MBAFT 6204 CORPORATE FINANCE

Editorial Board
Dr. Kumar Bijoy
Associate Director, Campus of Open Learning,
University of Delhi
Dr. Rajdeep Singh
Associate Professor, Department of Commerce,
University of Delhi

Content Writers
Mr. Subhash Manda, Prof. (Dr.) Birendra Prasad,
Dr. CA Madhu Totla, Mr. Amit Kumar,
Mr. Kanwaljeet Singh, Dr. Akanksha Khurana,
Dr. Tarunika Jain Agrawal, Mrs. Juhi Batra
Academic Coordinator
Mr. Deekshant Awasthi

© Department of Distance and Continuing Education

ISBN: 978-81-19169-09-2
1st Edition: 2023
E-mail: ddceprinting@col.du.ac.in
management@col.du.ac.in

Published by:
Department of Distance and Continuing Education
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Disclaimer
MBAFT 6204 CORPORATE FINANCE

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This material is useful for similar courses of other management programmes

running under DDCE, SOL/COL, University of Delhi.

Corporate Finance
BBA-FIA (DSC-7), Semester –III, Course Credit - 4

Financial Management
BMS (DSC-11), Semester – IV, Course Credit - 4

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© Department of Distance & Continuing Education, Campus of Open Learning,
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
School of Open Learning, University of Delhi
 Contents

PAGE

Lesson 1 : Financial Management - An Overview

1.1 Learning Objectives 1
1.2 Introduction 2
1.3 Meaning of Financial Management 2
1.4 Scope of Financial Management 4
1.5 Evolution of Financial Management 5
1.6 Decisions or Function of Financial Management 7
1.7 Objective/Goal of Financial Management 11
1.8 Agency Issues 15
1.9 Financial Management and Other Areas of Management 18
1.10 Corporate Governance and Corporate Social Responsibility 20
1.11 Summary 23
1.12 Answers to In-Text Questions 24
1.13 Self-Assessment Questions 25
1.14 References 25
1.15 Suggested Readings 25

Lesson 2 : The Time Value of Money

2.1 Learning Objectives 27
2.2 Introduction 27
2.3 Time Lines and Notation 28
2.4 )XWXUH 9DOXH RI D 6LQJOH &DVKÀRZ 
2.5 Simple Interest 31
2.6 Doubling Period 32
2.7 Effective Versus Nominal Rate 32
2.8 3UHVHQW 9DOXH RI D 6LQJOH &DVKÀRZ 

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 MBAFT 6204 CORPORATE FINANCE

PAGE

2.9 Present Value of an Uneven Series 35

2.10 Relationship Between FVIF(k,n) and PVIF(k,n) 36
2.11 Shorter Discounting Period 36
2.12 Annuity 37
2.13 Relationship Between FVIFA(k,n) and PVIFA(k,n) 40
2.14 Present Value of a Growing Annuity 40
2.15 Present Value of a Perpetuity 40
2.16 Important Steps to Solve Problems (The Time Value of Money) 41
2.17 Summary 44
2.18 Answers to In-Text Questions 45
2.19 Self-Assessment Questions 46
2.20 References 48

Lesson 3 : Cost of Capital

3.1 Learning Objectives 
3.2 Introduction 50
3.3 9DULRXV &ODVVL¿FDWLRQV RI &RVWV RI &DSLWDO 51
3.4 0HDVXUHPHQW RI 6SHFL¿F &RVWV RI &DSLWDO 52
3.5 Calculation of Weighted Average Costs of Capital (WACC) 63
3.6 International Dimensions to Cost of Capital 66
3.7 Summary 67
3.8 Answers to In-Text Questions 68
3.9 Self-Assessment Questions 
3.10 References 
3.11 Suggested Readings 70

Lesson 4 : Investment Decisions

4.1 Learning Objectives 71
4.2 Introduction 72
4.3 Types of Capital Budgeting Decision Situations 74

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 CONTENTS

PAGE

4.4 (VWLPDWLRQ RI &RVWV DQG %HQH¿WV 

4.5 Process of Capital Budgeting 76
4.6 Evaluation Techniques 80
4.7 NPV vs. IRR 87
4.8 3UR¿WDELOLW\ ,QGH[ 3, 0HWKRG 
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4.11 6HOI$VVHVVPHQW 4XHVWLRQV 
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Lesson 5 : Risk Analysis in Capital Budgeting

5.1 Learning Objectives 100
5.2 Introduction 100
5.3 'H¿QLWLRQ RI 5LVN 101
5.4 Sources of Risk 103
5.5 Sensitivity Analysis 104
5.6 Methods to Adjust Risk in Capital Budgeting 106
5.7 Summary 
5.8 Answers to In-Text Questions 120
5.9 Self-Assessment Questions 120
5.10 References & Suggested Reading 121

Lesson 6 : Capital Structure: Theory and Practice

6.1 Learning Objectives 122
6.2 Introduction: Meaning of Capital Structure 123
6.3 Factors Affecting Capital Structure Decisions 123
6.4 Theories of Capital Structure 125
6.5 Checklist for Optimal Capital Structure 136
6.6 Financial Distress and Capital Structure (Bankruptcy and Agency Costs) 136
6.7 6XPPDU\ 

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 MBAFT 6204 CORPORATE FINANCE

PAGE

6.8 Answers to In-Text Questions 140

6.9 Self-Assessment Questions 140
6.10 References 142
6.11 Suggested Readings 142

Lesson 7 : Leverage and EBIT-EPS Analysis

7.1 Learning Objectives 143
7.2 Introduction 144
7.3 Concept of Leverage 145
7.4 5HODWLRQV %HWZHHQ 6DOHV DQG 3UR¿W 
7.5 Operating Leverage 147
7.6 )LQDQFLDO /HYHUDJH 
7.7 Combined Leverage 150
7.8 EBIT-EPS Analysis 154
7.9 Practical Problems 165
7.10 Answers to In-Text Questions 170
7.11 Self-Assessment Questions 170
7.12 References 171
7.13 Suggested Readings 171

Lesson 8 : Dividend Policy Decisions

8.1 Learning Objectives 173
8.2 Introduction 174
8.3 Factors Determining Dividend Policy 176
8.4 0HDVXUHV RI 'LYLGHQG 3ROLFLHV 
8.5 Theories of Dividend 180
8.6 )RUPV RI 'LYLGHQG 3ROLFLHV 
8.7 'LYLGHQG 3ROLFLHV LQ 3UDFWLFH 
8.8 6XPPDU\ 
8.9 $QVZHUV WR ,Q7H[W 4XHVWLRQV 

iv PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
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 CONTENTS

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8.10 6HOI$VVHVVPHQW 4XHVWLRQV 

8.11 5HIHUHQFHV 
8.12 6XJJHVWHG 5HDGLQJV 

Lesson 9 : Working Capital Management

9.1 /HDUQLQJ 2EMHFWLYHV 
9.2 ,QWURGXFWLRQ 
9.3 &ODVVL¿FDWLRQ RI :RUNLQJ &DSLWDO 
9.4 Working Capital Policies & its Management 204
9.5 5LVN 5HWXUQ 7UDGH RII 
9.6 Cash Management 212
9.7 Receivable Management 224
9.8 Summary 233
9.9 Answers to In-Text Questions 233
9.10 Self-Assessment Questions 234
9.11 References 236
9.12 Suggested Readings 236
Glossary 237

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L E S S O N

1
Financial Management -
An Overview
Subhash Manda
Assistant Professor
Shaheed Rajguru College of Applied Sciences for Women
University of Delhi
Email-Id: subhashchoudhary98732@gmail.com

STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3 Meaning of Financial Management
1.4 Scope of Financial Management
1.5 Evolution of Financial Management
1.6 Decisions or Function of Financial Management
1.7 Objective/Goal of Financial Management
1.8 Agency Issues
1.9 Financial Management and Other Areas of Management
1.10 Corporate Governance and Corporate Social Responsibility
1.11 Summary
1.12 Answers to In-Text Questions
1.13 Self-Assessment Questions
1.14 References
1.15 Suggested Readings

1.1 Learning Objectives

‹ To understand the evolution and growth of finance function.
‹ To understand that maximising shareholders’ wealth is preferable to maximising
profits.

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 MBAFT 6204 CORPORATE FINANCE

Notes ‹ To discover the Agency cost and how to address it.

‹ To understand the concept of corporate governance and CSR from
financial management perspective of the company.

1.2 Introduction
The goal of financial management is to maximize the value of the
company and, by extension, the wealth of the company’s owners or
shareholders. This is done by planning, raising and using the necessary
financial resources in the best way possible. Financial management is
all about planning, getting the money you need, and using it in the best
way possible. Recently, managing a company’s finances has become a
separate and important part of managing the company as a whole. The
effectiveness and quality of the financial decisions that are made by a
company largely determine whether or not that company will be successful
in business. In this context, the role of financial manager takes on a very
important significance. A company’s financial manager is accountable for
all of the company’s financial activities, including the planning, raising,
distribution and control of funds in the most efficient manner possible.
As a result, financial management pertains to the administration of the
finances of a company.

1.3 Meaning of Financial Management

Financial management is the job of a company’s managers to plan and
control how the company’s money is used. In other words, it is focused
on acquiring, financing and managing assets to achieve the overall goal
of the business, which is primarily to maximise shareholder value.
It aims to obtain capital at the lowest possible cost and use it to maximise
return while maintaining the optimal degree of risk.
According to Phillippatus, “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.”
In terms of Joshep and massie, “Financial management is the operational
activity of a business that is responsible for obtaining and effectively
utilizing the funds necessary for efficient operations”.

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 FINANCIAL MANAGEMENT - AN OVERVIEW

There are two basic aspects of financial management viz., procurement of Notes
funds and an effective use of these funds to achieve business objectives.
Procurement of funds
Since money can be obtained from various sources, getting it is always
a complicated problem for businesses. Several of the funding options
for a business enterprise include: equity (owners’ capital); bonds; bank
borrowing; angel financing; and so on.
Different sources of funds have different characteristics in terms of risk,
cost and control. The cost of funds should be kept to a bare minimum,
which necessitates a careful balancing of risk and control factors. Another
important factor to consider when selecting a source of new business
finance is striking a balance between equity and debt to ensure the funding
structure suits the business.
Let’s talk about equity and debt in terms of cost, control, and risk. The
funds raised through the issuance of equity shares are the least risky for
the firm because there is no need to repay equity capital unless the firm
is liquidated.
However, in terms of cost, equity capital is typically the most expensive
source of funds. This is because shareholders’ dividend expectations are
typically higher than the prevalent interest rate, and dividends are an
appropriation of profit that is not allowable as an expense under the
Income-tax Act.
Furthermore, the issuance of new public shares or a further public offering
may dilute the control of existing shareholders.
The funds raised through the issuance of debt or the raising of loans are
the riskiest for the firm because there is a requirement to repay principal
and interest amounts in the form of instalment payments, whether the
firm is profitable or not. As a company, you have to pay it. It’s a kind
of legal obligation.
But on the other side, if a company issues debt, then it can claim a
deduction for interest, which is provided by the Income-tax Act. That is
why we say that debt is cheaper than equity because it provides a tax
advantage. It will benefit us by lowering the amount of tax.
Aside from that, if a company raises funds by issuing debt, there is no
dilution of the company’s ownership. It will simply create an obligation

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 MBAFT 6204 CORPORATE FINANCE

Notes that the company must meet in terms of timely repayment of interest and
the principal amount of money.
Utilization of Fund
As the financial manager of your company, you need to use money in the
best way possible. You must identify instances where funds are sitting idle
or where proper use of funds is not being made. All funds are obtained
at a certain cost and with a certain amount of risk. There is no point in
running the business if these funds are not used in such a way that they
generate an income greater than the cost of acquiring them. As a result,
it is critical to use the funds wisely and profitably.
There are two ways to study the scope of financial management:
1. The Traditional Approach, and
2. The Modern Approach.

1.4 Scope of Financial Management

1.4.1 The Traditional Approach

The scope of financial management was restricted by this approach to the
process of raising and administering the funds that were necessary for
businesses to meet their financial obligations. This strategy put more and
more emphasis on companies getting the money they needed to meet their
different financial needs. This emphasis has led to the following results:
‹ The emergence of an increasing number of financial institutions to
satisfy the demand for business financing.
‹ The creation of a variety of different financial instruments, such
as shares, debentures, bonds, and so on, could have been used to
raise funds.
As a result, the traditional approach centred on the task of determining
how the required funds could be raised from the combination of sources
that were available in the most effective manner. The function of finance
was concerned with the acquisition of finances in order to finance the
activities of expanding or diversifying the business. The function of
finance was not an essential part of the daily managerial activities.

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 FINANCIAL MANAGEMENT - AN OVERVIEW

‹ There is no emphasis on the wise use of funds. The main criticism Notes
of this approach is that it focuses solely on the acquisition of funds.
The more important aspect of funds, namely their cautious use or
allocation, was totally neglected.
‹ The long-term resources were the primary focus of attention, and the
long-term finances were the only ones that were of any significance.
The idea of working capital and how to effectively manage it was
essentially non-existent at the time.
‹ This approach was a way of looking at finance from the outside.
It said that the finance function was all about getting money and
managing it. It focused on the relationship between the company
and the people who give it money. So, everything was looked at
from the point of view of the people who gave money, i.e., from
the outside. Questions like how to spend money wisely, how to
predict expected returns, how to keep the cost of capital as low as
possible, etc. were completely ignored.

1.4.2 The Modern Approach

Due to changes in technology, industrialization, rapid economic growth,
more competition, the creation of management information systems, and the
rise of professional management, the definition of financial management
has changed to include decisions about both raising money and using
it wisely. So, the modern approach includes not only the process of
getting money but also the process of putting that money to good use
among an organization’s assets. This method sees financial management
as an integrated part of overall management and gives a conceptual and
analytical framework for making financial decisions.

1.5 Evolution of Financial Management

Over time, the nature and scope of financial management have evolved
and broadened. Over the last 50 years, financial management has evolved
gradually. There are three stages in the evolution of financial management.
During the second half of the twentieth century, finance emerged as a
distinct field of study. However, some casual references to the finance

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 MBAFT 6204 CORPORATE FINANCE

Notes function had been made prior to that. The evolution of finance functions
and changes in their scope resulted from two factors: 1. Continuous
growth and diversity in business. 2. The gradual introduction of new
financial analysis tools.

1.5.1 Traditional Phase upto 1940

At first, finance was considered to be a component of economics and
received no special attention. Owners of businesses were more focused
on daily operations. In the past, managing cash and preserving records
all fell under the responsibility of the financial manager. A financial
manager was only specifically requested when it was necessary for him
to look for fresh sources of funding whenever there was a perceived
need for the funds:
‹ The function of finance was concerned with the acquisition of finances
in order to finance the activities of expanding or diversifying the
business. The function of finance was not an essential part of the
daily managerial activities.
‹ The finance function was specifically considered from the perspective
of the fund suppliers, i.e., the lenders, both individuals and institutions.
‹ The long-term resources were the primary focus of attention, and the
long-term finances were the only ones that were of any significance.
The idea of working capital and how to effectively manage it was
essentially non-existent at the time.
‹ At the time, finance was more descriptive than analytical.

1.5.2 Transitional Phase

During this period, financial management was almost identical in terms
of its nature and scope as it was during the traditional phase. In spite
of this, there was a growing emphasis placed on planning, acquiring,
managing, and controlling cash in order to meet the day-to-day monetary
requirements of the company.

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 FINANCIAL MANAGEMENT - AN OVERVIEW

1.5.3 Modern Phase Notes

The finance function has become increasingly analytical and decision

oriented as a result of the gradual increase in competition and the rapid
growth in business that has occurred in recent years, as well as the regular
occurrence of boom and recession in economic activities. The scope of
the finance function has been expanded even further, and it now not
only includes methods of acquiring funds at episodic events, but also the
most efficient utilisation possible through the utilisation of data based
on analytical decision making.
Now, a finance manager’s job is more like that of a professional manager.
He or she is in charge of getting the company to raise capital, allocating
the capital to different projects, and measuring the results of each project.
The function of finance now encompasses both the acquisition of funds
and the distribution of those funds.
The development of the theory of portfolio management in 1952 by Harry
Markowitz, the Theory of Leverage and Valuation of firm by Modigliani
and Miller in 1958, and the Option Valuation Model by Black and Scholes
in the 1973s are all considered to be significant milestones in the journey
that led to the development of modern financial management.
These new developments actually mark the beginning of the process of
developing an integrated theory of financial management. This theory will
ultimately include such topics as the theory of efficient capital markets,
capital budgeting, the theory of capital structure, dividend policy, working
capital management, risk and uncertainty dimensions of financial decision
making, and so on.

1.6 Decisions or Function of Financial Management

1.6.1 Capital Budgeting Decisions

The most crucial choices a company makes involve its capital budgeting
decisions. These decisions involve a long-term commitment of available
funds with the hope of receiving a sufficient return on them in the future.

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 MBAFT 6204 CORPORATE FINANCE

Notes It should be noted that capital budgeting decisions have an impact on

the business’s survival and growth. Hence, any wrong decision in this
context may have an adverse impact on the survival and future growth
prospects of the business.
In capital budgeting decisions, a financial manager tries to find profitable
opportunities where they can generate more cash inflows than cash
outflows. Here we need to take the following decisions as a financial
manager in capital budgeting:
Whether we should invest in a particular project or not.
Whether we should continue investing in a particular project or discontinue
it.
When making decisions regarding capital budgeting, one must balance
the potential for loss with the potential for gain. The risk associated with
investing in a small plant or project is significantly lower than the risk
associated with investing in a large plant or project. On the other hand,
a small project typically results in a smaller return than a large project
does. Before deciding on the best size for the project to take on, it is
important to do a thorough risk and return assessment.

1.6.2 Financing Decisions

Financing decisions are those where capital formation (capital structure)
has to be finalized. Once the requirement for funds is established, a
decision has to be taken regarding the sources from where such funds
can be arranged at minimum cost.
When, where, and how to acquire funds to meet the firm’s investment
needs. As a financial manager, we need to determine the proportion of
debt and equity. We always strive for an optimal capital structure when
the market value of a share is maximised.
While taking a decision regarding the formation of capital, the following
factors must be properly evaluated:
Risk & Return
Because interest on debt is tax deductible, debt capital is typically considered
to be more cost effective than equity capital. Additionally, due to the
fact that debt is paid before equity, investors face a lower level of risk,

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 FINANCIAL MANAGEMENT - AN OVERVIEW

and as a result, they require a lower rate of return on debt investments. Notes
But from the perspective of the company, having an excessive amount of
debt is riskier than having equity capital because debt obligations have
to be met regardless of whether or not the company is making a profit.
On the one hand, debt has a lower cost of capital, so employing more
debt would mean higher returns; however, this would also mean taking
on more risk. On the other hand, equity capital gives a lower return due
to its higher cost of capital, but it takes on less risk.
Control
If a company is going to raise funds by issuing debt in the market, then
it will not impact the ownership of the company, and there will be no
diversification of ownership. But at the same time, if the company is issuing
equity in the market, then there will be a diversification of ownership of
the company, which leads to less control for existing shareholders over
the company.

1.6.3 Dividend Decisions

In the dividend decision, the decision is to be made whether to distribute
the dividend or not. A company’s finance manager needs to determine
what portion of its profit after taxes should be kept in the company to
meet future investment requirements and what portion should be given
to shareholders in the form of dividends. Should the company keep all
of the profits for itself, keep some and give the rest away, or distribute
all of the profits?
The decision regarding the dividend also involves a risk return trade-off.
Investors typically anticipate dividends due to the fact that dividends
resolve the future uncertainty that is attached to capital gains. Therefore,
a company should pay out dividends. When a company that has profitable
investment opportunities pays dividends, however, the company is forced
to raise capital from external sources, which is a more expensive option
than keeping the money it has already earned. As a result, the return on
projects is lower. In the case of growing businesses, a high dividend pay-
out carries a lower risk but also leads to a lower return, whereas a low
dividend pay-out carries a higher risk but ultimately results in a higher

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 MBAFT 6204 CORPORATE FINANCE

Notes return. Therefore, a firm has to strike a balance between dividends and
retained earnings so as to satisfy investors’ expectations.

1.6.4 Working Capital Decisions

The management of a company’s short-term or current assets, such
as inventory, cash, and receivables, as well as the management of the
company’s short-term or current liabilities, such as creditors and bills
payable, are both aspects of working capital management. Management
of working capital involves addressing the following issues:
‹ What are some potential sources for raising funds for the short
term?
‹ How much of the total amount should be raised from each of the
various sources of short-term funding?
‹ What are the optimal levels of cash and inventory that should be
maintained?
‹ When dealing with customers, what kind of credit policy should
the company implement?
The manager of finances is responsible for estimating the total amount
of funds required for working capital as well as individual investments
in various components. If a company follows a conservative policy
regarding its working capital and makes larger investments in its current
assets, it will increase its liquidity and, as a result, lower its risk of going
bankrupt; however, this will have a negative impact on the company’s
ability to generate profits.
On the other hand, if a company decides to implement an aggressive policy
regarding its working capital, it may be able to boost its profitability by
limiting its investment in working capital; however, this will result in an
unfavourable liquidity position for the company. Both risk and return, as
well as profitability and liquidity, are inversely related to one another.
Therefore, the finance manager should have optimum level of working
capital.

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 FINANCIAL MANAGEMENT - AN OVERVIEW

1.7 Objective/Goal of Financial Management Notes

Each and every business is created with certain goals or objectives

to be achieved during its lifetime. An operationally useful criterion
is required for financial management. This criterion would serve as a
yardstick for various financial decisions, including capital budgeting,
capital structure, dividend policy, and working capital management. The
goal is to establish a structure within which the most effective choices
regarding one’s financial situation can be made. The vision, mission, and
overall goals and objectives of the corporation should serve as the basis
for determining what the objective of financial management should be.
The objective would provide a framework within which optimal financial
decisions can be taken.

1.7.1 Profit Maximization Objective

Profit maximisation was emphasised as an important goal of financial
management during the traditional phase. Profit is the primary goal of
any business. It can be said that the majority of businesses exist primarily
to make money. Profit is the yardstick for measuring the efficiency of
business operations. Profit maximisation as a financial management
objective means that all financial decisions in a company are guided
by the amount of profits that the financial decision generates or saves.
Unprofitable projects and alternative investment options would be rejected.
If there are insufficient funds to finance all profitable investment projects,
the ones with the highest profits will be chosen.
Advantages of Profit Maximization
‹ The primary goal of most businesses is to earn profits.
‹ Profit can be used to assess the success of business operations.
‹ Profit maximization ensures efficient use of scarce financial resources
by allocating these resources to uses that generate the highest profits.
Limitations of Profit maximization
‹ Profit a vague and confusing concept: The term profit is not
specifically defined. It can refer to overall profit, incremental profit,
profit before taxes, or profit after taxes.

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 MBAFT 6204 CORPORATE FINANCE

Notes ‹ Ignorance of risk: The goal of maximising profits must be approached

with a comprehension of the risks that are involved. There is a
direct relationship between the levels of risk and profits. There
are a lot of high-profit opportunities that involve higher risks. The
greater the risk, the greater the potential for gain. If increasing
profits is the main objective, consideration of the risk aspect is
totally ignored. This suggests that financial managers are willing to
go along with highly risky propositions if they will result in large
profits. In actuality, risk is a very significant factor that must be
weighed against the desired level of profit, but these two factors
must be kept in proper proportion.
‹ It ignores time value of money: There is no consideration given to
the order in which benefits will be received (cash inflows). It does
not make any difference between cash inflows occurring at different
points in time.
‹ Based on Accounting Profit: Management can easily affect accounting
profits by changing the accounting policies that are used to figure
out accounting profits.
‹ Against corporate responsibility: The concept of corporate respon-
sibility is in direct conflict with the purpose of maximising profits.
If the main purpose of a company is to maximise its objectives,
then the company may engage in a variety of immoral and illegal
acts that would not normally be wanted. The purpose of a busi-
ness organisation is not merely to maximise profits; rather, it is to
produce value for the company’s owners as well as for its other
stakeholders. It is considered impractical, inappropriate, and immoral
in today’s modern business world to maximise profits at all costs.

1.7.2 Shareholder Wealth Maximization objective

The maximisation of shareholder wealth is regarded as the goal of
modern-day financial management. It overcomes the limitations of the
Profit Maximization objective and provides a realistic objective by being
based on the concept of cash flows and taking into consideration the
timing of benefits.

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 FINANCIAL MANAGEMENT - AN OVERVIEW

The current market value of the company’s shares, as well as reserves, Notes
surplus, and accumulated profits, are all part of the wealth of the company’s
shareholders. However, the market value of a share is the most important
component here.
The market value of the shares, also known as the market capitalization,
is equal to the market price multiplied by the total number of outstanding
shares.
Market Capitalization = Market price of share × total number of outstanding shares
As a result, the company’s financial manager should make all financial
decisions in order to maximise the market value of the company’s shares.
Now, considering that the total number of shares will not change over
the course of some specified amount of time, the objective of the finance
manager should be to achieve the highest possible market price for each
share, with the goal of increasing the wealth of the shareholders. A
finance manager has the potential to achieve a higher share price more
quickly by selecting projects with high risk and high return. On the other
hand, this strategy might fail, which would lead to a significant drop in
share prices. If shareholders are unhappy with the way management is
operating the company or the progress it is making, they can voice their
displeasure by selling company shares, which will result in a decrease
in the price of those shares.
This is also referred to as maximizing value or ensuring that your net
present worth is as high as possible. This objective is to maximise, for
the benefit of shareholders, the net present value of a course of action.
This is based on the assumption that the financial manager will work
towards increasing the value of shareholders’ total investments as much
as possible. In this context, the goal of the finance managers would
be to increase the value of each and every investment project that the
company chooses to pursue and implement. In order to accomplish
this, the net present value of a project is calculated using the project’s
anticipated cash inflows and outflows, in addition to the firm’s cost of
capital (discount rate). You can calculate the Net Present Value (NPV) of
a project by deducting the present value of all cash outflows associated
with the project from the present value of all cash inflows experienced
by the project over the course of its lifetime.

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Notes Net present value = Present value of cash inflows – Present value of cash outflow

The objective of maximising the wealth of shareholders takes into account

cash flows, the timing of benefits, and risks associated with expected
benefits. Because it is based on the idea of cash flows and takes into
account both the timing of benefits and the risks associated with them, it
is capable of overcoming the constraints that are imposed by the objective
of profit maximisation and offers a more realistic objective.
Advantages of shareholders’ wealth maximization
(i) The goal of wealth maximisation is to increase the value of
shareholders’ investments as well as their overall wealth. Therefore,
is regarded as a more valuable goal than maximising profits.
(ii) Unlike profit, the concept of cash flows is clear and unambiguous,
and it serves as the foundation for this method. In this context,
cash inflow is regarded as an advantage, while cash outflow is
considered a cost associated with a specific decision.
(iii) The process of maximising wealth takes into account the order
in which benefits (cash inflows) and expenses take place (cash
outflows). As a result, it takes into account the value that money
has over time.
(iv) The process of maximising wealth takes into account the risk that
is associated with the occurrence of cash flows.
(v) The goal of wealth maximisation is to direct a company’s financial
resources towards those activities that will yield the greatest financial
return for the company’s shareholders.
(vi) The goal of maximising the wealth of shareholders contributes to
the maintenance of the economic well-being of the society as a
whole by promoting the effective utilisation of the limited financial
resources available to the society.
Criticism of shareholders’ wealth maximization objective
Even the intention of maximising wealth for shareholders is being called
into question as more people are becoming concerned about the social
responsibility of corporations.

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Maximizing wealth is criticised on the grounds that its only goal is to Notes
maximise the wealth of shareholders, and it does not consider the welfare
of other important stakeholders in the company, such as management,
creditors, employees, suppliers, distributors, customers, and so on. This
is one of the main criticisms levelled against wealth maximisation. The
criteria for wealth maximisation is to maximise the price at which a
company’s shares are sold on the market. However, in the real world,
the price of a company’s shares is influenced by a large number of
factors over which the company has no control. In order to manipulate
the market price of the share, the management might also engage in
unethical business practises. As a result, there is a growing demand for
the objective of maximising the wealth of stakeholders, as opposed to
the objective of maximising the wealth of shareholders.

1.8 Agency Issues

Ownership and management are two separate concepts in today’s modern
business enterprises. The agency problem refers to the potential for conflicts
of interest to arise in business organisations as a result of the separation
of ownership and management. When one person or organisation, known
as the principal, hires another person or organisation, known as the agent,
to carry out some service on their behalf, an agency relationship is formed
between the principal and the agent. For performing required services,
decision-making powers are delegated to the agent by the principal.
The following are the two most common types of agency relationships
that occur in business organisations from the perspective of financial
management:
1. between shareholders and managers
2. between shareholders and creditors

1.8.1 Agency Problem I (Shareholders vs. Managers)

The fact that managers in several large firms own only a very small
percentage of the total firm’s shares is the root cause of the large majority
of agency conflicts that occur between shareholders and managers. Because
of this, a number of managerial goals that are in competition with the

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Notes objective of maximising the wealth of shareholders end up taking priority.

The following reasons explain why this occurs:
1. By actively pursuing the rapid expansion of the company, managers
are attempting to reduce the likelihood of a hostile takeover of the
company and to improve their own job security.
2. The goal of managers is to lead large organisations so that they
can improve their power and status as well as their financial and
non-financial benefits.
3. Managers may also look into the possibility of creating additional
job opportunities for managers at the middle and lower levels of
the organisation.
4. Managers may avoid taking high investment and financing risks that
may otherwise be needed to maximize shareholders’ wealth. Such
“satisfying” behaviour of managers will frustrate the objective of
Shareholder Wealth Maximization as a normative guide.
In addition, a moral hazard problem may also occur because managers
who are acting in their capacity as agents of Shareholders (the principal)
may use the delegated authority to take actions that are in their interest
rather than in the interest of Shareholders. This may cause a conflict of
interest. The reason for this is that shareholders are unable to keep track
of everything that managers do and all of the decisions they make.
Agency costs are the costs that are incurred by shareholders to minimise
both agency conflicts and the moral hazard problem. More specifically,
agency costs are the costs that are incurred by shareholders to ensure
that managers pursue the goal of maximising shareholder wealth.
The following is a list of the primary types of agency costs that the
shareholders are responsible for bearing:
1. Costs incurred for the purpose of monitoring managerial actions,
such as the price of conducting audits.
2. The costs associated with establishing an organisational structure
that reduces the likelihood of managers pursuing conflicting goals.
For example in the case, the expense of recruiting Independent
investors to serve on the board of directors.

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3. The opportunity costs incurred as a result of restrictions imposed Notes

by shareholders on the ability of managers to take actions that are
designed to increase the wealth of shareholders.
The following are examples of mechanisms that shareholders commonly
use to ensure that managers prioritise the maximisation of shareholder
wealth over any other competing goals:
1. Managerial Compensation Plans: These plans are made to attract
and keep good managers and to encourage them to do things that
increase the wealth of shareholders. These plans are designed with
the following goals in mind: because managers are more likely
to pursue the goal of shareholder wealth maximisation through
increasing the firm’s share prices if they themselves hold a large
amount of funds in shares, the majority of large companies provide
managers with stock bonuses or executive stock options, both of
which allow them to purchase shares in the future at a given price.
2. Direct Intervention by Shareholders: This might take the form of
shareholders proposing changes to the way the company operates,
nominating a candidate for the board of directors, or supporting
a motion during the annual general meeting even if managers are
against it.
3. The Threat of Firing: Shareholders have become more organised and
aware of their rights in recent years. As a result, the possibility of a
large corporation’s top management being removed has significantly
increased.
4. The Threat of Hostile Takeovers: These are possible outcomes
that can occur in the event that the share price of a company is
significantly discounted in comparison to its intrinsic price or actual
worth. When a hostile takeover occurs, the majority of managers are
either fired or, if they are allowed to keep their jobs, they suffer
a loss of power and position. So, there is a significant incentive
for management to aim towards the maximisation of share prices
in order to reduce the possibility of an unfriendly acquisition.

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Notes 1.8.2 Agency Conflict II (Shareholders vs. Creditors)

Creditors, who are lenders of funds to the company, want the following
things: Stability in the firm’s earnings so that they can timely meet all
obligations of payment of interest and repayment of principle; Investment
of funds in projects with lower levels of risk; and Maintenance of a healthy
amount of current and fixed assets that can be converted into cash in the
event that the company is unable to meet its obligations.
But, in order to maximise shareholder wealth, shareholders may take
action through management, causing the company to do the following:
Invest funds in risky projects that cause instability and fluctuation in
earnings; Sell assets that were safe backups for creditors, and borrow
additional funds that increase the riskiness and chance of default for both
existing and new creditors.
As a result, managers, who act as agents for both shareholders and
creditors, ought to behave in a manner that is relatively balanced. They
shouldn’t take any actions that will benefit one side at the expense of
the other in order to ensure that the legitimate claims of both sides will
be protected and satisfied.

1.9 Financial Management and Other Areas of Management

Financial management is not a completely separate field because it is an
important part of the management process as a whole. It makes a lot of
use of related disciplines and fields of study, like accounting, economics,
production, marketing, and quantitative methods. Even though these fields
of study are related, there are important differences between them. The
following are some of the relationships that will be discussed:

1.9.1 Financial Management and Accounting

Financial accounting is the process of keeping track of financial transactions
so that interested parties can get useful information. Financial management
procedures for managing the finance-related transactions for the purpose
of maximizing shareholders’ wealth over a period of time.

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The main focus of financial accounting is the “accurate recording” and Notes
“accurate reporting” of finance-related transactions. The focus of financial
management is on future decision-making. Therefore, accuracy can’t be
guaranteed.
The success of financial management depends on the successful
implementation of financial accounting. Hence, financial management and
financial accounting are not contrary; rather, they complement each other.

1.9.2 Financial Management and Economics

Different economic theories help financial managers make decisions
when they are faced with real-life business situations. So, it’s important
for a financial manager to understand economic concepts like analysing
demand and supply, how costs change over time, pricing theory, marginal
analysis, and models for making the most money in different market
situations. The most important things for a finance manager are budgeting,
forecasting, planning for profits, and evaluating alternative investment
proposals. In order to be successful in fund raising, a finance manager
needs to have a solid understanding of how financial institutions and the
capital market operate.

1.9.3 Financial Management and Production Department

During day-to-day business activities, various decisions are taken, like
purchase policies, supplier selection, timing of purchases, whether to
make or buy, whether to retain or replace existing machines, etc. All these
decisions have financial implications, and therefore, finance is regarded
as a very important factor.

1.9.4 Financial Management and Marketing

Marketing managers are in charge of making marketing plans, predicting
what customers will want, deciding on pricing, product promotion,
product mix, market segmentation, targeting, and positioning, as well
as the choice of distribution channels and the length of those channels.
In these situations, every choice has a payoff in the form of benefits
gained compared to costs that have to be paid over time. The marketing

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Notes department and the finance managers work together to figure out whether
or not different marketing strategies are financially viable. After all, the
finance manager approves funding for selected proposals.

1.9.5 Financial Management and Statistics

In the modern era, financial management has moved toward a more
analytical and empirical approach. This needs a wide range of statistical
tools and methods, such as measures of central tendency and measures of
dispersion, correlation and regression, sampling and estimation, hypothesis
testing, and many others. These methods are widely used for taking
financial management decisions like capital budgeting, capital structure,
dividends, working capital, etc.

1.10 Corporate Governance and Corporate Social Res-

ponsibility
Corporate Governance
A system designed to ensure that businesses are run in a manner that is
beneficial to all of the stakeholders is known as “corporate governance.”
These are the various parties that have a vested interest in the organization’s
efficient operation, continued growth, and continued prosperity. These
include the company’s shareholders, management, and employees, as
well as its banks and other financial institutions, society, and various
governments. These stakeholders have divergent interest.
Stakeholders Interest of stakeholders in the company
Shareholders Maximization of wealth by increasing the market price (share)
of the company.
Management High-paying remuneration and incentives; power and status
within the company; and actual control over its operations.
Bank and Get repayment of the interest and principal (instalment) amounts
Lenders on time.
Employees Job security, promotion and retirement benefits etc.
Government The organisation should be run in an honest and fair manner, and
its taxes should be paid to the government in a timely manner.
Society Safe products, environment friendly products.

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The existence of competing interests among the various stakeholders Notes

gives rise to the requirement for efficient corporate governance. The
term “corporate governance” refers to a set of rules, procedures, and
customs, among other things, that a company must adhere to in order to
successfully manage its business in a way that is beneficial to all of its
stakeholders. The objective of maximising the wealth of shareholders is
also consistent with the objective of achieving maximum value for all
stakeholders. When it comes to the management of the company, good
corporate governance will bring about increased transparency and fairness.
The company will be monitored independently and will give full and
honest disclosure of relevant information’s in its various reports.
Corporate Social Responsibility
Should business be concerned about the well-being of society as a
whole? Should a business exist solely to maximise the wealth of its
shareholders, or should it also care for its employees, customers, and
society as a whole? Is it the business’s responsibility to provide safe
working conditions for employees, safe products for customers, and a
safe environment for society? Should the company donate a portion of its
profits to charity? The answers to all of these questions are dependent on
how socially responsible a business is. In today’s business environment,
it is impossible to avoid social responsibility. The fulfilment of these
social responsibilities will come at a price. But there is no way out.
Being socially responsible will ultimately benefit the company in the long
run. All of India’s leading corporations are involved in Corporate Social
Responsibility (CSR) programmes in areas such as education, health, job
creation, skill development, and empowerment of the weaker sections of
society.
IN-TEXT QUESTIONS
1. The concept of financial management is:
(a) Profit maximization
(b) All features of obtaining and using financial resources
for company operations
(c) Organization of funds
(d) Effective Management of every company

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Notes 2. What is the primary goal of financial management?

(a) To minimise the risk
(b) To maximise the owner’s wealth
(c) To maximise the return
(d) To raise profit
3. In his/her traditional role the financial manager is responsible
for:
(a) Proper utilisation of funds
(b) Arrangement of financial resources
(c) Acquiring capital assets of the organization
(d) Efficient management of capital
4. _____ Maximization objective ignores timing of benefit i.e. time
value of money.
(a) Profit
(b) Wealth
(c) Value
(d) Both (a) & (b)
5. Which is not a part of Investment Decision in Financial Management?
(a) Dividend Payout Decision
(b) Capital Budgeting Decision
(c) Working Capital Management
(d) Credit Policy towards Customers
6. Maximizing the wealth of the shareholders is reflected in:
(a) Maximizing Market Price of Equity shares
(b) Maximizing Cash Balance
(c) Maximizing Retained Earnings
(d) Maximizing Issued Capital
7. Which of the following is considered as complementary to
Financial Management?
(a) Cost Accounting

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FINANCIAL MANAGEMENT - AN OVERVIEW

(b) Management Accounting Notes

(c) Financial Accounting

(d) Corporate Accounting
8. The decision function of financial management can be broken
down into the _______decisions.
(a) Financing and investment
(b) Investment, financing and asset management
(c) Financing and dividend
(d) Capital budgeting, cash management, and credit management
9. In Financial Management, the term risk refers to:
(a) Chances of Incurring Losses
(b) Variability of Future Outcome
(c) Chances of no return
(d) None of the above
10. Which of the following represents the financing decision?
(a) Designing Optimal Capital Structure
(b) Declaring Dividend
(c) Paying Interest on loans
(d) None of the above

1.11 Summary
‹ The goal of financial management is to make sure that money is
raised (through financing) and spent (on assets, working capital,
etc.) in the best way possible.
‹ In today’s world, good financial management involves more than just
getting (procurement) money. It also involves making three different
kinds of decisions about investments, dividends, and financing.
‹ Investment decisions relate to the selection of various assets in which
a company should commit its funds in order to maximise returns
on its investment with the overall goal of wealth maximization.

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Notes ‹ The acquisition of required funds at the required time with the lowest
possible cost of capital is the primary concern of the financing
decision.
‹ Dividend decision decides the portion of profit to be distributed
among shareholders and the portion of profit to be retained in the
business for further investment.
‹ During the traditional phase, the only focus of financial management
was the acquisition of funds.
‹ The modern phase of financial management is concerned with both
the acquisition of funds and their efficient and effective utilisation
to achieve the best possible results.
‹ In today’s real-world situations, which are uncertain and multi-period
in nature, shareholder wealth maximisation is a better objective than
profit maximisation.
‹ There is a possibility that managers will act against the interests
of the shareholders in order to achieve the goals that they have set
for themselves. The term for this dilemma is known as the agency
problem.

1.12 Answers to In-Text Questions

1. (b) All features of obtaining and using financial resources for

company operations
2. (b) To maximise the owner’s wealth
3. (b) Arrangement of financial resources
4. (a) Profit
5. (a) Dividend Payout Decision
6. (a) Maximizing Market Price of Equity shares
7. (c) Financial Accounting
8. (b) Investment, financing and asset management
9. (b) Variability of Future Outcome
10. (a) Designing Optimal Capital Structure

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1.13 Self-Assessment Questions Notes

1. If you are a financial manager in your company, then what are the
major types of financial management decisions that you would take
while doing your job? Describe.
2. Traditional financial management was concerned with raising of
funds as well as optimum utilization. Do you agree? Explain.
3. Profit maximization should be the objective of financial management.
Do you agree? Explain.
4. “The corporate firm will attempt to maximize the shareholders’
wealth by taking action that increase the current value per share
of existing stock of the firms” Comment.

1.14 References
‹ Prasanna Chandra, “Financial Management: Theory and Practice”,
9th ed, Mc Graw Hill.
‹ Horne, James C V. and John M. Wachowicz, Jr. “Fundamentals of
Financial Management.13th ed; FT Prentice Hall, Pearson Education.
‹ Pandey, I.M. Financial Management: Theory and Practices, Vikas
Publishing House.
‹ Khan, M.Y. & Jain, P.K. Financial Management Text Problem and
Cases, Tata McGraw Hill Publishing Co. Ltd.
‹ Dr. Vanita tripathi, “Basic Financial Management”, taxmann’s.

1.15 Suggested Readings

‹ Chandra, P. (2015). Financial Management (9th ed.). McGraw Hill.
‹ Brigham, E.& Houston, J. (2014). Fundamentals of Financial Management
(14th ed.). Thomson.

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L E S S O N

2
The Time Value of Money
Prof. (Dr.) Birendra Prasad
Managing Director
NIRGOM Learning Solutions and
Advisory Services Pvt Ltd., Delhi NCR
Email-Id: drbprasad@yahoo.in

STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Time Lines and Notation
2.4 )XWXUH 9DOXH RI D 6LQJOH &DVKÀRZ
2.5 Simple Interest
2.6 Doubling Period
2.7 Effective versus Nominal Rate
2.8 3UHVHQW 9DOXH RI D 6LQJOH &DVKÀRZ
2.9 Present Value of an Uneven Series
2.10 Relationship Between FVIF(k,n) and PVIF(k,n)
2.11 Shorter Discounting Period
2.12 Annuity
2.13 Relationship Between FVIFA(k,n) and PVIFA(k,n)
2.14 Present Value of a Growing Annuity
2.15 Present Value of a Perpetuity
2.16 Important Steps to Solve Problems (The Time Value of Money)
2.17 Summary
2.18 Answers to In-Text Questions
2.19 Self-Assessment Questions
2.20 References

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 THE TIME VALUE OF MONEY

2.1 Learning Objectives Notes

After studying this lesson carefully, you should be able to:

‹ Understand the significance of The Time Value of Money.

