CA ASPIRANTS-ICAN

Theories for Exam

1. Meaning of `Financial Management
Financial management is that managerial activity which is concerned with planning & controlling of firm’s financial resources. In other
words, it is concerned with acquiring, financing & managing assets to accomplish the overall goal of a business enterprise (mainly to
maximize the shareholder’s wealth).
Financial management comprises the forecasting, planning, organizing, directing, coordinating and controlling of all activities relating to
acquisition & application of the financial resources of an undertaking in keeping with its financial objective. Financial Management is
concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm.
Financial management is concerned with efficient acquisition (financing) & allocation (investments in assets, working capital, etc.) of
funds with an objective to make profit (dividend) for owners.
In other words, focus of financial management is to address 3 major financial decision areas viz. Investment, Financing & Dividend
decisions.

2. Basic aspects of Financial management

i. Procurement of funds: Obtaining funds from different sources like equity, debentures, funding from banks, etc. Funds can be
obtained from different sources having different characteristics in terms of risk, cost and control. The funds raised from the issue of
equity shares are the best from the risk point of view since repayment is required only at the time of liquidation. However, it is also the most
costly source of finance due to dividend expectations of shareholders. On the other hand, debentures are cheaper than equity shares due
to their tax advantage. However, they are usually riskier than equity shares. There are thus risk, cost and control considerations
which a finance manager must consider while procuring funds. The cost of funds should be at the minimum level for that a proper
balancing of risk and control factors must be carried out.
ii. Effective utilization of funds: Employment of funds properly & profitably. The Finance Manager has to ensure that funds are not
kept idle or there is no improper use of funds. The funds are to be invested in a manner such that they generate returns higher than
the cost of capital to the firm. Besides this, decisions to invest in fixed assets are to be taken only after sound analysis using capital
budgeting techniques. Similarly, adequate working capital should be maintained so as to avoid the risk of insolvency.

3. Objectives of Financial management

i. Profit maximization: Profit maximization means that primary objective of a company is to earn profit.
ii. Wealth/value maximization: It means that the primary goal of a firm should be to maximize its market value & implies that business
decisions should seek to increase the net present value of the economic profits of the firm.
Wealth maximization is considered superior to profit maximization objective. It is due to the following reasons:
 Wealth maximization considers all future cash flows, dividends, EPS, risk of a decision etc. whereas profit maximization does not
consider any of them.
 A firm that wishes to maximize the shareholder’s wealth may pay regular dividends whereas a firm with the objective of profit
maximization may refrain from dividend payment to its shareholders.
 Shareholders would prefer an increase in the firm’s wealth against its generation of increasing flow of profits.
 The market price of a share reflects the shareholders expected return, considering the long term prospects of the firm, reflects the
differences in timings of the returns, considers risk & recognizes the importance of distribution of returns.
The maximization of a firm’s value as reflected in the market price of a share is viewed as a proper goal of a firm. The profit
maximization can be considered as a part of the wealth maximization strategy.
However, profit maximization cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue
importance, a number of problems can arise. Some of these have been discussed below:
(i) The term profit is vague. It does not clarify what exactly it means. It conveys a different meaning to different people. For example, profit
may be in short term or long term period; it may be total profit or rate of profit etc.
(ii) Profit maximization has to be attempted with a realization of risks involved. There is a direct relationship between risk and
profit. Many risky propositions yield high profit. Higher the risk, higher is the possibility of profits. If profit maximization is the only
goal, then risk factor is altogether ignored. This implies that finance manager will accept highly risky proposals also, if they give high profits.
In practice, however, risk is very important consideration and has to be balanced with the profit objective.
(iii)Profit maximization as an objective does not take into account the time pattern of returns. Proposal A may give a higher
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amount of profits as compared to proposal B, yet if the returns of proposal A begin to flow say 10 years later, proposal B may be
preferred which may have lower overall profit but the returns flow is more early and quick.
(iv)Profit maximization as an objective is too narrow. It fails to take into account the social considerations as also the obligations to various
interests of workers, consumers, society, as well as ethical trade practices. If these factors are ignored, a company cannotsurvive
for long. Profit maximization at the cost of social and moral obligations is a short sighted policy.
According to Van Horne, “Value of a firm is represented by the market price of the company's common stock. The market price of a firm's
stock represents the focal judgment of all market participants as to what the value of the particular firm is. It takes into account present
and prospective future earnings per share, the timing and risk of these earnings, the dividend policy of the firm and many other factors that
bear upon the market price of the stock. The market price serves as a performance index or report card of the firm's progress. It
indicates how well management is doing on behalf of stockholders.”

4. Importance of Financial management

Importance of Financial Management cannot be over-emphasized. It is, indeed, the key to successful business operations. Without
proper administration of finance, no business enterprise can reach its full potentials for growth and success. Money is to an enterprise, what
oil is to an engine. Financial management is all about planning investment, funding the investment, monitoring expenses againstbudget
and managing gains from the investments. Financial management means management of all matters related to an organization’s finances.
The best way to demonstrate the importance of good financial management is to describe some of the tasks that it involves:-

 Taking care not to over-invest in fixed assets

 Balancing cash-outflow with cash-inflows
 Ensuring that there is a sufficient level of short-term working capital
 Setting sales revenue targets that will deliver growth
 Increasing gross profit by setting the correct pricing for products or services
 Controlling the level of general and administrative expenses by finding more cost-efficient ways of running the day-to-day
business operations, and
 Tax planning that will minimize the taxes a business has to pay.
5. Scope of Financial management
As an integral part of the overall management, financial management is mainly concerned with acquisition and use of funds by an
organization. Based on financial management guru Ezra Solomon’s concept of financial management, following aspects are taken up in detail
under the study of financial management:
(a) Determination of size of the enterprise and determination of rate of growth.
(b) Determining the composition of assets of the enterprise.
(c) Determining the mix of enterprise’s financing i.e. consideration of level of debt to equity, etc.
(d) Analysis, planning and control of financial affairs of the enterprise.
The scope of financial management has undergone changes over the years. Until the middle of this century, its scope was limited to
procurement of funds under major events in the life of the enterprise such as promotion, expansion, merger, etc. In the modern times,
the financial management includes besides procurement of funds, the three different kinds of decisions as well namely investment,
financing and dividend. All the three types of decisions would be dealt in detail during the course of this chapter.
The given figure depicts the overview of the scope and functions of financial management. It also gives the interrelation between the
market value, financial decisions and risk return trade off. The finance manager, in a bid to maximize shareholders’ wealth, should strive
to maximize returns in relation to the given risk; he should seek courses of actions that avoid unnecessary risks. To ensure maximum
return, funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and properly utilized.
An Overview of Financial Management

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6. Inter-relationship between Investment, Financing and Dividend Decisions:

The finance functions are divided into three major decisions, viz., investment, financing and dividend decisions. It is correct to say that
these decisions are inter-related because the underlying objective of these three decisions is the same, i.e. maximization of
shareholders’ wealth. Since investment, financing and dividend decisions are all interrelated, one has to consider the joint impact of
these decisions on the market price of the company’s shares and these decisions should also be solved jointly. The decision to invest in a
new project needs the finance for the investment. The financing decision, in turn, is influenced by and influences dividend decision
because retained earnings used in internal financing deprive shareholders of their dividends. An efficient financial management can
ensure optimal joint decisions. This is possible by evaluating each decision in relation to its effect on the shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter-relationship and to see how they can help in maximizing
the shareholders’ wealth i.e. market price of the company’s shares.
Investment decision: The investment of long term funds is made after a careful assessment of the various projects through capital
budgeting and uncertainty analysis. However, only that investment proposal is to be accepted which is expected to yield at least so
much return as is adequate to meet its cost of financing. This have an influence on the profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds involves different issues. The finance manager
has to maintain a proper balance between long-term and short-term funds. With the total volume of long-term funds, he has to ensure a proper
mix of loan funds and owner’s funds. The optimum financing mix will increase return to equity shareholders and thus maximizetheir
wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He assists the top
management in deciding as to what portion of the profit should be paid to the shareholders by way of dividends and what portion should be
retained in the business. An optimal dividend pay-out ratio maximizes shareholders’ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are to be taken jointly
keeping in view their joint effect on the shareholders’ wealth.

7. Relationship of Financial management with related disciplines

As an integral part of the overall management, financial management is not a totally independent area. It draws heavily on related
disciplines and areas of study namely economics, accounting, production, marketing and quantitative methods. Even though these
disciplines are inter-related, there are key differences among them. Some of the relationships are being discussed below:

Financial Management and Accounting: The relationship between financial management and accounting are closely related to the
extent that accounting is an important input in financial decision making. In other words, accounting is a necessary input into the
financial management function.
Financial accounting generates information relating to operations of the organization. The outcome of accounting is the financial
statements such as balance sheet, income statement, and the statement of changes in financial position. The information contained in
these statements and reports helps the financial managers in gauging the past performance and future directions of the organization.

Though financial management and accounting are closely related, still they differ in the treatment of funds and also with regards to
decision making. Some of the differences are:-

Treatment of Funds
In accounting, the measurement of funds is based on the accrual principle i.e. revenue is recognized at the point of sale and not when
collected and expenses are recognized when they are incurred rather than when actually paid. The accrual based accounting data do
not reflect fully the financial conditions of the organization. An organization which has earned profit (sales less expenses) may said to
be profitable in the accounting sense but it may not be able to meet its current obligations due to shortage of liquidity as a result of say,
uncollectible receivables. Such an organization will not survive regardless of its levels of profits. Whereas, the treatment of funds, in
financial management is based on cash flows. The revenues are recognized only when cash is actually received (i.e. cash inflow) and
expenses are recognized on actual payment (i.e. cash outflow). This is so because the finance manager is concerned with maintaining
solvency of the organization by providing the cash flows necessary to satisfy its obligations and acquiring and financing the assets
needed to achieve the goals of the organization. Thus, cash flow based returns help financial managers to avoid insolvency and
achieve desired financial goals.
Decision – making
The purpose of accounting is to collect and present financial data on the past, present and future operations of the organization. The
financial manager uses these data for financial decision making. It is not that the financial managers cannot collect data or

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accountants cannot make decisions. But the chief focus of an accountant is to collect data and present the data while the financial
manager’s primary responsibility relates to financial planning, controlling and decision making. Thus, in a way it can be stated that
financial management begins where accounting ends.
Financial Management and Other Related Disciplines: For its day to day decision making process, financial management also
draws on other related disciplines such as marketing, production and quantitative methods apart from accounting. For instance,
financial managers should consider the impact of new product development and promotion plans made in marketing area since their
plans will require capital outlays and have an impact on the projected cash flows. Likewise, changes in the production process may
require capital expenditures which the financial managers must evaluate and finance. Finally, the tools and techniques of analysis
developed in the quantitative methods discipline are helpful in analyzing complex financial management problems.
8. Concept of Time Value of Money
It means money has time value. A rupee today is more valuable than a rupee a year hence. We use rate of interest to express the time value
of money.
9. Reasons for Time value of money
There are three reasons why money can be more valuable today than in the future.
(i) Preference for Present Consumption: Individuals have a preference for current consumption in comparison to future consumption.In
order to forego the present consumption for a future one, they need a strong incentive. Say for example, if the individual’s present
preference is very strong then he has to be offered a very high incentive to forego it like a higher rate of interest and vice versa.
(ii) Inflation: Inflation means when prices of things rise faster than they actually should. When there is inflation, the value of currency
decreases over time. If the inflation is more, then the gap between the value of money today to the value of money in future is more. So,
greater the inflation, greater is the gap and vice versa.
(iii)Risk: Risk of uncertainty in the future lowers the value of money. Say for example, non-receipt of payment, uncertainty of investor’s life
or any other contingency which may result in non-payment or reduction in payment.
Time value of money results from the concept of interest. So it is now time to discuss Interest.
10. Simple Interest
It may be defined as Interest that is calculated as a simple percentage of the original principal amount. Please note the word “Original”.
The formula for calculating simple interest is:

SI = P0 (i) (n) Where,

SI = simple interest in rupees
P0 = original principal
i = interest rate per time period (in decimals)
n = number of time periods
If we add principal to the interest, we will get the total future value (FV) . (Future vale is also known as Terminal Value). For any simple
interest rate, the future value of an account at the end of n period is:-
FVn = P0+ SI = P0 + P0 (i)(n)
11. Compound Interest
If interest is calculated on original principal amount it is simple interest. When interest is calculated on total of previously earned interest
and the original principal it compound interest. Naturally, the amount calculated on the basis of compound interest rate is higher than
when calculated with the simple rate.

Typical conversion periods are given below:

Conversion Period Description
1 day Compounded daily
1 month Compounded monthly
3 months Compounded quarterly
6 months Compounded semiannually
12 months Compounded annually
Thus, the accrued amount FVn on a principal P after n payment periods at i (in decimal) rate of interest per payment period is given by:
FVn = P0 (1 + i) n
Where,
𝐴𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟
i= =
𝑁𝑜.𝑜𝑓 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑘
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𝑟 ) n , when compounding is done k times a year at an annual interest r.

FVn = P0 (1 +
𝑘

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FVn = P0 , where, FVIFi,n is the future value interest factor at i% for n periods equal (1 + i)n .

12. Effective rate of interest

It is the actual equivalent annual rate of interest at which an investment grows in value when interest is credited more often than once a
year. If interest is paid m times in a year it can be found by calculating:
𝑖
Ei = (1 + ) m - 1
𝑚
13. Present value
“Present Value” is the current value of a “Future Amount”. It can also be defined as the amount to be invested today (Present Value) at a
given rate over specified period to equal the “Future Amount”.
If we reverse the flow by saying that we expect a fixed amount after n number of years, and we also know the current prevailing interest
rate, then by discounting the future amount, at the given interest rate, we will get the present value of investment to be made.

Compounding

Present Value Future Value

Discounting

Discounting future amount converts it into present value amount. Similarly, compounding converts present value amount into future
value amount.
Therefore, we can say that the present value of a sum of money to be received at a future date is determined by discounting the future
value at the interest rate that the money could earn over the period. This process is known as Discounting. The figure below shows
graphically how the present value interest factor varies in response to changes in interest rate and time. The present value interest
factor declines as the interest rate rises and as the length of time increases.
PVIFr, n

0 percent
100

6 percent
75

10 percent
50

14 percent
25

Periods
0
2 4 6 8 10 12
Graphic View of Discounting

The present value interest rate or the future value interest rate is known as the discount rate. This discount rate is the rate with which
the present value or the future value is traded off. A higher discount rate will result in a lower value for the amount in the future. This
rate also represents the opportunity cost as it captures the returns that an individual would have made on the next best opportunity.
Since finding present value is simply the reverse of finding Future Value (FV), the formula for Future Value (FV) can be readily
transformed into a Present Value formula. Therefore the P0, the Present Value becomes:-
𝐹𝑉𝑛
P0 =
(1+𝑖)𝑛

Where, FVn = Future value n years hence

i = Rate of interest per annum
n = Number of years for which discounting is done.
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14. Annuity
An annuity is a stream of regular periodic payment made or received for a specified period of time. In an ordinary annuity, payments or
receipts occur at the end of each period.
15. Perpetuity
Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date and continue indefinitely or perpetually. Fixed
coupon payments on permanently invested (irredeemable) sums of money are prime examples of perpetuities.
The formula for evaluating perpetuity is relatively straight forward. Two points which are important to understand in this regard are:
(a) The value of the perpetuity is finite because receipts that are anticipated far in the future have extremely low present value (today's
value of the future cash flows).
(b) Additionally, because the principal is never repaid, there is no present value for the principal.
Therefore the price of perpetuity is simply the coupon amount over the appropriate discount rate or yield.
𝐴
Present value of perpetuity (PV) =
𝑟
Where, A = Annual cash flow
r = Rate of Interest
16. Growth rate
Rate by which future cash flow increases or decreases. However, we should not confuse it with interest rate, which is only used for
discounting the cash flows.
17. Sinking fund
It is the fund created for a specified purpose by way of sequence of periodic payments over a time period at a specified interest rate.
18. Meaning of Cost of Capital
Cost of Capital refers to the discount rate that is used in determining the present value of the estimated future cash proceeds of the
business/new project and eventually deciding whether the business/new project is worth undertaking or now. It is also the minimum
rate of return that a firm must earn on its investment which will maintain the market value of share at its current level. The cost of each source
of capital (Equity Share or Debt) is called specific cost of capital. When these specific costs are combined for all the sources of capital for a
business, then we arrive at overall cost of capital for a business.
19. Weighted average cost of capital (WACC)
WACC (weighted average cost of capital) represents the investors' opportunity cost of taking on the risk of putting money into a
company.
Since every company has a capital structure i.e. what percentage of funds comes from retained earnings, equity shares, preference
shares, debt and bonds, so by taking a weighted average, it can be seen how much cost/interest the company has to pay for every
rupee it borrows/invest. This is the weighted average cost of capital.
The weighted average cost of capital for a firm is of use in two major areas:-
1. In consideration of the firm's position;
2. Evaluation of proposed changes necessitating a change in the firm's capital. Thus, a weighted average technique may be used in a
quasi-marginal way to evaluate a proposed investment project, such as the construction of a new building.
Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure.
That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.
K0 = % D (mkt) (Ki) (1 – t) + (% Psmkt) Kp + (Cs mkt) Ke
Where,
K0 = Overall cost of capital
Ki = Before tax cost of debt
1–t = 1 – Corporate tax rate
Kp = Cost of preference capital
Ke = Cost of equity
% Dmkt = % of debt in capital structure
%Psmkt = % of preference share in capital structure
% Cs = % of equity share in capital structure.
20. Cost of the perpetual debt

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The cost of perpetual debt is the rate of return which the lenders expect from such debt. The coupon rate of interest or market yield on
debt approximately represents the cost of debt.
Another aspect which needs mention regarding the cost of perpetual debt is that effective cost of debt should be computed as after-tax
cost not before tax. The coupon or nominal rate written in the face of the debt document is the before cost of debt. Therefore, adjustment
in the coupon rate is essential to obtain the after tax cost of perpetual debt.

In order to compute the cost of perpetual debt, following types of data is required:
i) Net cash proceeds/inflows from the particular type of debt,
ii)Net cash outflows in terms of amount of periodic interest payment and repayment of principal in installments or lump sum on maturity.
Since the interest paid on debt by a firm is tax deductible, it is essential that the effect cost of the debt is obtained after considering the
tax savings generated as a result of interest payment.
Another important aspect which also needs consideration is that the bonds and debentures can be issued at (i) par, (ii) discount and (iii)
premium. The coupon rate of interest needs adjustment to ascertain the actual cost of debt.
Following two formulas are employed to determine the cost of perpetual debt:
Ki = I
SV
Kd = I (1 – t)
SV
Where,
ki = Before tax cost of debt,
kd = Tax-adjusted cost of debt,
I = Annual interest payment
SV = Sale proceeds of the bond/debenture
t = Tax Rate
21. Floatation cost and Transaction Costs
Floatation cost refers to the cost involved in raising capital from the market, for instance, underwriting, commission, brokerage and other
expenses. The presence of floatation costs affects the balancing nature of internal (retained earnings) and external (dividend payments)
financing. The introduction of floatation costs implies that the net proceeds from the sale of new shares would be less than the face
value of the shares, depending upon their size.

