Unit I

Nature of Financial Management

Financial management is concerned with the management of funds. It can be defined as the process of
acquisition & utilization of funds by an organization. It deals with the flow of funds in such a way that
the rate of return is maximized after due consideration of costs & risks. Financial Management is of
prime importance to an organization as a functional area since procurement of funds & its best
utilization is the key to the success of any business. The term Financial Management is of recent origin
& has gained significance in the present-day world. It has undergone fundamental changes in its scope
& coverage over the years.
Nature of Financial Management: Financial Management aims at the judicious use of resources to
maximize the returns. While taking financial management decisions, the following points are to be
considered:
• Evaluation of Financial Needs: The financial needs of the organization are to be evaluated both for
short term as well as long term. The financial plan determines the funds required for both fixed &
current assets.
• Determination of Capital Structure: Capital Structure refers to the proportion of debt & equity to
the total capital employed. The financial manager must take appropriate decisions with regard to the
use of debt & equity for short term & long-term requirements.
• Choosing an Appropriate Source of Finance: Once the capital structure is decided, the finance
manager must select an appropriate source of finance after a critical examination of costs & benefits.
The source selected should be able to maximize returns while minimizing risks & costs.
• Deciding the Pattern of Investment: On attainment of funds, the finance manager must decide how
& where to invest these funds. While taking these decisions, techniques such as capital budgeting,
opportunity costs etc. can be used.
• Effective Cash Management: Cash is required for several purposes & management of cash is a
vital function of financial management. In order to manage cash, a cash flow statement must be prepared
regularly.
• Exercising Financial Control: The finance manager can employ techniques such as return on
investment, ratio analysis etc. to control the finances. With the help of these devices, he can evaluate
the performance & take corrective action, if necessary.
• Effective Utilization of Surplus: The surplus realized must be effectively utilized to maximize the
shareholders wealth. Effective utilization of surplus leads to growth & development of the organization.
Relationship of Financial Management with other Branches: Financial Management is one of the
important aspects of overall management, which is directly related with various functional departments
like personnel, marketing and production. Financial Management covers a wide area with

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multidimensional approaches. The relationship of Financial Management with other disciplines can be
discussed as follows:
• Financial Management and Economics: Economic concepts like micro and macro-economics are
directly applied with the financial management approaches. Investment decisions, micro and macro
environmental factors are closely associated with the functions of financial manager. Financial
management also uses the economic equations like money value discount factor, economic order
quantity etc. Financial economics is one of the emerging areas, which provides immense opportunities
to finance and economic areas.
• Financial Management and Accounting: Accounting records includes the financial information of
the business concern. Hence, we can easily understand the relationship between the financial
management and accounting. In the olden days, both financial management and accounting were
treated as the same discipline and then it has been merged as Management Accounting because this part
is very much helpful to finance manager to take decisions. But nowadays, financial management and
accounting disciplines are separate but interrelated.
• Financial Management and Mathematics: Modern approaches of the financial
management applied large number of mathematical and statistical tools and techniques. They are also
called as econometrics. Economic Order Quantity, Discount Factor, Time Value of Money, Cost of
Capital, Capital Structure Theories, Dividend Theories, Ratio Analysis and Working Capital Analysis
are used as mathematical and statistical tools and techniques in the field of financial management.
• Financial Management and Production Management: Production management is the operational
part of the business concern, which helps to convert the money into profit. Profit of the concern depends
upon the production performance. Production performance needs finance, because production
department requires raw material, machinery, wages, operating expenses etc. These expenditures are
decided and estimated by the financial department and the finance manager allocates the appropriate
finance to production department. The finance manager must be aware of the operational process and
finance required for each process of production activities.
• Financial Management and Marketing: The produced goods are sold in the market with
innovative and modern approaches. For this, the marketing department needs finance to meet their
requirements. The finance manager or finance department is responsible to allocate the adequate finance
to the marketing department. Hence, marketing and financial management are interrelated and depends
on each other.
• Financial Management and Human Resource: Financial management is also related with human
resource department, which provides manpower to all the functional areas of the management. Financial
manager should carefully evaluate the requirement of manpower to each department and allocate the
finance to the human resource department as wages, salary, remuneration, commission, bonus, pension

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and other monetary benefits to the human resource department. Hence, financial management is directly
related with human resource management.

Scope of Financial Management: The scope of financial management can be discussed by two
approaches, namely - Traditional & Modern approach.
Traditional Approach: The traditional approach to financial management refers to the initial stages of
its evolution when it was referred to as Corporation Finance. It evolved during the 1920’s & lasted
till the 1950’s. The objective of corporation finance was the financing of the corporate enterprises. The
scope was limited as it was concerned only with the procurement of funds i.e., Raising of Funds. It
covered three interrelated aspects of raising & administering resources from outside, namely:
• The financial institutions which comprise the capital markets
• The financial instruments through which funds are raised from the capital markets & related aspects
of practices & procedures of capital markets
• The legal & accounting relationship between a firm & its sources of funds
Criticisms of the Traditional Approach:
• It had an outsider-looking-in approach rather than the insider-looking-out approach. It means
that it considered the viewpoint of external agencies such as investors, investment bankers etc. who
are outsiders. It implies that no consideration is given to the viewpoint of those who had to take these
decisions i.e., the insiders. The limitation was that the internal decision making was completely
ignored.
• It focused primarily on the financing of the corporate enterprises thereby ignoring the non-corporate
organizations. These non-corporate enterprises are an important aspect of any economy.
• Importance was given to long term financing thereby ignoring the working capital management
which is equally important. It is said that short term success is a pre-requisite for long term success.
• It was concerned only with the procurement of funds & did not consider the important aspect of
allocation or utilization of resources.
• The traditional approach was built around episodic events such as mergers, amalgamations etc.
which were rare occurrences. Logically, the day-to-day financial issues should have been
considered.
Therefore, the traditional approach implied a very narrow scope for financial management & was
replaced by the modern approach
Modern Approach: The modern approach to financial management is broader as it provides a
conceptual & analytical framework for decision making. According to this approach, financial
management involves both acquisition as well as allocation of funds. Along with the raising of funds,
the objective of financial management is the efficient & wise allocation of funds. The modern approach
focuses on:
• How large should an enterprise be?

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 • In what form should it hold its assets?
• What should be the composition of its liabilities?
The three questions given covered between them the major financial problems of a firm. It means that
financial management is concerned with the solutions of three major problems relating to the financial
operations of a firm – Investment Decision, Financing Decision & Dividend Decision.
Investment decision: The investment decision refers to the selection of assets in which the funds will
be invested by a firm. The assets can be either long term assets which earn revenue over a period of
time or short term / current assets which can be converted into cash in a short period. In other words,
these are referred to as Capital Budgeting & Working Capital Management.
• Capital Budgeting: It is the most crucial financial decision for a firm. The first aspect of capital
budgeting decision relates to the choice of the new asset out of the alternatives available or the
reallocation of capital if the existing asset fails to justify the funds committed. The second aspect is
the analysis of risks & uncertainties. Lastly, the evaluation of the capital budgeting decision which
implies the cost of capital.
• Working Capital Management: It is concerned with the management of current assets i.e. Cash,
Inventory & Receivables. It is an integral part of financial management as short term survival is a
prerequisite for long term success. One aspect of working capital management is the trade-off
between profitability & liquidity. In addition to this, the individual current assets are to be managed
efficiently such that neither inadequate nor unnecessary funds are locked up.
Financing Decision: Financing decision refers to determining the Financing-Mix, Capital Structure
or Leverage. Capital Structure refers to the proportion of debt & equity capital to the total capital
employed by the firm. The financing decision of the firm relates to the choice of the proportion of these
sources to finance the investment requirement. The first aspect of the financing decision is the theory
of capital structure shows a theoretical relationship between the use of debt & the return to shareholders.
The use of debt implies a higher return to the shareholders as well as a financial risk. Therefore, a
balance between debt & equity is necessary to ensure a trade-off between risk & return to shareholders.
A capital structure with a reasonable proportion of debt & equity capital is called the Optimum Capital
Structure.
Dividend Decision: The third major decision of financial management is the dividend decision. The
dividend should be analysed in relation to the financing decision. The alternatives available to the firm
with regards to profits are that they can either be distributed among the shareholders or retained in the
business. This depends up on the dividend pay-out ratio i.e. what proportion of net profits should be
paid to the shareholders as dividend. The firm should strike a balance between declaring dividend &
retaining earnings as it has an impact on the market value of shares & its liquidity position.

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Thus, the modern approach has broadened the scope of financial management which involves the
solutions of three major decisions namely, investment, financing & dividend. These are interrelated &
should be jointly taken so that the financial decision making is optimal.
Objectives of Financial Management: The objectives of financial management provide a framework
for optimum financial decision making. They are concerned with designing a method of operating
internal investment & financing of a firm. It is generally accepted that the financial objective of the firm
is to maximize the owner’s economic welfare. The two widely discussed approaches are profit
maximization & wealth maximization approach.
Profit Maximization Approach: The profit maximization criterion implies that the investment,
financing & dividend decisions of a firm should be oriented to the maximization of profits. According
to this approach, actions that increase profits should be under taken & those that decrease profit should
be avoided. Profits can be maximized either by increasing the output or decreasing the cost. In other
words, profits can be maximized by the efficient use of scarce resources. The rationale behind profit
maximization is that profit is a test of economic efficiency. It provides a yardstick by which economic
performance can be judged. It also leads to the efficient allocation of resources. It ensures maximum
social welfare. Financial management is concerned with the efficient use of capital. Therefore, profit
maximization should be the criterion for financial management decisions.
However, it had the following limitations:
- Ambiguity: Profit maximization leads to ambiguity as the term Profit is vague & varies depending
on the accounting principles applied. It is also amenable to different interpretations by different people.
- Timing of Benefits: It ignores the timing of the benefits. While calculating the profitability, the
bigger the better principle is adopted, as the decision is based on the total benefits received over the
whole life, irrespective of when they were received.
- Quality of Benefits: The most important technical limitation of profit maximization is that is
ignores the quality aspect of the benefits associated with the financial course of action. The term quality
refers to the degree of certainty with which the benefits can be expected. Therefore, the problem of
uncertainty renders the profit maximization unsuitable as an operational criterion for financial
management as it considers only the size of benefits & gives no weight age to the degree of uncertainty
of the future benefits.
Wealth Maximization Approach: It is also known as Value Maximization or Net Present Worth
Maximization. Value Maximization is universally accepted as an appropriate operational decision
criterion for financial management decisions as it removes all the limitations of the profit maximization
criterion. It satisfies all the three requirements – exactness, quality of benefits & the time value of
money. Under this method, the Net Present Value or Wealth of a course of action is to be maximized.
The net present value is the difference between the gross present value of the benefits of that action &
the investment required to achieve those benefits. On the other hand, the gross present value of the same
is determined by discounting / capitalizing its benefits at a rate which reflects their timing & uncertainty.

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The wealth maximization criterion is based on the concept of cash flows generated by the decision
rather than the accounting profit. Measuring benefits in terms of cash flows avoids the ambiguity
associated with the accounting profits. Another important feature of wealth maximization is that it
considers both the quantity & quality of benefits as it incorporates the time value of money. The value
of a stream of future cash flows must consider, along with the expected value of flows, their degree of
uncertainty. It means that necessary adjustments must be made in the cash flow pattern in order to
incorporate the risk & also make an allowance for differences in the timing of benefits.
It is clear that the net present value maximization criterion is superior to the profit maximization
criterion as an operational objective. The value maximization decision criterion involves a comparison
of value to cost. An action that has a discounted value, reflecting both time & risk exceeds its cost can
be said to create value. Such actions should be undertaken. Conversely, actions with values less than
cost reduce the value of the firm & should be rejected. In case of mutually exclusive alternatives, when
only one is to be chosen, the alternative with the greatest net present value should be selected.
Differences between Profit Maximization & Wealth Maximization
Profit Maximization Wealth Maximization
The primary objective is maximization of profit The primary objective is maximization of wealth
It considers accounting profit It considers cash flows
Profit is vague & subject to different Cash Flow is clear & precise
interpretation
It considers only the quantity of benefits It considers both the quantity & quality of
benefits
It is based on the principle the bigger the better It is based on the principle the earlier the better
It takes into account the total benefits rec’d, It considers the timing of the benefit along with
irrespective of when it is rec’d the volume
It does not consider the time value of money It considers the time value of money as cash flows
are discounted at a rate that reflects both risk &
time
There is no balance between risk & return It strikes a balance between risk & return
Decisions are based on the amount of return Decisions are based on the comparison of costs &
benefits

Conflict of Goal between Management & Owners: Agency Problem – A characteristic feature of
corporate enterprise is the separation between ownership & management. The shareholders are owners
of the company whereas management is by the Board of Directors, elected by the shareholders. The
management is entrusted with the responsibility of the day-to-day management of the company.
Therefore, the management enjoys substantial autonomy in regard to the affairs of the firm. With widely

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diffused ownership, scattered & ill-organized shareholders hardly exercise any control on management
which may be inclined to act in its own interests rather than those of the owners. However, as owners,
the shareholders have a right to change the management. Due to the threat of being dislodged for poor
performance, the management would have a natural inclination to achieve a minimum acceptable level
of performance. This would fulfil the shareholders requirements while focusing on their personal goals.
However, the conflicting goals of management objective of survival & maximizing owner’s wealth can
be harmonized by the provision of appropriate incentives & monitoring of agents.
• Incentives to Agents: The managers can be given incentives in different forms such as stock options,
performance shares, cash bonus & perquisites. Stock options include conferring the right to acquire
shares of the enterprise at a special / concessional price. A performance incentive could be issue of
shares based on the performance of management as reflected in the rate of return & cash incentives
linked to performance targets.
• Monitoring of Agents: Monitoring of agents can be done by:
- Bonding the agent i.e., the enterprise obtains a fidelity bond from the managers stating that they will
be liable in case of losses caused due to the dishonest acts of the managers
- Auditing financial statements & limiting decision making by the management. The audit & control
procedures & limiting managerial decisions are intended to ensure that the actions of the
management further the interests of the shareholders.
The above-mentioned policies to mitigate the agency problems involve cost. But it is the price that the
owners have to pay to harmonize the conflicting goals between them & the management of the
enterprise.
Organization of Finance Function: The responsibilities for financial management are spread
throughout the organization in the sense that financial management is an integral part of the job for
managers involved in planning, allocation of resources & control. Nevertheless, financial management
is highly specialized in nature & is handled by specialists. Financial decisions are of crucial importance.
It is therefore essential to set up an efficient organization for financial management functions.
As finance is a functional area, the ultimate responsibility for carrying out financial management
functions lie with the top management i.e., the Board of Directors / Managing Director / Chief Executive
Officer / or a Committee of the Board. However, the exact nature of the organization of the financial
management function varies from organization to organization depending on a number of factors such
as size & nature of the firm, type of financial operations, financial policy of the firm etc. Similarly, the
designation may also change from firm to firm.
The following figure gives the organization of the financial management function in a large typical
firm:

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 Board of Directors

Managing Director / Chairman

Vice President / Director (Finance)

Treasurer Controller

Organization of Finance Function: The job of the chief financial executive does not only cover routine
aspects of finance and accounting but he is also closely associated with the formulation of policies as
well as decision making. Under him are controllers & treasurers. The tasks of financial management &
allied areas like accounting are distributed between these two key financial officers whose functions are
as follows:
Treasurer: The main concern of the treasurer is with the financing, investment & dividend decisions
of the concern. His range of functions includes the following:
• Financial Planning: He is primarily concerned with the preparation of financial plans. To fulfill
this responsibility, he has to prepare investment programs, forecast borrowing requirements,
estimate cash flows & advise on dividend policy
• Management of cash: The treasure has to manage the bank accounts & deposits of the company.
He has to keep a record of cash receipts & payments
• Management of Credit: It includes determination of credit policy & credit limits of customers. He
has to ensure efficient management of receivables including trade discounts & credit terms
• Negotiations: The Treasurer estimates the long term borrowing needs of the organization &
negotiates with the banks & other financial institutions for raising the required finance. He also
manages the timely payments of interest & principal to the various lenders
• Authorized Signatory: The Treasurer acts as the authorized signatory on behalf of the organization
& signs on documents such as cheques, bill etc.
• Security: He is responsible for the safe custody of funds, assets & securities of the firm.
Controller: The functions of the controller are mainly related to accounting & control. The typical
functions performed by him are as follows:
• Accounting functions: He has to maintain the books of accounts. He also determines the various
procedures to be followed while maintaining the books of accounts.

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• Planning for Control: The Controller prepares a plan for effective control which is a part of the
overall management function
• Evaluating the performance & taking corrective action: The Controller measures the actual
performance with that of the plans to ensure that the plans are being implemented. He also initiates
corrective action, wherever necessary.
• Tax Administration: Financial Controller is also responsible for preparation & filing of tax returns
on behalf of the organization. He also advises the management on tax saving measures.
• Audit: Internal audit & control functions are an integral part of the Controller’s functions
• Liaison with Government: The Financial Controller has to ensure that the firm is abiding by all the
rules & laws that it is subject to. He also has to submit to the govt. the various statements as required
by law.

