculated on-
a) Principal amount b) Interest amount
c) Principal amount + Interest amount d) Installment amount
12. As per the concept of “time value of money” the value of money_____
a) is higher in later years than earlier years
b) is higher in earlier years than in later years
c) is equal in all the years
d) none of the above
13. Compound interest is calculated on-
a) Principle amount only b) Interest amount
c) Time value of money d) None of these
14. While evaluating capital investment proposals, the time value of money is
considered incase of-
a) Pay back method b) Discounted cash flow
method
c) ARR method d) None of these
15. To increase a given present value the discount rate should be adjusted:
a) Downward b) Upward
c) No adjustment d) None of these
16. Both the future and present value of a sum of money are based on-
a) Interest rate b) Time Period
c) Both a & b d) All of the above
17. An annuity is-
a) A series of unequal but consecutive payments
b) A series of equal but consecutive payments
c) A series of equal but non- consecutive payments
d) More than one payment
18. What does the time value of money (TVM) concept suggest?
a) Money grows faster over time
8
 b) Money has the same value at any point in time
c) The value of money can change over time
d) Money depreciates over time
19. Which of the following factors is NOT considered in time value of money
calculations?
a) Present value b) Future value
c) Inflation d) Risk
20.What is the formula for calculating future value (FV) in a simple interest
scenario?
a) FV = PV * (1 + r * t) b) FV = PV / (1 + r * t)
c) FV = PV + r * t d) FV = PV * r * t
21. In the context of time value of money, what does the term "discounting"
refer to?
a) Reducing the value of future cash flows to their present value
b) Increasing the value of present cash flows to their future value
c) Ignoring the time factor in financial calculations
d) Adjusting for inflation
22. Which interest rate is used to discount future cash flows in the calculation
of present value?
a) Nominal interest rate
b) Effective interest rate
c) Discount rate
d) Compound interest rate
23. How does an increase in the discount rate affect the present value of future
cash flows?
a) Increases
b) Decreases
c) Remains unchanged
d) Depends on the time period
24. What is the time value of money principle that suggests a dollar received
today is worth more than a dollar received in the future?
a) Future value b) Present value
c) Discounting d) Compounding
25. If the interest rate is 8%, what is the present value of $1,000 to be received
in one year?
A) $925.93 B) $925.00
C) $1,080.00 D) $1,080.36
26. If the interest rate is 6% per annum, how long will it take for an investment
to double in value?
a) 6 years b) 10 years
c) 12 years d) 16 years
27. What is the relationship between the interest rate and the present value of a
future cash flow?
9
 a) Inverse relationship b) Direct relationship
c) No relationship d) Depends on the compounding
frequency
28. In a time value of money calculation, if the compounding frequency
increases, what happens to the future value?
a) Increases b) Decreases
c) Remains unchanged d) Depends on the interest rate
29. What is the term for the process of determining the present value of a future
cash flow?
a) Compounding b) Discounting
c) Accumulation d) Inflation
30. What is the time value of money principle that suggests a dollar received
today is worth more than a dollar received in the future?
a) Future value b) Present value
c) Discounting d) Compounding
31. What does the time value of money concept emphasize?
A) Present purchasing power
B) Future uncertainty
C) Historical trends
D) Current market conditions
32. Which factor is the foundation of time value of money calculations?
A) Interest rates
B) Inflation rates
C) Currency exchange rates
D) Stock market performance
33. How does compounding affect the future value of money?
A) It decreases it
B) It has no effect
C) It increases it
D) It stabilizes it
34. What is the primary purpose of discounting cash flows in time value of
money analysis?
A) To increase the cash flows
B) To adjust for inflation
C) To decrease the present value
D) To calculate taxes
35. Question: Which formula is used to calculate the future value of a single
sum?
A) PV = FV / (1 + r)^n
B) FV = PV * (1 + r)^n
C) FV = PV / (1 + r)^n
D) PV = FV * (1 + r)^n

10
 LEVERAGE ANALYSIS

• Leverage may be defined as the employment of an asset or fund which

the firm pays a fixed cost or fixed return. The leverage is also described
by some as ‘trading on equity’
• Leverage is the ratio of the net rate of return on shareholders’ equity and
the net rate of return on total capitalisation
OPERATING LEVERAGE
• There are certain fixed expenses in the business which do not change with
the level of output or sales. They remain constant in the short run. Due to
these expenses, operating profits increase more rapidly than the volume
of sales. This situation is known as ‘Operating Leverage’
• Degree of Operating Leverage[DOL] = % change in EBIT / % change in
sales
• OR C/EBIT
• Operating leverage depends on the proportion of fixed operating expenses
in total operating expenses of the firm. If there are no fixed operating
expenses in a firm, there will be no operating leverage in it, that is, its
operating profit will increase by the same amount as its sales. But if there
are fixed operating expenses in a firm, its operating profit will increase by
more than its sales. The greater the ratio of fixed operating costs in total
operating expenses of a firm, the higher will be operating leverage in it.
• Example : Airline CompanyAirlines provides a good example of a very
high operating leverage There is a large amount of fixed cost in it. Even
cost on petrol is like fixed cost, because the consumption of petrol in the
airplane will be the same whether it carries only one passenger or 100
passengers. The amount of variable cost is small on the other hand, as
only expenses on tickets and snacks are included in it. Consequently, the
larger the number of passengers, the larger will the amount of freight
charges a large part of it representing the profit of the airlines. Thus profit
changes more severely than the number of passengers. As against this,
operating leverage is very low in retail trade. There is a large amount of
variable cost and extremely small amount of fixed cost in retail trade.

11
FINANCIAL LEVERAGE [ TRADING ON EQUITY]
• Financial leverage refers to the inclusion of securities carrying a fixed
financial burden such as debentures and preference shares along with
equity shares in the capital structure of a company.
• When a company includes in its capital structure debentures and
preference shares in addition to equity shares, financial leverage is said to
be used.
• Financial leverage is therefore known as Trading on Equity. This is
because, through the use of equity, a company incurs debts which carry a
lower rate of interest making it possible to pay higher dividend to the
equity shareholders. Of course, this happens only when the cost of capital
obtained through debentures and preference Shares is lower than rate of
return on the investment in business of the company.
• DFL = EBIT / EBT
COMBINED LEVERAGE
• The policy regarding capital structure should be framed keeping in view
the combined effect of operating leverage and financial leverage both.
• Combined leverage = DOL x DFL
= C/EBIT x EBIT / EBT
= C/EBT
Considering the combined effect of both leverages, we feel that if the degree of
both these leverages is very high, business will become more risky. Because a
high degree of these leverages implies a greater amount of fixed costs and also a
high proportion of funds imposing a fixed burden of financial charges in the
total amount of funds with the company. On the other hand, too low a degree of
both leverages also is undesirable. Because a low degree of these leverages
suggests that the amount of fixed costs is too small and the proportion of debts
in total capital of the company is also extremely low. As the result of such a
policy, the management will be deprived of a large number of profitable
opportunities of investment. If operating leverage is high and financial leverage
is low, it means that the management has adopted a very careful approach in
connection with debt capital. But the optimum situation is that in which
operating leverage is high and financial leverage is, low.

Sometimes an auckward situation arises due to the attempts to raise the rate of

12
return on equity shares keeping in view the financial leverage only. Many
companies in India are carelessly raising the proportion of debt capital. This is
risky as the amount of fixed expenses is large in their business because the
degree of both leverages will move up as the result of this policy. The
conclusion is that if financial leverage is to be kept high, that is, if funds are to
be obtained mainly through preference shares, debentures and other long term
debts, then the base should be strengthened by keeping operating leverage

ILLUSTRATION [1]
A simplified Income statement of ABC Ltd is given below. Calculate its degree
of Operating Leverage, Degree of Financial Leverage and degree of Combined
Leverage
Income statement for the year 31/3/2019

Sales 10,50,000
Less: Variable Cost 7,67,000
Contribution 2,83,000
Less : Fixed Cost 75,000
EBIT 2,08,000
Less: Interest 1,10,000
EBT 98,000
Less: Taxes [30%] 29,400
Net Income 68,600

SOLUTION
• Operating Leverage = C/ EBIT = 283000 / 208000 = 1.36
• Financial Leverage = EBIT / EBT = 208000 / 98000 = 2.12
• Combined leverage = DOL x DFL
= C/EBIT x EBIT / EBT
= C/EBT
• = 1.36 x 2.12 = 2.88

13
ILLUSTRATION [2]
A firm has sales of Rs. 75,00,000, variable cost of Rs. 42,00,000 and fixed cost
of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% interest and equity of Rs.
55,00,000
What are the Operating, Financial and Combined Leverage of the firm?
SOLUTION
Sales = 75,00,000
- V. Cost = 42,00,000
Contribution = 33,00,000
- Fixed Cost = 6,00,000
EBIT = 27,00,000
- Interest 4,05,000
EBT = 22,95,000
• Operating Leverage = C/EBIT = 33,00,000 / 27,00,000 = 1.22
• Financial Leverage = EBIT / EBT = 27,00,000 / 22,95,000 = 1.18
• Combined leverage = 1.22 x 1.18 = 1.44
ILLUSTRATION [3]
A company is contemplating to buy a new pant, which will require investment
of Rs 10,00,000. The plant is expected to earn a profit of Rs 1,60,000 before
interest and taxes. In choosing a financial plan, the company has an objective of
maximizing earning per share. It has three alternatives of issuing debentures Rs.
1,50,000 or Rs 4,00,000 or Rs. 7,00,000. The rates of interest in each of the
alternatives would be as under:
Upto Rs 1,50,000 9% p.a.
Between Rs 1,50,000 and Rs 6,00,000 12% p.a.
Over Rs. 6,00,001 18% p.a.
The current market price per share is Rs. 25 and is expected to drop to Rs 20,
if funds are borrowed in excess of Rs. 5,00,000. Assume a tax rate of 50%. Give
your opinion on the basis of EPS in each of the above alternatives.
SOLUTION

14
 Alternative -1 = 150000 x9% = 13500
Alternative -2 = upto 150000 = 13500
250000 x 12% = 30,000 = 435000
Alternative -3 = upto 150000 = 13500
450000 x 12% = 54000
100000 x 18% = 18000 = 85500
Particulars Alt-1 [Deb = Alt-2 [Deb = Alt -3 [Deb =
150000] 400000] 700000]
EBIT 160000 160000 160000
- Interest 13500 43500 85500
146500 116500 74500
- Tax 73250 58250 37250
PAT 73250 58250 37250
÷ No. of ES 34000 24000 15000
EPS 2.15 2.43 2.48

[ Theory Questions]
1. Write features of appropriate capital structure
2. Write determinants of capital structure
3. Discuss patterns of Capital Structure
4. Write a note on ‘Operating Leverage’
5. Write a note on ‘Financial Leverage’
6. Write a note on ‘Combined Leverage’
[Multiple Choice Questions]
[36] Financial Leverage refers to rate of change in Earning Per Share for a given
change in which earnings?
[A] Before Taxes [B] Before Interest
[C] Before Interest and tax [D] After Interest and tax
[37] Operating Leverage helps in the analysis of ___

15
 [A] Business Risk [B] Financing Risk
[C] Production Risk [D] Credit Risk
[38] In ____ leverage conditions of no profit no loss is created
[A] Operating [B] Financial
[C] Break Even Operating [D] Total
[39] Operating leverage =_____
[A] Contribution + Earnings before interest and tax
[B] Earnings before interest and tax/ contribution
[C] Contribution x Earnings before interest and tax
[D] Contribution + Earnings before interest and tax
[40] The level at which total operating expenses are equal to the amount of total
interest is called _____
[A] Break even financial leverage
[B] Break even combined leverage
[C] Financial leverage
[D] Both [a] and [b]
[41] It is risky to have both operating leverage and ____ at a high level .
[A] Financial leverage [B] Combined leverage
[C] Both [A] AND [B] [D] No Leverage
[42] _____may be defined as the employment of an asset or fund which the firm
pays a fixed cost or fixed return.
[A] Leverage [B] Assets [C] Finance [D] Bank
[43] The ____is also described by some as ‘trading on equity’
[A] Leverage [B] Assets
[C] Equity shares [D] Bank
[44] Leverage is the ratio of the net rate of return on shareholders’ equity and
the net rate of return on total capitalization
[A] True [B] False [C] Can’t say [D] None

16
[45] There are certain _____in the business which do not change with the level
of output or sales.
[A] fixed expenses [B] Variable expenses
[C] Semi variable expenses [D] No Expense
[46] _____ remain constant in the short run.
[A] fixed expenses [B] Variable expenses
[C] Semi variable expenses [D] No Expense
[47] Due to _____ expenses, operating profits increase more rapidly than the
volume of sales.
[A] fixed expenses [B] Variable expenses
[C] Semi variable expenses [D] No Expense
[48] Due to fixed expenses, operating profits increase more rapidly than the
volume of sales. This situation is known as ‘______’
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage
[49] Degree of _______ = % change in EBIT / % change in sales
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage
[50] Degree of _____= % change in EBIT / % change in sales
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage
[51] Example of proper Operating leverage is ___
[A] Airline Company [B] Manufacturing company
[C] Cement Company [D] Zero Leverage
[52] _____refers to the inclusion of securities carrying a fixed financial burden
such as debentures and preference shares along with equity shares in the capital
structure of a company.
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage

17
[53] When a company includes in its capital structure debentures and preference
shares in addition to equity shares,_____ is said to be used.
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage
[54] ________is therefore known as Trading on Equity
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage
[55] Degree of______ = EBIT / EBT
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage
[56] The policy regarding capital structure should be framed keeping in view
the combined effect of operating leverage and financial leverage both.
[A] True [B] False [C] Can’t say [D] None
[57] _____= DOL x DFL
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] None
[58] _____= C/EBIT x EBIT / EBT
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage
[59]_______ = C/EBT
[A] Operating Leverage [B] Financial Leverage
[C] Combined Leverage [D] Zero Leverage
[60] _____arises due to changes in internal and external factors making
profitability of business more unstable
[A] Financial risk [B] Business risk
[C] Zero risk [D] Bone
[61] Risk is unavoidable in any business
[A] True [B] False [C] Can’t say [D] None

18
[62]_____ is linked with the relative proportions of various types of capital
employed in business
[A] Financial risk [B] Business risk
[C] Zero risk [D] None
[63] If only equity share capital is used in business, _____is non-existent
[A] Financial risk [B] Business risk
[C] Zero risk [D] Bone
[64]______ arises when debts are introduced in capital structure
[A] Financial risk [B] Business risk
[C] Zero risk [D] Bone
[65] The profit of the company is shared by three parties : _____
[A] the government, debenture holders and shareholders.
[B] the government, debenture holders and Creditors.
[C] the government, debenture holders and employees
[D] None
[66] The company can improve the market value of its business by reducing the
share of the government in its profit through_____.
[A] financial leverage [B] Operating leverage
[C] Combined leverage [D] Zero Leverage
[67] EBIT – EPS Analysis is a method to study the effects of leverage, under
various levels of _____which involves comparison of alternative methods of
financing.
[A] EBIT [B] EPS [C] Debt [D] None
[68] ____is an uncertain factor and its changeability has to be taken into
account in deciding the extent to which leverage should be used
[A] EBIT
[B] EPS
[C] Debt
[D] PAT

19
[69] EPS varies with the extent of leverage and with changes in ____
[A] EBIT [B] EPS [C] Debt [D] PAT
[70] When leverage is used, EPS rises more in good years and falls more in bad
year.
[A] True [B] False [C] Can’t say [D] None

[CLASSWORK]
Sum 1
A simplified Income statement of ABC Ltd is given below. Calculate its degree
of Operating Leverage, Degree of Financial Leverage and degree of Combined
Leverage
Income statement for the year 31/3/2019

Sales 10,50,000
Less: Variable Cost 7,67,000
Contribution 2,83,000
Less : Fixed Cost 75,000
EBIT 2,08,000
Less: Interest 1,10,000
EBT 98,000
Less: Taxes [30%] 29,400
Net Income 68,600

Sum -2 A firm has sales of Rs. 75,00,000, variable cost of Rs. 42,00,000 and
fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% interest and
equity of Rs. 55,00,000
[1] Does it have favorable financial leverage ?
[2] What are the Operating, Financial and Combined Leverage of the firm?
[3]If the sales drop to Rs. 50,00,000, what will be the new EBIT?
[4] At what level, the EBT of the firm will be equal to zero?
Sum 3
A company is contemplating to buy a new plant, which will require investment
of Rs 10,00,000. The plant is expected to earn a profit of Rs 1,60,000 before
20
interest and taxes. In choosing a financial plan, the company has an objective of
maximizing earning per share. It has three alternatives of issuing debentures Rs.
1,50,000 or Rs 4,00,000 or Rs. 7,00,000. The rates of interest in each of the
alternatives would be as under:
Upto Rs 1,50,000 9% p.a.
Between Rs 1,50,000 and Rs 6,00,000 12% p.a.
Over Rs. 6,00,001 18% p.a.
The current market price per share is Rs. 25 and is expected to drop to Rs 20,
if funds are borrowed in excess of Rs. 5,00,000. Assume a tax rate of 50%. Give
your opinion on the basis of EPS in each of the above alternatives.
Sum 4
A company is considering to install a new plant, which needs an investment of
Rs 25 lakhs. The company presents two alternatives:
[a] Proportion of equity shares and debentures of 60:40
[b] Proportion of equity shares and debentures of 50:50
If first alternative is adopted, the equity shares can be sold at Rs 30 per share
and debentures cab be issued at an interest rate of 12% p.a. If however, second
alternative is adopted, equity shares can be sold at Rs 20 per share and
debentures can be issued at 14% rate of interest. The new plant is expected to
earn a profit of Rs. 4,00,000 before interest and taxes
If the tax rate is 50%, which alternative should be adopted on the basis of
earning per share? Compute financial leverage in both cases.
Sum 5
A company needs Rs 600000 to invest in a new project. The following three
financial plans are feasible:
[1] The company may issue 60,000 equity shares at Rs. 10 per share.
[2] The company may issue 30,000 equity shares at Rs 10 per share and 12%
3,000 debentures at Rs 100 each
[3] The company may issue 30,000 equity shares at Rs 10 per share and 12%
3000 preference shares at Rs 100 each

21
If the company’s profit before interest and taxes are Rs 12,000, 24000, 48000,
72000, 120000 respectively. What are the earnings per share under each of the
financial plans? Assume income tax rate of 50%
Sum 6
A company has an operating profit [EBIT] of Rs. 3,20,000. Its capital structure
consists of the following securities:
Particulars Amount
10% Debentures 10,00,000
12% Preference Shares 2,00,000
Equity Shares of Rs 100 each 10,00,000
Income tax rate is 50%
From the above information, find out EPS
Sum 7
ABC Ltd and XYZ Ltd are the two identical companies except the capital
structure which is as under
Capital Structure ABC Ltd XYZ Ltd
Equity share Capital Rs 50,000 Rs 10,000
[Shares of Rs. 10 each]
10% Debentures -- Rs 40,000
Find out the earnings per share [EPS] of both companies. EBIT IS 20,000
and Tax rate is 60%.

[HOME WORK]

SUM 1
A company intends to start a new manufacturing unit for which it needs
1,50,000. The new factory is expected to yield an annual EBIT of 2,50,000. In
choosing a financial plan, the company has an objective of maximising earning
per share (EPS). It has three alternatives of issuing debentures 150000or 600000
or 9,00,000. The rate of interest in each case would be (l) upto 200000 at 10%
(ii) over 2,00,000 upto 8,00,000 at 11% and (iii) over 8,00,000 at 18%.
The current market price per share is 30 and it is expected to drop to 24, if the
funds are borrowed in excess of 7,00,000, Assume tax rate to be 50 per cent.
Give your opinion on all these alternatives on the basis of earnings per share.

22
SUM 2
A company intends to establish a new factory for which an investment of
20,00,000 is required. The company is considering two alternatives.
(a) Proportion of Equity Shares and Debentures to be maintained at 70:30 and
(b) Proportion of Equity Shares and Debentures to be kept at 50:50.
If the first alternative is accepted, then equity shares can be sold at 40 per share
and debentures can be issued at an interest rate of 10% p.a. If however, second
alternative is adopted equity shares are sold for 25 per share and debentures can
be issued at 12% interest p.a. The factory is expected to earn 3,20,000 before
interest and taxes. If the tax rate is 50%, which alternative should be accepted
on the basis of earnings per share ? In both cases, compute the Financial
Leverage.
SUM3
A company needs 8,00,000 for purchase of a new machinery.
The following three financial plans are feasible.
(1) The company may issue 80,000 Equity Shares at 10 per share.
(2) The company may issue 40,000 Equity Shares at 10 per share and 10%
4,000 debentures at 100.
(3) The company may issue 40,000 Equity Shares at 10 per share and 10%
40,000. Preference Shares at 10 per share.
If the company's earning before interest and taxes are 16,000, 32,000, 64,000,
96,000 and 1,60,000 respy. what are the earnings per share under each of the
three financial plans ? Assume a corporate tax rate of 50 per cent.

SUM 4
Determine the earnings per share (EPS) of ABC Textile Company which has an
operating income (EBIT) of 1,60,000. Its capital structure consists of the
following securities
(i) 10% Debentures 500000
(ii) 12% Preference Shares 100000
(iii) Equity Shares of 100 each 400000
The company is in the 50% tax bracket. Determine. (i) the firm's EPS and (ii)
the financial leverage.