Transaction costs refer to costs associated with the sale of securities by the shareholder investors. In the Modigliani Miller Hypothesis, it
is assumed that if dividends are not paid (or earnings are retained), the investors desirous of current income to meet consumption need
can sell a part of their holdings without incurring any cost, like brokerage and so on. This is obviously an unrealistic assumption. Since
the sale of securities involves cost, to get current income equivalent to the dividend, if paid, the investors would have to sell securities in
excess of income that they will receive.
22. Meaning of Capital Structure
Capital structure refers to the mix of a firm’s capitalization (i.e. mix of long term sources of funds such as debentures, preference share
capital, equity share capital and retained earnings for meeting total capital requirement).
Capital Structure decision refers to deciding the forms of financing (which sources to be tapped), their actual requirements (amount to be
funded) and their relative proportions (mix) in total capitalization.
Normally, a finance manager tries to choose a pattern of capital structure which minimizes cost of capital and maximizes the owners’
return.
23. Fundamental Principles Governing Capital Structure
The fundamental principles are:
i. Cost Principle: According to this principle, an ideal pattern or capital structure is one that minimizes cost of capital structure and
maximizes earnings per share (EPS Risk Principle: According to this principle, reliance is placed more on common equity for
financing capital requirements than excessive use of debt. Use of more and more debt means higher commitment in form of interest payout.
This would lead to erosion of shareholders value in unfavorable business situation.
ii. Control Principle: While designing a capital structure, the finance manager may also keep in mind that existing management control and
ownership remains undisturbed.
iii. Flexibility Principle: It means that the management chooses such a combination of sources of financing which it finds easier to
adjust according to changes in need of funds in future too.
iv. Other Considerations: Besides above principles, other factors such as nature of industry, timing of issue and competition in the
industry should also be considered.
24. Capital Structure Theories
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The following approaches explain the relationship between cost of capital, capital structure and value of the firm:Net income approach
(a) Net operating income approach
(b) Modigliani-Miller approach
(c) Traditional approach.
However, the following assumptions are made to understand this relationship.
 There are only two kinds of funds used by a firm i.e. debt and equity.
 Taxes are not considered.
 The payout ratio is 100%.
 The firm’s total financing remains constant.
 Business risk is constant over time.
 The firm has perpetual life.
(a) Net Income Approach (NI): According to this approach, capital structure decision is relevant to the value of the firm. An increase in
financial leverage will lead to decline in the weighted average cost of capital, while the value of the firm as well as market price of
ordinary share will increase. Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a
consequent decline in the value as well as market price of equity shares.
(b) Net Operating Income Approach (NOI): NOI means earnings before interest and tax. 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 a result, the division between debt and equity is
irrelevant. As per this approach, an increase in the use of debt which is apparently cheaper is offset by an increase in the equity
capitalization rate. This happens because equity investors seek higher compensation as they are opposed to greater risk due to the
existence of fixed return securities in the capital structure.
Assumptions of Net Operating Income (NOI) Theory of Capital Structure:
According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is
independent of the capital structure of the firm.
Assumptions
(a) The corporate income taxes do not exist.
(b) The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not important.
(c) The increase in proportion of debt in capital structure leads to change in risk perception of the shareholders.
(d) The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.
(c) Modigliani-Miller Approach (MM): The NOI approach is definitional or conceptual and lacks behavioral significance. It does not
provide operational justification for irrelevance of capital structure.
However, Modigliani-Miller approach provides behavioral justification for constant overall cost of capital and, therefore, totals value of
the firm.
The approach is based on further additional assumptions like:
 Capital markets are perfect. All information is freely available and there are no transaction costs.
 All investors are rational.
 Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk.
 Non-existence of corporate taxes.

Based on the above assumptions, Modigliani-Miller derived the following three propositions:
(i) Total market value of a firm is equal to its expected net operating income dividend by the discount rate appropriate to its risk class
decided by the market.
(ii) The expected yield on equity is equal to the risk-free rate plus a premium determined as per the following equation: Kc = Ko + (Ko–
Kd) B/S
(iii) Average cost of capital is not affected by financial decision.

(d) Traditional Approach: This approach favors 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.
The principle implication of this approach is that the cost of capital is dependent on the capital structure and there is an optimal capital
structure which minimizes cost of capital.
At the optimal capital structure, the real marginal cost of debt and equity is the same. Before the optimal point, the real marginal cost of debt
is less than real marginal cost of equity and beyond this optimal point the real marginal cost of debt is more than real marginal cost of
equity.
25. Optimum Capital Structure:
Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital structure of a firm. According to
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this, if a company takes on debt, the value of the firm increases up to a certain point. Beyond that value of the firm will start to decrease.If
the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. Therefore,
company should select its appropriate capital structure with due consideration of all factors.

26. Meaning of Capital Structure and its Differentiation from Financial Structure
Capital Structure refers to the combination of debt and equity which a company uses to finance its long-term operations. It is the
permanent financing of the company representing long-term sources of capital i.e. owner’s equity and long-term debts but excludes
current liabilities. On the other hand, Financial Structure is the entire left- hand side of the balance sheet which represents all the long-
term and short-term sources of capital. Thus, capital structure is only a part of financial structure.
27. Trading on equity
The term trading on equity means debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide
debt have a limited share in the firm’s earning and hence want to be protected in terms of earnings and values represented by equity
capital. Since fixed charges do not vary with firms earnings before interest and tax, a magnified effect is produced on earning per share.
Whether the leverage is favorable, in the sense, increase in earnings per share more proportionately to the increased earnings before
interest and tax, depends on the profitability of investment proposal. If the rate of returns on investment exceeds their explicit cost,
financial leverage is said to be positive.

28. Leverage
Leverage means use of source of funds bearing fixed financial payments like debt in capital structure. The term Leverage in general
refers to a relationship between two interrelated variables. In financial analysis it represents the influence of one financial variable over
some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings Before Interest and Tax
(EBIT), Earning per share (EPS) etc.
There are three commonly used measures of leverage in financial analysis.
(i) Operating Leverage
(ii) Financial Leverage
(iii) Combined Leverage

(i) Operating Leverage

Operating leverage (OL) maybe defined as the employment of an asset with a fixed cost in the hope that sufficient revenue will be
generated to cover all the fixed and variable costs.
The use of assets for which a company pays a fixed cost is called operating leverage. Operating leverage is the ratio of net operating
income before fixed charges to net operating income after fixed charges. Degree of operating leverage is equal to the percentage
increase in the net operating income to the percentage increase in the output.
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
DOL = or,
𝐸𝐵𝐼𝑇 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠

(ii) Financial Leverage: Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in order to increase earnings per
share.’ In other words, it is the use of company funds on which it pays a limited return. Financial leverage involves the use of funds
obtained at a fixed cost in the hope of increasing the return to common stockholders.
Degree of financial leverage is the ratio of the percentage increase in earnings per share (EPS) to the percentage increase in earnings before
interest and taxes (EBIT).
DFL = 𝐸𝐵𝐼𝑇
or, (if there is preference capital)
𝐸𝐵𝐼𝑇
𝑃𝑟𝑒𝑓. 𝐷𝑖𝑣.
𝐸𝐵𝑇 𝐸𝐵𝑇−
1−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒

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% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
Or,
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
(iii) Degree of Combined Leverage: Combined leverage maybe defined as the potential use of fixed costs, both operating and financial,
which magnifies the effect of sales volume change on the earning per share of the firm.
Degree of combined leverage (DCL) is the ratio of percentage change in earning per share to the percentage change in sales. It
indicates the effect the sales changes will have on EPS.
Degree of combined leverage =Degree of operating leverage × Degree of financial leverage
DCL =DOL ×DFL
Where,
DCL = Degree of combined leverage
DOL = Degree of operating leverage
DFL = Degree of financial leverage
29. EBIT-EPS Analysis
The basic objective of financial management is to design an appropriate capital structure which can provide the highest earnings per
share (EPS) over the firm’s expected range of earnings before interest and taxes (EBIT).
EPS measures a firm’s performance for the investors. The level of EBIT varies from year to year and represents the success of a firm’s
operations. EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm.
The objective of this analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen.
Financial Break-even and Indifference Analysis
Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial charges i.e. interest and preference
dividends. It denotes the level of EBIT for which the firm’s EPS equals zero.
𝑃𝑟𝑒𝑓.𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Financial BEP = Interest +
1−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
If the EBIT is less than the financial breakeven point, then the EPS will be negative but if the expected level of EBIT is more than the
breakeven point, then more fixed costs financing instruments can be taken in the capital structure, otherwise, equity would be preferred.
EBIT- EPS breakeven analysis is used for determining the appropriate amount of debt a firm might carry.
Another method of considering the impact of various financing alternatives on earnings per share is to prepare the EBIT chart or the
range of Earnings Chart. This chart shows the likely EPS at various probable EBIT levels. Thus, under one particular alternative, EPS
may be ` 2 at a given EBIT level. However, the EPS may go down if another alternative of financing is chosen even though the EBIT
remains at the same level. At a given EBIT, earnings per share under various alternatives of financing may be plotted. A straight line
representing the EPS at various levels of EBIT under the alternative may be drawn. Wherever this line intersects, it is known as break-
even point. This point is a useful guide in formulating the capital structure. This is known as EPS equivalency point or indifference point
since this shows that, between the two given alternatives of financing (i.e., regardless of leverage in the financial plans), EPS would be
the same at the given level of EBIT.
The equivalency or indifference point can also be calculated algebraically in the following manner:
(EBIT –I1 )(1−T) = (EBIT −I2 )(1−T )
E1 E2
Where,
EBIT = Indifference point
E1 = Number of equity shares in Alternative 1
E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
12 = Interest charges in Alternative 2
T = Tax-rate
30. Major considerations in capital structure planning
There are three major considerations, i.e. risk, cost of capital and control, which help the finance manager in determining the proportion in
which he can raise funds from various sources.
Although, three factors, i.e., risk, cost and control determine the capital structure of a particular business undertaking at a given point of time.
Risk: The finance manager attempts to design the capital structure in such a manner, so that risk and cost are the least and the control
of the existing management is diluted to the least extent. However, there are also subsidiary factors also like − marketability of the issue,
maneuverability and flexibility of the capital structure, timing of raising the funds. Risk is of two kinds, i.e. Financial risk and Business
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risk. Here, we are concerned primarily with the financial risk. Financial risk also is of two types:
• Risk of cash insolvency
• Risk of variation in the expected earnings available to equity share-holders

Cost of Capital: Cost is an important consideration in capital structure decisions. It is obvious that a business should be at least capable
of earning enough revenue to meet its cost of capital and finance its growth. Hence, along with a risk as a factor, the finance manager
has to consider the cost aspect carefully while determining the capital structure.

Control: Along with cost and risk factors, the control aspect is also an important consideration in planning the capital structure. When a
company issues further equity shares, it automatically dilutes the controlling interest of the present owners. Similarly, preference
shareholders can have voting rights and thereby affect the composition of the Board of Directors, in case dividends on such shares arenot
paid for two consecutive years.
Financial institutions normally stipulate that they shall have one or more directors on the Boards. Hence, when the management agreesto
raise loans from financial institutions, by implication it agrees to forego a part of its control over the company. It is obvious, therefore, that
decisions concerning capital structure are taken after keeping the control factor in mind.
31. Overcapitalization and its Causes and Consequences
It is a situation where a firm has more capital than it needs or in other words assets are worth less than its issued share capital, and
earnings are insufficient to pay dividend and interest

Causes of Over Capitalization

Over-capitalization arises due to following reasons:
(i) Raising more money through issue of shares or debentures than company can employ profitably.
(ii) Borrowing huge amount at higher rate than rate at which company can earn.
(iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution of dividends at a higher rate.
(v) Wrong estimation of earnings and capitalization.
Consequences of Over-Capitalization
Over-capitalization results in the following consequences:
(i) Considerable reduction in the rate of dividend and interest payments.
(ii) Reduction in the market price of shares.
(iii) Resorting to “window dressing”.
(iv) Some companies may opt for reorganization. However, sometimes the matter gets worse and the company may go into liquidation.
32. Meaning of Portfolio Management
Portfolio management involves selection of securities, continuous buying & selling of securities in the portfolio, to optimize returns with a
view to meet the objective of an investor.
33. Principles of Portfolio management
The following are the two basic principles for effective portfolio management;
i. Effective investment planning for the investment in securities by considering the;
 Fiscal, financial & monetary policies of the government of Nepal & Nepal Rastra Bank.
 Industrial & economic environment and its impact on industry prospects in terms of prospective technology changes, competition in
the market, capacity utilization with industry & demand prospects, etc.
ii. Constant review of investment:
 Assessment of quality of management of the companies in which investment has already been made or composed to be made.
 Financial & trend analysis of company’s balance sheet, P/L a/c.
 Analysis of security market & its trend.
34. Objectives of portfolio management
i. Ensuring safety & security of the principal amount invested.
ii. Earning stable income to facilitate planning.
iii.Attaining capital growth on investment by investing in growth security to earn more than average.
iv. Ensuring investment in liquid securities.
v. Diversify the investment in various securities across various sectors to reduce risk.
vi. Investing judiciously so that investor is given income/capital gain to suit his tax status.
35. Portfolio return: Two-asset case
Under two-asset case, portfolio return is equal to the weighted average of the return of individual assets (securities) in which weights
being equal to the proportion of investments in each asset.
Weighted avg. return = W AR A + W BR B
36. Portfolio risk: Two-asset case
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It means risk associated with assets underlying in portfolio. It is measured in terms of variance or standard deviation.
Standard deviation = √𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒
Std. Dev. = √(𝑆𝐷𝐴 𝑥 𝑊𝐴)2 + (𝑆𝐷𝐵 𝑥 𝑊𝐵)2 + 2 (𝑆𝐷𝐴 𝑥 𝑊𝐴)𝑥(𝑆𝐷𝐵 𝑥 𝑊𝐵)𝑥 𝑟(𝐴, 𝐵)
37. Portfolio management & security analysis
The risk & return of a security is calculated under this chapter of financial management. The return shows the % return on investment in
the form of dividend, interest & capital appreciation during investment period. If there may be varieties of outcome, the risk shows the
deviation from average (mean) return.
𝑃𝑒𝑟𝑖𝑜𝑑 𝑒𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦+𝐷𝑖𝑣.𝑜𝑟 𝐼𝑛𝑡.𝑖𝑛𝑐𝑜𝑚𝑒−𝑃𝑒𝑟𝑖𝑜𝑑 𝑏𝑒𝑔𝑔𝑖𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
% return = x 100%
𝑃𝑒𝑟𝑖𝑜𝑑 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦

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Preference of Investor:
 An investor who prefers security with maximum return ignores its risk counterpart. He is not worried about risk.
 An investor who prefers security with minimum risk ignores its return counterpart.
 An investor who selects a balanced security, his preference is on that security which has lower proportionate risk (CV).
38. Co-variance & Correlation of return of two securities
Co-variance shows the combined deviation for co-movement of two securities whereas correlation shows the interrelation of return
between two securities.
𝐶𝑜−𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡𝑤𝑜 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
Correlation =
𝑆𝐷1 𝑋 𝑆𝐷2
𝑅𝑖𝑠𝑘
Co-variance =
𝑅𝑒𝑡𝑢𝑟𝑛
39. Standard deviation
SD of a security shows the overall risk prevailing in that security. This overall risk has two parts;
i. Systematic risk
ii. Unsystematic risk
The systematic risk affects all securities. It cannot be eliminated altogether. The unsystematic risk is peculiar to the given security. It can
be eliminated by taking suitable actions.
The systematic risk of a security is referred as a Beta Security (β). Beta security is expressed as systematic risk in a security as a
proportion of systematic risk in overall market. The overall systematic risk in market is always assumed as 1. Hence Beta market is
taken as 1 & Beta security is expressed in proportionate term surrounding 1.
𝑆𝐷 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
Beta security (β) = correlation of security with market return (r SM) x
𝑆𝐷 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡

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It is used to find the required return by investor in this security & for this purpose, Capital-assets pricing model (CAPM) is used. The
overall return of security consists of risk free return & risk premium.
Required return = Risk free return + Beta security x Normal market risk premium
RR = RF + β (RM - RF)
It provides the required rate of return of security. It is compared with available rate of return for the security.
(a) If available return is more than required return, then it is beneficial to purchase the security & it is said as underpriced security.
(b) If available return is less than required return, then it results into loss & hence not beneficial to purchase. Such security is said an
overpriced security & it should be sold.
(c) If available return is equal to required return, the security is said fairly priced security. It may be purchased, sold or hold. All actions
provide indifferent position (no profit, no loss).
40. Capital Assets Pricing Model (CAPM)
The CAPM explains the relationship between expected return, non-diversifiable risk & the valuation of security. It considers the required
rate of return of a security on the basis of its contribution to the total risk. It is based on the premises that the diversifiable risk of a
security is estimated when more & more securities are added to the portfolio.
However, the systematic risk can’t be diversified & is correlated with that of the market portfolio. All securities do not have same level of
systematic risk. Therefore, the required rate of return goes with the level of systematic risk. The systematic risk can be measured by
Beta (β).
Under CAPM, the expected return from a security can be expressed as;
RR = RF + β (RM - RF)
The model shows that the expected return of a security consists of the risk free rate of return & risk premium. The CAPM when plotted
on a graph paper is known as Security Market Line (SML).
A major implication of CAPM is that not only every security but all portfolios must be plotted on SML. This implies that in an efficient
market, all securities are expected to yield returns commensurate with their riskiness measured by β.
Assumptions of CAPM:
i. The investor’s objective is to maximize the utility of terminal wealth.
ii. Investors make choice on the basis of risk & return.
iii.Investors have homogenous expectation of risk & return.
iv. Investors have identical time horizon.
v. Information is freely & simultaneously available to investors.
vi. There is a risk free asset & investors can borrow & lend unlimited amounts at the risk free rate.
vii. There is no tax, transactions cost & other restrictions in the market.
viii.Total assets quantity is fixed & all assets are marketable & divisible.
41. Beta
Beta is a measure of investment’s systematic risk. It measures systematic risk associated with an investment in relation to total risk
attached with market portfolio.
A security with β > 1 = Aggressive security
β < 1 = Defensive security
β = 1 = Neutral security
β may be calculated as follows;
𝑆𝐷 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
Beta security (β) = correlation of security with market return (r SM) x
𝑆𝐷 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡
42. Method of performing analysis at Financial Statements
(a) Horizontal analysis