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 List of Questions

Short Answer Questions – 4 Marks

1. Define Financial Management

2. Investment Decision

3. Dividend Decision

4. Financing Decision

5. Traditional approach to the scope of financial management.

6. Differentiate between profit maximization & wealth maximization

Essay Questions – 12 Marks

1. Explain in detail the nature & scope of financial management

2. Define financial management. Discuss its relationship with other disciplines.

3. What are the objectives of financial management?

4. Write a note on the conflict of goal between management & owners

5. What is the organization of the finance function?

Assignment Question

1. Discuss the objectives of Financial Management.

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 Unit II
Time Value of Money
The wealth maximization objective of financial management is superior to the profit maximization as
it incorporates the time value of money. Any financial decision taken today has implications in the
future as the benefits are received in future. A financial decision involves cash outflows in the form of
payments to vendors or investment in assets / projects. Similarly, it receives cash inflows as return on
the investment. It is on the comparison of the cash outflows & cash inflows that financial decisions are
based. In order to have a logical & meaningful comparison between cash flows that accrue in different
time periods, it is necessary to convert them to a common point of time. This is referred to as the Time
Value of Money or Time Preference for Money.
The value of money changes with time. It means that the value of a unit of money is different in different
time periods. The value of a sum of money received today is more than its value received in future. In
other words, the sum of money received in future is less valuable than it is today. The main reason for
time preference for money is to be found in the reinvestment opportunities for funds which are received
earlier. It is expressed in terms of a rate of return, popularly known as the discount rate. The expected
rate of return as also the time value of money will vary from individual to individual depending on his
needs & preferences. In other words, the reasons for time preference for money are risk, preference for
consumption & investment opportunities
Risk: Any money to be received in future is subject to a lot of uncertainties. Therefore, it is risky. There
is no guarantee that the money will be received or not as it involves risk
Preference for Consumption: Many individuals or firms prefer to consume today rather than wait for
the future. Therefore, there is time value for money.
Investment Opportunities: The money that is received today can be re-invested so as to earn return
on it. It means that the investment made today will definitely earn returns greater than its present value.
Similarly, business firms also make decisions having long term financial implications. The capital
budgeting decision generally involves the current cash outflows in terms of the amount required to
purchase a new machine or launch a new project & the execution of the scheme generates future cash
inflows during its useful life. Thus, time value of money is of crucial significance. There are several
techniques to evaluate the time value of money such as the Compounding & the Discounting
Technique.
Compounding / Future Value Technique: Future Value refers to the value of an asset or cash at a
particular date in the future which is equivalent to the value of a specified sum at present. Using this
technique, we can find out the future value of a certain sum of money. Interest is compounded when
the amount earned as interest on the initial deposit is re-invested i.e. the interest becomes a part of the
principal at the end of the compounding period. This procedure can continue for an indefinite number
of years. The compounding of interest can be calculated as:

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 A = P (1 + i) n
Where: A = Amount at the end of the period
P = Principal at the beginning of the period
i = Rate of interest
n = Number of years
This is the fundamental equation of compound interest. This formula can be readily applied for wide
ranges of i & n. However, calculations will become tedious & time consuming if the number of years
involved is large. In order to simplify the compound interest calculations, compound interest tables for
values (1+i)n for wide ranges of i & n are given in Table A / A-1.
According to this table, the future value can be calculated as:
FV = P(CVIF n,i)
The compound interest phenomenon is generally associated with various savings institutions. These
institutions pay compound interest on savings deposited with them.
Semi Annual & Quarterly Compounding: The above formula is applicable if the interest is
compounded annually. But, in certain cases, the interest may be compounded either semi-annually or
quarterly. Then, the formula is to be slightly modified as:
A = P (1 + i/m) mn
where: A = Amount at the end of the period
P = Principal at the beginning of the period
i = Rate of interest
n = Number of years
m = number of times per year compounding is done
Note: The more frequently the interest is compounded, the greater is the amount accumulated. This is
because interest is earned more frequently.
Future / Compound Value of a Series of Cash Flows: In certain cases, there may be several cash
flows at different periodical intervals. In such a case, the future values are to be calculated for the
different values individually & then added up.
Future / Compound Value of an Annuity: An annuity is a stream of equal annual cash flows. It is a
fixed amount paid or received each year for a specified number of years. In other words, Annuity refers
to a certain amount paid or received at the end of a certain period, usually a year for a fixed number of
years. Annuities involve calculations based upon the regular periodic contribution or receipt of a fixed
sum of money.
FVA = CVIFA (A)
where: FVA = Future Value of an Annuity
A = Value of Annuity
CVIFA = Factor value

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This is the fundamental equation of compound interest of an annuity. However, calculations will
become tedious & time consuming if the number of years involved is large. In order to simplify the
compound interest calculations, compound interest tables for annuities are given in Table B / A-2.
Compound value interest tables are of great help in the field of investment banking as they guide
investors & depositors as to what sum of money paid for a certain number of years at a given rate of
interest will amount to.
Discounting / Present Value technique: Present Value refers to the present worth of a future sum of
money. Using this technique, we can find out the present value of a future sum of money. The present
value of a rupee that will be received in the future will be less than the value of a rupee in hand today.
In present value technique, future sums are converted into present values. Given a positive rate of
interest, the present value of future rupees will always be lower. This is why it is called as discounting.
It is concerned with determining the present value of a future amount, assuming that the decision maker
has an opportunity to earn a certain return on his investment, known as the discount rate. Thus, present
value is a reciprocal of the compounded value.
The discounted value can be calculated as:
P = A / ( 1 + i)n
Where P = Present value of the future sum to be received / spent
A = Sum to be received / spent in future
i = Rate of interest
n = Number of years
Thus, the present value is a reciprocal of the compounding value.
This is the fundamental equation of present values. This formula can be readily applied for wide
ranges of i & n. However, calculations will become tedious & time consuming if the number of years
involved is large. In order to simplify the compound interest calculations, compound interest tables for
values (1+i)n for wide ranges of i & n are given in Table C / A-3.
P = A(PVIF)
Present Value of a Series of Cash Flows: In Capital Budgeting decisions, the firm may be interested
in the present value of a series of cash flows in different time periods. To determine the present value
of such a mixed stream of cash flows, one has to determine the present value of each future payment
individually & then added up to find out the total present value of the stream of cash flows. The formula
is:
P = C1/(1+i)1 + C2/(1+i) 2 + C3/(1+i) 3 + Cn/(1+i)n
where: P = Present Value of Series of Cash Flows
C1,C2,….Cn = Cash flows in the period 1,2,…..n
i = Rate of interest
n = Number of Years

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This is the fundamental equation of present values. This formula can be readily applied for wide
ranges of i & n. However, calculations will become tedious & time consuming if the number of years
involved is large. In order to simplify the present value calculations, present value tables for values
Cn/(1+i)n for wide ranges of i & n are given in Table C / A-3.
P = A(PVIF)
Present Value of Annuity: Annuity is a series of equal cash flows of an amount each time. The
present value of an annuity can be calculated by multiplying the annuity amount by the sum of the
present value factors for each year of the life of the annuity. Such readymade calculations are
available in Table E / A-4. This table presents the sum of present values for an annuity (PVIFA)/
annuity discount factor of Re1/- for wide ranges of i & n.
P = C(ADF)
Present Value of Perpetuity: An Annuity that occurs forever is called as perpetuity. Perpetuity is a
financial instrument that promises to pay an equal cash flow per period forever, i.e. an infinite series of
payments of a fixed amount. In case of perpetuity, the appropriate factor if found out by merely dividing
one by the discount rate or we can directly refer to the present value interest factor, annuity table
PV = A / R
Where A = Annuity
R = Rate of Interest
Differences between Single Cash Flow, Annuity & Perpetuity: Cash Flows refer to the inflow or
outflow of cash relevant to a particular project. In other words, cash flows are the receipts & payments
on account of a new venture. The cash flows can be a single cash flow or continuous in nature. If the
cash flow occurs only once during the life of the project, it is known as a single cash flow. Generally, a
single cash flow occurs at the inception of the project in the form of a cash outflow. The project
generates additional revenues either on a periodical basis or for life. If the cash inflow is of the same
amount for a specific number of years, it is known as an annuity. But, if the annuity is forever, it is
known as perpetuity.
Point of Diff. Single Cash Flow Annuity Perpetuity
Cash Flow Only Once Annually Forever
Amount Uneven Even Even
Inflow or Outflow Generally, Outflow Inflow Inflow
Period At inception End of every year End of every year

Differences between Compounding & Discounting: Compounding & Discounting are the two
techniques used in evaluating the time value of money. Compounding is used to ascertain the future
value of a present sum of money. Future value is used to ascertain the present value of a future sum of
money. They both consider the fact that value of money changes over a period of time.

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 Point of Diff Compounding Discounting
Also known as Future Value Present Value
Used to Ascertain future value of a present Ascertain the present value of a future
sum sum
Amount More than the present value Less than the future value
Used by Financial Institutions Corporate Entities

Practical Applications of Compounding & Discounting techniques: These techniques have several
important applications in the area of finance & investment. Some of these are:
• To accumulate a future sum to repay an existing liability at some future date
• To provide funds for replacement of an asset in future after its useful life.
• To determine the amount of annual installment when the amount of loan taken from a bank or
financial institution is to be repaid in a specified number of equal annual installments.
• To find out the growth rate of dividend paid by a company over a period of time.
• To determine the current values of debentures as the interest payments are made periodically over
the life of the debenture.

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 List of Questions

Short Answer Questions – 4 Marks

1. Write a note on time value of money

2. What is meant by Compounding technique?

3. What is meant by Discounting technique?

4. Differentiate between compounding & discounting.

5. Differentiate between single cash flow, annuity & perpetuity

6. What are the practical applications of compounding &discounting?

Essay Questions – 12 Marks

1. What is Time Value of Money? Explain Compounding & Discounting.

Assignment Question

1. Write a note on Time Value of Money.

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 Time Value of Money
Problems - Future / Compound Value
1. Suppose Rs.2,000/- is deposited in a savings bank @ 6% p.a. for 3 years, calculate the amount earned
at the end of the period.
(Ans: Rs. 2,382/-)

2. What will be the amount earned if interest is 8% p.a. in problem 1?

(Ans: Rs. 2,519/-)

3. Find out the future value of Rs. 5,000/- @ 6% p.a. for 5 years
(Ans: Rs. 6,691/-)

4. X invests Rs. 1,000/- for 3 years in a savings account that pays 10% interest p.a. Calculate future
value
(Ans: Rs. 1,331/-)

5. Calculate the future value of Rs. 4,000/- invested for 4 years & the interest on it is compounded at
12% p.a. half yearly. Find out the compounded value
(Ans: Rs. 6,375/-)

6. Mrs. Piyush deposit Rs. 6,000/- in bank for 5 years & the interest on it is compounded at 12%p.a. if
interest is calculated quarterly. Calculate the future value
(Ans: Rs. 10,837/-)

7. Calculate the future value of annuity of Rs. 8,000/- deposited at the end of each year at 6% for a
period of 5 years
(Ans: Rs. 45,097/-)

8. What will be the future value of Rs. 1,000/- @ 8% for 3 years if interest is compounded half yearly
& quarterly?
(Ans: Half Yearly Rs. 1,265/-; Quarterly Rs. 1,268/-)
Note: If compounding happens more than once, rate is to be divided by the number of times the
compounding is done & years are to be multiplied by the same no
9. If Mrs. Santa deposits Rs. 1,00,000/- at the beginning of each year & desires to know the
accumulated value of her amount at the end of 4 years @ 10% rate of interest, what would be the amount
(Ans: Rs. 4,64,100/-)

17
10. Mr. Vijay Raj is depositing Rs. 2,000/- at the end of each year in a recurring deposit which pays 9%
p.a. compounded interest. How much amount Mr. Vijay Raj gets at the end of the 5th year.
(Ans: Rs. 11,969/-)

11. Determine the future value at the end of 5 years @ 5% p.a.

I II III IV V
1,000 2,000 3,000 4,000 5,000
(Ans: Rs. 17,972/-)

12. Determine the future value of the following cash flows @ 10% p.a.
I II III IV V
2,500 3,000 3,500 4,000 5,000
(Ans: Rs. 24,948/-)

13. Mr. Mahesh invest Rs. 5,000/-; Rs. 7,000/- & Rs. 9,000/- for three years respectively @ 10% p.a.
interest. What is the amount he gets at the end of the third year?
FVIF @ 10% 1 Year – 1.100; 2 Year – 1.210; 3 Year – 1.331
(Ans: Rs. 25,949/-)

18
 Present Value

1. Calculate the present value of Rs. 10,000/- rec’d after 5 years @10%p..a
(Ans: Rs. 6,209/-)

2. Calculate the present value of annual cash flows Rs. 1,000/- for 5 years @ 10%p.a.
(Ans: Rs. 3,791/-)

3. Mr. Saha is to receive Rs. 12,000/- after 5 years from now. His time preference for money is 12%p.a..
According to discount factor table, the present value discount factor at 12% for 5 years for Re. 1/- is
0.567. Calculate the present value.
(Ans: Rs. 6,804/-)

4. Find out the present value of the following cash inflows @ 10% p.a.
I II III IV V
500 1,000 1,500 2,000 2,500
(Ans: Rs. 5,326/-)

5. Find out the present value of the following cash inflows @ 15% p.a.
I II III IV V
10,000 12,000 15,000 20,000 25,000
(Ans: Rs. 51,498/-)

6. Find out the value of Rs. 500/- invested in perpetuity @ 5%p.a.

(Ans: Rs. 10,000/-)

7. Find out the value of Rs.12, 500/- invested in perpetuity @ 14%p.a.

(Ans: Rs. 89,286/-)

8. What is the value of Rs. 10,000/- invested in perpetuity at 10%p.a.

(Ans: Rs. 1,00,000/-)

9. Sanvi Ltd. had taken a freehold land for an annual rent of Rs. 1,200/-. Find out the present value of
the free hold land which is enjoyable in perpetuity if the interest rate is 8% p.a.
(Ans: Rs. 15,000/-)

19
10. You can make two different investments. The interest you receive on the first investment is Rs. 120/-
per year for three years. You receive Rs. 300/- on the second investment in the third year & nothing
in the first two years. If your discount rate is 10%, what is the present value of each of these
investments?
(Ans: (i) Rs. 298/-; (ii) Rs. 225/-)

20
 Capital Budgeting
Capital budgeting is the process of making investment decisions in capital expenditure. A capital
expenditure is an expenditure incurred in acquiring fixed assets, the benefits of which are expected to
be received over several years in future. The distinctive feature of capital budgeting decision is that the
expenditure is incurred at a certain point of time whereas its benefits accrue in the future at different
points of time. Therefore, capital expenditure decisions are known as Strategic Investment Decisions.
Features of Capital Budgeting:
• Large Investments: Capital budgeting decisions involve huge investment of funds. But the funds
available with the firm are always limited. The demand for funds always far exceeds the resources
available.
• Long Term Commitment of Funds: Capital expenditure not only involves large amount of funds
but also funds for long term commitment which increases the financial risk.
• Irreversible Nature: Most of the Capital budgeting decisions are irreversible in nature i.e. once the
decision is taken it cannot be written back without incurring heavy losses.
• Difficulties of Investment Decision: Long term investment decisions are difficult to be taken
because the decisions extend beyond the current year, the future is uncertain & there is a high degree
of risk
Methods of Capital Budgeting: The methods of capital budgeting can be broadly classified as
traditional & time adjusted methods. The Traditional methods include Pay Back Period & Average
Rate of Return while the time adjusted methods include Net Present Value, Internal Rate of Return
& Profitability Index methods.
Traditional Methods:
Pay Back Period (PBP): It is the period within which the investment pays back itself. Every capital
expenditure pays itself back within a certain period either from the additional earnings or reduction in
costs. Under this method, various investments are ranked according to the length of their PBP, such that
the investment with the shortest PBP is preferred to the one which has a longer PBP. In case of
evaluation of a single project, it is adopted if it pays back for itself within a period specified by the
management, otherwise the project is rejected.
PBP can be ascertained as follows:
a) Calculate the annual cash inflows (net profit) before depreciation & after taxes
b) PBP = Cash outlay of the project / Annual Cash Inflows
Note: The above formula can be adopted if the project generates constant cash inflows
c) If the annual cash inflows are unequal, PBP can be calculated by adding all the cash inflows until
the total is equal to the initial cash outlay of the project
Average Rate of Return (ARR): It is also known as Accounting Rate of Return method. It is the rate
of return the capital budgeting decision yields. This method takes into account the earning expected

21
from the investment over their whole life. It is known as Accounting Rate of Return method because it
takes into account PAT which is the accounting profit. This method ranks the various projects in the
descending order of ARR. The project with a highest return is accepted. In case of a single project, the
ARR is compared with the standard rate or return or minimum rate. If the ARR is greater than the
standard rate, the project is to be accepted, otherwise it is to be rejected. In case of mutually exclusive
projects, the one with the highest ARR is to be accepted.
ARR = Average annual PAT / Average Investment * 100
Note: If there is scrap value, Net Investment = Investment – Scrap value
Average annual PAT = Total PAT / No. of years
Average Investment = (Initial Cost of Investment + Installation Expenses – Salvage Value ) / 2 +
Salvage Value + Additional NWK
Discounted Cash Flows/ Time Adjusted Techniques: The traditional methods of capital budgeting
suffer from serious limitations that give equal weight to the present & future cash flows. These methods
did not consider the time value of money. The discounted cash flow techniques take into account the
profitability along with the time value of money. The cash flows are discounted with reference to the
time gap between the different cash flows & a predetermined discount rate with reference to the time
gap between different cash flows. It is based on the rule the earlier the better in evaluating a capital
budgeting proposal. The cash outflows & cash inflows of different time periods are made comparable
by discounting them. The different methods are as follows:
Net Present Value (NPV): It is the sum of present values of all cash inflows, less the present values of
all cash outflows. Thus, NPV is the sum of the discounted values of all cash flows pertaining to a
proposal.
NPV can be either positive or negative, depending upon whether there is a net inflow or outflow from
the project.
Decision Rule: If NPV is positive –Accept the Proposal [+ve NPV = PV CFAT > Co]
If NPV is negative – Reject the Proposal [_ve NPV = PV CFAT < Co]
Note: In case of mutually exclusive proposal, the one with the highest NPV is to be accepted.
Internal Rate of Return (IRR) method: IRR of a proposal is defined as the discount rate at which the
NPV of the proposal is equal to 0. It is the rate generated by the proposal internally. In other words,
IRR is the discount rate at which the present value of cash inflows is equal to the present value of the
cash outflow. It is ascertained by trail & error method.
Procedure for Calculation of IRR:
When annual cash flows are equal for all years of the project i.e. annuity CFAT
• Determine the PBP
• In the table of PV of annuity of rupee 1, look for a year that is equal or closest to the life of the
project.

22
• In the year row, find two PV values or discount factor closest to PBP, but one bigger & one smaller
than it
• From the top row of the table, note interest rates corresponding to these PV
• Apply interpolation formula:
Where PV Co = Present value of cash outflow
PVCFAT = Present value of cash inflow
PV = Difference in calculated present values of inflows
r = either of the two interest rates used in the formula
r = difference in interest rates
When differential cash flows are given:
• Calculate average annual cash inflow to get fake annuity
• Determine fake PBP as : Cash Outlay / Annual CFAT
• Look for the factor in Table D closest to the fake PBP. The result will be a rough approximation of
IRR because it is based on fake PBP & fake annuity
• Adjust IRR obtained as above by comparing the average annual CFAT to the actual differential
CFAT. If actual CFAT is higher in the initial years than the average CFAT, take a higher rate & vice
versa.
• Find out the PV of differential CFAT, taking IRR as the rate estimated by using Table C
• Calculate PV using the discount rate. If PV CFAT – Co, i.e. NPV = 0 , it is the IRR. Otherwise repeat
with a different rate. Stop once two consecutive discount rates that cause NPV to be positive &
negative respectively have been calculated.
• Apply interpolation formula to calculate the actual IRR
• IRR = rl [ PV CFATrl – PVCo ] /
List of Questions
Short Answer Questions – 4 Marks
1. Capital Budgeting
2. PBP
3. ARR
4. NPV
5. IRR
Essay Questions – 12 Marks
1. What is capital budgeting? Explain its features.
2. Write a note on Capital Budgeting techniques.