‹ Understand how to compare two different cashflows which occur at

different point of time.
‹ Know the value of the projected cashflows at any specific time (as
per your need and requirements) irrespective of wherever cashflow
actually occurs.
‹ Understand the relationship between present value and future value.

‹ Design the payments/receipts planning by using the concept that any

specific point of time (as per need or convenience).
Value of Total Cash Inflows = Value of Total Cash Outflows.
‹ Plan the future strategy based on expected cashflows (inflows/
outflows).

2.2 Introduction
Money has time value as it earns interest. Besides, if left for compounding,
it earns interest on the principal amount and also on the previously
earned interest. As a result, a rupee invested today can grow to a rupee
plus interest and interest-on-the-interest at some future period. A rupee
today is more valuable than a rupee at some future date. The reasons
are as follows:
‹ In general, current consumption is preferred in comparison to future
consumption.
‹ Given timeframe to us, our capital can be productively employed to
generate positive returns.
‹ The purchasing power of a rupee today is more than the purchasing
power of the same later on. (We have assumed the inflationary
period)
In real life situations, cashflows occurat different point of time. It really
becomes difficult to compare the cashflows which actually occurs at
different point of time or may be with different magnitude. Thus, we
need to deal with the magnitude as well as direction. Indeed, it becomes
a gigantic task and a reasonable level of understanding the nuances of

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 MBAFT 6204 CORPORATE FINANCE

Notes the time value of money immensely helps us. For example, to compare
the cashflows which have occurred at different point of time, we need to
bring all given cashflows at the same point of time (either by discounting
or compounding). Needless to say, it becomes extremely important to
understand the conceptual framework along with the insights of the time
value of the money. Thus, the tools of compounding and discounting
come in forefront and understanding the multi-faceted aspects of the
time value of the money becomes extremely important and helpful for
making financial decisions.

2.3 Time Lines and Notation

When cashflows occur at different point of time, it is important for us
to use the time line. A time line refers to plotting the given cashflows
against the time period where it actually occurs. It shows the timing
and the amount of each cashflow in a cash flow stream. For example, a
cashflow stream of INR 10,000 at the end of each year for the next five
years along with an interest rate @ 12% is as follows:

Here, 0(zero) refers to the period right now i.e., the present time. Any
cashflow which occurs right now is already in present value terms
and hence it does not require further adjustment. Further, we need to
understand the difference between a period of time and a point in time.
For example, Period 2 is the is the two years portion of time between
point 0 and point 2 and so on. The cashflow occurring at point 2 is the
cashflow that occurs at the end of period 2. Finally, we need to specify
the discount rate for each period on the time line. It is worth noting that
discounting/compounding rate may differ from period to period as per the
given situation. In general, a cashflow occurring at the end of year n is
equivalent to the cashflow occurring at the beginning of the year (n+1).

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 THE TIME VALUE OF MONEY

2.4 Future Value of a Single Cashflow Notes

Let us assume one deposits INR 20,000 for a period of three years which
fetches a return of 9% per annum. At the end of 3 years, this deposit
would grow as follows:
Year Amount (in INR) Amount
(in INR)
st st
1 year Principal amount at the beginning of 1 year 20,000
Interest for the year (INR 20,000 × 0.09) 1,800
st
Thus, new principal amount at the end of the 1 year 21,800
nd nd
2 year Principal amount at the beginning of the 2 year 21,800
Interest for the year (INR 21,800 × 0.09) 1,962
nd
Thus, new principal amount at the end of the 2 year 23,762
rd rd
3 year Principal amount at the beginning of the 3 year 23,762
Interest for the year (INR 23,762 × 0.09) 2138.58
Principal at the end of 3rd year 25900.58
The process of investing money and reinvesting the interest earned on it
is called compounding. Now, the future value of a single cashflow after
n years (along with the interest earned on it) @ k per cent is as follows:
FVn = Amount (Present Value) × (1+ k)n
In the above equation, (1+ k)n is referred to as FVIF(k,n) and it is read
as Future Value Interest Factor at the rate of k per cent for n years. In
short, we call (1+k)n as Future Value Interest Factor (or simply the
Future Value Factor).
For better understanding, let us find out the future value of amount A
at the end of n years with an interest rate k per cent per annum. Let us
further assume that FVi represents the future value at the end of i years.
Now, we have
Future value at the end of 1st year (FV1)A×(1+k) i.e. A × (1+k)1
Future value at the end of 2nd year (FV2)[A×(1+k)]×(1+k) i.e. A × (1+k)2
Future value at the end of 3rd year (FV3)[A×(1+k)2]×(1+k) i.e. A × (1+k)3
Future value at the end of 4th year (FV4)[A×(1+k)3]×(1+k) i.e. A × (1+k)4
…………………………………………………………………………………
…………………………………………………………………………………

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Notes Future value at the end of nth year (FVn)[A × (1+k)(n-1)]×(1+k)i.e. A×

(1+k)n
‹ FVn = Amount × (1+k)n
where,
FVn = Future value of the amount at the end of n years
k = Interest rate (in decimal)
n = Number of years
In the above equation, (1+k)n is referred to as FVIF(k,n). Now, we would
rewrite the above equation as
FVn = A × FVIF(k,n)
For solving future value problems, we need to find out the future value
factors. For this, let us consider an example:
Example: Aryan deposits INR 5,000 in a bank today which pays 12 per
cent interest per annum and it is compounded annually. How much will
the deposit grow at the end of 16 years?
Solution:
Future value of the deposit amount at the end of 16th year (FV16)
= INR 5000 × FVIF(12%,16)
= INR 5000 × 6.130 = INR 30,650
Thus, the deposit would become INR 30,650 at the end of 16 years.
Note: The Annuity/present/future value tables suffers with lots of limitations.
It contains values for a limited number of interest rates. Thus, we would
require our own way of calculation such as using a calculator, excel etc.
FVIF(k,n) for various combinations
n/k 6% 7% 10% 12%
2 1.124 1.145 1.210 1.254
4 1.262 1.311 1.464 1.574
6 1.419 1.501 1772 1.974
8 1.594 1.718 2.144 2.476
10 1.791 1.967 2.594 3.106

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2.5 Simple Interest Notes

As of now, we have assumed that the investment is done at compound rate

of interest which actually assumes that each interest payment is reinvested
further to earn interest for the rest of the period. In such case, the value
of the investment at the end of the future period is computed as follows:
Future Value = Present Value×[1+(Interest rate × Number of years)]
= PV × [1 + (k × n)]

Graphic View of Compounding

For example, an investment of INR 91,000 with an interest rate of 10

per cent simple interest rate in 11 years would be equal to:
INR 91,000 [1 + (0.11x 5 ] = INR 91,000 ×1.55 = INR 1,41,050

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Notes 2.6 Doubling Period

Rule of 72
In general, we tend to get information on number of years or rate of
interest which would make our investment doubled. By using FVIF table,
it is indeed time consuming and we often lack ready reference. Thus, for
ready and quick reference, we use Rule of 72, the doubling period concept.
It simply states that for doubling the investment, the multiplication of the
rate of interest and number of years would be 72. For example, if the
rate of interest is 8 per cent per annum, then to double our investment,
it should take around 9 years (72/8 = 9). Similarly, to double our
investment in 6 years, we need to invest our money at the rate of 12%
(72/6 = 12). This short-cut method suffers with limitations and for
precision, we need to use FVIF(k,n).
Rule of 69
If we need more precision in terms of value what we obtain from the
Rule of 72, we would use Rule of 69. By this rule, the doubling period
is equal to:
0.35 +69/ Interest Rate (in %)
For example, the doubling period for the 12 percent interest rate would
be equal to:
0.35 + 69/12 = 0.35 + 5.75 = 6.1 years
Thus, for doubling the amount with interest rate @ 12% per annum would
be 6.1 years. Also, we can verify that the required doubling period as
per the Rule of 72 would be 6 years(72/12 = 6). Hence, we would find
different doubling period values as per the Rule of 69 and Rule of 72
respectively.

2.7 Effective Versus Nominal Rate

The general relationship between the effective interest rate and the stated
annual interest rate is as follows:
Effective interest rate = [1+Nominal Annual Interest Rate /m]m - 1
Example: Compute the effective rate of interest when nominal rate of
interest is 24% per annum and it is compounded annually, semi-annually,
quarterly and monthly.

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Solution: When compounding is done annually, we have m = 12/12 = 1 Notes

‹ Required effective rate of interest = [1+0.24/1]1 – 1 = [1+0.24]1 – 1
= [1.24]1 – 1 = 0.24 = 24%
When compounding is done semi-annually,
we have m = 12/6 = 2
‹ Required effective rate of interest = [1+0.24/2]2 – 1= [1+0.12]2 – 1
= [1.12]2 – 1 = 0.2544 = 25.44%
When compounding is done quarterly,
we have m = 12/3 = 4
‹ Required effective rate of interest = [1+0.24/4]4 – 1 = [1+0.06]4 – 1
= [1.06]4 – 1 = 0.2625 – 1 = 26.25%
When compounding is done monthly,
we have m = 12/1 = 12
‹ Required effective rate of interest = [1+0.24/12]12 – 1 = [1+0.02]12 – 1
= [1.02]12 – 1 =0.2682 = 26.82%
Thus, we conclude the above results in the tabular form as follows:
Compounding Nominal Rate Effective Rate Remarks
(in %) (in %)
Annually 24% 24% 24% = 24%
Semi-annually 24% 25.44% 25.44% > 24%
Quarterly 24% 26.25% 26.25% > 24%
Monthly 24% 26.82% 26.82% > 24%
By the above table, the relationship between effective rate of interest and
nominal rate of interest can be very well understood i.e., effective rate
of interest is always greater or equal to nominal rate of interest. Now,
we would write the relationship as follows:
(IIHFWLYH UDWH RI LQWHUHVW  • 1RPLQDO UDWH RI LQWHUHVW

2.8 Present Value of a Single Cashflow

Let us assume that at the end of n years, the value of the amount is A.
Now, the present value is:

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Notes PV = A × PVIF(k, n)
where,
PV = Present value of the cashflow occurring at the end of n years
A = Value of the amount at the end of n years
PVIF(k,n) = Present value interest factor at the rate of k% for n years
k = Interest rate (in %)
n = Number of years
PVIF(k,n) is read as Present Value Interest Factor at the rate of k percent
for n years. It is a discounting factor and hence the present value of
any amount is always smaller than the actual amount.
Example: Compute the present value of INR 70,000 receivable 9 years
from now and rate of discount is 16 percent?
Solution:
Required Present Value
= INR 70,000 ×PVIF(16%,9)
= INR 70,000 × 0.263
= INR 18,410
Value of PVIF(k,n) for various combinations of k and n
n/r 8% 10% 12% 14%
4 0.735 0.683 0.636 0.592
6 0.630 0.565 0.507 0.456
8 0.540 0.467 0.404 0.351
1 0 0.463 0.386 0.322 0.270
1 2 0.397 0.319 0.257 0.208
Graphic View of Discounting
The above table graphically depicts how the Present Value Interest Factor
varies in response to changes in interest rate and time. The PVIF(k,n)
declines as the interest rate and length of time increases.

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Notes

2.9 Present Value of an Uneven Series

In real life situations, we often come across uneven cashflow streams.
For example, the dividend stream for the equity share is usually uneven
and fluctuating.
The present value of an uneven cashflow stream is calculated as follows:
PVn = A1/(1+k)+A2/(1+k)2+ A3 /(1+k)3 +.............+ An/(1 +k)n =
™$i(1+k)i
where,
PVn = Present Value of a Cashflow stream
Ai = Cashflow occurring at the end of year i
k = Discount rate
n = Duration of the Cashflow stream
The following table shows the calculation of the present value of an
uneven cash flow stream using a discount rate of 10 per cent.
Year Cashflow (in PVIF(10%.n) Present Value of each
INR) Cash Flow (in INR)
3 2,000 0.751 1502
5 7,000 0.621 4347
8 11,000 0.467 5137
10 17,000 0.386 6562
12 25,000 0.319 7975
Present Value (in total) 25,523

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Notes 2.10 Relationship Between FVIF(k,n) and PVIF(k,n)

FVIF(k,n) × PVIF(k,n) = 1
PVIF(k,n) = 1/FVIF(k,n)
FVIF(k,n) = 1/ PVIF(k,n)

2.11 Shorter Discounting Period

Sometimes cash flows have to be discounted more frequently than once a
year say for example semi-annually, quarterly, monthly, or daily. In such
case of intra-year compounding, the shorter discounting period implies
that the number of periods increase and the discount rate applicable per
period decreases. The general formula for calculating the present value
in the case of shorter discounting period is as follows:
PV = FVn (1/1 + k/m)mn
where,
PV = present value
FVn = Cash flow after n year
m = frequency of compounding i.e. number of times per year
discounting is done
k = annual discount rate n = Number of years
For better understanding, let us consider a cashflow of INR 10,000 which
is supposed to be received at the end of 4th year. Now, to compute the
present value of this cashflow when the compounding is done quarterly
and the discount rate is 12 per cent, we would proceed as follows:
In the given case, as the compounding is done quarterly ? m = 4.
Now, the present value is:
PV = INR 10,000 × PVIF(k/m, mxn) = INR 10,000 × PVIF(12%/4, 4×4)
= INR 10,000 × PVIF(3%, 16) = INR 10,000 × 0.6232 = INR 6,232
Thus, the required present value of INR 10,000 which is expected to be
received at the end of 4th year along with interest rate 12% per annum
being compounded quarterly is INR 6,232.

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2.12 Annuity Notes

An annuity can be defined as a stream of equal cashflows occurring

at regular intervals. For example, EMIs, Insurance premium, Recurring
deposits etc.
If the cashflows occur at the end of the period, the annuity is called
Regular Annuity. Similarly, if the cashflows occur at the beginning
of the period, it is referred to as Annuity Due. If the annuity begins
with some deferment period, it is referred to as Deferred Annuity. It is
interesting to note that the deferred annuity may be either Annuity due
or Regular annuity. The important fact to be noted here is that annuity
table is made on the basic assumption that the cashflows occurs at the
end of the period.

2.12.1 Future Value of Annuity

FVAn = Amount × FVIFA(k,n)
where, FVIFA(k,n) = [(1+ k)n -1]/k
k = Interest rate (in %)
n = Number of years
In the above equation, [(1+ k)n -1]/k is referred to as FVIFA(k,n) and it
is read as Future Value Interest Factor Annuity at the rate of k per cent
for n years. In short, we call it as Future Value Interest Factor Annuity
(or simply the Future Value Annuity Factor). The concept of future value
of annuity can be applied in a variety of contexts.
Example:
Suppose you deposit INR 1,000 annually for 5 years and your deposit
earn a compound interest rate of 10 per cent. Compute the value of the
accumulated deposit at the end of 5 years assuming that each deposit
occurs at the end of the year.
Solution:
The required value of the deposit at the end of 5 years
= INR 1,000 × FVIFA(10%,5) = INR 1,000 × 6.105 = INR 6,105

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Notes 2.12.2 TimeLine for the Annuity

Value of FVIFA(k,n) for Various Combinations of k and n

n/k 6% 8% 10% 12% 14%
2 2.060 2.080 2.100 2.120 2.140
4 4.375 4.507 4.641 4.779 4.921
6 6.975 7.336 7.716 8.115 8.536
8 9.897 10.636 11.436 12.299 13.232
10 13.181 14.487 15.937 17.548 19.337
12 16.869 18.977 21.384 24.133 27.270

2.12.3 Sinking Fund Factor

The inverse of FVIFA(k,n) is referred to as Sinking Fund Factor.
Thus, the Sinking Fund Factor is equal to k/[(1+ k)n -1]
k = Interest rate (in %)
n = Number of years
If we need to get a target amount in future by depositing an equal amount
at the end of every year, we need to simply multiply the target amount
by sinking fund factor to arrive at the required amount which needs to
be deposited at the end of every year.

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2.12.4 Present Value of an Annuity Notes

PVA = Amount × PVIFA(k,n)

Where, PVIFA(k,n) = [(1+ k)n -1]/k (1+k)n
k = Interest rate (in %)
n = No. of years
In the above equation, [(1+ k)n -1]/k (1+ k)n] is referred to as PVIFA(k,n)
and it is read as Present Value Interest Factor Annuity at the rate of k
per cent for n years. In short, we call it as Present Value Interest Factor
Annuity (or simply the Present Value Annuity Factor). The concept of
present value of annuity is extensively utilized for financial evaluation
of a project.
Example: Suppose you deposit INR 23,000 annually for 12 years and
your deposit earn a compound interest rate of 8 per cent. Compute the
present value of the accumulated deposit assuming each deposit occurs
at the end of the year.
Solution: The required present value of the deposit
= INR 23,000 × PVIFA(8%,12) = INR 23,000 × 7.536 = INR 1,73,328
Thus, the required present value of the accumulated deposit is INR 1,73,328.
PVIFA(k,n) for different combinations of k and n

2.12.5 Capital Recovery Factor

n/r 6% 8% 10% 72% 14%
2 1.833 1.783 1.737 1.690 1.647
4 3,165 3.312 3.170 3.037 2.914
6 4.917 4.623 4.355 4.111 3.889
8 6.210 5.747 5.335 4.968 4.639
10 7.360 6.710 6.145 5.650 5.216
12 8.384 7.536 6.814 6.194 5.660
The inverse of PVIFA(k,n) is referred to as Capital Recovery Factor. Thus,
the Capital Recovery Factor is equal to [k × (1+ k)n]/[(1+ k)n -1]
where,
k = Interest rate (in %)
n = Number of years

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Notes If we need to get a target amount right now in lieu of depositing an

equal amount at the end of every year for n years, we need to simply
multiply the target amount by capital recovery factor. This would give
us the amount which we actually need to deposit at the end of every
year for n years.

2.13 Relationship Between FVIFA(k,n) and PVIFA(k,n)

FVIFA(k,n) × PVIF(k,n) = PVIFA(k,n)
PVIFA(k,n) × FVIF(k,n) = FVIFA(k,n)

2.14 Present Value of a Growing Annuity

A cash flow that grows at a constant rate for a specified period of time
is a growing annuity. The time line of a growing annuity is shown below:

The above formula can be used when the growth rate is less than the
discount rate i.e., g<k.
Example: Suppose you have the right of mining for the next 20 years
over which you expect to get 100 tons per year. The current price per
ton INR 5,000, but it is expected to increase at a rate of 6 per cent per
year. The discount rate is 10 per cent. Compute the present value of the
expected income from this mine.
Solution: The required present value of the expected income from mine
= INR 5,000 × 100 × (1.06) [1-(1.0620/1.1020)]/[0.10-0.06]
= INR 69,34,392.

2.15 Present Value of a Perpetuity

A perpetuity is perpetual annuity i.e., it is an annuity of infinite duration.
The present value of a perpetuity is expressed as follows:

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PV’= A/k Notes

where, P’ = Present Value of Perpetuity
A = Amount (equal cashflows)
Note: Future Value of perpetuity cannot be determined.

2.16 Important Steps to Solve Problems (The Time Value

of Money)
Step I: Make a Time Line.
Step II: Plot the Cashflow Streams (Inflow as well as Outflow) on the
Time Line against the period it has occurred.
Step III: Choose a Focal Time.
Step IV: At the Focal Time, the equation would be as follows:
PV or FV of Inflows = PV or FV of Outflows
Step V: After solving the above equation, we get the desired/unknown
value.
Note: While using the table (discounting/compounding), we need to be
extremely cautious to observe whether the given annuity is Annuity Due
or Regular Annuity. As annuity table is made on the basic assumption
that it is a regular annuity, hence, in the case of Annuity Due, we first
convert this into regular annuity and thereafter we use annuity table.
Also, we need to be very careful while plotting the cashflow streams on
the time line. Also, inflows and outflows must be clearly distinguished.
For example, we can plot the inflow and outflow as follows:
Inflow of INR 700 INR 700
Outflow of INR 9,000 (INR 9,000)
IN-TEXT QUESTIONS
1. What is the Time Value of Money (TVM) concept in the corporate
finance state?
(a) Money earned today is worth more than the same amount
in the future
(b) Money earned today is worth less than the same amount
in the future

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Notes (c) Money earned today and future has the same value
(d) Money earned in the future is unpredictable
2. Which of the following formulas represents the Future Value
(FV) of an investment given a Present Value (PV), interest rate
(r), and number of periods (n)?
(a) FV = PV × (1 + r)^n
(b) FV = PV / (1 - r)^n
(c) FV = PV × (1 - r)^n
(d) FV = PV / (1 + r)^n
3. What does the term “discounting” refer to in the context of the
Time Value of Money?
(a) Calculating the present value of future cash flows
(b) Calculating the future value of present cash flows
(c) Calculating the interest rate for an investment
(d) Calculating the average value of money over time
4. Which factor has the most significant impact on the future value
of an investment?
(a) Present value (PV)
(b) Interest rate (r)
(c) Number of periods (n)
(d) Type of investment
5. What does the term “compounding” mean in the context of Time
Value of Money?
(a) Adding interest to the principal amount and then earning
interest on both the principal and interest
(b) Subtracting interest from the principal amount
(c) Calculating the present value of an investment
(d) Calculating the future value of an investment
6. If you invest $1,000 today at an annual interest rate of 8%,
what will be the future value of the investment after 5 years,
assuming compound interest?

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(a) $1,146.93 Notes

(b) $1,469.33
(c) $1,480.00
(d) $1,080.00
7. Which of the following statements is true regarding the relationship
between the Present Value (PV) and the Future Value (FV) of
an investment?
(a) PV is always greater than FV
(b) PV is always equal to FV
(c) PV is always less than FV
(d) The relationship between PV and FV depends on the
interest rate and time period
8. If the interest rate is 10% per year, what is the present value of
$1,000 to be received after 3 years?
(a) $751.32
(b) $620.92
(c) $909.09
(d) $727.27
9. What is the formula for calculating the Present Value (PV) of
a future cash flow (FV) given an interest rate (r) and number
of periods (n)?
(a) PV = FV × (1 - r)^n
(b) PV = FV × (1 + r)^n
(c) PV = FV / (1 - r)^n
(d) PV = FV / (1 + r)^n
10. Which of the following best describes the concept of the Time
Value of Money?
(a) Money grows at a constant rate over time
(b) Money has different values at different points in time
(c) Money’s value remains the same over time
(d) Money’s value is determined by the government

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Notes 2.17 Summary

‹ Money has a time value. If left for compounding, it earns interest
on the principal amount and also on the previously earned interest.
‹ A cash flow refers to the cash which we either expect to receive (a
cash inflow) or cash we expect to pay someone (a cash outflow).
‹ The reasons for Time Value of Money are because of people prefer
current consumption to future consumption, we can productively
employ our capital generate positive returns and finally the presence
of inflation makes our money more powerful today than a year
hence. The purchasing power of a rupee today is more than what
we have later on.
‹ Future value at the end of nth year is (FVn) = A × (1+k)n
In this equation, (1+k)n is referred to as FVIF(k,n).
‹ For doubling period, we use Rule of 72 and Rule of 69. Rule of 72
is simpler in comparison to Rule of 69 because of less precision.
‹ The general relationship between the effective interest rate and the
stated annual interest rate is
Effective interest rate = [1+Nominal Annual Interest Rate /m]m – 1.
  (IIHFWLYH UDWH RI LQWHUHVW • 1RPLQDO UDWH RI LQWHUHVW
‹ The present value of a single cash flow is PV = A × PVIF(k,n)
‹ The present value of an uneven cashflow stream is PVn ™$i(1+k)i
‹ The Relationship between FVIF(k,n) and PVIF(k,n) is FVIF(k,n) × PVIF(k,n)
= 1
‹ The general formula for calculating the present value in the case
of shorter discounting period is PV = FVn (1/1 + k/m)mn
‹ An annuity can be defined as a stream of constant cashflows
occurring at regular intervals for a finite period. If the cashflows
occur at the end of the period, it is called Regular Annuity. On the
other side, if the cashflows occur at the beginning of the period,
it is referred to as Annuity Due. If the annuity begins with some
deferment period, it is referred to as Deferred Annuity. Interestingly,
deferred annuity would be either Annuity due or Regular annuity.

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‹ The present value of an annuity is equal to PVA = Amount × Notes

PVIFA(k,n)
‹ The inverse of PVIFA(k,n) is referred to as Capital Recovery Factor
and the inverse of FVIFA(k,n) is referred to as Sinking Fund Factor.
‹ The Relationship between FVIFA(k,n) and PVIFA(k,n) is FVIFA(k,n)×PVIF(k,n)
= PVIFA(k,n)
‹ A perpetuity is an annuity of infinite duration. The PV perpetuity
is A/k.
‹ The important steps solve the problems of The Time Value of Money
are as follows:
(i) Make a Time Line.
(ii) Plot the Cash flow Streams (Inflow as well as Outflow) on the
Time Line
(iii) Choose a Focal Time. (It is the most important step)
(iv) At the Focal Time, we have
PV(FV) of Cash Inflows = PV(FV) of Cash Outflows
While solving the above, we would get the desired/unknown value

2.18 Answers to In-Text Questions

1. (a) Money earned today is worth more than the same amount in
the future
2. (a) FV = PV × (1 + r)^n
3. (a) Calculating the present value of future cash flows
4. (b) Interest rate (r)
5. (a) Adding interest to the principal amount, and then earning interest
on both the principal and interest
6. (b) $1,469.33
7. (c) PV is always less than FV
8. (a) $751.32
9. (d) PV = FV/(1 + r)^n
10. (b) Money has different values at different points in time

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Notes 2.19 Self-Assessment Questions

1. Compute the value of a deposit INR 8,900 today after 9 years if the
interest rate is 13 per cent per annum.
2. If you deposit INR 8,000 today at 6 per cent rate of interest, how
many years (roughly) will this amount grow to INR 2,56,000? Use
the rule of 72 for computation.
3. You have deposited INR 7,000 today @ 8% interest per annum.
How long would this take to become INR 56,000?
4. Ramesh offers you INR 40,000 at the end of 12 years for a deposit
of INR 5,000 right now. Compute the interest rate implied in his
offer.
5. Akshat deposits INR 4,000 at the end of each year for first 7 years,
and Rs. 9,000 a year for 13 years thereafter. How much amount
he can expect to be accumulated at the end of 25 years, if the rate
of interest is 6 per cent per annum and the compounding is done
annually?
6. Aryan saves INR 4,000 each year for 4 years, and INR 12,000 for
6 years thereafter. If the rate of interest is 7 per cent per annum
compounded annually, compute the accumulated value of his savings
at the end of 10 years.
7. XYZ Ltd offers you to pay an amount of INR 2,50,000 at the end
of 7 years if you agree to deposit INR 24,000 each year for first
5 years. Compute the interest rate earned on your deposit.
8. Compute the present value of an income stream which provides INR
20,000 at the end of year 1, INR 45,000 at the end of year 4 and
INR 90,000 during each of the years 9 through 15. Assume the
interest rate @ 8 per cent per annum.
9. Sudarshan promises you to pay INR 62,000 annually for 4 years if
you agree to deposit with him INR 95,000 right now. Compute the
interest rate offered by Sudarshan. Assume that the first payment
occurs at the end of 2nd year.
10. Rajesh requires INR 95,000 at the beginning of each year from 2018
to 2022. For this, how much should he deposit (in equal amounts)
at the end of each year from 2011 to 2015, if the interest rate is
9 per cent per annum.

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11. After seven years, Mr Lokesh will receive a pension of INR 12,000 Notes
per month for 20 years. How much can Mr. Lokesh borrow now at
7.5 per cent interest rate so that the borrowed amount is paid with
35 per cent of the pension amount?
The interest will be accumulated till the first pension amount
becomes receivable.
12. Mugabe Corporation has to retire INR 25 million of debentures
each at the end of 6, 7, and 8 years from now. How much should
the firm deposit in a sinking fund account annually for 4 years, in
order to meet the debenture retirement need?
The net interest rate earned is 7 per cent.
CASE STUDY
Mr. Suresh wants your advice on his investment plan. He is 55 years
and has INR 3,00,000 in the bank. He plans to work for 5 years more
and retire at the age of 60. His present salary is INR 9,00,000 per
year. He expects his salary to increase at the rate of 15 per cent per
year until his retirement. He has decided to invest his bank balance
and future savings in a balanced mutual fund scheme that he believes
to get a return of 6 per cent per year. You come forward to help him
in answering few questions given below. You have chosen to ignore
the tax factor:
(a) Once he retires at the age of 60, he would like to withdraw INR
12,00,000 per year for his routine needs for the coming 20 years
(His life expectancy is 80 years). Each annual withdrawal will
be made at the end of the year.
(b) Compute the value of his investments to meet his retirement
need when he turns 60 years.
(c) How much should he deposit each year in saving scheme for the
next 15 years so that he withdraws INR 12,00,000 per annum
from the beginning of the 16th year for a period of 20 years?
His savings would occur at the end of each year.
(d) Suresh is curious to keep aside INR 9,00,000 per year for donation
in the last 4 years of his life. Each donation is expected to be made

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 MBAFT 6204 CORPORATE FINANCE

Notes at the beginning of the year. Also, he has decided to maintain

INR 30,00,000 for his granddaughter’s educational support at
the end of his life.
(e) Compute the value of his accumulated wealth. The accumulated
wealth must fulfil his need for donation and granddaughter’s
educational expenses.
(f) Suresh wants to find out the present value of his lifetime income
from salary. His current salary is paid at the end of the year
which is INR 9,00,000. Compute the present value of his total
salary income. Assume that his salary will increase @ 15
percent per annum until retirement and the discount rate is 6%
per annum.

2.20 References
‹ Fundamentals of Financial Management, Chandra, Prasanna (Tata
McGraw Hill Pvt. Ltd.).
‹ Essentials of Corporate Finance, Ross, Stephen A; Westerfield,
Randolph W.; Jordan, Bradford D. (McGraw Hill).
‹ Financial Management, Pandey, I M (Vikas Publishing House).
‹ Corporate Finance and Investment, Pike, Richard; Neale, Bill (Prentice
Hall).
‹ Financial Management & Policy, Horne, James C Van (Prentice Hall).
‹ Essentials of Corporate Finance, Ross, Stephen A; Westerfield,
Randolph W; Jordan, Bradford D. (McGraw Hill Pvt. Ltd.).
‹ Corporate Finance: Theory & Practice, Damodaran, Aswath (John
Wiley & Sons).
‹ Principles of Corporate Finance, Brealey, Richard A; Myers, Stewart
C (Tata McGraw Hill Pvt. Ltd.).

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L E S S O N

3
Cost of Capital
Dr. CA Madhu Totla
Assistant Professor
SSCBS
University of Delhi
Email-Id: madhumaheshwari@sscbsdu.ac.in

STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 9DULRXV &ODVVL¿FDWLRQV RI &RVWV RI &DSLWDO
3.4 0HDVXUHPHQW RI 6SHFL¿F &RVWV RI &DSLWDO
3.5 Calculation of Weighted Average Costs of Capital (WACC)
3.6 International Dimensions to Cost of Capital
3.7 Summary
3.8 Answers to In-Text Questions
3.9 Self-Assessment Questions
3.10 References
3.11 Suggested Readings

3.1 Learning Objectives

‹ Understanding the concept of cost of capital, implicit cost, explicit cost, historical
cost and future cost, average cost and marginal cost.
‹ Measurement of cost of debt - perpetual and redeemable.
‹ Measurement of cost of preference share capital - irredeemable and redeemable.
‹ Measurement of cost of equity.
‹ Understanding of the Capital Asset Pricing Model (CAPM).
‹ Understanding the concept of retained earnings implicit cost.

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 MBAFT 6204 CORPORATE FINANCE

Notes ‹ Determination or measurement of weighted average cost of capital.

‹ Understanding of the cost of capital in the international scenario.

3.2 Introduction
The cost of capital plays a significant and crucial role in any firm’s
investment and financing decisions. No investment project can be evaluated
without taking into account the cost of capital. The firm uses the cost of
capital as an indicator or a measuring stick to determine how beneficial
is a project for the firm. Debt, preference share capital, equity capital
and retained earnings are amongst the various sources of finance a firm
can raise. All these sources have some cost which is widely known as
the cost of capital of any organisation. In other words, the cost of capital
is that rate of return; an organisation or an entity needs to pay to the
providers of finance which may be agreed upon or is expected by them.
It compensates the suppliers of funds for a time as well as risk. In terms
of capital budgeting, the cost of capital is the discount rate used to figure
out the present value of the expected future cash flows to decide whether
the project is worth accepting for maintaining the market value of the
firm constant.
Prof. Ezra Solomon defines the cost of capital as “the minimum required
rate of earning or the cut-off rate for capital expenditure”.
The cost of capital is also known as the discount rate, the minimum
required rate of return, the cut-off rate or the hurdle rate. It is the
combination of the risk-free rate of return and a premium for undertaking
risk about the project.
The cost of capital which is the minimal or lowest required rate of return
envisaged by the providers of funds depends on the prevailing risk-free
rate of return and the associated risk factors of the firm. The risk-free rate
is the interest or the rate of return on government securities and the risk
associated with the firm can be a business risk or financial risk or both.
These three factors play a major role in determining the cost of capital
of any firm. Business risk is the uncertainty associated with the firm
not being able to meet its fixed operating expenses and financial risk is
the uncertainty associated with the firm not being able to meet its fixed
financing costs such as interest on debt and dividend on preference shares.

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 COST OF CAPITAL

3.3 Various Classifications of Costs of Capital Notes

The cost of capital can be categorised in numerous ways:

‹ Specific Cost and the Composite Cost
‹ Implicit and Explicit Cost
‹ Historical and Future Cost
‹ Average and Marginal Cost
Specific Cost and Composite Cost
The cost of raising each source of finance individually is termed as the
specific cost of capital of that source. Thus, we have the cost of debt
(redeemable and perpetual), cost of preference shares capital (irredeemable
and redeemable), cost of equity share capital and that of retained earnings.
Combining the individual cost of various sources of finances gives us the
composite cost of capital or the combined cost of capital or the overall
cost of capital. The cost of raising debt is an example of a specific cost
while if the firm’s overall cost of capital of all sources (debt, preference
and equity capital along with retained earnings) combined together is say
9%, then it is called as composite cost.
Implicit and Explicit Cost
Implicit cost is the opportunity cost and arises when different alternative
use of funds is being considered. According to James Porterfield, “Implicit
costs is the rate of return associated with the best investment opportunity
that will be foregone if the project under consideration by the firm is
accepted.” These costs are known to be economic costs.
Explicit cost is the cost or amount being paid by the firm to raise and
utilise finances. It may be either the stated rate or otherwise which a
firm bear to use the finances. It is the interest rate at which the present
value of cash inflows (raising funds) equals the present value of the cash
outflows related to utilising of funds (interest, dividend etc.). These costs
are known to be out-of-pocket costs.
Implicit costs do not require any outlay of cash whereas explicit costs
entail cash outflow. Explicit costs are measurable and thus recorded but
implicit costs cannot be measured and thus not recorded.

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Notes Retained earnings used as a source of finance will not have any explicit
costs but only implicit costs.
If the firm has issued 9% preference share capital, then this 9% is the
explicit cost. But when say the retained earnings could be used elsewhere
giving a return of 12%, then this 12% is the implicit cost of retained
earnings.
Historical and Future Cost
Costs that have already been incurred are the historical cost whereas
the expected or anticipated cost of a project’s funding is known as the
future cost. The knowledge of historical and future costs helps in making
a comparative analysis of actual and projected costs.
The cost of existing sources of funds is the historical cost while if the
firm raises capital in future at say 15%, then this 15% is the future cost
of capital.
Average and Marginal Costs
The average cost of capital is the weighted average cost of each given
fund type, with weights being the percentage of different sources of
long-term funds in the firm’s balance sheet. Its computation involves
determining the cost of each given source of capital and then assigning
each source a weight as per the proportion and then finding out the sum
of the product of the individual costs with the assigned weight.
Marginal cost is the incremental cost or the differential costs incurred
for raising new funds. This cost is being used for the evaluation of any
long-term investment for which additional finances need to be raised
exclusively at a cost. Suppose a firm raises additional debt, then the cost
of raising this additional debt is the marginal cost.

3.4 Measurement of Specific Costs of Capital

3.4.1 Cost of Debt

The cost of debt may be described as the required rate of return which
must be earned by investments financed through debt to keep the earnings
of equity shareholders constant. Outflows related to debt involve the

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 COST OF CAPITAL

payment of interest and principal as per the terms of the debt. Interest is Notes
always payable on the face value of the debt even if the debt is issued
on premium or discount or at par.
The cost of debt is calculated both for perpetual (irredeemable) and
redeemable debt.
(a) Cost of Perpetual Debt
Perpetual debt just involves payment of interest on the face value of the
debt and hence the calculation of the cost of perpetual debt is simple.
The cost of perpetual debt is given by:
ki = I/SP
kd = I (1-t)/SP
Where,
I = Annual interest payment on a debt
SP = Sale proceeds of debt
t = Tax rate
ki = Before-tax cost of perpetual debt
kd = After-tax cost of perpetual debt
Example 3.1: X Ltd. has issued an 8 per cent perpetual (irredeemable)
debt of Rs. 5,00,000 and the prevailing tax rate of 25 per cent. Find out
the cost of debt (before tax and after-tax) assuming the debt is offered
at (i) par, (ii) 5% premium, and (iii) 5% discount.
Solution:
(i) Debt offered at par
Before-tax cost of perpetual debt, ki = Rs. 40,000/Rs. 5,00,000 =
8 per cent. After-tax cost of perpetual debt, kd = ki (1 – t) = 8%
(1 – 0.25) = 6 per cent.
(ii) Offered at a premium
Before-tax cost of perpetual debt, ki = Rs. 40,000/Rs. 5,25,000 =
7.62 per cent. After-tax cost of perpetual debt, kd = ki (1 – t) =
7.62% (1 – 0.25) = 5.71 per cent.

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Notes (iii) Offered at discount

Before-tax cost of perpetual debt, ki = Rs. 40,000/Rs. 4,75,000
= 8.42 per cent. After-tax cost of perpetual debt, kd = ki (1 – t) =
8.42% (1 – 0.25) = 6.32 per cent.
(b) Cost of Redeemable Debt
Redeemable debt involves payment of interest and principal of the debt.
When the repayment of the principal is only at maturity the calculation
of the cost of redeemable debt is calculated using (i) The trial-and-error
method (ii) Short cut method.
The formula for the calculation of the cost of debt by the trial-and-error
method is given by—
n
COI t COPn
CI 0 – ∑ +
t =1 (1 + K d ) (1 + K d ) n
t

Where,
CI0 = Net cash proceeds from the issue of debt.
COI1 + COI2 + ... + COIn = Cash outflow on account of interest payments
in periods 1, 2 and so on, till maturity after adjusting tax savings on
interest payment.
COPn = Principal repayment on maturity
kd = Cost of debt after tax.
If the repayment of the principal is in several instalments instead of a
one-time payment at maturity, then the formula for calculation of the
cost of debt is given by:
n
COI t + COPt
CI 0 – ∑
t =1 (1 + K d )t

The cost of debt using short cut method is given by –

I (1 – t ) + ( RV – SP ) / N
Kd =
( RV + SP ) / 2
Where,
kd = Cost of debt post-tax.
I = Interest payable on the debt annually
RV = Amount payable on redemption of debt.

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 COST OF CAPITAL

SP = Sale proceeds of debt. Notes

N = Number of years of the life of debt
However, the shortcut method cannot be used in the case of principal
repayment in instalments.
Example 3.2: X Ltd. offers a 10 per cent redeemable debt of Rs. 5,00,000
face value for 5 years and the applicable tax rate is 25 per cent. Determine
the cost of debt after tax assuming the debt is offered at a 10 per cent
discount and the floatation cost involved is estimated to be 2%.
Solution: Calculation of the cost of debt by the trial-and-error method –
CI0 = Rs. 5,00,000 - Rs. 50,000 (discount -10%) - Rs. 10,000 (floatation
cost - 2%) = Rs. 4,40,000 Cash outflow on account of interest payments
in years 1, 2, 3, 4, and 5 after adjusting tax savings on interest payments
= Rs. 50,000 - Rs. 12,500 (tax) = Rs. 37,500.
COPn = Principal repayment at the end of 5th year = Rs. 5,00,000
5
37,500 5,00,000
4,40,000 = ∑ +
t =1 (1 + kd )t (1 + kd )5

The cost of debt kd in the given equation can be obtained by the trial-
and-error method similar to the calculation of IRR in capital budgeting
decisions.
4,40,000 = 37,500 (PVIFAr,5) + 5,00,000 (PVIFr,5)
Trying with r = 10%
37,500 (3.791) + 5,00,000 (.621) = 4,52,663
Trying with r = 11%
37,500 (3.696) + 5,00,000 (.593) = 4,35,100
Hence, by interpolation—
4,52,663 – 4,40,000
kd = 10% + = 10% + .721
4,52,663 – 4,35,100

By shortcut method—
t (1 – t ) + ( RV – SP ) / N
kd =
( RV + SP) / 2

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Notes 50,000(1 – .25) + (5,00,000 – 4, 40,000) /5

kd =
(5,00,000 + 4, 40,000) /2

37,500 + 12,000
kd = = 10.53%
4, 70,000

3.4.2 Cost of Preference Share Capital

Preference shares have the characteristics of both debt as well as equity
share capital. They are entitled to dividends at the given fixed rate.
However, the dividend payment is not entitled to the tax deduction as it
is an appropriation of profits and not an expense. There are two kinds
of Preference shares: (i) Preference shares that cannot be redeemed
(Irredeemable) (ii) Preference shares that are to be redeemed after the
specified tenure (redeemable).
(a) Cost of preference shares which are irredeemable
The calculation of the cost of preference share capital which is irredeemable
is given by—
kp = PD/SP
Where,
PD = Annual dividend on preference shares.
SP = Sale proceeds on the issue of preference shares.
kp = Cost of irredeemable preference share.
Example 3.3: X Ltd. has offered 10 per cent irredeemable preference
shares of Rs. 5,00,000 and the floatation cost is 2 per cent. Determine
the cost of preference share capital if it is offered at (i) par, (ii) 5%
premium, and (iii) 5% discount.
Solution:
(i) Preference shares offered at par
Cost of preference shares, kp = Rs. 50,000/Rs. 4,90,000 = 10.20
per cent
(ii) Offered at a premium
Cost of preference shares, kp = Rs. 50,000/Rs. 5,15, 000 = 9.71
per cent

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 COST OF CAPITAL

(iii) Offered at discount Notes

Cost of preference shares, kp = Rs. 50,000/Rs. 4,65,000 = 10.75
per cent
(c) Cost of Preference Shares which are Redeemable
Redeemable preference share capital involves the payment of dividends
and capital. The calculation of cost of preference share capital which is
redeemable can be calculated using (i) Trial-and-error method (ii) Short
cut method.
The trial-and-error method: The cost of redeemable preference share is
given by—
n
PDt Pn
Pn – ∑ +
t =1 (1 + K p ) (1 + K p ) n
t

Where,
P0 = Net cash proceeds from the issue of redeemable preference shares.
PD1 + PD2 + ... + PDn = Cash outflow on account of annual dividend
payments in periods 1, 2 and so on, till redemption.
Pn = Capital repayment on redemption.
Kp = Cost of preference shares which are redeemable.
The cost of preference shares capital which is redeemable, using short
cut method is given by–
PD + ( RV – SP ) / N
Kp =
( RV + SP ) / 2

Where,
Kp = Cost of redeemable preference share capital.
PD = Annual dividend payment on preference share capital.
RV = Amount payable on redemption of preference share capital.
SP = Sale proceeds of preference share capital.
N = Number of years for redemption of preference shares.
Example 3.4: X Ltd. offers 10 per cent redeemable preference shares
of nominal value Rs. 1,000 per share which are to be redeemed at the
end of 25 years from now. Find out the cost of preference share capital

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 MBAFT 6204 CORPORATE FINANCE

Notes assuming the preference shares are issued at par and the floatation cost
involved is estimated to be 2.5%.
Solution: By shortcut method—
PD + ( RV – SP ) / N
kp =
( RV + SP ) / 2

100 + (1,000 – 975) / 25

Kp =
(1,000 + 975) / 2

100 + 1
Kp = = 10.23%
987.5
Hence, the cost of redeemable preference share capital is 10.23%.