23
 Note : The above materials has been compile from the below mention
reference book

Reference Books:
Author/s Name of the Publisher
Book
1 Datar and Rajan Horngren’s Cost Pearson
Accounting – A
managerial
Emphasis
2 Gary Cokins Management Tata
Accounting – McGraw
Making it work
3 Cheng and Management Chapman
Podolsky Accounting & Hall
4 Sekhar and Management Oxford
Rajagopalan Accounting

24
 FACULTY OF COMMERCE

2023 – 24
SEMESTER 4

SUBJECT: FINANCIAL MANAGEMENT

UNIT: 3
Cost of Capital

COMPILED BY:
Dr. Bhavna Parwani Prof. Saurin Patel

STUDY MATERIAL FOR REFERENCE ONLY

 COST OF CAPITAL

SR. TOPICS
NO
1 INTRODUCTION
2 MEANING OF COST OF CAPITAL
3 SIGNIFICANCE OF COST OF CAPITAL
4 VARIOUS CONCEPT OF COST OF CAPITAL
5 SPECIFIC COSTS OF COST OF CAPITAL FOR
VARIOUS SOURCES OF FINANCE
6 WEIGHTED AVERAGE COST OF CAPITAL
7 CAPM Model
8 Section A [ Theory Questions]
9 Section B [ MCQs]
10 Section C [ Short Questions]
11 Section D [ Long Sums]
12 Section E [ Home Work]

1
INTRODUCTION
• The cost of capital is a very important factor to be considered in deciding
the firm’s capital structure. It is one of the bases of the theories of
financial management.
• Before determining the capital structure, of a company is required to
compute the cost of capital of various sources of finance and compare
them.
• On that basis the company decides which source of finance is the best and
in the interest of the owners and even the creditors
MEANING
• From the viewpoint of investors, cost of capital is the reward of
postponement of his present needs, so as to get a fair return on his
investment in future.
• From the view point of the company, the cost of capital refers to the
financial burden that a company has to bear in financing its business
through various sources.
DEFINITION
• According to I. M. Pandey ‘ The cost of Capital is simply the rate of
return the funds used should produce to justify their use within the firm in
the light of the wealth maximisation objective’
• Khan and Jain ‘The cost of capital is the minimum rate of return that a
firm must earn on its investments for the market value of the firm to
remain unchanged ’
• Hamptom ‘ Cost of capital is the rate of return which a firm requires from
an investment in order to increase the value of the firm in the market
place ’

SIGNIFICANCE OF THE COST OF CAPITAL

The concept of cost of capital is important in financial management in
many ways. Especially, it is useful in deciding the capital structure of a
company. It has great significance in the field of financial management.
Recently, increasing attention is being paid to it by the academicians, as also by
2
the newly appointed financial managers of the companies. In the past, the
concept of cost of capital was neglected. Most of the economists took it for
granted that cost of capital is not affected by the capital structure of a company.
But at present this concept plays an important role in the determination of
capital structure and in capital budgeting both. The significance of the concept
of cost of capital will be clear from the following :

[1] For Capital Budgeting Decisions : The concept of cost Of capital helps in
making financial decisions. Specially, in case of capital budgeting, it is used as
a decision criterion in capital decision. If the present value of cash flows of the
project is greater than the present value of investment in it, the project would be
accepted. The rate of discount that is used to calculate the present value of
future cash flows of the project is nothing but the cost of capital. Thus, cost of
capital is the minimum rate of return required on investment projects. It is the
rate of discount which is used to evaluate the profitability of an investment
project. Thus minimum rate of return of an investment project' cut-off rate,
target rate and hurdle rate are all synonyms used for the cost of capital.
If the investment project is to be evaluated on the basis of an internal rate of
return, the project will be acceptable when the internal rate of return exceeds the
cost of capital.
[2] Maintaining Market Value of Shares : An important decision in the field of
financial planning is concerning maximisation of the equity shareholders'
wealth. For the maximisation of equity shareholders' wealth, it is necessary that
market value of shares are maintained at a high level. The cost of capital is in
fact that minimum rate of return which maintains the market value of shares as
its current level If a company succeeds in raising its earnings the market value
of its shares would naturally move above this level. Thus, cost of capital serves
as a criterion which helps in optimum utilisation of company's financial
resources.
[3] Helps in Designing Capital Structure : A proper capital structure can be built
with the help of the concept of cost of capital. The lower the cost of capital, the
stronger can be the market value of the firm. That is, they can move towards the
goal of wealth maximisation. Hence the capital structure should be planned in
such a manner that cost of capital is minimised. This will raise the market value
of the firm.
[4] Issue of New Securities : If an investment scheme is found profitable, it may
be necessary to issue new securities to raise money for this investment scheme.
3
The concept of cost of capital provides guidance in deciding which type of
securities should be used for this purpose. For taking such decisions the
following must be taken into consideration: the nature of existing capital
structure, the cost of capital of different sources of finance, the effect on
aggregate cost of capital when money is raised through debts instead of equity
shares etc. How to raise the required finance can be decided on the basis of the
information about cost of existing capital and that of raising additional capital.
[5] To Evaluate the Performance of Top Management : The concept of cost of
capital is helpful also in evaluating the financial performance of the top
management. For this purpose, actual profitability of the new scheme of
investment is to be compared with the projected overall cost of capital, and
actual cost incurred in raising required funds is also to be assessed.
[6] Financial Decisions : The concept of cost of capital is important in many
other areas of financial decision making such as dividend decisions, working
capital policy, capital budgeting decisions etc. The decision about dividends to
be taken on the basis of the amount of profit that is to be reserved in the
company, and the amount of reserves depends on the relation between its capital
cost on the one hand and possible rate of return if it is invested in business, on
the other.

VARIOUS CONCEPTS OF COST OF CAPITAL

The meaning of cost of capital given above is a general meaning. It fact, there
are various concepts of cost of capital which are relevant for different purposes.
Some of these concepts are discussed below
(1) Future Cost and Historical Cost : Historical cost is the cost of capital raised
in the past, while future cost is the cost of capital to be raised in future. It is the
future cost of capital which is significant in making financial decisions) For
example, while making capital investment decisions, a comparison is made
between the rate of return Of the investment, and the cost of funds to be raised
to finance it. In Other words, it is the future cost of capital which is relevant in
decision making. Historical costs are important in that they help in predicting
the future costs.
(2) Specific Cost and Combined Cost (There are various sources
of finance such as equity shares, preference shares, debentures and
long term loans. These are called components of capital. The cost each of these
components of capital is called specific cost. For example, if the cost of raising

4
funds through debentures is 15 per cent, then Is per cent is the specific cost of
debentures If the concept of specific cost of capital is used, the cost of capital o
a project would be assessed on the basis of specific cost of various sources of
finance used to raised funds for it.
But when the cost of raising funds from all sources is considered jointly, it is
known as composite or combined cost of capital. It is called weighted average
cost of capital also). It is the combined cost of capital which is significant in
measuring the profitability of an investment scheme.
(3) Average Cost and Marginal Cost : Average cost is the weighted average of
all specific costs of various components of capital used. The weights assigned to
different components of capital are according to their proportions in capital
structure. The marginal cost is the average cost of additional funds raised for a
new investment scheme.For most of the financial decisions and for capital
budgeting purposes, it is the concept of marginal cost which is more important.
Here too, a distinction can be made between the specific average cost of
additional capital and total marginal cost for the company as a whole. If
additional funds are to be raised through debentures, the cost of debentures is
called marginal cost, while the average capital cost incurred when these
additional funds are raised through different sources is known as total marginal
cost. In capital budgeting decisions, the concept of total marginal cost is more
useful.
(4) Explicit Cost and Implicit Cost : The explicit cost of anysource of finance is
the rate of discount which equates the present value of its cash inflows with the
present value of its cash outflows. For example, if a company decides to issue
debentures to raise the cash inflow to the company will be If rate of interest is
10 per cent and if debentures are of seven years' duration, the annual cash
outflow will be 50,000 and payment of the principal sum of at the end of
seventh year will also be a cash outflow. Explicit cost is that rate of discount
which equates the present of all these cash outflows with the present value of
cash inflow of 5 lakhs.
According to this interpretation the explicit cost of an interest free loan will be
nil, while the explicit cost of a loan carrying interest, will be equal to that rate of
discount which equates the cash receipt with the present value of the future
interest payments plus the payment of the principal amount of the loan. The
explicit cost of a free gift will be 100% because neither interest nor principal
amount is to be paid in this case.
Implicit cost refers to the rate of return associated with the best alternative
5
investment opportunity that will be foregone if the project under consideration
by the firm were accepted. Thus when investible funds have alternative uses, the
firm has to choose between them. The implicit cost of the chosen investment
scheme is the rate of return on the best alternative that the firm has to sacrifice.
Implicit cost arises when funds are invested in a particular project
(5) Spot Cost and Normalised Cost : Spot cost is that rate which is prevailing in
the market at a certain point of time when a financing decision is to be taken
involving appraisal of alternatives. Normalised cost is that cost which is found
out by some averaging process so that cyclical element is removed from it.

SPECIFIC COSTS OF CAPITAL FOR VARIOUS SOURCES OF

FINANCE
COST OF DEBT
[A] Cost of Perpetual Debt [ irredeemable ]
The cost of Debt is the interest rate specified at the time of incurring
debtor issuing the debentures.
Cost of debt [Ki] =
Interest / Amount of Principal x 100
= I/P x 100
Here I = Interest , annual
P = Net amount [proceeds ] of debentures
Impact of Tax
This is cost of debt before tax. If tax is taken into consideration, the cost of debt
would be less than this. Because interest paid on debt is tax deductible, which
reduces the tax liability of the company.
Cost of debt after tax =Kd = I ( 1-t) or Ki (1-t)
Here I = Interest payable
t = tax rate

6
Cost of Floatation
• Certain costs are to be incurred to issue the shares or debentures. The
examples are the cost of printing prospectus, legal expenses,
advertisement cost, underwriting commission, brokerage etc.
• To the extent these costs are to be borne, the company receives a smaller
amount of money, it raises the cost
[B] Cost of Redeemable Debentures
• If the debentures are redeemable, that is, its principal amount is to be
returned within a particular period, the cost of debt is calculated by the
following formula:
• Cost of Debt Before tax =
(R+X)
½(F+P)
Here: R = Interest per Debenture
F= Future Redeemable Value of Debenture
P= Net Proceeds of Debenture

X= Average annual premium or discount

X= 1/n(F-P), where n = Number of years

COST OF PREFERENCE CAPITAL

[A.] Irredeemable Preference Shares
• Kp = D/P x 100
• Kp = Cost of preference capita
• D= Preference Dividend
• P= Net Proceeds

7
[B] Redeemable Preference shares
• When preference shares are redeemable, i.e. when the principal amount is
to be returned after a period, it entails two types of burden : principal
amount and dividend.
• [Now according to the Indian Companies Act, all preference shares must
be redeemable and must be redeemed within maximum period of 20
years]
• The formula used for computing the cost of preference capital is the same
as that used for debentures, except that it is not to be adjusted for tax as
the preference dividend is not tax deductible.
• Hence the Formula will be as follows :
• Kp = _R+X _
½ (F+P)
Where , X = 1/n(F-P)

COST OF EQUITY CAPITAL

There are two approaches available for calculating the cost of equity
[A] Dividend Approach
• Under this method, cost of equity capital is based on dividend. The
formula is also based on the rate of dividend which the company is to pay
in future. The cost of equity shares is that rate of return which equates the
present value of expected divided per share with the present value of the
net earning.
• Ke = D/P + g
• D= dividend per share
• P= net proceeds per share
• G= growth rate of dividend

8
[B] Earning Approach
• Under this method, the earnings of the company, and not its dividends,
are used as the basis for calculating the cost of equity capital. Here the
ratio of earnings to market price [earning price ratio] is used to calculate
the cost of equity share capital.
• Ke = E/P
• Here E= Earning per share [EPS]
• P = Net proceeds per share

COST OF RETAINED EARNINGS

When the company raises funds by issuing debentures, it required to pay
interest at fixed rate. Even on preference shares, it has to pay dividend at a fixed
rate. If however, it makes use of profits retained in the business, it is not
required to pay any interest or dividend. Hence, some people consider it as a
cost free source of finance. But this is an incorrect belief. Had this earnings
[which is uncommitted reserves and surplus] been distributed among
shareholders, they would have invested them somewhere else. Thus the cost of
retained earnings is the return the shareholder had foregone by not investing his
share of earnings elsewhere
“The cost of retained earnings may be defined as opportunity cost in terms
dividends foregone by the or withheld from the equity shareholders”
Kr = Ke (1-t) (1-B)

WEIGHTED AVERAGE COST OF CAPITAL

We have calculated specific cost of the source of capital which is used to obtain
funds for investment project and applied it to evaluate the profitability of this
project
However, combined or composite cost of capital is derived from the various
specific costs of capital and used to make choice of investment projects.

9
The combined or composite cost means the weighted average of the specific
costs of different sources of capital where each source of capital is assigned a
weightage according to its relative share in the capital structure of the company.
There are three stages-
1. First, the specific cost of each source of capital is calculated separately
i.e. the cost of equity capital, the cost of debenture etc.
2. Then the specific cost of each source of capital is multiplied by its
relative share in capital structure
3. The weighted costs of all sources thus obtained are then added together
and weighted average is ascertained

CAPITAL ASSET PRICING MODEL [CAPM MODEL]

This model was developed by William F Sharpe and John Linter in the 1960s.
CAPM is a model that describes the relationship between risk and expected
return. It explains the behaviour of security prices. The relationship between
expected return and unavoidable risk, and the valuation of securities that
follows, is the essence of the capital asset pricing model

This model divides the cost of equity into two components “ one, risk-free
return generally obtained in government securities and second, risk premium for
investing in shares
Risk may be defined as the likelihood that the actual return from an investment
will be less than the expected or forecast return. In other words, it is the
variability of return from an investment
In case of securities, there are two types if risks. [1] Unsystematic risk or
diversifiable risk or avoidable risk [2] Systematic risk or unavoidable risk. The
unsystematic risk is specific to a particular firm such as strikes, loss of a big
contract, increase in customs duty by the government on the materials used by
the firm etc.
An investor can eliminate or reduce this risk by diversifying the security
investment. He can sell some of these securities and buy securities of other firm.

10
But systematic risk is unavoidable . It affects all firms. It arises in account of the
economy-wide uncertainties, it cannot be avoided or reduced through
diversification .e.g. it may arise due to inflation, war, change in government
interest rate policy, change in tax policy etc.
There are two types of securities in which investment can be made. The first is a
risk-free security whose return [income] over the whole period is know with
certainty. For example, in India, Relief Bonds carry a fixed rate of tax-free
return. It has a zero variance or standard deviation. The risk-free security will
have the same return under all types of economic conditions, The second type of
security is risky security like equity shares available in the market.
There are many ways to measure risk, some of them are as follows : (1)
Beta Co-efficient : It is a mathematical value that measures the risk of one
security in terms of its effects on the risk of .a group of securities or assets, -
which is called a portfolio (Portfolio means a combination of securities of
various companies held by a firm or an individual Combinations of a variety of
securities are called portfolios.) The expected return on a portfolio is the sum of
the returns on individual securities multiplied by their respective weights. Thus
it is a weighted average rate of return. It measures market-related risk. A high
beta (ß) indicates a high level of risk and a low beta represents a low level of
risk. (2) Standard deviation : It is a measure of dispersion of expected
returns. It is a statistical concept and is used to measure risk from holding a
single security, A high std. deviation represents a large dispersion of return and
is a high risk and a low deviation represents a low risk. (3) Co-efficient of
Variation : It is a measure of relative dispersion of risk. It converts std.
deviation of expected values into relative values to enable comparison. The
larger the CU the larger the relative risk of security. (4) Sensitivity Analysis :
This is a method of considering a number of possible returns while evaluating
an asset risk. Three values are calculated, the worst (pessimistic) the expected
(most likely) and the best (optimistic) return. The difference between optimistic
and pessimistic results is the range which is the basic measure of risk. The
greater the range, the more risky the security is. The probability distribution is
also used to measure the risk, if a particular event is sure to happen, its
probability is loo percent. If the possibility is that the event is likely to happen 8
times out of 10, the probability is 80%.
Risk-Return Relationship : In order to be acceptable, a higher-risk security must
offer a higher forecast return than a lower-risk security. If we draw a graph on
which we show expected return and degree of risk, the "market line" will be
11
formed, which will slope upwards, suggesting that higher the risk, higher is the
return expected.
Market Line

Expected Return

Degree of Risk

As seen above, the CAPM model describes the relationship or trade-off

(balancing) between risk and expected return.
Basic Assumptions : This model is based on following basic
(l) The capital markets are efficient in the sense that share prices are based on
all available information.
(2) Investors are risk-averse. They prefer the securities giving the highest return
for a given level of risk or the lowest risk for a given level of return.
(3) All investors are in general agreement about the expected return and risk of
the securities.
(4) Their expectations are based on single-time period (i.e. one-year period).
(5) All investors can lend or borrow at a, risk-free rate of interest.
(6) No investor is large enough to influence the market price of a share.
The CAPM provides a framework of measuring the systematic risk of an
individual security. The risk of individual security is measured by (beta).
CAPM assumes that in market equilibrium, expected risk-return relationship of
all individual securities are in equilibrium and all securities lie along this line. If
some individual security is giving a higher return than the systematic return and
provides excess return than required by the market, it will be underpriced. So
investors would be attracted towards this security and its demand would
increase, its prices would also increase. This will bring down the expected
return and now the security which was placed above the security line, would
now lie on the market line. Similar will be case with overvalued security which
lies below the market line. The security will become unattractive because of low
rate of return and investors will sell it, the prices will fall and expected return
will rise until it falls on the security marketline.

12
ILLUSTRATION 1
A company’s annual earnings amount to Rs. 1,20,000. Shareholders
expect 10% rate of return. If the company’s earnings are distributed
among shareholders, then they can earn 10% return in other companies.
The rate of brokerage in new investment may be taken as 3%. If the
company wants to retain its earnings with it, at what rate should make
earnings? Assume that the shareholders are in 30% tax group
SOLUTION
Here
Ke = 10
t= 30%
B=3%
Kr =Ke(1-t) (1-B)
= 10(1-0.30) (1-0.03)
= 10 (0.70) (0.97)
= 0.0679 = 6.79%

ILLUSTRATION 2
Face value of a share is Rs. 10 and is quoted at Rs. 50 at the stock market.
Current rate of dividend is 50% and this is expected to grow at a steady
rate of 5% p.a. Calculate the cost of equity
SOLUTION
D= 5 + 5% = 5.25
P = 50
Ke = D/P + g

= 5.25 / 50 + 0.05
= 15.5%

13
 ILLUSTRATION 3
X company issued 1,000 11% Redeemable preference shares of Rs. 100
each at a discount of 5%. The cost of share issue amounted to Rs 3000.
These shares are to be redeemed at par after 10 years. Find out the cost of
capital of preference shares. What would be the cost of capital, if the
preference shares are irredeemable?
SOLUTION
• When PS are redeemable
Cost of Pref Shares Kp = R + 1/n (F-P)
1/n (F+P)
Here R = 11
N= 10 years
F = 100
P= (100 -5-3 Floatation cost ) = 92
= 11 + 1/10 (100-92)
1/10 (100+92)
= 12.29%
• When PS are irredeemable
Kp = D/P = 11/92 = 11.96%

SECTION A [THEORY QUESTIONS]

1. Define cost of capital and write its significance
2. Write a short note on [a] Cost of Debt [b] Cost of Preference shares
[c] cost of Equity Capital [d] Cost of retained earnings
3. Explain Weighted Average cost of capital
4. Explain various concept of cost
5. Write a detailed note on CAPM Model
14
 SECTION B [MCQs]
1. Cost of capital is the ______________ acceptable rate of return on new investments
made by the firm from the viewpoint of creditors and investors in the firm’s securities
(A) Minimum
(B) Maximum
(C) Double
(D) Half
2. From the viewpoint of investors, cost of capital is the _________ of postponement of
his present needs.
(A) Reward
(B) Burden
(C) Concept
(D) meaning
3. From the view point of the company, the cost of capital is ______
(A) Reward
(B) Financial Burden
(C) Concept
(D) Meaning
4. Cost of capital is ________ factor in financial decision making.
(A) Decisive
(B) Not important
(C) Regular
(D) None
5. The main responsibility of financial manager is to ________________for the
company
(A) Raise adequate finance
(B) Manage sales promotion
(C) Solve problems of employees
(D) HR placement
6. The cost of capital is the __________ required rate of earnings of capital expenditure
(A) Minimum
(B) Maximum
(C) Double
(D) Half
7. Cost of capital is the rate of return which a firm requires from an investment in order
to ________ the value of the firm in the market place
(A) Increase
(B) Decrease
(C) Constant
(D) Half
8. The cost of capital is the minimum rate of return that a firm must earn on its
investments for the market value of the firm to remain ___________
(A) Unchanged
(B) Changed
(C) Fluctuating
(D) None
15
9. Before determining the ________ , a company is required to compute the cost of
capital of various source of finance and compare them.
(A) Capital structure
(B) Profit
(C) Loss
(D) Statement
10. Which of the following is the significance of Cost of Capital
(A) For capital budgeting decision
(B) For determining the profit or loss
(C) For preparing the auditors report
(D) Disclosure
11. Which of the following is the significance of Cost of Capital
(A) For Maintaining the Market Value of the shares
(B) For finding the clerical errors
(C) For determining the Profit or loss
(D) None
12. ______________ is the cost of capital raised in the past
(A) Historical Cost
(B) Future Cost
(C) Average Cost
(D) Weighted Average Cost
13. _________ is the cost of capital to be raised in future.
(A) Historical Cost
(B) Future Cost
(C) Average Cost
(D) Weighted Average Cost
14. Various sources of finance like equity shares, preference shares, debentures etc are
called __________
(A) Components of capital
(B) Cost of capital
(C) Need for capital
(D) Use of Capital
15. The cost of each of the components of capital is called __________
(A) Specific cost
(B) Combined cost
(C) Future Cost
(D) Weighted Average Cost
16. When the cost of raising funds from all the sources is considered jointly, it is known
as _________
(A) Specific cost
(B) Combined cost
(C) Average cost
(D) Weighted Average Cost

17. ____________is the weighted average of all specific costs of various components of
capital used.

16
 (A) Average cost
(B) Marginal Cost
(C) Historical Cost
(D) Weighted Average Cost
18. The weights assigned to different components of capital are according to different
components of capital according to their ___________in capital structure.
(A) Proportions
(B) Part
(C) Logic
(D) None
19. _________ is the average cost of additional funds raised for a new investment raised
for a new investment scheme.
(A) Marginal Cost
(B) Historical Cost
(C) Future Cost
(D) Weighted Average Cost
20. _________ of any source of finance is the rate of discount which equates the present
value of its cash inflows with the present value of its cash outflows.
(A) Explicit cost
(B) Implicit cost
(C) Future cost
(D) Weighted Average Cost
21. __________ refers to the rate of return associated with the best alternative investment
opportunity that will be foregone if the project under consideration by the firm were
accepted.
(A) Explicit cost
(B) Implicit cost
(C) Future Cost
(D) Weighted Average Cost
22. Implicit cost is also known as ________
(A) Opportunity cost
(B) Explicit cost
(C) Future Cost
(D) Weighted Average Cost
23. ________ is that rate which is prevailing in the market at a certain point of time when
a financing decision is to be taken involving appraisal of alternatives.
(A) Spot Cost
(B) Normalized cost
(C) Implicit cost
(D) Weighted Average Cost
24. ________ is that cost which is found out by some averaging process so that cyclical
element is removed from it
(A) Spot Cost
(B) Normalized Cost
(C) Implicit cost
(D) Weighted Average Cost

17
25. Specific cost of Debt includes
(A) Cost of Perpetual Debt
(B) Cost of Redeemable debentures
(C) Both (A) and (B)
(D) None
26. Capital is raised through that source which is most economical and the cheapest.
(A) True
(B) False
(C) Can’t say
(D) None
27. Printing prospectus, legal expenses, advertisement expenses etc are the examples of
_____
(A) Cost of Floatation
(B) Cost of debentures
(C) Cost of Equity
(D) Cost of Debt
28. To the extent the floatation cost is to be borne, the company receives a smaller
amount of money.
(A) True
(B) False
(C) Cant say
(D) None
29. If the debentures are issued at premium, the company receives a ______ amount than
the face value of its debentures.
(A) Larger
(B) Smaller
(C) Equal
(D) Half
30. If the debentures are issued at premium, the company receives a larger amount than
the face value of its debentures and hence its cost of debt ___________
(A) Goes down
(B) Goes up
(C) Remains same
(D) None
31. Perpetual debentures are _____
(A) Redeemable debentures
(B) Irredeemable debentures
(C) Convertible debentures
(D) No Debentures
32. In case of formula of redeemable debentures, n = _______________
(A) Number of years
(B) No years
(C) Not possible
(D) Not issued
33. A company issued 10% perpetual debentures of ₹ 100 each to raise ₹ 5,00,000. Tax
rate is 55%, Calculate cost of debentures when issued at par.