23
 Capital Budgeting - Problems
Pay Back Period (PBP)
1. X Ltd. intends to invest Rs. 1,00,000/- on a capital project. The project generates annual net cash
inflows @ 15,000/- p.a. for a period of 8 years. At the end of the 8 th year, the salvage value is Rs.
20,000/-. Calculate the PBP
(Ans: 6.67 years)

2. ABC Ltd. presents the following information: Calculate PBP

Project cost – Rs. 10,00,000/-; Estimated Life – 10 years
Annual profit after depreciation @10% p.a. but before tax @50%- Rs. 2,00,000/.
(Ans: 5 years)

3. The cost of a project is Rs. 40,00,000/- yielding an annual return of Rs. 6,00,000/- after charging
depreciation @ 12.5% but before tax @ 50%. Calculate PBP.
(Ans: 5 years)

4. A project costs Rs. 50,000/- & has a scrap value of Rs. 10,000/-. Its stream of cash flows through
five years is Rs. 10,000/-, Rs. 12,000/-, Rs. 14,000/-, Rs. 16,000/- & Rs. 20,000/- Calculate the PBP.
(Ans: 3.875 years)

5. Calculate PBP: Investment – Rs. 4,00,000/-

Year I II III IV V
CFAT 1,00,000 1,00,000 80,000 80,000 40,000
(Ans: 5 years)

6. Calculate the PBP of the following projects, each requiring a cash outlay of Rs. 1,00,000/-. Suggest
which projects are acceptable if the standard PBP is 5 years.
Years Project A Project B Project C
1 30,000 30,000 10,000
2 30,000 40,000 20,000
3 30,000 20,000 30,000
4 30,000 10,000 40,000
5 30,000 5,000
(Ans: Project A – 3.33 years, Project B & C – 4 years)

24
 Accounting Rate of Return (ARR)

1. X Ltd. Invested Rs. 1,00,000/- on some project. The project generates profits before depreciation &
tax @ 35,000/- p.a. for a period of 5 years. The scrap value of the project at the end of 5th year is 0.
Determine ARR for the project assuming 50% tax rate & straight-line method of depreciation.
(Ans – 15%)

2. A project requires an investment of Rs. 6,00,000/- & has a scrap value of Rs. 30,000/- after 4 years.
It is expected to yield profits after depreciation & taxes during the 4 years amounting to Rs. 40,000/-
, Rs. 60,000/-, Rs. 50,000/- & Rs. 30,000/-. Calculate the ARR.
(Ans – 14.29%)

3. A project costs Rs. 1,00,000/- & has a scrap value of Rs. 10,000/-. The profit before depreciation &
tax through five years is Rs. 20,000/-, Rs. 25,000/-, Rs. 30,000/-, Rs. 35,000/- & Rs. 40,000/-.
Assuming a 35% tax & depreciation on straight line basis, calculate the ARR.
(Ans – 14.18%)

4. A Ltd wants to purchase a machine. Two machines X & Y are available in the market. The cost of
each machine is Rs. 1,00,000/-. Their expected lives are 5 years. Net profits before tax during the
expected life of the machines are as follows:
Years Machine X Machine Y
I 10,000 7,000
II 15,000 13,000
III 13,000 15,000
IV 20,000 25,000
V 17,000 20,000
TOTAL 75,000 80,000
Note: The average rate of tax is 50%.
From the above information, ascertain which one is more profitable.
(Ans – Machine X 15% & Machine Y 16%
Machine Y is acceptable as it has a higher ARR)

5. Calculate the ARR for projects A & B from the following

Investments Project A – Rs. 20,000/- Project B – Rs. 30,000/-
Expected Life 4 years 5 years
Salvage Value Nil Nil

25
 Projected Income (after interest, depreciation & taxes)
Years Project A Project B
I 2,000 3,000
II 1,500 3,000
III 1,500 2,000
IV 1,000 1,000
V - 1,000
TOTAL 6,000 10,000
If the required rate of return is 12%, which project should be undertaken?
(ARR: Project A – 15%; Project B – 13.33%. Both the projects are acceptable as they have an
ARR > Required Rate of Return. Project A should be accepted as it has a higher ARR)

26
 Net Present Value (NPV)

1. Calculate the NPV for project A which initially costs Rs. 3,000/- & generates annual cash inflow of
1,000/-, 900/-, 800/-, 700/- & 600/- in 5 years. The discount rate is assumed to be @ 10% p.a.
(Ans – NPV – 105/-)

2. From the following data presented by X Ltd. Suggest the most attractive proposal on the basis of
NPV method bearing in mind that future incomes are discounted @12%
Proposal X Proposal Y
Investments 9,500 20,000
Estimated Income I year 4,000 8,000
II year 4,000 8,000
III year 4,500 12,000
(Ans – Proposal X - 463/-; Proposal Y – 2,060/-)
Project Y is acceptable as it is having a higher NPV

3. A project costing Rs. 10,00,000/- has life of 10 years after which its scrap value is likely to be Rs.
1,00,000/-. The firm’s discount rate is 12%. The project is expected to yield an annual profit after
tax of Rs. 1,00,000/-, depreciation being charged on straight line basis. At 12% the present value of
1Re. received annually for 10 years is 5.650 & the value of 1 Re. received at the end of 10 th year is
Rs. 0.322. Ascertain the net value of the project & state whether we should go for the project.
(Ans – 1,05,700/-)

4. Management of a firm desires to purchase a machine. Two machines are available in the market –
Machine A & Machine B. which of the two alternatives will be more profitable under the NPV
method.
Particulars Machine A Machine B
Initial outlay 40,000 50,000
Annual net earnings 20,000 15,000
(After tax but before depreciation)
Estimated Life 4 Years 8 Years
The rate of interest may be taken @ 10%p.a.
(Ans – Machine A 23,398, Machine B 33,022)
Machine B is acceptable as it is having a higher NPV

27
5. A chemical company is considering investing in a project that costs Rs. 4,00,000/-. The estimated
salvage value of zero. Tax rate is @ 50%. The company uses straight line depreciation & the
proposed project has cash flows before depreciation & tax (CFBT) as follows:
Years 1 2 3 4 5

PBDT 1,00,000/- 1,50,000/- 2,00,000 2,50,000 3,00,000

Determine NPV @ 15%

(Ans – 46,081)

6. X Ltd is considering investing in a project requiring capital outlay of Rs. 2,00,000/-. Forecast for
annual income after depreciation but before tax is:
YEARS 1 2 3 4 5

PBT 1,00,000 1,00,000 80,000 80,000 40,000

Depreciation may be taken @20% on original cost & taxation @50% of net income. You are required
to evaluate the project according to NPV method taking cost of capital as 10%.
(Ans – 1,08,199)

7. Y Ltd furnished the following data. You are asked to suggest whether the project should be accepted
or not, assuming that the cost of capital is 10% & investment required is Rs. 50,000/-
YEAR I II III IV V

CASH FLOW 18,000 16,000 14,000 12,000 10,000

PVF @ 10% 0.909 0.826 0.751 0.683 0.621

(Ans – NPV – 4,498/-)

8. The relevant data on three projects are given below. Choose the best project on the basis of NPV &
justify. (Use an interest rate @20%)
A B C
Investment 60,000 60,000 60,000
Return at end of Year I 30,000 20,000 25,000
Return at end of Year II 20,000 30,000 25,000
Return at end of Year III 20,000 19,000 25,000
(Ans – NPV Project A (-) 9,539/-; Project B (-) 11,507/-; Project C (-) 7,337/-
None of the projects are acceptable as they have a negative NPV

28
 Internal Rate in Return
1. An equipment requires an initial investment of Rs. 6,000/-. The cash flow is estimated at Rs.
2,000/- each year for 5 years. Calculate the IRR
(Ans: IRR - 19.87%)

2. Calculate the IRR from the following data

Investment required Rs. 12,000/-
Annual cash flow is expected at Rs. 3,500/- for 5 years
(Ans: IRR – 14.05 %)

3. The estimated cost of a project is Rs 32,400/-. Its expected life is 3 years which generates a cash
flow of Rs. 16,000/-, Rs. 14,000/- & Rs. 12,000/- respectively. Calculate IRR.
(Ans: IRR – 15%)

4. Compute the IRR from the following data & suggest whether the project should be accepted or not:
Investment Rs. 2,77,000/-
Cost of capital 12%
Year I II III IV V
Cash Flow 60,000 1,00,000 1,20,000 60,000 40,000
(Ans: IRR – 12.40%)

5. X ltd. has currently under examination a project which has the following cash flows over a period of
time.
Year I II III IV V
Cash Flow 50,000 60,000 80,000 90,000 1,25,000
Cost of the machinery to be installed works out to Rs. 3,00,000/- & the machine is depreciated @ 20%
p.a. on straight basis. Income tax rate is 50%. If the average cost of capital is 11%, would you
recommend accepting the project under IRR.
(Ans: IRR – 9.36%)

29
 Unit III
Sources of Finance
Finance is the most important requirement of every business. Finance is required at every stage – from
inception to expansion & even for the day-to-day management of the business. The financial
requirements of a business vary depending up on a number of factors such as size & nature of the
business, volume of capital investment, market conditions etc. Finance is available from several sources
to meet the varying needs of the business. The financial requirements & the sources of finance can be
analysed as follows:
Sources of Finance
Short Term Medium Term Long Term
< 1 Year 1 – 5 Years > 5 Years
Indigenous bankers Preference Shares Equity Shares
Commercial banks Debentures Preference Shares
Public deposits Public Deposits Retained earnings
Advances Institutional Finance Debentures
Inter Corporate Deposits - Institutional Finance
- - Lease Financing
On the basis of the period for which finance is required, the sources of finance can be classified as short
term, medium term & long term.
Short Term Finance: The finance required for a period less than one year is known as short term
finance. Short term funds are required to meet the working capital requirement of the business. The
different sources of short-term finance are as follows:
• Indigenous Bankers: Private money lenders used to be the primary source of finance prior to the
establishment of commercial banks & other financial institutions. They would charge a very high
rate of interest & exploit the customers in different ways. Indigenous bankers are a variation of
money lenders wherein they deal in public money but are not organized or regulated as per the
provisions of the Banking Companies (Regulation) Act 1949. But, with the development of
institutional credit, dependence on indigenous bankers has reduced drastically. However, even
today, certain organizations especially in the rural areas depend on these bankers to meet their
working capital requirements.
• Commercial Banks: Commercial banks extend short term assistance to industries in the form of
direct loans, overdraft, cash credit & discounting of bills of exchange. They charge a higher rate of
interest when compared to the interest allowed on deposits.
• Public Deposits: Companies accept deposits from the general public to meet their working capital
requirements. Generally, such deposits are unsecured. Investors prefer such deposits due to their
short maturity period & attractive interest rates.

30
• Advances: In certain cases, joint stock companies accept advance against the orders rec’d from
customers. Such an advance ensures confirmation of order & serves as a source of finance.
• Inter Corporate Deposits: Companies give short term deposits to other companies to solve the
working capital crisis, if any. Such deposits are given for a short period as part of mutual
understanding between companies.
Medium Term Finance: The finance required for a period ranging between one to five years is known
as medium term finance. It is required for incurring expenses such as heavy advertising campaign,
repairs & renewals etc. The different sources of medium term finance are as follows:
• Preference Shares
• Debentures
• Public Deposits
• Institutional Finance
Long Term Finance: The finance required for a period greater than 5 years is known as long term
finance. Long term funds are required to create production facilities through the purchase of fixed assets.
Long term funds are generally raised at the time of inception or if the firm is going in for an expansion
or diversification. The different sources of long-term finance are as follows:
• Equity Shares: They are also known as ordinary shares. They represent the ownership capital. The
equity shareholders are the residual owners of the company & enjoy unrestricted claims on the
income & assets of the company. They enjoy control over the company which they exercise through
their voting rights. They are the last claimants to the income & assets of the company. The rate of
dividend payable to the equity shareholders varies with the company’s performance. As equity
capital is exposed to maximum risk, it is also known as risk capital.
• Preference Shares: The shares that enjoy a preferential right to receive dividend at a fixed rate &
be repaid capital are known as preference shares. Whenever the company earns profits, it has to
declare dividend at the fixed rate to preference shareholders before declaring dividend to the equity
shareholders. Similarly, in case of liquidation, preference shareholders are to be redeemed capital
before payment to equity shareholders. In India, Preference shares are to be redeemed within 20
years from the date of issue.
• Retained Earnings: They are the undistributed profits of the company. Retained earnings are an
internal source of finance. They are also referred to as Ploughing back of Profits or Reserves &
Surpluses. Every joint stock company sets aside a part of its earnings as retained earnings. The
amount of earnings to be set aside has a bearing both on profitability as well as liquidity of the firm.
Therefore, the company has to exercise caution while retaining earnings.
• Debentures: They are the debts or loans raised by a joint stock company under its common seal.
The debenture holders are the creditors of the company & are to be paid interest at a fixed rate,

31
 irrespective of the company’s performance. Debentures are secured by a charge on the assets of the
company. Generally, debentures are to be redeemed after a specified period as per the terms of issue.
• Institutional Finance: Financial Institutions like IDBI, ICICI, IFC etc extend long term technical
& financial assistance to trade & industry. Financial assistance is provided in the form of long term
loans, deferred payment facility for import of machinery, guaranteeing loans etc. Technical
assistance is provided in the form of preparation of project report, consultancy services for
expansion, diversification etc.
• Lease Financing: Industrial concerns can make use of fixed assets such as land, buildings,
machinery etc. for a long period of time without outright purchase. Such an agreement is called as
lease agreement. It is an indirect source of finance where in the lease financing companies or
government provide fixed assets to manufacturing concerns on a rental basis for a long period of
time.
Shares: The capital of a joint stock company is divided into small denominations called shares.
According to Section 2(46) of the Indian Companies Act 1956, a share can be defined as, a share in
the share capital of the company & includes stock, except where a distinction between shares &
stocks is expressed or implied. Shares can either equity or preference shares.
Equity Shares: They are also known as ordinary shares. They represent the ownership capital. The
equity shareholders are the residual owners of the company & enjoy unrestricted claim on the income
& assets of the company. It means that they are to be paid a variable rate of dividend after payment to
other categories of shares. There is no compulsion to pay dividend & the rate of dividend varies with
the company’s performance. Similarly, in case of liquidation, they are to be repaid capital after payment
to third parties & other categories of shares. They enjoy control over the company which they exercise
through their voting rights. Equity capital is also called as risk capital as it is exposed to maximum
risk.
Features: Equity share have the following features:
• Perpetual in Nature: Equity capital is perpetual in nature as it is to be redeemed only on liquidation.
It means that equity capital is available to the company as long as it is in existence. It will be repaid
to the shareholders only when the company closes down.
However, it provides liquidity to the shareholders as the shares can be traded in the stock exchange.
• Claims on Income: The equity shareholders are the last claimants to the income of the company as
they are to be paid dividend after payment to other categories of shares. The rate of dividend payable
to the equity shareholders varies with the company’s performance. Also, there is no legal obligation
that dividend must be declared to equity shareholders even in case of sufficient profits. Also,
whatever is left belongs to the equity shareholders.
• Claims on Assets: The equity shareholders are the last claimants to the assets of the company. It
means that, in case of liquidation, they are to be repaid capital after payment to other categories of

32
 shares. In other words, after the claims of third parties & preference shareholders are satisfied,
whatever is left belongs to the equity shareholders.
• Controlling Power: The equity shareholders are the owners of the company & enjoy control over
the company which they exercise through their voting rights. The voting rights are proportionate to
their shareholding as every share carries one vote each. The equity shareholders elect a Board of
Directors to manage the firm on their behalf.
• Limited Liability: The liability of the equity shareholders is limited to the extent of face value of
shares held by them i.e. their investment. They are liable to pay the uncalled amount on shares. It
means that their personal property is safe & maximum they can lose is their investment.
• No Security: There is no security provided to the equity shareholders as the company does not create
any charge on its assets for equity shares. The equity shareholders bear all risks & hence are also
referred to as risk capital.
• Pre-Emptive Right: The equity shareholders are entitled to pre-emptive right as per Section 81 of
the Indian Companies Act 1956. It means that, whenever an existing company issues new shares,
they are to be first offered to the existing equity shareholders before offering them to the general
public. This right of equity shareholders is known as pre-emptive right & such an issue is Rights
Issue.
Merits: Equity shares have the following advantages:
- It is available to the company as long as it is in existence as it enjoys perpetual existence
- There is no legal obligation to pay dividend even in case of sufficient profits
- There is no charge on the assets of the company
- The equity shareholders are owners of the company & enjoy control over the company through
their voting rights.
- The equity shareholders are entitled to pre-emptive rights
- In the long run, equity shareholders gain more by way of higher dividends & appreciation in the
value of shares
Demerits: Equity shares have the following disadvantages:
- Equity capital is the most expensive source of finance.
- It may lead to overcapitalization
- There are chances of speculation which has an adverse effect on the value of shares
- There is no guarantee of dividend every year
- Equity shares are not attractive to risk-averse investors
Preference Shares: Preference shares are the shares that enjoy a preferential right to receive dividend
at a fixed rate & be repaid capital as per Section 85 of the Indian Companies Act 1956. Whenever a
company earns profits, it has to pay the fixed rate of dividend to the preference shareholders before
payment to the equity shareholders. The rate of dividend payable is pre-determined & informed to the