3.4.3 Cost of Equity Share Capital

The cost of equity capital is the lowest or minimal rate of return a
business need to generate on that part of investment which is financed by
equity, to keep the market price of its shares stable. Equity shareholders
are those individuals or entities who are real risk takers in the company
and hence desire a return higher than the return given to debt providers
and preference shareholders. They get dividends on their investments
even though that’s not a legal binding on the company to pay and is paid
only if the company makes a sufficient profit. It becomes imperative to
consider the expected rate of return to figure out the cost of equity capital.
And figuring out the expected return is a very difficult task. Different
approaches have been developed to sort this issue: (i) Dividend Approach
(ii) Capital Asset Pricing Model (CAPM) Approach.
(a) Dividend Approach
This approach is based on the Dividend Valuation Model. This method
measures the cost of equity on the basis of desired rate of return in the
context of dividend pay-out in future on the equity shares. Consequently,
cost of equity capital which is usually written as ke, is the discount rate
that equals the present value of all expected future dividends to the net
proceeds from the sale of a share (in case of new share or additional
shares are being issued) or the current market price of a share (in case
of existing share purchase from market).

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When dividends grow at a constant rate (g), uniformly perpetually ke is Notes

given by:
n
D1 (1 + g)t –1
P0 (1 – f ) = ∑
t =1 (1 + K e )t

or,
D1
P0 =
ke – g

or,
D1
ke = +g
P0

Where,
D1 = Dividend which is expected at the end of first year.
P0 = Price of the equity shares currently prevailing in the market or the
net proceeds per share.
g = Growth rate in dividend (assumed to be constant growth rate)
ke = Cost of equity capital.
When dividends grow at a varying rate, ke is given by:
5
D0 (1 + g1 )t ∞
D5 (1 + g2 )t –5
P0 (1 – f ) = ∑ + ∑
t =1 (1 + K e )t t =6 (1 + K e )t

Where,
g1 = Growth rate in dividend for first 5 years.
g2 = Growth rate in dividend for 5th year onwards.
Nonetheless, the dividend growth model suffers with many practical issues
like it can be applied only for those companies which pay dividend and
doesn’t take into account the risk factor involved in forecasting growth
rates of dividends.
Example 3.5: The current market price of equity shares of X Ltd. is
Rs. 1,000 and expected dividend at the end of current year is Rs. 88.
Determine the cost of equity capital if the dividend grows at a constant
rate of 5%.

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 MBAFT 6204 CORPORATE FINANCE

Notes Solution: Cost of equity capital when the growth rate is constant is
calculated by—
D1
ke = +g
P0

88
ke = + .05
1000
ke =.138 = 13.8%
Example 3.6: X Ltd. forecasts a growth rate of 10 per cent p.a. for
next three years and them it is likely to fall and stabilise at 7 per cent
p.a. The dividend paid during last year was Rs. 5 and the desired rate
of return of equity investors is 12 per cent. Determine the value of the
equity share of X Ltd. as on date using dividend model.
Solution: Intrinsic value of an equity share of X Ltd. is the sum of the
present values of (i) dividends during years 1 through 3 and (ii) the
expected market price immediately after 3 years, based on constant growth
rate of 7 per cent per annum
Present value of dividends of year 1-3
Year Dividend PVIF (12%) PV of dividend
1 5.5 .893 4.91
2 6.05 .797 4.82
3 6.65 .712 4.74
Total 14.47
At the end of year 3, the market price of equity share will be:
D4
P3 =
ke – g

7.13
P0 =
.12 – 0.7
P0 = 142.42
Present value of Rs. 142.42 = 142.42 × .712 = 101.40
Intrinsic value of equity share as on date is Rs. 14.47 + Rs. 101.40 =
Rs. 115.87.

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 COST OF CAPITAL

(b) Capital Asset Pricing Model Approach Notes

The alternative method to determine cost of equity capital is the CAPM
approach. CAPM was originally developed to have a better understanding
of the behaviour of security prices and offers a mean for investors to
evaluate the influence of prospective investments in shares and other
securities on their overall portfolio risk and return. It basically explains
the risk reward trade-off for shares.
Assumptions of the CAPM approach.
(i) There are no restrictions on investments.
(ii) All investors have same (identical) expectations with respect to
returns, variance and correlation of returns of all securities.
(iii) All investors have the same piece of information which is freely
available in the market.
(iv) Market prices cannot be significantly impacted by any single investor.
(v) No taxes exist on investments and income in the economy.
As per CAPM approach, the investor is concerned with only the systematic
risk (non-diversifiable risk) as the unsystematic risk (diversifiable) can be
eliminated by the investor with the help of holding a diversified portfolio.
As per CAPM, the systematic risk is of a security is measured in term
RI FRHIILFLHQW EHWD %HWD ȕ LV D PHDVXUH WR FRPSDUH KRZ YRODWLOH D
security’s return is to the returns of a diversified (broad based) portfolio.
Beta may be described as an indicator to depict how closely the return on
a security/investment moves with the return n market. Beta of a broad-
based market portfolio is one. Beta coefficient of any security of one
would mean that the risk of that specified security is same as that of the
risk of the market. This means that the security returns completely move
in the same direction and magnitude as of the market returns. A negative
beta coefficient shows that the relationship is in the opposite direction.
Beta coefficient of zero (0) indicates that there is no market related risk.
With the perspective of the cost of equity capital, Capital Asset Pricing
Model describes the association between the desired rate of return (cost
of equity capital) and the systematic (non-diversifiable) risk of the firm
with the help of beta.
Where,

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Notes ke = rf + b(km – rf)

ke = Cost of equity capital
rf = Rate of risk free return
b = Beta coefficient of the security
km = Return on market portfolio
Example 3.7: X Ltd. wishes to determine its cost of equity capital. The
risk-free rate of return is 8 per cent and the beta of the security is 1.4.
The return expected on the market portfolio is 11.5 per cent.
Solution: As per CAPM, cost of equity capital: ke = rf + b(km – rf)
ke = .08 + 1.4 (.115 - .08)
ke = .08 + .049
ke = .129 = 12.9%
The CAPM approach of calculating cost of equity capital considers
risk in the form of beta coefficient which is completely ignored by the
dividend approach and also the CAPM approach helps in determining
the cost of equity for those firms who do not pay dividends. However,
the dividend approach provides for adjustment of floatation cost incurred
for raising equity which is ignored in CAPM approach. And also, CAPM
faces practical difficulties in the right estimation of beta coefficient and
risk-free rate of return.

3.4.4 Cost of Retained Earnings

Retained earnings of a company as a source of finance, has no obligations
for payment of any interest or dividend. It does not have any explicit cost
but involves implicit cost. As the earnings would have been distributed
as dividends if not retained by the company and the shareholders could
have earned something on it or consumed it. Shareholders have to forego
dividends and this is the opportunity cost of retained earnings. Cost of
retained earnings can thus be defined as the opportunity cost or the returns
foregone by the shareholders on the dividends.
External yield criteria approach may be used to determine the cost of
equity capital. This approach lays that the cost of retained earnings is the
return that the company could have earned had it invested this money in

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any external investment rather than distributing it to shareholders in the Notes

form of dividend. The company need to choose such investment which
has the same level of risk as that of the company itself. Thus, external
yield approach represents an opportunity cost which is justifiable from
economic point of view. We can infer that the opportunity cost which can
be used consistently (kr) is likely to be equal to ke. However, kr is bound
to be lower than ke because of floatation cost and dividend distribution
tax along with personal tax on dividend income of shareholders.
IN-TEXT QUESTIONS
Please indicate if the following statements are correct or incorrect:
1. Beta is an indicator of unsystematic risk.
2. High rate of corporate tax leads to a higher cost of debt.
3. Equity capital has no specific cost of capital as there is no legal
obligation of payment of dividends on equity capital.
4. Retained earnings do not have any cost of capital.
5. Cost of retained earnings is higher than the cost of equity.
6. Composite cost of capital will increase after payment of the
long-term debt in full.

3.5 Calculation of Weighted Average Costs of Capital (WACC)

The cost of capital is the composite cost of capital or the overall cost of
capital or the weighted average cost of capital is the weighted average
cost of each individual source of finance.
Cost of Overall
Cost of Cost of
Cost of Debt Retained Cost of
Preference Equity
× Weight Earnings × Capital
× Weight × Weight
Weight (WACC)

Overall Cost of Capital

The use of weighted average over simple average is required because of
the different proportions of the various sources of funds being used by
the company in its capital structure. Weighted average cost of capital (ko)
is calculated as follows:

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Notes (i) Determining the cost of each specific source of fund.

(ii) Assigning weights to each source of fund.
(iii) Calculating the product of each specific cost with respective weights
and then adding up all together.
It can be shown as: ko = kdwd + kpwp + kewe + krwr
Weights can be historical weights or marginal weights. Historical weights
can again be categorised into book value weights or market value weights.
Marginal weights use that percentage or proportion of each source of
finance, the company plans to raise additionally and use. The basis of
weights is the additional or new or incremental raising of funds. The
marginal weights can be used to calculate WACC when the project is
financed through raising of fresh funds only. It cannot be used when the
existing sources of finance are being utilised. It also ignores the existing
capital structure of the firm.
Historical weights utilise the existing proportion of the various sources of
finance in the current capital mix of the organisation. Historical weights
can be book value weights or market value weights. Book value weights
represent the proportion of various sources of finance as recorded in the
books or the financial statements of the company. Whereas market value
weights are based on the market value of various sources of finance (debt,
equity and preference shares) of the organisation, when they are traded
in the market. Market value weights are preferred as the amount of fresh
capital to be raised can be determined and the genuine cost of capital in
true sense can be calculated. However, getting market prices of various
sources of finance is not operationally easy and also weights based on
market prices fluctuate too much. From operational stand point, book value
weights are easy and straightforward and also the organisations’ capital
structure and its target capital structure is based on book value weights.
So, taking book value weights aid in analysing the capital structure.
Example 3.8: X Ltd.’s cost of capital of various sources of finance is:
Debt (after tax) 10 per cent
Preference share 15 per cent Equity share 20 per cent
The capital structure of X Ltd.:
Debt Rs. 15,00,000
Preference capital Rs. 10,00,000 Equity capital Rs. 75,00,000.

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 COST OF CAPITAL

Determine the weighted average cost of capital of X Ltd. using book Notes
value weights.
Means of finance Amount Weight Cost (%) Weighted
(Rs.) Cost
Debt 15,00,000 .15 .10 .015
Preference Share 10,00,000 .10 .15 .015
Equity Share 75,00,000 .75 .20 .15
Total 1,00,00,000 1.00 .180
Solution:
Weighted average cost of capital (WACC) of X Ltd. is 18%.
Example 3.9: X Ltd.’s cost of capital of individual sources of finance
is: Debt (after tax) 8 per cent.
Preference shares 12 per cent
Equity shares 18 per cent
Equity capital Rs. 60,00,000
The market value of these sources of finance is as follows:
Debt Rs. 23,00,000
Preference capital Rs. 18,00,000 Equity capital Rs. 79,00,000.
Find out the weighted average cost of capital.
Solution:
Means of finance Amount Weight Cost (%) Weighted
(Rs.) Cost
Debt 23,00,000 .192 .08 .0153
Preference Share Capital 18,00,000 .15 .12 .018
Equity Share 79,00,000 .658 .18 .1185
Total 1,20,00,000 1.00
Weighted Average Cost of Capital (WACC) of X Ltd. is 15.18%.
IN-TEXT QUESTIONS
Fill in the blanks:
7. Cost of preference share capital is ________ than the cost of
equity capital.
8. __________ is the cheapest source of finance.

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Notes 9. ____________ is a measure of systematic risk.

10. Retained earnings do not have any ________ cost. They carry
only ________ cost.
11. Cost of __________is highest among all the sources of finance.
12. Cost of capital of a company is the minimum required return
rate to keep the firm’s value__________.
13. __________method involves computing the cost of equity by
dividing the dividend by market price/net proceeds per share.
14. Cost of retained Earnings is equal to__________.
15. If tax rate declines, cost of debt will __________.

3.6 International Dimensions to Cost of Capital

International cost of capital has not been defined properly but it can be
taken as the opportunity cost of investing which is being forgone in favour
of investment in any foreign market. It is referred as the minimum expected
or required rate of return on investments made in foreign markets which
helps in drawing funds into that market. As risk and return go hand in
hand, meaning higher the risk higher will be the expected return. This
transmits into a higher international cost of capital in developing and
emerging economies. These economies are highly unstable and therefore
the high risk. Thus, the concept of cost of capital in international scenario
is similar to the cost of capital concept in general parlance.
There are various approaches towards international cost of capital like:
The World Capital Asset Pricing Model (CAPM), The World Multifactor
CAPM Model, Goldman Model, The Sovereign Spread Volatility Ratio
Model etc. CAPM and Multifactor CAPM are the most widely accepted
approaches for determination of international cost of capital in liquid
markets. However, both of these approaches do not work in emerging
markets. CAPM needs to be modified in these emerging economies for
the specific nature of risk and potential economic and financial shocks
specific to that foreign market.

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 COST OF CAPITAL

The cost of capital in international markets can be determined using the Notes
reference rate or the risk-free rate in the home market and then adding a
risk premium, which is in specific reference to the foreign market getting
investment. This risk premium has to be calculated taking into account
the various shocks the economy is vulnerable to and not just on the basis
of the price signals emanating from these economies.

3.7 Summary
‹ The cost of capital is the discount rate used to figure out the
present value of the expected future cash flows to decide whether
the project is worth accepting for maintaining the market value of
the firm constant.
‹ Implicit cost is the opportunity cost and arises when different
alternative use of funds is being considered. Explicit cost is the
cost being paid by the firm to raise and use funds.
‹ The cost of debt is the rate of return which must be earned by
investments financed through debt to keep the earnings of equity
shareholders constant.
‹ The cost of perpetual debt is given by:
ki = I/SP
kd = I (1 – t)/SP
‹ The cost of redeemable debt is given by shortcut method,
I (1 – t ) + ( RV – SP ) / N
kd =
( RV + SP ) / 2

‹ The cost of redeemable preference share is given by—

n
PDt Pn
P0 – ∑ +
t =1 (1 + K p ) (1 + K p ) n
t

‹ The cost of equity capital is the minimal or lowest rate of return

an organisation must generate on that part of the investment which
is financed by equity, to preserve the market value of its shares.
D
Cost of equity capital, ke = P + g by dividend model.
1
‹
0

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Notes ‹ CAPM describes the association between the desired rate of return
(cost of equity capital) and the systematic (non-diversifiable) risk
of the firm with the help of beta.
ke = rf + b(km – rf)
‹ Cost of retained earnings can be defined as the opportunity cost or
the returns foregone by the shareholders on the dividends.
‹ The composite cost of capital or the overall cost of capital denoted
by ko (WACC) is the weighted average cost of each individual means
of finance.
k o = k dw d + k pw p + k ew e + k rw r
‹ Marginal weights use that percentage or proportion of each source
of finance, the company plans to raise additionally and use.
‹ Historical weights use the existing proportion of the various sources
of finance in the current capital mix of the organisation. These
weights may be based on either book value of different means of
finance or on the market value of different means of finance utilised
by the organisation.

3.8 Answers to In-Text Questions

1. Incorrect
2. Incorrect
3. Incorrect
4. Incorrect
5. Incorrect
6. Correct
7. Higher
8. Debt
9. Beta
10. Explicit, implicit
11. Equity
12. Constant

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 COST OF CAPITAL

13. Dividend yield method Notes

14. Cost of equity
15. Increases

3.9 Self-Assessment Questions

1. Why is cost of capital important in financial decision making?
2. What do you understand by “Marginal cost of capital?”
3. What is business risk? Discuss the reasons of it.
4. Explain financial risk.
5. How does the tax rate affect the cost of capital.
6. Explain how is debt a cheaper source of finance than equity.
7. Examine the different methods for determining cost of equity capital.
8. Explain how the cost of capital affects the process of evaluation of
the proposals of capital budgeting.
9. “As retained earnings do not have any explicit costs, its free of
cost.” Critically examine.
10. Explain the rationale of using market value weights for determining
WACC.
11. Calculate the overall cost of capital (WACC) given that Ke is 18%,
and the company wants to raise and invests Rs. 15 crores in a project:
(a) The company wants to maintain a debt equity ratio of 1:1.
(b) It expects to retain Rs. 3 crores of its profits and intends to
use for the funding of this project.
(c) The first Rs. 2 crores raised through debt will be at interest
rate of 10% and thereafter at the interest rate of 12%.
(d) The applicable tax rate is 25%.

3.10 References
‹ Fundamentals of Financial Management, J.V. Horne & J.M. Wachowicz,
13th ed. Prentice Hall.

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Notes ‹ Fundamentals of Financial Management, I.M. Pandey, Theory and

Practices, 11th ed., Vikas Publishing House.
‹ Financial Management: Text Problem and Cases, M.Y. Khan & P.K.
Jain, 8th ed., Tata McGraw Hill Publishing Co. Ltd.
‹ Financial Management: Theory, Concepts and Problems with excel
applications and case studies, 6th revised edition Dr. R.S. Rustagi,
Taxmann.
‹ Fundamentals of Financial Management: with Excel application
supplement, Surender Singh and Rajeev Kaur, Mayur Paperbacks.

3.11 Suggested Readings

‹ Latest edition of the following text books to be used.
‹ Fundamentals of Financial Management, J.V. Horne & J.M. Wachowicz,
Prentice Hall Fundamentals of Financial Management, I.M. Pandey,
Theory and Practices, Vikas Publishing House.
‹ Financial Management: Text Problem and Cases, M.Y. Khan & P.K.
Jain, Tata McGraw Hill Publishing Co. Ltd.

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L E S S O N

4
Investment Decisions
Amit Kumar
Assistant Professor
SSCBS
University of Delhi
Email-Id: amit.catlog@sscbsdu.ac.in

STRUCTURE
4.1 Learning Objectives
4.2 Introduction
4.3 Types of Capital Budgeting Decision Situations
4.4 (VWLPDWLRQ RI &RVWV DQG %HQH¿WV
4.5 Process of Capital Budgeting
4.6 Evaluation Techniques
4.7 NPV vs. IRR
4.8 3UR¿WDELOLW\ ,QGH[ 3,  0HWKRG
4.9 Summary
4.10 $QVZHUV WR ,Q7H[W 4XHVWLRQV
4.11 6HOI$VVHVVPHQW 4XHVWLRQV
4.12 References & Suggested Readings

4.1 Learning Objectives

‹ To discuss the relevance and need of long term asset mix decisions.
‹ To familiarize and train the students with the process of identifying the costs and
benefits from an investment proposal.
‹ To discuss the concept, application, interpretation and critical analysis of various non-
time value of money adjusted and time value of money adjusted capital budgeting
evaluation techniques.
‹ To discuss the situations of conflicting rankings by NPV and IRR techniques.

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Notes 4.2 Introduction

Investment decisions refer to the investment in long-term asset or fixed
asset mix decisions which provide returns during its useful economic
life. These assets operate for more than a year. These decisions involve
a substantial cost (cash outflow) at the beginning of the operations (cost
of new machine, plant, manufacturing/service facility etc.) with benefits
(cash inflows) occurring over a long period of time. Proposed investment
decisions may lead to increase in net benefits either through increase in
revenue or decrease in costs. Thus, capital budgeting decisions relate
to selection of a long-term asset or investment proposal or course of
action that generally involves use of funds today but generate regular
and recurring benefits in future. It may include the purchase of land,
building, plant, machinery etc. or on a program of research to develop
innovative products and promotional/adverting/marketing campaign. The
objective is to create a portfolio of long-term investments that will make
the maximum contribution to the owners’ wealth in a given situation.
Capital budgeting decisions could fall into the following categories:
– Addition to existing long-term assets.
– Modification of the existing long term assets.
– Replacement of old with the new long term assets.
– Disposition of long term assets.

4.2.1 Importance of Capital Budgeting Decisions

Long term asset mix decisions are major decisions that shape the present
and future of any business organization. They determine the return
earning capacity of a business organization and thus have a significant
impact on the wealth of the owners/shareholders. A change in the wealth
creation capability will impact the investment decisions of both the
current and potential investors. It also determines the creditworthiness
of the business entity leading to easy access to debt avenues to fund
these and other business expenses. Business entities with greater access
to capital markets are able to raise funds at a lower cost due to lower
risk attached to their investments which gives a boost to their market

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 INVESTMENT DECISIONS

valuations. Capital budgeting decisions are highly important because of Notes

the following four reasons:
‹ Long term Effects: Decisions to purchase or not purchase certain
long-term assets will impact the overall operations of the business
entity in the long run. It will determine the scale, process, efficiency
and market share of the entity in the long run as these assets have
a useful life of more than a year. These are strategic decisions that
have long term bearing on the profitability of the firm.
‹ Substantial Investment of Funds: It involves an engagement of a
large block of capital resources available and for a longer duration.
Capital being a scarce resource with an opportunity cost attached to
it makes it essential for the business to utilize it the most optimal
way by parking the funds in the best investment opportunity
available. Therefore, utmost care has to be taken in making long
term asset mix decisions. It is a basic principle to spend more time
and effort in decisions that need the deployment of a large chunk
of the available funds and is followed even in personal purchases.
We are more careful in buying a house versus a car versus a laptop
versus daily needs (stationary, edible items etc.)
‹ Irreversible Nature: These decisions become all the more important
because it is very difficult to reverse the investment in fixed assets.
It entails a relatively large loss of value in a short span of time
due to non-availability of structured and organized market for old
assets. A large sum of money is lost in dismantling the assets
with the installation costs becoming sunk costs at the same time.
Sometimes, it is also difficult to sell customized assets appropriate
for a particular business setup which results in large losses on their
sale.
‹ Competitive Strength: Capital budgeting decisions result in investment
of firm’s resources in the assets that help them to build and maintain
the competitive strength of the entity. Investment in an automated
machine may result in cost efficiency and superior quality of goods
and services. R&D expenditures may lead to innovations that
resolve the existing problems of society or increase the utility of
existing products with large commercial value attached to it. Thus

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Notes it determines and hives a competitive edge against other firms in

the same industry.

4.3 Types of Capital Budgeting Decision Situations

Decision making of investment in long term assets can be majorly classified
into 3 situations or cases:
1. Accept/Reject: This situation refers to evaluation of a single investment
project/proposal. It also includes the evaluation of independent
projects where there is more than one investment project under
consideration at the same time, but the projects are not substitute/
mutually exclusive to each other. The acceptance/rejection of one
project is not dependent on the acceptance/rejection of the other
projects. Therefore, the single project or each project in the latter
case is accepted for investment if the return earned is greater than
the required rate of return.
2. Mutually Exclusive: This situation refers to the circumstance when
more than one investment options are available (type of technology,
location of business, brand of machine etc.) for the same business
purpose. All the options are acceptable based on the accept/reject
criterion of minimum rate of return or possible positive wealth
creation. Since the requirement is of only one type of technology/
location/brand of machine, thus acceptance of one will result in the
rejection of the other. The option which generates the maximum
wealth on the total capital available is chosen over other.
3. Capital Rationing: We will accept/invest in all the projects that
generate positive wealth in the presence of availability of infinite
capital resources. Capital turns out to be scarce and is thereby limited
in reality. This makes it inevitable to optimally ration the available
investible budget in the portfolio of projects that will maximize the
existing wealth based on the available profitable projects.

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4.4 Estimation of Costs and Benefits Notes

4.4.1 Cash Flows vs. Accounting Profits

Measurement of costs and benefits from a project raises a debate on
what is a better way of capturing the costs and benefits - Profits or Cash
Flows? Accounting principles and standards provide ample flexibility to
the business entities to change or choose different approaches of reporting
various items in the P&L Account to ensure that financial statements give
a more transparent and appropriate view of the state of affairs. This results
in a different profit number based on the method of depreciation, stock
valuation and allocation of expenses used by different accountants for the
same transactions. This makes profit a very ambiguous measure whereas
cash flows are based on actual inflow and outflow of real cash and cannot
be manipulated unlike profits. Profits are based on accrual system which
further make it vulnerable to management of reported earnings by use
of discretionary accruals and does not take into consideration the time
element of money. This further compounds the evaluation problem for
projects with unequal lives. Thus, cash flows are a more objective and
transparent metric and thereby a superior measure of capturing the wealth/
value creation by projects. They are not ambiguous, cannot be managed/
manipulate and take into account the time preference for money.

4.4.2 Incremental/Differential/Relevant Cost-Benefit Mea-

surement
We should include or try to capture all the benefits and costs that will
arise solely due to the undertaking of the proposed investment. All the
cash flows arising from the project which are incremental in nature must
be estimated and used in the evaluation process. Cash flows that will
occur irrespective of the undertaking of the project under consideration
are not relevant to the evaluation for acceptance/rejection of the project.
For example. R&D expenses, marketing survey expenses, allocated
overheads etc. already incurred to develop a new product or find out if
the production can be increased are sunk costs. They have been incurred
even before the investment in the new machine or project and would

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Notes have happened even if the result of the R&D/market survey would be
opposite to the expected positive result. Change in cash flows of existing
projects/machines/products because of the new projects/machines/products
are incremental and thus relevant for the evaluation of the new project
under consideration for investment.

4.5 Process of Capital Budgeting

4.5.1 Steps in Capital Budgeting Evaluation Process

The process involved in the evaluation of capital budgeting projects is
based on the following sequence of steps:
1. Estimate the costs and benefits from the project.
2. Estimate the minimum required rate of return.
3. Convert these costs and benefits to a single figure.
4. Compare this against a predetermined amount, rate or time period.
5. Make a choice based on the accept/reject criterion of various evaluation
techniques.

4.5.2 Assumptions of Capital Budgeting

1. All the cash flows take place at the end of each time period.
2. There is no change in the risk i.e. quantum and timing of cash
flows are known with certainty.
3. Existence of perfect capital markets.
4. Projects are infinitely divisible but they exhibit decreasing return to
scale.
5. Cash flows are independent of each other overtime and other investment
decisions.
6. Rational decision parties.
7. It is a well-behaved project or conventional cash flow project:
‹ Cash Flows of the Project: Only incremental cash flows are
considered for evaluating a project. The cash flows that are

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generated only due to the acceptance of the project should be Notes

considered whether they are inflow or outflow.
Relevant Cash Outflows Irrelevant Cash Outflows
Allocated overheads
Variable Wages/salaries (existing)
Variable material cost Sunk Costs
Increase in fixed cost
Increase in overheads
Cost of project/machine/
investment
Increase in taxes
‹ Changes in Working Capital: Only changes in requirements are
considered which will have an effect in the initial cash outlay,
during the economic life and at the end of the project.

4.5.3 Cash Flows of the Project

‹ Tax Effect: It can have a positive effect in terms of carried over
losses and negative effect due to tax outflow on profits.
‹ Depreciation & Amortization Effect: These don’t have any effect on
cash flows directly but have a positive impact in terms of reducing
the tax which is a cash outflow.
‹ Effect on Indirect Overheads: The indirect expenses/overheads
are allocated to the different products on the basis of wages paid,
materials used etc. If these are not affected by the project, these
overheads are ignored.
‹ Effect on Other Projects: If the new project is not economically
independent, its effects should be considered on the existing projects.
Cost of New Machine
+ Installation Cost
+ / - Working Capital
- Sale Proceeds

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Notes Initial Cash Outlay Estimation of Cash Flows

Cash Less Cash Less de- Operating Less Profit Add De- Operating Add/less Add Add/ Cash
Sales Cash Inflows preciation cash tax after preciation Cash decrease/ salvage less flow
Revenue Operating before Inflow tax flow increase value tax after
Cost tax before after tax in effect tax
tax working of
Years capital sale
1
2
3
4
5

Calculation of Depreciation
Depreciation is calculated according to the Income-tax Act.
Assets are grouped together into different blocks and each block is charged
the same rate of depreciation on the written down value of the block.
WDV of the block at the beginning of the year.
(+) Purchase of new assets within the block during the year.
(-) Sale/salvage proceeds of assets from the block during the year.
= WDV of the block at the end of the year.
Depreciation = Depreciation rate (%) × WDV at the end
Short Term Capital Loss/Gain
Sale/salvage proceeds of assets from the block during the year
(-) WDV of the block at the beginning of the year
(-) Purchase of new assets within the block during the year
= Short Term Capital Gain/Short Term Capital Loss
Tax Effect of Sale = Short Term Capital Gain/Loss × Tax Rate (%)
Loss will reduce the taxable profits and result in reduction in taxes. Gain
will increase the taxable profits and result in increase in taxes. Thus tax
effect of loss is treated as inflow (add) whereas for gains it is treated
as an outflow (less).
If the block of assets continues to exist after sale of the machinery, then
losses are not recognized and the remaining WDV is depreciated over
the years whereas profits are recognized in the same year as Short term
Capital Gain.

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If the block of assets ceases to exist after sale of the machinery, then Notes
both losses and profits are recognized in the same year as Short term
Capital Loss/Gain.
Example: An iron ore company is considering investing in a new
processing facility. The company extracts ore from an open pit mine.
During a year, 1,20,000 tonnes of ore is extracted. If the output from the
extraction process is sold immediately upon removal of dirt, rocks and
other impurities, a price of Rs. 500 per ton of ore can be obtained. The
company has estimated that its extraction costs amount to 50 per cent
of the net realisable value of the ore. As an alternative to selling all the
ore at Rs. 500 per tonne, it is possible to process further 25 per cent of
the output. The additional cash cost of further processing would be Rs.
50 per ton. The proposed ore would yield 60 per cent final output, and
can be sold at Rs. 1,500 per ton. For additional processing, the company
would have to install equipment costing Rs. 80 lakhs. The equipment is
subject to 10 per cent depreciation per annum on reducing balance (WDV)
basis/method. It is expected to have a useful life of 5 years. Additional
working capital requirement is estimated at Rs. 8 lakhs. The company’s
cut-off rate for such investments is 15 per cent. Corporate tax rate is 30
per cent. Assuming there is no other plant and machinery subject to 10
per cent depreciation, should the company install the equipment if the
expected salvage value is Rs. 10 lakhs.
Cash Outflows
Cost of Machine + 80,00,000
Additional Working
Capital 8,00,000
Total Cash Outflow 88,00,000
Cash Inflows
Year Cash Sales Less: Deprecia- Cash Flow Less: Earnings
Revenue Cash tion Before Tax Tax After Tax
1 12000000 1500000 800000 9700000 2910000 6790000
2 12000000 1500000 720000 9780000 2934000 6846000
3 12000000 1500000 648000 9852000 2955600 6896400
4 12000000 1500000 583200 9916800 2975040 6941760
5 12000000 1500000 0 10500000 3150000 7350000

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Notes Earnings Depreciation CFAT Salvage Tax Working Gross

After Tax Value Benefit Capital Cash flow
6790000 800000 7590000 7590000
6846000 720000 7566000 7566000
6896400 648000 7544400 7544400
6941760 583200 7524960 7524960
7350000 0 7350000 1000000 1274640 800000 10424640

Year 1 2 3 4 5
Asset Value 8000000 7200000 6480000 5832000 5248800
Depreciation 800000 720000 648000 583200 0
Note: No depreciation is charged in the terminal year as the block consists
of a single asset:
Gross Cash Flow Present Value
7590000 Rs. 66,00,000.00
7566000 Rs. 57,20,982.99
7544400 Rs. 49,60,565.46
7524960 Rs. 43,02,420.30
10424640 Rs. 51,82,888.48
Total Present Value Rs. 2,67,66,857.24
Cash Outflows Rs. 88,00,000.00
Net Present Value (NPV) Rs. 1,79,66,857.24
Since the NPV is positive, the machine should be installed

4.6 Evaluation Techniques

4.6.1 Traditional Techniques/Non-Time Adjusted Techniques

4.6.1.1 Payback Period
The payback period is the length of time required to recover the initial
cash outlay on the project. For example, if a project involves a cash
outlay of Rs. 8,00,000 and generates cash inflows of Rs. 1,00,000,
Rs. 2,50,000, Rs. 2,50,000, and Rs. 2,00,000, in the first, second, third, and
fourth years, respectively, its payback period is 4 years because the sum
of cash inflows during 4 years is equal to the initial outlay. If the amount

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of cash inflow is a uniform amount, the payback period is calculated by Notes

dividing the initial cash outflow by regular inflows. For e.g. If a project
involves a cash outlay of Rs. 6,00,000 and generates yearly cash inflows
of Rs. 1,00,000, the payback period will be 6,00,000/1,00,000 = 6 years.
One might utilize the payback term as a deciding factor when deciding
whether to accept or reject investment proposals. This approach may be
used, for example, to compare the actual payback to a predefined payback,
or the payback established by management in terms of the maximum
amount of time in which the initial investment must be returned. The
project would be approved if the actual payback duration is smaller than
the projected payback; if not, it would be refused. The payback can also
be applied as a ranking system. Projects that are mutually incompatible
may be prioritized in order of the length of the payback period when
taking that into consideration. Thus, the project having the shortest pay
back may be assigned rank one, followed in that order so that the project
with the longest pay back would be ranked last. Obviously, projects with
shorter payback period will be selected.
One major drawback of this method of evaluation is that it does not
consider time value of money. Moreover, it completely ignores all cash
inflows after the payback period. It is biased against projects with long
gestation periods such as infrastructure projects.
Is Payback Period an appropriate evaluation measure for projects?
1. Simplicity: It is simple and easy to understand and calculate.
2. Sufficiency: The method does not consider the total benefits arising
out of the proposal over its lifetime. It only gives importance to
cash flows occurring till the payback period and thus does not fulfil
this condition.
3. Objectivity: It is objective as benefits are based on cash flows and
not on the accounting profit.
4. Consistency: This method is not consistent with the objective of
maximizing shareholders’ wealth as it is only concerned with the
speed of recovery of the initial investment. It does not consider the
overall wealth creation capability of a project.
5. Reasonable: The assumption of reinvestment rate of cash flows made
under this method are not reasonable as it does not consider the

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Notes time value of money and thus does not assume any reinvestment
rate.
4.6.1.2 Accounting Rate of Return
Accounting Rate of Return (ARR) is a method of evaluation also known
as Average rate of return. It is calculated by dividing the Average profit
obtained from the project by the Average book value of the investment.
The average profits after taxes are determined by adding up the after-tax
profits expected for each year of the project’s life and dividing the result
by the number of years. In the case of annuity, the average after-tax profits
are equal to any year’s profits. The average investment is determined by
dividing the net investment by number of years. For e.g.
Year Investment Profit After Tax (PAT)
1 40000 30000
2 30000 32000
3 50000 34000
4 60000 36000
5 70000 38000
Total 2500000 170000
Average Investment = 250000/5 = 50000 Average PAT = 170000/5 = 34000
ARR = 34000/50000 = 68%.
Points to consider:
‹ The higher the ARR, more attractive is the project.
‹ As an accept-reject criterion, the actual ARR would be compared
with a predetermined or a minimum required rate of return or cut-
off rate.
‹ It is simple and easy to calculate.
‹ Since it is calculated using an average method, it can also be calculated
using limited data.
Shortcomings:
‹ It is based upon accounting profit, rather than cash flow which is
generally considered a better measure.
‹ It does not account for time value of money.

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‹ It does not provide any guidance on what the target return should Notes
be.
‹ It does not differentiate between the size of the investment required
for each project. Competing investment proposals may have the
same ARR, but may require different average investments.

4.6.2 Discounted Cashflow Techniques

4.6.2.1 1HW 3UHVHQW 9DOXH 139
Definition: Net Present Value (NPV) is the present value of outflows
subtracted from the present value of inflows in each year.
n
CFt S + Wn n
COt
NPV = ∑ + n –∑
t =1 (1 + K ) (1 + K )
t n
t =0 (1 + K )t

Decision Rule: When NPV>0, the project should be accepted as it would

lead to value addition.
When NPV<0, the project should be rejected as it would lead to value
destruction.
Zero NPV of the project means that the firm is indifferent to the project.
The acceptance/rejection of the project would not lead to change in the
value of the firm.
Example. Calculate the NPV of the project with the cash flows given
in the table and having an initial outflow of Rs. 60,000. Let the interest
rate be 15%.
Year 1 2 3 4 5
Cash
Inflows 15000 18000 20000 23000 26000
Ans. The Present Value (PV) Factor can be calculated using the table:
Year 1 2 3 4 5
Cash
Inflows 15000 18000 20000 23000 26000
PV Factor 0.869565 0.7561437 0.657516 0.571753 0.497177
PV 13043.48 13610.586 13150.32 13150.32 12926.6
NPV 5881.309

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Notes The NPV is calculated by subtracting the outflow (Rs. 60000) from the
sum of the total inflows (Rs. 65881).
Is NPV an appropriate evaluation measure for projects?
1. Simplicity: It is difficult to calculate as compared to conventional
methods such as average rate of return and payback period.
2. Sufficiency: This method considers the total benefits arising out of
the proposal over its lifetime.
3. Objectivity: Benefits are based on cash flows and not on the
accounting profit.
4. Consistency: This method is consistent with the objective of
maximizing shareholders’ wealth as it helps in selecting projects
with the highest wealth addition capacity amongst the available
investment options.
5. Reasonable: The assumptions made under this method are reasonable
as it assumes that the reinvestment rate is the cost of capital which
is a quite conservative estimate.
In a nutshell, the present value approach is a strategy for choosing
investment projects that is theoretically sound. However, it also has some
restrictions. First of all, in contrast to the pay back technique or even the
ARR approach, it is challenging to calculate, comprehend, and utilize.
Naturally, this is a small problem. The computation of the necessary rate
of return to discount the cash flows is the second, and more significant,
issue with the present value technique. Because various discount rates
would result in different present values, the discount rate is the most
crucial component employed in present value calculations. With a change
in the discount rate, a proposal’s relative attractiveness will alter.
4.6.2.2 ,QWHUQDO 5DWH RI 5HWXUQ ,55
Definition: Internal Rate of Return (IRR) is the rate of discount that
equates the present value of cash inflows to cash outflows. Here, NPV=0
n
CFt S + Wn
Zero = ∑ + n – CO0
t =1 (1 + r ) (1 + r ) n
t

Decision Rule: If IRR > rate of discount (k), the project should be
accepted. If IRR < rate of discount (k), the project should not be accepted.
How is IRR calculated?

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Method 1: When the cash flows are in the form of annuities: Notes
1. Calculate the payback period by dividing the cash outflow by the
cash inflows.
2. Look for the values closest payback value in the Present Value for
Annuity (PVAF) Table corresponding to the number of years.
3. Take the value closest to the payback period value. One value should
be more than the PB period and the other smaller than the value.
4. Determine the IRR value by interpolation.
Example. A project costs Rs. 40,000 and is expected to generate cash
inflows of Rs. 10000 annually for 5 years. Calculate the IRR of the project.
Ans. Payback Period: 40000/10000 = 4
Using PVAF table, we find the value 4 between 7% (value of 4.100) and
8% (value of 3.99). The value of IRR thus lies between 7% and 8%.
IRR = 7 + (4.100 – 4)/(4.100 – 3.99) = 7.9%
Using the higher interest rate,
IRR = 8 – (4 – 3.99)/(4.100 – 3.99) = 7.9%
Method 2: When the cash flows is a mixed stream:
1. Divide the total cash flows over the life of the project by the number
of years to get a fake annuity.
2. Determine the payback period (PB) by dividing the total inflows by
the fake annuity.
3. The value from the table of Present Value of Annuity (PVAF) closest
to the value determined in step 2 will be a close approximation of
the IRR.
4. There is an adjustment required according to the actual cash flows.
If the cash flows at the beginning of the cash flow stream are
higher than the average cashflows, revise the IRR upwards. This is
because greater recovery of funds is happening in the initial years.
Similarly, if the cash flows during the beginning are lower than
average cash flow, the IRR should be revised downwards.
5. The actual value of the IRR can be value be determined by trial
and error. The NPV is calculated at the indicative IRR arrived
using the above steps. We use the method of interpolation after we

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Notes get two rates, one at which the NPV is negative and the other at
which it is positive. The difference between the two rates should
not be kept more than 1%. Interpolation assumes that the PVFs
are evenly distributed between two rates of interest, which is false
as the discounting factors are based on an exponential function.
Therefore, larger is the range between the two rates used for
interpolation, larger will be the inaccuracy of the IRR calculated
using interpolation.
Example. The firm wants to invest in a project that produces the cash
flows as given in the table. Calculate the IRR of the project if the initial
investment is 60000:
Year 1 2 3 4 5
Cash
Inflows 15000 18000 20000 23000 26000
Ans. The total inflows from the project are Rs. 102000, which when
divided by the life of the project gives us a fake annuity of Rs. 20400.
Then the initial investment of Rs. 60000 is divided by the fake annuity
of Rs. 20400 giving us a Payback Period of 2.94.
Now we find the value closest to the PB value from the PVAF table, we
obtain value of 2.99 (interest rate of 20%) and value of 2.92 (interest
rate of 21%).
Since the actual cash flows are smaller (follow an increasing trend) in
the initial years, thus the trial and error to get 2 rates with positive and
negative NPV for interpolation, will start at a rate slightly lower than
20%. How much lower to start is a matter of intuitive judgment?
Is IRR an appropriate evaluation measure for projects?
1. Simplicity: This method involves calculation using trial and error
and hence it is a difficult measure.
2. Sufficiency: The method considers the total benefits arising out of
the proposal over its lifetime as all the cash flows are discounted
back.
3. Objectivity: Benefits are based on cash flows of the project and not
on the accounting profit.

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4. Consistency: The method has the objective of shareholder wealth Notes

maximization but does not meet this condition when comparing two
projects with highly different initial outlays.
5. Reasonable: The assumptions made under this method are not
reasonable as it assumes the reinvestment rate to be IRR itself. It
is not realistic to assume that the cash flows can be invested in a
similarly profitable projects in all years in future having the same
IRR as the project under consideration.
Its theoretical soundness notwithstanding, the IRR suffers from serious
limitations.
First, it involves tedious calculations. As shown above, it generally
involves complicated computational problems. Secondly, it produces
multiple rates which can be confusing. Thirdly, in evaluating mutually
exclusive proposals, the project with the highest IRR would be picked
up to the exclusion of all others. However, in practice, it may not turn
out to be the one which is the most profitable and consistent with the
objectives of the firm, that is, maximisation of the shareholders’ wealth.
Finally, under the IRR method, it is assumed that all intermediate cash
flows are reinvested at the IRR itself. Fourthly, IRR for projects with
unconventional cash flows may be indeterminate. Finally, the same
accept/reject rule (IRR should be greater than WACC/required rate) is
not feasible for borrowing projects.