18
 (A) 4.5%
(B) 4.18%
(C) 4.9%
(D) 6%
34. A company issued 10% perpetual debentures of ₹ 100 each to raise ₹ 5,00,000. Tax
rate is 55%, Calculate cost of debentures when issued at premium of 8%.
(A) 4.5%
(B) 4.18%
(C) 4.9%
(D) 6%
35. A company issued 7 years 10% debentures at a price of ₹ 93 to raise ₹ 5,00,000. Face
value is ₹ 100, tax rate is 50%, calculate kd.
(A) 11.4%
(B) 5.7%
(C) 6%
(D) 6.8%
36. It is compulsory to pay _____
(A) Interest to debentures holders
(B) Dividend to equity share holders
(C) EPS
(D) EBIT
37. When preference shares are redeemable, it entails two types of burden on the
company : principle amount and dividend.
(A) True
(B) False
(C) Cant say
(D) None
38. According to the companies act, all preference shares must be _______
(A) Redeemable
(B) Irredeemable
(C) Convertible
(D) No shares
39. According to the companies act, preference shares must be redeemed within a
maximum period of _____ years
(A) 10
(B) 20
(C) 15
(D) 20
40. The shareholders invest their money in equity shares with an expectation of receiving
______
(A) Dividends
(B) Interest
(C) Subsidy
(D) None
41. In case of equity shares the rate of dividend is never fixed.
(A) True

19
 (B) False
(C) Can’t say
(D) None
42. In case of company taken into liquidation, the ____________ receive the capital last,
only when some surplus is left.
(A) Equity shareholders
(B) Debenture holders
(C) Preference share holders
(D) Liquidator
43. The approach used to calculate the cost of equity is _____
(A) Dividend Approach
(B) Earning Approach
(C) Both (A) and (B)
(D) None
44. Cost of equity is know as ____
(A) Kd
(B) Kp
(C) Ke
(D) Kr
45. It profit remains the same, the dividend per equity share will ______ with increase in
the number of equity shares.
(A) Decline
(B) Increase
(C) Remain same
(D) Half
46. When the growth rate of dividend changes rapidly, ______ approach is used to find
cost of equity
(A) Dividend
(B) Earning
(C) Both
(D) None
47. In dividend approach formula ‘g’ stands for _____
(A) Growth rate of dividend
(B) Green rate
(C) Gross rate
(D) Gap
48. Under ______ the earnings of the company, not its dividend are used as the basis for
calculating the cost of equity capital.
(A) Earning approach
(B) Dividend approach
(C) Both
(D) None
49. Retained earnings are cost free source of finance?
(A) True
(B) False
(C) Can’t say

20
 (D) None
50. The cost of retained earnings is ______
(A) Opportunity cost
(B) Historical Cost
(C) Permanent cost
(D) Weighted Average Cost
51. The formula to calculate Kr =_________
(A) Ke (1-t) (1-B)
(B) Ke (1-t)
(C) Ke (1-B)
(D) None
52. Capital asset pricing model (CAPM) is a model that describes the relationship
between _________________
(A) Risk and expected return
(B) Risk and historical cost
(C) Risk and opportunity cost
(D) Weighted Average Cost
53. In case of securities risks are ___________
(A) Systematic risk only
(B) Unsystematic risk only
(C) Both systematic and unsystematic risk
(D) None
54. _______ risk cannot be avoided or reduced through diversification
(A) Systematic risk
(B) Unsystematic risk
(C) Both
(D) None
55. Risk increased due to inflation, war, change in tax policy are examples of ______
(A) Systematic risk
(B) Unsystematic risk
(C) Both
(D) None
56. _______ arises due to worldwide uncertainties.
(A) Systematic risk
(B) Unsystematic risk
(C) Both
(D) None
57. _____________ is specified to a particular firm
(A) Systematic risk
(B) Unsystematic risk
(C) Both
(D) None
58. Strikes and loss of a big contract are the examples of ______
(A) Systematic risk
(B) Unsystematic risk
(C) Both

21
 (D) None
59. _____ may be defined as the likelihood that the actual return from an investment will
be less than the expected return.
(A) Risk
(B) Finance
(C) Capital
(D) None
60. ________ is a mathematical value that measures risk of one security in terms of its
effects on the risk of a group of securities
(A) Beta Co-efficient
(B) Market Co-efficient
(C) Risk Co efficient
(D) None
61. _____________ means a combination of securities of various companies held by a
firm or an individual.
(A) Portfolio
(B) Investment
(C) Shares
(D) Image
62. A high standard deviation represents a large dispersion of return and is a ________
(A) High risk
(B) Low risk
(C) No risk
(D) Zero Risk
63. ________ converts standard deviation of expected values into relative values to
enable comparison
(A) Co-efficient of variation
(B) Beta Co-efficient
(C) Risk Co-efficient
(D) None
64. ________is the method of considering a number of possible returns while evaluating
an asset risk.
(A) Sensitivity analysis
(B) Financial analysis
(C) Capital Analysis
(D) None
65. In sensitivity analysis, ________ values are calculated
(A) 2
(B) 3
(C) 4
(D) 5
66. In sensitivity analysis, the difference between optimistic and pessimistic results is the
range which is the basic measure of _____
(A) Risk
(B) Return
(C) Capital

22
 (D) None
67. The most expensive sources of fund is ___
(A) New equity shares
(B) New preference shares
(C) New debentures
(D) No ES
68. ______ is considered in analysis of cost of capital
(A) Long term capital
(B) Short term capital
(C) Borrowed capital
(D) None
69. Weighted average cost of capital is calculated by ____
(A) Only Book Value
(B) Only Market value
(C) Both book value and Market value
(D) Weighted average Value
70. If tax is taken into consideration, __________ would be less.
(A) Cost of Debt
(B) Cost of Equity
(C) Cost of Presence shares
(D) None

SECTION C [SHORT QUESTIONS]

1. The current market price of ₹10 equity shares is ₹ 50. The expected dividend for the
next year is ₹ 3. The dividend rate grows at 8% per annum. Tax is 30%. Calculate ke.
2. Assuming that a firm pays 50% tax, compute cost of 8.5% preference shares sold at
par.
3. B ltd. Issued 10% preference shares of ₹100 each, the floatation cost is estimated at
5%, what would be cost of capital?
4. If total earnings of a company is ₹3,60,000 and number of shares are 30,000. If P =
84, find ke.

5. If D= 6, P= 96, Tax rate = 50%, g= 5%, find Ke.

6. Company issues 10% irredeemable preference shares of ₹ 100 each. The floatation
expense is 4%, calculate cost of capital when shares issued at par.
7. Company issues 10% irredeemable preference shares of ₹ 100 each. The floatation
expense is 4%, calculate cost of capital when shares issued at 5% Premium
8. Company issues 10% irredeemable preference shares of ₹ 100 each. The floatation
expense is 4%, calculate cost of capital when shares issued at 5% discount.
9. A company issued 10% perpetual debentures of ₹ 100 each to raise ₹ 5,00,000. Tax
rate is 55%, Calculate cost of debentures when issued at discount of 8%.
10. A company issued 7 years 10% debentures at a price of ₹ 93 to raise ₹ 5,00,000. Face
value is ₹ 100, tax rate is 50%, calculate ki.

23
 SECTION D [LONG SUMS]
Sum 1
A company issues 10% debentures to raise Rs. 5,00,000 at par, calculate the
cost of debt
Sum 2
A company has issued 5000 10% debentures of Rs 100 each. The rate is 50%.
Calculate the cost of debentures under following circumstances.
[i] If they are issued at a discount of 10%
[ii] If they are issued at a premium of 10%

Sum 3
A company has issued 10% perpetual debentures of Rs. 100 each to raise Rs 5
lakhs. The tax rate is 55%. Calculate the cost of debentures under the following
circumstances: If they are issued [1] at par [2] at premium of 8% [3] at a
discount of 8%

Sum 4
A company issued 10,000, 15% irredeemable debentures of Rs 100. The
company paid following floatation charges : Underwriting commission 1.5%,
Brokerage 0.5% and other charges Rs 10,000. If the tax rate is 50%. Calculate
the cost of debenture under the following circumstances
[1] If they are issued at par
[2] If they are issued at a discount of 10%
[3] If they are issued at a premium of 10%
Sum 5
A company issued seven year 10% debenture at a price of Rs. 93 to raise Rs.
5,00,000. The face value of the debenture is Rs. 100. The tax rate is 50%.
Calculate the post tax cost of this issue.

24
Sum 6
A company issued 10% debentures of Rs. 100 each at par. The debentures are to
be repaid after 10 years. These debentures are floated at their face value, but the
cost of floatation comes to 4%. The tax rate is 55%. Calculate the cost of debt
Sum 7
A company has issued 10% irredeemable preference shares of Rs. 100 each. If
the shares are issued at par, what is the cost of capital. Also calculate the cost of
capital if shares are issued at a premium of 10%
Sum 8
A company issues 10% irredeemable preference shares of Rs 100 each. The
floatation expenses are 4% and the shares are issued at par. Compute the cost of
capital, issued at 5% discount and issued at 5% premium
Sum 9
A Limited has issued 12% debentures of Rs 100 each with 10 years maturity at
a discount of 5%. If tax rate is 50%, compute the after tax cost of debentures.
Sum 10
A limited has issued 12% debentures of Rs 100 each redeemable after 10 years
to raise Rs 2,00,000.The floatation cost is 4%. If tax rate is 20%, calculate the
cost of debentures.
Sum 11
A company issues 10% redeemable preference shares of Rs 100 each, to be
redeemed after 10 years. The floatation cost is estimated at 4% of the expected
sale proceeds. Compute the cost of preference capital, if the rate of taxation is
55%
Sum 12
X company issued 1,000 11% Redeemable preference shares of Rs. 100 each at
a discount of 5%. The cost of share issue amounted to Rs 3000. These shares
are to be redeemed at par after 10 years. Find out the cost of capital of
preference shares
What would be the cost of capital, if the preference shares are irredeemable?
25
Sum 13
Market price of equity share of a company is Rs. 50 and the dividend is Rs. 2
per share. The growth rate of dividend is 8% per annum. Calculate the cost of
equity shares
Sum 14
A company wants to issue equity shares of Rs 100 each. The floatation cost per
share is 4% of the market price of share. The company wants to pay a dividend
of Rs 6 per share. The growth rate of dividend is estimated to be 5%. Calculate
the cost of new equity capital
Sum 15
Present earnings of a company amounts to Rs. 3,60,000 and the number of its
existing equity shares is 30,000. The current market price is Rs. 100 per share.
The capital structure of the company includes no debts. The company wants to
issue new equity shares at 10% discount to raise Rs. 9,00,000 to finance its
expansion scheme. The floatation cost of new equity shares is 6%. If the
company’s earning is constant, what will be the cost of equity share capital ?
Sum 16
The current earning of C Ltd is Rs 4,00,000 and the number of its existing
equity shares is 50,000. The current market price is Rs 50 per share. Its capital
structure includes no debts. The company wants to issue new equity shares of
Rs 15,00,000 at 5% discount to finance its expansion project. The floatation
cost is estimated at 5%. If the earning of the company is stable, what will be the
cost of equity capital?
Sum 17
Market value of the equity shares of C Ltd is Rs 30. It pays a dividend of Rs 4
per share. The growth rate of dividend is 6%. Compute the cost of Equity
Capital.
Sum 18
C Ltd. intends to issue new equity shares of Rs. 10 each. The floatation cost per
share is 5% of the market price of share. The company wants to pay a dividend

26
of Rs. 1.20 per share and the growth rate of dividend is estimated to be 6%.
Compute the cost of new equity capital.
Sum 19
Face value of a share is Rs. 10 and is quoted at Rs. 50 at the stock market.
Current rate of dividend is 50% and this is expected to grow at a steady rate of
5% p.a. Calculate the cost of equity
Sum 20
The current market price of Rs 10 equity shares is Rs 50. The expected dividend
for the next year is Rs 3. The dividend rate grows at 8% per annum. 30% tax
rate is applicable to the company. Calculate cost of Equity Capital.
Sum 21
A company’s annual earnings amount to Rs. 1,20,000. Shareholders expect 10%
rate of return. If the company’s earnings are distributed among shareholders,
then they can earn 10% return in other companies. The rate of brokerage in new
investment may be taken as 3%. If the company wants to retain its earnings with
it, at what rate should make earnings? Assume that the shareholders are in 30%
tax group
Sum 22
The annual earning of D Ltd is Rs. 5,00,000. Shareholders expect 12% rate of
return. If the company’s earnings are distributed among shareholders, they
would earn 10% return by investing in other company. The rate of brokerage in
new investment is 2%. If the company wants to retain its earnings, what would
be the cost of Capital ?
Assume that shareholders are in 35% tax group
Sum 23

The proportion of various sources of finance in the capital structure of the company is as follows:

Particulars [Rs in Lakhs] Percent

Debentures 50 25
Preference Share Capital 20 10
Equity Share Capital 60 30
Retain Earnings 70 35
200 lakhs 100%
The specific costs of raising finance from various sources are given below:

27
 Debenture 6%

Preference Share Capital 8%

Equity Share Capital 12%

Retained Earnings 10%

Calculate weighted average cost of capital

Sum 24

The Following details are extracted from a company:

Particulars Amount
Equity Share Capital 2,00,000
Reserves and Surplus 1,30,000
8% Debentures 1,70,000
The rate of tax is 50%. Dividend on equity share is 12%. Calculate weighted average cost of
Capital

Sum 25

A company has on its books the following amounts and specific costs of each type of capital:

Types of Capital Book Value Market Value Specific Cost

Debentures 6,00,000 5,70,000 6.0%
Preference Share Capital 1,40,000 1,60,000 9.0%
Equity Share Capital 8,00,000 15,40,000 14.0%
Retained Earnings 3,00,000 --- 10.0%
18,40,000 22,70,000
From the above information, find out the weighted average cost of capital using [1] Book value
weights and [2] Market Value Weights

Sum 26

A company has the following specific cost along with Book and Market Value Weights.

Types of Capital Cost Book Value Weights Market Value Weights

Equity 15% 0.50 0.52
Preference shares 12% 0.30 0.28
Debentures 10% 0.20 0.20
1.00 1.00
Calculate Weighted Average Cost of Capital, using Book Value Weights and Market Value Weights

Sum 27

Jesika Ltd. has the following Capital Structure

Particulars Market Value Book Value Cost[ %]

28
Equity Share Capital 80 120 18
Preference share Capital 30 20 15
Fully secured Debentures 40 40 14
Calculate company’s weighted Average cost of capital based on both Market values and Book values.
Cost of individual source of capital is net of tax.

Sum 28

From the following information, calculate weighted average overall cost of capital using [a] Book
Value Weights and [b] Market value weight

Source Book Value Market Value

Equity share capital 45,000 90,000
Retained Earnings 15,000 ---
Preference share capital 10,000 10,000
Debentures 30,000 30,000
After tax cost of different sources of finance is as follows:
Equity share capital 14%
Retained earnings 13%
Preference share capital 10%
Debentures 5%

Sum 29

The total assets of Sarangpur Ltd. are Rs. 4,00, for which funds have been raised as follows:
Debentures Rs 1,30,000, Equity shares Rs 2,25,000 and General Reserve Rs 45,000. The profit of the
company after interest and taxes for the year ended 31 stDecember ,2019 is Rs 33750. The rate of
interest on debentures is 10% and tax rate is 55%. The equity shares are Rs 100 each and there are
2250 such shares whose market value is Rs 140

Determine the weighted average cost of capital

Sum 30

A company has a following capital structure :

Particulars Amount
8% Debentures of Rs 100 each 14,00,000
12% Red. Preference shares of Rs 100 each 3,50,000
Equity shares of Rs 10 each 17,50,000
35,00,000

Other information is as follows:

1. Market price of Debentures is Rs 105

2. Market price of preference share is Rs 115

3. Market value of Equity shares is Rs 20

29
Anticipated external financing opportunities are :

[1] 8% Debentures of Rs. 100, payable at par after 10 years, 4% floatation costs, and sale price Rs
100

[2] 12% Preference shares of Rs 100, redeemable at par after 12 years, 4% floatation costs and sale
price Rs 100

[3] Equity shares, 3% floatation costs and sale price Rs 20

[4] The dividend expected on the equity share at the end of the year is Rs. 2 per share, the
anticipated growth rate in dividend is 6% and the company has the practice of paying all its earnings
in the form of dividends

[5] The tax rate is 50%

From the above information, calculate Weighted Average cost on the basis of the following:

(1) Book value weights

(2) Market Value weights

SECTION [HOME WORK]

Sum 1.

The ten year debenture of a firm can be sold at a rate of Rs 90. The face value of a debenture
is Rs 100 and the coupon rate of interest is 8%. If 50% tax rate is assumed, calculate the after
tax cost of debt.

Sum 2.

A company issues 10% preference share capital without a maturity date. The face value per
preference share is Rs 100 but the issue price is Rs 95. What is the cost of this issue?

Sum 3.

The current market price of a share is Rs 90 and the expected dividend per share next year is
Rs 4.50. If the dividends are expected to grow at a rate of 7%, calculate the cost of equity.

Sum 4.

Assuming that the firm pays tax at 50%, compute the after – tax cost of capital in the
following cases:

[i] A 8 1/2 % preference share sold at par

[ii] A ten year, 8%, Rs 1000 per bond sold at Rs 950 less 4% underwriting commission

30
[iii] An ordinary share selling at a current market price of Rs 120 and paying a current
dividend of Rs 9 per share which is expected to grow at a rate of 8%

Sum 5.

Issue of 1,00,000 debentures with a coupon rate of 15%, each of Rs 100 repayable after 5
years at a premium of 5%. The issue costs amounted to Rs 4,00,000, calculate the cost of debt
assuming 40% tax bracket.

Sum 6

Equity share capital [each share Rs 10] Rs 5,00,000. Expected dividend rate in the next year
= Rs 1.62. Current market price = Rs 32.40. Growth rate in earnings and dividend =8%.
Calculate the cost of equity capital. Assume 40% tax bracket

Sum 7

Z company issues 10% debentures of 10 years maturity. The face value of the debentures is
Rs 100 and its issue price is Rs 94. The company pays Rs 4 floatation costs. If the tax rate is
50%, compute the cost of debentures.

31
 Note : The above materials has been compile from the below
mention reference book

Reference Books:
Author/s Name of the Book Publisher
1 Datar and Rajan Horngren’s Cost Pearson
Accounting – A
managerial
Emphasis
2 Gary Cokins Management Tata
Accounting – McGraw
Making it work
3 Cheng and Management Chapman
Podolsky Accounting & Hall
4 Sekhar and Management Oxford
Rajagopalan Accounting

32
 FACULTY OF COMMERCE

2023 – 24
SEMESTER 4

SUBJECT: FINANCIAL MANAGEMENT

UNIT : 4
Capital Structure

Prepared BY :
Dr. Krupa Bhatt Prof. Meghavi Thaker

STUDY MATERIAL FOR REFERENCE ONLY

 What Is Capital Structure?
Capital structure is the particular combination of debt and equity used by a company to
finance its overall operations and growth.
Equity capital arises from ownership shares in a company and claims to its future cash flows
and profits. Debt comes in the form of bond issues or loans, while equity may come in the
form of common stock, preferred stock, or retained earnings. Short-term debt is also
considered to be part of the capital structure.
 Capital structure is how a company funds its overall operations and growth.
 Debt consists of borrowed money that is due back to the lender, commonly with interest
expense.
 Equity consists of ownership rights in the company, without the need to pay back any
investment.
Optimal Capital Structure
Companies that use more debt than equity to finance their assets and fund operating activities
have a high leverage ratio and an aggressive capital structure. A company that pays for assets
with more equity than debt has a low leverage ratio and a conservative capital structure. That
said, a high leverage ratio and an aggressive capital structure can also lead to higher growth
rates, whereas a conservative capital structure can lead to lower growth rates.
Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total
liabilities by total equity. Savvy companies have learned to incorporate both debt and equity
into their corporate strategies. At times, however, companies may rely too heavily on external
funding and debt in particular. Investors can monitor a firm's capital structure by tracking the
D/E ratio and comparing it against the company's industry peers.
Types of Capital Structure
The meaning of Capital structure can be described as the arrangement of capital by using
different sources of long term funds which consists of two broad types, equity and debt. The
different types of funds that are raised by a firm include preference shares, equity shares,
retained earnings, long-term loans etc. These funds are raised for running the business.
Equity Capital
Equity capital is the money owned by the shareholders or owners. It consists of two different
types
a) Retained earnings: Retained earnings are part of the profit that has been kept separately by
the organisation and which will help in strengthening the business.
 b) Contributed Capital: Contributed capital is the amount of money which the company
owners have invested at the time of opening the company or received from shareholders as a
price for ownership of the company.
Debt Capital
Debt capital is referred to as the borrowed money that is utilised in business. There are
different forms of debt capital.
1. Long Term Bonds: These types of bonds are considered the safest of the debts as they have an
extended repayment period, and only interest needs to be repaid while the principal needs to
be paid at maturity.
2. Short Term Commercial Paper: This is a type of short term debt instrument that is used by
companies to raise capital for a short period of time
 Importance of Capital Structure:
1. Increase in value of the firm: A sound capital structure of a company helps to
increase the market price of shares and securities which, in turn, lead to increase in
the value of the firm.
2. Utilisation of available funds:
A good capital structure enables a business enterprise to utilise the available funds
fully. A properly designed capital structure ensures the determination of the
financial requirements of the firm and raise the funds in such proportions from
various sources for their best possible utilisation. A sound capital structure protects
the business enterprise from over-capitalisation and under-capitalisation.
3. Maximisation of return: A sound capital structure enables management to
increase the profits of a company in the form of higher return to the equity
shareholders i.e., increase in earnings per share. This can be done by the
mechanism of trading on equity i.e., it refers to increase in the proportion of debt
capital in the capital structure which is the cheapest source of capital. If the rate of
return on capital employed (i.e., shareholders’ fund + long- term borrowings)
exceeds the fixed rate of interest paid to debt-holders, the company is said to be
trading on equity.
4. Minimisation of cost of capital:
A sound capital structure of any business enterprise maximises shareholders’
wealth through minimisation of the overall cost of capital. This can also be done by
incorporating long-term debt capital in the capital structure as the cost of debt
capital is lower than the cost of equity or preference share capital since the interest
 on debt is tax deductible.
5. Solvency or liquidity position: A sound capital structure never allows a
business enterprise to go for too much raising of debt capital because, at the time
of poor earning, the solvency is disturbed for compulsory payment of interest to
.the debt-supplier.
6. Flexibility:
A sound capital structure provides a room for expansion or reduction of debt
capital so that, according to changing conditions, adjustment of capital can be
made.
7. Undisturbed controlling: A good capital structure does not allow the equity
shareholders control on business to be diluted.
8. Minimisation of financial risk: If debt component increases in the capital
structure of a company, the financial risk (i.e., payment of fixed interest charges
and repayment of principal amount of debt in time) will also increase. A sound
capital structure protects a business enterprise from such financial risk through a
judicious mix of debt and equity in the capital struc
Factors Determining Capital Structure:
The following factors influence the capital structure decisions:
1. Risk of cash insolvency:
Risk of cash insolvency arises due to failure to pay fixed interest
liabilities. Generally, the higher proportion of debt in capital structure
compels the company to pay higher rate of interest on debt irrespective
of the fact that the fund is available or not. The non-payment of interest
charges and principal amount in time call for liquidation of the
company.
2. Risk in variation of earnings:
The higher the debt content in the capital structure of a company, the
higher will be the risk of variation in the expected earnings available to
equity shareholders. If return on investment on total capital employed
(i.e., shareholders’ fund plus long-term debt) exceeds the interest rate,
the shareholders get a higher return.
On the other hand, if interest rate exceeds return on investment, the
shareholders may not get any return at all.
3. Cost of capital:
Cost of capital means cost of raising the capital from different sources of
funds. It is the price paid for using the capital. A business enterprise
should generate enough revenue to meet its cost of capital and finance
its future growth. The finance manager should consider the cost of each
source of fund while designing the capital structure of a company.
4. Control:
The consideration of retaining control of the business is an important
factor in capital structure decisions. If the existing equity shareholders
do not like to dilute the control, they may prefer debt capital to equity
capital, as former has no voting rights.
5. Trading on equity:
The use of fixed interest bearing securities along with owner’s equity as
sources of finance is known as trading on equity. It is an arrangement by
which the company aims at increasing the return on equity shares by the
use of fixed interest bearing securities (i.e., debenture, preference shares
etc.).
6. Government policies:
Capital structure is influenced by Government policies, rules and
regulations of SEBI and lending policies of financial institutions which
change the financial pattern of the company totally. Monetary and fiscal
policies of the Government will also affect the capital structure
decisions
 Example of capital structure
Capital Structure Theories

3. Net Income Approach (NI)

According to this approach, capital structure decision is relevant to the value of the firm. An
increase in financial leverage (Debt Proportion) will lead to decline in the weighted average
cost of capital (WACC), while the value of the firm as well as market price of ordinary share
will increase.