33
investors at the time of issue itself. Similarly, in case of liquidation, they are to be repaid capital before
payment to equity shareholders. However, they are not entitled to any voting rights. In India, preference
shares are to be redeemed within 20 years from the date of issue.
Features: Preference shares have the following features:
• Maturity: In India, preference shares are to be redeemed within 20 years from the date of issue as
per the term of issue. Generally, preference shares are redeemed only if they are fully paid.
Redemption of preference shares can be either out of profits or from fresh issue of shares.
• Claims on Income: The preference shareholders have a priority of claim on the income of the
company. The preference shareholders are to be paid dividend at a fixed rate before payment to
equity shareholders.
In case of cumulative preference shares, the right to dividend gets accumulated in case of
insufficient profits.
Similarly, in case of participating preference shares, the preference shareholders are entitled to a
share in the surplus profits of the company
• Claims on Assets: The preference shareholders have a priority of claim on the assets of the
company. However, this claim arises only on liquidation. It means that, in case of liquidation,
preference shares are to be repaid before equity shares.
In case of participating preference shares, the preference shareholders are entitled to a share in
the surplus assets of the company along with the equity shareholders
• Controlling Power: The preference shareholders do not have any control over the company as they
are not entitled to any voting rights. They can exercise rights only related to that category of shares
However, if the company defaults in payment of dividend or repayment of capital, the preference
shareholders acquire voting rights on par with equity shareholders
Merits: The preference shares have the following advantages:
- They are economical when compared to equity shares as dividend is at a fixed rate
- They are flexible as they can be raised when there is a need & repaid when the need is over
- There is no charge created on the assets of the company
- There is no fear of dilution of control as they are not entitled to voting rights
- If the company is earning sufficient profits, it increases the profitability to equity shares as
preference shares are entitled to a fixed rate of dividend only
- It is a safe investment for risk-averse investors as they are assured of a fixed rate of return
- The preference shareholders have a priority of payment of dividend & repayment of capital
- In case of cumulative preference shares, they are assured of dividend every year, irrespective of
the company’s performance
- In case of participating preference shares, the shareholders are entitled to a share in the surplus
profits & assets of the company

34
Demerits: The preference shares have the following disadvantages:
- They are expensive when compared to debt capital
- There is fear of dilution of control if the company defaults in payment of dividend or repayment of
capital
- Cumulative preference shares are a burden to the company as dividend has to be paid at a fixed rate,
irrespective of profits
- The preference shareholders get a lower rate of return when compared to equity shares
Debentures: It is a written acknowledgement of debt or loan raised by a joint stock company under its
common seal. According to Section 2(12) of the Indian Company’s Act 1956, a debenture can be
defined as debenture includes debenture stocks, bonds or other securities of a company, whether
constituting a charge on the assets or not. The debenture holders are the creditors of the company &
are to be paid interest at a fixed rate, irrespective of the company’s performance. Debentures are secured
by a charge on the assets of the company. The charge may be fixed or floating. Generally, debentures
are redeemed after a specified period as per the terms of issue.
Features: Debentures have the following features:
• Maturity: Debentures are to be redeemed after a specified period as per the terms of issue. It means
that, at the time of issue itself, the company will specify when the debentures will be repaid
• Claims on Income: The debenture holders are entitled to a fixed rate of interest at periodical
intervals, irrespective of the company’s performance. It means that the company has to pay a pre-
determined rate of interest to the debenture holders whether it earns profits or not.
• Claims on Assets: The claim of the debenture holders is secured by a charge on the assets of the
company. The charge may be either fixed or floating. The company cannot sell such assets, except
to redeem the debentures
• Controlling Power: The debenture holders do not have any control over the company as they are
the creditors of the company.
However, if the company defaults in payment of interest or repayment of capital, the debenture
holders can take control of the company.
• Debenture Trust: To protect the interests of the debenture holders, SEBI has issued guidelines for
the constitution of a debenture trust. A debenture trust is a body of people representing different
interests such as debenture holders, shareholders, management, representatives of financial
institutions, government etc. formed for the purpose of protecting the interests of the debenture
holders.
Merits: Debentures have the following advantages:
- They are economical when compared to shares as they rate of interest payable is less than the
dividend payable on shares
- The rate of interest is fixed & assured, irrespective of the company’s performance

35
 - It enables the company to trade on equity as it increases the shareholders profitability
- There is no fear of dilution of control as they are not entitled to voting rights
- It is a tax advantage to the company as the interest is a charge against profits
- It is a safe investment for risk-averse investors as they are assured of a fixed rate of return at
periodical intervals
- The investment is fully secured as the company creates a charge on its assets as security
- The interests of the debenture holders are protected by the Debenture Trust as per the guidelines of
SEBI
Demerits: Debentures have the following disadvantages:
- Interest has to be paid at a fixed rate, irrespective of the company’s performance
- It creates a charge on the assets of the company
- There is fear of dilution of control if the company fails to pay the interest or the principal.
- It is not advisable to use debentures in case the demand is highly elastic
Differences between Equity & Debt
Point of Difference Equity Debt
Part of Ownership Capital Debt Capital
Owners Shareholders Debenture Holders
Life Perpetual Specified period
Return Dividend Interest
Rate of Return Varies with the company’s Fixed
performance
Certainty of Return Uncertain Certain
Priority After payment to other Priority of payment, irrespective of
categories profits
Accounting treatment Appropriation of profits Charge against profit
Security No security Charge on the assets as security
Voting Rights Entitled to Voting Rights No Voting Rights
Conversion No Conversion Can be converted into equity shares

36
 List of Questions

Short Answer Questions – 4 Marks

1. Explain the different sources of short-term finance
2. Differentiate between debt & equity

Essay Questions – 12 Marks

1. What are the different sources of long-term finance? Explain
2. Write a note on short term sources of finance
3. Write a note on equity shares.
4. Explain the features, merits & demerits of preference shares.
5. What is a debenture? What are its features, merits & demerits?
Assignment Question
1. Define Equity Shares. Give its features, merits & demerits.

37
 Capital Structure

A firm can finance its investments either through ownership funds or borrowed funds. Ownership funds
refer to equity share capital; preference share capital & retained earnings whereas borrowed funds
include debentures & other long-term loans raised from banks & other financial institutions. Capital
Structure refers to the proportion of debt & equity to the total capital employed by a firm. Capital
structure means the pattern of capital employed by the firm. It is a financial plan in which the various
sources of finance are mixed in such a proportion that the firm has an optimum capital structure. An
optimum capital structure is one which minimises cost & risks while maximising returns. Every firm
tries to have an optimum capital structure as it affects both the cost of capital as well as the expected
returns. If a firm uses more of equity capital, the risk is less but the cost is high. On the other hand, if it
uses more of debt capital, the cost is less but the risk is high. Therefore, it has to strike the right balance
between equity & debt.

Determinants of Capital Structure:

Factors determining Capital Structure

Internal External Others

• Nature & Size of firm • Trade Cycles
• Operational Activities
• Cost of Capital • Interest Rates
• Fin’l Leverage
• Degree of Risk • Tax Policy
• Earnings
• Control • Availability of Funds
• Age of the Firm
• Creditworthiness • Investors Attitude
• Govt. Policies
• Transferability • Stock Prices
• Trading on Equity
• Flexibility

The determinants of capital structure can be broadly classified as Internal, External & Others
Internal Factors: They can be discussed as follows:

• Nature & Size of the Firm: The size of the firm determines the amount of capital structure as small
firms find it difficult to mobilize funds as investors do not want to invest as the risk is high. In case
of a large firm, it is relatively easy to procure funds from a variety of sources.
• Cost of Capital: Every source of capital comes at a cost. The cost directly affects the profitability
of the firm. Therefore, the finance manager aims to minimize cost. Debt capital is economical
compared to equity.

38
• Degree of Risk: The risk is higher in debt financing compared to equity as interest has to be paid at
a fixed rate, irrespective of profits. Hence, the degree of risk involved also affects the capital
structure decision.
• Control: The equity shareholders are the owners of the company & enjoy control over the company.
While issuing new shares, they do not want such control to be diluted & prefer debt over equity.
• Creditworthiness: A firm can borrow funds depending on its creditworthiness i.e. the ability to
repay. This depends upon the liquidity, solvency & profitability position of the firm. Financial
Institutions will grant loans only when they are satisfied about repayment of capital along with
interest.
• Transferability: A firm can easily raise funds only when the investors are assured of transferability.
It means that the securities are highly liquid. This is possible only when the securities are listed in
the Stock Exchange.
• Trading on Equity: This is the device by which equity shareholders enjoy a large amount of profit
at the cost of other fixed interest & fixed dividend bearing securities i.e. by the use of debentures &
preference shares. But, trading on equity is profitable only when the profit is large enough to declare
dividend to equity shareholders after payment of interest on debentures & a fixed rate of preference
dividend
• Flexibility: Flexibility in the capital structure should be maintained by the firm bearing in mind the
future course of action to be implemented for the greater interest of the firm. When a firm raises
additional funds for profitable investment opportunities, the same is referred to as a flexible capital
structure as the composition of the capital structure changes. A firm may need funds for various
purposes for which borrowing powers are applied. This is possible only in case of a flexible capital
structure. If there is flexibility in the capital structure, a firm may go in for debt or equity, whichever
is more favourable based on the market conditions.

External Factors: There are certain factors beyond the control of the firm which have a bearing on the
capital structure. They are as follows:
• Trade Cycles: Every industry has a definite pattern of trade cycles. This also affects the capital
structure as during depression, the firm relies more on debt capital while during the booming period
use of equity is more in comparison to debt.
• Interest Rates: The interest rates on debentures also impact the capital structure. If the rate of return
is less than the cost of debentures, the firm opts for equity finance and vice versa.
• Tax Policy: Interest on debentures is a charge against profits & therefore is a tax deductible
expenditure. But dividend is a taxable expenditure. Therefore, the tax policy also matters while
deciding the capital structure.

39
• Availability of Funds: The firm decides its composition of the capital structure on the basis of
availability of funds in the capital market. As the firm aims for an optimum capital structure, it has
to strike the right balance between the cost & return of each source of finance.
• Investors Attitude: If the investors are risk averse, the company has to go in for debt capital as
against equity capital. But, if the investors are willing to take risks, then equity capital is preferred.
Thus, the attitude of investors is one of the external factors that determines the capital structure.
• Stock Prices: If the stock market is bearish, then the firm uses debt capital as a source of finance,
but, if it is bullish & looking promising, then equity is the preferred source.
Others: Apart from the internal & external factors, there are certain general determinants of capital
structure. They are as follows:
• Operational Activities: The operational activities do influence the capital structure as it affects the
profitability of the firm. In case of a manufacturing concern, the rate of return is higher in comparison
to a trading concern as investment in fixed assets is more when compared to current assets.
• Financial Leverage: It may be expressed when the residual net income does not vary in direct
proportion to the operating profit. This leverage reveals the change in taxable income in comparison
to changes in operations. In other words, a major part is played by interest on debt financing,
debenture interest & preference dividend in the entire capital structure. A firm that uses more of debt
is highly leveraged & vice versa.
• Earnings: If the firm is able to earn stable earnings, then it can rely on debt capital as it can service
the debt without any problem. But, if the earnings are not stable, the firm is forced to use equity
rather than debt. Thus, earnings play a vital role in determining the capital structure.
• Age of the Firm: At inception, a firm has to raise equity capital as it will be difficult to raise debt
capital as they are yet to establish themselves in the market. An established firm, on the other hand,
can choose between equity & debt as it has already proved itself.
• Govt. Policies: The Monetary & Fiscal policies of the govt. are also the determinants of capital
structure.

EBIT - EPS Analysis: EBIT –EPS analysis is a tool used in financial management for the insight into
the capital structure. It helps in the analysis of examining the effect of financial leverage to analysis the
behaviour of EPS with the varying levels of EBIT under the financial decision.
• EPS [Equity Shares] = (EBIT – I) (1-t) / N
where I = Interest, t = Tax, N = No. of Shares
• EPS [Preference Shares] = (EBIT – I) (1-t) – P/ N
where P= Preference Dividend

40
 List of Questions
Short Answer Questions – 4 Marks
1. Define Capital Structure
2. Write a note on EBIT-EPS analysis.
Essay Questions – 12 Marks
1. What are the determinants of Capital Structure?

41
 EBIT-EPS Analysis - Problems

1.X Ltd, a widely held company is considering a major expansion of its production facilities & the
following alternatives are available. The face value of each equity share is Rs. 100/-

Particulars Alternatives
A B C
Share Capital 50,00,000 20,00,000 10,00,000
14% Debentures - 20,00,000 15,00,000
18% Loan from Financial Institutions - 10,00,000 25,00,000
Expected Rate of Return before tax is 25%. The rate of dividend of the company is not less than
20%. The company has low debt corporate taxation @ 50%. Which alternative would you choose?
Ans: Alternative C is the most preferred as it has the highest rate of return @ Rs.29.50/-

2. A company needs Rs. 5,00,000/- for purchase of a new machinery. The following plans are feasible.
(a) Issue of 50,000 ordinary shares @ Rs. 10/- per share
(b) Issue of 25,000 shares @ Rs. 10/- per share & issue of 2,500 8% debentures @ Rs. 100/- per
debenture
(c) Issue of 25,000 ordinary shares @ Rs. 10/- per share & 2,500 preference shares @ Rs. 100/- each
which carry a dividend @ 12% p.a.
Assumptions:
(i) Company’s EBIT would be Rs. 60,000/- p.a. after the purchase of new machinery
(ii) Income tax rate @50%
(iii) Which alternative would you recommend & why?
[Ans: Alternative B is the most preferred as it has the highest EPS at Re. 0.80/-]

3. Y Ltd. has an equity share capital of Rs. 5,00,000/-[ Face Value Rs. 100/- each]. To meet the
expenditure of an expansion program, the company wishes to raise Rs. 3,00,000/- & the following
4 alternatives are available to raise the funds
Plan A: To have full money from equity shares
Plan B: To have Rs. 1,00,000/- from equity shares & Rs. 2,00,000/- from borrowings from a financial
institution @ 10% p.a.
Plan C: Full money borrowing @ 10% p.a.
Plan D: Rs. 1,00,000/- in equity shares & Rs. 2,00,000/- from preference shares @ 8% p.a. dividend
The company is having a present earning of Rs. 1,50,000/-. The corporate tax is 50%. Suggest the
most suitable plan to raise the required funds
[Ans: Alternative C is the most preferred as it has the highest EPS @ Rs. 12/-]

42
4. Company A is presently having a capital structure of 10,000 ordinary shares of Rs. 500/- each. The
company proposes to raise additional Rs. 50,00,000/- for a major expansion program & is
considering four possible financial plans
I II III IV
Equity Shares 10,000 @ 500/- 5,000 @ 500/- - 5,000 @ 500/-
10% Pref Shares - - - 5,000 @ 500/-
12% Term Loan - Rs. 25,00,000/- - -
13% Term Loan - - Rs. 50,00,000/- -
The additional input of capital would double the company’s present earnings before interest & tax from
the level of Rs. 6,00,000/-. Assume a tax rate @30%
You are required to calculate the impact on Earning per Share [EPS] for the shareholders under the four
alternative plans & comment
[Ans: Plan I & II may be preferred as they have the highest EPS @ Rs. 42/-]

5. X Ltd is considering 3 different plans to finance its total project cost of Rs. 100 lakhs. These are:
--------------- Rs. In Lakhs ---------------
Plan A Plan B Plan C
Equity Shares [ Rs. 100/- per share] 50 34 25
7% Debentures 50 66 75
Sales for the first 3 years of operation are estimated at Rs. 100 lakhs, Rs. 125 lakhs & Rs. 150 lakhs
respectively. 10% profit before interest & tax is forecast to be achieved. Corporate taxation may be
taken at 50%
Compute the EPS in each of the alternative plans of financing for the three years
[Ans: Plan C is recommended as it has the highest EPS in all the 3 years]

43
 Cost of Capital
The cost of capital is the most significant criteria used for evaluating capital budgeting decisions. It is
a yardstick to measure the value of investment proposals. Cost of Capital is the minimum required rate
of return, cut off rate, standard rate etc. In operational terms, it is the minimum rate of return that
firm must earn on its investment i.e., it refers to the discount rate which is used while determining
the present value of estimated future cash flows. However, in economic terms, the cost of capital is
the cost of raising funds required to finance the proposed project i.e., the borrowing rate of the
firm. It can also be referred to as the opportunity cost of funds, in terms of lending rate i.e., the expected
earnings by investing outside. It can be concluded that the cost of capital is the rate of return that a firm
must earn on its investments to maintain the market value & attract funds. According to Ezra Solomon,
the cost of capital is the minimum required rate of earnings or the cut-off rate of capital
expenditure.
Classification of Cost of Capital: The cost of capital can be broadly classified as follows:
• Explicit & Implicit Cost:
The explicit cost of capital is the discount rate that equates the present value of the incremental cash
flows with the present value of its incremental cash outflows. Explicit cost arises when the capital
is raised
Implicit cost arises when the firm considers alternative uses of the funds raised i.e. its opportunity
cost. It can be defined as the rate of return associated with the best investment opportunity for the
firm & its shareholders that will be foregone if the project presently under consideration by the firm
was accepted. Thus, Explicit cost arises when funds are raised while implicit cost arises when funds
are used.
• Future & Historical Cost:
Future Costs are the expected costs of funds for financing a particular project.
Historical Costs, on the other hand, are already incurred costs. They are useful for projecting future
costs.
• Specific Cost: The cost of each component of capital i.e. Equity Shares, Preference Shares,
Debentures, Term loans etc. are termed as specific costs. While determining the average cost of
capital, the specific costs are considered. This is particularly useful where the profitability of the
project is evaluated on the basis of the specific source of funds availed for financing the project.
• Average & Marginal Cost:
Average Cost is the weighted average cost of each component of the funds invested by the firm for
a particular project i.e., proportionate cost of each element in the total investment. The weights are
in proportion to the shares of each component of capital in the total capital structure or investment.
But average cost has the following computational problems:

44
 - Refers to the measurement of cost of each specific source of capital
- Requires assignment of proper weights to each component of capital
- Is the overall cost of capital affected by the changes in the composition of capital?
Marginal Cost is the cost of obtaining another rupee of new capital. Marginal cost reveals the cost
of additional capital raised by the firm for current and /or fixed capital investment. It means that the
marginal cost of capital will be less than the average cost of capital
• Overall / Composite / Combined Cost: The term cost of capital is used to denote the overall
composite cost of capital or the weighted average cost of each specific type of fund. In other words,
when specific costs are combined to find out the overall cost of capital, it may be called as the
composite or weighted average cost of capital.
Computation of Cost of Capital:
Cost of Debt (Kd): Debt may be issued at par, premium at discount. They may be perpetual or
redeemable debt. Perpetual debt is called as irredeemable debt. Cost of debt is denoted as (K d)
Debt Issued at Par: Par is also known as Face Value. An amount of interest payable in the cost of
debt after adjusting taxes is known as debt issued at par.
Kd = I * (1-t) / NP * 100
where I = Interest & t = Tax
Debt Issued at Premium & Discount: Premium refers to greater than face value while discount is less
than face value. It is redeemable after the expiry of any given period. Its price differs from the face
value.