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This technique is also known as “Comparative analysis”. It is conducted by setting consecutive balance sheet, income statement or
statement of cash flow side-by-side & reviewing changes in individual categories on a year to year or multi-year basis. The most
important item revealed by comparative financial statement analysis is “trend”.
A comparison of statements over several years reveals direction, speed & extent of a trend. The horizontal financial statement
analysis is done by restating amount of each item or group of items as a percentage. Such % are calculated by selecting a base
year & assigned a weight of 100 to the amount of each item in the base year statement. Thereafter, the amounts of similar items or groups
of item in prior or subsequent financial statements are expressed as a % of the base year amount.
The horizontal analysis may be prepared to reveal;
 The absolute amount of different items in monetary terms.
 The amount of periodic changes in monetary terms.
 The % of periodic changes to reveal the proportionate change.
(b) Vertical analysis
It represents the relationship of different items of a financial statement with some common item by expressing each item as a % of
the common item.
The procedure of analysis of financial statement under vertical analysis is as under;
i. In Balance sheet:
e.g., the asset as well as the liabilities & equity are each expressed as a 100% & each item in these categories is expressed as a
% of the respective totals.
ii. In the common size Income statement:
Turnover is expressed as 100% & every item in the income statement is expressed as a % of turnover.
From the vertical analysis, an analyst can compare the % mark-up of revenue items & how they have been generated. The
strategy may include increase/decrease of certain expenditure.
43. Ratio analysis
It is defined as the systematic use of ratio to interpret the financial statement so that the strengths & weaknesses of a firm as well as its
historical performance & current financial condition can be determined.
The validation of ratio analysis lies in the fact that it makes related information comparable. A single figure by itself has no meaning but when
expressed in terms of a related figure, it may yield significant information.
44. Types of ratios
The ratios can be classified into following four broad categories:
(i) Liquidity Ratios
(ii) Capital Structure/Leverage Ratios
(iii) Activity Ratios
(iv) Profitability Ratios
i. Liquidity Ratios:
The terms ‘liquidity’ and ‘short-term solvency’ are used synonymously. Liquidity or short-term solvency means ability of the business to
pay its short-term liabilities. Inability to pay-off short-term liabilities affects its credibility as well as its credit rating. Continuous default on
the part of the business leads to commercial bankruptcy. Eventually such commercial bankruptcy may lead to its sickness and
dissolution. Short-term lenders and creditors of a business are very much interested to know its state of liquidity because of their financial
stake.
Traditionally, two ratios are used to highlight the business ‘liquidity’. These are current ratio and quick ratio. Other ratios include cash
ratio, interval measure ratio and net working capital ratio.
Types of Liquidity Ratio:
(a) Current ratio
(b) Quick ratio
(c) Cash ratio/ Absolute liquidity ratio
(d) Basic Defense Interval
(e) Net working capital ratio
(a) Current Ratios: The Current Ratio is one of the best known measures of financial strength. It is the most common measure of short- term
liquidity. It is also referred as the working capital ratio because net working capital is the difference between current assets and current
liabilities.
Current Ratio = Current Assets / Current Liabilities
Where,
Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances +
Receivables/ Accruals + Loans and Advances + Disposable
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Investments
Current Liabilities = Creditors for goods and services + Short-term Loans + Bank
Overdraft + Cash Credit + Outstanding Expenses + Provision
for Taxation + Proposed Dividend + Unclaimed Dividend
A generally acceptable current ratio is 2 to 1.
(b) Quick Ratios: The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity.
Quick Ratio or Acid Test Ratio = Quick Assets/ Current Liabilities Where,
Quick Assets = Current Assets −Inventories
Current Liabilities = As mentioned under Current Ratio.
The Quick Ratio is a much more conservative measure of short- term liquidity than the Current Ratio.
Quick Assets consist of only cash and near cash assets. Inventories are deducted from current assets on the belief that these are not ‘near
cash assets’ and also because in times of financial difficulty inventory may be saleable only at liquidation value. But in a seller’smarket
inventories are also near cash assets.
An acid-test of 1:1 is considered satisfactory unless the majority of “quick assets" are in accounts receivable, and the pattern of accounts
receivable collection lags behind the schedule for paying current liabilities.
(c) Cash Ratio/ Absolute Liquidity Ratio: The cash ratio measures the absolute liquidity of the business. This ratio considers only the
absolute liquidity available with the firm. This ratio is calculated as:
Cash Ratio = Cash + Marketable Securities
Current Liabilities
A subsequent innovation in ratio analysis, the Absolute Liquidity Ratio eliminates any unknowns surrounding receivables. The Absolute
Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities.
(d) Basic Defense Interval
(Cash + Receivables + Marketable Securities)
Basic Defense Interval =
(Operating Expenses + Interest + Income Taxes)/365
If for some reason all the company’s revenues were to suddenly cease, the Basic Defense Interval would help determine the
number of days the company can cover its cash expenses without the aid of additional financing.
(e) Net Working Capital Ratio: Net working capital is more a measure of cash flow than a ratio. The result of this calculation must be a
positive number. It is calculated as shown below:
Net Working Capital Ratio = Current Assets – Current Liabilities (excluding short-term bank borrowing)
Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are often tied to
minimum working capital requirements.
ii. Capital structure/Leverage Ratios
The capital structure/leverage ratios may be defined as those financial ratios which measure the long term stability and structure of the
firm. These ratios indicate the mix of funds provided by owners and lenders and assure the lenders of the long term funds with regard to:
(i) Periodic payment of interest during the period of the loan and
(ii) Repayment of principal amount on maturity.
Therefore leverage ratios are of two types:
(a) Capital structure ratios and
(b) Coverage ratios.
Capital Structure Ratios:
These ratios provide an insight into the financing techniques used by a business and focus, as a consequence, on the long-term
solvency position.
From the balance sheet one can get only the absolute fund employed and its sources, but only capital structure ratios show the relative

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weight of different sources.

Three popularly used capital structure ratios are:
(a) Equity Ratio
Shareholders' Equity
Equity Ratio =
Total Capital Employed
This ratio indicates proportion of owners’ fund to total fund invested in the business. Traditionally, it is believed that higher the
proportion of owners’ fund lower is the degree of risk.
(b) Debt Ratio
Total Debt
Debt Ratio = Capital Employed
Total debt includes short and long term borrowings from financial institutions, debentures/bonds, deferred payment arrangements for
buying capital equipments, bank borrowings, public deposits and any other interest bearing loan. Capital employed includes total debt
and net worth.
This ratio is used to analyze the long-term solvency of a firm.
(c) Debt to Equity Ratio
Total Liabilities
Debt to Equity Ratio = Shareholders' Equity

Note: Sometimes only interest-bearing, long term debt is used instead of total liabilities.
A high ratio here means less protection for creditors. A low ratio, on the other hand, indicates a wider safety cushion (i.e., creditors feel
the owner's funds can help absorb possible losses of income and capital).
This ratio indicates the proportion of debt fund in relation to equity. This ratio is very often referred in capital structure decision as well
as in the legislation dealing with the capital structure decisions (i.e. issue of shares and debentures). Lenders are also very keen to
know this ratio since it shows relative weights of debt and equity.
Debt equity ratio is the indicator of firm’s financial leverage.
According to the traditional school, cost of capital firstly decreases due to the higher dose of leverage, reaches minimum and thereafter
increases, so infinite increase in leverage (i.e. debt-equity ratio) is not possible. Presently, there is no norm for maximum debt-equity
ratio. Lending institutions generally set their own norms considering the capital intensity and other factors.

(d) Debt to Total Assets Ratio: This ratio measures the proportion of total assets financed with debt and, therefore, the extent of
financial leverage.
Debt to Total Assets = Total Liabilities
Total Assets
Coverage Ratios:

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The coverage ratios measure the firm’s ability to service the fixed liabilities. These ratios establish the relationship between fixed claims
and what is normally available out of which these claims are to be paid. The fixed claims consist of:
(i) Interest on loans
(ii) Preference dividend
(iii) Amortization of principal or repayment of the installment of loans or redemption of preference capital on maturity.
The following are important coverage ratios:
(a) Debt Service Coverage Ratio: Lenders are interested in debt service coverage to judge the firm’s ability to pay off current interest
and installments.
Debt Service Coverage Ratio = Earnings available for debt service
Interest +Installments
Earning for debt service = Net profit + Non-cash operating expenses like depreciation
and other amortizations + Non-operating adjustments like
loss on sale of + Fixed assets + Interest on Debt Fund.
(b) Interest Coverage Ratio: This ratio also known as “times interest earned ratio” indicates the firm’s ability to meet interest (and other
fixed-charges) obligations. This ratio is computed as:
EBIT
Interest Coverage Ratio =
Interest
Earnings before interest and taxes are used in the numerator of this ratio because the ability to pay interest is not affected by tax
burden as interest on debt funds is deductible expense.
This ratio indicates the extent to which earnings may fall without causing any embarrassment to the firm regarding the payment of
interest charges.
A high interest coverage ratio means that an enterprise can easily meet its interest obligations even if earnings before interest and
taxes suffer a considerable decline. A lower ratio indicates excessive use of debt or inefficient operations.
(c) Preference Dividend Coverage Ratio: This ratio measures the ability of a firm to pay dividend on preference shares which carry a
stated rate of return. This ratio is computed as:
EAT
Preference Dividend Coverage Ratio =
Preference dividend liability

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Earnings after tax is considered because unlike debt on which interest is charged on the profit of the firm, the preference dividend is
treated as appropriation of profit. This ratio indicates margin of safety available to the preference shareholders. A higher ratio is
desirable from preference shareholders point of view.
(d) Capital Gearing Ratio: In addition to debt-equity ratio, sometimes capital gearing ratio is also calculated to show the proportion of fixed
interest (dividend) bearing capital to funds belonging to equity shareholders.

Capital Gearing Ratio = (Preference Share Capital + Debentures + Long Term Loan)
(Equity Share Capital + Reserves & Surplus − Losses)
For judging long term solvency position, in addition to debt-equity ratio and capital gearing ratio, the following ratios are also used:
Fixed Assets
(i)
Long Term Fund
It is expected that fixed assets and core working capital are to be covered by long term fund.
In various industries the proportion of fixed assets and current assets are different. So there is no uniform standard of this ratio too. But it
should be less than one. If it is more than one, it means short-term fund has been used to finance fixed assets. Very often many
companies resort to such practice during expansion. This may be a temporary arrangement but not a long term remedy.
(ii) Proprietary Ratio = Proprietary Fund
Total Assets
Proprietary fund includes Equity Share Capital + Preference Share Capital + Reserve & Surplus – Fictitious Assets.
Total assets exclude fictitious assets and losses.
iii. Activity Ratios:
The activity ratios are also called the Turnover ratios or Performance ratios.
These ratios are employed to evaluate the efficiency with which the firm manages and utilizes its assets. For this reason, they are often called
‘Asset management ratios’. These ratios usually indicate the frequency of sales with respect to its assets. These assets may be capital
assets or working capital or average inventory.
These ratios are usually calculated with reference to sales/cost of goods sold and are expressed in terms of rate or times. Some of the
important activity ratios are as follows:
(a) Capital Turnover Ratio
Sales
Capital Turnover Ratio = Capital Employed
This ratio indicates the firm’s ability of generating sales per rupee of long term investment. The higher the ratio, the more efficient is the
utilization of owner’s and long-term creditors’ funds.
(b) Fixed Assets Turnover Ratio: It measures the efficiency with which the firm uses its fixed assets.
Fixed Assets Turnover Ratio = Sales
Capital Assets
A high fixed assets turnover ratio indicates efficient utilization of fixed assets in generating sales. A firm whose plant and machinery are
old may show a higher fixed assets turnover ratio than the firm which has purchased them recently.
(c) Total Asset Turnover Ratio: This ratio measures the efficiency with which the firm uses its total assets. This ratio is computed as:
Sales
Total Asset Turnover = Average Total Assets
(d) Working Capital Turnover
Sales
Working Capital Turnover = Working Capital
Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover, and Creditors Turnover.
(i) Inventory Turnover Ratio: This ratio also known as stock turnover ratio establishes the relationship between the cost of goods
sold during the year and average inventory held during the year. It measures the efficiency with which a firm utilizes or manages
its inventory. It is calculated as follows:
Sales
Inventory Turnover Ratio = Average Inventory*

* Average Inventory = Opening Stock +Closing Stock

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2
Very often inventory turnover is calculated with reference to cost of sales instead of sales. In that case inventory turnover will be
calculated as: Cost of Sales
Average Stock
Note: In the case of inventory of raw material the inventory turnover ratio is calculated using the following formula;
Raw Material Consumed
Average Raw Material Stock
This ratio indicates that how fast inventory is used or sold. A high ratio is good from the view point of liquidity and vice versa. A low
ratio would indicate that inventory is not used/ sold/ lost and stays in a shelf or in the warehouse for a long time.
(ii) Debtors’ Turnover Ratio: It is also known as ‘Receivables Turnover’ ratio. In case firm sells goods on credit, the realization of
sales revenue is delayed and the receivables are created. The cash is realised from these receivables later on.
The speed with which these receivables are collected affects the liquidity position of the firm. The debtor’s turnover ratio throws light
on the collection and credit policies of the firm. It measures the efficiency with which management is managing its accounts
receivables. It is calculated as follows:
Sales/Average Accounts Receivable
As account receivables pertain only to credit sales, it is often recommended to compute the debtor’s turnover with reference to
credit sales instead of total sales, the debtor’s turnover would be;
Credit Sales/Average Accounts Receivable
Debtors’ turnover ratio indicates the average collection period. However, the average collection period can be directly calculated as
follows:

Average Collection Period = Average Accounts Receivables

Average Daily Credit Sales
Average Daily Credit Sales = Credit Sales
365
The average collection period measures the average number of days it takes to collect an account receivable. This ratio is also
referred to as the number of days of receivable and the number of day’s sales in receivables.

(iii) Creditors’ Turnover Ratio: This ratio is calculated on the same lines as receivable turnover ratio is calculated. This ratio shows
the velocity of debt payment by the firm. It is calculated as follows:
Creditors Turnover Ratio = Annual Net Credit Purchases
Average Accounts Payable
A low creditor’s turnover ratio reflects liberal credit terms granted by supplies. While a high ratio shows that accounts are settled
rapidly.
Credit Purchases
Average Accounts Payable
Similarly, average payment period can be calculated using:
Average Accounts Payable
Average Daily Credit Purchases
In determining the credit policy, debtor’s turnover and average collection period provide a unique guideline.
The firm can compare what credit period it receives from the suppliers and what it offers to the customers. Also it can compare the
average credit period offered to the customers in the industry to which it belongs.
iv. Profitability Ratios:
The profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflect the final results of business
operations. They are some of the most closely watched and widely quoted ratios. Management attempts to maximize these ratios to
maximize firm value.
The results of the firm can be evaluated in terms of its earnings with reference to a given level of assets or sales or owner’s interest etc.
Therefore, the profitability ratios are broadly classified in four categories:
(i) Profitability ratios required for analysis from owners’ point of view
(ii) Profitability ratios based on assets/investments
(iii) Profitability ratios based on sales of the firm
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(iv) Profitability ratios based on capital market information.

Profitability Ratios Required for Analysis from Owner’s Point of View
(a) Return on Equity (ROE): Return on Equity measures the profitability of equity funds invested in the firm. This ratio reveals how
profitably of the owners’ funds have been utilized by the firm. It also measures the percentage return generated to equity shareholders.
This ratio is computed as:
ROE = Profit after taxes
Net worth
Return on equity is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return
on equity with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdraw cash and
reinvest it elsewhere. Many investors fail to realize, however, that two companies can have the same return on equity, yet one can be a
much better business.
Composition of Return on Equity using the DuPont Model:
There are three components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset
turnover, and the equity multiplier. By examining each input individually, the sources of a company's return on equity can be discovered and
compared to its competitors.
(i) Net Profit Margin: The net profit margin is simply the after-tax profit a company generates for each rupee of revenue. Net profit
margins vary across industries, making it important to compare a potential investment against its competitors. Although the general
rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit
margin in a bid to attract higher sales.
Net profit margin = Net Income ÷ Revenue
Net profit margin is a safety cushion; the lower the margin, the less room for error. A business with 1% margins has no room for flawed
execution. Small miscalculations on management’s part could lead to tremendous losses with little or no warning.
(ii) Asset Turnover: The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated
as follows:
Asset Turnover = Revenue ÷ Assets
The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset
turnover. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-
volume) and determine which one is the more attractive business.
(iii) Equity Multiplier: It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return
on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the
result of debt. The equity multiplier is calculated as follows:
Equity Multiplier = Assets ÷ Shareholders’ Equity.
Calculation of Return on Equity
To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and
equity multiplier.)
Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier)
(b) Earnings per Share: The profitability of a firm from the point of view of ordinary shareholders can be measured in terms of number
of equity shares. This is known as Earnings per share. It is calculated as follows:

Earnings per share (EPS) = Net profit available to equity holders

Number of ordinary shares outstanding
(c) Dividend per Share: Earnings per share as stated above reflect the profitability of a firm per share; it does not reflect how much
profit is paid as dividend and how much is retained by the business. Dividend per share ratio indicates the amount of profit distributed to
shareholders per share. It is calculated as:
Dividend per share = Total profits distributed to equity share holders
Number of equity shares
(d) Price Earnings Ratio: The price earnings ratio indicates the expectation of equity investors about the earnings of the firm. It relates
earnings to market price and is generally taken as a summary measure of growth potential of an investment, risk characteristics,
shareholders orientation, corporate image and degree of liquidity. It is calculated as:
PE Ratio = Market price per share
Earnings per share
(e) Dividend Payout Ratio: This ratio measures the dividend paid in relation to net earnings. It is determined to see to how much extent
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earnings per share have been retained by the management for the business. It is computed as:
Dividend Payout Ratio = Dividend per Equity Share
Earnings per Share
(a) Return on Investment (ROI): ROI is the most important ratio of all. It is the percentage of return on funds invested in the business
by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. It compares
earnings with capital invested in the company. The ROI is calculated as follows:
Return
ROI = Capital Employed × 100
Return Sales
= × × 100
Sales Capital Employed
Return × 100 = Profitability Ratio
Sales
Sales
Capital Employed = Capital Turnover Ratio

So, ROI = Profitability Ratio × Capital Turnover Ratio

ROI can be improved either by improving operating profit ratio or capital turnover or by both.
(b) Return on Capital Employed (ROCE): It is another variation of ROI. The ROCE is calculated as follows:
EBIT
ROCE = Capital Employed × 100
Where,
Capital Employed = Equity Share Capital
+ Reserve and Surplus
+ Pref. Share Capital
+ Debentures and other long term loan
– Misc. expenditure and losses
– Non-trade Investments

Intangible assets (assets which have no physical existence like goodwill, patents and trademarks) should be included in the capital
employed. But no fictitious asset should be included within capital employed.
ROCE should always be higher than the rate at which the company borrows.
Intangible assets (assets which have no physical existence like goodwill, patents and trademarks) should be included in the capital
employed. But no fictitious asset should be included within capital employed.
(c) Return on Assets (ROA): The profitability ratio is measured in terms of relationship between net profits and assets employed to
earn that profit. This ratio measures the profitability of the firm in terms of assets employed in the firm. The ROA may be measured as
follows:

ROA = Net profit after taxes Or

Average total assets
Net profit after taxes
=
Average tangible assets
= Net profit after taxes
Average fixed assets

Profitability Ratios based on Sales of Firm

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(a) Gross Profit Ratio: It measures the percentage of each sale in rupees remaining after payment for the goods sold.
G.P ratio = Gross profit x 100
Sales
This ratio is used to compare departmental profitability or product profitability. If costs are classified suitably into fixed and variable
elements, then instead of Gross Profit Ratio one can also find out P/V ratio.