As per NI Approach:


o Kd and Ke will remain constant.
o Ko will decrease with the help of use of Debt.
o MV of Equity and Firm will increase with the help of use of Debt.
Formulae:

Value of Share (S) = Or =V–D

Value of Debt (D) = Face Value of Debt

Value of Firm (V) = S + D Or =

Cost of Capital (Ko) = Or = KeWe + KdWd

Cost of Equity (Ke) =

Note: Ke and Ko of unlevered firm are same.

4. Traditional Approach

This approach favours that as a result of financial leverage up to some point, cost of capital
comes down and value of firm increases. However, beyond that point, reverse trends emerge.

As per Traditional Approach:


o Kd, Ke, Ko and MV of Equity and MV of Firm are variable
o Company has to select capital structure with lowest Ko or highest MV of Firm
Net Operating Income Approach (NOI)

According to this approach, capital structure decisions of the firm are irrelevant. Any change
in the leverage will not lead to any change in the total value of the firm and the market price
of shares, as the overall cost of capital is independent of the degree of leverage.

As per NOI Approach:


o Kd, Ko and MV of Firm will remain constant in case of without tax structure.
o Kd will remain constant in case of with tax structure, with the increase in Debt,
MV of firm will increase and Ko will decrease

Value of Firms as per NOI Approach: Step 1: Calculate Value of Unlevered Firm:

Value of Unlevered Firm (V U) =

Step 2: Calculate Value of Levered Firm:

Value of Levered Firm (VL) = VU + DT

6. Modiglani-Miller Approach (MM)

The NOI approach is definitional or conceptual and lacks behavioral significance. However,
Modigliani-Miller approach provides behavioural justification for constant overall cost of
capital and therefore, total value of the firm.

Assumptions of MM Approach


o Capital markets are perfect
o All information is freely available
o There are no transaction costs
o All investors are rational
o Firms can be grouped into ‘Equivalent risk classes’
o Non-existence of corporate taxes

 Optimum capital structure

Introduction

The optimal capital structure of a company refers to the proportion in which it structures its
equity and debt. It is designed to maintain the perfect balance between maximising the wealth
and worth of the company and minimising its cost of capital.

The objective of a company is to determine the lowest weighted average cost of capital
(WACC) while deciding on its capital structure. The WACC is the weighted average of its
cost of equity and debt. It is not mandatory for a company to take any debt.
A company can have a capital structure that is all-equity, or a structure with minimal debt. It
also depends on the industry the company belongs to because standard capital structures vary
from industry to industry and whether the company is a private or public company.

Key Points in Designing an Optimal Capital Structure

1. Maximise the company's wealth An optimal capital structure will maximise the company's
net worth, wealth, and market value. The wealth of the company is calculated in terms of the
present value of future cash flows. This is discounted by the WACC.

2. Minimise the cost of capital The lower the cost of the capital, the lower is the risk of
insolvency. Companies in industries that have uncertain future cash flows should keep their
cost of financing minimal. The lower the cost of capital, the higher will be its present value of
future cash flows.

3. Simplicity in structure It should be simple to structure and understand. A complicated

capital structure will only create confusion.

4. Maintain control An optimal capital structure maintains the owners' rights and control. It is
also flexible and gives scope for future borrowing whenever necessary, without losing
control.

How is the WACC calculated?

WACC =[D (Kd)/ (D+E)] +[D (Ke) x (1 - t)/ (D + E)]

where, D = Total debt E = Total equity Kd = Cost of debt Ke = Cost of equity t = Tax rate

n a business, numerous factors affect a company’s finances and cash flow. The sources of
capital have significant implications for the firm as they affect its value. It is easy for a
company to take debts to keep the production going as it is the least costly form of capital. It
is due to the fact that the cost of debt (interest) is a tax-deductible expense and relatively less
risky.

However, excess borrowing not only increases a firm’s risk of bankruptcy but also affects its
ability to pay dividends. In the event of loss, the firm still has to make interest payments on
debts. As a result, it reduces the profit available for dividend distribution. It leads to increased
risks to equity shareholders. In such an event, shareholders have to be compensated for the
enhanced risk. Thus, the cost of equity rises, eroding the benefits of cheap debt.

On the one hand, it is beneficial for a company to reduce equity, which is relatively
expensive, and take debt. But, on the other hand, a company has to constantly look for cheap
resources and sound financial planning and execution to ensure they do not take a heavy debt
on them. Thus, the company designs the optimum capital structure to beat it.
Illustrations

Practical sum of capital structure

1.In ABC LTD co. Total asset is 10,00000.while total debt is 5,00000. Find out and calculate
debt to asset ratio and give description. Apart from this, find out followings
A. Debt to equity ratio if equity capital is 8,00000 and debt is 4,00000.
B. Debt to equity ratio if equity decreases to 6,00000 and debt is same as above 4,00000.

Solution

Total asset=10,00000

Debt structure=5,00000 .In this company assets are higher than debts. If we want to find out
debt to asset ratio then the formula is as below.

Company’s total amount of debt /Company’s total asset

5,00000/10,00000=0.5

The above 0.5 says that total debt(50%) are financed by creditors and 60% are financed by
owners. So the company has reasonable amount of debt and equity.

A. If equity capital is 8,00000 and debt is 4,00000. It ,means how much debt a company has
as compare to its asset.

formula is Debt/equity=Total liabilities/total shareholder’s equity

4,00000/8,00000=0.5

B. If equity reduces to 6,00000 and debt remains same 4,00000

The answer is =4,00000/6,00000=0.66 which shows that dependency on debt is increased and
equity weightage is reduced.

2.In XYZ ltd if revenue for a time period is 1,00000.Total expenses are 50,000 and taxes
applicable are 20,000.Find out Net income. Explain concept of net income approach.
Solution :The concept of NI is famous and commonly accepted approach. It explains about
the actual income from revenue . Apart from this, According to this approach, capital
structure decision is relevant to the value of the firm. An increase in financial leverage (Debt
Proportion) will lead to decline in the weighted average cost of capital (WACC), while the
value of the firm as well as market price of ordinary share will increase.
So formula is revenue- total exps- taxes applicable= Net income
1,00000- 50,000=50,000 is revenue after exps
Now, 50,000 revenue after exps- tax 20,000=30,000
Here Net income is 30,000 which depicts the actual profit , capital structure decision is
relevant to the value of the firm. An increase in financial leverage (Debt Proportion) will lead
to decline in the weighted average cost of capital (WACC), while the value of the firm as
well as market price of ordinary share will increase.
Example -3 : The net operating income of a company is 200000. Its capital structure includes
8% debenture of Rs. 500000 while the rate of overall cost of capital is 10 %.
Compute the cost of equity capital.
Solution : (a) When debentures are worth Rs. 5,00,000 :
Net operating income (NOl) Rs. 2,00,000
Rate of overall cost of capital 10%
Total value of the firm 2,00,000 ÷ 10% = Rs. 20,00,000
Less : Debentures Rs. 5,00,000
Value of equity shares 15,00,000
Increased earning on equity shares 2,00,000 - 40,000 = Rs. 1,60,000
Cost of equity capital (or rate of capitalisation) = 1,60,000
15,00,000 * 100
= 10.67 per cent
Here Cost of Equity Capital = Ke = EBIT - Interest
S
5. 00,000
Average Cost of Capital Ko = 8% * 500000 + 10.67 * 1500000
20,00,000 20,00,000
= 2% + 8% = 10%
Thus the overall cost of capital remains the same at 10%.

Example-4: 1 An Example on Trading on Equity

Suppose a company needs capital of Rs. 1,00,000 and expects to earn a profit of Rs. 10,000.
If the entire capital is raised in the form of equity shares, it can' give 10 per cent dividend to
equity shareholders. But if it resorts to trading on equity by raising Rs. 50,000 through the
issue of debentures bearing 5 per cent interest, then it can give 15 per cent dividend to its
equity shareholders.
Solution:
Earning of the company Rs. 10,000
Less : Interest (5% on debentures) Rs. 2,500
Earnings available for equity shares Rs.7,500
Total Capital Rs. 100000
-Debenture Rs. 50000
Equity capital Rs. 50000
Profit of Rs. 7500 will be distributed on equity capital of 50000
Dividend = 7500 * 100 = 15%
1 50000
It follows that (i) when capital is raised entirely in the form of equity shares, the rate of
dividend is 10 per cent. (ii) But through trading on equity, dividend rate can be increased to
15 per cent.

TRADING ON EQUITY
1. INTRODUCTION

Trading on equity is a type of finance where debt generates profits for a company's
shareholders. When a business takes on new debt through bonds, loans, bonds, or preferred
shares, trading on equity takes place. The business then makes use of these money to acquire
assets that will yield profits greater than the interest on the new loan. As an alternative,
financial leverage is trading on equity. It is deemed successful if it increases profit margins
for the business and provides investors with a better return on their investment. This is how
businesses often increase earnings per share.

The reason "trading on equity" got its name is that the company's loan amount from creditors
is determined by the strength of its equity. Companies typically use their equity to their
advantage to borrow money on favorable terms. If the loan amount is high relative to the
equity of the business.

2. ADVANTAGES OF TRADING ON EQUITY

Enhanced earnings: By borrowing the funds necessary, the company creates for itself more
avenues of earning revenue by obtaining new assets.

Tax treatment is favourable– The borrowed funds have an interest expense that is tax
deductible. So, the borrowing company has to pay lower tax. So, basically, the new debt
results in a reduction of the total cost for the borrower.

3. DISADVATAGES OF TRADING ON EQUITY

Trading on equity has its own set of risk factors. It may result in further losses if the interest
expense cannot be paid off by the business. You should note that such borrowings can cause
high-risk situations for a business, which is depending on the borrowed amount to finance its
operations.

If there is an unexpected rise in the interest rates, it can cause losses because the financial
burden of the interest would increase for the company. So, while trading on equity holds the
promise of potential increased returns, there is also a real risk of bankruptcy you must take
into account.

4. WHEN WILL IT BE CONSIDERED SUCCESSFUL?

Trading on equity is likely to be profitable in the following cases-

When a company that is well-established resorts to such means financing

The nature of the company’s business is not speculative

the company has profits and sales that are both regular and stable

It is because of the above points that public utility concerns frequently use this financing
concept. These organisations have ample liquidity to allow for large scale borrowing.

5. CONCLUSION
Trading on equity may result in uneven earnings, so it impacts the stock options by increasing
their recognised cost. When an increase in earnings occurs, it is option holders who are most
likely to cash their options. Since the earnings are not fixed, the chances of the holder earning
a higher return are greater.

So, it is more likely that managers will use this option more that owners. Using the process,
managers have the opportunity to increase the worth of the stock options. A business that is
run by a family, on the other hand, has financial security as its high priority, so, it is unlikely
that they would go this route.

As the bottom line, we can view trading on equity as a sort of trade-off. A company uses its
equity as a way to get more funds in order to purchase new assets, and uses these new assets
to pay for its debt.

SECTION A LONG QS

1. Explain capital structure with examples

2. Explain different components with ideal capital structure
3. Explain NI and NOI approach.
4. What is traditional and MM approach?
5. Write a note on trading on equity.

SECTION B SHORT QS

1. What is trading on equity? Give example.

2. A capital comprises of which components?
3. What is debt capital?
4. Give a chart of any capital structure.
5. Which approach of capital structure is suitable in modern
organization ?

SECTION C MCQS.

MULTIPLE CHOICE QUESTION

1. What is Capital Structure?

A. Physical assets owned by a company
B. The mix of a company's debt and equity financing
C. The total revenue generated by a company
D. The number of employees in a company
2. Which of the following is a component of capital structure?
A. Marketing strategy
B. Human resources
C. Long-term debt
D. Short-term liabilities
3. Why is capital structure important for a company?
A. It determines the CEO's salary
B. It impacts the company's tax rate
C. It influences the company's risk and return
D. It dictates the product pricing strategy
4. What does equity represent in capital structure?
A. Borrowed funds B. Ownership stake of shareholders
C. Interest payments D. Short-term liabilities
5. Which of the following is a characteristic of a high-leverage capital structure?
A. Lower financial risk B. Higher potential returns
C. Reduced dependence on debt D. Limited shareholder control
6. What is the primary goal of optimizing capital structure?
A. Minimizing shareholder wealth
B. Maximizing financial risk
C. Achieving an optimal balance between debt and equity
D. Eliminating all debt
7. How does debt in the capital structure impact financial leverage?
A. Increases financial risk B. Decreases financial risk
C. Has no effect on financial risk D. Reduces shareholder control
8. Why is Capital Structure important for a company?
A. It determines the CEO's salary
B. It influences the company's risk and return
C. It dictates the product pricing strategy
D. It impacts the company's logo design
9. What role does Capital Structure play in financial decision-making?
A. Determines the company's color scheme
B. Impacts the company's advertising strategy
C. Affects the cost of capital and financial performance
D. Dictates the company's office location
10. How does an optimal Capital Structure contribute to shareholder wealth?
A. By minimizing financial risk
B. By maximizing long-term debt
C. By balancing debt and equity to maximize value
D. By eliminating equity financing
11. What is one consequence of having too much debt in the Capital Structure?
A. Increased financial stability B. Lower interest payments
C. Higher financial risk D. Reduced shareholder control
12. How can an optimal Capital Structure enhance a company's competitiveness?
A. By lowering product quality B. By increasing financial risk
C. By reducing the cost of capital D. By ignoring market trends
13. What impact does Capital Structure have on a company's ability to attract investors?
A. None, as it's solely determined by product quality
B. It influences the risk and return profile, attracting or deterring investors
C. Investors are only interested in a company's logo
D. Capital Structure has no relation to investor interest
14. How does a well-managed Capital Structure impact a company's cost of capital?
A. Increases it B. Has no effect
C. Decreases it D. Unpredictable
15. What does the concept of financial leverage signify in the context of Capital Structure?
A. The company's ability to dance around financial issues
B. The use of debt to magnify returns
C. How much a company relies on equity financing
D. The number of financial decisions a company makes
16. In what way can an optimal Capital Structure contribute to a company's resilience during
economic downturns?
A. By increasing financial vulnerability
B. By reducing the need for cost-cutting measures
C. By relying solely on short-term liabilities
D. By avoiding debt altogether
17. What factor does Capital Structure heavily influence in a company's financial decision-
making?
A. The company's choice of office furniture
B. The color scheme of the company's logo
C. The timing of product launches
D. The risk and return trade-off
18. How does a balanced Capital Structure contribute to strategic flexibility for a company?
A. By restricting financial options
B. By limiting the company's market reach
C. By providing a mix of financing sources for adaptability
D. By avoiding long-term planning
19. Which theory suggests that the cost of capital is minimized at the point where the
weighted average cost of capital (WACC) is the lowest?
A. Modigliani-Miller Proposition I B. Modigliani-Miller Proposition II
C. Trade-off Theory D. Pecking Order Theory
20. According to the Modigliani-Miller Proposition II, what factor influences a company's
cost of equity?
A. Debt-equity ratio B. Tax rate
C. Risk-free rate D. Dividend payout ratio
21. Which theory acknowledges the existence of bankruptcy costs and suggests an optimal
level of debt to balance tax advantages and financial distress costs?
A. Trade-off Theory B. Modigliani-Miller Proposition I
C. Pecking Order Theory D. Agency Cost Theory
22. According to the Pecking Order Theory, what is the preferred source of financing for a
company?
A. Equity B. Debt
C. Retained Earnings D. Preferred Stock
23. Which theory suggests that firms prefer internal financing and only resort to external
financing when internal sources are exhausted?
A. Pecking Order Theory B. Modigliani-Miller Proposition II
C. Trade-off Theory D. Agency Cost Theory
24. According to the Agency Cost Theory, what issue arises when managers prioritize their
interests over those of shareholders?
A. Financial distress B. Agency costs
C. Tax advantages D. Optimal capital structure
25. Which theory emphasizes the signaling effect of financing decisions and suggests that
firms prefer internal financing to external financing?
A. Modigliani-Miller Proposition I B. Trade-off Theory
C. Pecking Order Theory D. Agency Cost Theory
26. According to Modigliani-Miller Proposition II, what happens to the cost of equity as the
debt-equity ratio increases?
A. Increases B. Decreases
C. Remains constant D. Becomes unpredictable
27. Which theory suggests that firms adjust their capital structure to maintain an optimal
debt-equity ratio to maximize firm value?
A. Trade-off Theory B. Pecking Order Theory
C. Modigliani-Miller Proposition I D. Market Timing Theory
28. According to the Market Timing Theory, when do firms prefer to issue equity?
A. When stock prices are high B. When stock prices are low
C. Regardless of stock prices D. Only during economic downturns
29. Which theory suggests that firms have a target leverage ratio and adjust their capital
structure based on deviations from this target?
A. Static Trade-off Theory B. Dynamic Trade-off Theory
C. Market Timing Theory D. Pecking Order Theory
30. According to the Static Trade-off Theory, what do firms balance when determining their
optimal capital structure?
A. Debt and equity issuance costs
B. Tax benefits and financial distress costs
C. Internal and external financing preferences
D. Agency costs and signaling effects
31. How does an increase in debt in the capital structure typically affect the cost of capital?
A. Increases both the cost of debt and equity
B. Decreases the cost of debt and equity
C. Increases the cost of debt and decreases the cost of equity
D. Decreases the cost of debt and increases the cost of equity
32. What concept suggests that there is an optimal capital structure that minimizes the overall
cost of capital for a firm?
A. Market Timing Theory B. Modigliani-Miller Proposition I
C. Dynamic Trade-off Theory D. Pecking Order Theory
33. How does a higher cost of debt impact a company's overall cost of capital?
A. Decreases overall cost of capital
B. Increases overall cost of capital
C. Has no impact on overall cost of capital
D. Makes the overall cost of capital unpredictable
34. According to the Static Trade-off Theory, what is the relationship between the tax shield
from debt and financial distress costs in determining the optimal capital structure?
A. They have no relationship
B. Tax shield exceeds financial distress costs
C. Financial distress costs exceed tax shield
D. They are always equal
35. How does a decrease in the cost of equity impact a firm's weighted average cost of capital
(WACC) when using more equity in the capital structure?
A. Increases WACC B. Decreases WACC
C. Has no impact on WACC D. Makes WACC unpredictable
36. In the context of the Pecking Order Theory, what does the theory suggest about the
linkage between internal and external financing and the cost of capital?
A. Internal financing reduces the cost of capital
B. External financing reduces the cost of capital
C. Internal financing increases the cost of capital
D. External financing has no impact on the cost of capital
37. How does an increase in the cost of debt impact a firm's weighted average cost of capital
(WACC) when using more debt in the capital structure?
A. Increases WACC B. Decreases WACC
C. Has no impact on WACC D. Makes WACC unpredictable
38. According to the Dynamic Trade-off Theory, how do firms adjust their capital structure
over time in response to changing conditions?
A. They maintain a constant debt-equity ratio
B. They never adjust their capital structure
C. They actively change their capital structure to optimize value
D. They only use internal financing
39. What role does the cost of capital play in the pecking order of financing choices
according to the Pecking Order Theory?
A. It is the primary determinant of financing choices
B. It is irrelevant to the pecking order
C. It is considered only after all other factors
D. It is inversely related to financing choices
40. How does an optimal capital structure, as suggested by the Static Trade-off Theory,
balance the benefits of debt and equity?
A. By maximizing debt regardless of costs
B. By minimizing debt to avoid financial distress
C. By achieving an equilibrium between tax benefits and financial distress costs
D. By solely focusing on equity financing
41. In the context of the Market Timing Theory, when do firms prefer debt financing?
A. When stock prices are high B. When stock prices are low
C. Regardless of stock prices D. Only during economic downturns
42. How does the cost of capital influence a firm's decision-making process regarding capital
structure adjustments?
A. It is the sole determinant of capital structure changes
B. It is considered alongside other factors such as risk, market conditions, and financial goals
C. It has no relevance to capital structure decisions
D. It is only relevant for short-term financing decisions
43. What is capital structure?
A. The physical assets of a company
B. The mix of a company's debt and equity financing
C. The number of employees in a company
D. The market share of a company
44. Which component represents ownership in a company's capital structure?
A. Debt B. Equity
C. Retained Earnings D. Short-term liabilities
45. What does debt financing in a company's capital structure involve?
A. Selling ownership shares B. Borrowing money
C. Using retained earnings D. Issuing dividends
46. How does the debt-to-equity ratio influence capital structure?
A. It has no impact on capital structure
B. Higher ratio indicates more equity
C. Lower ratio indicates more debt
D. Both B and C
47. Why is achieving an optimal capital structure important for a company?
A. It guarantees high profits B. It minimizes financial risk
C. It eliminates the need for debt D. It ensures low competition
48. In the context of capital structure, what is financial leverage?
A. The use of equity financing B. The mix of debt and equity
C. The proportion of retained earnings D. The total assets of a company
49. What does the Pecking Order Theory suggest about a company's preference for financing
sources?
A. Companies prefer debt over equity
B. Companies prefer internal financing over external financing
C. Companies prefer equity over debt
D. Companies have no preference for financing sources
50. Which theory suggests that companies prefer to use internal financing first and resort to
external financing only if necessary?
A. Market Timing Theory B. Modigliani-Miller Proposition I
C. Pecking Order Theory D. Static Trade-off Theory
51. How does the Modigliani-Miller Proposition I view the relationship between capital
structure and firm value?
A. Capital structure has no impact on firm value
B. Higher debt increases firm value
C. Higher equity increases firm value
D. Only retained earnings impact firm value
52. According to the Trade-off Theory, what does a company balance when determining its
optimal capital structure?
A. Debt and equity issuance costs
B. Tax benefits and financial distress costs
C. Internal and external financing preferences
D. Agency costs and signaling effects
53. How does the Pecking Order Theory explain the order of preference for financing sources
in companies?
A. Companies prefer debt first, then equity
B. Companies prefer equity first, then debt
C. Companies have no preference for financing sources
D. Companies only use internal financing
54. What factor does the Static Trade-off Theory consider in determining the optimal mix of
debt and equity?
A. Market conditions
B. The company's age
C. Tax advantages and financial distress costs
D. Competition in the industry
55. According to the Market Timing Theory, when do companies prefer equity financing?
A. When stock prices are high B. When stock prices are low
C. Regardless of stock prices D. Only during economic downturns
56. What does "trading on equity" refer to in financial terms?
A. Buying and selling stocks
B. Borrowing funds to invest in assets that generate higher returns
C. Conducting business transactions on the stock market
D. Trading company bonds for equity shares
57. How does trading on equity magnify returns for shareholders?
A. By reducing financial leverage
B. By increasing the cost of debt
C. By leveraging borrowed funds to generate higher returns than the cost of debt
D. By avoiding debt entirely
58. What financial metric is used to assess the extent of trading on equity for a company?
A. Return on Assets (ROA) B. Debt-to-Equity Ratio
C. Price-to-Earnings (P/E) Ratio D. Return on Investment (ROI)
59. In the context of trading on equity, what does a high debt-to-equity ratio indicate?
A. Conservative financial management
B. Low financial risk
C. Aggressive financial management with higher leverage
D. Limited use of external financing
60. How does a company benefit from successful trading on equity when its returns exceed
the cost of debt?
A. By decreasing shareholder wealth
B. By increasing financial risk
C. By maximizing profitability for shareholders
D. By avoiding external financing
61. What is the potential drawback or risk associated with trading on equity?
A. Increased financial stability
B. Higher returns for shareholders
C. Amplified financial losses in case of poor investment returns
D. Lower interest payments on debt
62. How does a company achieve trading on equity?
A. By avoiding debt entirely
B. By reducing shareholder dividends
C. By borrowing funds to invest in projects with higher returns than the cost of debt
D. By relying solely on internal financing
63. In trading on equity, what is the primary source of funds for investment projects?
A. Share capital B. Retained earnings
C. Borrowed funds (debt) D. Preferred stock
64. What financial principle supports the idea of trading on equity as a strategy to enhance
shareholder returns?
A. Principle of Conservatism B. Principle of Leverage
C. Principle of Risk Aversion D. Principle of Liquidity
65. How does a decrease in the cost of debt impact the attractiveness of trading on equity for
a company?
A. Makes trading on equity more attractive
B. Has no impact on trading on equity
C. Makes trading on equity less attractive
D. Eliminates the need for trading on equity
66. What financial metric is used to evaluate the efficiency of trading on equity in generating
returns for shareholders?
A. Return on Investment (ROI) B. Return on Assets (ROA)
C. Debt Ratio D. Equity Turnover Ratio
67. What does the term "equity multiplier" represent in the context of trading on equity?
A. The number of equity transactions on the stock market
B. The ratio of a company's total assets to its equity
C. The price-to-earnings ratio
D. The percentage of equity held by institutional investors
68. How does a high degree of trading on equity impact a company's financial risk?
A. Decreases financial risk B. Increases financial risk
C. Has no impact on financial risk D. Makes financial risk unpredictable
69. What is the primary benefit of trading on equity when the return on investment exceeds
the cost of debt?
A. Lower financial leverage B. Reduced profitability
C. Maximizing shareholder wealth D. Decreased reliance on external financing
70. What financial concept is often associated with the idea of trading on equity?
A. Liquidity preference B. Return on investment
C. Time value of money D. Operating leverage

REFERENCES:

The above material has been compiled from the below mentioned reference books and
official data from websites.