Kd = C + 1/n (P-I) (1-t)

________________
½ (P+I)

Where C = Fixed Charges p.a. / Annual Interest / Coupon Interest

P = Face Value, I = Price at which bond is sold or net proceeds
t = Tax n = No. of years / Time Period / Life of the debt
Perpetual Debt: It is also called as irredeemable debt as it is to be repaid only on liquidation. It is
adopted to maintain a constant amount of debt in the capital structure of the organization to tax.

Kd = I(1-t) / NP * 100
Where t = Tax, I = Interest in Value,
NP = Net Proceeds / Net revenue

Cost of Equity (Ke): The cost of equity is the maximum rate of return that the company must finance
on its equity shares of its investments in order to leave unchanged market price of its stock. The cost of
equity share capital can be computed in the following ways:

45
 • Dividend Yield Method: Ke = D /NP or D / MP
where D = Expected Dividend, MP = Market Price, NP = Net Proceeds
• Dividend Yield + Growth Method: Ke = (D/NP) +G or (D/MP)+G
where G = Growth
• Earnings Yield Method: Ke = (EPS/NP) or (EPS/MP)
where EPS = earnings per share.
• Earnings Growth Method: Ke = ( EPS / NP )+ G or ( EPS / MP ) + G
Where G = Growth
Cost of Retained Earnings (Kre): When an organisation decides to retain the profits earned during the
year without disclosing the level of profit to the internal or external investors, then such earnings are
called as retained earnings. They are also referred to as the undistributed profits of the company.
Note: Disclosure of profits earned sometimes can be partial depending upon the decision taken in the
annual general body meeting of the organization.
Kre = ( D/NP) +G (1-t) (1-b) / Kre = Ke (1-t ) (1-b)
where t = Tax, b = Cost of Purchasing / Borrowings / Brokerage
Cost of Preference Share Capital (Kp): Preference shares are those shares that carry a fixed rate of
dividend. They enjoy a priority to payment of preference dividend. But, dividend is payable only in
case of profits. There is no legal binding on the Board of Directors to pay dividend but if any dividend
is paid to equity Shares, then it has to be paid to the preference shareholders first.
Kp = ( D / PS or NP or MP)
where D = annual dividend, PS = preference share capital
Note: If Preference shares are issued at premium or discount and are redeemable after a specified
period of time then
Kp = D + 1/n (P-I)/ ½ (P + I)

where D = Dividend payable , n = No. of years,

P = Face Value, I = Issue Price
Computation of Overall Cost of Capital:
- Compute specific cost of each source of finance
- Assign proper weights to each source of finance
- Find out weighted cost
Weighted Cost = Cost * Weight
- Calculate Total Weights & Total Weighted Cost
- Weighted Average Cost of Capital = Total Weighted Cost / Total Weights
The weighted average cost of capital can change either due to a change in the cost of each component,
change in weight or both

46
Selection or Assignment of Weights:
(i) Book Value Weights: It is used for actual or historical weights. Under this method, weights are
the relative proportions of the various sources of capital to the total capital structure of the firm.
The advantage of this method is that the weights are easily available from the published annual
reports of the firm. Moreover, every firm sets its capital structure targets in terms of values rather
than market value. The analysis of capital structure in terms of debt-equity ratio is also dependent
on book values
(ii) Market Value Weights: Under this method, the market values of each source of finance are used
as weights. This is advisable for the following reasons:
- The market value of the securities is a close approximate to the actual amount to be rec’d from
the proceeds of such securities
- The cost of each specific source is calculated according to the prevailing market price
However, it has operational difficulties as the market value fluctuates frequently & is not readily
available. The analysis of capital structure in terms of debt-equity ratio is also based on book value
rather than market value.
(iii) Marginal Value Weights: When the weights are assigned to specific costs by the proportion of
each type of fund to the total funds that are raised, it is known as marginal weights. It means that
the weights correspond to the proportion of financing inputs a firm intends to employ to finance a
proposed investment proposal.
List of Questions

Short Answer Questions – 4 Marks

1. What are the concepts of cost?

2. Give a classification of Cost of Capital.

3. Write a note on WACC.

Essay Questions – 12 Marks

1. Write a note on Cost of Capital

47
 Cost of Capital - Problems
Cost of Debt - Irredeemable Debt

(i) Before Tax - Kdb = I / NP * 100

Where I = Interest in Value
NP = Net Proceeds = Issue Price – Floatation Costs
(ii) After Tax - Kda = I / NP (1 – t) * 100
Where t = Tax Rate

1. X Ltd. issues Rs. 50,000/- 8% debentures at par. The tax rate applicable to the company is 50%.
Compute the cost of debt capital before & after tax.
[Kdb = 8%; Kda = 4%]

2. Y Ltd. issues Rs. 50,000/- 8% debentures at a premium of 10%. The tax rate applicable to the
company is 60%. Compute the cost of debt before & after tax.
[Kdb = 7.27%; Kda = 2.91%]

3. A Ltd. issues Rs. 50,000/- 8% debentures at a discount of 5%. The tax rate applicable to the company
is 50%. Compute the cost of debt capital before & after tax.
[Kdb = 8.42%; Kda = 4.21%]

4. B Ltd. issues Rs. 1,00,000/- 9% debentures at a premium of 10%. The floatation costs are 2%. The
tax rate applicable to the company is 60%. Compute the cost of debt capital before & after tax.
Note: Floatation costs are to be applied on the Issue Price
[Kdb =8.35 %; Kda = 3.34%]

5. X Ltd. issues 50,000/- 8% debentures or Rs. 10 each at a premium of 10%. The cost of floatation are
2% The tax rate applicable to the company is 60%. Compute the cost of debt capital
[Kda = 2.97%]

48
 Cost of Debt – Redeemable Debt
(i) Before Tax - Kdb = I + [1 / n ( RV – NP) / ½ (RV + NP) ]* 100
Where I = Interest in Value
n = No. of Years / Life of debentures
RV = redemption Value
NP = Net Proceeds = Issue Price – Floatation Costs
(ii) After Tax - Kdb = I [ 1 – t) + [1 / n ( RV – NP) / ½ (RV + NP) ]* 100
Where t = Tax Rate

1. A company issues Rs. 10,00,000 10% redeemable debentures at a discount of 5%. The costs of
floatation amounted to Rs. 30,000/-. The debentures are redeemable after 5 years. Calculate the
before tax & after-tax cost of debt charging tax @50%.
[(i) Kdb = 12.08%; (ii) Kda = 6.875%]

2. A 5-year Rs. 100/- debenture of a firm can be sold for a net price of Rs. 96.50/-. The coupon rate of
interest is 14% p.a. & the debenture will be redeemed at 5% premium on maturity. The firm’s tax
rate is 40%. Calculate the before tax & after-tax cost of debt.
[(i) Kdb = 15.58%; (ii) Kda = 10.02%]

3. Assuming that a firm pays tax @50%, compute the after-tax cost of debt capital in the following
cases
(i) A Rs. 100/- perpetual bond sold at par, coupon interest being 7%
(ii) A 10 year, 8% Rs. 1000/- per bond sold at Rs. 950/- less 4% underwriting commission
[(i) Kda = 3.5%; (ii) Kdb = 5.1%]

4. A company issues 5,000 12% debentures of Rs. 100/- each. The debentures are redeemable after the
expiry of a fixed period of 7 years. The company is in the tax bracket of 35%. Calculate
(i) The after-tax cost of debt if the debentures are issued at (a) Par (b) Discount of 10% (c) Premium
of 10%
(ii) If brokerage is paid at 2%, what will be the cost of debentures, is the issue is at par
[(i) (a) 7.8%; (b) 9.71%; (c ) 6.07% (ii) 8.17%]

5. X ltd. issues 10 years debt of Rs. 100/- at a discount of 10%. Coupon interest is 8%.
Calculate the cost of debt assuming tax @ 50%
[Kda = 5.26%]

49
 Cost of Preference Shares
Irredeemable Preference Shares
Kp = D / NP
Where D = Dividend in Value
NP = Net Proceeds = Issue Price – Floatation Cost
1. A company issues 10,000 10% preference shares of Rs. 100/- each. Cost of issue is Rs.2/- per share.
Calculate the cost of preference shares if the shares are issued (a) At Par (b) At 10% premium (c) At
5% discount
[(a) Kp = 10.2%; (b) Kp = 9.26%; (c) Kp = 10.75%; ]

2. A company issues 10,000 12% preference shares of Rs. 100/- each at a discount of 5%. Cost of
raising capital is Rs. 2,000/-. Calculate the cost of preference shares.
[ Kp = 12.66%]

3. XYZ Ltd. issues 20,000 12% preference shares of Rs. 100/- each. Calculate Kp.
[ Kp = 12%]

4. A company issues 15,000 12% preference shares of Rs. 10/- each. The cost of issue per share is Rs.
3.25ps. Calculate Kp (i) At Par (ii) At 12% Premium (iii) At 10% Discount
[(i) Kp = 17.78%; (ii) 15.09% ; (iii) 20.87%]

Redeemable Preference Shares

Kpr = D + 1/n (MV – NP) / ½ (MV + NP)
Where D = Dividend in Value
n = No. of Years / Life of Preference Shares
MV = Maturity Value
NP = Net Proceeds = Issue Price – Floatation Cost

1. A company issues 10,000, 10% preference shares of Rs. 100/- each redeemable after 10 years at a
premium of 5%. The cost of issue is Rs. 2/- per share. Calculate the cost of preference share
[Kpr = 10.54%]

2. A company issues 1,000 7% preference shares of Rs. 100/- each at a premium of 10% redeemable
after 5 years at par. Compute the cost of preference share.
[Kpr = 4.76%]

50
3. Assume that the firm pays a tax @ 50%. Compute the after tax cost of preference shares sold at Rs.
100/- with a 9% dividend & a redemption price of Rs. 110/- if the company redeems it after 5 years
[ Kpr = 10.476%]

4. ABC company issues 2,000 10% preference shares of Rs. 100/- each, repayable at Rs. 95/- at the
end of 10th year. Calculate the cost of preference shares.
[ Kpr = 9.74%]

5. A company issues 3,000 12% preference shares of Rs. 100/- each, redeemable after a period of 12
years at a rate of Rs. 72.90/-. Calculate Kpr
[ Kpr = 11.27%]
Cost of Equity
1. ABC Ltd has declared Rs. 25/- as dividend on each share. The current market price is Rs 60/-.
Calculate cost of equity under dividend yield method.
[Ke = 41.67%]

2. A company issues 1000 equity shares of Rs. 100/- each at a premium of 10%. The company has
been earning Rs. 20/- as dividend on each share. The market price of share is expected to be Rs 160/-
. Calculate Ke.
[Ke at NP = 18.18% & at MP = 12.5%]

3. X Company quotes its shares in the stock exchange at Rs. 120/- each. The dividend paid on each
share is Rs. 30/-. The expected annual growth is 5 %. Calculate K e using dividend yield + growth
method.
[Ke = 30%]

4. A company plans to issue 1000 equity shares of Rs. 100/- each. The growth is expected to be 5 %.
The flotation cost / net proceeds are expected to be 5% less than the share price. The dividend paid
by the company is Rs.10/- per share. Calculate Ke if Market Price is Rs. 150/-.
[Ke at NP = 15.53% & at MP = 11.67%]

5. The current market price of an equity share of a company is Rs. 90/-. The dividend paid is Rs.4.50/-
per share. Calculate Ke if the growth is expected to be 7%.
[Ke = 12%]

51
6. R Ltd shares are trading currently at Rs. 70/- with an outstanding number of shares of 500000. The
expected profit after tax is Rs. 84,00,000/-. Calculate Ke on the basis of EPS model.
[Ke = 24%]

7. D ltd issued 3000 equity shares of Rs. 100/- each. The company has earned a profit of Rs. 18,000/-
after tax. The market price of the share is Rs 150/-. The dividend paid is Rs. 10/ per share. Calculate
cost of equity using the dividend yield method and earnings yield method.
[Dividend Yield Method - Ke = 6.67%; Earnings Yield Method - Ke = 4%]

8. The current MP of an equity share of Rs 10/- is Rs. 20/-. The EPS is Rs. 3/-. Growth rate in earning
is given at 10%. Calculate cost of equity.
[Ke at MP = 25%; Ke at NP = 40%]

9. Z ltd is currently trading its equity shares at Rs. 95.20/-. The expected earnings after tax is Rs.
74,50,000/-. Which has an outstanding share of 25 lakhs? Calculate Ke.
[Ke = 3.13%]

10. Sangeetha ltd has 600000 equity shares of Rs. 10/- each. They earned a profit of Rs.9,00,000/- after
tax. If the market price of these shares is Rs. 20/- per share, calculate Ke.
[Ke = 7.5%]
Cost of Retained Earnings
1. A firm’s Ke is 15%, average tax rate is expected to be 40% with a brokerage cost of 2%. Calculate
Kre. [Kre = 8.82%]

2. F Ltd has its cost of equity at 12%. The average tax is 60 %, brokerage cost is 2 %. Calculate Kre.
[Kre = 4.70%]

3. S ltd has its cost of equity at 10%, the average tax is 20 % while the brokerage cost is 2 % .
Calculate Kre. [Kre = 7.84%]

4. Calculate the cost of retained earnings of U Ltd if the market price of share is Rs.120/-, cost of
brokerage is 5 %, growth is 6%, the Dividend per share is Rs. 12/- & the tax is 20 %.
[Kre = 12.16%]
5. Calculate the cost of retained earnings of H Ltd if market price of share is Rs.150/, cost of
brokerage is 6 %, growth is 8% while the Dividend per share is Rs.12 & tax is 35 %.
[Kre = 9.78%]

52
 Weighted Average Cost of Capital – Problems

1. The cost of capital [after tax] of a firm of the specific sources is:
Cost of Debt 4.5%
Cost of Preference Shares 10.5%
Cost of Equity Shares 15.6%
Cost of Retained Earnings 15.0%
Capital Structure:
Debt Capital 2,00,000
Preference Share Capital 3,00,000
Equity Share Capital 4,00,000
Retained Earnings 1,00,000
Total Capital 10,00,000
Calculate the weighted average cost of capital using book value weights
[Ans: 11.79%]

2. The book value of capital structure of X Ltd. was:

Securities Amount After Tax Cost
Equity Share Capital [Rs. 100/- each] 10,00,000 -
12% Preference Share Capital 5,00,000 12%
Retained Earnings 5,00,000 -
10% Debentures 2,00,000 10%
12^ Term Loan 3,00,000 12%
Calculate the Weighted Average Cost assuming that the expected rate of dividend was Rs. 20/- per share
[Ans: 16.64%]

3. X Ltd. presented the following capital structure & after-Tax Costs

Sources Amount Proportion After Tax Cost
Debt 30,00,000 25% 6%
Pref. Share Capital 24,00,000 20% 12%
Equity Share Capital 36,00,000 30% 15%
Retained Earnings 30,00,000 25% 14%
120,00,000 100%
Compute Weighted Average Cost of Capital
[Ans: 11.90%]

53
4. A firm has the following capital structure & after-tax cost for the different sources of funds used:
Sources Amount Proportion % After Tax Cost %
Debt 4,50,000 30 7
Pref. Share Capital 3,75,000 25 10
Equity Share Capital 6,75,000 45 15
15,00,000 100
Calculate Weighted Average Cost of Capital using Book Value Weights
[Ans:11.35%]

54
 Dividend Policy Decision
Dividend is the return of shareholders investment. It is the divisible profit which is distributed amongst
the owners of the company in proportion to their shareholding. In other words, it is the share of profits
of a company divided amongst its shareholders.
Types of Dividends:
Types of Dividend

Source Medium Timing

• Retained Earnings • Cash Dividend • Interim Dividend

• Stock Dividend • Final Dividend

• Current Profit
• Bond Dividend
• Scrip Dividend

Cash Dividend: The dividend that is declared & paid in cash is known as cash dividend. It is the most
preferred & used type of dividend. A company can declare cash dividend only if it has enough cash
resources.
Stock Dividend: The dividend that is declared & paid in the form of stock is known as stock dividend.
In other words, if shares are issued in lieu of cash dividend, it is known as stock dividend. The free
shares issued to the shareholders are known as bonus shares. It is also referred to as capitalization of
free reserves. It means that the company converts its retained earnings into share capital. SEBI has laid
certain restrictions on the issue of stock dividend.
Bond Dividend: The dividend that is declared & paid in the form of bond is known as bond dividend.
It means that the company issues bonds / debentures to its investors in lieu of a cash dividend, the
shareholder additionally becomes a creditor of the company. The bond carries interest at a pre-
determined rate.
Scrip Dividend: The dividend that is declared & paid in the form of scrip is known as scrip dividend.
It is a promissory note issued by the company in lieu of a cash dividend. It may or may not carry interest
& is generally issued for a short period. The company issues a scrip dividend when it does not have
enough cash resources but is expecting a cash inflow in a short span of time. The shareholders can
encash the scrips on maturity.

Dividend Policy is the policy which concerns the quantum of profits to be distributed by way of
dividend. This policy implies that the company introduces a pattern of dividend payment through their
Board of Directors. The power to recommend dividend policy & declaration of dividend vests
completely on the Board of Directors.

55
Determinants of Dividend Policy: The primary determinants of the dividend policy can be classified
as external factors & internal factors.
External Factors: The external factors that determine the dividend policy are:
• State of Economy: The prevailing conditions in the economy influence the dividend policy of the
firm. If the economy is buoyant, the firm can declare dividend as it likes. But, if there are uncertain
business & economic conditions, depression or inflation, the firm prefers to retain earning rather than
declare dividend.
• Capital Market Conditions: The capital market conditions affect the dividend policy to the extent
to which the firm has access to the capital market. If the access is easy, it an adopt a liberal dividend
policy & vice versa. If the capital markets are not forthcoming, it is easier to rely on retained earnings.
• Legal, Contractual Constraints & Restrictions: It is one of the significant factors as there is no
legal binding on the company to declare dividend. As per Indian Companies Act1956, dividend has to
be paid either out of current year or previous year’s profits after charging depreciation. However, the
Central Govt. has been empowered to allow any company for paying profits out of current year’s profits
before charging depreciation. The dividend must be paid in cash, although a company can capitalize
profits or reserves for issuing bonus shares or making partly paid up shares into fully paid up. If the
Central Govt. permits, a company can declare dividends out of accumulated profits. Similarly, the
Income Tax Act 1961precribes certain restrictions on payment of dividend. Therefore, the company
has to abide by all these legal provisions while declaring dividend
Contractual Restrictions are imposed by lenders of the firm. This also affects the dividend policy
• Tax Policy: The tax policy of the govt. also affects the dividend policy of the firm as decisions such
as cash dividend or bonus shares are dependent on them. Generally, cash dividend is not attractive to
the investors who are in the higher tax brackets. Therefore, a firm follows a tax oriented dividend policy
by
- Not declaring dividend & assisting shareholders to secure their returns by sale of bonus shares
- Following a policy of regular share dividend in lieu of cash dividend
• Inflation: If the economy is experiencing inflationary conditions, the dividend policy is directly
affected as rising prices lead to decrease in fund availability. So, the company relies on retained earnings
for its needs. Hence, the dividend is affected.
• Stability of Dividends: A significant factor that contributes to the dividend policy decision is the
stability of dividends payable. The investors favour a stable dividend. Stable dividend refers to the
consistent dividend payments.
• Stability of Earnings: If a firm is able to earn stable or consistent profits, it can have a stable
dividend policy. But, if the earnings are irregular or fluctuating, the dividend policy is affected.