4.7 NPV vs. IRR

NPV and IRR would give the same results in conventional investment
projects where outflows tend to occur at earlier stages and are followed by
a series of cash flows. Here both the decision rules converge i.e. NPV > 0
and IRR>discount rate. This happens as IRR is the rate at which NPV is
0 and thus if IRR is greater than WACC (discounting rate used in NPV),
the discounting factors at WACC will be larger in comparison to IRR
(lower the rate higher the PVF). This will result in increase in present
value of cash inflows of the project whereas the value of initial outlay
remain same as the PVF at any rate today will be 1. Hence the NPV at
WACC lower than IRR will be positive. The situations in which the two
methods will give a concurrent accept/reject decision will be in respect

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Notes of conventional and independent projects. A conventional investment is

one in which the cash flow pattern is such that an initial investment
(outlay or cash outflow) is followed by a series of cash inflows. Thus,
in the case of such investments, cash outflows are confined to the initial
period. The independent proposals refer to investments, the acceptance
of which does not preclude the acceptance of others so that all profitable
proposals can be accepted and there are no constraints in accepting all
profitable projects.

However, they can offer contradictory results. In such cases, we divide the
projects into mutually exclusive categories which can be of two types:
1. Technical Exclusiveness: Here the alternative projects offer differing
profitability. We choose the one with the higher profitability.
2. Financial Exclusiveness: Here a project offering higher profit may
be selected over a project offering higher profitability due to capital
rationing. (The exclusiveness due to limited funds).
The three major conflicts that arise here are: -
Size Disparity Problem: This can be attributed to differing initial
investments in the mutually exclusive projects. Here, if the cash outlay
of a project is more the other, NPV and IRR may give differing rankings.
Example
Particular Project A Project B
Outflows (10000) (14000)
Inflows at end of Year 1 13000 18000
IRR 30% 29%
Hurdle Rate 10% 10%
NPV 1818.18 2363.62

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Thus the 2 projects rank differently under the 2 methods. When faced Notes
with mutually exclusive projects, each having a positive NPV, the one
with the largest NPV will have the most beneficial effect on shareholders’
wealth and thus should be selected.
Incremental analysis involves computation of IRR of the incremental
outlay of the project requiring bigger initial investment.
Time Disparity Problem: Here the projects differ on the basis of the
timing of the cash flows to be generated. Even if the project outlays are
same, the cash flows may be different in different time periods which
might give conflicting rankings. Here, we give priority to NPV over IRR.
Example:
Time CFATS of Project A CFATS of Project B
0 -11500 -11500
1 6000 3000
2 5000 4000
3 4000 5000
4 1500 6000
IRR 20.06% 18.21%
NPV @ 9% 2364.36 2730.48
Projects with unequal lives (Life Disparity): If projects have unequal
lives, they can have conflicting rankings. Here we can adjust the time
horizons to a common standard assuming that the technology, price of
capital asset and operating costs and revenues stays the same. We thus
compare in multiples of the project up to a common time frame. This
referred to as the Common Time Horizon Approach. The NPV for the
common time frame is compared to select the project with the highest
NPV.
Another method is the Equivalent Annual Net Present Value (EANPV)
which is determined by dividing the NPV of cash flows of the project
by the annuity factor corresponding to the life of the project at the given
cost of capital. The project with the higher EANPV is selected.

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Notes Example: Common time Horizon Approach

Particulars Project A Project B
Initial outlay 10000 20000
Inflows after taxes
Year-end 1 8000 8000
2 7000 9000
3 nil 7000
4 nil 6000
Required rate of return 10%
Project A
Year Cash flows PV factor Total present value
0 (10000) 1.000 (10000)
1 8000 0.909 7272
2 7000 0.826 5782
3 (10000) 0.826 (8260)
3 8000 0.751 6008
4 7000 0.683 4781
NPV 5583

Project B
Year Cash flows PV factor Total present value
0 (20000) 1.000 (20000)
1 8000 0.909 7272
2 9000 0.826 7434
3 7000 0.751 5257
4 6000 0.683 4098
NPV 4061
Example: EANPV Approach
Determination of NPV
Initial Outlay of Project A= Rs. 100000 Initial Outlay of Project B= Rs. 125000
Project Years CFAT per PV factor @ Total PV of NPV
annum 10% CFATs
A 5 30000 3.791 113730 13730
B 8 27000 5.335 144045 19045

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EANPV of the Project = NPV/PVAF for the life of the project @ cost Notes
of capital
EANPV (A) = 13730/3.791= 3621.74
EANPV (B) = 19045/5.335= 3569.82

4.8 Profitability Index (PI) Method

Definition – PI measures the present value of returns divided by the
total amount invested. PI = Present value cash inflows/Present value of
cash outflows
Decision Rule – If PI > 1, the project should be accepted
If PI < 1, the project should not be accepted
PI is related to NPV. When PI > 1 then NPV is positive but if PI < 1,
NPV is negative Is PI an appropriate evaluation measure for projects?
1. Simplicity: It is relatively simple and easy to understand and
calculate.
2. Sufficiency: The method considers the total benefits arising out of
the proposal over its lifetime.
3. Objectivity: Benefits are based on cash flows of the project and not
on the accounting profit.
4. Consistency: The method has the objective of shareholder wealth
maximisation.
5. Reasonable: The assumptions made under this method are reasonable.
The reinvestment rate is same as NPV method.
Example: Calculate the PI of the project with the cash flows given in
the table and having an initial outflow of Rs. 60,000. Let the interest
rate be 15%.
Solution: The Present Value (PV) Factor can be calculated using the table
Year 1 2 3 4 5
Cash
Inflows 15000 18000 20000 23000 26000
PV Factor 0.869565 0.7561437 0.657516 0.571753 0.497177
PV 13043.48 13610.586 13150.32 13150.32 12926.6
NPV 5881.309

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Notes Present Value (PV) of total Inflows = Rs. 65881

Total Outflows = Rs. 60000
PI = 65881/60000
= 1.09
The PI complies with nearly all of the criteria for a good investment
criterion, much like the other discounted cash flow approaches. It takes
into account every aspect of capital budgeting, including the sum of
benefits and the time value of money, among others. It is a good approach
to capital budgeting conceptually. Despite being NPV-based, it is a more
effective evaluation method in a capital-rationing scenario than NPV.
For example, two projects may have the same NPV of Rs. 20,000, but
project A requires a Rs. 70,000 initial investment whereas project B just
requires a Rs. 50,000 beginning investment. The PI approach will advise
choosing Project B as the best option. However, the NPV technique will
yield equal rankings for both projects.
Because the PI technique assessees the value of projects in terms of
their relative rather than absolute magnitudes, it is thus preferable to the
NPV method. However, the NPV technique might be preferable to the PI
method in some instances that are mutually incompatible. However, this
approach is more challenging to comprehend. Additionally, it requires
less processing than IRR but more than the conventional approaches. PI
method based ranking and selection of projects will give the most optimal
portfolio of projects that will maximise the overall wealth generated on
the total capital available, when the projects are perfectly divisible. It
appears to be the best approach in this situation as it ensures that each
rupee of capital generates the maximum possible NPV possible from the
available investment options.
IN-TEXT QUESTIONS
1. Which of the following is NOT a typical capital budgeting
decision?
(a) Purchase of new machinery
(b) Routine maintenance of existing equipment
(c) Expansion of a production facility
(d) Launching a new product line

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2. What is the primary objective of capital budgeting? Notes

(a) Minimizing operational costs

(b) Maximizing short-term profits
(c) Maximizing shareholder wealth
(d) Minimizing tax liabilities
3. Which capital budgeting method measures the time it takes to
recover the initial investment?
(a) IRR (Internal Rate of Return)
(b) NPV (Net Present Value)
(c) Payback Period
(d) PI (Profitability Index)
4. The IRR of an investment is 10%. If the required rate of return
is 12%, should the project be accepted or rejected?
(a) Accepted
(b) Rejected
(c) Cannot be determined with this information
(d) Need additional information
5. If a project’s Present Value of future cash flows is $ 10,000,
and the initial investment is $ 8,000, what is the NPV ratio
(Profitability Index)?
(a) 1.25
(b) 0.8
(c) 0.2
(d) 12.5%
6. A project with an IRR of 15% should be compared to the____.
(a) Risk-free rate
(b) Market interest rate
(c) Project’s required rate of return
(d) Inflation rate

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Notes 7. Which of the following is true about the payback period?

(a) It considers the time value of money
(b) It is a measure of profitability
(c) A shorter payback period is generally preferred
(d) It is not related to capital budgeting
8. You are considering a project with the following cash flows:
Year 0: -$ 50,000, Year 1: $ 20,000, Year 2: $ 25,000, Year 3:
$ 30,000. What is the NPV of the project at a discount rate of
10%?
(a) $ 2,115
(b) $ 3,000
(c) $ 4,000
(d) -$ 2,000
9. The IRR method can be challenging when evaluating projects
with:
(a) Single cash outflow at Year 0
(b) Consistent cash flows over time
(c) Mutually exclusive alternatives
(d) Varying cash flow signs (both inflows and outflows)
10. What does the IRR represent in a capital budgeting context?
(a) The percentage of initial investment recovered
(b) The discount rate that makes the project’s NPV equal to
zero
(c) The project’s payback period
(d) The accounting rate of return

4.9 Summary
‹ Investment or capital budgeting/long term asset mix decisions refer to
the selection of assets/projects that will need substantial commitments
of funds today and will generate return over the useful life which
is more than one year. These decisions may result in increase in

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revenue or decrease in cost or both. They include replacement, Notes

expansion, modification etc. of the existing production and service
facilities.
‹ Investment decisions are important as they:
„ have long term impact on the business
„ involve substantial amount of funds
„ are irreversible in nature
„ determine the competitive strength
‹ There are two decision making situations of:
„ Accept/Reject-Pertaining to a single/independent project.
„ Mutually Exclusive-Selection of one out of many available
options.
‹ Cash flows are used as a measure of costs and benefits as it is more
precise, cannot be manipulated and considers time value of money
unlike accounting profits. The incremental cash flows are only
relevant for the decision making.
‹ Depreciation calculation is based on the block of assets rule of
Income-tax Act. Depreciation is included in the analysis despite
being a non-cash expense as it impacts the tax outflow calculation.
‹ Traditional Techniques of Evaluation:
„ Payback Period: It refers to the time period required to
recover the initial investment. The investment is accepted if
the calculated payback is equal to or less than the required
period. It fulfils the simplicity and objectivity conditions but
does not satisfy the sufficiency, consistency and reasonableness
conditions.
„ Accounting Rate of return: It is average rate of profits earned
during the life of the asset/project. It fulfils the simplicity
and sufficiency conditions but does not satisfy the objectivity,
consistency and reasonableness conditions.
‹ Time Adjusted Techniques of Evaluation:
‹ Net Present Value (NPV): It is difference between the present
value of cash inflows and outflows calculated at the required/

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Notes hurdle rate. The investment is accepted if the NPV is greater

than 0. It fulfils the simplicity, sufficiency, objectivity,
consistency and reasonableness conditions.
„ Internal rate of Return (IRR): It is the expected annualized
average rate of return generated by the investment project. It
is the rate at which the present value of cash inflows is equal
to cash outflows. The investment is accepted if the IRR is
greater than the required/hurdle rate. It fulfils the sufficiency,
objectivity, and consistency but does not satisfy the simplicity
and reasonableness conditions.
„ Profitability Index (PI): PI is the relative form of NPV
technique. It is the NPV/present value of cash inflow earned
per rupee of initial outflow. The investment is accepted if the
PI is greater than 0/1. It fulfils the simplicity, sufficiency,
objectivity, consistency and reasonableness conditions. It is
used under capital rationing circumstances.
‹ NPV and IRR may give conflicting results/rankings in case of mutually
exclusive projects under 3 circumstances:
„ Projects with unequal lives (EANPV or Common Horizon
Approach is used)
„ Project with disparity in timing/pattern of cash flows (NPV is
preferred)
„ Projects with unequal size (Incremental NPV/IRR is used)

4.10 Answers to In-Text Questions

1. (b) Routine maintenance of existing equipment

2. (c) Maximizing shareholder wealth
3. (c) Payback Period
4. (b) Rejected
5. (a) 1.25
6. (c) Project’s required rate of return
7. (c) A shorter payback period is generally preferred

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8. (a) $ 2,115 Notes

9. (d) Varying cash flow signs (both inflows and outflows)
10. (b) The discount rate that makes the project’s NPV equal to zero

4.11 Self-Assessment Questions

1. Why are cash flows a superior metric over accounting profits for
estimating the costs and benefits of an investment decision?
2. Differentiate between ARR and Payback Period method of capital
budgeting.
3. Compare NPV and IRR techniques. Comment on the situations when
these techniques give conflicting results.
4. Which technique is more appropriate in a capital rationing situation
and why?
5. Write short notes on the following:
‹ EANPV vs Common Time Horizon approach
‹ Incremental cash flow analysis
‹ Importance of capital budgeting
‹ Depreciation estimation under capital budgeting decisions
6. A company plans to invest in a project costing Rs. 1,00,000 with an
expected life of 5 years and the salvage value of Rs. 10,000. The
project requires an additional working capital of Rs. 10,000 and is
expected to earn a profit after tax of Rs. 15,000 per annum during
its life. Calculate the Accounting Rate of Return of this project?
7. Determine the average rate of return from the following data of two
machines, A and B and comment on which machine is better.
Machine A Machine B
Cost 50000 50000
Year PAT PAT
1 3000 10000
2 6000 9000
3 8000 8000
4 9000 6000

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Notes Machine A Machine B

5 10000 3000
36000 36000
Estimated life (in years) 5 5
Estimated Salvage Value 2000 2000
8. A project requires a cash outflow of Rs. 40000 and is expected to
generate cash inflows over next five years as follows:
Year 1 2 3 4 5
CFATs 5000 10000 18000 8000 5000
What is the payback period of this project? What is the payback
period of the project if the project requires Rs. 15000 as the cash
outflow?
9. Tata Sons Ltd. is planning to purchase a plant to expand its production.
The cost of the plant is Rs. 25 lakhs and has a useful life of 5
years. It belongs to the block of 25% depreciation on w.d.v basis.
It is the only asset in the block. It will be scrapped at Rs. 5 lakhs
at the end of its life. PBDT will increase by Rs. 8 lakhs p.a. and
the fixed cost will decrease by Rs. 50000 p.a. Tax rate is 30% and
the required rate of return is 10%. Advise using NPV technique,
whether it is worthwhile to invest in the new plant.
10. RIL Ltd. is planning to replace a manually operated rig with a fully
automated rig to improve its production efficiency. The cost of the
new rig is Rs. 10 lakhs and has a useful life of 4 years. It belongs
to the block of 20% depreciation on w.d.v basis. It will be scrapped
at Rs. 1 lakh at the end of its life. The current realizable value of
the old rig is Rs. 2 lakhs. It was purchased 3 years back at Rs. 6
lakhs and has a remaining useful life of 4 years. Sales will increase
by Rs. 3 lakhs p.a. and the variable cost is 40 per cent of sales.
Sales will grow at the rate of 10% every year. Additional working
capital required at the end of first year will be Rs. 1 lakh. The
old rig belongs to the same block and there are no other assets in
the block. Tax rate is 30% and the required rate of return is 12%.
Advise using NPV technique, whether it is worthwhile to replace
the old rig with the fully automated variant.

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 INVESTMENT DECISIONS

11. Evaluate the two projects based on the Profitability Index technique. Notes
The cost of capital is 12%.
Project A Project B
Cash outflow 40000 35000
Cash inflows
1 50000 30000
2 49000 32000

4.12 References & Suggested Readings

‹ Khan M.Y. and Jain P.K. (2018). )LQDQFLDO 0DQDJHPHQW McGraw
Hill Education (India) Private Limited.
‹ Pandey I.M. (2021). )LQDQFLDO0DQDJHPHQW Vikas Publishing House.
‹ Brealey R.A., Myers S.C., Allen F. and Mohanty P. (2017). Principles
of Corporate )LQDQFH 0F*UDZ +LOO (GXFDWLRQ
‹ Bhalla V.K. (2014). Financial Management. S. Chand Publications.
‹ Horne J.V. and Wachowicz J. (2008). Fundamentals of Financial
Management. Pearson.

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L E S S O N

5
Risk Analysis in Capital
Budgeting
Amit Kumar
Assistant Professor
SSCBS
University of Delhi
Email-Id: amit.catlog@sscbsdu.ac.in

STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 'H¿QLWLRQ RI 5LVN
5.4 Sources of Risk
5.5 Sensitivity Analysis
5.6 0HWKRGV WR $GMXVW 5LVN LQ &DSLWDO %XGJHWLQJ
5.7 Summary
5.8 $QVZHUV WR ,Q7H[W 4XHVWLRQV
5.9 6HOI$VVHVVPHQW 4XHVWLRQV
5.10 References & Suggested Reading

5.1 Learning Objectives

‹ To explain the concept and measurement of risk.
‹ To incorporate the element of risk in capital budgeting/investment decisions.
‹ To describe and explain the various risk adjusted techniques of evaluation in capital
budgeting decisions.

5.2 Introduction
It is difficult to ignore the significance of the risk factor in capital planning. Profitability
and risk are actually intertwined. It is quite likely that a project with a high chance of

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 RISK ANALYSIS IN CAPITAL BUDGETING

success will simultaneously raise the firm’s perceived risk. This risk vs. Notes
profit trade-off would affect how investors see the company both before
and after a certain proposal is accepted. Investors would not view a
company favourably if it accepted a plan that increased the firm’s risk.
This can negatively affect the share price, the firm’s overall value, and
its objective. As a result, the risk component must be taken into account
while analyzing capital budgeting.
When investing in a project, there is an opportunity cost due to the
degree of risk involved. Risk must be adjusted in order to determine if
the project’s profits are commensurate with the risks taken and whether
investing in the project is preferable to other available investment
opportunities. Moreover, risk adjustment is necessary in order to determine
the true value of the cash inflows. A higher risk will result in a larger
risk premium and hence a higher expected return.

5.3 Definition of Risk

As already established, risk analysis should be integrated in the capital
budgeting approach. In general, if all other factors are equal, a company
would be wise to accept a project that is less dangerous and reject the
ones that are highly risky. This proposal is consistent with the premise
that the management is averse to risk. The advantages of the project are
taken into account while making the capital budgeting choice. Cash flows
are used to measure these advantages. On the basis of several assumptions,
future returns are estimated. In other words, the real returns in terms of
cash inflows rely on a number of variables including the pricing, sales
volume, advertising campaign’s efficacy, competition, production expenses
and so forth.
The status of the economy, the rate of inflation, among others, have an
impact on each of these factors. The accuracy with which these characteristics
are predicted will have a significant impact on the projections of future
returns and, consequently, the dependability of the investment choice.
There are good grounds to think that regardless of how thoroughly the
variables affecting future returns from the project are predicted, the actual
returns will not exactly match the estimate. In other words, the estimates
and actual returns will differ. Technically speaking, this is called risk.

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Notes The word risk with regard to capital budgeting/investment choice may,
thus, be defined as the variability in the actual returns originating from
a project during its working life, in proportion to the projected return as
forecasted at the time of making the capital budgeting decision.
The risk scenario is one in which it is known how likely it is that a
specific event will occur. Under the circumstances of ambiguity, these
probabilities are unknown. Therefore, the distinction between risk and
uncertainty is that variability in risk is lower than in uncertainty. In other
words, there is a difference between the two in a strict mathematical sense.
Uncertainty refers to the outcomes of a particular event that are too
unknown to attach any probability of occurrence, whereas risk refers to
a group of distinct outcomes for a given occurrence that may be assigned
probabilities. Risk therefore arises whenever the decision-maker is able
to assign probabilities to potential outcomes. This occurs when the
decision-maker has historical information to draw upon, in order to assign
probability to prior initiatives of a similar nature. When a decision-maker
lacks historical data from which to create a probability distribution and
must rely instead on educated estimates to create a subjective probability
distribution, there is uncertainty.
For instance, if the proposed initiative is entirely new to the company, the
decision-maker may be able to subjectively assign probability to alternative
possibilities through study and conversation with others. There would be
no danger in such circumstances if the future profits were definite, that
is, if they could be predicted with accuracy. The risk associated with the
investment choice would be higher, the less accurately they are predicted.
The type of project will determine the risk and return variability.
An example of risk-free investment is the U.S. Treasury Bonds which
are issued and backed by the federal government. Except in these rare
instances, the investment choice is plagued by the issue of unpredictable
returns, which can vary greatly depending on the decision’s nature and
objective. As a result, choosing to launch a new product rather than
expanding an existing one will result in more unpredictable profits. The
projections of returns from capital budgeting projects that focus on cost
reduction will also be less risky than those that aim to increase revenues.
In regards to capital budgeting, risk is essentially the difference between

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expected and actual returns. The more variation there is between the two, Notes
the riskier the project will be.

5.4 Sources of Risk

1. Project Specific Risks: Risks that are unique to a certain project
and have an impact on its cash flows include risks connected to the
project’s timely completion, resource misallocation, incorrect cash
flow calculation and more. E.g. - Risks associated with building a
dam are unique and different compared to building a windmill.
2. Firm-specific risk: This category includes risks that are unique to a
given company, such as a downgrade in credit rating of the company,
a change in top management, breach of intellectual property rights
and other laws and regulations, conflicts with employees, etc. All of
these elements have an impact on an entity’s cash flows and ability
to acquire finance. For instance, technology risk varies between two
IT companies.
3. Industry-Specific Risks: Hazards relevant to the industry in which
the firm operates. Risks include government regulation, changes in
technology, entry of new players, etc. For instance, the alcoholic
beverages sector is subject to legal age restrictions.
4. Competition Risk: Dangers associated with competition in the
market where a firm operates are known as competition risks. These
risks include entrance risk for competitors, product dynamism, and
changes in customer taste and preference, among others.
5. Economic Risk: These risks are associated with macro-economic
conditions, such as adjustments to central banks’ monetary and
fiscal policies. They include implementation of a new tax regime,
inflation control measures, adjustments to GDP, changes in aggregate
demand, savings, net disposable income, etc.
6. International risk: These risks relate to situations brought on by
global economic conditions, such as limitations on free trade,
barriers to market access, economic crashes, bilateral agreements,
and geographic and political circumstances. For instance, limiting
the outsourcing of labour to other countries.

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Notes 5.5 Sensitivity Analysis

Sensitivity analysis is one tool that conveys risk in more specific terms.
It reveals the degree to which estimation mistakes affect the predicted
project parameters such as predicted cash flow, discount rate and project
life. The study along these lines is crucial since there will always
be estimation mistakes and because the future is never definite. By
considering a variety of potential outcomes while assessing a project,
sensitivity analysis corrects estimating inaccuracies. To give the decision-
maker insight into the diversity of the results, sensitivity analysis uses a
procedure that involves evaluating a project using a variety of predicted
cash flows. Distinct cash flow projections are given by sensitivity analysis
based on three different hypotheses. (i) The worst case scenario, (ii) the
base case scenario (most likely), and (iii) the best case scenario in terms
of project outcomes.

5.5.1 Assigning Probability

Sensitivity analysis offers many estimates of how much money a
project will make in the future. As a result, it is better than forecasting
a single value since it provides a more accurate understanding of the
returns’ variability. But it has a drawback in that it doesn’t reveal the
likelihood of these variants happening. The likelihood of the occurrence
of the changes should also be provided in order to address this flaw in
sensitivity analysis and produce a more accurate forecast. Therefore, a
more accurate way to quantify cash flow variability would be to assign
probabilities to predicted cash flows. The idea of probability is useful
since it expresses the likelihood in percentage terms of each potential
cash flow. For instance, if chances of realizing a certain cash flow were
slim, we can assign a low 30% probability to it.
Similarly, if a cash flow has a probability of 1, it will definitely happen.
E.g. - In the case of contractual obligations of cash outflow. On the other
hand, probability of 0 means that the cash flow prediction has no chance
of ever happening. As a result, the likelihood of getting a specific cash
flow forecast would be anywhere between zero and one. There are two
processes in quantifying return variability. First, probabilities are assigned

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 RISK ANALYSIS IN CAPITAL BUDGETING

based on the likelihood that a specific cash flow forecast will materialize. Notes
Probabilities can be assigned in an objective or subjective manner.
The term “objective probability” refers to the determination of a probability
based on several observations made in distinct yet identical circumstances
and based on past experiences of events occurring or not. However, because
they do not meet the condition of independent observations recurring
over time, objective probability is not very useful in capital budgeting
circumstances. Instead, they are based on a single occurrence. Subjective
or individual probability assignments are those that are not supported by
the objective evidence of several trials of the same occurrence. It is the
process of arbitrarily assigning probability to cash flow forecasts based
on personal experience and judgment.
Calculating the project’s estimated return is the second phase. The
anticipated value of a project is a weighted average return, where the
weights are the probability given to the various expected occurrences.
It is arrived at by multiplying the predicted cash flows by the assigned
probabilities.
Sensitivity analysis may also be used to determine the impact of changes
in important factors, such as sales volume, profit margins, cost of raw
materials, interest expenses, cost of capital, and so on, on the anticipated
outcome (expressed in terms of NPV) of the proposed investment project.
Keeping the impact of other variables constant, just one variable is taken
into account for analytical purposes at one particular moment.
Example: An amusement park determines a positive NPV of Rs. 1 crore
for investment in a new ride, requiring a cash outlay of Rs. 30 lakhs. Its
senior management may want to know the impact of change in ticket
prices on the NPV of the project. If a small rise in ticket prices causes
demand and subsequently revenue to fall drastically, the project may result
in a negative NPV. Hence, it can be concluded that the proposed ride is a
high risk project. On the other hand, if it turns out that the NPV remains
positive despite a 20% decline in income, the project might be considered
to have low risk. In addition, the management could do sensitivity tests in
light of rising variable expenses. The identified important factors to the
basic NPV can then be subjected to sensitivity analysis in this manner.
If a modest adjustment results in a magnified change in NPV, the project
is considered to be extremely sensitive.

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Notes These illustrations effectively show how valuable sensitivity analysis is

as a method of determining the risks connected to the proposed project.
To evaluate the effects of changes in important factors on NPV, a visual
depiction will be equally helpful; the flatter the curve, the lower the risk;
the steeper the curve, the riskier the project is. Determining how sensitive
the NPV is to changes in any of the key variables and identifying which
variable has the biggest impact on the NPV are thus the main goals of
sensitivity analysis. Clearly, sensitivity analysis gives the decision-maker
a good understanding of how risky the project is.

5.6 Methods to Adjust Risk in Capital Budgeting

1. Risk-adjusted Discount Rate Approach.
2. Certainty-Equivalent Approach.
3. Decision-tree Approach.
4. Probability Distribution Approach.

5.6.1 Risk-adjusted Discount Rate Approach

The risk-adjusted discount rate approach (RADR) is a method used to
calculate the present value of future cash flows by taking into account
the risk associated with those cash flows. In other words, it is a method
used to determine the value of an investment based on the expected return
and the level of risk involved.
The RADR approach is commonly used in finance, especially in corporate
finance, to evaluate potential investment opportunities. The basic concept
behind the RADR approach is that an investor should demand a higher
rate of return for investments that carry a higher level of risk. This is
because riskier investments are less certain and therefore require a higher
return to compensate for the added uncertainty.
To calculate the RADR, a company must first determine the risk-free
rate, which is the rate of return on an investment with no risk, such as
a U.S. Treasury bond. The risk-free rate serves as a benchmark for the
expected rate of return on a particular investment. The company must
then determine the expected rate of return for the specific investment

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being considered. This expected rate of return is based on factors such Notes
as the investment’s industry, historical performance and projected growth.
Once the risk-free rate and expected rate of return have been determined,
the company can then calculate the risk premium. The risk premium is the
additional rate of return that investors demand for taking on the specific
risks associated with the investment. This risk premium is based on the
riskiness of the investment and is calculated by subtracting the risk-free
rate from the expected rate of return.
The risk premium is then multiplied by the probability of the investment
achieving its expected return. The probability of achieving the expected
return is calculated based on factors such as the company’s track record,
the current economic climate, and any potential industry-specific risks.
The result is a risk-adjusted discount rate, which is used to calculate the
present value of the investment’s expected cash flows.
The RADR approach is a useful tool for evaluating investment opportunities
because it takes into account the level of risk involved. By considering
the risk associated with an investment, the RADR approach provides a
more accurate picture of the potential return on investment. This approach
is particularly important for companies that operate in industries with
high levels of risk, such as the technology or pharmaceutical industries.
It is possible to apply the Risk-adjusted Discount Rate Approach to both
the NPV and the IRR. The risk-adjusted rate would be used to compute
NPV if the NPV approach were to be used to analyze a capital expenditure
decision. The plan would proceed if the NPV is positive. If the NPV is
negative, the project should be abandoned. If the internal rate of return
(IRR) was the decision criterion, it would be compared to the risk-adjusted
required rate of return (RADR). The proposal would be approved if the
IRR is more than the risk-adjusted rate; otherwise, it would not.
CFATt
NPV = ∑ tn=1 – CO
(1 + K r )

CFATt = expected Cash flow after tax in year t

Kr = risk adjusted discount rate
CO = Cash outflow

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Notes Illustration: Find whether the project should be accepted or not:

Year Cash Inflow
1 50,000
2 45,000
3 40,000
4 37,500
Initial Outlay 1,00,000
Risk-free discount rate 6%
Risk adjusted rate 20%
Solution.
Year Cash Co-efficient NPV of Cashflow NPV of Cashflow
Inflow (at 20%) (at 38%)
0 1,00,000 1 -1,00,000 -1,00,000
1 50,000 0.83333333 41666.66667 36231.88406
2 45,000 0.69444444 31250 27173.91304
3 40,000 0.5787037 23148.14815 20128.82448
4 37,500 0.48225309 18084.49074 15725.64412
NPV 14149.30556 -739.7342995
Given the expected cash flows and estimated risk-adjusted discount rate,
the project’s expected NPV is positive, and the project should be accepted.
If the risk-adjusted discount rate is 38 per cent, the NPV will be negative
(Rs. 739.73). Then, the project will have to be rejected. If the riskiness
of the return from the same project differs for future periods, different
rates of discount for different future periods can be used.
One of the key benefits of the RADR approach is that it allows companies
to make more informed investment decisions. By taking into account
the level of risk associated with an investment, companies can better
assess the potential return and make more strategic decisions. This can
help companies avoid investing in projects that have a low probability
of success or that carry a high level of risk.
Another benefit of the RADR approach is that it can be used to compare
investment opportunities with different levels of risk. By calculating the
risk-adjusted discount rate for each investment, companies can determine
which investments offer the best risk-adjusted return. This can help
companies prioritize investments and allocate resources more effectively.

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However, there are also some limitations to the RADR approach. One Notes
of the key challenges is determining the appropriate level of risk for a
particular investment. The level of risk can be difficult to quantify and is
often subjective. Additionally, the RADR approach relies on assumptions
about future performance, which may not always be accurate. Finally, the
RADR approach is only one of many tools that can be used to evaluate
investment opportunities and should be used in conjunction with other
methods to get a more comprehensive picture of potential risks and returns.
In conclusion, the risk-adjusted discount rate approach is a powerful
tool for evaluating investment opportunities. By taking into account the
level of risk associated with an investment, companies can make more
informed decisions and allocate resources more effectively. While the
approach has its limitations, it is a valuable tool for any company looking
to evaluate potential investment opportunities and maximize returns while
minimizing risk.

5.6.2 Certainty-Equivalent Approach

The Certainty-Equivalent Approach is a method used in capital budgeting
to assess the value of an investment based on its expected cash flows and
the investor’s risk tolerance. This approach takes into account the fact that
investors are often risk-averse and may require additional compensation
to take on uncertain cash flows. The certainty-equivalent approach allows
investors to compare investment options with different levels of risk and
uncertainty, and determine the minimum return they would require to
accept an investment with risky cash flows.
The basic idea of the certainty-equivalent approach is to calculate the
certain cash flow that would provide the same level of satisfaction as
the expected cash flow of an investment with uncertain cash flows. This
certain cash flow is known as the certainty equivalent, and it represents
the minimum amount of guaranteed cash flow that an investor would
accept in lieu of the uncertain cash flow of the investment. To calculate
the certainty equivalent, an investor must first determine their risk
tolerance, which is the minimum return they require for taking on a
given level of risk.

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Notes Once the investor’s risk tolerance has been established, the next step is to
use a risk premium to adjust the expected cash flow of the investment for
the level of risk associated with the investment. The risk premium is the
additional return an investor requires for taking on risk, and it is typically
calculated as the difference between the expected return on a risk-free
investment and the expected return on the investment being evaluated.
Thus the certainty equivalent co-efficient is calculated by dividing the
certain cash flow (that gives the same satisfaction) by the corresponding
risky cash flow. For example, if riskless amount of Rs. 19000 at the end
of first year gives the same utility as risky amount of Rs. 20000 then the
certainty equivalent co-efficient will be 19000/20000= 0.95. It means 95
paisa of certain/risk-free cash flow is equally preferred to Re. 1 by the
management at the end of first year. The value of certainty equivalent
co-efficient decreases with time period as risk is higher in time periods
further in the future. The riskless cash flows are obtained as a product
of risky cash flows and the respective certainty equivalent co-efficient.
These cash flows are then discounted at the riskless rate and not the
cost of capital to calculate the NPV. In case of IRR technique, the IRR
calculated using the riskless cash flows are compared with the riskless
rate and not the WACC for acceptance/rejection of the project.
Illustration
Year Co-efficient Cash Inflow
1 0.95 50,000
2 0.8 45,000
3 0.77 40,000
4 0.7 37,500

Year 1 0.95 × 50,000 47,500

Year 2 0.80 × 45,000 36,000
Year 3 0.77 × 40,000 30,800
Year 4 0.70 × 37,500 26,250
Initial Outlay 1,00,000
WACC= 10%
Risk-free rate = 7%

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NPV = [(47,500/(1 + 0.07)^1) + (36,000/(1 + 0.07)^2) + (30,800/ Notes

(1 + 0.07)^3) + (26,250/(1 + 0.07)^4)] - 1,00,000
NPV = 21,004.29
Since the NPV is positive, the project should be accepted on the
certainty equivalent cash flow basis.
The NPV approach or the IRR method can be used as the decision-
criterion in this situation. If the NPV of the certainty-equivalent cash flow
is positive, the proposal would be accepted using the NPV technique;
otherwise, it would be rejected. If the IRR technique is used, the internal
rate of return (r), which compares the risk-free discount rate to the present
value of certainty-equivalent cash inflows and outflows, would be used.
As is customary with this methodology, the investment proposal would
be approved if rate of return surpasses the risk-free rate. Otherwise, it
would be turned down. By comparing the certainty equivalents of the
two investment options, the investor can determine which option provides
the best value for their risk tolerance.
The certainty-equivalent approach is a useful tool in capital budgeting
because it allows investors to compare investment options with different
levels of risk and uncertainty. By adjusting the expected cash flows of an
investment for the level of risk associated with it, investors can calculate
the minimum return they require to be compensated for taking on risk,
and compare that return to the expected return of the investment. This
approach can help investors make more informed investment decisions
and choose the option that provides the best balance between risk and
return. RADR Approach incorporates risk involved in capital budgeting by
adjusting the discount rate whereas certainty equivalent approach works
by adjusting the cash flows.

5.6.3 Decision-tree Approach

Capital budgeting decisions are often complex and involve a lot of
uncertainty. Decision tree analysis is one approach that organizations can
use to make informed capital budgeting decisions.
A decision tree is a graphical representation of a decision-making process.
It is a model that is used to evaluate the outcomes of different decisions
based on a set of probabilities. Decision trees are useful in capital

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Notes budgeting because they can help decision-makers visualize and quantify
the potential outcomes of different investment opportunities.
The decision tree is made up of three main components: Decision nodes,
chance nodes and end nodes. A decision node represents a point in the
decision-making process where a decision must be made. A chance node
represents a point in the process where an uncertain event may occur. An
end node represents the final outcome of the decision-making process.
The decision tree begins with a decision node that represents the choice of
whether or not to invest in a particular project. If the decision is made to
invest, the next decision node represents the choice of which investment
option to choose. The chance nodes represent the uncertain events that
may occur during the life of the investment, such as changes in interest
rates, changes in the economy, or changes in consumer demand.
Each chance node is associated with a set of probabilities that reflect
the likelihood of different outcomes. The probabilities are typically based
on historical data, expert opinions, or other sources of information. The
probabilities are used to calculate the expected value of each decision
path, which is the sum of the products of the probabilities and the payoffs
for each outcome.
The end nodes represent the final outcomes of the decision-making
process. These outcomes can be either positive or negative, and they are
associated with a specific payoff or cost. The payoffs and costs can be
in the form of cash flows, net present value, internal rate of return, or
other measures of financial performance.
The decision tree analysis is conducted by calculating the expected value
of each decision path. The decision path with the highest expected value
is considered to be the optimal decision. The decision tree analysis
provides decision-makers with a systematic and transparent approach to
evaluate investment opportunities and select the best option. The decision
tree analysis is particularly useful in capital budgeting because it can
help decision-makers deal with uncertainty and risk. Capital budgeting
decisions often involve a significant amount of risk, and decision-makers
need to be able to evaluate the potential outcomes of different investment
options under different scenarios. The decision tree analysis also helps
decision-makers to identify the critical factors that influence the outcomes
of the investment. For example, if the decision tree analysis reveals that

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the outcome of an investment is highly sensitive to changes in interest Notes

rates, decision-makers can focus on developing strategies to manage
interest rate risk.
In addition to providing a systematic approach to evaluate investment
opportunities, the decision tree analysis can also help decision-makers
to communicate their decisions to stakeholders. Decision trees are easy
to understand, and they can help decision-makers explain the rationale
for their decisions in a clear and concise manner.
The decision-tree approach in capital budgeting involves several steps:
Step 1: Identify the Investment Opportunities
The first step in the decision-tree approach is to identify potential
investment opportunities. These could be projects, products, or services
that the organization is considering investing in to generate long-term
returns.
Step 2: Identify the Relevant Factors
The second step is to identify the relevant factors that could impact the
success or failure of the investment opportunities. These factors could
include market conditions, competition, regulatory changes, economic
conditions, and other variables that could influence the investment’s
performance.
Step 3: Develop the Decision Tree
The third step in the decision-tree approach is to create a decision tree
that maps out the potential outcomes of each investment opportunity. The
decision tree should include the various possible outcomes, the probability
of each outcome, and the expected returns associated with each outcome.
Decision trees can be created using software tools or even hand-drawn
diagrams.
Step 4: Analyze the Decision Tree
The fourth step is to analyze the decision tree to determine the best
investment opportunity. Decision-makers can use a variety of methods to
evaluate the decision tree, such as the net present value (NPV) method,
the internal rate of return (IRR) method, or the payback period method.

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Notes

Despite its many advantages, the decision tree analysis also has some
limitations. One of the main limitations is the difficulty of accurately
estimating the probabilities of different outcomes. The accuracy of the
probabilities is essential to the accuracy of the expected value calculation.
If the probabilities are inaccurate, the expected value calculation will
also be inaccurate.
Another limitation is the assumption that decision-makers are rational and
can accurately evaluate the potential outcomes of different investment
options. In reality, decision-makers may be subject to biases and may not
have all the information they need to make informed decisions.
In conclusion, decision tree analysis is a useful tool for capital budgeting
decisions. It provides decision-makers with a systematic and transparent
approach to evaluate investment opportunities and select the best option

5.6.4 Probability Distribution Approach

One of the most common methods used in capital budgeting is the net
present value (NPV) approach, which involves calculating the present
value of expected cash inflows and outflows associated with an investment.
However, the NPV approach is often based on point estimates of future
cash flows, which can be uncertain and subject to significant risk.

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To address these issues, capital budgeting practitioners often use a Notes

probability distribution approach to estimate the expected NPV of a project.
The probability distribution approach involves developing a probability
distribution of expected cash flows and using this distribution to estimate
the expected NPV.
Developing a Probability Distribution of Expected Cash Flows
To develop a probability distribution of expected cash flows, capital
budgeting practitioners often use historical data and expert opinions to
estimate the possible outcomes associated with a project. For example,
if a project involves investing in new equipment to increase production
capacity, practitioners might consider different levels of production and
potential revenue streams. They would then estimate the probability of each
possible outcome occurring, based on historical data and expert opinions.
To develop a probability distribution, practitioners must first identify the
possible outcomes associated with a project. In the example of investing
in new equipment to increase production capacity, possible outcomes
might include increased production, decreased production, or production
that stays the same. Next, practitioners would estimate the probability of
each possible outcome occurring. This might involve analyzing historical
production data or consulting with subject matter experts to develop a
more accurate estimate.
Once the possible outcomes and their probabilities have been identified,
practitioners can use this information to develop a probability distribution.
A probability distribution represents the range of possible outcomes and
their associated probabilities. For example, a normal probability distribution
might be used to represent the possible outcomes associated with a
project. The distribution might show the expected level of production on
the x-axis and the probability of that level of production on the y-axis.
The area under the curve represents the probability of different levels of
production occurring.
Calculating the Expected NPV
Once a probability distribution of expected cash flows has been developed,
practitioners can use this distribution to calculate the expected NPV. The
expected NPV is calculated as the weighted average of the NPV for
each possible outcome, where the weights are the probabilities of each

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Notes outcome. For example, if a project has three possible outcomes with
probabilities of 20%, 50% and 30%, practitioners would calculate the
expected NPV as follows:
Expected NPV = (NPV1 × 0.20) + (NPV2 × 0.50) + (NPV3 × 0.30)
Where NPV1, NPV2 and NPV3 represent the NPV for each of the three
possible outcomes.
Using Sensitivity Analysis to Evaluate the Impact of Different
Assumptions
One of the benefits of using a probability distribution approach is that it
allows for a more comprehensive analysis of a project’s potential outcomes.
However, the approach requires a significant amount of data and expertise
to create an accurate probability distribution. Additionally, there is always
some uncertainty in the estimates. Therefore, it is important to carefully
evaluate the inputs used in creating the probability distribution and to
use sensitivity analysis to assess the impact of different assumptions on
the expected NPV.
Sensitivity analysis involves testing the impact of different assumptions
on the expected NPV. For example, practitioners might test the impact of
changing the estimated probabilities of different outcomes or the estimated
cash flows associated with each outcome. By testing the impact of different
assumptions, practitioners can better understand the risk associated with
a project and make more informed investment decisions.
IN-TEXT QUESTIONS
1. What is the Certainty Equivalent (CE) in the context of the
Certainty Equivalent Approach?
(a) The minimum rate of return required by investors
(b) The present value of risky cash flows
(c) The guaranteed cash flow equivalent to the risky cash
flow
(d) The rate used for discounting risk-free cash flows
2. In the Certainty Equivalent Approach, a higher certainty equivalent
implies:
(a) Higher risk and lower expected returns
(b) Lower risk and higher expected returns

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(c) Lower risk and lower expected returns Notes

(d) Higher risk and higher expected returns

3. What does the Risk-Adjusted Discount Rate (RADR) represent?
(a) The discount rate used to calculate the project’s Net
Present Value (NPV)
(b) The rate at which risky cash flows are adjusted for inflation
(c) The minimum acceptable rate of return
(d) The discount rate used to incorporate the project’s risk
into the analysis
4. When applying the Risk-Adjusted Discount Rate (RADR) to a
project, which of the following statements is correct?
(a) The RADR is always equal to the required rate of return
(b) The RADR is used to determine the project’s payback
period
(c) The RADR is higher than the required rate of return for
riskier projects
(d) The RADR is used to calculate the project’s accounting
rate of return
5. In capital budgeting, the Decision Tree Approach is primarily
used for:
(a) Estimating the initial investment cost
(b) Analyzing the project’s cash flows under uncertainty
(c) Determining the payback period of a project
(d) Calculating the Net Present Value (NPV) of a project
6. Which approach is particularly useful when evaluating projects
with significant uncertainty and multiple possible outcomes?
(a) Probability Distribution Approach
(b) Payback Period Approach
(c) Accounting Rate of Return Approach
(d) Net Present Value (NPV) Approach

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Notes 7. You are evaluating two investment opportunities. Project A

offers a guaranteed cash flow of $ 60,000, while Project B is
a risky project with a 30% chance of generating $ 80,000 and
a 70% chance of generating $ 40,000. What is the Certainty
Equivalent (CE) for Project B?
(a) $ 48,000
(b) $ 60,000
(c) $ 52,000
(d) $ 56,000
8. You are evaluating a project with expected cash flows as follows:
Year 1: $ 30,000, Year 2: $ 40,000, Year 3: $ 50,000. The risk-
free rate is 5%, and the project’s risk premium is 10%. What
is the Risk-Adjusted Discount Rate (RADR) for this project?
(a) 5%
(b) 10%
(c) 15%
(d) 20%
9. In the context of the Modified Internal Rate of Return (MIRR),
which of the following statements is true?
(a) MIRR considers the reinvestment rate for positive cash
flows
(b) MIRR is equivalent to the Net Present Value (NPV) for
all projects
(c) MIRR is the same as the traditional Internal Rate of
Return (IRR)
(d) MIRR is calculated using the payback period
10. When evaluating a project using the Modified Internal Rate
of Return (MIRR), a higher MIRR compared to the project’s
required rate of return suggests:
(a) The project is not financially viable
(b) The project is acceptable and adds value to the firm
(c) The project is too risky
(d) The project should be evaluated using the Payback Period

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5.7 Summary Notes

‹ Risk analysis should be integrated in the capital budgeting approach.