P/V Ratio = Sales − Variable Cost × 100

Sales
Fixed cost remaining same, higher P/V Ratio lowers the breakeven point.
Operating profit ratio is also calculated to evaluate operating performance of business.
(b) Operating Profit Ratio
Operating profit ratio = Operating profit x 100
Sales
Where,
Operating Profit = Sales – Cost of Sales – Expenses
Operating profit ratio measures the percentage of each sale in rupees that remains after the payment of all costs and expenses except
for interest and taxes. This ratio is followed closely by analysts because it focuses on operating results. Operating profit is often referred
to as earnings before interest and taxes or EBIT.
(c) Net Profit Ratio: It measures overall profitability of the business.

Net Profit Ratio = Net Profit × 100

Sales
Net Profit ratio finds the proportion of revenue that finds its way into profits.
Profitability Ratios based on Capital Market Information
These ratios are called Market ratios. They involve measures that consider the market value of the company’s shares. Frequently share prices
data are punched with the accounting data to generate new set of information. These are (a) Price- Earnings Ratio, (b) Yield, (c) Market
Value/Book Value per share.
(a) Price- Earnings Ratio: It is the most commonly quoted market measure.

Price −Earnings Ratio (P/E Ratio) = Average Share Price

EPS
(Sometimes it is also calculated with reference to closing share price).
P/E Ratio = Closing Share Price
EPS
(c) Yield
Dividend
Yield = Average Share Price ×100
Dividend
or Closing Share Price × 100
This ratio indicates return on investment; this may be on average investment or closing investment. Dividend (%) indicates return on
paid up value of shares. But yield (%) is the indicator of true return in which share capital is taken at its market value.
(c) Market Value/Book Value per Share: It provides evaluation of how investors view the company’s past and future performance.
Market value per share =
Average Share Price
Book value per share Net worth/ Number of Equity Shares
Closing Share Price
Or
Net worth / Number of Equity Shares
This ratio indicates market response of the shareholders’ investment. Undoubtedly, higher the ratios better is the shareholders’
position in terms of return and capital gains.
45. Application of Ratio Analysis in Financial Decision Making
Financial Ratios for Evaluating Performance
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(a) Liquidity Position: With the help of ratio analysis one can draw conclusions regarding liquidity position of a firm. The liquidity
position of a firm would be satisfactory if it is able to meet its obligations when they become due. This ability is reflected in the
liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short-term
loans.
(b) Long-term Solvency: Ratio analysis is equally useful for assessing the long-term financial viability of a firm. This aspect of the
financial position of a borrower is of concern to the long term creditors, security analysts and the present and potential owners of a
business.
The long term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and
operating efficiency.
The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or whether
heavily loaded with debt in which case its solvency is exposed to serious strain.
Similarly, the various profitability ratios would reveal whether or not the firm is able to offer adequate return to its owners
consistent with the risk involved.
(c) Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. The
various activity ratios measure this kind of operational efficiency.
In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets –
total as well as its components.
(d) Overall Profitability: Unlike the outside parties which are interested in one aspect of the financial position of a firm, the
management is constantly concerned about the overall profitability of the enterprise. That is, they are concerned about the ability
of the firm to meet its short-term as well as long-term obligations to its creditors, to ensure a reasonable return to its owners and
secure optimum utilization of the assets of the firm. This is possible if an integrated view is taken and all the ratios are considered
together.
(e) Inter-firm Comparison: Ratio analysis not only throws light on the financial position of a firm but also serves as a stepping stone
to remedial measures. This is made possible due to inter-firm comparison/comparison with industry averages.
A single figure of particular ratio is meaningless unless it is related to some standard or norm. One of the popular techniques is to compare
the ratios of a firm with the industry average. It should be reasonably expected that the performance of a firm should be in broad
conformity with that of the industry to which it belongs.
An inter-firm comparison would demonstrate the relative position vis-a -vis its competitors. If the results are at variance either with the
industry average or with those of the competitors, the firm can seek to identify the probable reasons and, in the light, take
remedial measures.
Ratios not only perform post mortem of operations, but also serve as barometer for future. Ratios have predictory value and they
are very helpful in forecasting and planning the business activities for a future. It helps in budgeting. Conclusions are drawn on the basis
of the analysis obtained by using ratio analysis. The decisions affected may be whether to supply goods on credit to a concern,
whether bank loans will be made available, etc.
(f) Financial Ratios for Budgeting: In this field ratios are able to provide a great deal of assistance, budget is only an estimate of
future activity based on past experience, in the making of which the relationship between different spheres of activities are
invaluable. It is usually possible to estimate budgeted figures using financial ratios.
Ratios also can be made use of for measuring actual performance with budgeted estimates. They indicate directions in which
adjustments should be made either in the budget or in performance to bring them closer to each other.
46. Limitations of Financial Ratios
The limitations of financial ratios are listed below:
(i) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases ratios
calculated on the basis of aggregate data cannot be used for inter-firm comparisons.
(ii) Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such
distortions of financial data are also carried in the financial ratios.
(iii) Seasonal factors may also influence financial data.
(iv) To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.): The business may make
some year-end adjustments. Such window dressing can change the character of financial ratios which would be different had there been
no such change.
(v) Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the

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accounting ratios.
There is no standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are compared with the
industry average. But if a firm desires to be above the average, then industry average becomes a low standard. On the other hand, for a
below average firm, industry averages become too high a standard to achieve.

47. Cash Flow Statement

The cash flow statement is an important planning tool in the hands of management. A cash flow statement is useful for short-
termplnning.
A business enterprise needs sufficient cash to meet its various obligations in the near future such as payment for purchase of fixed
assets, payment of debts maturing in the near future, expenses of the business, etc. A historical analysis of the different sources and
applications of cash will enable the management to make reliable cash flow projections for the immediate future.

48. Definitions:
(a) Cash comprises cash on hand and demand deposits with banks.
(b) Cash equivalents are short term highly liquid investments that are readily convertible into known amounts of cash and which are
subject to an insignificant risk of changes in value.
(c) Cash flows are inflows and outflows of cash and cash equivalents.
(d) Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or
financing activities.
(e) Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
(f) Financing activities are activities that result in changes in the size and composition of the owners’ capital (including preference
share capital in the case of a company) and borrowings of the enterprise.

Presentation of Cash Flow Statement

The cash flow statement should report cash flows during the period classified into following categories:-
a. Operating activities
b. Investing activities
c. Financing activities
Classification by activity provides information that allows users to assess the impact of those activities on the financial position of the
enterprise and the amount of its cash and cash equivalents. This information may also be used to evaluate the relationships among
those activities.
A single transaction may include mix of cash flows that are classified differently. For example, the installment paid in respect of a fixed
asset acquired on deferred payment basis includes both interest and loan, the interest element is classified under financing activities and the
loan element is classified under investing activities.
Operating Activities:
Cash flows from operating activities are primarily derived from the principal revenue- producing activities of the enterprise. Therefore,
they generally result from the transactions and other events that enter into the determination of net profit or loss. Examples of cash flows from
operating activities are:
(a) Cash receipts from the sale of goods and the rendering of services;
(b) Cash receipts from royalties, fees, commissions and other revenue;
(c) Cash payments to suppliers for goods and services;
(d) Cash payments to and on behalf of employees;
(e) Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and other policy benefits;
(f) Cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and
(g) Cash receipts and payments relating to futures contracts, forward contracts, option contracts and swap contracts when the
contracts are held for dealing or trading purposes.

Some Additional Points

Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included in the determination of net profit
or loss. However, the cash flows relating to such transactions are cash flows from investing activities.
An enterprise may hold securities and loans for dealing or trading purposes, in which case they are similar to inventory acquired
specifically for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading securities are classified as

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operating activities. Similarly loans made by financial enterprises are usually classified as operating activities since they relate to the
main revenue-producing activity of that enterprise.
Investing Activities:
The activities of acquisition and disposal of long-term assets and other investments not included in cash equivalents are investing
activities. Separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which
expenditures have been made for resources intended to generate future income and cash flows.
Examples of cash flows arising from investing activities are:
(a) Cash payments to acquire fixed assets (including intangibles). These payments include those relating to capitalized research and
development costs and self-constructed fixed assets;
(b) Cash receipts from disposal of fixed assets (including intangibles);
(c) Cash payments to acquire shares, warrants or debt instruments of other enterprises and interests in joint ventures (other than
payments for those instruments considered to be cash equivalents and those held for dealing or trading purposes);
(d) Cash receipts from disposal of shares, warrants or debt instruments of other enterprises and interests in joint ventures (other than
receipts from those instruments considered to be cash equivalents and those held for dealing or trading purposes);
(e) Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise);
(f) Cash receipts from the repayment of advances and loans made to third parties (other than advances and loans of a financial
enterprise);
(g) Cash payments for futures contracts, forward contracts, option contracts and swap contracts except when the contracts are held
for dealing or trading purposes, or the payments are classified as financing activities; and
(h) Cash receipts from futures contracts, forward contracts, option contacts and swap contracts except when the contracts are held
for dealing or trading purposes or the receipts are classified as financing activities.
When a contract is accounted for as a hedge of an identifiable position, the cash flows of the contract are classified in the same manner
as the cash flows of the position being hedged.
Financing Activities:
Financing activities are those activities which result in change in size and composition of owner’s capital and borrowing of the
organization. The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims
on future cash flows by providers of funds (both capital and borrowings) to the enterprise.
Examples of cash flows arising from financing activities are:
(a) Cash proceeds from issuing shares or other similar instruments;
(b) Cash proceeds from issuing debentures, loans, notes, bonds and other short or long-term borrowings; and
(c) Cash repayments of amounts borrowed.

Methods of preparation of CFS

There are two methods of converting net profit into net cash flows from operating activities-
(i) Direct method, and
(ii) Indirect method.
(i) Direct Method: Under direct method, actual cash receipts (for a period) from operating revenues and actual cash payments (for a period)
for operating expenses are arranged and presented in the cash flow statement. The difference between cash receipts and cash
payments is the net cash flow from operating activities. It is in effect a cash basis Profit and Loss account.
Under direct method, items like depreciation, amortization of intangible assets, preliminary expenses, debenture discount, etc. are
ignored from cash flow statement since the direct method includes only cash transactions and non-cash items are omitted.
Likewise, no adjustment is made for loss or gain on the sale of fixed assets and investments.
(ii) Indirect Method: In this method, the net profit (loss) is used as the base then adjusted for items that affected net profit but did not affect
cash.
Non-cash and non-operating charges in the Profit and Loss account are added back to the net profit while non-cash and non-operating credits
are deducted to calculate operating profit before working capital changes. It is a partial conversion of accrual basis profit to cash basis profit.
Further necessary adjustments are made for increase or decrease in current assets and current liabilities to obtain net cash from operating
activities

49. Definition of Capital Budgeting

Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the goal of investors’ wealth
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maximization. When a business makes a capital investment (assets such as equipment, building, land etc.) it incurs a cash outlay in the
expectation of future benefits. The expected benefits generally extend beyond one year in the future. Out of different investment
proposals available to a business, it has to choose a proposal that provides the best return and the return equals to, or greater than,
that required by the investors.
In simple terms, Capital Budgeting involves:-
 Evaluating investment project proposals that are strategic to business overall objectives;
 Estimating and evaluating post-tax incremental cash flows for each of the investment proposals; and
 Selection an investment proposal that maximizes the return to the investors.
However, Capital Budgeting excludes certain investment decisions, wherein, the benefits of investment proposals cannot be directly
quantified. For example, management may be considering a proposal to build a recreation room for employees. The decision in this
case will be based on qualitative factors, such as management − employee relations, with less consideration on direct financial returns.
However, most investment proposals considered by management will require quantitative estimates of the benefits to be derived from
accepting the project. A bad decision can be detrimental to the value of the organization over a long period of time.

50. Purpose of capital budgeting

The capital budgeting decisions are important, crucial and critical business decisions due to following reasons:
(i) Substantial expenditure: Capital budgeting decisions involves the investment of substantial amount of funds. It is therefore necessary
for a firm to make such decisions after a thoughtful consideration so as to result in the profitable use of its scarce resources. The hasty and
incorrect decisions would not only result into huge losses but may also account for the failure of the firm.
(ii) Long time period: The capital budgeting decision has its effect over a long period of time. These decisions not only affect the future
benefits and costs of the firm but also influence the rate and direction of growth of the firm.
(iii) Irreversibility: Most of the investment decisions are irreversible. Once they are taken, the firm may not be in a position to reverse
them back. This is because, as it is difficult to find a buyer for the second-hand capital items.
(iv) Complex decision: The capital investment decision involves an assessment of future events, which in fact is difficult to predict.
Further it is quite difficult to estimate in quantitative terms all the benefits or the costs relating to a particular investment decision.

51. Capital Budgeting Process

The extent to which the capital budgeting process needs to be formalized and systematic procedures established
depends on the size of the organization; number of projects to be considered; direct financial benefit of each project considered by itself;
the composition of the firm's existing assets and management's desire to change that composition; timing of expenditures associated
with the projects that are finally accepted.
(i) Planning: The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then
enters the planning phase when the potential effect on the firm's fortunes is assessed and the ability of the management of the firm to
exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form
of a proposal to enter the evaluation phase.
(ii) Evaluation: This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal
techniques, ranging from the simple payback method and accounting rate of return to the more sophisticated discounted cash flow
techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision
in the light of prevailing circumstances.
(iii) Selection: Considering the returns and risks associated with the individual projects as well as the cost of capital to the organization,
the organization will choose among projects so as to maximize shareholders’ wealth.
(iv) Implementation: When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and
begin the implementation of the project.
(v) Control: The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure
progress reports, performance reports comparing actual performance against plans set and post completion audits.
(vi) Review: When a project terminates, or even before, the organization should review the entire project to explain its success or
failure. This phase may have implication for firms planning and evaluation procedures. Further, the review may produce ideas for new
proposals to be undertaken in the future.
52. Types of Capital Investment Decisions
There are many ways to classify the capital budgeting decision. Generally capital investment decisions are classified in two ways. One
way is to classify them on the basis of firm’s existence. Another way is to classify them on the basis of decision situation.
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On the basis of firm’s existence: The capital budgeting decisions are taken by both newly incorporated firms as well as by existing
firms. The new firms may be required to take decision in respect of selection of a plant to be installed. The existing firm may be required
to take decisions to meet the requirement of new environment or to face the challenges of competition. These decisions may be
classified as follows:
(i) Replacement and Modernization decisions: The replacement and modernization decisions aim at to improve operating efficiencyand
to reduce cost. Generally all types of plant and machinery require replacement either because of the economic life of the plant or machinery
is over or because it has become technologically outdated. The former decision is known as replacement decisions andlatter is known
as modernization decisions. Both replacement and modernization decisions are called cost reduction decisions.
(ii) Expansion decisions: Existing successful firms may experience growth in demand of their product line. If such firms experience
shortage or delay in the delivery of their products due to inadequate production facilities, they may consider proposal to add capacity
to existing product line.
(iii)Diversification decisions: These decisions require evaluation of proposals to diversify into new product lines, new markets etc. for
reducing the risk of failure by dealing in different products or by operating in several markets. Both expansion and diversification
decisions are called revenue expansion decisions.
On the basis of decision situation: The capital budgeting decisions on the basis of decision situation are classified as follows:
(i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or more alternative proposals are such that the
acceptance of one proposal will exclude the acceptance of the other alternative proposals. For instance, a firm may be considering
proposal to install a semi-automatic or highly automatic machine. If the firm installs a semi-automatic machine it excludes the
acceptance of proposal to install highly automatic machine.
(ii) Accept-reject decisions: The accept-reject decisions occur when proposals are independent and do not compete with each other.
The firm may accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which give a
higher return than certain desired rate of return are accepted and the rest are rejected
(iii)Contingent decisions: The contingent decisions are dependable proposals. The investment in one proposal requires investment in one
or more other proposals. For example, if a company accepts a proposal to set up a factory in remote area it may have to invest in
infrastructure also e.g. building of roads, houses for employees etc.

53. Project Cash Flows

One of the most important tasks in capital budgeting is estimating future cash flows for a project. The final decision we make at the end
of the capital budgeting process is no better than the accuracy of our cash flow estimates. The estimation of costs and benefits are
made with the help of inputs provided by marketing, production, engineering, costing, purchase, taxation, and other departments. The
project cash flow stream consists of cash outflows and cash inflows. The costs are denoted as cash outflows whereas the benefits are denoted
as cash inflows. An investment decision implies the choice of an objective, an appraisal technique and the project’s life. The objective
and technique must be related to definite period of time.