56
• Cost of Financing: The cost of financing affects the dividend policy as the company cannot pay a
higher rate of dividend if the external financing is expensive. It has to depend on internal sources to
meet its requirements.
Internal Factors: The following internal factors also affect the dividend policy:
• Dividend Payout Ratio: It refers to the percentage of net earnings distributed as dividend amongst
the shareholders. Dividend Payout Ratio is a significant managerial decision with regard to what
proportions of the divisible profits should be distributed as dividend & what proportion to be
retained. This decision is based on the liquidity position of the firm along with the growth rate
expected & the control over the firm. The management has to strike the right balance between
declaring dividend & retaining earnings as it has an impact on both liquidity & profitability.
• Liquidity Position: If the company is having sufficient cash resources, it can declare a higher rate
of dividend. But, if there is a shortage of cash in spite of high profits, the company cannot afford to
declare a high rate of dividend.
• Rate of Return: If the ROI is high, the firm can declare higher dividends. But if the return on capital
employed is lower than the return on outside investment, the shareholders may not be interested in
continuing their investment unless the returns are high.
• Divisible Profits: It refers to that part of the net profits that are available for distribution as dividend
amongst the shareholders. This is subject to certain restrictions as per the Indian Companies Act
1956 & therefore affects the dividend policy.
• Degree of Control: The shareholders do not want to sacrifice control over the company affairs for
which they do not depend on internal source of funds. As a result, they want to retain a major part
of the retained earnings & thus affect the dividend policy.
List of Questions

Short Answer Questions – 4 Marks

1. Write a note on dividend policy decision.

2. What are the types of dividends? Discuss.

Essay Questions – 12 Marks

1. What are the determinants of dividend policy?

57
 Unit IV
Working Capital Management
Working capital is also referred to as Revolving, Circulating or Floating capital. Working capital
refers to the capital required for the day-to-day management of the business. It plays an important role
in the smooth functioning of the business. Working capital management may be defined as the
management of the firm’s sources & uses of working capital to maximize the shareholders wealth. The
management of working capital affects both the profitability as well as liquidity of the business.
Inefficient working capital management may lead to shortage of funds or funds lying idle. The goal of
working capital management is to manage the firm’s current assets & current liabilities in such a way
that a satisfactory level of working capital is maintained.
Working capital can be either Gross Working Capital or Net Working Capital. Gross working capital
refers to the total of current assets whereas net working capital is the excess of current assets over
current liabilities.
Current assets are the assets that can be quickly converted into cash, normally within one year. Current
assets include cash & bank balances, inventories, receivables, marketable securities, prepaid expenses
& accrued incomes. Current liabilities are the debts that are payable within one year. Current liabilities
include bank overdraft, payables, outstanding expenses & pre-received incomes.
Objectives of Working Capital Management: Working capital management includes management of
all current assets & current liabilities individually. The current assets should be large enough to cover
the current liabilities in order to ensure a reasonable margin of safety. The goal of working capital
management is to manage the current assets & liabilities in such a way that an acceptable level of net
working capital is maintained. The objectives are:
• To maintain liquidity of operations, the business should have enough funds to meet its day-to-
day expenses.
• To optimize investment in current assets so that funds are not locked unnecessarily.
• To have an optimum working capital such that it does not result in shortage of funds.
• To maintain a proper balance between the marginal return on investment in current assets & on
the capital employed to finance these assets.
Determinants of Working Capital: The quantum of working capital depends upon a number of factors
that are as follows:
• Size & Nature of the business: The amount of working capital is based on the size & the nature of
the business. Small organizations require less working capital & vice versa. The nature of the
business also influences the amount of working capital. Public utilities generally offer their services
primarily on cash basis. Therefore, they have the least requirement of working capital. In case of
trading concerns & financial enterprises, they have to maintain a sufficient amount of cash,
inventories & book debts. Therefore, they need to invest proportionately large amounts in working

58
 capital. The manufacturing concerns need more of fixed assets when compared to current assets.
Hence, the need for working capital is not so high as in case of a trading concern.
• Demand of the business: If the demand for the goods is seasonal, the working capital requirement
in the season is large when compared to the off season. It is also based on the production policy to a
great extent. But, if the demand is steady, the working capital requirement is also limited or not so
high.
• Production Cycle: The term production or manufacturing cycle refers to the time involved in the
manufacture of goods. It covers the time span between the procurement of raw materials & the
completion of the manufacturing process leading to the production of finished goods. The longer the
time span, greater is the requirement of working capital & vice-versa.
• Business Cycle: The working capital requirements are also influenced by the nature of the business
cycle. Business fluctuations lead to cyclical & seasonal changes which effect the working capital
requirements. When the market is at its boom, working capital requirement is increased as there is a
need for more inventories. Similarly, in case of recessionary conditions, there is a lower need for
working capital.
• Credit Policy: The credit policy relating to purchases & sales also has an impact on the quantum of
working capital. The sales credit policy influences the book debts. Higher the book debts, greater is
the working capital requirement & vice versa. On the other hand, if credit is granted liberally by the
suppliers, the working capital need is reduced.
• Growth & Expansion: As an organization grows, the need for working capital enhances. The
composition of working capital in a growing firm is also determined by the economic policies &
corporate practices.
• Availability of Raw Materials: The supply of raw materials also influences the working capital
requirements of a firm. Uninterrupted flow of raw materials means less amount of working capital
is required. If there is a disruption or time gap between placing the order & receipt of goods, the
working capital requirement increases as the firm has to hold an adequate stock of raw materials to
ensure smooth production. Even, seasonal availability of raw materials influences the amount of
working capital.
List of Questions

Short Answer Questions – 4 Marks

1. What are the objectives of Working Capital Management?

Essay Questions – 12 Marks

1. What are the determinants of Working Capital?

Assignment Question
1. Define Working Capital. What are the determinants of Working Capital?

59
 Working Capital Management - Problems

1. A pro forma cost sheet of a company provides the following information:

Amount per unit
Elements of cost Raw Materials Rs. 80
Direct Labour 30
Overheads 60
Total Cost 170
Profit 30
Selling Price 200
The following further particulars are available:
Raw materials are in stock on average – one month, Materials are in process (completion stage –
50%), on average – half a month, Finished goods in stock, on average one month.
Credit allowed by suppliers is one month; Credit allowed to debtors is two months; Average time lag
in payment of wages is 1.5 weeks & one month in overhead expenses; one fourth of the output is sold
against cash; Cash in hand & at bank is desired at Rs. 3,65,000/.
You are required to prepare a statement showing the working capital needed to finance a level of
activity of 1,04,000 units of production. You may assume that the production is carried on evenly
throughout the year & wages & overheads accrue similarly. For calculations purpose, 4 weeks are to
be taken as a month
(Ans : Net Working Capital : Rs. 36,95,000/-)

2. While preparing a project report on behalf of your client, you have collected the following
information. Estimate the net working capital required for that project. Add 10% to your computed
figure to allow for contingencies.
Amount per unit
Elements of cost Raw Materials Rs. 40
Direct Labour 20
Overheads ( excl. of depr Rs 10/-) 30
Total Cost 90
Additional information:
Level of activity of 1,00,000 units of production p.a.
Raw materials are in stock on average – 4 weeks
Materials are in process (completion stage – 50%), on average – 2 weeks
Finished goods in stock, on average – 4 weeks
Credit allowed by suppliers is – 4 weeks
Credit allowed to debtors is average – 8 weeks

60
Average time lag in payment of expenses is 1.5 weeks
Cash in hand & at bank is desired at Rs. 25,000/-
You may assume that the production is carried on evenly throughout the year (52 weeks) & wages &
overheads accrue similarly. All sales are on credit basis only.
(Ans : Net Working Capital : Rs. 22,07,693/-)

3. You are supplied with the following information in respect of XYZ Ltd for the ensuing year.
Production of the year – 69,000 units
Raw materials in store – 2 months consumption
Production process – 1 month
Finished goods in store – 3 months
Credit allowed by creditors – 2 months
Credit given to debtors – 3 months
Selling price per unit – Rs. 50/-
Raw material @ 50% of the selling price
Direct wages @ 10% of the selling price
Manufacturing & administrative overheads @ 16% of the selling price
Selling overheads @ 4% of the selling price.
There is a regular production & sales cycle & wages, overheads accrue evenly. Wages are paid in
the next month of accrual. Materials are introduced in the beginning of the production cycle. You
are required to ascertain its working capital requirement.
(Ans : Net Working Capital : Rs. 14,97,825/-)
Note: Selling overheads should be added only to debtors & not for any other item

4. Prepare an estimate of working capital requirements from the following information of trading
concern.
Projected annual sales 1,00,000 units
Selling Price Rs. 8/- per unit
% of net profits on sales 25%
Average credit period allowed by suppliers 4 weeks
Average credit period allowed to debtors 8 weeks
Average stock holding 12 weeks
Allow 10% for contingencies
(Ans : Working Capital requirement - Rs. 2,03,078/-)

61
5. The cost sheet of a company provides the following information:
Elements of Cost Amount per unit (Rs)
Raw Materials 50
Direct labour 20
Overheads 10
Total Cost (TC) 80
Profit 20
Selling Price (SP) 100
The following particulars are available:
(i) Raw materials are in stock, on an average one month
(ii) Materials are in process, on an average half a month
(iii) Finished goods are in stock on an average one month
(iv) Credit allowed by suppliers is one month
(v) Credit allowed to debtors is one month
(vi) Lag in payment of wages is two weeks
One fourth of the sales are against cash.
Cash in hand & at banks is expected to be Rs. 20,000/-
Prepare a statement showing the working capital needed to finance a level of activity of 1,30,000
units of output per annum.
(Ans : Working Capital requirement - Rs. 16,45,000/-)

6. You are given the following information:

Elements of Cost Amount per unit (Rs)
Raw Materials 50
Direct labour 30
Overheads ( incl. depreciation Rs. 10/-) 40
Total Cost (TC) 120
Profit 20
Selling Price(SP) 140
Average Raw materials are in stock for one month. Materials are in process for half a month on an
average. Credit allowed by suppliers is 1 month. Credit allowed to debtors is one month. Average
lag in payment of wages is 10 days & payment of overheads 30 days. Cash on hand is expected to
be Rs. 1,00,000/-. Finished goods lie in the warehouse for one month.
25% of the sales are against cash.
You are required to prepare a statement showing the working capital needed to finance a level of
activity of 54,000 units of output per annum. Assume that 1 year = 12 months & 1 year = 360 days
(Ans : Working Capital requirement - Rs. 9,66,250/-)

62
7. The management of Manek Ltd. has called for a statement showing the working capital needed to
finance a level of activity of 3,00,000 units of output for the year. The cost structure for the
company’s product, for the above-mentioned activity is detailed below.
Cost per unit
Raw materials 20
Direct labour 5
Overheads 15
Total Cost 40
Profit 10
Selling Price 50
(a) Raw materials are held in stock, on an average for two months.
(b) WIP (100% in respect of raw materials & 50% in respect of labour & overheads) will be
approximately half month’s production.
(c) Finished goods remain in warehouse on an average for a month.
(d) Suppliers of materials extend a month’s credit.
(e) Two months credit allowed to sundry debtors, calculations to be made on selling price.
(f) Minimum cash balance of Rs. 25,000/- is expected to be maintained.
(g) The production pattern is assumed to be even during the year. Assume that 1 year = 12 months
Prepare a statement showing working capital requirement.
(Ans : Working Capital requirement - Rs. 44,00,000/-)

8. You are required to prepare for the Board of Directors of Excel Company Limited, a statement
showing the working capital needed to finance a level of activity of 5,400 units of output per annum.
You are given the following information:
Cost Amount per unit (Rs)
Raw Materials 8
Direct labour 2
Overheads 6
Total Cost (TC) 16
Profit 4
Selling Price(SP) 20
Raw materials are in stock on an average for one month. Materials are in process for half a month on
an average. Credit allowed by suppliers is 1 month. Finished goods are in stock on an average for six
weeks. Credit allowed to debtors is two months. Lag in payment of wages is 1 ½ weeks. Cash on hand
& at bank is expected to be Rs. 7,300/-. You are informed that production is carried on evenly during
the year & wages & overheads accrue similarly.
(Ans : Working Capital requirement - Rs. 32,742/-)

63
9. From the following information, you are required to estimate the net working capital
Cost per Unit (Rs)
Raw Materials 400
Direct Labour 150
Overheads 300
Total 850
Additional information:
Selling price – Rs. 1,000/- per unit
Output – 52,000 units p.a.
Raw materials in stock – Average 4 weeks
Work-in-progress – Average 2 weeks (Assume 50% completion with full material consumption)
Finished goods in stock – Average 4 weeks
Credit allowed to debtors – Average 8 weeks
Credit allowed by suppliers – Average 4 weeks
Cash at bank expected to be Rs. 70,000/-
Assume that production is sustained at an even pace during the 52 weeks of the year. All sales are credit
sales. State any other assumption that you might have made during calculations.
(Ans : Working Capital requirement - Rs. 115,20,000/-)

10. On the basis of the programme formulated to put into operation with effect from 1st January 2021,
the management of Amex Ltd. desires to know that amount of working capital required to finance
the production programme
The % of cost to sales is:
Materials - 50%
Labour - 20%
Overheads - 10%
Production in 2020 was 12,000 units & it is proposed to maintain the same during 2014
Additional Information:
(a) Raw materials are to remain in the stores on an average period of one month
(b) Each unit of production will be in process for one month on an average
(c) Finished goods are to stay in the warehouse on an average of two months
(d) Credit allowed to debtors is four months & Credit allowed by suppliers is two months
(e) Delay in payment of wages is 1/2 month & overheads is one month
(f) Cash is required for contingencies Rs 20,000/-
(g) Selling price per unit is Rs. 12/-
Production is carried on evenly throughout the year & wages & overheads accrued similarly.
(Ans : Rs. 77,000/-)

64
 Cash Management
Cash is an important current asset. A business requires cash for meeting various needs. The assets
acquired by cash help the business to earn revenue. The goods
That are manufactured or service rendered are sold to acquire cash. A firm has to maintain a certain
level of cash for this purpose. There is always a gap between cash inflows & cash outflows. Therefore,
a financial manager has to synchronize the same. Perfect synchronization of cash receipts & payments
is only an ideal situation, far from reality.
Motives for holding cash: Cash is the most important requirement of every business. It requires or
holds cash for the following reasons:
• Transaction Motive: One of the main requirements of cash is for transaction purpose. It refers to
the holding of cash to finance transactions entered into in the regular course of business. Transaction
cash flows include receipts & payments. Receipts can be on account of sales, incomes or from
debtors. Similarly, payment can be for purchases, expenses or to creditors. These receipts &
payments constitute a continuous two-way flow of cash. But, these two generally do not synchronize.
To ensure that the firm can meet its obligations as & when they become due, it must have an adequate
cash balance. The requirement of cash balances to meet routine cash needs is known as transaction
motive. Such motive refers to the holding of cash to meet anticipated obligations whose timing is
not perfectly synchronized with the cash receipts.
• Precautionary Motive: The business may face unprecedented circumstances where in there is an
unplanned expenditure to be met. To meet such unforeseen circumstances, the business has to hold
cash. The cash balances held in reserve for such random & unforeseen fluctuations in cash flows are
called as precautionary balances. Thus, precautionary balances serve to provide a cushion for
unexpected contingencies.
• Speculative Motive: It refers to the desire of the firm to take advantage of opportunities which
present themselves at unexpected moments & which are typically outside the normal course of
business. While precautionary motive is defensive in nature, speculative motive represents a positive
& an aggressive nature.
• Compensating Motive: One of the motives for holding cash is to compensate banks for providing
certain services & loans. Usually, clients are required to maintain a minimum balance of cash with
the bank. Since, this balance cannot be used for transaction purposes banks use the amount to earn
returns. Such a balance is known as compensating balance. Compensating balances are also required
by some firms to raise loans from banks. When the supply of credit is restricted & interest rates are
rising, banks require a borrower to maintain a minimum balance in his account as a precedent to the
grant of loan. The compensating balance can be either an absolute balance or a minimum average
balance over a period of time.
Of all of the above, the two most important motives are transaction & compensation motives.