In general, if all other factors are equal, a company would be wise
to accept a project that is less dangerous and reject the ones that
are highly risky.
‹ The risk scenario is one in which the probability of occurrence of
a specific event is known. Under the circumstances of uncertainty,
these probabilities are unknown.
‹ Sources of Risk:
„ Project Specific Risks
„ Firm Specific Risks
„ Industry-Specific Risks
„ Competition Risk
„ Economic Risk
„ International Risk
‹ Sensitivity Analysis: This approach helps to find the predicted results
for different combinations and variations in the forecasted parameters/
inputs such as cash flows, growth rate, cost, sales, discounting rate
etc. This helps in testing the worthiness of a project for a range of
input values and thus accounts for inaccuracies in prediction.
‹ Methods to adjust Risk in Capital Budgeting:
„ Risk-adjusted Discount Rate Approach (RADR): Cash Flows
are discounted at the RADR to determine the NPV. RADR is
based on risk free rate and risk premium for the risk involved
in the investment project.
„ Certainty-Equivalent Approach (CE): The cash flows for
different years are multiplied with the CE for the respective
years. CE is based on the utility derived from the risky and
riskless cash flows in a year. All the riskless cash flows
obtained with the help of CE co-efficients is discounted at
the risk free rate to calculate the NPV. IRR is compared with
the risk free rate and not the hurdle rate/cost of capital.

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Notes „ Decision-tree Approach: A decision tree is a graphical

representation of a decision-making process. It is a model
that is used to evaluate the outcomes of different decisions
based on a set of probabilities. The decision tree is made
up of three main components: Decision nodes, chance nodes
and end nodes. The decision tree analysis is conducted by
calculating the expected value of each decision path. The
decision path with the highest expected value is considered
to be the optimal decision.
Probability Distribution Approach: We can use a probability distribution
approach to estimate the expected NPV of a project. The probability
distribution approach involves developing a probability distribution of
expected cash flows and using this distribution to estimate the expected
NPV. We use historical data and expert opinions to estimate the possible
outcomes associated with a project.

5.8 Answers to In-Text Questions

1. (c) The guaranteed cash flow equivalent to the risky cash flow
2. (b) Lower risk and higher expected returns
3. (d) The discount rate used to incorporate the project’s risk into the
analysis
4. (c) The RADR is higher than the required rate of return for riskier
projects
5. (b) Analyzing the project’s cash flows under uncertainty
6. (a) Probability Distribution Approach
7. (c) $ 52,000
8. (c) 15%
9. (a) MIRR considers the reinvestment rate for positive cash flows
10. (b) The project is acceptable and adds value to the firm

5.9 Self-Assessment Questions

1. Explain the importance of risk analysis in capital budgeting decisions.
2. Explain the different sources of risk for an investment proposal.

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3. Differentiate between RADR and Certainty Equivalent approach of Notes

risk adjustment in investment decisions.
4. How is Probability Distribution approach used in risk analysis of
investment decisions.
5. Explain the method and technique of sensitivity analysis in capital
budgeting.
6. Describe the decision tree approach of risk adjustment in capital
budgeting.
7. A company is considering to purchase an equipment for Rs. 50000.
The machine has a useful life of 4 years and will generate an expected
CFATs of Rs. 30000 per annum. WACC is 10% and the RADR is
15%. Is it worthwhile to investment in the new equipment?
8. A company is planning to invest in either of the 2 options available.
Use the certainty equivalent (CE) approach to select the project
from the two options based on the information given below:
Year CFATs of CE of CFATs of CE of
Project A Project A Project B Project B
0 -30000 1 -30000 1
1 20000 0.85 15000 0.9
2 15000 0.8 30000 0.7
3 40000 0.6 30000 0.65
4 15000 0.55 15000 0.6
The cost of capital is 10% and the risk-free rate is 5%.

5.10 References & Suggested Reading

‹ Khan M.Y. and Jain P.K. (2018). )LQDQFLDO 0DQDJHPHQW. McGraw
Hill Education (India) Private Limited.
‹ Pandey I.M. (2021). )LQDQFLDO0DQDJHPHQW. Vikas Publishing House.
‹ Brealey R.A., Myers S.C., Allen F. and Mohanty P. (2017). Principles
of Corporate Finance. McGraw Hill Education.
‹ Bhalla V.K. (2014). )LQDQFLDO0DQDJHPHQW. S. Chand Publications.
‹ Horne J.V. and Wachowicz J. (2008). Fundamentals of Financial
0DQDJHPHQW. Pearson.

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L E S S O N

6
Capital Structure: Theory
and Practice
Mr. Kanwaljeet Singh
Assistant Professor
Shri Aurobindo College of Commerce and Management
Punjab University, Chandigarh
Email-Id: kanwaljeet255@gmail.com

STRUCTURE
6.1 Learning Objectives
6.2 ,QWURGXFWLRQ 0HDQLQJ RI &DSLWDO 6WUXFWXUH
6.3 Factors Affecting Capital Structure Decisions
6.4 Theories of Capital Structure
6.5 Checklist for Optimal Capital Structure
6.6 )LQDQFLDO 'LVWUHVV DQG &DSLWDO 6WUXFWXUH %DQNUXSWF\ DQG $JHQF\ &RVWV
6.7 Summary
6.8 $QVZHUV WR ,Q7H[W 4XHVWLRQV
6.9 6HOI$VVHVVPHQW 4XHVWLRQV
6.10 References
6.11 Suggested Readings

6.1 Learning Objectives

‹ To understand the meaning of capital structure.
‹ To understand the factors affecting capital structure decisions.
‹ To explain about theories of capital structure decisions.
‹ Checklist for optimal capital structure decisions.

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6.2 Introduction: Meaning of Capital Structure Notes

Meaning of Capital Structure: Capital Structure is referred to as the

ratio of different kinds of securities equity shares, preference shares and
long-term borrowings raised by a firm as long-term finance. The capital
structure involves two decisions:
(a) Type of securities to be issued are equity shares, preference shares
and long-term borrowings (Debentures).
(b) Relative ratio of securities can be determined by process of capital
gearing. On this basis, the companies are divided into two:
1. Highly geared companies: Those companies whose proportion
of Debt dominates total capitalization.
2. Low geared companies: Those companies whose equity capital
dominates total capitalization.
Capital Structure is to be decided keeping in factor in
mind to maximise the earning per share to equity
shareholders as they are the real owners of company.
The Earning Per Share (EPS) is calculated in such a
manner:
Earning before interest and tax (EBIT)
Less: Interest (XXX)
Earning before tax
Less: Tax (XXX)
Earning after interest and tax/Earning available for
Shareholders
Less: Preference Dividend (XXX)
Earning available for equity shareholders
Earnings per share (Earning available for equity shareholders/ XXX
No. of equity shares)

6.3 Factors Affecting Capital Structure Decisions

Following are the factors that play an important role in determining the
capital structure:
1. Costs of capital: It is the cost that is incurred in raising capital
from different fund sources. A firm or a business should generate

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Notes sufficient revenue so that the cost of capital can be met and growth
can be financed.
2. Degree of Control: The equity shareholders have more rights in
a company than the preference shareholders or the debenture
shareholders. The capital structure of a firm will be determined by
the type of shareholders and the limit of their voting rights.
3. Trading on Equity: For a firm which uses more equity as a source
of finance to borrow new funds to increase returns. Trading on
equity is said to occur when the rate of return on total capital is
more than the rate of interest paid on debentures or rate of interest
on the new debt borrowed.
4. Government Policies: The capital structure is also impacted by the
rules and policies set by the government. Changes in monetary and
fiscal policies result in bringing about changes in capital structure
decisions.
5. Stability of Sales: An established business which has a growing
market and high sales turnover, the company is in position to meet
fixed commitments. Interest on debentures must be paid regardless of
profit. Therefore, when sales are high, thereby the profits are high,
and company is in better position to meet such fixed commitments
like interest on debentures and dividends on preference shares.
If company is having unstable sales, then the company is not in
position to meet fixed obligations. So, equity capital proves to be
safe in such cases.
6. Sizes of a Company: small size business firms capital structure
generally consists of loans from banks and retained profits. While
on the other hand, big companies having goodwill, stability and an
established profit can easily go for issuance of shares and debentures
as well as loans and borrowings from financial institutions. The
bigger the size, the wider is total capitalization.
7. Flexibility of Financial Plan: In an enterprise, the capital structure
should be such that there is both contractions as well as relaxation
in plans. Debentures and loans can be refunded back as the time
requires. While equity capital cannot be refunded at any point which
provides rigidity to plans. Therefore, in order to make the capital

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structure possible, the company should go for issue of debentures Notes

and other loans.
8. Choice of Investors: The company’s policy generally is to have
different categories of investors for securities. Therefore, a capital
structure should give enough choice to all kind of investors to
invest. Bold and adventurous investors generally go for equity
shares and loans and debentures are generally raised keeping into
mind conscious investors.
9. Capital Market Condition: In the lifetime of the company, the
market price of the shares has got an important influence. During
the depression period, the company’s capital structure generally
consists of debentures and loans. While in period of boons and
inflation, the company’s capital should consist of share capital
generally equity shares.
10. Period of Financing: When company wants to raise finance for short
period, it goes for loans from banks and other institutions, while
for long period it goes for issue of shares and debentures.

6.4 Theories of Capital Structure

The capital structure theories explore the relationship between the use of
debt and equity financing and the value of the firm. If the use of debt is
profitable then it increases the value of the firm and vice versa. Capital
structure theories explain the relationship among the capital structure,
the cost of capital and value of the firm. The capital structure of a firm
should be such as it maximises the value of the firm (shareholders wealth).
Such a capital structure is called optimum capital structure. There are
different theories which explain the relationship among capital structure
or financing mix (debt–equity ratio), cost of capital and valuation of a
company. According to one school of thought, the capital structure affects
cost of capital of a company and its value. According to the other school
of thought, there is no relationship among the capital structure, cost of
capital of a company, and its value. Capital structure theories belong to
two categories:
(a) Theories of Relevance.
(b) Theories of Irrelevance.

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Notes
Theories of
Capital Structure

Theory of Theory of
Relevance irrelevance
(Capital Structure (Capital structure
has impact on has no impact on
value of firm) value of firm)

Net Income Traditional Net Operating

MM Approach
approach Approach Income Approach

6.4.1 Assumptions of Capital structure

1. The company uses only two sources of funds, that is debt and
equity.
2. There are no corporate taxes.
3. The firm’s total assets are given, and they do not change. In other
words, the investment decisions are assumed to be constant.
4. The dividend pay-out ratio is 100 per cent which means that whole
of the earnings is distributed as dividends and there are no retained
earnings.
5. The operating profits (EBIT) of the company are given and not
expected to grow.
6. The company’s total financing remains constant. The company can
change its capital structure either by redeeming the debentures with
the help of issuing shares or by raising more debt and reducing the
equity capital.
7. The business risk remains constant and is assumed to be independent
of capital structure and financial risk.

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8. All investors have the same probability distribution of future expected Notes
operating earnings (EBIT) for a given firm.
9. The firm has a perpetual life.

6.4.2 Net Income Approach

This approach was given by Durand. According to this approach, capital
structure decision affects the value of the firm. A change in the capital
structure (Financial leverage or Debt-equity ratio) causes a change in the
overall cost of capital and the value of the firm. Use of higher debt in
the capital structure will decrease the overall cost of capital and increase
the value of the firm and the market price of equity shares. On the other
hand, a decrease in the use of debt in capital structure will lead to an
increase in the overall cost of capital and a decrease in the value of the
firm and the market price of equity shares. This approach is based on
three assumptions:
(a) There are no taxes.
(b) The cost of debt is less than the cost of equity.
(c) The use of debt does not change the risk perception of investors.
According to NI approach, financial leverage is an important variable in
capital structure decision of a company. By making a judicious use of
debt and equity, a company can achieve an optimum capital structure.
The optimum capital structure is one at which the overall cost of capital
(K0) is minimum, and the value of the firm is maximum. At this capital
structure, the market price of the equity share will be the highest. According
to NI approach, the value of the firm can be determined as follows:
V = S + D
Where, V = Total market value of the firm S = Total market value of
equity
Market value of equity (S) = Earnings available for equity shareholders
(NI)/Ke Earnings available for equity shareholders = EBIT – I
D = Total market value of debt
Ke = Equity capitalisation rate (Ke)

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Notes Overall cost of capital or weighted Average Cost of capital can be

calculated as:
Ko = EBIT/V
where Ko = Overall cost of capital

Example: A company expects a net income of Rs. 80,000. It has

Rs. 2,00,000, 8% Debentures. The equity capitalisation rate of the company
is 10%. (a) Calculate the value of firm and overall capitalisation rate
according to Net income Approach. (b) If the debenture debt is increased
to Rs. 3,00,000, what shall be the value of firm and overall capitalisation
rate?
Solution:
(a) Net Income Rs. 80,000
Less Interest on 8% Debentures of Rs. 2,00,000 (16,000)
Earnings available for equity shareholders 64,000

Market Value of equity (S) = 64,000 × 100/10 = Rs. 6,40,000

Market Value of Debt = Rs. 2,00,000
Value of the firm (S+ D) = Rs. 8,40,000
Ko = EBIT/V × 100
= 80,000 / 8,40,000 × 100 = 9.52%
(b) If debenture is increased to Rs. 3,00,000
Net Income Rs. 80,000
Less Interest on 8% Debentures of Rs. 3,00,000 (24,000)
Earnings available for equity shareholders 56,000

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Market Value of equity (S) = 56,000 × 100/10 = Rs 5,60,000 Notes

Market Value of Debt = Rs. 3,00,000
Value of the firm (S + D) = Rs. 8,60,000
Ko = EBIT/V × 100
= 80,000/8,60,000 × 100 = 9.30%
Thus, with the increase in debt financing the value firm is increased and
the overall cost of capital has decreased.

6.4.3 Traditional Approach

Net Income (NI) Approach and Net Operating Income (NOI) Approach
are the two extremes of the relationship between the capital structure and
value of the firm. While Net Income Approach explains that the capital
structure affects the overall cost of capital and the total value of the firm,
the Net Operating Income Approach suggests that the capital structure
is totally irrelevant. Traditional Approach is a compromising viewpoint
between Net Income Approach and Net Operating Income Approach.
Partly it has the features of both the approaches. Therefore, it is a mid-
way approach. The Traditional Approach is similar to the NI Approach
to the extent that it says that leverage affects the overall cost of capital
and total value of the firm. However, it does not accept the viewpoint
of NI Approach that the value of the firm will necessarily increase for
all degrees of financial leverage. it is similar to the viewpoint of NOI
Approach that beyond a certain degree of leverage, the overall cost of
capital increases, as a result of which the total value of the firm decreases.
But it is different from the NOI Approach as it does not accept the view
that the overall cost of capital is constant for all degrees of leverage. The
essence of the Traditional Approach is that a firm by making a judicious
use of debt and equity in its capital structure can increase its total value
and decrease the overall cost of capital. This is because debt is a cheaper
source of finance due to tax deductibility of interest in comparison to
equity shares. The use of cheaper source of funds (debt) by replacing
equity capital will reduce the overall cost of capital. However, if the debt
is raised further, it will increase financial risk for the investors, leading
to an higher equity capitalisation rate (Ke ). But the increase in equity
capitalisation rate (Ke) may not be so high as to offset the benefit of

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Notes cheaper debt. But, if the debt is increased further, it will increase financial
risk both for equity shareholders and creditors. They will demand higher
rate of return from the firm. In other words, it will increase the equity
capitalisation rate (Ke) as well as the cost of debt (Kd). Thus, the use
of debt beyond a certain point will raise the overall cost of capital and
decrease the value of the firm. Hence, the use of debt up to a certain
point will increase the value of the firm and beyond that point it will
decrease the value of the firm. At this level of debt-equity mix, the capital
structure of the firm would be optimum. At this level, the overall cost
of capital would be the minimum. At this level, the marginal real cost
of debt (both implicit and explicit) would be equal to the real cost of
equity. In conclusion, it can be said that financial leverage is favourable
up to a certain level but after a certain point it starts operating adversely.

Traditional Approach
Example: Compute the market value of firm, value of shares and the
average cost of capital from the following:
Rs.
Net operating Income 2,00,000
Total Investment 10,00,000
Equity capitalisation rate:
If firm uses no Debt. 10%
If firm uses Rs. 4,00,000 Debt. 11%
If firm uses Rs. 6,00,000 Debt. 13%
Assume that Rs. 4,00,000 Debenture can be raised at 5% rate of interest
whereas Rs. 6,00,000 debentures can be raised at 6%.

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Solution: Computation of Market value of firm & the average cost of Notes
capital:
No Debt Rs. 4,00,000 Rs. 6,00,000
5% Debentures 6% Debentures
Net operating Rs. 2,00,000 Rs. 2,00,000 Rs. 2,00,000
Income
Less Interest Nil 20,000 36,000
on debt
Earnings 2,00,000 1,80,000 1,64,000
available
for equity
shareholders
Ke 10% 11% 13%
Market value 20,00,000 16,36,363 12,61,538
of Equity(s)
S= EBIT -I/Ke
Market value Nil 4,00,000 6,00,000
of debt
Value of firm 20,00,000 20,36,363 18,61,538
Average cost 2,00,000/20,00,000×100 2,00,000/20,36,363×100 2,00,000/18,61,538×100
of capital 10% 9.8% 10.7%
EBIT/V×100
Thus, it is clear that when debt is increased to Rs. 4,00,000 then value
of firm increases and overall cost of capital is reduced but when debt
is increased to Rs. 6,00,000 debentures, the value of firm decreases and
overall cost of capital increases.

6.4.4 Net Operating Income (NOI) Approach

This approach was also suggested by Durand but it is opposite to Net
Income approach. According to this approach, the value of the firm is
independent of its capital structure. The change in capital structure does
not cause change in the value of the firm, market price of shares and
weighted average cost of capital. According to this approach, the market
values the firm as a whole and it does not split the value of the firm
into value of the equity and value of the debt. The overall cost of capital
(Ko) is constant for all degrees of financial leverage. The value of the
firm is ascertained as follows:

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Notes V = EBIT/ Ko
Where V = Value of firm
EBIT = Earnings before interest and tax Ko = Overall cost of capital
The value of equity is residual, which is calculated by deducting the
value of debt (D) from the total value of the firm (V).
Thus, total value of equity (S) = V – D.
When a company increases the proportion of debt in its capital structure,
it increases the financial risk for equity shareholders. As a result of
increase in the financial risk, the equity shareholders expect higher rate of
return from the company to get compensated for higher risk. It means, it
increases the cost of equity Ke. In this way, the benefit of using cheaper
debt is neutralised by the implicit cost of equity, as a result of which
overall cost of capital remains the same. The cost of equity or equity
capitalisation rate is calculated as below:
Cost of equity or Equity capitalisation rate (Ke) = EBIT – I/S × 100
According to NOI approach, there is nothing like optimum capital structure
as the total value of the firm and market price of shares are not affected
by the level of financial leverage.
Assumptions: This approach is based on the following assumptions:
1. The overall cost of capital (Ko) remains constant for all degrees of
financial leverage or debt-equity ratio.
2. There are no corporate taxes.
3. The investors values the firm as a whole and do not split the value
of the firm into value of equity and value of debt.
4. The increase of proportion of debt in the capital structure results
in an increase in the financial risk which causes an increase in the
cost of equity (Ke).
5. The weighted average or overall cost of capital (K o) remains
constant.
The concept will be explained with the help of example:
Example: (a) A company expect a net income of Rs. 1,00,000. It has Rs.
5,00,000 6% Debentures. The overall capitalisation rate is 10%. Calculate

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the value of the firm and the equity capitalisation rate (cost of equity) Notes
according to the Net Operating Income Approach.
(b) If the debenture debt is increased to Rs. 7,50,000. What will be the
effect on the value of the firm and the equity capitalisation rate?
Solution: Net Operating Income = Rs. 1,00,000 Overall Cost of Capital
(Ko) = 10%
Market Value of the firm (V) = EBIT/K o = Rs. 1,00,000/.10 =
Rs. 10,00,000 Value of equity (S) = V- D = Rs. 10,00,000 – Rs. 5,00,000
= Rs. 5,00,000
Cost of equity (Ke) = EBIT – I/S × 100 = Rs. 70,000/Rs. 5,00,000 × 100
= 14%
(c) Market Value of the firm (V) = EBIT/K o = Rs. 1,00,000/.10 =
Rs. 10,00,000 (same as in (a))
Now D = Rs. 7,50,000
So, Value of equity (S) = V - D = Rs. 10,00,000 – Rs. 7,50,000 =
Rs. 2,50,000
So, Cost of equity (Ke) = EBIT – I/S × 100 = Rs. 55,000/Rs. 2,50,000
× 100 = 22%
Thus, it is evident that value of firm remains constant, and cost of equity
increase due to increase in degree of financial leverage.

6.4.5 Modigliani-Miller (MM) Approach

The Modigliani-Miller (MM) approach is also similar to the net Operating
Income approach. However, the NOI approach does not provide operational
justification for irrelevance of capital structure to the valuation of the firm,
and it is of definitional nature while MM approach provides behavioural
justification for constant cost of capital and value of the firm. In other
words, MM approach says that the weighted average cost of capital and
hence, the total value of the firm does not change with the change in the
capital structure. The behavioural justification in MM approach lies in
the arbitrage process. Arbitrage means buying an asset in one market at
lower price and selling the same in another market at higher price. This
arbitrage process restores equilibrium in both the markets.

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Notes Assumptions: The MM approach is based on the following assumptions:

1. The dividend pay-out ratio is 100%, that is, there are no retained
earnings.
2. There are no corporate taxes.
3. The capital markets are perfect.
4. There are no transaction costs.
5. The investors are free to buy and sell the securities.
6. The investors can borrow without restrictions on the same terms
as the firm can.
7. All investors have the same information without cost.
8. The investors are rational in behaviour.
9. All investors have the same expectation of a firm’s net operating
income (EBIT) and evaluate the firm on that basis.
10. All firms can be divided into equivalent or homogeneous risk class.
It means that the expected earnings have similar risk characteristics.
MM Model: without Corporate Taxes
Market Value of Firm (v) = EBIT/Ke Market Value of equity (s) S = V – B
Firm’s leveraged cost of equity = Cost of equity + (cost of equity – Cost
of debt)
Example: The following information is available regarding A Ltd.:
(i) A Ltd. currently has no debt, it is an all-equity company.
(ii) Expected EBIT = Rs. 48 lakhs. EBIT is not expected to increase
overnight, so A Ltd. is in no growth situation.
(iii) There are no taxes, so T = 0 per cent.
(iv) A Ltd. pays out all its income as dividends.
(v) If A Ltd. begins to use debt, it can borrow at the rate kd =8 per cent.
This borrowing rate is constant, and it is independent of the amount
of debt. Any money raised by selling debt would be used to retire
common stock, so A Ltd. asset would remain constant.
(vi) The risk of A Ltd. assets, and thus its EBIT, is such that its
shareholders require a rate of return ke = 12 per cent, if no debt is
used.

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Using MM Model without corporate taxes and assuming a debt of Notes

Rs. 2 crore; you are required to:
(a) Determine the firm’s total market value.
(b) Determine the firm’s value of equity.
(c) Determine the firm’s leverage cost of equity.
Solution: Firm’s Total Value of Firm:
V = EBIT/Ke = Rs. 48,00,000/.12 = Rs. 4 crores
Firm’s Market value of equity = V - D = Rs. 4 crore – Rs. 2 crore =
Rs. 2 crores Firm’s
leverage cost of equity = cost of equity + (cost of equity – cost
of debt)
= 12% + (12% - 8%) = 16%
MM Model: When Corporate Taxes Exists
Value of unlevered firm Vu = EBIT/ Ke (1 – t)
Value of levered firm Vu = Vu + tD
Where, EBIT = Earnings before interest and tax
S = Market Value of Equity
D = Debt
t = Tax rate
Example: There are two firms A and B which are identical except that
does not use any debt in its financing, while B has Rs. 2,00,000 5%
Debentures in its financing. Both the firms have earnings before interest
and tax of Rs. 50,000 and the equity capitalisation rate is 10%. Assuming
the corporation tax of 50% calculate the value of the firm using M & M
approach.
Solution: The market value of firm A which does not use any debt.
Vu = EBIT/Ko (1-t)
= Rs. 50,000/.10 (1 - .50) = Rs. 2,50,000
The market value of firm B which uses Debt of Rs. 2,00,000

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Notes Value of levered firm = Vu + tD

= Rs. 2,50,000 + .5 × 2,00,000
= Rs. 3,50,000

6.5 Checklist for Optimal Capital Structure

A sound or an optimal capital structure should have the following essential
features:
‹ There should be maximum utilisation of leverage.
‹ Capital structure should be flexible so that it can be easily altered
as per the requirement.
‹ To avoid undue financial/business risk with the increase of debt.
‹ Use of debt should be within capacity of firm. It should be in position
to meet its loan and interest liabilities.
‹ There should be minimum loss of control risk.
‹ It should avoid undue restrictions on usage of debt.
‹ It should be simple and easy to understand and operate.
‹ It should minimise the cost of financing and maximising earning per
share.

6.6 Financial Distress and Capital Structure (Bankruptcy

and Agency Costs)
When firm uses more and more debt of leverage in its capital structure
the financial risks of firm increases then it will be difficult for firm to
pay the fixed interest liability to the lenders and may force the firm
to liquidate then firm may run into the costs of financial distress and
bankruptcy, the firm which are less levered and use more of equity may
not have to face bankruptcy costs because they not have to pay dividends
to shareholders in case of insufficient profits. Bankruptcy costs includes
the direct costs of litigation and manging the firm in liquidation. It is
fact that due to the use of leverage the firm enjoys the tax benefits, but
the bankruptcy costs work against its advantage. Thus, firm must do cost
benefit analysis for optimal capital structure decisions.

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Further when firm raises debt the lenders of debt put unjustified restrictions Notes
in loan utilisation agreement which leads to lesser independence of
management in decision making called as agency costs. With the increase
of debt proportion in capital structure of firm lenders put on more and
more restrictions/conditions on firm even charging higher rate of interest.
Thus, highly levered firm must bear more agency costs than unlevered
firm.

IN-TEXT QUESTIONS
1. Which of the following falls under the criteria for determining
a capital Structure?
(a) Simplicity
(b) Flexibility
(c) Minimum risk
(d) All of the above
2. Which of the following factors affect capital structure?
(a) Size of business
(b) Form of business organizations
(c) Stability of earnings
(d) All of the above
3. Voting rights in the company are held by:
(a) Equity shareholders
(b) Preference shareholders
(c) Debenture holders
(d) All of the above
4. Who are the real owners of the company whom we consider
while deciding the company’s capital structure?
(a) Equity shareholders
(b) Preference shareholders
(c) Debenture holders
(d) All of the above

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Notes 5. Net operating income is covered under:

(a) Theory of relevance
(b) Theory of irrelevance
(c) Both (a) and (b)
(d) None of the above
6. The value of firm will remain constant whether the project is
financed from debt or equity is stated under which theory.
(a) Net Income approach
(b) Net operating income approach
(c) Traditional approach
(d) All the above
7. In the case of the Net Income approach, what will be the impact
of the increase in debt on the overall cost of capital?
(a) Increase
(b) Decrease
(c) No impact
(d) None of the above
8. In case of the Net Operating Income approach, what will be
the impact of increase in debt on value of firm?
(a) Increase
(b) Decrease
(c) No impact
(d) None of the above
9. Bankruptcy cost will be high in case of:
(a) High-levered firm
(b) Less levered firm
(c) Both (a) and (b)
(d) None of the above
10. Which of the following is not an approach to the Capital
Structure?
(a) Gross Profit Approach
(b) Net Operating Income Approach

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(c) Net Income Approach Notes

(d) Modigliani and Miller Approach

6.7 Summary
Capital Structure is referred to as the ratio of different kinds of securities
equity shares, preference shares and long-term borrowings raised by a
firm as long-term finance. The capital structure involves two decisions—
A firm which uses more debt to increase the value of firm is known as
highly levered firm. A firm which uses less debt in capital structure is
known as less levered firm.
The use of more debt to increase earnings per share is also known as
trading on equity or financial leverage.
Further there are many factors which impact the capital structure decision
are as follows:
costs of capital; Degree of Control; Trading on Equity; Government
Policies; Stability of sales; sizes of a company; flexibility of financial
plan; Choice of investors; Capital market condition; Period of financing.
Further theory of capital structure divide in two parts:
Theory of Relevance: Which says the value of firm will be increase
with increase in debt in total capitalisation which is further classified
into two categories i.e., Net income approach and traditional approach.
Theory of Irrelevance: Which says the value of firm will be increase
with increase in debt in total capitalisation which is further classified into
two categories i.e., Net operating income approach and MM approach.
Every firm has objective to achieve the target of optimal capital mix and
taking into consideration factors as usage of leverage, flexibility, helpful
in reducing overall cost of capital, with in capacity limit of firm, should
have minimum loss of control and should be easy to use.
Bankruptcy and Agency Costs: A company using high amount of debt
in its capital proportion have to face sometimes bankruptcy and agency
costs as compared to unlevered firm because company have to pay interests
even in case of insufficient profits and sometimes lender charging higher
rate of interests as well as undue restrictions on usage of loan amount
which is known as agency costs.

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Notes 6.8 Answers to In-Text Questions

1. (d) All of the above

2. (d) All of the above
3. (a) Equity shareholders
4. (a) Equity shareholders
5. (b) Theory of irrelevance
6. (b) Net operating income approach
7. (b) Decrease
8. (c) No impact
9. (a) High-levered firm
10. (a) Gross Profit Approach

6.9 Self-Assessment Questions

1. What is meant by capital structure? Discuss the factors affecting

capital structure.
2. What is an optimum capital structure? Bring out the qualities of
an optimum capital structure.
3. Write short notes on the following:
(i) Significance of Capital Structure
(ii) Trading on Equity
(iii) Optimum Capital Structure
(iv) Debt Capacity
4. What do you mean by flexible capital structure? Is a flexible capital
structure more costly?
5. (i) Is debt a cheaper source than equity share capital? If so, why?
(ii) How do the considerations of control and size affect the capital
structure decision?

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6. Explain Net Operating Income (NOI) Approach to capital structure. Notes

How is it different from (NI) Approach?
7. Briefly discuss the MM Approach to capital structure. What are the
limitations of this approach?
8. What is Optimum Capital Structure? Explain fully Traditional
Approach to Capital Structure.
9. Two companies M and N are identical. The financial detail of both
the companies are given as below:
Particulars Company M Company N
Total Assets 60,00,000 60,00,000
EBIT 20% 20%
10% debenture 36,00,000
Equity capital 44,00,000 60,00,000
Capitalisation rate 15% 15%
Compute the value of M and N using (i) Net Income Approach (ii)
Net operating income approach.
[Ans. (i) M Ltd. 64,00,000 N Ltd. 40,00,000 (ii) M Ltd. 58,00,000
N Ltd. 40,00,000]
10. The firms A and B are identical all respects including risk factors
except for Debt Equity Mix. Firm A as issued 12% debentures of
Rs. 15 lakhs, while B has issued only equity. Both the firms earn
30% before interest and taxes on their total assets of Rs. 25 lakhs.
Assuming a tax rate of 50% and capitalisation rate of 20% for an
all-equity company, you are required to compute the value of two
firms, using.
(i) Net Income Approach (ii) New Operating Income Approach.
[Ans. (i) Firm A Rs. 29,25,000; Firm B Rs.18,75,000 (ii) Firm A
Rs. 25,25,000; Firm B Rs.18,75,000]
11. A company expects a net Income of Rs. 80,000. It has Rs. 2,00,000,
8% Debentures. The equity capitalisation rate of the company is
10%. Calculate the value of firm and overall capitalisation rate
according to the net income Approach (ignore income tax)
[Ans. Value of firm Rs. 8,40,000; Overall capitalisation rate 9.51%]

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Notes 6.10 References

‹ Pandey, I.M. (2006). Financial Management. Vikas Publishing House
Pvt. Ltd.
‹ Khan, M.Y. and Jain P.K. Financial management: Text and Problems.
Tata McGraw Hill.
‹ Rustagi, R.P., Fundamentals of Financial management, Taxmann,
New Delhi.
‹ Chandra, P. Financial Management-Theory and Practice, Tata McGraw
Hill.

6.11 Suggested Readings

‹ Pandey, I.M. (2006). Financial Management. Vikas Publishing House
Pvt. Ltd. - Ninth Edition.
‹ Rustagi, R.P., Fundamentals of Financial management, Taxmann,
New Delhi.
‹ Khan, M.Y. and Jain, P.K., Financial management Vikas Publishing
house Ltd., New Delhi. Tripathi, Vanita, Basic Financial Management,
Taxmann Publications.

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L E S S O N

7
Leverage and
EBIT-EPS Analysis
Dr. Akanksha Khurana
Assistant Professor
Delhi College of Arts and Commerce
University of Delhi
Email-Id: akanksha.khurana@dcac.du.ac.in

STRUCTURE
7.1 Learning Objectives
7.2 Introduction
7.3 Concept of Leverage
7.4 5HODWLRQV %HWZHHQ 6DOHV DQG 3UR¿W
7.5 Operating Leverage
7.6 Financial Leverage
7.7 Combined Leverage
7.8 EBIT-EPS Analysis
7.9 Practical Problems
7.10 Answers to In-Text Questions
7.11 Self-Assessment Questions
7.12 References
7.13 Suggested Readings

7.1 Learning Objectives

‹ Understand the concept of leverage.
‹ Learn different types of leverage and study the relationship between them.

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Notes ‹ Study the relationship between sales and profit.

‹ Understanding the concept of EBIT-EPS analysis.

7.2 Introduction
Financial management has become a fascinating and engaging field of
study for both academic researchers and professional financial managers.
All decisions made by an individual or a corporation that have financial
repercussions fall under the category of financial management. The basic
idea of finance is that it deals with the study of money and its flow.
It is the key role of a finance manager of any company. So before moving
on to the concept of leverage, one must understand what are the key areas
a finance manager must focus on. A finance manager must ensure that all
decisions about the raising and use of resources are made effectively and
that no resources are left unused. His role and responsibilities become
more significant as the organization gets bigger and there are more
financial transactions.
According to modern approach, the three key decisions for which a
finance manager is responsible are:
‹ Where does the firm invest its money – Long-term assets or short
term current asset? (Investment Decision)
‹ What will the sources of funds, i.e., how, and where to acquire
funds to meet the investment requirement of a firm – Debt or Equity
(Financing Decision)
‹ Whether distribute all its profit to shareholders or to reinvest in
the company? (Dividend Decision)
This chapter focuses on two major techniques (Leverage Analysis and
EBIT-EPS Analysis) that helps the finance manager to make an informed
financial decisions making regarding when, where and how a corporation
should acquire funds. Since a company typically benefits the greatest
when the market value of its share increases, which not only signals the
firm’s growth but also increases investor wealth. The important factors
which a finance manager needs to take into consideration while designing
a optimal capital structure are cost, risk, liquidity, control and condition
of the market.

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Thus, finance manager role is not limited to budgeting. He must plan, Notes
arrange, manage, and control financial activities to help the company
meet its financial goals. Finance Managers are extremely concerned with
the risk and return for shareholders as it relates to the organization’s
debt-equity balance. If the borrowed funds exceed the funds provided
by the owners, the earnings of the shareholders increase and raises the
organization’s risk at the same time. The return and risk to the shareholders
will be very low in a case where the proportion of equity funds exceeds
the proportion of borrowed money. This emphasises the need of having
an ideal capital structure where risk and shareholder return are balanced.
Finance managers can make informed decisions about their short-term and
long-term goals by carefully considering the impact of capital structure,
where risk and shareholder return are balanced. Thus, the use of leverage
and EBIT-EPS analysis aids in putting the overall situation into proper
perspective.
Thus, planning, arranging, managing, and controlling financial activities,
such as the acquisition and use of an organization’s funds, is known as
financial management. It entails applying general management ideas to
the company’s financial resources.
The concept of leverage comes under the financing decision being taken
by the financial manager. The financing decision focuses on various
sources of finance in the enterprise, i.e., shareholder’s funds or borrowed
funds. It focuses majorly on —
(a) How much fund is needed? and
(b) How to decide the sources of funds and choose the best combination
to raise the required funds?

7.3 Concept of Leverage

The term “leverage” refers to a company’s capacity to increase the return
to its owners by utilising fixed-cost resources or finances. Leverage is the
use of fixed assets or funds for which a company must pay fixed charges
or a fixed rate of interest (fixed financial obligations), regardless of the
volume of operations or the volume of operating profit.

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Notes Fixed operating costs result from the usage of fixed assets by a company
and fixed financial costs incurs when it uses sources of capital structure
for which it must pay fixed cost. The risk and expected return are higher
the more leverage there is, and vice versa. Given that a fixed cost or
return has a major impact on the profits available to equity shareholders,
leverage can either be favourable or unfavourable.
The proportionate relationship between debt and equity is referred to as
the capital structure. While liabilities plus equity on the balance sheet’s
left side show a company’s financial structure. The techniques which
are commonly used to quantify the risk-return characteristics between
alternative capital structures (long-term sources only) are leverage and
EBIT-EPS Analysis.
Leverage means the relationship between any two interrelated variables.
Algebraically, the formula for leverage is—
Leverage = % Change in Dependent Variable/% Change in Independent
Variable
It reflects the degree of responsiveness in the dependent variable to a
change independent variable.
Example 7.1: A firm increased its advertising expenses from Rs. 50,000
to Rs. 60,000 which resulted in the increase of sales of T.V. from 1000
units to 1500 units. Thus, the leverage will be—
Leverage = % Change in unit sold/% Change in Advertising Expenses
= 50/20=2.5
This means that the percentage change in the number of units sold is 2.5
times the percentage change in advertising.

7.4 Relations Between Sales and Profit

A company’s sales income directly affects its operating profit, which in
turn determines how much profit is made accessible to equity owners.
Operating profits (EBIT) can be used to determine the functional relationship
between sales revenue and EPS as follows:
Sales Revenue EBIT
(Variable Cost) (Interest)

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Contribution PBT Notes

(Fixed Cost) (Tax)
EBIT PAT
The left side of the table demonstrates how the level of EBIT is influenced
by the level of sales revenue, and the right side demonstrates how the
level of profit after taxes, or EPS, is influenced by the level of EBIT.

7.5 Operating Leverage

Operating Leverage focuses on a fixed component of the cost. The
operating leverage quantifies how closely sales revenue and profitability
are related. It gauges the impact of shifting sales revenue levels on EBIT
levels. To determine operating leverage, the percentage change in EBIT
is divided by the percentage change in sales revenue.
Operating Leverage = % Change in EBIT / % Change in Sales Revenue
Example 7.2: The following are the details of the sale done by Mr. Arun
Traders—
Particulars Scenario 1 Scenario 2
Sales (Units) 5,000 6,000
Selling Price (SP) 10 10
Sales Revenue (Sales × SP) 50,000 60,000
Variable Cost (VC) 7 7
Total Profit (EBIT) (Sales × (SP-VC)) 15,000 18,000
Thus, from the above details operating leverage can be calculated as—
Operating Leverage = % Change in EBIT / % Change in Sales Revenue
= Increase in EBIT/EBIT/Increase in Sales Revenue/Sales Revenue
= 3,000/15,000/10,000/50,000 = 1
When the Operational Leverage is 1, it means that the EBIT level is in
direct relation to the total amount of sales. This is because the entire
cost is variable (no fixed costs) in the structure. Whenever the percentage
change in EBIT is more than the percentage change in sales then OL
will be greater than 1 and vice versa. The existence of a fixed element
in the firm’s cost structure leads to the emergence of the OL. Thus, the

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Notes firm’s position or capacity to increase the impact of a change in sales

above the level of EBIT is described as the OL.
Degree of Operating Leverage (DOL)
The degree of operating leverage is the relationship between a percentage
change in the profits resulting from a percentage change in sales.
Degree of Operating Leverage = Contribution/EBIT
The DOL would be higher if fixed costs were higher relative to variable
costs. At any given sales volume, the DOL may also be measured as a
percentage of the contribution to the EBIT.
The following aspects can be inferred from the above discussion:
‹ The OL is the percentage change in EBIT caused by a 1% change in
sales. Fixed cost in the cost structure is the primary reason for OL
to occur. Without fixed cost, there will not be OL. The percentage
change in EBIT will be equal to the percentage change in sales.
‹ A positive DOL indicates that the company is functioning over the
break-even point and that both the EBIT and sales will fluctuate in
the same manner.
‹ A negative DOL indicates that the company is operating below the
break-even point, which will result in a negative EBIT.
Significance and Application of Operating Leverage
A firm’s risk often increases with the amount of operating leverage.
When operating leverage is significant, a little increase in sales will
lead to a larger increase in EBIT and vice versa. Thus, the presence of
substantial operating leverage indicates a high-risk circumstance. The
company can safeguard itself from the risks of operating leverage and
the ensuing operating risk by operating sufficiently above the break-even
point. Operating leverage approaches its maximum near break-even point.
In making capital budgeting decisions also operating leverage is very
crucial. Capital budgeting was the initial application for which this idea
was developed. By considering the quantity of fixed-cost investment and
its potential implications, long-term profit planning is also achieved.