Financial Engineering and Financial Martand Telsan

Management
Financial Management I.M. Pandey
Financial Management Prasanna Chandra
Financial Management P.K. Jain

******************************
 FACULTY OF COMMERCE

2023 – 24
SEMESTER 4

SUBJECT:
FINANCIAL MANAGEMENT

UNIT 5: WORKING CAPITAL MANAGEMENT

Compiled By:

Dr. Jaimin Patel and Dr. Shimoni Trivedi

STUDY MATERIAL FOR REFERENCE ONLY

 UNIT 5 WORKING CAPITAL MANAGEMENT

Sr. No. Topic

1. Introduction
2. Meaning of working capital and the controversy
3. Types of Working Capital
4. Characteristics of working capital
5. Factors determining working capital requirements
6. Management of Cash
7. Management of receivables
8. Management of Inventory

1. INTRODUCTION
Business capital is broadly divided into two groups: Fixed Capital and Working Capital .Fixed
capital refers to the funds invested in such permanent assets as land, building,machinery etc. while
working capital refers to the funds locked up in materials, working-in-progress,finished goods,r
eceivables and cash etc. Since these assets are known as current assets, in very simple terms, ‘working
capital may be defined as capital invested in current assets.’ It will be shown later, however, that this
definition of working capital has become controversial.

Current assets are those assets which can be converted into cash within a period of one year or less.
The examples are the stocks of raw materials, work-in-progress and finished
products,receivables,cash etc. In addition, working capital is required also products. to meet the day-
to-day expenses on wages,salaries,power etc. All these assets are converted into cash within a short
period of time and the cash received is again invested into these assets.
Thus, it is as constantly revolving or circulating. Hence, working capital is also known as ‘circulating
capital’ or ‘floating capital’.

From the view point of manufacturing process, working capital means that part of capital which is
required to keep the flow of production, raw materials have to be purchased at a right time and in
right quantity, stocks of work-in-progress and finished products have to be maintained; expenditures
have to be incurred on labour electricity, administrative matters etc.till the end of production process
and goods have to be sold mostly on credit. The funds which are used to meet these requirements are
called working capital.

The main point of difference between fixed capital and working capital is like this . Fixed assets
are of long run duration and are not converted into cash within a period of one year, whereas current
assets are converted into cash within a period of one year or less. Hence, the problems of fixed assets
belong to the field of capital budgeting, while the problems of working capital belong to the field of
cash budgeting. The other difference pertains to the divisibility of investments. The investment in
current assets is divisible into small units to a large extent as compared to investment in fixed assets.
2. MEANING OF WORKING CAPITAL AND THE CONTROVERSY:
According to Hoagland, "Working capital is descriptive of that capital which is not fixed. But
the more common use of the working capital is to consider it as the difference between the book
value of the current assets and current liabilities.”
On the other hand, Gerstenberg holds that, ‘Circulating capital means current assets of a company
that are changed in the ordinary course of business from one form to another, as for example, from
cash to inventories, inventories to receivables, receivables into cash.’
Thus, Hoagland views working capital as the excess of current assets over current liabilities, while
Gerstenberg views it as the total of all current assets.

Field and Baker also define working capital as aggregate value of all current assets of business.As
against this,Lincoln opinion that working capital equals the aggregate value of current assets minus
aggregate value of current liabilities. Thus, there are two different
opinions about the meaning of the term working capital

(1) According to one school of thought, working capital represents all current assets of a
company.This view is supported by such authorities as Field, Baker, Malott and Mead. They believe
that working capital represents those assets which change their form during the process of production.
Working capital =Total Current Assets
The main argument in favour of the concept in which total of all current assets is regarded as the
measure of working capital are as follows :(a)There are two types of assets of a company; fixed assets
and current assets. Similarly there are two types of capital: fixed capital and working capital.
Generally, fixed assets constitute the fixed capital of a company. Hence, logic demands that current
assets should be considered as the working capital of the company . (b)According to this definition,
there would be an increase in the working capital with every increase in the funds that the company
borrows. This is because these funds help it to meet its requirements of current assets. (c) Every
management in interested in the total current assets as it has to continue smoothly the operation of
the enterprise. They are not much interested in the sources of capital. The total of current assets is a
more useful
concept for them. (d) Under company organisation, the ownership of capital is of little significance,
it is the total amount of capital that matters most. The issue of ownership of capital is of course
important in the case of sole proprietorship and partnership but not in the case of company
organisation. Hence the concept of working capital as total current assets
is more preferable in the modern age of company organisation

(2) According to the other school of thought, working capital is the excess of current assets over
current liabilities. This concept is advocated by such authorities as Lincoln, Stevens and Saliers
Working capital =Current asset - Current liabilities.
Current assets include cash, accounts receivable, notes receivable advances on contracts, inventories
etc. Current liabilities include accounts payable, notes payable, accrued expenses, temporary loans
etc. Under this concept, an attempt is made to measure net working capital of the company.
 The arguments of this school of thought regarding working capital as the excess of current assets
over current liabilities are as follows:
(1) This definition of working capital is in use since long.(2)This concept gives an idea of the extent
of protection afforded to the shareholders and creditors. It also enable them to judge the financial
soundness of the concern. If current assets are increased by short term borrowing there will be no
increase in the financial strength of the company or in the extent of protection of the creditors’
interest, as these depend of the owned capital only. (3)This concept of working capital is most useful
in times of emergency. Any concern can successfully tide over the periods of emergency with the
help of its surplus of current assets which are not to be repaid. (4)This concept is of great use in
comparing the financial position of two companies with an equal total amount of current assets.
To avoid the confusion involved in the interpretation of working capital, it is suggested that total
current assets should be described as gross working capital, while excess of total current assets over
total current liabilities should be designated as net working capital. In the other words,
(1)Current assets = Gross working capital.
(2)Current assets - Current liabilities = Net working capital
We shall use the term working capital in the sense of net current assets. A list of current assets and
current liabilities is given below.
The difference between them represents working capital

Current Assets Current Liabilities

Inventories Creditors
Debtors Bills payable
Bill receivable Bank overdraft
Spare parts Other short term loans
Non-trading investments Accrued expenses
Advance payments Provision for taxes
Cash on hand Proposed dividends
Cash at bank Unpaid dividends
Advance receipts

3. TYPES OF WORKING CAPITAL

Basically, two types of working capital are needed in business permanent working capital which
is permanently blocked in business and variable working capital which varies with the requirements
of business. These two types of working capital are the bases for a convenient classifications of
working capital] as follows:
 Let us consider each of these types of working capital in some details.
(1) Permanent Working Capital : It is that part of working capital which is permanently locked
up in current assets. Some cash is required to maintain stocks of raw materials and finished goods at
their normal level, and also is for paying wages and salaries regularly. Permanent working capital is
of two kinds: Initial working capital and Regular working capital.
(a) Initial Working Capital : In the initial period of its operation, a company must have enough
money to pay certain expenses before the business yields a cash receipts. In the initial years, banks
may not grant loans or overdrafts, sales may have to be made on credit and it may be necessary to
make payments to the creditors immediately. Hence the
necessary funds will have to be supplied by the owners themselves in the initial years.
(b) Regular Working Capital : It is the working capital required to continue the regular business
operations. It is required to maintain regular stocks of raw materials and work in progress and also
of the finished goods which must be maintained permanently at a definite level. Regular working
capital is the excess of current assets over current liabilities. It ensures a smooth operation of the
business.
(2) Variable Working Capital: It is that part of working capital which is required to meet the
seasonal needs as well as special needs of the business. It is therefore subdivided into two parts: as
seasonal working capital and Special working capital.
(a)Seasonal Working Capital : Some business enterprises require additional working capital
during a particular season For example,the sugar mills have to purchase sugarcane in particular
season and have to employ additional labour to process it. They must meet this requirement by
providing additional funds for a temporary period.
(b) Special Working Capital : In all enterprises, some unforeseen events do occur when extra
funds are needed to tide over such situation. Some of these events are : sudden increase in demand
for the final product (when a war breaks out, for example) downward movement of prices and sales
during depression necessitating extra working funds, considerable rise in prices of raw materials so
that more funds will be
needed to maintain their stock at the normal level; and strikes or natural calamities which also force
the management to provide for additional funds.
 The difference between permanent working capital and variable working capital may be
represented in terms of diagrams as follows:

But if the long term trend of working capital is to move up, instead of remaining constant at a
definite level as shown in the above diagram, then both the curves will be upward sloping as shown
in the diagram below:

4.CHARACTERISTICS OF WORKING CAPITAL :

The features of working capital distinguishing it from the fixed capital are as follows
Characteristics of Working Capital
(1) Short-term needs
(2) Circular movement
(3) An element of permanency
(4) An element of fluctuation
(5) Liquidity
(6) Less risky
(7) Special accounting system not needed
(8) Different proportion for each industry

(1)Short-term Needs: Working capital is used to acquire current assets which get converted into
cash in a short period. In this respect it differs from fixed capital which represents funds locked in
long term assets. The duration of the working capital depends on the length of production process,
the time that elapses in the sale and the waiting period of the cash receipt
(2) Circular Movement : Working capital is constantly converted into cash which again turns into
working capital. This process of conversion goes on continuously. The cash is used to purchase
current assets and when the goods are produced and sold out,those current assets are transformed into
cash. Thus it moves in a circular away. That is why working capital is also describes as circulating
capital.

(3)An Element of Permanency: Though working capital is a short term capital, it is required
always and forever. As stated before working capital is necessary to continue the productive activity
of the enterprise. Hence so long as production continues, the enterprise will constantly remain in
need of working capital. The working capital that is required
permanently is called permanent or regular working capital.

(4) An Element of Fluctuation : Though the requirement of working capital is felt permanently,
its requirement fluctuates more widely than that of fixed capital. The requirement of working capital
varies directly with the level of production. It varies with the variation of the purchase and sale policy;
price level and the level of demand also. The portion of working capital that changes with production
sale, price etc. is called variable working capital.

(5) Liquidity : Working capital is more liquid than fixed capital. If need arises, working capital
can be converted into cash within a short period and without much loss. A company in need of cash
can get it through the conversion of its working capital by insisting on quick
recovery of its bills receivable and by expediting sales of its product It is due to this trait of working
capital that the companies with a larger amount of working capital feel more secure.

(6) Less Risky: Funds invested in fixed assets get locked up for a long period of time and cannot
be recovered easily There is also danger of fixed assets like machinery getting obsolete due to
technological innovations. Hence investment in fixed capital is comparatively more risky. As against
this, investment in current assets is less risky as it is a short term investment. Working capital involves
more of physical risk only, and that too is limited. Working capital involves financial or economic
risk to much less extent because the
variations of product prices are less severe generally. Moreover, working capital gets converted into
cash again and again, therefore, it is free from the risk arising out of technological changes

(7) Special Accounting System not Needed : Since fixed capital is invested in long term assets,
it becomes necessary to adopt various systems of estimating depreciation, On the other hand working
capital is invested in short term assets which last for one year only. Hence it is not necessary to adopt
special accounting system for them.

(8) Different proportion for Each Industry: In every industry proportion of working capital is
different as per type of business and nature of business.e.g. In building or ship industry proportion of
working capital is high. While in public utility enterprises where services are sold-speedily, the
proportion of working capital is less. This way proportion of working capital changes from industry
to industry.

5.FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

There are a number of factors which determine the amount of working capital requirements in
business. Therefore, it is not possible to give general principles applicable to all enterprises equally.
It is desirable to analyse the factors in the context of each particular unit. We may point out some
basic factors influencing working capital requirements

Factors Determining Working Capital Requirements

(1) Nature and volume of business.
(2) Size ofbusiness
(3) Length of manufacturing cycle.
(4) Business fluctuations
(5) Production policy.
(6) Credit policy of the unit.
(7) Availability of eredit.
(8) Growth and expansion
(9) Profit and its distribution
(10) Stock turnover rate
(11) Price level fluctuations
(12) Operating efficiency
(13) Requirement of cash
(14) Importance of Raw-materials in production cost.

(1) Nature and Volume of Business : The nature and volume of business is an important factor
in deciding the amount of working capital. For example, the amount of working capital is generally
more in trading concerns and in service units as compared to the manufacturing units. The retail
trading units have also to invest large funds in working capital. In some manufacturing units also,
the working capital holds a significant place. On the other hand, public utilities require less working
capital. Other manufacturing units need more working capital as compared to public utilities.
The relation between the volume of business and the requirement of the working capital is more
and clear. The bigger the size of the units, the more will be the requirement of working capital.

(2) Size or Business: There is a direct and clear relationship between the size of business and
requirement of working capital.Larger the size of business the size of operation is also large and the
requirement of working capital is more

(3) Length of Manufacturing Cycle : The time that elapses from the purchase and use of raw
materials to the production of finished goods is called manufacturing cycle. The longer the period a
manufacturing cycle takes, the larger is the amount of working capital required,
because the funds get locked up in production process for a longer period of time.
It is in view of this that, when alternative methods of production are available, the method with
the shortest manufacturing cycle should be chosen (assuming other factors to be equal). Once a choice
is made,care is taken to see that the manufacturing cycle is completed Within a specified period.
Any delay in production is bound to increase the requirement of working capital.

(4) Business Fluctuations: Business fluctuations are of two types: seasonal fluctuations which
arise out of seasonal changes in demand for the product and cyclical fluctuations which occur due to
ups and downs of economic activities in the country as a whole.
If demand for the product is seasonal, production will have to be increased during its season, and
it will have to be reduced during the off season. Correspondingly, there will be fluctuations in the
requirement of working capital. The business unit will have to face some other problems in addition
to this one. It has to bear extra expenses to increase production when product demand increases. It
has to bear costs even to maintain work force and physical facilities during slack season. For this
reason, many units prefer to continue production even during slack season and increase the level of
their inventories

The cyclical fluctuations are made up of periods of prosperity and depression. The sales and prices
increase during prosperity necessitating more working capital in the form of inventories and book-
debts. If new investment is made in fixed capital to meet additional demand for the product, then also
there will be an increase in working capital requirement. Generally, business units adopt the policy
to borrow funds on a large scale to increase investment in working capital. As against this, the
requirement of working capital gets reduced during depression and therefore they adopt the policy of
reducing their short term debts.

(5) Production Policy : The production policy of business is also an important determinant of
working capital requirement. If the policy of Constant Production is adopted, there are two possible
effects. If demand for the product is regular and constant, this policy helps in reducing working
capital requirement to the lowest possible level. But if demand for the product is seasonal, this policy
raises the level of inventory during off season and thereby increases the working capital requirement.
If the cost of maintaining inventory is considerably high, the policy of varying production according
to demand is preferred. If
the unit produces varied products, it can reduce the requirement of working capital by adjusting the
structure of production to the changes in demand.

(6) Credit Policy of the Unit : In the present-day circumstances, almost all units have to sell goods
one credit The nature of credit policy is an important consideration in deciding the amount of working
capital requirement. The larger the volume of credit sales the greater will be the requirement of
working capital. Also, the longer the period the collection of payment takes, the greater will be the
requirement of working capital.
 Generally, the credit policy of an individual firm depends on the norms of the industry to which
the firm belongs. Yes it is possible to pursue different credit policies for different customers in
accordance with their credit- worthiness To ignore creditworthiness of the individual customers can
be dangerous to the firm, In addition. it necessary that the firm should be prompt in collection of
payments. Any slackness in this respect will increase the requirement of working capital and will
increase the chance of bad debts,

(7) Availability of Credit : The amount of credit that a firm can obtain, as also the length of the
credit period significantly affects working capital requirement. The greater the prospects of getting
credit, the smaller will be its requirement of working capital, because it can easily purchase raw
materials and other requirements on credit.
Creditworthiness can also be interpreted to mean that the firm can function smoothly even with
a smaller amount of working capital if it is assured that it can obtain loans from the bank immediately
and easily. The firm does not need then to keep a wide margin of safety.

(8) Growth and Expansion: The working capital requirements increase with growth and
expansion of business.hence planning of the working capital requirements and its procurement must
go hand in with the planning of the growth and expansion of the firm. The implementation of the
production plan that aims at the growth or expansion of the unit necessitates more of fixed capital
and working capital both.
Even the expansion of the volume of sales increases the requirements of working capital. Of
course,it is difficult to establish a quantitative relationship between them. An important point to be
noted is that the requirements of working capital emerge before the growth or expansion actually
takes place.

(9) Profit and its Distribution : The net profit of a firm isa good index of the resources available
to it to meet its capital requirements But, from the viewpoint of working capital requirement, it is the
profit in the form of cash which is important, and not the net profit. The profit available in the form
of cash is called cash profit and it can be assessed by deducting non-cash items from the net profit of
the firm. The larger the amount of cash profit, the greater will be the possibility of acquiring working
capital.
But, in fact the entire amount of cash profit may not be available to meet working capital needs.
The portion of cash profit which is available for this purpose depends
on the profit distribution policy. The policies with regard to distribution of dividends, ploughing back
of profit and tax payments will determine the portion of cash profit which the firm can use to meet
its working capital needs. Even depreciation policy can influence the amount of cash available, as
depreciation of capital assets is deductible item of expenditure and it reduces tax liability

(10) Stock Turnover Rate : Requirement.of working capital depends upon stock turnover rate.
If stock turnover rate is high the requirement of working capital is less. Conversely, if stock turnover
rate is less the requirement of working capital is more. When raw materials are converted into the
finished goods, how speedily it is being sold is know as stock turnover or stock turnover rate Or
stock transfer. If the stock turnover rate is low, it means more working capital is being invested in
stock. Stock turnover rate can be increased by sales promotion efforts,efficient sales organisation and
liberal sales policy.

(11) Price Level Fluctuations : A general statement may be made that with price rise, a firm will
require more funds to purchase its current assets. In other words, the requirements of working capital
will increase with the rise in prices. But all firms may not be affected equally. The prices of all current
assets never go up to the same extent. Prices of some current assets rise less rapidly than those of the
others. Hence for the firms which use such current assets, the working capital capital need will
increase by a smaller amount, Besides, if it is possible to pass on the burden of high prices of raw
materials to the customers by raising the prices of final product, then also there will be no increase
in working capital requirements.

(12) Operating Efficiency : If a firm is efficient, it can use its

resources economically, and thereby it can reduce cost and earn more profit. Thus, the working
capital requirement can be reduced by more efficient use of the current assets.

(13) Requirement of Cash : Cash balance is a part of current assets. Requirement of cash affects
the requirement of working capital. Cash is required more for payment to labour, wages, taxes, rent,
different expenses, payment for purchases etc. If proportion of such expenses is more, the
requirement of working capital is also more and if its proportion is less the requirement of working
capital is less

(14) Importance of Raw-materials in Production Cost : Industries in which the proportion of

raw-material expenses in the production costs is high, the working capital requirement is more in it,
because expenses are to be incurred for purchasing raw-materials, to store it and for transferring it,
hence more working capital is required.

MANAGEMENT OF CASH:
Cash is the medium of exchange which allows management to carry on the various activities of
the business on day to day basis. It includes coins, currency, cheques held by the firm and the balance
in its bank accounts. In a broader sense, it also includes 'Near Cash Assets such as marketable
securities and time deposits with the bank.
A firm should hold sufficient cash, neither more, nor less If the firm holds surplus cash, this
excessive cash remains idle, which simply increases the cost without contributing anything towards
the profitability of firm. On the other hand, if the organisation is always running with shortage of the
cash, its trading and/or manufacturing operations will be disrupted and ultimately profitability of the
firm will be affected. As Sydney Robbins has put it, "A business wants to get hold of it in the shortest
possible time, but to keep the least possible quantity on hand'.
 Cash management involves the following four factors:
(a) Ascertainment of the minimum cash balance and controlling the levels of cash.
(b) Controlling cash inflows
(c) Controlling cash outflows
(d) Optimum investment of surplus cash

Controlling the Levels of Cash :

Tools available for controlling levels of cash.
(i)Preparing Cash Budget : Cash Budget is a statement showing estimated cash inflows and cash
outflows over the next planning period. The surplus or shortfall in cash is highlighted by the cash
budget.
(ii)Providing for contingencies : Cash budget takes care of estimated cash inflows and cash
outflows. In addition, a suitable minimum amount of cash must be kept for meeting unforeseen
contingencies such as strikes, floods, short-term recession etc.
(iii) Consideration of cost of shortage of cash : Such costs may arise when the firm is not able to
meet its obligation in time. The cost arises in terms of loss of firm's reputation or additional cost of
borrowing at higher rate of interest.
(iv)Availability of other sources of funds : If there are other sources, from which cash can be
arranged at shorter periods, then levels of cash may be kept little lower.

Motives for Holding Cash:

These are four primary motives for holding cash (a) Transaction Motive (b) Precautionary
motive (c)Speculative motive and (d)Compensating Motive.
(a) Transaction Motive: This motive refers to the holding of cash in order to meet the day-to-day
expenses of the business. These transactions including purchase of raw material, packing materials,
wages, operating expenses, taxes, dividend etc. (1) Since the timing of cash inflows and
the cash outflows differ significantly, a minimum cash balance is required. At the same time, there
is regular inflow of cash from sales proceeds, income from investments etc. But inflows and outflows
of cash do not perfectly coincide. (2) Sometimes the firm has surplus cash in certain periods, which
the firm invests in easily marketable securities.These are sold and cash realised when need for
payment arises in business. (3) Some firms keep cash on hand to meet some anticipated payments. It
may invest such surplus cash in such a way that it will mature when anticipated payment is to be
made. (4) The company is also required to keep some cash on hand to make regular annual payments.
e.g. once in a year, cash is needed to pay dividend. Similarly advance tax is payable every three
months for which a firm is required
to hold some cash. Here again it can be invested in short term marketable securities.
(b) Precautionary Motive : This motive for holding cash refers to maintaining a cash balance to
meet unexpected contingencies, which may arise as a result of
-Uncontrollable circumstances, such as floods, strikes, earthquakes etc.
-Sharp increase in the cost of materials,labour etc.
-Unexpected delay in collection of accounts receivables.
Thus precautionary balance is required to meet unforeseen contingencies. If the event for which
cash balance is kept is more unpredictable, the larger would be the cash needed.careful planning,
less cash would be required.
If the firm has a good prestige in the market,it can borrow from banks or from other sources at a
short notice,it will required less cash to be maintained for contingencies. Insurance against some of
the risks may also come to to the the help, in in the sense that money can be recovered from insurance
company and so less cash may be maintained.in
But no cut and dried formula can be suggested. Conditions would differ from industry to industry
and also from firm to firm. It is for the finance manager to determine the cash to be held looking to
the circumstances available. Generally such cash is held in the form of marketable securities, so that
it can earn some return.