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Cash Management: Cash management has assumed a lot of importance because cash is the most
significant current asset. It is required to meet the business obligations. Improper management of cash
may lead to wastage of scarce resources or risk of shortage of funds. Cash management involves the
following:
• Cash Planning: It is a technique used to plan & control the use of cash. A projected cash flow
statement is prepared based on present operations & anticipated future activities. The cash inflows
from various sources may be anticipated & cash outflows will determine the possible use of cash.
• Cash Forecasts & Budgeting: A cash budget is the most important device for the control of receipts
& payments of cash. A cash budget is an estimate of cash receipts & payments during a particular
future period. It is analysis of flow of cash. The short-term forecasts can be made with the help of
cash flow projections. The finance manager can make estimates of likely receipts in the near future
& payments during that period. The finance manager should keep in mind the sources from where
he can raise short term funds, if necessary. He should also plan for productive utilization of surplus
funds. Similarly, the long-term cash forecasts are also essential for proper cash planning.
Objectives of Cash Management: The basic objectives of cash management are to meet the cash
disbursement needs & to minimize the funds committed to cash balances.
• Meeting Payment schedule: In the normal course of business, firms have to make payments of cash
on a continuous basis to suppliers of goods, employees & so on. At the same time, there is a constant
cash inflow from sales, debtors etc. the basic objective of cash management is to meet the cash
disbursement needs i.e., to ensure that the firm makes its payments on time. The advantages of
adequate cash are:
- It helps to maintain a healthy relationship with bank, suppliers etc
- It helps the firm to avail cash discounts by making timely payments
- It ensures loyalty on the part of employees thereby reducing labour turnover
- It improves the credit worthiness of the firm
- It enables the firm to take advantage of opportunities available
- It prevents insolvency on account of the firm’s inability to pay its debts
- It is helpful during emergencies
• Minimizing funds committed to cash balances: The next objective of cash management is to
minimize the cash balance. A high level of cash balance ensures prompt payment. But, it also implies
that large funds will remain idle as cash is the most unproductive asset. The aim of cash management
is to ensure that the firm maintains an optimal level of cash balance.
Cash Budget: It is imperative for an organization to hold adequate cash such that it is neither in excess
nor deficit. Therefore, the firm has to assess its cash needs properly. For this, it prepares a cash budget.
It is the most important tool in cash management. It is a device to help a firm to plan & control the use
of cash. It is a statement showing the cash inflows & outflows over the planning horizon. The net cash

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position i.e., surplus or deficiency is highlighted by the cash budget. The objectives of preparing a cash
budget are:
- To coordinate the timings of the cash needs as it indicates the time when there is a need to raise
additional funds or invest surplus funds.
- It enables the firm to avail cash discounts when there are surplus funds
- It also enables the firm to plan when it has to raise additional funds & make necessary
arrangements for the same
Thus, the principal aim of the cash budget, as a tool to predict cash flows over a given period of time,
is to make optimum utilization of cash resources
Advantages of Cash Budget:
• It facilitates the accurate estimation of cash requirement along with their timing
• It facilitates planning of cash resources such that it can be utilized optimally
• It gives information about the surplus or deficit of cash which can be adjusted accordingly
Management of Float: Float is the difference between the balance shown as per the firm’s records &
the bank’s records. The Float should be managed effectively such that the length of the cash cycle is
reduced. To reduce the time span between the time customer makes a payment & funds are available
for use by the firm, the management using the following techniques:
• Concentration Banking: Under this system, firm which have a large number of branches spread in
different places, select some strategically located branches as collection centers for recurring
payments by customers. It means that the firm has multiple collection centers instead of one. This
ensures speedy collection of receivables. The payments that are received are deposited in the local
account after meeting local expenses. The surplus funds are transferred from these local banks to a
central or concentration bank. A concentration bank is one in which the company has a major account
– usually a disbursement account. In other words, collections are decentralized while payments
are centralized.
Advantages:
• The mailing time is reduced as bills are raised locally
• The cheque collection time is also reduced as collections are decentralized
• It enables the firm to store & manage cash effectively
Thus, concentration banking, as a decentralised billing & multiple collection points system, is a useful
device to expedite the collections of accounts receivables.
• Lock Box System: One of the ways to accelerate the flow of funds is a lock box arrangement as it
eliminates the cheque processing that is undertaken in concentration banking. Under this system, the
firm hires a post office box under the control of a bank at important collection centres. The customers
are directed to remit their payments to the lock box. The local banks are authorized to collect the
remittances / cheques received from customers. These banks pick up the cheques multiple times in

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 a day & deposit the same to the firm’s account. The banks send the deposit slip together with a list
of payments & other enclosures to the firm by way of proof record & information after crediting the
respective account of the firm. After the realization of the cheques, the surplus funds are transferred
to the central account of the firm.
In this case also, collections are decentralized. It is an improvement over the concentration banking
as the collection process is eliminated. This speeds up the collections.
Advantages:
• The time lag between cheques received & actually deposited in bank is eliminated.
• It also reduces overhead expenses
• It facilitates control by separating remittance from the accounts section
• It also reduces the credit losses by expediting the time at which the data is posted into the ledgers

List of Questions

Short Answer Questions – 4 Marks

1. What are the motives for holding cash?

2. Write a note on cash management

3. What are the objectives of cash management?

Essay Questions – 12 Marks

1. What is a Cash Budget? What are its advantages?

2. What are the techniques of cash management?

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 Cash Budget - Problems
1. From the following forecast of income & expenditure, prepare a cash budget for the months
January to April, 2017
Months Sales Purchases Wages Manu. Admin Selling
(Credit) (Credit) Expenses Expenses Expenses
2016
Nov 35,000 15,000 3,000 1,150 1,060 500
Dec 35,000 20,000 3,200 1,225 1,040 550
2017
Jan 25,000 15,000 2,500 990 1,100 600
Feb 30,000 20,000 3,000 1,050 1,150 620
Mar 35,000 22,500 2,400 1,100 1,220 570
Apr 40,000 25,000 2,600 1,200 1,180 710
Additional information is as follows:
1. The customers are allowed a credit period of 2 months
2. A dividend of Rs. 10,000/- is payable in April, 2017
3. Capital expenditure is to be incurred: Plant purchased on 15th January for Rs. 5,000/-; a Building
has been purchased on 1st March & the payments are to be made in monthly installments of Rs.
2,000/- each.
4. The creditors are allowing a two months credit period.
5. Wages are to be paid on the 1st of the next month
6. Lag in payment of expenses is one month
7. Balance of cash on hand as on 1st January, 2017 is Rs. 15,000/-
(Ans: Balance of cash as on 30th April, 2017 is Rs. 28,685/-)

2. The income & expenditure forecasts for the months March to Aug’20 are:
Months Sales Purchases Wages Manu. Admin Selling
(Credit) (Credit) Expenses Expenses Expenses
Mar 60,000 36,000 9,000 3,500 2,000 4,000
Apr 62,000 38,000 8,000 3,750 1,500 5,000
May 64,000 33,000 10,000 4,000 2,500 4,500
Jun 58,000 35,000 8,500 3,750 2,000 3,500
Jul 56,000 39,000 9,500 5,000 1,000 3,500
Aug 60,000 34,000 8,000 5,200 1,500 4,500
You are given the following additional information:

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(a) Plant costing Rs. 16,000/- is due for delivery in July, payable 10% on delivery & the balance after
3 months
(b) Advance tax of Rs. 8,000/- is payable in March & June each
(c) Creditors allow 2 months credit & debtors are paying one month late.
(d) Lag of one month in expenses
(e) Opening balance of cash Rs. 8,000/-
Prepare cash budget for the months May to July
(Ans: Cl. Balance: May – Rs. 15,750; June – Rs 12,750 & July- Rs. 18,400/-)

3. ABC Co. wishes to arrange overdraft facility with its bankers during the period April to June, 2020.
Prepare a cash budget from the following data.
Months Sales Purchases Wages
Feb 1,80,000 1,24,800 12,000
Mar 1,92,000 1,44,000 14,000
Apr 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
Jun 1,26,000 2,68,000 15,000
The following additional information is provided:
- 50% of the credit sales are realized in the month following the sales & remaining 50% in the second
month following
- Creditors are paid in the month following the purchases
- Cash at bank (estimated) as on 1.4.2020 – Rs. 25,000/-
Note : Assume that wages are paid on the 1st of the next month
(Ans: Closing Balance: Apr – Rs. 53,000/-; May – O/D Rs 51,000/- & Jun- O/D Rs.1,66,000/-)

4. A company expects to have Rs. 25,000/- in bank on 1st May, 2020 & requires you to prepare an
estimate of cash position during the three months – May to July, 2020
Months Sales Purchases Wages Office Factory Selling
(Credit) (Credit) Expenses Expenses Expenses
2020
Mar 50,000 30,000 6,000 4,000 5,000 3,000
Apr 56,000 32,000 6,500 4,000 5,500 3,000
May 60,000 35,000 7,000 4,000 6,000 3,500
Jun 80,000 40,000 9,000 4,000 7,500 4,500
Jul 90,000 40,000 9,500 4,000 8,000 4,500

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Other Information:
- 20% of sales are in cash, rem. amount is collected in the month following the sales
- Suppliers supply goods at two months credit
- Wages & Expenses are paid in the month following the one in which they are incurred
- The company pays dividend to shareholders & bonus to workers of Rs. 10,000/- & Rs. 15,000/-
respectively in the month of May
- Plant has been ordered & is expected to be received in June. It will cost Rs. 80,000/- to be paid in
June
- Income tax Rs. 25,000/- is payable in July
(Ans: Cl. Balance: May – Rs. 7,800/-; Jun– O/D Rs 60,700/- & Jul - O/D Rs. 63,700/

5. From the following data, prepare Cash Budget for April, May & June 2020
Month Sales Purchases Wages Expenses

Feb 1,20,000 84,000 10,000 7,000

Mar 1,30,000 1,00,000 12,000 8,000

Apr 80,000 1,04,000 8,000 6,000

May 1,16,000 1,06,000 10,000 12,000

Jun 88,000 80,000 8,000 6,000

Additional Information:
Sales: 20% realized in the month of sales, discount allowed 2%. Balance realized equally in two
subsequent months
Purchases: These are paid in the month following the month of supply
Wages: 25% paid in arrears in the following month
Miscellaneous expenses: paid a month in arrears
Rent: Rs. 1,000/- per month paid quarterly advance due in April
Income tax: Advance tax Rs. 25,000/- due on or before 15th June
Income from investments: Rs. 5,000/- received quarterly in April, July etc.
Cash in hand: Rs. 5,000/- on 1st April, 2020
(Ans: Cl. Balance: Apr – Rs. 5,680/-; May – Rs (-) 7,084/- & Jun - Rs. (-) 62,936/)

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 Unit V
Receivables Management
Receivables Management is also referred to as Credit Management. The term Receivables is defined
as debt owed by the customers to the firm on account of credit sales or services availed in the regular
course of business. Thus, accounts receivables represent an extension of credit to customers, allowing
them a reasonable period of time in which they can pay for the goods purchased or services availed.
The objective of receivables management is to promote sales & profits until that point is reached
where the return on investment in further funding receivables is less than the cost of funds raised
to finance that additional credit. The specific costs & benefits which are relevant to the determination
of the objectives of receivables management are as follows:
Costs: The major categories of costs associated with the extension of credit & accounts receivables are
as follows:
• Collection Costs: They are the administrative costs incurred in collecting the receivables from
debtors. They include expenses in creation & maintenance of a separate credit department, collecting
& maintaining information on credit etc.
• Capital Cost: The increased level of accounts receivable is an investment in current assets. They
have to be financed by involving a cost. There is a time gap between credit sales & realization of
these sales. Capital is required to bridge this gap. The cost on the use of additional capital to support
sales is therefore a part of the cost of extending credit.
• Delinquency Costs: This cost arises out of the failure of the customers to meet their obligations &
payments on credit sales that are due after the expiry of the credit period. The important
components include blocking up of funds, expenses incurred to initiate collection etc.
• Default Costs: The firm may not be able to recover certain dues. Such dues are referred to as bad
debts & are to be written off. Such costs are known as default costs associated with credit sales &
accounts receivables.
Benefits: The other factor that has a bearing on accounts receivables management is the benefits arising
from credit sales. The benefits include an increase in sales& anticipated profits. The firm may extend
credit to increase sales to existing customers or to attract new customers. This motive for investment in
receivables is known as growth motive. In certain cases, credit is granted to face the competition in the
market. This motive is known as sales retention.
Therefore, investment in receivables involves both costs & benefits. The extension of credit has a major
impact on sales, costs & profitability. Other things being constant, a relatively liberal policy will
produce larger sales with an increase in costs. Therefore, accounts receivables management should aim
a trade-off between profits & risks. It can be concluded that the decision to commit funds to
receivables will be based on a comparison of the benefits & costs involved, while determining the
optimum level of receivables. The costs & benefits compared are marginal costs & benefits. The

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firm should consider only the incremental benefits & costs that result from a change in the receivables
or trade credit policy. A firm can improve its profitability through a properly conceived trade credit
policy or receivables management.

Credit Policies: The firm’s objective with respect to receivables management is not merely to collect
receivables quickly, but also examine the benefit-cost trade-off involved in the receivables
management. A major decision in this regard is the credit policies. The credit policy of a firm provides
the frame work to determine:
1. Whether or not to extend credit to a customer?
2. How much credit to extend?
The credit policy of a firm has two broad dimensions – Credit Standards & Credit Analysis
Credit Standards: The term credit standard represents the basic criteria for extension of credit to
a customer. The quantitative basis of establishing credit standards are factors such as credit ratings,
credit references, average payment period & certain financial ratios. The overall standards can be
classified as restrictive / tight or non-restrictive / liberal. The trade-off with reference to credit
standards covers:
- Collection Costs
- Average Collection Period
- Level of Bad Debts
- Level of Sales
These factors should be considered while deciding whether to relax credit standards or tighten them. If
standards are relaxed, more credit is granted & vice-versa. The implications of these are as follows:
• Collection Costs: The implications of relaxed credit standards are more credit, a larger credit
department & increase in collection costs. The effect of tightening credit will have the reverse
impact. These costs are mostly semi-variable. This is because up to a certain point the existing staff
will be able to manage the increase in work load, but beyond a certain point, additional staff has to
be employed.
• Average Collection Period: The investment in accounts receivables involves a capital cost as funds
have to be arranged by the firm to finance them till the customers pay. Moreover, the higher the
accounts receivable, the higher is the capital or carrying costs. A change in the credit standards leads
to a change in the level of accounts receivables either through a change in sales or collections. A
relaxed credit standard leads to an increase in the accounts receivables. Further, relaxed credit
standards would mean that credit is extended liberally such that it is available even to less worthy
customers who take longer time to pay. In contrast, a tightening of credit, no doubt results in decrease
in sales & accounts receivables, but it ensures that credit is granted to credit-worthy customers who
pay on time, thereby reducing the average level of accounts receivables. Thus, a change in sales &

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 a change in the collection period together with a relaxation in credit standards would produce higher
carrying costs while tightening the credit standards has the reverse impact.
• Bad Debts: Another factor affected by a change in the credit standards is the amount of bad debts.
They can be expected to increase with relaxation in credit standards & vice-versa.
• Sales Volume: Changing credit standards can also be expected to change the volume of sales. As
standards are relaxed, sales are expected to increase & vice-versa
Credit Analysis: A firm should also develop procedures for evaluating credit applicants. The credit
investigation process has two basic steps – namely, obtaining credit information & analysis of credit
information
• Obtaining Credit Information: The first step in credit analysis is obtaining information on the
basis of which to base the evaluation of a customer. The sources of information are:
- Internal: Usually, firms require all its customers to fill various forms giving details about financial
standing. They are also give references with whom the firm can contact to judge the credit-
worthiness of the customers. Another internal source of credit information is obtained from the
records of the firm. It is likely that a particular customer may have enjoyed credit facility in the past.
- External: The availability of information from external sources to assess the credit worthiness of
customers depends up on the development of institutional facilities & industry practices. Depending
up on the availability of information, the following external sources may be employed to collect
information:
- Financial Statements: The financial statements contain useful information about the applicant’s
financial viability, liquidity, profitability & debt capacity. Although, they do not directly reveal the
repayment record, they are helpful in assessing the overall financial position of the firm, which
significantly determines the credit standing.
- Bank References: Another important source is the applicant’s bank. The applicant may be required
to ask his banker to give necessary information. In certain cases, the firm may approach the banker
directly for information.
- Trade References: It refers to the collection of information from firm with whom the applicant has
dealings & who on the basis of their experience can vouch for the applicant.
- Credit Bureau Reports: Specialist Credit Bureau reports from organizations supplying credit
information can also be utilized.
• Analysis of Credit Information: Once the credit information has been collected from different
sources, it should be analyzed to determine the credit worthiness of the applicant. Though there are
no standard procedures, it should cover the following:
- Quantitative: The assessment of the quantitative aspects is based on the factual information
available. The first step is to prepare an aging schedule of the accounts payable of the applicant as
well as calculate the average age of accounts payable. This gives an insight into the past payment

74
 pattern of the customer. Another step of analyzing the credit information is through a ratio analysis
of liquidity, profitability & debt capacity of the customer. These ratios can be compared with the
industry standards to reveal the financial strength of the customer.
- Qualitative: The quantitative assessment should be supplemented by a qualitative / subjective
interpretation of the customer’s credit worthiness. It would cover aspects relating to the quality of
management. References from other suppliers, banks & specialist bureau report are used to draw
conclusions. In the ultimate analysis, the decision whether to extend credit to the applicant & to what
amount to extend depends up on the subjective interpretation of his credit standing.
Cash Discount: A business firm may offer cash discounts to their customers to speed up the payment
of debts at a certain specified rate. Cash discount is the discount given to the customer for prompt
payment of cash. The cash discount terms reveal the rate of discount & the period for which the discount
has been offered. As such, if the customer has not availed cash discount, he has to pay by the net date,
as originally agreed upon. The credit terms include both the cash discount & the credit period. It
indicates the following:
- Rate of cash discount
- Period of discount
- Period of credit
However, the decision about cash discount depends upon the comparative study between costs &
benefits. The cost represents the amount of discount on offer & the opportunity saving is the benefit. It
means that the average balance of debtors is reduced if there is a policy of cash discount.
Ageing Schedule: On the basis of trend of collection from customers, a firm prepares an ageing
schedule of debtors who are divided according to the outstanding period of debts to be collected. It
gives important information about the collection system, the efficiency of the credit collection
department etc. It enables intra-firm & inter-firm comparisons. It also provides inputs to facilitate
decision making.
Ageing schedule is drawn on the basis of the number of days outstanding. It helps us to understand the
type & nature of customers accounts & their trend of payments. It also gives vital information regarding
quality of debtors, overdue accounts etc.
List of Questions

Short Answer Questions – 4 Marks

1. Cash Discount

2. Ageing Schedule

Essay Questions – 12 Marks

1. What are costs & benefits of receivables management?

2. Write a note on Credit Policy.

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 Inventory Management
Every business need inventory for its smooth running of its activities. It serves as a link between
production & distribution. Generally, there is a time gap between production & supply & inventory is
needed to bridge this gap. The unforeseen fluctuations in the demand & supply of goods also support
the need for inventory. It also provides a cushion against fluctuations in prices. Therefore, inventory
management is an integral aspect of working capital management. The term inventory refers to the
stock of the products a firm is offering for sale & the components that make up the product. The assets
the form stores as inventory includes raw materials, work-in-progress & finished goods. The primary
objective of inventory management is the maximization of owner’s wealth. Inventory management
involves minimizing the investment in inventory while maintaining a perfect balance between demand
& supply. These can also be expressed as costs & benefits associated with inventory management. The
firm can minimize costs by maintaining a small amount of inventory because it involves a lower cost.
But inventories also provide benefits to the extent that they facilitate the smooth functioning of the
organization. Larger the inventory, the better it is for the organization. It implies that the firm should
try to maintain an optimum level of inventory.
Costs of Holding Inventory: The basic objective of inventory management is to minimize the costs of
holding inventory. The costs associated with inventory are basically ordering & carrying costs.
• Ordering Costs: The costs incurred to procure inventory are referred to as ordering costs. These
include preparing a purchase order or requisition & receiving, inspecting & collection of goods. The
cost of placing an order consists of clerical costs & costs of stationery. As they are fixed per order, they
are referred to as set up costs. If the orders are frequent, higher are these costs. On the other hand, if
the firm maintains a large inventory, ordering costs will also reduce proportionately. But acquisition of
a large quantity would increase the cost associated with the maintenance of inventory.
• Carrying Costs: The costs incurred to maintain the inventory are referred to as carrying costs. These
can be further subdivided as storage costs & opportunity costs. Storage costs are those costs that are
required to ensure safety of the inventory & efficient handling. Opportunity costs refer to the return on
investment if the funds were not locked up in inventory. It includes the expenses incurred on raising of
funds to finance the acquisition of inventory. The carrying costs & inventory size are positively related
& move in the same direction. The sum of carrying & opportunity costs represents the total cost of
inventory. These should be compared with the benefits arising out of inventory to determine the
optimum level of inventory.
Benefits of Holding Inventory: The benefits of holding inventory are the benefits in purchasing,
production & selling. These three are interrelated. Without inventory, purchasing & production would
be completely dependent on sales. This is true in the long run. But, in the short run, they are rigidly
related & these three key activities cannot be carried out efficiently. Therefore, inventories enable

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firms in the short run to produce at a rate greater than purchase of raw materials & vice-versa
or sell at a rate greater than production & vice-versa. The effect of inventory on these variables can
be discussed as follows:
• Benefits in purchasing: If the purchasing of materials & other requirements is not dependent on
production or sales, it enables the firm to go in for larger purchases. This results in low ordering costs
as it reduces the number of orders. Secondly, discounts & favorable terms can be obtained. It also helps
the firm to purchase before anticipated increase in prices & thus save costs.
• Benefits in production: Finished goods inventory enables production at a rate different from that
of sales, especially in case of seasonal sales. The firm can either produce more during the peak season
& less during the lean season & vice-versa. On the other hand, it can have a stable production policy
wherein production is carried out throughout the year & inventory is built up to meet the additional
demand during the peak season. This is more economical as it ensures effective utilization of all assets
uniformly throughout the year. Thus, inventory helps the firm to coordinate its production scheduling
so as to avoid disruption & accompanying costs.
• Benefits in sales: The maintenance of inventory also helps the firm to increase its sales. If the firm
does not maintain an inventory of finished goods, it has to sell only on the basis of it production.
Inventory serves to bridge a gap between production & sales. It enables the firm to withstand
competition in the market. Inventory thus helps to build brand loyalty.
The appropriate level of inventory should be determined in terms of a trade-off between benefits &
costs associated with maintaining inventory.
Techniques of Inventory Management:
• Economic Order Quantity (EOQ): The cost of inventory includes ordering costs & carrying costs.
The quantity of material to be ordered at one time is known as EOQ. EOQ is the optimum level of
inventory. It minimizes the total cost associated with inventory management. The order for the material
should be large enough to take advantage of the trade discount & bulk transport costs. But it should not
be so large that it involves heavy expenditure on interest, storage & insurance.
Assumptions:
- the firm is certain about its annual requirements
- the usage of inventory is steady over a period of time
- the orders placed to replenish inventory are received exactly at that point when inventories reach
zero
EOQ = 2CO / I
• A B C Analysis: In this analysis, the materials are classified into different categories for a selective
approach for material control. An analysis of the material costs show that a small percentage of items
contribute a large percentage of value of consumption & a large percentage of items in the materials
contribute a small percentage of value. In between these two extremes will fall those items the

77
percentage of which is more or less equal to their value. Items falling in the first category are treated as
A category, items of second category B & the third category C. Such an analysis is known as ABC
Analysis. It is also referred to as Always Better Control. The materials are categorized on the basis of
descending order of their values. ABC analysis measures the cost significance of each item of material.
It concentrates on important items. Therefore, it can also be referred to as by Control by Importance
& Exception. The significance of this analysis is that a very close control is exercised over the items
of group A while a little less for group B & least for group C. All types of material control are to be
strictly applied in the same order.
Advantages:
- Management by exception can be applied
- Investment in inventory is minimized
- Storage costs are reduced accordingly.
Determining stock levels: The firm has to maintain an optimum level of inventory. For this, it can
define various levels that are as follows:
- Minimum Level / Safety Stock Level: It represents the minimum quantity of material which must
be always maintained. This quantity is fixed so that production may not be held up due to shortage
of materials. It considers the lead time, rate of consumption of material during the lead time & the
nature of material.
Min level = Re-order level – (Normal consumption x Normal Re-order period)
- Maximum Level: It represents the maximum quantity of material which can be held in stock at any
time. Overstocking should be avoided as it leads to blockage of funds, risk of obsolescence,
depreciation, damage of goods etc.
Max Level = Re-order Level + Re-order Quantity – (Min Consumption x Min Re-order Period)
- Average Stock level:
Average level = Min Stock Level + ½ Re-order Quantity
Average level = ½ ( Min Stock Level + Max Stock Level )
- Re-order level: It is the level of stock which requires the store keeper to requisition for fresh
supplies. In other words, it is the level at which fresh orders are placed. The level is fixed in between
the minimum & the maximum levels
Re-order level = Min Level + Cons. during the time to get fresh supplies
Or
Re-order level = Max Consumption x Max Re-order period
List of Questions
1. What are the Costs & Benefits of holding inventory?
2. What are the techniques of inventory management?
Assignment Question
1. What are the Costs & Benefits of holding inventory?

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 Inventory Management – Problems
1. Calculate the ordering level of material A from the following particulars:
- Minimum limit – 500 units
- Maximum limit – 2,500 units
- Daily requirement of materials – 100 units
- Time required for fresh deliveries – 10 days
(Ans: 1,500 units)

2. Calculate Re-order level

- Maximum consumption – 300 units per day
- Minimum consumption – 200 units per day
- Re-order period – 8 to 10 days
(Ans: Re-order level 3,000 units)

3. From the following, calculate minimum stock level, maximum stock level & re-order level
- Minimum consumption – 150 units per day
- Maximum consumption – 200 units per day
- Normal consumption – 160 units per day
- Re-order period – 10 – 15 days
- Re-order quantity – 1,600 units
- Normal re-order period – 12 days
(Ans: Re-order level – 3,000; Min level – 1,080; Max level – 3,100 units)

4. From the following, calculate minimum stock level, maximum stock level & re-order level
- Minimum consumption – 100 units per day
- Maximum consumption – 150 units per day
- Normal consumption – 120 units per day
- Re-order period – 10 – 15 days
- Re-order quantity – 1,500 units
- Normal re-order period – 12 days
(Ans: Re-order level – 2,250 ; Min level – 810 ; Max level – 2,750 units)

5. Find out the Economic Order Quantity from the following particulars
Annual Usage – 6,000 units
Cost of material per unit – Rs 20/-

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 Cost of placing & receiving one order – Rs. 120/-
Annual Carrying Cost of one unit – 10% of inventory value
(Ans: 849 units)

6. Find out the Economic Order Quantity from the following particulars
Annual Usage – Rs. 1,20,000/-
Cost of placing & receiving one order – Rs. 60/-
Annual Carrying Cost – 10% of inventory value
(Ans: EOQ – Rs. 12,000)

7. Find out the Economic Order Quantity, number of orders to be placed & total cost of EOQ from the
following particulars
Annual Usage – 60,000 units
Ordering Cost per order – Rs. 600/-
Opportunity cost (cost of capital) of investment – Re. 1/- per unit
Cost of deterioration, taxes, insurance, supervision cost etc. – Re 1 per unit
(Ans: EOQ – 6,000 units; No. of orders – 10; Total cost – Rs. 12,000/-)

8. From the following, find out EOQ

Annual usage: 10,000 units
Cost of placing & receiving one order: Rs. 50/-
Cost of materials per unit: Rs. 25
Annual carrying cost: 10% of inventory value
(Ans: EOQ – 632 units)

9. From the following, find out EOQ

Annual usage: Rs. 2,00,000/-
Cost of placing & receiving one order: Rs. 80/-
Annual carrying cost: 10% of inventory value
(Ans: EOQ – Rs. 17,889/-)

10. The annual demand for a product is 6400 units. The unit cost is Rs. 6/- & inventory carrying cost
per unit p.a. is 25% of the average inventory cost. If the cost of procurement is Rs. 75/-, determine:
- EOQ
- Number of orders per annum
- Time between two consecutive orders
(Ans: EOQ – 800 units; No. of orders – 8; Time – 1.5 months)

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 Internal Assessment I - Question Bank
Section A: Multiple Choice Questions
1. Financial Management deal with [ ]
(a) Acquisition of funds (b) Utilization of funds (c) Both a & b (d) Neither a nor b
2. Financial Management was earlier known as [ ]
(a) Corporation Finance (b) Financial Accounting (c) Management Accounting (d) None of these
3. The objective of financial management is [ ]
(a) Profit Maximisation (b) Wealth Maximisation (c) Both a & b (d) Neither a nor b
4. Capital Structure refers to [ ]
(a) Debt (b) Equity (c) Debt & Equity (d) Preference
5. The term profit is [ ]
(a) Clear (b) Vague (c) Precise (d) None of these
6. Wealth Maximization is also known as [ ]
(a) Value Maximization (b) Profit Maximization (c) Both a & b (d) Neither a nor b
7. Composition of assets [ ]
(a) Financing decision (b) Investment decision (c) Dividend decision (d) None of these
8. Raising of funds [ ]
(a) Financing decision (b) Investment decision (c) Dividend decision (d) None of these
9. Dividend Payout Ratio [ ]
(a) Financing decision (b) Investment decision (c) Dividend decision (d) None of these
10. Key Finance officers of a company [ ]
(a) Finance Director (b) Treasurer (c) Controller (d) All of these
11. Separation between ownership & management [ ]
(a) Joint Stock Co. (b) Agency Conflict (c) Division of Labour (d) None of these
12. Time Value of Money is also known as [ ]
(a) Time preference (b) Value preference (c) Wealth preference (d) All of these
13. Techniques of time value of money [ ]
(a) Compounding (b) Discounting (c) Both of these (d) None of these
14. Compounding is also known as [ ]
(a) Future Value (b) Present Value (c) Zero Value (d) None of these
15. Discounting is also known as [ ]
(a) Future Value (b) Present Value (c) Zero Value (d) None of these
16. Even cash flows every year [ ]
(a) Perpetuity (b) Uneven Series (c) Annuity (d) All of these
17. An annuity that runs forever [ ]
(a) Perpetuity (b) Uneven Series (c) Annuity (d) All of these

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18. The future value is always _______ than the present value [ ]
(a) Equal (b) Zero (c) More (d) Less
19. The present value is always _______ than the future value [ ]
(a) Equal (b) Zero (c) More (d) Less
20. The present value of cash inflow is equal to the cash outflow [ ]
(a) PBP (b) IRR (c) ARR (d) NPV
21. A project is accepted if it has a ___________ NPV [ ]
(a) Zero (b) Positive (c) Negative (d) Equal
22. IRR stands for [ ]
(a) Internal Rate of Return (b) Internal Risk of Return (c) Intrinsic Risk Rate (d) Intrinsic Rate Report
23. Both NPV & PI give the same result [ ]
(a) No (b) Yes (c) Maybe (d) Need not
24. The time within which an investment pays itself back [ ]
(a) IRR (b) PI (c) ARR (d) PBP
25. Time value of money is due to [ ]
(a) Risk (b) Preference for Consumption (c) Reinvestment (d) All of these
Section B: Fill in the blanks
2. Financial Management was known as ___________ in the1920’s.
1. Treasurer is concerned with ______________.
2. Controller is concerned with ______________.
3. Purchase of asset to replace an obsolete asset is a ________________ decision.
4. The profit to be distributed as dividend is known as ____________.
5. The conflict between shareholders & management is known as _______________.
6. Keeping a close watch on management is ____________________
7. The three major financial decisions are __________, __________ & ____________________.
8. The day-to-day management of funds is known as ________________________.
9. ________________________-is also known as Risk Capital.
10. Long term investment decision is known as __________________.
11. Financing decision tries to strike a balance between _____________ & _______________.
12. A high dividend payout ratio leads to ____________________.
13. Uncertainty is referred to as ________________________.
14. Perpetuity is an annuity that runs __________________.
15. A series of equal annual cashflows is known as an ____________________.
16. The formula for PBP is __________________.
17. If the cash inflows are exactly equal to the outflows, it is known as ________________________.
18. ARR is also known as ________________________.
19. The decision to accept a project in NPV is based on a ______________ NPV.

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20. A capital budgeting decision that incorporates the time value of money is known as
_________________________.
21. Equating cash flows occurring at different time periods is known as _________________________
22. Discounting is also known as _____________________.
23. Compounding is also known as _______________________.
Section C: Answer in one word, phrase or sentence
1. Financial Management
2. Controller
3. Capital Budgeting
4. Working Capital Management
5. Investment Decision
6. Financing Decision
7. Dividend Decision
8. PBP
9. ARR
10. IRR
11. NPV
12. Time Value of Money
13. Compounding
14. Discounting
15. Practical Applications of Compounding & Discounting

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 Internal Assessment II - Question Bank
Section A: Multiple Choice Questions
1. The capital required for a long period of time is [ ]
(a) Working Capital (b) Fixed Capital (c) Both a & b (d) Neither a nor b
2. Ordinary shares are [ ]
(a) Deferred Shares (b) Preference Shares (c) Equity Shares (d) None of these
3. Equity shares are to be redeemed [ ]
(a) Liquidation (b) Fixed period (c) 5 years (d) 15 years
4. Life of Preference Shares in India [ ]
(a) 1 year (b) 5 years (c) 15 years (d) 20 years
5. Equity Shareholders are ___________ claimants [ ]
(a) Residual (b) First (c) Priority (d) None of these
6. Dividend gets accumulated in case of insufficient profits [ ]
(a) Participating (b) Cumulative (c) Convertible (d) Redeemable
7. Deferred shares are issued to [ ]
(a) Promoters (b) Investment decision (c) Dividend decision (d) None of these
8. Shares issued in lieu of dividend are [ ]
(a) Equity Shares (b) Preference Shares (c) Deferred Shares (d) Bonus Shares
9. Right of equity shareholders to new shares [ ]
(a) Pre-emptive Right (b) Ownership Right (c) Bonus Shares (d) None of these
10. Total of Current Assets is [ ]
(a) Short Term Funds (b) Long Term Funds (c) Capital Budgeting (d) Working Capital
11. Working Capital = [ ]
(a) Current Assets (b) Current Assets – Current Liabilities (c) Current Assets + Current Liabilities (d)
Current Assets = Current Liabilities
12. The time between procurement of raw materials & realization of sales [ ]
(a) Operating Cycle (b) Production Cycle (c) Sales Cycle (d) None of these
13. The level of stock which optimizes risk & return [ ]
(a) Reorder level (b) EOQ (c) Minimum Stock Level (d) Maximum Stock Level
14. Time to purchase fresh supplies [ ]
(b) Reorder level (b) EOQ (c) Minimum Stock Level (d) Maximum Stock Level
15. EOQ stands for [ ]
(a) Easy Order Quantity (b) Every Order Quantity (c) Economic Order Quantity (d) None of these
16. Categorization of inventory based on value [ ]
(a) Reorder Quantity (b) EOQ (c) ABC Analysis (d) All of these
17. Working Capital is also known as [ ]

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(a) Circulating (b) Revolving (c) Both a & b (d) Neither a nor b
18. Production cycle is also known as [ ]
(a) Manufacturing (b) Trading (c) Purchasing (d) Selling
19. Cash balance maintained to meet requirements of bank [ ]
(a) Transactional (b) Speculative (c) Precautionary (d) Compensating
20. Cash balance maintained for day to day requirements [ ]
(a) Transactional (b) Speculative (c) Precautionary (d) Compensating
21. Cash balance maintained to take advantage of opportunities [ ]
(a) Transactional (b) Speculative (c) Precautionary (d) Compensating
22. Undistributed profits of the firm [ ]
(a) Reserves & Surpluses (b) Retained Earnings (c) Both (d) None
23. Part of the profits distributed as dividends [ ]
(a) Bonus Shares (b) Dividend Payout Ratio (c) EPS (d) None of these
24. Discount allowed for prompt payment [ ]
(a) Trade Discount (b) Cash Discount (c) Bonus (d) Concession
25. Costs incurred to procure inventory [ ]
(a) Ordering Costs (b) Collection Costs (c) Holding Costs (d) None of these
Section B: Fill in the blanks
1. Risk free capital is ____________________.
2. The right to new shares is known as _________________.
3. Shares that are entitled to a fixed rate of return are ____________.
4. Part of debt capital is ________________.
5. Debenture holders are __________________ of the company.
6. _____________ shareholders are entitled to voting rights.
7. ABC analysis stands for ___________________.
8. Criteria for extension of credit is ____________________.
9. Set up costs are also known as __________________.
10. The formula for EOQ is _____________________.
11. The costs that arise due to bad debts are known as ___________________.
12. __________________ is the difference in balance as per the firm’s records against the bank’s
records.
13. Segregation of debtors on the basis of their outstanding period is known as
______________________.
14. Weights on the basis of the proportion of each source of finance to the total capital employed is
_________________________.
15. Discount rate is referred to as the _________________.
16. Return on shareholders investment is ________________________.

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17. Dividend paid in between two Balance Sheets is known as ______________________ dividend.
18. ______________________ are free shares.
19. ____________________ creates a charge on the assets of the company.
20. __________________ shareholders are entitled to a dual rate of return.
21. ___________________ shareholders can carry forward their right to dividend.
22. Cash balance maintained to satisfy legal requirements is _________________.
23. Cash balance maintained to take advantage of opportunities is ___________________.
24. _____________ is an estimate of receipts & payments during a certain period in future.
25. The level at which order has to be placed for fresh supplies is ___________________.
Section C: Answer in one word, phrase or sentence
1. Equity Share
2. Preference Share
3. Debenture
4. Retained Earnings
5. Working Capital
6. Cash Budget
7. EOQ
8. Inventory Management
9. Credit Policy
10. Cash Discount
11. Capital Structure
12. Cost of Capital
13. WACC
14. Dividend
15. Receivables Management

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