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7.6 Financial Leverage Notes

The Financial Leverage (FL) gauges how closely EBIT and EPS are
related and represents how changes in EBIT affect EPS levels. The FL
is calculated as the percentage change in EPS divided by the percentage
change in EBIT. It evaluates how sensitive EPS is to a change in EBIT.
Financial Leverage = % change in EPS/% change in EBIT
= Increase in EPS/EPS/Increase in EBIT/EBIT
Example 7.3: The following are the details of the profit earned by Mr.
Arun Traders—
Particulars Scenario 1 Scenario 2
EBIT 5000 6000
Interest & Tax 0 0
Equity Share Capital 100000 100000
No. of Shares 1000 1000
EPS – (PAT/No. of shares) 5000/1000 = 5 6000/1000 = 6
Thus, from the above details financial leverage can be calculated as—
Financial Leverage = % Change in EPS/% Change in EBIT
= Increase in EPS/EPS/Increase in EBIT/EBIT
= 1/5/1000/5000 = 1
As a result, the FL may be described as an increase in EPS of a certain
percentage that corresponds to an equal increase in EBIT. The company’s
increase in EPS may be greater than proportionate to the level increase
in EBIT. In other words, an increase or decrease in EBIT has a greater
impact on EPS levels. This magnifying effect is made possible by fixed
finance charges.
Degree of Financial Leverage (DFL)
The degree of financial leverage is the relationship between a percentage
change in the EPS resulting from a percentage change in the profit.
Degree of Financial Leverage = EBIT/PBT (EBIT - Financial Charge)
The DFL is majorly affected by the fixed financial charge. At any given
profit volume, the DFL may also be measured as a percentage of EBIT
to the PBT.

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Notes The following aspects can be inferred from the above discussion:
‹ Financial leverage can be stated as a relationship between a change
in EBIT results in a change in EPS. Fixed financial costs (in the
form of interest and dividends on preferred stock) cause the FL to
emerge. There will not be an FL if there is no definite financial
liability i.e., the percentage change in EPS and EBIT will be the
same percentage and FL will be 1.
‹ A positive FL indicates that the company is running at an EBIT
level over the financial break-even threshold and that both EPS and
EBIT will fluctuate in the same direction as EBIT.
‹ A negative FL indicates that the company is running below the point
at which it will break even financially and result in a negative EPS.
Significance and Application of Financial Leverage
Planning for the capital structure and planning for profits both benefit from
financial leverage. The use of financial leverage assists the company’s
financial managers in determining the capital structure. Financial risk
and fixed cost are both elevated by significant financial leverage. A rise
in fixed expenses could drive the business into liquidation. A small rise
in EBIT will result in a larger increase in EPS when financial leverage
is high. Yet, even a minor decrease in EBIT will result in a big loss in
EPS, or it could disappear. Thus, the presence of significant financial
leverage denotes a high-risk situation. The corporation can protect itself
from the risks of financial leverage and the resulting financial risk by
operating sufficiently above the financial break-even point.

7.7 Combined Leverage

The Combined Leverage (CL) is a result of the OL and the FL, not a
separate sort of leverage analysis. The CL may be defined as the percentage
change in EPS for a specific percentage change in the amount of sales
revenue.
Combined Leverage = OL × FL= %
Change in EPS / % Change in Sales
Both operating and financial leverage magnifies the returns and collectively
affects income. The ability of the company to cover its fixed costs (both

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operating and financial) is a key factor in both leverages. If both leverages Notes
are used, the outcome will reveal the impact of shifting sales relative to
shifting taxable earnings.
The following aspects can be inferred from the above discussion:
‹ The change in EPS as a result of a change in sales level is known
as the combined leverage.
‹ A positive CL indicates that both the EPS and sales will fluctuate
in the same direction and that the leverage is being calculated for
a sales level higher than the break-even level.
‹ A negative CL indicates that EPS will be negative and that the
leverage is being computed at sales levels that are below the financial
break-even level.
SOLVED
Illustration 1: From the following data available for two companies,
compute DOL, DFL and DCL and comment on the relative risks of the
firm.
Particulars Priya Ltd. Supriya Ltd.
Sales 5,00,000 4,00,000
Variable Cost 30% of sales 30% of sales
Fixed Cost 30,000 40,000
Interest 1,50,000 1,00,000

Particulars Priya Ltd. Supriya Ltd.

Sales 5,00,000 4,00,000
(Variable Cost) (1,50,000) (1,20,000)
Contribution 3,50,000 2,80,000
(Fixed Cost) (30,000) (40,000)
EBIT 3,20,000 2,40,000
(Interest) (1,50,000) (1,00,000)
EBT 1,70,000 1,40,000
DOL = Contribution/ EBIT 1.09 1.17
DFL = EBIT/ EBT 1.88 1.71
DCL= DOL × DFL 2.06 2

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Notes The operating leverage is higher in Supriya Ltd. as compare to Priya

Ltd. therefore operating risk of Supriya Ltd. is higher than Priya Ltd.
The financial leverage is higher in Priya Ltd. as compare to Supriya Ltd.,
therefore financial risk of Priya Ltd. is higher than Supriya Ltd.
The total risk measured by the degree of combined leverage is higher
in Priya Ltd. as compare to Supriya Ltd., therefore total of Priya Ltd. is
higher than Supriya Ltd.
Illustration 2: The following data is available for Rimjhim Ltd.
Calculate ROI, Operating, Financial and Combined Leverage. Also ascertain
the level at which EBIT is zero.
Solution:
1. ROI –
EBIT = Sales – VC – FC = 10,00,000-4,00,000-1,80,000
= 4,20,000
ROI = EBIT/Total Capital =4,20,000/10,50,000 = 0.4 (40%)
2. DOL = Contribution/EBIT
= 6,00,000/4,20,000=1.43
3. DFL = EBIT/EBT
= 4,20,000/3,70,000=1.14
4. DCL = OL × FL = 1.43 × 1.14= 1.62
5. Sales Level when EBIT will be 0
P/V ratio = Contribution/Total Sales × 100
= 6,00,000/10,00,000 × 100=60%
Fixed Cost = 1,80,000+50,000=2,30,000
BEP = FC / P/V Ratio = 2,30,000/60%
= 3,83,333
Illustration 3: Using the data below, prepare the income statement and
find EPS of Anish Ltd.-
Variable Cost as a %age of sales- 50%
Interest expense- Rs. 4,00,000

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DOL- 5 Notes
DFL- 3
Income Tax rate- 50%
No. of Equity Shares- 5000
Solution:
Income Statement
Particulars Amount
Sales 30,00,000
(VC) (15,00,000)
Contribution 15,00,000
(FC) (9,00,000)
EBIT 6,00,000
(Interest) (4,00,000)
EBT 2,00,000
(Tax) (1,00,000)
EAT 1,00,000
Equity Shares 5000
EPS 20
Working Notes-
1. DFL = EBIT/(EBIT-Interest)
3 = EBIT/(EBIT - 4,00,000)
3 EBIT - 12,00,000 = EBIT
EBIT = 12,00,000/2 = Rs. 6,00,000
2. DOL= (Sales-VC)/EBIT 5 = (S – 0.2 S)/6,00,000
(S- 0.5 S) = 30,00,000
3. VC = 0.5 × Sales = 0.5 × 30,00,000 = 15,00,000
4. FC = Sales - VC - EBIT
= 30,00,000 – 15,00,000 – 6,00,000 = 9,00,000
Illustration 4: Calculate different types of leverages from the information
given below:
Sales = 10,000
VC – 50% of Sales EBIT = 3,000

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Notes EBT = 1,500

Tax Rate – 50%
Calculate %age change in EPS if sales increased by 10%.
Solution:
Particulars Amount
Sales 10,000
(VC) 5,000
Contribution 5,000
(FC) 2,000
EBIT 3,000
(Interest) 1,500
EBT 1,500
(Tax) 750
EAT 750
1. DOL = Contribution/EBIT= 1.67
2. DFL = EBIT/EBT = 2
3. DCL = DOL × DFL = 3.33
4. DCL = % age change in EPS/%age change in Sales
3.33 = % age change in EPS/10%
%age change in EPS = 3.33 × 10%
= 33.3%

7.8 EBIT-EPS Analysis

EBIT-EPS research examines how various financing structures or financial
leverage affect the amount of profit available to shareholders. EBIT-EPS
Analysis is used to research the impact of leverage. It entails contrasting
alternate finance ideas under various alternative financing strategies. To
finance its investment activities, a company might choose from different
capital structures. The companies can choose to be an all-equity firm, an
equity- preference firm, or any of the various other combinations of stock,
preference shares, and borrowed cash. Yet, for all of these scenarios, the
amount of sales revenue and the level of EBIT are meaningless because
the financing scheme does not affect on either. In actuality, the EBIT

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level and sales are impacted by investment decisions. Given a level of Notes
EBIT, a certain mix of financing will result in a specific EPS, therefore
there will be different EPS for various financing patterns.
A business may choose from the following options to raise capital:
‹ All Equity
‹ All Debt
‹ A combination of Debt, and Equity
‹ A Combination of Debt, Equity and Preference share
Example 7.4: To start a project, a corporation is considering raising an
additional Rs. 10,00,000 in funding. The project is expected to generate
an EBIT of Rs. 3,00,000. There are the following alternate strategies
available:
1. To raise Rs. 10,00,000 via equity shares worth Rs. 100 each.
2. To raise Rs. 3,00,000 through equity and the remaining 7000, 10%
Preference shares priced at Rs. 100.
3. To raise Rs. 5,00,000 via equity shares and Rs. 5,00,000 via 10%
Debentures.
4. To raise Rs 3,00,000 through equity shares, Rs. 3,00,000 through
10% Debentures, and Rs. 4,00,000 through 10% preference shares.
What alternative is better given that the corporation is in the 50% tax
bracket?
Option 1 Option 2 Option 3 Option 4
Equity Share Capital 10,00,000 3,00,000 5,00,000 3,00,000
10% Pref. Share Capital - 7,00,000 - 4,00,000
10% Debentures - - 5,00,000 3,00,000
Total Funds 10,00,000 10,00,000 10,00,000 10,00,000
EBIT 3,00,000 3,00,000 3,00,000 3,00,000
(Interest) - - (50000) (30000)
PBT 3,00,000 3,00,000 2,50,000 2,70,000
(Tax)- 50% (1,50,000) (1,50,000) (1,25,000) (1,35,000)
PAT 1,50,000 1,50,000 1,25,000 1,35,000
(Preference Dividend) - (70,000) - (40,000)
Profit for Equity Shareholders 1,50,000 80,000 1,25,000 95,000
Equity Shares 10,000 3000 5000 3000
EPS 15 22.67 25 31.67

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Notes In this instance, the financial plan associated with option 4 appears
to be the greatest because it produces the highest EPS of 31.67. The
company has used all available financial leverage in this proposal. On
a total investment of Rs. 10,00,000, the company anticipates making an
EBIT of Rs. 3,00,000, which will result in a 30% profit. This return is
15% after taxes, or 30% multiplied by (1-.5). However, the cost of 10%
debentures after taxes is 5%, or 10% (1-.5), while the cost of preference
shares after taxes is just 10%. The company has used 30% debt, 40%
preference shares, and 30% equity share capital in option 4, and the
benefits of using 30% debt (which has an after-tax cost of only 5%) and
40% is invested in preference shares, which only cost 10%. As a result,
the company projects an EPS of Rs. 31.67.
If the company decides to use just equity funding, the EPS will be
Rs. 15, which is exactly equal to the return on investment after taxes.
Nevertheless, in option 2, where 70% of the funds are raised by issuing
12% preference shares, the additional 7.6% is made available to equity
shareholders, increasing EPS from Rs. 15 to Rs. 22.67. The extra advantage
flowing to equity shareholders increases further in Option 3 (where 10%
debt is also introduced), and the EPS further rises to Rs. 25. Since the
after-tax cost of preference shares and debentures is lower than the after-
tax return on total investment, the company anticipates an improvement
in EPS as more and more debt and preference share funding is accessed.
As a result, the financial leverage only benefits EPS if the ROI exceeds
the cost of debt. If the ROI is lower than the cost of debt, it will more
likely have a negative impact. Because of this Financial leverage is also
known as a “twin-edged sword”. The below mentioned example will explain
how EBIT will vary in different economic condition and will explain how
high debt financing can be suicidal for the firm. Thus, finance manager
needs to strike off a balance and reach to optimal capital structure.
Varying EBIT with different patterns
Suppose there are three firms Anita Ltd., Binita Ltd. and Vinita Ltd. Except
for leverage, these companies are identical in every way. The following
is a presentation of the financial positions of the three companies:

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Capital Structure Anita Binita Vinita Notes

Ltd. Ltd. Ltd.
Equity Share Capital (Rs. 100 each) 10,00,000 5,00,000 2,50,000
8% Debentures - 5,00,000 7,50,000
Total Capital 10,00,000 10,00,000 10,00,000
Depending on the state of the economy, these companies are anticipated to
generate a ROI at various levels. The ROI is anticipated to be 10% under
typical circumstances, but it may vary by 3% on either side depending
on whether the economy is doing well or poorly.
The following presentations are pertinent and have been shown:
Poor Normal Good
Total Assets 10,00,000 10,00,000 10,00,000
ROI 7% 10% 13%
EBIT 70,000 1,00,000 1,30,000

Anita Ltd. (0% Leverage)

Particulars Poor Normal Good
EBIT 70,000 1,00,000 1,30,000
(Interest) - - -
PBT 70,000 1,00,000 1,30,000
(Tax @ 50%) (35,000) (50,000) (65,000)
PAT 35,000 50,000 65,000
Equity Shares 10,000 10,000 10,000
EPS 3.5 5 6.5

Binita Ltd. (50% Leverage)

Particulars Poor Normal Good
EBIT 70,000 1,00,000 1,30,000
(Interest) (40,000) (40,000) (40,000)
PBT 30,000 60,000 90,000
(Tax @ 50%) (15,000) (30,000) (45,000)
PAT 15,000 30,000 45,000
Equity Shares 5,000 5,000 5,000
EPS 3 6 9

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Notes Vinita Ltd. (75% Leverage)

Particulars Poor Normal Good
EBIT 70,000 1,00,000 1,30,000
(Interest) (60,000) (60,000) (60,000)
PBT 10,000 40,000 70,000
(Tax @ 50%) (5,000) (20,000) (35,000)
PAT 5,000 20,000 35,000
Equity Shares 2,500 2,500 2,500
EPS 2 8 14
The impact of financial leverage on shareholder returns under different
EBIT levels can be examined based on the numbers mentioned above. For
this reason, the EPS of various companies in normal economic conditions,
which is 10%, may both be taken at 100, and position of other EBIT and
EPS numbers may be shown on a relative basis as follows:
Poor Normal Good
EBIT 70 100 130
Anita Ltd. (0% Leverage)
EPS 70 100 130
%age from Normal -30% - +30%

Binita Ltd. (50% Leverage)

EPS 50 100 150
%age from Normal -50% - +50%
Vinita Ltd. (75% Leverage)
EPS 25 100 175
%age from Normal -75% - +75%
The above data clearly shows that the EBIT level increases by 30%
(or from 10% to 13%) when economic conditions shift from normal to
good. Due to the lack of leverage at the company Anita Ltd., its EBIT
cannot be amplified, resulting in a 30% increase in EPS for the year.
Nonetheless, the company Binita Ltd. (with 50% leverage) was able to
improve Earnings (from Rs. 6 to Rs. 9). Similarly, Vinita Ltd. was able
to boost EPS by 75% while using leverage of 75%. (From Rs. 8 to
Rs. 14). So, the leverage has a magnifying effect on the EPS when the
economy improves.

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On the other side, the situation is simply reversed if the economy worsens Notes
and the EBIT level drops by 30% (from 10% ROI to 7% ROI). In this
instance, Anita Ltd. EPS only decreases by 30% (from Rs. 5 to Rs. 3.5),
whereas Binita Ltd. EPS (with 50% leverage) decreases by 50%. (From
Rs. 6 to Rs. 3). The decline is more extreme as EPS drops by 75% in the
case of Z & Co. (from Rs. 8 to Rs. 2). So, the magnifying effect on the
EPS when economic conditions decline is greater when leverage is high.
Thus, because of this financial leverage is called a ‘double-edged sword’.
Financial Break-even Level
A company’s EBIT level is said to be at a financial break-even point if
it is enough to pay the fixed financial costs. The following formula can
be used to determine EBIT’s financial break- even point:
The financial break-even EBIT level if the company invests only in debt
(and not preferred shares) is:
Financial Break-even Level EBIT= Interest Charge
The firm’s financial breakeven EBIT will be decided by both the interest
charge and the fixed preference dividend if the firm has invested in both
debt and preference share capital. It should be emphasized that while
the financial break-even point is before taxes, the preference dividend is
only due from profit after taxes. In such a case, the financial break-even
point is as follows-
Financial Break-even Level EBIT= Interest Charge +
Preference Dividend/ (1-t) Indifference Point/Level
An EBIT level is said to be indifferent when the EPS stays constant
regardless of the debt-to- equity ratio. A company may assess the impact
of various financial strategies on the level of EPS for a specific level
of EBIT while constructing a capital structure. The company may have
two or more financial strategies that provide the same EPS for a specific
EBIT is regarded as an indifference level of EBIT. The indifference point
analysis makes use of the financial break-even point and the return from
different capital arrangements.
The after-tax cost of debt is just equal to the ROI at the EBIT indifference
level. The company would not care whether the money is raised by the
issue of debt securities or by the issue of stock.

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Notes Suppose if we continue with Example 7.4 and assume that we have an
existing share capital of Rs. 5,00,000 and we must raise an additional Rs.
10,00,000. In option 1, we have issued all equity shares while in Option
2, debt is issued.
Option 1 Option 2
Equity Share Capital (Existing) 5,00,000 5,00,000
Equity Share Capital (New) 10,00,000 -
10% Debentures - 10,00,000
Total Funds 15,00,000 15,00,000
EBIT 1,50,000 1,50,000
(Interest) (1,00,000)
PBT 1,50,000 50,000
(Tax)- 50% (75,000) (25000)
Profit for Equity Shareholders 75,000 25,000
Equity Shares 15000 5000
EPS 5 5
So, regardless of whether the additional funds are raised by the issuing of
equity share capital or by the issue of 10% debt, the EPS is anticipated
to be Rs. 5 at the EBIT level of Rs. 1,50,000. This EBIT level of
Rs. 1,50,000 is known as the indifference level of EBIT.
The following table shows the EPS for both financial plans if the company
expects EBIT of Rs. 50,000 or Rs. 2,00,000
Option 1 Option 2
Equity Share Capital (Existing) 5,00,000 5,00,000 5,00,000 5,00,000
Equity Share Capital (New) 10,00,000 10,00,000 - -
10% Debentures - - 10,00,000 10,00,000
Total Funds 15,00,000 15,00,000 15,00,000 15,00,000
EBIT 50,000 2,00,000 50,000 2,00,000
(Interest) - - (1,00,000) (1,00,000)
PBT 50,000 2,00,000 (50,000) 1,00,000
(Tax)- 50% 25,000 1,00,000 (25,000) (50,000)
Profit for Equity Shareholders 25,000 1,00,000 (25,000) 50,000
Equity Shares 15,000 15,000 5,000 5000
EPS 1.67 6.67 -5 10

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Graphically the data can be plotted as follows- Notes

According to the data and graph, the EPS for a leveraged option (i.e., debt
financing) is lower at Rs. (5) than the EPS for an unleveraged option,
which is Rs. 1.67, for an EBIT level below the indifference level of
Rs. 1,50,000. But, in the case of a levered option, the EPS is greater at
Rs. 10 compared to Rs. 6.67 in the case of an unlevered option if the
EBIT is higher than the indifference level.
From the perspective of the equity shareholders, if the company expects
to generate precisely the same amount of EBIT at the point where the
EBIT-EPS lines cross, it would not care which capital structure it chose
because the EPS would be the same under either scenario.
Indifference level of EBIT may be ascertained graphically or algebraically.
The formula for different scenarios is as follows:
1. The indifference level for an All-equity plan and Debt-Equity plan
will be arrived as follows:
EBIT (1-t)/ N1 = (EBIT- Interest (1-t))/ N2
2. The indifference level for an Debt-Equity plan and Debt-Equity
plan will be arrived as follows:
(EBIT- Interest (1-t))/ N1 = (EBIT- Interest (1-t))/ N2
3. The indifference level for an All-equity plan and Equity-Preference
plan will be arrived as follows:
EBIT (1-t)/ N1 = EBIT- Interest (1-t)-PD/ N2

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Notes 4. The indifference level for an All-equity plan and Equity-Preference-

Debt plan will be arrived as follows-
EBIT (1-t)/ N1 = (EBIT- Interest) (1-t) -PD/ N2
The value of EBIT in the above equations is indifference level of EBIT
and the EPS under the two financial plans will be same.
Shortcomings of EBIT/EPS Analysis
EBIT-EPS aids in making a better financial strategy. However, it might
come with two issues, specifically:
1. There won’t be an EBIT indifference point if neither of the two
alternative financial plans—which are mutually exclusive—invokes
the issuance of fresh equity shares.
If in example 7.4, no equity share will be issued, i.e., either 10%
debt or 10% preference shares are issued then-
(EBIT-1,00,000) (1-0.5) / 5000 = EBIT (1-05) – 1,00,000 / 5000
0.5 EBIT-50,000 = 0.5 EBIT – 1,00,000
0 = -50,000
2. Sometimes, a particular collection of alternative financial strategies
may produce negative EPS, resulting in a negative indifference level
of EBIT.
Solved Illustrations
Illustration 5: Amit Ltd. existing capital structure consists of equity
capital – 1,000 share of Rs. 100 each. Now the company wants to expand
and had to raise 5,00,000 to fulfil its business requirement. The company
has following alternatives:
I. Issue 10% Debentures
II. 10% Preference share of Rs. 50 each
III. Issue equity share capital of Rs. 100 each Level of EBIT is 2,00,000
and Tax is charged @ 50%
Solution:
Particulars I II III
Equity Share Capital (Existing) 10,00,000 10,00,000 10,00,000
Equity Share Capital (New) - - 5,00,000

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Particulars I II III Notes

12% Pref. Share Capital - 5,00,000 -
10% Debentures 5,00,000 - -
Total Funds 15,00,000 15,00,000 15,00,000
EBIT 2,00,000 2,00,000 2,00,000
(Interest) (50,000) - -
PBT 1,50,000 2,00,000 2,00,000
(Tax)- 50% 75,000 1,00,000 1,00,000
PAT (75,000) 1,00,000 (1,00,000)
(Preference Dividend) - (60,000) -
Profit for Equity Shareholders 75,000 40,000 1,00,000
Equity Shares 1,000 1,000 1,500
EPS 75 40 66.67
Since EPS is highest in Option I, thus it is the optimal choice of alternative.
Illustration 6: Omax Ltd. has currently capital of Rs. 10,00,000 in the
form of 1,000 shares of Rs. 100 each. It has following plans to raise
Rs. 5,00,000:
(a) Issue of equity shares 2,000 of Rs. 100 each and Debentures @10%
of remaining Rs. 3,00,000.
(b) Issues of Preference shares for Rs. 5,00,000 carrying dividend of
12%
(c) Issue of equity shares 1,000 of Rs. 100 each, preference shares for
Rs. 1,00,000 carrying dividend of 12% and Debentures @ 10% of
remaining Rs. 3,00,000.
Calculate indifference point between, assume tax @ 50%
(a) Plan (a) and (b)
(b) Plan (b) and (c)
(c) Plan (a) and (c)
Solution:
(a) (EBIT – 30,000) (1-0.5) / 3000 = [(EBIT-0) (1-0.5) – 60,000)] /
1000
0.5 EBIT – 15,000 = 1.5 EBIT – 1,80,000
EBIT = 1,65,000

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Notes (b) [(EBIT-0) (1-0.5) – 60,000)] / 1000 = [(EBIT – 30,000) (1-0.5) –

12,000)] / 2000
EBIT – 1,20,000 = 0.5 EBIT -15,000 – 12,000
EBIT = 1,86,000
(c) (EBIT – 30,000) (1-0.5) / 3000 = [(EBIT – 30,000) (1-0.5) – 12,000)]/
2000
2(0.5 EBIT – 15,000) = 3(0.5 EBIT – 15,000 – 12,000)
EBIT = 1,02,000
The relationship between two associated variables is determined in leverage
analysis. Operational leverage, financial leverage, and combined leverage
are all calculated in financial management. The relationship between
sales and EBIT is established by the operating relationship. It gauges the
impact of shifting sales revenue levels on EBIT levels. Fixed costs lead
to the appearance of operating leverage. The financial leverage gauges
how quickly the EPS adjusts to changes in EBIT. The fixed financial
charges, such as interest and dividends on preferred stock, are what
cause the financial leverage to occur. The percentage change in EPS
for a percentage change in sales can also be calculated using combined
leverage. Leverage is beneficial in many aspects some of them are- how
operating leverage aids in planning fixed asset investments, financial
leverage aids in planning capital structures, combined leverage aids in
profit planning, etc.
The effects of various capital structure types can also be examined using
EBIT-EPS analysis. The impact of various capital mix types on EPS is
considered by the EBIT-EPS Analysis. Given a certain level of EBIT, a
specific combination of different sources will produce that level of EPS, so
different financing strategies would result in different levels of EPS. The
EBIT level at which a company’s EPS is zero is known as the financial
break-even level of EBIT. A level of EBIT that is indifferent is one where
both financial strategies result in the same EPS. The company would not
care if money is raised through one capital mix or another because both
will result in the same level of EPS at a different level of EBIT.
So, we can conclude that high financial leverage should not be used by a
company because if the company has high operating leverage. Similarly,
a company with low operating leverage would benefit from having high

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financial leverage. The likelihood of taking on additional risk will rise Notes
if both leverages are increased.

7.9 Practical Problems

1. From the following data available for two companies, compute DOL,
DFL and DCL and comment on the relative risks of the firm.
Particulars P Ltd. S Ltd.
Sales 5,00,000 3,50,000
Variable Cost 40% of sales 40% of sales
Fixed Cost 30,000 25,000
Interest 1,00,000 90,000
Answers:
Particulars P Ltd. S Ltd.
DOL 1.11 1.14
DFL 1.59 1.95
DCL 1.76 2.21
2. Sumit Ltd. existing capital structure consists of equity capital- 1,500
share of Rs. 100 each. Now the company wants to expand and had
to raise 7,00,000 to fulfil its business requirement. The company
has following alternatives-
I. Issue 10% Debentures
II. 12% Preference share of Rs. 50 each
III. Issue equity share capital of Rs. 100 each Level of EBIT is
2,00,000 and Tax is charged @ 50%
Advise which method is best mode of financing for Amit Ltd.
Answer: Option III is the best
3. Calculate different types of leverages from the information given
below:
(a) Sales = 12,000
(b) VC – 50% of Sales
(c) EBIT = 3,000

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Notes (d) EBT = 2,000

(e) Tax Rate – 50%
Calculate %age change in EPS if sales increased by 5%.
Answer:
DOL 2
DFL 1.5
DCL 3
%change in EPS 15
Illustration 1: From the following data available for two companies,
compute DOL, DFL and DCL and comment on the relative risks of the
firm.
Particulars Priya Ltd. Supriya Ltd.
Sales 5,00,000 4,00,000
Variable Cost 30% of sales 30% of sales
Fixed Cost 30,000 40,000
Interest 1,50,000 1,00,000
Solution:
Particulars Priya Ltd. Supriya Ltd.
Sales 5,00,000 4,00,000
(Variable Cost) (1,50,000) (1,20,000)
Contribution 3,50,000 2,80,000
(Fixed Cost) (30,000) (40,000)
EBIT 3,20,000 2,40,000
(Interest) (1,50,000) (1,00,000)
EBT 1,70,000 1,40,000
DOL = Contribution/ EBIT 1.09 1.17
DFL = EBIT/ EBT 1.88 1.71
DCL= DOL × DFL 2.06 2
The operating leverage is higher in Supriya Ltd. as compare to Priya
Ltd., therefore operating risk of Supriya Ltd. is higher than Priya Ltd.
The financial leverage is higher in Priya Ltd. as compare to Supriya Ltd.,
therefore financial risk of Priya Ltd. is higher than Supriya Ltd.

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The total risk measured by the degree of combined leverage is higher Notes
in Priya Ltd. as compare to Supriya Ltd., therefore total of Priya Ltd. is
higher than Supriya Ltd.
Illustration 2: The following data is available for Rimjhim Ltd.
Particulars Rs.
Sales 10,00,000
Variable Cost 4,00,000
Fixed Cost 1,80,000
Debt 5,00,000
Interest on Debt 10%
Equity Capital 5,50,000
Calculate ROI, Operating, Financial and Combined Leverage. Also ascertain
the level at which EBIT is zero.
Solution:
1. ROI-
EBIT = Sales- VC- FC = 10,00,000-4,00,000- 1,80,000
= 4,20,000
ROI = EBIT/ Total Capital = 4,20,000/10,50,000 = 0.4 (40%)
2. DOL = Contribution /EBIT
= 6,00,000/ 4,20,000 = 1.43
3. DFL = EBIT/EBT
= 4,20,000/3,70,000 = 1.14
4. DCL = OL × FL = 1.43 × 1.14= 1.62
5. Sales Level when EBIT will be 0
P/V ratio = Contribution/ Total sales × 100
= 6,00,000/10,00,000 × 100 = 60%
Fixed Cost = 1,80,000+ 50,000 = 2,30,000
BEP = FC / P/V Ratio = 2,30,000/ 60%
= 3,83,333

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Notes IN-TEXT QUESTIONS

1. Analysis of _____ risk is studied with the help of Operating
Leverage:
(a) Financial
(b) Business
(c) Credit
(d) Production
2. If fixed cost will be zero, then which among the following will
be true?
(a) OL= 0
(b) FL= 0
(c) OL= 1
(d) FL= 1
3. Which among the following is an indicator of high financial
risk?
(a) More debt as compared to equity
(b) Risky Investments
(c) Fixed Assets purchased with debts
(d) All the Above
4. Generally speaking, leverage is ______.
(a) Relationship between Fixed Cost and Profit
(b) Relationship between Fixed Cost and Sales
(c) Relationship between two interrelated variables
(d) Relationship between two unrelated variables
5. Operating leverage indicates the tendency of operating EBIT
to vary disproportionately with _______.
(a) Sales
(b) Fixed Cost
(c) EPS
(d) PAT

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6. Degree of _______ is the ratio of the percentage increase in Notes

earnings per share (EPS) to the percentage increase in earnings
before interest and taxes (EBIT).
(a) Operating Leverage
(b) ROI Leverage
(c) Combined Leverage
(d) Financial Leverage
7. A firm’s degree of total leverage (DTL) is equal to its degree
of operating leverage____________ by its degree of financial
leverage (DFL).
(a) Divided by
(b) Plus
(c) Multiplied by
(d) Minus
8. If the EBIT is less than the financial breakeven point, then the
EPS will be:
(a) Positive
(b) Negative
(c) Zero
(d) Maximum
9. An EBIT-EPS indifference analysis chart is used for:
(a) Ff Evaluating the effects of business risk on EPS
(b) Determining the impact of a change in sales on EBIT
(c) Examining EPS results for alternative financing plans at
varying EBIT levels
(d) Showing the changes in EPS quality over time
10. Indifference Level of EBIT is one at which EPS is:
(a) Zero
(b) Maximum
(c) Minimum
(d) None of these

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Notes 7.10 Answers to In-Text Questions

1. (b) Business
2. (a) OL= 0
3. (d) All the Above
4. (c) Relationship between two interrelated variables
5. (a) Sales
6. (d) Financial Leverage
7. (c) Multiplied by
8. (b) Negative
9. (c) Examining EPS results for alternative financing plans at varying
EBIT levels
10. (b) Maximum

7.11 Self-Assessment Questions

1. Describe the meaning of leverage. Explain different types of leverage.
2. What is Operating Leverage? State its application.
3. What do you mean by Financial Leverage? Analyse how financial
leverage affects EPS.
4. Differentiate between financial and operating leverage. How can the
two leverages be calculated?
5. Write a short note on Combined Leverage. Explain its significance.
6. How can EBIT-EPS analysis be used to select the optimal financing
mix?
7. Define EBIT-EPS Analysis. State how is it different from leverage
analysis.
8. Describe the relationship between EBIT and EPS in the capital
structure decision framework.
9. What are the flaws of the EBIT–EPS Analysis?
10. From the following data available for two companies, compute DOL,
DFL and DCL and comment on the relative risks of the firm.

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7.12 References Notes

‹ Singh, Dr. J.K. (2016). Basic Financial Management (IInd ed.).

Galgotia Publishing Company.
‹ Horne, James C. Van & Wachowicz, John M. (2009): Fundamentals
of Financial Management (13th ed.). Pearson Education.
‹ Rustagi, Dr. R.P. (2022). Financial Management (VIth ed.). Taxmann
Publications.
‹ Pandey, I.M. (2017). Financial Management (XIth ed.). Vikas Publishing
House.
‹ Online References—
„ https://egyankosh.ac.in/bitstream/123456789/16123/1/Unit-13.
pdf
„ https://www.shivajicollege.ac.in/sPanel/uploads/econtent/
883e0eb128825203628e49bcb accef31.pdf
„ https://web.sol.du.ac.in/info/bcom-hons-semester-v
„ https://www.learncram.com/cs-executive/leverages-financial-
management-mcq/
„ https://cmatutors.com/leverage-mcq/
„ https://www.learncram.com/cs-executive/capital-structure-financial-
management-mcq/
„ https://www.mbamcq.com/financial-management/34.php
„ https://www.investopedia.com

7.13 Suggested Readings

‹ Brealey, R.A., Myers, S.C., Allen, F.,& Mohanty, P. (2014). Principles
of Corporate Finance (11th ed.). Tata McGraw Hill.
‹ Brigham, E.F., & Daves, P.R. (2016). Intermediate Financial Management
(12th ed.). South Western.
‹ Brigham, E.& Houston, J. (2014). Fundamentals of Financial
Management (14th ed.). Thomson.

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 MBAFT 6204 CORPORATE FINANCE

Notes ‹ Keown, A.J., Martin, J.D., Petty, J.W., & Scott, Jr. (2017). Foundations
of Finance (9th ed.). Pearson Prentice Hall.
‹ Megginson, W.L., Smart, S.B., & Gitman, L.J. (2009). Corporate
Finance (2nd ed.) Thomson.
‹ Chandra, P. (2015). Financial Management (9th ed.). McGraw Hill.
‹ Ross, S.A., Westerfield, R.W., Jaffe, J., & Jordan, B.D. (2016):
Fundamentals of Corporate Finance (11th ed.). Tata McGraw Hill.
Master of Business Administration 20.
‹ Wachowicz, V. (2009): Fundamentals of Financial Management
(13th ed.). Pearson Education.
‹ Watson, D., & Head, A. (2016). Corporate Finance- Principles and
Practice (7th ed.). Pearson Education.
‹ Brigham, E.F., & Ehrhardt, M.C. (2015). Financial Management:
Theory & Practice (15th ed.). Engage Learning.

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L E S S O N

8
Dividend Policy Decisions
Dr. Tarunika Jain Agrawal
Assistant Professor
Sri Aurobindo College (M)
University of Delhi
Email-Id: Tarunika.jain@gmail.com

STRUCTURE
8.1 Learning Objectives
8.2 Introduction
8.3 Factors Determining Dividend Policy
8.4 Measures of Dividend Policies
8.5 Theories of Dividend
8.6 Forms of Dividend Policies
8.7 Dividend Policies in Practice
8.8 Summary
8.9 Answers to In-Text Questions
8.10 Self-Assessment Questions
8.11 References
8.12 Suggested Readings

8.1 Learning Objectives

‹ To acquaint the learner with the meaning, types, and significance of dividends.
‹ To highlight the various factors which influence the determination of dividend policy.
‹ To compare dividend policy theories and explain the implications of each for company
value.
‹ To understand the dividend policies followed in practice.

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Notes 8.2 Introduction

A business organization always aims to earn profits for its shareholders.
The income generated after meeting all obligations by the firm belongs to
the shareholders. The part of earnings that is distributed amongst equity
shareholders is called dividend. The optimum dividend policy would
maximize the value of the firm. The question of what ratio income earned
to retain or distribute is a dividend decision or policy.
The main issue involving a firm’s dividend decision is whether to retain
and invest the profits for future growth needs or distribute them among
the shareholders. Along with the amount, the timing of dividends plays
a vital role in influencing a company’s market value. Thus, Dividend
policy also pertains to the stability or continuity of dividends. Moreover,
the firm must choose between the different types of dividends – cash or
stock. Hence, the formulation of a dividend policy is a complex decision.
It needs careful consideration of various factors. The financial manager
needs to be aware of the capital market trends and the government’s tax
policies, besides the rationale behind the company’s investment program.
Next, let’s try understanding the management’s motivations for paying
dividends.
A clientele-based explanation: Investors can be grouped according to
their preference for dividends and capital gains. These groups are referred
to as clientele. Notably, investors in the low tax brackets may invest
in dividend-paying stocks and vice versa. In contrast, low-tax-bracket
investors (corporations and pension funds) may choose high dividend
payouts. The possible explanation could be that investors like dividends
as it addresses the concerns of a substantial number of investors regarding
the uncertain future firm performance. Generally, investor confidence is
higher for a firm paying continuous dividends.
The informational content of dividends or signaling effect: In the
real world, information asymmetry exists, which is the difference in the
information available to insiders and outsiders. The firm’s management
has access to more information about the firm’s current and future
performance than the shareholders. In such a situation, dividends can
signal to the market that you believe you have good future cash flow

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prospects. Suppose management decides to reduce dividends per share. In Notes

that case, it sends a negative signal about the firm’s future performance,
resulting in a fall in the share’s market price. Thus, in practice, companies
refrain from increasing dividends unless they wish to continue in the
future. Likewise, firms do not cut dividends unless they are in financial
distress, which suggests deterioration in the company’s long-term growth
prospects. However, dividend initiation could send mixed signals to the
stakeholders. On the one hand, it offers belief in an optimistic future
(a positive sign); on the other, it could mean that the company lacks
profitable reinvestment opportunities—a negative symbol.
Agency Issues Between shareholders and managers: Agency costs reflect
the inefficiencies due to the divergence of interests between managers
and stockholders. One aspect of the agency issue is that managers may
be incentivized to overinvest (empire building), leading to investment in
some negative NPV projects, reducing stockholder wealth. One way to
reduce agency costs is to pay more dividends. Generally, a growing firm
has a higher proportion of retained earnings than dividends, in contrast
to mature firms.
Generally, a stable dividend policy (in the form of a constant dividend
per share or a constant dividend payout ratio) benefits the firm.
Constant dividend per share means a fixed dividend is paid each year to
the shareholders, irrespective of the fluctuations in the earnings. However,
the policy may be reviewed after a few years, and the dividend would
then be changed and kept steady for the future.
The constant dividend payout ratio is when a company consistently pays
out a set portion of its earnings as dividends to its shareholders. For
example, if a company has a payout ratio of 50%, it pays out half of its
earnings as dividends. A constant dividend payout ratio policy provides
stability and predictability for shareholders, who can count on a consistent
income level from their investments. It can also signal to investors that
the company has a solid and stable financial position and is committed
to returning value to its shareholders.

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Notes 8.3 Factors Determining Dividend Policy

Several factors can affect a company’s dividend policy, including:
‹ Financial performance: A company’s financial performance, including
its earnings, cash flow, and debt levels, can significantly determine
its dividend policy. Companies with strong financial performance are
more likely to pay dividends. In contrast, companies with weaker
financial performance may reduce or eliminate dividends.
‹ Growth prospects: Companies with high growth potential may
reinvest earnings into the business instead of paying dividends to
support future growth.
‹ Investment opportunities: Companies may also consider the availability
of attractive investment opportunities when making decisions about
their dividend policy. Companies with a high demand for capital
may choose to retain earnings to finance growth.
‹ Expected volatility of future earnings: Firms tie their target payout
ratio to long- run sustainable profits. They are reluctant to increase
dividends unless the reversal is not anticipated shortly. Hence, when
earnings are volatile, firms are more cautious in changing dividend
payout.
‹ Industry and competition: The level of competition and the
characteristics of the industry in which a company operates can
also impact its dividend policy. For example, companies in highly
competitive industries may choose to retain earnings to invest in
research and development or to acquire new technology.
‹ Tax considerations: Dividend tax rates can also play a role in a
company’s dividend policy. Generally, in countries where capital
gains are taxed at a favourable rate compared to dividends, high-
tax-bracket investors (like some individuals) prefer low dividend
payouts and vice versa.
‹ Flotation costs: When a company issues new shares of common stock,
a flotation cost of 3% to 7% is taken from the capital raised to pay
for investment bankers and other costs associated with issuing the
new stock. Since retained earnings have no such fee, the cost of
new equity capital is always higher than that of retained earnings.

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Larger companies typically have lower flotation costs as compared Notes

to smaller companies. Generally, the higher the floatation costs,
the lower the dividend payout, given the need for equity capital in
positive NPV projects.
‹ Contractual and legal restrictions: Companies may be restricted
from paying dividends by legal requirements or implicit limits
caused by the business’s cash needs. In some countries, dividends
paid cannot be more than retained earnings.
‹ Debt covenants are designed to protect bondholders and dictate things
a company must or must not do. Many covenants require a firm to
meet or exceed a particular target for liquidity ratios (e.g., current
ratio) and coverage ratios (e.g., interest coverage ratio) before they
can pay a dividend.
‹ Need for liquidity: Financial flexibility is significant during times
of crisis when liquidity dries up, and credit may be hard to obtain.
Thus, it is prudent to conserve funds to face future emergencies.
‹ Debt Market conditions: If the debt market is flushed with funds
and the firm has financial flexibility, it may like to distribute its
earnings as dividends and raise resources in the debt market to
finance the growth opportunity. On the other hand, if the firm
has a low credit rating or exhausted its debt capacity, it will be
compelled to use internally generated funds for growth and have a
low dividend payout ratio.
‹ Control considerations: If a firm pays dividends and raises fresh
equity to finance the growth opportunity, it incurs transaction costs
and dilutes control.
‹ The Nature of Business: Is a critical determinant of a company’s
dividend policy. Enterprises with stable revenues are positioned to
formulate consistent dividend policies, for instance, public utilites.

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Notes

I-Start up II-Rapid III-High IV-Mature V-Decline Stage

Expansion Growth Growth
None None Very Low Increasing High Capacity
to pay
dividends
High, but High, Moderate, Low, as Low, as External
constrained by relative to relative to projects projects funding
infrastructure firm value firm value dry up dry up needs
Negative or Negative Low, High, More Internal
low or low relative to relative to than funding
funding funding funding needs
needs needs needs
A firm’s dividend policy and financing choice follow its life cycle stage.
There are five stages in the growth life cycle: start-up, rapid expansion,
high growth, mature growth, and decline stage. The life cycle analysis
of dividend policy is a framework for evaluating a company’s dividend
policy changes over its life cycle. During each stage, the company faces
different financial and operational challenges, which can influence its
dividend policy.
In conclusion, a company’s dividend policy can be influenced by various
factors, including its financial performance, growth prospects, industry and
competition, investment opportunities, stock price, and tax considerations.
Companies should consider all of these factors when deciding their
dividend policy.