(c)Speculative Motive: It refer to the desire of a firm to keep cash to take advantage of profitable
opportunities, which are outside the normal course of business. It helps to take advantage of
- Purchasing raw materials at reduced prices by availing the benefits of cash discount.
- Speculating on interest rate movements etc.
The holding of cash for speculative motive by a business firm should not indulge in speculative
transactions, as it involves risks that can put firm in trouble. Another viewpoint is that surplus cash,
if any, should also be invested in
sound securities, so that it earns some return. Such transactions made at times will raise the
profitability of business. However, it requires caution, foresight and skill. Hence, the best way is not
to hold cash for speculative
motive.

(d) Compensating Motive : Banks provide different types of services to the firms. e.g. clearance of
cheque, transfer of funds etc. against a nominal fee or commission. Generally, clients (firms) are
required to maintain a minimum cash balance at the bank which cannot be utilised by them for
transaction purpose. The bank can use the same generating returns. To get compensated for free
services, the provide
to customers, the banks require the clients to always keep a bank balance sufficient to earn a return
equal to the cost of services. Such balance are called compensating balance
According to Prof.L.M. Pandey, the amount of cash to be held for the first two motives, which are
two most important motives, the following factors must be taken into account:
(1) The expected cash inflows and outflows based on cash budget.
(2) The degree of deviation between expected and actual net cash flows
(3) The maturity structure of the firm 's liabilities.
(4) The firm's ability to borrow at short notice in the event of any emergency
(5) The philosophy of management insolvency regarding liquidity and risk of insolvency.
(6) The efficient planning and control of cash
 MANAGEMENT OF RECEIVABLES :
When goods are sold on credit in business the price of the goods becomes receivable. We know
this amount as
"Trade Debtors” or "Debtors" or Receivables' Or Accounts Receivables”. These receivables are
assets of the business.
There are three important features of this asset:
(1) It involves an element of risk There is no risk in cash sales, but credit sales,there is a risk of bad
debts.
(2) It is based on economic value. When sale is made,economic value immediately passes to the
buyer while it will pass to the seller in future.
(3) It implies futurity in the sense that the money is receivable in future.

In the present competitive economic system, credit sales are essential, unless the goods sold are
in short supply. The money involved receivables is blocked till future and the management has to
arrange for the funds through debt or through issuing equity shares.
Thus there is an opportunity cost of receivables. However, credit sales is essential in order to meet
the severe competition. And so the management of receivable requires great care. It must be so
managed that the benefit available from additional sales (ie. profit from additional sales) and the cost
of funds raised to finance the additional credit coincide.
Management of receivable is important from another view point also. It is an important
component of current assets and in India It forms about one-third of current assets. The funds are tied
up in trade debtors and if proper care is not taken, it will affect the profitability.

Meaning of Receivables
When a firms sells goods for cash , payments are received immediately and therefore no
receivables are created. However, when a firm sells goods or services on credit,payments are received
only at a future date and receivables are created. It is an essential marketing tool in modern business
trade. Credit sales creates receivables which the firm is expected to collect in near future. A firm
grants credit to its customers so that its sales are not lost to competitors.
Account receivable constitute significant portion of the total current assets of the business after
inventories.
(1)According to Hampton "receivables are asset accounts representing amounts owed to the firm as
a result of the sale of goods/services in ordinary course of business
(2)O.M. Joy writes ‘The term. Receivables is defined asa debt owed to the firm by customers arising
from sale of goods or services in the ordinary course of business.
(3) According to. Bolten the objective of receivable management is “to Promote sales and profits
unit that point is reached where return on investment in further funding receivables is less than the
cost of funds raised to finance that- additional capital""
This means that an organisation can continue to be liberal in its credit policy till the point is
reached where cost of extending credit exceeds the benefits arising out of liberal credit terms . The
costs and benefits mentioned above are enumerated below.
 Objectives of Maintaining Receivables:
Credit sale is an essential part of the modem business operations. Particularly in a situation
where there is competition, no business can survive without selling goods or services on credit. There
is bound some level of permanent receivables. We can identify three main objectives of maintaining
receivables.
(1) To Achieve Growth in Sales : It is natural that a firm which sells on credit will get more sales
than the firm which sells only for cash.Many customers do not like to pay cash when they make
purchases. They may not, have enough cash at the time of purchase and must wait until they resell
the
goods before they have money to pay them. Some business firms may wan the bill to be sent to their
accounts department, where they would be checked before payment is made. Because of such
practices of customers,the firm
which sells on credit will have larger sales
(2)To Increase Profits: Due to practice of selling goods on credit,there will be increased sales and
it will result into higher profits for the firm.This will happen only
When the gross margin is greater than the additional cost associated with the credit policy. The
additional margin should be greater than the collection costs, loss of bad debts and also the
Opportunity costs. If it is not possible to cover these costs, it would be better to make additional sales
for cash only.
(3)To Meet Competition: Where competition prevails all firms in that business will adopt similar
policy as regards credit sales.Of course, credit policy varies widely from industry to industry.e.g
intextile industry,there is a practice of granting credit of 180 days due to severe competition,but
automobile industry, no credit sale is there Of course the practice of hire-purchase selling is prevalent
there. A firm would lose the customers if it does not fall in line with competitors as regards credit
sales.

MANAGEMENT OF INVENTORY:
Inventory is composed of assets that will be sold in future in the normal course of business
operations. To the finance manager,inventory connotes the value of raw materials, consumables,
spares, work-in-progress, finished goods and scrap in which a company's funds have been invested.
He considers the inventory as blockage of money.
Inventory means tangible property held
(i) for sale in the ordinary course of business or
(ii)in the process of production for such sale or
(iii) for consumption in the production of goods or services for sale
It is interesting to learn that different departments of the same organisations have different
purposes of holding inventory. The production manager favours relatively higher levels of inventory
so that production process runs smoothly. The marketing manager prefers to have reserves of finished
goods so that availability of product is ensured even if demand for the product keeps fluctuating. On
the other hand, the finance managers justify limited stock levels because of them, inventory is money
blocked which doesn't earn interest
At the outset, it is essential to be clear about the meaning of the term inventory control. Inventory
has a wider meaning. Inventory refers to the stocks, not only of materials, but of finished and semi-
finished goods, spare parts, tools and equipment and general stores like oil, grease, belt etc.

(1)Inventory control refers to a planned method to determine which items to purchase, how much
to purchase and how much to keep in stock, so that the costs of purchase and storage both are
minimised without adversely affecting either production or sales.
In other words, ‘ inventory control means the decision of the firm as to the extent to which
inventories can be economically stored.
It is necessary to carefully decide how much goods produced or purchased should be kept in stock,
because storing each unit of inventory has advantages and disadvantages both from the view point of
cost. If Inventory is too large, for instance, production is continuous and customers demand can be
easily met. But too large an inventory.This is the essence of inventory control.

Types of Inventory:
(i) Raw Materials : These are goods which have not yet been committed to production in a
manufacturing firm. They may consist of basic Raw Materials or finished components. In many of
the cases the finished goods of one industry becomes the raw materials of another industry e.g.the
finished goods of a spinning millis the yarn, which becomes the raw material for a weaving mill.

(ii)Work-in-Process : This includes those materials which have been committed to the production
process but have not yet been completed. They are unfinished goods and lying at various stages of
production.

(iii) Semi-finished goods : Goods which are not in saleable state, on which some processes have
been performed and which require further processing before being transferred into finished stock
godown are known as semi-finished goods.

(iv) Finished Goods : These are completed products awaiting sale. They are the final output of the
production process in a manufacturing firm. The levels of the three different kinds of inventories
depend upon the nature of the business. For example, a manufacturer will have high levels of all the
three kinds of inventory, while a retailer or wholesaler will have high level of inventories of finished
goods only.

(v) Supplies : Another kind of inventory, supplies (or stores and spares)or what is called consumable
stores is also maintained by the firm. These Materials are of low value and they do not enter the
production process, example oil
fuel, bulbs, soaps etc.
 (vi) Component Parts :When two or more parts are to be joined to prepare a final product,
component parts are either bought from outside or are manufactured in the factory.These parts also
form a considerable value of the total inventory. e.g. a motor-car is manufactured by assembling
more than 2,500 parts.

(vii)Scrap : The waste of materials arising during manufacturing process is also a part of the
inventory. Even defective pieces to be disposed off are a part of inventory.

(viii)Defective work : Defective work is that product which contains a manufacturing defect and
cannot be corrected, then they are sold as seconds.

Motives for Holding Inventory

Martin and Miller identified three general motives for holding inventories,
(a)Transaction Motive: An Important Reason For Maintaining Inventory levels is the transaction
motive.This refer to the need of maintaining inventory facilitate smooth production and sales
operations.The transaction motive for holding inventory is to satisfy expected level of operations in
the firm.
(b) Precautionary Motive: Precautionary motive for holding inventory is to provide a safeguard
or cushion in case the actual level of activity is different than anticipated. This inventory serves as a
reserve when there is unpredictable changes in the demand and supply forces. e.g. it may be that due
to some unforeseen circumstances government may restrict import of some important basic raw
material or there may be unexpected big order received from customer to supply a large quantity of
finished goods.

(c) Speculative Motive :It refers to the desire of a firm to take advantage of opportunities of rising
prices which present themselves at unexpected moments and which are typically outside the normal
course of business. While precautionary motive is defensive in nature in that firms to meet
unexpected contingent situations the Speculative motive is defensive in nature in that firms keep
inventory to meet unexpected contingent situation the speculative Motive represents an aggressive
approach to exploit profitable opportunities. Advance purchase of raw materials in inflationary times
is one form of speculative behaviour.

Functions of Inventory Control:

If the inventories are not useful, no business firm will like to tie-up even a rupee in inventory. In
fact,inventories have proved to be highly useful. This is due to the following functions they perform.`
(1) Inventory gives Protection against Uncertainties: Sometime, forecasts of market demand
go wrong, creating disturbances in production flow. Such disturbances can bec easily
absorbed through the use of inventories. Supposing thereis an unexpected sudden increase in
the demand for the company's product. In such a case production will require additional
materials. These materials can be easily withdrawn from the stocks i.e. inventory. Thus, the
requirement of production and sales department can always be fulfilled through inventories.
 (2) Inventory Enables Continuous Production forSeasonal Goods :
Even in industries in which products of seasonal demand are manufactured,men and machines are
continuously and smoothly used. This is made possible due to the provision of adequate inventory.
For instance woollen cloth is in demand only during winter and yet woollen industry functions
throughout the year continuously, using men and materials that it has employed. Only due to
inventory it is possible to continue production throughout the year though the demand is seasonal.

(3) Inventory helps in getting quantity discounts: It is on account of inventory that a company
can have the facility of discounts associated with large scale buying of materials. Also, inventory of
finished goods allows it thereby get all the economies of large scale production.

Section A Long Questions:

1. State the meaning of working capital and discuss its characteristics.
2. Explain types of Working capital.
3. Explain Factors determining requirement of working capital.
4. Explain Management of Cash
5. Explain Management of Receivables
6. Explain Management of Inventories.

Section B : Multiple Choice Questions :

1. Which of the following show’s modern view of working capital?

a) Current assets b) Current liabilities
c) Current assets-current liabilities d)None

2. As per Gesternberg’s idea, working capital means total of,

a) Current assets b) Current liabilities
c)Current assets- Current liabilities d) None

3. As per Hoagland viewpoint, working capital is, _____.

a) Excess of current assets over current liabilities b.) Only current liabilities
c) Fixed assets d.) None

4. Which motive refers to the holding of cash in order to holding cash in order to
meet day to day expenses of business?
a) Transaction Motive b) Speculative Motive
c) Precautionary Motive d) Compensating Motive

5. Which motive for holding cash refers to maintain cash balance to meet
unexpected/ Contingencies which may arise due to uncontrollable
circumstances?
a) Transaction Motive b) Speculative Motive
c) Precautionary Motive d) Compensating Motive

6. When goods are sold on credit in the business the price of goods
becomes receivables, it is known as
a) Accounts Receivables b) Accounts payable
c) Total Creditors d) Inventory

7.Some business enterprises require additional working capital during a

particular season is called ____ Working capital.
a) Seasonal b) Regular c) Initial d) Special

8.____Working capital required to continue the regular business operations.

a) Regular b) Seasonal c) Initial d) Special

9.Variable working capital is divided into parts.

a)Two b) Four c) Five d) Ten

10.Initial working capital and regular working capital are part of Working
capital.
a) Permanent or fixed b) Variable c) Both(a)&(b) d) None of above

11. In all enterprises some unforeseen events do occure when extra funds are
needed to tide over such situation is called _____.
a) Special working capital b)Fixed working capital
c)Fluctuating working capital d) Seasonal working capital

12. Some business enterprises require additional working capital during a particular season
is called _____ working capital.
a) Special working capital b)Fixed working capital
c)Fluctuating working capital d) Seasonal working capital

13. _____ required to continue the regular business operations.

a) Working capital b)Fixed working capital
c)Fluctuating working capital d) Seasonal working capital

14. A company must have enough money to pay certain expenses before the business
yields a cash receipts is called ____.
a) Special working capital b)Fixed working capital
c)Fluctuating working capital d) Initial working capital
 15.The party who provides working capital indirectly like, suppliers of raw material is
known as ____.
a)Trade creditors b) Special working capital
c) Fixed working capital d) Working capital

16. The asset which can be easily converted into cash/ cash on hand , this characteristic is
called _____.
a) liquidity b) stock turnover c) credit risk d) Transaction Motive

17. Net working capital = Current assets less current liabilities

a) Current assets less current liabilities b) Current assets
c) Current assets add current liabilities d) Current liabilities

18._____ and ____ are part of permanent working capital.

a) Initial workind capital and regular working capital
b) Special working capitalFixed working capital
c) Initial working capital and Special working capital
d) Regular working capital and fixed working capital

19. Identify factors determining working capital.

a) Nature and volume of business. b) Size ofbusiness
c) Length of manufacturing cycle. d) All of the mentioned

20. When raw materials are converted into the finished goods, how speedily it is being
sold is know as ____.
a) stock turnover rate b) labour turnover rate
c) stock d) liquidity .

21. The capital invested in total current assets of business concern is known as ___.
a) Gross working capital b) Net working capital
c) Length of manufacturing cycle. d) All of the mentioned

22. Which of the following physical capital is a working capital for a factory ?
a) Building b) Tools c) Raw materials d) None of the mentioned

23. Which of the following is not a source of working capital ?

a) Commercial paper b) Bank Overdraft
c) Discounting of bills d) Unsecured term loan

24. Which of the following statement is not true with regard to the use of fixed capital ?
a) It affects the long term growth of the business b) Large amount of funds are involved
c) Business risk involved is low d) Investment decisions are irreversible
 25. Net Working capital refers to _____.
a) Total assets (-) Fixed assets b) Current assets (-) Current liabilities
c) Current assets (-) inventories d) Current assets

26. Working capital refers _____.

a) It affects the long term growth of the business b) Large amount of funds are involved
c) Business risk involved is low d) Investment decisions are irreversible

27. Working capital requirements are low when an organisation has _____.
a) High technology b) High creditors c) High debtors d) High inventory

28. Major current assets are ______.

a) Cash & marketable securities b) debtors c) inventory (stock) d) All of the mentioned

29. Basic current liabilities are _____.

a) Acc.payable & bills payable b) bank overdraft c) outstanding expenses d)All of the mentioned

30. There are two concepts of working capital gross and ____.
a.) Zero b) Net c.) cumulative d.) distinctive

31. Working capital is also known as ____ capital .

a.) Current assets b) Operating c.) Projecting d.) Operation

32. ______ working capital refers to the firms investment in current assets.
a.) Zero b.) Net c) Gross d.) Distinctive

33. In finance , working capital means the same thing as ____ assets.
a.) Current b.) Fixed c.) Total d.) None of the mentioned

34. A ____ Net working capital will arise when current assets exceed current liabilities .
a.) Summative b.) Negative c.) Excessive d.) Positive

35. _____ varies inversely with profitability .

a.) Risk b.) Assets c.) liquidity d.) Revenue

36. The major current assets are _____

a) cash and marketable securities b) accounts receivable (debtors)
c) inventory (stock) d) All of the above

37. The basic current liabilities are _____

 a) accounts payable and bills payable b) bank overdraft
c) outstanding expenses d) All of the above

38. There are two concepts of working capital gross and ____
a) Zero b) Net c) Cumulative d) distinctive

39. Working capital is also known as___ capital.

a) current asset b) Operating c) projecting d) Operation capital

40. ______ working Capital refers to the firm’s investment in current assets.
a) Zero b) Net c) Gross d) Distinctive

41. In finance, “working capital” means the same thing as _______ assets.
a) Current b) Fixed c) Total d) All of the above

42. Working capital is calculated as _____

a) Core current assets less core current liabilities b) Current assets less current liabilities
c) Core current assets less current liabilities d) Liquid assets less current liabilities

43. ______ working capital refers to the difference between current assets and current liabilities.
a) Zero b) Net c) Gross d) Distinctive

44. A _______ net working capital will arise when current assets exceed current liabilities.
a) Summative b) Negative c) Excessive d) Positive

45. A ______ net working capital occurs when current liabilities are in excess of current assets.
a) Positive b) Negative c) Excessive d) Zero

46. _____is not an advantage of trade credit.

a) buyout financing b) informality c) easy availability d) flexibility

47. ________ refers to the funds, which an organisation must possess to finance its day to day
operations.
a) Retained earnings b) Fixed capital c) Working Capital d) All of the above

48. Investment in current assets should be _____

a) just adequate b) more c) less d) maximum

49. _______ varies inversely with profitability.

a) Risk b) Assets c) Liquidity d) Revenue
50. Capital intensive firms rely on ______
a) debt b) retained earnings c) short term debts d) Equity

51. On the basis of _____, working capital is classified as gross working capital and net working
capital.
a) concept b) time c) future d) work

52. ______ cycle analyzes the accounts receivable, inventory, and accounts payable cycles in terms
of a number of days?
a) Business b) Current asset c) Operation d) Operating

53. _______ method is not used for calculating working capital cycle.
a) Trial and error method b) Regression analysis method
c) Percentage of sales method d) Operating cycle approach

54. On the basis of _____, working capital may be classified as: 1) Permanent or fixed working
capital. 2) Temporary or variable working capital.
a) concept b) time c) future d) work

55. Operating cycle is also called as _____

a) Business cycle b) Working capital cycle c) Working cycle d) Current asset cycle

56. Spontaneous financing consists of ______

a) a line of credit b) short-term loans c) accounts receivable d) accounts payable

57. Working capital is also known as___

a) Operation capital b) Operating capital
c) Current assets capital d) Capital relating to main projects of the company

58. Positive working capital means that __

A. The company is able to pay off its long-term liabilities.
B. The company is able to select profitable projects.
C. The company is unable to meet its short-term liabilities.
D. The company is able to pay off its short-term liabilities.

59. Which of the following would not be financed from working capital?
a) Cash float .b) Accounts receivable.
c) Credit sales d) A new personal computer for the office.

60. Motives for Holding Cash are ___.

a) Transaction Motive b) Precautionary motive c) Speculative motive d) All of above

61. Capital intensive firms rely on ______

a) debt b) retained earnings c) short term debts d) Equity
62. On the basis of _____, working capital is classified as gross working capital and net working
capital.
a) concept b) time c) future d) work

63. ______ cycle analyzes the accounts receivable, inventory, and accounts payable cycles in
terms of a number of days?
a) Business b) Current asset c) Operation d) Operating

64. Fluctuating Working Capital is also called as ____.

a) Reserve Margin Working Capital b) Temporary Working Capital
c) Permanent Working Capital d) Variable working capital

65. Operating cycle is also called as _____.

a) Working cycle b) Business cycle c) Current asset cycle d) Working capital cycle

66. Which of the following represents the amount utilized at the time of contingencies?
a) Reserve Working Capital b) Net working capital
c) Extra working capital. d) Fixed working capital

67. Permanent Working Capital is also known as ____.

a) Fixed working capital b) Temporary working capital
c) Long term funds. d) Gross margin working capital

68. A lower current assets/fixed assets ratio means ___.

a) Matching/hedging Approach b) Aggressive current assets policy
c) Riskier current assets policy d) Conservative current assets pol-icy

69. Any amount over and above the permanent level of working capital is known
as______ working capital .
a) Temporary b) Fluctuating c) Variable d) All of the above

70. Permanent working capital ____.

a) Varies with seasonal need b) Includes fixed assets
c) Includes accounts payable
d) Is the number of current assets required to meet a firm’s long-term minimum needs.
SUMS:
Q-1 Prepare a statement of working capital requirement from the following
information:

Per Unit Rs.

Raw material 180

Direct Labour 80
Overheads 150

Total Cost 410

Profit 120

Selling Price 530

1. Estimated output 1,56,000 units (Yearly)

2. Raw Materials are in stock on an average for one month.

3. Materials are in process on an average for one month.

4. Finished goods are in stock on an average for one month.

5. Credit allowed by suppliers is one month.

6. Credit allowed to customers is 2 months.

7. Lag in payment of Wages is 1 ½ month and of Overhead is 1 month.

8. All sales are on Credit.

9. Cash in hand and Bank Balance to be kept is Rs.80,000.

10. Production is carried evenly throughout the year.

11. Wages and Overheads accrued evenly throughout the year.

12. For contingencies 10% is to be provided.

Q-2 Prepare a statement of working capital requirement from the following

information:

Per Unit Rs.

 Raw material 150

Direct Labour 50

Overheads 100

Total Cost 300

Profit 100

Selling Price 400

1. Estimated output 1,20,000 units (Yearly)

2. Raw Materials are in stock on an average for one month.

3. Materials are in process on an average for one month.

4. Finished goods are in stock on an average for one month.

5. Credit allowed by suppliers is one and half month.

6. Credit allowed to customers is 1 month.

7. Lag in payment of Wages is ½ month and of Overhead is 1 month.

8. All sales are on Credit.

9. Cash in hand and Bank Balance to be kept is Rs.90,000.

10. Production is carried evenly throughout the year.

11. Wages and Overheads accrued evenly throughout the year.

12. For contingencies 10% is to be provided.

Q-3 Prepare an estimate of working capital

requirements:
Projected Annual Sale 96,000 units

Selling Price Rs.50 per unit

Raw Material cost Rs.20 per unit

Direct Labour cost Rs.15 per unit

Overheads Rs.10 per unit
Additional information:

1. Raw materials remain in stock on an average for 1 month.

2. Goods remain in Production process for 1 month on an average.

3. 1 ½ month are allowed to debtors. 50% of sales are on cash basis

4. The firm gets 5 weeks credit from suppliers.

5. Finished goods remain in stock for one month.

6. Lag in payment of wages and overhead expenses is ½ month.

7. Cash required Rs.35,000.

8. Raw materials are issued to production in the initial stage.

9. Wages and overheads are incurred uniformly throughout the year.

10.Assume 48 weeks in a year.

Q-4 Prepare an estimate of working capital

requirements:

Projected Annual Sale 2,16,000 units

Selling Price Rs.85 per unit

Raw Material cost Rs.35 per unit

Direct Labour cost Rs.18 per unit

Overheads Rs.12 per unit

Additional information:

1. Raw materials remain in stock on an average for 6 weeks.

2. Goods remain in Production process for 1 month on an average.

3. 1 ½ month are allowed to debtors. 50% of sales are on cash basis

4. The firm gets 6 weeks credit from suppliers.

 5. Finished goods remain in stock for 5weeks.

6. Lag in payment of wages and overhead expenses is 4 weeks.

7. Cash required Rs.40,000.

8. Raw materials are issued to production in the initial stage.

9. Wages and overheads are incurred uniformly throughout the year.

10.Assume 48 weeks in a year.

Q-5 From following information, prepare an estimate of working capital requirements:

Projected Annual Sale 1,04,000 units

Selling Price Rs.30 per unit

Raw Material cost 40% of Selling Price

Direct Labour cost 30% of Selling Price

Overheads 20% of selling Price

1. Raw materials remain in stock on an average for 3 weeks.

2. Goods remain in Production process for 4 weeks on an average

3. 5 weeks are allowed to debtors to pay while firm gets 3 week credit from
suppliers.