The life of the project may be determined by taking into consideration the following factors:
(i) Technological obsolescence;
(ii) Physical deterioration; and
(iii) A decline in demand for the output of the project.
No matter how good a company's maintenance policy, its technological forecasting ability or its demand forecasting ability, uncertainty
will always be present because of the difficulty in predicting the duration of a project life.
Calculating Cash Flows: It is helpful to place project cash flows into three categories:-
a) Initial Cash Outflow: The initial cash out flow for a project is calculated as follows:-Cost of New Asset(s)
+ Installation/Set-Up Costs
+ (-) Increase (Decrease) in Net Working Capital Level
(e) Net Proceeds from sale of Old Asset (If it is a replacement situation)
+(-) Taxes (tax saving) due to sale of Old Asset (If it is a replacement situation)
= Initial Cash Outflow
b) Interim Incremental Cash Flows: After making the initial cash outflow that is necessary to begin implementing a project, the firm
hopes to benefit from the future cash inflows generated by the project. It is calculated as follows:-
Net increase (decrease) in Operating Revenue
- (+) Net increase (decrease) in Operating Expenses excluding depreciation
= Net change in income before taxes
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- (+) Net increase (decrease) in taxes

= Net change in income after taxes
+(-) Net increase (decrease) in tax depreciation charges
= Incremental net cash flow for the period
c) Terminal-Year Incremental Net Cash Flow: We now pay attention to the Net Cash Flow in the terminal year of the project. For the
purpose of Terminal Year we will first calculate the incremental net cash flow for the period as calculated in point (b) above and
further to it we will make adjustments in order to arrive at Terminal-Year Incremental Net Cash flow as follows:-
Incremental net cash flow for the period
+(-) Final salvage value (disposal costs) of asset
- (+) Taxes (tax saving) due to sale or disposal of asset
+ (-) Decreased (increased) level of Net Working Capital
= Terminal Year incremental net cash flow

54. Basic Principles for Measuring Project Cash Flows

For developing the project cash flows the following principles must be kept in mind:
1. Incremental Principle: The cash flows of a project must be measured in incremental terms. To ascertain a project’s incremental cash
flows, one has to look at what happens to the cash flows of the firm 'with the project and without the project', and not before the project
and after the project as is sometimes done. The difference between the two reflects the incremental cash flows attributable to the
project.
Project cash flows for year t = Cash flow for the firm with the project for year t
- Cash flow for the firm without the project for year t.
2. Long Term Funds Principle: A project may be evaluated from various points of view: total funds point of view, long-term funds point of view,
and equity point of view. The measurement of cash flows as well as the While dividends pose no difficulty as they come only from profit
after taxes, interest needs to be handled properly. Since interest is usually deducted in the process of arriving at profit after tax, an amount
equal to interest (1 − tax rate) should be added back to the figure of profit after tax.
i.e. Profit before interest and tax (1 − tax rate)
= (Profit before tax + interest) (1 − tax rate)
= (Profit before tax) (1 − tax rate) + (interest) (1 − tax rate)
= Profit after tax + interest (1 − tax rate)
Thus, whether the tax rate is applied directly to the profit before interest and tax figure or whether the tax − adjusted interest, which is
simply interest (1 − tax rate), is added to profit after tax, we get the same result.
3. Exclusion of Financing Costs Principle: When cash flows relating to long-term funds are being defined, financing costs of long-term funds
(interest on long-term debt and equity dividend) should be excluded from the analysis. The question arises why? The weighted average
cost of capital used for evaluating the cash flows takes into account the cost of long-term funds. Put differently, the interest and dividend
payments are reflected in the weighted average cost of capital. Hence, if interest on long-term debt and dividend on equity capital are
deducted in defining the cash flows, the cost of long-term funds will be counted twice.
The exclusion of financing costs principle means that:
(i) The interest on long-term debt (or interest) is ignored while computing profits and taxes and;
(ii) The expected dividends are deemed irrelevant in cash flow analysis.
While dividends pose no difficulty as they come only from profit after taxes, interest needs to be handled properly. Since interest is
usually deducted in the process of arriving at profit after tax, an amount equal to interest (1 − tax rate) should be added back to the
figure of profit after tax.
That is,
Profit before interest and tax (1 − tax rate)
= (Profit before tax + interest) (1 − tax rate)
= (Profit before tax) (1 − tax rate) + (interest) (1 − tax rate)
= Profit after tax + interest (1 − tax rate)
Thus, whether the tax rate is applied directly to the profit before interest and tax figure or whether the tax − adjusted interest, which is
simply interest (1 − tax rate), is added to profit after tax, we get the same result.
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4. Post−tax Principle: Tax payments like other payments must be properly deducted in deriving the cash flows. That is, cash flows must
be defined in post-tax terms.
54. Capital Budgeting Techniques
In order to maximize the return to the shareholders of a company, it is important that the best or most profitable investment projects are
selected; as the results for making a bad long-term investment decision can be both financially and strategically devastating, particular care
needs to be taken with investment project selection and evaluation. There are a number of techniques available for appraisal of
investment proposals and can be classified as presented below:

(I) Payback Period: The payback period of an investment is the length of time required for the cumulative total net cash flows from the
investment to equal the total initial cash outlays. At that point in time, the investor has recovered the money invested in the project.
Steps:-
(a) The first steps in calculating the payback period is determining the total initial capital investment and
(b) The second step is calculating/estimating the annual expected after-t ax net cash flows over the useful life of the investment.
1. When the net cash flows are uniform over the useful life of the project, the number of years in the payback period can be calculated
using the following equation:

Payback period = Total initial capital investment

Annual expected after - tax net cash flow

2. When the annual expected after-tax net cash flows are not uniform, the cumulative cash inflow from operations must be calculated for
each year by subtracting cash outlays for operations and taxes from cash inflows and summing the results until the total is equal to the
initial capital investment. For the last year we need to compute the fraction of the year that is needed to complete the total payback.

Advantages
 It is easy to compute.
 It is easy to understand as it provides a quick estimate of the time needed for the organization to recoup the cash invested.
 The length of the payback period can also serve as an estimate of a project’s risk; the longer the payback period, the riskier the
project as long-term predictions are less reliable. In some industries with high obsolescence risk like software industry or in situations where
an organization is short on cash, short payback periods often become the determining factor for investments.
Limitations
 It ignores the time value of money. As long as the payback periods for two projects are the same, the payback period technique
considers them equal as investments, even if one project generates most of its net cash inflows in the early years of the project while
the other project generates most of its net cash inflows in the latter years of the payback period.
 A second limitation of this technique is its failure to consider an investment’s total profitability; it only considers cash flows from the
initiation of the project until it’s payback period and ignores cash flows after the payback period.
 Lastly, use of the payback period technique may cause organizations to place too much emphasis on short payback periods thereby
ignoring the need to invest in long-term projects that would enhance its competitive position.
Some Accountants calculate payback period after discounting the cash flows by a predetermined rate and the payback period so
calculated is called, ‘Discounted payback period’.
(II) Payback Reciprocal: As the name indicates it is the reciprocal of payback period. A major drawback of the payback period
method of capital budgeting is that it does not indicate any cut off period for the purpose of investment decision. It is, however,
argued that the reciprocal of the payback would be a close approximation of the internal rate of return if the life of the project is at
least twice the payback period and the project generates equal amount of the annual cash inflows. In practice, the payback reciprocal
is a helpful tool for quickly estimating the rate of return of a project provided its life is at least twice the payback period.
The payback reciprocal can be calculated as follows:
Average annual cash in flow
Initial investment
(III) Accounting (Book) Rate of Return (ARR): The accounting rate of return of an investment measures the average annual net
income of the project (incremental income) as a percentage of the investment.
Accounting rate of return = Average annual net income
Investment
The numerator is the average annual net income generated by the project over its useful life. The denominator can be either the
initial investment or the average investment over the useful life of the project.
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Some organizations prefer the initial investment because it is objectively determined and is not influenced by either the choice of the
depreciation method or the estimation of the salvage value. Either of these amounts is used in practice but it is important that the
same method be used for all investments under consideration.Advantages
 This technique uses readily available data that is routinely generated for financial reports and does not require any special
procedures to generate data.
 This method may also mirror the method used to evaluate performance on the operating results of an investment and management
performance. Using the same procedure in both decision-making and performance evaluation ensures consistency.
 Lastly, the calculation of the accounting rate of return method considers all net incomes over the entire life of the project and provides
a measure of the investment’s profitability.
Limitations
 The accounting rate of return technique, like the payback period technique, ignores the time value of money and considers the value
of all cash flows to be equal.
 The technique uses accounting numbers that are dependent on the organization’s choice of accounting procedures, and different
accounting procedures, e.g., depreciation methods, can lead to substantially different amounts for an investment’s net income and
book values.
 The method uses net income rather than cash flows; while net income is a useful measure of profitability, the net cash flow is a better
measure of an investment’s performance.
Furthermore, inclusion of only the book value of the invested asset ignores the fact that a project can require commitments of
working.
(IV) Net Present Value Technique (NPV): The net present value technique is a discounted cash flow method that considers the time value
of money in evaluating capital investments. An investment has cash flows throughout its life, and it is assumed that a rupee of cash
flow in the early years of an investment is worth more than a rupee of cash flow in a later year.
The net present value method uses a specified discount rate to bring all subsequent net cash inflows after the initial investment to
their present values (the time of the initial investment or year 0).
Determining Discount Rate
Theoretically, the discount rate or desired rate of return on an investment is the rate of return the firm would have earned by investing
the same funds in the best available alternative investment that has the same risk. Determining the best alternative opportunity available is
difficult in practical terms so rather than using the true opportunity cost, organizations often use an alternative measure for the desired rate
of return. An organization may establish a minimum rate of return that all capital projects must meet; this minimum could be based on an
industry average or the cost of other investment opportunities. Many organizations choose to use the overall cost of capital as the desired rate
of return; the cost of capital is the cost that an organization has incurred in raising funds or expects to incur in raising the funds needed
for an investment.
The net present value of a project is the amount, in current rupees, the investment earns after yielding the desired rate of return in each period.
Net present value = Present value of net cash flow - Total net initial investment The steps to calculating net present value are:-
1. Determine the net cash inflow in each year of the investment
2. Select the desired rate of return
3. Find the discount factor for each year based on the desired rate of return selected
4. Determine the present values of the net cash flows by multiplying the cash flows by the discount factors
5. Total the amounts for all years in the life of the project
6. Lastly subtract the total net initial investment.
Advantages
 NPV method takes into account the time value of money.
 The whole stream of cash flows is considered.
 The net present value can be seen as the addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic
financial objectives.
 The NPV uses the discounted cash flows i.e., expresses cash flows in terms of current rupees. The NPVs of different projects
therefore can be compared. It implies that each project can be evaluated independent of others on its own merit.
Limitations
 It involves difficult calculations.
 The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on
accurate estimation of these two factors which may be quite difficult in practice.
(V) Desirability Factor/Profitability Index/Present Value Index Method (PI): In the above illustration the students may have

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seen how with the help of discounted cash flow technique, the two alternative proposals for capital expenditure can be compared. In certain
cases we have to compare a number of proposals each involving different amounts of cash inflows.
One of the methods of comparing such proposals is to work out what is known as the ‘Desirability factor’, or ‘Profitability index’ or
‘Present Value Index Method ’. In general terms a project is acceptable if its profitability index value is greater than 1.
Mathematically:
The desirability factor is calculated as below:
Sum of discounted cash in flows
Initial cash outlay or Total discounted cash outflow (as the case may)
Advantages
 The method also uses the concept of time value of money and is a better project evaluation technique than NPV.
Limitations
 Profitability index fails as a guide in resolving capital rationing where projects are indivisible.
 Once a single large project with high NPV is selected, possibility of accepting several small projects which together may have higher NPV
than the single project is excluded.
 Also situations may arise where a project with a lower profitability index selected may generate cash flows in such a way that another
project can be taken up one or two years later, the total NPV in such case being more than the one with a project with highest
Profitability Index.
The Profitability Index approach thus cannot be used indiscriminately but all other type of alternatives of projects will have to be
worked out.
(VI) Internal Rate of Return Method (IRR): The internal rate of return method considers the time value of money, the initial cash
investment, and all cash flows from the investment. But unlike the net present value method, the internal rate of return method does
not use the desired rate of return but estimates the discount rate that makes the present value of subsequent net cash flows equal to
the initial investment. This discount rate is called IRR.
IRR Definition: Internal rate of return for an investment proposal is the discount rate that equates the present value of the expected net
cash flows with the initial cash outflow.
This IRR is then compared to a criterion rate of return that can be the organization’s desired rate of return for evaluating capital
investments.
Calculating IRR: The procedures for computing the internal rate of return vary with the pattern of net cash flows over the useful life of an
investment.
Scenario 1: For an investment with uniform cash flows over its life, the following equation is used:
Step 1: Total initial investment = Annual net cash flow x Annuity discount factor of the discount rate for the number of periods of the
investment’s useful life
If A is the annuity discount factor, then

A = Total initial cash disbursements and commitments for the investment Annual
(equal) net cash flows from the investment
Step 2: Once A has been calculated, the discount rate is the interest rate that has the same discount factor as A in the annuity table along the
row for the number of periods of the useful life of the investment. This computed discount rate or the internal rate of return will be
compared to the criterion rate the organization has selected to assess the investment’s desirability.

Scenario 2: When the net cash flows are not uniform over the life of the investment, the determination of the discount rate can involve trial
and error and interpolation between interest rates. It should be noted that there are several spreadsheet programs available for
computing both net present value and internal rate of return that facilitate the capital budgeting process.
i. Acceptance Rule: The use of IRR, as a criterion to accept capital investment decision involves a comparison of IRR with the
required rate of return known as cut off rate. The project should the accepted if IRR is greater than cut-off rate. If IRR is equal to cut
off rate the firm is indifferent. If IRR less than cut off rate the project is rejected.
ii. Internal Rate of Return and Mutually Exclusive Projects: Projects are called mutually exclusive, when the selection of one
precludes the selection of others e.g. in case a company owns a piece of land which can be put to use for either of the two different projects
S or L, then such projects are mutually exclusive to each other i.e. the selection of one project necessarily means the rejection of
the other.
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iii. The Reinvestment Assumption: The Net Present Value technique assumes that all cash flows can be reinvested at the discount
rate used for calculating the NPV. This is a logical assumption since the use of the NPV technique implies that all projects which
provide a higher return than the discounting factor are accepted.
In contrast, IRR technique assumes that all cash flows are reinvested at the projects IRR. This assumption means that projects with heavy
cash flows in the early years will be favored by the IRR method vis-à-vis projects which have got heavy cash flows in the later years. This
implicit reinvestment assumption means that Projects like A, with cash flows concentrated in the earlier years of life will
be preferred by the method relative to Projects such as B.
iv. Projects with Unequal Lives:
v. Multiple Internal Rate of Return: In cases where project cash flows change signs or reverse during the life of a project e.g. an
initial cash outflow is followed by cash inflows and subsequently followed by a major cash outflow, there may be more than one IRR.
In such situations if the cost of capital is less than the two IRR’s, a decision can be made easily, however otherwise the IRR decision
rule may turn out to be misleading as the project should only be invested if the cost of capital is between IRR1 and IRR2.. To understand
the concept of multiple IRR it is necessary to understand the implicit re- investment assumption in both NPV and IRR techniques.

Advantages
 This method makes use of the concept of time value of money.
 All the cash flows in the project are considered.
 IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it with the cost of capital
 IRR technique helps in achieving the objective of minimization of shareholders wealth.
Limitations
 The calculation process is tedious if there are more than one cash outflows interspersed between the cash inflows, there can be
multiple IRR, the interpretation of which is difficult.
 The IRR approach creates a peculiar situation if we compare two projects with different inflow/outflow patterns.
 It is assumed that under this method all the future cash inflows of a proposal are reinvested at a rate equal to the IRR. It is ridiculous
to imagine that the same firm has an ability to reinvest the cash flows at a rate equal to IRR.
 If mutually exclusive projects are considered as investment options which have considerably different cash outlays. A project with a larger
fund commitment but lower IRR contributes more in terms of absolute NPV and increases the shareholders’ wealth. In such situation
decisions based only on IRR criterion may not be correct.

vi. Modified Internal Rate of Return (MIRR)

The MIRR addresses some of these deficiencies e.g., it eliminates multiple IRR rates; it addresses the reinvestment rate issue and
produces results which are consistent with the Net Present Value method.
Under this method, all cash flows, apart from the initial investment, are brought to the terminal value using an appropriate discount
rate (usually the Cost of Capital). This results in a single stream of cash inflow in the terminal year. The MIRR is obtained by
assuming a single outflow in the zeroth year and the terminal cash inflow as mentioned above. The discount rate which equates the present
value of the terminal cash inflow to the zeroth year outflow is called the MIRR.
The decision criterion of MIRR is same as IRR i.e. you accept an investment if MIRR is larger than required rate of return and reject if
it is lower than the required rate of return.
(VII) Comparison of Net Present Value and Internal Rate of Return Methods
Similarity
 Both the net present value and the internal rate of return methods are discounted cash flow methods which mean that they consider
the time value of money.
 Both these techniques consider all cash flows over the expected useful life of the investment.
Differences
 The results of NPV and IRR methods regarding the choice of an asset under certain circumstances are mutually contradictory under
two methods.
 The NPV is expressed in financial values whereas IRR is expressed in percentage terms.
 In the NPV, cash flows are assumed to be reinvested at cost of capital rate whereas in IRR, reinvestment is assumed to be made at
IRR rates.
Under IRR method, a project is selected when IRR is greater than cut-off date, whereas, under NPV method, a project is accepted
with positive NPV.

(VIII) Discounted Payback Period Method: Some accountants prefers to calculate payback period after discounting the cash flow by a
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predetermined rate and the payback period so calculated is called, ‘Discounted payback period’. One of the most popular economic
criteria for evaluating capital projects also is the payback period. Payback period is the time required for cumulative cash inflows to
recover the cash outflows of the project.
The problem with the Payback Period is that it ignores the time value of money. In order to correct this, we can use discounted cash flows
in calculating the payback period.
55. Capital rationing
Rationing is the process hereby the limited funds available are allocated amongst the financially viable projects which are not mutually
exclusive under consideration so as to maximize the wealth of the shareholders. Thus, capital rationing situation is said to exist if:
i. Limited funds are available for investment.
ii. More than one financially viable projected which are not mutually exclusive are under consideration.
In order to invest in all projects with a positive net present value a company must be able to raise funds as and when it needs them: this
is only possible in a perfect capital market. In practice capital markets are not perfect and the capital available for investment is likely to
be limited or rationed. The causes of capital rationing may be external (hard capital rationing) or internal (soft capital rationing).
Soft capital rationing is more common than hard capital rationing. When a company cannot raise external finance even though it wishes
to do so, this may be because providers of debt finance see the company as being too risky. In terms of financial risk, the company's
gearing may be seen as too high, or its interest cover may be seen as too low. From a business risk point of view, lenders may be
uncertain whether a company's future profits will be sufficient to meet increased future interest payments because its trading prospects
are poor, or because they are seen as too variable.
When managers impose restrictions on the funds they are prepared to make available for capital investment, soft capital rationing is said
to occur. One reason for soft capital rationing is that managers may not want to raise new external finance.

For example, they may not wish to raise new debt finance because they believe it would be unwise to commit the company to meeting
future interest payments given the current economic outlook. They may not wish to issue new equity because the finance needed is
insufficient to justify the transaction costs of a new issue, or because they wish to avoid dilution of control.
Another reason for soft capital rationing is that managers may prefer slower organic growth, where they can remain in control of the
growth process, to the sudden growth arising from taking on one or more large investment projects.
A key reason for soft capital rationing is the desire by managers to make capital investments compete for funds, i.e. to create an internal
market for investment funds. This competition for funds is likely to weed out weaker or marginal projects, thereby channeling funds to
more robust investment projects with better chances of success and larger margins of safety, and reducing the risk and uncertainty
associated with capital investment.

56. External Capital Rationing and Internal Capital Rationing

External Capital Rationing mainly occurs on account of the imperfections in capital markets. Imperfections may be caused be
deficiencies in market information or by rigidities of attitude that may hamper the free flow of capital. For example, A Ltd. is a closely held
company. It borrows from the financial institutions as much as it can. It still has investment opportunities, which can be financed by
issuing equity capital. But it doesn't issue shares. The owners- managers do not approve the idea of the public issue of shares because
of the fear of losing control of the business.
Internal capital Rationing is caused by self- imposed restrictions by the management. Various types of constraints may be imposed. e.g., it
may be decided not to obtain additional funds by incurring debt. This may be part of management's conservative financial policy.
Management may fix an arbitrary limit to the amount of funds to be invested by the divisional managers. Sometimes, management may resort
to capital rationing by requiring a minimum rate of return higher than the cost of capital.
57. Distinctions between hire purchase and lease financing
Basis of Hire Purchase Lease Financing
Difference
Ownership It passes to the user (hirer) on The lessor (finance company) is the owner and
payment of last installment. ownership never passes to the lessee.
Down payment 20% - 30% of the cost is paid as There is no down payment in Lease Financing
down payment.
Depreciation Depreciation is charged in books of Depreciation is charged in the books of lessor.
Hirer (User).
Maintenance Cost is borne by the hirer (user). In operating lease it is charged to lessor (seller) and
in case of finance lease it is charged to lessee.
Capitalization It is done in the books of hirer. It is done in the books of leasing company

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Tax Benefits Hirer is allowed to claim depreciation Entire lease rentals are taxable for lessee.
and claim finance charge.
Risk of The risk of obsolescence is born by In operating lease it is born by lessor (seller) and in
Obsolescence hirer. case of finance lease it is borne by lessee.
Reporting The asset is shown in balance sheet The asset is shown in the notes of the financial
of hirer and the installment payable statement.
as a liability.
58. Discuss the need for social cost benefit analysis
Several hundred crores of rupees are committed every year to various public projects. Analysis of such projects has to be done with
reference to social costs and benefits. Since they cannot be expected to yield an adequate commercial return on the funds employed, at least
during the short run.
Social cost benefit analysis is important for the private corporations also who have a moral responsibility to undertake socially desirable
projects.
The need for social cost benefit analysis arises due to the following:
(i) The market prices used to measure costs & benefits in project analysis, may not represent social values due to market imperfections.
(ii) Monetary cost benefit analysis fails to consider the external positive & negative effects of a project.
(iii) Taxes & subsidies are transfer payments & hence irrelevant in national economic profitability analysis.
(iv)The redistribution benefit because of project needs to be captured.
(v) The merit wants are important appraisal criteria for social cost benefit analysis.
59. Significance of Decision Tree Analysis:
Decision may have several implications. It is generally observed that the present investment for future investments decisions. Such
complex investment decisions involve a sequence of decisions over time. It is also argued that since present choices modify future
alternatives, industrial activity cannot be reduced to a single decision and must be viewed as a sequence of decisions extending from
the present time into the future. These sequential decisions are taken on the bases of decision tree analysis. While constructing and
using decision tree, some important steps to be considered are as follows:
(i) Investment proposal should be properly defined.
(ii) Decision alternatives should be clearly clarified.
(iii) The decision tree should be properly graphed indicating the decision points, chances, events and other data.
(iv) The results should be analyzed and the best alternative should be selected.

60. Introduction to W.C. management

Working Capital Management involves managing the balance between firm’s short-term assets and its short-term liabilities. The goal
of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both
maturing short-term debt and upcoming operational expenses. The interaction between current assets and current liabilities is,
therefore, the main theme of the theory of working capital management.
There are many aspects of working capital management which makes it important function of financial management.
 Time: Working capital management requires much of the finance manager’s time.
 Investment: Working capital represents a large portion of the total investment in assets.
 Credibility: Working capital management has great significance for all firms but it is very critical for small firms.
 Growth: The need for working capital is directly related to the firm’s growth.

61. Importance of Working Capital

Management of working capital is an essential task of the finance manager. He has to ensure that the amount of working capital
available with his concern is neither too large nor too small for its requirements.
A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay
huge amount as interest on such funds. If the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity
of working capital may lead to a situation where the firm may not be able to meet its liabilities.
The various studies conducted by the Bureau of Public Enterprises have shown that one of the reasons for the poor performanceof
public sector undertakings in our country has been the large amount of funds locked up in working capital. This results in over
capitalization. Over capitalization implies that a company has too large funds for its requirements, resulting in a low rate of
return, a situation which implies a less than optimal use of resources. A firm, therefore, has to be very careful in estimating its
working capital requirements.
Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure
the survival of the business in the long-term as well. When businesses make investment decisions they must not only consider the
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financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of the additional
current assets that are usually required with any expansion of activity. For e.g.:-
 Increased production leads to holding of additional stocks of raw materials and work-in- progress.
 An increased sale usually means that the level of debtors will increase.
 A general increase in the firm’s scale of operations tends to imply a need for greater levels of working capital.
62. Optimum Working Capital
If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money
quickly. Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the
best indicator of the working capital situation.
It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital.
This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus it is considered that
there is a comfortable liquidity position if liquid current assets are equal to current liabilities.
Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have, for years,
considered the current ratio at ‘two’ and the acid test ratio at ‘one’ as indicators of a good working capital situation. As a thumb rule,
this may be quite adequate.
However, it should be remembered that optimum working capital can be determined only with reference to the particular
circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the sundry debtors are
as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound.
In nutshell, a firm should have adequate working capital to run its business operations. Both excessive as well as inadequate working
capital positions are dangerous.
63. Determinants of Working Capital
Working capital management is concerned with:-
a) Maintaining adequate working capital (management of the level of individual current assets and the current liabilities) &
b) Financing of the working capital.
For the point a) above, a Finance Manager needs to plan and compute the working capital requirement for its business. And once
the requirement has been computed he needs to ensure that it is financed properly. This whole exercise is nothing but Working
Capital Management.
Sound financial and statistical techniques, supported by judgment should be used to predict the quantum of working capital required
at different times. Some of the factors which need to be considered while planning for working capital requirement are:-
 Cash – Identify the cash balance which allows for the business to meet day-to-day expenses, but reduces cash holding
costs.
 Inventory – Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials
and hence increases cash flow; the techniques like Just in Time (JIT) and Economic order quantity (EOQ) are usedfor this.
 Debtors – Identify the appropriate credit policy, i.e., credit terms which will attract customers, such that any impact on
cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa).
The tools like Discounts and allowances are used for this.
 Short-term Financing Options – Inventory is ideally financed by credit granted by the supplier; dependent on the cash
conversion cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash”
through “factoring” in order to finance working capital requirements.
 Nature of Business - For e.g. in a business of restaurant, most of the sales are in Cash. Therefore need for working capital
is very less.
 Market and Demand Conditions - For e.g. if an item’s demand far exceeds its production, the working capital requirement would
be less as investment in finished good inventory would be very less.
 Technology and Manufacturing Policies - For e.g. in some businesses the demand for goods is seasonal, in that case
a business may follow a policy for steady production throughout over the whole year or instead may choose policy of
production only during the demand season.
 Operating Efficiency – A company can reduce the working capital requirement by eliminating waste, improving
coordination etc.
 Price Level Changes – For e.g. rising prices necessitate the use of more funds for maintaining an existing level of activity.
For the same level of current assets, higher cash outlays are required. Therefore the effect of rising prices is that a higher amount
of working capital is required.

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CA ASPIRANTS-ICAN

64. Estimating Working Capital Needs

Operating cycle is one of the most reliable methods of Computation of Working Capital. However, other methods like ratio of sales
and ratio of fixed investment may also be used to determine the Working Capital requirements. These methods are briefly
explained as follows:
(i) Current Assets Holding Period: To estimate working capital needs based on the average holding period of current assets
and relating them to costs based on the company’s experience in the previous year. This method is essentially based on the
Operating Cycle Concept.
(ii) Ratio of Sales: To estimate working capital needs as a ratio of sales on the assumption that current assets change with changes
in sales.
(iii) Ratio of Fixed Investments: To estimate Working Capital requirements as a percentage of fixed investments.
A number of factors will, however, be impacting the choice of method of estimating Working Capital. Factors such as seasonal
fluctuations, accurate sales forecast, investment cost and variability in sales price would generally be considered. The production
cycle and credit and collection policies of the firm will have an impact on Working Capital requirements. Therefore, they should be
given due weightage in projecting Working Capital requirements.
65. Operating or Working Capital Cycle
A useful tool for managing working capital is the operating cycle.
The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of number of days. For
example:
 Accounts receivables are analyzed by the average number of days it takes to collect an account.
 Inventory is analyzed by the average number of days it takes to turn over the sale of a product (from the point it comes in
the store to the point it is converted to cash or an account receivable).
 Accounts payables are analyzed by the average number of days it takes to pay a supplier invoice.
Operating/Working Capital Cycle Definition
Working Capital cycle indicates the length of time between a company’s paying for materials, entering into stock and receiving the
cash from sales of finished goods. It can be determined by adding the number of days required for each stage in the cycle. Most
businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone.
Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or
by externally borrowed funds or by a combination of the two.
In the form of an equation, the operating cycle process can be expressed as follows:
Operating Cycle = R + W + F + D – C
Where,
R = Raw material storage period
W = Work-in-progress holding period
F = Finished goods storage period
D = Debtors collection period
C = Credit period availed
The various components of operating cycle may be calculated as shown below:
Average stock of raw material
(1) Raw material storage period =
Average cost of raw material consumptionper day
Average work - in - progress inventory
(2) Work - in - progress holding period = Average cost of production per day

Average stock of finished goods

(3) Finished goods storage period = Average cost of goods sold per day

Average book debts

(4) Debtors collection period =
Average Credit Sales per day
Average trade creditors
(5) Credit period availed = Average credit purchases per day

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66. Effect of Double Shift Working on Working Capital Requirements
The greatest economy in introducing double shift is the greater use of fixed assets. Though production increases but little or
very marginal funds may be required for additional assets.
But increase in the number of hours of production has an effect on the working capital requirements. Let’s see the impact of
double shift on some of the components of working capital:-
 It is obvious that in double shift working, an increase in stocks will be required as the production rises. However, it isquite
possible that the increase may not be proportionate to the rise in production since the minimum level of stocks may not be very
much higher. Thus, it is quite likely that the level of stocks may not be required to be doubled as the production goes up two-
fold.
 The amount of materials in process will not change due to double shift working since work started in the first shift will be
completed in the second; hence, capital tied up in materials in process will be the same as with single shift working. As such the
cost of work-in-process will not change unless the second shift’s workers are paid at a higher rate.
67. Liquidity versus Profitability Issue in Management of Working Capital
Working capital management entails the control and monitoring of all components of working capital i.e. cash, marketable
securities, debtors, creditors etc. Finance manager has to pay particular attention to the levels of current assets and their
financing. To decide the level of financing of current assets, the risk return trade off must be taken into account. The level of
current assets can be measured by creating a relationship between current assets and fixed assets. A firm may follow a
conservative, aggressive or moderate policy.

A conservative policy means lower return and risk while an aggressive policy produces higher return and risk. The two important
aims of the working capital management are profitability and solvency. A liquid firm has less risk of insolvency i.e. it will hardly
experience a cash shortage or a stock out situation. However, there is a cost associated with maintaining a sound liquidity
position.
So, to have a higher profitability the firm may have to sacrifice solvency and maintain a relatively low level of current assets.

68. Determinants of Dividend Policy

The investor of share of a company expects return on investment. This return is made available in the form of dividend & in the form
of capital appreciation.
There are no. of following factors affecting dividend decision of the company;
(i) Dividend Payout ratio: A certain share of earnings to be distributed as dividend has to be worked out. This involves the decision to
pay out or to retain. The payment of dividends results in the reduction of cash and, therefore, depletion of assets. In order to maintain
the desired level of assets as well as to finance the investment opportunities, the company has to decide upon the payout ratio. D/P
ratio should be determined with two bold objectives – maximizing the wealth of the firms’ owners and providing sufficient funds to
finance growth.

39
 (ii) Stability of Dividends: Generally investors favor a stable dividend policy. The policy should be consistent and there should be a
certain minimum dividend that should be paid regularly. The liability can take any form, namely, constant dividend per share; stable
D/P ratio and constant dividend per share plus something extra. Because this entails – the investor’s desire for current income, it
contains the information content about the profitability or efficient working of the company; creating interest for institutional investor’s
etc.
(iii) Legal, Contractual and Internal Constraints and Restriction: Legal and Contractual requirements have to be followed. All
requirements of Companies Act, SEBI guidelines, capital impairment guidelines, net profit and insolvency etc., have to be kept in mind while
declaring dividend. For example, insolvent firm is prohibited from paying dividends; before paying dividend accumulated losses have to be
set off, however, the dividends can be paid out of current or previous years’ profit. Also there may be some contractual requirements
which are to be honored. Maintenance of certain debt equity ratio may be such requirements. In addition, there may be certain
internal constraints which are unique to the firm concerned. There may be growth prospects, financial requirements, availability of
funds, earning stability and control etc.
(iv) Owner’s Considerations: This may include the tax status of shareholders, their opportunities for investment dilution of ownership etc.
(v) Capital Market Conditions and Inflation: Capital market conditions and rate of inflation also play a dominant role in determining the dividend
policy. The extent to which a firm has access to capital market, also affects the dividend policy. A firm having easy access to capital market
will follow a liberal dividend policy as compared to the firm having limited access. Sometime dividends are paid to keep the firms ‘eligible’
for certain things in the capital market. In inflation, rising prices eat into the value of money of investors which they are receiving as
dividends. Good companies will try to compensate for rate of inflation by paying higher dividends. Replacement decision of the
companies also affects the dividend policy.

69. MM approach
According to MM, the dividend decision of the company does not affect the decision of the investor to invest in share of the
company today at current market price. It is priced at zero period (P0).
Whether the company will pay dividend or skip dividend, the investor will continue to invest in share at current price (P0). His/her
decision will not be changed by dividend decision of the company.
Assumptions:
(i) Shareholders expect annual reward for their investment as they require cash for meeting needs of personal consumption.
(ii) Tax considerations sometimes may be relevant. For example, dividend might be tax free receipt, whereas some part of capital gains
may be taxable.
(iii) Other forms of investment such as bank deposits, bonds etc. fetch cash returns periodically, investors will shun companies which do
not pay appropriate dividend.
(iv) In certain situations, there could be penalties for non-declaration of dividend, e.g. tax on undistributed profits of certain companies.
Under MM approach, we use following formula to calculate current price of the share;
𝑃1+𝐷1
P0 =
1+𝐾𝑒

70. Traditional & Walter Approach to Dividend Policy

According to the traditional position expounded by Graham and Dodd, the stock market places considerably more weight on
dividends than on retained earnings. For them, the stock market is overwhelmingly in favour of liberal dividends as against niggardly
dividends. Their view is expressed quantitatively in the following valuation model:
P = m (D + E/3) Where,
P = Market Price per share
D = Dividend per share
E = Earnings per share m = a Multiplier.
As per this model, in the valuation of shares the weight attached to dividends is equal to four times the weight attached to retained
earnings. In the model prescribed, E is replaced by (D+R) so that
P = m {D + (D+R)/3}
= m (4D/3) + m (R/3)

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 The weights provided by Graham and Dodd are based on their subjective judgments and not derived from objective empirical
analysis. Notwithstanding the subjectivity of these weights, the major contention of the traditional position is that a liberal payout
policy has a favorable impact on stock prices.

Walter model
The formula given by Prof. James E. Walter shows how dividend can be used to maximize the wealth position of equity holders.
He argues that in the long run, share prices reflect only the present value of expected dividends. Retentions influence stock prices
only through their effect on further dividends. It can envisage different possible market prices in different situations and considers internal
rate of return, market capitalization rate and dividend payout ratio in the determination of market value of shares.
Walter Model focuses on two factors which influences Market Price
Dividend Per Share.
Relationship between Internal Rate of Return (IRR) on retained earnings and market expectations (cost of capital).
If IRR > Cost of Capital, Share price can be even higher in spite of low dividend.
Walter further suggests the existence of following 3 types of firms;
i. Growing concern (where r > Ke)
The internal rate of return is more than required rate of return in case of growing concern. In this case, the concern shall not pay
dividend. The dividend payout (D/P) ratio should be 0%. If it follows the D/P ratio 0%, the price per share (P0) will be maximum.
ii. Declining concern (where r < Ke)
In this type of concern, the available internal rate of return from projects is lower than cost of equity.
In this type of concern, the payment of dividend should be kept 100% to have the maximum share price.

iii. Constant concern (where r = Ke)

In this case, the company may keep any dividend payout ratio ranging from 0% to 100%. In all types of D/P ratio, the price per
share will be the same which means the D/P ratio does not affect the share price.
Under Walter model, we use following formula to calculate current price of the share;
𝑟
𝐷+(𝐸−𝐷)𝑥
𝐾𝑒
P0 =
𝐾𝑒

71. Dividend Growth Model

The dividend growth model suggests that the dividend will grow at constant growth rate i.e. uniform growth rate (g) for infinite future.
The investor purchase share from the market at current price (P0). He receives the future cash inflow in the form of dividend for
infinite future.
The investor has some required rate of return from the amount invested in the share which is called required rate of return of investor
(i.e. cost of equity to the company, Ke) & which is used as discount rate to discount the future cash inflows in the form of dividend.
The present value of all cash inflows in future will be equal to the amount which the investor is willing to offer as price of the share.
Hence, the fair current price of the share is equal to the sum of present value of all future inflows which satisfy the required return of
investor.
The following formula is used to find current price of the share under dividend growth model;
𝐷1
P0 =
𝐾𝑒−𝑔

72. Gordon model

The Gordon model is similar to dividend growth model. The price per share is calculated as follows;
𝐸 𝑥 (1−𝑏)
P0 =
𝐾𝑒−(𝑏𝑥𝑟)

73. Yield to call (YTC) and Yield to Maturity (YTM)

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 The Yield to maturity (YTM) or redemption yield of a bond or debentures, is the internal rate of return (IRR, overall interest rate)
earned by an investor who buys the bond or debenture today at the market price, assuming that the bond will be held until maturity,
and that all coupon and principal payments will be made on schedule. Yield to maturity is actually an estimation of future return, as
the rate at which coupon payments can be reinvested at when received is unknown. It enables investors to compare the merits of
different financial instruments.

The Yield to call (YTC) is one of the variants of YTM. It is the rate of return if held up to call. When a bond or debenture is callable
(can be repurchased by the issuer before the maturity), the market looks also to the Yield to call, which is the same calculation of the YTM,
but assumes that the bond will be called, so the cash flow is shortened.

74. Book Building

Book Building is defined as a process undertaken by which a demand for the securities proposed to be issued by a corporate body is
elicited and built up and the price for such securities is assessed for the determination of the quantum of such securities to be issued
by means of a notice, circular, advertisement, document or information memoranda or offer document.

75. Random Walk Theory

Many investment managers and stock analysts believe that the stock market prices can never be predicted because they are not a result
of any underlying factors but are more statistical ups and downs. This hypothesis is known as Random Walk Hypothesis which states that
the behavior of stock market prices is unpredictable and that there is no relationship between the present prices of theshares and
their future prices. Proponents of this hypothesis argue that stock markets prices are independent. A British Statistician,
M.G. Kendell, found that changes in security prices behave as if they are generated by a suitably designed roulette wheel for which each
outcome is statistically independent of the past history. In other words, the fact that there are peaks and troughs in the stock
exchange prices is a mere happening- successive peak and troughs are unconnected. In the layman’s language it may be said that the
prices on the stock exchange behave exactly the way a drunkard would behave while walking in a blind lane, i.e., up and downwith
an unsteady gait going in any directions he likes, bending on one side once and on the other side the second time.

76. Dividend Signaling

According to dividend signaling hypothesis, dividend changes provide an effective way of allowing management to convey believable
information to the market about the firm’s expected future cash flows. By conveying the favorable information in a believable way, the
dividend decision is used to show effect on the value of firm. Firms are careful in announcing their dividend decisions. Most of the
firms follow stable dividends or gradually increasing dividends. Many investors consider dividends as a part of regular income to
meet their expenses. Hence, they prefer a predictable pattern of dividends rather than fluctuating pattern. A fall in the dividend
income may lead to sale of some shares, on the other hand when the dividend income increases, an investor may invest some of the
proceeds as reinvestment in shares, and thus the share price tends to increase. Moreover, the dividend policy of firms, convey a lot
to the investors. Increasing dividends signal better prospects of the company. On the contrary, decreasing dividends signals bad
earning expectations. In addition, stable dividends are signs of stable earnings of the company. On the other hand, varying dividends lead
to uncertainty in the mind of shareholders.

77. Financial restructuring

Financial restructuring is carried out internally in the firm with the consent of its various stakeholders. Financial restructuring is a
suitable mode of restructuring of corporate firms that have incurred accumulated sizable losses for/over a number of years. As a
sequel, the share capital of such firms, in many cases, gets substantially eroded/ lost; in fact, in some cases, accumulated losses
over the years may be more than the share capital, causing negative net worth. Given such a dismal state of financial affairs, a vast
majority of such firms are likely to have a dubious potential for liquidation.
Can some of these firms be revived? Financial restructuring is one of such a measure for the revival of only those firms that hold
promise/prospects for better financial performance in the years to come. To achieve the desired objective, such firms warrant / merit a
restart with a fresh balance sheet, which does not contain past accumulated losses and fictitious assets and shows share capital at
its real / true worth.
78. Distinguish between Money market and Capital Market
The capital market deals in financial assets. Financial Assets comprises of shares, debentures, mutual fund etc. The capital market
is also known as stock market.

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 Stock market and money market are two basic components of financial system. Capital market-deals with long and medium term
instruments of financing while money market deals with short term instruments. Some of the points of distinction between capital
market and money market are as follows:

SN Money Market Capital Market

1. There is no classification between primary market and There is a classification between primary market and
secondary market. secondary market.
2. It deals for funds of short-term requirement. It deals with funds of long-term requirement.
3. Money market instruments include interbank call money, Capital Market instruments are shares and debt
notice money up to three months, commercial paper, 91 instruments.
days treasury bills.
4. Money market participants are banks, financial institution, Capital Market participants include retail investors,
Central Bank and Government. institutional investors like Mutual Funds, Financial
Institution, corporate and banks.

79. Bridge Finance:

Bridge finance refers to loans taken by a company normally from commercial banks for a short period because of pending
disbursement of loans sanctioned by financial institutions. Though it is a of short term nature but since it is an important step in the
facilitation of long term loan, therefore it is being discussed along with the long term sources of funds. Normally, it takes time for
financial institutions to disburse loans to companies. However, once the loans are approved by the term lending institutions,
companies, in order not to lose further time in starting their projects, arrange short term loans from commercial banks.
The bridge loans are repaid/ adjusted out of the term loans as and when disbursed by the concerned institutions. Bridge loans are
normally secured by hypothecating movable assets, personal guarantees and demand promissory notes. Generally, the rate of
interest on bridge finance is higher as compared with that on term loans.

80. Venture Capital Financing

The venture capital financing refers to financing of new high risky venture promoted by qualified entrepreneurs who lack
experience and funds to give shape to their ideas. In broad sense, under venture capital financing venture capitalist make
investment to purchase equity or debt securities from inexperienced entrepreneurs who undertake highly risky ventures with a
potential of success. Some of the characteristics of Venture Capital Funding are:-
 It is basically an equity finance in new companies.
 It can be viewed as a long term investment in growth-oriented small/medium firms.
 Apart from providing funds, the investor also provides support in form of sales strategy, business networking and management
expertise, enabling the growth of the entrepreneur.
Some common methods of venture capital financing are as follows:
(i) Equity financing: The venture capital undertakings generally require funds for a longer period but may not be able to provide
returns to the investors during the initial stages. Therefore, the venture capital finance is generally provided by way of equity share
capital.
(ii) Conditional loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is
paid on such loans. In India venture capital financiers charge royalty ranging between 2 and 15 per cent; actual rate depends on
other factors of the venture such as gestation period, cash flow patterns, risk and other factors of the enterprise. Some Venture
capital financiers give a choice to the enterprise of paying a high rate of interest instead of royalty on sales once it becomes
commercially sound.
(iii) Income note: It is a hybrid security which combines the features of both conventional loan and conditional loan. The entrepreneur has
to pay both interest and royalty on sales but at substantially low rates.
(iv) Participating debenture: Such security carries charges in three phases — in the startup phase no interest is charged, next stage a
low rate of interest is charged up to a particular level of operation, after that, a high rate of interest is required to be paid.

43
 81. Debt Securitization
Securitization is a process in which illiquid assets are pooled into marketable securities that can be sold to investors. The process
leads to the creation of financial instruments that represent ownership interest in, or are secured by a segregated income producing asset
or pool of assets. These assets are generally secured by personal or real property such as automobiles, real estate, or equipment
loans but in some cases are unsecured.

82. Lease financing

Leasing is a general contract between the owner and user of the asset over a specified period of time. The asset is purchased
initially by the lessor (leasing company) and thereafter leased to the user (Lessee Company) which pays a specified rent at periodical
intervals. Thus, leasing is an alternative to the purchase of an asset out of own or borrowed funds. Moreover, lease finance can be
arranged much faster as compared to term loans from financial institutions.

Types of Lease Contracts: Broadly lease contracts can be divided into following two categories:
(a) Operating Lease (b) Finance Lease.
(a) Operating Lease: A lease is classified as an operating lease if it does not secure for the lessor the recovery of capital outlay plus a return
on the funds invested during the lease term. Normally, this is callable lease and is cancelable with proper notice. The term of this type
of lease is shorter than the asset’s economic life. The lessee is obliged to make payment until the lease expiration, which
approaches useful life of the asset.
An operating lease is particularly attractive to companies that continually update or replace equipment and want to use equipment
without ownership, but also want to return equipment at lease end and avoid technological obsolescence.
(b) Financial Lease: In contrast to operating lease, a financial lease is longer term in nature & non-cancellable. In general term financial lease
can be regarded as any leasing arrangement that is to finance the use of equipment for the major parts of its useful life. The lessee
has the right to use the equipment while the lessor retains legal title. It is also called capital lease, as it is nothing but a loan in disguise.
Thus it can be said a contract involving payments over an obligatory period of specified sums sufficient in total to amortize the capital
outlay of the lessor & give some profit.

83. Seed capital assistance

The Seed capital assistance scheme is designed by IDBI for professionally or technically qualified entrepreneurs and/or persons
possessing relevant experience, skills and entrepreneurial traits but lack adequate financial resources. All the projects eligible for
financial assistance from IDBI, directly or indirectly through refinance are eligible under the scheme.

84. Global Depository Receipts (GDRs):

It is a negotiable certificate denominated in US dollars which represents a Non-US company’s publically traded local currency equity shares.
GDRs are created when the local currency shares of an Indian company are delivered to Depository’s local custodian Bankagainst
which the Depository bank issues depository receipts in US dollars. The GDRs may be traded freely in the overseas marketlike any
other dollar-expressed security either on a foreign stock exchange or in the over-the-counter market or among qualified institutional
buyers.

85. Euro Convertible Bond:

Euro Convertible bonds are quasi-debt securities (unsecured) which can be converted into depository receipts or local shares. ECBs
offer the investor an option to convert the bond into equity at a fixed price after the minimum lock in period. The price of equity shares
at the time of conversion will have a premium element. The bonds carry a fixed rate of interest. These are bearer securities and
generally the issue of such bonds may carry two options viz. call option and put option. A call option allows the company to force
conversion if the market price of the shares exceeds a particular percentage of the conversion price. A put option allows the investors
to get his money back before maturity. In the case of ECBs, the payment of interest and the redemption of the bonds will be made by
the issuer company in US dollars. ECBs issues are listed at London or Luxemburg stock exchanges.
86. American Depository Receipts (ADRs):

44
 American Depository Receipts (ADRs) are securities offered by non- US companies who want to list on any of the US exchanges. It is a
derivative instrument. It represents a certain number of company’s shares. These are used by depository bank against a fee income.
ADRs allow US investors to buy shares of these companies without the cost of investing directly in a foreign stock exchange. ADRs are
listed on either NYSE or NASDAQ. It facilitates integration of global capital markets. The company can use the ADR route either to get
international listing or to raise money in international capital market.

87. Deep Discount Bonds vs. Zero Coupon Bonds:

Deep Discount Bonds (DDBs) are in the form of zero interest bonds. These bonds are sold at a discounted value and on maturity face value
is paid to the investors. In such bonds, there is no interest payout during lock-in period.
A zero coupon bond (ZCB) does not carry any interest but it is sold by the issuing company at a discount. The difference between
discounted value and maturing or face value represents the interest to be earned by the investor on such bonds.

88. Concept of Factoring and its Main Advantages:

Factoring involves provision of specialized services relating to credit investigation, sales ledger management purchase and collection
of debts, credit protection as well as provision of finance against receivables and risk bearing. In factoring, accounts receivables are
generally sold to a financial institution (a subsidiary of commercial bank – called “factor”), who charges commission and bears the
credit risks associated with the accounts receivables purchased by it.
Advantages of Factoring
The main advantages of factoring are:
(a) The firm can convert accounts receivables into cash without bothering about repayment.
(b) Factoring ensures a definite pattern of cash inflows.
c) Continuous factoring virtually eliminates the need for the credit department. Factoring is gaining popularity as useful source of
financing short-term funds requirement of business enterprises because of the inherent advantage of flexibility it affords to the
borrowing firm. The seller firm may continue to finance its receivables on a more or less automatic basis. If sales expand or contract it
can vary the financing proportionally.
d) Unlike an unsecured loan, compensating balances are not required in this case. Another advantage consists of relieving the borrowing firm
of substantially credit and collection costs and from a considerable part of cash management.
Recourse and Non-recourse Factoring
A recourse or pure factoring, the factor firm is only involved in the work of collection of the receivables. It does not bear any risk of
default by the debtors. Such a risk will have to be invariably borne by the selling firm. Thus, in case of default by a customer, the
selling firm will have to refund the amount of advance together with charges as per the agreement which was given by the factor to
the selling firm against the receivables. In a non-recourse factoring, the factor firm purchases the receivable of the selling firm by
paying the agreed amount (sales value less commission) to the latter. The payment may be made immediately or after receiving from
the customer buying. The main feature of non-recourse factoring is that the risk of default by the buyer is borne by the factor firm and
the selling firm receives the sales amount. Thus, this type of factoring will result in the purchase of receivable by the factor firm.
In non-recourse factoring, the factor also undertakes the receivables management including evaluation of creditworthiness, thereby also
assessing the risk of bad debts. In this type of factoring, the factor firm will normally insist on discounting the seller’s entire book debts
subject to careful examination of the debtors and their creditworthiness. In such cases, the seller is entitled to sell to other customers
not evaluated as credit-worthy but these sales would obviously be excluded from the services of the nonrecourse factor.
Distinguish between Factoring and Forfaiting
Basis of Difference Factoring Forfaiting
Extent of Finance Usually 80%of the value of the invoice is considered 100% Financing
for advance.
Creditworthiness Factor does the credit rating of the counterparty in The forfeiting bank relies on the
case of a non-recourse factoring transaction. credibility of the availing bank.
Service Provided Day to day administration of sales and other allied No services are provided
services are provided.
Maturity Advances are short-term in nature. Advances are generally medium- term.

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 89. Stock Re-Purchase
Stock repurchase is a method, in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing EPS
and often increasing the price of the stock. Stock repurchase are an alternative to dividends for transmitting cash to stock holders.
Firm may repurchase its own stock, if a firm has excess cash, it may repurchase its own stock leaving fewer shares outstanding and
increasing the earnings per share. The benefits to the shareholder are the same under a cash dividend policy and stock repurchase. Firm
also repurchase their stock if the stock price is low, the market often sees the stock repurchase as a signal to future prosperity. Stock of
being taken over by another firm. Stock repurchases can be made in open market or on tender offers or on negotiation basis.

90. Proxy fight and takeover

Management always solicits stockholders proxies and usually gets them. However if earnings are poor and stockholders are
dissatisfied, an outside group might solicit the proxies in an effort to overthrow management and take control of the business. This is
known as proxy fight.
Takeover is art action whereby a person or group succeeds in ousting a firm’s management and taking control of the company. In
recent years, there are cases, where attempts have been made by one corporation to take over another by purchasing a majority ofthe
outstanding stock.

91. Financial Intermediaries

Financial Intermediaries are the various financial institutions such as pension funds, insurance companies, banks, buildings,
societies, unit trusts and specialist investment institutions. Their role is to accept deposit from personal and corporate savers to lend to
customers via the capital and money markets. They perform vital economic service of:
i. Re-packaging finance: collecting small amounts of finance and re-packaging into larger bundles for specific lending requirements.
ii. Risk-reduction: investing sums, on behalf of individuals and companies into large, well-diversified investment portfolios.
iii. Liquidity transformation: bringing together short term lenders and long term borrowers
iv. Cost reduction and advice: minimizing transaction costs and providing low cost services to lenders and borrowers.
92. Financial distress
Financial distress refers to financial failure. Failure can be defined in several ways, and some failures do not necessarily result in the
collapse and dissolution of the firm. Failure in an economic sense could mean that a firm is losing money-revenues do not cover its costs.
It could mean that its earnings rate is less than its cost of capital. A related definition would be that the present value of cash flows
of the firm is less than its obligations. In still another sense, failure occurs when the firm’s actual cash flows are short of its expected
cash flows-its projections have not been met.
Direct costs of financial distress include the costs of insolvency.
Following are the other direct costs of financial distress:
i. Long period taken in the bankruptcy cases may cause deterioration of the conditions of the company‘s assets.
ii. Liquidation of the assets may be delayed due to conflicting interests of creditors and other stakeholders.
iii.When the assets are sold under distress prices, they may fetch a price that is significantly lower than their current values.
iv. Legal and administrative costs related to the bankruptcy proceedings are generally quite high.
93. Commercial Paper
It is an important money market instrument in advanced countries like USA to raise short term funds. It is a form of unsecured
promissory note issued by firms to raise short term funds. The commercial paper market in the USA is a blue-chip market where
financially sound and highest rated companies are able to issue commercial papers. The buyers of commercial paper include banks,
insurance companies, unit trusts and firms with surplus funds to invest for a short period with minimum risk. Given this objective of
the investors in the commercial paper market, there would be demand for commercial papers of highly creditworthy companies.
94. Leveraged Buyout
It is an ownership transfer consummated primarily with debt. Sometimes it is also called as asset- based financing, the debt is secured
by the assets of the enterprise involved. While some leveraged buyouts involve the acquisition of an entire company, many involve the
purchase of a division of a company or some other subunit. Frequently the sale is to the management of the division being sold, the
company having decided that the division no longer fits its strategic objectives. Another distinct feature is that leveraged buyouts are

46
 cash purchases, as opposed to stock purchases. Finally the business unit involved invariably becomes a privately held as opposed to
a publicly held company.

95. Retention policy and Pay Out policy

The firms resort to different dividend policies according to the situations. The firms deciding to retain the internal accruals and deciding
not to pay dividends are called retention policy. Whereas the firms deciding to pay the dividends are called pay out policy. The higher
retention policy will lead to lower pay out policy and vice-versa.

96. Reason for purchasing its own stock

If a firm has excess cash, it may repurchase its own stock leaving fewer shares outstanding and increasing the earnings per share.
Stock repurchase may be alternative to paying cash dividends. The benefits to the shareholder are the same under a cash dividend
policy and stock repurchase. Firms also repurchase their stock if the stock price is low. The market often sees the stock repurchases
as a signal to future prosperity.
Stock repurchases may be used for employee stock options. Stock repurchases reduces the possibility of being taken over by another firm.
Stock repurchases can be made in open market or on tender offer or on negotiation basis.

97. William J Baumal vs. Miller- Orr Cash Management Model:

According to William J Baumal’s Economic order quantity model optimum cash level is that level of cash where the carryingcosts
and transactions costs are the minimum. The carrying costs refer to the cost of holding cash, namely, the interest foregone on
marketable securities. The transaction costs refer to the cost involved in getting the marketable securities converted into cash.
This happens when the firm falls short of cash and has to sell the securities resulting in clerical, brokerage, registration and other costs.
The optimum cash balance according to this model will be that point where these two costs are equal. The formula for determining
optimum cash balance is:
Where,
2𝑈 𝑥 𝑃
C = √
𝑆
C = Optimum cash balance
U = Annual (monthly) cash disbursements
P = Fixed cost per transaction
S = Opportunity cost of one rupee p.a. (or p.m.)
Miller-Orr cash management model is a net cash flow stochastic model. This model is designed to determine the time and size
of transfers between an investment account and cash account. In this model control limits are set for cash balances. These limits may
consist of h as upper limit, z as the return point, and zero as the lower limit.
When the cash balances reach the upper limit, the transfer of cash equal to h-z is invested in marketable securities account. When
it touches the lower limit, a transfer from marketable securities account to cash account is made. During the period when cash
balance stays between (h,z) and (z, o ) i.e high and low limits no transactions between cash and marketable securities account is
made. The high and low limits of cash balance are set up on the basis of fixed cost associated with the securities transactions, the
opportunity cost of holding cash and the degree of likely fluctuations in cash balances. These limits satisfy the demands for cash
at the lowest possible total costs.

98. Miller – Orr Cash Management Model

According to this model the net cash flow is completely stochastic. When changes in cash balance occur randomly,
the application of control theory serves a useful purpose. The Miller–Orr model is one of such control limit models. This
model is designed to determine the time and size of transfers between an investment account and cash account. In this
model control limits are set for cash balances. These limits may consist of ‘h’ as upper limit, ‘z’ as the return point and
zero as the lower limit

47
 When the cash balance reaches the upper limit, the transfer of cash equal to ‘h – z’ is invested in marketable securitiesaccount.
When it touches the lower limit, a transfer from marketable securities account to cash account is made. During the period
when cash balance stays between (h, z) and (z, 0) i.e. high and low limits, no transactions between cash and marketable securities
account is made. The high and low limits of cash balance are set up on the basis of fixed cost associated with the securities
transaction, the opportunities cost of holding cash and degree of likely fluctuations in cash balances. These limits
satisfy the demands for cash at the lowest possible total costs.

99. Advantages of Electronic Cash Management System

(i) Significant saving in time.
(ii) Decrease in interest costs.
(iii) Less paper work
(iv) Greater accounting accuracy.
(v) More control over time and funds.
(vi) Supports electronic payments.
(vii) Faster transfer of funds from one location to another, where required.
(viii)Speedy conversion of various instruments into cash.
(ix) Making available funds wherever required, whenever required.
(x) Reduction in the amount of ‘idle float’ to the maximum possible extent.
(xi) Ensures no idle funds are placed at any place in the organization.
(xii) It makes inter-bank balancing of funds much easier.
(xiii)It is a true form of centralized ‘Cash Management’.
(xiv) Produces faster electronic reconciliation.
(xv) Allows for detection of book-keeping errors
(xvi) Reduces the number of cheques issued.

100. Functions of Treasury department

The functions of treasury department management is to ensure proper usage, storage and risk management of liquid funds
so as to ensure that the organization is able to meet its obligations, collect its receivables and also maximize the
return on its investments. Towards this end the treasury function may be divided into the following:
(i) Cash Management: The efficient collection and payment of cash both inside the organization and to third parties
is the function of treasury department. Treasury normally manages surplus funds in an investment portfolio.
(ii) Currency Management: The treasury department manages the foreign currency risk exposure of the company. It advises
on the currency to be used when invoicing overseas sales. It also manages any net exchange exposures in accordance
with the company policy.

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(iii) Fund Management: Treasury department is responsible for planning and sourcing the company’s short, medium and long-term
cash needs. It also participates in the decision on capital structure and forecasts future interest and foreign currency rates.
(iv) Banking: Since short-term finance can come in the form of bank loans or through the sale of commercial paper in
the money market, therefore, treasury department carries out negotiations with bankers and acts as the initial point of
contact with them.
(v) Corporate Finance: Treasury department is involved with both acquisition and disinvestment activities within
the group. In addition, it is often responsible for investor relations.