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The objective of the finance manager while formulating the dividend Notes
policy is to maximize shareholders’ wealth. There are several measures
used to evaluate a company’s dividend policy, including:
Dividend yield: This is the annual dividend amount divided by the stock
price, expressed as a percentage. A high dividend yield can signal that
the company is paying a significant portion of its earnings as dividends,
which attracts income-seeking investors.
Dividend yield = Dividends per share/Stock price
Dividend payout ratio: This is the ratio of dividends paid to earnings,
expressed as a percentage. In other words, dividend per share to earnings
per share. The earnings per share are computed by dividing profits after
tax by the number of equity shares outstanding. A high payout ratio
suggests that a firm is paying out a significant portion of its earnings as
dividends, which can reduce its ability to reinvest in growth opportunities.
Dividend payout ratio = Dividends per share/Earnings per share
Dividend coverage ratio: This is the ratio of earnings to dividends,
expressed as a multiple. A high coverage ratio indicates that the company’s
profits are more than sufficient to cover its dividends, which can signify
financial stability.
These measures can provide valuable insights into a company’s dividend
policy. Still, they should be evaluated in the context of the company’s
overall financial position and growth prospects.

8.4 Measures of Dividend Policies

The relationship between dividends and firm value is multifaceted. Some
argue that dividends can create firm value by signaling the company’s
financial strength, reducing the cost of capital, and attracting investors. A
company that pays consistent and predictable dividends can also increase
investor confidence and reduce uncertainty about the future. On the other
hand, some argue that paying dividends can reduce firm value by reducing
the amount of capital available for reinvestment and growth. Suppose a
company has a high payout ratio. In that case, it may be unable to invest

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Notes in new projects or opportunities, limiting its future growth prospects.

Ultimately, the impact of dividends on firm value depends on multiple
factors, including the company’s financial position, growth prospects,
and market conditions. Companies need to consider their circumstances
when deciding on a dividend policy.

8.5 Theories of Dividend

The theory of dividend relevance
It refers to the idea that a company’s dividend policy can significantly
impact its stock price. According to this theory, investors value dividends
because they provide a tangible return on investment. As a result, a
company’s stock’s market price directly relates to its dividends’ amount
and stability. There are two primary schools of thought within the theory
of dividend relevance. The Bird-in-the-Hand Theory states that investors
prefer a higher current dividend to a lower recent dividend and a promise
of future capital gains. In other words, a company’s current dividend
payment is more valuable to investors than the possibility of future
capital gains. The Tax Preference Theory states that investors prefer a
lower current dividend and the option of future capital gains because of
the tax benefits associated with capital gains. Capital gains are taxed at
a lower rate than dividends in many countries.
Walter Model
Prof. James E. Walter introduced Walter’s Model. This model considers
the firm’s value as the sum of two components - an infinite stream of
dividend, D, and an infinite stream of retained earnings, E – D, reinvested
at a constant rate of k, which are generated each year for an infinite
length of time. Thus, it links the value of the firm to the earning level,
dividend level, reinvestment rate, and the shareholders’ expectations
Basic Assumptions
‹ Funding of new projects is done through earnings alone.
‹ The growth opportunities do not alter the firm’s risk profile as a
whole. Therefore the market capitalization rate remains constant.
‹ The firm is a going concern, and the pricing model assumes perpetual
earnings.

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 DIVIDEND POLICY DECISIONS

‹ There is an implied assumption that the reinvestment rate ‘k’ remains Notes
constant. The optimum dividend policy is determined based on k.
‹ If the firm’s cost of capital, k, exceeds shareholder’s expectations,
r, then the optimum dividend policy is 100% retention,
‹ if k < r, then the optimum is 100% payout, and
‹ when k = r, the dividend policy is immaterial.
D k ( E – D) / r
P0 = +
r r
Where P0 is the stock’s market price
D is the most recent annual dividend payment per share
r is the firm’s rate of return
k is the firm’s cost of capital
The following illustration helps to understand the relevance of dividend
policy under Walters’s Model.
k > r k < r k = r
E = Rs. 20 E = Rs. 20 E = Rs. 20
D = Rs. 10 D = Rs. 10 D = Rs. 10
k = 20% k = 12% k = 16%
r = 16% r = 16% r = 16%
k k k
D + (E - D)
r
D+
r
( E-D) D+
r
( E-D)
P0 = P0= P0=
r r r

0.20 0.12 0.16

10 +
0.16
(20 − 10) 10 +
0.16
( 20 -10) 10 +
0.16
(20 − 10)
= =
0.16 0.16 0.16

=140.63 =109.37 =125.00

The dividend increased to 75% (Rs. 15 per share)

0.20 15 + 0.12 0.16

15 + (20 − 15) (20 − 15) 15 + (20 − 15)
P0 = 0.16 P0 = 0.16 P0 = 0.16
0.16 0.16 0.16

= 132.81 = 117.19 = 125.00

The dividend decreased to 25% (Rs. 5 per share)

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Notes
0.20 0.12 0.16
5+ (20 − 5) 5+ (20 − 5) 5+ (20 − 5)
P0 = 0.16 P0 = 0.16 P0 = 0.16
0.16 0.16 0.16

= 148.44 = 101.62 = 125.00

If the dividend payout If the dividend payout Price remains the same
increases, the price rises, the price increases irrespective of dividend
decreases for a growth for a declining firm. payout for a normal firm
firm
Gordon Model
The Gordon Model is named after Myron J. Gordon. It is also known
as the Gordon Growth Model, is a mathematical model that assumes
that dividends will grow at a constant rate and that the stock price
will eventually equal the present value of these future dividends. Its
assumptions and conclusions are similar to Walter’s model. It has two
additional assumptions
‹ The constant cost of capital is more than the growth rate
‹ The firm’s growth rate is the product of its rate of return and
retention ratio. The formula used is:
P = {EPS × (1-b)} / (k-g)
Where,
P = market price per share
EPS = earnings per share
b = retention ratio of the firm
(1-b) = payout ratio of the firm
k = cost of capital of the firm
g = growth rate of the firm = b × r
The bird-in-the-hand argument suggests that increased dividend means
increased certainty of the cash flows. Since this helps reduce the discount
rate, the firm’s value must improve with the increased dividend.
Example: Assume a company has a current dividend per share of Rs.
1.50, a discount rate of 10%, and a dividend growth rate of 5%.
Intrinsic value = Rs. 1.50/(0.10 - 0.05) = $30

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Suppose the current market price of the stock is less than this value. In Notes
that case, the stock may be considered undervalued and a good investment
opportunity. Conversely, the stock may be overvalued if the market price
is higher than the intrinsic value.
Theory of irrelevance – MM Hypothesis
The theory of dividend irrelevance, also known as the Miller-Modigliani
theorem, states that a company’s dividend policy does not affect its stock
price or the total return to shareholders. According to this theory, the
market adjusts for changes in a company’s dividend policy so that the
firm’s overall value remains the same. Still, there would be a transfer of
wealth from old shareholders to new shareholders. Homemade dividend
enables individual investors to make their dividend policy by buying
and selling shares to adjust current income. They can undo the corporate
action in their capacities.
Assumptions of the theory of dividend irrelevance:
‹ Perfect capital markets: Investors have complete and accurate
information about the company and its financial condition. All
investors homogeneously interpret the information. They can buy
and sell securities without transaction costs. It also implies that the
shares were infinitesimally divisible and buying/selling actions do
not influence the price.
‹ No taxes: There are no taxes on dividends or capital gains, so the
tax treatment of dividends does not affect shareholder value.
‹ No restrictions on capital: Investors are free to buy and sell securities
as they please, so the company’s dividend policy does not affect
its capital availability.
The theory of dividend irrelevance suggests that companies can pay
dividends, buy back shares, or retain earnings without affecting the
company’s overall value.
The two propositions of the Modigliani-Miller theory of dividend
irrelevance are:
‹ A firm’s dividend policy has no effect on its stock price.
Proposition 1 states that investors are indifferent between receiving
dividends and retaining earnings. It also implies that the firm’s
value is determined solely by its earning power and risk.

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Notes ‹ The total return to shareholders (dividends plus capital gains) is

determined by the firm’s investments’ earning power and risk. It
is independent of how earnings are divided between dividends and
retained earnings.
Proposition 2 means that the firm’s dividend policy does not affect
the total amount of cash flows that shareholders receive, but only
the timing and form of those cash flows. Proposition 2 assumes
that the firm can reinvest earnings at the same rate of return as its
existing projects, that investors can borrow and lend at the same
interest rate, and that there are no other factors that affect the value
of the firm’s investments.
Overall, the Modigliani-Miller theory of dividend irrelevance suggests
that the decision to pay dividends or retain earnings should be based
on the firm’s investment opportunities and capital needs rather than on
the perceived preferences of shareholders. However, the theory has been
subject to criticism and refinement over the years. Empirical evidence has
shown that dividend policy can affect firm value and investor behaviour,
especially in the presence of taxes and other frictions.
To understand MM’s argument, recognize that any shareholder can construct
their dividend policy (at least theoretically). For example, a firm is not
paying dividends, and a shareholder wants a 5 per cent dividend. They
can “create” it by selling 5 per cent of their stock. Conversely, suppose a
company pays a higher dividend than an investor desires. In that case, the
investor can use the unwanted dividends to buy additional company stock
shares. If investors can buy and sell shares, creating their dividend policy
without incurring costs, the firm’s dividend policy would be irrelevant.
However, investors who want additional dividends must incur brokerage
costs to sell shares and pay taxes on any capital gains. Investors who do
not wish dividends incur brokerage costs to purchase shares with their
dividends. Because taxes and brokerage costs certainly exist, dividend
policy may be relevant.
If the company has ‘n’ number of equity shares outstanding, then the
firm’s value is n times Po.
nP0 = [1/(1 + k)] × [nD1 + nP1]

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The profits retained depend upon the amount of dividends paid, i.e., nD1. Notes
Whatever capital funds need is not financed by retained earnings (i.e.,
E-nD) must be financed by the issue of fresh share capital.
nP0 = [1/(1 + k)] × [(nD1 + n P1)+ mP1- mP1]
nP0 = [1/(1 + k)] × [nD1 + (n + m) P1- (I-(E – nD1)]
nP0 = [1/(1 + k)] × [nD, + (n + m) P, - I+E-nD1]
nP0 = [1/(1 + k)] × [(n + m) P1 - I+ E]
MM has concluded that the firm’s value, nP0, does not depend on Since,
D, is not found in the final equation, the dividend decision and hence
the dividend policy is irrelevant.
Under MM Model, the number of new equity shares, m, to be issued can
be found as follows: m = [I-(E-mD,)]÷P1
The table given below illustrates the arbitrage process of MM theory.
Existing Shares (Nos.) 1,000 1,000 1,000 1,000 1,000
Current Price (Rs.) 500 500 500 500 500
Returns Required (%) 20% 20% 20% 20% 20%
Dividend per Share - 25 30 35 40
Projected Price (Ex Dividend) 600 575 570 565 560
Investment Required 600,000 600,000 600,000 600,000 600,000
Earnings Available 400,000 400,000 400,000 400,000 400,000
Dividend - 25,000 30,000 35,000 40,000
New Capital Required 200,000 225,000 230,000 235,000 240,000
Nos. of New Shares Issued 333.33 391.30 403.51 415.93 428.57
Total Market Value (Rs.) 80,000 80,000 80,000 80,000 80,000
Impact of Taxes on MM theory of dividend irrelevance
In practice, however, taxes and other market imperfections can make
dividend policy-relevant, as they can impact the after-tax return to
shareholders. Under perfect market conditions, the theory of irrelevance
holds good. But several real-world factors make the dividend policy
relevant. Prominent among these factors are:
‹ Presence of taxes, and
‹ Frictions in the markets.

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Notes When taxes are considered, the MM theory of dividend irrelevance does
not hold in its original form because taxes create a cost to investors who
receive dividends and a benefit to investors who receive capital gains.
This means that investors are not indifferent between dividends and capital
gains, and the firm’s value is affected by its dividend policy. Specifically,
the impact of taxes on the MM theory of dividend irrelevance can be
summarized as follows:
1. Taxes on dividends create a cost to investors, reducing future dividends’
net present value. This means that a firm that pays dividends will
have a lower stock price than one that retains earnings, all else equal.
Therefore, firms may retain earnings instead of paying dividends
to avoid this tax cost.
2. Taxes on capital gains benefit investors, increasing the net present
value of future capital gains. This means that a firm that retains
earnings and invests them in profitable projects will have a higher
stock price than one that pays dividends, all else equal. Therefore,
firms may retain earnings and invest them in profitable projects to
generate shareholder capital gains.
Overall, the impact of taxes on the MM theory of dividend irrelevance
suggests that the decision to pay dividends or retain earnings should
consider the tax preferences of shareholders and the tax consequences for
the firm. In particular, firms may pay dividends when their shareholders
have a high tax rate on capital gains or excess cash that cannot be invested
profitably. Conversely, firms may choose to retain earnings and invest
them in profitable projects when their shareholders have a low tax rate
on capital gains or attractive investment opportunities.
Neutrality Theory of Dividend
The neutrality theory of dividends, also known as the bird-in-hand theory,
suggests that investors prefer to receive dividends rather than capital gains,
all else being equal. This theory contrasts with the Modigliani-Miller
dividend irrelevance theory, which means that investors are indifferent
between receiving dividends and capital gains.
The neutrality theory of dividends assumes that investors value current
income more than future income and view dividends as a more certain
and predictable source of income than capital gains. According to this

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theory, when a firm pays a dividend, it signals to investors that it has Notes
sufficient cash flows and stable earnings to support the payout, increasing
its perceived value and credibility.
The neutrality theory of dividends mainly implies that firms with a high
dividend payout ratio should have a higher stock price than firms with
a low or zero payout ratio, all else being equal. This is because a high
payout ratio signals to investors that the firm is financially stable and
has sufficient cash flows to support the dividend payout, which increases
the firm’s perceived value and reduces the uncertainty and risk associated
with future cash flows.
However, the neutrality theory of dividends has been criticized and refined
over the years. Empirical evidence has shown that the relationship between
dividend policy and firm value is more complex than initially assumed.
In particular, the theory does not consider investors’ tax preferences
and information asymmetry, as well as the impact of external factors
such as market conditions, industry trends, and regulatory environment.
Therefore, the decision to pay dividends or retain earnings should be
based on a careful analysis of the firm’s financial and strategic goals
and the preferences and expectations of its shareholders.
Black Scholes dividend theory
The Black-Scholes dividend theory is a modification of the Black-Scholes
option pricing model that considers the impact of dividends on the price
of an underlying stock. The Black-Scholes option pricing model was
developed by Fischer Black and Myron Scholes in 1973, and investors
and financial analysts widely use it to value stock options and other
financial derivatives.
The Black-Scholes dividend theory assumes that the price of a stock will
decrease by the present value of expected future dividends during the
life of an option. This means that a stock that pays higher dividends will
have a lower option value than one that pays lower dividends, all else
equal. The theory is based on the no-arbitrage principle, which suggests
that two assets with identical payoffs should have the same price.
The formula for the Black-Scholes dividend model is similar to the
original Black-Scholes formula, with an adjustment for the present value
of expected dividends:

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Notes C = S_0 N(d_1) - X e^(-rT) N(d_2) - PV(D)

where:
C = the call option price
S_0 = the current stock price
X = the option strike price
r = the risk-free interest rate
T = the time to expiration of the option
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PV(D) = the present value of expected dividends during the life of the
option
The Black-Scholes dividend theory has several implications for investors
and financial analysts. First, it suggests that the value of a call option
will decrease as the expected dividend payments increase because the
expected future price of the stock will be lower. Second, it suggests that
the value of a put option will increase as the expected dividend payments
increase because the expected future price of the stock will be lower.
Finally, it suggests that the decision to pay dividends or retain earnings
should be based on a careful analysis of the impact on the firm’s stock
price and option values, as well as the preferences and expectations of
its shareholders.
Pecking Order theory
The pecking order theory is a financial theory that describes how companies
choose their financing sources. The theory suggests that companies prefer
internal financing first, then debt financing, and finally equity financing
as a last resort.
The pecking order theory is based on the idea that managers have better
information about the company’s internal financial condition than external
investors and therefore are better equipped to make financing decisions.
As a result, managers will generally prefer to use internal financing
sources, such as retained earnings, to fund new projects or investments.
If internal financing is insufficient, managers will turn to debt financing,
as it is generally less expensive than equity financing.
According to the pecking order theory, using equity financing is seen
as a last resort. It can be costly and may signal to investors that the
company does not have good investment opportunities or is in financial

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distress. As a result, companies may avoid issuing equity or may do so Notes

only when they have exhausted all other financing options.
The pecking order theory has several implications for investors and
financial analysts. First, it suggests that companies with high levels of
internal financing are generally more financially stable and have better
investment opportunities, as they can fund their projects without relying on
external financing. Second, it suggests that companies with high debt levels
may be perceived as riskier by investors, as they are more vulnerable to
changes in interest rates and have higher debt service obligations. Finally,
it suggests that the decision to issue equity should be based on a careful
analysis of the company’s financial condition, investment opportunities,
and the preferences and expectations of its shareholders.

8.6 Forms of Dividend Policies

There are several forms of dividends, including:
‹ A cash dividend is paid when company distributes its earnings to
the shareholders through cash payments. It is a way for a company
to return a share of profit to its investors and reward them for their
investment. Cash dividends are usually paid out regularly (such as
quarterly or annually). They can be reinvested in the company or
used by the shareholder for other purposes.
‹ Stock Dividends are also referred to as bonus shares. The issue
of bonus shares as a form of dividend is a way for companies to
distribute additional shares to shareholders, usually in proportion to
their existing holdings. When a company issues bonus shares, the
total number of outstanding shares increases, but the market value
of each share decreases proportionally.
‹ Property Dividends represent a payment made in the form of tangible
assets, such as real estate or precious metals. It is not a popular
way to distribute dividends.
‹ Liquidating dividends are payments made to shareholders as a return
on investment when a company is being dissolved or liquidated.
‹ A special dividend is a one-time payment outside the company’s
regular dividend schedule. The type of dividend a company pays,
and the amount and frequency of payments, are typically determined
by the company’s board of directors.

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Notes Next, let us understand the concept of bonus shares and share buyback
as a form of a dividend.
Bonus shares: The issue of bonus shares as a form of dividend is a way
for companies to distribute additional shares to shareholders, usually
in proportion to their existing holdings. When a company issues bonus
shares, the total number of outstanding shares increases, but the market
value of each share decreases proportionally. The main advantage of
issuing bonus shares as a form of dividend is that it allows companies
to distribute profits to shareholders without reducing their cash reserves.
Additionally, bonus shares can temporarily boost the stock price, as the
increased supply of shares can lead to a drop in the market value of each
share. However, there are also some disadvantages to issuing bonus shares.
For example, diluting existing shares can reduce the company’s earnings
per share (EPS), negatively impacting the stock price. Additionally, the
increased supply of shares can make it more difficult for the company
to raise capital. In conclusion, the issue of bonus shares as a form of
dividend can provide both benefits and drawbacks for a company, and its
suitability will depend on the specific circumstances of each case. Before
deciding, companies should consider the potential impact of issuing bonus
shares on their financial position, market value, and long-term growth
prospects.
Share Buybacks: In a share buyback, companies buy back their shares
with cash and either cancel them or keep them in a treasury for reissuing
them later. The articles of association of the company should authorize
share buyback. Post-buyback cancellation of shares is compulsory in India.
A common rationale for share repurchases (versus dividends):
1. Potential tax advantages: Often, capital gains are taxed favourably
compared to dividends.
2. Share price support/signaling: Management wants to signal better
prospects for the firm.
3. Added flexibility: Reduces the need for “sticky” dividends in the
future.
4. Offsets dilution from employee stock options.
5. Increases financial leverage by reducing the equity in the balance
sheet, thereby improving the EPS.

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6. Use Excess Cash: If a company has excess cash that it cannot Notes
effectively reinvest in its business, a share buyback can effectively
return value to shareholders.

8.7 Dividend Policies in Practice

In India, the board of directors usually determines a company’s dividend
policy, which is subject to approval by its shareholders. Companies in India
generally have a mix of cash and stock dividends, with cash dividends
being the most common.
Many Indian companies follow a stable dividend policy, aiming to maintain
a consistent level of dividend payments over time. It provides stability
and predictability for shareholders, perceived as a sign of a financially
stable and well-run company.
However, some companies in India adopt a residual dividend policy,
where they only pay dividends if they have excess cash after investing
in growth opportunities. This policy allows companies to adjust their
dividend payments based on their financial performance and investment
needs. Still, it can also result in a more volatile dividend policy. In
recent years, share buybacks have become more common in India as
companies seek to return excess cash to shareholders or support their
share price. However, the regulations surrounding share buybacks in
India are complex, and companies must adhere to strict guidelines and
disclosure requirements. The Companies Act, 2013 and the Securities and
Exchange Board of India (SEBI) regulations offer a broad regulatory and
legal framework for dividend policies in India.
Microsoft Dividend Policy, founded in 1975, declared its first dividend
in 2003. It was the first company that had not paid a cash dividend for
such a long period.
IN-TEXT QUESTIONS
1. Which of the given options is a valid reason for dividend
relevance?
(a) Informational content
(b) Reduction of uncertainty
(c) Some investors’ preference for current income
(d) All of the above

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Notes 2. When a company declares a dividend, which of the following

is typically not considered?
(a) The company’s current financial performance
(b) The company’s future growth prospects
(c) The company’s current dividend policy
(d) The CEO’s personal preference for a new car
3. What are those funds used for when a company does not pay
dividends?
(a) Repaying debt
(b) Investing in new projects or acquisitions
(c) Buying back shares
(d) All of the above
4. Which of the following is a disadvantage of paying dividends
to shareholders?
(a) It can reduce the company’s flexibility to invest in new
projects or opportunities
(b) It can decrease the company’s stock price
(c) It can increase the company’s tax liability
(d) None of the above
5. The Modigliani-Miller theorem (MM theorem) states that the
value of a firm is:
(a) Directly affected by its tax structure
(b) Not affected by its dividend policy
(c) Affected by its dividend policy
(d) Not affected by transaction costs
6. According to the dividend irrelevance theory, the amount of
dividends a company pays has:
(a) No impact on its stock price
(b) A positive impact on its stock price
(c) A negative impact on its stock price
(d) No impact on its financial performance

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7. Which of the given options is a benefit of paying dividends to Notes

shareholders according to the dividend relevance theory?
(a) It can signal the company’s financial stability and earning
power to the market
(b) It can reduce the company’s flexibility to invest in new
projects or opportunities
(c) It can increase the company’s tax liability
(d) None of the above
8. According to Walter’s model, the firm should pay a 100%
dividend when:
(a) r<k
(b) r>k
(c) r=k
(d) None of the above
9. Which of the given statements is NOT true in the context of
the Gordon model:
(a) When r = k, the dividend payout does not affect the price
(b) The optimum payout ratio is 100% when r > k
(c) For a growth firm, the market price decreases when the
payout is increased
(d) For a firm with r<k, the market price increases when the
payout ratio increases
10. From the given options, identify the determinants of dividend
policy:
(i) taxation policy of the government
(ii) nature of the business
(iii) Stability of dividends
(a) Only (i)
(b) Only (ii)
(c) Only (iii)
(d) All of (i), (ii) and (iii)

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Notes 11. Which of the following theories is a theory of dividend relevance:

(a) Walter’s model
(b) Gordon’s model
(c) Residual theory of dividend
(d) Both (a) and (b)
12. The dividend irrelevance argument of the MM Model is based
on the following:
(a) Issue of Debentures
(b) Issue of Bonus Shares
(c) Arbitrage
(d) Hedging
13. ‘A bird in the hand argument is illustrated through which model:
of dividend theory
(a) Gordon Model
(b) Walter Model
(c) MM theory
(d) Residual theory
14. Which options can be considered a valid rationale for share
buybacks?
(a) Signaling effect
(b) Potential tax advantage
(c) Increasing financial leverage
(d) Increase dilution from employee stock options
15. Which of the following statement is TRUE concerning the
Clientele effect in the case of dividends?
(a) Investors in the low tax brackets prefer dividend-paying
stocks
(b) Dividends are sticky and convey information to investors
(c) Dividends transfer wealth from lenders to equity holders
(d) Investors in the high tax brackets prefer dividend-paying
stocks

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8.8 Summary Notes

‹ There are divergent views regarding the impact of dividend policy

(dividend payout, D/P ratio) on the share’s market price and the
firm’s value.
‹ According to one view represented by Walter, Gordon, and others,
the D/P ratio is relevant and certainly affects the market price of
shares. The value of P is maximum when D is zero (in situations
of r > k); when r < k, the value of E = D gives maximum P.
‹ Gordon’s proposition that the firm’s dividend policy is relevant is
based on two tenable assumptions: (i) investors are risk averse, and
(ii) they put a positive premium on current incomes/dividends.
‹ The investors evaluate the retained earnings as a risky promise as
they perceive the future dividend receipts as uncertain concerning
the amount and timing.
‹ According to Gordon, the market value of a share is equal to the
present value of future dividend streams. The P value increases
with the D/P ratio and is maximum when there are no retentions.
‹ Cash dividends can only be paid if available earnings are more than
the required funds to meet the desired debt-equity ratio.
‹ It results in fluctuating dividend payments, as the earnings of a firm
and profitable investment opportunities available to it are likely to
vary from year to year.
‹ The dividend payment ratio may vary between zero to one hundred
depending on the size of earnings, capital expenditure requirements,
and the desired debt-equity ratio.
‹ The other view, led by Modigliani and Miller (MM), takes a
diametrically opposite position and contends that a firm’s dividend
policy does not affect its value.
‹ The arguments supporting MM do not stand the test of scrutiny
under real- world/business situations. The significant factors affecting
the validity of the MM model are (i) tax effect, (ii) flotation cost,
(iii) transaction and inconvenience costs, (iv) preference for current
dividend, and (v) resolution of uncertainty.

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Notes ‹ The available empirical evidence seems to support the view that
dividend policy is relevant. A firm should try to follow an optimum
dividend policy that maximizes the shareholder’s wealth in the long
run.

8.9 Answers to In-Text Questions

1. (d) All of the above

2. (d) The CEO’s personal preference for a new car
3. (d) All of the above
4. (a) It can reduce the company’s flexibility to invest in new projects
or opportunities
5. (b) Not affected by its dividend policy
6. (a) No impact on its stock price
7. (a) It can signal the company’s financial stability and earning power
to the market
8. (a) r<k
9. (b) The optimum payout ratio is 100% when r < k
10. (d) All of (i), (ii) and (iii)
11. (d) Both (a) and (b)
12. (c) Arbitrage
13. (a) Gordon Model
14. (d) Increase dilution from employee stock options
15. (a) Investors in the low tax brackets prefer dividend-paying stocks

8.10 Self-Assessment Questions

1. What is a dividend policy?
2. Why do companies choose to pay dividends?
3. What are the different types of dividends?
4. What factors influence a company’s decision to pay dividends?
5. How does the payout ratio impact a company’s dividend policy?

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6. What is the impact of dividends on a company’s stock price? Notes

7. What are the benefits and drawbacks of paying dividends?

8.11 References
‹ Eugene F Brigham, Michael C Ehrhardt, Financial Management Text
& Cases, Cengage Learning India Pvt. Ltd.
‹ I.M. Pandey, Financial Management, Vikas Publishing House (P.)
Ltd.

8.12 Suggested Readings

‹ J.C. Horne, Financial Management and Policy, Prentice Hall of India.
‹ M.Y. Khan and P. K. Jain, Financial Management, Text, Problems,
and Cases, Tata McGraw Hill New, Delhi.
‹ R. Srivastava and A. Misra, Financial Management, Oxford University
Press.
‹ P. Chandra, Financial Management-Theory and Practice, Tata McGraw
Hill New, Delhi.

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L E S S O N

9
Working Capital
Management
Mrs. Juhi Batra
Assistant Professor
Shaheed Rajguru College of Applied Sciences for Women
Email-Id: juhi9294@gmail.com

STRUCTURE
9.1 Learning Objectives
9.2 Introduction
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9.12 Suggested Readings

9.1 Learning Objectives

‹ Comprehending working capital management policies and strategies.
‹ Analysing the impact of working capital policies on organisation’s profitability,
liquidity & solvency position.
‹ Evaluating cash management techniques to maximize shareholder’s wealth.
‹ Deploying account receivable management tactics to build value for firm.

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9.2 Introduction Notes

A company’s working capital is a gauge of its liquidity and immediate

financial stability. Every business need funds to carry out its operations
be it acquiring resources for ongoing operations or funding new projects.
Working capital is the money needed by a company to cover its ongoing
day to day expenses. Existence of working capital is indispensable in a
firm. Some industries with longer production cycles, slower inventory
turnover and longer gestation period may have greater working capital
requirements. In contrast, retail businesses with daily interactions with
thousands of consumers may frequently generate short-term money far
more quickly and may have fewer working capital requirements.
Working capital is centred on current assets and current liabilities.
Current assets are the liquid resources belonging to the entity that can
be converted into cash in less than a year. For instance, bank balance,
cash in hand, inventories, bills receivables, investments in short-term
securities, debtors and prepaid expenses. The current liability is another
element of working capital. The total of all current liabilities is the amount
that business entity owes to outsiders and must pay within a year. The
current liabilities include bills payable, creditors, accounts payable and
outstanding expenses.

9.3 Classification of Working Capital

Working capital can be referred in two distinct ways: gross working
capital and net working capital.

Gross working capital (also referred to as total working capital) is a

firm’s total investment in its current assets. It is a quantitative concept.
Decisions pertaining to gross working capital focuses on optimum investment
in current assets and source of financing them. Excessive investment
in current assets may diminish a firm’s profitability while inadequate

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Notes investment can cause hindrances in carrying out daily operations and
can endanger firm liquidity in meeting current financial commitments.
Changing business activity will lead to change in working capital needs
and will warrant prompt action from management. It is inevitable to
strive for equilibrium.
Net working capital is the difference between current assets and current
liabilities for a business. It is a qualitative concept where the balance
sheet’s current assets and current liabilities are compared and the resulting
gap is labelled as the company’s net working capital. It is an estimation
of the amount that has to be deployed from the permanent source of funds
to fulfil working capital needs as the extent to which current liabilities
can get delayed, makes funds available to provide for the rest of the
working capital needs.
The company’s liquidity position is assessed by Net Working Capital
(NWC). If a business has a sizable positive net working capital, it indicates
the company’s strong short-term financial health because it means the
company has enough liquid assets to cover immediate obligations and
internally fund business expansion. A very high net working capital
may point to excessive inventory. Negative net working capital indicates
inefficient asset utilization and raises the possibility of a liquidity problem
for the organization. Even with significant investments in fixed assets, a
business may still experience operational and financial difficulties if short
term liabilities become due. This could result in increased borrowing,
untimely payments to creditors and suppliers, and a consequent decline
in the company’s corporate credit rating. The company may even have
to file for bankruptcy. Decisions pertaining to net working capital also
includes optimum mix of Non-current and current funds for financing
the current assets.
Net working capital = Current Assets – Current Liabilities
Considering periodicity: The need for operating cash is ongoing. When
business activity is at its peak or during a specific season, more working
capital is needed. Working capital can be classified into two groups as
follows based on periodicity:
1. Permanent operating capital
2. Variable working capital

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1. Permanent working capital refers to the portion of working capital Notes

that is permanently used up in financing for current assets for
the smooth operation of the business. There is a minimal amount
of current assets needed to run the business in a smooth fashion
throughout the year even during slack period. Hence funds are
invested to provide for the minimal level of current assets at all
times and also known as fixed working capital.
2. Temporary or variable working capital refers to a temporary
and varying quantity of working capital needed over and above
permanent working capital to meet the needs of changing business
activities over time. Variable working capital can shift from one
asset to another and fluctuates according to the growth or decline in
business activity. Extra sum may be needed during the year’s busiest
business seasons. To fulfil the seasonal liquidity of the economy,
additional working capital is necessary. Additional working capital
could also be required to supply additional current assets to meet
unforeseen events or special activities like the execution of special
projects or intensive marketing campaigns.
Figure 9.1 depicts and brings out differences in permanent and variable
working capital. It showcases that permanent working capital may be
changing (growing or falling) at a constant rate over a period of time or
may remain stable for years. Temporary working capital is varying at all
times as can be seen in Figure 9.1.

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Notes

Figure 9.1: Fixed & Variable Working Capital

Determinants of Working Capital
The amount of working capital depends on the following factor.

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1. Business Size and Nature of Business Notes

A company’s need for working capital is largely impacted by the
nature of its line of work and scale of operations. Trading and financial
companies invest very little in fixed assets, but they need to invest a lot
of money in working capital. To meet the varied and ongoing demand of
its consumers, retail businesses must maintain enormous stockpiles of a
variety of commodities. Similarly a public utility mostly uses fixed assets
in its operations, but a merchandising department often relies on inventory
and receivables. Compared to huge corporations, smaller businesses have
lower proportions of cash, receivables and inventories.
2. Market Competitiveness
If the conditions prevailing in the market are competitive and substitutes
to firm’s offerings are available, then the firm needs to follow liberal
credit policy for its customers and it needs to maintain adequate inventory
to meet the customer orders as and when they are placed.
3. Business Cycle
Volume of sales has the most direct relation with the extent of working
capital. Sales volumes change drastically as the economy enters into boom,
depression or recessionary cycles. During times of prosperity, business
increases and during times of depression, it decreases. As a result, times
of prosperity require more working capital, whereas times of depression
require less.
4. Inventory Conversion Cycle
The inventory conversion cycle, also known as the production cycle, is
the length of time it takes to transform raw resources into completed
goods. The better the efficiency, the longer the production cycle. Short
production cycle will warrant a lesser amount of working capital. The
amount of working capital is influenced by inventory turnover and the
cost per unit of the sold commodities. The amount of working capital
increases as this expense rises.
5. Creditor Policy
Terms of purchase and sales also have a bearing on working capital. The
loan security is significant to creditors. If creditors of a firm follow a
conservative approach of credit disbursement then they may desire the
firm to have high liquidity. On the other hand, less money will be invested
in inventory if the credit terms for purchases are more advantageous and

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Notes those for sales are restrictive. Working capital needs might be decreased
with more benevolent lending terms i.e. If a business is given more time
to pay creditors or its suppliers, it will have lesser working capital needs.
A company with better credit lines will require less operating capital.
6. Seasonal Fluctuations
The amount of variable working capital is impacted by seasonal fluctuations
in sales. The demand for certain goods may frequently be of a seasonal
nature. So inventories are purchased during certain seasons only. The size
of the working capital in one period may, therefore, be bigger than that
in another. Seasonality component must be factored while forecasting
demand and estimating raw material requirements.

9.4 Working Capital Policies & its Management

Management of working capital comprises managing inventory, cash,
debtors, short term marketable securities and creditors. Actual sales in
previous year and sales forecast for the year indicates the extent and
composition of various current assets required. A considerable amount
of financial manager’s time and firm’s investment is devoted to working
capital. Investment decisions of the firm determine its profitability, growth
prospects and build value for the firm in the long run. Hence extent of
investment in current assets and its source of funding must be constantly
reviewed as they are critical to firms’ immediate profitability and its
value in long run. Sub-optimal decisions in working capital management
may not support sales growth or may tie up idle assets and lead to loss
worthy circumstances. Short-term capital decisions are imperative from
a liquidity and profitability perspective so that it helps in maximizing
shareholders wealth.
Following are policies pertaining to amount of investment in current assets:
Current Asset to Sales Ratio
Sales volume & sales forecast for the year directly influences the extent
and composition of various current assets required. Sales forecast may not
corroborate with actual demand. In that case the extent of current assets
determined on the basis of sales forecast might turn out to be inadequate
or excessive. During an unexpected rise in demand, the current assets
will have to be risen, landing firms in a tight working capital position.

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To avoid such circumstances, financial managers should determine the Notes

minimum working capital required at all times and safety cover for each
of current assets for different sales levels.
Conservative Policy: Firms following conservative policy are risk averse
and add more than proportionately to current assets in relation to addition
in sales activity. Firms adopting conservative policy generally have high
current asset to fixed asset ratio.
Aggressive Policy: Firms following aggressive policy are risk taking
and add less than proportionately to current assets in relation to addition
in sales posing the threat of illiquidity and insolvency. Firms adopting
aggressive policy generally have low current asset to fixed asset ratio.
Moderate Policy: Moderate policy meets above mentioned policies in
the middle. Firm following moderate policy adds up to current assets in
the same proportion as addition in sales activity.

Figure 9.2: Working Capital Policies

Policies for Financing Current Assets
Current assets may be financed using long term funds like owner’s equity,
retained earnings, bank loan etc. or short-term funds like commercial
paper, short term debt from bank or factoring of receivables.

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Notes According to the levels of risk involved and mix of short-term & long-term
funds, three general strategies—hedging, aggressive and conservative—can
help a corporation finance its working capital more effectively.
1. Conservative Strategy
An organization adopting conservative approach that is majorly dependent
on a long-term source of financing to finance minimum working capital
needed at all times as well as part of cyclical working capital. A firm
only uses this method when it is necessary to minimize risk as much
as possible. Deploying long-term funds does away with any possibility
of shortage or illiquidity. To ensure low risk, the management strictly
controls the credit restrictions.
Additionally, to ensure adequate cash flow, current assets must always
be greater than current liabilities. For low-risk, short-term sources are
used as little as possible. Therefore, following a cautious working capital
financing policy result in under utilization of funds, which lowers returns
and compromises growth. Firms may invest under-utilized funds in short
term securities. Figure 9.3 depicts conservative approach.

Figure 9.3: Financing of Working Capital - Conservative Approach

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2. Aggressive Strategy Notes

Aggressive policies carry the most risk and, as a result, have the potential
for increased growth. It doesn’t presume to have any reserves on hand
to meet unforeseen working capital needs. It implies that only a small
fraction of long-term borrowing is used to fund permanent operating
capital. Short-term borrowing is used to cover the remaining costs and
temporary working capital, including seasonal changes. Companies that
follow this strategy make sure that the value of their current assets, such
as debtors, is kept to a minimum by requiring prompt payments or limiting
credit sales. The management further asserts that payments to creditors
are delayed. This working capital policy is an option for organizations
looking to grow more quickly. However, due to the high level of risk,
sound business judgment and adept money management are essential. This
strategy entails the biggest risk but also offers the best chance to lower
interest costs and boost a company’s profitability. Figure 9.4 depicts an
aggressive approach.

Figure 9.4: Financing of Working Capital - Aggressive Approach

3. Hedging Strategy
Adopting this method, also known as a matching policy, guarantees
that a company’s current assets and short-term liabilities are always in
balance. This policy basically seeks to strike a compromise between the

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Notes two extreme approaches, both in terms of risk and growth potential. This
approach suggests matching the expected life of the asset with that of the
funding source. For example, if a company wishes to finance machinery
having a life of 20 years, it may finance the same by issuing a 20-year
bond with its principal value equivalent to cost of machinery. Similarly,
a firm may raise funds via commercial paper having a tenure of a month
to finance inventory. Thereby most organizations observing this strategy
use long-term sources of finance to invest in fixed current assets and
resort to short-term funding options for current asset financing.
Figure 9.5 depicts the hedging/moderate approach. The non-current assets
and fixed working capital making up for total fixed assets are being
financed via long term source of funds while temporary working capital
is financed through short term financing.

Figure 9.5: Financing of Working Capital - Hedging Approach

IN-TEXT QUESTIONS
1. In which of the following, the permanent working capital is
financed by long-term source of funds?
(a) Hedging Approach
(b) Aggressive Approach

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(c) Conservative Approach Notes

(d) All of the above

2. Negative Net Working Capital implies that:
(a) Long-term funds have been used for long-term assets
(b) Long-term funds have been used for current assets
(c) Short-term funds have been used for fixed assets
(d) Short-term funds have been used for current assets
3. Management of working capital implies trade—off between:
(a) Cost and Revenue
(b) Assets and Liabilities
(c) Debtors and Creditors
(d) Liquidity and Profitability
4. Gross Working Capital is equal to:
(a) Total Assets
(b) Total Liabilities
(c) Total Current Assets
(d) Total Current Liabilities

9.5 Risk Return Trade Off

Liquidity v/s Profitability
The risk return trade off in working capital is predominantly about the
tussle between liquidity and profitability. Precise estimation of the amount
of working capital required will let the company spend just enough in
current assets. The current asset holdings would be at the minimum
level if there was absolute assurance as excessive investment in current
assets won’t provide expected return on investment and reduce cash
flows. Conversely, a lower investment in current assets may result in
disrupted production and sales due to frequent stockouts and a failure
to pay creditors in time.
Since it is impossible to predict operating demands with accuracy, the
company faces the dilemma of how much current assets to carry. Different

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Notes risk-return implications apply to conservative or aggressive policy that a

firm may follow to guide its working capital management.
Solvency and profitability are the two main goals of working capital
management. When used technically, the term “solvency” refers to the
company’s ongoing capacity to pay for maturing liabilities. Creditors and
lenders anticipate timely payment of their claim. The company needs to
have a sizable investment in current asset holdings to guarantee solvency.
Therefore, a liquid company has a lower chance of going out of business
because it rarely runs out of cash or shares.
However, keeping a strong liquidity position comes at a price. The firm
will have a significant amount of cash invested in existing assets hampering
the profitability of the company if these investments remain dormant. The
company’s profitability will increase as a result of having fewer funds
invested in idle current assets, but its solvency would be in jeopardy and
it would be more vulnerable to cash shortages and stock outs.
Short-term financing v/s long-term financing
Deployment of long-term and short-term funds to finance current assets
also involves a trade-off. Long-term debt is costly and usage of them to
finance short-term assets can reduce overall return on investment but they
provide flexibility and are less risky in terms of rendering firms illiquid
during tight working capital positions.
Hence, the company should minimize both the total cost of liquidity and
the cost of illiquidity in order to balance the profitability-solvency knot.
Illustration 9.1 numerically explains the risk return syndrome.
Illustration 9.1
Balance Sheet of ABC Ltd. as on 31st December 2022 is as follows:
Liabilities Amount Assets Amount
Share capital 4,00,000 Non-current assets 6,00,000
Debentures 3,00,000 Current assets 2,00,000
Current liabilities 1,00,000
Total 8,00,000 Total 8,00,000
The firm is earning 11% return on non-current assets and 2.5% return
on current assets. Find out the effect on liquidity and profitability of the
firm in following cases:

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1. Increase in current assets by 30% Notes

2. Decrease in current assets by 30% Solution
The earnings of the firm may be ascertained as follows:
Particulars Present Increase Decrease
Current in current in current
Assets assets by assets by
30% 30%
Current assets 200000 260000 140000
Non-current assets 600000 600000 600000
Return on non-current assets @ 11% 66000 66000 66000
Return on current assets @ 2.5% 5000 6500 3500
Total Return 71000 72500 69500
Ratio of current asset to total asset 25.00% 30.23% 18.92%
Current liabilities 100000 160000 40000
Ratio of current asset to current 2 1.625 3.5
liabilities
Return as a percentage of total assets 8.88% 8.43% 9.39%
Here Financial manager is financing short-term assets with short-term
financing therefore it can be observed that increase in current assets
decreases current asset to current liability ratio while decrease in current
asset affects ratio otherwise. Increasing the financing of current assets
decreases the overall profitability of firm as can be noticed in return on
asset ratio. Financial Manager should strike an optimal balance while
investing in working capital as excessive funds in current assets may
hamper the profitability.