4. Finished goods remain in stock for one month.

5. Lag in payment of wages and overhead expenses is two weeks.

6. 50% of the sales are on cash basis.

7. Assume that goods in process are 100% complete with respect to material but
only 50% in conversion costs.

8. Assume that there are 52 weeks in a year and 4 weeks in a month.

Q-6 From following information, prepare an estimate of working capital requirements:

Projected Annual Sale 78,000 units
Selling Price Rs.80 per unit
 Raw Material cost 30% of Selling Price

Direct Labour cost 20% of Selling Price

Overheads 10% of selling Price

1. Raw materials remain in stock on an average for 5 weeks.

2. Goods remain in Production process for 4 weeks on an average

3. 4 weeks are allowed to debtors to pay while firm gets 5 week credit from
suppliers.

4. Finished goods remain in stock for one and half months.

5. Lag in payment of wages and overhead expenses is three weeks.

6. 40% of the sales are on cash basis.

7. Assume that goods in process are 100% complete with respect to material but
only 50% in conversion costs.

8. Assume that there are 52 weeks in a year and 4 weeks in a month.

Q-7 You are required to advise the management about the average amount of working
capital from the following information. You are required to add 10% to the computed
figure for contingencies.

Assuming 52 weeks in a year, calculate the working capital requirement.

Amount for
the year (Rs.)
(i) Average amount locked up for stocks :Stocks
of finished goods 60,000
Stocks of stores and materials 90,000

(ii) Average credit given

Inland sales 6 weeks 26,00,000
Export sales 2 weeks 13,00,000

(iii) Lag in the payment of:

Wages 1.5 weeks 10,40,000
Stocks, materials etc 6 weeks 13,00,000
 Rent etc. 6 weeks 52,000
Directors and Manager’s salary 1 month 1,80,000
Office staff salaries 2 weeks 2,60,000
Traveller’s commission 3 months 1,00,000
Misc. expenses 2 months 3,00,000
(iv) Payment made in advance
Sundry expenses 3 months 40,000
(paid quarterly in advance)

(v) Undrawn profits on the average throughout the 1,55,000

Year

HOME-WORK : LONG QUESTIONS

Q-1 Prepare a statement of working capital requirement from the following

information:

Per Unit Rs.

Raw material 200

Direct Labour 75

Overheads 25

Total Cost 300

Profit 100

Selling Price 400

1. Estimated output 2,88,000 units (Yearly)

2. Raw Materials are in stock on an average for two months.

3. Materials are in process on an average for one month.

4. Finished goods are in stock on an average for two months.

5. Credit allowed by suppliers is one and half month.

 6. Credit allowed to customers is one and half month.

7. Lag in payment of Wages is ½ month and of Overhead is ½ month.

8. All sales are on Credit.

9. Cash in hand and Bank Balance to be kept is Rs.1,00,000.

10. Production is carried evenly throughout the year.

11. Wages and Overheads accrued evenly throughout the year.

12. For contingencies 10% is to be provided.

Q-2 Prepare an estimate of working capital

requirements:
Projected Annual Sale 2,08,000 units

Selling Price Rs.70 per unit

Raw Material cost Rs.30 per unit

Direct Labour cost Rs.10 per unit

Overheads Rs.10 per unit

Additional information:

1. Raw materials remain in stock on an average for 8 weeks.

2. Goods remain in Production process for 4 weeks on an average.

3. 6 weeks are allowed to debtors. 50% of sales are on cash basis

4. The firm gets 8 weeks credit from suppliers.

5. Finished goods remain in stock for 4 weeks.

6. Lag in payment of wages is 3 weeks & overhead expenses it is 4 weeks.

7. Cash required Rs.60,000.

8. Raw materials are issued to production in the initial stage.

9. Wages and overheads are incurred uniformly throughout the year.

 10. Assume 52 weeks in a year.

Q-3 From following information, prepare an estimate of working capital requirements:

Projected Annual Sale 2,08,000 units

Selling Price Rs.80 per unit

Raw Material cost 40% of Selling Price

Direct Labour cost 20% of Selling Price

Overheads 10% of selling Price

1. Raw materials remain in stock on an average for 6 weeks.

2. Goods remain in Production process for 6 weeks on an average

3. 5 weeks are allowed to debtors to pay while firm gets 4 week credit from
suppliers.

4. Finished goods remain in stock for 5 weeks.

5. Lag in payment of wages and overhead expenses is ½ month.

6. 30% of the sales are on cash basis.

7. Assume that goods in process are 100% complete with respect to material but
only 50% in conversion costs.

8. Assume that there are 52 weeks in a year and 4 weeks in a month.

REFERENCES:
The above material has been compiled from the below mentioned reference books.

Financial Engineering and Financial Martand Telsan

Management
Financial Management P.K. Jain
Financial Management I.M. Pandey
Financial Management Prasanna Chandra
 FACULTY OF COMMERCE
2023 – 24
SEMESTER 4
SUBJECT: FINANCIAL MANAGEMENT
UNIT 6 -DIVIDEND THEORY , MUTUAL FUND
AND FOREIGN RISK MANAGEMENT
PREPARED BY,
DR. KRUPA BHATT PROF. SAURIN PATEL

STUDY MATERIAL FOR REFERENCE ONLY

UNIT 6
Unit 6 : Dividend Theory , Mutual Fund and Foreign risk management
1. Dividend Theory Introduction and Meaning
2. Factors to be considered in dividend policy
3. Factors affecting dividend policy
4. Forms in which dividend is distributed
5. Various dividend models
6. Mutual fund types
7. Examples of mutual funds

1) →Introduction
When the business concerns decide dividend policy, they have to consider certain factors
such as retained earnings and the nature of shareholder of the business concern. The manager
must take careful decisions on how the profit should be distributed among shareholders. It is
very important and crucial part of the business concern, because these decisions are directly
related with the value of the business concern and shareholder’s wealth. Like financing
decision and investment decision, dividend decision is also a major part of the financial
manager.
Dividend policy decision has a significant effect on the credit standing of the firm, its share
prices and its future growth. If the firm follows a liberal dividend policy, it will not be able to
build sufficient internal resources and its future growth may be hampered leading to fall in
the value of the firm. Another consequence of the liberal dividend policy is that the
shareholders will receive higher dividends and would be satisfied as most of the investors
have preference for current income. But that would also reduce their chances of capital gains.
Of course, in respect of preference dividend, the management has little freedom, as its rate of
dividend is fixed and it has to be paid in priority to dividend paid to equity shareholders.
Similarly, there are certain restrictions on the payment of dividend placed by the government
and they have to be abided by. The management has no freedom in that respect.
The dividend and retained earning are the two alternative aspect of financial decision.
If it is decided to pay a particular amount as dividend, the remaining earning become the
retained earnings. Conversely, if it decided to retain a particular amount of earnings as
retained earnings, the balance of earnings automatically becomes dividend amount. Thus,

1
both decisions are complementary to each other. No decision can be taken independent of the
other.
Another important aspect of dividend policy is whether the dividend decision is taken first or
whether the retention decision should be made first. There is no rule and it all depends upon
the circumstances available in the firm. If the firm has on hand some investment programme
of growth, expansion or replacement, which requires a particular amount to be invested, then
the retention decision is first taken. However, it is generally the dividend decision which is
made first.
→ 6.1) Meaning
Dividend refers to the business concerns net profits distributed among the shareholders. It
may also be termed as the part of the profit of a business concern, which is distributed among
its shareholders.
According to the Institute of Chartered Accountant of India, dividend is defined as “a
distribution to shareholders out of profits or reserves available for this purpose”.

→ 2) Factors to be considered in dividend policy

the company's net profit is to be distributed to the shareholders and how much of it should be
retained in the business for meeting the investment requirements.

This decision should be taken keeping in mind the overall objective of maximising
shareholders' wealth.
The factors determining the dividend policy of a firm are as
follows:
1) Dividend payout (D/P) ratio
2) The preference of shareholder
3) The Requirement of company for Finance :
4) Constraints on paying Dividend
5) Stability of dividends
6) Owner’s considerations
7) Capital market considerations
8) Inflation

1) Dividend Payout (D/P) ratio:

2
The D/P ratio indicates the percentage share of the net earnings distributed to the
shareholders as dividend.
Given the objective of wealth maximisation, the D/p ratio should be such can maximise the
wealth of its owners in the long run.
In practice, investors, in general, have a clear cut preference for dividends because of
uncertainty and imperfect capital markets.
Therefore, a low D/P ratio may cause a decline in share prices, while a high ratio may lead to
a rise in the market price of the shares.

2) The Preference of shareholders

The shareholders are the real owners of the company and the management should give due
consideration to the expectations of the shareholders. Most of the shareholders like to get
maximum dividend in cash, while some shareholders like to get the benefit of capital gains in
the form of appreciation in the value of shares.
This is particularly the case of those investors who are in the maximum tax bracket, as they
will have to pay less tax on capital gains.
In case of closely-held companies, the number of shareholders are few, and closely know one
another or are from the same group. The task of directors in determining dividend policy is
not difficult in their case, as the directors have an idea of their expectations. Most of them are
rich shareholders, who prefer capital gains to cash dividend and directors determine the
dividend policy accordingly.

3) The Requirement of company for Finance.

The directors should take into account the need of the company for funds required for growth
and expansion. Of course, the shareholders would wish that they should get maximum
dividend. But there are other parties linked with the company like employees, creditors,
society, customers etc. and their interest demands that the company should retain some part
of its earnings. The company should retain a major part of its earnings in the beginning to
strengthen its financial position.
The directors should neither adopt a policy of 100% pay out nor 100% retention. It is said
that the company should retain its earnings when there exists profitable investment

3
opportunities, that is when its rate of return is more than the its cost of capital or the rate
which the shareholders expect.

4) Constraints on paying Dividend

There are certain restrictions on payment of dividend, which the directors have to take into
account
(i) Legal Requirements : The dividend policy has to be determined in the legal framework.
Government of every country puts certain restrictions on payment of dividend in public
interest. For example, in India Sec. 205 of Indian Companies Act prescribes that the company
can pay dividends only out of current profits after providing depreciation on its fixed assets
or out of current profits after providing for depreciation on its fixed assets or out of past
accumulated profits after providing for depreciation.
This has to be complied with. Secondly, according to Companies Act dividend has to be paid
in cash only. But the law has allowed companies to capitalise its reserves and issue fully paid
bonus shares.
(ii) Restrictions by Loan Creditors : When a company obtains loan from external sources, the
creditors may put certain restrictions to protect their interest. The restrictions may be that the
company cannot pay dividend until it reaches a certain level of earnings or it may be a limit
on the percentage of dividend. If may also be in the form of a certain percentage of net
earnings as retention ratio. If such stipulations are not observed, there may be a penalty in the
form of the whole amount of principal and interest becoming payable immediately.

(iii) Liquidity: The liquidity of funds is a very important consideration regarding to dividend
policy. If the company has enough liquid resources, it can easily pay dividend. However,
certain companies may have earned handsome profits, but may not have enough cash to pay
dividend, Particularly, in case of companies which are newly established, or which are likely
to embark upon an expansion plan or which has to redeem its debentures very shortly may be
in such a position. They have to keep their pay out ratio lower. But mature companies, would
have enough liquid assets and they have few profitable investment opportunities and so they
are able to pay liberal dividend. Liquidity is thus a very important constrain of dividend
policy.
(iv) Financial Position: The dividend policy is also constrained by the financial condition of
the company. If the firm is a mature firm, it will have enough retained earnings and also it has

4
an easy access to external sources of funds. It can therefore afford to adopt a liberal dividend
policy. It is not so with the growth firm, as it will not have sufficient reserves and may not
have easy access to external funds.
(v) Maintaining Control: The desire of management or a group of shareholders to maintain
control over the company has a strong influence on dividend policy. If a company pays high
dividends, its liquid position will be adversely affected and it will have to issue new shares to
raise additional funds to invest in new profitable opportunities. In such a situation, the
management group, which is not able to buy the additional shares may los control, as another
group may buy a large chunk of the new issue.
(vi) Stability of Earnings: A firm having a stable income over a long period of time will be
more liberal in its dividend policy. Of course, the level of earnings is also a factor to be
considered. But, it is doubtless that stability of earnings has a significant impact on formation
of dividend policy. In case of public utilities and firms dealing in necessities of life, there
would be relatively stable earnings and they can afford to be liberal in payout ratio.
(vii) Opportunities for Growth : When a firm has more profitable opportunities available for
investment, it will follow a policy of high retention and low pay out ratio. Particularly, the
growth firms, which wants to grow and develop will be following a policy of high retention,
as it will have difficult access to external sources of finance. However, one thing must be
remembered that this policy of low dividends should be followed only when profitable
investment opportunities are available. Otherwise, the carnings retained cannot be profitably
employed and the return from such investment may be lower than the expectations of
investors, resulting in lowering of owners' wealth. In such a situation, it would be better to
pay high dividends, so that shareholders can invest it at a higher rate of return.
If such firms need funds for expansion, it can raise funds externally.
(viii) Access to Capital Markets: The fact whether a firm has easy access to capital market or
limited access has an important bearing on determination of dividend policy. If a firm has an
access to capital market, it can afford to adopt liberal dividend policy. Only financially strong
or large-sized firms have such an advantage. If the firm does not have easy access to capital
market, it cannot raise funds externally easily and so it will have to depend more on retained
earnings for funds required for its expansion programmes. Secondly, in order to be eligible to
get finance from financial institutions, the firms are required to declare a minimum dividend
for at least some years.
(ix) Inflation: Inflation or continuously rising prices have an impact on dividend policy.
When prices are rising, the assets become costlier while depreciation is charged only on old

5
historical values, as replacement value depreciation is not allowed by income-tax authorities.
Hence, when assets are to be replaced, the amount of depreciation accumulated is not enough
to buy new assets.

5) Stability of dividends:
The second major aspect of the dividend policy of a firm is the stability of dividends. The
investors favour a stable dividend as much as they favour the payment of dividends.
Dividend stability refers to the consistency or lack of variability in the stream of dividends
which means that a certain minimum amount of dividend is paid regularly.

The stability of dividends can take any of the following three forms:

a) Constant dividend per share

b) Constant payout ratio
c) Constant dividend per share plus extra dividend

The investors prefer a stable dividend policy for a number of reasons, such as, desire for
current income, informational content and institutional requirements.
6) Owner’s considerations:
The dividend policy is also likely to be affected by the owner’s considerations of
(a) the tax status of the shareholders,
(b) their opportunities of investment, and
(c) the dilution of ownership.
7) Capital Market Considerations:
Another set of factors that can strongly affect dividend policy is the extent to which the firm
has access to the capital markets.
A firm which has easy access to the capital market can follow a liberal dividend policy,
whereas a firm having only limited access to the capital markets is likely to adopt low
dividend payout ratio as they are likely to rely, to a greater extent, on retained earnings as a
source of financing their investments.

8) Inflation:

6
Inflation is another factor which affects the firm’s dividend decisions. With rising prices,
funds generated from depreciation may be inadequate to replace obsolete equipments. As a
result D/P ratio tends to be low during period of inflation.

→ 3) Factors affecting dividend policy

There is no definite answer to the question as to what should be the quantum of dividend
every year. A number of factors affect it and the final figure of dividend is determined only
after considering the following
(1) Type of Business: The type of business carried on by the company influences the
dividend policy. If the company is in a business which has a stable demand and stable
earnings, it can follow a stable dividend policy. While a company which deals in luxury items
has irregular flow of income and cannot adopt a steady dividend policy. Generally,
companies dealing in necessities of life, public utilities etc. have stable income.

(2) Current Year's Earnings: A company has to determine the amount of dividend keeping in
view the actual earnings of the current year only. Of course, the whole of earnings is not
distributed by the company every year, but it is the base of dividend policy. Even the
companies following stable dividend policy makes some changes within a certain limit on the
basis of current year's profit.
(3) Past Dividends : To a lesser extent the dividends declared during previous years must also
be considered. Shareholders do expect that the company would pay not less than dividend
paid in the past. Of course, if circumstances change, departure has to be made from the past
trend of dividends. But generally directors are reluctant to reduce the previous vear's rate of
dividend and if need be, they would try to maintain the rate of dividend, withdrawing from
the past accumulated profit.
(4) Estimate of Future Earnings : A company cannot adopt a stable dividend policy without
taking into account the estimates of future earnings.
The current year's rate is rationally determined only when estimate of future earnings is
considered. If the profit is likely to rise in future, then only the directors can think of raising

7
current dividend. If the future is not so bright, the current dividend cannot be increased, as the
rational dividend policy cannot ignore the fluctuations in earnings from year to year.
(5) Future Needs of Capital: The current profit is divided into retained earnings and
dividend. When the company is in need of additional capital for future expansion of business,
has to restrict its rate of dividend and keep a major part of its current earnings for meeting
working capital needs and fixed capital requirements of expansion of business. Particularly,
small companies and newly established companies have no other source of raising finance
and would therefore depend mainly on this source.
(6) Fluctuations in Business: The alternative waves of depression and boom in business has a
considerable impact on dividend policy. A wise management would adjust itself to the
changes in business from time to time. During boom period, a company should build up a
good amount of reserves, so that it can withstand the period of depression and can maintain a
stable dividend policy. If need be, the company can easily raise finance by maintaining high
rate of dividend.
(7) Present Amount of Reserves: A company having sufficient amount of reserves would be
able to face the times of low demand with confidence. The prudent management would
therefore, try to build up, sufficient reserves during boom period by restricting the rate of
dividend and thus try to strengthen its financial position.
(8) Distribution of Shareholdings: If the company is a closely-held, it is easy for the Board to
postpone the dividend and transfer the entire profit to reserves. However, in case the
shareholding is widely distributed, with a large number of shareholders, it would be difficult
for the Board to take decision of reducing or suspending dividend.
(9) Age of the Company: The dividend policy is affected by the fact whether a company is an
old and established one or is a now one
A new company cannot afford to declare a high rate of dividend from the beginning, as it has
to fall back on retained earnings for its requirements of funds for expansion. However, an
established company would have built On enough reserves and can afford to be liberal in
dividend distribution.
(10) Position of Liquidity: Dividend is payable in cash as per provisions of Companies Act.
Hence, the directors are required to consider the liquid position before declaring dividend. A
company may have good deal of profit but may not have enough cash. In that case dividend
Bas to be postponed of the lower rate of dividend should be declared. Even if the present
liquid position may be satisfactory, the company may require cash to buy assets for

8
expansion of business. In that case too, management should postpone payment of dividend.
There is thus a direct link between liquid position and payment of dividend.
(11) Government Policy: The changes in government fiscal policies industrial and labour
policies considerably affect the working of some or all of the business firms. Their profits are
affected either favourably or adversely. Dividend policy has to be adjusted to such changes.
In some cases, the government may restrict the rate of dividend in certain industries or
impose tax if the rate of dividend exceeds a particular limit. Dividend policy is thus affected
by changes in government policies.
(12) Taxation: Due to high rates of taxes, the company's profits are reduced, leading to a
lower rate of dividend. In case of closely-held companies the shareholders who are mostly in
the highest tax brackets would like to receive less dividend and opt for capital gains. (It must
be noted at this stage that dividends declared by Indian companies are completely tax-free in
the hands of the shareholders and so this argument does not hold good). Many companies
would like to issue bonus shares frequently instead of paying high rates of dividend.

(13) Legal Restrictions: The Companies Acts of various countries may put restrictions of
payment of dividends. For example, according to Sec. 205 of Indian Companies Act, no
dividend can be paid without providing depreciation on fixed assets, dividend has to be paid
in cash, dividend warrants must be dispatched within 30 days of declaration of dividend etc.
No dividend can be paid out of capital. It has to be paid out of earrings of the company.
(14) Attitude of Management: The attitude of management has considerable impact on
dividend policy. The management with foresight and conservative attitude would declare
lower dividend and major part of the profit would be kept in business to strengthen its
financial position. The management with liberal attitude would be liberal in dividend policy.
Prudent management would always adopt a bit conservative dividend policy.

• Forms in which dividend is distributed

Introduction

Dividends are payments made by companies to shareholders as a reward for investing in the
company. They are usually paid out quarterly or annually, and businesses can offer various
types of dividend. In this article we will look at and discuss the different types of dividends
and how they work. We will also look at some of the advantages and disadvantages of each
type. Knowing the types of dividends available can help you make a well informed decision
about investing in stocks. So let's dive in and look at the different various forms of dividend.

9
What are Dividends?

Companies reward their shareholders by paying out dividends. These payments can be made
in the form of cash, stocks, other assets, and more; they are also typically based on the
company's profits but could come from debt instruments.

The types of dividends a company pays out depending on the types of securities they offer.
Common types include ordinary (cash) dividends, stock/share, property, and
liquidating/special dividends.

• What are the Different Types of Dividends?

If you want to know what are the types of dividend that businesses pay out, each with its
advantages and disadvantages, keep reading.

1. Cash dividends

These are the most common type of dividends, paid out in cash. A company pays out a
certain portion of its profits as dividends to shareholders. For example, An IT firm, XYZ, has
made Rs 500 crores in profit for the year 2020. They decided to pay their shareholders 20%
of that amount as a dividend, which would be Rs 100 Crore INR (500 Cr x 0.20).

This would mean each shareholder would receive a certain dividend amount, depending on
how much stock they own.

The advantages and disadvantages of cash dividends depend on the company's financial
situation. On the one hand, shareholders can benefit from receiving a dividend payment in the
form of cash; on the other hand, companies have less money to reinvest in their businesses,
which can limit growth potential.

Cash dividends provide an immediate return but also mean less money for companies to
reinvest and grow.

2. Stock dividends

As the name suggests, stock dividends are paid out as additional shares instead of cash. For
example, XYZ IT firm decided to pay its shareholders 20% of its profits as a stock dividend.
This would mean each shareholder will receive an additional share for every five shares they
own.

The advantage of stock dividends is that they can increase a shareholder's potential returns
without them having to invest more money. Additionally, companies won't have to part with
their profits as they do with cash dividends.
On the downside, they also don't provide immediate benefits and tend to carry more risk than
cash dividends. The market value of the new shares could be lower or higher than when the
original investment was made.

3. Property dividends

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These various forms of dividend are paid out as assets instead of cash or shares. This could be
anything from real estate to antiques and can even include intangible assets such as patents or
copyrights.

The advantage of property dividends is that they can diversify an investment portfolio and
may provide more tax benefits than other types of dividends. On the downside, there is
always a risk that the value of these types of assets may decline over time, limiting potential
returns.
For example, XYZ IT firm pays its shareholders 10% of its profits as property dividends.
This would mean each shareholder will receive an additional asset worth Rs 50 Lakhs INR
(500 Cr x 0.10).

4. Scrip dividends

Scrip dividends are similar to stock dividends, but instead of receiving additional shares
directly from the company, shareholders receive a scrip or voucher that can be exchanged for
shares on the market.

The advantage of scrip dividends is that they can provide more flexibility to investors as it
allows them to decide when and how much of their dividend money should be used for
reinvestment. On the downside, there is always a risk that the value of these types of assets
may decline over time, limiting potential returns.

For example, XYZ IT firm decides to pay its shareholders 10% of its profits as a scrip
dividend. This would mean each shareholder will receive a scrip worth Rs 50 Lakhs INR
(500 Cr x 0.10) that can be exchanged for market shares later.

5. Liquidating dividends

Liquidating dividends are paid out to shareholders when a company is winding down its
operations, and there isn't enough money left to pay out other different types of dividends.

The advantage of liquidating dividends is that they can provide a return for shareholders even
if the business has failed. On the downside, it typically means that all remaining assets will be
sold off to pay the dividend, and the company will cease to exist.
For example, XYZ IT firm decides to pay its shareholders 50% of its remaining assets as a
liquidating dividend. This would mean each shareholder will receive an amount equivalent to
Rs 250 Lakhs INR (500 Cr x 0.50) from the sale of the company's assets.

• Famous Various Dividend Models:

• Traditional Model
• Walter Model
• Gordon Model
• Miller & Modigliani Position

Traditional Models

It is given by B Graham and DL Dodd. This model lays down a clear emphasis on the
relationship between the dividends and the stock market. According to this model, the stock
value responds positively to higher dividends and negatively when there are low dividends.

11
This model establishes the relationship between market price and dividends using a
multiplier.
P/E ratios are directly related to the dividend payout ratios that is, a higher dividend payout
ratio will increase the P/E ratio and vice-versa.
P = m (D+E/3)
In which; P = market price
M = multiplier
D = Dividend per share
E = Earnings per share

Limitations:

• P/E ratios are directly related to the dividend payout ratios is not true for a firm’s
whose payout is low but its earnings are increasing.
• This approach does not hold good for those firm whose payout is high but have slow
growth rate.

Walter Model

The dividend policy given by James E Walter considers that dividends are relevant and they
do affect the share price.In this model, he studied the relationship between the internal rate of
return (r) and the cost of capital of the firm (K), to give a dividend policy that maximizes the
shareholders’ wealth.
The model studies the relevance of the dividend policy in three situations;
r > Ke
r < Ke
r = Ke
According to Walter When r > Ke the firm has to adopt Zero% payout policy.
r < ke the firm has to adopt 100% payout policy.
r = ke any policy between 0 to 100% payout.

Gordon’s Model:

One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.

Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.

. Modigliani and Miller’s hypothesis:

According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does
not affect the wealth of the shareholders. They argue that the value of the firm depends on the
firm’s earnings which result from its investment policy.

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Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm. M – M’s hypothesis of irrelevance is based on the following assumptions.

1. The firm operates in perfect capital market

2. Taxes do not exist

3. The firm has a fixed investment policy

4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.

• What are the Types of Dividend Policies?

Companies follow different patterns for paying out dividends. The patterns depend on the
type of dividend policy chosen by them. There are four different types of dividend policy that
companies usually follow, and they are:

Stable Dividend Policy

A stable dividend policy involves fixing a certain amount of dividend that the shareholders
periodically receive. Even if the company incurs a loss, the amount of dividend does not
change.

Regular Dividend Policy

In a regular dividend policy, the company fixes a certain percentage of dividend from the
company’s profits. When the profits are high, the dividend payment will automatically be
high. While the profits are low, the dividend payment will remain low. Experts usually
considers this to be the most appropriate policy for paying dividends and creating goodwill.

Irregular Dividend Policy

In an irregular dividend policy, the dividend payment solely depends on the company’s
decision. If the company decides to pay a dividend to the shareholders, then the shareholders
get the dividend. The decision solely depends on the company’s priorities. If the company has
a new project to fund, then it may decide to retain the profits within the company instead of
distributing it.

No Dividend Policy

In no dividend policy, the company always retains the profits and doesn’t distribute them to
its shareholders. Usually, growth-oriented companies follow the no dividend policy. The
strategy might suit companies who aim for growth. However, it may discourage investors
who are looking for sustainable income in the long term.

What is the Difference Between a Cash Dividend and a Stock Dividend?

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Dividend-paying companies often pay shareholders cash as a percentage of the share price. A
cash dividend is a regular cash payment by a company to its shareholders. The money that the
company issues as a dividend is often a percentage of free cash that it doesn’t use for any
investment.

On the other hand, stock dividends are in the form of more company shares. For example,
when a company announces a 10% stock dividend, it means that an investor with 100 shares
is eligible to get ten shares as a stock dividend. Therefore, the investor will now have 110
shares.

Cash dividends are taxable. At the same time, stock dividends are subject to tax only when
the investor chooses to turn around and sell the extra stocks for cash.

• Advantages of Mutual Funds

Liquidity

Unless you opt for close-ended mutual funds, it is relatively easier to buy and exit a mutual
fund scheme. You can sell your open-ended equity mutual fund units when the stock market
is high and make a profit. Do keep an eye on the exit load and expense ratio of the mutual
fund.

Diversification

Equity mutual funds have their share of risks as their performance is based on the stock
market movements. Hence, the fund manager spreads your investment across stocks of
companies across various industries and different sectors called diversification. In this way,
when one asset class doesn’t perform, the other sectors can compensate to avoid loss for
investors.

Expert Management

A mutual fund is good for investors who don’t have the time or skills to do the research and
asset allocation. A fund manager takes care of it all and makes decisions on what to do with
your investment.

The fund manager and the team of researchers decide on the appropriate securities such as
equity, debt or a mix of both depending on the investment objectives of the fund. Moreover,
the fund manager also decides on how long to hold the securities.

Your fund manager’s reputation and track record in fund management should be an essential
criterion for you to choose a mutual fund. The expense ratio (which cannot be more than
2.25% annualised of the daily net assets as per SEBI) includes the fees of the fund manager.

Less cost for bulk transactions

You must have noticed how price drops with the purchase of increased volumes. For
instance, if a 100g toothpaste costs Rs 10, you might get a 500g pack for say, Rs 40.

14
Invest in smaller denominations

By investing in smaller denominations of as low as Rs 500 per SIP instalment, you can
stagger your investments in mutual funds over some time. This reduces the average cost of
investment – you spread your investment across stock market lows and highs. Regular
(monthly or quarterly) investments, as opposed to lumpsum investments, give you the benefit
of rupee cost averaging.

Costs of managing the mutual fund

The salary of the market analysts and fund manager comes from the investors along with the
operational costs of the fund. Total fund management charges are one of the first parameters
to consider when choosing a mutual fund. Higher management fees do not guarantee better
fund performance.

Exit Load

You have exit load as fees charged by AMCs when exiting a mutual fund. It discourages
investors from redeeming investments for some time. This indirectly works like a lock-in
period that fund houses use to maintain stability of funds. It also helps the fund manager
garner the required funds to purchase the appropriate securities at the right price and time.

Dilution

While diversification averages your risks of loss, it can also dilute your profits. Hence, you
should not invest in many mutual funds at a time.

As you have just read above, the benefits of mutual funds can undoubtedly override the
disadvantages, if you make informed choices.

However, investors may not have the time, knowledge or patience to research and analyse
different mutual funds. Investing with Clear Tax could solve this problem as we have already
done the homework for you by handpicking the top-rated funds from the best fund houses in
the country.

• Types of mutual funds

Mutual fund types can be classified based on various characteristics. Learn more about
different mutual fund types below:

• Equity Funds
• Debt Funds
• Money Market Funds
• Hybrid Funds
• Growth Funds
• Income Funds
• Liquid Funds
• Tax-Saving Funds
• Aggressive Growth Funds
• Capital Protection Funds

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 • Fixed Maturity Funds
• Pension Funds

1. Based on Asset Class

The classification of mutual funds based on asset class is as follows:

Equity Funds

Equity funds primarily invest in stocks, and hence go by the name of stock funds as well.
They invest the money pooled in from various investors from diverse backgrounds into
shares/stocks of different companies. The gains and losses associated with these funds
depend solely on how the invested shares perform (price-hikes or price-drops) in the stock
market. Also, equity funds have the potential to generate significant returns over a period.
Hence, the risk associated with these funds also tends to be comparatively higher.

Debt Funds

Debt funds invest primarily in fixed-income securities such as bonds, securities and treasury
bills. They invest in various fixed income instruments such as Fixed Maturity Plans (FMPs),
Gilt Funds, Liquid Funds, Short-Term Plans, Long-Term Bonds and Monthly Income Plans,
among others. Since the investments come with a fixed interest rate and maturity date, it can
be a great option for passive investors looking for regular income (interest and capital
appreciation) with minimal risks.

Money Market Funds

Investors trade stocks in the stock market. In the same way, investors also invest in the
money market, also known as capital market or cash market. The government runs it in
association with banks, financial institutions and other corporations by issuing money market
securities like bonds, T-bills, dated securities and certificates of deposits, among others. The
fund manager invests your money and disburses regular dividends in return. Opting for a
short-term plan (not more than 13 months) can lower the risk of investment considerably on
such funds.

Hybrid Funds

As the name suggests, hybrid funds (Balanced Funds) is an optimum mix of bonds and
stocks, thereby bridging the gap between equity funds and debt funds. The ratio can either be
variable or fixed. In short, it takes the best of two mutual funds by distributing, say, 60% of
assets in stocks and the rest in bonds or vice versa. Hybrid funds are suitable for investors
looking to take more risks for ‘debt plus returns’ benefit rather than sticking to lower but
steady income schemes.

2. Based on Investment Goals

Here are the different types of mutual funds based on investment goals:

1.Growth Funds

16
Growth funds usually allocate a considerable portion in shares and growth sectors, suitable
for investors (mostly Millennials) who have a surplus of idle money to be distributed in
riskier plans (albeit with possibly high returns) or are positive about the scheme.

2.Income Funds

Income funds belong to the family of debt mutual funds that distribute their money in a mix
of bonds, certificate of deposits and securities among others. Helmed by skilled fund
managers who keep the portfolio in tandem with the rate fluctuations without compromising
on the portfolio’s creditworthiness, income funds have historically earned investors better
returns than deposits. They are best suited for risk-averse investors with a 2-3 years
perspective.

3.Liquid Funds

Like income funds, liquid funds also belong to the debt fund category as they invest in debt
instruments and money market with a tenure of up to 91 days. The maximum sum allowed to
invest is Rs 10 lakh. A highlighting feature that differentiates liquid funds from other debt
funds is the way the Net Asset Value is calculated. The NAV of liquid funds is calculated for
365 days (including Sundays) while for others, only business days are considered.

4.Tax-Saving Funds

ELSS or Equity Linked Saving Scheme, over the years, have climbed up the ranks among all
categories of investors. Not only do they offer the benefit of wealth maximisation while
allowing you to save on taxes, but they also come with the lowest lock-in period of only three
years

5.Aggressive Growth Funds

Slightly on the riskier side when choosing where to invest in, the Aggressive Growth Fund is
designed to make steep monetary gains. Though susceptible to market volatility, one can
decide on the fund as per the beta (the tool to gauge the fund’s movement in comparison with
the market). Example, if the market shows a beta of 1, an aggressive growth fund will reflect
a higher beta, say, 1.10 or above.

6.Capital Protection Funds

If protecting the principal is the priority, Capital Protection Funds serves the purpose while
earning relatively smaller returns (12% at best). The fund manager invests a portion of the
money in bonds or Certificates of Deposits and the rest towards equities.

Open-Ended Funds

Open-ended funds do not have any particular constraint such as a specific period or the
number of units which can be traded. These funds allow investors to trade funds at their
convenience and exit when required at the prevailing NAV (Net Asset Value).

Closed-Ended Funds

17
In closed-ended funds, the unit capital to invest is pre-defined. Meaning the fund company
cannot sell more than the pre-agreed number of units. Some funds also come with a New
Fund Offer (NFO) period; wherein there is a deadline to buy units.

There are many other types of mutual funds apart from the above.
Few examples of good performing mutual funds in India.

• ICICI Prudential Focused Bluechip Equity Fund

• Aditya Birla Sun Life Small & Midcap Fund
• Tata Equity PE Fund
• HDFC Monthly Income Plan – MTP
• L&T Tax Advantage Fund
• SBI Nifty Index Fund
• Kotak Corporate Bond Fund
• Canara Robeco Gilt PGS
• DSP BlackRock Balanced Fund
• Axis Liquid Fund

SECTION A LONG QUESTIONS

1. Explain the concept of dividend and factors affecting dividend.
2. Explain factors to be considered during dividend policy.
3. What do you mean by dividend policies?
4. Explain various types of dividend policies.
5. What is mutual fund? Explain types of mutual funds.
6. Write a note on following dividend models

• Traditional Model
• Walter Model
• Gordon Model
• Miller & Modigliani Position

SECION B SHORT QUESTIONS

1. What do you means by cash and stock dividend?

2. Explain any 3 types of dividend policies.
3. Explain Walter and Gorden model in short.
4. What is mutual fund?
5. Explain any three types of mutual fund with examples.

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MULTIPLE CHOICE QUESTIONS

01) When the business concerns decide dividend policy, they have to consider certain
factors such as retained ________________________and the nature of shareholder of
the business concern.
A) Expenses B) Earnings C) Capital D) Drawings

02) The manager must take careful decisions on how the profit should be distributed
among , It is very important and crucial part of the business concern.
A) Management B) Share holder C) Employees D) Government

03) When the business concerns decide dividend policy, they have to consider certain
factors such as retained earnings and the nature of ____________________ of
the business concern.
A) Share holder B) Employees C) Capital D) Drawings

04) Decisions are directly related with the value of the business concern and shareholder’s
wealth. Like financing decision and investment decision, dividend decision is also a
major part of the ______________ manager.
A) Manufacturing B) Operating C) Financial D) Sales

05) Dividend refers to the business concerns _________ distributed among the shareholders.
It may also be termed as the part of the profit of a business concern, which is distributed
among its shareholders.
A) Net profit B) Expenses C) Capital D) Drawings

06) According to the Institute of dividend is defined ______________________

as “a distribution to shareholders out of profits or reserves available for this purpose”.
A) House of commerce B) Chartered statistics of India,
C) Chartered Accountant of India, D) House of Economics

07) When dividend payable either in cash or stock at the option of the shareholder is called

19
 __________________dividend.
A) Optional B) script C) bond D) Property

08) Some company may pay dividend in the form of asset that it is holing and which is
superfluous for it is called _______________dividend.
A) Optional B) script C) bond D) property

09) When the firm does not pay out fixed dividend regularly,
it is ______________ dividend policy.
A) Irregular B) regular C) No immediate D) liberal

10) The Dividend pay out ratio indicates the percentage share of the ________________
distributed to the shareholders as dividend.
A) Net expenses B) Net capital C) Net assets D) Net earning

11) In practice, investors, in general, have a clear-cut preference for ____________because

of uncertainty and imperfect capital markets.
A) Drawings B) Dividends C) Provident fund D) Cash

12) In practice, investors, in general, have a clear-cut preference for dividends because
of uncertainty and imperfect __________________.
A) Whole-sales markets B) Revenues markets
C) Capital markets D) Provident fund

13) Given the objective of wealth maximisation, the dividend pay-out ratio should be such
can ________________ the wealth of its owners in the long run.
A) Minimise B) Maximise C) decreased D) be stable

14) A low dividend pay-out ratio may cause a ______________ in share prices, while a high
ratio may lead to a rise in the market price of the shares.
A) Increase B) Expand C) Bullish rise D) decline

15) A low dividend pay-out ratio may cause a decline in share prices, while a high
ratio may lead to a rise in the _________________ of the shares.

20
 A) Fase value B) market price C) Book value D) Sales value

16) Most of the shareholders like to get maximum dividend in cash, while some
shareholders like to get the benefit of _________in the form of appreciation in the
value of shares.
A) Loss B) profit C) Capital loss D) Capital Gain

17) The task of directors in determining __________ is not difficult in their case, as the
directors have an idea of their expectations.
A) Intrinsic value B) dividend policy C) tax rate D) Capital structure

18) In case of __________ companies, the number of shareholders is very large. They have
different requirements of dividends and capital gains. It is difficult in such case to
determine a dividend policy which can satisfy all.
A) Widely-held B) Closely-held C) new D) defaulter

19) The task of directors in determining dividend policy is not difficult in their case, as
the directors have an idea of their ______________.
A) Intrinsic value B) expectation C) tax rate D) living style

20) In case of _____________ companies, the number of shareholders are few, and closely
know one another or are from the same group. Most of them are rich shareholders, who
prefer capital gains to cash dividend and directors determine the dividend policy
accordingly.
A) Widely-held B) Closely-held C) new D) defaulter

21) Where a dividend has been declared by a company, it has to be paid within days
from the date of declaration.
a) 30 b) 45 c)50 d) 5

22) When money transferred to the unpaid dividend account of a company, which remains
unpaid or unclaimed for a period of years, shall be transferred by the company to
“Investor education and protection Fund”

21
 a) 7 b) 8 c) 2 d) 4

23) Small shareholders buy a few shares of a few companies. They act on the advice of
their _______________ and friends.
A) Defaulter B) Broker C) Government D) SEBI

24) Retired and old persons are interested in regular dividend income.
They invest their ______________amount and savings with a view to getting regular
income for consumption purposes
a) Provident fund b) salary c) expenses d) None

25) __________ investors like banks, insurance companies, Unit Trust etc. buy
substantial shares of various companies and hold them for a very long time.
They are interested in profitable investments and would prefer regular income.
A) Small B) Institutional C) Defaulter D) None

26) Under Legal Requirements of the dividend policy has to be determined in the
__________________.
A) section framework B) legal framework
C) religious framework D) school framework

27) Under legal requirements of dividend policy, in India ______ of Indian Companies
Act prescribes that the company can pay dividends only out of current profits after
providing depreciation on its fixed assets
A) Sec. 205 B) Sec 305 C) Sec 105 D) Sec. 405

28) The company cannot pay dividend out of ________, as it would reduce the security
available to creditors.
A) Fixed deposits B) Capital C) Bank balance D) Drawings

29) When a company obtains loan from external sources, the ______ may put certain
restrictions to pay dividend until it reaches a certain level to protect their interest.

22
 A) Creditors B) Debtors C) Bank D) Government

30) When a company obtains loan from __________, the Creditors may put certain
restrictions to pay dividend until it reaches a certain level to protect their interest.
A) External source B) Debtors C) Bank D) Government

31) Inflation is another factor which affects the firm’s ____________ decisions.
A) Capital B) dividend C) Bank balance D) Drawings

32) having good growth opportunities retain more money out of their earnings so as
to finance the required investment. Therefore the dividend declared in growth
companies is _____________ than that in the non-growth companies.
A) Smaller B) High C) Maximum D) Increasing

33) Dividend involves an _____________ of cash. Availability of enough case is

necessary for payment or declaration of dividends.
A) Depreciation B) Inflow C) Out-flow D) None

34) If the dividend is paid in the form of_______ to the shareholders, it is called cash
dividend. It is paid periodically out the business concerns EAIT
A) Cash B) Credit C) New debenture D) New Shares

35) Stock dividend is paid in the form of the company stock due to raising of
more finance. Under this type, cash is retained by the business concern.
Stock dividend may be bonus issue.
A) Stock dividend B) Bond dividend C) tax dividend D) None

36) _______ dividend is also known as script dividend. If the company does not have
sufficient funds, they promises to pay the shareholder at a future specific date
with the help of issue of bond
A) Stock B) Inflow C) Bond D) Property

37) Property dividends are paid in the form of some assets other than cash.
It will distributed under the exceptional circumstance.

23
 A) Stock B) Inflow C) Bond D) Property

38) Dividend payable at the usual rate is called as _______________ policy.

This type of policy is suitable to the small investors, retired persons and others.
A) Cash dividend B) Regular dividend
C) stable dividend D) No dividend policy.

39) _____________ policy means payment of certain minimum amount of

dividend regularly( Constant dividend per share Constant payout ratio )
A) Cash dividend B) Regular dividend
C) stable dividend D) No dividend policy.

40) When the companies are facing ( Financial problem ) constraints of earnings
and unsuccessful business operation, they may follow____________.
A) irregular dividend policy B) Regular dividend policy
C) stable dividend D) No dividend

41) Sometimes the company may follow __________ because of its unfavourable
working capital position of the amount required for future growth of the concerns.
A) irregular dividend policy B) Regular dividend policy
C) stable dividend D) No dividend policy

42) Sometimes the company may follow no dividend policy because of its unfavourable
_____________ position of the amount required for future growth of the concerns.
A) Working Drawings B) Assets
C) working capital D) Investments

43) The First player of the Mutual fund industry was .

A) ICICI MF B) UTI MF C) SBI MF D) LIC MF

44) UTI mutual fund was set up in the Year

A) 1963 B) 1986 C) 1956 D) 1947
45) Who establishes the Mutual Fund in India?

24
 A) Securities Exchange Board of India B) Asset Management Company
C) Sponsor D) Shareholders

46) As investors are rational, they want to avoid risk. The payment of ____________
completely removes any chance of risk.
A) Proposed dividends B) Future dividend
C) Current dividends D) GST

47) The rational investors can reasonably be expected to prefer current dividend. They
will place less importance on _______________ as compared to current dividend.
A) Proposed dividends B) Future dividend
C) Current dividends D) GST

48) Modigliani and Miller maintain that dividend policy has no effect on the__________
of the firm and is, therefore, of no consequence.
A) Share B) dividend C) Tax D) GST

49) According to _______ Regulations, 1996, “Mutual Fund means a fund established in
the form of trust to raise monies through the sale if units to the public or a section
of public under one or more schemes for investing in securities,
A) SEBI B) SBI C) USBC D) GST

50) According to SEBI Regulations, 1996, “___________ means a fund established in

the form of trust to raise monies through the sale if units to the public or a section
of public under one or more schemes for investing in securities,
A) Provident Fund B) Mutual Fund C) Loan D) GST

51) The value of one unit of investment in Mutual fund is called the
A) Net Asset Value B) Issue value C) Market value D) Gross Asset value

52) schemes not exposed to sudden and large movements of funds.

A) Fixed maturity plan B) Open-Ended Funds
C) Close-Ended Funds D) Interval fund

25
53) Dividend income received from mutual in the hands of unit holders

A) Fully Taxable B) Fully Exempt C) Partly Exempt D) Partly Taxable

54) Which of the following is not a limitation of mutual funds?

A) No guarantee of return B) Fees and Expenses

C) Poor Performance D) Professional Management

55) What are the reasons for economies of scale to the benefit of Mutual funds?
A) Large volumes of trade B) Portfolio diversification

C) Risk reduction D) Loss

56) A minimum start-up capital of about is required for open-ended schemes

A) 500 million B) 1000 million C) 350 million D) 200 million

57) ___________ are considered high-risk funds but also tend to provide high returns.
A) Equity Funds B) Money Market Funds
C) Balanced or Hybrid Funds D) Debt Funds

58) HDFC Sensex ETF is an example of .

A) Sector Funds B) Index Funds C) Fund of funds D) International funds

59) AMFI was incorporated on .

A) 22nd August 1995 B) 12th April 1992 C) 1st April 1935 D) 15th August 1947

60) Which type of fund is more volatile?

A) Large-cap funds B) Mid-cap funds
C) Small-cap funds D) Hybrid Funds

61) An investor pays a tax on the dividend that he receives from a mutual fund scheme at

A) 10% B) 20% C) 30% D) Tax is not applicable

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62) Mutual Fund schemes are first offered to investors through.
A) Stock exchange B) New Fund Offer
C) Initial Public Offer D) AMFI

63) Which of the following banks launched the first mutual fund in India?
A) SBI B) Canara Bank C) Bank of India D) Indian Bank

64) SIP is a____________________.

A) Method of regular investment B) Name of a mutual fund
C) Brand of a tea stock D) Method of one time investment

65) SIP stands for .

A) Systematic investment plan B) Simple investment plan
C) Simplified investment programmed D) Single investment plan

66) The is the market value of the securities that mutual funds have
purchased minus any liabilities per unit.
A) Net asset value B) Book value C) Gross asset value D) Net worth value

67) Which payment mode is not applicable while purchasing mutual fund scheme?
A) Cheque B) Demand Draft C) Cash D) Pay Order

68) are an important link between fund managers and investors.

A) Trustees B) Asset Management Company
C) Custodian D) Registrar And Transfer Agents

69) Transaction cost is with investment in Mutual Funds.

A) high B) low C) very high D) Nil

70) helps to improve the risk return relationship.

A) Diversification B) Liquidity
C) Professional Management D) tax

REFERENCES:

The above material has been compiled from the below mentioned reference books and

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official data from websites.

Financial Engineering and Financial Martand Telsan

Management
Financial Management I.M. Pandey
Financial Management Prasanna Chandra
Financial Management P.K. Jain

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