101. Virtual Banking and its Advantages

Virtual banking refers to the provision of banking and related services through the use of information technology
without direct recourse to the bank by the customer.
The advantages of virtual banking services are as follows:
 Lower cost of handling a transaction.
 The increased speed of response to customer requirements.
 The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.
 Virtual banking allows the possibility of improved and a range of services being made available to the customer
rapidly, accurately and at his convenience.

102. Management of Marketable Securities is an Integral Part of Investment of Cash

Management of marketable securities is an integral part of investment of cash as it serves both the purposes of liquidity
and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating, it is possible
to invest excess funds in some short term securities, which can be liquidated when need for cash is felt. The selection of
securities should be guided by three principles namely safety, maturity and marketability.

103. Lock Box System:

Another means to accelerate the flow of funds is a lock box system. The purpose of lock box system is to eliminate the
time between the receipts of remittances by the company and deposited in the bank. A lock box arrangement
usually is on regional basis which a company chooses according to its billing patterns.

104. Four Kinds of Float with reference to Management of Cash

The four kinds of float are:
(i) Billing Float: The time between the sale and the mailing of the invoice is the billing float.
(ii) Mail Float: This is the time when a cheque is being processed by post office, messenger service or othermeans
of delivery.
(iii) Cheque processing float: This is the time required for the seller to sort, record and deposit the cheque
after it has been received by the company.
(iv) Bank processing float: This is the time from the deposit of the cheque to the crediting of funds in the seller’s
account.
105. Forms of Bank Credit
The various forms of bank credit in financing the working capital of a business organization are:
(a) Cash credit
(b) Bank overdraft
(c) Bills discounting
(d) Bill acceptance
(e) Line of credit
(f) Letter of credit and
(g) Bank guarantees
106. Forms of Bank Credit

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 Some of the forms of bank credit are:
(i) Short Term Loans: In a loan account, the entire advance is disbursed at one time either in cash or by transfer to the
current account of the borrower. It is a single advance and given against securities like shares, government securities,
life insurance policies and fixed deposit receipts, etc.
(ii) Overdraft: Under this facility, customers are allowed to withdraw in excess of credit balance standing intheir
Current Account. A fixed limit is therefore granted to the borrower within which the borrower is allowed to overdraw
his account.
(iii) Clean Overdrafts: Request for clean advances are entertained only from parties which are financially sound and
reputed for their integrity. The bank has to rely upon the personal security of the borrowers.
(iv) Cash Credits: Cash Credit is an arrangement under which a customer is allowed an advance up to certain limit against
credit granted by bank. Interest is not charged on the full amount of the advance but on the amount actually availed
of by him.
(v) Advances against goods: Goods are charged to the bank either by way of pledge or by way of hypothecation. Goods
include all forms of movables which are offered to the bank as security.
(vi) Bills Purchased/Discounted: These advances are allowed against the security of bills which may be clean or
documentary.
Usance bills maturing at a future date or sight are discounted by the banks for approved parties. The borrower is paid
the present worth and the bank collects the full amount on maturity.
(vii) Advance against documents of title to goods: A document becomes a document of title to goods when its
possession is recognized by law or business custom as possession of the goods like bill of lading, dock warehouse
keeper's certificate, railway receipt, etc. An advance against the pledge of such documents is an advance against the
pledge of goods themselves.
(viii) Advance against supply of bills: Advances against bills for supply of goods to government or semi-government
departments against firm orders after acceptance of tender fall under this category. It is this debt that is assigned
to the bank by endorsement of supply bills and executing irrevocable power of attorney in favor of the banks for
receiving the amount of supply bills from the Government departments.
107. Concentration Banking: In concentration banking the company establishes a number of strategic collection centers in different
regions instead of a single collection center at the head office. This system reduces the period between the time a
customer mails in his remittances and the time when they become spendable funds with the company. Payments received
by the different collection centers are deposited with their respective local banks which in turn transfer all surplus funds
to the concentration bank of head office.

108. Different Types of Packing Credit

Packing credit may be of the following types:
(i) Clean Packing credit: This is an advance made available to an exporter only on production of a firm export order
or a letter of credit without exercising any charge or control over raw material or finished goods. It is a clean type of
export advance. Each proposal is weighted according to particular requirements of the trade and credit
worthiness of the exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee Corporation
(ECGC) cover should be obtained by the bank.
(ii) Packing credit against hypothecation of goods: Export finance is made available on certain terms and conditions where
the exporter has pledgeable interest and the goods are hypothecated to the bank as security with stipulated margin.
At the time of utilizing the advance, the exporter is required to submit along with the firm export order orletter of
credit, relative stock statements and thereafter continue submitting them every fortnight and whenever there is any
movement in stocks.
(iii) Packing credit against pledge of goods: Export finance is made available on certain terms and conditions where
the exportable finished goods are pledged to the banks with approved clearing agents who will ship the same from
time to time as required by the exporter. The possession of the goods so pledged lies with the bank and is kept under
its lock and key.
(iv) E.C.G.C. guarantee: Any loan given to an exporter for the manufacture, processing, purchasing, or packing of goods
meant for export against a firm order qualifies for the packing credit guarantee issued by Export Credit Guarantee
Corporation.

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 (v) Forward exchange contract: Another requirement of packing credit facility is that if the export bill is to be drawn in
a foreign currency, the exporter should enter into a forward exchange contact with the bank, thereby avoiding risk
involved in a possible change in the rate of exchange.
109. Revolving credit agreement
A revolving credit agreement is a formal commitment by a bank to lend up to a certain amount of money to a company over
a specified period of time. This type of debt is for a short term, usually up to 3 months. The company may, however, renew
or borrow additional amount up to the limit of agreement throughout the duration of the commitment. Although commitment
can be obtained for a shorter period as well, most revolving credit commitments are provided for 3 years. The interest term
of the revolving credit agreements are similar to but slightly higher (usually between 0.25 to 0.50 per cent higher) than the
rate at which a firm can borrow on a short term basis under a line of credit. The banks generally charge commitment fee
usually around 0.5 percent per annum on the difference between the amount borrowed and the maximum limit amount.
This type of borrowing arrangement is very useful at times when the firm is not certain about its fund requirements. The
borrowing company will have flexibility in the access to funds at the time of uncertainty and can make more definite credit
arrangement when the situation of uncertainty is resolved.
110. Discrete Probability Distribution and Continuous Probability Distribution
In case of ‘Discrete Probability Distribution’ the number of possible outcome is limited or finite. Suppose, if we assume that
there will be only three states of economy; recession, normal or boom, this will be the example of discrete probability
distribution. In other hand, if we assume that there will be unlimited or infinite number of possible outcomes that will be the
case of continuous probability distribution. With continuous distribution, it is more appropriate to ask what the probability is of
obtaining at least some specified rate of return than to ask what the probability is of exactly that rate.

111. Asset Beta Vs. Equity Beta

Assets of a leveraged firm are financed by debt and equity. Therefore, the assets beta should be the weighted average of the
equity beta and the debt beta. For an unlevered (all equity) firm, the asset beta and the equity beta would be the same. Debt
is less risky than equity. Hence the beta of debt will be lower than the equity beta. In case of the risk free debt, beta will be
zero. For a levered firm, the proportion of equity will be less than 1. Therefore, the beta of asset will be less than the beta of equity.
There is also a linear relationship between the equity beta and the financial leverage. As the financial leverage increases,
the equity beta also increases. The equity beta is equal to the asset beta if debt is zero.
112. Business Risk and Financial Risk
Business Risk is defined as the uncertainty inherent in projections of future Return on Assets (ROA), or of Returns on Equity
(ROE) if the firm uses no debt. Business risk is the single most important determinant of capital structure. Business risk
varies from one industry to another and also among firms in given industry.
Financial risk is the additional risk placed on the common stockholders as a result of using financial leverage, which results when
a firm uses fixed income securities (debt and preferred stock) to raise capital. Thus, it is the portion of stockholders‟ risk, over
and above basic business risk, resulting from the manner in which the firm is financed.
113. Risk aversion Vs. Risk diversification
Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with
more certain, but possibly lower, expected payoff. For example, a risk-averse investor might choose to put his or her money
into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high returns, but also has a
chance of becoming worthless. An investor is said to be risk averse if he prefers less risk to more risk, all else being equal.
Risk diversification refers to minimization of risk which an investor may choose by investing in various types of securities.
An investor may not want to concentrate his investment in a single risky security, as a result of which he may choose to
invest in various other securities to minimize his level of risk and harmonize his returns.
114. Investment bankers Vs. Mortgage bankers
Investment bankers are middlemen who are involved in the sale of stocks and bonds. When a company decides to raise
funds, an investment bank comes up with the proposal to buy the issue at wholesale and then go to sell the same to
investors at retail. Being in the business of matching users of funds with suppliers, investment bankers can sell issues more
efficiently than the issuing company. For the services provided, they receive fee as the difference between the amounts
received from the sale of securities to the public and the amount paid to the companies.

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 Mortgage bankers are involved in acquiring and placing mortgages. The mortgages to the mortgage bankers come through
the individuals, businesses and builders and real estate agents. These bankers do not hold mortgages in their own portfolios
for a long time. They usually service these for the ultimate investors. They receive fees from the ultimate investor for the
services provided to them.
115. Horizontal merger Vs. Vertical merger
Horizontal merger takes place when two or more corporate firms dealing in similar lines of activity combine together.
Elimination or reduction in competition, putting an end to price cutting, economies of scale in production, research and
development, marketing and management are often cited motives underlying such mergers.
Vertical merger occurs when a firm acquires firms upstream from it and/ or firms downstream from it. In the case of an
upstream merger, it extends to the suppliers of raw materials, and to those firms that sell eventually to the consumer in the
event of a downstream merger. Thus the combination involves two or more stages of production or distribution that are
usually separate. Lower buying cost of materials, lower distribution costs, assured supplies and market, increasing or
creating barriers to entry for potential competitors or placing them at a cost disadvantage are the chief gains accruing from
such mergers.
116. Operating breakeven point Vs. Financial breakeven point
The operating breakeven point is defined as the units of output at which total revenues are equal to total operating costs
(fixed costs plus variable costs). The operating breakeven point is calculated as follows:
Operating BEP = Fixed Cost/ Contribution Margin.
Financial breakeven point is the situation where EBIT equals to financing cost. In this analysis, the firms needs to just cover
all of its financing costs and produce earnings per share equal to zero. Financial Breakeven analysis can be used to help
determine the impact of the firm's financing mix on the earnings available to common stockholders.
117. Annuities and Annuities Due
The term annuity refers to any terminating stream of fixed payments over a specified period of time. This usage is most
commonly seen in discussions of finance, usually in connection with the valuation of the stream of payments, taking into
account time value of money concepts, such as interest rate and future value. Examples of annuities are regular deposits to a
savings account, monthly home mortgage payments, and monthly insurance payments. Annuities are classified by the
frequency of payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other
interval of time. An annuity-due is an annuity whose payments are made at the beginning of each period. Deposits in
savings, rent or lease payments, and insurance premiums are examples of annuities due.
118. Information Asymmetry
Information asymmetry deals with the study of decisions in transactions where one party has more or better information than
the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind
of market failure in the worst case. Examples of this problem are adverse selection, moral hazard, and information monopoly. Most
commonly, information asymmetries are studied in the context of principal-agent problems. Information asymmetry causes
misinforming and is essential in every communication process.
Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other(s)
do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or
effectively retaliate for breaches of, certain parts of an agreement whereas the other(s) cannot.
119. Over the counter (OTC) market
Over-the-counter market functions as part of the secondary market for stocks and bonds not listed on a stock exchange. The
market is composed of brokers and dealers who stand ready to buy and sell securities at quoted prices. Most corporate
bonds and a growing number of stocks are traded over-the-counter instead of being traded on an organized exchange.
The OTC market these days has become highly mechanized with market participants linked together by a telecommunication
network. Unlike the organized exchange, the participants of a OTC market do not come together in a single place. A network
is maintained and price quotations are made instantaneously. In the past, most companies preferred to list their shares on
major exchanges as a matter of prestige and necessity. This has undergone change due to the rapid development in the field
of electronics.
120. The Risk- Return Trade Off

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 This principle steps that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with
low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns. According to
the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost.
Because of the risk-return trade off, you must be aware of your personal risk tolerance when choosing investments for your
portfolio. Taking on some risk is the price of achieving returns; therefore, if you want to make money, you can't cut out all
risk. The goal instead is to find an appropriate balance - one that generates some profit, but still allows you to sleep at night.
121. Capital Planning Vs. Capital Rationing
A proper plan for a company's capital expenditures is called Capital Planning. Capital expenditures are payments made over a
period of more than one year. They are used to acquire assets or improve the useful life of existing assets; an example of a capital
expenditure is the funding to construct a factory. Making a capital budget must account for the potential profitability of the plans
involved. Calculating the net present value or the internal rate of return are two methods for determining a capital budget.
The act of placing restrictions on the amount of new investments or projects undertaken by a company is called Capital
Rationing. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on
the specific sections of the budget. Companies may want to implement capital rationing in situations where past returns of
investment were lower than expected.
122. Treasury bills and Certificate of deposits
Treasury bills are sold by the government on a discount basis. As a result, the investor does not get actual payment of
interest on the Treasury bills. The return to the investor is in the form of difference between the purchase price and face (or
par) value of the bill. These bills are issued without the investor’s name upon them, i.e. in the bearer form. This feature of the
treasury bills makes them easily transferable from one investor to another. The secondary market also exists for these bills
making them highly liquid. It is also considered risk-free since it has the backing and guarantee of the government.
Certificate of deposits (CDs) are marketable receipts for funds that have been deposited in a bank/financial institution for a
specified period of time. The funds thus deposited earn a fixed rate of interest. The denomination and the maturities are
agreed upon as per the needs and wishes of the investor. Since the CDs are not sold at discount, the investor receives the
amount deposited plus the interest earned thereon. A secondary market also exists for the CDs. These may be issued in the
registered or bearer form. The second types of CDs are most common and popular due to their easy transferability and
liquidity.
123. Permanent working capital Vs. Variable working capital
Permanent working capital is the minimum amount of gross working capital which is always maintained in spite of the
increase or decrease in the sales during the year. It comprises of the minimum cash balance, minimum inventory level etc. If
a firm does not face a seasonal cycle then it will have only a permanent working capital requirement.
Variable working capital is the amount of gross working capital that exceeds the amount of permanent working capital at any time
during the year. It is also important for the finance manager to decide sources for financing seasonal current assets. The variable
working capital is the result of the periodic fluctuations of the gross working capital. For example, wheat mill may have higher
inventories at the time of harvesting wheat. It causes the increase in gross working capital
124. Capital Assets Pricing Model Vs. Arbitrage Pricing Model
The capital asset pricing model (CAPM) states that the return on a stock depends on whether the stock's price follows prices
in the market as a whole. CAPM is useful because it is a statistical representation of past risk. Even though past performance
is no guarantee for future success there is a higher probability that a consistent past performer will continue to do well over a new
untested entry in the market.
Arbitrage pricing model (APM) holds that the expected return of a financial asset is largely based on its "beta".Beta is the
measure of the relationship between company related factors which influence financial performance and the overall market in
which the latter competes. Typically a company which has a beta of one will reflect the market whereas a beta score of 0.75
means that a company will move up or down to the extent of 75 per cent of the corresponding market movement.

125. Private equity

Private equity refers to the composition of equity and debt investment in the companies that are not publicly traded on a stock
exchange. It is generally made by a private equity firm, a venture capital firm or an angel investor, each of which have their

53
 own set of goals, preferences and investment strategies. Nonetheless, all provide working capital to a target company to
nurture expansion, new-product development, or restructuring of the company’s operations, management, or ownership.
Among the most common investment strategies in private equity are: leveraged buyouts, venture capital, growth capital,
distressed investments and mezzanine capital. In a typical leveraged buyout transaction, a private equity firm buys majority control
of an existing or mature firm. This is distinct from a venture capital or growth capital investment, in which the investors (typically
venture capital firms or angel investors) invest in young, growing or emerging companies, and rarely obtain majority control. It is
also often grouped into a broader category called private capital, generally used to describe capital supportingany long-
term, illiquid investment strategy.

126. Debt Trap

Debt Trap is a situation where you add on a new debt in order to pay an existing debt. Generally, when the firm in
overleveraged all the credit sources are exhausted, firm arrives at a situation of debt trap. It is a situation in which an entity
borrows money, but does not have enough money to make the interest payments on the loan, so it takes out another loan
with its own interest payments--to cover the first loan's payments. They will likely have to borrow again to pay off the second loan,
creating a crippling cycle. It is an incentive structure that lures individuals into accepting long-term debt obligations under
conditions that strongly favor the lender. Victims of debt traps are often prevented from discharging the debt through
techniques such as unusually high or variable interest rates, changing payment plans, and unreasonably high penalties for
late payments.
127. NEPSE Index
The Nepal Stock Exchange is a value weighted index of all shares listed at the Nepal Stock Exchange and calculated on a
daily basis (for the days market remain open) at the closing price. The calculation of the NEPSE index is based on the
concept of the market capitalization which is the sum of the market capitalization of all the company listed in the Nepal Stock
Exchange. If the ratio of current period market capitalization to the base period market capitalization is multiplied by the
multiplier 100, we get NEPSE index. This method of index calculation is called value weighted method.
Total Market Capitalization of all the Companies Listed
NEPSE Index = --------------------------------------------------------------------------------------- 100
Total Base Year`s Market Capitalization
However in reality, the number of the listed companies keeps on changing, and the number of the outstanding shares also
keeps on changing as the company issues right shares or bonus shares or common shares at the time of capital needs. The actual
practice to adjust the base period is as follows:

Adjusted Base Period = New Market Capitalization including new listing x Base Year's Market Capitalization
New Market Capitalizations excluding new listing
128. Risk and Uncertainty
In common parlance, the terms Risk and Uncertainty have synonymous meaning. However, they differ from each other. Risk may
be defined as the chance of future loss that can be foreseen. In other word, in case of risk an estimate can be made about
the degree of happening of the loss. This is usually done by assigning to the probabilities of risk on the basis of past data
and the probable trends.
Uncertainty may be defined as ‘the unforeseen chance for future loss or damages.’ In case of uncertainty, since the firm
cannot anticipate the future loss, and hence it cannot directly deal with it in its planning process, as is possible in the case of risk.
For example, a firm cannot foresee the loss which may be due to destruction of its plant in account of earthquake.
129. Euro convertible bonds Vs. Euro convertible zero bonds
Euro convertible bond is a Euro bond, a debt instrument which gives the bond holders an option to convert them into a pre-
determined number of equity shares of the company. Usually the price of the equity shares at the time of conversion will have a
call option (where the issuer company has the option of calling/buying the bonds for redemption prior to the maturity date) or
a put option (which gives the holder the option to put/sell his bonds to the issuer company at a predetermined date & price).
Euro convertible zero bonds are structured as convertible bond. No interest is payable on the bonds. But conversion of bonds
takes place on maturity at a predetermined price. Usually there is a five years maturity period and they are treated as
deferred equity issue.

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