IN-TEXT QUESTIONS
5. Which of the following needs to be true for a firm engaged in
retailing:
(a) High fixed cost
(b) Low liquidity
(c) High liquidity
(d) High inventory turnover
6. “Financial Manager needs to strike a compromise between
liquidity and profitability”. (True/False)

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Notes 9.6 Cash Management

Businesses utilize cash on a regular basis to pay their debt commitments
and operating expenditures, such as taxes, employee wages, inventory
purchases, advertising costs etc. For long-term assets like property, plant,
and equipment (PP&E) and other non-current assets, cash is employed as
investment capital. For businesses to maintain adequate business stability,
a variety of cash inflows and outflows must be carefully managed.
Maintaining cash balances is a key issue for financial managers.
Cash may be referred to fiat currency, cash at bank, demand draft, cheques
held by the enterprise. In a broader sense cash comprises cash & cash
equivalents. The cash equivalents are assets that can be readily converted
into cash like marketable securities or short-term deposits with banks.
The process of controlling cash inflows and outflows is known as Cash
Management. Cash is the main asset utilized to invest in and cover any
liability, therefore this procedure is crucial for businesses. There are
numerous alternatives for managing cash. In addition to giving organizations
a window into their financial state, cash management may also be utilized
to boost profitability by addressing liquidity issues.
Cash flows involved in day-to-day operations are dominated by changes in
accounts receivables and accounts payable. A business can take numerous
actions to increase the efficiency of its payables and receivables, which
will ultimately result in more working capital and improved operating
cash flow. Businesses may provide discounts enticing clients to pay early
or on time, look for better financing terms for debt, use technology like
automatic billing and electronic payments for payables administration as
that will enable quicker and simpler payments.
Cash management calls for (i) effective cash forecasting and reporting
systems, and (ii) achieving the best possible conservation strategies and
use of cash resources.
Motives for holding cash
Every firm needs to maintain a minimum balance of cash and near cash
assets for a variety of reasons. Three main motives behind maintaining
a healthy cash & bank balance are Transactional, Precautionary and
Speculative.

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1. Transactional Motive: A business needs cash to conduct daily Notes

business transactions. The money is required to cover obligations
like staff wages, freight charges, inventory purchases, buying tools
or paying general expenses. The lack of perfect synchronization
between cash receipts and payments causes the cash demands to
arise. Sometimes cash payments exceed cash collections, and vice
versa because of which firms need to maintain a minimum cash
balance at all times. Funds requirement may be forecasted on the
basis of probable payments and receipts in the near future. If more
money is required for payments than for receipts, a bank overdraft
may be used to raise the extra funds. However, if cash receipts
exceed payments, it may be invested in marketable securities.
The maturity of securities may be modified to account for future
payments, including interest and dividends.
2. Precautionary Motive: A business must maintain cash on hand to
cover a variety of eventualities. Even though monetary inflows and
outflows are predicted, these figures could change. For instance,
a debtor who was supposed to pay after 3 days might need more
time while a supplier who had extended credit for 15 days might
not have the necessary goods. As purchases might be made from
new vendors, cash might be needed rather than credit in certain
circumstances. Such emergencies frequently occur in a business. A
business must set aside money for these unforeseen circumstances.
The ability to generate money quickly should be possible. Cash
held back for unforeseen expenses is either ineffective or still ideal.
However, such money may be put in marketable assets with a short
maturity or low risk that could provide cash as and when needed.
3. Speculative Motive: The speculative motive involves keeping money
on hand to invest in lucrative chances as they come along. Such
chances don’t present themselves frequently. Conjectures concerning
these possibilities’ occurrence can only be made. For instance, a
company might want to make purchases at the temporary drop in
raw material prices. If a company has cash on hand, then it may
leverage such unexpected opportunities of making profit. These
opportunities are transient in nature as they vanish away if not
capitalized immediately.

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Notes Cash Conversion Cycle

The Cash Conversion Cycle (CCC) is a metric that expresses the time in
days that a firm takes to convert its investments in inventory and other
resources into cash flows from sales. CCC attempts to measure how long
each net input rupees is tied up in the production and sales process before
it gets converted into cash received. This metric takes into account how
much time the company needs to sell its inventory, how much time it
takes to collect receivables, and how much time it has to pay its bills.
The CCC is one of several quantitative measures that help evaluate the
efficiency of a company’s operations and management. An increasing
CCC should prompt more research and analysis based on other indicators,
whereas falling CCC values over numerous periods are encouraging signs.
The cash conversion cycle is also called the Net Operating Cycle (NOC)
as the same is driven from Gross Operating Cycle (GOC). GOC is the
time involved in acquiring raw material, transferring raw material to
production centres, converting the same into finished goods, selling the
goods and realizing cash out of those sales. The length of the gross
operating cycle is thereby the sum of following:
(a) Inventory Conversion Period (ICP) i.e., the time taken from
procurement to conversion of raw material into finished goods sales.
ICP can be decomposed into following:
Raw Material Conversion Period (RMCP): Time taken to move
procured raw material to production centers.
Work In Progress Conversion Period (WPCP): Time taken to engage
raw material into production processes.
Finished Goods Conversion Period (FGCP): Time taken to convert
finished goods into cash sales and credit sales.
(b) Receivable Conversion Period (RCP): Time taken from credit sales
occurrence and collection from debtors.
GOC = ICP + RCP
Cash Conversion Cycle is calculated by deducting Deferral Period
(DP) from gross operating period. Deferral period is the time period
by which payables owed to creditors can be postponed.
NOC or CCC = GOC - CC

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For calculation, above mentioned periods may be calculated as: Notes

$YHUDJH UDZ PDWHULDO VWRFN
50&3 = × 365
7RWDO UDZ PDWHULDO FRQVXPSWLRQ

$YHUDJH ZRUN LQ SURJUHVV

:3&3 = × 365
7RWDO FRVW RI FRQVXPSWLRQ

$YHUDJH ILQLVKHG JRRGV

)*&3 = × 365
7RWDO FRVW RI JRRG VROG

Average receivables
5&3 = × 365
7RWDO FUHGLW VDOHV

$YHUDJH SD\DEOHV
'3 = × 365
7RWDO FUHGLW SXUFKDVHV

Note:
1. Average of opening and closing balances of respective items will
be used to calculate average value in formulas.
2. In order to arrive at denominator values on “per day” basis, the
entire fraction is multiplied by the number of days in the specific
period which is assumed to be a fiscal year.
The CCC is lengthened when management takes longer time to collect
unpaid invoices, keeps an excessive amount of inventory on hand, or
pays its bills too rapidly. Since it takes longer to create income, a longer
CCC can force small businesses into bankruptcy. The CCC is shortened
when a business collects past-due payments swiftly, accurately predicts
its inventory needs, or pays its invoices slowly. A smaller CCC indicates
improved business health and helps in growing profitability. The cash
conversion cycle and operating cycle can also be understood with the
help of following Figure 9.6.

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Notes

Figure 9.6: Cash Conversion Cycle

Internal Control System for Cash Management
The financial management should take action to quickly recover money
from creditors, and for this reason the company should create an effective
internal control system. There should be a built-in method for prompt
recovery from the debtors after the credit sales are completed. When
customer checks or draughts are received, there shouldn’t be any delay
in depositing these receipts with the bank.
Collection Centres
To avoid mail delays, a company may establish collection centres (banks)
throughout the nation. This strategy minimizes the amount of time needed
for dispatch, collection, etc. by opening the collection centres as close to
the debtors as possible. Instead of sending payments to the central office,
the company may instruct clients to mail their payments to a local bank
or collection agency. By reducing collecting time through focus banking,
improved cash management is achieved. The choice of collection centres
must, however, take into account the amount of billing and activity in a
certain geographic area.
Lock Box System
Customers who use the lock-box system mail their payments to a post
office box close to their place of employment. The business makes
arrangements with a bank to rapidly collect the payments and credit them
to the business’s account. The lock-box method is only cost-effective if
a considerable volume of payments is being accepted at a given location

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because the costs associated with maintaining the system could be high. Notes
Commercial banks, on the other hand, typically offer their major clients
the services of collecting the checks from the client’s office and submitting
the high value checks to the clearing system on the same day. Both of
these services contribute to the huge clients’ float. These advantages are
not, however, unpaid. The bank typically assesses a fee for each check
that is processed through the system.
A firm can improve its cash management and lower its cash requirements
by exercising effective control over cash outflows or payments. A financial
manager should make every effort to sluggish the payments. However,
caution must be exercised to prevent damage to the company’s reputation
and credit standing. The discount that creditors offer in exchange for quick
payment must be fairly assessed in terms of the costs and advantages of
the discounts.
Regarding the management of inflows and outflows, using float is a
crucial strategy to shorten the cash cycle. There is typically a delay
between the time the check is written and the time it is cleared when a
business receives or makes payments via checks, etc. The time that passes
between the point at which the paying company writes a check and the
point at which the funds supporting the check are actually debited in the
bank account is referred to as the float for the paying firm. The period
of time between receiving the check and having the money available in
its account is known as the payee company’s “float.” Float consists of
three parts:
Mail Time: It is the duration between the issue of a cheque and its
receipt by the payee.
Processing Time: This is the period of time between receiving a check
and depositing it in the payee’s bank account.
Collection Time: This is the period of time required to move money
from the payer’s account to the payee’s account via the banking system.
This collection time is often the third or fourth including the day a check
is deposited.
Payment float is the sum of checks issued but not yet presented for
payment. The receipt float is the total amount of uncleared checks that
have been deposited in banks. Net float is the distinction between the

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Notes payment float and the reception float. Firm should strive to maintain a
positive net float.
Optimum Cash Balance
The primary key issue as identified under discussion of cash management
is the amount of minimum cash balance and safety cover maintained
by organizations at all times. Firms make cash budgets on the basis
of forecasted receipts and payments for subsequent periods. Shortages
may be dealt by liquidating marketable securities, sourcing from new
credit lines while surpluses should be invested in short-term securities.
Determination of optimum cash balance will mean striking a balance
between risk and return. Few models have been advised to deal with
optimum cash balance conundrum.
Baumol’s Model
William Baumol proposed a model similar to the Economic Order Quantity
Model of Inventory management. He came to the conclusion that money
might also be viewed as a certain kind of stock, one that is essential
for conducting business. Similar to carrying cost and ordering cost in
EOQ model of inventory management, holding cost and transaction cost
of replenishing cash comes into play while deriving optimal cash in
Baumol’s Model.
Holding cost of cash is its opportunity cost of holding cash in hand in
place of investing the same in interest yielding marketable securities.
Holding cost of cash is the interest foregone on such securities.
Transaction Cost of replenishing cash is the brokerage & commission
charged while liquidating marketable securities.
The model’s goal is to minimize the sum of opportunity cost and transaction
cost, which represents the entire cost of keeping cash.
Fundamental presumptions of the model are as follows:
‹ Amount of cash requirement throughout the period is known &
certain.
‹ Steady and predictable cash inflow.
‹ Stable interest rate for the entire term when investing in securities.
‹ Transaction cost of liquidating securities is known and stable.
‹ Cash transfers are done with immediate effect without any delay.

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Assuming that the firm begins with a cash balance of “a” amount by Notes
selling securities. While bearing day to day expenses, the cash balance
will deplete and will become nil. The firm will be again replenishing “a”
amount of cash. So, at all times the firm is holding a/2 cash on average.
If return on foregone short-term investment is “r” then the holding cost
will be as follows:
Total Holding cost = r × (a/2)
Transaction cost will be charged every time cash is replenished with “a”
amount. Number of times a transaction will take place will be equivalent
to total funds needed during the year “T” divided by amount replenished
in every transaction “a”. The transaction cost is assumed to be c per
transaction.
Total Transaction cost = c × (T/a)
Total cost of cash requirement = r × (a/2) + c × (T/a)
Holding cost increases as cash balance “a” increases while transaction
cost will fall if “a” increases as the number of transactions will be lesser.
The model strikes a balance by determining cash balance that minimizes
cost as depicted in Figure 9.7.

Figure 9.7: Baumol’s Cash Model

6RXUFH 5XVWDJL 53 )XQGDPHQWDOV RI )LQDQFLDO PDQDJHPHQW
7D[PDQQ 1HZ 'HOKL

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Notes Following is the formula driven for optimisation problem:

2F7
A* =
r

Where
A* = optimum cash balance i.e. the balance replenished every time the
transaction is carried out.
c = cost per transaction
T = total amount of funds needed during the year.
r = rate of return foregone on marketable securities.
A* will increase as transaction cost “c” increases while the cash balance
will decrease if holding cost “r” increases.
Illustration 9.2
ACC Ltd. requires Rs. 5 lakh in cash for meeting its transaction needs
over the next five months. This amount is available with ACC Ltd. in
the form of marketable securities. It can earn 18 per cent annual yield
on its marketable securities. The conversion of marketable securities into
cash entails a fixed cost of Rs. 500 per transaction. Find the optimum
cash conversion size.
Solution:
Opportunity cost “r” = (18/12) × 5 = 7.5%
which is 0.075 per rupee; Rounding it off – Rs. 81650 is the optimum
transaction size; Average cash holding = C/2 = 81650/2 = 40825; No.
of transactions = T/C = 500000/81650
= 6.12 or simply 6; Average No. of days per transaction (we are assuming
30 days per month) = 150/6 = 25 days; Per day usage of cash = 81650/25
= 3266
Miller Orr Model
Miller and Orr (1966) Model is an improvement over Baumol’s model which
is not applicable in case cash requirement is not steady. The inventory
type model cannot be employed when there is significant uncertainty
regarding cash flows. Further on Baumol model also ignore the situation
of cash surplus. Miller and Orr claimed that the cash balances fluctuate

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 WORKING CAPITAL MANAGEMENT

randomly based on empirical evidence. It does not get consumed at a Notes

consistent rate.
According to the Miller-Orr model, changes in cash balance during a
specific period are random both in terms of amount and direction. The
model presupposes that of the two assets, i.e. (i) cash and marketable
securities, the latter has a marginal yield and (ii) a seamless transfer of
cash to marketable securities and vice versa is achievable, albeit at a
price. For the cash balance, the model provides two control limitations.
H is a ceiling above which cash balance should not go & a lower limit,
L, below which the cash level is not permitted to go, and must not be
allowed to go. Within these constraints, the cash balance should be
permitted to fluctuate. At this stage, if the cash level has reached the
upper control limit, H, some of the cash should be invested in marketable
securities so that the cash balance falls to the return level, R, which is a
predetermined amount. R is established as the goal cash balance. If the
cash balance drops to level L, it is necessary to sell enough marketable
securities to raise money, bringing the balance back up to level R. As
long as the cash balance is between the and marketable securities, no
transaction between the two.
Management determines the lower limit, L, based on how much risk of
a cash deficit the firm is willing to bear, which in turn depends on both
the availability of borrowings and the repercussions of a cash shortfall.
The model computes a gap between the lower and higher limit that
diminishes the total of transaction costs and holding opportunity costs.
There are three steps in the model. Setting a cash balance’s bottom bound.
Estimating the variability in future cash flows is the second phase. The
third step is to calculate the spread as a result of the market interest rate,
transaction costs, and fluctuation. Adding this spread to the lower cash
limit will determine the upper limit.

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Notes

Figure 9.8: Miller Orr Model

6RXUFH 5XVWDJL 53 )XQGDPHQWDOV RI )LQDQFLDO 0DQDJHPHQW
379
Z=
4i

where,
T = Transaction cost
V = Variance of daily cash flows
i = Daily % interest rate on investments
If the firm take ‘L’ to be lower limit of cash balance, then the return
level may be defined as R = L + Z, and the upper limit H is defined as
H = 3Z + L
For instance: The minimum cash balance of Rs. 10,000 is required at A.
Co. and transferring money from the bank costs Rs. 40 per transaction.
Inspection of daily cash flows over the past year suggests that the standard
deviation is Rs. 3,000 per day, and hence the variance (standard deviation
squared) is Rs. 9 million. The interest rate is 0.03% per day.
Calculate:
(i) the spread between the upper and lower limits
(ii) the upper limit
(iii) the return point
Solution:
(i) Spread = 3 (3/4 × 50× 9,000,000/0.0003)1/3 = Rs. 31,200
(ii) Upper limit = 10,000 + 31,200 = Rs. 41,200

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 WORKING CAPITAL MANAGEMENT

Illustration 9.3 Notes

The following details concerning S Limited’s cash management system
are provided. Marketable securities have a 15% annual yield. Marketable
securities transactions have a fixed cost per transaction of Rs. 2000.
The daily cash balance change’s standard deviation is 4,000 rupees. The
cash balance must be at least Rs. 50,000. Determine return point and
upper limit.
Solution:
379
Z= s
4i

3 × 2000 × 4000 × 4000

Z= s
4 × 0.0416

Z = 8324.77
Return Point = 8324.777 + 50000 = Rs. 58324.777 H = 3Z + L
H = Upper limit = 3 × 8327.777 + 50000 = Rs. 74983.331

IN-TEXT QUESTIONS
7. Operating cycle of a firm can be shortened by:
(a) Increasing credit period to customers
(b) Increasing stock of raw material
(c) Increasing working-in-progress period
(d) Increasing credit period from suppliers
8. NOC is equal to:
(a) GOC – DP
(b) RMCP - RCP
(c) GOC + DP
(d) WPCP - CC
9. Find out the Cash Conversion Period if Receivable Conversion
Period is 40 days, Deferral Period in 30 days and Inventory
Holding Period in 25 days:

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 MBAFT 6204 CORPORATE FINANCE

Notes (a) 30 days

(b) 25 days
(c) 35 days
(d) 45 days

9.7 Receivable Management

Account receivables are significant part of current assets and working
capital. Account receivables arise from debt extended by company to
its customers on its credit sales. The loan extended to customers does
not provide any interest income while it is just a facility provided on
purchases. Firms may adopt a liberal or a stringent credit policy. A liberal
one will help boost sales and increase profit potential while a stringent
one will reduce the cost of default and increase liquidity. Receivable
Management involves compromising a balance between liberal and stringent
credit policy through a careful evaluation. Formulating credit standards,
terms of extending credit and developing collection policy is all part of
receivables management.
Costs associated with Receivables Management
The explicit cost associated with managing account receivable is financing
cost, administrative cost, delinquency cost & cost of bad debt.
Financing Cost: Extending credit lengthens the operating and cash
conversion cycle causing funds to be blocked for a longer time. So,
fund demand has to be met by external or internal sources both of which
carry cost.
Administrative Cost: The cost incurred on maintaining credit sales record.
Cost pertaining to procuring creditworthiness information of customers
before extending credit also forms part of administrative cost.
Delinquency Cost: Delay in payments also calls for sending reminders,
legal notices and cost of those funds that remain stuck for longer than
expected time.

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Cost of Bad Debt: Default caused by customers will call for writing bad Notes
debt off against the firm’s profits.
Cost of receivables management may be represented as per following
Figure 9.9.

Figure 9.9: Costs incurred in Receivable Management

Important Aspects of Receivables Management
The receivables management must be attempted by adopting a systematic
approach and considering the following aspects of receivables management:
1. The credit policy.
2. The credit evaluation.
Credit Policy
The fundamental choice to be made under credit policy in relation to
receivables is how much and under what conditions firm should issue
credit to a customer. Credit standard and terms of credit are determined
with credit policy:
(i) Credit Standards: It is necessary to establish credit standards that
gets used when choosing consumers for extending credit. Influence
of a specific standard on sales volume, firm’s overall bad debts,
and the cost of collection must be assessed.

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Notes (ii) Credit Terms: The credit terms outline the specifics of how the
credit will be made available, such as the duration of the credit
offer, the interest rate, and the default costs. Following are various
factors constituted in credit terms:
(a) Duration: The period of time during which consumers may
postpone payment will predominantly depend upon customary
practices prevalent in that particular industry and market.
Typically, the credit duration ranges from 3 to 60 days.
Extending the credit period boosts sales, whereas shortening
it has a diversionary impact. Changing the credit period policy
or deviating from conventional practices in the market must
be analyzed cautiously.
(b) Discount Policies: Customers are extended a cash discount to
encourage them to make payments on time. 3/10, 2/20, net
30 refers to a monetary discount of 3% if payment is made
within 10 days, a discount of 2% if payment is made within
20 days, and a full payment requirement of 30% if payment
is not made within 30 days of the sale date. When a business
gives a cash discount, it wants to strengthen its financial
position by accelerating the flow of cash into the business.
The duration of the cash discount impacts the cash conversion
cycle.
(c) Cost of Discount: The cost of discount offered must be
compared to the cost of funding. For instance if a company’s
usual collection time is 30 days, one way to shorten that
time is to give a cash discount of 2% if the payment is made
within 10 days. A customer with a Rs. 10000 balance who was
paying in 30 days now receives the 2% discount and makes
their payment of Rs. 9800 on the tenth day. As a result, the
company will have Rs. 9800 for 20 days (or 30 - 10), and the
price is 200. The following formula can be used to determine
the discount’s annual cost:

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 WORKING CAPITAL MANAGEMENT

200 365 Notes

Cost of discount = × × 100 = 27.24%
9800 20
37.24% is the annual cost of discount which should be measured and
assessed against the cost of raising funds. The formula may be standardized
as follows:
Discount % 365
Annualized Cost of discount = × × 100
100 – 'LVFRXQW % &UHGLW SHULRG – 'LVFRXQW SHULRG
Increasing the discount rate for the same payment period or keeping it
constant for a longer payment period is liberalizing the discount rate
which will improve cash sales.
Credit Evaluation & Control
Before extending credit to customers, it is important to take note of their
solvency and liquidity position. Collecting the right data and analysis of
it will constitute credit evaluation. Bank statements, reports by credit
rating agencies, credit ranking scores provided on recently issued fixed
income securities can be used to assess creditworthiness of customer.
After gathering all relevant credit data, it is necessary to analyze it in
order to draw a conclusion about the creditworthiness of a potential
consumer. The well-known “five C’s” of credit are: Character, cashflow,
capital, collateral and conditions in the economy. These traits can shed
light on the customer’s or default risk. The default risk may be used for
pricing the credit extended.
Ratio Analysis: Credit Monitoring constitutes analysing key financial
ratios like Gross profit ratio, Net profit ratio, Current ratio, Quick ratio,
Stock turnover ratio, Net worth, Asset turnover, Current asset turnover,
Working capital turnover, Fixed asset turnover, Debt-Equity ratio, Debt
service coverage ratio etc.
Controlling receivables after extending credit is imperative. Average collection
period may be calculated to monitor receivables. The average collection
period is the length of time it takes for a company to obtain accounts
receivable payments due from its clients. To make sure companies have
enough cash on hand to cover their financial responsibilities, businesses
employ the average collection period. For businesses that largely rely
on receivables for their cash flows, the average collection period is a
crucial number since it shows how well a company manages its accounts
receivable. In general, a shorter average collecting time is preferable

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 MBAFT 6204 CORPORATE FINANCE

Notes to a longer one. An organization’s ability to collect money quickly is

indicated by a low average collection period. This could indicate that
the company’s loan terms are excessively stringent, too.
Average Collection Period = 365 × (Average Accounts Receivables/Net
Credit Sales)
Firm may analyse their trend in receivables by computing average
collection period periodically.
Factoring Services
It is evident that a source of liquidity is required because the firm’s
finances are being blocked by its accounts receivable. The cost of
discomfort involved with calling each individual debtor is another factor
in the cost of collecting receivables, in addition to the delay between the
date of sale and the date of receipt of dues. In a financial transaction
known as factoring, a company sells its accounts receivable—that is, its
invoices—to a third party (referred to as a factor) at a discount. A factor
is a middleman who buys firms’ receivables in order to supply them with
cash. In essence, a factor is a source of capital that consents to pay the
business the amount of an invoice less a discount for commission and
other costs. By selling their receivables in exchange for a cash infusion
from the factoring company, businesses can better meet their short-term
liquidity demands. A factoring fee is the sum that the factoring business
charges and deducts from firm’s invoice to cover the cost of the factoring
service. Rates are established based on how long an invoice is outstanding.
The fee varies amongst factoring providers and is based on a number
of factors, including the industry, creditworthiness and invoice amount.
As a result, factoring serves only as a stand-in for internal receivables
management.
Forfaiting Services
Forfaiting is a form of financing of receivables pertaining to international
trade. It denotes the purchase of trade bills/ promissory notes by a bank/
financial institution without recourse to the seller. The purchase is in the
form of discounting the documents covering entire risk of non-payment
in collection. All risks and collection problems are fully the responsibility
of the purchaser (forfeiter) who pays cash to seller after discounting the

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 WORKING CAPITAL MANAGEMENT

bills/notes. The salient features of forfaiting as a form of export relating Notes

financing are as under:
(i) On a basis of deferred payment, the exporter sells and delivers items
to the importer.
(ii) In order to pay the exporter, including interest, the importer executes
a series of promissory notes in their favour.
(iii) The exporter receives the bills or notes. The bank that backs the
promissory notes or bills may or may not be the bank of the importer.
An Aval, which is a bank’s endorsement ensuring importer payment,
is what the guarantee by the bank is known as.
(iv) The exporter and a forfeiter, often a reputable bank, enter into a
forfaiting arrangement. The exporter sells the availed notes/bills to
the bank at a discount without recours and receives the payment.
(v) The forfeiter may keep these notes or bills until they are paid in
full by the bank of the importer.
Factoring v/s Forfaiting
Cross-border factoring and forfaiting are comparable to the extent that
they both share the traits of non-recourse and advance payment. But,
they are different in a number of crucial ways:
(a) The factor funds between 75% and 85% of the note’s or bill’s
value and preserves a factor reserve that is paid upon maturity. The
forfeiter discounts the entire note’s or bill’s value.
(b) Under the forfaiting arrangement, the avalling bank’s unconditional
and irrevocable guarantee plays a crucial role, whereas in a financing
agreement, especially one of the non-recourse variety, the export
factor bases his credit judgment on the exporter’s credit standards.
(c) While factoring also includes ledger management, collection and
other services, forfaiting is a pure financial transaction.
(d) In essence, factoring is a form of short-term finance. Finance notes
and invoices that result from deferred credit transactions that span
three to five years are forfaited.
(e) A forfeiter charges a premium for this risk; a factor does not protect
against variations in exchange rates.

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 MBAFT 6204 CORPORATE FINANCE

Notes Inventory Management

The company’s inventory refers to and comprises both the products and
services that are currently being sold by the company as well as the raw
materials and other parts that are utilised to produce those products and
services. A retail store owner maintains a stock of finished goods that are
available to customers upon request. On the other hand, a manufacturing
company must maintain a stockpile of all the physical components utilised
in the production process in addition to the finished goods they are making.
Each company keeps a certain amount of raw materials, work-in-progress
and finished goods on hand, based on the needs of the business and other
factors. Having inventory benefits it, without a question, but there are also
costs associated with keeping inventory. Without these expenses, there
would have been no inventory management issues and every company
would have kept a higher and higher amount of stocks. Costs associated
with holding inventory include storage cost, financing cost and cost of
placing order for raw material.
A fundamental trade-off between risk and return must be made when
investing in inventories, just like it is when choosing other current
assets. The danger is that the various business processes won’t work
independently if the inventory level is too low. The savings from lower
inventory levels cause the return. Storage and other expenses expand
together with the amount of the inventory. As a result, when inventory
levels rise, the danger of running out of stock declines while the cost of
maintaining inventory rises.
One of the widely used techniques deployed for inventory management
is “Economic Order Quantity Model”.
Economic Order Quantity Model
The finance manager must find solutions to the order quantity problem and
the order point problem, two interrelated challenges, in order to manage
the investment in inventory. In order to reduce the expenses associated
with various inventory levels, inventory management primarily focuses on
maintaining an ideal level of inventory. The amount of units purchased in
a single lot and the rate at which those units are used or sold determine
the average level of inventory, in large part. With careful consideration
of the quantity ordered, the carrying cost of the average level and the
yearly demand, entity can optimize investment in inventory.

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 WORKING CAPITAL MANAGEMENT

The Economic Order Quantity (EOQ) methodology aims to identify the Notes
orders’ minimum total cost of inventory. It is predicated on the idea that
total inventory cost equals total carrying cost plus total ordering cost.
The EOQ model is based on the following assumptions:
(a) The total usage of a particular item for a given period (usually
a year) is known with certainty and that the usage rate is even
throughout the period.
(b) That there is no time gap between placing an order and getting its
supply.
(c) The cost per order of an item is constant and the cost of carrying
inventory is also fixed and is given as a percentage of average
value of inventory.
(d) That there are only two costs associated with the inventory, and
these are the cost of ordering and the cost of carrying the inventory.
Given the above assumption, the EOQ model may be presented as follows:
2AO
(24 =
c
where, EOQ = Economic quantity per order. A = Total Annual requirement
for the item.
O = Ordering cost per order of that item.
C = Carrying cost per unit per annum.
The total ordering cost for any particular item is decreasing as the size
per order is increasing. This will happen because with the increase in
size of the order, the total number of orders for a particular item will
decrease resulting in decrease in the total order cost. The total annual
carrying cost is increasing with the increase in order size. This will
happen because the firm would be keeping more and more items in the
stores. However, the total cost of inventory (i.e., the total carrying cost
+ the total ordering cost) initially reduces with the increase in size of
order but then increases with the increase in size of order. The trade-off
of these two costs is attained at the level at which the total annual cost
is the least. At this particular level, the order size is designated as the
economic order quantity. If the firm places the orders for that item of
this economic order quantity, then the total annual cost of inventory of
that item will be minimized.

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 MBAFT 6204 CORPORATE FINANCE

Notes ABC Analysis

There are other inventory management techniques including ABC Analysis.
The ABC analysis classifies various inventory items into three sets or
groups of priority and allocates managerial efforts in proportion of the
priority. The most important items are classified as class A, those of
intermediate importance are classified as class B and the remaining items
are classified as class C. The financial manager should monitor different
items belonging to different groups in that order of priority. Utmost
attention is required for class A item, followed by items in class B and
then items in class C. Different items are given priority order on the
basis of total value of annual consumption. Item with the highest value
is given top priority and so on. The annual consumption value of all the
items, already arranged in priority order, are then shown in cumulative
terms for each and every item. Thereafter, the running cumulative totals
of annual value of consumption are expressed as a percentage of total
value of consumption. 7KH EDVLF SUHPLVH RI $%& DQDO\VLV LV WKDW HYHU\
VLQJOHLWHPLQDQLQYHQWRU\GRHVQ¶WKDYHHTXDOYDOXHDQGGHPDQG±VRPH
LWHPVFRVWPXFKPRUHWKDQRWKHUV,QFRQWUDVWVRPHLWHPVDUHXVHGPRUH
IUHTXHQWO\ DQG WKH UHPDLQLQJ DUH D PL[ RI ERWK

IN-TEXT QUESTIONS
10. Creditors turnover ratio may be worked out with the help of
following formula:
(a) Purchases/Trade Payables
(b) (Credit Purchases/Trade Payables) × 365
(c) (Trade Payables/Purchases) × 365
(d) Trade Payables/Purchases
11. Increasing volume of receivables without matching increase in
sales is reflected by:
(a) A low Receivables turnover ratio
(b) A high Receivables turnover ratio
(c) A high creditors turnover ratio
(d) A low creditors turnover ratio

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9.8 Summary Notes

Working capital can refer to either gross working capital, which is the
sum of all current assets, or net working capital, which is the difference
between current assets and liabilities. The amount of working capital a
company needs to operate depends on a number of variables, including
the business’ operating cycle, nature, seasonality, business cycle changes,
competitiveness in the market, credit policy, supplier conditions, etc.
According to the Hedging Approach, long-term financing should be used
for permanent requirements while short-term financing should be used for
temporary requirements. The Conservative Approach, on the other hand,
recommends funding the need for working capital in the first instance
from long-term sources. According to the Aggressive Approach, even a
small portion of a permanent requirement financed with current assets.
In a larger sense, cash management relates to controlling cash and bank
balances as well as controlling cash inflows and outflows banking for
concentration. Float management and the lock box system are two methods
for controlling the flow of cash. The ideal quantity of cash on hand is
the level that the business should be at to minimise the cost of keeping
cash on hand. The ideal cash balance provided by Baumol’s model tries
to reduce the overall cost of retaining cash. According to the Miller-Orr
model, a company should keep its cash balance between a lower and
upper limit. Receivable Management involves compromising a balance
between liberal and stringent credit policy through a careful evaluation.
Formulating credit standards, terms of extending credit and developing
collection policy is all part of receivables management.

9.9 Answers to In-Text Questions

1. (d) All of the above

2. (b) Long-term funds have been used for current assets
3. (d) Liquidity & Profitability
4. (c) Total Current Assets
5. (c) High Liquidity
6. True
7. (d) Increasing credit period from suppliers

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 MBAFT 6204 CORPORATE FINANCE

Notes 8. (a) GOC - DP

9. (c) 35 days
10. (b) (Credit Purchases/Trade Payables) × 365
11. (a) A low Receivables turnover ratio

9.10 Self-Assessment Questions

1. Calculate the Operating cycle from the following figures related to
Y company:
Particulars Average amount Average value
Outstanding per day
Raw Material inventory 1,80,000
Work-in-progress inventory 96,000
Finished goods inventory 1,20,000
Debtors 1,50,000
Creditors 1,00,000
Purchase of Raw Material 2,500
Cost of Sales 4,000
Sales 5,000.
2. The annual cash requirement of B Ltd. is Rs. 10 Lakhs. The company
has marketable securities in lot sizes of Rs. 50,000, Rs. 1,00,000,
Rs. 2,00,000, Rs. 2,50,000 and Rs. 5,00,000. Cost of conversion of
marketable securities per lot is Rs. 1,000. The company can earn
5% annual yield on its securities. You are required to prepare a
table indicating which lot size will have to be sold by the company.
Also calculate the economic lot size can be obtained by the Baumal
Model.
3. How would you describe the seasonal industry’s working capital
needs, where you have been appointed finance manager? Use the
example to support your response.
4. “Efficient cash management will aim at maximizing the availability
of cash inflows by decentralizing collections and decelerating cash
outflows by centralizing the disbursements”? Discuss and explain.

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5. Stapler Ltd. receives cash at gradual and steady rate of 3,50,000 Notes
p.a. The cash can be invested by the company to give a return of
12% p.a. However, every time, it invests, it has to meet transaction
expenses of 50 plus 1% brokerage of the amount invested. Another
investment broker has approach the company to take up the investment
work. He has offered to charge 100 per transaction plus 0.8% of
the amount invested. Should the company accept the offer?
6. A company believes that it is possible to increase sales if credit
terms are relaxed. The profit plan, based on the old credit terms,
envisages projected sales at 10,00,000, a 30 per cent profit-volume
ratio, fixed cost at 50,000, bad debts of 1.00 per cent and an accounts
receivable turnover ratio of 10 times. The relaxed credit policy is
expected to increase sales to 12,00,000. However, bad debts will rise
to 2 per cent of sales, the accounts receivable turnover ratio will
be decreased to 6 times. Should the company adopt new (relaxed)
credit policy, assuming the company’s target rate of return is 20
per cent.
7. A company is currently engaged in the business of manufacturing
computer component. The computer component is currently sold for
1,000 and its variable cost is 800. For the year ended, the company
sold on an average 500 components per month. Presently company
grants one month credit to its customers. The company is thinking
of extending the credit to two months on account of which the
following is expected: Increase in Sales : 25 per cent Increase in
Stock : 2,00,000 Increase in Creditors : 1,00,000 You are required
to advise the company whether or not to extend the credit terms.
If all customers avail the credit period of two months. Company
expects a minimum return of 40% on investment.
8. ABC Ltd. is examining the question of relaxing its credit policy. It
sells at present 20,000 units at a price of 100 per unit, the variable
cost per unit is 88 and average cost per unit at the current sales
volume is 92. All the sales are on credit, the average collection period
being 36 days. A relaxed credit policy is expected to increase sales
by 10% and the average age of receivables to 60 days. Assuming
15% return, should the firm relax its credit policy?

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Notes 9.11 References

‹ Pandey, I.M. (2006). )LQDQFLDO0DQDJHPHQW Vikas Publishing House
Pvt. Ltd.
‹ Khan, M.Y. and Jain P.K. Financial Management: Text and Problems.
Tata McGraw Hill.
‹ Rustagi, R.P., Fundamentals of Financial Management, Taxmann,
New Delhi.
‹ Chandra, P. Financial Management-Theory and Practice, Tata McGraw
Hill.

9.12 Suggested Readings

‹ Pandey, I.M. (2006).)LQDQFLDO0DQDJHPHQWVikas Publishing House
Pvt. Ltd. - Ninth Edition.
‹ Rustagi, R.P., )XQGDPHQWDOV RI )LQDQFLDO 0DQDJHPHQW Taxmann,
New Delhi.
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House Ltd., New Delhi. Tripathi, Vanita,%DVLF)LQDQFLDO0DQDJHPHQW
Taxmann Publications.
‹ K.V. Smith- 0DQDJHPHQW RI :RUNLQJ &DSLWDO McGraw-Hill New
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 Glossary
Accounts Payable: An account in the general ledger known as “Accounts Payable” denotes
a business’ responsibility to settle a recent debt with one of its suppliers or creditors.
Accounts Receivables: The balance of money owed to a business for goods or services
delivered or utilised but not yet paid for by clients is known as accounts receivable (AR).
On the balance sheet, accounts receivable is shown as a current asset. Any money that
customers owe for purchases they made using credit is known as AR.
Agency Costs: These are the costs associated with monitoring and controlling managers
who may not act in the best interest of shareholders.
Asset Turnover: The asset turnover ratio measures the value of a company’s sales or
revenues relative to the value of its assets. The asset turnover ratio can be used as an
indicator of the efficiency with which a company is using its assets to generate revenue.
Bankruptcy: Bankruptcy is a legal proceeding initiated when a person or business is
unable to repay outstanding debts or obligations. It offers a fresh start for people who
can no longer afford to pay their bills.
Beta: ȕ  LV D PHDVXUH WR FRPSDUH YRODWLOLW\ RI DQ\ ILQDQFLDO DVVHWV UHWXUQ WR WKH UHWXUQV
of a diversified portfolio.
Bills of Exchange: A bill of exchange is a written document that binds one party to pay
another party a specific amount of money on demand or at a specific date. It is most
commonly used in international trade.
Bird-in-the-hand Theory: It states that investors prefer a current dividend to a future
capital gain. Therefore companies that pay higher dividends will have a higher stock price.
Capital Structure: It is proportion of equity capital and debt in total capital of firm.
Cash Flow: The net quantity of cash and cash flow are referred to as cash flow. Equivalents
moving in and out of a business. Money spent and money received reflect inflows and
outflows, respectively. Fundamentally, a company’s capacity to produce positive cash
flows, or more specifically, its capacity to optimise long-term free cash flow, determines
its ability to create value for shareholders (FCF). FCF is the cash a company generates
from its regular business activities after deducting any funds used for capital expenditures.
Clientele Effect: The idea that companies attract a particular type of investor based on
their dividend policy and that changing the policy can result in a change in the composition
of the company’s investor base.

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 MBAFT 6204 CORPORATE FINANCE

Notes Cost of Capital: It is the discount rate used to figure out the present
value of the expected future cash flows.
Cost of Debt before Tax: It is the return to debt investors.
Cost of Equity: It is the return expected by equity shareholders.
Customer: A company or organisation that owes money on an invoice
that the factor (i.e., the client’s customers) purchased is known as a
customer or account debtor.
Debt Service Coverage Ratio: It is a measurement of a firm’s available
cash flow to pay current debt obligations. The DSCR shows investors
whether a company has enough income to pay its debts.
Dividend: A portion of a company’s profits paid to shareholders.
Dividend Irrelevance: The idea that a company’s dividend policy has
no impact on its stock price and that investors are indifferent to whether
a company pays dividends or not.
Dividend Relevance: The idea that a company’s dividend policy impacts its
stock price and that investors prefer companies that pay higher dividends.
Dividend Yield: A financial ratio that measures the amount of dividends
paid relative to a company’s stock price.
EBIT: Earnings Before Interest and Taxes (EBIT), is a measure of how
profitable a business is. Revenue less costs, excluding taxes and interest,
is the formula for calculating EBIT. Operating earnings, operating profit
and profit before interest and taxes are other names for EBIT.
EPS: The measure of a company’s profitability per share of its stock is
its Earnings per share (EPS). EPS might be reduced by issuing additional
shares through secondary offerings, convertible instruments, or employee
stock options.
Fixed Asset Turnover: Fixed Asset Turnover (FAT) is an efficiency ratio
that indicates how well or efficiently a business uses fixed assets to
generate sales. This ratio divides net sales by net fixed assets, calculated
over an annual period.
Historical Weights: These are the existing proportion of sources of capital.
Information Content of Dividends: A company’s dividend policy contains
information about its prospects, which can affect its stock price.

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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 GLOSSARY

Levered Firm: Firm which uses debt in its capital structure is said Notes
levered firm.
Marginal Cost of Capital: It is cost of raising one extra unit of capital.
Marginal Weights: These are the proportion of new funds being raised.
Modigliani-Miller Theorem (MM Theorem): A theory that states that
a company’s dividend policy is irrelevant in a perfect capital market and
that the market will correctly value a company regardless of whether it
pays dividends or not.
Net Worth: A person’s or company’s net worth is the value of their
assets less the amount of obligations they have. It is a crucial indicator
for assessing a company’s health because it offers a helpful overview of
its present financial situation.
Overall Cost of Capital: It is the weighted average cost of each individual
source of finance.
Payout Ratio: The proportion of a company’s earnings paid out as
dividends.
Profit Volume: (P/V) Ratio measures the rate at which profit fluctuates
in response to changes in sales volume. It is one of the crucial ratios
for determining profitability because it shows the contribution made in
relation to sales.
Retention Ratio: The proportion of a company’s earnings that are not paid
out as dividends but are instead retained for reinvestment in the business.
Return on Investment: (RoI) is a performance metric used to assess an
investment’s effectiveness or profitability or to compare the effectiveness
of several investments. RoI aims to quantify the amount of return on a
specific investment in relation to the cost of the investment.
Risk Free Rate: It is taken as return on government securities.
Share Buy-Back: A process where a company repurchases its shares,
reducing the number of outstanding shares and increasing the value of
remaining shares.
Signaling Effect: The idea that a company’s dividend policy sends a
signal to the market about its financial health.

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 MBAFT 6204 CORPORATE FINANCE

Notes Unlevered Firm: Firm which does not uses debt in its capital structure
is said levered firm.
WACC: It is the weighted average cost (overall cost of capital) of all
sources of long-term capital employed by the firm.
Walter’s Model: A theory that states that the dividend policy of a company
has an impact on its stock price, but only under certain conditions, such
as the presence of taxes and transaction costs.
Working Capital Turnover: A ratio called working capital turnover
assesses how well a business uses its working capital to promote sales
and expansion. Working capital turnover, also known as net sales to
working capital, gauges the connection between the resources utilised to
finance an organization’s operations and the revenues that organisation
generates to maintain operations and make a profit.

240 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi