FINANCIAL MANAGEMENT

(BBA 301)

Jaipur National University

Directorate of Distance Education
_________________________________________________________________________________
Established by Government of Rajasthan
Approved by UGC under Sec 2(f) of UGC ACT 1956
(Recognised by Joint Committee of UGC-AICTE-DEC, Govt. of India)
 FINANCIAL MANAGEMENT
Financial Management: Meaning, importance and objectives.

Financial decisions: Financial planning – objectives and principles of sound financial planning.

Concepts in Valuation:, Valuation Concepts, Valuation of Securities viz., Debentures, Preference Shares and
Equity Shares.

Time Value of Money: Concept; compounding and Discounting Concepts; Present Value of a Single Amount;
present Value of an annuity; Future value of a Single Amount; Future value of an annuity.

Financial Statements and Financial Statement Analysis: Meaning, Nature, Importance and Limitations of
Financial Statements; Meaning, Objectives, Types and Methods of Financial Statement Analysis

Capital structure: Factors influencing capital structure, EBIT, EPS analysis. Types of leverages.

Ratio Analysis: Meaning, Utility, Limitations, process of Analysis, Classification of Accounting Ratios,
Important Accounting Ratios used in measuring liquidity, solvency, profitability and managerial efficiency,
Computation and Interpretation of these Ratios.

Management of working capital: Meaning, importance of working capital, excess or inadequate working
capital, determinants of working capital requirements, Management of Cash. Management of inventory.

Break Even Analysis: Meaning, importance, objectives and practical approaches of break even analysis,

Dividend policy: Introduction, importance, objectives and determinants of dividend policy, types of dividend.

Capital Budgeting: Capital expenditure decisions, Pay-back period, return on investment, discounted cash
flow. Cost of capital.

Sources of Finance: Classification of Sources of Finance, Security Financing, Loan Financing, Project
Financing, Loan Syndication- Book Building, New Financial Institutions and Instruments viz., Depositories,
Factoring,

Dividend, Bonus and Rights: Dividend Policy, Relevance and Irrelevance Concepts of Dividend, Corporate
Dividend Practices in India.

Working Capital Management: Concept, Management of Cash, Management of Inventories, Management of

Accounts Receivable and Accounts Payable, Over and Under Trading.

Analysis of Changes in Financial Position: Funds Flow: Meaning and Purposes of Funds Flow Statement
 1
Financial Management
CONTENTS
Objectives
Introduction
1.1 Meaning of Financial Management
1.2 Importance of Financial Management
1.3 Objectives of Financial Management
1.4 Summary
1.5 Keywords
1.6 Self Assessment Questions
1.7 Review Questions

Objectives
After studying this chapter, you will be able:
Define meaning of financial management
Describe importance
Understand the objectives

Introduction
The management of the finances of a business / organization in order to achieve financial objectives
Taking a commercial business as the most common organizational structure, the key objectives of financial
management would be to:
Create wealth for the business
Generate cash, and
Provide an adequate return on investment bearing in mind the risks that the business is taking and the
resources invested
There are three key elements to the process of financial management:
(1) Financial Planning
Management need to ensure that enough funding is available at the right time to meet the needs of the
business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund
sales made on credit.
In the medium and long term, funding may be required for significant additions to the productive capacity of
the business or to make acquisitions.
(2) Financial Control
Financial control is a critically important activity to help the business ensure that the business is meeting its
objectives. Financial control addresses questions such as:
Are assets being used efficiently?
Are the businesses assets secure?
Do management act in the best interest of shareholders and in accordance with business rules?

(3) Financial Decision-making

The key aspects of financial decision-making relate to investment, financing and dividends:
Investments must be financed in some way – however there are always financing alternatives that can be
considered. For example it is possible to raise finance from selling new shares, borrowing from banks or
taking credit from suppliers
A key financing decision is whether profits earned by the business should be retained rather than
distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding
to reinvest in growing revenues and profits further.

Traditional Areas of Financial Management

Finance in all sense of it is about cash flows. The management activities of finance can be viewed from four
areas. Namely,
Capital structure
Capital budgeting
Long-term financing
Working capital management
Business concern needs finance to meet their requirements in the economic world. Any kind of business
activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business
concerns are big or small, they need finance to fulfil their business activities. In the modern world, all the
activities are concerned with the economic activities and very particular to earning profit through any venture
or activities. The entire business activities are directly related with making profit. (According to the economics
concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and
profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements.
Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and
unique characters. Increasing the profit is the main aim of any kind of economic activity.

1.1 Meaning of Financial Management

Financial management is an integral part of overall management. It is concerned with the duties of the
financial managers in the business firm. The term financial management has been defined by researcher, ―It is
concerned with the efficient use of an important economic resource namely, capital funds‖. The most popular
and acceptable definition of financial management as ―Financial Management deals with procurement of funds
and their effective utilization in the business‖. Financial management as an application of general managerial
principles to the area of financial decision-making. Another definition financial management ―is an area of
financial decision-making, harmonizing individual motives and enterprise goals‖.

Thus, Financial Management is mainly concerned with the effective funds management in the business. In
simple words, Financial Management as practiced by business firms can be called as Corporation Finance or
Business Finance.
Meaning of Finance
Finance may be defined as the art and science of managing money. It includes financial service and financial
instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function
is the procurement of funds and their effective utilization in business concerns. The concept of finance
includes capital, funds, money, and amount. But each word is having unique meaning. Studying and
understanding the concept of finance become an important part of the business concern.

Definition of Finance
According to the researcher, ―Finance is the art and science of managing money‖. Or the word ‗finance‘
connotes ‗management of money‘. Another defines finance as ―the Science on study of the management of
funds‘ and the management of fund as the system that includes the circulation of money, the granting of credit,
the making of investments, and the provision of banking facilities.

Definition of Business Finance

Business finance is that business activity which concerns with the acquisition and conversation of capital funds
in meeting financial needs and overall objectives of a business enterprise‖. Or Business finance can broadly be
defined as the activity concerned with planning, raising, controlling, administering of the funds used in the
business‖. Business finance deals primarily with raising, administering and disbursing funds by privately
owned business units operating in nonfinancial fields of industry‖. Corporate finance is concerned with
budgeting, financial forecasting, cash management, credit administration, investment analysis and fund
procurement of the business concern and the business concern needs to adopt modern technology and
application suitable to the global environment. Another definition that corporation finance deals with the
financial problems of corporate enterprises. These problems include the financial aspects of the promotion of
new enterprises and their administration during early development, the accounting problems connected with
the distinction between capital and income, the administrative questions created by growth and expansion, and
finally, the financial adjustments required for the bolstering up or rehabilitation of a corporation which has
come into financial difficulties.

1.1.1 Types of Finance

Finance is one of the important and integral part of business concerns, hence, it plays a major role in every part
of the business activities. It is used in all the area of the activities under the different names. (See Figure 1.1)

Figure 1.1: Types of finance.

Private finance, which includes the individual, firms, business or corporate financial activities to meet the
requirements. Public finance which concerns with revenue and disbursement of government such as Central
Government, State Government and Semi-Government Financial matters.

1.1.2 Scope of Financial Management

Financial management is one of the important parts of overall management, which is directly related with
various functional departments like personnel, marketing and production.
Financial management covers wide area with multidimensional approaches. The following are the important
scope of financial management.
Financial Management and Economics
Economic concepts like micro and macroeconomics 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 area, which provides
immense opportunities to finance, and economical 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 periods, both
financial management and accounting are treated as a 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 now
a day‘s financial management and accounting discipline are separate and interrelated.

Financial Management or 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, present 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 multiple 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 financial manager must be aware of the operational process
and finance required for each process of production activities.

Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For this, the marketing
department needs finance to meet their requirements. The financial 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 and other monetary benefits to the human resource department.
Hence, financial management is directly related with human resource management.

1.2 Importance of Financial Management

Financial management importance can be explained as management of money matters. It deals with managing
money in all areas of life. Financial management includes personal financial management and organizational
financial management. Personal finance management will help us manage the finance of our home which
includes budgeting; saving, investing, debt management and other aspects related to personal money where by
an individual can achieve personal goals. Whereas organizational finance management means the management
of finance of a business or organization in order to achieve financial objectives. In an organization the key
objectives of financial management would be to create wealth for business, generate cash and gain maximum
profits from the investments of the business considering the risks involved. Financial management is very
important for both individuals and organizations because it deals with managing the funds. It guides a
company and individual to make optimum use of money to achieve maximum returns. For an individual
financial management will help to save more and thus invest more. Since in includes debt management, it will
guide the individual to create a financial plan whereby all the debts are paid on time. It will help to spend less
and earn more; this will lead to more savings and thus a secure future. Financial management will help in
retirement and investment planning.
Lack of financial management in business will lead to losses and closure of business. With the study of
financial management we can protect the business from miss management of money. Without proper financial
management debts will not be paid in time and may make the businessman insolvent. Financial management
will study the balance sheet of the company and keeps a watch on all sensitive facts that can endanger business
into loss. It teaches us that we should think about cost, risk and control in any business and borrowed money
must be minimum. It also explains the importance of time, risk and returns on investment. We should get our
money within a short period of time, all these facts are important for success of any business.
Financial management consists of several aspects of business where a finance manager makes decisions on the
basis of the financial data with regards to allocating funds, financing business and to develop policies to
achieve business goals. Different types of accounting tools are used to manage finance in any business. For
example ratios are used to compare performance of the business periodically and also with other businesses.
The profitability ratio measure the profit margin, return on assets and return on equity. The liquidity ratio
measures the current ratio and quick ratio that provide information on the company‘s ability to pay off debts.
This ratio analysis enables the organization to compare and measure its performance. Financial management
evaluates the performance of the business and keeps a check on the profitability aspect of the business.

Some of the importance of the financial management is as follows:

Financial Planning
Financial management helps to determine the financial requirement of the business concern and leads to take
financial planning of the concern. Financial planning is an important part of the business concern, which helps
to promotion of an enterprise.

Acquisition of Funds
Financial management involves the acquisition of required finance to the business concern. Acquiring needed
funds play a major part of the financial management, which involve possible source of finance at minimum
cost.
Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the business concern. When
the finance manager uses the funds properly, they can reduce the cost of capital and increase the value of the
firm.

Financial Decision
Financial management helps to take sound financial decision in the business concern. Financial decision will
affect the entire business operation of the concern. Because there is a direct relationship with various
department functions such as marketing, production personnel, etc.

Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of funds by the business
concern. Financial management helps to improve the profitability position of the concern with the help of
strong financial control devices such as budgetary control, ratio analysis and cost volume profit analysis.

Increase the Value of the Firm

Financial management is very important in the field of increasing the wealth of the investors and the business
concern. Ultimate aim of any business concern will achieve the maximum profit and higher profitability leads
to maximize the wealth of the investors as well as the nation.

Promoting Savings
Savings are possible only when the business concern earns higher profitability and maximizing wealth.
Effective financial management helps to promoting and mobilizing individual and corporate savings.
Nowadays financial management is also popularly known as business finance or corporate finances. The
business concern or corporate sectors cannot function without the importance of the financial management.

1.3 Objectives of Financial Management

Effective procurement and efficient use of finance lead to proper utilization of the finance by the business
concern. It is the essential part of the financial manager. Hence, the financial manager must determine the
basic objectives of the financial management. (See Figure 1.2)

Figure 1.2: Objectives of financial management.

1). Profit Maximization:
Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for
the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the
concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit
of the concern. Profit maximization consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business
operation for profit maximization.
2. Ultimate aim of the business concern is earning profit; hence, it considers all the possible ways to increase
the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of
the business concern.
4. Profit maximization objectives help to reduce the risk of the business.

Favourable Arguments for Profit Maximization

The following important points are in support of the profit maximization objectives of the business concern:
Main aim is earning profit.
Profit is the parameter of the business operation.
Profit reduces risk of the business concern.
Profit is the main source of finance.
Profitability meets the social needs also.

Unfavourable Arguments for Profit Maximization

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

Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:
It is vague
In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding
earning habits of the business concern.

It ignores the time value of money

Profit maximization does not consider the time value of money or the net present value of the cash inflow. It
leads certain differences between the actual cash inflow and net present cash flow during a particular period.

It ignores risk
Profit maximization does not consider risk of the business concern. Risks may be internal or external which
will affect the overall operation of the business concern.

2). Wealth Maximization:

Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in
the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those
who are involved in the business concern. Wealth maximization is also known as value maximization or net
present worth maximization. This objective is a universally accepted concept in the field of business.
Favourable Arguments for Wealth Maximization
Wealth maximization is superior to the profit maximization because the main aim of the business concern
under this concept is to improve the value or wealth of the shareholders.
Wealth maximization considers the comparison of the value to cost associated with the business concern.
Total value detected from the total cost incurred for the business operation. It provides extract value of the
business concern.
Wealth maximization considers both time and risk of the business concern.
Wealth maximization provides efficient allocation of resources.
It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization

Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to
present day business activities.
Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit
maximization.
Wealth maximization creates ownership-management controversy.
Management alone enjoys certain benefits.
The ultimate aim of the wealth maximization objectives is to maximize the profit.
Wealth maximization can be activated only with the help of the profitable position of the business concern

3). Proper Estimation of Total Financial Requirements:

Proper estimation of total financial requirements is a very important objective of financial management. The
finance manager must estimate the total financial requirements of the company. He must find out how much
finance is required to start and run the company. He must find out the fixed capital and working capital
requirements of the company. His estimation must be correct. If not, there will be shortage or surplus of
finance. Estimating the financial requirements is a very difficult job. The finance manager must consider many
factors, such as the type of technology used by company, number of employees employed, scale of operations,
legal requirements, etc.

4). Proper Mobilisation:

Mobilisation (collection) of finance is an important objective of financial management. After estimating the
financial requirements, the finance manager must decide about the sources of finance. He can collect finance
from many sources such as shares, debentures, bank loans, etc. There must be a proper balance between owned
finance and borrowed finance. The company must borrow money at a low rate of interest.

5). Proper Utilisation of Finance:

Proper utilisation of finance is an important objective of financial management. The finance manager must
make optimum utilisation of finance. He must use the finance profitable. He must not waste the finance of the
company. He must not invest the company's finance in unprofitable projects. He must not block the company's
finance in inventories. He must have a short credit period.

6). Maintaining Proper Cash Flow:

Maintaining proper cash flow is a short-term objective of financial management. The company must have a
proper cash flow to pay the day-to-day expenses such as purchase of raw materials, payment of wages and
salaries, rent, electricity bills, etc. If the company has a good cash flow, it can take advantage of many
opportunities such as getting cash discounts on purchases, large-scale purchasing, and giving credit to
customers, etc. A healthy cash flow improves the chances of survival and success of the company.

7). Survival of Company:

Survival is the most important objective of financial management. The company must survive in this
competitive business world. The finance manager must be very careful while making financial decisions. One
wrong decision can make the company sick, and it will close down.

8). Creating Reserves:

One of the objectives of financial management is to create reserves. The company must not distribute the full
profit as a dividend to the shareholders. It must keep a part of it profit as reserves. Reserves can be used for
future growth and expansion. It can also be used to face contingencies in the future.

9). Proper Coordination:

Financial management must try to have proper coordination between the finance department and other
departments of the company.

10). Create Goodwill:

Financial management must try to create goodwill for the company. It must improve the image and reputation
of the company. Goodwill helps the company to survive in the short-term and succeed in the long-term. It also
helps the company during bad times.

11). Increase Efficiency:

Financial management also tries to increase the efficiency of all the departments of the company. Proper
distribution of finance to all the departments will increase the efficiency of the entire company.

12). Financial discipline:

Financial management also tries to create a financial discipline. Financial discipline means:-
To invest finance only in productive areas. This will bring high returns (profits) to the company.
To avoid wastage and misuse of finance.

13). Reduce cost of capital:

Financial management tries to reduce the cost of capital. That is, it tries to borrow money at a low rate of
interest. The finance manager must plan the capital structure in such a way that the cost of capital it
minimised.

14). Reduce Operating Risks:

Financial management also tries to reduce the operating risks. There are many risks and uncertainties in a
business. The finance manager must take steps to reduce these risks. He must avoid high-risk projects. He
must also take proper insurance.

15). Prepare Capital Structure:

Financial management also prepares the capital structure. It decides the ratio between owned finance and
borrowed finance. It brings a proper balance between the different sources of capital. This balance is necessary
for liquidity, economy, flexibility and stability.
Did You Know?
The Financial Management Service is one of Treasury's newer major bureaus, having been established as the
Bureau of Government Financial Operations in 1974.

Caution
The return on investment must always be more than the cost of capital, risk investment should be least.

Case Study-Finance Software Company Wins Enterprise Contract with Client-Based Cloud Solution
―Windows Azure has brought our product to life. 360Lifecycle is more cost-effective and secure, requires less
support, and is faster to deploy. We can market the product to companies of any size.‖
Paul Merrigan, Chief Executive Officer, Lifetime Financial Management Lifetime Financial Management
wanted to reduce support costs and expand the target market for its customer relationship management (CRM)
application 360 Lifecycle. Dot Net Solutions helped Chief Executive Officer Paul Merrigan and his team
migrate the rich-client solution to run on the Windows Azure platform. Since then, Merrigan has significantly
cut support costs and won a five-year contract with intrinsic financial services.

Business Needs
In 2004, Merrigan asked software developer David Steele to create an application to support his mortgage
advisors in managing customer opportunities. At the time, Merrigan had worked in the financial services
industry for 15 years and was confident that he had the experience and skills to understand the needs of
advisors. Together with Steele, he created an in-house CRM application called 360Lifecycle, which proved to
be a highly valuable addition to the business. Merrigan says: ―At the height of the global recession in 2008,
our business prospered because 360 Lifecycle provided an easy way for advisors to manage customer
relationships, while highlighting new business leads and opportunities.‖ The software alerted employees to
business opportunities that they might otherwise have missed due to their large customer portfolios. This
success attracted the attention of competitors, which were soon asking Merrigan why his company was doing
so well during such a difficult time. This inspired the company to market the software as a standalone product
for other financial advisory businesses. In 2009, Lifetime Financial Management attracted its first customer for
360Lifecycle—a firm of 30 advisors—and within months another nine customers had subscribed to the
software. Merrigan had found a significant new business stream, but the sudden interest and accumulation of
customers came with a large support requirement—something for which the company had not time to plan.
Each customer wanted to purchase its own servers to host the application, and it took up to a week for Lifetime
Financial Management to provision servers for each customer. They dedicated two employees to deal with
support requirements, but as the number of users increased, it became a challenge for the company to keep up
with the volume of general enquiries and product and security updates.

Solution
In 2010, Dot Net Solutions for advice on the next stage of development for 360Lifecycle. The Microsoft
Partner is an expert on the Windows Azure platform, and was confident that the client software could be
developed as a software-as-a-service application in the cloud. ―The goal was to transform 360Lifecycle from a
single-tenant to a multi-tenant cloud-based architecture. We arranged for the Lifetime Financial Management
development team to be involved in a three-week proof of concept (POC) and training session at the Microsoft
Technology Centre in Reading.‖
The aims of the POC were to demonstrate the scalability and performance gains to be made by developing the
software with Windows Azure. ―It is a common misconception that desktop clients cannot work in the cloud.
The POC showed Lifetime Financial Management that the application was both highly scalable and performed
better in the cloud.‖
360Lifecycle software is now run as a cloud-based service downloaded onto a laptop, computer, or tablet PC.
360Lifecycle servers are hosted in Microsoft data centres, providing 99.99% uptime. New customers do not
need to purchase hardware to host the service, and can be provisioned in less than a minute. Once an update or
new functionality is configured, it to all customers at the same time. Windows Azure is financed on a pay go
basis and Lifetime Financial Management only pays for what its customers consume.
By January 2011, all customers were migrated to the cloud-based service. We completed most of the project
within eight weeks. It was a rapid turnaround from initial discussion to seeing the product go live. Customer
migration was completed in stages, and customers did not experience any disruption to service.

Benefits
Lifetime Financial Management recently won a contract supporting up to 2,000 users at Intrinsic Financial
Services. According to Merrigan, attracting enterprise customers such as Intrinsic is only possible by
delivering the product as a cloud-based service. He says: ―Windows Azure has brought our product to life. 360
Lifecycle is more cost-effective and secure, requires less support, and is faster to deploy. We can market the
product to companies of any size.‖ Cloud finance model increases profit margins. Lifetime Financial
Management pays for what it consumes and can tailor pricing to suit its understanding of customer use. ―Our
contract with Intrinsic Financial Services is to support up to 2,000 users for five years,‖ he says. The contract
is charged on a per-user, per-month basis, and Lifetime Financial Management has no plans to expand the
support team.
Small support team manages thousands of customers. The 360Lifecycle team can configure new customers in
less than two minutes, and deploy updates and functionality at the click of a mouse. Merrigan says his team is
now equipped to manage the support requirements for thousands of customers. ―The application runs a lot
faster now that It is hosted on web servers in Microsoft data centres, and it comes with a Microsoft SLA of
99.99 % uptime, which we pass on to our customers,‖ he says. Scalable software expands potential market. For
small businesses, hardware costs are often a barrier to purchasing the software they need, while for large
businesses, flexibility and scalability are crucial. Merrigan says: ―360Lifecycle on Windows Azure addresses
both market concerns by removing the upfront hardware costs and incorporating them into a manageable,
monthly fee per user. For large businesses, server provisioning is managed at the click of a mouse, and
performance is adjusted to suit application use.‖

Questions
1. What do you mean by business needs?
2. Explain the benefits of lifetime financial management.

1.4 Summary
Business concern needs finance to meet their requirements in the economic world. Any kind of business
activity depends on the finance.
The most popular and acceptable definition of financial management as ―Financial Management deals with
procurement of funds and their effective utilization in the business‖.
Finance may be called as capital, investment, fund etc., but each term is having different meanings and
unique characters. Increasing the profit is the main aim of any kind of economic activity.
Business finance is that business activity which concerns with the acquisition and conversation of capital
funds in meeting financial needs and overall objectives of a business enterprise‖. Or Business finance can
broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds
used in the business‖.
 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.

1.5 Keywords
Assets: In financial accounting, assets are economic resources. Anything tangible or intangible that is capable
of being owned or controlled to produce value and that is held to have positive economic value is considered
an asset.
Investment: Investment has different meanings in finance and economics. Finance investment is putting
money into something with the expectation of gain that upon thorough analysis has a high degree of security
for the principal amount, as well as security of return, within an expected period of time.
Mortgage: It is a way to use one's real property, like land, a house, or a building, as a guarantee for a loan to
get money.
Organization: An organization is a social entity that has a collective goal and is linked to an external
environment. The word is derived from the Greek word organon, itself derived from the better-known word
ergon which means "organ" – a compartment for a particular task.
Procurement: It is the acquisition of goods or services. It is favourable that the goods/services are appropriate
and that they are procured at the best possible cost to meet the needs of the purchaser in terms of quality and
quantity, time, and location.
Shareholders: A shareholder or stockholder is an individual or institution (including a corporation) that legally
owns a share of stock in a public or private corporation.

1.6 Self Assessment Questions

1. Financial Management deals with .................. of funds and their effective utilization in the business.
(a) money (b) share
(c) procurement (d) investment

2. Financial Management is mainly concerned with the effective funds management in the............
(a) organization (b) business
(c) market (d) None of these

3. The concept of finance includes capital, funds, money, and amount.

(a) True (b) False

4. Economic concepts like micro and macroeconomics are directly applied with the ..............approaches.
(a) employee management (b) financial management
(c) production management (d) None of these

5. Business finance cannot broadly be defined as the activity concerned with planning, raising, controlling,
administering of the funds used in the business.
(a) True (b) False

6. Production performance needs finance, because production department requires ............, machinery.
(a) capital (b) material
(c) raw material (d) None of these
7. Modern approaches of the financial management applied large number of mathematical and statistical tools
and techniques.
(a) True (b) False

8. The financial manager or finance department is responsible to allocate the adequate finance to
the.............................
(a) HR department (b) marketing department
(c) financial department (d) production department

9. Financial planning is an important part of the business concern, which helps to promotion of an enterprise.
(a) True (b) False

10. ..................maximization is also called as cashing per share maximization.

(a) finance (b) loss
(c) Profit (d) None of these

1.7 Review Questions

1. What is financial management process?
2. What do you mean by financial management?
3. Explain the types of finance with flow chart.
4. What is scope of financial management in future?
5. Define the difference between micro and macro economics.
6. What is importance of financial management in organizations?
7. Explain the objectives of financial management.
8. What is the impact of financial management on economics?
9. Discuss the advantage and disadvantage of planning and performance in financial management.
10. Write a short note on:
Financial planning
Financial decision
Financial controlling

Answers for Self Assessment Questions

1. (c) 2. (b) 3. (a) 4. (b) 5. (b)
6. (c) 7.(a) 8.(b) 9.(a) 10. (c)
 2
Financial Decisions
CONTENTS
Objectives
Introduction
2.1 Organization of the Finance Functions
2.2 Concept of Time Value of Money
2.3 Summary
2.4 Keywords
2.5 Self Assessment Questions
2.6 Review Questions

Objectives
After studying this chapter, you will be able:
Discuss the organization of the finance functions
Describe concept of time value of money

Introduction
Decision making may take place at an individual or organizational level. The process may involve establishing
objectives, gathering relevant information, identifying alternatives, setting criteria for the decision, and
selecting the best option. The nature of the decision-making process within an organization is influenced by its
culture and structure, and a number of theoretical models have been developed. Decision theory can be used to
assist in the process of decision making. Specific techniques used in decision making include heuristics and
decision trees. Computer systems designed to assist managerial decision making are known as decision
support systems. All the major functions or decisions – Investment function, Finance function, Liquidity
function and Dividend function, are inter-related and inter-connected. They are inter-related because the goal
of all the functions is one and the same. Their ultimate objective is only one – achievement of maximization of
shareholders‘ wealth or maximizing the market value of the shares. All the decisions are also inter-connected
or inter-dependent also. Let us illustrate both these aspects with an example.

Example: If a firm wants to undertake a project requiring funds, this investment decision cannot be taken, in
isolation, without considering the availability of finances, which is a finance decision. Both the decisions are
inter-connected. If the firm allocates more funds for fixed assets, lesser amount would be available for current
assets. So, financing decision and liquidity decision are inter-connected.
The firm has two options to finance the project, either from internal resources or raising funds, externally,
from the market. If the firm decides to meet the total project cost only from internal resources, the profits,
otherwise available for distribution in the form of dividend, have to be retained to meet the project cost. Here,
the finance decision has influenced the dividend decision. So, an efficient financial management takes the
optimal decision by considering the implications or impact of all the decisions, together, on the market value
of the company‘s shares. The decision has to be taken considering all the angles, simultaneously.

No Function is Superior
All the functions are important. Importance of the function depends on the situation of the firm. If a firm has
adequate investment opportunities but experiences difficulty to raise funds, then the finance function is
superior to the firm, at that juncture. It does not mean that investment decision is less important compared to
finance decision, always. The essence is no financial function or decision is superior to others. (See Figure 2.1)

Figure 2.1: Goal of financial management.

Nature of Financial Management

The nature of financial management is the relationship with economics and accounting, its functions and its
scope. Financial management is the way and the means of making money, the application of the functions of
planning and control to the finance function. The modern approach to financial management is to find out
how much money is required by the company and then to source at least that amount. The amount should then
be invested to ensure that the objectives of the financial management and the company as a whole are met. To
break this down into simple terms, financial management have the responsibility to estimate the funds
required, raise the funds and finally to invest the funds. When raising finance a financial management team
should ensure that they strike a balance of owned and borrowed funds. This is simply so the company does not
have too big an amount of debt on its hands. Once the funds have been raised it is important to spend them
wisely, normally on fixed assets and using the balance as working capital. Most fixed assets that would be
purchased by a company will be expensive so they need to be able to produce work for a considerable period
of time. Working capital will be required for the day-to-day running of the company, and for emergencies.
This working capital should not be too large as spare money may gain interest in the bank but it should be
cycled back into the company. An important decision of financial management is how much to pay the
shareholders, and how much to retain as working capital for the business. Shareholders expectations and the
company performance as whole need to be taken into consideration when making this decision.

2.1 Organization of the Finance Functions

Finance functions can be divided into three major decisions, which the firm must make, namely the investment
decision, the finance decision, and the dividend decision. Each of these decisions must be considered in
relation to the objective of the firm: an optimal combination of the three decisions will maximize the value of
the share to its shareholders. Since, these decisions are interrelated; we must consider their joint impact on the
market price of the firm‘s stock.

2.1.1 Investment Decision

The investment decision is the most important one among the three decisions. It relates to the selection of
assets in which funds are invested by the firm. The assets, which can be acquired, fall into two broad groups:
1. Long-term assets which will yield a return over a period of time in future.
2. Short-term current assets which are convertible into cash in the normal course of business usually within a
year.
Accordingly, the asset selection decision of a firm is of two types. The first of these involving the first
category of assets is popularly known as capital budgeting. The other one, which refers to short-term assets, is
designated as liquidity decision.

Capital Budgeting Decision

It is the most crucial financial decision of a firm which relates to the selection of an investment proposal
whose benefits are likely to arise in future over the life-time of the project. The first aspect of the capital
budgeting decision is the choice of the investment out of the available alternatives. The selection will be
always based on the relative benefits and returns associated with it. Therefore, the measurement of the worth
of the investment proposal is a major element in the capital budgeting decision. Another aspect of the capital
budgeting decision is the analysis of risk and uncertainty. As, the benefits from the proposed investment relate
to the future period, their accrual is uncertain. Thus, an element of risk in the sense of uncertainty of future
benefits is involved. Investment should be evaluated in relation to the risk associated with it. Finally, this
return should be judged with a certain norm, which is referred by several names such as cut-off rate, required
rate, hurdle rate, minimum rate of return, etc. The correct standard to use for this purpose is the company‘s
cost of capital, which is another important aspect of the capital budgeting decision.

Liquidity Decision
The liquidity decision is concerned with the management of the current assets, which is a pre-requisite to long-
term success of any business firm. The main objective of the current assets: management is the trade - off
between profitability and liquidity. There is a conflict between these two concepts. If a firm does not have
adequate working capital, it may become illiquid and consequently fail to meet its current obligations thus
inviting the risk of bankruptcy. On the contrary, if the current assets are too large, the profitability is adversely
affected. Hence, the key strategy and the main consideration in ensuring a trade-off between profitability and
liquidity is the major objective of the liquidity decision. Besides, the funds should be invested optimally in the
individual current assets to avoid inadequacy or excessive locking up of funds in these assets. Thus, the
liquidity decision should obtain the basic two ingredients, i.e. overview of working capital management and
the efficient allocation of funds on the individual current assets.

2.1.2 Financing Decision

The second major decision of the firm is the financing decision for determining the best financing mix of the
firm. After determining the asset-mix, the financial manager must decide the mode of raising the funds to meet
the firm‘s investment requirements. The major issue in this Decision is to determine the proportion of equity
and debt capital. Since the involvement of debt capital affects the return and risk of shareholders, the financial
manager should get the optimal capital structure to maximize the shareholders‘ return with financial
management: minimum risk, in other words the cost of capital is the lowest and the market value of An
Introduction the share is the highest at that combination of debt and equity.
Thus, the financing decision covers two inter-related aspects:
(i) Capital structure theory
(ii) Capital structure decision

2.1.3 Dividend Decision

The third important decision of a firm is its dividend policy. The financial manager must decide whether the
firm should distribute all profits or retain it in the firm or distribute part and retain the balance. The dividend
decision should be taken in terms of its impact on the shareholders‘ wealth. The optimum dividend policy is
one, which maximizes the market value of share. Thus, if the shareholders are not indifferent to the firm‘s
dividend policy, the financial manager must determine the optimum dividend-payout ratio. Another important
aspect of the dividend decision is the factors determining dividend policy of the firm in practice. To
summaries, the financial management involves the solution o f the three decisions of the firm according to the
modern approach. The traditional approach with a very narrow perception was devoid of an integrated
conceptual and analytical framework. In contrast the modern approach has broadened the scope of financial
management to ensure the optimum decisions by fulfilling the objectives of the business firm.

2.1.4 Functional Areas of Modern Financial Management

Financial management, at present is not confined to raising and allocating funds. The study of financial
institutions like stock exchange, capital, market, etc. is also emphasized because they influenced under writing
of securities and corporate promotion. Company finance was considered to be the major domain of financial
management. The scope of this subject has widened to cover capital structure, dividend policies, profit
planning and control, depreciation policies. Some of the functional areas covered in financial management as:

Determining Financial Needs

A finance manager is supposed to meet financial needs of the enterprise. For this purpose, he should determine
financial needs of the concern. Funds are needed to meet promotional expenses, fixed and working capital
needs. The requirement of fixed assets is related to types of industry. A manufacturing concern will require
more investments in fixed assets than a trading concern. The working capital needs depend upon scale of
operations. Larger the scale of operations, the higher will be the needs for working capital. A wrong
assessment of financial needs may jeopardize the survival of a concern.

Choosing the Sources of Funds

A number of sources may be available for raising funds. A concern may be resort to issue of share capital and
debentures. Financial institutions may be requested to provide long-term funds. The working capital needs
may be met by getting cash credit or overdraft facilities from commercial bands. A finance manager has to be
very careful and cautions in approaching different sources.
Financial Analysis and Interpretation
The analysis and interpretation of financial statements is an important task of a finance manager. He is
expected to know about the profitability, liquidity position, short term and long-term financial position of the
concern. For this purpose, a number of ratios have to be calculated. The interpretation of various ratios is also
essential to reach certain conclusions financial analysis and interpretation has become an important area of
financial management.

Cost-Volume Profit Analysis

This is popularly known as ―CVP relationship‖. For this purpose, fixed costs, variable costs and semi variable
costs have to be analyzed. Fixed costs are more or less constant for varying sales volumes. Variable costs vary
according to the sales volume. Semi-variable costs are either fixed or variable in the short-term. The financial
manager has to ensure that the income of the firm will cover its variable costs, for there is no point in being in
business, if this is not accomplished. Moreover, a firm will have to generate an adequate income to cover its
fixed costs as well. The financial manager has to find out the break-even point that is, the point at which the
total costs are matched by total sales or total revenue.

Working Capital Management

Working capital refers to that part of firm‘s capital which is required for financing short-term or current assets
such as cash, receivables and inventories. It is essential to maintain proper level of these assets. Finance
manager is required to determine the quantum of such assets.

Dividend Policy
Dividend is the reward of the shareholders for investments made by them in the shares of the company. The
investors are interested in earning the maximum return on their investments whereas management wants to
retain profits for future financing. These contradictory aims will have to be reconciled in the interests of
shareholders and the company. Dividend policy is an important area of financial management because the
interest of the shareholders and the needs of the company are directly related to it.

Capital Budgeting
Capital budgeting is the process of making investment decisions in capital expenditures. It is an expenditure
the benefits of which are expected to be received over a period of time exceeding one year. It is expenditure
for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of
years in future. Capital budgeting decisions are vital to any organization. Any unsound investment decision
may prove to be fatal for the very existence of the concern.

2.2 Concept of Time Value of Money

Money has time value. A rupee today is more valuable than a year hence. It is on this concept ―the time value
of money‖ is based. The recognition of the time value of money and risk is extremely vital in financial
decision making. Most financial decisions such as the purchase of assets or procurement of funds, affect the
firm‘s cash flows in different time periods. For example, if a fixed asset is purchased, it will require an
immediate cash outlay and will generate cash flows during many future periods. Similarly if the firm borrows
funds from a bank or from any other source, it receives cash and commits an obligation to pay interest and
repay principal in future periods.
The firm may also raise funds by issuing equity shares. The firm‘s cash balance will increase at the time shares
are issued, but as the firm pays dividends in future, the outflow of cash will occur. Sound decision-making
requires that the cash flows which a firm is expected to give up over period should be logically comparable. In
fact, the absolute cash flows which differ in timing and risk are not directly comparable. Cash flows become
logically comparable when they are appropriately adjusted for their differences in timing and risk. The
recognition of the time value of money and risk is extremely vital in financial decision-making. If the timing
and risk of cash flows is not considered, the firm may make decisions which may allow it to miss its objective
of maximizing the owner‘s welfare. The welfare of owners would be maximized when Net Present Value is
created from making a financial decision. It is thus, time value concept which is important for financial
decisions. Thus, we conclude that time value of money is central to the concept of finance. It recognizes that
the value of money is different at different points of time. Since money can be put to productive use, its value
is different depending upon when it is received or paid. In simpler terms, the value of a certain amount of
money today is more valuable than its value tomorrow.

It is not because of the uncertainty involved with time but purely on account of timing. The difference in the
value of money today and tomorrow is referred as time value of money. The time value of money establishes
that there is a preference of having money at present than a future point of time.
It means
(a) That a person will have to pay in future more, for a rupee received today.
For example: Suppose your father gave we 100 on tenth birthday. You deposited this amount in a bank at 10%
rate of interest for one year. How much future sum would you receive after one year? You would receive 110
Future sum = Principal + Interest
= 100 + 0.10 × 100
= 110
What would be the future sum if you deposited 100 for two years?
You would now receive interest on interest earned after one year.
Future sum = 100 1.102
= 121
We express this procedure of calculating as compound value or future value of a sum.
(b) A person may accept less today, for a rupee to be received in the future. Thus, the inverse of compounding
process is termed as discounting. Here we can find the value of future cash flow as on today.

2.2.1 Reasons for Time Value Of Money

Money has time value because of the following reasons:
Risk and Uncertainty
Future is always uncertain and risky. Outflow of cash is in our control as payments to parties are made by us.
There is no certainty for future cash inflows. Cash inflows are dependent out on our Creditor, Bank etc. As an
individual or firm is not certain about future cash receipts, it prefers receiving cash now.

Inflation
In an inflationary economy, the money received today, has more purchasing power than the money to be
received in future. In other words, a rupee today represents a greater real purchasing power than a rupee a year
hence.

Consumption
Individuals generally prefer current consumption to future consumption.

Investment Opportunities
An investor can profitably employ a rupee received today, to give him a higher value to be received tomorrow
or after a certain period of time. Thus, the fundamental principle behind the concept of time value of money is
that, a sum of money received today, is worth more than if the same is received after a certain period of time.
For example, if an individual‘s given an alternative either to receive 10,000 now or after one year, one will
prefer 10,000 now. This is because, today, he may be in a position to purchase more goods with this money
than what he is going to get for the same amount after one year. Thus, time value of money is a vital
consideration in making financial decision. Let us take some examples:

Example: A project needs an initial investment of 1, 00,000. It is expected to give a return of 20,000 per
annum at the end of each year, for six years. The project thus involves a cash outflow of 1, 00,000 in the ‗zero
year‘ and cash inflows of 20,000 per year, for six years. In order to decide, whether to accept or reject the
project, it is necessary that the present value of cash inflows received annually for six years is ascertained and
compared with the initial investment of 1,00,000. The firm will accept the project only when the present value
of cash inflows at the desired rate of interest exceeds the initial investment or at least equals the initial
investment of 1, 00,000.

Example: A firm has to choose between two projects. One involves an outlay of 10 lakes with a return of 12%
from the first year onwards, for ten years. The other requires an investment of 10 lakes with a return of 14%
per annum for 15 years commencing with the beginning of the sixth year of the project. In order to make a
choice between these two projects, it is necessary to compare the cash outflows and the cash inflows resulting
from the project. In order to make a meaningful comparison, it is necessary that the two variables are strictly
comparable. It is possible only when the time element is incorporated in the relevant calculations. This reflects
the need for comparing the cash flows arising at different points of time in decision-making.

2.2.2 Concepts or Techniques of Valuation

The Time value of money implies
(i) That a person will have to pay in future more for a rupee received today.
(ii) A person may accept less today for a rupee to be received in future.

There are two techniques for adjusting time value of money. They are:
1. Compounding Techniques/Future Value Techniques
2. Discounting/Present Value Techniques

The value of money at a future date with a given interest rate is called future value. Similarly, the worth of
money today that is receivable or payable at a future date is called Present Value.

Compounding Techniques/Future Value Technique

In this concept, the interest earned on the initial principal amount becomes a part of the principal at the end of
the compounding period.
For Example: Suppose you invest 1000 for three years in a saving account that pays 10% interest per year. If
you let r interest income be reinvested, your investment will grow as follows:

Table 2.1: Compounding techniques

First year: Principal at the beginning 1,000
Interest for the year (1,000 × 0.10) 100
Principal at the end 1,100
Second year: Principal at the beginning 1,100
Interest for the year (1,100 × 0.10) 110
Principal at the end 1210
 Third year: Principal at the beginning 1210
Interest for the year (1210 × 0.10) 121
Principal at the end 1331

This process of compounding will continue for an indefinite time period. The process of investing money as
well as reinvesting interest earned there on is called Compounding. But the way it has gone about calculating
the future value will prove to be cumbersome if the future value over long maturity periods of 20 years to 30
years is to be calculated.
A generalized procedure for calculating the future value of a single amount compounded annually is as
follows:
Formula: FV n PV (1 r ) n
n
In this equation (1 r ) is called the future value interest factor (FVIF).
Where, FV n = Future value of the initial flow n year hence
PV = Initial cash flow
r = Annual rate of Interest
n = number of years
By taking into consideration, the above example, we get the same result

FV n PV (1 r ) n
1, 000(1.10) 3
FV n 1331

Discounting/Present Value Techniques

Present value is the exact opposite of future value. The present value of a future cash inflow or outflow is the
amount of current cash that is of equivalent value to the decision maker. The process of determining present
value of a future payment or receipts or a series of future payments or receipts is called discounting. The
compound interest rate used for discounting cash flows is also called the discount rate.

Did You Know?

Banknotes were first issued in Europe by Stockholms Banco in 1661, and were again also used alongside
coins.

Caution
Fixed assets should only be purchased if they can add value to the business, especially long-term value.

Case Study-Understanding Financial Decisions at Sainsbury's

The Better Decisions, Real Value (BDRV) toolkit helped Sainsbury‘s Energy and Environment team to
develop a clear business case for making its stores more energy efficient and to identify financial benefits
which had been overlooked. They found that the business‘s decision-making process for large investments did
not factor in some of the main incentives for energy-saving.

Background
Sainsbury‘s needed to decide how much to invest in making its stores more energy efficient. Initiatives like
this are a key part of its sustainability strategy, but still need to be approved by the investment board.
The Energy and Environment team, part of Sainsbury‘s property division, wanted to be able to articulate the
business case for the investment as clearly as possible to ensure the project would go ahead. One challenge
they faced was that estimates suggested there would be a long payback period before the energy efficiency
improvements yielded a financial return. They also wanted to capture less tangible benefits as well as direct
financial savings, for example, the clear reputational benefits of the initiative. The project team began by
assessing the ‗pathways‘ by which the energy efficiency improvements could add most value to the business,
using the BDRV pathways tool. The team identified a need to look more deeply into how the investment board
made its decisions. They found that a simplified calculation used to assess Net Present Value (a measure of
how much the financial benefits from a project outweigh the costs) did not take into account some of the most
important direct financial incentives for energy-saving. For example, cost savings for Sainsbury's from the
Carbon Reduction Commitment were omitted.

Sainsbury’s benefit from the project

Sainsbury‘s identified an important blind-spot: its investment appraisal ignored some significant financial
benefits of energy efficiency. The team also developed a better understanding of the processes and tools used
for financial decision-making, and built a closer relationship with their finance colleagues. The Energy and
Environment team is now better equipped to identify and communicate the wider business benefits of good
energy decisions. They also have greater confidence in articulating a clear business case for other strategic
sustainability decisions.

BDRV toolkit
Using the pathways tool on a real business issue helped us to clarify and expand on the different ways that
sustainability initiatives can provide business value. The latest toolkit version incorporates our experience
from this and other projects, as well as feedback from a range of experts in business sustainability . By
working with finance teams, we learnt how some financial tools are ill-equipped to deal with the complexity of
sustainability and the softer numbers that often come out of attempts to quantify the financial benefits of
initiatives in this area. This helped us develop the Ready Reckoned tool, which offers guidance on overcoming
these obstacles and providing numbers that are ‗good enough‘.

Questions
1. Discuss the financial decisions at Sainsbury's.
2. How did Sainsbury‘s benefit from the project?

2.3 Summary
The nature of financial management is the relationship with economics and accounting, its functions and
its scope.
Profit maximization is also called as cashing per share maximization. It leads to maximize the business
operation for profit maximization.
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern.
Financial decision is the process may involve establishing objectives, gathering relevant information,
identifying alternatives, setting criteria for the decision, and selecting the best option.
The financial manager must decide whether the firm should distribute all profits or retain it in the firm or
distribute part and retain the balance.
2.4 Keywords
Accountancy: It is the process of communicating financial information about a business entity to users such as
shareholders and managers.
Bankruptcy: Bankruptcy is a legal status of an insolvent person or an organization, that is, one who cannot
repay the debts they owe to creditors.
Capital Budgeting: It (or investment appraisal) is the planning process used to determine whether an
organization's long term investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth pursuing. It is budget for major capital, or investment.
Stock exchange: A stock exchange is a regulated market which provides services for stock brokers and traders
to trade stocks, bonds, and other securities.
Trade – off: It (or tradeoff) is a situation that involves losing one quality or aspect of something in return for
gaining another quality or aspect. It often implies a decision to be made with full comprehension of both the
upside and downside of a particular choice.

2.5 Self Assessment Questions

1. Computer systems designed to assist managerial decision making are known as…
(a) planning support system (b) decision support systems
(c) both (d) None of these

2. Finance functions can be divided into three major decisions, which the firm must make, namely the
investment decision, the finance decision, and the dividend decision.
(a) True (b) False

3. …………….assets which will yield a return over a period of time in future.

(a) Short-term (b) Long-term
(c) Intangible assets (d) Tangible assets

4. The measurement of the worth of the investment proposal is a major element in the ……..decision.
(a) production management (b) financial management
(c) capital budgeting (d) None of these

5. The main objective of the current assets: management is the trade - off between profitability and liquidity.
(a) True (b) False

6. The financial manager must determine the optimum dividend-payout ratio.

(a) True (b) False

7. The major issue in Decision is to determine the proportion of equity and…………...

(a) liablity (b) debt capital
(c) both (d) None of these

8. The recognition of the time value of ...............is extremely vital in financial decision making.
(a) risk and uncertainty (b) marketing and risk
(c) timing and risk (d) money and risk
9. Capital budgeting decisions are not essential to any organization.
(a) True (b) False

10. The compound interest rate used for discounting cash flows is also called the………….
(a) cutoff rate (b) rate of interest
(c) discount rate (d) None of these

2.6 Review Questions

1. What do you understand by financial decisions?
2. What are organization finance functions?
3. Explain the concept of time value of money?
4. What do you mean by nature of financial management?
5. What is capital budgeting decision? Explain process.
6. Discuss about financing decision.
7. What are benefit of financial analysis and interpretation?
8. Explain the process of risk and uncertainty.
9. What are concepts of valuation?
10. Explain the keywords:
Future Value Technique
Inflation
Dividend Policy

Answers for Self Assessment Questions

1. (b) 2. (a) 3. (b) 4. (c) 5. (a)
6. (a) 7.(b) 8.(d) 9.(b) 10. (c)
 3
Financial Planning
CONTENTS
Objectives
Introduction
3.1 Objectives of Financial Planning
3.2 Principles of Sound Financial Planning
3.3 Summary
3.4 Keywords
3.5 Self Assessment Questions
3.6 Review Questions

Objectives
After studying this chapter, you will be able:
Discuss the objectives
Describe principles of sound financial planning

Introduction
Financial planning means to prepare the financial plan. A financial plan is also called Capital Plan.
A financial plan is an estimate of the total capital requirements of the company. It selects the most economical
sources of finance. It also tells us how to use this finance profitably. Financial plan gives a total picture of the
future financial activities of the company.

Financial Planning is the mathematical sum of following parameters:-

Financial Resources (FR) + Financial Techniques (FT) = Financial Planning.
A financial plan contains answers to the following questions:-
How much finance (short-term, medium-term and long-term) will be required by the company?
 From where this finance will be acquired (gathered)? In other words, what are the sources of finance? That
is, owned capital (promoter contribution, share capital) and borrowed capital (debentures, loans,
overdrafts, etc.).
How the company will use this acquired finance? That is, application or utilization of funds.

Financial plan is generally prepared during promotion stage. It is prepared by the Promoters (entrepreneurs)
with the help of experienced (practising) professionals. The promoters must be very careful while preparing
the financial plan. This is because a bad financial plan will lead to over-capitalization or under-capitalization.
It is very difficult to correct a bad financial plan. Hence immense care must be taken while preparing a
financial plan.

Types of Financial Plans

After the company starts, the finance manager does the financial planning.
The types of financial plans are depicted and briefly explained below.(See Figure 3.1)

Figure 3.1: Types of financial plans.

There are three types of financial plans:

a) Short-term financial plan is prepared for maximum one year. This plan looks after the working capital needs
of the company.
b). Medium-term financial plan is prepared for a period of one to five years. This plan looks after replacement
and maintenance of assets, research and development, etc.
c). Long-term financial plan is prepared for a period of more than five years. It looks after the long-term
financial objectives of the company, its capital structure, expansion activities, etc.

What Does A Financial Planner Do?

A financial planner is someone who uses the financial planning process to help us figure out how to meet your
life goals. The planner can take a `big picture` view of your financial situation and make financial planning
recommendations that are right for us. The planner can look at all of your needs including budgeting and
saving, taxes, investments, insurance and retirement planning. Or, the planner may work with us on a single
financial issue but within the context of your overall situation. This big picture approach to your financial
goals sets a financial planner apart from other financial advisers who may have been trained to focus only on a
particular area of your financial life. The financial planner is the best friend we need to advice on ways of
achieving financial goals. He is a client-oriented professional who works in the best interest of customers.
When we have a professional relationship with a planner that does not mean that he replaces other
professionals such as lawyers or accountants. A planner is a coordinator who works with others in making the
planning process work.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programmes and budgets regarding
the financial activities of a concern. This ensures effective and adequate financial and investment policies. The
importance can be outlined as-
1. Adequate funds have to be ensured.
2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that
stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise
financial planning.
4. Financial Planning helps in making growth and expansion programmers which help in long-run survival of
the company.
5. Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily
through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company.
This helps in ensuring stability and profitability in concern.

3.1 Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:
a. Determining capital requirements- This will depend upon factors like cost of current and fixed assets,
promotional expenses and long- range planning. Capital requirements have to be looked with both aspects:
short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and
proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term
and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible
manner at least cost in order to get maximum returns on investment.

A comprehensive financial plan entails planning for the future with a tax minimization focus while ensuring
your wealth is properly transitioned to future owners. We deal with the leading providers of insurance,
accounting and legal services. We will work to develop solutions in all areas of personal and corporate
financial planning and risk management.

Protecting Your Family

Mitigating your risk should be a key component to any financial plan. We incorporate analyses for life
insurance, living benefits (Disability Insurance, Critical Illness, Long Term Care, health and dental) and estate
planning insurance.
Protecting Your Retirement
Accumulating retirement assets in a tax-efficient manner and ensuring that we will not outlive your income are
typical retirement planning concerns. We work to determine what level of savings we need to make in order to
reach your goals.

Protecting Your Estate

We can help us determine which tools will work best to help ensure that your assets are managed and
transferred to your heirs with minimum inconvenience and expenses, while minimizing the impact of taxes for
your estate.

Protecting Your Business

We offer various financial tools for your small business and employees, such as retirement planning,
shareholder agreements, insurance planning, and investment diversification. We also offer transition of shares
between generations, and advice for professionals looking to incorporate their practice.

Protecting Your Legacy

We understand your desire to support worthy organizations and give back to your communities. We can help
we to identify numerous financial benefits, such as immediate tax deductions and capital gains savings, so that
we are charitable contributions are maximized and your personal financial goals are attained.

3.1.1 Steps in Financial Planning

Six Steps of Financial Planning
1. Establish financial goals.
2. Gather relevant data.
3. Analyze the data.
4. Develop a plan for achieving goals.
5. Implement the plan.
6. Monitor the plan.

Step 1: Establish Financial Goals

Few people begin a vacation without having a specific destination in mind. In contrast, millions of people
make significant financial decisions without having a specific financial destination. Goal setting is critical to
creating a successful financial plan, but few people actually set clearly defined goals. By leading the client
through the goal-setting exercise, the financial advisor not only helps establish reasonable, achievable goals,
but also sets the tone for the entire financial planning process. Clients typically express concern about such
topics as retirement income, education funding, premature death, disability, taxation, qualified plan
distribution, and a myriad of others. Sometimes clients enumerate specific, prioritized goals, but they are more
likely to present a vague list of worries that suggest anxiety and frustration rather than direction. The advisor‘s
responsibility is to help the client transform these feelings into goals.

Advisors should question clients to learn what they are trying to accomplish. Usually the response is couched
in general terms, such as ―Well, we want to have a comfortable standard of living when we retire.‖ At first
glance this seems to be a reasonable goal, but a closer evaluation reveals that this goal is far too vague. When
do they want to retire? What is meant by ―comfortable‖? Do they want to consider inflation? Do they want to
retire on ―interest only‖ or draw down their accumulated portfolio over their expected lives?
Step 2: Gather Relevant Data
Because there are many client concerns that a financial advisor may need to address, the advisor will have to
gather considerable information from the client. Defining the client‘s current situation, determining what the
client‘s desired future situation is and when it is to be achieved, and establishing what the client is willing and
able to do in order to get there require information. This information must be accurate, complete, up-to-date,
relevant to the client‘s goals, and well organized. Otherwise, financial plans based on the information will be
deficient—perhaps erroneous, inappropriate, inconsistent with the client‘s other goals, or dangerous to the
client‘s financial well-being. After a client expresses goals, objectives, and concerns, the advisor gathers all
the information about the client that is relevant to the problem(s) to be solved and/or to the type of plan to be
prepared. The more complex the client‘s situation and the more varied the number of his or her goals, the
greater the information-gathering task. Two broad types of information will need to be gathered: objective and
subjective.

A few examples of objective (factual) information that might be needed from the client include a list of
securities holdings, inventory of assets and liabilities, a description of the present arrangement for distribution
of the client‘s (and spouse‘s) assets at death, a list of annual income and expenditures, and a summary of
present insurance coverage‘s. Of at least equal importance is the subjective information about the client. The
financial advisor often will need to gather information about the hopes, fears, values, preferences, attitudes,
and nonfinancial goals of the client (and spouse). One piece of information worthy of special attention is the
client‘s financial risk tolerance. Advisors must determine the client‘s (and spouse‘s) attitude toward risk before
making recommendations, preferably through use of a scientific, third-party evaluation. The American
College‘s Survey of Financial Risk Tolerance2 provides the type of analysis that helps the advisor suggest
alternatives that are truly appropriate for the client. Such information offers the additional benefit of helping
avoid (or at least defend) lawsuits from a dissatisfied client.

Step 3: Analyze the Data

Once the relevant information about the client has been gathered, organized, and checked for accuracy,
consistency, and completeness, the financial advisor‘s next task is to analyze the client‘s present financial
condition. The objective here is to determine where the client is now in relationship to the goals that were
established by the client in step one. This analysis may reveal certain strengths in the client‘s present position
relative to those goals. For example, the client may be living well within his or her means, and thus resources
are available with which to meet some wealth accumulation goals within a reasonable time period. Maybe the
client has a liberal set of health insurance coverage‘s through his or her employer, thereby adequately covering
the risks associated with serious disability. Perhaps the client‘s will has been reviewed recently by his or her
attorney and brought up-to-date to reflect the client‘s desired estate plan. More than likely, however, the
financial advisor‘s analysis of the client‘s present financial position will disclose a number of weaknesses or
conditions that are hindering achievement of the client‘s goals. For example, the client may be paying
unnecessarily high federal income taxes or using debt unwisely. The client‘s portfolio of investments may be
inconsistent with his or her financial risk tolerance. Maybe the client‘s business interest is not being used
efficiently to achieve his or her personal insurance protection goals, or important loss-causing possibilities
have been overlooked, such as the client‘s exposure to huge lawsuits arising out of the possible negligent use
of an automobile by someone other than the client.
One conclusion from the advisor‘s analysis may be that the client cannot attain the goals established in step
one. For example, the client‘s resources and investment returns may preclude reaching a specified retirement
income goal. In this case, the advisor helps the client to lower the goal or shows what changes the client must
make to achieve the goal. Postponing retirement, saving more money, seeking higher returns, and deciding to
deplete principal during retirement are four ways to help achieve the goal. Presented with alternatives, the
client can restate the original goal by either lowering it or revising restrictive criteria to make it achievable.

Step 4: Develop a Plan for Achieving Goals

After the information about the client has been analyzed and, if necessary, the goals to be achieved have been
refined, the advisor‘s next job is to devise a realistic financial plan for bringing the client from his or her
present financial position to the attainment of those goals. Since no two clients are alike, a well-drawn
financial plan must be tailored to the individual, with all the advisor‘s recommended strategies designed for
each particular client‘s needs, abilities, and goals. The plan must be the client‘s plan, not the advisor‘s plan. It
is unlikely that any individual advisor can maintain an up-to-date familiarity with all the strategies that might
be appropriate for his or her clients. Based on his or her education and professional specialization, the advisor
is likely to rely on a limited number of ―tried and true‖ strategies for treating the most frequently encountered
planning problems. When additional expertise is needed, the advisor should always consult with a specialist in
the field in question to help him or her design the client‘s overall plan.

Also there is usually more than one way for a client‘s financial goals to be achieved. When this is the case, the
advisor should present alternative strategies for the client to consider and should explain the advantages and
disadvantages of each strategy. Strategies that will help achieve multiple goals should be highlighted. The
financial plan that is developed should be specific. It should detail who is to do what, when, and with what
resources. Implicit in plan development is the importance of obtaining client approval. It follows that the plan
must not only be reasonable; it must also be acceptable to the client. Usually interaction between advisor and
client continues during plan development, providing constant feedback to increase the likelihood that the client
will approve the plan.

Step 5: Implement the Plan

The mere giving of financial advice, no matter how solid the foundation, on which it is based, does not
constitute financial planning. A financial plan is useful to the client only if it is put into action. Therefore, part
of the advisor‘s responsibility is to see that plan implementation is carried out properly according to the
schedule agreed upon with the client. Financial plans that are of limited scope and limited complexity may be
implemented for the client entirely by the advisor. For other plans, however, additional specialized
professional expertise will be needed. For example, such legal instruments as wills and trust documents may
have to be drawn up, insurance policies may have to be purchased, or investment securities may have to be
acquired. Part of the advisor‘s responsibility is to motivate and assist the client in completing each of the steps
necessary for full plan implementation.

Step 6: Monitor the Plan

The relationship between the financial advisor and the client should be an ongoing one. Therefore, the sixth
and final step in the financial planning process is to monitor the client‘s plan. Normally the advisor meets with
the client at least once each year to review the plan, or more frequently if changing circumstances warrant it.
The first part of this review process should involve measuring the performance of the implementation vehicles.
Second, updates should be obtained concerning changes in the client‘s personal and financial situation. Third,
changes that have occurred in the economic, tax, or financial environment should be reviewed with the client.
If this periodic review of the plan indicates satisfactory performance in light of the client‘s current goals and
circumstances, no action needs to be taken. However, if performance is not acceptable or if there is a
significant change in the client‘s personal or financial circumstances or goals or in the economic, tax, or
financial environment, the advisor and client should revise the plan to fit the new situation. This revision
process should follow the same six steps used to develop the original plan, though the time and effort needed
will probably be less than in the original process.

3.2 Principles of Sound Financial Planning

Adhering to sound principles is important, regardless of the grant source. Solid practices in this area help to
build a relationship of trust with funders and make the management process within an organization more
orderly. This effective practice from Company LLP was developed from materials shared at the Financial
Management Institute in San Diego. The Ten Principles of Sound Financial Management adopted by the Board
of Supervisors on October 22, 1975, endorsed a set of policies designed to contribute to the County‘s fiscal
management and maintain the County‘s "triple A" bond rating. The County has maintained its superior rating
in large part due to its firm adherence to these policies. The County's exceptional "triple A" bond rating gives
its bonds an unusually high level of marketability and results in the County being able to borrow for needed
capital improvements at low interest rates, thus realizing significant savings now and in the future for the
citizens of Fairfax County.

1. Planning Policy: The planning system in the County will continue as a dynamic process, which is
synchronized with the capital improvement program, capital budget and operating budget. The County‘s land
use plans shall not be allowed to become static. There will continue to be periodic reviews of the plans at least
every five years. Small area plans shall not be modified without consideration of contiguous plans. The Capital
Improvement Program will be structured to implement plans for new and expanded capital facilities as
contained in the County‘s Comprehensive Plan and other facility plans. The Capital Improvement Program
will also include support for periodic reinvestment in aging capital and technology infrastructure sufficient to
ensure no loss of service and continued safety of operation.

2. Annual Budget Plans: Annual budgets shall continue to show fiscal restraint. Annual budgets will be
balanced between projected total funds available and total disbursements including established reserves.
A managed reserve shall be maintained in the General Fund at a level sufficient to provide for temporary
financing of critical unforeseen disbursements of a catastrophic emergency nature. The reserve will be
maintained at a level of not less than two percent of total Combined General Fund disbursements in any
given fiscal year.
A Revenue Stabilization Fund (RSF) shall be maintained in addition to the managed reserve at a level
sufficient to permit orderly adjustment to changes resulting from curtailment of revenue. The ultimate
target level for the RSF will be three percent of total General Fund Disbursements in any given fiscal year.
After an initial deposit, this level may be achieved by incremental additions over many years. Use of the
RSF should only occur in times of severe economic stress. Accordingly, a withdrawal from the RSF will
not be made unless the projected revenues reflect a decrease of more than 1.5 percent from the current year
estimate and any such withdrawal may not exceed one half of the RSF fund balance in that year. Until the
target level is reached, the Board of Supervisors will allocate to the RSF a minimum of 40 percent of non-
recurring balances identified at quarterly reviews.
Budgetary adjustments which propose to use available general funds identified at quarterly reviews should
be minimized to address only critical issues. The use of non-recurring funds should only be directed to
capital expenditures to the extent possible.
The budget shall include funds for cyclic and scheduled replacement or rehabilitation of equipment and
other property in order to minimize disruption of budgetary planning from irregularly scheduled monetary
demands.
3. Cash Balances: It is imperative that positive cash balances exist in the General Fund at the end of each
fiscal year. If an operating deficit appears to be forthcoming in the current fiscal year wherein total
disbursements will exceed the total funds available, the Board will take appropriate action to balance revenues
and expenditures as necessary so as to end each fiscal year with a positive cash balance.

4. Debt Ratios: The County‘s debt ratios shall be maintained at the following levels:
Net debt as a percentage of estimated market value shall be less than 3 percent.
Debt service expenditures as a percentage of General Fund disbursements shall not exceed 10 percent. The
County will continue to emphasize pay-as-you-go capital financing. Financing capital projects from
current revenues is indicative of the County‘s intent to use purposeful restraint in incurring long-term debt.
For planning purposes annual bond sales shall be structured such that the County‘s debt burden shall not
exceed the 3 and 10 percent limits. To that end sales of general obligation bonds and general obligation
supported debt will be managed so as not to exceed a target of INR200 million per year, or INR1 billion
over 5 years, with a technical limit of INR225 million in any given year. Excluded from this cap are
refunding bonds, revenue bonds or other non-General Fund supported debt.
For purposes of this principle, debt of the General Fund incurred subject to annual appropriation shall be
treated on a par with general obligation debt and included in the calculation of debt ratio limits. Excluded
from the cap are leases secured by equipment, operating leases, and capital leases with no net impact to the
General Fund.
For purposes of this principle, payments for equipment or other business property, except real estate,
purchased through long-term lease-purchase payment plans secured by the equipment will be considered
to be operating expenses of the County. Annual General Fund payments for such leases shall not exceed 3
percent of annual General Fund disbursements, net of the School transfer. Annual equipment lease-
purchase payments by the Schools and other governmental entities of the County should not exceed 3
percent of their respective disbursements.

5. Cash Management: The County‘s cash management policies shall reflect a primary focus of ensuring the
safety of public assets while maintaining needed liquidity and achieving a favourable return on investment.
These policies have been certified by external professional review as fully conforming to the recognized best
practices in the industry. As an essential element of a sound and professional financial management process,
the policies and practices of this system shall receive the continued support of all County agencies and
component units.

6. Internal Controls: A comprehensive system of financial internal controls shall be maintained in order to
protect the County‘s assets and sustain the integrity of the County‘s financial systems. Managers at all levels
shall be responsible for implementing sound controls and for regularly monitoring and measuring their
effectiveness.

7. Performance Measurement: To ensure Fairfax County remains a high performing organization all efforts
shall be made to improve the productivity of the County‘s programs and its employees through performance
measurement. The County is committed to continuous improvement of productivity and service through
analysis and measurement of actual performance objectives and customer feedback.

8. Reducing Duplication: A continuing effort shall be made to reduce duplicative functions within the County
government and its autonomous and semi-autonomous agencies, particularly those that receive appropriations
from the General Fund. To that end, business process redesign and reorganization will be encouraged
whenever increased efficiency or effectiveness can be demonstrated.
9. Underlying Debt and Moral Obligations: The proliferation of debt related to but not directly support by the
County‘s General Fund shall be closely monitored and controlled to the extent possible, including revenue
bonds of agencies supported by the General Fund, the use of the County‘s moral obligation and underlying
debt.
A moral obligation exists when the Board of Supervisors has made a commitment to support the debt of
another jurisdiction to prevent a potential default, and the County is not otherwise responsible or obligated
to pay the annual debt service. The County‘s moral obligation will be authorized only under the most
controlled circumstances and secured by extremely tight covenants to protect the credit of the County. The
County‘s moral obligation shall only be used to enhance the credit worthiness of an agency of the County
or regional partnership for an essential project and only after the most stringent safeguards has been
employed to reduce the risk and protect the financial integrity of the County.
Underlying debt includes tax supported debt issued by towns or districts in the County, which debt is not
an obligation of the County, but nevertheless adds to the debt burden of the taxpayers within those
jurisdictions in the County. The issuance of underlying debt, insofar as it is under the control of the Board
of Supervisors, will be carefully analyzed for fiscal soundness, the additional burden placed on taxpayers
and the potential risk to the General Fund for any explicit or implicit moral obligation.

10. Diversified Economy: Fairfax County must continue to diversify its economic base by encouraging
commercial and, in particular, industrial employment and associated revenues. Such business and industry
must be in accord with the plans and ordinances of the County.

Did You Know?

The most recent amendment to the Ten Principles was in April 2002 reflecting changes in the economy and the
market place in the 14 years since the last amendments in 1988.

Caution
Before the financial advisor begins the information-gathering process, he or she should give certain
information to the client.

Case Study-Ryan Harms Archimet Architectural Metalwork

Entering Ryan Harms‘ workshop is like entering a dungeon – strange metal shapes loom out of the gloom,
harsh machinery screeches and sparks fly. The you hear laughter and joking. A ray of light shines out from his
upper floor eyrie and Ryan comes down to explain his business. He creates custom-made gates, balustrades
and staircases in metal. His products are specially designed and hand-made by his expert team. They have
spent the last nine months on a huge job completely refurbishing a house in St John‘s Wood. ―We put in four
staircases, two driveway gates, front door, and many other hand-forged details, all in mirror polished stainless
steel for a property developer.‖ After training in 3D crafts, and having sculpture exhibitions, Ryan worked his
way up in a traditional blacksmiths, from ―Tea Boy to Master Craftsman‖. Leaving that company to travel on
his honeymoon, Ryan returned to find a job with Archimet. After only being there two months the owner
offered to sell the business to him. ―I thought well: why not? That‘s a good opportunity now, and started off,
built the business.‖
The business aspect has been a steep learning curve. Ryan is a hands-on person and does most of the book-
keeping himself, relying on the team & co for advice. Ryan admits that it has not been easy, and at one
particular time the finances of the business became strained because of poor financial planning, it was very
stressful, but with the intervention, the business managed its cash flow better and is now moving to new
premises in Kent, which is a huge barn set on an idyllic farm 15 minutes from his home. It even has space for
his retired uncle to devote himself to his hobby of making rocking horses. Creativity seems to be a family trait.
Ryan is confident about the future – with his Kent workshop manufacturing the products and his London team
fitting them, his client-base is secure, and he is returning to what started him off in his career: metal sculpture.
―One thing I found so interesting with metal was that it was an object that was always looked upon as tough
and hard, but one thing I got enjoyment out of when you were forging it was that you could manipulate it to
any shape you wanted. In this job you can be confined to certain extent if you are making a staircase, but with
sculpture you are a lot freer and you can be a lot more creative.‖
Questions
1. Explain about Archimet architectural metalwork.
2. How describe the financial planning built the business?

3.3 Summary
Determining capital requirements- This will depend upon factors like cost of current and fixed assets,
promotional expenses and long- range planning.
A comprehensive financial plan entails planning for the future with a tax minimization focus while
ensuring our wealth is properly transitioned to future owners.
The financial plan that is developed should be specific. It should detail who is to do what, when, and with
what resources. Implicit in plan development is the importance of obtaining client approval.
The relationship between the financial advisor and the client should be an ongoing one. Therefore, the
sixth and final step in the financial planning process is to monitor the client‘s plan.
Annual Budget Plans: Annual budgets shall continue to show fiscal restraint. Annual budgets will be
balanced between projected total funds available and total disbursements including established reserves.
A moral obligation exists when the Board of Supervisors has made a commitment to support the debt of
another jurisdiction to prevent a potential default, and the County is not otherwise responsible or obligated
to pay the annual debt service.

3.4 Keywords
Capital expenditure: It is incurred when a business spends money either to buy fixed assets or to add to the
value of an existing fixed asset with a useful life extending beyond the taxable year.
Capital Plan: A Capital Improvement Plan (Program), or CIP, is a short-range plan, usually four to ten years,
which identifies capital projects and equipment purchases, provides a planning schedule and identifies options
for financing the plan.
Debenture: A debenture is a document that either creates a debt or acknowledges it, and it is a debt without
collateral.
Economy: An economy consists of the economic systems of a country or other area; the labour, capital, and
land resources; and the manufacturing, production, trade, distribution, and consumption of goods and services
of that area.
Financial plan: It is a series of steps or goals used by an individual or business, the progressive and
cumulative attainment of which are designed to accomplish a final financial goal.
Integrity: Integrity is a concept of consistency of actions, values, methods, measures, principles, expectations,
and outcomes.

3.5 Self Assessment Questions

1. A financial plan is an estimate of the total capital requirements of the………….
(a) client (b) investments
(c) company (d) None of these

2. Long-term financial plan is prepared for a period of more than five years.
(a) True (b) False

3. The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in
the business.
(a) True (b) False

4. The advisor‘s responsibility is to help the client transform their feelings into………...
(a) confidence (b) goals
(c) planning (d) None of these

5. The financial advisor often will need to gather information about the hopes, fears, values, preferences,
attitudes, and nonfinancial goals of the client.
(a) True (b) False

6. The …………..of the review process should involve measuring the performance of the implementation
vehicles.
(a) third part (b) fourth part
(c) second part (d) first part

7. The Ten Principles of Sound Financial Management adopted by the Board of Supervisors on………..
(a) October 22, 1974 (b) October 22, 1972
(c) October 22, 1975 (d) None of these

8. The ..........in the County will continue as a dynamic process, which is synchronized with the capital
improvement program, capital budget.
(a) decision support system (b) planning system
(c) management system (d) financial system

9. Two broad types of information will need to be gathered: ……...

(a) cutoff rate and discount rate (b) short- term and long- term
(c) objective and subjective (d) None of these

10. The County‘s moral obligation shall only be used to enhance the credit worthiness of an agency of the
County.
(a) True (b) False

3.6 Review Questions

1. What is financial planning? How can apply in marketing?
2. What do you mean by principles of sound financial planning?
3. What are objectives of financial planning?
4. Explain the types of financial plans.
5. What is importance of financial planning?
6. How can describe that planning is useful to take decision?
7. What are advantage and disadvantage of planning?
8. How can say that planning is very important to achieve the goals?
9. Describe the steps in financial planning.
10. Describe briefly
Cash management
Internal controls
Cash balances

Answers for Self Assessment Questions

1. (c) 2. (a) 3. (a) 4. (b) 5. (a)
6. (d) 7.(c) 8.(b) 9.(c) 10. (a)
 4
Capital Structure
CONTENTS
Objectives
Introduction
4.1 Factors influencing capital structure
4.2 EBIT-EPS Analysis
4.3 Summary
4.4 Keywords
4.5 Self Assessment Questions
4.6 Review Questions

Objectives
After studying this chapter, you will be able:
Understand factors influencing capital structure
Describe the EBIT-EPS analysis

Introduction
Finance is an important input for any type of business and is needed for working capital and for permanent
investment. The total funds employed in a business are obtained from various sources. A part of the funds are
brought in by the owners and the rest is borrowed from others-individuals and institutions. While some of the
funds are permanently held in business, such as share capital and reserves (owned funds), some others are held
for a long period such as long-term borrowings or debentures, and still some other funds are in the nature of
short-term borrowings: The entire composition of these funds constitute the overall financial structure of the
firm. We are aware that short-term funds keep on shifting quite often. As such the proportion of various
sources for short-term funds cannot perhaps be rigidly laid down. The firm has to follow a flexible approach.
A more definite policy is often laid down for the composition of long-term funds, known as capital structure.
More significant aspects of the policy are the debt equity ratio and the dividend decision.

The latter affects the building up of retained earnings which is an important component of long-term owned
funds. Since the permanent or long-term funds often occupy a large portion of total funds and involve long-
term policy decision, the term financial structure is often used to mean the capital structure of the firm.
There are certain sources of long-term funds which are generally available to the corporate enterprises. The
main sources are: share capital (owners' funds) and long-term debt including debentures (creditors' funds). The
profit earned from operations is owners' funds-which may be retained in the business or distributed to the
owners (shareholders) as dividend. The portion of profits retained in the business is a reinvestment of owners'
funds. Hence, it is also a source of long-term funds. All these sources together are the main constituents of the
capital of the business, that is, its capital structure. Capital Structure is referred to as the ratio of different
kinds of securities raised by a firm as long-term finance. The capital structure involves two decisions-
a). Type of securities to be issued are equity shares, preference shares and long term borrowings( Debentures).
b). Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies
are divided into two-
Highly geared companies- Those companies whose proportion of equity capitalization is small.
Low geared companies- Those companies whose equity capital dominates total capitalization.

For example - There are two companies A and B. Total capitalization amounts to be Rs. 20 lakh in each case.
The ratio of equity capital to total capitalization in company A is Rs. 5 lakh, while in company B, ratio of
equity capital is Rs. 15 lakh to total capitalization, i.e., in Company A, proportion is 25% and in company B,
proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is
low geared company.

Factors Determining Capital Structure:

1. Trading on Equity- The word ―equity‖ denotes the ownership of the company. Trading on equity means
taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional
profits that equity shareholders earn because of issuance of debentures and preference shares. It is based
on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital
is lower than the general rate of company‘s earnings, equity shareholders are at advantage which means a
company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading
on equity becomes more important when expectations of shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected representatives of equity
shareholders. These members have got maximum voting rights in a concern as compared to the preference
shareholders and debenture holders. Preference shareholders have reasonably less voting rights while
debenture holders have no voting rights. If the company‘s management policies are such that they want to
retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather
than equity shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there are both
contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires.
While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order
to make the capital structure possible, the company should go for issue of debentures and other loans.
4. Choice of investors- The Company‘s policy generally is to have different categories of investors for
securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold
and adventurous investors generally go for equity shares and loans and debentures are generally raised
keeping into mind conscious investors.
5. Capital market condition- In the lifetime of the company, the market price of the shares has got an
important influence. During the depression period, the company‘s capital structure generally consists of
debentures and loans. While in period of boons and inflation, the company‘s capital should consist of
share capital generally equity shares.
6. Period of financing- When company wants to raise finance for short period, it goes for loans from banks
and other institutions; while for long period it goes for issue of shares and debentures.
7. Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are
raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of
finance as compared to equity shares where equity shareholders demand an extra share in profits.
8. Stability of sales- An established business which has a growing market and high sales turnover, the
company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of
profit. Therefore, when sales are high, thereby the profits are high and company is in better position to
meet such fixed commitments like interest on debentures and dividends on preference shares. If company
is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital
proves to be safe in such cases.
9. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and
retained profits. While on the other hand, big companies having goodwill, stability and an established
profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial
institutions. The bigger the size, the wider is total capitalization.

Features of an Appropriate Capital Structure

Capital structure is usually planned keeping in view the interests of the ordinary shareholders. The ordinary
shareholders are the ultimate owners of the company and have the right to elect the directors. While
developing an appropriate capital structure for his company, the financial manager should aim at maximizing
the long-term market price of equity shares. In practice, for most companies within an industry, there would be
a range of appropriate capital structures within which there are not many differences in the market values of
shares. A capital structure in this context can be determined empirically. For example, a company may be in an
industry that has an average debt to total capital ratio of 60 per cent. It may be empirically found that the
shareholders in general do not mind the company operating within a 15 per cent range of the industry's average
capital structure. Thus, the appropriate capital structure for the company ranges between 45 per cent to 75 per
cent debt to total capital ratio. The management of the company should try to seek the capital structure near the
top of this range in order to make maximum use of favourable leverage, subject to other requirements such as
flexibility, solvency, etc.
A sound appropriate capital structure should have the following features:
Profitability: The capital structure of the company should be most advantageous, within the constraints.
Maximum use of leverage at a minimum cost should be made.

Solvency: The use of excessive debt threatens the solvency of the company. Debt should be used judiciously.

Flexibility: The capital structure should be flexible to meet the changing conditions. It should be possible for a
company to adapt its capital structure with minimum cost and delay if warranted by a changed situation. It
should also be possible for the company to provide funds whenever needed to finance its profitable activities.

In other words, from the solvency point of view we need to approach capital structuring with due conservation.
The debt capacity of the company which depends on its ability to generate future cash flows should not be
exceeded. It should have enough cash to pay periodic fixed charges to creditors and the principal sum on
maturity. The above are the general features of an appropriate capital structure. The particular characteristics
of a company may reflect some additional specific features. Further, the emphasis given to each of these
features may differ from company to company. For example, a company may give more importance to
flexibility than to retaining the control which could be another desired feature, while another company may be
more concerned about solvency than about any other requirement. Furthermore, the relative importance of
these requirements may change with changing conditions.

4.1 Factors influencing capital structure

The primary factors that influence a company's capital-structure decision are:
1. Business risk
2. Company's tax exposure
3. Financial flexibility
4. Management style
5. Growth rate
6. Market Conditions

1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the
lower the optimal debt ratio. As an example, let's compare a utility company with a retail apparel company. A
utility company generally has more stability in earnings. The company has less risk in its business given its
stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its
earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the
business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower
optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with
the capital structure in both good times and bad.

2. Company's Tax Exposure

Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing
a project is attractive because the tax deductibility of the debt payments protects some income from taxes.

3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies
typically have no problem raising capital when sales are growing and earnings are strong. However, given a
company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort
to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a
company's debt level, the more financial flexibility a company has. The airline industry is a good example. In
good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that
situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too
debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may
doubt the airline's ability to service its existing debt when it has new debt loaded on top.

4. Management Style
Management styles range from aggressive too conservative. The more conservative a management's approach
is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm
quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share

5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money
to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically
unstable and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms
typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash
flow, which can be used to finance projects when they arise.

6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm
needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies'
access to capital because of market concerns, the interest rate to borrow may be higher than a company would
want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more
normal state before the company tries to access funds for the plant.

4.2 EBIT-EPS Analysis

EBIT - Earnings Before Interest and Taxes. Accountants like to use the term Net Operating Income for this
income statement item, but finance people usually refer to it as EBIT (pronounced as it is spelled - E, B, I, T).
Either way, on an income statement, it is the amount of income that a company has after subtracting operating
expenses from sales (hence the term net operating income). Another way of looking at it is that this is the
income that the company has before subtracting interest and taxes (hence, EBIT). EPS – Earnings Per Share.
This is the amount of income that the common stockholders are entitled to receive (per share of stock owned).
This income may be paid out in the form of dividends, retained and reinvested by the company, or a
combination of both. We need to raise additional money by issuing debt, preferred stock, or common stock.
Which alternative will allow me to have the highest earnings per share? This question calls for an EBIT/EPS
analysis. Simply put, this simply means that we will calculate what our earnings per share will be at various
levels of sales (and EBIT). Actually, it is not necessary to start with sales. Since a company's EBIT, or net
operating income, is not affected by how the company is financed, we can skip down the income statement to
the EBIT line and begin there.
In other words,
we assume a certain level of sales,
calculate our estimated EBIT at that level, and
Then calculate what our EPS will be for each alternative form of financing (debt, preferred stock, and
common stock).

Effective business management requires careful planning and decision-making about the balance of debt and
equity used in financing the business. The EBIT-EPS approach is one method available to managers to guide
them in making decisions about capital structure. To benefit from the EBIT-EPS approach, it helps to
understand the basics of how it works, as well as its advantages and drawbacks. The EBIT-EPS approach is
one tool managers use to decide on the right mix of debt and equity financing in a business's capital structure.
In the EBIT-EPS approach, the business plots graphs of its performance at different possible debt-to-equity
ratios, such as 40 percent debt to 60 percent equity. In a basic graph, the earnings per share as a data point is
plotted for each level of earnings before interest and taxes at different debt-to-equity ratios. The graph is then
analyzed to determine the ideal level of debt-to-equity for the business.

Once the relationship between EBIT and EPS is plotted for different capital structures, the investor can
analyze the graph, focusing on two key challenges. The level of EBIT where EPS is zero, called the break-
even point, and the graph's slope, which visually represents the company's risk. A steeper slope conveys a
higher risk -- greater loss per share at lower EBIT level. A steeper slope also means a higher return, and that
the company needs to earn less EBIT to produce greater EPS. The breakeven point is also important because it
tells the business how much EBIT there must be to avoid losses, and varies at different proportions of debt to
equity.

4.2.1 The EBIT/EPS Graph

Once the tables have been constructed, we can draw the graph below. We simply plot the earnings per share
under each alternative for each of our EBIT levels and connect the dots to draw the lines.
Relationships
Notice the following points:

1. The preferred stock line is parallel to the debt line and lies below the debt line. This will always be the case
because debt has two distinct advantages over preferred stock:
debt is the cheaper form of financing (i.e., the interest rate is less than the preferred dividend yield)
because it enjoys greater protection in the event of bankruptcy or default), and
Interest on the debt is tax-deductible and preferred stock dividends are not tax-deductible.
This means that the EPS will always be higher under debt financing than under preferred stock financing.
Since both options pay a fixed rate, they offer similar effects of leverage - leading to the parallel lines above.
Preferred stock may offset this quantitative advantage with some qualitative ones (less restrictive provisions,
etc.), but debt financing will always offer the higher earnings per share - a big advantage. Since common stock
financing offers a smaller degree of leverage, the slope of the common stock line is less than the other two
lines. This leads to two "crossover points" where the common stock line crosses the other two lines. These are
indifference points.

Did You Know?

Their first 'proposition' was that the value of a company is independent of its capital structure. Their second
'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged
firm, plus an added premium for financial risk.

Caution
Good business ethics should place the customer as one of the important stakeholders and should give the
customer his or her due share.

Case Study-Factors Influencing Capital Structures: An Analysis of Companies in Malaysia

The Capital Structure areas pertaining to the functions of corporate finance has been experiencing tremendous
growth ever since the publication of the seminal; this process has been further accelerated since 1980‟ s.
Research enquiries into the positive and negative aspects of debts on corporate wealth maximization has led to
the emergence of numerous varied capital structure theories. The theories that are making their mark today are
broadly oriented to income taxes (corporate and personal), bankruptcy costs, and asymmetric information and
agency conflicts. These theories have highlighted many variables such as corporate debt-determinants with
some of them having conflicting explanations and thus the capital structure arena has become a puzzle.
Empirical investigations, across countries over time, with their conflicting outcomes have contributed the
current complexity of capital structure discussions. These complexities have led to the emergence of different
complexions in the received major theories of capital structure, via:, the trade-off and pecking order theories.
The functions discharged by debts in order to mitigate the various corporate ills and the consequences that
follow are aspects that are actively considered by companies in matters that rely on debts. The present paper,
tests the effects of some of the selected variables that under the major capital structure theories based on the
company‘s‟ debt levels. Size, Growth and Profitability Variables represent the conventional variable that is
incorporated into studies on capital structure determinants.
Size: It is represented, more often than not by tangible assets (either Fixed Assets or Total Assets) and is
postulated, under the Trade-off Theory that is positively related to debt. The underlying argument is that big
companies (i.e. companies with large quantities of tangible assets) face less volatility in their fortunes, and,
therefore, can have more financial risks in the form of debts. The effect of size on leverage under the pecking
order. They argue that firms with fewer tangible assets will have more debts since debt is used as a signal for
future prospects. Size, in this study, is measured by taking into consideration the natural log of the Fixed
Assets (LOGFA).

Growth: It generates demands for external capital and growth opportunities and needs signals to reach the
investors. The asymmetric information approach develops positive relationships between Debt and Growth
Opportunities. It found positive relations between Leverage and Growth Opportunities. Price / Earnings (P/E)
Ratio are used as the measure of growth opportunities (GRPE) in this study.
Profitability: Firms‟ Profitability is another important variable for conventional prescriptions, credited with
the ability to be a relevant predictor of debt levels. Highly profitable companies are able to generate more
retained earnings and therefore, are able to rely more on the internal resources for financing growth which
would reduce the need to resort to external funds like debts. Hence, Debt and Profitability are inversely
related; a positive relation between debt and profitability is also tenable as the latter speaks about the ability of
the companies‟ to repay. The Asymmetric information approach also assigns positive relations. The
Company‘s profitability is represented, in this study, by (profit-after tax) ÷ (Total Assets) and is referred to as
PROFIM. The above three variables constitute the primary factors of a set of debt-predictors. These factors are
more often referred to as conventional debt predictors. The following six are also added to the debt
predictors‟ list. Each of them represents most of the recent theories pertaining to capital structure.
Non-Debt Tax Shields: The Principal Advantage from debt capital is because of tax- deductibility of interest
charges that leads to the capitalized value of tax shields. If companies are able to muster this tax advantage
through other arrangements like leases, hire purchases etc., companies would rely less and less on debts.
Hence Debt and non-debt-tax shields are negatively related. This is measured as: (Depreciation + Lease
payments+ Hire Purchase Instalments) ÷ (Total Assets). It is designated as NDTS.
Safety Consideration: In addition to the advantages offered by debt capital to companies, it also poses a very
significant threat; that is, the threat of bankruptcy. Companies which are sensitive to this threat should
maintain adequate (and often higher levels of) interest coverage and total coverage ratios. The companies‟
concern for safety from debts and the consequent cautious approach towards debts are reflected in these
coverage ratios. Higher coverage ratios and low debt ratios go together. This „safety consideration‟ is
measured through the simple „Interest Coverage Ratio‟ : (EBIT) (Annual Interest paid). This is denoted as
COFAC (concern for adequate cover).
Free Cash Flow: whenever managers secure free cash flows on the table, they tend to indulge in wasteful
expenditure which may be detrimental to the corporate goal; this is all the more so with entrenched managers.
They, formally calls it the Free Cash Flow hypothesis. To curb this tendency on the part of managers,
company owners (shareholders) introduce debts into the capital structure as and this would reduce the
discretionary cash flow to a greater extent. The Company‘s debt is than positively related to Free Cash Flow.
Free Cash Flow is measured as: (Profit after tax + Depreciation) – (Additional investment in operating assets).
This variable carries the notation FCF.
Financial Slack: Companies maintain financial slack in the form of cash, marketable securities and unutilized
debt capacity to avoid under investment due to the unwillingness of issuing equity. This is measured in its
simpler version and is followed in empirical studies as: (Cash + Marketable Securities) ÷ (Total Assets) and is
referred to as FINSLACK.

Questions
1. In above case study, explain the capital structure of companies in Malaysia.
2. What is LOGFA? Explain.

4.3 Summary
 Capital structure is usually planned keeping in view the interests of the ordinary shareholders. The
ordinary shareholders are the ultimate owners of the company and have the right to elect the directors.
Financial flexibility is essentially the firm's ability to raise capital in bad times. It should come as no
surprise that companies typically have no problem raising capital when sales are growing and earnings are
strong.
Management styles range from aggressive too conservative. The more conservative a management's
approach is, the less inclined it is to use debt to increase profits.
EBIT - Earnings Before Interest and Taxes. Accountants like to use the term Net Operating Income for
this income statement item, but finance people usually refer to it as EBIT (pronounced as it is spelled - E,
B, I, T).
Earnings Per Share (EPS) is the amount of income that the common stockholders are entitled to receive
(per share of stock owned).

4.4 Keywords
Capital Structure: In finance, capital structure refers to the way a corporation finances its assets through some
combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure'
of its liabilities.
Investor: An investor is someone who allocates capital with the expectation of a financial return. The types of
investments include, — equity, debt securities, real estate, currency, commodity, derivatives such as put and
call options, etc.
Inflation: It is a rise in the general level of prices of goods and services in an economy over a period of time.
When the general price level rises, each unit of currency buys fewer goods and services.
Turnover: It is sometimes the name for a measure of how quickly inventory is sold (inventory turnover). A
high turnover means that goods are sold quickly, while a low turnover means that goods are sold more slowly.
Leverage: In finance, it is a general term for any technique to multiply gains and losses. Common ways to
attain leverage are borrowing money, buying fixed assets and using derivatives.

4.5 Self Assessment Questions

1. We need to raise additional money by issuing debt, preferred stock, or common stock. Which alternative
will allow our to have the highest EPS? This calls EBIT/EPS analysis.
(a) True (b) False

2. The entire composition of the .....................constitutes the overall financial structure of the firm.
(a) employee (b) investments
(c) funds (d) None of these

3. The main sources are: share capital (owners' funds) and short-term debt including debentures (creditors'
funds).
(a) True (b) False

4. The primary factors that influence a company's capital-structure decision is.....

(a) business risk (b) growth rate
(c) both (d) planning
5. During the depression period, the company‘s capital structure generally consists of debentures and loans.
(a) True (b) False

6. The company has more risk in its business given its stable revenue stream.
(a) True (b) False

7. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up
the growth of the company's………..
(a) EIPS (b) EBIT
(c) EPS (d) None of these

8. The conflict that arises with method is that the revenues of growth firms are typically unstable and
unproven.
(a) market conditions (b) financial flexibility
(c) business risk (d) growth rate

9. Market conditions can have a significant impact on a company's capital-structure condition.

(a) True (b) False

10. This income may be paid out in the form of dividends, retained and reinvested by the company, it is
pronounced by…………...
(a) discount rate (b) EBIT
(c) EPS (d) None of these

4.6 Review Questions

1. What is the meaning of capital structure?
2. What do you mean by factors influencing capital structure?
3. Explain EBIT-EPS analysis.
4. What are factors of capital structures?
5. Explain briefly:
Degree of control
Cost of financing
6. Write down the features of capital structure.
7. Write short notes on following keywords:
Company's tax exposure
Financial flexibility
Management style
8. What do you understand by growth rate of firm?
9. Define relationships between EBIT and EPS.
10. What are issues in capital structure?

Answers for Self Assessment Questions

1. (a) 2. (c) 3. (b) 4. (c) 5. (a)
6. (b) 7.(c) 8.(d) 9.(a) 10. (c)
 5
Leverages
CONTENTS
Objectives
Introduction
5.1 Concept of the Leverages
5.2 Types of leverages
5.3 Summary
5.4 Keywords
5.5 Self Assessment Questions
5.6 Review Questions

Objectives
After studying this chapter, you will be able:
Understand the concept of the Leverages
Describe types of leverages

Introduction
Leverage is a practice which can help a business drive up its gains / losses. In business language, if a firm has
fixed expenses in P/L account or debt in capital structure, the firm is said to be levered. Now-a-days, almost no
business is away from leverage but very few have struck a balance. In finance, leverage is very closely related
to fixed expenses. We can safely state that by introduction of expenses which are fixed in nature, we are
leveraging a firm. By fixed expenses, we refer to the expenses, the amount of which remains unchanged
irrespective of the activity of the business. For example, amount of investment made in fixed assets or interest
paid on loans does not change with a normal change in the amount of sales. Neither they decrease with
decrease in sales and nor they increase with increase in sales.

There are different basis for classifying business expenses. For our convenience, let us classify fixed expenses
into operating fixed expenses such as depreciation on fixed expenses, salaries etc, and financial fixed expenses
such as interest and dividend on preference shares. Similar to them, leverages are also of two types – financial
leverage and operating leverage.

Financial Leverage: Financial leverage is a leverage created with the help of debt component in the capital
structure of a company. Higher the debt, higher would be the financial leverage because with higher debt
comes the higher amount of interest that needs to be paid. Leverage can be both good and bad for a business
depending on the situation. If a firm is able to generate a higher return on investment (ROI) than the interest
rate it is paying, leverage will have its positive effect shareholder‘s return. The darker side is that if the said
situation is opposite, higher leverage can take a business to a worst situation like bankruptcy.

Operating Leverage: Operating leverage, just like the financial leverage, is a result of operating fixed
expenses. Higher the fixed expense, higher is the operating leverage. Like the financial leverage had an impact
on the shareholder‘s return or say earnings per share, operating leverage directly impacts the operating profits
(Profits before Interest and Taxes (PBIT)). Under good economic conditions, due to operating leverage, an
increase of 1% in sales will have more than 1% change in operating profits.

So, we need to be very careful in adding any of the leverages to your business viz. financial leverage or
operating leverage as it can also work as a double edged sword. In other words, the degree to which an
investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of
bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in
the future. Financial leverage is not always bad, however; it can increase the shareholders' return on their
investment and often there is tax advantages associated with borrowing. Also called leverage Note: Leverage
is general term for any technique to multiply gains and losses.

5.1 Concept of the Leverages

Consider for a moment the common use of the terms `level' and ` leverage'. Webster's dictionary defines them
as follows:
‗Lever‘ is an inducing or compelling force.
‗Leverage‘ is the action of a lever or the mechanical advantage gained by it; it also means `effectiveness' or
`power'

The common interpretation of leverage is derived from the use or manipulation of a tool or device termed as
lever, which provides a substantive clue to the meaning and nature, of financial leverage. Could you guess it?
Your reply we guess, may well be in the negative. Now, suppose we suggest that our lever is the use of debt or
borrowed funds in financing the acquisition of assets. Would we get somewhere near the concept of the term
financial leverage? Probably, we need a little explanation. We will do that. We have to look at the following
simple (and hypothetical) facts about the GTB (Gain Through Borrowing) Limited.
The GTB Limited wanted to purchase fixed assets worth Rs. 80 lakhs for the execution of a project, which was
to be financed by raising share capital of Rs. 30 lakhs and term loans of Rs. 50 lakhs. The company was
required to earn a minimum return of 20% on its share capital. Other companies of this type were earning this
much and unless GTB Limited provided at least this return, no investor would be attracted to buy its shares.

The GTB Limited pays tax at 40% and is not required to pay any tax on the interest charges on term-loans.
We may do our calculations for the two situations. We now pose a question : What happens to the company's
net return (after interest and taxes) on equity if (a) the whole of Rs. 80 lakhs is financed by selling share
capital, and (b) the scheme of financing as envisaged in the problem is implemented? We may assume GTB's
earning power to be 40% (before taxes and interest) on total assets of Rs. 80 lakhs.
We present for your verification a solution below:
 Table 5.1: Effect of Financial Leverage

If your solution tallies with ours, we may be wondering at the results. The net return on equity is 24% when no
debt is used but it is 46% when debt is used. There is a considerable increase in the net return. It is conceivable
that a similar outcome may be nowhere near in some other situations even if debt is employed. At this
juncture, we would premise that the use of debt funds in a profit-making and tax-paying business improves the
net equity returns. The effect which the use of debt funds produces on returns is called financial leverage.

5.1.1 Measures of Financial Leverage

The amount of debt which a firm employs or proposes to employ can be expressed in relation to total assets or
total equity. Equity will include paid-up capital, reserves and total assets will be taken at net value. Even
though, both equity shares and assets can be measured at market values, the present discussion will use only
book values. Market values are difficult to obtain, fluctuate widely and are not available for new undertakings
which also make use of the concept of financial leverage in planning their sources of finance. We will
illustrate two ratios viz., Debt-equity and Debt-assets ratios both of which are computed from Balance Sheet
data and are inter-related. We may note that this section measures the use of financial leverage and not its
effects. We shall explain the concept of financial leverage with the help of an example. Bharat Engines
Limited plans to acquire total assets amounting to Rs. 1 crore. The company has only two sources of finance
viz.; debt and equity. The Finance Director wants to know the changes that will take place in the Debt-equity
and Debt-assets ratios for various debt levels i.e., (a) Zero (b) Rs. 10 lakh (c) Rs. 20 lakh (d) Rs. 30 lakh (e)
Rs. 50 lakh (f) Rs. 80 lakh (g) Rs. 1 crore. The table 5.2 provides the required calculations:

Table 5.2: Debt-assets and Debt-equity Ratios

(Total investment in assets = Rs 100 lakh)

Please study the last two columns of the above table. The following analysis reflects the basic properties of the
two ratios and indicates their inter-relationship:
a) The Debt-assets ratio rises at a constant rate and reaches a maximum of 100%
The Debt-equity ratio grows exponentially and reaches infinity (∞ )
b) The two ratios are mathematically related and can be derived from each other.
The following relationships may be used for such derivations:
Debt - assets Ratio (D/A) = D/E Ratio / 1 + D / E Ratio (1)
Debt - equity Ratio (DIE) = D/ A Ratio / 1-D/A Ratio (2)

5.1.2 Effects of Financial Leverage

The level of financial leverage of a certain company is determined by getting the total value of debt and the
equity and the ratio of debt. Leverage is commonly described as the use of borrowed money to make an
investment and return on that investment. It is more risky for a company to have a high ration of financial
leverage. It has also been noticed that on the outcome of financial leverage: if the level or point of financial
leverage is high, the more rise is anticipated profit on company is equity. Thus, financial leverage is used in
various circumstances as a means of altering the cash flow and financial position of a company. There are four
positions which show a relationship with the level of financial leverage. First, is the relation of equity and
debt, for instance, the rate of capital? Another is the influences on business production and cycle of financial
leverage. Then the company is industry and branch whole financial leverage level. And also the correlation
between the current financial leverage ratio of the company and the middle leverage level. Lastly, the
conformity of company is mission and philosophy with the situation connected to the relation of financial
leverage. The outcome of the financial leverage can also be utilized to boost income and growth however, it is
much common for business industries in the phase of the young and teens. Financial leverage ratio is relative
to variability of profit and contrary to stability. Company‘s profits with high rate leverage level differ with the
same condition as with the company‘s profits with lesser leverage level.

Another factor that affects leverage ratio is the company‘s flexibility, its dynamics and openness that concerns
on the changes and development of technology, possibilities and industry. Companies having high leverage
levels has lower flexible procedure because of the fact that they are more accountable for all the creditors and
sometimes must fill some restrictions and agreements on their investments and capital use. Companies with
high leverage level usually become less successful due to situation of transforming environment and the need
of taking uncertain decisions. Because of this, they might not able to apply or utilize growth opportunities for
expansion of business. One more risk of using financial leverage as a tool to increase revenue is the reality that
the change between profits and company‘s debt remains positive. If the company‘s profit relative amount to
equity is higher, the debt exceeds the amount of the profit then the effect of leverage is gone and the debt
remains. It is therefore that the level of financial leverage must have a good understanding of financial or
business management. To determine the return rate upon return of leverage simply calculate the difference
among the rate of interest on assets and debts, then multiply the difference to the relative amount of liability or
debt to the equity and add up the anticipated return on assets. Industries that are growing fast allocate only
little level of than those stably growing company. In most cases, the effects of financial leverage are used to
improve the company‘s financial condition and earnings but it should not be accepted as a principle rather it
requires comprehensive analysis of the present condition of the environment.

The example in Table 5.1 introduced to a possible effect of financial leverage on return on equity. We must
have noted one important consideration in the use of borrowed funds, that is, the improvement in net equity
returns which such a move brings about.
In fact, the effect of financial leverage is also measured through another variable viz., earnings per share
(EPS). This is done in the case of joint stock companies which have raised their proprietary capital by selling
units of such capital known as equity shares. Earnings per share are obtained by dividing earnings (after
interest and taxes) by total equity. We may note that if a company has preference shares also on its capital
structure, net equity earnings will be arrived at after deducting interest, taxes and preference dividends. Capital
structure refers to the permanent long-term financing of a company represented by a mix of long-term debt,
preference shares, and net-worth (which included paid-up capital, reserves and surpluses). When the sum total
of capital structure components is added to short-term debt, it is known as financial structure. Financial
Leverage and its effects are a crucial consideration in planning and designing capital structures. We may
reiterate that the effects of financial leverage are not always clear and identical in various states of profitability
and debt proportions. It may be necessary to explore these effects before a particular long-term finance-mix is
recommended for implementation.

5.1.3 Financing Sources

Having learnt about the need, importance and types of financial requirements, now we must know from where
the businessmen get the required amount of funds to meet the short-term, medium term and long term
requirements. Who provides them the required amount? Let us learn about the various sources from which the
businessmen generally arrange money for business purposes. Broadly speaking, there are two main categories
of sources from which the businessmen can get the required funds for their business.
These are:
(1) Internal source
(2) External source

We know that to start a business the businessman either invests his own money or borrows from outsiders or
uses both the sources. When the businessman invests his own money (called owner‘s capital), and retains a
part of the profits earned in the business it constitute the internal sources of finance. It is an integral part of
every business organization and it is cost effective. But, this source has its own limitations. Hence the business
houses have to resort to the external sources of finance. The various external sources from where businessmen
can get the finance include, friends and relatives, banks and other financial institutions, moneylenders, capital
market, manufacturers and producers, customers, foreign financial institutions and agencies, etc. It is observed
that the scope of raising funds also depends upon the nature and form of business organization. For example, a
sole proprietorship form of business organization has very limited sources from which it can arrange funds for
the business.
These are:
(a) Own Savings
(b) Friends and Relatives
(c) Moneylenders
(d) Commercial Banks
(e) Finance Companies
(f) Manufactures and Suppliers
(g) Retained Profits

The same sources of financing are also available in case of partnership firms. In both sole proprietorship and
partnership form of business organization, long term capital is generally provided by the owners themselves by
way of investing their own savings and retaining a part of the profits generated by the business and the rest of
the above sources are mostly used for their short-term financial needs. However, in case of companies, the
following are the usual sources of finance.
(a) Capital Market
(b) Financial Institutions
(c) Public Deposits
(d) Commercial Banks
(e) Leasing Companies
(f) Investment Trusts
(g) Retained Profits.

5.2 Types of leverages

Leverage is very scientific tool in the hand of finance manager. Finance manager uses this tool for making
effective financial structure of company. Financial structure is just mix of debt and equity and with help of
leverage, finance manager gets fund with effective ratio of debt and equity. In simple word leverage is power
and relationship between two interrelated variables. These variables may be output, sale, cost and profit.
Finance manager calculates these leverage by apply formula and then uses them for taking decision in favour
of company's shareholder. Main aim of leverage testing is maximize the earning of shareholder and reduce the
risk of company.

Type of leverage:-
Company's finance manager tests three types of leverage:-
1. Operating leverage
It is first type of leverage. Operating leverage is % change in earnings before interest and tax divided by %
change in sale. If company is charging fixed cost, the operating leverage tells the EBIT will greater than sale
because due to increasing sale of fixed cost per unit will decrease and it will increase EBIT higher than sale.

Formula
Operating Leverage = % change in EBIT / % change in Sale
This leverage is very helpful for finance manager because, if operating leverage is more than or suppose it is
two then it means if sale will increase 100% then earning will increase 200%. At this time, finance manager
can get more loans for increasing the earning of shareholders.

2. Financial leverage
It is second type of leverage. Financial leverage is known as trading on equity. If any company's finance
manager knows that company's return on investment is more than interest on loan or borrowing obligation. At
this time, if company needs more money, then finance manager gets its loan and bought the asset from same
loan. So, any technique in which any asset is purchased with loan and trying to increase EPS, then this is
called financial leverage.

Formula for calculating financial leverage

= % change in Earning per share / % change in earnings before interest and tax
= % change in EPS / % change in EBIT
This formula explains the relationship between % change in EPS and % change in EBIT and after deep study
of this financial leverage, finance manager decides to get appropriate loan for buying assets.

3. Combined leverage
It is the product of operating leverage and financial leverage.
Combined leverage = Operating leverage X financial leverage
= % change in EBIT / % change in sale X % change in EPS / % change in EBIT
High operating leverage and high financial leverage combination is high risky for business.
Good combination is that in which lower operating leverage with high financial leverage.
5.2.1 Implications
Total risk can be divided into two parts: business risk and financial risk. Business risk refers to the stability of
a company's assets if it uses no debt or preferred stock financing. Business risk stems from the unpredictable
nature of doing business, i.e., the unpredictability of consumer demand for products and services. As a result,
it also involves the uncertainty of long-term profitability. When a company uses debt or preferred stock
financing, additional risk—financial risk—is placed on the company's common shareholders. They demand a
higher expected return for assuming this additional risk, which in turn, raises a company's costs. Consequently,
companies with high degrees of business risk tend to be financed with relatively low amounts of debt. The
opposite also holds: companies with low amounts of business risk can afford to use more debt financing while
keeping total risk at tolerable levels. Moreover, using debt as leverage is a successful tool during periods of
inflation. Debt fails, however, to provide leverage during periods of deflation, such as the period during the
late 1990s brought on by the Asian financial crisis.

5.2.2 Leverage and Risk

It is essential to distinguish between the concepts of leverage and risk. Unfortunately, there is a common
misconception that a levered asset is always riskier than an unlevered asset, even if the levered asset has low
risk, and the unlevered asset is highly risky. Leverage is the link between the underlying or inherent risk of an
asset and the actual risk of the investor‘s exposure to that asset.

Thus, the investor‘s actual risk has two components:

1. The market risk (beta) of the asset being purchased; and
2. The leverage that is applied to the investment.

The key question to consider: Which is more ―risky‖ a fund with low net market exposure and ―borrowing
leverage‖ of 1.5 times capital, or a fund with 100% market exposure and a beta of 1.5 but no ―borrowing
leverage?‖ For a given capital base, leverage allows investors to build up a larger investment position and thus
a higher exposure to specific risks. Buying riskier assets or increasing the leverage ratio applied to a given set
of assets increases the risk of the overall investment, and hence the capital base. Therefore, if a portfolio has
very low market risk (e.g., arbitrage/relative value hedge fund strategies often have very low market
exposure), then higher leverage may be acceptable for these strategies than for strategies that have greater
market exposure, such as long/short equity or global macro. For this reason, relative value strategies such as
fixed-income arbitrage or convertible arbitrage may use leverage of 5-10 X capital and 3-4 X capital,
respectively, while directional strategies, such as long/short equity, may restrict their leverage to 2 X capital.
In fact, a levered portfolio of low-risk assets may well carry less risk than an unlevered portfolio of high-risk
assets. Therefore, investors should not concern themselves with leverage %, but rather focus on the risk/return
relationship that is associated with a particular portfolio construction. In this way, investors can determine the
optimal allocation to a specific strategy in a diversified portfolio: ―If investors can get used to looking at
leverage in a less prejudicial, black-and-white way – ‗no leverage is good and any leverage is bad‘ – I believe
that they will understand that a moderately leveraged, highly diversified portfolio is considerably less risky
than an unleveraged non-diversified one.‖

5.2.3 Advantages and Disadvantages of Leverage

In totality, leverage has its advantages under good economic situations and at the same time, it is not free from
disadvantages.

Advantages of Higher Leverage: Take operating leverage, the operating profits can see a sharp increase with a
small change in sales as most part of the expenses are stagnant and cannot further increase with sales.
Likewise, if we consider financial leverage, the earnings share of each shareholder will increase significantly
with an increase in operating profits. Here, higher the degree of leverage, higher will be percentage increase in
operating profits and earnings per share.

Disadvantages of Higher Leverage: Leverage inherits the risk of bankruptcy along with it. In case of operating
leverage, fixed expenses extend the breakeven point for a business. Breakeven means the minimum activity
(sales) required for achieving no loss / no profit situation. Financial leverage increases the minimum
requirement of operating profits to meet with the expense of interest. In any case, if the required activity level
not achieved, bankruptcy or cash losses become certain. Looking at the pros and cons of leverage, it seems that
a balance is required between the rewards and risks associated with leverage.

Limitations of Financial Leverage

1. It may cause dividends to disappear altogether and, indeed, may be responsible for the insolvency and even
bankruptcy of a corporation.
2. Companies enjoying a fairly regular income can employ borrowed funds more safely than those with widely
fluctuating incomes.
3. Beyond a certain point, additional capital cannot be employed to produce are turn in excess of the payments
which must be made for its use or sufficiently in excess thereof is justify its employment.
4. The bigger the amount of funds borrowed, the higher the interest rate of corporation may be forced to pay in
order to market its successive Issues of bonds. Such increase in interest rates, if carried far off, may offset all
the advantages of trading on equity. But such a general principle does not inevitably follow. A growing
company progressively increasing its net earnings through trading on equity may present such an earnings
exhibit as to make possible a further trading on equity at low or lower rates. Moreover, money rates may fall.

Did You Know?

Modigliani and Miller were the first authors who developed leverage theory in 1958.

Caution
The degree of leverage should not be too high which invites the bankruptcy and on the contrary it should not
be too low that we lose out on the benefits and the viability of a business itself comes under question.

Case Study-Factors that Influence Financial Leverage of Canadian Firms

The purpose of this study is to find the factors that influence financial leverage of Canadian firms. Financial
leverage, in the context of this study, is defined as the degree to which a firm utilizes borrowed money. Capital
structure choices are the tough choices because higher leverage can lead to risk of bankruptcy. However, this
does not mean that financial leverage is always bad. Financial leverage can increase shareholders‘ return on
investment and often there is tax advantages associated with borrowing. Therefore, financial leverage decision
is important and a firm can use a specific mix of debt and equity to finance its operations. Firms can choose
among many alternative capital structures. For example, firms can issue a large amount of debt or very little
debt. Firms have options of arranging lease financing, use warrants, issue convertible bonds, sign forward
contracts or trade bond swaps. They can also issue dozens of distinct securities in countless combinations.
The determinants of capital structure have been debated for many years and still represent one of the main
unsolved issues in the corporate finance literature. Many theoretical studies and much empirical research have
addressed these issues, but there is not yet a fully supported and unanimously accepted theory. Indeed, what
makes the capital structure (financial leverage) debate so exciting is that only a few of the developed theories
have been tested by empirical studies and the theories themselves lead to different, not mutually exclusive and
sometimes opposed, results and conclusions. This study examines the factors that influence financial leverage
of Canadian firms. A variety of variables those are potentially responsible for determining leverage decisions
in companies can be found in the literature. In this study, the selection of exploratory variables is based on the
current empirical studies on capital structure. The choice is sometimes limited, however, because of lack of
relevant data. As a result, the final set of proxy variables includes nine factors: collateralized assets,
profitability, effective tax rate, non-debt tax shield, firm size, growth opportunities, and number of
subsidiaries, leverage, and industry dummy.

The variables, together with theoretical predictions as to the direction of their influence on debt ratio and
proxies, are summarized in this. First, it focuses on Canadian manufacturing and service firms, while only
limited research has been conducted on such firms recently. Second, this study validates some of the findings
of authors by testing the relations of financial leverage with collateralized assets, profitability, effective tax
rate, non-debt tax shield, firm size, growth opportunities, number of subsidiaries, and industry dummy of the
sample firms. If internal financing does not meet the needs of the firm, they use external financing. First firms
apply for bank loan, then for public debts, and as a last resort, equity financing is used. Thus the profitable
firms are less likely to opt for debt for new projects because they have the available funds in the form of
retained earnings. In order to attain their objectives, firms need to efficiently manage their funds. To respond
to global competition firms need to make massive capital investment in modern technologies, infrastructure,
product development and product promotion and so on. Such investments may promote productivity and
efficiency. There are several sources of financing those investments.

Financial leverage is one of them. In its simplest form, financial leverage is the amount of debt used to finance
a firm's assets and projects. It is good to note that during the great depression and throughout the 1930s and
1940s, financial leverage was predominantly viewed as a clear evil. It was perceived that huge amount of debt
leads to financial distress. However, such a view point is no more universal. Nowadays, financial leverage is
seen as important resource for the production of goods and services as well as for their distribution. Financial
leverage is an important component in capital structure along with equity and retained earnings. One of the
main debates in Corporate Finance is the impact of financial leverage on a firm‘s investment. Among the
various sources of corporate financing, financial leverage is perceived to have both positive and negative
attributes as a debt financing instrument. The issuance of debt commits a firm to pay cash as interest and
principal. A firm with significantly more debt than equity is considered to be highly leveraged. Leverage helps
both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses
leverage to make an investment and the investment moves against the investor, his or her loss would be much
greater than it would have been if the investment had not been leveraged. Therefore leverage magnifies both
gains and losses. In the business world, firms can utilise leverage and try to generate shareholder wealth, but if
it fails to do so, the interest expense and credit risk of default payment can destroy shareholder value.

Questions
1. What is financial leverage of Canadian firms?
2. How to measure the leverage?

5.3 Summary
Leverage is a practice which can help a business drive up its gains / losses. In business language, if a firm
has fixed expenses in P/L account or debt in capital structure.
Financial leverage is a leverage created with the help of debt component in the capital structure of a
company.
 Operating leverage, just like the financial leverage, is a result of operating fixed expenses. Higher the fixed
expense, higher is the operating leverage.
The amount of debt which a firm employs or proposes to employ can be expressed in relation to total
assets or total equity. Equity will include paid-up capital and reserves and total assets will be taken at net
value.
Leverage is very scientific tool in the hand of finance manager. Finance manager uses this tool for making
effective financial structure of company.

5.4 Keywords
Capital markets: It provides for the buying and selling of long term debt or equity backed securities.
Equity sharing: It is also known as shared ownership or in the US as housing equity partnership (HEP), allows
a person to purchase a share in their home even if they cannot afford a mortgage on the whole of the current
value.
Leverage: It (sometimes referred to as gearing in the United Kingdom, or solvency in Australia) is a general
term for any technique to multiply gains and losses.
Profit: It is the difference between the purchase and the component costs of delivered goods and/or services
and any operating or other expenses.
Tax: It is to impose a financial charge or other levy upon a taxpayer (an individual or legal entity) by a state or
the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by
many administrative divisions.
Leverage Factor: It is refers to the ratio of long-term debt to total assets.

5.5 Self Assessment Questions

1. Financial leverage is a leverage created with the help of debt component in the ..............of a company.
(a) marketing structure (b) capital structure
(c) investment (d) None of these

2. Due to operating leverage, an increase of 1% in sales will have more than ........change in operating profits.
(a) 3% (b) 2%
(c) 1% (d) 5%

3. Financial leverage is always bad, however; it can increase the shareholders' return on their investment.
(a) True (b) False

4. The common interpretation of leverage is derived from the use or manipulation of a tool.
(a) True (b) False

5. Equity will include paid-up capital, reserves and ..............will be taken at net value.
(a) total debt (b) total assets
(c) total investment (d) None of these

6. Debt-equity and Debt-assets ratios both of which are computed from ..................and are inter-related.
(a) Excel data (b) analysis data
(c) Balance Sheet data (d) None of these
7. The level of financial leverage of a certain company is determined by getting the total value of debt and the
equity and the..............
(a) ratio of assets (b) ratio of debt
(c) ratio of profit (d) None of these

8. In simple word leverage is power and relationship between two interrelated variables. These variables may
be output, ...................and profit.
(a) assets (b) capital
(c) sale, cost (d) None of these

9. It is first type of leverage. Operating leverage is % change in earnings before interest and tax divided by %
change in sale.
(a) True (b) False

10. Total risk can be divided into two parts: business risk and....................
(a) financial risk (b) financial goals
(c) market risk (d) None of these

5.6 Review Questions

1. How does the use of financial leverage affect the break-even point? Illustrate?
2. In what way is financial leverage related, to operating leverage?
3. Explain the four types of preference shares a company can issue.
4. Differentiate between ‗Shares‘ and ‗Debentures‘ as sources of long-term finance
5. What is trading on equity?
6. What is average stock level?
7. What are effects of financial leverage?
8. Explain internal source and external source.
9. Define briefly
a) Capital Market
b) Financial Institutions
c) Public Deposits
10. What do you mean by leverage and risk?

Answers for Self Assessment Questions

1. (b) 2. (c) 3. (b) 4. (a) 5. (b)
6. (c) 7.(b) 8.(c) 9.(a) 10. (a)
 6
Management of Working Capital
CONTENTS
Objectives
Introduction
6.1 Meaning of Capital Working
6.2 Importance of Working Capital
6.3 Excess or Inadequate Working Capital
6.4 Determinants of Working Capital Requirements
6.5 Summary
6.6 Keywords
6.7 Self Assessment Questions
6.8 Review Questions

Objectives
After studying this chapter, you will be able:
Understand the meaning of Capital Working
Discuss the importance of working capital
Explain the excess or inadequate working capital
Discuss the determinants of working capital requirements

Introduction
Effective financial management is the outcome, among other things, of proper management of investment of
funds in business. Funds can be invested for permanent or long-term purposes such as acquisition of fixed
assets, diversification and expansion of business, renovation or modernization of plants and machinery, and
research and development. Funds are also needed for short-term purposes, that is, for current operations of the
business. For example, if we are managing a manufacturing unit we will have to arrange for procurement of
raw material, payment of wages to your workmen and for meeting routine expenses. All the goods, which are
manufactured in a given time period may not be sold in that period. Hence, some goods remain in stock, e.g.,
raw material, semi-finished (manufacturing -in-process) goods and finished marketable goods. Funds are thus
blocked in different types of inventory. Again, the whole of the stock of finished goods may not be sold
against ready cash; some of it may be sold on credit. The credit sales also involve blocking of funds with
debtors till cash is received or the bills are cleared.
Working Capital refers to firm's investment in short-term assets, viz. cash, short-term securities, accounts
receivable (debtors) and inventories of raw materials, work-in-process and finished goods. It can also be
regarded as that portion of the firm's total capital, which is employed in short-term operations. It refers to all
aspects of current assets and current liabilities. In simple words, we can say that working capital is the
investment needed for carrying out day-to-day operations of the business smoothly. The management of
working capital is no less important than the management of long-term financial investment.

Principles of Working Capital Management

The following are the principles of working capital management:
Principles of the risk variation─ Risk here refers to the inability of firm to maintain sufficient current assets to
pay its obligations. If working capital is varied relative to sales, the amount of risk that a firm assumes is also
varied and the opportunity for gain or loss is increased. In other words, there is a definite relationship between
the degree of risk and the rate of return. As a firm assumes more risk, the opportunity for gain or loss
increases. As the level of working capital relative to sales decreases, the degree of risk increases. When the
degree of risk increases, the opportunity for gain and loss also increases. Thus, if the level of working capital
goes up, amount of risk goes down, and vice-versa, the opportunity for gain is like-wise adversely affected.

Principle of equity position─ According to this principle, the amount of working capital invested in each
component should be adequately justified by a firm‘s equity position. Every rupee invested in the working
capital should contribute to the net worth of the firm.

Principle of cost of capital─ This principle emphasizes that different sources of finance have different cost of
capital. It should be remembered that the cost of capital moves inversely with risk. Thus, additional risk capital
results in decline in the cost of capital.

Principle of maturity of payment─ A company should make every effort to relate maturity of payments to its
flow of internally generated funds. There should be the least disparity between the maturities of a firm‘s short-
term debt instruments and its flow of internally generated funds, because a greater risk is generated with
greater disparity. A margin of safety should, however, be provided for any short-term debt payment.

6.1 Meaning of Working Capital

Working Capital is the amount of Capital that a Business has available to meet the day-to-day cash
requirements of its operations. Working Capital is the difference between resources in cash or readily
convertible into cash (Current Assets) and organizational commitments for which cash will soon be required
(Current Liabilities). It refers to the amount of Current Assets that exceeds Current Liabilities (i.e. CA - CL).
Working Capital refers to that part of the firm‘s Capital, which is required for Financing Short-Term or
Current Assets such as Cash, Marketable Securities, Debtors and Inventories. Working Capital is also known
as Revolving or Circulating Capital or Short-Term Capital. Working Capital is the money used to make goods
and attract sales. The less Working Capital used to attract sales, the higher is likely to be the return on
investment. Working Capital management is about the commercial and financial aspects of Inventory, credit,
purchasing, marketing, and royalty and investment policy. The higher the profit margin, the lower is likely to
be the level of Working Capital tied up in creating and selling titles. The faster that we create and sell the
books the higher is likely to be the return on investment. Thus when we have been using the word investment
on pricing, we have been discussing Working Capital.
Significance
We will hardly find a running business firm, which does not require some amount of working capital. Even a
fully equipped manufacturing firm is sure to collapse without (a) an adequate supply of raw materials to
process, (b) cash to meet the wage bill, (c) the capacity to wait for the market for its finished products, and (d)
the ability to grant credit to its customers. Similarly, a commercial enterprise is virtually good for nothing
without merchandise to sell. Working capital, thus, is the life-blood of a business. As a matter of fact, any
organisation, whether profit-oriented or otherwise, will not be able to carry on day-to-day activities without
adequate working capital.

6.1.1 Business Uses of Working Capital

Just as working capital has several meanings, firms use it in many ways. Most fundamentally, working capital
investment is the lifeblood of a company. Without it, a firm cannot stay in business. Thus, the first, and most
critical, use of working capital is providing the ongoing investment in short-term assets that a company needs
to operate. A business requires a minimum cash balance to meet basic day-to-day expenses and to provide a
reserve for unexpected costs. It also needs working capital for prepaid business costs, such as licenses,
insurance policies, or security deposits. Furthermore, all businesses invest in some amount of inventory, from
a law firm‘s stock of office supplies to the large inventories needed by retail and wholesale enterprises.
Without some amount of working capital finance, businesses could not open and operate. A second purpose of
working capital is addressing seasonal or cyclical financing needs. Here, working capital finance supports the
build up of short-term assets needed to generate revenue, but which come before the receipt of cash. For
example, a toy manufacturer must produce and ship its products for the holiday shopping season several
months before it receives cash payment from stores. Since most businesses do not receive prepayment for
goods and services, they need to finance these purchase, production, sales, and collection costs prior to
receiving payment from customers.

Another way to view this function of working capital is providing liquidity. Adequate and appropriate working
capital financing ensures that a firm has sufficient cash flow to pay its bills as it awaits the full collection of
revenue. When working capital is not sufficiently or appropriately financed, a firm can run out of cash and
face bankruptcy. A profitable firm with competitive goods or services can still be forced into bankruptcy if it
has not adequately financed its working capital needs and runs out of cash. Working capital is also needed to
sustain a firm‘s growth. As a business grows, it needs larger investments in inventory, accounts receivable,
personnel, and other items to realize increased sales. A final use of working capital is to undertake activities to
improve business operations and remain competitive, such as product development, ongoing product and
process improvements, and cultivating new markets. With firms facing heightened competition, these
improvements often need to be integrated into operations on a continuous basis. Consequently, they are more
likely to be incurred as small repeated costs than as large infrequent investments. This is especially true for
small firms that cannot afford the cost and risks of large fixed investments in research and development
projects or new facilities. Ongoing investments in product and process improvement and market expansion,
therefore, often must be addressed through working capital finance.

6.1.2 Classification of Working Capital

The quantitative concept of Working Capital is known as gross working capital while that under qualitative
concept is known as net working capital. Working capital can be classified in various ways. The important
classifications are as given below:

Conceptual classification – There are two concept of working capital viz., quantitative and qualitative. The
quantitative concept takes into account as the current assets while the qualitative concept takes into account the
excess of current assets over current liabilities. Deficit of working capital exists where the amount of current
liabilities exceeds the amount of current assets. The above can be summarised as follows:
(i) Gross Working Capital = Total Current Assets
(ii) Net Working Capital = Excess of Current Assets over Current Liabilities
(iii) Working Capital Deficit = Excess of Current Liabilities over Current Assets.

Classification on the basis of financial reports – The information of working capital can be collected from
Balance Sheet or Profit and Loss Account; as such the working capital may be classified as follows:
(i) Cash Working Capital – This is calculated from the information contained in profit and loss account. This
concept of working capital has assumed a great significance in recent years as it shows the adequacy of cash
flow in business. It is based on ‗Operating Cycle Concept‘s.
(ii) Balance Sheet Working Capital – The data for Balance Sheet Working Capital is collected from the
balance sheet. On this basis the Working Capital can also be divided in three more types, viz., gross Working
Capital and net Working Capital deficit.

Classification on the Basis of Variability – Gross Working Capital can be divided in two categories viz.,
(i) Permanent or fixed working capital, and (ii) Temporary, Seasonal or variable working capital. Such type of
classification is very important for hedging decisions.
(i) Temporary working capital: Temporary Working Capital is also called as fluctuating or seasonal working
capital. This represents additional investment needed during prosperity and favourable seasons. It increases
with the growth of the business. ‖Temporary working capital is the additional assets required to meet the
variations in sales above the permanent level.‖
This can be calculated as follows:
Temporary Working Capital = Total Current Assets – permanent Current Assets Working

(ii) Permanent Working Capital: It is a part of total current assets which is not changed due to variation in
sales. There is always a minimum level of cash, inventories, and accounts receivables which is always
maintained in the business even if sales are reduced to a minimum. Amount of such investment is called as
permanent working capital. ―Permanent Working Capital is the amount of working capital that persists over
time regardless of fluctuations in sales.‖This is also called as regular working capital.

6.2 Importance of Working Capital

Because of its close relationship with day-to-day operations of a business, a study of working capital and its
management is of major importance to internal, as well as external analysts. It is being increasingly realised
that inadequacy or mismanagement of working capital is the leading cause of business failures. We must not
lose sight of the fact that management of working capital is an integral part of the overall financial
management and, ultimately, of the overall corporate management. Working capital management thus throws a
challenge and should be a welcome opportunity for a financial manager who is ready to play a pivotal role in
his organisation. Neglect of management of working capital may result in technical insolvency and even
liquidation of a business unit. With receivables and inventories tending to grow and with increasing demand
for bank credit in the wake of strict regulation of credit in India by the Central Bank, managers need to
develop a long-term perspective for managing working capital. Inefficient working capital management may
cause either inadequate or excessive working capital, which is dangerous.
A firm may have to face the following adverse consequences from inadequate working capital:
Growth may be stunted. It may become difficult for the firm to undertake profitable projects due to non-
availability of funds.
1. Implementation of operating plans may become difficult and consequently the firm's profit goals may not be
achieved.
2. Operating inefficiencies may creep in due to difficulties in meeting even day to day commitments.
3. Fixed assets may not be efficiently utilised due to lack of working funds, thus lowering the rate of return on
investments in the process.
4. Attractive credit opportunities may have to be lost due to paucity of working capital.
5. The firm loses its reputation when it is not in a position to honour its short-term obligations. As a result, the
firm is likely to face tight credit terms.

On the other hand, excessive working capital may pose the following dangers:
1. Excess of working capital may result in unnecessary accumulation of inventories, increasing the chances of
inventory mishandling, waste, and theft.
2. It may provide an undue incentive for adopting too liberal a credit policy and slackening of collection of
receivables, causing a higher incidence of bad debts.
This has an adverse effect on profits.
3. Excessive working capital may make management complacent, leading eventually to managerial
inefficiency.
4. It may encourage the tendency to accumulate inventories for making speculative profits, causing a liberal
dividend policy, which becomes difficult to maintain when the firm is unable to make speculative profits.
An enlightened management, therefore, should maintain the right amount of working capital on a continuous
basis. Financial and statistical techniques can be helpful in predicting the quantum of working capital needed
at different points of time.

Difference between the Working Capital Management and the Fixed Assets Management
In fact management of working capital is similar to that of fixed assets management in the sense that in both
cases a firm analyses their effects on its profitability and risk. However, fixed assets management and working
capital management differ in three important ways. Firstly, in managing fixed assets time is very important.
Consequently, discounting and compounding aspects of time element play a significant role in capital
budgeting and a minor one in the working capital management. Secondly, large holdings of current assets
specially cash, strengthen a firm‘s liquidity position (and reduce risks), but they also reduce overall
profitability. Thirdly, the level of fixed as well as current assets depends upon the expected sales, but it is only
current assets, which can be adjusted with sales fluctuations in the short-run.

6.3 Excess or Inadequate Working Capital

Every business concern should have adequate amount of working capital to run its business operations. It
should have neither redundant or excess working capital nor inadequate nor shortages of working capital. Both
excess as well as short working capital positions are bad for any business. However, it is the inadequate
working capital which is more dangerous from the point of view of the firm.

6.3.1 Disadvantages of Inadequate Working Capital

Every business needs some amounts of working capital. The need for working capital arises due to the time
gap between production and realization of cash from sales. There are time gaps in purchase of raw material
and production; and sales; and realization of cash.
Excessive or Inadequate Working Capital the Dangerous
The firm should maintain a sound working capital position. It should have adequate working capital to run its
business operations. Both excessive as well as inadequate working capital positions are dangerous from the
firm‘s point of view. Excessive Working capital means idle funds, which earn no profit for the firm paucity of
working capital not only impairs firm‘s profitability but also results in production interruptions and in
efficiencies.

The dangers of excessive Working Capital are as follows:

1) A firm may be tempted to over trade and lose heavily.
2) The situation may lead to unnecessary purchases and accumulation of inventories. This cause more chances
of theft, waste, losses, etc.
3) These arise an imbalance between liquidity and profitability.
4) It means funds are idle when funds are idle; no profit is earned when it is so, and the rate of return on its
investments goes down.
5) The situation leads to greater production, which may not have matching demand.
6) The excess of working capital may lead to carelessness about cost of production.

In adequate working capital is also bad and has the following dangers:
1) It stagnates growth. It becomes difficult for the firm to undertake profitable projects for non-availability of
working capital funds.
2) It may fail to pay its dividend because of non-availability of funds.
3) Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitment.
4) Fixed assets are not efficiently utilized for the lack of working capital funds thus the profitability would
deteriorate.
5) It may not be able to take advantage of cash discount
6) The firm loses its reputation when it is not in position to honour its short-term obligation. As a result, the
firm faces tight credit terms. An enlightened management should, therefore maintain a right amount of
Working Capital on continuous basis only them a proper functioning if business operations will be ensured.

Factors Influencing Working Capital Requirement

Numerous factors can influence the size and need of working capital in a concern. So no set rule or formula
can be framed. It is rightly observed that, ―There is no precise way to determine the exact amount of gross or
net working capital for every enterprise. The data and problem of each company should be analysed to
determine the amount of working capital. Briefly, the optimum level of current assets depends upon following
determinants.

Nature of business: Trading and industrial concerns require more funds for working capital. Concerns engaged
in public utility services need less working capital. For example, if a concern is engaged in electric supply, it
will need less current assets, firstly due to cash nature of the transactions and secondly due to sale of services.
However, it will invest more in fixed assets. In addition to it, the investment varies concern to concern,
depending upon the size of business, the nature of the product, and the production technique.

Conditions of supply: If the supply of inventory is prompt and adequate, less funds will be needed. But, if the
supply is seasonal or unpredictable, more funds will be invested in inventory. Investment in working capital
will fluctuate in case of seasonal nature of supply of raw materials, spare parts and stores.

Production policy: In case of seasonal fluctuations in sales, production will fluctuate accordingly and
ultimately requirement of working capital will also fluctuate. However, sales department may follow a policy
of off-season discount, so that sales and production can be distributed smoothly throughout the year and sharp,
variations in working capital requirement are avoided.
Seasonal Operations-- It is not always possible to shift the burden of production and sale to slack period. For
example, in case of sugar mill more working capital will be needed at the time of crop and manufacturing.

Credit Availability: If credit facility is available from banks and suppliers on favourable terms and conditions,
less working capital will be needed. If such facilities are not available more working capital will be needed to
avoid risk.

Credit policy of enterprises: In some enterprises most of the sale is at cash and even it is received in advance
while, in other sales is at credit and payments are received only after a month or two. In former case less
working capital is needed than the later. The credit terms depend largely on norms of industry but enterprise
some flexibility and discretion. In order to ensure that unnecessary funds are not tied up in book debts, the
enterprise should follow a rationalized credit policy based on the credit standing of the customers and other
relevant factors.

Growth and expansion: The need of working capital is increasing with the growth and expansion of an
enterprise. It is difficult to precisely determine the relationship between volume of sales and the working
capital needs. The critical fact, however, is that the need for increased working capital funds does not follow
growth in business activities but precedes it. It is clear that advance planning is essential for a growing
concern.

Price level change: With the increase in price level more and more working capital will be needed for the
same magnitude of current assets. The effect of rising prices will be different for different enterprises.

Circulation of working capital: Less working capital will be needed with the increase in circulation of working
capital and vice-versa. Circulation means time required to complete one cycle i.e. from cash to material, from
material to work-in-progress, form work-in-progress to finished goods, from finished goods to accounts
receivable and from accounts receivable to cash.

Volume of sale: This is directly indicated with working capital requirement, with the increase in sales more
working capital is needed for finished goods and debtors, its vice versa is also true.

Liquidity and profitability: There is a negative relationship between liquidity and profitability. When working
capital in relation to sales is increased it will reduce risk and profitability on one side and will increase
liquidity on the other side.

Management ability: Proper co-ordination in production and distribution of goods may reduce the requirement
of working capital, as minimum funds will be invested in absolute inventory, non-recoverable debts, etc.

External Environment: with development of financial institutions, means of communication, transport facility,
etc., needs of working capital is reduced because it can be available as and when needed.

6.4 Determinants of Working Capital Requirements

There are no set of rules or formulas to determine the working capital requirements of a firm. The corporate
management has to consider a number of factors to determine the level of working capital. The amount of
working capital that a firm would need is affected not only by the factors associated with the firm itself but is
also affected by economic, monetary and general business environment. Among the various factors the
following are important ones.

Nature and Size of Business

The working capital needs of a firm are basically influenced by the nature of its business. Trading and
financial firms generally have a low investment in fixed assets, but require a large investment in working
capital. Retail stores, for example, must carry large stocks of a variety of merchandise to satisfy the varied
demand of their customers. Some manufacturing businesses' like tobacco, and construction firms also have to
invest substantially in working capital but only a nominal amount in fixed assets. In contrast, public utilities
have a limited need for working capital and have to invest abundantly in fixed assets. Their working capital
requirements are nominal because they have cash sales only and they supply services, not products. Thus, the
amount of funds tied up with debtors or in stocks is either nil or very small. The working capital needs of most
of the manufacturing concerns fall between the two extreme requirements of trading firms and public utilities.
The size of business also has an important impact on its working capital needs. Size may be measured in terms
of the scale of operations. A firm with larger scale of operations will need more working capital than a small
firm. The hazards and contingencies inherent in a particular type of business also have an influence in deciding
the magnitude of working capital in terms of keeping liquid resources.

Manufacturing Cycle
The manufacturing cycle starts with the purchase of raw materials and is completed with the production of
finished goods. If the manufacturing cycle involves a longer period the need for working capital will be more,
because an extended manufacturing time span means a larger tie-up of funds in inventories. Any delay at any
stage of manufacturing process will result in accumulation of work-in-process and will enhance the
requirement of working capital. We may have observed that firms making heavy machinery or other such
products, involving long manufacturing cycle, attempt to minimise their investment in inventories (and thereby
in working capital) by seeking advance or periodic payments from customers.

Business Fluctuations
Seasonal and cyclical fluctuations in demand for a product affect the working capital requirement
considerably, especially the temporary working capital requirements of the firm. An upward swing in the
economy leads to increased sales, resulting in an increase in the firm's investment in inventory and receivables
or book debts. On the other hand, a decline in the economy may register a fall in sales and, consequently, a fall
in the levels of stocks and book debts. Seasonal fluctuations may also create production problems. Increase in
production level may be expensive during peak periods. A firm may follow a policy of steady production in all
seasons to utilise its resources to the fullest extent. This will mean accumulation of inventories in off-season
and their quick disposal in peak season. Therefore, financial arrangements for seasonal working capital
requirement should be made in advance. The financial plan should be flexible enough to take care of any
seasonal fluctuations.

Production Policy
If a firm follows steady production policy, even when the demand is seasonal, inventory will accumulate
during off-season periods and there will be higher inventory costs and risks. If the costs and risks of
maintaining a constant production schedule are high, the firm may adopt the policy of varying its production
schedule in accordance with the changes in demand. Firms whose physical facilities can be utilised for
manufacturing a variety of products can have the advantage of diversified activities. Such firms manufacture
their main products during the season and other products during off-season. Thus, production policies may
differ from firm to firm, depending upon the circumstances. Accordingly, the need for working capital will
also vary.

Turnover of Circulating Capital

The speed with which the operating cycle completes its round (i.e., cash → raw materials → finished product
→ accounts receivables → cash) plays a decisive role in influencing the working capital needs.

Credit Terms
The credit policy of the firm affects the size of working capital by influencing the level of book debts. Though
the credit terms granted to customers to a great extent depend upon the norms and practices of the industry or
trade to which the firm belongs; yet it may endeavour to shape its credit policy within such constraints. A long
collection period will generally mean tying of larger funds in book debts. Slack collection procedures may
even increase the chances of bad debts. The working capital requirements of a firm are also affected by credit
terms granted by its creditors. A firm enjoying liberal credit terms will need less working capital.

Growth and Expansion Activities

As a company grows, logically, larger amount of working capital will be needed, though it is difficult to state
any firm rules regarding the relationship between growth in the volume of a firm's business and its working
capital needs. The fact to recognize is that the need for increased working capital funds may precede the
growth in business activities, rather than following it. The shift in composition of working capital in a
company may be observed with changes in economic circumstances and corporate practices. Growing
industries require more working capital than those that are static.

Operating Efficiency
Operating efficiency means optimum utilisation of resources. The firm can minimise its need for working
capital by efficiently controlling its operating costs. With increased operating efficiency the use of working
capital is improved and pace of cash cycle is accelerated. Better utilisation of resources improves profitability
and helps in relieving the pressure on working capital.

Price Level Changes

Generally, rising price level requires a higher investment in working capital. With increasing prices the same
levels of current assets need enhanced investment. However, firms which can immediately revise prices of
their products upwards may not face a severe working capital problem in periods of rising levels. The effects
of increasing price level may, however, be felt differently by different firms due to variations in individual
prices. It is possible that some companies may not be affected by the rising prices, whereas others may be
badly hit by it.

Other Factors
There are some other factors, which affect the determination of the need for working capital. A high net profit
margin contributes towards the working capital pool. The net profit is a source of working capital to the extent
it has been earned in cash. The cash inflow can be calculated by adjusting non-cash items such as depreciation,
out-standing expenses, losses written off, etc, from the net profit.
The firm's appropriation policy, that is, the policy to retain or distribute profits also has a bearing on working
capital. Payment of dividend consumes cash resources and thus reduces the firm's working capital to that
extent. If the profits are retained in the business, the firm's working capital position will be strengthened.
In general, working capital needs also depend upon the means of transport and communication. If they are not
well developed, the industries will have to keep huge stocks of raw materials, spares, finished goods, etc. at
places of production, as well as at distribution outlets.

Did You Know?

Permanent working capital is that amount of capital which must be in cash or current assets for continuing the
activities of business.

Caution
New facilities and equipment are not the only assets required for growth; firms also must finance the working
capital needed to support sales growth.

Case Study-Cytec Industries

Cytec Industries Inc. is a global specialty chemicals and Materials Company focused on developing,
manufacturing and selling value-added products. Its products serve a diverse range of end markets including
aerospace, adhesive, automotive and industrial coatings, chemical intermediates, inks, mining and plastics.
Headquartered in New Jersey, Cytec has operations in more than 35 countries.

Funding future growth

In the second half of 2008, Cytec foresaw a strong downward trend in the economy and its business activity.
Cytec's businesses tend to be cyclical, although not all fit in the same part of the economic cycle. Senior
management knew that focusing on cash would be critical to riding out the coming downturn and positioning
the company for an eventual recovery. The market having reduced its share price; Cytec needed to amend its
bank facility covenants and wanted to take the proactive step of refinancing senior debt due in 2010 by the end
of the third quarter of 2009. So the pressure was on to demonstrate to the capital markets that Cytec could
continue to generate cash through the downturn in the business cycle. Cytec's working capital levels had been
increasing year-over-year as a result of growth and acquisitions. The company compared poorly to the industry
peer group. Cytec's own analysis showed excess working capital of more than INR200 million. When markets
were strong, the focus had been on earnings rather than the balance sheet. Understanding the downward trend
in the business cycle, the company's management team realized that better working capital management would
be the most effective lever to boost cash generation.

"We recognized the opportunity to tap excess working capital to invest in the businesses that will shape our
future," Cytec's vice president and Chief Financial Officer. "When the economy began to deteriorate in 2008,
we decided to accelerate this effort." Furthermore, to sustain the changes, Cytec would need better metrics and
reporting capabilities. Importantly, it would need to change its culture, effectively embedding a focus on
working capital into decision-making throughout the organization. "We want our people to understand how
their day-to-day activities affect working capital," Vice President, Global Supply Chain, and Cytec Specialty
Chemicals. "Anytime an individual makes a decision, he or she should ask, 'What impact will this have on
working capital?'"
Charting the course for improvement
To help the company formulate a plan for accelerating working capital improvements without negatively
affecting customer service, Cytec sought assistance from REL. "Just about anyone can take steps to address
working capital, but we wanted to make sure our results were sustainable," notes . "We wanted a partner who
understands this and working capital is REL's business." Partnering with the Cytec team, REL outlined a clear,
detailed, practical path for analyzing and addressing several key functional areas that affect working capital,
with project teams assigned to each area. Over a six-week period, team members examined a sample of Cytec's
operating locations on two continents, conducted in-depth interviews with front-line personnel and analyzed
transaction-level activities to identify potential drivers of increased working capital. A key component of
REL's analysis involved a nine-box segmentation model, used to differentiate products, suppliers and
customers according to key attributes. "The nine-box segmentation model was crucial to the success of this
project," says Cytec Specialty Chemicals Controller Duncan Taylor. "It is a simple model, but it really
changed the focus for us by providing the quantitative basis for segmentation."
Based on its analysis, REL estimated that Cytec could exceed its working capital improvement goal by:
Standardizing collections processes across geographies and units, developing differentiated credit and
collection policies based on customer characteristics and implementing an escalation process to avoid overdue
receivables. Updating inventory parameters and creating a tool for making intelligent trade-offs between cost
and service levels for different categories of products. Negotiating improved payment terms with key suppliers
and implementing a payment clock to ensure bills were not paid before they were due. Before the analysis,
Cytec's management expected that the main working capital benefits would come from inventory reduction. In
fact, the analysis showed that there were greater near-term improvements available in payables and
receivables. These quick wins improved the overall cash flow of the project and help fund the longer-term
inventory work stream. "We knew that we were on the right track," says, "but the analysis provided the
evidence and specificity that enabled us to refocus priorities across functions and gain support for moving
forward." Together, REL and Cytec used the findings to create a comprehensive business case for process
changes that helped obtain buy-in from senior leaders as well as operational teams.

Building a Cash Culture

Just a few months into the implementation process, Cytec executives observed their own people "talking" the
new concepts and applying them with discipline in their day-to-day activities. "We were able to generate some
quick wins, particularly in the payables and receivables area". "Once people saw the successes, everyone
wanted to be involved." Taylor credits the project with helping the company's culture evolve. "This project, for
example, brought new exposure to the credit group and emphasized the importance of its role in facilitating
collections rather than just managing credit risk. In the process, the group became," he comments. Guided by
REL's project management approach, which included frequent status reviews and strong coordination between
multinational teams, Cytec initiated a five-month effort to implement the recommended process changes in its
Specialty Chemicals business unit. Implementation in its Engineered Materials unit began several months
later. Cytec teams participated actively in the process and in REL-led workshops, in effect becoming subject
matter experts who now apply the tools and best practices to accelerate and sustain the benefits. "We were
impressed with how REL explained the various concepts involved, with its emphasis on knowledge transfer,
and with its collaborative, team-oriented approach," says Taylor. "REL involved Cytec in every aspect of the
effort, rather than doing everything with Cytec personnel watching."

REL also helped Cytec define the operational metrics and key performance indicators that it is using to
measure these processes going forward, using Cytec's data warehouse to produce reports that provide greater
performance insight for the three key process areas addressed. "If we change the way we look at things, then
those things will change,‖ "We had all of this information before, but we were not able to get to it efficiently
and present it in the right way." Strong sponsorship and visible leadership support were instrumental in helping
Cytec move quickly to address its goal. Leaders communicated its progress and successes widely and
reorganized regular departmental and management meetings to focus on the metrics that drive working capital.
In addition, the company adapted its incentive compensation structure at all levels to reward individuals for
achieving company-wide working capital goals.

Surpassed expectations, sustainable processes

Less than a year after it began incorporating REL's recommendations, Cytec surpassed its own working capital
reduction goals through a combination of changes to its receivables, inventory management and payables
processes. This has occurred even as the company continues to roll out the changes to other regions of the
world. Within each process area, Cytec made significant progress against its key metrics. For example, it
realized reductions in days inventory on hand, day‘s sales outstanding, and days to pay. Most importantly, by
turning working capital into cash, Cytec remained focused on its future vision for growth and was able to
continue investing in the businesses that are critical to that vision, even through a challenging economic
environment. Simply put, the new management processes give the company a competitive edge.

Questions
1. What are factors that affecting customer service in Cytec Industries?
2. Explain nine-box segmentation model.

6.5 Summary
Working Capital is the amount of Capital that a Business has available to meet the day-to-day cash
requirements of its operations.
Working Capital is the difference between resources in cash or readily convertible into cash (Current
Assets) and organizational commitments for which cash will soon be required (Current Liabilities). It
refers to the amount of Current Assets that exceeds Current Liabilities (i.e. CA - CL).
The quantitative concept of Working Capital is known as gross working capital while that under
qualitative concept is known as net working capital.
 The information of working capital can be collected from Balance Sheet or Profit and Loss Account; as
such the working capital may be classified.
There are no set of rules or formulas to determine the working capital requirements of a firm. The
corporate management has to consider a number of factors to determine the level of working capital.
Operating efficiency means optimum utilisation of resources. The firm can minimise its need for working
capital by efficiently controlling its operating costs.

6.6 Keywords
Credit terms: the credit terms granted to customers to a great extent depend upon the norms and practices of
the industry or trade to which the firm belongs.
Gross Working Capital: Gross working capital is sum of current assets of a company and does not account for
current liabilities.
Liabilities: Liabilities in financial accounting need not be legally enforceable; but can be based on equitable
obligations or constructive obligations.
Permanent Working Capital: It is a part of total current assets which is not changed due to variation in sales.
Working capital: Working capital is a financial metric which represents operating liquidity available to a
business, organization, or other entity, including governmental entity.

6.7 Self Assessment Questions

1. Working Capital refers to firm's investment in............................
(a) fixed assets (b) long-term assets
(c) short-term assets (d) None of these

2. Working Capital is also known as Revolving or Circulating Capital or Short-Term Capital.

(a) True (b) False

3. There are two concept of working capital viz., quantitative and qualitative.
(a) True (b) False

4. Net Working Capital =

(a) Excess of Fixed Assets over Fixed Liabilities
(b) Excess of Current Assets over Current Liabilities
(c) Excess of Current Liabilities over Current Assets
(d) None of these

5. The data for Balance Sheet Working Capital is collected from the credit sheet.
(a) True (b) False

6. Temporary Working Capital =

(a) Total Current Assets * permanent Current Assets Working
(b Total Current Assets + permanent Current Assets Working
(c) Excess of Fixed Assets - Fixed Liabilities
(d) Total Current Assets - permanent Current Assets Working

7. The need for working capital arises due to the time gap between ……….and realization of cash from sales.
(a) production (b) assets
(c) sale (d) None of these

8. Trading and financial firms generally have a low investment in...........

(a) fixed liabilities (b) fixed investment
(c) fixed assets (d) financial groth

9. The manufacturing cycle starts with the purchase of ……….and is completed with the production of
finished goods.
(a) materials (b) raw materials
(c) goods (d) None of these

10. Increase in production level may be expensive during peak periods.

(a) True (b) False

6.8 Review Questions

1. What do you understand by the meaning of capital working?
2. Discuss the disadvantages of inadequate working capital.
3. How can you define that factors influencing working capital requirement?
4. What do you mean by determinants of working capital requirements?
5. Briefly explain the importance of capital working
6. Explain the principles of working capital management.
7. What are business uses of working capital?
8. Define the classification of working capital.
9. Explain the difference between the working capital management and the fixed assets management.
10. Write short note on the following:
Nature and Size of Business
Business Fluctuations

Answers for Self Assessment Questions

1. (c) 2. (a) 3. (a) 4. (b) 5. (b)
6. (d) 7.(a) 8.(c) 9.(b) 10. (a)
 7
Cash Management
CONTENTS
Objectives
Introduction
7.1 Concept of Cash Management
7.2 Factors Determining the Cash Balance
7.3 Cash System
7.4 Summary
7.5 Keywords
7.6 Self Assessment Questions
7.7 Review Questions

Objectives
After studying this chapter, you will be able:
Describe concept of cash management
Understand the factors determining the cash balance
Define the cash system

Introduction
Cash management is a broad term that refers to the collection, concentration, and disbursement of cash. It
encompasses a company‘s level of liquidity, its management of cash balance, and its short-term investment
strategies. In some ways, managing cash flow is the most important job of business managers. ―Cash, like the
blood stream in the human body, gives vitality and strength to business enterprises.‖ Though, cash hold the
smallest portion of total current assets. However, cash is both the beginning and end of working capital cycle
cash, inventories, receivables and cash. It is the cash, which keeps the business going. Hence, every enterprise
has to hold necessary cash for its existence. Moreover, ―Steady and healthy circulation of cash throughout the
entire business operations is the basis of business solvency.‖ Nevertheless, cash like any other asset of a
company is treated as a tool of profit. Further, today the emphasis is on the right amount of cash, at the right
time, at the right place and at the right cost.

Maintenance of surplus cash by a company unless there are special reasons for doing so, is regarded as a bad
sigh of cash management. Holding of cash balance has an implicit cost in the form of its opportunity cost.
Cash may be interpreted under two concepts. In narrow sense, ―Cash is very important business asset, but
although coin and paper currency can be inspected and handled, the major part of the cash of most enterprises
is in the form of bank checking accounts, which represent claims to money rather than tangible property‖.
Legal tender, cheques, bank drafts, money orders and demand deposits in banks. In general, nothing should be
considered unrestricted cash unless it is available to the management for disbursement of any nature. Thus,
from the above quotations we may conclude that in narrow sense cash means cash in hand and at bank but in
wider sense, it is the deposit in banks, currency, cheques, bank draft etc. in addition to cash in hand and at
bank. Cash management includes management of marketable securities also, because in modern terminology
money comprises marketable securities and actual cash in hand or in bank.

Meaning and Definition

The term cash management refers to the management of cash resource in such a way that generally accepted
business objectives could be achieved. In this context, the objectives of a firm can be unified as bringing about
consistency between maximum possible profitability and liquidity of a firm. Cash management may be defined
as the ability of a management in recognizing the problems related with cash which may come across in future
course of action, finding appropriate solution to curb such problems if they arise, and finally delegating these
solutions to the competent authority for carrying them out The choice between liquidity and profitability
creates a state of confusion. It is cash management that can provide solution to this dilemma. Cash
management may be regarded as an art that assists in establishing equilibrium between liquidity and
profitability to ensure undisturbed functioning of a firm towards attaining its business objectives.

Cash itself is not capable of generating any sort of income on its own. It rather is the prime requirement of
income generating sources and functions. Thus, a firm should go for minimum possible balance of cash, yet
maintaining its adequacy for the obvious reason of firm's solvency. Cash management deals with maintaining
sufficient quantity of cash in such a way that the quantity denotes the lowest adequate cash figure to meet
business obligations. Cash management involves managing cash flows (into and out of the firm), within the
firm and the cash balances held by a concern at a point of time. The words, 'managing cash and the cash
balances' as specified above does not mean optimization of cash and near cash items but also point towards
providing a protective shield to the business obligations. "Cash management is concerned with minimizing
unproductive cash balances, investing temporarily excess cash advantageously and to make the best possible
arrangement for meeting planned and unexpected demands on the firms' cash."

7.1 Concept of Cash Management

Having a firm grip on cash management strategy will help to keep a cash reserve in case of need. The need
may be an emergency or it may be a large purchase with a price that is too good to pass up, but either way the
funds will be available for use. The first step involves maximizing cash flow. We will also start building up an
emergency nest egg by putting it into a fund that earns interest but is still accessible in times of financial crisis.
As our business begins to grow and payments become predictable, investing in certificates of deposit with
staggered maturity dates becomes an option. There are many other options available, and speaking to our local
bank cash management department can help to figure out which ones are right for us. Learn more about the
following cash management key terms: cash flow, projections, key financial ratios, profit-and-loss projections,
disbursements and cash resource optimization.

Cash flow
Cash flow is our profit and loss affected by our accounts receivable, inventory, accounts payable and our
capital expenditures, as well as what we have borrowed.
Projections
Cash flow projections are a forecast of anticipated cash needs. Use projections to look at in short-term and
long-term goals.

Key financial ratios

The key financial ratios for business are the ratios that help to make sense of the figures from financial
statements.

Profit-and-loss projections
Profit-and-loss projections are long-term forecasts for business.

Disbursements
Disbursements are company's payables and cash outflow. There are a variety of products and services
available to help and manage the money flowing in that direction.

Cash resource optimization

Cash resource optimization is making the most of the available money on hand by using short-term investment
solutions to give interest on the funds.

7.1.1 Scope of Cash Management

Efficient cash management processes are pre-requisites to execute payments, collect receivables and manage
liquidity. Managing the channels of collections, payments and accounting information efficiently becomes
imperative with growth in business transaction volumes. This includes enabling greater connectivity to internal
corporate systems, expanding the scope of cash management services to include ―full-cycle‖ processes (i.e.,
from purchase order to reconciliation) via ecommerce, or cash management services targeted at the needs of
specific customer segments. Cost optimization and value-add services are customer demands that necessitate
the creation of a mechanism to service the various customer groups.

7.1.2 General Principles of Cash Management

Harry Gross has suggested certain general principles of cash management that, essentially add efficiency to
cash management. These principles reflecting cause and effect relationship having universal applications give
a scientific outlook to the subject of cash management. While, the application of these principles in accordance
with the changing conditions and business environment requiring high degree of skill and tact which places
cash management in the category of art. Thus, we can say that cash management like any other subject of
management is both science and art for it has well-established principles capable of being skilfully modified as
per the requirements. The principles of management are follows:

Determinable Variations of Cash Needs

A reasonable portion of funds, in the form of cash is required to be kept aside to overcome the period
anticipated as the period of cash deficit. This period may either be short and temporary or last for a longer
duration of time. Normal and regular payment of cash leads to small reductions in the cash balance at periodic
intervals. Making this payment to different employees on different days of a week can equalize these
reductions. Another technique for balancing the level of cash is to schedule the cash disbursements to creditors
during that period when accounts receivables collected amounts to a large sum but without putting the good
will at stake.
Contingency Cash Requirement
There may arise certain instances, which fall beyond the forecast of the management. These constitute
unforeseen calamities, which are too difficult to be provided for in the normal course of the business. Such
contingencies always demand for special cash requirements that was not estimated and provided for in the cash
budget. Rejections of wholesale product, large amount of bad debts, strikes, lockouts etc. are a few among
these contingencies. Only a prior experience and investigation of other similar companies prove helpful as a
customary practice. A practical procedure is to protect the business from such calamities like bad-debt losses,
fire etc. by way of insurance coverage.

Availability of External Cash

Another factor that is of great importance to the cash management is the availability of funds from outside
sources. There resources aid in providing credit facility to the firm, which materialized the firm‘s objectives of
holding minimum cash balance. As such if a firm succeeds in acquiring sufficient funds from external sources
like banks or private financers, shareholders, government agencies etc., the need for maintaining cash reserves
diminishes.

Maximizing Cash Receipts

Every financial manager aims at making the best possible use of cash receipts. Again, cash receipts if tackled
prudently results in minimizing cash requirements of a concern. For this purpose, the comparative cost of
granting cash discount to customer and the policy of charging interest expense for borrowing must be
evaluated on continuous basis to determine the futility of either of the alternative or both of them during that
particular period for maximizing cash receipts. Yet, the under mentioned techniques proved helpful in this
context:

Concentration Banking
Under this system, a company establishes banking centres for collection of cash in different areas. Thereby,
the company instructs its customers of adjoining areas to send their payments to those centres. The collection
amount is then deposited with the local bank by these centres as early as possible. Whereby, the collected
funds are transferred to the company‘s central bank accounts operated by the head office.

Local Box System

Under this system, a company rents out the local post offices boxes of different cities and the customers are
asked to forward their remittances to it. These remittances are picked by the authorized lock bank from these
boxes to be transferred to the company‘s central bank operated by the head office.

Reviewing Credit Procedures

It aids in determining the impact of slow payers and bad debtors on cash. The accounts of slow paying
customers should be reviewed to determine the volume of cash tied up. As a matter of fact, too strict a credit
policy involves rejections of sales. Thus, curtailing the cash inflow. On the other hand, too lenient, a credit
policy would increase the number of slow payments and bad debts again decreasing the cash inflows.

Minimizing Credit Period

Shortening the terms allowed to the customers would definitely accelerate the cash inflow side-by-side
revising the discount offered would prevent the customers from using the credit for financing their own
operations profitably.
Others
Introducing various procedures for special handling of large to very large remittances or foreign remittances
such as, persona! Pick up of large sum of cash using airmail, special delivery and similar techniques to
accelerate such collections.

Minimizing Cash Disbursements

The motive of minimizing cash payments is the ultimate benefit derived from maximizing cash receipts. Cash
disbursement can be brought under control by preventing fraudulent practices, serving time draft to creditors
of large sum, making staggered payments to creditors and for payrolls etc.

Maximizing Cash Utilization

Although a surplus of cash is a luxury, yet money is costly. Moreover, proper and optimum utilization of cash
always makes way for achievement of the motive of maximizing cash receipts and minimizing cash payments.
At times, a concern finds itself with funds in excess of its requirement, which lay idle without bringing any
return to it. At the same time, the concern finds it unwise to dispose it, as the concern shall soon need it. In
such conditions, efforts should be made in investing these funds in some interest bearing securities. There are
certain basic strategies suggested in which prove evidently helpful in managing cash if employed by the cash
management. Pay accounts payables as late as possible without damaging the firm‘s credit rating, but take
advantage of the favourable cash discount, if any. Turnover, the inventories as quickly as possible, avoiding
stock outs that might result in shutting down the productions line or loss of sales. Collect accounts receivables
as early as possible without losing future loss sales because of high-pressure collections techniques. Cash
discounts, if they are economically justifiable, may be used to accomplish this objective.

7.1.3 Function of Cash Management

―Cash management is concerned with minimizing unproductive cash balances, investing temporarily excess
cash advantageously and to make the best possible arrangements for meeting planned and unexpected demands
on the firm‘s cash.‖ Cash Management must aim to reduce the required level of cash but minimize the risk of
being unable to discharge claims against the company as they arise. All these aims and motives of cash
management largely depend upon the efficient and effective functioning of cash management. Cash
management functions can be studied under five heads, namely, cash planning, managing cash flow,
controlling cash flow, optimizing the cash level and investing idle cash. All these functions are discussed
below in details:

Cash Planning
Good planning is the very foundation of attaining success. For any management decision, planning is the
foremost requirement. ―Planning is basically an intellectual process, pre-disposition to do things in an orderly
way, to think before acting and to act in the light of facts rather than of a guess.‖ Cash planning is a technique,
which comprises of planning for and controlling of cash. It is a management process of forecasting the future
need of cash, its available resources and various uses for a specified period. Cash planning, thus, deals at
length with formulation of necessary cash policies and procedures in order to carry on business continuously
and on sound lines. Good cash planning aims at providing cash, not only for regular but also for irregular and
abnormal requirements.

Managing Cash Flows

The heading simply suggests an idea of managing properly the flow of cash coming inside the business i.e.
cash inflow and cash moving out of the business i.e. cash outflow. These two are said to be properly managed
only, if a firm succeeds in accelerating the rate of cash inflow together with minimizing the cash outflow. As
observed expediting collections, avoiding unnecessary inventories, improving control over payments etc.
contribute to better management of cash. Whereby, a business can conserve cash and thereof would require
lesser cash balance for its operations.

Controlling the Cash Flows

As forecasting is not an exact science because it is based on certain assumptions. Therefore, cash planning will
inevitably be at variance with the results actually obtained. For this reason, control becomes an unavoidable
function of cash management. Moreover, cash controlling becomes essential as it increases the availability of
usable cash from within the enterprise. As it is obvious that greater the speed of cash flow cycle, It greater
would be the number of times a firm can convert its goods and services into cash and so lesser will be the cash
requirement to finance the desired volume of business during that period. Furthermore, every enterprise is in
possession of some hidden cash, which if traced out substantially decreases the cash requirement of the
enterprise.

Optimizing the Cash Level

The foremost need of maintaining optimum level of cash is to meet the necessary requirements and to settle
the obligations well in time. Optimization of cash level may be related to establishing equilibrium between risk
and the related profit expected to be earned by the company.

Investing Idle Cash

Idle cash or surplus cash refers to the excess of cash inflows over cash outflows, which do not have any
specific operations or any other purpose to solve currently. Generally, a firm is required to hold cash for
meeting working needs facing contingencies and to maintain as well as develop goodwill of bankers. The
problems of investing this excess amount of cash arise simply because it contributes nothing towards
profitability of the firm as idle cash precisely earns no returns. Further permanent disposal of such cash is not
possible, as the concern may again need this cash after a short while. But, if such cash is deposited with the
bank, it definitely would earn a nominal rate of interest paid by the bank. A much better returns than the bank
interest can be expected if a company deploys idle cash in marketable securities. There are not yet another
group of enterprise that neither invests in marketable securities nor willing to get interest instead do they prefer
to deposit excess cash for improving relations with banks by helping them in meeting bank requirements for
compensating balances for services and loans.

7.1.4 Objectives of Cash Management

There are two major objectives for cash management in a firm
(a) Meeting payments schedule and
(b) Minimizing funds held in the form of cash balances.

Meeting Payments Schedule

In the normal course of functioning, a firm will have to make many payments by cash to its employees,
suppliers, infrastructure bills, etc. It will also receive cash through sales of its products and collection of
receivables. Both these do not happen simultaneously. A basic objective of cash management is therefore to
meet the payment schedule in time. Timely payments will help the firm to maintain its creditworthiness in the
market and to foster good and cordial relationships with creditors and suppliers. Creditors give a cash discount
if payments are made in time and the firm can avail this discount as well. Trade credit refers to the credit
extended by the supplier of goods and services in the normal course of business transactions. Generally, cash
is not paid immediately for purchases but after an agreed period of time. There is deferral of payment and is a
source of finance. Trade credit does not involve explicit interest charges, but there is an implicit cost involved.
If the credit terms are, say, 2/10, net 30, it means the company will get a cash discount of 2% for prompt
payment made within 10 days or else the entire payment is to be made within 30 days. Since the net amount is
due within 30 days, not availing discount means paying an extra 2% for 20-day period. The other advantage of
meeting the payments in time is that it prevents bankruptcy that arises out of the firm‘s inability to honour its
commitments. At the same time, care should be taken not to keep large cash reserves as it involves high cost.

Minimize Funds Committed To Cash Balances

Trying to achieve the second objective is very difficult. A high level of cash balances will help the firm to
meet its first objective discussed above, but keeping excess reserves is also not desirable as funds in its
original form is idle cash and a non-earning asset. It is not profitable for firms to keep huge balances. A low
level of cash balances may mean failure to meet the payment schedule. The aim of cash management is
therefore to have an optimal level of cash by bringing about a proper synchronization of inflows and outflows
and check the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of
mismatches between inflows and outflows. The efficiency of cash management can be augmented by
controlling a few important factors described below:

Prompt billing and mailing: There is a time lag between the dispatch of goods and preparation of invoice.
Reduction of this gap will bring in early remittances.

Collection of cheques and remittances of cash: It is generally found that there is a delay in the receipt of
cheques and their deposits into banks. The delay can be reduced by speeding up the process of collection and
depositing cash or other instruments from customers. The concept of ‗float‘ helps firms to a certain extent in
cash management. Float arises because of the practice of banks not crediting firm‘s account in its books when
a cheque is deposited by it and not debit firm‘s account in its books when a cheque is issued by it until the
cheque is cleared and cash is realized or paid respectively. A firm issues and receives cheques on a regular
basis. It can take advantage of the concept of float. Whenever cheques are deposited with the bank, credit
balance increases in the firm‘s books but not in bank‘s books until the cheque is cleared and money realized.
This refers to ‗collection float‘, that is, the amount of cheques deposited into a bank and clearance awaited.
Likewise the firm may take benefit of ‗payment float‘. The difference between payment float and collection
float is called as ‗net float‘. When net float is positive, the balance in the firm‘s books is less than the bank‘s
books; When net float is negative; The firm‘s book balance is higher than in the bank‘s books.

Did You Know?

Cost optimization and value-add services are customer demands that necessitate the creation of a mechanism
to service the customer groups.

7.2 Factors Determining the Cash Balance

The factors that determine the required cash balances are:
1) Synchronization of cash flows
2) Short costs
3) Excess cash balance
4) Procurement and management and
5) Uncertainty
Synchronization of Cash Flows
The need for maintaining cash balances arises from the non-synchronization of the inflows and outflows of
cash: if the receipts and payments of cash perfectly coincide or balance each other, there would be no need for
cash balances. The first consideration in determining the cash need is, therefore, the extent of non-
synchronization of cash receipts and disbursements. For this purpose, the inflows and outflows have to be
forecast over a period of time, depending upon the planning horizon which is typically a one-year period with
each of the 12 months being a sub period. The technique adopted is a cash budget. A properly prepared budget
will pinpoint the months/periods when the firm will have an excess or a shortage of cash.

Short Costs
Another general factor to be considered in determining cash needs is the cost associated with a shortfall in the
cash needs. The cash forecast presented in the cash budget would reveal periods of cash shortages. In addition,
there may be some unexpected shortfall. Every shortage of cash-whether expected or unexpected- involves a
cost ‗depending upon these verity, duration and frequency of the shortfall and how the shortage is covered.
Expenses incurred as a result of shortfall is called short costs. Included in the short costs are the following:
1. Transaction costs associated with raising cash to tide over the shortage. This is usually the brokerage
incurred in relation to the sale of some short-term near-cash assets such as marketable securities.
2. Borrowing costs associated with borrowing to cover the shortage. These include items such as interest on
loan; commitment charges and other expenses relating to the loan.
3. Loss of cash-discount, that is, a substantial loss because of a temporary shortage of cash.
4. Cost associated with deterioration of the credit rating which is reflected in higher bank charges on loans,
stoppage of supplies, demands for cash payment, refusal to sell, loss of image and the attendant decline in
sales and profits.
5. Penalty rates by banks to meet a shortfall in compensating balances.

Excess Cash Balance Costs

The cost of having excessively large cash balances is known as the excess cash balance cost. If large funds are
idle, the implication is that the firm has missed opportunities to invest those funds and have thereby lost
interest which it would otherwise have earned. This loss of interest is primarily the excess cost.

Procurement and Management

These are the costs associated with establishing and operating cash management staff and activities. They are
generally fixed and are mainly accounted for by salary, storage, handling of securities, and so on.

Uncertainty and Cash Management

The impact of uncertainty on cash management is also relevant as cash flows cannot be predicted with
complete accuracy. The first requirement is a precautionary cushion to cope with irregularities in cash flows,
unexpected delays in collection and disbursements, defaults and unexpected cash needs.
The impact of uncertainty on cash management can, however, be mitigated through
1. Improved forecasting of tax payments, capital expenditure, dividends, and so on; and
2. Increased ability to borrow through overdraft facility.

Determining Cash Need

After the examination of the pertinent considerations and cost that determine cash needs, the next aspect
relates to the determination of cash needs.
There are two approaches to derive an optimal cash balance, namely
(a) Minimizing cost cash models and
(b) Cash budget

Cash Management/Conversion Models

While it is true that financial managers need not necessarily follow cash management models exactly but a
familiarity with them provides an insight into the normative framework as to how cash management should be
conducted. One the important analytical model for cash management is the Baumol Model.

7.2.1 Baumol Model

The Baumol model of cash management is one of many by which cash is managed by companies. It is
extensively used and highly useful for the purpose of cash management.
Use of Baumol Model
The Baumol model enables companies to find out their desirable level of cash balance under certainty.

Relevance
At present many companies make an effort to reduce the costs incurred by owning cash. They also strive to
spend less money on changing marketable securities to cash. The Baumol model of cash management is useful
in this regard.

Assumptions
There are certain assumptions or ideas that are critical with respect to the Baumol model of cash management:
The particular company should be able to change the securities that they own into cash, keeping the cost of
transaction the same. Under normal circumstances, all such deals have variable costs and fixed costs.
The company is capable of predicting its cash necessities. They should be able to do this with a level of
certainty. The company should also get a fixed amount of money. They should be getting this money at
regular intervals.
The company is aware of the opportunity cost required for holding cash. It should stay the same for a
considerable length of time.
The company should be making its cash payments at a consistent rate over a certain period of time. In
other words, the rate of cash out flow should be regular.

Equational Representations in Baumol Model of Cash Management:

•Holding Cost = k(C/2)
•Total Cost = k(C/2) + c(T/C)
•Transaction Cost = c(T/C)

Illustration
The ABC Ltd requires Rs. 30 lakhs in cash to meet its transaction needs during the next three month cash
planning period. It holds marketable securities of an equal amount. The annual yield on these marketable
securities is 20%. The conversion of these securities into cash entails a fixed cost of cash per order. Assuming
ABC Ltd can sell its marketable securities in any of the five lot size: Rs 1,50,000; Rs 3,00,000; Rs 6,00,000;
Rs7,50,000; Rs 15,00,000; prepare a table indicating the economic lot size using numerical analysis.
Solution:
Formula to calculate
optimal conversion amount: C=2bT/i
Where C=optimal conversion amount/amount of marketable securities converted in to cash per order;
b= cost of conversion into cash per lot/transaction;
T= projected cash requirement during the planning period;
i= interest rate earned per planning period on investment in marketable securities.

7.3 Cash System

Cash system is a new entrant in the Indian Banking Scenario. Cash system is a mechanism to efficiently
manage cash flow in order to reduce risks, minimize costs and maximize profits. Generally Cash Management
comprises integrated collection, payments, liquidity management, and receivables functions. Speedy collection
of outstation instruments is one of the major products under cash system. Cash system offers customized
collection and payment services, which allow companies to reduce the realization time of cheques and
streamline their cash flows. As the companies get access to their funds faster, the need for companies to
borrow cash comes down, and lowers their interest payout. In return, the banks charge the companies a fee
based on the volume of the transaction, the location of the cheque collection centre and speed of delivery.
Some banks even buy the cheques and pay the corporate immediately; charging an interest fee for the number
of days it takes them to in cash the cheques.

7.3.1 Need of Cash System

Managing liquidity is complex, as cash is volatile. For a business spread across various locations, managing
outstation fund-collections and disbursements can often be a time-consuming, expensive and exasperating
proposition. Delays of days or even weeks in realizing outstation cheques, constant tracking and follow-up to
transfer funds from outstation collection accounts, uncertainty and delays regarding information on the fate of
the cheque is common. These affect the company‘s liquidity position and it has to bear a higher interest cost. A
remedy to this hazard surely is the practice of cash management. Business entities with large network of
branches, sales outlets often have client base with wide geographic spread. Getting receivables through
cheques, drafts and other clearing instruments into their possession itself consumes considerable time. Besides,
often they find it difficult to have access to funds at the required time since banks pass on the credit only on
realization. Corporate are not certain of the time lag to get the instruments collected through normal channel of
banks and get the funds credited to their accounts which hinders the treasury management portfolio and strain
their liquidity and profitability. Sectors such as telecom, utility services, mutual funds and insurance
companies benefit most from it because they can pool their receipts from different locations in different forms
(online, cheques, ECS and credit cards) in a seamless manner.

Did You Know?

The first computer-driven cash registers were basically a mainframe computer packaged as a store controller
that could control certain registers.

Caution
The evaluation of credit policy must be conducted for introducing essential amendments.

Case Study-Cash Expenditure Management Solution (Capex)

The Client
India‘s leading food and Beverages Company and largest multinational investor in India. The group has built
an expansive beverage and foods business. To support its operations, our client has established 43 bottling
plants in India, of which 15 are company owned and 28 are franchisee owned.

The Challenge
With growing market establishments and employee strength, it had become vital for our client to put into place
a robust system to handle cash expenditure requests. Hundreds of cash requests are initiated by the plants and
operation units for operational purposes, which kept pending on mails and reported on complex, excel sheets.
With manufacturing and production units being set up across the country; our client faced the complex process
of approvals from numerous managers from across the organization and locations. Critical investment
decisions are often delayed of lost in the volumes of paperwork. In addition, approvals over verbal and email
communication are creating inconsistency. Management lacks visibility and transparency to see where the
requests are pending in the organization tree and expedite the process. The lack of a single, defined process
makes the job of tracking and managing capital expenditure requests difficult and time consuming

Figure 1: Expense management system.

The Solution
COMM-IT consulted our client to implement workflow based business process management solution (BPMS)
to remove bottlenecks in their cash approvals. Developed on Microsoft .NET framework synchronized with
our client‘s investments on Microsoft technology. The solution‘s backbone is its scalable architecture which
embeds BPM engine which is customized to sustain complex organizational hierarchies. The cash requests
now are properly channelized basis its amount and region, the initiator can attach supporting documents for its
approval. Using CAPEX, staff members generate approval requests and managers respond using a single web-
based application. Each request is tracked and managed to provide business managers with up-to-date
information for all capital expenditure purchases. The application allows each request to be submitted,
received, reviewed, approved, tracked, monitored, and reported. Managers are now confident that they are
making the right investment decisions within the company‘s budget ensuring that localized objectives are
aligned with the company‘s strategies.

Questions
1. Discuss the basic challenges of Cash Expenditure Management Solution (Capex).
2. Draw a working flow diagram of Cash Expenditure Management Solution.

7.4 Summary
Automated Clearing House provides a safe, efficient method to move money without the expense of paper
check stock or a wire transfer.
Cash management processes are pre-requisites to execute payments, collect receivables and manage
liquidity.
Speculative motive finds its origin out of the desire of an enterprise to avail itself the benefits of the
opportunities arising at unexpected moments that do not happen to exist in the normal course of business.
Collections system will bring in late accounts at a lower cost than addressing the issue in house, and then
which type of collections firm use.
Marketable securities are temporary investments one company might make in another company, with the
hope of providing higher returns to its investors.

7.5 Keywords
Bad Check Recovery: Focusing primarily on making good bounced checks through direct draft systems,
money order, and other cash based fulfillment.
Cash Flow: It is all about balancing the cash coming into the business with the cash going out.
Cash Management: It is a broad term that refers to the collection, concentration, and disbursement of cash.
Contingency Collections: The agency charges a percentage based on the amount to collect and age of the
account.
Positive Pay: It is a fraud prevention technique used to notify any non-authorized checks before they clear in
account.

7.6 Self Assessment Questions

1. A practical procedure is to protect the business from such calamities like ............losses, fire etc.
(a) debt (b) credit
(c) bad-debt (d) investment

2. Normal and regular payment of cash leads to small reductions in the ............at periodic intervals.
(a) credit balance (b) book balance
(c) cash balance (d) debit balance

3. Managing the channels of collections, payments and accounting information efficiently becomes imperative
with growth in business transaction volumes.
(a) True (b) False

4. The collected funds are transferred to the company‘s central bank accounts operated by the.................
(a) manager (b) head office
(c) accountant (d) None of these

5. Turnover, the inventories as quickly as possible, avoiding stock outs that might result in shutting down the
productions line or loss of sales.
(a) True (b) False

6. The motive of minimizing cash payments is the ultimate benefit derived from ..................receipts
machinery.
(a) maximizing interest (b) cash flow
(c) maximizing cash (d) None of these

7. The cost of having excessively large cash balances is known as the receipt cash balance cost.
(a) True (b) False

8. Pay accounts payables as late as possible without damaging the firm‘s...................

(a) debit rating (b) performance
(c) rate of interest (d) credit rating

9. The Baumol model enables companies to find out their desirable level of cash balance under certainty.
(a) True (b) False

10. Cash system is a mechanism to efficiently manage ..................in order to reduce risks.
(a) cash balance (b) loss
(c) cash flow (d) None of these

7.7 Review Questions

1. Explain the meaning and definition of cash management.
2. Briefly define the scope of cash management in business.
3. What are principles of cash management?
4. Explain the objectives of cash management.
5. What do you understand by procurement and management?
6. What is Baumol model? Explain.
7. Explain the following keywords:
Excess cash balance
Uncertainty
Cash System
8. What do you mean by cash flow?
9. Why we the need of cash system?
10. Write short note on:
Local box system
Cash Planning

Answers for Self Assessment Questions

1. (b) 2. (b) 3. (c) 4. (a) 5. (a)
6. (b) 7.( a) 8.( c) 9.( b) 10. (b)
 8
Inventory Management
CONTENTS
Objectives
Introduction
8.1 Scope of Inventory Management
8.2 Type of Control Required
8.3 Cost of Holding Inventories
8.4 Summary
8.5 Keywords
8.6 Self Assessment Questions
8.7 Review Questions

Objectives
After studying this chapter, you will be able:
Explain the scope of inventory management
Define the type of control required
Describe the cost of holding inventories

Introduction
Many small business owners is one of the more visible and tangible aspects of doing business. Raw materials,
goods in process and finished goods all represent various forms of inventory. In other word, ―Inventory
management is a very important function that determines the health of the supply chain as well as the impacts
the financial health of the balance sheet‖. Inventory management is the process of efficiently overseeing the
constant flow of units into and out of an existing inventory. This process usually involves controlling the
transfer in of units in order to prevent the inventory from becoming too high, or dwindling to levels that could
put the operation of the company into jeopardy. Competent inventory management also seeks to control the
costs associated with the inventory, both from the perspective of the total value of the goods included and the
tax burden generated by the cumulative value of the inventory.

Balancing the various tasks of inventory management means paying attention to three key aspects of any
inventory. The first aspect has to do with time. In terms of materials acquired for inclusion in the total
inventory, this means understanding how long it takes for a supplier to process an order and execute a delivery.
Inventory management also demands that a solid understanding of how long it will take for those materials to
transfer out of the inventory be established. Knowing these two important lead times makes it possible to know
when to place an order and how many units must be ordered to keep production running smoothly. Calculating
what is known as buffer stock is also key to effective inventory management. Essentially, buffer stock is
additional units above and beyond the minimum number required to maintain production levels. For example,
the manager may determine that it would be a good idea to keep one or two extra units of a given machine part
on hand, just in case an emergency situation arises or one of the units proves to be defective once installed.
Creating this cushion or buffer helps to minimize the chance for production to be interrupted due to a lack of
essential parts in the operation supply inventory.

Inventory management is not limited to documenting the delivery of raw materials and the movement of those
materials into operational process. The movement of those materials as they go through the various stages of
the operation is also important. Typically known as a goods or work in progress inventory, tracking materials
as they are used to create finished goods also helps to identify the need to adjust ordering amounts before the
raw materials inventory gets dangerously low or is inflated to an unfavourable level. Finally, inventory
management has to do with keeping accurate records of finished goods that are ready for shipment. This often
means posting the production of newly completed goods to the inventory totals as well as subtracting the most
recent shipments of finished goods to buyers. When the company has a return policy in place, there is usually a
sub-category contained in the finished goods inventory to account for any returned goods that are reclassified
as refurbished or second grade quality. Accurately maintaining figures on the finished goods inventory makes
it possible to quickly convey information to sales personnel as to what is available and ready for shipment at
any given time. In addition to maintaining control of the volume and movement of various inventories,
inventory management also makes it possible to prepare accurate records that are used for accessing any taxes
due on each inventory type. Without precise data regarding unit volumes within each phase of the overall
operation, the company cannot accurately calculate the tax amounts. This could lead to underpaying the taxes
due and possibly incurring stiff penalties in the event of an independent audit.

8.1 Scope of Inventory Management

A significant example concerning inventory management is allocation of responsibilities and authorities.
Inventory control problems can easily arise when for instance nobody is in the organization is responsible for
the inventory or the responsible person has insufficient authorities to carry out the task. Likewise, high
inventory values indicating a lack of control may just be the result of inaccurate inventory records or of a
reporting system that does not function well control and efficiency are the essence of Inventory Management
program and it is what Scope does best.

Our complete customers-focused solution to Inventory Management makes sure that we have the products
need when need them. The Inventory Management program begins with a foundation that is focused on basic
data integrity. From there, the concentration is on combining an effective and disciplined application of best
practices and proven processes that rely on this data to establish a baseline for improvement. Scope builds high
quality inventory databases from real shelf inventory, purchasing files and current inventory data. We then
insure the appropriate identifying and purchasing information is associated with each inventoried item and
provides systems and solutions to maintain the inventory databases. Scope can help regain control and manage
inventory. Unlike many consulting and integration companies that simply make recommendations and leave to
make it happen, Scope can implement the suggested solutions and integrate them with current inventory
management program. We can manage a project from beginning to end, or in phases, as budget, timeline, and
resource needs dictate.
8.1.1 Inventory Management and Evaluation
Decisions about the desired level of inventory are difficult to relate to the goal of shareholder wealth
maximization. Presumably maintenance of inadequate inventories could reduce profitability and create
additional uncertainty about shareholders returns. Whether such added risk can be diversified away is open to
question but some tendency to raise risk premiums contained in the cost of capital and to reduce the value of
equity shares may be present. In the other direction, excessive inventory levels may reduce risk of production
disruptions as well as risk premiums in the cost of capital may also raise carrying costs more than enough to
offset such gains. The precise optimum point, in a valuation sense is by no means clear. However, in
determining valuation method to use, consideration is given to the size and turnover of inventories, the price
outlook, tax laws, and prevailing practices in the field. The financial manager‘s influence will be felt
particularly in establishing underlying policies, while the expert in the different areas play important roles in
evaluating the implication f different procedures from the view point of their specialties.

The evaluation of inventory is significant from the stand-point of both the balance sheet and the income
statement. In the former, the inventory valuation influences the cutting assets, the total assets, the ratio
between current assets and current liabilities and the retained earnings. In the later the inventory evaluation
may influence the cost of goods sold and the net profits. Under the normal circumstances, financial statements
reflecting the results of the operation of a business enterprise during a particular period are preferred on a
going concern basis. Consistent with this concept of continuing operations, there will always be goods on hand
available for sale. The goods owned at the end of an accounting periodical seldom be exactly comparable to
the goods in which the opening inventory, but the purpose of inventory will be the same; to make possible
uninterrupted realization of income through sales.

Average Cost Method

The exact amount of the computed cost for an individual item is generally of little significance. In fact, in the
determination of cost for inventory purpose no one prescribed procedure can be used. For determining the
valuation of inventories, consistency from year to year is of prime importance and for this using average costs
rather than specifically identified costs seems to be more appropriate. The averaging process is in one sense a
concept of a flow of costs, but it can also be viewed as merely a Compilation of the actual cost for a group of
similar items under circumstances where the amount paid for each item has no significance. The entire group
of items is considered as single entity; and when particular items are separated, they are treated as merely a
proportionate part of the whole. In this method normally weighted average prices are taken, Purchase of each
type of material in stock are taken together and an average price completed. If the prices fluctuate
considerably, many calculations will be involved. It is usual to calculate a new average after each delivery.
The pricing book, if issued and the stores ledger will require frequent amendment. Since average prices are
charged and, therefore whether the charges to production represent current replacement costs depends on the
turnover of the stocks. In a period of rising prices slow turnover will tend to mean that costs which are lower
than present day costs will be charged. In these statements there is an over statement of profit. In appropriate
circumstances the use of the average cost will have a stabilizing effect of prices used for issues and therefore
profits. Computations of income which attempt to reflect the actual flow of goods are not necessarily the most
meaningful to business management, investors or creditors. Each of these groups is normally more concerned
with what the future earning of the business enterprise will be than with the amount which could be realized
from the inventory if it were liquidated completely and the activity discontinued.

First-In, First-out (FIFO) Inventory Method

Under FIFO method, cost is computed on the assumption that goods sold or consumed are those which have
been longest on hand and that those remaining the stock present the latest purchases or production. Items
received first are assumed to be used first and therefore prices charged are those paid for the early purchases.
Prices charged are actual prices, and therefore there is no question of having to re-calculate a new price each
time a new purchase in received. Care has to be taken to ensure that each quantity is issued at the correct
prices. If prices are rising, costs of products will be understated and therefore profit will tend to be overstated.
On the other hand, stock valuations should approximate current replacement values.

Base Stock Method

Under the base stock method the minimum quantity of raw materials or other goods without which
management considers the operations cannot be continued, except for : limited periods, is treated as being a
fixed asset subject to constant renewal. The base quantity is carried forward at the cost of the original stock. If
a quantity of goods larger than the base stock is owned at the end of any period, the excess will be carried at its
identified cost or at the cost determined under FIFO method. This is considered a temporary condition.
If at the end of an interim accounting period, the inventory of any LIFO group is below the opening inventory,
an estimate should be made of the closing inventory for the year. Assuming that at the interim date no
reduction is expected for the year, cost of sales for the interim period should be charged with the cost of goods
purchased plus an estimated amount to cover the cost to be incurred in making good the temporary decrease in
inventory, and an account should be established (ordinarily shown among current liabilities) for the differences
between the estimated replacement cost and the FIFO inventory cost of the quantities to the interim date.
An indication of the extent to which inventory is composed of raw materials, work in process, and finished
goods may be significant for balance sheet.

The artificiality of paper profits resulting from assigning a larger amount to a closing inventory merely
because market prices have increased-when from the standpoint of physical attributes the opening and the
closing inventories are comparable-has' particular practical significance when tax rates are high only the
income remaining after paying taxes can be used to replace inventories, expand the plant, pay dividends and so
forth. The higher the taxes the lower is the rate of earnings, and the greater is the proportion of the year's
earnings needed to maintain inventories during a period of rising prices. Assuming no additional capital is
invested for this purchase, the portion of net earnings of business needed to maintain the inventory required for
continuing operations during a period of rising X costs can be expressed as a formula. If
I-Cost of inventory at the beginning of the year T-Turnover rate for the inventory investment
R-Rate of earnings stated as the percentage which the net income after tax is of the total cost of goods for the
year.
Net Earnings = I x T x R
Income tax rates are significant in the analysis of the consequences of 'increases in inventory replacements cost
because of their effect on the amount of net earnings. Every increase in income tax rate cause a reduction in
the rate of earnings and results in a larger portion of the net earnings being required to maintain the inventory
during a period of rising costs. Costing an inventory by reference to LIFO assumption to the flow of the costs
will not alter the amount required to maintain or the intrinsic value of the inventory, but its use will tend to
keep the increase in cost out of the computed income from operations. Also, any reduction in the amount of
income taxes payable by a business will result in more case being available to maintain the inventory and for
other needs of the enterprise.

8.1.2 Controlling Inventory

Controlling inventory does not have to be an onerous or complex proposition. It is a process and thoughtful
inventory management. There are no hard and fast rules to abide by, but some extremely useful guidelines to
help thinking about the subject. A five step process has been designed that will help any business bring this
potential problem under control to think systematically thorough the process and allow the business to make
the most efficient use possible of the resources represented. The final decisions, of course, must be the result
of good judgment, and not the product of a mechanical set of formulas.

STEP 1: Inventory Planning

Inventory control requires inventory planning. Inventory refers to more than the goods on hand in the retail
operation, service business, or manufacturing facility. It also represents goods that must be in transit for arrival
after the goods in the store or plant are sold or used. An ideal inventory control system would arrange for the
arrival of new goods at the same moment the last item has been sold or used. The economic order quantity, or
base orders, depends upon the amount of cash (or credit) available to invest in inventories, the number of units
that qualify for a quantity discount from the manufacturer, and the amount of time goods spend in shipment.

STEP 2: Establish order cycles

If demand can be predicted for the product or if demand can be measured on a regular basis, regular ordering
quantities can be set up that take into consideration the most economic relationships among the costs of
preparing an order, the aggregate shipping costs, and the economic order cost. When demand is regular, it is
possible to program regular ordering levels so that stock-outs will be avoided and costs will be minimized. If it
is known that every so many weeks or months a certain quantity of goods will sold at a steady pace, then
replacements should be scheduled to arrive with equal regularity. It is useful to focus on items whose costs
justify such control, recognizing that in some cases control efforts may cost more the items worth. At the same
time, it is also necessary to include low return items that are critical to the overall sales effort. If the business
experiences seasonal cycles, it is important to recognize the demands that will be placed on suppliers as well
as other sellers.

A given firm must recognize that if it begins to run out of product in the middle of a busy season, other sellers
are also beginning to run out and are looking for more goods. The problem is compounded in that the producer
may have already switched over to next season‘s production and so is not interested in (or probably even
capable of) filling any further orders for the current selling season. Production resources are likely to already
be allocated to filling orders for the next selling season. Changes in this momentum would be extremely costly
for both the supplier and the customer. On the other hand, because suppliers have problems with inventory
control, just as sellers do, they may be interested in making deals to induce customers to purchase inventories
off season, usually at substantial savings. They want to shift the carrying costs of purchase and storage from
the seller to the buyer. Thus, there are seasonal implications to inventory control as well, both positive and
negative. The point is that these seasonable implications must be built into the planning process in order to
support an effective inventory management system.

STEP 3: Balance Inventory Levels

Efficient or inefficient management of merchandise inventory by a firm is a major factor between healthy
profits and operating at a loss. There are both market-related and budget-related issues that must be dealt with
in terms of coming up with an ideal inventory balance:
• Is the inventory correct for the market being served?
• Does the inventory have the proper turnover?
• What is the ideal inventory for a typical retailer or wholesaler in this business?
To answer the last question first, the ideal inventory is the inventory that does not lose profitable sales and can
still justify the investment in each part of its whole. An inventory that is not compatible with the firm‘s market
will lose profitable sales. Customers who cannot find the items they desire in one store or from one supplier
are forced to go to a competitor. Customer will be especially irritated if the item out of stock is one they would
normally expect to find from such a supplier. Repeated experiences of this type will motivate customers to
become regular customers of competitors.

STEP 4: Review Stocks

Items sitting on the shelf as obsolete inventory are simply dead capital. Keeping inventory up to date and
devoid of obsolete merchandise is another critical aspect of good inventory control. This is particularly
important with style merchandise, but it is important with any merchandise that is turning at a lower rate than
the average stock turns for that particular business. One of the important principles newer sellers frequently
find difficult is the need to mark down merchandise that is not moving well. Markups are usually highest when
a new style first comes out. As the style fades, efficient sellers gradually begin to mark it down to avoid being
stuck with large inventories, thus keeping inventory capital working. They will begin to mark down their
inventory, take less gross margin, and return the funds to working capital rather than have their investment
stand on the shelves as obsolete merchandise. Markdowns are an important part of the working capital cycle.
Even though the margins on markdown sales are lower, turning these items into cash allows purchase other,
more current goods, where we can make the margin desire.

Keeping an inventory fresh and up to date requires constant attention by any organization, large or small. Style
merchandise should be disposed of before the style fades. Fad merchandise must have its inventory levels kept
in line with the passing fancy. Obsolete merchandise usually must be sold at less than normal markup or even
as loss leaders where it is priced more competitively. Loss leader pricing strategies can also serve to attract
more' consumer traffic for the business thus creating opportunities to sell other merchandise as well as well as
the obsolete items. Technologically obsolete merchandise should normally be removed from inventory at any
cost. Stock turnover is really the way businesses make money. It is not so much the profit per unit of sale that
makes money for the business, but sales on a regular basis over time that eventually results in profitability.
Turnover averages are available for virtually any industry or business maintaining inventories and having
sales. These figures act as an efficient and effective benchmark with which to compare the business in
question, in order to determine its effectiveness relative to its capital investment. Too frequent inventory turns
can be as great a potential problem as too few. Too frequent inventory turns may indicate the business is trying
to overwork a limited capital base, and may carry with it the attendant costs of stock-outs and unhappy and lost
customers.

Stock turns or turns over, is the number of times the "average" inventory of a given product is sold annually. It
is an important concept because it helps to determine what the inventory level should be to achieve or support
the sales levels predicted or desired. Inventory turnover is computed by dividing the volume of goods sold by
the average inventory. Stock turns or inventory turnover can be calculated by the following equations:

Stock Turn = Cost of Goods Sold/Average Inventory at Cost inventory for a given period of time.

If the inventory is recorded at cost, stock turn equals cost of goods sold divided by the average inventory. If
the inventory is recorded at sales value, stock turn is equal to sales divided by average inventory. Stock turns
four times a year on the average for many businesses. Jewelry stores are slow, with two turns a year and
grocery stores may go up to 45 turns a year. In the accumulation of comparative data for any particular type of
firm, a wide variation will be found for most significant statistical comparisons. Averages are just that, and
often most firms in the group are somewhat different from that result. Nevertheless, they serve as very useful
guides for the adequacy of industry turnover, and for other ratios as well. The important thing for each firm is
to know how the firm compares with the averages and to deter- mine whether deviations from the averages are
to its benefits or disadvantage.
STEP 5: Follow-up and Control
Periodic reviews of the inventory to detect slow-moving or obsolete stock and to identify fast sellers are
essential for proper inventory management. Taking regular and periodic inventories must be more than just
totaling the costs. Any clerk can do the work of recording an inventory. However, it is the responsibility of key
management to study the figures and review the items themselves in order to make correct decisions about the
disposal, replacement, or discontinuance of different segments of the inventory base. Just as an airline cannot
make money with its airplanes on the ground, a firm cannot earn a profit in the absence of sales of goods.
Keeping the inventory attractive to customers is a prime prerequisite for healthy sales. Again, the seller's
inventory is usually his largest investment. It will earn profits in direct proportion to the effort and skill applied
in its management. Inventory quantities must be organized and measured carefully. Minimum stocks must be
assured to prevent stock-outs or the lack of product. At the same time, they must be balanced against excessive
inventory because of carrying costs. In larger retail organizations and in many manufacturing operations,
purchasing has evolved as a distinct new and separate phase of management to achieve the dual objective of
higher turnover and lower investment. If this type of strategy is to be utilized, however, extremely careful
attention and constant review must be built into the management system in order to avoid getting caught short
by unexpected changes in the larger business environment.

Did You Know?

By the 1980s the first inventory control computer programs that could run on a PC were starting to see use.

8.2 Type of Control Required

It concerns most managers of agricultural marketing and supply businesses, whether they are retail, wholesale,
or service oriented. The value of a manager to a marketing and supply business depends on his ability to
manage inventories effectively. The total cost of maintaining the desired inventory level must be held down to
a reasonable figure, but the inventory must also be large enough to permit the company to effectively
merchandise the products and services it sells. If the manager does not control his inventories to accomplish
both of these objectives, the business may not be able to prosper or even to survive against competition.

8.2.1 Controlling Inventories

Purchase systematically: Place orders for materials long enough beforehand so there will not be a shortage
between ordering and delivery. Let the inventory become relatively low before reordering but keep enough on
hand to meet current needs. There are costs associated with keeping large inventories. Likewise, there are costs
if we deplete stock. Do not hold ―dead‖ lines or items.

Keep track of inventories. When stock is received, be sure that what was ordered was delivered. Make sure
that the amount received is added to the inventory. Physical inventories should be taken frequently to find out
which items are not selling so we can discontinue them as quickly as possible, to spot shortages in
merchandise that may be due to theft, to note deterioration that may occur, and to decide when to reorder.

Make someone responsible for checking the inventory: Delegate the responsibility for specific parts of the
total inventory effort to the persons in the organization who are best qualified to do the job. Be sure those to
whom we delegate responsibility know exactly what they are supposed to do.

Use storage facilities efficiently: Assign space to each item in stock. Arrange the storage area to permit the
handling of stock with the least amount of effort and in such a way that stock can be easily found, the quantity
determined and recorded, and the stock removed if necessary. Arrange the warehouse and sales area so the
items that sell rapidly can be most easily picked up by the customer or restocked in the display area readily by
the employees. Use mechanical means to handle and move supplies whenever the volume warrants it. This will
reduce the amount of labor used in handling stock. Plan to use space interchangeably with seasonal items and
thus reduce the cost of storage space.

Be aware of inventory turnovers: Know what the turnover of each commodity is and if possible compare this
with the turnover of the same items by other similar firms. Inventory turnover ratio is determined by dividing
the volume of sales of merchandise by the level of inventory at a point in time, such as the first of each month.
For example, the sales of fertilizer in May amounted to INR 143,000 and the fertilizer inventory at the end of
May was INR 16,300. The inventory turnover ratio for May thus was INR 143,000/INR 16,300, or 8.8 to 1.
That is, there was an INR 8.80 turnover of fertilizer for every dollar‘s worth in stock at the end of the period a
zero inventory, which would give a ratio of infinity, would not be desirable because the objective of
management is to maintain the level of inventory at a level that will permit the most effective merchandising.
The most profitable inventory turnover ratio varies with each commodity. Generally, high inventory is needed
for rapidly moving commodities if the merchandising effort is going to be efficient and effective. Good
examples of this are feed and grain. Other commodities move more slowly but require that a small stock be on
hand at all times. Farm machinery is a good example of this. The demand for some items, such as seed, is
seasonal and requires large inventories at certain times of the year. Increase selling efforts or reduce the
average stock of slow-moving items. If an item cannot be sold, discontinue stocking it immediately. Dead
items are real losers

Know the costs of inventories: Because costs of inventories are very closely related to size of inventories, the
manager should keep his inventory as small as possible consistent with a good merchandising program.
The costs of carrying inventories can be a large percentage of the sale value of the inventory. The costs are
often 20-25% or more of the total value of the inventory.

Avoid holding lines of merchandise that: Compete with one another. Stocking too many lines is asking for
inventory problems. Choose the lines of merchandise carefully and then vigorously sell a limited number of
lines. Duplication of items that occurs when the company carries multiple lines can more easily result in larger
inventories and increased inventory holding costs.

8.3 Cost of Holding Inventories

Management of inventory is a powerful driver of financial performance. In response to slowing growth and
pressures on profitability, many companies today are exploring new ways to manage inventory better.
Improved inventory management frees up cash to be invested elsewhere, allows products to be sold at lower
prices, facilitates entrance into new markets, and delivers other benefits that improve financial performance
and create competitive advantage. The importance of inventory management, there appears to be little
consensus on how to estimate the real cost of holding inventory the total cost. Knowing that cost is key to
analyzing the benefits and costs associated with any inventory management initiative. The main factors
comprising the total cost of holding inventory, which include both noncapital carrying costs and the capital
carrying charge. We explain why supply chain management professionals need to develop better estimates of
noncapital carrying costs to calculate the true value of projects designed to reduce inventory. Exclusion or
minimization of these costs can understate the value of supply chain initiatives and can result in rejection of
projects that should be accepted. It also explains that many companies are using a cost of capital that
significantly understates the inventory capital carrying charge and thereby leads to non optimal decisions in
such areas as transportation, sourcing, and network design. We demonstrate why use of a weighted average
cost of capital is a better approach and how, in the end, it leads to better inventory-management decisions.

8.3.1 Total Cost of Holding Inventory

The elements that make up the total cost of holding inventory (inventory noncapital carrying costs plus
inventory capital charge). This total cost is often expressed as a percentage of the overall investment in
inventory to facilitate comparison over time and across companies. We have found that many companies use a
noncapital carrying cost of around 10%. The challenge that they have is making credible estimates of the
noncapital carrying cost components for decision-making purposes. Another major challenge centers on the
cost-of-capital figures used. Many companies apply a rate in the neighbourhood of 5%, which significantly
understates the reality. For the great majority of companies, an inventory capital charge of least 15% (meaning
before-tax cost of capital) is more appropriate. Before laying out the methodology for arriving at a more
accurate capital-charge number, we first briefly review issues related to estimating inventory noncapital
carrying costs.

8.3.2 Inventory Noncapital Carrying Costs

It estimates that at a macro level, noncapital carrying costs are approximately 19% of inventory. Our
experience, however, is that the average rate applied companies is closer to 10%. This percentage tends to vary
by industry with a key driver being risk of obsolescence. One retailer we studied, for example, used a rate of
6% while an electronics company used a 15% rate. There are several challenges in estimating inventory
noncapital carrying costs. For one, many companies‘ information systems do not capture these costs in a way
that provides useful information for decision making. While this cost information may be captured at an
enterprise-wide level and applied to total inventory, often it is not available for a product line, geography,
customer group, or channel. Another challenge understands how these costs, which can be fixed or variable,
vary with changes in inventory. For example, a reduction in inventory resulting from improved supply chain
management tends to reduce obsolescence, insurance, and taxes. But unless there is a significant change in the
network design, warehousing and other inventory-related costs tend to remain about the same.

When evaluating supply chain initiatives, companies often discount or even omit the benefits of reducing
inventory noncapital carrying costs because they do not possess credible estimates of these costs. Most agree
that these benefits exist. But without credible estimates, the benefits typically are excluded from the analysis.
This practice is understandable. Nevertheless, if the impact on these costs cannot be reasonably measured, the
true value of many supply chain initiatives will be understated. For example, suppose an initiative is expected
to permanently reduce inventory by INR10 million. The variable noncapital carrying costs as a percentage of
inventories are 10% the marginal tax rate is 40% and the after-tax cost of capital is 9%. The equation below
shows that the value of this initiative is the change in the total value of inventory. That value is INR10 million
if noncapital carrying costs are excluded. However, the value is substantially higher—almost INR7 million
higher—when the impact on noncapital carrying costs is included.

8.3.3 Inventory Capital Charge

The inventory capital charge is calculated as: inventory × cost of capital. When calculated correctly, this
charge often exceeds the noncapital carrying costs. Unfortunately, the capital charge often is underestimated
because the wrong cost of capital is applied. Typically, this is the result of one of two factors: (1) a mismatch
between the risk of inventory and the cost of capital, or (2) the mixing of after-tax capital charges with before-
tax noncapital carrying charges. Let us first The cost of capital is one of the most important concepts in finance
and a key building block in valuation and in estimating total costs. Unfortunately, it is often viewed as one of
the more esoteric financial concepts. Plus, it is one of the most confusing for those who must use it for
decision making. This confusion often stems from a lack of understanding of what comprises the cost of
capital and the nature of risk-return relationships.

Simply stated, the cost of capital is the opportunity cost of investing in an asset relative to the expected return
on assets of similar risk. This is comparable to how we evaluate investments in our personal lives. For
example, suppose that over the last year earned 8% on a portfolio of stocks. How well did portfolio perform?
To answer this question, many of us compare the return on our portfolio to the performance of an index of
stocks of similar risk. If our portfolio is comprised of a well-diversified group of stocks, we likely would use
an index like the S&P 500. Suppose that over the last year, the S&P 500 returned 6%. Then our return of 8%
compares favourably. If the S&P 500 returned 10%, on the other hand, then that 8% return was less
favourable.

8.3.4 The Weighted Average Cost of Capital

Given the inherent risk of inventory, we recommend that companies use a weighted average cost of capital
(WACC) to calculate the inventory capital charge. WACC is the opportunity cost for a company‘s average risk
investment. Theoretically, a different WACC should be applied to investments of different risk. But as a
practical matter, the same weighted average cost typically is applied internally to all investments unless there
is a substantial difference in risk. WACC is comprised of the cost of equity and the after-tax cost of debt. The
cost of equity is the cost of providing shareholders competitive returns on their invested dollars. The cost of
debt is simply the overall interest rate on the debt taken on to finance the project, reduced by the tax benefit of
interest expense. Expressed as a percentage, cost of capital is the average of the required return on equity and
the interest rate on debt, weighted by the proportion of equity and debt, respectively, to total capitalization.
The concept of the weighted average cost of capital can be explained within the context of one‘s personal
investment portfolio. Suppose portfolio has 30% invested in corporate bonds that have an expected return of
6%. The remaining 70% is invested in stocks with a long-term expected return of 11%. The weighted average
expected return on portfolio is approximately 9.5% (30% × 6% + 70% × 11%).In evaluating the future value
of retirement savings and other decisions; we would use the blended rate of 9.5%.

8.3.5 Determining Inventory Costs

Inventory costs are real but they are also difficult to determine because they cannot be taken directly from
accounting records. Inventory costs for individual items make it necessary to prorate costs of equipment,
space, labour for handling, utilities, insurance, taxes on land and buildings, depreciation on buildings and
handling equipment, clerical help, unemployment insurance for certain personnel, social security for all
―space,‖ ―handling,‖ and ―inventory service‖ personnel, and a proportionate share of administrative overhead.
The cost of holding inventories may make the payoff so great that the manager cannot afford not to do it. Also,
when inventory costs have been determined once, it is a much simpler task to make the necessary adjustments
in each of the costs.
One way to view the total annual cost of carrying inventory is as a percentage of total inventory value. For
example, if a company‘s average inventory is INR 25,000 and the average inventory carrying cost is 20%, it
will cost the company INR 5,000 per year to carry an average inventory of INR 25,000. An inventory holding
cost that is 20% of the average value of inventory is probably too low. Estimates of inventory holding costs for
agricultural supply businesses usually range from 20 35 %. The costs that need to be included in the total
inventory carrying cost are:

Storage space costs: These include taxes on land and buildings; insurance on buildings; depreciation on
buildings and warehouses owned; rent (if paid); materials for repairs and maintenance on buildings; utilities;
and janitor, watchman, and maintenance costs.
Handling costs: These include depreciation on equipment; fuel for equipment; maintenance and repair of
equipment and insurance and taxes on equipment.

Risk costs on inventory: These include insurance on inventory; obsolescence of inventory; physical
deterioration of inventory; pilferage; and losses resulting from inventory price declines.

Inventory service costs: These include taxes on inventory; labour costs of handling and maintaining stock
clerical costs for inventory records; contribution to Social Security by employer based on prorated time
devoted to inventories by employees; unemployment compensation insurance based on prorated time of
―inventory involved‖ personnel; employer contribution to pension plans, and group life, health, and accident
insurance programs based on prorated time of ―inventory involved‖ personnel; and an appropriate
proportionate share for administrative overhead, including all taxes, Social Security, pension, and employer
contributions to insurance programs for administrative personnel who are involved.

Capital costs: These include interest on money invested in inventory; interest on money invested in inventory
handling and control equipment; and interest on money invested in land and buildings to store inventory (if
land and buildings are owned).

Cost summary: The information about the hypothetical company that follows shows how a manager can
develop a better understanding of how he can use the knowledge he has about inventory holding costs to make
better management decisions.

Caution
Time should be spent developing a system tailored to the needs of each business.

Did You Know?

A team at Harvard University designed the first modern Inventory Management check-out system in the early
1930s.

Case study-OrthoRehab Improves Inventory Management with BlackBerry

OrthoRehab provides an advanced technology called Continuous Passive Motion (CPM) that helps
postoperative patients exercise limbs and joints to promote faster healing. Managing this inventory – more
than 17,000 pieces of equipment – was proving ineffective with their current paper-based method. Paperwork
was lagging two to four weeks behind service and support, leaving the company unsure of where its equipment
was and slowing down their billing processes. In 2003, they looked at leveraging their current BlackBerry®
solution for management into the field. The field solution involved barcode scanning with BlackBerry
handhelds, deployed with Flowfinity Forms, an electronic forms application. Each of the 173 OrthoRehab
field workers was equipped with a laser scanner tethered to a BlackBerry handheld, so CPM units could be
instantly scanned, electronically recorded at patient sites and the information relayed wirelessly to the
corporate headquarters.
The company received compelling ROI, such as:
A reduction in inventory tracking paperwork and an increase in accurate reporting
More efficiency in separating billing and inventory tracking
Financial losses reduced by $250,000/year in unreported losses
Increased employee productivity and enhanced patient care
Reduced administrative work in updating the master database OrthoRehab had always tracked its
inventory using a paper-based process. Their Patient Service Representatives manually completed a form
 every time one of the company‘s CPM units was transferred to a patient, hospital or clinic. The form was
faxed to regional or corporate centers, where it was transferred to an electronic billing database. With more
than 17,000 pieces of equipment in rotation at all times, paperwork lagged two to four weeks behind
services. The lack of precision meant 2,000 to 3,000 devices could show up missing during an inventory
period, costing the company both time and money.

Investigating a Wireless Solution

In 2001, OrthoRehab began looking for a better way, with electronic tracking through another mobility
solutions provider. A limited roll out tested a combined PDA and scanner. The results were unimpressive.
With a battery life of less than one day, and the need to synch the device to a desktop computer, the company
found the solution was not meeting its goals. The price also proved prohibitive, at $1,500 per device.
―We just wanted to come up with a way for inventory to be recorded electronically every time it was touched,‖
says Brian Tower, Director of Information Technology. ―I was also trying to separate inventory from billing.
Because the two had been joined for so long, it was having a negative effect on our revenue.‖ In 2003, already
using BlackBerry for senior levels of management, they realized the solution could also be used in the field.
―We figured out that we could take information from a device, communicate it to the BlackBerry handheld and
then bring it into our database,‖ says Tower.

A wireless inventory tracking solution was built on the BlackBerry handheld, with a tethered scanner, using a
Flowfinity application for tracking and forms. The system would run over AT&T‘s GSM/GPRS network.
BlackBerry could offer its well-documented superior battery life, giving mobile workers a reliable solution at a
competitive price per handheld. BlackBerry push technology meant that field workers were always online,
receiving important data in close to real-time, rather than having to dial-up or synch up handhelds at the end of
the day. All of this was enabled on the BlackBerry Enterprise Serve.

Seamless Integration
Minimal time was required for system integration, largely because the Java™ platform used with BlackBerry
is engineered for ease of deployment across multiple systems. It took a developer only one month to integrate
the new solution with the existing Microsoft .NET system. Tower and his team used Flowfinity Forms, a data
collection application, to develop electronic versions of the original paper forms. No custom programming was
required to make these forms digital and the software was up-and-running within 72 hours. Each of the 173
field workers – including Patient Service Representatives and sales representatives – was given a BlackBerry
handheld with a laser-tethered scanner. The user simply scanned the barcode on the CPM units at the patient
site. They then input data into a simple form on their BlackBerry handheld, which was wirelessly sent to
corporate headquarters, where it was entered into the billing system.

―The second that we sent the handhelds out there, it really increased everyone‘s effectiveness,‖ says Tower.
OrthoRehab can now see where their inventory is at-a-glance and which patients have been set up with CPM
units. Improved inventory tracking has increased the accountability of individual regional offices. The
electronic forms and barcode scanning eliminated human errors (a major concern for health care providers),
such as illegible information or having product serial numbers recorded incorrectly. Before, OrthoRehab found
itself relying on billing to track the movement of their inventory. With much of their inventory going
unreported because of the inefficiencies of the system, they were losing revenue. They now estimate saving
$250,000 annually with their new wireless solution. The billing process is faster, accurate and inventory can
be tracked up-to-the-minute.
―Compared to what we were losing,‖ says Tower, ―it‘s practically a no-brainer as far as how quick we‘re going
to pick up our investment.
The solution was both a necessity and an investment well worth making.‖
In addition, BlackBerry has helped improve security. Under HIPPA, companies like OrthoRehab must follow
certain guidelines when transmitting patient data to ensure the patient‘s privacy. Under the old system,
confidential information was faxed over phone lines, which do not guarantee security. With Triple DES
encryption, OrthoRehab is now able to securely communicate patient data. The greatest benefits have certainly
been felt at the bottom line. Now that OrthoRehab can track its inventory better, they can also order it more
effectively. ―If we can obtain goods at a lower cost and get inventory to somebody more quickly, then the
bottom line is felt by everyone,‖ says Tower.

Unexpected Benefits
But there were spin-off benefits that Ortho Rehab did not expect. ―BlackBerry has become the norm for our
organization now,‖ says Tower.
―When field workers realized that so much of what they do on a day-to-day basis could be rolled up in this
little device and how much more efficient they could be, then a few heads started to turn.‖ In fact, 80% of
OrthoRehab‘s 225 staff uses BlackBerry on a regular basis. Productivity has improved because of the
integrated features of a BlackBerry handheld – mobile email access, phone and calendaring. ―Before we pretty
much lived and died by cell phones and pagers,‖ says Tower. ―If people had to check their email, they would
run into their local offices and connect via some type of remote access.‖ Email accessibility on BlackBerry
handhelds has even helped Patient Service Representatives locate patients‘ houses more easily. Locating an
address used to require a phone call and a fax back with directions from a regional office. This could result in
lost productivity as employees stood at fax machines waiting for paperwork to come through. Now, reps go
online and find the directions themselves on their handhelds.

―Just that kind of thing alone is knocking off two hours a day,‖ says Tower.
―For years, the field was pushing us to supply them with laptops,‖ says Tower. ―But with BlackBerry, they
already get email and calendar.
So the push back from the field for laptops became almost nil and we could retire the need for that program
and expense.‖

The Future
Everyone at OrthoRehab is excited about the opportunities that have opened up as a result of the wireless
solution. They now have a list of potential new applications. The next project they have planned is to transfer
their patient agreement form from paper to a wireless application.
Tower and his team are working to recreate this form on the BlackBerry handheld, which will eventually allow
them to easily transfer the information to their database. Other forms that are candidates for this kind of
process include insurance information, co-pays and even physician prescriptions.
―We have just started down this road and there are so many opportunities ahead of us,‖ says Tower. ―Whatever
we consolidate and get into a form on the BlackBerry handheld is going to be a win for us.
The Benefits
While OrthoRehab has discovered excellent financial ROI, they have equally enjoyed the unexpected benefits
of their new wireless solution, including:
A reduction in inventory tracking paperwork and an increase in accurate reporting
Billing and inventory tracking separated for greater efficiency
Financial losses reduced by $250,000/year in unreported losses
Increased employee productivity and improved patient care
 Reduced administrative work in updating the master database
Expedited processes enables more rapid billing
Greater employee morale and more communication between mobile and office employees.
Questions
1. Discuss the Investigating a Wireless Solution of Inventory Management with BlackBerry.
2. Define the conclusions of the OrthoRehab Improves Inventory Management with BlackBerry.

8.4 Summary
Inventory management is the process of efficiently overseeing the constant flow of units into and out of an
existing inventory.
The evaluation of inventory is significant from the stand-point of both the balance sheet and the income
statement.
Controlling inventory does not have to be an onerous or complex proposition. It is a process and
thoughtful inventory management.
The inventory capital charge is calculated as: inventory × cost of capital.
Inventory costs are real but they are also difficult to determine because they cannot be taken directly from
accounting records

8.5 Keywords
Handling costs: These include depreciation on equipment; fuel for equipment; maintenance and repair of
equipment and insurance and taxes on equipment.
Inventory management: ―Inventory management is a very important function that determines the health of the
supply chain as well as the impacts the financial health of the balance sheet‖.
Inventory Planning: Inventory control requires inventory planning. Inventory refers to more than the goods
on hand in the retail operation, service business, or manufacturing facility.
Risk costs on inventory: These include insurance on inventory; obsolescence of inventory; physical
deterioration of inventory; pilferage; and losses resulting from inventory price declines.
Weighted Average Cost of Capital (WACC): The weighted average cost of capital (WACC) is the rate that a
company is expected to pay on average to all its security holders to finance its assets.

8.6 Self Assessment Questions

1. One use of inventory is
(a) To provide a hedge against inflation.
(b) to tightly link a firm's production with its customers' demand.
(c) to ensure that item cost is maximized.
(d) to tightly link production and distribution processes.

2. The evaluation of inventory is significant from the stand-point of both the balance sheet and the income
statement.
(a) true (b) false

3. Controlling inventory does not have to be .

(a) complex position (b) complex proposition
(c) Both (a)and(b) (d) complex
4. Management of inventory is a powerful driver of performance
(a) pecuniary (b) material
(c) financial (d) none of these

5. The inventory capital charge is calculated as:

(a) inventory × cost of capital (b) inventory × charge of capital
(c) inventory × value of capital (d) inventory × price of capital

6. Inventory management is a very important function that determines the health of the supply chain as well as
the impacts the financial health of the balance sheet.
(a) detailed report (b) balance sheet
(c) account book (d) balance plate

7. Efficient or inefficient management of merchandise inventory by a firm is a major factor between and
operating at a loss
(a) healthy gain (b) healthy benefit
(c) healthy profits (d) healthy margin

8. Stock turnover is really the way businesses make .

(a) riches (b) money
(c) wealth (d) rich

9. The cost of capital is the opportunity cost of investing in an asset relative to the expected return on assets of
.
(a) identical risk. (b) equal risk.
(c) likerisk. (d) similar risk.

10. is the opportunity cost for a company‘s average risk investment.

(a) WACC. (b) WbCC.
(c) WACS (d) WACD.

8.7 Review Questions

1. State the significance of inventory management.
2. What is the first-out (FIFO) inventory method?
3. What measures are taken for controlling inventories?
4. Explain the cost of holding inventories.
5. What do you understand by inventory capital charge?
6. What are the factors that determine inventory costs?
7. What do you understand by the weighted average cost of capital?
8. Explain the balance inventory levels.
9. What do you understand by the inventory management and evaluation?
10. Discuss the average cost method.
Answers for Self Assessment Questions
1. (a) 2. (a) 3. (b) 4. (c) 5. (a)
6. (b) 7.(c) 8.(b) 9.(d) 10. (a)
 9
Break Even Analysis
CONTENTS
Objectives
Introduction
9.1 Meaning of Breakeven Analysis
9.2 Breakeven Point Analysis
9.3 Importance of Breakeven Analysis
9.4 Cost-Volume-Profit (C-V-P) Relationship
9.5 Contribution of P/V Ratio (Profit/Volume Ratio)
9.6 Summary
9.7 Keywords
9.8 Self Assessment Questions
9.9 Review Questions

Objectives
After studying this chapter, you will be able:
Define the meaning of breakeven analysis
Explain breakeven point analysis
Discuss the importance of breakeven analysis
Explain the cost-volume-profit (c-v-p) relationship
Describe the contribution of p/v ratio (profit/volume ratio)

Introduction
Break-even analysis is a technique widely used by production management and management accountants. It is
based on categorizing production costs between those which are ―variable‖ (costs that change when the
production output changes) and those that are ―fixed‖ (costs not directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume,
sales value or production at which the business makes neither a profit nor a loss (the ―break-even point‖).
The costs that vary with a decision should only be included in decision analysis. For many decisions that
involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed
costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the
short term or managers are reluctant to alter them in the short term. Marginal costing distinguishes between
fixed costs and variable costs as convention ally classified. The marginal cost of a product ―is its variable
cost‖. This is normally taken to be; direct labor, direct material, direct expenses and the variable part of
overheads.

9.1 Meaning of Breakeven Analysis

The break-even Analysis lets we determine what us need to sell, monthly or annually, to cover ourselves costs
of doing business—our break-even point. Example shows the Break-even Analysis table:

Table9.1: Break-even analysis

The Break-even Analysis table calculates a break-even point based on fixed costs, variable costs per unit of
sales, and revenue per unit of sales.

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity
shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The
point at which neither profit nor loss is made is known as the "break-even point" and is represented on the
chart below by the intersection of the two lines:

Figure 9.1: Line OA represents.

In the Figure 9.1 above, the line OA represents the variation of income at varying levels of production activity
(―output‖). OB represents the total fixed costs in the business. As output increases, variable costs are incurred,
meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than
Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is
made.

Fixed Costs
Fixed costs are those business costs that are not directly related to the level of production or output. In other
words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the
same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g.
adding a new factory unit) or through the growth in overheads required to support a larger, more complex
business.
Examples of fixed costs:
Rent and rates
Depreciation
Research and development
Marketing costs (non- revenue related)
Administration costs

Variable Costs
Variable costs are those costs which vary directly with the level of output. They represent payment output-
related inputs such as raw materials, direct labor, fuel and revenue-related costs such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a particular product or
service and allocated to a particular cost centre. Raw materials and the wages those working on the production
line are good examples. Indirect variable costs cannot be directly attributable to production but they do vary
with output. These include depreciation (where it is calculated related to output - e.g. machine hours),
maintenance and certain labor costs.

Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorizing business costs, in
reality there are some costs which are fixed in nature but which increase when output reaches certain levels.
These are largely related to the overall "scale" and/or complexity of the business. For example, when a
business has relatively low levels of output or sales, it may not require costs associated with functions such as
human resource management or a fully-resourced finance department. However, as the scale of the business
grows (e.g. output, number people employed, number and complexity of transactions) then more resources are
required. If production rises suddenly then some short-term increase in warehousing and/or transport may be
required. In these circumstances, we say that part of the cost is variable and part fixed.

9.2 Breakeven Point Analysis

Breakeven point is the level of sales at which profit is zero. According to this definition, at breakeven point
sales are equal to fixed cost plus variable cost. This concept is further explained by the following equation:
Breakeven Sales = Fixed Cost + Variable Cost
The breakeven point can be calculated using either the equation method or contribution margin method. These
two methods are equivalent.

9.2.1 Equation Method

The equation method centers on the contribution approach to the income statement. The format of this
statement can be expressed in equation form as follows:
Profit = (Sales − Variable expenses) − Fixed expenses
Rearranging this equation slightly yields the following equation, which is widely used in cost volume profit
(CVP) analysis:
Sales = Variable expenses + Fixed expenses + Profit
According to the definition of breakeven point, breakeven point is the level of sales where profits are zero.
Therefore the breakeven point can be computed by finding that point where sales just equal the total of the
variable expenses plus fixed expenses and profit is zero.

Example
For example we can use the following data to calculate breakeven point.
Sales price per unit = INR250
Variable cost per unit = INR150
Total fixed expenses = INR35,000
Calculate breakeven Point:
Calculation:
Sales = Variable expenses + Fixed expenses + Profit
INR250Q* = INR150Q* + INR35, 000 + INR0**
INR100Q = INR35000
Q = INR35, 000 /INR100
Q = 350 Units
Q* = Number (Quantity) of units sold.
**The breakeven point can be computed by finding that point where profit is zero
The breakeven point in sales dollars can be computed by multiplying the breakeven level of unit sales by the
selling price per unit.
350 Units × INR250 Per unit = INR87, 500

9.2.2 Contribution Margin Method

The contribution margin method is actually just a short cut conversion of the equation method already
described. The approach centers on the idea discussed earlier that each unit sold provides a certain amount of
contribution margin that goes toward covering fixed cost. To find out how many units must be sold to break
even, divide the total fixed cost by the unit contribution margin.
Breakeven point in units = Fixed expenses / Unit contribution margin
INR35, 000 / INR100* per unit
350 Units
*INR250 (Sales) − INR150 (Variable exp.)
A variation of this method uses the Contribution Margin ratio (CM ratio) instead of the unit contribution
margin. The result is the break even in total sales dollars rather than in total units sold.
Breakeven point in total sales dollars = Fixed expenses / CM ratio
INR35, 000 / 0.40
= INR87, 500
This approach is particularly suitable in situations where a company has multiple products lines and wishes to
compute a single breakeven point for the company as a whole.
The following formula is also used to calculate breakeven point
Break Even Sales in Dollars = [Fixed Cost / 1 – (Variable Cost / Sales)]
This formula can produce the same answer:
Break Even Point = [INR35, 000 / 1 – (150 / 250)]
= INR35, 000 / 1 – 0.6
= INR35, 000 / 0.4
= INR87, 500

9.2.3 Assumption of Break Even Point

The Break-even Analysis depends on three key assumptions:
Average Per-Unit Sales Price (Per-Unit Revenue)
This is the price that receives per unit of sales. Take into account sales discounts and special offers. Get this
number from Sales Forecast. For non-unit based businesses, make the per-unit revenue INR1 and enter our
costs as a percent of a dollar. The most common questions about this input relate to averaging many different
products into a single estimate.

Average Per-Unit Cost

This is the incremental cost, or variable cost, of each unit of sales. If we buy goods for resale, this is what one
paid, on average, for the goods sell. If we sell a service, this is what it costs, per dollar of revenue or unit of
service delivered, to deliver that service. If we are using a Units-Based Sales Forecast table (for manufacturing
and mixed business types), we can project unit costs from the Sales Forecast table. If we are using the basic
Sales Forecast table for retail, service and distribution businesses, use a percentage estimate, example, a retail
store running a 50% margin would have a per-unit cost of .5, and per-unit revenue of 1.

Monthly Fixed Costs

Technically, a break-even analysis defines fixed costs as costs that would continue even if we went broke.
Instead, we recommend that we use our regular running fixed costs, including payroll and normal expenses
(total monthly Operating Expenses). This will give a better insight on financial realities. If averaging and
estimating is difficult, use Profit and Loss table to calculate a working fixed cost estimate it will be a rough
estimate, but it will provide a useful input for a conservative Break-even Analysis.

9.3 Importance of Breakeven Analysis

The Breakeven Point in a business is when it's not making a profit or losing money Sounds simple, right?
Well, Breakeven Point is? Probably not. Most business owners either do not know it or think they know it,
with neither exactly knowing Breakeven can be expressed as a Dollar amount or Unit Sales and once
determined, one have a Target to reach through a carefully thought out Business Plan. Without an established
Breakeven Target, our Strategic Plan is floundering. It is very important to understand that increased Sales do
not always translate into increased Profits. Many companies have gone out of business by ignoring the
importance of Breakeven Analysis, thinking increased Sales will lead to certain Profitability Unfortunately,
more often than not, the company's Variable Costs, or those directly derived from sales levels, get
exponentially larger as Sales Volume Grows. Not knowing the Variable Costs is a silent killer for many
companies.
We do not make a profit until we cover all the variable costs incurred, and all the fixed costs. The point at
which this is reached is known as the "breakeven point". And the more we sell after this point is reached, the
more profit is made. We can calculate where this point is by dividing our overheads (i.e. the fixed costs) by
our Gross Profit margin. Let's take an example.

Gross Profit margin: 35%

Overheads: INR200, 000

Breakeven: INR200, 000 / .35 = INR571,428

That is, we would need sales of INR571, 428 just to cover all fixed costs. All sales after that point would
contribute a 35% of the value of sale to our profits. So the lower gross profit margin the flatter the sales line on
graph, and the more have to sell before break even. If our fixed costs increase, and there are no other changes,
then we will have to sell more before we make a profit. We can increase our overall profits by going out -
increasing sales. Or we can do so by going up, selling lower volumes but with greater margins.

Advantages of Break Even Analysis

The main advantages of breakeven point analysis are that it explains the relationship between cost, production,
volume and returns. It can be extended to show how changes in fixed cost, variable cost, commodity prices,
and revenues will affect profit levels and break even points. Break even analysis is most useful when used with
partial budgeting, capital budgeting techniques. The major benefits to use break even analysis are that it
indicates the lowest amount of business activity necessary to prevent losses.

Disadvantages of Breakeven Analysis

• Assumes that sales prices are constant at all levels of output.
• Assumes production and sales are the same.
• Breakeven charts may be time consuming to prepare.
• It can only apply to a single product or single mix of products.

9.3.1 Marginal Costing

Marginal costing is formally defined as: ‗the accounting system in which variable costs are charged to cost
units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special
value is in decision making‘ (Terminology).
The term ‗contribution‘ mentioned in the formal definition is the term given to the difference between Sales
and Marginal cost. Thus

Marginal Cost = Variable Cost Direct Labor + Direct Material + Direct Expense + Variable Overheads

Contribution Sales Marginal Cost

The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal
costs of a department or batch or operation. The meaning is usually clear from the context.

Theory of Marginal Costing

The theory of marginal costing as follows:
In relation to a given volume of output, additional output can normally be obtained at less than proportionate
cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the
aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease
in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, by understood in the following two steps:
1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an
output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of INR3, 000 and
if by increasing the output by one unit the cost goes up to INR3, 002, the marginal cost of additional
output will be INR.2.
2. If an increase in output is more than one, the total increase in cost divided by the total increase in output
will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from
1000 units and the total cost to produce these units is INR1, 045, the average marginal cost per unit is
INR2.25. It can be described as follows:
3.
= INR2.25

The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and
variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning
of marginal cost. Marginal cost means the cost of the marginal or last unit produced. It is also defined as the
cost of one more or one less unit produced besides existing level of production. In this connection, a unit may
mean a single commodity, a dozen, a gross or any other measure of goods. For example, if a manufacturing
firm produces X unit at a cost of INR 300 and X+1 units at a cost of INR 320, the cost of an additional unit
will be INR 20 which is marginal cost. Similarly if the production of X-1 units comes down to INR 280, the
cost of marginal unit will be INR 20 (300–280).

The marginal cost varies directly with the volume of production and marginal cost per unit remains the same.
It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain
any element of fixed cost which is kept separate under marginal cost technique. Marginal costing may be
defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for
managerial decision-making. Rather it is simply a method or technique of the analysis of cost information for
the guidance of management which tries to find out an effect on profit due to changes in the volume of output.
There are different phrases being used for this technique of costing. Marginal costing is a popular phrase, it is
known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal
costing. Marginal costing technique has given birth to a very useful concept of contribution where contribution
is given by: Sales revenue less variable cost (marginal cost) Contribution may be defined as the profit before
the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal
to fixed cost plus profit (C = F + P). In case a firm neither makes profit nor suffers loss, contribution will be
just equal to fixed cost (C = F). This is known as breakeven point. The concept of contribution is very useful in
marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V
ratio which remains the same under given conditions of production and sales.

9.4 Cost-Volume-Profit (C-V-P) Relationship

C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically, we all are concerned with in-
depth analysis and application of CVP in practical world of industry management. Marginal cost varies
directly with the volume of production or output. On the other hand, fixed cost remains unaltered regardless of
the volume of output within the scale of production already fixed by management. In case if cost behavior is
related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable
cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then
there is a change in profit. Being a manager, one constantly strives to relate these elements in order to achieve
the maximum profit. Apart from profit projection, the concept of Cost-Volume-Profit (CVP) is relevant to
virtually all decision-making areas, particularly in the short run. The relationship among cost, revenue and
profit at different levels may be expressed in graphs such as breakeven charts, profit volume graphs, or in
various statement forms. Profit depends on a large number of factors, most important of which are the cost of
manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales depends upon
the volume of production and market forces which in turn is related to costs. Management has no control over
market. In order to achieve certain level of profitability, it has to exercise control and management of costs,
mainly variable cost. This is because fixed cost is a non-controllable cost.

But then, cost is based on the following factors:

• Volume of production
• Product mix
• Internal efficiency and the productivity of the factors of production
• Methods of production and technology
• Size of batches
• Size of plan

Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This
enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes
in price of product/services.

Following are the three approaches to a CVP analysis:

• Cost and revenue equations
• Contribution margin
• Profit graph

Objectives of Cost-Volume-Profit Analysis

1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on
one hand and volume on the other.
2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of
activities.
3. Cost-volume-profit analysis assists in evaluating performance for the purpose of control.
4. Such analysis may assist management in formulating pricing policies by projecting the effect of different
price structures on cost and profit.

Limitations of Cost-Volume Profit Analysis

The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of
which may not occur in practice
Following are the main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not
undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast
with reasonable accuracy the volume of sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant which in reality is
difficult to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship
between cost and profit will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all
levels of activity and fixed cost remains constant throughout the range of volume being considered. However,
such situations may not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant, though sometimes they
may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock
carried over to the next financial year does not contain any component of fixed cost. Inventory should be
valued at full cost in reality

Sensitivity Analysis or What If Analysis and Uncertainty

Sensitivity analysis is relatively a new term in management accounting. It is a ―what if‖ technique that
managers use to examine how a result will change if the original predicted data are not achieved or if an
underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers the following questions:
a. What will be the operating income if units sold decrease by 15% from original prediction?
b. What will be the operating income if variable cost per unit increases by 20%?
The sensitivity of operating income to various possible outcomes broadens the perspective of management
regarding what might actually occur before making cost commitments. A spreadsheet can be used to conduct
CVP-based sensitivity analysis in a systematic and efficient way. With the help of a spreadsheet, this analysis
can be easily conducted to examine the effect and interaction of changes in selling prices, variable cost per
unit, fixed costs and target operating incomes.

9.5 Contribution of P/V Ratio (Profit/Volume Ratio)

When the contribution from sales is expressed as a sales value percentage, then it is known as profit/volume
ratio (or P/V ratio). The relationship between the contribution and sales is expressed by it. Sound ‗financial
health‘ of a company‘s product is indicated by better P/V ratio. The change in profit due to change in volume
is reflected by this is reflected by this ratio. If expressed on equal footing with sales, it will show how large the
contribution will appear. If size of sales is INR 100, then P/V ratio of 60% will mean that contribution is INR
60.
One important characteristic of P/V ratio is that at all levels of output it will remain constant because at
various levels, variable cost as a proportion of sales remains constant. When P/V ratio is considered in
conjunction with margin of safety, it becomes particularly useful. P/V ratio can be referred by other terms like:
(a) marginal income ratio, (b) contribution to sales ratio, and (c) variable profit ratio.
P/V ratio may be expressed as:
P/V ratio= Contribution / Sales
= (Sales – Variable cost)/ Sales
= (1- Variable cost)/ Sales
Or, P/V ratio = (Fixed Cost + Profit)/ Sales
It is also possible to express the ratio in terms of percentage by multiplying by 100. Thus a relationship
between the contribution and sales is established by the profit/volume ratio. Hence it might be better to call it
as a Contribution/Sales ratio (or C/S ratio), though the term Profit/Volume ratio (P/V ratio) is now widely
called.

Also, by comparing the change in contribution to change in sales or by change in profit to change in sales, it is
possible to compute the ratio. Because it is assumed that the fixed cost will remain the same at different levels
of output, an increase in contribution will mean increase in profit.
Thereby, P/V ratio = (Change in contribution)/ Change in sales
= Or, Change in profit / Change in Sales
Improvement in P/V ratio should always be tried to be bought in by the management. The higher the rate, the
greater will be the contribution towards fixed costs and profit.
Improvement of P/V Ratio
By the following ways, an improvement in this ratio can be achieved by:
1. The selling price increase; but the risk that the volume of sales might be affected in involved in it.
2. By purchasing the latest machinery, a reduction in the variable cost per unit can be achieved, thereby
cutting the hours which may be required to complete each operation. However, higher fixed costs such as
depreciation and insurance might offset this reduction.
3. By concentrating on those products by which highest contribution can be achieved.
4. For doing business analysis, in the hands of management, the P/V ratio is an invaluable tool.

Advantages of P/V Ratio

Some of its uses are under mentioned:
1. This ratio determines profitability of a line of product and also overall profitability of a number of
products;
2. This ratio compares the profitability of different lines of products, sales, companies, factories etc.
3. This ratio calculates break-even sales, profit at different levels of output, turnover which may be required
for a desired profit or to offset reduction in price or to meet increased expenditure.

Limitations of P/V Ratio

Using of P/V ratio for deciding the product-worthy additional sales efforts and productive capacity and host of
other managerial exercises; is a growing trend among managers.
Following are the limitations of the use of P/V ratio:
1. On excess of revenues over variable cost, the P/V ratio heavily leans on.
2. The capital outlays that are required by the additional productive capacity and the additional fixed costs,
that are added, are not taken into consideration by the P/V ratio.
3. The profitable products lines which might be emphasized and unprofitable product lines which might be
re-evaluated for elimination, can be suggested by the inspection of P/V ratio of the products. Final
decision cannot be taken by mere inspection of P/V ratio. For this purpose, for taking into consideration
differential cost of the decision and opportunity costs etc, analysis has to be broadened. Thereby, only the
area that needs to be probed is indicated.
4. Because only an indication regarding the relative profitability of the products or product lines is given by
the P/V ratio, for the purpose of decision making, it has been referred to as the questionable device. P/V
ratio are good for forming impression and not for making decision provided other things are equal.

Margin of Safety
A principle of investing in which an investor only purchases securities when the market price is significantly
below its intrinsic value. In other words, when market price is significantly below our estimation of the
intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with
minimal downside risk.
The term was popularized by Benjamin Graham (known as "the father of value investing") and his followers,
most notably Warren Buffett. Margin of safety does not guarantee a successful investment, but it does provide
room for error in an analyst's judgment. Determining a company's "true" worth (its intrinsic value) is highly
subjective. Each investor has a different way of calculating intrinsic value which may or may not be correct.
Plus, it's notoriously difficult to predict a company's earnings. Margin of safety provides a cushion against
errors in calculation. Margin of safety is a concept used in many areas of life, not just finance. For example,
consider engineers building a bridge that must support 100 tons of traffic. Would the bridge be built to handle
exactly 100 tons? Probably not, it would be much more prudent to build the bridge to handle, say, 130 tons, to
ensure that the bridge will not collapse under a heavy load. The same can be done with securities. If one feel
that a stock is worth INR10, buying it at INR7.50 will give you a margin of safety in case your analysis turns
out to be incorrect and the stock is really only worth INR9. There is no universal standard to determine how
wide the "margin" in margin of safety should be. Each investor must come up with his or her own
methodology.

The formula or equation for the calculation of margin of safety is as follows:

Margin of Safety = Total budgeted or actual sales − Breakeven sales
The margin of safety can also be expressed in percentage form. This percentage is obtained by dividing the
margin of safety in dollar terms by total sales. Following equation is used for this purpose.
Margin of Safety = Margin of safety in dollars / Total budgeted or actual sales

Example
Sales (400 units INR250) INR100, 000
Break even sales INR87, 500
Calculate margin of safety

Calculation:
Sales (400units @INR250) INR100, 000
Break even sales INR87, 500
---------------
Margin of safety in dollars INR 12,500
Margin of safety as a percentage of sales:
12,500 / 100,000
= 12.5%
It means that at the current level of sales and with the company's current prices and cost structure, a reduction
in sales of INR12, 500, or 12.5%, would result in just breaking even. In a single product firm, the margin of
safety can also be expressed in terms of the number of units sold by dividing the margin of safety in dollars by
the selling price per unit. In this case, the margin of safety is 50 units (INR12, 500 ÷ INR 250 units = 50 units).

Did You Know?

Benjamin Graham and David Dodd, founders of value investing, coined the term margin of safety in their
seminal 1934 book, Security Analysis.

Caution
It should be clearly understood that marginal costing is not a method of costing like process costing or job
costing.

Case Study-Maximizing Category Sales by Optimizing Product Mix

Situation
An internet based, home delivery service had moved from a start-up mode into a phase of improving and
refining its business model. As a part of this effort, the company established a goal to optimize its category,
brand and SKU portfolio to best meet the needs of its consumer base. This goal resulted in the need to assess
select categories in order to ensure that the category‘s brand and SKU portfolio offered maximum sales
opportunities and aligned with consumer demographics while streamlining supply chain logistics.
Several factors were contributing to under optimized category and brand selections, including:
A decentralized stocking process that resulted in an inconsistent approach to product mix (categories,
brands and SKUs varied widely market to market).
 Critical sub-categories/segments were not stocked in some markets.
Brand/SKU selection was not aligned with consumer demographics/preferences/trends.
Products specific to local market preferences were not being uniformly maximize.
DHC was asked to assess several categories (Food, HBC, General Merchandise, Magazines) and to
provide product mix optimization recommendations.

Solution
To develop recommendations for an improved product mix, DHC conducted a number of key analyses:
Identification of the roles that each category would play (destination, routine, occasional, convenience).
Outside, relevant industry research reviews designed to supplement the client‘s proprietary data and to
provide a broader industry perspective (ACNielsen, IRI, Harrington, and Progressive Grocer).
KAD Analysis (keep/add/drop) – a detailed, SKU level analysis for each category, segment, brand to
determine which SKUs should be stocked.
Segment Opportunity Analysis – by combining client specific market basket analyses and syndicated data,
DHC projected the volume potential for key category segments.
Consumer Segmentation Analyses – combined consumer demographic, product demographic and client
consumer profile data, designed to ensure that the product mix was aligned with the client‘s customer mix.
Numerous Pareto analyses.

These analyses enabled DHC to determine the relevant market drivers that would result in an optimized
product mix and an efficient assortment.
These analyses provided the foundation for DHC to provide a comprehensive series of recommendations,
including:
1. Establishment of category roles and a decision criteria for future evaluation of new categories
2. Determination of the categories and segments to carry
3. Suggested SKUs to stock within each segment
4. Regional brands and SKUs that would address local market tastes and preferences

Result
In addition to implementing DHC‘s product mix recommendations, the client adopted a centralized approach
to category roles and SKU selection. Products stocked were uniform across markets but each market was
permitted to stock products with strong local appeal. The client was able to reduce inventories while offering a
stronger, more targeted and relevant product mix. This approach also resulted in stronger corporate purchasing
power and more favorable pricing/terms from suppliers. Supply chain logistics were improved due to a more
consolidated SKU line-up. All of these factors contributed to improved corporate operating margins.
Questions
1. What are the situation maximizing category sales by optimizing product mix?
2. Explain the DHC‘s product mix.

9.6 Summary
Breakeven point is the level of sales where profits are zero. Therefore the breakeven point can be
computed by finding that point where sales just equal the total of the variable expenses plus fixed expenses
and profit is zero.
The main advantages of breakeven point analysis are that it explains the relationship between cost,
production, volume and returns.
 Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one
more or one less unit produced besides existing level of production.
C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically, we all are concerned with
in-depth analysis and application of CVP in practical world of industry management.
The CVP analysis is generally made under certain limitations and with certain assumed conditions, some
of which may not occur in practice.
When the contribution from sales is expressed as a sales value percentage, then it is known as
profit/volume ratio (or P/V ratio).
Using of P/V ratio for deciding the product-worthy additional sales efforts and productive capacity and
host of other managerial exercises; is a growing trend among managers.
When market price is significantly below our estimation of the intrinsic value, the difference is the margin
of safety.

9.7 Keywords
Break Even Analysis: It can be extended to show how changes in fixed cost, variable cost, commodity prices,
and revenues will affect profit levels and break even points.
Break-even chart: It is a graphical representation of costs at various levels of activity shown on the same chart
as the variation of income (or sales, revenue) with the same variation in activity.
Breakeven point: It is the level of sales at which profit is zero. At breakeven point sales are equal to fixed cost
plus variable cost.
Fixed costs: There are those business costs that are not directly related to the level of production or output.
Marginal costing: It is the accounting system in which variable costs are charged to cost units and the fixed
costs of the period are written-off in full against the aggregate contribution.

9.8 Self Assessment Questions

1. The point at which neither profit nor loss is made is known as the ...........
(a) lower point (b) break-even point
(c) high point (d) target point

2. The contribution margin method is actually just a short cut conversion of the ...............
(a) graphic method (b) euler method
(c) fixed costs (d) equation method

3. Inventories are not valued at variable cost and fixed cost is treated as period cost.
(a) True (b) False

4. P/V ratio=
(a) Sales/Contribution (b) Contribution + Sales
(c) Contribution / Sales (d) None of these

5. Margin of Safety = Total budgeted or actual sales − Breakeven sales

(a) True (b) False

6. The term margin of safety was popularized by ..................

(a) Mark (b) Benjamin Graham.
(c) Graham Lio (d) None of these

7. Marginal Cost =
(a) Variable Cost Direct Labor + Direct Material + Variable Overheads.
(b) Variable Cost Direct Labor + Direct Expense + Variable Overheads.
(c) Variable Cost Direct Labor + Direct Material + Direct Expense .
(d) Variable Cost Direct Labor + Direct Material + Direct Expense + Variable Overheads.

8. The major benefits to use break even analysis are that it indicates the lowest amount of business activity
necessary to prevent losses.
(a) True (b) False

9. We do not make a profit until we cover all the variable costs incurred, and all the fixed costs.
(a) True (b) False

10. The selling price..........; but the risk that the volume of sales might be affected in involved in it.
(a) decrese (b) increase
(c) constant (d) None of these

9.9 Review Questions

1. What do you understand by breakeven analysis?
2. Explain the break-even chart.
3. Write short note on:
Fixed costs
Semi-variable costs
4. Describe equation method of breakeven point analysis.
5. What is assumption of breakeven point?
6. What are advantages of break even analysis?
7. Describe marginal costing.
8. What are objectives of cost-volume-profit analysis?
9. Explain limitations of cost-volume profit analysis.
10. What are advantages of p/v ratio and limitations of p/v ratio?

Answers for Self Assessment Questions

1. (b) 2. (d) 3. (b) 4. (c) 5. (a)
6. (b) 7.(d) 8.(a) 9.(a) 10. (b)
 10
Dividend Policy
CONTENTS
Objectives
Introduction
10.1 Importance of Dividend Policy
10.2 Objectives and Determinants of Dividend Policy
10.3 Types of Dividends
10.4 Walter's Model (Relevant)
10.5 Summary
10.6 Keywords
10.7 Self Assessment Questions
10.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Define the importance of dividend policy
Describe the objectives and determinants of dividend policy
Discuss the types of dividend
Understand the Walter's Model (Relevant)

Introduction
A dividend is nothing but a periodic sharing of profit by the company with its share holders. The dividend is
usually declared as a percent of the face value of the share. A 100% dividend on a share with a face value of 1
rupee means we would get rupee 1 for every share of that company hold. Once a company makes a profit,
management must decide on what to do with those profits. They could continue to retain the profits within the
company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the
company decides on whether to pay dividends they may establish a somewhat permanent dividend policy,
which may in turn impact on investors and perceptions of the company in the financial markets. What they
decide depends on the situation of the company now and in the future. It also depends on the preferences of
investors and potential investors. Dividend policy is the policy used by a company to decide how much it will
pay out to shareholders in dividends. In financial accounting course, learn that after deducting expense from
the revenue, a company generates profit. Part of the profit is kept in the company as retained earnings and the
other part is distributed as dividends to shareholders. From the share valuation model, the value of a share
depends very much on the amount of dividend distributed to shareholders. Dividends are usually distributed in
the form of cash (cash dividends) or share. When a company distributes a cash dividend, it must have
sufficient cash to do so. This creates a cash flow issue. Profit generated may not be in the form of cash. We
may verify this by looking at the cash flow statement of a company. A company may have profit of INR400
million but the cash only increase by INR190 million in a financial year. This is a concern to the management
as insufficient cash may mean the company is unable to distribute a dividend. Investors earn returns from their
shares in the form of capital gains and dividend yield. Dividend yield is an important ratio in evaluating
investment.

Dividend payout ratio is another important indicator:

Dividend payout ratio = Dividend per share ÷ Earnings per share

This ratio indicates how much of the profit is distributed as dividend to shareholders. The higher the dividend
payout ratio, the more attractive the share is to shareholders.

Dividend payout ratios vary among companies.

10.1 Importance of Dividend Policy

The purpose of business is the creation and maximization of profit. Profit management often becomes more of
a hoped-for effect of other business decisions, rather than a proactively predicted, managed and measured core
goal. It is ironic that the creation of profit is the central focus of all business activities, yet most of us spend our
time managing the factors which produce profit rather than managing profitability directly. Instead of making
decisions that indirectly influence profit, executives should be attempting to determine the effects of their
decisions on profitability ahead of time. Proactive profit management allows us to know the effects on
profitability of different resource allocations before we make the decision as to which resource to use. For
example if change 20% of our lower-profit activities to higher-profit activities, how does that affect on final
margin? If decide to tie our sales commissions more to profitability than volume, how will that add to our
margins?

The most successful organizations are those with the greatest ability to grow and manage profit. Since business
environments and variables are constantly changing it is essential that scarce business resources be
consistently reallocated to the most profitable activities. Profit is not necessarily in direct proportion to
production volume and machine loading. Activity and productivity, whether it is people or equipment, are two
entirely different elements. In business the most fundamental measure of productivity is profit contribution.
Most production records will tell management how well a piece of equipment operates, but not its contribution
to overall productivity. Ideally, when we compare contribution margin to production volume, the similarly, if
we divide customers into high/medium/low profitability, then the most profitable customers should be
consuming the most organizational resources. Sales efforts and incentives should also be devoted to the
highest profit product lines and marketplaces, and so on.
What many companies do not have is the ability to collect, interpret and use this information in a topical or
meaningful manner. Most of this information is only available to management in summary form through the
period reports produced by their accounting system. This information while necessary for other reasons is at
best ancient history and often is not relevant in making day to day manufacturing, estimating and pricing
decisions. Management must be diligent in interpreting these known facts and using them for the creation of
maximum profit.
(1) Desire for Current Income: Some investors like old persons, widow‘s etc. desire to get stable current
income to meet their living expenses. They invest their savings in shares with a view to get regular income for
their living. If they get low dividend, they would be compelled to sell some of their shares to meet their living
expenses. So they would prefer to invest in shares of those companies which pay regular and stable dividend
and would be prepared to pay a little high price for shares of such companies.
(2) Removes Investors Uncertainty: The stable dividend policy removes uncertainty in investors' mind about
dividend payment. Even if the earnings of the company decline and the company continues to pay the constant
amount of dividend, it would indicate that the management views the bright future prospects for the company.
Thus, the changes or no changes in dividends work as a source of information about firm's profitability.
(3) Additional Finance: The credit standing and prestige of the company paying stable dividend increases in
the eyes of the investors. When the company wants to raise additional finance, investors would be willing to
buy its shares or debentures. Particularly, small investors requiring regular income would like to invest their
savings in shares of companies paying stable dividends. Even the preference shares and debentures of such
companies would be easily subscribed, as the investors feel that such company would pay regular interest or
dividend.

Advantages of Stable Dividend Policy are:

As it offers the following advantages, the stable dividend policy is considered to be the best.

(A) Advantages to Investors

Investors prefer stable dividend policy due to following reasons:
1. Confidence among Shareholders. A regular and stable dividend payment creates confidence and removes
uncertainty from the minds of the shareholders. It presents a bright future of the company and thus gives
confidence to the shareholders.
2. Income Conscious Investors. As the investors are generally income conscious they favor a stable rate of
dividend and never an unstable rate of dividend.
3. Stability in Market Price of Shares. Other things being equal, the market prices vary with the rate of
dividend the company declares on its equity shares. The values of shares of a company having a stable
dividend policy do not fluctuate widely even if the earnings of the company are lower than the previous year.
Thus, this policy stabilizes the market price of the stock.
4. Encouragement to Institutional Investors. A stable dividend policy attracts institutional investors who
generally prepare a list of securities, mainly incorporating the securities of the companies having stable
dividend policy in which they invest their surpluses or their long-term funds such as pensions or provident
funds etc.

(B) Advantages to Company

A company is itself benefited by stable dividend policy in the following manner:
I. Increase in Goodwill and Credit of the Company. Stability and regularity of dividends affects the market
price of shares and increases the general credit of the company that pays the company in the long run.
2. Financial Planning. A company with stable dividend policy may formulate its financial planning faster and
easily because the financial manager can correctly estimate the future demand and supply of capital in the
firm. Timing of dividend payment can be forecasted easily by preparing cash flow statement.

Disadvantages
However, the stable dividend policy is not without any drawbacks. The greatest danger associated with a stable
dividend policy is that once it is adopted by the firm, it cannot be changed without seriously affecting the
company. Therefore it is prudent that the dividend rate is fixed at a lower level so that it can be maintained
even in years with reduced profits.

10.2 Objectives and Determinants of Dividend Policy

Determinants of dividend policy
The main determinants of dividend policy of a firm can be classified into:
1. Dividend payout ratio
2. Stability of dividends
3. Legal, contractual and internal constraints and restrictions
4. Owner's considerations
5. Capital market considerations and
6. Inflation.

Dividend payout ratio

Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as
dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the
firm. The retained earnings constitute a source of finance. The dividend payout ratio of a firm should be
determined with reference to two basic objectives – maximizing the wealth of the firm‘s owners and providing
sufficient funds to finance growth. These objectives are interrelated.

Stability of dividends
Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of
dividends can take any of the following three forms:
constant dividend per share
constant dividend payout ratio or
constant dividend per share plus extra dividend

Legal, contractual and internal constraints and restrictions

Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends
must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual
restrictions may be accepted by the company regarding payment of dividends when the company obtains
external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain
level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of
earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, and financial
requirements, availability of funds, earnings stability and control.

Owner's considerations
The dividend policy is also likely to be affected by the owner's considerations of the tax status of the
shareholders, their opportunities of investment and the dilution of ownership.

Capital market considerations

The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm
has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access
to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings
as a major source of financing for future growth.
Inflation
With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace
obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to
replace those assets. Thus, inflation affects dividend payout ratio in the negative side.

10.3 Types of Dividends

A dividend is generally considered to be a cash payment to the holders of company stock. However, there are
several types of dividends, several of which do not involve the payment of cash to shareholders. These
dividend types are:

Cash dividend: The cash dividend is by far the most common of the dividend types used. On the date of
declaration, the board of directors resolves to pay a certain dividend amount in cash to those investors holding
the company's stock on a specific date. The date of record is the date on which dividends are assigned to the
holders of the company's stock. On the date of payment, the company issues dividend payments.

Stock dividend: Stock dividend is paid in the form of the company stock due to rising of more finance. Under
this type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue is given only
to the existing shareholders of the business concern. A stock dividend is the issuance by a company of its
common stock to its common shareholders without any consideration. If the company issues less than 25
percent of the total number of previously outstanding shares, treat the transaction as a stock dividend. If the
transaction is for a greater proportion of the previously outstanding shares, then treat the transaction as a stock
split. To record a stock dividend, transfer from retained earnings to the capital stock and additional paid-in
capital accounts an amount equal to the fair value of the additional shares issued. The fair value of the
additional shares issued is based on their fair market value when the dividend is declared.

Property dividend: Property dividends are paid in the form of some assets other than cash. It will distribute
under the exceptional circumstance. This type of dividend is not published in India
A company may issue a non-monetary dividend to investors, rather than making a cash or stock payment.
Record this distribution at the fair market value of the assets distributed. Since the fair market value is likely to
vary somewhat from the book value of the assets, the company will likely record the variance as a gain or loss.

Scrip dividend: A company may not have sufficient funds to issue dividends in the near future, so instead it
issues a scrip dividend, which is essentially a promissory note (which may or may not include interest) to pay
shareholders at a later date. This dividend creates a note payable.

Liquidating dividend: When the board of directors wishes to return the capital originally contributed by
shareholders as a dividend, it is called a liquidating dividend, and may be a precursor to shutting down the
business. The accounting for a liquidating dividend is similar to the entries for a cash dividend, except that the
funds are considered to come from the additional paid-in capital account.

Regular Dividend: By dividend we mean regular dividend paid annually, proposed by the board of directors
and approved by the shareholders in general meeting. It is also known as final dividend because it is usually
paid after the finalization of accounts. It is generally paid in cash as a percentage of paid up capital, say 10 %
or 15 % of the capital. Sometimes, it is paid per share. No dividend is paid on calls in advance or calls in
arrears. The company is, however, authorized to make provisions in the Articles prohibiting the payment of
dividend on shares having calls in arrears.
Interim Dividend: If Articles so permit, the directors may decide to pay dividend at any time between the two
Annual General Meeting before finalizing the accounts. It is generally declared and paid when company has
earned heavy profits or abnormal profits during the year and directors which to pay the profits to shareholders.
Such payment of dividend in between the two Annual General meetings before finalizing the accounts is called
Interim Dividend. No Interim Dividend can be declared or paid unless depreciation for the full year (not
proportionately) has been provided for. It is, thus,, an extra dividend paid during the year requiring no need of
approval of the Annual General Meeting. It is paid in cash.

Dividend in Asset Form: If company is unable to pay dividend in cash or share form, company can pay
dividend by giving any his asset as gift form. Then, this type of dividend will be asset form dividend.

Final Dividend: Final dividend is given after declaring the final result of company in the form of financial
statements. Final and proposed dividend wills same if interim dividend is given in trial balance and final
dividend is given outside of trial balance.

Unclaimed Dividend: Unclaimed dividend is that dividend which declared by not claimed by a specific
shareholder. Suppose, information of dividend was sent but letter was returned to company due to any reason.

Bond Dividend: Bond dividend is also known as script dividend. If the company does not have sufficient
funds to pay cash dividend, the company promises to pay the shareholder at a future specific date with the help
of issue of bond

10.4 Walter's Model (Relevant)

Prof. James E. Walter argues that the choice of dividend policies almost always affect the value of the firm.
His model is based on the following assumptions
1. Internal financing: The firm finances all investment through retained earnings; i.e. debt or new equity is not
issued.

2. Constant return and cost of capital: the firm‘s rate of return, r , and its cost of capital, k , are constant.

3. 100% payout or retention: All earnings are either distributed as dividends or reinvested internally
immediately.

4. Infinite time: the firm has infinite life

Valuation Formula: Based on the above assumptions, Walter put forward the following formula:

P = DIV + (EPS-DIV) r/k

k
P = market price per share
DIV= dividend per share
EPS = earnings per share
DIV-EPS= retained earnings per share

r = firm‘s average rate of return

k= firm‘s cost o capital or capitalization rate
The above equation is reveals that the market price per share is the sum of two components:
The first component k
b. The second component (EPS-DIV) r/k is the present value of an infinite stream of
k returns from retained earnings.
Let us apply the theoretical formula to a practical illustration to improve our understanding. We will take three
models, one of a growth firm, the other normal firm and a declining firm.

Gordon’s Model
A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a
constant rate. Given a dividend per share that is payable in one year, and the assumption that the dividend
grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future
dividends.

Where:
D = Expected dividend per share one year from now
k = required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)

Did You Know?

The equation most always used is called the Gordon growth model. It is named after Myron J. Gordon, who
originally published it in 1959; although the theoretical underpin was provided by John Burr Williams in his
1938 text "The Theory of Investment Value".

Did You Know?

Otto Moritz Walter Model in 1891 – 1945 was a German general and later field marshal during World War II.

Caution
The optimum dividend policy should strike a balance between current dividends and future growth which
maximizes the price of the firm's shares.

Case Study-An Employer’s Guide to Overtime Rules

Completing a journey worthy of Odysseus, the Labour Dept.‘s on-again, off-again, much-debated, and long-
awaited revisions to the overtime pay regulations under the Fair Labour Standards Act took effect on Aug. 23.
Delayed by partisan wrangling for over a year and at various times thought to be near a political death, the
changes are the first significant overhaul of the overtime pay rules in more than 50 years. These Labour
regulations determine which employees are eligible for ―time and a half‖ premium pay for hours worked in
excess of 40 in a workweek, and which employees are ―exempt‖ from the overtime pay requirements.

Organized labour has viewed the regulations as significantly weakening overtime pay protections for many
workers, and even the publication of the final rule in April did not stop Congressional efforts to scuttle the
changes. Now employers must quickly move beyond the role of spectators to a big-picture political saga, and
grapple with the practical effects of the changes on their workforces.

While most employers have already taken substantial steps to ensure compliance with the new regulations, a
number of industry surveys have shown many employers still struggling to come up to speed. Complicating
the compliance effort is the fact that, for many employers, implementing the new regulations will entail their
first comprehensive review of company pay practices in decades.
The Basics
The first step for an employer is to understand what has changed, and what has not. Typically, employees are
eligible for overtime premium pay (as ―non-exempt employees‖) unless they hold positions falling within one
of three ―white collar‖ exemptions.

To fit within these three exemptions -- executive, administrative, and professional a position must both:
1. Require the performance of particular, and typically discretionary, duties; and
2. Be paid on a salaried, rather than hourly, basis, though there are several notable exceptions to the ―salary
basis‖ requirement, including doctors, lawyers, teachers, certain skilled computer professionals, outside
salesmen, and managers who own at least 20% of a business.

The new regulations loosen some of the standards on both prongs of this analysis. They broaden in important
ways the white collar ―duties‖ tests. They also relax some of the criteria for determining whether a position is
truly paid on a ―salary basis‖ (generally, payment of a predetermined amount for a workweek, which does not
vary based on the quality or quantity of work performed) or is instead, effectively, compensated by the hour.

The “Duties” Tests

Executive Employees
As under the current regulations, an ―executive‖ employee must have as her ―primary duty‖ the management
of an enterprise, or a customarily recognized department or subdivision of the enterprise. The ―primary duty‖
test, however, has been made significantly more flexible, both for ―executive‖ positions and for
―administrative‖ and ―professional‖ employees.

First, while duties that involve more than half an employee‘s time will still generally be considered ―primary,‖
the new regulations provide greater leeway for a finding of exempt status, even where less than 50% of the
employee‘s time is taken up with exempt functions.

Second, under the new regulations, non-exempt tasks that are ―directly and closely related‖ to an employee‘s
exempt responsibilities may now be counted as exempt work in determining the employee‘s primary duties.
The standard for what constitutes ―management‖ duties also has been expanded, as has the definition of a
customarily recognized ―department or subdivision‖ of an enterprise. As a result of these changes, a number of
employees previously just outside the executive-employee exemption should now be safely within it.
Nonetheless, even under the new regulations, not every ―manager‖ or supervisor will necessarily be an
―executive.‖

Administrative Employees
Administrative Employees must have as their primary duty the performance of office or no manual work
directly related to the management or general business operations of the employer or the employer‘s customers
-- and those primary duties must include the exercise of discretion and independent judgment with respect to
matters of significance (because of the ―discretion and independent judgment‖ requirement, there are many
―administrative‖ employees in every organization, including most ―administrative assistants,‖ who are not
covered by the ―administrative‖ exemption, and who must be paid overtime premium pay). While this duties
test is largely unchanged under the new regulations, the number of positions likely to meet the test has
increased. The new regulations‘ examples of the types of positions which may be treated as ―administrative,‖
and of the kind of work properly viewed as involving ―discretion and independent judgment,‖ both suggest a
broader compass for this exemption. As well, several existing criteria have been dropped under the new
regulations. These included the requirement that an administrative position must either directly assist another
exempt employee, or perform special projects under only general supervision, and the requirement that
―discretion and independent judgment‖ be exercised ―consistently‖ or ―customarily and regularly.‖

Professional Employees
Professional Employees must have as their primary duties work requiring knowledge of an advanced type,
work in a field of science or learning, or work customarily acquired by a prolonged course of specialized
intellectual instruction. In addition to loosening the ―primary duty‖ test (as discussed above), the new
regulations make clear that occupations whose educational prerequisites involve three years of no specialized
college instruction and a fourth year in an accredited specialized program will generally be exempt.

Highly Compensated Employees

Highly Compensated Employees also create an entirely new class of exempt employees: those with a total
annual compensation of at least INR100,000. So long as these employees customarily and regularly perform at
least one of the exempt duties of an executive, administrative, or professional employee (even if that duty is
not their primary duty), they may be treated as exempt. At least INR455 per week of this compensation,
however, must be paid on a salary or fee basis the balance may be in the form of commissions,
nondiscretionary bonuses, and other non-discretionary income.

Questions
1. What is the employer‘s guide to overtime rules?
2. What are the highly compensated employees?

10.5 Summary
A dividend policy is a company's approach to distributing profits back to its owners or stockholders. If a
company is in a growth mode, it may decide that it will not pay dividends, but rather re-invest its profits
(retained earnings) in the business.
A stock split or stock divide increases the number of shares in a public company. The price is adjusted
such that the before and after market capitalization of the company remains the same and dilution does not
occur.
Prof. James E. Walter argues that the choice of dividend policies almost always affect the value of the
firm.
A bonus share is a free share of stock given to current shareholders in a company, based upon the number
of shares that the shareholder already owns
A reverse stock split or reverse split is a process by a company of issuing to each shareholder in that
company a smaller number of new shares in proportion to that shareholder's original shares that are
subsequently canceled.

10.6 Keywords
Dividends: Dividends are payments made by a corporation to its shareholder members. It is the portion of
corporate profits paid out to stockholders.
Finance: Finance is the study of how investors allocate their assets over time under conditions of certainty and
uncertainty. A key point in finance, which affects decisions, is the time value of money.
Liquidity: Market liquidity is an asset's ability to be sold without causing a significant movement in the price
and with minimum loss of value.
Management: Management is the act of getting people together to accomplish desired goals and objectives
using available resources efficiently and effectively.
Stock split: A stock split or stock divide increases the number of shares in a public company. The price is
adjusted such that the before and after market capitalization of the company remains the same and dilution
does not occur.

10.7 Self Assessment Questions

1. Dividend policy is the policy used by a company to decide how much it will pay out to shareholders in
dividends.
(a) True (b) False

2. Dividend payout ratio =

(a) Dividend per share + Earnings per share (b) Dividend per share - Earnings per share
(c) Dividend per share - Earnings per share (d) Dividend per share ÷ Earnings per share

3. The most successful organizations are those with the greatest ability to grow and manage profit.
(a) True (b) False

4. Economic Activity and, whether it is people or equipment, are two entirely different elements.
(a) performance (b) productivity
(c) dividend policy (d) None of these

5. Determinants of dividend policy are:

(a) Stability of dividends (b) Inflation
(c) both (a), (b) (d) None of these

6. Dividend policy involves the decision to pay out earnings or to retain them for ...........in the firm.
(a) investment (b) reinvestment
(c) dividend (d) None of these

7. The date of record is the date on which dividends are assigned to the holders of the company's stock.
(a) True (b) False

8. Bond dividend is also known as..............................

(a) Interim Dividend (b) market dividend
(c) script dividend (d) inflation dividend

9. In Walter's Model (Relevant) k represents by......................

(a) value (b) constant
(c) rate (d) average

10. Valuation formula is:

(a) P = DIV + (EPS-DIV) 1/k (b) P = DIV + (EPS+DIV) r/k
(c) P = DIV - (EPS-DIV) r/k (d) P = DIV + (EPS-DIV) r/k
10.8 Review Questions
1. What do you mean by dividend policy?
2. Explain advantages of stable dividend policy?
3. Define disadvantages of dividend policy.
4. What are determinants of dividend policy?
5. Distinguish between stability of dividends and dividend payout ratio.
6. What are capital market considerations?
7. Discuss Walter's Model (relevant) of dividend policy.
8. Write short note on:
Liquidating dividend
Interim Dividend
9. Explain difference among cash dividend, stock dividend and bond dividend.
10. Explain Gordon‘s Model.

Answers for Self Assessment Questions

1. (a) 2. (d) 3. (a) 4. (b) 5. (c)
6. (b) 7.(a) 8.(c) 9.(b) 10. (d)
 11
Market Based Ratios
CONTENTS
Objectives
Introduction
11.1 Earnings per Share (EPS)
11.2 Price Earnings Ratio (P/E Ratio)
11.3 Market Price to Book Value Ratio (P/BV Ratio)
11.4 Dividends Payout Ratio
11.5 Book Value Ratio
11.6 Dividend Yield Ratio
11.7 Du Pont Analysis
11.8 Summary
11.9 Keywords
11.10 Self Assessment Questions
11.11 Review Questions

Objectives
After studying this chapter, you will be able:
Explain the earnings per share
Explain the price earnings ratio
Understand the market price to book value ratio
Explain the dividend payout ratio
Explain the book value ratio
Explain the dividend yield ratio
Understand the Du Pont Analysis

Introduction
Information level is one of the most important factors which determine financial market efficiency. Investors
can increase their profits according to the impact of this information on stock prices. Efficient market is one in
which investors cannot profit by using the existing information in the market. Information gathering from
financial tables is the basic information which investors use in investing; through financial ratios from these
financial tables, investors seek the ways to get abnormal returns. The market where investors can get abnormal
returns by using past prices or financial ratios is not weak form efficient as well. Investors can diversify their
investments by examining the present value and estimating future value of their companies. In addition, stocks
are the most preferred investment instruments since they provide higher return than other instruments. Thus,
the factors determining stock returns are one of the most important subjects in finance literature. In
determining the market value of companies, market-based ratios are the most used ones by investors. Investors
can forecast the real value of stocks by using market based ratios such as price to earnings ratio (P/E), earnings
per share (EPS) and market to book ratio (M/B). If the real value of stock is greater than the market value of
stock, investors will prefer to buy this stock. In this respect, market based ratios are important indicators for
investment decisions.

11.1 Earnings per Share (EPS)

Earnings per share are a company‘s total earnings divided by the total number of shares outstanding. It is
calculated using annual earnings, usually after interest and taxes and after deducting the preference shares
dividends, so as to compute the portion of total profit which is attributable to the ordinary shareholders. In this
case, total earnings would be divided by the total number of ordinary shares outstanding.
There are three types of EPS numbers:
1. A trailing EPS (calculated using the previous year‘s earnings),
2. A current EPS (uses the current year), and
3. Forward EPS (a projection for the coming year).

Moreover, different accounting policies regarding the handling of new issue of ordinary shares, have led to the
need of several computation approaches to the EPS ratio, in order to reflect in the best way possible the
appropriate information for the users-stakeholders of the firm being analyzed. For this reason, there is the
computation of the Basic EPS, the EPS Adjusted reflecting any bonus issue or rights issue or option/warrants
exercise and the Diluted EPS - DEPS which reflects the convertible bonds or shares to ordinary shares (the
approaches are being determined by the accounting policies in effect). Existing shareholders can look at the
DEPS to see the effect on current profitability of commitments already entered into to issue ordinary shares in
the future. What is important is that very often EPS is used as a considerable tool-indicator of a firm‘s
performance. It measures performance from the perspective of investors and potential investors. Additionally,
it shows the amount of earnings available to each ordinary shareholder, so that it indicates the potential return
on individual investments. These results can be achieved by comparing the EPS of either different entities or
the same entity‘s in different accounting periods, or even better, using both. Sometimes, the trend in EPS may
be more accurate performance indicator than the trend in profit, though it is based on profit on ordinary
activities after taxation.
Formula of earnings per share is:
Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend) / No. of equity shares (common
shares)

Example
Calculate the EPS, given the following figures:
Ordinary shares of INR 1 each: INR 700,000
6% Preference shares of INR 1 each: INR 200,000
10% Debentures INR 100,000
Net profit after tax INR 330,000
Ordinary share dividends INR 80,000
Preference share dividends INR 12,000

Solution:
Earnings per share = (330,000 - 12,000) / 700,000 = INR 0.45 (correct to 2 decimal places)

11.2 Price Earnings Ratio (P/E Ratio)

The price/earnings ratio (P/E ratio) provides a comparison of the current market price of a share of stock and
that stock‘s earnings per share, or EPS (which is figured by dividing a company‘s net income by its number of
shares of common stock outstanding). For example, if a company‘s stock sold for INR 30 per share and it
posted earnings per share of INR 1.50, that company would have a P/E ratio of 15. A company‘s P/E ratio
typically rises as a result of increases in its stock price, an indicator of the stock‘s popularity.
P/E = Stock Price / EPS

‗The price-earnings ratio is part of the everyday vocabulary of investors in the stock market,‖ noted Richard A.
Brealey and Stewart C. Myers in Principles of Corporate Finance, because a company‘s P/E ratio is often
viewed as an indicator of future stock performance. ―The high P/E shows that investors think that the firm has
good growth opportunities, that its earnings are relatively safe and deserve a low capitalization rate, or both.‖
John B. Thomas observed in the Indianapolis Business Journal, however, that‖ while accepting that a high P/E
ratio is usually a sign of high expectations, analysts and brokers nonetheless are quick to caution that the ratios
are only part of the puzzle.‖ A company may post an artificially high P/E ratio as a result of factors that can
either boost stock prices or diminish earnings per share. Restructuring charges, merger and acquisition rumors
(whether true or false), and high dividend yields all have the capacity to push a company‘s P/E ratio upward.
In other instances, legitimately high P/E ratios can be adversely impacted down the road by such factors as
market conditions, technology, and increased competition from new rivals (who may, in fact, be drawn to the
industry by the company‘s previously posted P/E ratios).

Conversely, while a low P/E ratio is often a good indication that a company is struggling, appearances can
again be deceiving. In addition, different industry sectors often have diverse P/E ratio averages. A company
may have a fairly low P/E ratio when compared with all other corporations; when compared with the other
companies within its industry, however, it may be a leader. Finally, a company that posts a loss has no
earnings to compare with its stock price. As a result, no P/E ratio can be determined for the company. Still,
these companies may remain viable choices for investment if an investor decides that the company under
examination is headed toward future profitability. Since so many factors can influence a company‘s P/E ratio,
industry analysts caution against relying on it too heavily in making investment decisions. As one analyst
remarked to the Indianapolis Business Journal, while a company‘s P/E ratio is a valuable and often accurate
investment tool, ―if we are going to buy and sell stocks based on a P/E ratio, we are not going to make money.
We had better look at why it is high or low.‖

The P/E ratio became even trickier for investors to interpret in the late 1990s, as the stock market continually
reached all time highs and numerous large-company stocks were traded at valuations more than two times their
five-year expected growth rates. A general rule of thumb for investing states that a stock should sell at about
its expected growth rate. For example, if a company‘s earnings were expected to grow at 12 percent per year,
its stock should carry a P/E ratio of 12. ―In normal times, investors preferred to buy shares in companies
whose fortunes were expected to improve in coming years. They had shop for companies whose future
earnings-growth rates were expected to exceed current price/earnings multiples,‖ Gretchen Morgenson wrote
in Forbes. ―But these are not normal times. The folks who are buying these shares are closing their eyes to
ordinary standards of value. Call them see-no-evil stocks.‖ As an example, Procter and Gamble shares were
trading at 28 times the company‘s latest 12-month earnings as of late 1997, and this high figure was hardly
exceptional. While some analysts argued that the high P/E ratios were justified due to falling long-term interest
rates and low inflation, others warned that they left no room for a downturn in earnings at the companies
boasting high stock prices. ―Buying overpriced stocks because we think they will become even more
expensive he Greater Fool theory as worked out pretty well in recent markets,‖

Example:
The market price of a share is INR 30 and earnings per share are INR [Link] price earnings ratio.

Calculation:
Price earnings ratio = 30 / 5
=6
The market value of every one rupee of earning is six times or INR 6. The ratio is useful in financial
forecasting. It also helps in knowing whether the share of a company are under or overvalued. For example, if
the earning per share of AB limited is INR 20, its market price INR 140 and earnings ratio of similar
companies is 8, it means that the market value of a share of AB Limited should be INR 160 (i.e., 8 × 20). The
share of AB Limited is, therefore, undervalued in the market by INR 20. In case the price earnings ratio of
similar companies is only 6, the value of the share of AB Limited should have been INR 120 (i.e., 6 × 20), thus
the share is overvalued by INR 20.

11.3 Market Price to Book Value Ratio (P/BV Ratio)

Market price to book value ratio formula is:
Market Price per Share
P / B Ratio
Book Value per Share

The Price to Book Ratio formula, sometimes referred to as the market to book ratio, is used to compare a
company‘s net assets available to common shareholders relative to the sale price of its stock. The formula for
price to book value is the stock price per share divided by the book value per share. The stock price per share
can be found as the amount listed as such through the secondary stock market. The book value per share is
considered to be the total equity for common stockholders which can be found on a company‘s balance sheet.

11.3.1 Use of Price to Book Value Formula

The price to book value formula can be used by investors to show how the market perceives the value of a
particular stock to be. A ratio over one implies that the market is willing to pay more than the equity per share.
A ratio under one implies that the market is willing to pay less. A price to book value of less than one can
imply that the company is not running up to par. This, along with other factors, could also lead to a hostile
takeover.

11.3.2 Issues with the Price to Book Value Formula

One may argue that a ratio under one implies that the company is perceived as being a worse investment than
if it were above one. On the other hand, another may argue that the stock is underpriced and a favorable
investment. Due to these discrepancies of opinion, using other stock valuation methods along with or apart
from the price to book value formula may be beneficial.
Another issue with the price to book value formula is that there are many underlying factors that can affect the
formula such as issuing new stock, paying dividends, and stock repurchases. It is possible for a company to
manipulate this ratio by various means which is why it is important to not use any one particular financial
formula in isolation.

Example
There are a couple ways to calculate book value, depending on the company. For purposes of this example, we
shall assume that the best measure of book value is Total Assets - Total Liabilities. We shall also assume that
the stock of Company XYZ is trading at INR 6 per share and there are 100 shares outstanding.
Balance Sheet for Company XYZ
Year ending December 31, 2009

Assets
Cash 1,000
Accounts Receivable 500
Inventory 500
Total Current Assets 2,000
Liabilities
Accounts Payable 500
Current Long-Term Debt 500
Total Current Liabilities 1,000
Long Term Debt 500
Total Liabilities 1,500
Owners’ Equity 500

P/B ratio = Stock Price / Book Value per share

Book value: 2,000 - 1,500 = 500 (note that this is the same as owners‘ equity)
Book value per share: 500 / 100 = INR 5
P/B ratio = INR 6 / INR 5 = 1.2
A P/B ratio of less than 1.0 can indicate that a stock is undervalued, while a ratio of greater than 1.0 may
indicate that a stock is overvalued.

11.4 Dividends Payout Ratio

Dividends payout ratio is:
Dividends
Dividend Payout Ratio
Net Income
The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount of total net
income of a company. The amount that is not paid out in dividends to stockholders is held by the company for
growth. The amount that is kept by the company is called retained earnings.
Net income shown in the formula can be found on the company‘s income statement.
This formula is used by some when considering whether to invest in a profitable company that pays out
dividends versus a profitable company that has high growth potential. In other words, this formula takes into
consideration steady income versus reinvestment for possible future earnings, assuming the company has a net
income.
Alternative Formula

I. 1 – retention ratio

The retention ratio and the dividend payout ratio together equal 1 or 100% of net income. The premise is that
whatever amount not paid in dividends is kept by the company to reinvest for expansion. A simple example
would be a company who pays out 100% of their net income in dividends. In this situation, net income would
be equal to dividends. Using the formula for this example, the dividend payout ratio would be 1 or 100%. The
retention ratio would be 0 or 0% as they do not retain and reinvest any of their earnings for growth. Using the
alternative formula 1 - 0 would be 1. Alternatively, a company who pays no dividends would have a 0
dividend payout ratio and a 1 retention ratio, which means that the company reinvests all of their net income
for growth.

II.
Dividends per share(DPS)
Earnings per share(EPS)

The dividend payout ratio formula can also be restated on a ―per share‖ basis. If the dividend per share and
earnings per share is known, the dividend payout ratio can be calculated using the same concept of dividends
paid divided by earnings, or net income.

Example
Calculate dividend payout ratio and retained earnings from the following data:
Net Profit 10,000 No. of equity shares 3,000
Provision for taxation 5,000 Dividend per equity share INR 0.40
Preference dividend 2,000
Payout Ratio = (INR 0.40 / INR 1) × 100
= 40%
Retained Earnings Ratio = (INR 0.60 /INR 1) × 100
= 60%

11.5 Book Value Ratio

Book Value means the value of the equity that is owned by shareholders according to the financial statements.
Book Value is calculated from the Balance Sheet. Book Value is usually shown directly on the Balance Sheet
as the total equity value. Usually the total equity (Book Value) is a subtotal that adds up the value of the
original common share dollars invested in the company at the IPO and any secondary offerings including
amounts received for warrants and options plus retained earnings. (Often there are a few other smaller items
added in, such as gains or losses on foreign exchange rates). Alternatively, Book Value can also be calculated
as the total Asset value minus all items on the liability side of the balance sheet that are not part of common
equity. Book Value is also referred to as the net asset value since it is the value of assets net of (after
subtracting) all debts and liabilities of all kinds. However in recent years net asset value has also been used to
mean net market value of assets rather than the accounting book value. Some companies use preferred shares.
These should not be included in the calculation of Book Value. Some companies (legally but rather
annoyingly) show these preferred shares in the same subtotal as common equity and in that case they have to
subtract out.
11.5.1 Book Value per Share Calculation
Unless we are Warren Buffett is not likely going to buy the whole company. Therefore, we are interested in
Book Value per share. To calculate Book Value per share divide Book Value by the current diluted number of
common shares outstanding. Often the number of shares is shown directly on the income statement. The
diluted number of shares can also be calculated by dividing the latest quarter net income by the diluted
earnings per share in the latest quarter. (If there has been a share issue in the quarter this will not be completely
accurate but it is usually close enough). Additionally we can find the number of shares in the notes to the
financial statements, under ―common shares‖. Ideally we should use the diluted number of shares but we can
use the actual number of shares at the quarter end if the diluted number is not provided. Book Value per share
is also known as the net asset value per share since it is the book value of assets per share net of (after
subtracting) all liabilities per share.

Example:
Let us assume that Company XYZ has 10,000,000 shares outstanding, which are trading at INR 3 per share.
The company also recorded INR 15,000,000 of tangible book value last year. Using the formula above, we can
calculate Company XYZ‘s price to tangible book value as follows:

Price to Tangible Book Value = INR 3 / (INR 15,000,000/10,000,000) = 2.0

The data needed to calculate a company‘s tangible book value is usually on its balance sheet.
Why It Matters:
The price-to-tangible book value ratio excludes the book value of a company‘s intellectual property and other
intangible assets, such as patents and goodwill. As such, it represents what debt holders or investors would
receive if the company liquidated its physical assets (assuming that it could get book value for all of those
assets). If a stock is trading below its tangible book value per share, analysts might consider the company
undervalued because investors would receive more than the share price if the company were to liquidate.
Likewise, if a company is trading above its tangible book value (as is the case in our example), investors could
be left holding the bag if the company has to liquidate.

11.6 Dividend Yield Ratio

The dividend yield ratio shows the amount of dividends that a company pays to its investors in comparison to
the market price of its stock. Thus, the dividend yield ratio is the return on investment to an investor if the
investor were to have bought the stock at the market price on the measurement date.
Formula: Divide the annual dividends paid per share of stock by the market price of the stock at the end of the
measurement period. Since the market price of the stock is measured on a single date, and that measurement
may not be representative of the stock price over the measurement period, we may consider using an average
stock price. The basic calculation is:

Annual dividends paid per share

Market price of the stock

Example: ABC Company pays dividends of INR 4.50 and INR 5.50 per share to its investors in the current
fiscal year. At the end of the fiscal year, the market price of its stock is INR 80.00. Its dividend yield ratio is:

INR 10 Dividends paid

INR 80 Share price
= 12.5% Dividend yield ratio

Cautions: A problem with the measurement is whether you should include in the numerator only dividends
paid, or also dividends declared but not yet paid. It is possible that there will be overlap in the measurement
periods if you use both dividends paid and dividends declared. For example, a company pays INR 10.00 in
dividends during the fiscal year, but then also declares a dividend just before the end of the reporting period. If
you are measuring based on cash received, you should not include the amount of the dividend declared;
instead, measure it in the following fiscal year, when you receive the cash from the dividend.

Did You Know?

Dividend yield fell out of favor somewhat during the 1990s because of an increasing emphasis on price
appreciation over dividends as the main form of return on investments.

11.7 Du Pont Analysis

The DuPont Model, developed in 1914 by F. Donaldson Brown of chemical company DuPont de Nemours &
Co, is a set of financial ratios and key figures relating to the Return on Investment (ROI). It is a technique that
can be used to analyze the profitability of a company using traditional performance figures. It integrates
elements of the Income Statement with those of the Balance Sheet.

ROI = (Profit + Cost of Capital) / (Average Capital)

Whereas cost of capital refers to the interest payment for liabilities and average capital refers to the annual
average of owner‘s equity and liabilities
Enhancing the equation with (Revenue / Revenue),

ROI = ((Profit + Cost of Capital) / Revenue) × (Revenue / Average Capital)

in words: ROI = Net Profit Margin × Total Assets Turnover

Figure 9.1: DuPont Model

11.7.1 Return on Equity Financial Expression
Efficient use of assets is important for the profitability and growth of any organization. One of the easiest ways
to gauge whether a company is an asset creator or cash user is to look at the return on equity (ROE) ratio. ROE
is a strong measure of how well management is creating value for shareholders.
In its simplest form, ROE is calculated:
Annual Earnings/Shareholder‘s Equity
If the result of this basic ROE ratio increases over time, it is generally considered a good sign. However, the
ratio can also rise when the company takes on more debt, increasing leverage, but decreasing shareholder
equity – a risky situation.
To avoid the false positive that the simple ROE calculation can give, the DuPont Analysis, a more in-depth
method of determining Return on Equity, was developed in the early 1900s.

11.7.2 Origin of DuPont Analysis

F. Donaldson Brown, a staff person in DuPont‘s Treasury department, developed the DuPont model of return
on equity. The DuPont Analysis provides a starting point for determining the strengths and weaknesses of a
company. The model is built on three components, which cover the areas of profitability, operating efficiency
and leverage (liquidity).

11.7.3 Components of the DuPont Analysis

1. Net Margin (Net Income/Sales). This ratio measures after tax profitability -- how much profit a company
makes for every INR 1.00 it generates in revenue. Net Income and Sales figures can be found on the Income
Statement.
It should be noted that, in order to generate more sales, management might reduce the net profit by reducing
prices. Lowest-cost firms (like Wal-Mart) have used this strategy very effectively.

2. Asset Turnover (Sales/Total Assets). This ratio indicates the amount of sales generated for every dollar‘s
worth of assets. This evaluates the firm‘s efficiency in using its assets. Typically, the higher, the better.
However, this ratio tends to be inversely related to the net margin, i.e. the higher the net profit margin, the
lower the asset turnover. The Sales number to calculate this ratio is found on the Income Statement. The Asset
figures, however, come from the balance sheet. Income Statement items are measured over an interval of time,
while Balance Sheet items are measured at a specific point in time. This difference can skew the result.
Therefore, rather than using Total Assets, it‘s a good idea to use Average Assets to ensure a more meaningful
ratio.

3. Leverage Factor (Average Assets/Average Shareholder Equity). This ratio determines the extent to which
the company relies on debt financing. The higher the number, the more debt the company is carrying.
Averages are used to control any potential bias that may be caused by end-of-the-year values.

The DuPont Formula -- 3 Step Return on Equity

Net Income Sales Assets
Sales Assets Equity

Utilizing all three ratios, the DuPont Analysis provides deeper insight into the health of the organization versus
the simple ROE calculation (annual earnings/ shareholder‘s equity).
For instance, if a company‘s return on equity increases because of an improved net profit margin (net
income/sales) or due to increased asset turnover (sales/assets), this is a very positive sign. But, if the assets to
equity result is the reason for the increase, the company could very well be over leveraged (too much debt),
which puts the company in a more risky situation.
While the DuPont Analysis is a good starting point when analyzing the creditworthiness of an organization,
the result is not meaningful unless compared to an industry benchmark. If such a benchmark is not available,
we should at least do a trend analysis of the same company‘s return on equity over 3 or more years.

Example:
A hypothetical example aids us in grasping the value of the DuPont model. Consider two companies, company
A and company B, each with a ROE of 20%. Prima facie (or At first glance), they look like equally attractive
investments. Now, we can delve deeper by using the DuPont analysis:

ROE = (Net profit margin) × (Asset turnover) × (Equity multiplier)

For Company A: ROE (A) = 31% × 0.1× 6.5

For Company B: ROE (B) = 16% × 1.0× 1.2

We observe that even though both the companies generate the same ROE, their inherent components are very
different, and so communicate unique information regarding the company.

ROE of company A at 20% is mainly because of the high net profit margin (of 31%) and huge financial
leverage (of 6.5) that the company has. While a high net profit margin is desirable, financial leverage should
be optimum and not so high. For company B, even with a lower (lower than company A) net profit margin of
16%, it is able to generate an ROE of 20% as a result of its high asset turnover ratio which is fine.

While the DuPont method highlights key strategic aspects of the companies, it also raises important questions.
For instance, why is Company A‘s profit margin so high? And is that sustainable? Also, why does Company A
have so much debt on its books?

For Company B, an obvious question is ―is its profit margin in line with that of the sector‖.

Clearly, the DuPont method, through what it highlights, and the questions it raises, provides insights into these
company‘s strategies and operations, in a way that is not evident from just knowing their 20% ROE. This is
the power of this analysis.

Example:
Three-factor Analysis
Company A and B operate in the same market and are of the same size. Both earn a return of 15% on equity.
The following table shows their respective net profit margin, asset turnover and financial leverage.
Company A Company B
Net Profit Margin 10% 10%
Asset Turnover 1 1.5
Financial Leverage 1.5 1

Although both the companies have a return on equity of 15% their underlying strengths and weaknesses are
quite opposite. Company B is better than company A in using its assets to generate revenues but it is unable to
capitalize this advantage into higher return on equity due to its lower financial leverage. Company A can
improve by using its total assets more effectively in generating sales and company B can improve by raising
some debt.

11.7.4 Uses or Plus Point of DuPont Analysis or Chart

While choosing which assets to include in a portfolio, an in-depth analysis of the investment alternatives is
made. If one of the alternatives is an ownership share in a corporation, then it is observed that the DuPont ratio
is the best tool used to analyze that investment. The DuPont model was internally developed by Du Pont as a
tool to measure its investment projects, but eventually became widely used as a financial tool. The DuPont
analysis breaks down a company‘s return on equity (ROE) into three components.
1. Profit margin as measured by net income as a percentage of sales
2. Asset turnover which is net sales divided by the total assets of a firm
3. Degree of financial leverage as measured by the equity multiplier which is the ratio of total assets financed
by stockholders‘ equity

In formula form, DuPont return on equity is

ROE = net income/total stockholders‘ equity = Profit margin × Asset turnover × Equity multiplier
OR
ROE = net income/total stockholders‘ equity = net profit/net sales x net sales/total assets x total assets/total
stockholders‘ equity

Profit margin indicates how efficient the company‘s management is in operating the company and in
controlling costs. Asset turnover, on the other hand, measures the efficiency of the company in generating
sales for every dollar of asset. Lastly, the equity multiplier shows how leveraged a company is by computing
how much financing stockholders provided for every dollar of asset. Using the DuPont system in evaluating
alternative stock investments helps investors in comparing why ROEs of these stocks differ by identifying the
impact of operating efficiency, asset-use efficiency and financial leverage on the return on equity. It is not
enough that each of these stock investment alternatives be ranked according to ROEs, but what contributed to
their ROEs should also be analyzed. Other tools such as the return on investment and cash flows as a
percentage of sales, or any other income statement item, are just few of numerous financial tools that an
investor can easily use in investment analysis. Buying a stock is a serious commitment. We are committing a
portion of our wealth. We are also committing a part of our dream of becoming financially independent.
Hence, stock investment analysis should be taken very seriously.

11.7.5 Advantages or DuPont Analysis

Fundamentally, any decision that influences product prices, per unit costs, volume or efficiency/productivity
(output per unit of input) will impact profit margin or turnover ratio. And any decision that affects the amount
and type of debt and equity used will impact the financial structure as well as cost. These financial concepts
are important to understand because every business in the world is competing for capital. Money flows where
the perceived risk adjusted return is greatest. If we as marketers of products and services to businesses
understand these financial concepts, we can better understand where we might be able to help our customers
the most. We need to understand how we deliver value to our business customers. Marketing value involves
much more than a pep rally/sales meeting rah-rah. It‘s a culture, a mindset, a strategy. To do it well, first need
to be able to define it. Understanding the financial concepts allow focusing on the key questions they should
answer to help define our value.
How do you or how can you help our customers:
Increase the price per unit of product they sell by adding new features and benefits to their products,
services, and systems
 Decrease the variable cost to produce, acquire or sell the unit.
Increase the number of units sold
Decrease the overhead by increasing their efficiency of operations
Increase asset turnover by
Minimizing the customer‘s work in process or finished goods inventory (and therefore total assets)
Decreasing fixed assets by outsourcing some processes, enabling some capital assets to be sold
To truly add value and set yourself apart from the competition, we need to know how to help your customers
Control one or more of their critical costs or
Exploit one or more of their critical revenue sources.

Did You Know?

The name comes from the DuPont Corporation that started using this formula in the 1920s.

Caution
Of course, the DuPont ratio and return on equity, for that matter, should not be used as the sole, investment
analysis tool in deciding on what stock to include in a portfolio.

Case Study-Mergers and Acquisitions: Exchange of Common Stock in a Merger

When an exchange of common stock is involved in an acquisition or merger agreement, two different
securities must be valued. In addition, a proper ratio of exchange must be found that reflects the respective
values of the shares. Moreover, in most cases, the acquirer has to pay a significant premium (between 15 and
25% is the common range) over the objective value of the shares of the acquired company. As the two stocks
are valued, any differences in the quality and breadth of trading in the securities markets can be an important
factor. If, for example, a large, well-established company acquires a new and fast-growing company, the
market‘s assessment of the value of the acquirer‘s stock is likely to be more reliable than that of the candidate,
whose stock may be thinly traded and unproven. But even if both companies had comparable market exposure,
the inherent difference in the nature and performance of the two companies may exhibit itself in, among other
indicators, a pronounced difference in price/earnings ratios.

Let us assume that Acquirer Corporation and Candidate, (or Target Corp.), have the following key dimensions
and performance data at the time of their merger negotiations:

Key Data Acquirer Corporation Candidate (Target) Corp

Current earnings EUR 50,000,000 EUR 10,000,000
Number of shares 10 million 10 million
(outstanding)
Earnings per share (EPS) EUR 5 EUR 1
Current market price (P) EUR 60 EUR 15
Price/earnings ratio (P/E) 12 x 15 x

Negotiations between the management teams have reached a point where, after Candidate had rejected several
offers, Acquirer now considers a price premium of about 20% over the current market value of Candidate‘s
stock necessary to make a deal. This would call for an exchange ratio of EUR 18/ EUR 60, or 0.3 shares of
Acquirer stock for each share of Candidate stock (meaning that 3 million new shares of Acquirer would be
issued to the shareholders of Candidate‘s stock). The impact on Acquirer would be as follows, at the combined
current levels of earnings (abstracting from possible synergy effects or benefits):
 Acquirer Corporation (after the merger)
Combined earnings (of the two companies) EUR 60,000,000
Number or shares (10 mil. old + 3 mil. new) 13 million
New earnings per share (new EPS combined) EUR 4.62
Old earnings per share (pre-merger EPS) EUR 5.00
Immediate dilution (difference between EPS) EUR 0.38

Under these conditions, Acquirer would suffer an immediate dilution of EUR 0.38 per share from the
combination (decline in EPS). Yet the fact that the stock of Candidate had a higher price/earnings ratio
suggests that smaller company has certain desirable attributes, which may include high growth in earnings, a
technologically protected position, and so on. Acquirer must consider two points: first, whether the earnings of
Candidate are likely to grow at a rate that will close the gap in earnings per share relatively quickly, aided by
any synergistic benefits available now. Second, Acquirer must judge whether the inclusion of Candidate is
likely to change the risk/reward characteristics of the combined company so as to improve the price/earnings
ratio—and thus help overcome the dilution. In our example, the earnings gap to be filled is 13 million shares
times EUR 0.38, or almost EUR 5 million in annual earnings, just to return to the current level of Acquirer‘s
earnings per share. How much in synergy benefits can be expected? Perhaps the ratio of exchange has to be
reconsidered in this light? But would the smaller company even be interested in being acquired at less than a
20 percent premium over the stock market value of its shares, a common inducement?
Note that a reversal of the price/earnings ratios in the example (see the table Key data) would dramatically
change both the terms of the offer and the reported performance of the combined companies. At 15 times
earnings, the price of Acquirer would be EUR 75 per share, while at 12 times earnings Candidate would sell at
EUR 12 per share. Given a 20 percent acquisition premium for Candidate‘s stock, the exchange ratio would be
EUR 14.40/EUR 75, or 0.192 shares of Acquirer for each share of Candidate. This would call for 1.92 million
new shares of Acquirer (to be issued), and the new earnings per share would amount to EUR 60,000,000 ÷
11,920,000, or EUR 5.03 per share, a slight net improvement even before realizing any synergistic benefits. In
this changed situation, both parties would be better off immediately, simply because we assumed the
price/earnings ratios to be reversed. This is but one simplified example, and thus only a quick glimpse of the
nature of the deliberations involved in exchanges of stock.

Questions
1. What are Mergers and Acquisitions?
2. Discuss the valuation of stock and process in mergers and acquisitions.

11.8 Summary
Earnings per share are a company‘s total earnings divided by the total number of shares outstanding.
The price/earnings ratio (P/E ratio) provides a comparison of the current market price of a share of stock
and that stock‘s earnings per share, or EPS (which is figured by dividing a company‘s net income by its
number of shares of common stock outstanding).
The Price to Book Ratio formula, sometimes referred to as the market to book ratio, is used to compare a
company‘s net assets available to common shareholders relative to the sale price of its stock.
Cash earnings per share indicate the amount of operating cash flow per share. This ratio is similar to EPS.
The only difference is that in this formula cash flow is used instead of net income.
Company‘s cash earnings per share can be compared with other companies‘ cash EPS – that‘s why it is
important for the investors.
 The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount of total
net income of a company.
The retention ratio and the dividend payout ratio together equal 1 or 100% of net income.
Book Value is also referred to as the net asset value since it is the value of assets net of (after subtracting)
all debts and liabilities of all kinds.

11.9 Keywords
Diluted Earnings per Share (DEPS): A performance metric used to gauge the quality of a company‘s
earnings per share (EPS) if all convertible securities were exercised. Convertible security refers to all
outstanding convertible preferred shares, convertible debentures, stock options (primarily employee based) and
warrants.
Downturn: Downward shift in an economic cycle, such as from expansion or steady-state to recession. A
stock market is in downturn when it changes from a bull market to a bear market.
Initial Public Offering – IPO: The first sale of stock by a private company to the public. IPOs are often issued
by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned
companies looking to become publicly traded.
Journal: In accounting, a book that includes all transactions and their appropriate accounts.
Shareholders: Shareholders are the owners of a company. They have the potential to profit if the company
does well, but that comes with the potential to lose if the company does poorly.

11.10 Self Assessment Questions

1. Investors can increase their profits according to the impact of this information on.
(a) planning (b) stock prices
(c) market value (d) None of these

2. Earnings per share are a company‘s total earnings divided by the total number of shares outstanding.
(a) True (b) False

3. Earnings per share (EPS) Ratio =

(a) (Net profit after tax + Preference dividend) / No. of equity shares (common shares)
(b) (Net profit after tax * Preference dividend) / No. of equity shares (common shares)
(c) (Net profit after tax − Preference dividend) / No. of equity shares (common shares)
(d) None of these

4. Market price to book value ratio formula is:

Monthly dividends paid per share
(a)
Market price of the interest
Market Price per Share
(b)
Book Value per Share
Market Price per credit
(c)
Book Value per Share
(d) None of these
5. The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount of total net
income of a company.
(a) True (b) False

6. The dividend payout ratio formula can also be restated on a ―per out‖ basis.
(a) True (b) False

7. Book Value is usually shown directly on the …………..as the total equity value.
(a) liablity (b) debt capital
(c) balance sheet (d) None of these

8. The dividend yield ratio formula is:

Annual dividends paid per share
(a)
Market price of the stock
Annual dividends paid per share
(b) 100
Market price of the stock
Monthly dividends paid per share
(c)
Market price of the stock
Monthly dividends paid per share
(d)
Market price of the interest

9. The DuPont Analysis provides a starting point for determining the strengths and weaknesses of a company.
(a) True (b) False

10. The DuPont Model, developed in ………….. by F. Donaldson Brown.

(a) 1912 (b) 1916
(c) 1915 (d) 1914

11.11 Review Questions

1. What are earnings per share (EPS)?
2. Explain the Price Earnings Ratio (P/E Ratio).
3. What is market price to book value ratio?
4. What are cash earnings per share ratio? Give an example?
5. What is dividend payout ratio?
6. Describe the book value ratio.
7. What do you understand by dividend yield ratio?
8. Explain the Du Pont Analysis.
9. Explain the advantages of Du Pont analysis.
10. Explain the Du Pont analysis model.

Answers for Self Assessment Questions

1. (b) 2. (a) 3. (c) 4. (b) 5. (a)
6. (b) 7.(c) 8.(a) 9.(a) 10. (d)
 12
Capital Budgeting
CONTENTS
Objectives
Introduction
12.1 Capital Expenditure Decisions
12.2 Capital Rationing Problems
12.3 Methods of Appraisal
12.4 Pay-Back Period Method
12.5 Risk Analysis in Capital Budgeting
12.6 Summary
12.7 Keywords
12.8 Self Assessment Questions
12.9 Review Questions

Objectives
After studying this chapter, you will be able:
Define the Capital expenditure decisions
Explain the capital rationing problems
Discuss the methods of appraisal
Describe pay-back period
Explain the risk analysis in capital budgeting

Introduction
Capital budgeting is the process of making investment decisions in capital expenditures. It is an expenditure
the benefits of which are expected to be received over a period of time exceeding one year. It is expenditure
for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of
years in future. Capital budgeting decisions are vital to any organization. Any unsound investment decision
may prove to be fatal for the very existence of the concern. Capital Budget is also known as "Investment
Decision Making or Capital Expenditure Decisions" or "Planning Capital Expenditure" etc. Normally such
decisions where investment of money and expected benefits arising there from are spread over more than one
year, it includes both rising of long-term funds as well as their utilization. Charles T. Horngnen has defined
capital budgeting as "Capital Budgeting is long term planning for making and financing proposed capital
outlays." In other words, capital budgeting is the decision making process by which a firm evaluates the
purchase of major fixed assets including building, machinery and equipment. According to Hamption, John.,
"Capital budgeting is concerned with the firm's formal process for the acquisition and investment of capital."
From the above definitions, it may be concluded that capital budgeting relates to the evaluation of several
alternative capital projects for the purpose of assessing those which have the highest rate of return on
investment.

Importance of Capital Budgeting

Capital budgeting is important because of the following reasons:
• Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.
• Capital budgeting involves commitment of large amount of funds.
• Capital decisions are required to assessment of future events which are uncertain.
• Wrong sale forecast; may lead to over or under investment of resources.
• In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a
market for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.
• Capital budgeting ensures the selection of right source of finance at the right time.
• Many firms fail, because they have too much or too little capital equipment.
• Investment decision taken by individual concern is of national importance because it determines
employment, economic activities and economic growth.

Objectives of Capital Budgeting

The following are the .important objectives of capital budgeting:
• To ensure the selection of the possible profitable capital projects.
• To ensure the effective control of capital expenditure in order to achieve by forecasting the long-term
financial requirements.
• To make estimation of capital expenditure during the budget period and to see that the benefits and costs
may be measured in terms of cash flow.
• Determining the required quantum takes place as per authorization and sanctions.
• To facilitate co-ordination of inter-departmental project funds among the competing capital projects.
• To ensure maximization of profit by allocating the available investible.

12.1 Capital Expenditure Decisions

Capital expenditures are defined as investments to acquire fixed or long lived assets from which a stream of
benefits is expected. Such expenditures represent an organization's commitment to produce and sell future
products and engage in other activities. Capital expenditure decisions, therefore, form a foundation for the
future profitability of a company. Capital expenditure activities are made up of two distinct processes: (a)
making the decision and (b) implementing it, which may include performing a post-appraisal.
Capital expenditure decisions are concerned with decisions regarding investment of funds in fixed and current
assets for getting returns for a number of years. Such decisions are extremely important because of following
reasons:
(i) Substantial sums of money are involved.
(ii) It may be difficult to reverse the decision.
(iii) Such decisions have considerable impact on the future of a firm.
There are two criteria for capital expenditure decisions:
(a) Accounting profit
(b) Cash flow.
Under Cash flow criterion, we require cash inflow, that is., post-tax profit before noncash items. Important
non-cash items are depreciation and apportioned fixed costs. By apportioned fixed costs we mean, such fixed
costs which are not being incurred because of the proposal but which are just being charged for determining
accounting profit.

Under cash flow criterion, two categories of methods are there:

• Payback period method,
• Methods based on discounted cash flows.

There are three important methods based on the discounted cash flows:
(a) Net present value,
(b) Profitability index,
(c) Internal rate of return.
Under cash flow approach, we consider the cash coming in and cash going out because of the project.

Pay Back Period (Pbp) Method /Approach

Pay back period is the period within which the project will pay back its cost.
Smaller the pay back period, better the project.
The main advantage of the method is its simplicity.
The main disadvantage is that it does not consider post pay back period profitability.
Pay back period can be calculated on the basis of simple cash flow or discounted cash flow.
PBP method is quite suitable when rate of becoming obsolete is quite high.
Generally it is calculated on the basis of undiscounted as follows. If there requirement of the question, we
may calculate it on the basis of discounted as follows.

12.1.1 Discounted Cash Flow Analysis

Under this approach we consider the time value of money.

NPV Method
NPV = PV of inflow – PV of outflow
If NPV is positive the project may be taken up. If NPV is zero, project may be taken up only if non financial
benefits are there. If NPV is negative project may not be taken up.

Profitablity Index Method

Present value of inflow
Present value of inflow
Profitability index (PI)
PV of outflow
If PI is more than one the project may be taken up. If PI is one project may be taken up only on the basis of
non-financial considerations. If PI is less than one the project may not be taken up. It is also called benefit cost
ratio or desirability Factor.
Suppose the PI of a five-year project is 1.50. It means that on an investment of rupee one, the present value of
the return that we will get over 5 years is Rs.0.50.
This return is exclusive of cost of capital i.e. this returns is net of cost of capital.
NPV v/s PI:
If we have to evaluate only project, we may either calculate NPV or PI, both will give same result.
If we have to evaluate two or more projects:
We should apply NPV method if funds are not key factors, that is.; our aim is maximization of profits.
We should apply PI method if funds are key factors, that is.; we want to maximize the rate of return on
funds employed.
Let‘s have an example to understand this point. A person is offered to two jobs and he can accept either.

Job Daily Wages Working Hours per day Wage per hour
First 350 7 50
Second 376 8 47

The answer is:

If time is key factor for him, he should opt for the first job (he should maximize his earning hour).
If time is not key factor for him, he should opt for the second job.

Concept of IRR
IRR is the rate of return on funds employed; it is calculated on the basis of discounted cash flow approach. It is
inclusive of cost of capital. For example, cost of capital is 10% and IRR is 15%, it means the total return on
the funds employed is 15%; out of which 10% is to meet the cost of capital and the balance it is extra profit
over and above cost of capital. IRR is that discounting rate at which NPV of a project is Zero.
Hence,
If NPV = 0 or PI = 1, than IRR is equal to discounting.
If NPV > zero or if PI > one, IRR is greater than discounting rate.
If NPV < zero or PI < one, than IRR is less than discounting rate.
For calculating IRR, we have to discount our cash flows at two such rates that at one rate NPV is + and at
the other rate the NPV is.
Having calculated the two NPVs, we apply interpolation technique to find IRR.
Interpolation Formula
NPV at lower rate
IRR Lower rate+ x Diff. in rates
Lower rate NPV-Higher rate NPV

12.2 Capital Rationing Problems

Corporate executives face three tasks in achieving good financial management. The first is largely
administrative and consists in finding an efficient procedure for preparing and reviewing capital budgets, for
delegating authority and fixing responsibility for expenditures, and for finding some means for ultimate
evaluation of completed investments. The second task is to forecast correctly the cash flows that can be
expected to result from specified investment proposals, as well as the liquid resources that will be available for
investment. The third task is to ration available capital or liquid resources among competing investment
opportunities. This is concerned with only this last task; it discusses three problems in the rationing of capital,
in the sense of liquid resources.
1. Given a firm's cost of capital and a management policy of using this cost to identify acceptable investment
proposals, which group of "independent" investment proposals should the firm accept? In other words,
how should the firm's cost of capital be used to distinguish between acceptable and unacceptable
investments? This is a problem that is typically faced by top management whenever it reviews and
approves a capital budget.
Before presenting the second problem with which this paper deals, the use of the word "independent" in the
preceding paragraph should be explained. Investment proposals are termed "independent" although not
completely accurately when the worth of the individual investment proposal is not profoundly affected by the
acceptance of others. For example, a proposal to invest in materials-handling equipment at location A may not
profoundly affect the value of a proposal to build a new warehouse in location B. It is clear that the
independence is never complete, but the degree of independence is markedly greater than for sets of so-called
"mutually exclusive" investment proposals. Acceptance of one proposal in such a set renders all others in the
same set clearly unacceptable-or even unthinkable. An example of mutually exclusive proposals would be
alternative makes of automotive equipment for the same fleet or alternative warehouse designs for the same
site. The choice among mutually exclusive proposals is usually faced later in the process of financial
management than is the initial approval of a capital budget. That is, the decision as to which make automotive
equipment to purchase, for example, typically comes later than the decision to purchase some maker of
equipment
2. Given a fixed sum of money to be used for capital investment, what group of investment proposals should
be undertaken? If a firm pursues a policy of fixing the size of its capital budget in dollars, without explicit
cognizance of, or reference to, its cost of capital, how can it best allocate that sum among competing
investment proposals? This problem will be considered both for proposals which require net outlays in
only one accounting period and for those which require outlays of more than one accounting period. In the
latter case, special difficulties arise.
3. How should a firm select the best among mutually exclusive alternatives? That is, when the management
of an enterprise, in attempting to make concrete and explicit proposals for expenditures of a type, which is
included in an approved capital budget, develops more than one plausible way of investing money in
conformance with the budget, how can it select the "best" way?

After presenting our solutions to these three problems, we shall discuss the solutions implied by the rate-of-
return method of capital budgeting. These solutions are worthy of special attention, since they are based on a
different principle from the solutions that we propose and since the rate-of-return method is the most
defensible method heretofore proposed in the business literature for maximizing corporate profits and net
worth.

12.2.1 The Three Problems

Given the cost of capital, what group of investments should be selected?
The question of determining the cost of capital is difficult, and we, happily, shall not discuss it. Although there
may be disagreement about methods of calculating a firm's cost of capital, there is substantial agreement that
the cost of capital is the rate at which a firm should discount future cash flows in order to determine their
present value. The first problem is to determine how selection should be made among "independent"
investment proposals, given this cost or rate. Assume that the firm's objective is to maximize the value of its
net worth not necessarily as measured by the accountant but rather as measured by the present value of its
expected cash flows. This assumption is commonly made by economists and even business practitioners who
have spoken on the subject. It is equivalent to asserting that the corporate management's objective is to
maximize the value of the owner's equity or, alternatively, the value of the owner's income from the business.
Given this objective and agreement about the significance of the firm's cost of capital, the problem of selecting
investment proposals becomes trivial in those situations where there is a well-defined cost of capital; namely,
proposals should be selected that have positive present values when discounted at the firm's cost of capital.
The things to discount are the net cash flows resulting from the investments, and these cash flows should take
taxes into account.
Given a fixed sum for capital investment, what group of investment proposals should be undertaken?
Some business firms-perhaps most-do not use the firm's cost of capital to distinguish between acceptable and
unacceptable investments but, instead, determine the magnitude of their capital budget in some other way that
results in fixing an absolute dollar limit on capital expenditures. Perhaps, for example, a corporate
management may determine for any one year that the capital budget shall not exceed estimated income after
taxes plus depreciation allowances, after specified dividend payments. It is probable that the sum fixed as the
limit is not radically different from the sum that would be expended if correct and explicit use were made of
the firm's cost of capital, since most business firms presumably do not long persist in policies antithetical to
the objective of making money. (The profit-maximizing principle is the one that makes use of the firm's cost of
capital, as described previously.) Nevertheless, there are probably some differences in the amount that would
be invested by a firm if it made correct use of the firm's cost of capital and the amount that would be invested
if it fixed its capital budget by other means, expressing the constraint on expenditures as being a maximum
outlay. At the very least, the differences in the ways of thinking suggest the usefulness to some firms of a
principle that indicates the "best" group of investments that can be made with a fixed sum of money.

The problem is trivial when there are net outlays in only one accounting period-typically, one year. In such
cases, investment proposals should be ranked according to their present value-at the firm's cost of capital-per
dollar of outlay required. Once investment proposals have been ranked according to this criterion, it is easy to
select the best group by starting with the investment proposal having the highest present value per dollar of
outlay and proceeding down the list until the fixed sum is exhausted. The problem can become more difficult
when discontinuities are taken into account. For large firms, the vast majority of investment proposals
constitute such a small proportion of their total capital budget that the problems created by discontinuities can
be disregarded at only insignificant cost, especially when the imprecision of the estimates of incomes is taken
into account. When a project constitutes a large proportion of the capital budget, the problem of discontinuities
may become serious, though not necessarily difficult to deal with. This problem can become serious because
of the obvious fact that accepting the large proposal because it is "richer" than smaller proposals may preclude
the possibility of accepting two or more smaller and less rich proposals, which, in combination, have a greater
value than the larger proposal. For example, suppose that the total amount available for investment were
INR1,000 and that only three investment proposals had been made: one requiring a net outlay of INR600 and
creating an increment in present value of INR1,000 and two others, each requiring a net outlay of INR500 and
each creating an increment in present value of INR600.

Under these circumstances, the adoption of the richest alternative, the first, would mean foregoing the other
two alternatives, even though in combination they would create an increment in present value of INR1,200 as
compared with the increment of INR1,000 resulting -from the adoption of the richest investment alternative.
Such discontinuities deserve special attention, but the general principles dealing with them will not be worked
out here, primarily because we do not know them. We shall, however, deal with the more serious difficulties
created by the necessity to choose among investment proposals some of which require net cash outlays in more
than one accounting period. In such cases a constraint is imposed not only by the fixed sum available for
capital investment in the first period but also by the fixed sums available to carry out present commitments in
subsequent time periods. Each such investment requires, so to speak, the use of two or more kinds of money-
money from the first period and money from each subsequent period in which net outlays are required. We
shall discuss only the case of investments requiring net outlays in two periods, for simplicity of exposition and
because the principle although not the mechanics is the same as for investments requiring net outlays in more
than two periods.
Selecting the Best among Mutually Exclusive Alternatives
Before moneys are actually expended in fulfillment of an approved capital budget, the firm usually considers
mutually exclusive alternative ways of making the generally described capital investment. When the firm is
operating without an absolute limit on the dollars to be invested, the solution to the problem of selecting the
best alternative is obvious. The best alternative is the one with the greatest present value at the firm's cost of
capital. When the firm is operating subject to the constraint of an absolute dollar limit on capital expenditures,
the problem is more difficult. Consider, first, the case in which there are net outlays in only one time period.
The solution is found by the following process:
1. From each set of mutually exclusive alternatives, select that alternative for which the following quantity is
a maximum: y – pc. Here y is the present value of the alternative; c is the net outlay required; and p is a
constant of a magnitude chosen initially according to the judgment of the analyst. (Remember that the
alternative of making no investment that is accepting y = 0 and c = 0 is always available, so that the
maximum in question is never negative.)
2. Compute the total outlays required to adopt all the investment proposals selected according to the principle
just specified.
3. If the total outlay required exceeds the total amount available, p should be increased; if the total amount
required is less than the amount available for investment, p should be reduced. By trial and error, a value
for p can be found that will equate the amount required for investment with that available for investment.

It should be clear that, as the value of p is increased, the importance of the product; pc, increases, with a
consequent increase in the probability that in each set of mutually exclusive alternatives, an alternative will be
selected that requires a smaller net outlay than is required with a smaller value for p. Thus increasing p tends
to reduce the total amount required to adopt the investment proposals selected according to the principle
indicated in above. Conversely, reducing p tends to increase the outlay required to adopt the investment
proposals selected according to this principle. When there are net outlays in more than one period, the
principle of solution is the same. Instead of maximizing the quantity (y - pc), it is necessary to maximize the
quantity (y – p1c1 - p2c2), where again c1 and c2 are the net outlays in the first and second periods and p1 and p2
are auxiliary multipliers.

Up to this point, we have not discussed the problem of rationing capital among both independent investment
proposals and sets of mutually exclusive investment proposals. Superficially, this problem seems different
from the one of rationing among mutually exclusive proposals only, but in fact the problems are the same. The
identity rests upon the fact that each so called "independent" proposal is and should be considered a member of
the set of proposals consisting of the independent proposal and of the always-present proposal to do nothing.
When independent proposals are viewed in this way, it can be seen that the case of rationing simultaneously
among independent proposals and sets of mutually exclusive proposals is really just a special case of rationing
among mutually exclusive proposals according to the principles outlined in the preceding paragraph. The
mechanics of solution are easily worked out. All that is required in order to make the solution the same as the
solution for what we have called "mutually exclusive" sets of alternatives is that each so-called "independent"
proposal be treated as a member of a mutually exclusive set consisting of itself and of the alternative of doing
nothing. Once this is done, it is possible to go into the familiar routine of selecting from each set that proposal
for which the expression (y - pc), or its appropriate modification to take account of constraints existing in more
than one time period, is a maximum. Again, of course, that value of p will have to be found which results in
matching as nearly as discontinuities permit the outlays required by the accepted proposals with the outlays
permitted by the stated budgetary constraints.
12.3 Methods of Appraisal
An appraisal is an opinion of value or the act or process of estimating value. This opinion or estimate is
derived by using three common approaches, all derived from the market.
1. The cost approach to determining value is to estimate what it would cost to replace or reproduce the
improvements as of the date of the appraisal, less the physical deterioration, the functional obsolescence
and the economic obsolescence. The remainder is added to the land value.
2. The comparison approach to determining value makes use of other benchmark properties of similar size
quality and location that have been recently sold. A comparison is made to the subject property.
3. The income approach to determining value is of primary importance in ascertaining the value of income
producing properties and has little weight in residential properties. This approach provides an objective
estimate of what a prudent investor would pay based upon the net income the property produces.
There are various methods of conducting an appraisal. Some companies still rely on the traditional methods,
while others follow the modern ones, including the 360 degree appraisal among others, and also many
traditional methods. Appraisal is a review process carried out to evaluate an employee‘s job performance after
a given period of time. Appraisals are important as they help to evaluate performance and aid increments, but
most importantly, they pin point the employee‘s strengths and weaknesses. Identifying the strengths help in
channelizing the resource in the right direction whereas, when the weaknesses are identified, they help the
employees to rectify them and perform better. There are various methods of conducting an appraisal. Some
companies still rely on the traditional methods, while others follow the modern ones, including the 360 degree
appraisal among others. There are many methods which are followed while doing an appraisal in a traditional
way.

12.3.1 Essay Appraisal Method

It also known as the Free Form Method, it requires a description of the employee‘s performance from the
supervisor. This description is the assessment of the employee‘s performance based on certain parameters:
A. Potential and on the job knowledge.
B. Attitude, behavioral pattern and perceptions.
C. Relation with the peers and the superiors.
D. Planning, organizing and handling capacities in times of need.
E. Knowledge and understanding of the company‘s policies.
This method is followed in combination with the Graphic Rating Scale. The biggest flaw of this system is that
it is not free of the bias of the evaluator. Again, sycophants tend to score more and the diligent ones suffer.
Also, the evaluator might lack the adequate writing ability, which might make the whole purpose a futility.

12.3.2 Graphic Rating Scale

This is one of the oldest and the most commonly used methods for appraisal used alongside Essay Appraisal
Method. In this method, a printed form is used for measuring both the quality and the quantity of work done by
an employee. The form has a graphic scale, indicating the various degrees of a particular trait. The factors
taken into consideration are both personal and the professional ones in nature. It is an easy to understand and
easy to use method where rating is done in a tabular form. But then, this method is also not bias free as the
supervisor may plot the graph depending on the rapport with the employee rather than objectively marking
performance.

12.3.3 Paired Comparison

This is a method of comparison where each employee is first compared with the peers, one at a time, and when
all the comparisons are done, the employees are given the final rankings.
12.3.4 Critical Incidents Method
In this traditional method of performance appraisal, the evaluator rates the employee on the basis of critical
events and how the employee reacts in such events essentially their behavioral patterns during those incidents.
This includes both the positive and the negative traits of the employee. This method objectively discusses an
employee‘s performance during such incidents. However, this method has drawn a lot of flak as the superior
has to make a note of critical incidents and the resulting employee behavior as and when they happen, which is
difficult under the circumstances always. Again, the minor incidents might get precedence over the major ones
as every individual tends to see things differently. Moreover, it is not very effective as every individual is
different and reacts and performs very differently in similar circumstances.

12.3.5 Checklist Method

This is the simplest way of evaluation wherein the rate r is given a checklist containing a description of the
employee behavior on the job. The duty of the superior is to find out which description best suits the
employee. The checklist contains many statements which might be appropriate in describing the employees on
the job performance. The flaw – the checklist might not contain a certain statement which best describes the
employee and is not free of the rater‘s bias. However, this system is widely used and accepted. Some of the
other popular traditional methods are straight ranking Method, Field Review, Confidential Report,
Behaviorally Anchored Scales, Forced Distribution and Management by Objectives (MBO). However, all the
traditional methods of appraisal mostly contain the element of bias and are not absolutely impartial, which to
an extent spoils the purpose. Hence, organizations these days opt for the modern methods to rein in
impartiality, though some still swear by the traditional methods.

12.4 Pay-Back Period Method

Pay-back period is also termed as "Pay-out period" or Pay-off period. Payout Period Method is one of the most
popular and widely recognized traditional methods of evaluating investment proposals. It is defined as the
number of years required to recover the initial investment in full with the help of the stream of annual cash
flows generated by the project.
Calculation of Pay-back Period: Pay-back period can be calculated into the following two different situations:
• In the case of constant annual cash inflows.
• In the case of uneven or unequal cash inflows.

In the Case of Constant Annual Cash inflows: If the project generates constant cash flow the
The payback method is popular because of its simplicity and power as an initial screening method. It is
especially good for high-risk projects in which the useful life of a project is difficult to determine. If a project
pays for itself in two years, then it matters less how long after two years the system lasts. The weakness of this
measure is its virtues: The method ignores the time value of money, the amount of cash flow after the payback
period, the disposal value (usually zero with computer systems), and the profitability of the investment.
Pay-back period can be computed by dividing cash outlays (original investment) by annual cash inflows.
The following formula can be used to ascertain pay-back period:

Cash Outlays (Initial Investment)

Pay back Period
AnnualCash Flows

In the case of Uneven or Unequal Cash Inflows: In the case of uneven or unequal cash inflows, the Pay-back
period is determined with the help of cumulative cash inflow. It can be calculated by adding up the cash
inflows until the total is equal to the initial investment.
Accept or Reject Criterion
Investment decisions based on pay-back period used by many firms to accept or reject an investment proposal.
Among the mutually exclusive or alternative projects whose pay-back periods are lower than the cut off
period. The project would be accepted. If not it would be rejected.

Advantages of Pay-back Period Method

It is an important guide to investment policy
It is simple to understand and easy to calculate
It facilitates to determine the liquidity and solvency of a firm
It helps to measure the profitable internal investment opportunities
It enables the firm to select an investment which yields a quick return on cash funds
It used as a method of ranking competitive projects
It ensures reduction of cost of capital expenditure.

Disadvantages of Pay-back Period Method

It does not measure the profitability of a project
It does not value projects of different economic lives
This method does not consider income beyond the pay-back period
It does not give proper weight to timing of cash flows
It does not indicate how to maximize value and ignores the relative profitability of the project
It does not consider cost of capital and interest factor which are very important factors in taking sound
investment decisions.

Improvement of Traditional Approach to Pay-back Period

The demerits of the pay-back period method may be eliminated in the following ways:
(a) Post Pay-back Profitability Method: One of the limitations of the pay-back period method is that it ignores
the post pay-back returns of project. To rectify the defect, post pay-back period method considers the amount
of profits earned after the pay-back period. This method is also known as Surplus Life over Payback Method.
According to this method, pay-back profitability is calculated by annual cash inflows in each of the year, after
the pay-back period. This can be expressed in percentage of investment.
Post Pay-back Profitability = Annual Cash Inflow x (Estimated Life - Pay-back Period)
The post pay-back profitability index can be determined by the following equation:

Post Payback Pr ofits

Post Pay back Pr ofitability Index 100
Initial Investments

(b) Discounted Pay-back Method: This method is designed to overcome the limitation of the payback period
method. When savings are not leveled, it is better to calculate the pay-back period by taking into consideration
the present value of cash inflows. Discounted pay-back method helps to measure the present value of all cash
inflows and outflows at an appropriate discount rate. The time period at which the cumulated present value of
cash inflows equals the present value of cash outflows is known as discounted pay-back period.

(c) Reciprocal Pay-back Period Method: This method helps to measure the expected rate of return of income
generated by a project. Reciprocal pay-back period method is a close approximation of the Time Adjusted
Rate of Return, if the earnings are leveled and the estimated life of the project is somewhat more than twice
the pay-back period. This can be calculated by the following formula:
 AnnualCash Inflows
Reciprocal Pay back Period 100
TotalInvestment

12.5 Risk Analysis in Capital Budgeting

Risk may be defined as the variation of actual cash flows from the expected cash flows. The term risk in
capital budgeting decisions may be defined as the variability that is likely to occur in future between the
estimated and the actual returns. Risk exists on account of the inability of the firm to make perfect forecasts of
cash flows. Risk arises in project evaluation because the firm cannot predict the occurrence of possible future
events with certainty and hence, cannot make any correct forecast about the cash flows. The uncertain
economic conditions are the sources of uncertainty in the cash flows.
For example, a company wants to produce and market a new product to their prospective customers. The
demand is affected by the general economic conditions. Demand may be very high if the country experiences
higher economic growth. On the other hand economic events like weakening of US dollar, subprime crises
may trigger economic slowdown. This may create a pessimistic demand drastically bringing down the estimate
of cash flows.

Risk is associated with the variability of future returns of a project. The greater the variability of the expected
returns the riskier the project. Every business decision involves risk. Risk arises out of the uncertain conditions
under which a firm has to operate its activities. Because of the inability of firms to forecast accurately cash
flows of future operations the firms face the risks of operations. The capital budgeting proposals are not based
on perfect forecast of costs and revenues because the assumptions about the future behavior of costs and
revenue may change. Decisions have to be made in advance assuming certain future economic conditions.
There are many factors that affect forecasts of investment, cost and revenue.
1. The business is affected by changes in political situations, monetary policies, taxation, interest rates,
policies of the central bank of the country on lending by banks etc.
2. Industry specific factors influence the demand for the products of the industry to which the firm belongs.
3. Company specific factors like change in management, wage negotiations with the workers, strikes or
lockouts affect company‘s cost and revenue positions.

Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management. The best
business decisions may not yield the desired results because the uncertain conditions likely to emerge in future
can materially alter the fortunes of the company. Every change gives birth to new challenges. New challenges
are the source of new opportunities. A proactive firm will convert every problem into successful enterprise
opportunities. A firm which avoids new opportunities for the inherent risk associated with it will stagnate and
degenerate. Successful firms have empirical history of successful management of risks.
Therefore, analyzing the risks of the project to reduce the element of uncertainty in execution has become an
essential aspect of today‘s corporate project management.

12.5.1 Types and sources of Risk in capital Budgeting

Risks in a project are many. It is possible to identify three separate and distinct types of risk in any project.
1. Stand Alone Risk: it is measured by the variability of expected returns of the project.
2. Portfolio Risk: A firm can be viewed as portfolio of projects having as certain degree of risk. When new
project added to the existing portfolio of project the risk profile the firm will alter. The degree of the
change in the risk depends on the covariance of return from the new project and the return from the
 existing portfolio of the projects. If the return from the new project is negatively correlated with the return
from portfolio, the risk of the firm will be further diversified away.
3. Market or beta risk: It is measured by the effect of the project on the beta of the firm. The market risk for a
project is difficult to estimate. Stand alone risk is the risk of a project when the project is considered in
isolation. Corporate risk is the projects risks to the risk of the firm. Market risk is systematic risk. The
market risk is the most important risk because of the direct influence it has on stock prices.

Sources of risk
The sources of risks are
1. Project specific risk
2. Competitive or Competition risk
3. Industry specific risk
4. International risk
5. Market risk

Project Specific Risk

The sources of this risk could be traced to something quite specific to the project. Managerial deficiencies or
error in estimation of cash flows or discount rate may lead to a situation of actual cash flows realized being
less than that projected.

Competitive Risk or Competition Risk

Unanticipated actions of a firm‘s competitors will materially affect the cash flows expected from a project.
Because of this the actual cash flows from a project will be less than that of the forecast.

Industry Specific
Industry specific risks are those that affect all the firms in the industry. It could be again grouped into
technological risk, commodity risk and legal risk. All these risks will affect the earnings and cash flows of the
project. The changes in technology affect all the firms not capable of adapting themselves to emerging new
technology. The best example is the case of firms manufacturing motor cycles with two strokes engines. When
technological innovations replaced the two stroke engines by the four stroke engines those firms which could
not adapt to new technology had to shut down their operations. Commodity risk is the risk arising from the
effect of price – changes on goods produced and marketed. Legal risk arises from changes in laws and
regulations applicable to the industry to which the firm belongs. The best example is the imposition of service
tax on apartments by the Government of India when the total number of apartments built by a firm engaged in
that industry exceeds a prescribed limit. Similarly changes in Import Export policy of the Government of India
have led to the closure of some firms or sickness of some firms.

International Risk
These types of risks are faced by firms whose business consists mainly of exports or those who procure their
main raw material from international markets.

Market Risk
Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and
all industries. Firms cannot diversify this risk in the normal course of business. Techniques used for
incorporation of risk factor in capital budgeting decisions. There are many techniques of incorporation of risk
perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology so
far as incorporation of risk in the evaluation process is concerned.
12.5.2 Risk Analysis in Capital Budgeting
The following methods are used for Risk Analysis in Capital Budgeting:
Sensitivity Analysis
This is also known as a "what if analysis". Because of the uncertainty of the future, if an entrepreneur wants to
know about the feasibility of a project in variable quantities, for example investments or sales change from the
anticipated value, sensitivity analysis can be a useful method. This is calculated in terms of NPV, or net
present value.

Scenario Analysis
In the case of scenario analysis, the focus is on the deviation of a number of interconnected variables. It is
different from sensitivity analysis, which usually concentrates on the change in one particular variable at a
specific point of time.

Break Even Analysis

The Break Even Analysis allows a company to determine the minimum production and sales amounts for a
project to avoid losing money. The lowest possible quantity at which no loss occurs is called the break-even
point. The break-even point can be delineated both in financial or accounting terms.

Hillier Model
In particular situations, the anticipated NPV and the standard deviation of NPV can be incurred with the help
of analytical derivation. There are situations where correlation between cash flows is either complete or
nonexistent.

Simulation Analysis
Simulation analysis is utilized for formulating the probability analysis for a criterion of merit with the help of
random blending of variable values that carry a relationship with the selected criterion.

Decision Tree Analysis

The principal steps of decision tree analysis are the definition of the decision tree and the assessment of the
alternatives.

Corporate Risk Analysis

Corporate risk analysis focuses on the analysis of risk that may influence the project in terms of the entire cash
flow of the firm. The corporate risk of a project refers to its share of the total risk of a company.

Risk Management
Risk management focuses on factors such as pricing strategy, fixed and variable costs, sequential investment,
insurance, financial leverage, long term arrangements, derivatives, strategic alliance and improvement of
information.

Selection of Project under Risk

This involves procedures such as payback period requirement, risk adjusted discount rate, judgmental
evaluation and certainty equivalent method.

Practical Risk Analysis

The techniques involved include the Acceptable Overall Certainty Index, Margin of Safety in Cost Figures,
Conservative Revenue Estimation, Flexible Investment Yardsticks and Judgment on Three Point Estimates.
Did You Know?
Hillier Model was first realized by F.S. Hillier.

Case Study-Capital Budgeting in Corporate Sector

Successful companies are always looking at ways in which they can change and develop. Change can trigger
corporate growth and Growth is essential for sustaining the viability, dynamism and value enhancing
capability of a company, which lead to higher profits and better the shareholders‟ value. To achieve the
desired growth, the firm has to be competitive in all functional areas especially in financial management which
is the back bone of any business. Primarily growth can be measured in terms of change in investments or sales.
A progressive business firm continually needs to expand its fixed assets and other resources to be competitive
in the race. Investment in fixed assets is an important indicator of corporate growth. The success of the
corporate in the long run depends upon the effectiveness with which the management makes capital
expenditure decisions. The finance manager should ensure that he has explored and identified potentially
lucrative investment opportunities and proposals and select the best one based on the opportunities identified.
In the dynamic business environment, making capital budgeting decisions are among the most important and
multifaceted of all management decisions as it represents major commitments of company‘s resources and
have serious consequences on the profitability and financial stability. Evaluation need to be done for the extent
of financial stability achieved by the firm‘s capital budgeting decisions over a period of time. In view of this,
this study has made an attempt to know the efficiency of the corporate sector‘s capital budgeting decisions.

Rationale of the Study

The success of any business depends on the adjustments and adaptations it makes in its operations to match the
external competitive environment. Swift reaction to the changing business environment is ensured only when
the organization is effective in decision-making in all its operational areas. This is a good sign for the growth-
oriented companies. Growth oriented companies need to invest sizable proportion of its capital in the fixed
assets constantly. Rate of investments in the corporate sector depends on the internal growth decisions relating
to various decisions viz. replacement, expansion, modernization, introduction of new product lines and also
capability of raising resources for financing growth. Thus, Capital budgeting decision is a major corporate
decision because it typically affects the firm‘s business performance for a long period of time. While making
capital budgeting decisions, the company needs to foresee the impact on its future performance. In view of
this, this research provides comprehensive analysis of the efficiency of the corporate sector‘s capital budgeting
decisions which got reflected in their financial statements.

Questions
1. Why capital budgeting decisions are important?
2. What is rationale of the study in corporate sector?

12.6 Summary
Capital expenditures are defined as investments to acquire fixed or long lived assets from which a stream
of benefits is expected.
An appraisal is an opinion of value or the act or process of estimating value. This opinion or estimate is
derived by using three common approaches, all derived from the market.
There are various methods of conducting an appraisal. Some companies still rely on the traditional
methods, while others follow the modern ones, including the 360 degree appraisal among others, and also
many traditional methods.
 The checklist contains many statements which might be appropriate in describing the employees on the job
performance.
It is defined as the number of years required to recover the initial investment in full with the help of the
stream of annual cash flows generated by the project.
Investment decisions based on pay-back period used by many firms to accept or reject an investment
proposal.
The term risk in capital budgeting decisions may be defined as the variability that is likely to occur in
future between the estimated and the actual returns.
Stand Alone Risk: it is measured by the variability of expected returns of the project.

12.7 Keywords
Appraisal: It is a review process carried out to evaluate an employee‘s job performance after a given period of
time.
Break Even Analysis: It allows a company to determine the minimum production and sales amounts for a
project to avoid losing money.
Capital budgeting: It is the process of making investment decisions in capital expenditures.
IRR: It is the rate of return on funds employed; it is calculated on the basis of discounted cash flow approach.
Pay Back Period: It is the period within which the project will pay back its cost.

12.8 Self Assessment Questions

1. Capital Budget is also known as ".............. Decision Making‖.
(a) Support (b) Investment
(c) short-term (d) None of these

2. Capital budgeting is concerned with the firm's formal process for the acquisition and investment of capital.
This given by...............................
(a) Hamption, John (b) John
(c) Linkon (d) Donald

3. Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.
(a) True (b) False

4. Capital expenditure activities are made up of two distinct processes:

(a) making the planning and implementing
(b) making the decision and goals
(c) making the decision and implementing
(d) None of these

5. NPV = PV of inflow + PV of outflow.

(a) True (b) False

6. Present value of inflow

Present value of inflow
(a) Profitability index (PI)
PV of outflow
 PV of outflow
(b Profitability index (PI)
Present value of inflow
PV of inflow
(c) Profitability index (PI)
Present value of inflow
PV of inflow
(d) Profitability index (PI)
PV of outflow

7. Corporate executives face ………………tasks in achieving good financial management.

(a) four (b) two
(c) three (d) None of these

8. Appraisals are important as they help to evaluate …………….and aid increments.

(a) results (b) performance
(c) both (a) and (b) (d) financial groth

9. Pay-back period is also termed as "Pay-out period" or Pay-off period.

(a) True (b) False

10. Pay-back period can be computed by dividing cash outlays (original investment) by……………...
(a) half cash inflows (b) monthly cash inflows
(c) annual cash inflows (d) None of these

12.9 Review Questions

1. What is the capital budgeting? And also explain the process of base budgeting.
2. Explain the discounted cash flow analysis.
3. What is concept of IRR?
4. What do you mean by capital rationing problems?
5. Define mutually exclusive alternatives in capital rationing.
6. What is essay appraisal method? Explain.
7. Write short note on:
Graphic Rating Scale
Checklist Method
8. Explain the advantage and disadvantages of pay-back period method?
9. How many types and sources of risk in capital Budgeting?
10. Explain briefly:
Competitive or Competition risk
Industry specific risk

Answers for Self Assessment Questions

1. (b) 2. (a) 3. (a) 4. (c) 5. (b)
6. (a) 7.(c) 8.(b) 9.(a) 10. (c)
 13
Process/Steps of Capital Budgeting
CONTENTS
Objectives
Introduction
13.1 Process/Steps of Capital Budgeting
13.2 Ranking of Capital budgeting
13.3 Return on Investment
13.4 Proposals and Classification of Investment Proposals
13.5 Types of Investment Risk
13.6 Replacement
13.7 Measurement of Risk
13.8 Summary
13.9 Keywords
13.10 Self Assessment Questions
13.11 Review Questions

Objectives
After studying this chapter, you will be able:
Define the process/steps of capital budgeting
Explain the ranking of capital budgeting
Define return on investment
Describe the proposals and classification of investment proposals
Explain the types of investment risk
Define the replacement
Discuss the measurement of risk

Introduction
The capital budgeting process is the process of identifying and evaluating capital projects, that is, projects
where the cash flow to the firm will be received over a period longer than a year. Any corporate decisions with
an impact on future earnings can be examined using this framework. Decisions about whether to buy a new
machine, expand business in another geographic area, move the corporate headquarters to Cleveland, or
replace a delivery truck, to name a few, can be examined using a capital budgeting analysis. For a number of
good reasons, capital budgeting may be the most important responsibility that a financial manager has. First,
since a capital budgeting decision often involves the purchase of costly long-term assets with lives of many
years, the decisions made may determine the future success of the firm. Second, the principles underlying the
capital budgeting process also apply to other corporate decisions, such as working capital management and
making strategic mergers and acquisitions. Finally, making good capital budgeting decisions is consistent with
management's primary goal of maximizing shareholder value.

13.1 Process/Steps of Capital Budgeting

The capital budgeting process defined in following steps:

13.1.1 Identification of Investment Proposals

The capital budgeting process begins with the identification of investment proposals. Investment opportunities
have to be identified or created; they do not occur automatically. Investment proposal of various types may
originate at different levels within a firm. Most proposals, in the nature of cost reduction or replacement or
processor product improvement takes place at plant level. The contribution of top management in generating
investment ideas is generally confined to expansion or diversification projects. The proposal may originate
systematically in a firm. In view of the fact that enough investment proposals should be generated to employ
the firm‘s funds fully well and efficiently, a systematic procedure for generating proposal may be evolved by a
firm. In a number of Indian companies, more than 50% of the investment ideas are generated at the plant level.
Indian companies uses a variety of methods to encourage idea generation.

13.1.2 Screening the Proposals

The expenditure planning committee screens the various proposals received from different departments. The
committee views these proposals from various angles to ensure that these are in accordance with the corporate
strategies, selection criterion of the firm and also do not lead to departmental imbalances.

13.1.3 Evaluation of Various Proposals

The evaluation of projects should be performed by group of experts who have no axe to grind. For example,
the production people may generally interested in having the most modern type of equipment and increased
production even of productivity is expected to be low and goods cannot be sold this attitude can bias their
estimates of cash flows of the proposed projects. Similarly, marketing executives may be too optimistic about
the sales prospects of goods manufactured, and overestimate the benefits of a proposed new product. It is
therefore, necessary to ensure that projects are scrutinized by an impartial group and that objectivity is
maintained in the evaluation process. A company in practice should take all care in selecting a method or
methods of investment evaluation. The criterion or criteria selected should be a true measure of evaluating if
the investment is profitable(in terms of cash flows), and it should lead the net increase in the company‘s
wealth(that is, its benefits should exceeds its costs adjusted for time value and risk).

13.1.4 Fixing Priorities

After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away.
But it may not be possible for the firm to invest immediately in all the acceptable proposals due to limitation of
funds. Hence, it is very essential to rank the various proposals and to establish priorities after considering
urgency, risk and profitability involved therein.
13.1.5 Final Approval and Preparation of Capital Expenditure Budget
Proposals meeting the evaluation and criteria are finally approved to be included in the capital expenditure
budget. However, proposals involving smaller investment may be decided at the lower for expenditure action.
The capital expenditure budget lays down the amount of estimated expenditure to be incurred on fixed assets
during the budget period.

13.1.6 Implementing Proposal

Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not
itself authorize to go ahead with the implementation of the project a request for authority to spend the amount
should further be made to the capital expenditure committee which may like to review the profitability of the
project, in the changed circumstances. Further, while implementing the project, it is better to assign
responsibilities for completing the project within the given time frame and cost limit so as to avoid
unnecessary delays and cost over runs. Network techniques used in the project management such as PRRT and
CPM can also be applied to control and monitor the implementing of the projects.

13.1.7 Performance Review

A capital projects reporting system is required to review and monitor the performance of investment projects
after the completion and during their life. The follow up comparison of the actual performance with original
estimate not only ensure better forecasting. Based on the follow up feedback, the company may reappraise its
projects and take remedial action. Indian company‘s practices control of capital expenditure through the use of
regular project reports. Some companies required quarterly reporting, monthly, half yearly and yet a few
companies require continuous reporting. In most of the companies the evaluation reports include information
on expenditure to date stage of physical completion, and revised total cost.

13.2 Ranking of Capital budgeting

When a number of projects appear to be acceptable on the basis of their profitability the projects will be
ranked in order of their profitability in order to determine the most profitable project. Ranking of capital
investment proposals is particularly necessary in the following two circumstances
(a)Where capital is rationed, i.e., there is a limit on funds available for investment.
(b) Where two or more investment opportunities are mutually exclusive, i.e., only one of the opportunities can
be undertaken.
Thus, the objective of ranking is to put the capital available to the best possible use. This will be clear from the
following example:

A Ltd. is considering the following five projects for capital expenditure. The company can spare a sum of Rs.
1, 50,000 and expect a minimum return of 15% before tax on the investment. The details of the projects are as
under:
Projects Capital Expenditure Estimated Savings Percentage return on
(Before tax) investments
(i) (ii) (iii) (iv)
A Rs. 50,000 Rs. 5,000 20
B 75,000 9,000 24
C 1,00,000 8,000 16
D 1,25,000 25,000 40
E 1,50,000 28,000 37
Tax rate may be taken as 50%
Solution:
On the basis of information given, project D seems to be the most profitable, since it is giving the highest
percentage return on investment. However, in case this project is taken up Rs.25, 000 will be the surplus
amount available with the company for alternative investment. In case project E is taken up, the full amount of
Rs.1, 50,000 would be used up. The difference between the additional investment required and Rs.25, 000 and
additional income is Rs. Rs 3,000 respectively over D giving a return rise of 12% on the balance of Rs.
25,000over D. In case such an opportunity is not available, the company should take up project E.

Did You Know?

The net present value (NPV) was first applied to Corporate Finance by Joel Dean in 1951.

13.3 Return on Investment

A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a
number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost
of the investment; the result is expressed as a percentage or a ratio.
The return on investment formula:
(Gain from Investment Cost of Investment)
ROI
Cost of Investment
In the formula "gains from investment", refers to the proceeds obtained as of selling the investment of interest.
Return on investment is a much admired metric because of its versatility and simplicity. That is, if an
investment does not have a positive ROI, or if there are additional opportunities with a higher ROI, then the
investment should be not be undertaken. Keep in mind that the calculation for return on investment and, then
the definition, can be modified to suit the situation -it all depends on what we include as returns and costs. The
definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as
such, there is no one "right" calculation.

For example, a marketer may compare two different products by dividing the gross profit that each product has
generated by its respective marketing expenses. A financial analyst, however, may compare the same two
products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by
the total value of all resources that have been employed to make and sell the product.
This flexibility has a weakness, as ROI calculations can be easily manipulated to suit the user's purposes, and
the result can be expressed in numerous different ways. When using this metric, make sure that understand
what inputs are being used. In other words the accounting rate of return (ARR), also known as the return on
investment (ROI), used accounting information, as revealed by financial statements, to measure the
profitability of an investment. The accounting rate of return is found out by dividing the average after tax
profit by the average investment. The average Investment would be equal to half of the original investment if it
is depreciated constantly. Alternatively, it can be found out dividing the total of the investment‘s book value
after depreciation by the life of the project. The accounting rate of return, thus, is an average rate and can be
determined by the following equation:
ARR=Average annual income (after tax and depreciation) ÷ Average investment
Where,
Average investment = Original investment÷2

Accept or Reject Criterion

As an accept or reject criterion, this method will accept all those projects whose ARR is higher than the
minimum rate established by the management and reject those projects which have ARR less than the
minimum rate. This method would rank a project as number one if it has highest ARR and lowest rank would
be signed to the project with lowest ARR.
Evaluation of ARR Method
It is simple to understand and use
The ARR can be readily calculated from the accounting data; unlike in the NPV and IRR methods, no
adjustments are required to arrive at cash flows of the project.
The ARR rule incorporates the entire stream of in calculating the project‘s profitability.

Advantages
It is very simple to understand and easy to calculate.
It uses the entire earnings of a project in calculating rate of return and hence gives a true view of
profitability.
As this method is based upon accounting profit, it can be readily calculated from the financial data.

Disadvantages
It ignores the time value of money.
It does not take in to account the cash flows, which are more important than the accounting profits.
It ignores the period in which the profit are earned as a 20% rate of return in 2 ½years is considered to be
better than 18%rate of return in 12 years. This method cannot be applied to a situation where investment in
project is to be made in parts.

13.4 Proposals and Classification of Investment Proposals

A proposal is a plan for solving a problem. Engineers and scientists write proposals to do such things as
research turbulent boundary layers, design turbine blades, and construct jet aircraft engines. The audience for a
proposal usually includes both managers and engineers. These audiences view proposals in different ways. For
instance, managers review proposals to see if the plan for solving the problem is cost effective. Engineers and
scientists, on the other hand, review proposals to see if the plan is technically feasible. A proposal is an
essential marketing document that helps cultivate an initial professional relationship between an organization
and a donor over a project to be implemented. The proposal outlines the plan of the implementing organization
about the project, giving extensive information about the intention, for implementing it, the ways to manage it
and the results to be delivered from it. A proposal is a very important document. In some cases, a concept note
precedes a proposal, briefing the basic facts of the project idea. However, the project idea faces a considerable
challenge when it has to be presented in a framework. The proposal has a framework that establishes ideas
formally for a clear understanding of the project for the donor. Besides, unless the ideas are not documented in
writing, they do not exist. Hence, a proposal facilitates appropriate words for the conception of an idea.
Proposals have recently become more sophisticated.
This reflects the increased competitiveness and larger resources existing in the NGO sector. The trend of
inviting proposals for contracting development program began with the allotment of substantial resources for
development that triggered off the mushrooming of NGOs around the world. Enormous opportunities existing
in the sector have led to the trend of making proposal writing a profession. Proposal writing poses many
challenges, especially for small and unskilled NGOs. Here, we discuss some basic and necessary information
required for developing a proposal.
There are three distinct categories of business proposals:
Formally solicited
Informally solicited
Unsolicited.
Solicited proposals are written in response to published requirements, contained in a Request for Proposal
(RFP), Request for Quotation (RFQ), and Request for Information (RFI) or an Invitation for Bid (IFB).
In a solicited proposal, a company or agency advertises that it desires the solution to a problem. In most cases,
this company or agency sends out a request for proposals, often called an RFP that presents a problem which
needs addressing. For example, if the Department of Energy desires research on reducing nitrogen oxide
emissions from diesel engines, then the Department announces its request, often in periodicals such as the
Commerce Business Daily. A company then reads the announcement and proposes a plan for doing the
research.

Informally solicited proposals are typically the result of conversations held between a vendor and a prospective
customer. The customer is interested enough in a product or service to ask for a proposal.

Unsolicited proposal: there is no request. Instead, an engineer on his or her own initiative recognizes a client's
problem, writes a proposal that first makes the client aware of the problem, and then presents a plan for
solving that problem. Unsolicited proposals often occur within a company.

13.4.1 Kinds of Capital Investment Proposals

A firm may have several investment proposals for its consideration. It may adopt one of them, some of them or
all of them depending upon whether they are independent, contingent or dependent or mutually exclusively.

Mutually Exclusive Investment Proposals

Two or more alternative proposals are said to be mutually exclusive when acceptance of one alternative result
in automatic rejection of all other proposals. The mutually exclusive decisions occur when a firm has more
than one alternative but competitive proposal before it. For example, if a company is considering investment in
one of two temperature control system, acceptance of one system will rule out the acceptance of another. Thus,
two or more mutually exclusive proposals cannot both or all be accepted. Some technique has to be used for
selecting the better or the one. Once this is done, other alternative automatically get eliminated.

Contingent Decisions or Dependent Proposals

These are proposals whose acceptance depends on the acceptance of one or more other proposals. For example
a new machine may have to be purchased on account of substantial expansion of plant. In this case investment
in the machine is dependent upon expansion of plant. When a contingent investment proposal is made, it
should also contain the proposal on which it is dependent in order to have a better perspective of the situation.
Any capital budgeting decision must be evaluated by the finance manager in its totality. The contingent
decision, if any, must be considered and evaluated simultaneously.

Independent Investment Proposals

These are proposals which do not compete with one another in a way that acceptance of one precludes the
possibility of acceptance of another. In case of such proposals the firm may straightway ―accept or reject‖ a
proposal on the basis of a minimum return on investment required. All those proposals which give a higher
return than a certain desired rate of return are accepted and the rest are rejected.
An accept-reject decision occurs when a proposal is independently accepted or rejected without regard any
other alternative proposal. This type of decision is made when
(i) Proposal‘s cost and benefit neither affect nor are affected by the cost and benefits of other proposals, and
(ii) Accepting or rejecting one proposal has not impact on the desirability of other proposals, and (iii) the
different proposals being considered are competitive.
13.5 Types of Investment Risk
Every investment opportunity carries some risks. In some investments, a certain type of risk may be
predominant, and others not so significant. A full understanding of the various important risks is essential for
taking calculated risks and making sensible investment decisions.
Nine major risks are present in varying degrees in different types of investments.

13.5.1 Risk of Loss of Principal

This is the most basic kind of risk. The principal is the original amount of money that we invested. If we buy a
stock or mutual fund or invest in real estate, there is no guarantee that we will get all of our principal back. we
can greatly reduce or eliminate the risk to our principal by keeping our money in a bank savings account,
purchasing a fixed term deposit (agreeing to deposit our money for a specified amount of time), or buying
investment grade bonds. But even when we guarantee our principal, there are still other kinds of risk.

13.5.2 Default Risk

This is the most frightening of all investment risks. The risk of non-payment refers to both the principal and
the interest. For all unsecured loans, e.g. loans based on promissory notes, company deposits, etc., this risk is
very high. Since there is no security attached, we can do nothing except, of course, go to a court when there is
a default in refund of capital or payment of accrued interest. Given the present circumstances of enormous
delays in our legal systems, even if we do go to court and even win the case, we will still be left wondering
who ended up being better off - we the borrower, or our lawyer!

13.5.3 Business Risk

The market value of our investment in equity shares depends upon the performance of the company we invest
in. If a company‘s business suffers and the company does not perform well, the market value of our share can
go down sharply. This invariably happens in the case of shares of companies which hit the IPO market with
issues at high premiums when the economy is in a good condition and the stock markets are bullish. Then if
these companies could not deliver upon their promises, their share prices fall drastically. When we invest
money in commercial, industrial and business enterprises, there is always the possibility of failure of that
business; and we may then get nothing, or very little, on a pro-rata basis in case of the firm's bankruptcy.
A recent example of a banking company where investors were exposed to business risk was of Global Trust
Bank. Global Trust Bank, promoted by Ramesh Gelli, slipped into serious problems towards the end of 2003
due to NPA-related issues.

However, the Reserve Bank of India's [Get Quote] decision to merge it with Oriental Bank of Commerce [Get
Quote] was timely. While this protected the interests of stakeholders such as depositors, employees, creditors
and borrowers was protected, interests of investors, especially small investors were ignored and they lost their
money. The greatest risk of buying shares in many budding enterprises is the promoter himself, who by
overstretching or swindling may ruin the business.

13.5.4 Liquidity Risk

Money has only a limited value if it is not readily available to us as and when we need it. In financial jargon,
the ready availability of money is called liquidity. An investment should not only be safe and profitable, but
also reasonably liquid. An asset or investment is said to be liquid if it can be converted into cash quickly, and
with little loss in value. Liquidity risk refers to the possibility of the investor not being able to realize its value
when required. This may happen either because the security cannot be sold in the market or prematurely
terminated, or because the resultant loss in value may be unrealistically high. Current and savings accounts in
a bank, National Savings Certificates, actively traded equity shares and debentures, etc. are fairly liquid
investments. In the case of a bank fixed deposit, we can raise loans up to 75% to 90% of the value of the
deposit; and to that extent, it is a liquid investment. Some banks offer attractive loan schemes against security
of approved investments, like selected company shares, debentures, National Savings Certificates, Units, etc.
Such options add to the liquidity of investments.

13.5.5 Purchasing Power Risk or Inflation Risk

Inflation means being broke with a lot of money in our pocket. When prices shoot up, the purchasing power of
our money goes down. Some economists consider inflation to be a disguised tax. Given the present rates of
inflation, it may sound surprising but among developing countries, India is often given good marks for
effective management of inflation. The average rate of inflation in India has been less than 8% p.a. during the
last two decades. However, the recent trend of rising inflation across the globe is posing serious challenge to
the governments and central banks. In India's case, inflation, in terms of the wholesale prices, which remained
benign during the last few years, began firming up from June 2006 onwards and topped double digits in the
third week of June 2008. The skyrocketing prices of crude oil in international markets as well as food items are
now the two major concerns facing the global economy, including India. Ironically, relatively ―safe‖ fixed
income investments, such as bank deposits and small savings instruments, etc., are more prone to ravages of
inflation risk because rising prices erode the purchasing power of our capital. ―Riskier‖ investments such as
equity shares are more likely to preserve the value of our capital over the medium term.

13.5.6 Interest Rate Risk

In this deregulated era, interest rate fluctuation is a common phenomenon with its consequent impact on
investment values and yields. Interest rate risk affects fixed income securities and refers to the risk of a change
in the value of our investment as a result of movement in interest rates. Suppose we have invested in a security
yielding 8% per annual. for 3 years. If the interest rates move up to 9% one year down the line, a similar
security can then be issued only at 9%. Due to the lower yield, the value of our security gets reduced.

13.5.7 Political Risk

The government has extraordinary powers to affect the economy; it may introduce legislation affecting some
industries or companies in which we have invested, or it may introduce legislation granting debt-relief to
certain sections of society, fixing ceilings of property, etc. One government may go and another come with a
totally different set of political and economic ideologies. In the process, the fortunes of many industries and
companies undergo a drastic change. Change in government policies is one reason for political risk. Whenever
there is a threat of war, financial markets become panicky. Nervous selling begins. Security prices plummet. In
case a war actually breaks out, it often leads to sheer pandemonium in the financial markets. Similarly,
markets become hesitant whenever elections are round the corner. The market prefers to wait and watch, rather
than gamble on poll predictions. International political developments also have an impact on the domestic
scene, what with markets becoming globalized. This was amply demonstrated by the aftermath of 9/11 events
in the USA and in the countdown to the Iraq war early in 2003. Through increased world trade, India is likely
to become much more prone to political events in its trading partner-countries.

13.5.8 Market Risk

Market risk is the risk of movement in security prices due to factors that affect the market as a whole. Natural
disasters can be one such factor. The most important of these factors is the phase (bearish or bullish) the
markets are going through. Stock markets and bond markets are affected by rising and falling prices due to
alternating bullish and bearish periods: Thus:
Bearish stock markets usually precede economic recessions.
 Bearish bond markets result generally from high market interest rates, which, in turn, are pushed by high
rates of inflation.
Bullish stock markets are witnessed during economic recovery and boom periods.
Bullish bond markets result from low interest rates and low rates of inflation.

13.5.9 Volatility
In simple term volatility is the range over which the value of an asset moves over some time, usually a year
(technically, the standard deviation over the return rate). If the price moves a lot, it is a high volatility asset,
whereas if it does not go anywhere quickly, it is low volatility. Low volatility usually seems more attractive,
but higher volatility typically delivers superior returns to compensate. Diversification can reduce volatility
without denting returns to the same degree. (Volatility risk has specific meanings, to do with options or
currencies, beyond the scope of this piece).

13.6 Replacement
The main objective of modernization and replacement is to improve operating efficiency and reduce costs.
Cost savings will reflect in the increased profits, but the firm‘s revenue may remain unchanged. Assets become
outdated and obsolete with Technological changes. The firm must decide to replace those asserts with new
assets that operate more economically. If Cement Company changes from semi automatic drying equipment to
fully automatic drying equipment, it is an example of modernization and replacement. Replacement decisions
help to introduce more efficient and economical assets and therefore, are also called reduction investments.
However, replacement decisions which involve substantial modernization and technological improvements
expand revenues as well as reduced costs.

Expansion
Sometimes, the firm may be interested in increasing the installed production capacity so as to increase the
market share. In such a case, the finance manager is required to evaluate the expansion program in terms of
marginal costs and marginal benefits.

Diversification
Sometimes, the firm may be interested to diversify into new product lines, markets; production of spare parts
etc. in such case, the finance manager is required to evaluate not only the marginal cost and benefits, but also
the effect of diversification on the existing market share and profitability. Both the expansion and
diversification decisions may also be known as revenue increasing decision

13.7 Measurement of Risk

There are two ways to measure risk.
Absolute Measures of Risk
Capital asset pricing model.

13.7.1 Absolute Measures of Risk

One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of dispersion
around a central tendency. For example, during a 15-year period from August 1, 1992, to July 31, 2007, the
average annualized total return of the S&P 500 Stock Index was 10.7%. This number tells us what happened
for the whole period, but it does not say what happened along the way. The average standard deviation of the
S&P 500 for that same period was 13.5%. Statistical theory tells us that in normal distributions (the familiar
bell-shaped curve) any given outcome should fall within one standard deviation of the mean about 67% of the
time and within two standard deviations about 95% of the time. Thus, an S&P 500 investor could expect the
return at any given point during this time to be 10.7% +/- 13.5% just under 70% of the time and +/- 27.0%
95% of the time.

13.7.2 Capital Asset Pricing Model

Theory of asset pricing as it requires us to have a working knowledge of first or second year university level
statistics and finance. Since this is an introductory, readers who are interested to learn more about the CAPM
and Modern portfolio theory are encouraged to attend a course in finance or seek advice from a qualified
advisor. Basically, the CAPM makes some major assumptions about investors and their preferences. In order
to use the CAPM to find the proper discount rate, one must know three things: a stock's beta, the nominal risk
free rate, and the expected return on the market. Stocks with betas greater than one are more risky than the
market and betas of less than one are less risky. For example, a stock with a beta of 1.5 is expected to gain
1.5% when the market rises 1%. Modern portfolio theory is also where the main ideas about diversification
come from. We will look at this concept in more detail later. For now, we can define a diversified portfolio as
containing securities which have little or no correlation to other securities in a portfolio or the market. These
securities are then placed in a portfolio in such a way as to minimize the volatility of the portfolio.
We may be scratching our head by now but this is essentially the basic concept of diversification and
minimizing risk. There are a lot of disadvantages and advantages to using the CAPM and MPT. One
assumption of the CAPM it will mention is that there are two types of risk. Market risk and firm specific risk.
The CAPM assumes that investors only get a premium return for taking on market risk because the firm
specific risk can be entirely eliminated through diversification. Thus, beta only measures market or non
diversifiable risk.

Did You Know?

The capital asset pricing model (CAPM) was introduced by Jack Treynor, William Sharpe, John Lintner and
Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern
portfolio theory.

Caution
Any capital budgeting decision must be evaluated by the finance manager in its totality.

Case Study-Capital Budgeting

We use a case study to explore further the issues raised. The case involves an international company investing
in a (fictitious) developing country. It also deals with the capital budgeting decision, method of financing and
the problem of determining a discount rate for international investment decisions. Zenobia is a developing
country situated on the coast of Africa. Its government, now democratically elected, has produced a program
of economic reforms aimed at promoting investment in the country and reducing its dependence on foreign
aid.
A major feature of this program is the privatization of companies and corporations which are currently 100%
owned by the government, e.g. hotels, breweries and coffee production. For the time being, the government is
not considering privatizing services such as post, railways or the provision of basic telecommunications (this is
mainly the fixed-line, voice telephony service). It does, however, wish to attract private capital to provide new
services such as cellular (mobile) telephones and data communication. Global Telecommunications Inc (GTI)
is a company registered in the USA but with global business interests. Its shares are not listed on a stock
exchange, but industry sources estimate that it could command a market capitalization of around Rs10, 000m.
It has established itself as a specialist in the provision of mobile telephone (cellular) services. It is currently
negotiating with the government of Zenobia (GoZ) for a license to provide such services in the country and has
already spent Rs25m in surveys and miscellaneous expenses. If GTI were successful in the negotiations, it
would be the company's first experience of working in a developing country.

Forecast Cash Flows

Based on a recent World Bank report, GTI estimates that there is a market for between 10,000 and 15,000
customers in a rectangular geographical area bounded by the capital city and three other main towns. The
proposed cellular service will operate in this relatively prosperous `urban rectangle' but the poorer, rural areas
outside the rectangle will not be covered. The market for 10,000 lines is, apart from potential disasters,
virtually guaranteed. GTI estimates that the initial investment for this number of lines will be Rs1250m. The
company has asked the government of Zenobia for a five-year exclusivity period (a period when no other
company will be allowed to enter the market to compete). Net operating cash flows, based on a network of
10,000 lines, are forecast to be:

Year: 1 2 3 4 5
Net operating 175 240 180 320 360
cash flows
(Rsm):

In year 6, competitors are likely to enter the market and cash flows are expected to fall to around Rs 300m per
annum. For the purposes of evaluation, GTI assumes this annual net cash flow will be maintained indefinitely
from year 6 onwards on a network of 10,000 lines. The figures are, of course, an extreme simplification of
what would be a complex appraisal. Cash flows would arise in both local currency and rupees (the ‗home‘
currency in this case). Forecasting the cash flows would be extremely difficult in the circumstances. However,
forecasting cash flows in any currency is fraught with difficulty and the procedure has not been covered.

Discount Rate
There is some dispute about the discount rate to be used for the evaluation of this project. The company's cost
of capital is 15% per annum constant, and this is the rate which is being suggested. However, the managing
director thinks this is a particularly risky project. Although all calculations and negotiations with the
government of Zenobia are in rupees, much of the cash inflow will be in local currency. The technical director
says that, as the project increases international diversification, it actually reduces the company's risk, so a
lower rate should be used. The finance director notes that the cash flows for each year are highly correlated
with those subsequent years and this also will affect risk.

Method of Financing
GTI is at present all equity financed. The company has sufficient cash flows from other projects to enable it to
finance the Zenobia deal internally. However, the IFC is prepared to offer 10% fixed interest rates on loans of
up to Rs1000m for investments of this nature. Capital is repaid at the end of the loan period, which must be a
minimum of five years. Interest is paid annually. No early repayment of the loan is permitted without severe
financial penalties. If GTI were to raise a similar amount of debt in the capital markets, it would currently be
obliged to pay 12.5% interest. GTI will be eligible for tax relief at 40% on loan interest payments.

Questions
1. Explain the forecast cash flows.
2. What are the challenges faces by Global Telecommunications Inc to run business in South Africa?
13.8 Summary
The capital budgeting process begins with the identification of investment proposals. Investment opportunities
have to be identified or created; they do not occur automatically. The capital expenditure budget lays down the
amount of estimated expenditure to be incurred on fixed assets during the budget period. A performance
measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different
investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment.
A proposal is a very important document. In some cases, a concept note precedes a proposal, briefing the basic
facts of the project idea. A full understanding of the various important risks is essential for taking calculated
risks and making sensible investment decisions. Interest rate risk affects fixed income securities and refers to
the risk of a change in the value of our investment as a result of movement in interest rates. Market risk is the
risk of movement in security prices due to factors that affect the market as a whole. Natural disasters can be
one such factor. Stock markets and bond markets are affected by rising and falling prices due to alternating
bullish and bearish periods.

13.9 Keywords
Capital Budgeting Process: It is the process of identifying and evaluating capital projects, that is, projects
where the cash flow to the firm will be received over a period longer than a year.
Inflation: It means being broke with a lot of money in our pocket.
Liquidity Risk: It refers to the possibility of the investor not being able to realize its value when required.
Political Risk: it may introduce legislation affecting some industries or companies, in which we have invested.
Return on Investment: refers to the proceeds obtained as of selling the investment of interest.

13.10 Self Assessment Questions

1. The objective of ............is to put the capital available to the best possible use.
(a) decision (b) ranking
(c) short-term assets (d) None of these

2. The evaluation of projects should be performed by group of experts who have axe to grind.
(a) True (b) False

3. The audience for a proposal usually includes both managers and engineers.
(a) True (b) False

4. The return on investment formula:

(Gain from Investment Cost of Investment)
(a) ROI
Cost of Interest
(Gain from Investment Cost of Investment)
(b) ROI
Cost of Interest
(Gain from Investment Cost of Investment)
(c) ROI
Cost of Investment
(Gain from Investment / Cost of Investment)
(d) ROI
Cost of Interest
5. The market value of our investment in equity shares depends upon the performance of the company we
invest in.
(a) True (b) False

6. The average rate of inflation in India has been less than…………. during the last two decades.
(a) 5% [Link] (b) 8% [Link]
(c) 4% [Link] (d) 10% [Link]

7. An asset or investment is said to be ……..if it can be converted into cash quickly, and with little loss in
value.
(a) flow (b) assets
(c) liquid (d) None of these

8. Average investment =.
(a) Original investment-2 (b) Original investment+2
(c) Original investment÷3 (d) Original investment÷2

9. The contribution of top management in generating investment ideas is generally confined to expansion or
diversification projects.
(a) True (b) False

10. In the case of a bank fixed deposit, we can raise loans up to ……….of the value of the deposit; and to that
extent, it is a liquid investment.
(a) 75% to 91% (b) 75% to 90%
(c) 72% to 90% (d) 70% to 95%

13.11 Review Questions

1. What do you understand by process/steps of capital budgeting?
2. Describe the identification of investment proposals.
3. What are final approval and preparation of capital expenditure budget?
4. Explain briefly:
Performance Review
Fixing Priorities
5. What are advantages of return on investment?
6. Explain accounting rate of return (ARR).
7. Write short note on:
Formally solicited
Informally solicited
8. Distinguish between mutually exclusive investment proposals and independent investment proposals.
9. Describe Capital asset pricing model.
10. What do you mean by investment risk?

Answers for Self Assessment Questions

1. (b) 2. (b) 3. (a) 4. (c) 5. (a)
6. (b) 7.(c) 8.(d) 9.(a) 10. (b)
 14
Cash Flow
CONTENTS
Objectives
Introduction
14.1 Discounted Cash Flow
14.2 Accelerating Cash Collections
14.3 Slowing Down Cash Payments
14.4 Optimizing Cash Flows
14.5 Summary
14.6 Keywords
14.7 Self Assessment Questions
14.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Describe discounted cash flow
Define accelerating cash collections
Discuss the slowing down cash payments
Understand the optimizing cash flows

Introduction
An accounting statement called the "statement of cash flows", which shows the amount of cash generated and
used by a company in a given period. It is calculated by adding noncash charges (such as depreciation) to net
income after taxes. Cash flow can be attributed to a specific project, or to a business as a whole. Cash flow can
be used as an indication of a company's financial strength.

Cash flows of a company can be classified into following:-

Operational cash flows: Cash comes and goes out of business as a result of the core business activities,
that is, due to the regular operations of the business. For example, receipts from sales, expenses on
purchasing raw materials, etc.
 Investment cash flows: Cash received or disbursed by making capital expenditures, investments or
acquisitions that will benefit the business in the long run. For example, investment in Plant and Machinery,
etc.
Financial cash flows: Cash received or disbursed as a result of financial activities, such as receiving or
paying loans, issuing or repurchasing stock, and paying dividends.

In an ideal world, a business will experience a consistently positive cash flow i.e. the amount of cash coming
into the business (cash inflow) is greater than the cash going out of the business (cash outflows). This would
allow a business to build up cash reserves with which to plug cash flow gaps, seek expansion and reassure
lenders and investors about the health of the business. However, it is important to note that income and
expenditure cash flows rarely occur together, with inflows often lagging behind. An important aim of effective
financial management must be to speed up the inflows and slow down the outflows.

Cash Inflows
The main cash inflows are:
payment for goods or services from customers
receipt of a bank loan
interest on savings and investments
shareholder investments
increased bank overdrafts or loans

Cash Outflows
The main cash outflows are:
purchase of stock, raw materials or tools
wages, rents and daily operating expenses
purchase of fixed assets - PCs, machinery, office furniture, etc
loan repayments
dividend payments
income tax, corporation tax, VAT and other taxes
reduced overdraft facilities

Many of the regular cash outflows, such as salaries, loan repayments and tax, have to be made on fixed dates.
A business must always be in a position to meet these payments, to avoid large fines or a disgruntled
workforce.
To improve everyday cash flow a business can:
ask customers to pay sooner
chase debts promptly and firmly
use factoring
ask for extended credit terms with suppliers
order less stock but more often
lease rather than buy equipment
improve profitability
Cash flow can also be improved by increasing borrowing (lending), or by putting more money into the
business. This is acceptable for coping with short-term downturns or to fund growth in line with the business
plan, but should not form the basis of day-to-day cash flow management.
14.1 Discounted Cash Flow
The discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows
available to all providers of capital, net of the cash needed to be invested for generating the projected growth.
The concept of DCF valuation is based on the principle that the value of a business or asset is inherently based
on its ability to generate cash flows for the providers of capital. To that extent, the DCF relies more on the
fundamental expectations of the business than on public market factors or historical precedents, and it is a
more theoretical approach relying on numerous assumptions. A DCF analysis yields the overall value of a
business (i.e. enterprise value), including both debt and equity. A discounted cash flow (DCF) is the most
fundamentally correct way of valuing an investment. Most other methods of valuation, such as valuation
ratios, can, to a large extent, be seen as simplified approximations of a DCF. The many estimates and
assumptions required by a DCF introduce a lot of uncertainty, often making it no better than simpler models.

The value of an asset is the value of the future benefits it brings. The value of an investment is that cash flows
that it will generate for the investor: interest payments, dividends, repayments, returns of capital, etc.
Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often
using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential
for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment,
the opportunity may be a good one.
Calculated as:

Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical
valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can
result in large changes in the value of a company. Instead of trying to project the cash flows to infinity,
terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years,
for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.

14.1.1 Key Components of a DCF

Free cash flow (FCF) – Cash generated by the assets of the business (tangible and intangible) available
for distribution to all providers of capital. FCF is often referred to as unlevered free cash flow, as it
represents cash flow available to all providers of capital and is not affected by the capital structure of the
business.
Terminal value (TV) – Value at the end of the FCF projection period (horizon period).
Discount rate – The rate used to discount projected FCFs and terminal value to their present values.

DCF Methodology
The DCF method of valuation involves projecting FCF over the horizon period, calculating the terminal value
at the end of that period, and discounting the projected FCFs and terminal value using the discount rate to
arrive at the NPV of the total expected cash flows of the business or asset.

Advantages and Disadvantages

Advantages Disadvantages
Theoretically, the DCF is arguably the most sound The accuracy of the valuation determined using the
method of valuation. DCF method is highly dependent on the quality of
The DCF method is forward-looking and depends the assumptions regarding FCF, TV, and discount
more future expectations rather than historical rate. As a result, DCF valuations are usually
results. expressed as a range of values rather than a single
The DCF method is more inward-looking, relying value by using a range of values for key inputs. It is
on the fundamental expectations of the business or also common to run the DCF analysis for different
asset, and is influenced to a lesser extent by volatile scenarios, such as a base case, an optimistic case,
external factors. and a pessimistic case to gauge the sensitivity of
The DCF analysis is focused on cash flow the valuation to various operating assumptions.
generation and is less affected by accounting While the inputs come from a variety of sources,
practices and assumptions. they must be viewed objectively in the aggregate
The DCF method allows expected (and different) before finalizing the DCF valuation.
operating strategies to be factored into the The TV often represents a large percentage of the
valuation. total DCF valuation. Valuation, in such cases, is
The DCF analysis also allows different components largely dependent on TV assumptions rather than
of a business or synergies to be valued separately. operating assumptions for the business or the asset.

Did you know?

In 1863, the Dowlais Iron Company had recovered from a business slump, but had no cash to invest for a new
blast furnace, despite having made a profit

14.2 Accelerating Cash Collections

A firm can conserve cash and reduce its requirements for cash balances if it can speed up its cash collections.
The first hurdle in accelerating the cash collection could be the firm itself. It may take a long time to process
the invoice. Days taken to get the invoice to buyers add to order processing delay. In India, Yet another
problem is with regard to the extra time enjoyed by the buyers in clearing of bills; particularly, the government
agencies take time beyond what is allowed by sellers in paying bills. Cash collections can be accelerated by
reducing the lag or gap between the time a customer pays bill and the time the cheque is collected and funds
become available for the firm‘s use.
The amount of cheques sent by customer which are not yet collected is called collection or deposit float.

14.2.1 Three Ways to Accelerate Cash Collections

As we know, accelerating cash collections is a crucial component. Here are three helpful management
techniques to consider:
Attend Pre-Construction Meetings
Get answers regarding payment processing so we are prepared.
When to bill each month
How many days for payment cycle
Discuss the billing breakdown for the schedule of values or billing line items
Discuss procedure on billing for ―stored materials‖
Discuss process of handling change orders should they arise
Ask for early release of retention money or reduction in retention percent
Develop a good relation with the person responsible for issuing payments
Ask if checks can be picked up in person instead of being mailed
Act on Preliminary Items Immediately
Sign and return contract
File Preliminary Lien Notice
Submit insurance certificates for Workers Comp and liability
Submit bonds when applicable
Shop drawings, submittals etc.
Determine method for acquiring billing percentages

Discuss Job Requirements with Subcontractors and Vendors

Issue subcontracts / purchase orders where applicable
Obtain insurance certificates as necessary
Clarify pay when paid policy and make it clear to our vendors and subcontractors the number of days it
will take to process their payments once we have been paid on the project.
Check the project specifications for details and use the maximum number of days to pay our vendors
whenever possible.
Incorporate retention withholding policy with subcontractors

14.3 Slowing Down Cash Payments

Cash is the lifeblood of every business. It is the most important asset for the operations of a business. A
healthy cash flow management is indispensable for a successful business. Cash flow refers to the movement of
money in and out of a business during a specific period of time. It is a record of a company‘s income and
expenses. It is calculated as the difference between cash inflows and cash outflows of a business. Cash inflow
is defined as the movement of money into a business from the sale of goods or services to the customers.
Whereas, cash outflow is defined as the movement of money out of a business in the form of payment of
expenses.
The aim is to slow down the cash payments as much as possible. This can be done with the help of following
techniques:
Attempts should be made by the company to get the maximum credit for the goods and services supplied
by it.
Payments to be made from single central account.
Use of bank draft rather than cheques in making payments.
Payments can be made from a bank which is distant from the bank of the company to which the payment
is to be made. This way transit time increases and firm will gain by this delay.
If a company is required to make the payment within the stipulated period, it should not make payment
before the specified date unless the company is entitled to cash discounts.
To effectively manage the cash flows, the companies need to do cash planning. It is a technique to plan for and
control the use of cash. It helps to anticipate present as well as the future cash flows and needs of the firm. It
wills synchronies the gap between cash surpluses and shortages. The best tool available with the company to
assess its needs for cash properly is to prepare the cash budget. A cash budget is the statement showing
estimated sources of cash receipts ( cash inflows) on one hand and the various applications of cash (cash
outflows) on the other hand.

The various items listed under cash inflows are

Cash sales; collection from debtors; interest/dividend received; issue of shares or debentures; receipt of loans
or borrowings; sale of fixed assets, etc.
While, the various items under Cash outflows are
payment to creditors; purchases of raw material; wages or salaries; various kinds of overheads; redemption of
shares/debentures ; loan instalments; purchase of fixed assets ;purchase of fixed assets ;interest; taxes;
dividends, etc.
Cash flow management begins with identifying the sources and the amount of income and expenditure of a
company.
A firm can manage its cash flows by following certain basic rules of accounting in the manner as described
below
Understand the cash flows in a broader perspective in order to any avoid financial troubles in future. It is
also considered as a fuel to run business efficiently.
Measure the cash flows and the changes in it over a time-period and categorize company‘s cash receipts
and outlays for every financial year. This can be done by preparing a statement of cash flows on monthly,
weekly or daily basis depending upon the requirement of business. The statement determines the short-
term sustainability of business. If cash is increasing (and cash flow is positive) then a company will be
deemed as healthy and solvent in the short-term and able to meet its cash needs. If the company is seeking
a loan, the statement shows the lender as to how the company is going to pay back loans and what its
present standing is.
Analyze cash flows which are done to compare timing and amount of cash inflows with that of cash
outflows. This will help the company plug problematic areas in cash flow cycle of the business and also
highlights the situations of cash shortages or cash surpluses. It also highlights the ability of a company to
meet its obligation of long-term debt with its internally generated cash.
Forecast cash flow of the business, that is, anticipate how much money the company will receive and how
much it will spend in different operations. Cash flow projection involves, adding cash on hand at the
beginning of the period along with other cash receipts from various sources and then adjusting them for
any anticipated changes such as capital improvements, loan interest and other interests, new funding
sources or expiration of previous funding sources, sales fluctuation, various programs undertaken by
company, etc. The next step is to have detailed knowledge of amounts and date of upcoming cash outlays
including rent, inventory control, office supplies, debt payments, maintenance charges, cash dividends, etc.
These cash flow projections should be updated regularly.
Improve the cash flows by encouraging people or company, who owe money, to pay it as soon as possible
and delaying cash outlays.
Concentrate more on the problem of timing of cash flows. This problem may occur either due to cash
surpluses or due to cash shortages. Cash surpluses arise when income is received earlier and has to be used
in the form of payment of expenses. In other words, it happens when the cash receipts exceeds the cash
expenses. While, cash shortages arise when expenses come in before the income and company unable to
pay its bills until the cash is received. In other words, it arises when cash receipts falls short of the cash
expenses. So, a business suitable strategy needs to be designed in order to deal with such a problem.

14.4 Optimizing Cash Flows

Cash inflows can be optimized by the following techniques:
Accelerating cash inflows
Minimizing currency conversion costs
Managing blocked funds
Managing inter subsidiary cash transfers
Each of these techniques is discussed in turn:
14.4.1 Accelerating Cash Inflows
The first goal in international cash management is to accelerate cash inflows since the more quickly the
inflows are received, the more quickly they can be invested or used for other purposes. Several managerial
practices are advocated for this endeavor, some of which may be implemented by the individual subsidiaries.
First, a corporation may establish lockboxes around the world, which are post office boxes to which customers
are instructed to send payment. When set up in appropriate locations, lockboxes can help reduce mailing time
(mail float). A bank usually processes incoming checks at a lockbox on a daily basis. Second, cash inflows can
be accelerated by using preauthorized payments, which allow a corporation to charge a customer‘s bank
account up to some limit. Both preauthorized payments and lockboxes are also used in a domestic setting.
Because international transactions may have a relatively long mailing time, these methods of accelerating cash
inflows can be quite valuable for an MNC.

14.4.2 Minimizing Currency Conversion Costs

Another technique for optimizing cash flow movements, netting, can be implemented with the joint effort of
subsidiaries or by the centralized cash management group. This technique optimizes cash flows by reducing
the administrative and transaction costs that result from currency conversion. Over time, netting has become
increasingly popular because it offers several key benefits. First, it reduces the number of cross-border
transactions between subsidiaries, thereby reducing the overall administrative cost of such cash transfers.
Second, it reduces the need for foreign exchange conversion since transactions occur less frequently, thereby
reducing the transaction costs associated with foreign exchange conversion. Third, the netting process imposes
tight control over information on transactions between subsidiaries. Thus, all subsidiaries engage in a more
coordinated effort to accurately report and settle their various accounts. Finally, cash flow forecasting is easier
since only net cash transfers are made at the end of each period, rather than individual cash transfers
throughout the period. Improved cash flow forecasting can enhance financing and investment decisions.

A bilateral netting system involves transactions between two units: between the parent and a subsidiary, or
between two subsidiaries. A multilateral netting system usually involves a more complex interchange among
the parent and several subsidiaries. For most large MNCs, a multilateral netting system would be necessary to
effectively reduce administrative and currency conversion costs. Such a system is normally centralized so that
all necessary information is consolidated. From the consolidated cash flow information, net cash flow
positions for each pair of units (subsidiaries, or whatever) are determined, and the actual reconciliation at the
end of each period can be dictated.

14.4.3 Managing Blocked Funds

Cash flows can also be affected by a host government‘s blockage of funds, which might occur if the
government requires all funds to remain within the country in order to create jobs and reduce unemployment.
To deal with funds blockage, the MNC may implement the same strategies used when a host country
government imposes high taxes. To make efficient use of these funds, the MNC may instruct the subsidiary to
set up a research and development division, which incurs costs and possibly generates revenues for other
subsidiaries another strategy is to use transfer pricing in a manner that will increase the expenses incurred by
the subsidiary. A host country government is likely to be more lenient on funds sent to cover expenses than on
earnings remitted to the parent.
When subsidiaries are restricted from transferring funds to the parent, the parent may instruct the subsidiary to
obtain financing from a local bank rather than from the parent. By borrowing through a local intermediary, the
subsidiary is assured that its earnings can be distributed to pay off previous financing. Overall, most methods
of managing blocked funds are intended to make efficient use of the funds by using them to cover expenses
that are transferred to that country.
14.4.4 Managing Inter Subsidiary Cash Transfers
Proper management of cash flows ca n also is beneficial to a subsidiary in need of funds. The leading or
lagging strategy can make efficient use of cash and thereby reduce debt. Some host governments prohibit the
practice by requiring that a payment between subsidiaries occur at the time the goods are transferred. Thus, an
MNC needs to be aware of any laws that restrict the use of this strategy.

14.4.5 Complications in Optimizing Cash Flow

Most complications encountered in optimizing cash flow can be classified into three categories:
Company-related characteristics
Government restrictions
Characteristics of banking systems
Each complication is discussed in turn.

Company-Related Characteristics
In some cases, optimizing cash flow can become complicated due to characteristics of the MNC. If one of the
subsidiaries delays payments to other subsidiaries for supplies received, the other subsidiaries may be forced to
borrow until the payments arrive. A centralized approach that monitors all inter subsidiary payments should be
able to minimize such problems.

Government Restrictions
The existence of government restrictions can disrupt a cash flow optimization policy. Some governments
prohibit the use of a netting system, as noted earlier. In addition, some countries periodically prevent cash
from leaving the country, thereby preventing net payments from being made. These problems can arise even
for MNCs that do not experience any company-related problems. Countries in Latin America commonly
impose restrictions that affect an MNC‘s cash flows.

Characteristics of Banking Systems

The abilities of banks to facilitate cash transfers for MNCs vary among countries. Banks in the India are
advanced in this field, but banks in some other countries do not offer services. MNCs prefer some form of
zero-balance account, where excess funds can be used to make payments but earn interest until they are used.
In addition, some MNCs benefit from the use of lockboxes. Such services are not available in some countries.

In addition, a bank may not update the MNC‘s bank account information sufficiently or provide a detailed
breakdown of fees for banking services. Without full use of banking resources and information, the
effectiveness of international cash management is limited. In addition, an MNC with subsidiaries in, say, eight
different countries will typically be dealing with eight different banking systems. Much progress has been
made in foreign banking systems in recent years. As time passes and a more uniform global banking system
emerges, such problems may be alleviated.

Did you know?

The centralized group may even maintain inventories of various currencies so that currency conversions for
the end-of-period net payments can be completed without significant transaction costs.

Caution
All companies must consult an accountant for managing its cash flows properly.
Case Study-Everest Roofing
Everest Roofing was a successful construction business whose sales continued to grow, despite more difficult
trading conditions. But, even while sales were rising, Everest had a growing cash flow problem. Most of their
suppliers were paid cash on delivery or on seven day terms, while it took them an average of 60 days to collect
on customer accounts. At the same time, expenses were on the rise as they ramped up to fulfil new orders. The
result was that their cash balance was shrinking, even while sales were soaring.
The Solution
First, Everest needed to understand the problem. So they created a cash flow tracker, plus a cash flow
projection for the rest of the financial year. Next, they used a loan to fund purchases of equipment, freeing up
extra cash. And they negotiated longer terms of trade with key suppliers. Finally, they agreed on new payment
terms with their customers and put a system in place to manage accounts receivable.
The Result
With new terms of trade in place, Everest increased their payments cycle to an average of 60 days, while
reducing the time lag between making a sale and banking the revenue to an average of 30 days.
By using a loan to pay for vehicles and equipment, instead of buying them out of current cash flow, they freed
up extra funds and made it possible for the assets to pay for themselves over the life of the loan.

Questions
1. Which types of growing cash flow problem arose into the Everest roofing?
2. What was the solution for this problem and how could they manage it?

14.5 Summary
Cash flow refers to the movement of money in and out of a business during a specific period of time.
The concept of DCF valuation is based on the principle that the value of a business or asset is inherently
based on its ability to generate cash flows for the providers of capital.
Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them to arrive at
a present value, which is used to evaluate the potential for investment.
Cash flows can also be affected by a host government‘s blockage of funds, which might occur if the
government requires all funds to remain within the country in order to create jobs and reduce
unemployment.
The value of an asset is the value of the future benefits it brings. The value of an investment is that cash
flows that it will generate for the investor: interest payments, dividends, repayments, returns of capital, etc.

14.6 Keywords
Cash Flow Forecasting: It is a key aspect of financial management of a business, planning its future cash
requirements to avoid a crisis of liquidity.
Debenture: A debenture is a document that either creates a debt or acknowledges it, and it is a debt without
collateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by large
companies to borrow money
Expenditure: A capital expenditure is incurred when a business spends money either to buy fixed assets or to
add to the value of an existing fixed asset with a useful life extending beyond the taxable year.
Investor: An investor is someone who puts money into something with the expectation of a financial return.
The types of investments include, equity, debt securities, real estate, currency, commodity, derivatives such as
put and call options, etc
Market liquidity: It is an asset‘s ability to be sold without causing a significant movement in the price and
with minimum loss of value. Money, or cash, is the most liquid asset, and can be used immediately to perform
economic actions like buying, selling, or paying debt, meeting immediate wants and needs.

14.7 Self Assessment Questions

1. The cash flow statement in the United States is most likely to appear using
(a) a "supplementary method." (b) a "direct method."
(c) an "indirect method." (d) a "flow of funds method."

2. For a profitable firm, total sources of funds will always total uses of funds.
(a) be equal to (b) be greater than
(c) be less than (d) have no consistent relationship to

3. Which of the following is NOT a cash outflow for the firm?

(a) depreciation. (b) dividends.
(c) interest payments. (d) taxes.

4. Which of the following would be considered a use of funds?

(a) a decrease in accounts receivable. (b) a decrease in cash.
(c) an increase in account payable. (d) an increase in cash.

5. Which of the following would be included in a cash budget?

(a) depreciation charges. (b) dividends
(c) goodwill. (d) patent amortization.

6. On an accounting statement of cash flows an "increase (decrease) in cash and cash equivalents" appears as
(a) a cash flow from operating activities. (b) a cash flow from investing activities.
(c) a cash flow from financing activities. (d) none of the above

7. A company has a negative cash flow from operating activities. What could explain this negative cash flow?
(a) A substantial investment in new fixed assets (b) High levels of dividend payments
(c) A sudden increase in credit sales (d) The repayment of a loan

8. Which one of the following companies is most likely to run into cash flow problems?
(a) A loss making company making components of vital strategic importance to the government?
(b) A profitable new retailer about to embark on ambitious expansion plans
(c) A company which has recently sold part of its operations so as to concentrate on its core areas
(d) A reasonably profitable, long established company with no expansion plans

9. Which one of the following is false?

(a) If cash outflows exceed cash inflows on an ongoing basis, the business will eventually run out of cash
(b) A profitable company will never run out of cash
(c) Rapidly expanding companies can sometimes face a cash shortage
(d) Cash is the lifeblood of a business and without it the business will die

10. Which of the following involves a movement of cash?

(a) Depreciation of fixed assets (b) A bonus issue
(c) A rights issue (d) Creation of a provision for pensions

14.8 Review Questions

1. What means of cash flow? Explain.
2. Describe the key components of a DCF.
3. What are the ways to accelerate cash collections?
4. Explain the operational cash flows.
5. Discuss the DCF methodology and advantages or disadvantages DCF.
6. Explain the slowing down cash payments.
7. Discuss about optimizing cash flows.
8. Describe the managing blocked funds.
9. What is managing inter subsidiary cash transfers?
10. Write a short note on:
Cash inflows
Cash outflows
Investment cash flows

Answers for Self Assessment Questions

1. (c) 2. (a) 3. (a) 4. (d) 5. (b)
6. (d) 7.( c) 8.( b) 9.( b) 10. (c)
 15
Cost of Capital
CONTENTS
Objectives
Introduction
15.1 Concept of Cost of Capital
15.2 Importance/Significance of Cost of Capital
15.3 Classification of Cost
15.4 Computation of Cost of Capital
15.5 Factors Affecting Weighted Average Cost of Capital (WACC)
15.6 Summary
15.7 Keywords
15.8 Self Assessment Questions
15.9 Review Question

Objectives
After studying this chapter, you will be able to:
Explain the Concept of Cost of Capital,
Define the Importance/Significance of Cost of Capital,
Describe the Classification of Cost
Explain the Computation of Cost of Capital
Define the Factors Affecting Weighted Average Cost of Capital (WACC)

Introduction
The concept of "cost of capital" is very important in financial management. It is weighted average cost of
various sources of finance used by a firm may be in form of debentures, preference share capital, retained
earnings and equity share capital. A decision to invest in a particular project depends upon the cost of capital
of the firm or the cut off rate which is minimum rate of return expected by the investors. When a firm is not
able to achieve cut off rate, the market value of share will fall. In fact, cost of capital is minimum rate of return
expected by its investors. Cost of capital is the required return necessary to make a capital budgeting project,
such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. A
company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the
long run, companies typically adhere to target weights for each of the sources of funding. When a capital
budgeting decision is being made, it is important to keep in mind how the capital structure may be affected.
Capital structure is a mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity. The capital structure represents how a firm finances its overall operations and growth by
using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while
equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working
capital requirements is also considered to be part of the capital structure. A company's proportion of short and
long-term debt is considered when analyzing capital structure. When people refer to capital structure they are
most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is.
Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value and minimizes the
firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax
deductibility. However, it is rarely the optimal structure since a company's risk generally increases as debt
increases. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is
an indication of financial fitness.

Assumption of Cost of Capital

Cost of capital is based on certain assumptions which are closely associated while calculatingand measuring
the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
[Link] consis of three important risks such as zero risk level, business risk and financial [Link] of capital can
be measured with the help of the following equation.
K=rj+ b + f
Where,
K=Cost of capital.
rj=the riskless cost of the particular type of finance.
b=the business risk premium.
f=the financial risk premium.

15.1 Concept of Cost of Capital

The concept of "cost of capital" is very important in financial management. It is weighted average cost of
various sources of finance used by a firm may be in form of debentures, preference share capital, retained
earnings and equity share capital. The rate we use to discount a company's future cash flows back to the
present is known as the company's required return, or cost of capital. A company's cost of capital is exactly as
its name implies. When a company raises capital from its lenders and owners, both types of investors require a
return on their investment. Lenders expect to be paid interest on their loans, while owners expect a return, too.
A stable, predictable company will have a low cost of capital, while a risky company with unpredictable cash
flows will have a higher cost of capital. That means, all else equal, that the riskier company's future cash flows
are worth less in present value terms, which is why stocks of stable companies often look more expensive on
the surface.
Cost of capital is determined by the market and represents the degree of perceived risk by investors. When
given the choice between two investments of equal risk, investors will generally choose the one providing the
higher return. The return an investor receives on a company security is the cost of that security to the company
that issued it. A company's overall cost of capital is a mixture of returns needed to compensate all creditors and
stockholders. This is often called the weighted average cost of capital, and refers to the weighted average costs
of the company's debt and equity. Cost of capital is an important component of business valuation work.
Because an investor expects his or her investment to grow by at least the cost of capital, cost of capital can be
used as a discount rate to calculate the fair value of an investment's cash flows. Investors frequently borrow
money to make investments, and analysts commonly make the mistake of equating cost of capital with the
interest rate on that money. It is important to remember that cost of capital is not dependent upon how and
where the capital was raised. Put another way, cost of capital is dependent on the use of funds, not the source
of funds.
The concept of cost of capital is a major standard for comparison used in finance decisions. Acceptance or
rejection of an investment project depends on the cost that the company has to pay for financing it. Good
financial management calls for selection of such projects, which are expected to earn returns, which are higher
than the cost of capital. It is therefore, important for the finance manager to calculate the cost of capital, which
the company has to pay and compare it with the rate of return, which the project is expected to earn. In capital
expenditure decisions, finance managers go on accepting projects arranged in descending order of rate of
return. He stops at the point where the cost of capital equals to the rate of return offered by the project. That is,
the finance manager finds out the break-even point of the project. Accepting any project beyond the break-
even point will cause financial loss for the company. The cost of capital is a guideline for determining the
optimum capital structure of a company.

15.2 Importance/Significance of Cost of Capital

Following terms of describe in Importance/Significance of Cost of Capital
15.2.1 Importance of Cost of Capital
The concept of cost of capital is a very important concept in financial management decision making. The
concept is however, a recent development and has relevance in almost every financial decision making but
prior to that development, the problem was ignored or by-passed.
The cost of capital is very important concept in the financial decision making. The progressive management
always likes to consider the cost of capital while taking financial decisions as it is very relevant in the
following spheres.

Designing the Capital Structure

The cost of capital is the significant factor in designing a balanced an optimal capital structure of a firm. While
designing it, the management has to consider the objective of maximizing the value of the firm and minimizing
cost of capital. I comparing the various specific costs of different sources of capital, the financial manager can
select the best and the most economical source of finance and can designed a sound and balanced capital
structure.

Capital Budgeting Decisions

The cost of capital sources as a very useful tool in the process of making capital budgeting decisions.
Acceptance or rejection of any investment proposal depends upon the cost of capital. A proposal shall not be
accepted till its rate of return is greater than the cost of capital. In various methods of discounted cash flows of
capital budgeting, cost of capital measured the financial performance and determines acceptability of all
investment proposals by discounting the cash flows.

Comparative Study of Sources of Financing

There are various sources of financing a project. Out of these, which source should be used at a particular?
Point of time is to be decided by comparing cost of different sources of financing. The source which bears the
minimum cost of capital would be selected. Although cost of capital is an important factor in such decisions,
but equally important are the considerations of retaining control and of avoiding risks.

Evaluations of Financial Performance of Top Management

The cost of capital can be used to evaluate the financial performance of the top executives. Such as evaluations
can be done by comparing actual profitability of the project undertaken with the actual cost of capital of funds
raise o finance the project. If the actual profitability of the project is more than the actual cost of capital, the
performance can be evaluated as satisfactory.

Knowledge of Firms Expected Income and Inherent Risks

Investors can know the firms expected income and risks inherent there in by cost of capital. If a firms cost of
capital is high, it means the firms present rate of earnings is less, risk is more and capital structure is
imbalanced, in such situations, investors expect higher rate of return.

Financing and Dividend Decisions

The concept of capital can be conveniently employed as a tool in making other important financial decisions.
On the basis, decisions can be taken regarding dividend policy, capitalization of profits and selections of
sources of working capital

15.2.2 Significance of Cost of Capital

It should be recognized at the outset that the cost of capital is one of the most difficult and disputed topics in
the finance theory. Financial experts express conflicting opinions as to the way in which the cost of capital can
be measured. It should be noted that it is a concept of vital importance in the financial decision-making. It is
useful as a standard for:
Evaluating investment decisions,
Designing a firm‘s debt policy, and
Appraising the financial performance of top management.

Investment Evaluation: The primary purpose of measuring the cost of capital is its use as a financial standard
evaluating the investment projects. In the NPV method, an investment project is accepted if it has a positive
NPY. The project‘s NPV is calculated by discounting its cash flows by the cost of capital. In this sense, the
cost of capital is the discount rate used for evaluating the desirability of an investment project. In the IRR
method, the investment project is accepted if it has an internal rate of return greater than the cost of capital. In
this context, the cost of capital is the minimum return on an investment project. It is also known as the cutoff,
or the target, or the hurdle rate. An investment project that provides .positive NPV when its cash flows are
discounted by the cost of capital makes a net contribution to the wealth of shareholders. If the project has zero
NPV, it means that it‘s a return just equal to the cost of capital, and the acceptance or rejection of the project
will not affect the wealth of shareholders The cost of capital is the minimum required rate of return on the
investment project that keeps the present wealth of shareholders unchanged. It may be, thus, noted that the cost
of capital represents a financial standard for allocating the firm‘s funds, supplied by owners and creditors, to
the various investment projects in the most efficient manner.

Designing Debt Policy: The debt policy of a firm is significant influenced by the cost consideration. In
designing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims
at cost of capital. The relationship between the cost of capital and the capital structure decision is discussed
later on. The cost of capital can also be useful in deciding about the methods of financing at a point of time.
For example, cost may be compared in choosing between leasing and borrowing. Of course, equally important
considerations are control and risk.

Performance Appraisal: Further, the cost of capital framework can be used to evaluate the financial
performance of top management. Such an evaluation will involve a comparison of actual profitability of the
investment projects undertaken by the firm with the project overall cost of capital, and the actual cost incurred
by management in raising the required funds. The cost of capital also plays a useful role in dividend decision
and investment in current assets. The chapters dealing with these decisions show their linkages the methods of
financing with the cost of capital.

15.3 Classification of Cost

There is various type of cost as:
15.3.1 Future Cost and Historical Cost
Future cost of capital refers to the expected cost of funds to be raised to finance a project. In contrast, historical
cost represents cost incurred in the past in acquiring funds. In financial decisions future cost of capital is
relatively more relevant and significant. While evaluating viability of a project, the finance manager compares
expected earnings from the project with expected cost of funds to finance the project. Likewise, in taking
financing decisions, attempt of the finance manager is to minimize future cost of capital and not the costs
already defrayed. This does not imply that historical cost is not relevant at all. In fact, it may serve as a
guideline in predicting future costs and in evaluating the past performance of the company.

15.3.2 Component Cost and Composite Cost

A company may contemplate to raise desired amount of funds by means of different sources including
debentures, preferred stock, and common stocks. These sources constitute components of funds. Each of these
components of funds involves cost to the company. Cost of each component of funds is designated as
component or specific cost of capital. When these component costs are combined to determine the overall cost
of capital, it is regarded as composite cost of capital, combined cost of capital or weighted cost of capital, the
composite cost of capital, thus, represents the average of the costs of each source of funds employed by the
company. For capital budgeting decision, composite cost of capital is relatively more relevant even though the
firm may finance one proposal with only one source of funds and another proposal with another source. This is
for the fact that it is the overall mix of financing over time which is materially significant in valuing firm as an
ongoing overall entity.

15.3.3 Average Cost and Marginal Cost

Average cast represents the weighted average of the costs of each source of funds employed by the enterprise,
the weights being the relative share of each source of funds in the capita! structure. Marginal cost of capital, by
contrast refers to incremental cost associated with new funds raised by the firm. Average cost is the average of
the component marginal costs, while the marginal cost is the specific concept used to comprise additional cost
of raising new funds. In financial decisions the marginal cost concept is most significant.

15.3.4 Explicit Cost and Implicit Cost

Cost of capital can be either explicit cost or implicit. The explicit cost of any source of capital is the discount
rate that equates the present value of the cash inflows that are incremental to the taking of the financing
opportunity with the present value of its incremental cash outlay. Thus, the explicit cost of capital is the
internal rate of return of the cash flows of financing opportunity.
A series of each flows are associated with a method of financing. At the time of acquisition of capital, cash
inflow occurs followed by the subsequent cash outflows in the form, of interest payment, repayment of
principal money or payment of dividends. Thus, if a company issues 10 per cent perpetual debentures worth
Rs. 10, 00,000, there will be cash inflow to the firm of the order of 1, 00,000. This will be followed by the
annual cash outflow of Rs. 1, 00,000. The rate of discount, that equates the present value of cash inflows with
the present value of cash outflows, would be the explicit cost of capital.

The technique of determination of the explicit cost of capital is similar to the one used to ascertain IRR, with
one difference, in the case of computation of the IRR, the cash outflows occur at the beginning followed by
subsequent cash inflows while in the computation of the IRR, the cash outflows occur at the beginning
followed by subsequent cash inflows, while in the computation of explicit cost of capital, cash inflow takes
place at the beginning followed by a series of cash inflow subsequently.

The formula used to compute the explicit cost of capital (C) is:

Where,
CI0 = net cash inflow in period O.
COt = cash outflow in period under reference
C = Explicit cost of capital
The explicit cost of an interest bearing debt will be the discount rate that equates the present value of the
contractual future payments of interest and principal with the net amount of cash received today. The explicit
cost of capital of a gift is minus 100 percent, since no cash outflow will occur in future.

Similarly, explicit cost of retained earnings which involve no future flows to or from the firm is minus 100 per
cent. This should not tempt one to infer that the retained earnings is cost free. As we shall discuss in the
subsequent paragraphs, retained earnings do cost the firm. The cost of retained earnings is the opportunity cost
of earning on investment elsewhere or in the company itself. Opportunity cost is technically termed as implicit
cost of capital. It is the rate of return on other investments available to the firm or the shareholders in addition
to that currently being considered. Thus, the implicit cost of capital may be defined as the rate of return
associated with the best investment opportunity for the firm and its Shareholders that will be foregone if the
project presently under consideration by the firm were accepted. In this connection it may be mentioned that
explicit costs arise when the firm raises funds for financing the project. It is in this sense that retained earnings
have implicit cost. Other forms of capital also have implicit costs once they are invested, Thus in a sense,
explicit costs may also be viewed as opportunity costs. This implies that a project should be rejected if it has a
negative present value when its cash flows are discounted by the explicit cost of capital

15.4 Computation of Cost of Capital

Computation of cost of capital consists of two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital

15.4.1 Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:
Cost of equity
 Cost of debt
Cost of preference share
Cost of retained earnings

Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of thefirm to determine its
share value.
Conceptually the cost of equity capital (Ke) defined as the Cost of equity can be calculated from the following
approach:
Dividend price (D/P) approach
Dividend price plus growth (D/P + g) approach
Earning price (E/P) approach
Realized yield approach

Dividend Price Approach

The cost of equity capital will be that rate of expected dividend which will maintain thepresent market price of
equity shares. Dividend price approach can be measured with the help of the following formula:

Where,
Ke= Cost of equity capital
D = Dividend per equity share
Np= Net proceeds of an equity share

Example
A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. Thecompany has been paying
25% dividend to equity shareholders for the past five years andexpects to maintain the same in the future also.
Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs. 175?

Solution:

=25/100× 100
=22.72%
If the market price of a equity share is Rs. 175.

=25/175× 100
=14.28%

Dividend Price plus Growth Approach

The cost of equity is calculated on the basis of the expected dividend rate per share plusgrowth in dividend. It
can be measured with the help of the following formula:
Where,
Ke= Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np= Net proceeds of an equity share

Example
(a)A company plans to issue 10000 new shares of Rs. 100 each at a par. Thefloatation costs are expected to be
4% of the share price. The company pays adividend of Rs. 12 per share initially and growth in dividends is
expected to be 5%.Compute the cost of new issue of equity shares

(b)If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity share capital

Solution
(a)

(b)

Example
The current market price of the shares of A Ltd. is Rs. 95. The floatation costs are Rs. 5 per share amounts to
Rs. 4.50 and are expected to grow at a rate of 7%. You are required to calculate the cost of equity share capital.
Solution
Market price Rs. 95
Dividend Rs. 4.50
Growth 7%
15.4.2 Measurement of Overall Cost of Capital
It is also called as weighted average cost of capital and composite cost of capital. Weightedaverage cost of
capital is the expected average future cost of funds over the long run found byweighting the cost of each
specific type of capital by its proportion in the firms capital structure.

The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the help of the following formula;
Ko=Kd Wd+ Kp Wp+ Ke We+ Kr Wr
Where,
Ko= Overall cost of capital
Kd= Cost of debt
Kp= Cost of preference share
Ke= Cost of equity
Kr= Cost of retained earnings
Wd= Percentage of debt of total capital
Wp= Percentage of preference share to total capital
We= Percentage of equity to total capital
Wr= Percentage of retained earnings

15.5 Factors Affecting Weighted Average Cost of Capital (WACC)

The cost of capital is affected by a number of factors. Some are beyond the firm‘s control, but others are
influenced by its financing and investment policies.

15.5.1 Controllable Factors Affecting the Cost of Capital

These are the factors affecting weighted average cost of capital that the company has control over:
Capital-structure policy
Dividend policy
Investment policy

Capital Structure Policy

Firm has control over its capital structure, targeting an optimal capital structure. As more debt is issued, the
cost of debt increases, and as more equity is issued, the cost of equity increases.

Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be changed. For
example, as the payout ratio of the company increases the breakpoint between lower-cost internally generated
equity and newly issued equity is lowered.

Investment Policy
It is assumed that, when making investment decisions, the company is making investments with similar
degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of
equity change.
15.5.2 Uncontrollable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company has no control over:
Level of interest rates
Tax rates

Level of Interest Rates

The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when
interest rates increase the cost of debt increases, which increases the cost of capital.

Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost
of capital.

Did You Know?

James E. Walter's model shows the relevance of dividend policy and its bearing on the value of the share.

Caution
Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order
to leave unchanged the market price of the shares.

Case Study-Marriott's Corporation: the Cost of Capital

Marriott Corporation is an international company who's the growth over the year has been more than
satisfactory.
In 1987, Marriott's sales grew up by 24% and its return on equity stood at 22%.
Moreover the sales and earnings pr share has doubled over the previous year.
The company operates in three divisions: lodging, contract services and restaurants which represents 41%,
46% and 13% of sales in 1987 respectively. Marriott is determined to develop and to enhance its position in
each division.
This main goal contains 3 others more detailed components:
To become the most profitable company.
To be the preferred employer.
To be the preferred provider.

In order to achieve its goal, the managers of Marriott have developed a financial strategy with 4 main
decisions.
Manage rather than own hotel assets
Invest in projects that increase shareholders values
Optimize the use of debt in the capital structure.
Repurchased Undervalued Shares.

How does Marriott use its estimate of its cost of capital? Does it make sense?
Marriott measured the opportunity cost of capital for investments of similar risk using the weighted average
cost of capital (WACC). To decide to the future firm investments, we need to analyse the financial its
structure. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used
internally by company directors to determine the economic feasibility of expansionary opportunities and
mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall
firm. To determine the opportunity cost of capital, Marriott required three inputs: debt capacity, debt cost, and
equity cost consistent with the amount of debt. The cost of capital depends on each division.
In fact the evaluation of the WACC is an appropriate tool to calculate the cost of capital for the corporation as
a whole and for each division.

The Cost of Equity

One of the two major components of WACC is the cost of equity. The cost of equity model takes into account
three values which we must calculate - a risk-free rate (rf), risk premium rate (expected market return - rf), and
Beta Value.
Before doing the calculations, we will justify our choices. We based it on the "Stocks, Bonds, Bills and
Inflation" (SBBI). This workmanship is a standard reference source for business appraisers. It has been
published annually since 1983.
• The risk free rate was 8.95%.
1. Note: there is a debate whether we should use long-term or short-term government bond rate as the risk-
free benchmark. However, it is typical to use the 10-year rate in the corporate setting, as practiced by
McKinsey and
2. Other consulting firms.
The cost of equity calculation
Cost of equity = Rf + beta x (Rm - Rf)
Cost of equity = 8.95 + 1.43 × (12.01 – 8.95) = 13.33

The Beta Value

As it is said in the case, we already know the equity beta (.097). But the capital structure (leverage) affects
beta estimates. In order to eliminate the effect of leverage, we will calculate the asset beta, which reflects the
sensitivity of the firm's assets abstracting from capital structure. That is why we have to convert the equity beta
into the asset beta. Then we can calculate the equity beta without the leverage effect.
To calculate the asset beta, we need the current debt value. The ratio D/V for the company is set at 41% so we
can find the ratio E/V is set at 59%. It comes from the exhibit 3 which says that the market leverage is the
book value of debt divided by the sum of the book value of debt plus the market value of equity.
Equity beta = 097
Equity value = 59%
Asset beta= 59% × 097=0.57

Questions
1. Write the summary of the above case study.
2. What is the weighted average cost of capital for Marriott Corporation?

15.6 Summary
Cost of capital is very important in financial management. It is weighted average cost of various sources of
finance used by a firm may be in form of debentures, preference share capital, retained earnings and equity
share capital.
Cost of capital is based on certain assumptions which are closely associated while calculating and
measuring the cost of capital.
The cost of capital is the significant factor in designing a balanced an optimal capital structure of a firm.
The cost of capital can be used to evaluate the financial performance of the top executives.
 The overall cost of capital is the weighted average of the costs of the various sources of the funds, weights
being the proportion of each source of funds in the total capital structure.
Marginal Weights represent the proportion of various sources of funds to be employed in raising additional
funds.

15.7 Keywords
Business Risk: Business risk is a possibility and the firm will not be able to operate successfully in the market.
Cost of Capital: Cost of capital is the minimum rate of return that must be earned on investment to maintain
the value of firm.
Cost of Equity: Cost of equity capital is the rate at which investors discount the expected dividends of thefirm
to determine its share value.
Designing debt policy The debt policy of a firm is significant influenced by the cost consideration
Tax Rates: Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases,
decreasing the cost of capital.

15.8 Self Assessment Questions

1. Cost of capital usually is expressed:
(a) In percentage terms, as a percentage of the face value of the investment.
(b) In percentage terms, as a percentage of the amount invested.
(c) In dollar terms, in real dollars.
(d) In dollar terms, in nominal dollars.

2. Cost of capital is market driven.

(a) True (b) False

3. Cost of capital is based on historical returns.

(a) True (b) False

4. Cost of capital is determined by the market and represents the degree of by investors
(a) perceived danger (b) perceived risk
(c) perceived riskiness (d) perceived hazard

5. The overall (weighted average) cost of capital is composed of a weighted average of ………….
(a) the cost of common equity and the cost of debt
(b) the cost of common equity and the cost of preferred stock
(c) the cost of preferred stock and the cost of debt
(d) the cost of common equity, the cost of preferred stock, and the cost of debt

6. When calculating the WACC for a firm, one should use the book values of debt and equity.
(a) True (b) False

7. The components of a company‘s capital structure include:

(a) Accounts payable, long-term debt, and preferred stock.
(b) Accounts payable, preferred stock, and common stock.
(c) Accounts payable, long-term debt, and common stock.
(d) Long-term debt, preferred stock, and common stock.

8. The debt policy of a firm is significant influenced by the consideration

(a) charge (b) cost
(c) expense (d) expenditure

9. Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the
cost of capital.
(a) True (b) False

10. Discounting at the WACC assumes that debt is rebalanced every period to maintain a constant ratio of debt
to market value of the firm.
(a) True (b) False

15.9 Review Questions

1. What is cost of capital?
2. Explain the classification of cost
3. Discuss various uses of the concept of cost of capital.
4. What are the factors affecting weighted average cost of capital
5. Explain the significance of cost of capital
6. Define the Capital Budgeting Decisions
7. Describe marginal cost of capital
8. How will you calculate weighted average cost of capital?
9. Discuss the computation of specific cost of capital.
10. A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation costs are expected to
be 4% of the share price. The company pays a dividend of Rs. 12 per share initially and growth in
dividends is expected to be 5%.Compute the cost of new issue of equity shares.

Answers for Self Assessment Questions

1. (b) 2.(a) 3.(b) 4.(b) 5.(d)
6. (b) 7.(d) 8.(b) 9.(a) 10.(a)
 INTERNATIONAL BUSINESS
(BBA 302)

Jaipur National University

Directorate of Distance Education
_________________________________________________________________________________
Established by Government of Rajasthan
Approved by UGC under Sec 2(f) of UGC ACT 1956
(Recognised by Joint Committee of UGC-AICTE-DEC, Govt. of India)
 INTERNATIONAL BUSINESS
International Business: Meaning, Domestic V/S I.B., Scope of I.B. Role of I.B. Driving forces of I.B. Forces
restricting I.B.

Global market entry strategies: Trading company, licensing, Franchising, FDI, Mergers and acquisition.

International Business Environment: Nature, Theories o International Trade, Ricardo‘s Theory, Heckscher-
Ohlin Theory

Culture: Definition, components, Imperatives. Political Environment: Political Systems, Major Political
objective –

Legal Environment: Laws relating to IB, Market entry laws, Product liabilities, warranties.

Global Economic Environment: Decision concerning global manufacturing and materials management,
managing global supply chains, product and branding decisions, distribution channels, international promotion
mix and pricing decisions, counter trade.

International Trade: World Trading Patterns, Trade Theories, Absolute Advantage, Comparative Advantage,
Modern theory. Barriers to World Trade, free trade vs protection tariff, Quotas. WTO,

Regional Integration: Foreign Direct Investment-Reasons, Volume and directions.

International Institutions: IMF, International Liquidity and SDRs, IBRD, IFC, IDA, ADB.

Foreign Exchange: Meaning, Types, Determination of Exchange Rates, Balance of Trade vs Balance of
Payment. Methods to correct adverse balance of Payment

Multinational Enterprises: Meaning of International Corporations, Role and importance of Multi-national

corporations in international business

Foreign Exchange Market: Meaning of Exchange Rate, Determination of Exchange rate – Fixed, Flexible
and, Managed.

International Financial Management: Balance of Trade and Balance of Payments, International Monetary
Fund (IMF) – Objectives and functions, World Bank – Objectives and Functions.

Regional Economic Grouping: Evolution, structure and functions , North Atlantic Free Trade Agreement
(NAFTA), South Asian Association for Regional Cooperation, (SAARC), European Union (E.U.), World
Trade Organization (WTO)

India’s Foreign Trade: Composition and direction of India‘s Foreign Trade since 1991, Current Foreign
Trade Policy of India. (2004-09), Role of Special Economic Zones (SEZs) in International, Business.
 1
International Business
CONTENTS
Objectives
Introduction
1.1 Meaning of International Business
1.2 Domestic V/S I.B
1.3 Scope of I.B
1.4 Role of I.B
1.5 Summary
1.6 Keywords
1.7 Self Assessment Questions
1.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain the Meaning of International Business
Define the Domestic V/S I.B
Discuss the Scope of I.B
Explain the Role of I.B

Introduction
The simplest definition for international business is ‗cross border economic activity‘. This has existed in
various forms ever since human communities began interacting with one another. When human tribes first
started trading beads or minerals like flint more than ten thousand years ago, they were engaging in prehistoric
forms of international business. Of course, trade has become slightly more complicated since then. Nowadays,
international business refers to the exchange not only of physical goods but also of services, capital,
technology, and human resources. The first point to make about this field is that it covers a very broad
spectrum of activities. We look at how firms can increase their profitability by expanding their operations in
foreign markets. We discuss the different strategies that firms pursue when competing internationally, consider
the pros and cons of these strategies, discuss the various factors that affect a firm‘s choice of strategy, and look
at the tactics firms adopt when competing head to head across various national markets.
Just as important is to recognize what makes international business distinct from other areas of study, and
where it overlaps with them. Many aspects of domestic business are also found in international business, but
they are treated differently because of the latter field‘s emphasis on cross- border aspects. Similarly,
international business covers most if not all of the same topics as international management but goes much
further. Where international management focuses mainly on decisions made by individuals operating within a
corporate setting, international business also incorporates the broader political, economic, social,
technological, philosophical, and environmental contexts within which firms operate. It is a very broad
discipline with connections to many if not most of the issues affecting people in their daily lives. The best
international business students and practitioners can analyze on many different levels and tend not to recognize
artificial borders between business, economics, and politics. Indeed, the ability and desire to embrace diversity
give this discipline its distinct philosophy and enduring attraction. International business may be defined
simply as business transactions that take place across national borders. This broad definition includes the very
small firm that exports (or imports) small quantity to only one country, as well as the very large global firm
with integrated operations and strategic alliances around the world. International business is a term used to
collectively describe all commercial transactions (private and governmental, sales, investments, logistics, and
transportation) that take place between two or more nations. Usually, private companies undertake such
transactions for profit; government sunder takes them for profit and for political reasons. It refers to all those
business activities which involves cross border transactions of goods, services, resources between two or more
nations. Transaction of economic resources include capital, skills, people etc. for international production of
physical godsend service such as finance, banking, insurance, construction etc.

1.1 Meaning of International Business

International Business conducts business transactions all over the world. These transactions include the
transfer of goods, services, technology, managerial knowledge, and capital to other countries. International
business involves exports and imports. International Business is known, called or referred as a Global Business
or an International Marketing. International business contains any kind of business activity that crosses
national perimeters. Though a number of definitions in the business literature can be found but no simple or
universally accepted definition exists for the term international business. At one end of the definitional range,
international business is defined as organization that buys and/or sells goods and services across two or more
national boundaries, even if management is located in a single country. At the other end of the spectrum,
international business is equated only with those big enterprises, which have operating units outside their own
country. In the middle are institutional arrangements that provide for some managerial direction of economic
activity taking place abroad but stop short of controlling ownership of the business carrying on the activity, for
example joint ventures with locally owned business or with foreign governments. In its traditional form of
international trade and finance as well as its newest form of multinational business operations, international
business has become massive in scale and has come to exercise a major influence over political, economic and
social from many types of comparative business studies and from knowledge of many aspects of foreign
business operations. In fact, sometimes the foreign operations and the comparative business are used as
synonymous for international business. Foreign business refers to domestic operations within a foreign
country. Comparative business focuses on similarities and differences among countries and business systems
for focuses on similarities and differences among countries and business operations and comparative business
as fields of enquiry do not have as their major point of interest the special problems that arise when business
activities cross national boundaries. For example, the vital question of potential conflicts between the nation-
state and the multinational firm, which receives major attention is international business, is not like to be
cantered or even peripheral in foreign operations and comparative business.
Did you know?
Successful international businesses or global businesses seem to become free of their own national boundaries.
They simply become very competent at navigating through the whole world market.

1.2 Domestic vs. International Business

Domestic business
Business rules are standardised and matured.
One language and culture.
Uniform financial climate.
Patriotism helps.
Single currency and taxation system.
Descriptive approach to study.
Product planning and development according to domestic markets.
Relatively stable marketing environment. Multiple.
Control of business activities is easy.
It is carried within the nation‘s boundaries.

International business
Business rules are highly diverse and unclear.
Many languages and differences in culture.
Varied financial climate.
Patriotism hinders.
Patriotism hinders.
Multiple currencies and taxation system
Integrative approach to study
Product Planning & development according to foreign markets.
Control of business activities is difficult.
It is carried across the nation‘s boundaries.

An international business is a business whose activities are carried out across national borders. This differs
from a domestic business because a domestic business is a business whose activities are carried out within the
borders of its geographical location. A domestic company is one that confines its activities to the local market,
be it city, state, or the country it is in. It deals, generally, with one currency, local customs and cultures,
business laws of commerce, taxes and products and services of a local nature. The international company on
the other hand deals with businesses and governments in one or more foreign countries and is subject to
treaties, tariffs. Currency rates of exchange, politics, cultural differences, taxes, fees, and penalties of each
country it is doing business in. It may also be conducting business in it is home country, but the emphasis is on
trading in the international marketplace.

The first aspect of differences is the mobility of production. There are some factors involve in mobility of
production such as the labor and capital. Usually, dealing with the international market entails lots of
restrictions as compared on the movement within a country. Aside from the legal restrictions, dealing with the
international market also varies in geographic influences, socio-cultural environments and economic
conditions. Another aspect of differences between domestic and international business is the systems and
practices. Obviously, there is a great difference from one country to another regarding the socio-economic
development, efficiency and cost of economic infrastructure, availability and market support services. In
addition, there is also a big difference in business practices and customs due to the socio-economic and
historical coincidences. In this sense, Conducting and managing international business operations is more
complex than undertaking domestic business. Differences in the nationality of parties involved, relatively less
mobility of factors of production, customer heterogeneity across markets, variations in business practices and
political systems, varied business regulations and policies, use of different currencies are the key aspects that
differentiate international businesses from domestic business. These, moreover, are the factors that make
international business much more complex and a difficult activity. Domestic company is main aim to improve
the sales on domestically and that company not thinking about the international. In international company in
one particular product they expand all over the country and may be possible on two another countries.

A domestic company is one that confines its activities to the local market, be it city, state, or the country it is
in. It deals, generally, with one currency, local customs and cultures, business laws of commerce, taxes and
products and services of a local nature. The international company on the other hand deals with businesses
and governments in one or more foreign countries and is subject to treaties, tariffs. Currency rates of exchange,
politics, cultural differences, taxes, fees, and penalties of each country it is doing business in. It may also be
conducting business in it is home country, but the emphasis is on trading in the international marketplace.
When a business takes its operations outside its national borders, the business environment changes. Clearly,
an organisation will have ‗inside-out‘ knowledge of its domestic environment, but this will rarely be the case
when it decides to go international. Understanding the business environment of the foreign country is crucial
to the successful launch of an international firm. Therefore, organisations must commit to a greater extent,
time and resources in order to understand the new environment. Below are some of the business environments
that may affect international business, their complexity are the main distinction between international and
domestic [Link] differences between international business and domestic business, it will make sense
to discuss issues involved in doing business internationally which will not otherwise be present or prove as
complicated as when doing business at home.

Did you know?

A domestic business typically has the advantage of only having to deal with its local currency, customs,
culture, regulations and tax system.

1.3 Scope of I.B

International business focus on the exacting problems and opportunities that emerge because a firm is
operating in more than one country in a very real sense, international business occupies the broadest and most
widespread study of the field of business, adapted to a fairly unique across the border environment. Many of
the parameters and environmental variables that are very important in international business (such as foreign
legal systems, foreign exchange markets, cultural differences, and different rates of inflation) are either largely
irrelevant to domestic business or are so reduced in range and complexity as to be of greatly diminished
significance. Thus, it might be said that domestic business is a special limited case of international business.
The distinguishing feature of international business is that international firms operate in environments that are
highly uncertain and where the rules of the game are often ambiguous, contradictory, and subject to rapid
change, as compared to the domestic environment. In fact, conducting international business is really not like
playing a whole new ball game, however, it is like playing in a different ballpark, where international
managers have to learn the factors unique to the playing field. Managers who are astute in identifying new
ways of doing business that satisfy the changing priorities of foreign governments have an obvious and major
competitive advantage over their competitors who cannot or will not adapt to these changing priorities. The
guiding principles of a firm engaged in international business activities should incorporate a global
perspective. A firm‘s guiding principles can be defined in terms of three board categories products
offered/market served, capabilities, and results. However, their perspective of the international business is
critical to understand the full meaning of international business. That is, the firm‘s senior management should
explicitly define the firm‘s guiding principles in terms of an international mandate rather than allow the firm‘s
guiding principles in terms as an incidental adjunct to its domestic activities. Incorporating an international
outlook into the firm‘s basic statement of purpose will help focus the attention of managers (at all levels of the
organization) on the opportunities (and hazards) outside the domestic economy. It must be stressed that the
impacts of the dynamic factors unique to the playing field for international business are felt in all relevant
stages of evolving and implementing business plans. The first broad stage of the process is to formulate
corporate guiding principles. As outlined below the first step in formulating and implementing a set of
business plans is to define the firm‘s guiding principles in the market place.

The guiding principles should, among other things, provide a long-term view of what the firm is striving to
become and provide direction to divisional and subsidiary manager‘s vehicle, some firms use ―the decision
circle‖ which is simply an interrelated set of strategic choices forced upon any firm faced with the
internationalization of its markets. These choices have to do with marketing, sourcing, labor, management,
ownership, finance, law, control, and public affairs. Here the first two marketing and sourcing-constitute the
basic strategies that encompass a firm‘s initial considerations. Essentially, management is answering two
questions: to whom are we going to sell what, and from where and how will we supply that market? We then
have a series of input strategies-labor, management, ownership, and financial. They are in their efforts to
develop their own business plans. As an obligation addressed essentially to the query, with what resources are
we going to implement the basic strategies? That is, where will we find the right people, willingness to carry
the risk, and the necessary funds? A third set of strategies- legal and control-respond to the problem of how the
firm is to structure itself of implement the basic strategies, given the resources it can muster. A final strategic
area, public affairs, is shown as a basic strategy simply because it places a restraint on all other strategy
choices each strategy area contains a number of subsidiary strategy options. The decision process that
normally starts in the marketing strategy area is an iterative one. As the decision maker proceeds around the
decision circle, selected strategies must be readjusted. Although these strategy areas are shown separately but
they obviously do not stand-alone. There must be constant reiteration as one move around the decision circle.
The sourcing obviously influences marketing strategy, as well as the reverse.

The target market may enjoy certain preferential relationships with other markets. That is, everything
influences everything else. Inasmuch as the number of options a firm faces is multiplied as it moves into
international market, decision-making becomes increasingly complex the deeper the firm becomes involved
internationally. One is dealing with multiple currency, legal, marketing, economic, political, and cultural
systems. Geographic and demographic factors differ widely. In fact, as one moves geographically, virtually
everything becomes a variable: there are few fixed factors. For our purposes here, a strategy is defined as an
element in a consciously devised overall plan of corporate development that, once made and implemented, is
difficult (i.e. costly) to change in the short run. By way of contrast, an operational or tactical decision is one
that sets up little or no institutionalized resistance to making a different decision in the near future. Some
theorists have differentiated among strategic, tactical, and operational, with the first being defined as those
decisions, that imply multi-year commitments; a tactical decision, one that can be shifted in roughly a year‘s
time; an operational decision, one subject to change in less than a year. In the international context, we suggest
that the tactical decision, as the phrase is used here, is elevated to the strategic level because of the rigidities in
the international environment not present in the purely domestic-for example, work force planning and overall
distribution decisions.
International business is a wide concept and it encompasses varied activities that make its scope even wider.
With the advent of the LPG Movement, the global Market place has shrinked and became one platform for
conducting market activities. Thus, capsulating a wide range of operations and activities under its scope:-

Exports and Imports

These are the main activities which are carried by firms in IB. Exports are goods and services produced in one
country but marketed in another country. It can be as:

Export Trade: In it, domestic marketing companies or firm sell or export their products to other countries.

Re-export trade: In it, raw materials or semi-finished goods are imported by marketing company from other
countries and are converted in finished goods. Then, the finished goods are exported to other countries.
Imports are goods and services produced in one country but bought by another country. It can be also as:

Import trade: In this goods are imported from various countries by international marketing and are sold in the
home country. Such activity is done due to non-availability of goods in sufficient quality or because of lower
comparative cost. Exports & Imports do not take place only in tangible goods, but also includes services as
those provided by international airlines, emise lines, hotels etc.

Foreign Direct Investment

FDI is equity fund invested in other nations. The FDI is undertaken by multinational enterprises who exercises
control of their foreign affliates like exports and imports. It is used by the firms to establish foothold in the
world market place. It may be in the form of :

Joint Venture: A joint venture is defined as a commercial collaboration between two or more unrelated parties
whereby they pool, exchange or integrate certain of their respective resources. They are usually formedto
undertake a specific project that has to be completed within a set period.

Wholly-owned subsidiary – This is done when a firm sees its long-term substantial interest in the foreign
market. A wholly owned subsidiary can be set up in a foreign market in two ways: The company can set up
totally new operations or can acquire an established firm and use the firm to promote its
Product.

Licensing/Franchising
Acc. to ‗Root‘- ―Licensing can be defined as a contractual arrangement whereby one company (Licensor)
makes an asset available to another company. (Licensee) in exchange for royalties, License fees or some other
form of compensation.‖ Franchising is a form of licensing. It is the practice whereby a company permits its
name, logo, cultural design and operations to be used in a new firm or store. These are the means of
establishing a foothold in foreign markets.

Management Contracting
A management contract is an arrangement under which operational control of an enterprise, which would
otherwise be exercised by the directors or managers appointed, is vested by contract in a separate enterprise
which performs the necessary managerial functions for a fee. In other words, it is a contract between two
companies, whereby one company provides managerial and technical expertise to the second company of the
agreement for a certain agreed period in return for monetary compensation. It allows the firm to benefit
directly from the sale of their knowledge and expertise and also provides opportunities for earning revenues in
related activities.

Turnkey Contracts
Turnkey contracts are those contracts under which a firm agrees to fully design, construct and equip a
manufacturing service facility and turn the profit over to the purchase. When it is ready for operation for
remuneration. These are common in IB in the supply of erection and commissioning of plants, construction
projects and franchising agreements.

Counter trade
Counter trade is a form of international trade in which certain export and import transactions are directly
linked with each other and in which imports of goods are paid for by export of goods. This is used as a strategy
to increase exports. A counter trade may take a variety of forms such as barter arrangement, compensation
arrangement, buy-back arrangement and counter-purchase arrangement.

1.4 Role of I.B

International business exports goods and services all over the world. This helps to earn valuable foreign
exchange. This foreign exchange is used to pay for imports. Foreign exchange helps to make the business
more profitable and to strengthen the economy of its country. International business makes optimum utilisation
of resources. This is because it produces goods on a very large scale for the international market. International
business utilises resources from all over the world. It uses the finance and technology of rich countries and the
raw materials and labour of the poor countries. International business achieves its objectives easily and
quickly. The main objective of an international business is to earn high profits. This objective is achieved
easily. This it because it uses the best technology. It has the best employees and managers. It produces high-
quality goods. It sells these goods all over the world. All this results in high profits for the international
business. International business spreads its business risk. This is because it does business all over the world.
So, a loss in one country can be balanced by a profit in another country. The surplus goods in one country can
be exported to another country. The surplus resources can also be transferred to other countries. All this helps
to minimise the business risks.

International business has very high organisation efficiency. This is because without efficiency, they will not
be able to face the competition in the international market. So, they use all the modern management techniques
to improve their efficiency. They hire the most qualified and experienced employees and managers. These
people are trained regularly. They are highly motivated with very high salaries and other benefits such as
international transfers, promotions, etc. All this results in high organisational efficiency, i.e. low costs and high
returns. International business brings a lot of foreign exchange for the country. Therefore, it gets many
benefits, facilities and concessions from the government. It gets many financial and tax benefits from the
government. International business can expand and diversify its activities. This is because it earns very high
profits. It also gets financial help from the government. International business produces high-quality goods at
low cost. It spends a lot of money on advertising all over the world. It uses superior technology, management
techniques, marketing techniques, etc. All this makes it more competitive. So, it can fight competition from
foreign companies.

Caution
It is necessary that people who are interested to get into the international market should get along with the
different factors prevailing in the international business.
Case Study-Documentary Credit M/S Auto India
M/S Auto India is a public limited company; they manufacture SUVs (sports utility vehicle), in technical
collaboration with General Motors of USA. The company has established their manufacturing base at
Ranjangaon in Pune. They have acquired an area of 250 acres and the total project cost is estimated at Rs 1500
crores. As per the projections, the company is slated to achieve a 25% market share in the Indian market,
within a period of two years. Out of the total project cost, 49% is brought in by General Motors and the rest is
tied up with financial institutions, international banks and Indian banks. The working capital is financed by a
consortium of banks in which Global bank, Pune branch, is the leader. The company imports many parts of the
car engine in a CKD (completely knocked down) condition from General Motors, Detroit, after establishing
import letters of credit through its main bankers, Global Bank, Pune Branch.
M/S Auto India approached Global Bank, Pune for opening of import letter of credit as per UCP ICC 600 for
USD 100,000, on sight basis, in favour of General Motors, Detroit.
Type of credit - Irrevocable negotiable
Application - UCP ICC 600
Applicant - M/S Auto India, Pune, India
Beneficiary - M/S General Motors, Detroit, USA
Issuing Bank - Global Bank, Pune, India
Advising Bank - The American Bank, New York
Negotiating Bank - The American Bank, New York
Reimbursing Bank - International Bank, New York
Availability - Negotiable at sight
Expiry - At the counters of The American Bank, New York
Amount - USD 100,000
Merchandise - Car engine parts
Quantity and price - 50 units @ USD 2000 per unit

Circumstances
Issuing Bank
Global Bank, Pune issued its irrevocable negotiable credit through its head office in Pune since Global Bank
co-ordinated all its accounting and communication functions at its head office. The Bank‘s head office
transmitted the credit through Swift network as instructed by its Pune branch to General Motors, Detroit,
through The American Bank, New York.
Advising Bank
The American Bank, New York advised the credit to General Motors, Detroit on receipt of the swift
transmission.
Credit
Along with other conditions, the credit clearly stated that the negotiating bank was to forward the documents
directly to Global Bank‘s head office at Pune.
Beneficiary
After export of the consignment, General Motors, Detroit presented the documents under the credit to The
American bank, New York.

Negotiating Bank
The American Bank, New York, examined the documents presented by General Motors and determined that
they were in compliance with the terms and conditions of the credit. The American bank negotiated the
documents and forwarded the documents, as per the credit terms, to the HO of Global Bank in Pune and
claimed reimbursement from International bank, New York.
Reimbursing Bank
International Bank, New York honoured the reimbursement claim by crediting the current account of the
American Bank, New York and debiting the account of Global Bank, Pune, in its books.

Issuing Bank Head Office

Global Bank‘s Head Office, at Pune, received the documents and after internal registration of the documents,
forwarded the documents to its Pune Branch by inter-office mail.

Issuing Bank Branch

On receipt of the documents by the Pune branch of Global Bank, they examined the documents and
determined that they were discrepant. They were (a) 60 units were shipped instead of 50 units, thereby
overdrawing the credit value by USD 2000 (b) Inspection certificate by Auto Inspection Council, USA is not
submitted, as per credit terms. Global Bank contacted Auto India for waiver of the discrepancies.

Applicant
Auto India requested for copies of the documents to be forwarded by fax and after reviewing the same, they
refused to waive the discrepancies.

Issuing Bank Branch

Global Bank, Pune Branch instructed its HO to transmit an authenticated swift to The American Bank, New
York stating that Global Bank had rejected the documents for the noted discrepancies, requesting the
American Bank‘s instructions as to disposal of the documents, and demanding a refund of the funds
reimbursed.

Issuing Bank Head Office

The HO of the Global Bank sent the authenticated swift message to the American Bank, New York, as
instructed by its Pune Branch.
Negotiating Bank
On receipt of the swift notification advising that Global Bank had rejected the documents for the stated
discrepancies, the American Bank informed Global Bank that it did not accept the rejection of the drawing
since the Global Bank did not comply with UCP 600 sub-article 14 for standard examination of documents.
Therefore, Global Bank was said to be stopped from dishonouring its irrevocable obligation.
Issuing Bank
Global Bank, Pune Branch responded by stating that they acted in accordance with UCP article 14, since their
action did not exceed five banking days following the day of receipt of the documents at their branch counters
after which they scrutinised the documents and determined to refuse them. They maintained that as per article
14 of UCP 600, they notified about the rejection of the documents, by swift, not later than the close of the fifth
banking day following the day of receipt of the documents. They had pointed out all the discrepancies and had
informed American Bank, New York that they were holding the documents at the latter‘s disposal.
Negotiating Bank
The American Bank, New York replied as follows:- We disagree with our position that we acted in accordance
with UCP 600 article 14. Documents were delivered by courier to our HO as per the terms of the credit, on
Monday, January 7, 2008. our swift notifying rejection of the documents was not sent until Wednesday, Jan
16, 2008 that is, on the eighth banking day after receipt of the documents by our bank.
Issuing Bank
Global Bank, Pune Branch, responded by stating that even though its HO received the documents on January
7,2008; the Global Bank‘s Pune Branch did not receive the documents until the following Thursday, January
10, 2008, and the swift advice rejecting the documents was sent within the time period permitted in UCP
article 14.
Negotiating Bank
The American Bank, New York, replied that it was not their concern how Global Bank‘s operational policy
impacted on their inability to comply with UCP. The American Bank, New York stated that in accordance
with the credit terms and conditions, documents were negotiated by them and forwarded to Global Bank‘s HO
by courier. The documents were received by Global Bank on Jan 7, 2008, and any notice of rejection of the
documents should have been given within the close of the fifth banking day following receipt of the
documents. Global Bank‘s Pune Branch failed to do so. Therefore, the American Bank, New York‘s position
was firm relative to UCP 600 article 14 and they would not refund the funds reimbursed.
Questions
1. Was Global Bank, Pune Branch correct in its argument, as the credit issuing bank?
2. Was the stand taken by The American Bank, New York correct, as the negotiating bank?

1.5 Summary
International business focus on the particular problems and opportunities that emerge because a firm is
operating in more than one country.
International business is defined as organization that buys and/or sells goods and services across two or
more national boundaries, even if management is located in a single country.
International business contains any kind of business activity that crosses national perimeters.
Domestic company is main aim to improve the sales on domestically and that company not thinking about
the international.
International business makes optimum utilisation of resources. This is because it produces goods on a very
large scale for the international market.

1.6 Keywords
Business operations business operations are more complex than undertaking domestic business.
Comparative business: Comparative business focuses on similarities and differences among countries and
business systems.
Decision making process: The decision process that normally starts in the marketing strategy area is an
iterative one. As the decision maker proceeds around the decision circle, selected strategies must be readjusted.
International business: international business is cross border economic activity.
International management: international management focuses mainly on decisions made by individuals
operating within a corporate setting.

1.7 Self Assessment Questions

1. International business is cross border economic activity.
(a) True (b) False

2. International business refers to the exchange....................

(a) Physical goods (b) capital
(c) Technology (d) All of these

3. International business is a term used to collectively describe commercial transactions which...................

(a) Private (b) governmental
(c) Sales (d) All of these

4. International Business conducts business transactions all over the world.

(a) True (b) False

5. The parameters and environmental variables that is very important in............................

(a) Domestic business (b) National business
(c) International business (d) All of these

6. International business produces...........................................

(a) Low -quality goods at high cost (b) high-quality goods at high cost
(c) high-quality goods at low cost (d) Low-quality goods at low cost

7. International business exports goods and services.......................

(a) all over the world (b) all over the Country
(c) Outside the country (d) none of these

8. International business makes.....................of resources

(a) Optimum utilisation (b) minimum utilisation
(c) Maximum utilisation (d) none of these

9. Domestic business is a business whose activities are carried out within the........................
(a) Border of country (b) Inside of country
(c) Outside of country (d) none of these

10. The international company deals with businesses and governments in...........................
(a) One foreign countries (b) All foreign countries
(c) One or more foreign countries (d) no foreign countries

1.8 Review Questions

1. Meaning of international business?
2. Why should we study International business?
3. Define international business and discuss the scope of international business.
4. Discuss briefly the importance of international business.
5. Discuss the modes of international business.
6. What is the difference between Domestic business and international business?
7. What is the role of competitors in international business?
8. International business utilizes resources from all over the world. Explain it.
9. Explain Organisation efficiency in International business.
10. What is the importance of parameters and environmental variables in international business?
Answers for Self Assessment Questions
1. (a) 2.(d) 3.(d) 4.(a) 5.(c)
6. (c) 7.(a) 8.(a) 9.(a) 10.(c)
 2
Strategy Development in International
Business
CONTENTS
Objectives
Introduction
2.1 The firm as a value chain
2.2 International business locations
2.3 Value chain Analysis
2.4 Cost benefits analysis
2.5 Business Entry Strategy-Exporting
2.6 Summary
2.7 Keywords
2.8 Self Assessment Questions
2.9 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain the firm as a value chain
Describe the international business locations
Define the value chain analysis
Explain the cost benefits analysis
Describe the business entry strategy-exporting

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2.1 The Firm as a Value Chain

In competition terms, value is the amount of money that buyers are willing to pay in return for what are being
given by the company. Value is reflected in total income – price reflection of the firm product or of the
product units that the firm can sell. A firm is profitable if the value it can obtain is higher than the costs
involved in the product making. To create value for the buyers, higher than production and delivery costs, is
the purpose of any generic strategy. Value chain describes the entire range of activities that are necessary to
bring a product or service from the setting up level, through different levels of production (involving a
combination of physical transformations and different services utilization), delivery, to final the consumer, and
doing away with it after using it. Value chain is an important construction in order to understand the way of
distributing the obtained income from design, production, marketing, coordination and recycling.
Value chain shows the total value and is made up of value activities and value margin.
Value activities are distinct activities from physical and technological point of view, developed by the firm.
These are the ―stones‖ with the help of which a firm creates a valuable product for its buyers. The value
margin is the difference between total value and the collective cost of value activities. The value margin can be
measured in different ways. The value chains of suppliers and distributors also include a value margin, whose
separate identification is important in order to understand a firm‘s cost position sources, because this margin is
a part of the total cost born by the buyer. Value activities can be classified in two broad categories, according
to Michael Porter: main activities and support activities. Main activities, represented in figure 1, are activities
implied in the physical creation of the product, its selling and the physical transfer to the buyer, as well as the
after - selling assistance. In any firm, main activities can be divided in the five generic categories indicated in
figure number 1. Support activities help main activities and they help one another, by providing raw material,
technology, human resources and ensuring different functions on the firm level. Thus, value activities are the
separate and distinct ―stones‖ of competitive advantage. The way in which each activity is done, together with
its economic laws, will decide whether a firm has low or high costs, besides its competitors. The way in which
each activity is done will also determine its contribution to the buyer‘s needs, that is, also, the differentiation.

Support activities

Figure.2.1: Value chain of the company.

2.1.1 Main activities

There are five generic categories of main activities involved by competition in any economic field, as
presented in figure number 2.1. Each category can be divided in a number of distinct activities that depend on
that field and on the firm‘s strategy:
Inbound logistics: Activities associated with the reception, storing and delivery of materials necessary to create
the product, such as materials handling, storing, stocks financial administration, vehicles and returning to
suppliers planning

Operations: Activities associated with raw materials turning into final products activities, such as processing,
packing, assembling, installations maintaining, testing, and endowment exploitation operations.
Outbound logistics: Activities associated with taking, storing and physical delivery of the product to the
buyers, such as final products storing, materials handling, delivery vehicles exploitation, orders taking and
operations planning.
Marketing and sales: Activities associated with product delivery and buyers involving, such as advertising,
promotion, sales staff, offers, channels choosing, relations with distributors and price setting up.

Service: Activities associated with service ensuring in order to increase or maintain the product value, such as
installation services, repairs, training, supplying spare parts and product fixing.

2.1.2 Support activities

Value support activities that competition involves in any field can be divided in four generic categories, such
as they presented in figure no. As well as main activities, support activities can be subdivided in different
value activities, characteristic to each field of activity. Procurement refers to the purchasing function. Among
purchased materials one can mention: raw materials, auxiliary production materials and other consumable
articles, as well as assets such as equipments, laboratory installations, office devices and buildings.
Technology development: Every value activity involves technology in one way or another: know-how,
proceedings or technology included in processing installations. The range of technologies used by most firms
is very wide, starting with documents typing and goods transport, to technologies included in the product
itself. Technology development consists of a range of activities that can be divided in efforts of improving the
product and the processing method. The development of the technology related to the product and to its
characteristics supports the whole value chain, while, other types of technological development are associated
to some specific activities, main or support activities. Technology development is important for the
competition advantage in all economic fields, in some of them even representing the competitive advantage
key. Human resources management: Human resources management consists in activities such as recruiting,
employing, training and paying all types of staff. Human resources management encourages both main
activities and individual support ones (for example: engineers employing), as well as the whole value chain
(for example: labor contracts negotiation).
Human resources management influences the competitive advantage in any firm, through the role it plays both
in determining professional competence and employees‘ motivation, as well as in determining employing and
training costs. In some fields, it represents the key to competitive advantage. Firm infrastructure: Firm‘s
infrastructure consists in a number of activities that involve general management, planning, financial
management, accountancy, legal assistance, relations with state authorities and quality management; unlike
other support activities, it usually encourages the whole value chain, not individual activities.

Types of activities
Within every category of main and support activities there are three types of activities that play a different role
in the strategic competitive advantage:
Direct. Activities directly involved in creating value for the buyer, such as assembling ones, components
processing, sales staff use, advertising, product projecting, recruitment, etc.
Indirect. Activities that make possible direct activities continuously, such as maintaining ones, planning,
endowments exploiting, sales staff management, research studies administration, recording suppliers.
Quality assuring. Activities that assure other activities quality, such as supervision ones, inspecting,
testing, revision, checking, adjusting and re-processing. Quality assuring is not synonymous with quality
management, because many value activities contribute to quality.

Within this context, a value chain analysis is a very important element that allows the following characteristics
observation:
it studies competitiveness nature and determinants, having a special contribution to the orientation towards
inter-connected groups of firms;
 concentrating on all chain links (not only on production) and on all activities in every link helps to identify
activities that are responsible of incomes growing and those that contribute to their decrease;
As a result of these differences referring to the nature of income along various links within the chain,
deciding people obtain clear information, necessary to formulate correct strategies and to take proper
decisions. Thus, according to these decisions one can improve the activity in a chain link in order to
generate higher incomes;
with the help of this analyses one can prove that even if a firm is competitive, its connection to the world
economy can require a certain concentration on macro-policies and institutional relations;
Participation on global markets, competitive at one time, cannot assure incomes increase in time.

Concentrating on the way involved by this participation, value chain analysis allows the firm‘s incomes
determinants understanding. Competitive advantages result from the firm‘s ability to perform the required
activities, either at lower costs, or in ways able to create value for the client and that allow the firm to ask for a
higher price. In order to examine the ways through which a firm can obtain and support a competitive
advantage, it is necessary to observe, individually, the activities generating value, along the value chain.
Competitive advantages require that the value chain of a firm to be rather a system than a collection of
separates parts. A firm is profitable if its value is higher than the total costs of performing all activities. In
order to gain competitive advantages higher than its competitors, a firm must either provide a similar value to
its client, or perform the activities in a unique way that create a higher value for the client that allows the firm
to ask for a better price differentiation. The firm may claim to have a competitive advantage gained long its
value chain only when its customers see the value provided by the firm as superior to that offered by its
competitors.
The chain coordinator has also an important role within the value chain, which must continuously see to value
obtaining all along the chain. The differences between value chains of competitors are a main source of
competitive advantage. Looking for sustainable competitive advantage, the firm should not limit only to its
own value chain, but it also should have in view the value chains of suppliers, distributors and, finally, of its
customers. Thus value supplying network takes form, which consists in the firm, suppliers, distributors, and,
finally, customers, that form a ―partnership‖ with one another in order to improve the whole system
performance. More firms today make up ―partnerships‖ with other members of the offer chain in order to
improve the performance of the value supplying network for the customer. Competition today does no longer
take place among individual competitors. It rather appears among whole networks of supplying value, created
by these competitors. Firms do no longer compete among themselves through themselves, but through their
marketing networks.

2.2 International Business Locations

Plant Location International (PLI) is a global service of IBM Global Business Services
Strategy & Transformation practice specialized in corporate location and economic development strategies.
Operating as a fully globally integrated service - with a global center of excellence in Brussels, Belgium,
supported by dedicated Global Delivery resources, and satellite teams in key markets – IBM-PLI provides
expert services to corporate clients for analyzing international business locations for expanding or
consolidating companies to select the optimal location (country/city). IBM-PLI also advises economic
development organizations on improving their areas‘ competitiveness, strategic marketing, developing value
propositions, and marketing tools, etc. IBM-PLI is a leading innovator in location strategy and economic
development tools and techniques, which are constantly being improved based on latest insight in corporate
location decision making. Examples are: Cost-Quality location screening methodology, assessing the trade-off
between cost and quality of communities as investment options for companies IBM-PLI‘s Location
Benchmarking Tool, based on this cost-quality methodology, allowing regions and cities to test their location‘s
value proposition for targeted activities and successfully market their communities to investors . The Global
Investment Locations Database (GILD) which tracks location decisions for contestable investment projects
around the world.

2.2.1 International Location

Multinationals have located subsidiary businesses in other countries for many years. In recent years, this trend
has gathered pace as part of globalization. There are specific reasons why businesses might want to locate
overseas.
International location
Some Reasons for International Location
• Historical - a sugar refining firm is likely to own plant in countries where sugar is grown, as well as a
network to market and service the business worldwide
• Service - many products and services need local country support - e.g. Bosch washing machines.
• Access to markets - companies manufacturing in EU have access to the whole market. Nissan opened in
Sunderland for this reason, and this also explains why they started making trucks in the USA, to access
that market.
• Access to raw materials - extraction of natural resources in countries where they are found.
• Access to labor - usually this means cheap labor where regulations are less stringent than in the UK.
• Tax avoidance - by means of transfer pricing, multinationals organize their affairs to minimize their
overall tax liability.
• Local incentives - regional grants and incentives are sometimes given to encourage overseas firms to set
up locally and boost the economy.

Some Problems of International Trade

Risks and uncertainties associated with international trade include the following; for some companies, these
risks are managed better by having international offices, factories and so on.
• Currency fluctuations
• Exchange controls
• Political instability and unrest
• Tariffs and other restrictive practices
• Language and cultural barriers - UK firms have an advantage that English is widely spoken around the
world.
• Differences in ethical approaches

Factors influencing locations

Different factors influencing plant location. Write a brief note on Product layout with an example.

Factors influencing plant location:-

1. Nature of the Product: The nature of the product to be manufactured will significantly affect the layout of
the plant. Stationary layout will be most suitable for heavy products while line layout will be best for the
manufacture for the light products because small and light products can be moved from one machine to
another very easily and, therefore, more attention can be paid to machine locations can be paid to machine
locations and handling of materials.

2. Volume of Production: Volume of production and the standardization of the product also affect the type of
layout. If standardized commodities are to be manufactured on large scale, line type of layout may be adopted.
3. Basic Managerial Policies and Decisions: The type of layout depends very much on the decisions and
policies of the management to be followed in producing the commodity with regard to the size of plant, kind
and quality of the product, scope for expansion to be provided for, the extent to which the plant is to be
integrated, amount of stocks to be carried at anytime, the kind of employee facilities to be provided etc.

4. Nature of Plant Location: The size shape and topography of the site at which the plant is located will
naturally affect the type of layout to be followed in view of the maximum utilization of the space available
.For e.g., if a site is near the railway line the arrangement of general layout for receiving and shipping and for
the best flow of production in and out the plant may be made by the side of the railway lines .If space is
narrow and the production process is lengthy, the layout of plant may be arranged on the land surface in the
following manner:

5. Type of Industry Process: This is one of the most important factors influencing the choice of type of plant
layout. Generally the types of layout particularly the arrangement of machines and work centers and the
location of workmen vary according to the nature of the industry to which the plant belongs. For the purpose
of lay out, industry may be classified into two broad categories:
(i) Intermittent and (ii) continuous. Intermittent type of industries is those, which manufacture different
component or different machines.

Such industries may manufacture the parts, when required according to the market needs. Examples of such
industries are shipbuilding plants. In this type of industry functional layout may be the best. In this type of
industry raw material are fed at one end and the finished goods are received at another end. A continuous
industry may either be analytical or synthetic. A analytical industry breaks up the raw material into several
parts during the course of production process or changes its form, e.g. oil and sugar refineries. A synthetic
industry on the other hand mixes the two or more materials to manufacture one product along with the process
of production or assembles several parts to get finished product. Cement and automobiles industries are the
examples of such industry. Line layout is more suitable in continuous process industries.

6. Types of Methods of Production: Layout plans may be different according to the method of production
proposed to be adopted. Any of the following three methods may be adopted for production- (1) Job order
production, (2) batch production, and (3) mass production. Under job production goods are produced
according to the orders of the customers and therefore, specification vary from customer to customer and the
production cannot be standardized. The machines and equipment can be arranged in a manner to suit the need
of all types of customers. Batch production carries the production of goods in batches or group at intervals. In
this type of manufacturing the product is standardized and production is made generally in anticipation of
sales. In such cases functional or process layout may be adopted. In case of mass production of standardized
goods, line layout is most suitable form of plant layout.

7. Nature of Machines: Nature of machines and equipment also affects the layout of plants. If machines are
heavy in weight or create noisy atmosphere, stationery layout may reasonably be adopted. Heavy machines are
generally fixed on the ground floor. Ample space should be provided for complicated machines to avoid
accidents.

8. Climate: Sometimes, temperature, illumination and air are the deciding factors in the location of machines
and their establishments. For example, in lantern manufacturing industry, the spray-painting room is built
along the factory wall to ensure the required temperature control and air expulsion and the process of spray
painting may be undertaken.
9. Nature of Material: Design and specification of materials, quantity and quality of materials and
combination of materials are probably the most important factors to be considered in planning a layout. So,
materials storage, space, volume and weight of raw materials, floor load capacity, ceiling height, method of
storing etc. should be given special consideration. This will affect the space and the efficiency of the
production process in the plant. It will facilitate economic production of goods and prompt materials flow and
soundly conceived materials handling system.

10. Type of Machine: Machines and equipment may be either general purpose or special purpose. In addition
certain tools are used. The requirements of each machine and equipment are quite different in terms of their
space; speed and material handling process and these factors should be given proper consideration while
choosing out a particular type of layout. This should also be considered that each machine and equipment is
used to its fullest capacity because machines involve a huge investment. For instance, under product layout,
certain machines may not be used to their full capacity so care should be taken to make full use of the capacity
of the machines and equipment.

11. Human Factor and Working Conditions: Men are the most important factor of production and therefore
special consideration for their safety and comforts should be given while planning a layout, specific safety
items like obstruction-free floor, workers not exposed to hazards, exit etc. should be provided for. The layout
should also provide for the comforts to the workers such as provision of rest rooms, drinking water and other
services etc. sufficient space is also to be provided for free movement of workers.

12. Characteristics of the Building: Shape of building, covered and open area, number of storey‘s, facilities of
elevators, parking area and so on also influence the layout plan. In most of the cases where building is hired,
layout is to be adjusted within the spaces available in the building. But if any building is to be constructed,
proper care should be given to construct it according to the layout plan drawn by experts. Special type of
construction is needed to accommodate huge or technical or complex or sophisticated machines and
equipment.

2.2.2 Product Layout

Product layout is also called as production lines or assembly lines. They are designed and laid out in such a
way that only a few products are capable of being manufactured or assembled. Materials flow through the
various facilities. These use special machines to perform specific operations to produce only one product at
one time. So, companies should set different set of machines for different products. Workers perform a narrow
range of activities to complete the operations on the product as it moves in a flow line. The operation times,
the sequence of movements and routing procedures are highly standardized to meet production requirements
which are synchronised with many such products to complete finished goods to meet demands. Using special
machines and implementing standardization in operations have many advantages which are listed below:
The skill required of the workers is low
Supervision is minimal
Training needs are small
1. Precautions to be taken are:
2. Constant check on the processes needs to be performed so that quality is assured.
3. Corrective measures have to be implemented immediately to avoid rejections, since, the quantities that get
manufactured will be continuous.
4. Check for the behavioural attitude of the worker. As jobs are repetitive, workers tend to be bored and lose
concentration. This may affect productivity and quality.
Product Layout Example: Let consider an example of Work allocation at an airport
Activity Average time, seconds
1. Deplane 20
2. Immigration 16
3. Baggage claim 40
4. Customs 24
5. Check baggage 18
6. Board domestic flight 15

2.3 Value Chain Analysis

A value chain analysis, providing both qualitative and quantitative background information, is to be
undertaken for all case studies (products) included in the project before an econometric analysis is undertaken.
Sources of information for this analysis may include secondary data, published or unpublished literature,
surveys, focus groups, and rapid appraisal.
The value chain analysis will include the following stages:

Production
Capture fishery or aquaculture:
This will include information on whether it is capture fishery or aquaculture, freshwater or marine, production
quantity, price and technology / technologies used in the harvest process. How many people are directly
employed in the production sector? What information is available on relative incomes of fishermen / fish
farmers and the non-fishing sector and how has this changed overtime? Are there fishermen‘s associations to
support fishermen/fish farmers in discussions with government, regulators and buyers? What is the structure of
fisheries management? Is it open access, licenses, net size regulations, etc.? How are regulations enforced? For
capture fisheries, stock information must be included.

Processing
This will include information about products produced (e.g. fresh, salted, dried, canned, refrigerated or
frozen), technology / technologies used, major inputs and costs. How many people work in the processing
sector? What proportion of catch is processed in the region and what proportion is sold out of the region or
exported for processing?

Transportation
This will include pre and post processing transportation, where applicable. Two things here, first, how
important is transportation in the fish supply chain and second, what is the cost of transportation and how has
this changed over time. Is transportation a public or private business matter?

Final consumption
What portion of the product is sold domestically versus exported? This includes information about what kind
of products are sold in the different markets.

Regulations
This would include fisheries management regulations for capture fisheries, entry / environmental regulations
for fish farms, sanitary/health regulations, tariffs and non-tariff barriers to trade etc. Also what regulations are
imposed on sale of fish? Are there restrictions on who can buy and sell fish?
Market structure
The product will be traded at each stage of the value chain (first hand market, intermediate market, export
market, retail market etc.). It is important to learn about market structure at different stages, in particular, how
many buyers and sellers there are. How are prices determined? Are fish sold under contract or in auction or
what? In addition, information about substitutes is required.

Data availability
This must give an overview of data availability (variables, length of time series etc.) at the different stages of
the value chain. For this section, follow the data requirements of both the structural and reduced form models
as set out in Bjørndal and Gordon (2010). Some products will go through different types of processing. An
example is given by tuna from the Maldives. This product will involve limited processing in the Maldives
before export to Sri Lanka or Thailand, where it is canned prior to export to overseas markets. Where this is
the case, the product must be followed throughout its lifecycle. As pointed out, this background analysis will
partly be qualitative and partly quantitative. The purpose is to give the reader a good understanding of the
relevant value chain. It will also be important for interpreting the results from the econometric price analyses.

2.4 Cost Benefits Analysis

In a world of finite public and private resources, we need a standard for evaluating trade-offs, setting priorities,
and finally making choices about how to allocate scarce resources among competing uses. Cost benefit
analysis provides a way of doing this. A cost benefit analysis, simply put, is the monetary or safety valuation
of the risk of performing a task (or performing a task in a certain way) vs. benefit of performing the task (or
performing the task in a certain way). One of the simplest examples is the use of gloves when performing
maintenance on a mechanical saw. What are the risks of not wearing gloves? What are the benefits? A
maintenance person may contact a saw blade during the performance of their work and cut themselves. Gloves
will protect the maintenance operator from cuts or severe lacerations, but the gloves may also impede the
maintenance operator from accessing small parts or points within the machine, making their task that much
more difficult. Weighing the risks and benefits is sometimes a confusing, and complicated, process, and is not
just a monetary or financial decision. Financial decisions many times determine whether or not equipment or
machinery is replaced. A simple return on investment (ROI) strategy is one of many types of investment
information that would go into a financial decision. A cost benefit analysis is more than a return on investment
strategy; there are many other factors that influence a decision. Safety is one of these factors

What is cost benefit analysis?

Cost benefit analysis (COBA) is a technique for assessing the monetary social costs and benefits of a capital
investment project over a given time period. The principles of cost-benefit analysis (CBA) are simple:

Appraisal of a project:
It is an economic technique for project appraisal, widely used in business as well as government spending
projects (for example should a business invest in a new information system)

Incorporates externalities into the equation:

It can, if required, include wider social/environmental impacts as well as ‗private‘ economic costs and benefits
so that externalities are incorporated into the decision process. In this way, COBA can be used to estimate the
social welfare effects of an investment
Time matters!
COBA can take account of the economics of time – known as discounting. This is important when looking at
environmental impacts of a project in the years ahead

2.4.1 Uses of COBA

COBA has traditionally been applied to big public sector projects such as new motorways, by-passes, dams,
tunnels, bridges, flood relief schemes and new power stations. Our example later considers some of the social
costs and benefits of the new Terminal 5 for Heathrow airport. The basic principles of COBA can be applied to
many other projects or programmes. For example, - public health programmes (e.g. the mass immunization of
children using new drugs), an investment in a new rail safety systems, or opening a new railway line. Another
example might be to use COBA in assessing the costs and benefits of introducing congestion charges for
motorists in London. Or the costs and benefits of the New Deal programme designed to reduce long-term
unemployment. Cost benefit analysis was also used during the recent inquiry into genetically modified foods.
Increasingly the principles of cost benefit analysis are being used to evaluate the returns from investment in
environmental projects such as wind farms and the development of other sources of renewable energy, an area
where the UK continues to lag behind. Because financial resources are scarce, COBA allows different projects
to be ranked according to those that provide the highest expected net gains in social welfare - this is
particularly important given the limitations of government spending.

The Main Stages in the Cost Benefit Analysis Approach

At the heart of any investment appraisal decision is this basic question – does a planned project lead to a net
increase in social welfare? Calculation of social costs & social benefits

This would include calculation of:

Tangible Benefits and Costs (i.e. direct costs and benefits)
Intangible Benefits and Costs (i.e. indirect costs and benefits – externalities)

This process is very important – it involves trying to identify all of the significant costs & benefits
Sensitivity analysis of events occurring
This relates to an important question - If estimate that a possible benefit (or cost) is £x million, how likely is
that outcome? If reasonably sure that a benefit or cost will ‗occur‘ – what is the scale of uncertainty about the
actual values of the costs and benefits?

Discounting the future value of benefits

Costs and benefits accrue over time. Individuals normally prefer to enjoy the benefits now rather than later –
so the value of future benefits has to be discounted
Comparing the costs and benefits to determine the net social rate of return

Comparing net rate of return from different projects

The government may have limited funds at its disposal and therefore faces a choice about which projects
should be given the go-ahead

2.4.2 Evaluation: Criticisms of COBA

There are several objections to the use of CBA for environmental impact assessment:
Problems in Attaching Valuations To Costs And Benefits: Some costs are easy to value such as the running
costs (e.g. staff costs) + capital costs (new equipment). Other costs are more difficult – not least when a project
has a significant impact on the environment. The value attached to the destruction of a habitat is to some
―priceless‖ and to others ―worthless‖. Costs are also subject to change over time – I.e. the construction costs of
a new bridge over a river or the introduction of electronic road pricing

The CBA May Not Cover Everyone Affected (I.E. All Third Parties): Inevitably with major construction
projects such as a new airport or a new road, there are a huge number of potential ―stakeholders‖ who stand to
be affected (positively or negatively) by the decision. COBA cannot hope to include all stakeholders there is a
risk that some groups might be left out of the decision process
Future generations – are they included in the analysis?
What of ―non-human‖ stakeholders?

Distributional consequences: Costs and benefits mean different things to different income groups - benefits to
the poor are usually worth more (or are they?). Those receiving benefits and those burdened with the costs of a
project may not be the same. Are the losers to be compensated? To many economists, the equity issue is as
important as the efficiency argument. Social welfare is not the same as individual welfare - What we want
individually may not be what we want collectively. Do we attach a different value to those who feel
―passionately‖ about something (for example the building of new housing on greenfield sites) contrasted with
those who are more ambivalent?

Valuing the environment: How are we to place a value on public goods such as the environment where there is
no market established for the valuation of ―property rights‖ over environmental resources? How does one
value ―nuisance‖ and ―aesthetic values‖?

Valuing human life: Some measurements of benefits require the valuation of human life – many people are
intrinsically opposed to any attempt to do this. This objection can be partly overcome if we focus instead on
the probability of a project ―reducing the risk of death‖ – and there are insurance markets in existence which
tell us something about how much people value their health and life when they take out insurance policies.

2.4.3 Revealed Preference – Valuing the Benefits from a Project

According to some economists, the valuation of benefits and costs used in COBA should reflect the
preferences revealed by choices which have actually been made by individuals and businesses in different
markets.

Consider this example:

20 employees are given the chance of using a new car park close to work for £5 per day or parking further
away from work for free – but involving an extra 10 minutes walk. Their decisions reveal how much they
value time. If they all choose to spend the £5 per day on car parking, this reveals that time is more important to
them than 50p per minute. If only half take up the car parking option, this reveals that average value of time to
them was 50p per minute. Hard choices made in markets are the best guide to private benefit.
Information contained in the demand curve tells us much about how much people are willing and able to pay
for something. This is important in revealed preference theory. When consumers make purchases at market
prices they reveal that the things they buy are at least as beneficial to them as the money they relinquish.

2.4.4 Cost Benefit Analysis in Practice – Heathrow Terminal 5

The debate over whether there should be a fifth terminal at Heathrow airport has fierce and long-lasting! The
official planning enquiry reported after 5 years and having cost many millions of pounds. The rival arguments
at the inquiry highlighted many examples of environmental impact (externalities) - noise, air quality, rivers etc.
- but concluded that these were not enough to refuse planning permission and that the new terminal project
should go ahead.

The Case for Terminal 5

Economic growth: Demand for air travel in south-east England is forecast to double in the next 20 years,
making expansion vital – many thousands of jobs and businesses depend on Heathrow airport expanding to
provide sufficient supply capacity to meet this growing demand. An increase in the capacity of Heathrow will
make best use of airport's existing infrastructure and land (nearly 3,000 acres).

The economy and trade: The UK will lose airlines and foreign investment to European rivals if it does not
meet demand. The benefits of a world-beating industry would be diminished – many sectors of our aviation
industry have a comparative advantage and add huge sums to our balance of payments

Jobs: The terminal 5 project will create or safeguard an estimated 16,500 jobs, as well as creating 6,000
construction jobs during the building phase – this will have multiplier effects on the local / regional and
national economy

Transport: The terminal will be the centre of a world-class transport interchange, with new Tube and rail links.
Car traffic would rise only slightly – the social costs of increased traffic congestion have been exaggerated by
the environmentalists

Environment: The site earmarked for terminal 5 is currently a disused sludge works, and any displaced wildlife
and plant life will be carefully relocated. The noise climate around Heathrow Airport has been improving for
many years, even though the number of aircraft movements has increased considerably – partly due to the
phasing out of older, nosier aircraft

Noise and night flights: BAA promises no increase in overall noise levels or in night flying. The number of
flights would rise only 8%

Objections to Terminal 5
Growth: BAA forecasts are misleading and will lead to uncontrolled expansion, rather than targeting better
solutions such as using existing space at other airports.
The economy: Heathrow already has the biggest capacity in Europe, and ambitions to extend its lead are
merely "commercial prestige" rather than having long term macroeconomic benefits
Jobs: Only 6,000 jobs will be created - a tiny fraction of all the new jobs in the South East. Local studies say
jobs will increase anyway even without a fifth terminal
Transport: There will be a significant increase in road-widening and car parks to cater for the tens of
thousands of extra car journeys to the airport every year
Environment: Air pollution will increase significantly, and hundreds of acres of wildlife and Green Belt land
will be lost forever. Plus the environmental costs of increased traffic congestion.
Noise and night flights: More flights will mean more noise under the flight paths, and the pressure for
controversial night flights and a third runway will increase – the regulators will be captured by the airlines and
airport authorities and will eventually be pressurized into giving way on allowing more night time flights.

Did you know?

The value chain is a concept from business management that was first described and popularized by Michael
Porter in his 1985
2.5 Business Entry Strategy-Exporting
A market entry strategy maps out how to sell, deliver and distribute products in another country.
How to enter an export market?
The three principal methods of selling to foreign markets are the following:

Direct Exports
Direct exports are when we market, sell and deliver products directly to the client. In the case of services,
negotiate, contract and work directly with the client. By avoiding a middleman, get a higher return on
investment, set lower prices and become more competitive. Furthermore, have a direct relationship with our
customers.

Indirect Exports
We could choose to export indirectly through an intermediary, such as a trading house, an agent, a
representative or foreign distributor. Depending on the arrangement, they can do some of the leg work for we,
but at a cost. For many new exporters, an intermediary may be the best way to enter a market.

Partnerships and Alliances

Choosing to form an alliance or partnership with a domestic or foreign company is another way to enter a
foreign market. Partnering with a foreign company can provide the expertise, technology, capital or market
access that might not be able to afford own. Allying with a Canadian company whose products or services
complement own can reduce costs through joint marketing efforts or the sharing of distribution channels.
International trade includes a number of other market-entry mechanisms, such as investments, joint ventures
and licensing agreements. For guidance on these, contact the Trade Commissioner Service in Canada.

2.5.1 Types of Export Intermediaries

Choosing to sell in foreign markets through an intermediary could save you time and money. They come in
several types:

Agents and Representatives

An agent secures orders from foreign customers in exchange for a commission. A representative is a
specialized agent who operates within a specific geographic area and who sells related lines of goods or
services. Both agents and representatives may be authorized to enter into contractual sales agreements with
foreign customers on behalf.

Trading Houses
Trading houses are domestic intermediaries that market goods or services abroad. A full-service trading house
can handle many aspects of exporting, such as market research, transportation, appointing distributors or
agents, exhibiting at trade fairs, advertising and preparing documentation.

Foreign Distributors
Unlike agents, distributors actually they set the selling price, provide buyer financing and look after warranty
and service needs. They also usually provide after-sales service in the foreign market.

Licensing, Investment
The Licensing Section administers the licensing provisions of the Securities Act, which require that all
individuals and entities who engage in purchases, sales, or providing advice concerning securities be licensed
by the Division, or properly exempted from licensure. The Licensing Section issues licenses to securities
dealers, salespersons, investment advisers, investment adviser representatives, SEC-registered investment
adviser notice filers, and investment officers in accordance with the Securities Act. The Licensing Section
investigates license applicants, administers the annual license renewal program, and maintains certain records
of and responds to public inquiries about former and current licenses. The Licensing Section also includes
field examiners, who conduct on-site examinations of investment advisors, securities dealers, and issuers of
securities to ensure compliance with the Securities Act.

FINRA Licensing Breakdown

The Financial Industry Regulatory Authority (formerly the National Association of Securities Dealers)
oversees all securities licensing procedures and requirements. This self-regulatory organization administers
many of the exams that must be passed to become a licensed financial professional. It also performs all
relevant disciplinary and record-keeping functions. FINRA offers several different types of licenses needed by
both representatives and supervisors. Each license corresponds to a specific type of business or investment.

Information for Investors

Investment advisers and their representatives operating in Washington (with certain exceptions) are required to
be licensed with the Securities Division. Persons who provide investment portfolio management for their
clients or who hold themselves out to the public as financial planners are among those required to be licensed.
The Division reviews investment adviser applications for the qualifications of their principals and their
disciplinary history, and the adequacy of the disclosure they are required to provide to clients. Applications
received for representative licensing are reviewed for disciplinary history and to ensure that appropriate
examinations have been passed or designations held. To check to see whether an investment adviser or
investment adviser representative is registered with the Securities Division or has any disciplinary history.
The Securities and Exchange Commission and the North American Securities Administrators Association
(NASAA) have a new website that allows investors to electronically access information about money
managers, financial planners and other investment advisers. The Investment Adviser Public Disclosure
(IAPD) website provides instant access to registration documents filed by more than 9,000 registered
investment advisers. The documents provide information about each adviser‘s business, advisory services and
fees, as well as disciplinary problems an adviser or its employees may have had during the last ten years.

Information for Applicants

All applicants, whether for state registration or federal notice filing status, must file over the Internet through
the Investment Adviser Registration Depository (IARD). In addition, applicants for state registration must file
additional documents directly with the Securities Division. Please see the links below for more specific
information. Applicants for investment adviser representative registration must apply via an electronic Form
U-4 on the IARD system, submitted by their firm. Renewal of investment adviser and investment adviser
representative registrations takes place through the IARD system after the first weekend in November.
Renewal information can be accessed.

Caution:
It's essential for exporters to have a clear understanding of the culture, customs and economic conditions of the
country where they want to do business.

Case Study-New Trinidad-Barbados solar energy joint-venture launched

BRIDGETOWN, Barbados, Monday, October 29, 2012 – Solaris Energy Ltd has opened the Caribbean‘s
newest and renewable energy manufacturing facility. This new 8,000 square-foot factory in St. Phillip,
Barbados, Solaris Energy enhances its 30-year history of providing solar powered products by increasing its
production of solar water heaters, expanding its portfolio of products, and reaching out to new international
markets. Solaris Energy‘s subsidiary Solaris Global Energy Limited will continue to produce flat plate solar
water heaters, including the popular Solaris 500; and add to its product line new vacuum tube solar water
heaters and photovoltaic (PV) electricity products and systems. The factory was officially opened by Senator
Darcy Boyce, Minister in the Office of the Prime Minister of Barbados, who also was the featured speaker.
Minister Boyce, who has responsibility for Telecommunications and Energy, Immigration and Invest
Barbados, said,:―This expanded and upgraded facility [is] helping this country get a little bit closer to realizing
the vision of this administration for a dynamic and strong renewable energy sector.‖

Citing the need to get solar water heaters into the homes of income groups that generally do not have them
now, Boyce spoke about encouraging research and development, marketing and financing of renewable energy
and energy efficiency systems made in the region. ―Solaris has already begun this work in research and
development as attested by their introduction of new materials, new technology for heat conversion and more
flexible sizing of systems,‖ he added. Keith Scotland, Chairman of Solaris Energy‘s Board of Directors said
the vision of the company is to provide affordable, renewable energy choices, and to show how collaboration
between nations is drives greater success. ―We at Solaris Energy are a combination of Bajan innovation and
Trini drive and entrepreneurial skill. This is a collaboration to which our group Chairman George Nicholas
remains committed to developing in order to be model for CARICOM countries in how co-operation between
entities of different Caribbean countries is essential to achieve a common goal.‖? Solaris Energy Ltd is based
in the Republic of Trinidad and Tobago and has more than 30 years of experience in manufacturing solar
energy products, mainly solar water heaters and photovoltaic systems, using superior materials at an attractive
price. Its subsidiary, Solaris Global Energy, Ltd. is based in Barbados and is the successor company to Aqua
Sol Components Limited, one of the three leading renewable energy manufacturing pioneers in the region.
Solaris Energy‘s dedication to energy efficiency will be further evident with the installation of a 50kW PV
system at its new factory before the end of this year. The system will generate enough electricity to fully
power operations at the factory, plus feed surplus energy into the grid. Solaris Energy will be the first
renewable energy products manufacturer in the region to be running fully on renewable energy

Question
1. Describe the energy efficiency.
2. What is a photovoltaic system?

2.6 Summary
Global Strategy helps companies tap into the power of Open Innovation.
Global Strategy identifies, analyzes and generates actionable information on commercial opportunities and
business intelligence, including products, technologies, companies and markets, competitive landscapes,
regulatory requirements, R&D pipelines, and more.
The nature of the product to be manufactured will significantly affect the layout of the plant.
Volume of production and the standardization of the product also affect the type of layout.
Nature of machines and equipment also affects the layout of plants. If machines are heavy in weight or
create noisy atmosphere, stationery layout may reasonably be adopted. Heavy machines are generally
fixed on the ground floor
COBA has traditionally been applied to big public sector projects such as new motorways, by-passes,
dams, tunnels, bridges, flood relief schemes and new power stations.
 Direct exports are when we market, sell and deliver products directly to the client. In the case of services,
negotiate, contract and work directly with the client.

2.7 Keywords
Investment: It has different meanings in finance and economics. Finance investment is putting money into
something with the expectation of gain that upon thorough analysis has a high degree of security for the
principal amount, as well as security of return, within an expected period of time.
Innovation: It is the development of new customer‘s value through solutions that meet new needs, inarticulate
needs, or old customer and market needs in new ways
Exploitation: It refers to the subjection of producers (the proletariat) to work for passive owners (bourgeoisie)
for less compensation than is equivalent to the actual amount of work done.
Regulation: It is a legal provision that creates, limits, or constrains a right, creates or limits a duty, or allocates
a responsibility.
Transportation: It is the movement of people, animals and goods from one location to another. Modes of
transport include air, rail, road, water, cable, pipeline, and space.

2.8 Self Assessment Questions

1. Global Strategy helps companies tap into the power of
(a) Open Innovation (b) Open novation
(c) unwind, Innovation (d) none of these

2. The nature of the product to be manufactured will significantly affect the layout of the plant.
(a) rooter (b) utgrowth
(c) plant (d) tree

3. Volume of production and the standardization of the product also affect the type of layout
(a)true (b)false

4. Product layout is also called as production lines or assembly lines

(a)true (b)false

5. Business strategy formulation includes which of the following elements?

(a)Guidelines and procedures to be used in carrying out a strategy.
(b)Resource allocation to define the organisation's relationship with its environment.
(c)The creation of a business vision.
(d)All of these.

6. In Value Chain Analysis, which of the following is not classed as a primary activity?
(a) Human resource management (b) Service.
(c) Outbound logistics (d) Sales and marketing.

7. In the business impacting IS Strategy approach:

(a)IS strategy is formulated according to business objectives.
(b)IS strategy strongly influences business strategy.
(c)business strategy is independent of IS strategy.
(d)IS strategy is independent of business strategy.

8. Direct exports are when we market, sell and deliver products directly to the client
(a)true (b)false

9. Strategic stretch involves:

(a) The fit between the organisation and its environment.
(b) Creating new opportunities by stretching and exploiting capabilities in new ways.
(c) The skills of the senior management.
(d) Utilising all the resources of an organisation to their full capacity.

10. The Value Chain model is comprised of primary activities and support activities. Which of the following
are not components of the primary activities?
(a) Operations. (b) Procurement.
(c) Service. (d) Outbound logistics.

2.9 Review Questions

1. Explain about open innovation?
2. Describe the value chain
3. What is the global expansion plan
4. What are the international business locations?
5. Explain the value chain analysis?
6. What is the cost benefits analysis?
7. Describe about business entry strategy. Explain the exporting
8. Explain the Types of export intermediaries
9. What is the Uses of COBA
10. Define the Factors influencing plant location

Answers for Self Assessment Questions

1. (a) 2.(c) 3.(a) 4.(a) 5.(d)
6. (a) 7.(a) 8.(a) 9.(b) 10.(b)
 3
Global Market Entry Strategies
CONTENTS
Objectives
Introduction
3.1 Trading company
3.2 Licensing and Franchising
3.3 FDI
3.4 Summary
3.5 Keywords
3.6 Self Assessment Questions
3.7 Review Questions

Objectives
After studying this chapter, you will be able to:
Understand about trading company
Describe the licensing and franchising
Explain the FDI

Introduction
There are numerous market entry strategies that organisations can utilise when establishing international
operations. Our choice will depend on which market we are aiming to enter and our organisational objectives.
Each strategy carries with it different levels of risk and various advantages and disadvantages. The path that
most businesses take is to establish a relationship with a foreign agent or distributor. A partnership like this
can be useful as experienced agents have local contacts and have a thorough understanding of the local
conditions and regulations. The main issue with this method is the lack of control over operations as to manage
the process from a distance and rely on agent to get the job done. Another common strategy is to set up a local
office in our intended market. The advantage of this is that greater control over marketing and distribution and
direct contact with customers. The problem with setting up a local office is the added expenses of rent and
employing at least one person to operate it. A larger scale operation may be able to make effective use of a
strategic alliance with another organisation. Joint ventures involve business agreeing to merge with an already
established business intended market. Joint ventures are a great way to gain access to skills, resources and
finance when entering into a new market. However, there are risks involved and we need to ensure that can
rely on business partner to work with to achieve the objectives of the venture.
Organisations can also look at the option of an acquisition or merger with a well established local business.
Buying into an established business can give we instant access to a customer base and can help we to avoid
some of the barriers of opening own business in an unfamiliar market. However, there is a significant amount
of financial investment involved and the risks will be carried entirely by Although not applicable to all
business types, franchising can also be an effective market entry strategy. If we can demonstrate an effective
business model and have a proven brand in our domestic market, we could try and sell a franchise in selected
markets around the world. Some of the most successful multi-national corporations have used franchising to
increase their international market share. This is far from all of the international market entry strategies that we
could utilise. The main point to weigh up is the risk versus reward. How much do we stand to lose if market
entry strategy fails to work? Also remember that we may need to use different market entry strategies for
different markets, as one success would not necessarily translate into another without adaptation.

3.1 Trading Company

Global Trading Company is an international corporation specializing in the import and export of commodities.
We are a family-owned business headquartered in Concord, California. We have two other branches, located
in Dubai, United Arab Emirates and Kunduz, Afghanistan. The synergy provided by operating three branches
in diverse geographic locations, allows for a truly unique international trading dynamic. International trade is
one of those areas where the value of practical experience cannot be overstated. It is also, in my view less
rightly, an area where some suggest that ―learning in the trenches‖ is the only way to go. Training, through
academic institutions, industry associations, corporate programs – and through organizations such as Canada‘s
FITT in Ottawa (partners in the launch of Globe Thoughts) is critically valuable, and has been evolving in its
breadth, depth and quality for many years. FITT has been promoting and conferring a competency-based
professional designation, the CITP or Certified International Trade Professional (referred to as the FIBP or
FITT International Business Professional outside of Canada) since the inception of the organization over
fifteen years ago. Lending a truly professional quality to the designations, FITT requires all CITP/FIBP
holders to agree to a Code of Ethics. Training is a process of development which, properly executed, makes
the learning process more efficient than simple ―learning by doing‖; well-designed training balances thought
leadership and best practices with lessons learned, and includes illustrative case studies and examples to bring
the material to life, and to lend a practical flavour to the learning process.
Perhaps as importantly, a well-designed and delivered training program, delivered through any number of
channels, from in-class to virtual, will provide valuable opportunities for networking, with course leaders,
guest speakers, and other students of international business. Experience, training and education, and high-
quality (and growing) networks are all critical to success in international trade and global business. The power
of program delivery channels, supported by a variety of technologies and course platforms, is unparalleled.
Training programs are increasingly multi-media based, easily suited to a variety of learning styles and
preferences, and easily delivered on a global basis. Training is a vital element of international trade and global
business. As a student of international business, it is equally true that the choice of training institutions and
sources is important: not all training is ―created equal‖, and the profile and credibility of the delivering
institution links directly to the credibility of the training as seen from the point of view of the market.
Program and course instructors are vital partners in the development and delivery of training – and the nature
and quality of their experience in international business ought to factor into a student‘s choices relative to
international business training. The best and most effective trainers do not just understand their material: they
live it.

International trade and global business is as old as civilization, and as dynamic in its practices, areas of focus,
and changing flows. The map of global business is always shifting, and the need to keep learning is a
fundamental reality of this business. Formal training in international trade is invaluable, and is, increasingly, a
competitive advantage in global business. The dynamic nature of international business demands a
commitment to continuous learning, and the training institution(s) and associations with which we choose to
align, will be even more beneficial to we if they support long-term professional development. Visit FITT to
learn more about a world-class organization with an unwavering commitment to quality training in
international business, and share thoughts, experiences and ideas around international business training, with
all of us on Globe Thoughts! Reshad Sulymankhel, President and CEO, established Global Trading Company
in 1980, specializing in the import of Lapis Lazuli (semi precious stones) from Afghanistan. Global tracing‘s
personnel is experienced in the principles and practices of international trading. Our competitive advantage is
rooted in management‘s ability to operate in diverse social, cultural, and economic environments GTS has
provided specialized and highly regarded procurement solutions for almost two decades. Our record for
optimizing supply chains means our customers can count on superior products - on time and on budget. As
procurement partners - GTS will focus on cost, delivery and supply chain improvement - allowing our
customers to realize improved competitive advantages and reduced global purchasing costs.
Our service centric model is built upon:
Continual customer service enhancements
Strategic product sourcing capabilities that meet customer time frames and budgets
Highest quality products and services
Error free supply chain execution
Innovative technology solutions

Some call this ‗value added‘ - we call it, ‗success‘.

Product Sourcing
GTS buys from hundreds of suppliers. We have a deep knowledge of the best sources to meet our customers
specialized needs. While our product line card display is abbreviated - should we require additional products
not listed here, please simply let us know.

Partnership
For GTS Corporation, partnership is at the very core of our services to we. We partner with manufacturers to
understand their products, their capabilities, and to uncover pricing efficiencies wherever possible. We also are
wholly focused on partnering with our customers to put these products and capabilities to work in the most
productive, efficient and profitable ways possible.

Value Added Solutions

We exist for the purpose of providing our customers the most cost-effective, OEM-based solutions in a highly
responsive manner. Benefit from:
Continual customer service enhancements
Strategic product sourcing capabilities that meet customer time frames and budgets
Highest quality products and services
Error free supply chain execution
Innovative technology solutions

Commitment
We help customers reduce their time to market, lower their total cost of ownership and administration, and
enhance their overall capabilities. We are dedicated to world-class service quality and total customer
satisfaction.
Quality
Our stringent quality control protocols and oversight during the entire physical sales process translates into a
proven high quality delivery system. We are gratified that our customers can have the confidence in our
systems and can entrust us with a critical aspect of their business.

Service
GTS Corporation offers sales, and technical support capabilities that not only enable us to provide the most
powerful line card to our customers, but to be their strategic business partner as well.

Did you know?

IFTC began its operations in 1951 as Importers and Exporters. With the changing Global Economic
Environment, the Company started diversifying into other areas such as Manufacturing and Representation of
Foreign Companies in India.

3.2 Licensing and Franchising

Licensing is the process of leasing a legally protected (that is, trademarked or copyrighted) entity – a name,
likeness, logo, trademark, graphic design, slogan, signature, character, or a combination of several of these
elements. The entity, known as the property or intellectual property, is then used in conjunction with a product.
Many major companies and the media consider licensing a significant marketing tool. Licensing is a marketing
and brand extension tool that is widely used by everyone from major corporations to the smallest of small
business. Entertainment, sports and fashion are the areas of licensing that are most readily apparent to
consumers, but the business reaches into the worlds of corporate brands, art, publishing, colleges and
universities and non-profit groups, to name a few.

Licensing can extend a corporate brand into new categories, areas of a store, or into new stores overall.
Licensing is a way to move a brand into new businesses without making a major investment in new
manufacturing processes, machinery or facilities. In a well-run licensing program, the property owner
maintains control over the brand image and how it‘s portrayed (via the approvals process and other contractual
strictures), but eventually reaps the benefit in additional revenue (royalties), but also in exposure in new
channels or store aisles. Choosing the correct market entry strategy is critical to long-term success. Most small
companies use the direct exporting strategy by engaging an agent or distributor but there are a number of
options for we to examine and these are discussed below in order of least costly and least control to most
expensive and most control. There are seven distinct market entry strategies for we to consider. The most
appropriate one is determined by market potential, degree of international expertise and experience and the
resources that we can commit to entering chosen international market. The strategy that we choose is also
determined to a certain extent by the country we have chosen to enter as discussed in the section on market
research.
Licensing, as a market entry strategy, is best used by those companies that have a component of intellectual
property in their product although it can be used by any type of company depending on what they are wanting
to license. We can license technology, a manufacturing process or the rights to market product. While
licensing can be complicated and intricate and as such it is important to have legal assistance in developing a
licensing agreement, there are three distinct components of all licensing agreements. The first is that the
agreement must be for a certain period of time that is negotiated by the licensor and the licensee. The more
technologically advanced product is and the degree of intellectual property buried in product the shorter the
time period of the license as advances in technology have changed the curve of the product life cycle. The
second component of any licensing agreement revolves around the price of the agreement. The price is
composed of two factors; the purchase price and the percentage we as the licensor will receive for each unit
sold over the term of the agreement. The third component is that the agreement needs to be for a specific
technology, manufacturing process or marketing activity. In licensing, as in other businesses, it is clear that we
are truly, for the first time, experiencing the age of the ―global economy‖. Nations outside the U.S. currently
account for about one third of the worldwide total of licensed product revenue. Not so many years ago, most
properties that were successful internationally were created and developed in the U.S. and then licensed in
international markets. While this is often still happening, as more licensors around the world enter the business
or expand existing activities, a healthy exchange of properties across the international arena is now common.
Creators of new properties naturally are trying to focus on international appeal as much as possible, as the
investment in developing and marketing a property has raised considerably. The use of licensing properties
internationally on a range of products potentially reduces both marketing costs and the volume of advertising
otherwise required for promoting the property individually.

There is no doubt that licensing in multiple global markets has important advantages for companies that either
cannot or do not wish to invest overseas or export their products, but before developing multinational
campaigns, licensors should keep a number of key issues in mind, such as the many cultural, linguistic, legal
and financial differences that exist in different territories. Thinking globally involves the ability to understand
markets beyond one‘s own country of origin and requires knowledge of the political and economic situation in
the country where a license is to be granted. Of particular importance is the understanding of global consumer
behaviour and the knowledge of the prospective licensee and his needs and capabilities.

3.2.1 Factors before Entering a New Region

As companies seek to tap new markets in other countries, the question arises as to whether licensing strategies
which are effective in one country will also be effective in other countries. Therefore it is particularly
important for a licensor to realize that each country differs in its specifics and must be looked at as a separate
territory. Differences may exist, not only in language and the relative effectiveness of different licensing
strategies, but also in such areas as market structures, retail patterns, legal systems and limitations, tax
implications.

3.2.2 Global Licensing

Licensing is a business development tool which can best be described as granting permission to a business or
an individual to do something that, without the licence, would be an infringement of Intellectual Property
rights. The person granting the licence is usually called the licensor, and the person receiving the licence is
usually called the licensee. (There may be more than one licensor or more than one licensee in a licence
agreement). There are various reasons for licensing but, for a licence to operate successfully, it must provide
business benefits to all the parties involved. Some of these reasons are:

Sharing Risk:
Where a licensor licenses the right to manufacture and sell products, the licensor receives revenues from that
licensing but does not take the risk of manufacturing, promoting and selling those products. On the other hand,
the licensee has the right to use the IP without the expense and risk of the research and the costs of developing
the product.

Additional Revenue Generation:

An owner of IP may commercialise the IP itself in one particular industry sector and may then obtain
additional income by licensing the IP to someone else to commercialise it in a different industry sector.
Increasing Market Penetration:
An owner of IP may license another business to sell in territories that the owner cannot, or does not want to,
cover.

Reducing Costs:
A business may ‗buy-in‘ an innovative product or process in order to reduce its own research and development
costs.

Saving Time:
A business may get its products or services to market more quickly by acquiring a licence to use existing IP
rather than ‗engineering around‘ that existing IP with the attendant risks of accusation of infringement.

Accessing Expertise:
By taking a licence, a business may tap into expertise that it does not have in-house. This is often the case
when accessing the expertise of an academic institution or a research organisation.

Collaboration:
Businesses may want to work together to develop new products and services. Such collaboration is often the
subject of a Technology Development Agreement prior to a formal licence.

Obtaining Competitive Advantage:

By acquiring a licence to use IP, a business may obtain an advantage over its competitors by denying them that
opportunity. The terms and conditions on which IP is licensed are very varied. The licensor and licensee
usually agree those terms and conditions by negotiation. The outcome of those negotiations will usually
depend on the relative bargaining power of each side. We are more likely to obtain favourable terms if we own
IP which protects a significant and distinctive innovation or work than if the potential licensee has several
equally attractive alternatives.

3.2.3 Franchising
Franchising is a business model in which many different owners share a single brand name. A parent company
allows entrepreneurs to use the company‘s strategies and trademarks; in exchange, the franchisee pays an
initial fee and royalties based on revenues. The parent company also provides the franchisee with support,
including advertising and training, as part of the franchising agreement. Franchising is a faster, cheaper form
of expansion than adding company-owned stores, because it costs the parent company much less when new
stores are owned and operated by a third party. On the flip side, potential for revenue growth is more limited
because the parent company will only earn a percentage of the earnings from each new store. 70 different
industries use the franchising business model, and according to the International Franchising Association the
sector earns more than $1.5 trillion in revenues each year. Another approach to international business is
licensing. Important point, license agreements entitle one company to produce or market another company‘s
product or to utilize its technology in return for a royalty or fee. Sounds good with our company. Here is an
example - a U.S business might obtain the rights to manufacture and sell a Scandinavian skin lotion in the
United States, using the Scandinavian formula and packaging design. The U.S Company would be responsible
for promoting and distributing the product, and it would pay the Scandinavian company a percentage of its
income from sales in exchange for the products rights. Licensing deals can also work the other way, with the
U.S. Company acting as the licenser and the overseas company as the licensee. Another important point, the
U.S. firm would avoid the shipping costs, trade barriers, and uncertainties associated with trying to enter other
markets, but it would still receive a portion of the revenue from overseas sales. Moreover, licensing
agreements are not restricted to international business. A company can also license its products or technology
to other companies in its domestic market.

Just going to expand a little on franchising:

This technique is getting expensive every day. Franchising is another was to expand into foreign markets. With
a franchise agreement, the franchisee obtains the rights to duplicate a specific product or service (ex.
restaurant, photocopy shop, or a video rental store). And the company selling the franchise obtains a royalty
fee in exchange. Holiday Inn Worldwide has used this approach to reach customers in over 60 countries. The
point is that by franchising the operation, a company can minimize the costs and risks of global expansion and
bypass certain trade restrictions.

3.3 FDI
Foreign Direct Investment (FDI) is now recognized as an important driver of growth in the country.
Government is, therefore, making all efforts to attract and facilitate FDI and investment from Non Resident
(NRIs) including Overseas Corporate Bodies (OCBs) that are predominantly owned by them, to complement
and supplement domestic investment. To make the investment in India attractive, investment and returns on
them are freely repatriable, except where the approval is subject to specific conditions such as lock in period
on original investment, dividend cap, foreign exchange neutrality, etc. as per the notified sectoral policy. The
condition of dividend balancing that was applicable to FDI in 22 specified consumer goods industries stands
withdrawn for dividends declared after 14th July 2000, the date on which Press Note No. 7 of 2000 series was
issued. Foreign direct investment is freely allowed in all sectors including the services sector, except a few
sectors where the existing and notified sectoral policy does not permit FDI beyond a ceiling. FDI for virtually
all items/activities can be brought in through the Automatic Route under powers delegated to the Reserve
Bank of India (RBI), and for the remaining items/activities through Government approval. Government
approvals are accorded on the recommendation of the Foreign Investment Promotion Board (FIPB).

3.3.1 Automatic Route

New Ventures
All items/activities for FDI/NRI/OCB investment up to 100% fall under the Automatic Route except those
covered under (i) to (iv) of Para 2.9. Whenever any investor chooses to make an application to the FIPB and
not to avail of the automatic route, he or she may do so. Investment in public sector units as also for
EOU/EPZ/EHTP/STP units would also qualify for the Automatic Route. Investment under the Automatic
Route shall continue to be governed by the notified sectoral policy and equity caps and RBI will ensure
compliance of the same. The National Industrial Classification (NIC) 1987 shall remain applicable for
description of activities and classification for all matters relating to FDI/NRI/OCB investment:
Areas/sectors/activities hitherto not open to FDI/NRI/OCB investment shall continue to be so unless otherwise
decided and notified by Government. Any change in sectoral policy/sectoral equity cap shall be notified by
the Secretariat for Industrial Assistance (SIA) in the Department of Industrial Policy & Promotion.

Existing Companies
Besides new companies, automatic route for FDI/NRI/OCB investment is also available to the existing
companies proposing to induct foreign equity. For existing companies with an expansion programme, the
additional requirements are that (i) the increase in equity level must result from the expansion of the equity
base of the existing company without the acquisition of existing shares by NRI/OCB/foreign investors, (ii) the
money to be remitted should be in foreign currency and (iii) proposed expansion programme should be in the
sector(s) under automatic route. Otherwise, the proposal would need Government approval through the FIPB.
For this the proposal must be supported by a Board Resolution of the existing Indian company.
1. For existing companies without an expansion programme, the additional requirements for eligibility for
automatic approval are (i) that they are engaged in the industries under automatic route, (ii) the increase in
equity level must be from expansion of the equity base and (iii) the foreign equity must be in foreign
currency.
2. The earlier SEBI requirement, applicable to public limited companies, that shares allotted on preferential
basis shall not be transferable in any manner for a period of 5 years from the date of their allotment has
now been modified to the extent that not more than 20 % of the entire contribution brought in by promoter
cumulatively in public or preferential issue shall be locked-in.
3. The automatic route for FDI and/or technology collaboration would not be available to those who have or
had any previous joint venture or technology transfer/trade mark agreement in the same or allied field in
India.
4. Equity participation by international financial institutions such as ADB, IFC, CDC, DEG, etc. in domestic
companies is permitted through automatic route subject to SEBI/RBI regulations and sector specific cap
on FDI.
5. In a major drive to simplify procedures for foreign direct investment under the ―automatic route‖, RBI has
given permission to Indian Companies to accept investment under this route without obtaining prior
approval from RBI. Investors are required to notify the Regional Office concerned of the RBI of receipt of
inward remittances within 30 days of such receipt and file required documentation within 30 days of issue
of shares to Foreign Investors. This facility is available to NRI/OCB investment also. [For procedure
relating to automatic approval, refer to para 8.1].

3.3.2 Government Approval

For the following categories, Government approval for FDI/NRI/OCB through the FIPB shall be necessary:
(i) All proposals that require an Industrial Licence which includes (1) the item requiring an Industrial Licence
under the Industries (Development & Regulation) Act, 1951; (2) foreign investment being more than 24 % in
the equity capital of units manufacturing items reserved for small scale industries; and (3) all items which
require an Industrial Licence in terms of the location policy notified by Government under the New Industrial
Policy of 1991.
(ii) All proposals in which the foreign collaborator has a previous venture/tie up in India.

Areas/sectors/activities hitherto not open to FDI/NRI/OCB investment shall continue to be so unless otherwise
decided and notified by Government. Any change in sectoral policy/sectoral equity cap shall be notified by
the Secretariat for Industrial Assistance (SIA) in the Department of Industrial Policy and Promotion.
RBI has granted general permission under Foreign Exchange Management Act (FEMA) in respect of
proposals approved by the Government. Indian companies getting foreign investment approval through FIPB
route do not require any further clearance from RBI for the purpose of receiving inward remittance and issue
of shares to the foreign investors. Such companies are, however, required to notify the Regional Office
concerned of the RBI of receipt of inward remittances within 30 days of such receipt and to file the required
documents with the concerned Regional Offices of the RBI within 30 days after issue of shares to the foreign
investors. For greater transparency in the approval process, Government has announced guidelines for
consideration of FDI proposals by the FIPB.

3.3.3 Issue and Valuation of Shares in Case of Existing Companies

Allotment of shares on preferential basis shall be as per the requirements of the Companies Act, 1956, which
will require special resolution in case of a public limited company.
In case of listed companies, valuation shall be as per the RBI/SEBI guidelines as follows:
a) The average of the weekly high and low of the closing prices of the related shares quoted on the Stock
Exchange during the six months preceding the relevant date or
b) The average of the weekly high and low of the closing prices of the related shares quoted on the Stock
Exchange during the two weeks preceding the relevant date.

The stock exchange referred to is the one at which the highest trading volume in respect of the share of the
company has been recorded during the preceding six months prior to the relevant date. The relevant date is the
date thirty days prior to the date on which the meeting of the General Body of the shareholder is convened. In
all other cases a company may issue shares as per the RBI regulation in accordance with the guidelines issued
by the erstwhile Controller of Capital Issues. Other relevant guidelines of Securities and Exchange Board of
India (SEBI)/(RBI) including the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 1997,
wherever applicable, would need to be followed.

3.3.4. Foreign Investment in the Small Scale Sector

Under the small scale policy, equity holding by other units including foreign equity in a small scale
undertaking is permissible up to 24 %. However there is no bar on higher equity holding for foreign
investment if the unit is willing to give up its small scale status. In case of foreign investment beyond 24 % in
a small scale unit which manufactures small scale reserved item(s), an industrial license carrying a mandatory
export obligation of 50 % would need to be obtained.

3.3.5 Foreign Investment Policy for Trading Activities

Foreign investment for trading can be approved through the automatic route up to 51% foreign equity, and
beyond this by the Government through FIPB. For approval through the automatic route, the requirement
would be that it is primarily export activities and the undertaking concerned is an export house/trading house/
super trading house/star trading house registered under the provisions of the Export and Import policy in force.

3.3.6 Other Modes of Foreign Direct Investments

1: Global Depository Receipts (GDR)/American Deposit Receipts (ADR)/Foreign Currency Convertible
Bonds (FCCB): Foreign Investment through GDRs/ADRs, Foreign Currency Convertible Bonds (FCCBs) is
treated as Foreign Direct Investment. Indian companies are allowed to raise equity capital in the international
market through the issue of GDR/ADRs/FCCBs. These are not subject to any ceilings on investment. An
applicant company seeking Government‘s approval in this regard should have a consistent track record for
good performance (financial or otherwise) for a minimum period of 3 years. This condition can be relaxed for
infrastructure projects such as power generation, telecommunication, petroleum exploration and refining,
ports, airports and roads. There is no restriction on the number of GDRs/ADRs/FCCBs to be floated by a
company or a group of companies in a financial year. A company engaged in the manufacture of items covered
under Automatic Route, whose direct foreign investment after a proposed GDR/ADR/FCCBs issue is likely to
exceed the percentage limits under the automatic route, or which is implementing a project falling under
Government approval route, would need to obtain prior Government clearance through FIPB before seeking
final approval from the Ministry of Finance. There are no end-use restrictions on GDR/ADR issue proceeds,
except for an express ban on investment in real estate and stock markets. The FCCB issue proceeds need to
conform to external commercial borrowing end use requirements; in addition, 25 % of the FCCB proceeds can
be used for general corporate restructuring.

3.3.7 Preference Shares

1: Foreign investment through preference shares is treated as foreign direct investment. Proposals are
processed either through the automatic route or FIPB as the case may be. The following guidelines apply to
issue of such shares:-
2: For all sectors, excluding those falling under Government approval, NRIs (which also includes PIOs) and
OCBs (an overseas corporate body means a company or other entity owned directly or indirectly to the extent
of at least 60% by NRIs) are eligible to bring investment through the automatic route of RBI. All other
proposals, which do not fulfil any or, all of the criteria for automatic approval are considered by the
Government through the FIPB.
3: The NRIs and OCBs are allowed to invest in housing and real estate development sector, in which foreign
direct investment is not permitted. They are allowed to hold up to 100 % equity in civil aviation sector in
which otherwise foreign equity only up to 40 % is permitted.

3.3.8 Procedure for Automatic Route

The proposals for approval under the automatic route are to be made to the Reserve Bank of India in the FC
(RBI) form. In a major drive to simplify procedures for foreign direct investment under the ―automatic route‖,
RBI has given permission to Indian Companies to accept investment under this route without obtaining prior
approval from Reserve Bank of India. However, investors are required to notify the concerned Regional
Offices of RBI of receipt of inward remittances within 30 days of such receipt and will have to file the
required documents with the concerned Regional Office of the RBI within 30 days after issue of shares to
foreign investors. This facility is available to NRI/OCB investment also.

3.3.9 Procedure for Government Approval

Foreign Investment Promotion Board (FIPB)
(a) All other proposals for foreign investment, including NRI/OCB investment and foreign investment in
EOU/EPZ/STP/EHTP units, which do not fulfil any or all of the parameters prescribed for automatic approval,
as given in paragraph 2.8, 3.1, and 3.2 are considered for approval by the Foreign Investment Promotion Board
(FIPB). The FIPB also grants composite approvals involving foreign technical collaborations and setting up of
Export Oriented Units involving foreign investment/foreign technical collaboration.

(b) For inward remittance and issue of shares to NRI/OCB up to 100 % equity also, prior permission of RBI is
not required. These companies have to file the required documents with the concerned Regional Offices of
RBI within 30 days after the issue of shares to NRIs/OCBs.

3.3.10 Foreign Technology Collaboration

Procedure for Automatic Approval
Applications for automatic approval for such foreign technology agreements should be submitted in Form FT
(RBI) with the concerned Regional Offices of Reserve Bank of India. No fee is payable. Approvals are
available within two weeks.

Procedure for Government Approval

All other proposals for foreign technology agreement, not meeting any or all of the parameters for automatic
approval, and all cases of extension of existing foreign technical collaboration agreement, are considered for
approval, on merits, by the Government. Application in respect of such proposals should be submitted in Form
FC-IL to the Secretariat for Industrial Assistance, Department of Industrial Policy and Promotion, Ministry of
Commerce and Industry, Udyog Bhavan, New Delhi. No fee is payable. The following information should
form part of the proposals submitted to SIA: On consideration of the proposal by the Project Approval
Board/FIPB, decisions are normally conveyed within 4 to 6 weeks of filing the application.
3.3.11 Foreign Investment Implementation Authority (FIIA)
Foreign Investment Implementation Authority (FIIA) was established on 9.8.1999 to assist the foreign
investors in getting necessary approvals and thereby facilitating quick translation of Foreign Direct Investment
(FDI) approvals into implementation. Fast Track Committees have been set up in 30 Ministries/Departments
for regular review of FDI mega projects (with proposed investment of Rs. 1 billion and above), and resolution
of any difficulties in consultation with the concerned Ministries/State Governments. Unresolved issues are
brought before FIIA.

Meetings of FIIA
FIIA‘s meetings are held on regional basis as also with investors from specific countries. In the meetings of
FIIA, apart from Government of India Ministries, senior officials from State Governments also participate.
Besides approval holders of unimplemented FDI projects with proposed investment of Rs. 100 crores and
above, representatives from apex industrial associations are also invited.

Regional Meetings of FIIA

For conducting meeting of FIIA, the Country is divided into four regions as under:

Meetings with Investors from Specific Countries

In addition to the regional meetings, separate meeting with Investors from major investing countries in India
are also held. In the recent past following meetings with investors from specific investing countries have been
held for special focus on their problems.
Meetings with investors from Netherlands and Italy in January 2002.
Meeting with investors from Switzerland in May 2002.
Meeting with investors from European Union countries in December 2002.
Meeting with investors from Republic of Korea in May 2003.

3.3.12 Issues Resolved by FIIA

Foreign Investment Implementation Authority has emerged as an effective problem-solving platform for the
foreign investors. Nearly 70% of the issues received from investors in FIIA have been resolved/decided.

3.3.13 Association of Industrial Organizations

FIIA has been seeking co-operation of apex industrial organizations viz., CII, ASSOCHAM, and FICCI,
JAPAN Chamber of Commerce in India and American Chamber of Commerce (AMCHAM), etc. Information
about meetings of FIIA is sent to such organizations to advise their members to participate in the meeting, in
case they are experiencing difficulties in implementation of their projects. Representatives of these
organisations are also invited to these meetings. CII, FICCI and ASSOCHAM have also been requested to
follow up with approval holders of mega projects to whom letters have been written by FIIA.

3.3.14 Direct Contact with Investors

Besides the meetings with the investors, FIIA has also taken the following initiatives to establish a direct
contact with foreign investors for resolution of their difficulties:
a. FIIA periodically writes to the approval holders of FDI mega projects, which are under implementation
or about which no information is available, to get a direct feedback on any difficulties being faced by them
in the implementation of their projects, which can be followed by FIIA with respective Ministries/State
Governments.
b. All fresh FIPB approvals issued since September 2001 contain information on FIIA and its e-mail address
for investors to approach FIIA in case of any difficulties.
c. Directors/Deputy Secretaries of DIPP have been designated as Nodal Officers to monitor FDI Mega
projects with concerned State Governments
d. Indian Missions abroad, who already receive FDI applications on behalf of FIPB, have been advised to
monitor implementation of FDI approvals emanating from their regions.

3.3.15 Foreign Investment Promotion Council (FIPC)

Apart from making the policy framework investor-friendly and transparent, promotional measures are also
taken to attract Foreign Direct Investment into the country. The Government has constituted a Foreign
Investment Promotion Council (FIPC) in the Ministry of Commerce and Industry. This comprises
professionals from Industry and Commerce. It has been set up to have a more target oriented approach toward
Foreign Direct Investment promotion. The basic function of the Council is to identify specific sectors/projects
within the country that require Foreign Direct Investment and target specific regions/countries of the world for
its mobilisation.

3.3.16 SIA’s Promotional Activities

As an investor friendly agency, it provides information and assistance to Indian and foreign companies in
setting up industry and making investments. It guides prospective entrepreneurs and disseminates information
and data on a regular basis through its two monthly newsletters the ―SIA Newsletter‖ and the ―SIA Statistics‖
as also through its Website address, i.e. [Link] It also assists potential investors in finding joint
venture partners and provides complete information on relevant policies and procedures, including those,
which are specific to sectors and the State Governments.

3.3.17 Investment Promotion and Infrastructure Development (IP & ID) Cell
In order to give further impetus to facilitation and monitoring of investment, as well as for better coordination
of infrastructural requirements for industry, a new cell called the ―Investment Promotion and Infrastructure
Development Cell‖ has been created. The functions of the Cell include:
a) Organising Symposiums, Seminars, etc. on investment promotion;
b) Liaison with State Governments regarding investment promotion;
c) Documentation of single window systems followed by various States;
d) Match-making service for investment promotion;
e) Coordination of progress of infrastructure sectors approved for investment/technology transfer, power,
telecom, ports, roads, etc.;
f) Facilitating Industrial Model Town Projects, and Industrial Parks, etc.;
g) Promotion of Private Investment including Foreign Investment in the infrastructure sector;
h) Compilation of sectoral policies, strategies and guidelines of infrastructure sectors, both in India and
abroad; and
i) Facilitating preparation of a perspective plan on infrastructure requirements for industry.

3.3.18 Entrepreneurial Assistance Unit (EAU) of the SIA

The Entrepreneurial Assistance Unit functioning under the Secretariat for Industrial Assistance, Department of
Industrial Policy and Promotion provides assistance to entrepreneurs on various subjects concerning
investment decisions. The unit receives all papers/applications related to industrial approvals and immediately
issues a computerised acknowledgement, which also has an identity/reference number. All correspondence
with the SIA should quote this number. In case of papers filed by post, the acknowledgement will be sent by
post. The Unit extends this facility to all papers/applications relating to IEMs, Industrial Licences, Foreign
Investment, Foreign Technology Agreements, 100 % EOUs, EHTP, STP Schemes, etc. The Unit also attends
to enquiries from entrepreneurs relating to a wide range of subjects concerning investment decisions. It
furnishes clarifications and arranges meetings with nodal officers in concerned Ministries/Organisations. The
Unit also provides information regarding the current status of applications filled for various industrial
approvals.

3.3.19 Web site, Online Chat and Bulletin Board Facilities

To facilitate the easy availability of information to the investors and provide information about the investment
climate in the country, state industrial policies, projects on offer, different publications, notifications and press
releases.
Department is hosting a web site [Link]. The web site contains the following:
• Ready Reckoned for Investing in India
• Manual on Industrial Policy and Procedures
• Press Notes, Notifications and Press Releases
• Industrial Policy Statements
• Latest Annual Report
• Information about Intellectual Property Rights
• Status of PAB/IEM and LOI
• Profile of selected industrial sectors
• Important Legislations
• Information about Attached and Subordinate Offices

The web site has the facility of on line chat between 4.00 P.M. to 5.00 P.M. (Indian Standard Time, GMT+5
½) on all working days. Investors can ask any question relating to FDI Policies and related issues which is
replied immediately. The on line chat facility is being utilized by the investors. Nearly 2000 queries were
responded during chat session in 2002. The web site also has provision of bulletin board. If the investor
cannot avail the on line chat facility, he/she can post the question on bulletin board at any time of the day. All
efforts are made to send a reply within 24 hours. On an average about three to four questions are received
everyday on the bulletin board.

3.3.20 International Centre for Alternative Dispute Resolution (ICADR)

International Centre for Alternative Dispute Resolution (ICADR) has been established as an autonomous
organization under the aegis of Ministry of Law, Justice and Company Affairs to promote settlement of
domestic and international disputes by different modes of alternate dispute resolution. ICADR has its
headquarters in New Delhi and has regional office in Lucknow and Hyderabad.

3.3.21 Current Position of India

Various studies have projected India among the top 5 favoured destination for FDI. Cumulative FDI equity
inflows has been Rs.5, 54,270 crore (1, 27,460 Million US$) for the period 1991–2009. This is attributed to
contribution from service sector, computer software, telecommunication, real estate etc. India‘s 83% of
cumulative FDI is contributed by nine countries while remaining 17 % by rest of the world. Country-wise, FDI
inflows to India are dominated by Mauritius (44 %), followed by the Singapore (9 %), United States (8 %) and
UK (4 %) (See: Table 3.1). Countries like Singapore, USA, and UK etc. invest in India mainly in service,
power, telecommunication, fuels, electric equipments, food processing sector.
 Table 3.1: Share of top investing countries FDI Equity Inflows

Though India has observed a remarkable rise in the flow of FDI over the last few years, it receives
comparatively much lesser FDI than China. Even smaller economies in Asia such as Hong Kong, Mauritius
and Singapore are much ahead of India in terms of FDI inflows (UNCTAD, WIR, 2007). This is largely due to
India‘s economic policy of protecting domestic enterprise and its dependence on domestic demand as
compared to above mentioned Newly Industrialized Asian Economies. There is a positive link between
FDI and India‘s growth story. India has been observing a consistent growth in net FDI flow. Ratio of
FDI Inflow to Gross Capital Formation has improved from 1.9 % during the period 1990–2000 to 9.6
% in the year 2008. Similarly ratio of FDI Outflow to Gross Capital Formation also improved from
0.1 % during 1999–200 to 4.1 % by the year 2008. This seems to be impressive when compared with
corresponding data for China, South Asia, Asia and Oceania, Developing Economies and even whole
world. Net FDI flow to China is reported to much more than India in absolute term.

Caution
A distributor should be able to handle the sourcing of retailers or buyers and the distribution of our products.

Did You Know?

On 14 September 2012, the government of India announced the opening of FDI in multi brand retail, subject to
approvals by individual states.

Case Study-Developing a B2B Market-Entry Strategy for a Mobile Telecom in Africa

The mobile telecommunications market in Africa is red hot, with more than half a billion mobile phones in use
across the continent. When business is this successful the desire to expand is often uppermost on the executive
agenda. This mobile telecom was anxious to move beyond the consumer segment to the business segment,
which represents exciting strategic choices on how to optimize the value of the network.
Situation
Our client was a mobile telecom in an established African market. The company‘s initial focus was on
providing consumer mobile services, but it was now ready to expand into providing structured offerings to the
business telecom market. With less than 50 percent of the market accounted for, business telecommunications
represented a major opportunity that would require key decisions about pricing packages, types of handsets,
contract relationships to provide for volume discounts, and value-added services.

Approach
Our A.T. Kearney team started by gaining an understanding of the market‘s characteristics in terms of size,
growth, competitive intensity, and customer segments. At the same time, we identified the major trends
driving business telecom, including simplified value propositions, indirect distribution, and the increasing
popularity of managed services. We examined competitors' value propositions and customers' needs. Our
analysis revealed a serious gap in the way that businesses were being served. Business customers wanted
higher quality products and managed services but also more reliable networks. We created a complete value
proposition for our client. We analyzed the client‘s capabilities to determine where it needed to improve or
adjust its internal processes, network reach, and marketing and sales skills, in order to provide the required
business handsets, products, and service.

Impact and Advantage

A.T. Kearney provided the company with a powerful market-entry strategy and a complete understanding of
what was required to succeed in Africa‘s B2B market, including a plan for building up the necessary
management skills. We identified areas across the company in IT, marketing, sales, and customer service that
required improvements in order to capitalize on the opportunity, and supported the company in making the
organizational adjustments.

Questions
1. Define network of value optimize.
2. Explain the impact and advantage of mobile telecom.

3.4 Summary
Organisations can also look at the option of an acquisition or merger with a well established local
business.
The synergy provided by operating three branches in diverse geographic locations, allows for a truly
unique international trading dynamic
The power of program delivery channels, supported by a variety of technologies and course platforms, is
unparalleled. Training programs are increasingly multi-media based, easily suited to a variety of learning
styles and preferences, and easily delivered on a global basis
Nations outside the U.S. currently account for about one third of the worldwide total of licensed product
revenue. Not so many years ago, most properties that were successful internationally were created and
developed in the U.S. and then licensed in international markets
As companies seek to tap new markets in other countries, the question arises as to whether licensing
strategies which are effective in one country will also be effective in other countries.
Government is, therefore, making all efforts to attract and facilitate FDI and investment from Non
Resident (NRIs) including Overseas Corporate Bodies (OCBs) that are predominantly owned by them, to
complement and supplement domestic investment
3.5 Keywords
Collaborations: It is a recursive process where two or more people or organizations work together to realize
shared goals, (this is more than the intersection of common goals seen in co-operative ventures, but a deep,
collective, determination to reach an identical objective
Franchising: It is a business model in which many different owners share a single brand name.
International trade: It is one of those areas where the value of practical experience cannot be overstated.
Licensing: It is a marketing and brand extension tool that is widely used by everyone from major corporations
to the smallest of small business.
Overseas Corporate Bodies: Those are predominantly owned by them, to complement and supplement
domestic investment

3.6 Self Assessment Questions

1: Which of the factors may encourage an organization to produce in foreign markets?
(a): Closeness to its customers. (b): Unfavourable foreign tariffs or quotas.
(c): Low production costs. (d): All of the above.

2: One third of the retail sales in ______ are derived from franchising.
(a) Europe (b) Romania
(c) Asia (d) The USA

3: Approximately 40% of Latin America‘s population is:

(a):Indian. (b): Nigerian.
(c): Brazilian (d): Cuban.

4: The formal difference between a joint venture and a strategic alliance is that the latter one is typically a(n):
(a): Equity alliance. (b): Non-equity alliance.
(c): Alliance involving an American organization. (d): Foreign operation.

5: The term ‗royalties‘ is closely associated with:

(a): contract manufacturing. (b): direct exporting.
(c): piggybacking. (d): licensing.

6: Strategic alliances often bring partners the following benefits:

(a): increased brand awareness through partner‘s channels.
(b): rapidly achieve scale, critical mass and momentum as well as access to partner‘s capital.
(c): access to their partner‘s distribution channels and international market presence as well as reduced R&D
costs and risks.
(d): all of the above.

7: One of the international agreements by which an organization establishes local production in foreign
countries without capital investment is:
(a): Direct export. (b): Piggybacking.
(c): Licensing. (d): Joint-venture.

8: In Japan, keiretsu is a form of industrial alliance involving:

(a): Six companies. (b): Hundreds of companies.
(c): two companies. (d): ten companies.

9: In line with a franchising agreement, a franchisee may use:

(a): Geographic exclusivity.
(b): Trademarks, copyright and trade secrets.
(c): patents, designs, trade secrets and business know-how.
(d): All of the above.

10: One of the following lists the global market entry modes from the highest level of risk/commitment to the
lowest:
(a): Acquisition-joint venture-licensing-exporting.
(b): Joint venture-licensing-exporting-acquisition.
(c): Exporting-acquisition-joint venture-licensing.
(d): Exporting-licensing-joint venture-acquisition

3.7 Review Questions

1. Explain about trading company.
2. Understand licensing and franchising
3. Describe the global licensing
4. Explain the FDI
5. Discuss about automatic route
6. Explain the government approval
7. Discuss about modes of FDI
8. Explain between online chat and bulletin board facilities
9. Describe the (ICADR)
10. Write short notes on:
Current position of India
Web site facility of FDI

Answers for Self Assessment Questions

1. (d) 2.(d) 3.(c) 4.(b) 5.(d)
6. (d) 7.(c) 8.(b) 9.(d) 10.(a)
 4
Mergers and Acquisition
CONTENTS
Objectives
Introduction
4.1 Mergers and acquisition
4.2 Corporate strategy and finance
4.3 Management dealing with the buying
4.4 Management dealing with the Selling
4.5 Dividing and combining of different companies
4.6 Summary
4.7 Keywords
4.8 Self Assessment Questions
4.9 Review Questions

Objectives
After studying this chapter, you will be able to:
Discuss mergers and acquisition
Explain corporate strategy and finance
Describe management dealing with the buying
Explain management dealing with the selling
Discuss dividing and combining of different companies

Introduction

A merger is a combination of two or more business entities. It has many of the characteristics of
both an asset purchase and a stock purchase. In it is simplest form a ―surviving‖ company will
issue cash, new stock or a combination of cash and stock to shareholders of a ―disappearing‖
company in exchange for the stock in the disappearing company. The surviving company then
takes title to all the disappearing corporation‘s assets and liabilities, and the disappearing
company ceases to exist. While mergers can proceed in various different forms depending on
specific needs, objectives and circumstances.
A merger is the time-tested transaction vehicle for recognizing the strength of combining two or
more business entities into a single venture. A merger can allow for the recognition of
economies of scale. While employees in duplicate positions may be laid off, the intent is often to
improve the bottom line by cutting overhead and increasing efficiencies. Tax consequences can
be neutralized or deferred. Properly structured, swapping stock will not result in any taxable
gain to the shareholders of either of the merging organizations. A merger can be a particularly
useful where certain contractual relationships of the target need to be preserved in order for the
buyer and seller to realize full value from the transaction. The subject of mergers, acquisitions,
buyouts and divestitures as covered in my Mergers & Acquisitions course. The purpose is to
delineate how and why a merger decision should be made. The course focuses on mergers and
acquisitions in the context of private as well as publicly traded companies. Acquisitions of
private companies account for the majority of transactions. To properly assess a potential
merger we need to perform fundamental strategic and financial analysis, but remain aware of the
idiosyncrasies that each potential merger contains.

A merger is a pivotal event for the companies involved. Both parties hope to benefit from the
greater efficiency and competitive strength found in the combined company. Strategies are
altered and as a result product lines are broadened, strengthened, or refocused; management
systems and personnel are changed; and levels and growth rates of profits are shifted. In many
instances, however, one side or the other (or both) lose substantial sums of money. Merger
costs, including the direct costs of attorneys, accountants, investment bankers, and consultants,
are substantial even though they are not a large percentage of the value of the merger. There is
also substantial cost in terms of time required by key employees to evaluate, complete, and
implement the merger. Perhaps half of all mergers and acquisitions fail or do not achieve the
desired results. Many mergers fail because projected synergies do not materialize, often due to
human obstacles. If a merger is not well received by the employees of the new entity, then its
chances of success are greatly diminished. It is critical that the parties involved in a merger
become skilled in managing change. Sometimes acquisitions fail for the acquiring company
simply because it pays too much for the acquired company. An understanding of pre- and post-
merger valuation analysis is required to avoid this pitfall.

Caution
The subject of mergers, acquisitions, buyouts and divestitures as covered in my Mergers &
Acquisitions course. The purpose is to delineate how and why a merger decision should be
made.

4.1 Mergers and acquisition

Mergers and acquisitions, and corporate restructuring are a big part of the corporate finance
world. Every day, Wall Street investment bankers arrange Mergers and acquisitions
transactions, which bring divide companies together to form larger ones. When they are not
creating big companies from smaller ones, corporate finance deals do the reverse and break up
companies through spinoffs, carve-outs or tracking stocks. Not surprisingly, these actions often
make the news. Deals can be worth hundreds of millions, or even billions, of dollars. They can
dictate the fortunes of the companies involved for years to come. Leading a Mergers and
acquisitions can represent the highlight of a whole career. And it is no wonder we hear about so
many of these transactions; they happen all the time. Next time we flip open the newspaper‘s
business section, odds are good that at least one headline will announce some kind of Mergers
and acquisitions transaction. Mergers and acquisitions are strategic decisions taken for
maximisation of a company's growth by enhancing its production and marketing operations.
They are being used in a wide array of fields such as information technology,
telecommunications, and business process outsourcing as well as in traditional businesses in
order to gain strength, expand the customer base, cut competition or enter into a new market or
product segment.

Types of Mergers and Acquisitions:

There are many types of mergers and acquisitions that redefine the business world with new
strategic alliances and improved corporate philosophies. From the business structure
perspective, some of the most common and significant types of mergers

Horizontal Merger
This kind of merger exists between two companies who compete in the same industry segment.
The two companies combine their operations and gains strength in terms of improved
performance, increased capital, and enhanced profits. This kind substantially reduces the
number of competitors in the segment and gives a higher edge over competition.

Vertical Merger
Vertical merger is a kind in which two or more companies in the same industry but in different
fields combine together in business. In this form, the companies in merger decide to combine all
the operations and productions under one shelter. It is like encompassing all the requirements
and products of a single industry segment.

Co-Generic Merger
Co-generic merger is a kind in which two or more companies in association are some way or the
other related to the production processes, business markets, or basic required technologies. It
includes the extension of the product line or acquiring components that are all the way required
in the daily operations. This kind offers great opportunities to businesses as it opens a hue
gateway to diversify around a common set of resources and strategic requirements.

Conglomerate Merger
Conglomerate merger is a kind of venture in which two or more companies belonging to
different industrial sectors combine their operations. All the merged companies are no way
related to their kind of business and product line rather their operations overlap that of each
other. This is just a unification of businesses from different verticals under one flagship
enterprise or firm.

Advantages of Mergers & Acquisitions

Accelerating a company‘s growth, particularly when its internal growth is constrained due to
paucity of resources. Internal growth requires that a company should develop its operating
facilities- manufacturing, research, marketing, etc. But, lack or inadequacy of resources and
time needed for internal development may constrain a company‘s pace of growth. Hence, a
company can acquire production facilities as well as other resources from outside through
mergers and acquisitions. Specially, for entering in new products/markets, the company may
lack technical skills and may require special marketing skills and a wide distribution network to
access different segments of markets. The company can acquire existing company or companies
with requisite infrastructure and skills and grow quickly.

Economies of scale
Arise when increase in the volume of production leads to a reduction in the cost of production
per unit. This is because, with merger, fixed costs are distributed over a large volume of
production causing the unit cost of production to decline. Economies of scale may also arise
from other indivisibilities such as production facilities, management functions and management
resources and systems. This is because a given function, facility or resource is utilized for a
large scale of operations by the combined firm.

Operating economies
Arise because, a combination of two or more firms may result in cost reduction due to operating
economies. In other words, a combined firm may avoid or reduce over-lapping functions and
consolidate its management functions such as manufacturing, marketing, R&D and thus reduce
operating costs. For example, a combined firm may eliminate duplicate channels of distribution,
or crate a centralized training center, or introduce an integrated planning and control system.

Synergy
Implies a situation where the combined firm is more valuable than the sum of the individual
combining firms. It refers to benefits other than those related to economies of scale. Operating
economies are one form of synergy benefits. But apart from operating economies, synergy may
also arise from enhanced managerial capabilities, creativity, innovativeness, R&D and market
coverage capacity due to the complementarily of resources and skills and a widened horizon of
opportunities.

Distinction between Mergers and Acquisitions

Although they are often uttered in the same breath and used as though they were synonymous,
the terms merger and acquisition mean slightly different things. An acquisition or takeover is the
buying of one organization by another. It can be a friendly takeover or hostile takeover. The
former case is such that a target company‘s executives are able to negotiate whereas the latter
case can be likened to the coming of an unwelcomed visitor. From a legal point of view, the
target company ceases to exist; the buyer ―swallows‖ the target business. In the pure sense of
the term, a merger happens when two firms, often of about the same size, agree to go forward as
a single new company rather than remain separately owned and operated. This kind of action is
more precisely referred to as a ―merger of equals.‖ Both companies' shares are surrendered and
a new company share is issued in its place. In practice, however, actual mergers of equals do not
happen very often; but because being bought or being taken over carries negative connotations,
the more palatable cognomination of ―merger‖ or ―buy-in‖ is adopt.

4.2 Corporate Strategy and Finance

Corporate strategy is the direction an organization takes with the objective of achieving business success in the
long term. Recent approaches have focused on the need for companies to adapt to and anticipate changes in the
business environment, i.e. a flexible strategy. The development of a corporate strategy involves establishing
the purpose and scope of the organization‘s activities and the nature of the business it is in, taking the
environment in which it operates, its position in the marketplace, and the competition it faces into
consideration; most times analyzed through a swot analysis. Business Dictionary defines a corporate strategy
as a strategy that recognizes the factors that are currently affecting the firm and its competitors and the factors
that may affect the firm and its competitors in the future. The firm develops policies and practices to establish
a new and creative role that will address those factors, giving the firm the competitive advantage. Business of a
firm is a match between a given product group and a given market. Market is to be defined from a strategic
point of view and the product is also to be defined from a strategic point of view. There is choice of market
segment and there is choice of specific product. Strategy will not be clear if market and product are specified
in general terms. The Corporate Strategy doctoral program prepares students to carry out research and teaching
that address issues affecting corporate character, actions, and success. Drawing from economic theory and
behavioral sciences, the program examines the firms' internal organization, it overall performance, and its
relationship with external environments.

Components of a Corporate Strategic

A corporate strategic plan is a document that describes the steps necessary for an organization to grow and
become more profitable. The benefits of strategic planning include making sure all members of an
organization are working toward common objectives, and that the corporation‘s resources---financial and
human---are allocated as efficiently as possible.

Mission Statement
A mission statement explains why the company is in business, and what value it intends to provide its
customers, its employees, its stakeholders and even society. The mission statement may not change from year
to year. Though sometimes only a paragraph, it often requires lengthy discussion among the executives
participating in the planning process, who may view the company and its objectives differently.

Analysis of current situation

Current situation also includes the economic and industry environment and how these may impact the
organization. A strategic plan for a company that is operating in a recession, or in an industry that is stagnant,
would look much different than one for a company in a booming industry.

Goals or Objectives
The most important goals and objectives are usually set first, such as revenue growth for the next three to five
years. But since reaching the larger goals is the result of achieving smaller, incremental goals, these must be
carefully thought out as well. Goals are set for each division or department. It is critical that the top executives
involve all the division or department heads in the process. Managers who are involved are more likely to
endorse the strategic plan and work energetically toward its achievement.

Corporate Finance
Money is the root to all business and hence turning our business dreams into a successful reality requires
specialist assistance and often calls for additional finance. An acquisition, disposal, flotation or overseas may
be the single biggest transaction we must have faced. The support of people who have years of experience in
these areas can make all the difference during the planning and execution of a transaction. Corporate Financial
Services are innovative providers of financial programs for professionals, business owners and their
companies. They help maximise personal income, retirement benefits and corporate profit while controlling
the cost of group insurance and employee benefits. As organisations simultaneously cope with globalisation,
new competitive threats and the need to reduce costs while improving performance, a strong and nimble
corporate finance team is critical to keeping the enterprise on track. At corporate financial services we
understand that time is valuable and many users of asset finance simply do not have the time to repeatedly
apply for finance, that is our job. We are leading corporate finance consultants in mumbai, India.

Financial advisory services

Financial Advisor can help us prepare for major milestones and life events that can impact our finances. A
Financial adviser is a professional who helps clients to maintain the desired of investment income, capital
gains and acceptable level of risk by using proper asset allocation. Many financial advisers receive a
commission payment for the various financial products that the broker, although fee – based planning is
becoming increasingly popular in the financial services industry. Financial advisers use stock, bonds, mutual
funds, real estate investment trust options, futures, notes and insurance products to the needs of their clients.
Some investment advisers only charge a fee based on the assets managed for the client. A further distinction
should be made between fee – based and fee-only advisers.

4.3 Management Dealing With the Buying

Effective purchasing management and professional buying works better when a good strategic framework
exists. Commonly, relationships between suppliers and customers are driven by personalities, or the needs of
the moment, whereas relationships and purchasing strategy should ideally be based on a combination of factors
reflecting the nature of each purchasing area, including: risk, complexity, value, the market and basic matters
of supply and demand. Bear in mind also that when buying anything we should be aware of the principles and
techniques of effective negotiation. It is likely that the person selling to we will be using them, so even if we
do not wish to adopt the approach and methods concerned, it is as well that we be able to recognise the tactics.
There are probably more supplier measurement processes than there are suppliers. Everyone is constantly
inventing and re-inventing some set of magic criteria that will measure supplier performance, and now of
course the trend is to make it all ‗e-capable‘ and self managing. Do not get tempted down this path. All of the
processes do basically the same thing - i.e., get a series of aspects of supply The key to success is to stick with
the same simple measure - and do it over time. It is by definition going to be a relative movement that we want
to see, not an absolute one. Only if we repeat the same process time and time again is this possible.

Purchasing management directs the flow of goods and services in a company and handles all data relating to
contact with suppliers. Effective purchasing management requires knowledge of the supply chain, business
and tax laws, invoice and inventory procedures, and transportation and logistics issues. Although a strong
knowledge of the products and services to be purchased is essential, purchasing management professionals
must also be able to plan, execute, and oversee purchasing strategies that are conducive to company
profitability. Sourcing reliable suppliers is a crucial part of purchasing management. Purchasing managers,
agents, and buyers usually learn about new products and services from Internet searches, trade shows, and
conferences. They meet with potential suppliers in their plants whenever possible. Skills in foreign languages
may be helpful for sourcing suppliers in other countries. Purchasing management professionals must always
assess potential suppliers in terms of the supplier‘s ability to deliver quality merchandise at a suitable price on
time. Purchasing management professionals must be good negotiators, understand technical product
information, have good mathematical ability, understand spreadsheet software, understand marketing
methodology, and be outstanding decision makers. Increased responsibilities in purchasing management
require good leadership skills, and higher positions often require a master‘s degree in a business related
subject. Entry level purchasing management positions such as junior buyers, assistant buyers, and purchasing
clerks, often require a college degree and some product knowledge.
Did you know?
An acquisition or takeover is the purchase of one business or company by another company or
other business entity. Such purchase may be of 100%, or nearly 100%, of the assets or
ownership equity of the acquired entity.

4.4 Management Dealing With the Selling

Most M&A professionals will tell us that buying a company is more difficult than selling one. Owners of
companies are bombarded on an almost daily basis from all sorts of Buyers. These would-be Buyers, be they
private equity firms or investment bankers working for a strategic Buyer, are little more than a commodity to
the owner of company with $10 million or more in revenue. Buyers are a dime a dozen. An added difficulty in
buying a company is that Sellers fall into two basic camps: those who know they want to sell and those who do
not want to sell. Deals offered by those who know they want to sell are difficult deals for Buyers because a
wise Seller has gone through the M&A process and has generated interest from multiple parties, thus putting
her in the enviable position of having options. Those who have no interest in selling are difficult deals because
they are not looking to do a deal! They are not selling their business. Period. And if the company has critical
mass — that is to say, sizeable revenues or profits or a strong brand name the owner is tired of receiving a
constant barrage of phone calls, e-mails, and letters from Buyers of all shapes and sizes who all say the same
thing: ―We have money, we are different, and we want to buy our company.‖

Even worse, many of these so-called Buyers are not seriously looking to buy and instead are on fishing
expeditions and have entrusted the cold-calling to the lowest-level executive they can find. Many times, the
person making the phone call is fresh out of business school, which means he probably has not yet learned any
real-life business lessons. Selling must be managed if it is going to contribute to firms overall objectives.
Although firms differ in specifics of how salespeople and the selling effort are managed, the sales process is
similar across firms. Formulating sales plan is the most basic of the three sales management functions. The
sales plan is a statement describing what is to be achieved and where and how the selling effort of salespeople
is to be directed. Setting Objectives Is central to sales management because this task specifies what is to be
achieved. In practice, objectives are set for the total sales force and for each salesperson. Selling objectives can
be output related and focused on dollar or unit sales volume, number of new customers added and profit.
The final function in the sales management process involves evaluating the sales force. It is at this point that
salespeople are assessed as to whether sales objectives were met and account management policies were
followed. Quantitative Assessments Called quotas are based on input- and output-related objectives set forth in
the sales plan. Input related measures focus on the actual activities performed by salespeople, such as those
involving sales calls, selling expenses, and account management policies. Output measures often appear in a
sales quota. A sales quota contains specific goals assigned to a sales person, sales team, branch sales officer, or
sales district for a stated period.
Sales management involves the analysis, planning, implementation and control of sales force activities.
Advertising consists of one-way, non-personal communication with target customer groups while the personal
selling involves two-way, personal communication between salespeople and individual consumers. Personal
selling can be more effective than advertising in more complex selling situations. The role of personal selling
varies from company to company. Personal selling is having flexibility of system it provides one to one
contact between the buyers and sellers. It Identify specific sales prospects the first step in the selling process is
prospecting identifying qualified potential customers. Approaching the right potential customers is crucial to
selling success. Direct contact with the potential buyers provides opportunity to demonstrate the product and to
customers and to answer the queries and questions of the customers. Answer questions during the presentation
step of the selling process, the salesperson tells the product ―story‖ to the buyer, showing how the product will
make or save money. The salesperson describes the product features but concentrates on presenting customer
benefits. Using a need-satisfaction approach, the salesperson starts with a search for the customer‘s needs by
getting the customer to do most of the talking. During demonstration there can be certain objections raised by
the customers, which can be overcome at very same time. Customers almost always have objections during the
presentation or when asked to place an order. The problem can be either logical or psychological, and
objections are often unspoken. In handling objections, the salesperson should use a positive approach, seek out
hidden objections, asks the buyer to clarify any objections, take objections as opportunities to provide more
information, and turn the objections into reasons for buying. Every salesperson needs training in the skills of
handling objections

4.5 Dividing and combining of different companies

Gather all debts the business accumulated, if any. Include any business credit cards, revolving lines of credit
and other short-term IOUs. Find out the remaining balances and add those amounts to the liabilities' side of the
balance sheet. Satisfy all the accounts payable. This includes any outstanding invoices that the business owes
to its suppliers, vendors and other service providers. Obtain an appraisal on all fixed assets including any real
estate, company automobiles and equipment. Include any computers and software that the business utilized
during its existence. Place classified ads in newspapers promoting the assets for sale. Use an auctioneer
company to get the highest price for the assets. Hire a realtor if we intend on selling any real estate property.
Pay off all the debts and accounts payable from the proceeds of the sale of the fixed assets. Divide the net
proceeds among the owners of the business according to their share ownership.

Combining company
Combining company‘s financial statements offers insight into the health of the company. Depending on the
size of a company and the complexity of its business, the financial statements may be a bit confusing,
particularly if the company has several subsidiaries with overseas operations. A parent company with a
controlling interest in a subsidiary consolidates the financial statements of its subsidiary into its own financial
statement.

Combined Financial Statements

A combined financial statement shows financial results of different subsidiary companies from that of the
parent company. The complete financial statement of one subsidiary is shown separately from another as a
stand-alone company. The benefit of combined financial statements is that it allows an investor to analyze the
results and gauge the performance of the individual subsidiary companies separately.

Consolidated Financial Statements

Consolidated financial statements aggregate the financial position of a parent company and its subsidiaries.
This allows an investor to check the overall health of the company in a holistic manner rather than viewing the
individual company‘s financial statements separately. In other words, the consolidated financial statements
agglomerate the results of the subsidiary businesses into the parent company‘s income statement, balance sheet
and cash flow statement.

Intercompany Transactions
Accounting treatment of both combined and consolidated financial statement eliminates intercompany
transactions. These are transactions that occur between the parent and subsidiary company. These transactions
must be eliminated to avoid double-counting, once on the books of the subsidiary and again on the parent‘s
books. This avoids misrepresenting transactions that distort actual results of the parent company and
subsidiary.

Income Statement
Both combined and consolidated financial statements add the subsidiary companies' income and expenses to
the parent company. This creates a total income and expenses for the entire group of companies, including the
parent.

Stockholder’s Equity
Consolidated financial statements simply eliminate the stockholder‘s equity section of the subsidiary.
Therefore, there are no changes to shareholder equity accounts, such as stock and retained earnings. In
contrast, combined financial statements add the stockholder‘s equity to that of the parent. This is because the
parent has controlling interest in the subsidiary group of companies.

Noncontrolling Interest
In both cases, combined and consolidated financial statements, accountants must keep track of the
noncontrolling interest relationship between the parent and subsidiary. This creates an account called
noncontrolling interest or minority interest, which tracks the part of the subsidiary not owned by the parent. In
the United States, a company with greater than 50 percent ownership of another company must consolidate its
financial statements.

Did You Know?

The combine was invented in the United States by Hiram Moore in 1834, and early versions were pulled by
horse or mule teams. In 1835, Moore built a full-scale version and by 1839, over 50 acres of crops were
harvested. By 1860, combine harvesters with a cutting width of several metres were used on American farms.

Case Study-Johnson & Johnson

Microsoft has accomplished this remarkable feat for more than two decades largely as a result of the very-
nearly unique skills and position of Bill Gates, the founder and until recently CEO and chairman of the
company. Arguably one of the few business geniuses of our generation, Gates had the insight and the influence
to grapple with uncertainty head-on. As much as we might admire the substance of Microsoft‘s strategy and
strategy-making, at a process level it is difficult to generalize from its experience, as very few of us are likely
ever to find ourselves in Bill Gates‘s position. Johnson & Johnson (J&J) provides a more illuminating case
study, revealing how mere mortals can achieve results that have so far been the preserve of the admired few. A
remarkable corporate success story, J&J has outperformed the general stock market for years, in part by
pioneering the next wave of cutting-edge management practices. And they appear to be on the cusp of
continuing that enviable tradition. Like many other large corporations, J&J maintains a ―corporate venture
capital‖ group called Johnson & Johnson Development Corporation (JJDC). Unlike most groups of this kind,
however, JJDC seems less obsessed with measuring success solely in terms of the returns on their portfolio of
investments. After all, if shareholders want exposure to venture capital-like investments, there are better and
more efficient mechanisms to create it — by investing in VC funds, for example. And in a $55 billion
corporate like J&J, creating material returns would require a level of investment far beyond the $500 million
currently under JJDC‘s management – a level that would almost certainty starve the existing businesses of the
investment they need to compete.

What is JJDC for, then? In short, it is the organ of the corporate office that manages the strategic risk faced by
the operating companies (OpCos). Working carefully with the OpCos, JJDC determines what strategic
uncertainties cloud an OpCo‘s competitive future, and which of those uncertainties the OpCo is exposed to as
a result of its strategic commitments. JJDC then creates the necessary strategic options so the OpCo can
continue to pursue its higher-risk, higher-return strategy…without the same level of risk. A key part of this
equation is driving the OpCos to pursue higher-risk strategies in the first place. Most operating companies,
whether divisions or stand-along going concerns, systematically trade returns for lower mortality rates. At J&J,
however, the corporate office sets demanding performance targets. The specifics are confidential, but for
example, the OpCos are responsible for delivering specified returns (e.g., 15% ROA) within specified time
periods (e.g., a three-year average) with specified resources (a capital expenditure and operating budget
approved by corporate). Without those targets, the OpCos would do what the majority of stand-alone business
units do: drift into mediocrity.

But if all J&J were able to do with its demanding performance hurdles were trade a portfolio of low-risk, low-
return OpCos for a portfolio of high-risk, high-return OpCos, it would merely have purchased a dollar for 20
nickels – creating the possibility of higher returns at the cost of higher risk. It is JJDC‘s involvement that
allows this portfolio to generate the returns associated with taking on greater risk without taking on the risk.
JJDC, then, does not merely seek out new growth opportunities, attempting to find ―winners‖ that will
compensate for any ―losers‖ in the existing portfolio. Rather, it creates strategic options that make it possible
for OpCos to adjust their strategies in ways they could not – at least, not without having to compromise their
ability to make and deliver on the strategic commitments necessary for extraordinary competitive success.
Consider how this has played out in the Ethicon Endosurgery (EES) OpCo. EES sells, among other medical
devices, a wide array of colonoscopes used for the interrogation of the colon and lower gastrointestinal tract in
order to diagnose and treat a variety of pathologies, including colon cancer.

For many years, the key to continued growth and profitability in the colonoscope business has been making the
devices better able to access ever-smaller body cavities, increasing the accuracy of diagnosis, and increasing
the surgeon‘s ability to remove ever-smaller patches of diseased tissue. The sales force in EES – the folks
delivering on plan – knocks on the doors of proctologists around the world to convince them that EES has the
best devices. At the OpCo level, however, a new strategic commitment is in the making: from ―better scopes‖
to ―less discomfort.‖ Growth in the colonoscopy business is a function of getting more people to get
colonoscopies, and an important way to do that is to reduce the pain associated with the procedure. There are
at least two ways to do this. One is to increase the ―intelligence‖ in the device so that the skill of the surgeon is
less a factor that it has been historically. The kinds of investment required to deliver these improvements fall
within the money, time, and performance constraints of OpCo management, and so this is a trade-off between
short and medium term considerations that is rightly left in their hands. A second pain management strategy,
however, involves pharmacological solutions and very sophisticated drug/device combinations. EES has the
budget to explore such solutions on its own; it is the complexity, uncertainty, and the time horizon associated
with drug-based solutions that create the challenge. Exploring new drugs and new drug applications falls into
the category of a strategic uncertainty for an OpCo committed to medical devices, and if EES were to get
pulled in that direction, it would be violating the principle of Requisite Uncertainty, with predictable and
negative results. Specifically, EES would likely be less able to execute effectively on its existing strategic
commitments, thereby compromising its ability to deliver returns. Consequently, it falls to JJDC to work with
EES to identify, make, and manage the seed investments needed to manage this strategy uncertainty. EES can
therefore focus on the commitments it must in order to hit the targets set for it by corporate without having
merely to accept the strategic risk that would come from ignoring the risks arising from a strategic shift from
―better scopes‖ to ―less pain.‖

Questions
1. At the OpCo level, what a new strategic commitment is taken?
2. What is the key part of the JJDC?

4.6 Summary
A merger is the time-tested transaction vehicle for recognizing the strength of combining two or more
business entities into a single venture. A merger can allow for the recognition of economies of scale.
Mergers and acquisitions, and corporate restructuring are a big part of the corporate finance world. Every
day, Wall Street investment bankers arrange Mergers and acquisitions transactions, which bring divide
companies together to form larger ones.
Conglomerate merger is a kind of venture in which two or more companies belonging to different
industrial sectors combine their operations.
Corporate strategy is the direction an organization takes with the objective of achieving business success
in the long term. Recent approaches have focused on the need for companies to adapt to and anticipate
changes in the business environment
A combined financial statement shows financial results of different subsidiary companies from that of the
parent company. The complete financial statement of one subsidiary is shown separately from another as a
stand-alone company.

4.7 Keywords
Co-generic merger: Co-generic merger is a kind in which two or more companies in association are some way
or the other related to the production processes, business markets, or basic required technologies.
Corporate strategy: Corporate strategy is the direction an organization takes with the objective of achieving
business success in the long term.
Merger: A merger is a combination of two or more business entities.
Operating economies: Operating economies is a combination of two or more firms may result in cost
reduction due to operating economies.
Vertical merger: It is a kind in which two or more companies in the same industry but in different fields
combine together in business.

4.8 Self Assessment Questions

1. Mergers and acquisitions, and corporate restructuring are a big part of the.................................
(a) Corporate finance world (b) corporate world
(c) Finance world (d) none of these

2. The final function in the sales management process involves evaluating the.......................
(a) Purchase force (b) corporate world
(c) Sales force (d) all of these

3. Sales management involves the.....................implementation and control of sales force activities.

(a) Analysis (b) planning
(c) Both (d) none of these

4. Personal selling is having flexibility of system it provides one to one contact between the....................... (a)
Buyers and sellers. (b) Buyers and buyers
(c) Sellers and sellers. (d) All of these

5. Consolidated financial statements aggregate the financial position of a.......................................

(a) Parent company (b) subsidiaries
(c) Both (d) none of these

6. A merger is a combination of two or more business entities.

(a) True (b) False

7. A merger cannot allow for the recognition of economies of scale.

(a) True (b) False

8. Vertical merger is a kind in which two or more companies in the same industry.
(a) True (b) False

9. A mission statement explains why the company is in business.

(a) True (b) False

10. Combining company‘s financial statements offers insight into the health of the company.
(a) True (b) False

4.9 Review Questions

1. Explain Horizontal Merger.
2. Discuss about the Vertical Merger and Co-Generic Merger.
3. What are the advantages of Mergers & Acquisitions?
4. What is the Distinction between Mergers and Acquisitions?
5. Describe the Corporate strategy.
6. Explain the Components of a Corporate Strategic.
7. Discuss about the Corporate Finance.
8. Discuss about the financial advisory services.
9. Management dealing with the buying. Explain it?
10. What are the advantages and disadvantage of combining company?

Answers for Self Assessment Questions

1. (a) 2.(c) 3.(c) 4.(a) 5.(c)
6. (a) 7.(b) 8.(a) 9.(a) 10.(a)
 5
Culture
CONTENTS
Objectives
Introduction
5.1 Definition of Culture
5.2 Components of Culture
5.3 Imperatives of Culture
5.4 Summary
5.5 Keywords
5.6 Self Assessment Questions
5.7 Review Questions

Objectives
After studying this chapter, you will be able to:
Definition of Culture
Components of Culture
Imperatives of Culture
Determinants of Culture

Introduction
Cultural is a fundamental part of our existence. It is that involved whole which includes knowledge, beliefs,
arts, morals, laws, customs and any other capabilities and habits acquired by man as a member of society.
From the definition it concludes that culture has both learning and teaching capabilities. However, these
processes may be centered on certain universal aspect of human behavior and activities such as house building,
food production, and preparation, clothing language, business culture. The reason why the culture is important
for business is because a research has been done on culture and international business is definitely a growth
area. The reason is because the business world is in many ways becoming one. Doing business in different
cultures requires adaption of conform to the value systems and norms of that culture. Adaption can embrace all
aspects of an international firm‘s operation in a foreign.

What is Culture?
Much has been written on the subject of culture and its consequences. Whilst on the surface most countries of
the world demonstrate cultural similarities, there are many differences, hidden below the surface. One can talk
about "the West", but Italians and English, both belonging to the so called "West", are very different in outlook
when one looks below the surface. The task of the global marketer is to find the similarities and differences in
culture and account for these in designing and developing marketing plans. Failure to do so can be disastrous.

Terpstran has defined culture as follows:

"The integrated sum total of learned behavioral traits that is manifests and shared by members of society".
Culture, therefore, according to this definition, is not transmitted genealogically. It is not, also innate, but
learned. Facets of culture are interrelated and it is shared by members of a group who define the boundaries.
Often different cultures exist side by side within countries, especially in Africa. It is not uncommon to have a
European culture, alongside an indigenous culture, say, for example, Shona, in Zimbabwe. Culture also reveals
itself in many ways and in preferences for colors, styles, religion, family ties and so on. The color red is very
popular in the west, but not popular in Islamic countries, where sober colors like black are preferred. Much
argument in the study of culture has revolved around the "standardization" versus "adaption" question. In the
search for standardization certain "universals" can be identified. Murdock suggested a list, including age
grading, religious rituals and athletic sport. Levitt suggested that traditional differences in task and doing
business were breaking down and this meant that standardization rather than adaption is becoming increasingly
prevalent. Culture, alongside economic factors, is probably one of the most important environmental variables
to consider in global marketing. Culture is very often hidden from view and can be easily overlooked.
Similarly, the need to overcome cultural myopia is paramount

5.1 Definition of Culture

Culture is the integrated sum total of learned behavioural traits that are shared by members of a society. Due to
globalisation and growing role of multinational enterprises, it has become essential for managers to acquire
knowledge of diverse cultural environments in order to achieve successful international business. Keegan has
summarised the importance of studying cultural environment for an International Marketer. The task of the
global marketers is two fold. Marketers must be prepared to recognize and understand the differences between
cultures and then incorporate this understanding into the marketing planning process so that appropriate
strategies and marketing programmes are adopted.
To formulate the marketing Strategies
To understand the behaviour of the prospective customers in the foreign land.
To cope up with cultural heterogeneity across different international market. Encompassing many
elements. The elements interact in a complex manner to determine the totality of a given culture. The
elements of a culture provide the basis of comparison between cultures and are used to assess the likely
impact of culture, cultural changes on IB.
To identify and explore the opportunity in the foreign market based on cultural perspective.
To harmonize the production and services with the target market.

Culture has long been on the agenda of management theorists. Culture change must mean changing the
corporate ethos, the images and values that inform action and this new way of understanding organizational
life must be brought into the management process. There are a number of central aspects of culture:
There is an evaluative element involving social expectations and standards; the values and beliefs that
people hold central and that bind organizational groups.
Culture is also a set of more material elements or artifacts. These are the signs and symbols that the
organization is recognized by but they are also the events, behaviours and people that embody culture.
 The medium of culture is social interaction, the web of communications that constitute a community. Here
a shared language is particularly important in expressing and signifying a distinctive organizational
culture.

Culture and Success

Deal and Kennedy argue that culture is the single most important factor accounting for success or failure in
organizations. They identified four key dimensions of culture:
1. Values: the beliefs that lie at the heart of the corporate culture.
2. Heroes: the people who embody values.
3. Rites and Rituals: routines of interaction that have strong symbolic qualities.
4. The Culture Network: the informal communication system or hidden hierarchy of power in the organization.
Peters and Waterman suggest a psychological theory of the link between organizational culture and business
performance. Culture can be looked upon as a reward of work; we sacrifice much to the organization and
culture is a form of return on effort.
Kanter refers to the paradox implicit in linking culture with change. On the surface culture have essentially
traditional and stable qualities, so how can we have a ‗culture of change?‘ Yet this is exactly what the
innovative organization needs.

Culture and the Management of Change

If real change is to occur in organizations rather than cosmetic or short lived change, it has to happen at the
cultural level. Corporate culture has many powerful attractions as a lever for change. The problem is how to
get a hand on the lever.
•Firstly, cultures can be explicitly created we have to be aware of what it takes to change an existing culture.
•The ability of companies to be culturally innovative is related to leadership and top management must be
responsible for building strong cultures. Leaders construct the social reality of the organization; they shape
values and attend to the drama and vision of the organization.
•Culture is frequently counter posed to formal rationality in this sense culture helps to resolve the dilemma of
bureaucracy; formal procedures are necessary for business integrity but they also stifle autonomy and
innovation.

The period from the mid 70s has been one of growing uncertainty for firms and in response to a changing
environment and business crises adaptable cultures that are responsive to change have become vital. Morgan
focuses on the whole organization, the cultivation of harmonious relations at all levels, the merging of
individual with common goals and a reliance on worker responsibility as success factors in organizational
culture.

Exploring Organizational Culture

Attempts to define organizational culture have adopted a number of different approaches. Some focus on
manifestations the heroes and villains, rites, rituals, myths and legends that populate organizations. Culture is
also socially constructed and reflects meanings that are constituted in interaction and that form commonly
accepted definitions of the situation. Culture is symbolic and is described by telling stories about how we feel
about the organization. A symbol stands for something more than itself and can be many things, but the point
is that a symbol is invested with meaning by us and expresses forms of understanding derived from past
collective experiences. The sociological view is that organizations exist in the minds of the members. Stories
about culture show how it acts as a sense making device.
Culture is unifying and refers to the processes that bind the organization together. Culture is then consensual
and not conflictual. The idea of corporate culture reinforces the unifying strengths of central goals and creates
a sense of common responsibility. Culture is holistic and refers to the essence the reality of the organization;
what it is like to work there, how people deal with each other and what behaviours are expected. All of the
above elements are interlocking; culture is rooted deep in unconscious sources but is represented in superficial
practices and behavior codes. Because organizations are social organisms and not mechanisms, the whole is
present in the parts and symbolic events become microcosms of the whole.

Classifying Cultures
One way of exploring cultures is to classify them into types.
[Link] Cultures: These are highly formalized, bound with regulations and paperwork and authority and
hierarchy dominate relations.
[Link] Cultures: These are the opposite, the preserve a strong sense of the basic mission of the organization
and teamwork is the basis on which jobs are designed.
[Link] Cultures: These have a single power source, which may be an individual or a corporate group.
Control of rewards is a major source of power.

Handy points out that these types are usually tied to a particular structure and design of organization. A role
culture has a typical pyramid structure. A task culture has flexible matrix structures. A power culture has web
like communications structure. Cultural analysis brings to centre stage a rich vein of behaviors and stands on
its head much of the conventional wisdom about organizations. Stories, legends, rituals and heroes are key
elements of organizational functioning and may actually serve more important objectives than formal decision
making. We need to consider in more depth the different ways in which culture has been used in organization
study.
Wilson and Rosenfield distinguish two schools of thought:
1. The analytical school stresses the context and history of the organization and how culture acts as a
socializing force controlling the behavior of members.
2. The applicable school view culture in terms of commitment to central goals and as a means of managing
successful organizational change.

Managing Culture
Corporate culture is really a kind of image for the company which top management would like to project. The
image of the organization differs according to where we view it. Even in companies with strong cultures the
social distance between senior management and shop floor reality can be very wide. Cultures are hardly
planned or predictable; they are the natural products of social interaction and evolve and emerge over time. So
is it valid to allow such a notion of culture to give way to a version of managed consensus? Pettigrew believes
that cultures can be shaped to suit strategic ends. He has in mind the idea that organizations have the capacity
to transform themselves from within. Even if cultures can be managed is this necessarily a good thing.

5.2 Components of Culture

Culture is a complex and multifaceted concept, becomes easier to hire and train literate people. The social
institution of education affects literacy, which in turn affects marketing promotion. It is much easier to
communicate with a literate market than to the one in which more of symbols and pictures are used countries
rich in educational facilities attract high-wage industries and also it. It encompasses the following elements:
those physical things found in nature unless they undergo some technological procedure. It can be divided into
2 parts –
Technology
Economics
Technology includes the techniques used in the creation of material goods. It is the technical know-how
possessed by the people of a society. Economics is the manner in which people employ their capabilities and
the resulting benefits. It includes production of goods and services, their distribution, consumption, income
derived from the creation of utilities and means of exchange. International marketers need to know the
material culture of a foreign land for making production and operational decisions. ‗Cateora‘ opines that
material culture affects the level of demand, the quality and types of product demanded and their functional
features, as well as the means of production of these goods and their distribution. Thus, the knowledge of
material culture helps the international marketer to understand the opportunities available in the foreign
country.

Social Institutions
Social Institutions refers to the way people relate to other people. It includes family, education, political
structures, social organisations, where people organize their activities in order to live in harmony with one
another. These institutions teach acceptable behaviour to live in a societal setup. Each institution has an effect
upon marketing because each influences behaviour values and the pattern of life. In cultures where the social
organizations result in close – knit family units, it is more effective to aim a promotional campaign at a family
unit then at an individual farm by member.

Man and the Universe

This includes religion, superstitions and their related power structures. Religion is the most sensitive element
of a culture. It affects lifestyles, beliefs, attitudes, social customs etc. Acceptance of certain types of food,
clothing and behaviour are frequently affected by religion and such acceptance can extent to the acceptance or
rejection of promotional messages. An International Marketer cannot afford to ignore the importance of myths,
beliefs, superstition etc because they are an integral part of the cultural fabric of a society and influences all
manners of behaviour.

Asthetics
Closely interwoven with the effect of people and the Universe are the cultural asthetics i.e. artistic tastes of a
culture, as expressed in arts, music, drama, dance etc. The asthetics are of interest to the International marketer
because of their role in interpreting the symbolic meanings of the various methods of artistic expressions,
colour and standards of beauty in a particular value, product styling is seldom successful. Insensitivity to the
asthetic value, not only leads to ineffective advertising, but it can also leads to offending the proposed
customer or creating a negative impression. Thus, we need to understand the asthetic value in the international
arena.

Language
Language is the foundation of any culture. It includes speech, written characters, numerals, symbols and
gestures of non-verbal

Communication
It is an obvious cultural difference that is essential to be learned for the success of any international
business practice. It helps to determine success in the following ways –
It provides a clearer understanding of a given situation.
It establishes the most effective and flaltering bridges to local people. Speaking the local language helps
the international manager to have a direct access to the hosts willingness to communicate openly in their
own language.
Language, properly and effectively learned, provides one of the most practical means of understanding
 another culture.
An understanding of the local language allows the person to pick up nuances, clinches, implied meanings
and other information that is not stated on tight.
It builds confidence and earn the respect and admiration of the local people, thereby making managers
more effective.
Thus, there is a strong interrelationship between culture and language.

Customs and Manners

Customs are common or established practices. It dictates how things are to be done and what society
collectively expects its members to do. Manners are behaviours that are regarded as appropriate in a particular
society. These are the pointers of an individual‘s character and are used in carrying the Things as dictated by
customs. Customs and manners differ from country to country. Table manners, business etignettes, bodily
expressions all large from region to region. Observing manners and respecting customs are essential
ingredients of successful negotiations in far and near Eastern cultures. Failure to understand and respect local
customs and manners may land the manager in trouble, besides losing business.

Caution
The international manager should understand the manners and customs of host country citizens.

Did you know?

In the 19th century, humanists such as English poet and essayist Matthew Arnold (1822–1888) used the word
"culture" to refer to an ideal of individual human refinement, of "the best that has been thought and said in the
world

5.3 Imperatives of Culture

There are number of compulsory or forceful factors of culture that effects international business. Altitudes and
values affect business behaviour, from it becomes necessary to know and analyse these factors.
Social Stratification System
In every culture values of some people are higher than others and this indicates a person class or status within
that culture. In business terms, this might mean valuing members of managerial groups more highly then
members of production groups. However, what determines the ranking or social stratification system varies
substantially from country to country. A person‘s ranking is partly determined by individual factor and partly
by the person‘s affiliations or memberships in the given groups.

Motivation
It has been observed that employees who are motivated to work hard and for long, prones to be more
productive as compared to non-motivated employees. On an aggregate basis this influences the economic
development of a country. International Organisations are more interested in the economic development of a
country as market for their product increases as economy grow. They are also interested for this motivational
factor as higher productivity yields to minimisation of production cost & optimisation of the available
resources. This increases the profits, which is the ultimate objective of every business activity.

Relationship Preference
There are a number of factors that affects business practices within the social stratification. No single group
can be a weak or a strong pressure group within a social set up. There are national differences in norms that
influence management styles and marketing behaviour. It becomes necessary for the international manager to
understand the complexities of different cultural values and offer useful tips to manage multicultural. One
important point of study is the employee‘s preferences as far as their conduct with their bosses, subordinates
and superiors are concerned. Power distance focuses on how a society deals with inequalities in the intellectual
and physical capabilities of people. High distance power cultures are found in societies that has inequalities of
power and wealth. In such countries, an autocratic style of management is preferred.

Low power distance cultures are found in societies where such inequalities are lowered as far as possible. A
Consultive style of leadership style is preferred in such societies. Attributes of individualism and collectivism
are required in each organisation depending on the need and the societal norms. Individualism exists where
people are valued in terms of their own achievements, status etc. Collectivist Societies view people as a group.
Tolerance for ambiguity. Higher & lower uncertainty avoidance shows the readiness to take risks and accept
change. On the other hand, countries with high Masculinity Scores place a great deal of importance on
earnings, recognition, advancement and challenge; while low masculity scores place great emphasis on a
friendly work environment, corporation and employment.

Risk Taking Behaviour

Nationalities differ in how people are happy to accept things, the way they are & low they feel about
controlling their destinies. A culture exhibiting uncertainty avoidance on the higher note, forbids the
international marketer to launch in that particular society. On the other hand, a belief in falatism, that every
event is inevitable, may prevent people from accepting the basic cause and effect relationship. The effect on
business in countries with a high degree of fatalism is that people plan less for uncertainties. Trust is one force
that acts as a prime factor for considering the International business activities. In societies where trust is high,
there tends to be better opportunities for growing business.

Information and task processing

The most important factor that becomes imperative for IB is the processing of the information collected and
using it aptly on the conduct of various activities. All the countries on the globe, reflects varied cultures, thus it
becomes crucial to understand and interpret the cultures rightly, as any kind of misinterpretation will land the
international marketer on the wrong perceptions, thus affecting the overall strategy. Thus, all the above factors
become imperative for international business conduct.

Did you know?

"In September 2005, the Object Management Group (OMG) voted to accept the Business Motivation Model as
the subject of a Request for Comment (RFC).

5.4 Determinants of Culture

The values and norms of a culture do not emerge fully formed. They are the evolutionary product of a number
of factors at work in a society. These factors include the prevailing political and economic philosophy, the
social structure of a society, and the dominant religion, language, and education. Remember that the chain of
causation runs both ways. While factors such as social structure and religion clearly influence the values and
norms of a society, it is also true that the values and norms of a society can influence social structure and
religion. The values and norms of a culture do not emerge fully formed. They are the evolutionary product of a
number of factors at work in a society. These factors include the prevailing political and economic philosophy,
the social structure of a society, and the dominant religion, language, and education. Remember that the chain
of causation runs both ways. While factors such as social structure and religion clearly influence the values
and norms of a society, it is also true that the values and norms of a society can influence social structure and
religion.

Did You Know?

"In September 2005, the Object Management Group (OMG) voted to accept the Business Motivation Model as
the subject of a Request for Comment (RFC).

Case Study-William Henry Gates, III and the Microsoft Money Machine
Several years ago, when his fortune was a mere several hundred million dollars, a weekly magazine labeled
Bill Gates as ‗America‘s richest nerd.' In 1992, at age 36, he had passed Donald Trump, Ross Perot and others
to be listed as America‘s wealthiest person by Forbes magazine; the value of his holdings had grown to an
estimated $ 6.3 billion. How did the free enterprise system help him to attain such phenomenal wealth?
After graduating from high school in Seattle in 1973, Gates went to Harvard. While there, he learned that the
personal computer [PC] was in the development stage. He dropped out of school and threw himself completely
into designing an operating system [the program that coordinates the hardware and software of the computer]
for the PC. His system, [S - DOS the Microsoft Disk Opening System] was so good that IBM agreed to use it
in their line of, personal computers. With IBM setting the industry standard, other computer manufacturers
quickly adopted MS DOS as well. Today it is estimated that more than 80% of all personal computers in the
world use this system: Gate‘s firm, Microsoft, Inc., makes money on every computer sold with MS-DOS as
the operating system.' In the 1992, the firm recorded $2.8 billion in revenue and $ 708 million in net profit. It
ranks third in size in the industry, behind IBM and Hewlett Packard. Gate‘s personal holdings of some 90
million shares of common stock represent about 33% ownership share of the company.

Microsoft also produces programs for word processing, spreadsheets, and a variety of other applications. One
of Gate‘s latest ventures has been to purchase the electronic reproduction rights to thousands of art and
photographic works from museums and libraries around the world. These will be used as a part of his plan for
interactive home entertainment systems. With extremely hard work, a creative mind, and a willingness to take
risks, Gates has demonstrated how the market rewards the successful entrepreneur. He was able to produce
what consumers wanted at a price they were willing to pay the result was that both and they are better off! This
is the essence of free market economic system. From the above case study, it would be clear how a pro-active,
imaginative and innovative entrepreneur can, carry the business with him. Though a school drops out. Gates
has climbed the pinnacle of business world, merely by his ability to anticipate the changes, in the personal
computer industry. Failure to read the business environment and initiate appropriate steps to protect the
business, can lead to a serious threat to existence itself. This would-be clsar from the following case on Maruti
Udyog of India and Doordarshan.

Questions
1. What do you understand by IBM?
2. What is the work of Operating system?

5.5 Summary
The integrated sum total of learned behavioral traits that is manifest and shared by members of society.
The study of culture has revolved around the "standardization" versus "adaption" question.
The management of a large organization noticed that many of their specialist employees were resigning.
The manager of a research team claims that as the manager, he is responsible for all of his team‘s new
ideas, and even files the patents for them in his own name.
 The increase in the number of cases of business failures due to fraud and other malpractices have started to
emerge as a very important catalyst to the increase in the discourse about the need to revitalize business
ethics awareness in the workplace.
Most business people are so busy working for their business or in their business that they never find the
time to work on their business

5.6 Keywords
Benefits: In the most general sense, the long-run monetary benefits of doing business in a country are a
function of the size of the market, the present wealth.
Culture: It comprises the entrenched but often unconscious beliefs, values and norms shared by members of
the organization.
Norms: These are the social rules that govern people‘s actions toward one another and it can be subdivided
further into two major categories folkways and mores.
The Group: In contrast to the Western emphasis on the individual, the group is the primary unit of social
organization in many other societies.
The old hierarchical model is no longer appropriate. The new model is global in scale, an interdependent
network.
Values: It forms the bedrock of a culture and provides the context within which a society‘s norms are
established and justified.

5.7 Self Assessment Questions

1. The culture is important for business
(a) True (b) False

2. Culture is the integrated sum total of learned behavioural traits that are shared by.............................
(a) Society (b) Chief of a society
(c) Members of a society (d) none of these

3. Culture change must mean changing the corporate ethos.

(a) True (b) False

4. The single most important factor accounting for ....................in organizations.

(a) Success (b) failure
(c) Success or failure both (d) none of these

5. Corporate culture has many powerful attractions as a lever for change

(a) True (b) False

6. Culture is symbolic and is not described by telling stories about how we feel about the organization
(a) True (b) False

7. A role culture has a typical pyramid structure. A task culture has. has.....................
(a) Flexible matrix structures (b) A power culture
(c) Web like communications structure (d) all of these
8. Material culture affects on the...............................
(a) High demand (b) level of demand
(c) Low demand (d) none of these

9. Language is the foundation of any culture. It includes......................................

(a) Speech (b) written characters
(c) Numerals and symbols (d) All of these

10. Forceful factors of culture effects on

(a) International business (b) Domestic business
(c) National business (d) none of these

5.8 Review Questions

1. Explain in brief:
Culture and the workplace
Cultural change
2. Define the values and norms of the culture.
3. Define the determinants of culture.
4. Cultural is a fundamental part of our existence. Explain it.
5. Discuss the culture and the management of change.
6. What do you know about exploring organizational culture?
7. What is the classification of culture?
8. Describe the components of culture.
9. Explain the determinants of culture.
10. Discuss about the Risk Taking Behaviour.

Answers for Self Assessment Questions

1. (a) 2.(c) 3.(a) 4.(c) 5.(a)
6. (b) 7.(d) 8.(b) 9.(d) 10.(a)
 6
Political Environment
CONTENTS
Objectives
Introduction
6.1 Political Environment
6.2 Political Systems
6.3 Political Systems6.4 Role of I.B
6.4 Major Political objective
6.5 Summary
6.6 Keywords
6.7 Self Assessment Questions
6.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Discuss Political Environment
Describe Political Systems
Explain Economic Systems
Major Political objective

Introduction
Political environment has a very important impact on every business operation no matter what its size, its area
of operation. Whether the company is domestic, national, international, large or small political factors of the
country it is located in will have an impact on it. And the most crucial & unavoidable realities of international
business are that both host and home governments are integral partners. Reflected in its policies and attitudes
toward business are a governments idea of how best to promote the national interest, considering its own
resources and political philosophy. A government control‘s and restricts a company‘s activities by encouraging
and offering support or by discouraging and banning or restricting its activities depending on the government.
Here steps in international law. International law recognizes the right of nations to grant or withhold
permission to do business within its political boundaries and control its citizens when it comes to conducting
business. Thus, political environment of countries is a critical concern for the international marketer and he
should examine the salient features of political features of global markets they plan to enter
6.1 Political Environment
Political environment refers to the influence of the system of government and judiciary in a nation. The system
of government in a nation wields considerable impact on its business. A political system that is stable, honest,
efficient and dynamic and which ensures political participation to the people and assures personal security to
the citizens is a primary factor for economic development. The political environment of international business
includes any national or international political factors that can effect the organisations operations or its
decision making.‘
The political environment comprises three dimensions:
(1) The host country environment.
(2) The International environment.
(3) The Home country environment.

All these dimensions have to be carefully analysed by an international marketer. The political set-up of any
country influences the carrying of international business as one needs to take decision as whether to invest or
not, how to develop the identified markets and how to plan the strategic formulation. Thus, political
environment is relevant to IB, as political factors play a vital role in the following areas.
(a) The nature of regulatory framework.
(b) The degree of government control over MNC activities.
(c) The relative importance of various pressure groups within a nation.
(d) The likelihood of trade embargoes i.e. prohibitions on trade with particular nation.
(e) The degree of lossess from political risks and the extent to which insurance can be taken.
(f) The tax regimes pertaining with specific countries.

Democracy is one of the basis form of political system. It refers to a political arrangement in which the
supreme power is vested in the people. It rests on the ideology that all citizens should be equal politically and
legally; should enjoy widespread freedom and should participate in political process. A democratic form of
government exhibits a system, where the public, in a democratic manner elects their representatives who do
the ruling. A representative democracy rests on the assumption that if the elected representatives fail to
perform adequately they will be voted down in the next election. India is the world‘s largest democracy.

The Principles of democracy

(1) Prominent rule of Law
(2) Universal right to vote
(3) Freedom of expression, speech and association.
(4) Limited term for elected officials.
(5) An accessability to political decision-making process.
(6) An independent and fair court system with high regard for individuals right
And property.

6.2 Political Systems

The political systems are the results of an historical development that was initiated by the expansive colonial
policies of the European and Euro-American states. The subsequent claims for self-government by indigenous
peoples have given rise to a number of new self-governing autonomous regions. The timing of this historical
trend has not been the same in all parts of the Arctic. One region may have been colonized several hundred
years ago, while other regions were only incorporated after World War II. One of the main trends is nation
building in the Arctic followed by decolonization and the growth of regional autonomy. Today, most of the
Arctic falls within states where a majority of the inhabitants live outside the Arctic region, with a range of
political structures to govern the relationships between the nation states and their northern regions. This
remarkable variation in the types of government arrangements reflects demographic, geographic, and political
variations. But a common theme is an increasing integration of indigenous affairs into mainstream local,
national, and regional government arrangements. Despite differences in political systems, a common feature of
Arctic politics is increased indigenous participation in political processes. The set of formal legal institutions
that constitute a ―government‖ or a ―state‖. This is the definition adopted by many studies of the legal or
constitutional arrangements of advanced political orders. More broadly defined, however, the term
comprehends actual as well as prescribed forms of political behavior, not only the legal organization of the
state but also the reality of how the state functions. Still more broadly defined, the political system is seen as a
set of ―processes of interaction‖ or as a subsystem of the social system interacting with other non-political
subsystems, such as the economic system.

This points to the importance of informal socio-political processes and emphasizes the study of political
development. Traditional legal or constitutional analysis, using the first definition, has produced a huge body
of literature on governmental structures, many of the specialized terms that are a part of the traditional
vocabulary of political science, and several instructive classifying schemes. Similarly, empirical analysis of
political processes and the effort to identify the underlying realities of governmental forms have yielded a rich
store of data and an important body of comparative theory. The third definition has inspired much scholarly
work that employs new kinds of data, new terms, and some new concepts and categories of analysis. The
discussion that follows draws on all three approaches to the study of political systems.

Typologies of Government
The most important type of political system in the modern world is the nation-state. The world today is divided
territorially into more than 190 countries, in each of which a national government claims to exercise
sovereignty—or the power of final authority—and seeks to compel obedience to its will by its citizens. This
fact of the world‘s political organization suggests the distinction employed among supranational, national, and
sub national political systems.

Supranational Political Systems

The formation of supranational relationships is a principal result of the division of the world into a number of
separate national entities, or states, that have contact with one another, share goals or needs, and face common
threats. In some cases, as in many alliances, these relationships are short-lived and fail to result in significant
institutional development. In other cases, they lead to interstate organizations and supranational systems. The
discussion below examines several types of supranational political systems, together with historical and
contemporary examples of each.

Empires
They are composed of peoples of different cultures and ethnic backgrounds, all empires are ultimately held
together by coercion and the threat of forcible recon quest. Imposing their rule on diverse political structures,
they are characterized by the centralization of power and the absence of effective representation of their
component parts. Although force is thus the primary instrument of imperial rule, it is also true that history
records many cases of multiethnic empires that were governed peaceably for considerable periods and were
often quite successful in maintaining order within their boundaries. The history of the ancient world is the
history of great empires—Egypt, China, Persia, and imperial Rome—whose autocratic regimes provided
relatively stable government for many subject peoples in immense territories over many centuries. Based on
military force and religious belief, the ancient despotisms were legitimized also by their achievements in
building great bureaucratic and legal structures, in developing vast irrigation and road systems, and in
providing the conditions for the support of high civilizations. Enhancing and transcending all other political
structures in their sphere, they could claim to function as effective schemes of universal order. In contrast to
the empires of the ancient world, the colonial empires of more recent times fell far short of universal status. In
part, these modern European empires were made up of ―colonies‖ in the original Greek sense; peopled by
immigrants from the mother country, the colonies usually established political structures similar to those of the
metropolitan centre and were often able to exercise a substantial measure of self-government. In part, also, the
European empires were composed of territories inhabited by native populations and administered by imperial
bureaucracies. The government of these territories was generally more coercive than in the European colonies
and more concerned with protection and supervision of the commercial, industrial, and other exploitative
interests of the imperial power. The disintegration of these empires occurred with astonishing speed. The two
world wars of the 20th century sapped the power of the metropolitan centers, while their own doctrines of
democracy, equality, and self-determination undermined the principle of imperial rule. Powers such as Britain
and France found it increasingly difficult to resist claims to independence couched in terms of the
representative concepts on which their home governments were based, and they lacked the military and
economic strength to continue their rule over restive native populations. In the two decades after 1945, nearly
all the major colonial territories won their independence; the great colonial empires that had once ruled more
than half the world were finally dismembered.

Leagues
One of the commonest forms of supranational organization in history is that of leagues, generally composed of
states seeking to resist some common military or economic threat by combining their forces. This was the case
with the early city leagues, such as the Achaean and Aetolian leagues in ancient Greece and the Hanseatic and
the Swabian leagues in Europe; and to a great extent it was the case with the League of Nations. Other
common features of leagues include the existence of some form of charter or agreement among the member
states, an assembly of representatives of the constituent members, an executive organ for the implementation
of the decisions of the assembly of representatives, and an arbitral or judicial body for adjudicating disputes.
The League of Nations was one of the great experiments in supranational organization of the 20th century and
the predecessor in several important respects of the United Nations. The initial membership of the League
consisted of twenty states. The United States failed to take membership in the League, but by 1928 the
organization had a total membership of fifty four. The machinery of the League consisted of an Assembly of
all the member countries, acting through agents of their governments; a council on which the great powers
were permanently represented and to which the other member powers were elected by the assembly for three-
year terms; a secretariat to administer the internal affairs of the league; and a number of specialized agencies,
such as the International Labor Organization, that were responsible for implementing various economic and
humanitarian programs on an international basis. The Covenant required that international disputes be
submitted to peaceful settlement with a provision for adjudication or arbitration by the Permanent Court of
International Justice or for intervention by the Council of the League. The Covenant also provided for the use
of financial and economic penalties, such as embargoes, to enforce the decisions of the League and for joint
military action against convicted aggressors. In practice, however, the League failed its most important tests
and was unable to master the crises that led to World War II and its own collapse.

Did You Know?

The Covenant of the League was drafted by a special commission of the Peace Conference after World War I,
with Pres. Woodrow Wilson of the United States as its leading advocate, and approved by a plenary
conference of the victorious powers in 1919.
6.3 Economic Systems
Thoughts, in any nation, are the greatest fortune the nation gains in her life if the nation is newly born; and
they are the greatest gift that any generation can receive from the preceding generation, provided the nation is
deep-rooted in the enlightened thought With regard to material wealth, scientific discoveries, industrial
inventions and the like, all of these are of much lower importance than thoughts. In fact, to gain such matters
depends on the thoughts, and preservation of these matters depends on the thoughts as well. If the material
wealth of a nation is destroyed, it is possible for it to be restored quickly as long as the nation preserves its
intellectual wealth. However, if the intellectual wealth collapses and the nation retain only its materialistic
wealth, this wealth will soon shrink and the nation will fall down into poverty. Most of the scientific
achievements which the nation once made can be regained, provided it does not lose its way of thinking.
Whereas, if it lost the productive way of thinking, it would soon regress and lose its discoveries and
inventions. Therefore, it is necessary to take care of the thoughts first. Based upon these thoughts, and
according to the productive way of thinking, material wealth is gained, and the achievement of scientific
discoveries, industrial inventions and the like is sought. What is meant by thoughts is the existence, within the
nation, of the process of thinking in its life affairs, such that the majority of its individuals use the information
that they have when facing events, so as to judge on them.
This means that they have thoughts which they contrive to use in life, and by using these thoughts frequently
and successfully, a productive way of thinking results. , so it is naturally deprived of the productive way of
thinking. The present generation did not receive from its preceding generation any ideas, be they naturally; it
did not receive a productive way of thinking. Did it attain by itself any thoughts or a productive way of
thinking As a result, it is natural for this generation to be seen in poverty, despite the abundance of material
resources in its lands. Likewise, it is natural to have no scientific discoveries and industrial inventions even
though it studies the theories of these discoveries and inventions and is aware of them. This is because it is
impossible to rush to gain them in a productive way, unless it possesses a productive way of thinking that is
unless it has thoughts and it is creative in using their thoughts in life. Therefore, it is inevitable for the Muslims
to establish for themselves thoughts and a productive way of thinking. Thereafter, they will be able to proceed,
based on that, to acquire material wealth, make scientific discoveries, and industrial inventions. Unless they do
this, they will not precede a single step; rather they will continue to go around in a vicious circle, exhausting
their mental and physical efforts, only to end up exactly where they began.

From this perspective, the society faces an economic problem, which is the relative shortage of commodities
and services. The inevitable result of this shortage is that some needs are either partially satisfied or not
satisfied at all. Since this is the situation, it is necessary that the members of society agree on rules that decide
which needs have to be satisfied and which needs are to be deprived. In other words, it is necessary to set a
rule that decides the manner of distributing the limited resources over the unlimited needs. So the problem to
address in their view is the needs and resources and not the man. Thus, the problem is to make available the
resources so as to satisfy the needs, but not necessarily the needs of every individual. Therefore, it is
necessary that the rules which are laid down by rules which guarantee the achievement of the highest possible
level of production, so as to achieve the highest supply of resources that is to supply the goods and services to
the nation as a whole, but not necessarily to each individual. Therefore, the problem of distributing the goods
and services is closely connected to the problem of production, and the objective of economic studies and
research is to increase the goods and services which are consumed by the society. It is not surprising.

The Economic System versus Economic Science

The economic system is that which determines how to distribute the wealth, how to possess it, and how to
spend or dispose of it. This determination follows a particular viewpoint in life, or ideology. Therefore, the
economic system in Islam is different from that of Socialism/Communism and that of Capitalism, since each
of these systems follows its own ideological viewpoint of life. Economic science discusses production, its
improvement, invention and improvement of its means. Economic science, as is the case with other sciences, is
universal to all nations and is not associated with a particular ideology. So for example, the view towards
ownership in Capitalism differs from that of Socialism/Communism, and differs from that in Islam. However,
discussing the improvement of production is a technical issue, which is purely scientific, and the same for all
people, no matter what their viewpoint about life is. This merger between the study of the needs and the means
of their satisfaction that is between producing the economic material and the manner of its distribution, and
bringing them as one issue and one subject, is an error, which resulted in mixing and interference in the
capitalists studies of economy. As a result the basis of the Capitalist economy is wrong. By including the
subject of satisfying the needs within the subject of the means of satisfying needs, and by viewing the means
of satisfaction only as satisfying a need, and not by any other consideration, economists concentrate on
production of wealth more than distribution of wealth. The importance of distribution of wealth to satisfy the
needs has become secondary.

Therefore, the capitalist economic system has one aim, which is to increase the country‘s wealth as a whole,
and it works to arrive at the highest possible level of production. It considers that the achievement of the
highest possible level of welfare for the members of society will come as a result of increasing the national
income by raising the level of production in the country, and in enabling individuals to take the wealth, as they
are left free to work in producing and possessing it. So the economy does not exist to satisfy the needs of the
individuals and to facilitate the satisfaction of every individual in the community, rather it is focused on the
augmentation of what satisfies the needs of the individuals that is it is focused on satisfying the needs of the
community by raising the level of production and increasing the national income of the country. Through the
availability of the national income, the distribution of income among the members of society occurs, by means
of freedom of possession and freedom of work. So it is left to the individuals to obtain what they can of the
wealth, everyone according to what he has of its productive factors, whether all the individuals or only some
individuals are satisfied.

The Socialist Economic System

Socialist economic system, with Communism being a part of it, it contradicts Capitalism. Most of the Socialist
ideas appeared in the Nineteenth century. The Socialists fought fiercely against the opinions of the liberal
school of thought that is they fought the Capitalist economic system. The powerful emergence of Socialism
was due to the iniquity which the society suffered under Capitalism and owing to its many fallacies and
inadequacies. By reviewing the Socialist schools of thought, it appears that they agree on three issues, which
distinguish them from other economic schools of thought.
•Achievement of a type of actual equality.
•Abolition of private property either completely or partially.
•The organization of production and distribution of the commodities and services by means of all of the
people.

However, despite their agreement over these three issues, they have fundamental differences over many points,
the most important of which are: The Socialist schools of thought differ in the form of the eventual equality
they aim to achieve. One group advocates arithmetic equality which means equality in everything of benefit,
thus each person is given an identical amount. Another group suggests common equality, which means
observing the ability of everyone when distributing work and looking at the needs of every individual when
distributing products. Equality in their view is established when the following principle is applied: ―From each
according to his strength that is his ability and to each according to his need a third group adopts equality.
The production fashion today does not conform to the system of ownership. Production no longer remains
individualistic that is being performed by the person alone, as it was in past ages, but rather has become
associative that is conducted by individuals together. At the same time however, the system of ownership has
not changed. So individual ownership continues and is still the basis of the system in current society. As a
result of this the working class, which participates in production, does not have a share in the ownership of the
capital, and remains under the mercy of the Capitalists (the owners of the capital), who do not by themselves
participate in production. The Capitalists exploit the labor force, paying it only subsistence wages and the
workers are compelled to accept it since they have nothing but their efforts to sustain themselves. The
difference between the value of the product and the labor wage, which Marx calls the surplus value, constitutes
the profit which the Capitalist monopolizes, while justice assumes it should be the share of the workers.

The Basis of the Economic System

The benefit in a thing represents the suitability of that thing to satisfy a need of man. Benefit comprises two
elements. One is the extent of desire for that particular thing felt by a human. The second is the merits existent
in the thing and its suitability to satisfy human needs, as opposed to the need of a particular person. This
benefit results from either human effort, the commodity, or from both of them. The form of human effort
includes the intellectual and the physical effort which he expends to initiate a property or a benefit from a
property. The term commodity includes everything possessed for utilization through buying, leasing or
borrowing, whether by consumption, such as an apple or by usage such as a car; or through utilizing it like
borrowing machinery or leasing a house. Property includes money such as gold and silver, commodities such
as clothes and foodstuffs, and immovable properties such as houses and factories and all other things which are
possessed. Since property itself satisfies human needs, and human effort is a means to obtain the property or its
benefit, then the property is the basis of the benefit, whilst man‘s effort is only a means that enables him to
obtain the property. Hence, man by his nature strives to obtain such wealth for possession. Therefore man‘s
effort and property are the tools which are used to satisfy his needs, they are the property which man strives to
possess. Therefore wealth is the property and the effort together prohibits benefiting from some of man‘s
actions, such as dancing and prostitution. It also prohibits the trade in commodities that are forbidden to be
eaten, whilst prohibiting the hiring actions that are forbidden to be performed. This refers to the utilization of
the property, and man‘s effort. However, regarding the method of possessing property and man‘s effort, has
put numerous laws regulating this ownership, such as laws of hunting and land reclamation, and the laws of
leasing, manufacturing, inheritance, donations and wills.

6.4 Major Political Objective

Require and restore trust, integrity and common sense in government and its elected officials with greater
accountability to its people. Establish a Constitutional Amendment requiring government to operate under a
Balanced Budget. Insist on strict adherence and interpretation of our Constitution by our representatives as
intended by our Nation‘s Founders. Reduce the size, scope and control of our government over economic,
business, entitlements and personal sectors Demand and Institute long-term fiscal spending policies to insure
inter-generational equity Establish and enact a Balanced Budget Amendment to the Constitution Replace the
existing Tax Code with either a national sales tax or Flat tax on all individuals and business while creating
special incentive programs to encourage industrial growth and employment Require Social Security, Medicare
and Grant program reform eliminating the over $180 Billion dollars of entitlement fraud. Government to
immediately begin to repay the borrowed trust funds to Social Security program. Government to begin paying
down the national debit. Require Annual Auditing of the Federal Reserve. Eliminate the further use of
Omnibus bills and legislation stopping or legislators from including ‗Pork Barrel Spending‘ in order to bribe a
fellow legislator(s) for their vote. Every bill MUST stand on its own! Require a National Referendum vote on
proposed Government run Entitlements or programs like Health Care, Cap & Trade etc... , Establish Electoral
and Campaign Finance Reform. Impose Term Limits on Legislators, special interest group donations and
campaign spending. Legal Reform of our Justice System, TORT reform, create plaintiff legal fee, cost and
damages liability act. Europe urgently needs a clear plan of action if it is to maintain its place in the shifting
global landscape, surmount the challenges of an ageing population and confront the need to switch to a greener
economy in a globalised world. These are complex issues and it is important to set clear objectives and define
the necessary steps to ensure a smooth transition to a new societal model. Commerce is dedicated to
contributing to Europe‘s recovery, as one of the most vibrant and productive sectors in the Union. The 6
million companies in wholesale and retail represented by Euro Commerce provide jobs to over 33 million
people - so one in seven jobs in Europe is in the commerce sector. Over 99% of our companies are SMEs and
many have been hit hard by the current recession. Commerce has a unique position in society, acting as the
link between manufacturers and consumers. Its overriding aim is to provide consumers with the products they
want at the right time, at the right place and at the best price.

Many people assume that commerce is a fairly simple business – not much more than taking products supplied
by others and selling them on to consumers. Yet, the reality is far more complex, involving a whole range of
activities, from food safety, environmental issues and transport strategies to consumer rights, payment systems
and new technologies. The steps from the producer to the consumer are many and various including - to name
but a few: manufacturing, processing, packaging, storage, transport. All these steps add costs which must be
built into prices. Because commerce is so competitive and margins so low, any additional regulatory burden
tends to reduce our productivity and further increase the end price to consumers. But, given its weight in the
economy and close relationship with consumers, the commerce sector can First, as a matter of principle, let us
support our SMEs. Less red tape, better regulation and access to credit on reasonable terms are essential for
small businesses to survive. Much has been said about this in the past, yet the practical impact felt by SMEs
during the last year has been all too limited. The EU ―2020 Strategy‖ must build on past experience and
deliver concrete solutions to promote growth at both EU and national level.

Secondly, to promote health and the environment, we need innovation. As a direct link with consumers,
companies in commerce take their role in supporting campaigns on healthy eating and sustainable
consumption very seriously. Yet our efforts cannot stand alone: European and national government action on
education is needed to change consumer behaviour. Neither should ill-judged regulation hinder the
development of voluntary programmes, such as REAP, the Retailers' Environmental Action Programme, the
full impact of which will depend on public authority efforts towards consumer education.

Thirdly, we need to improve the supply chain as a whole. Commerce is just one of many players in this
complex chain, all of whom have an impact on final consumer prices. Any initiative on prices must be aimed
at improving the competitiveness of the entire supply chain.

Lastly on this, we need to strengthen the single market: consistent implementation of the Services Directive
and an Internal Market Review which provides further market efficiencies are essential, as is a single euro
payments area which works to the benefit of all. The road is long. On more specific issues, our aims must be to
improve transport and enhance labour market skills. European transport policy should recognise the distinct
needs of businesses and consumers to ensure that the goods consumers want reach the high street in an
efficient, cost-effective way, while reducing environmental impact. On work skills, if we can promote more
flexibility, security and skills development, we can strike a balance between employment and social security
laws providing greater training opportunities and reducing non-wage labour costs
.
Finally, on the global level, we need to encourage free trade. Protectionism, vis-à-vis third countries or within
the single market, is anathema to competition: it provides no way out of a crisis and must be avoided. Free and
open international markets will allow us to source products from across the globe, stimulate growth in
developing economies and increase consumer choice at home. Above all, trade defence instruments, if proven
justified, must be predictable, certain and transparent. This might seem like a long list, but what we are asking
for is quite simple: a regulatory environment that stimulates competitiveness, innovation and employment.
Through more choice and lower prices, the primary beneficiaries will be consumers and the environment.

Caution
The EU ―2020 Strategy‖ must build on past experience and deliver concrete solutions to promote growth at
both EU and national level.

Case Study-Political Parties, Their Social Ties And Role In Political

Parties are political institutions linking society and state. As such they are of the greatest political relevance to
the relationships explored in parts two and three of the book. Not only are they a revealing reflection of state-
society relationships but in the right circumstances they themselves may help to shape these relationships, that
is, they can constitute an independent not merely a dependent political variable. The great number and variety
of parties make all attempts at definition perilous but the following is a good start. Parties are 'associations
formally organized with the explicit and declared purpose of acquiring and/or maintaining legal control, either
singly or in coalition Party institutional weakness also reflects the political and historical context: long periods
of authoritarian rule have often disrupted party development and have meant for other parties a very close
and debilitating association with the state.

Thirdly, however, it is exacerbated by the effects of globalization'. As Burnell observes, 'the context which
globalization now provides to the development of parties and party systems all around the world, and in new
democracies specifically differs profoundly from the international environment that faced political parties in
the formative days of today‘s long established democracies'. Thus reduced western support for authoritarian
regimes and more positive pressures for democratic opening have meant that rather than representing the
outcome of a gradual internal political process, ‗founding‘ multi-party elections have often arrived at
extremely short notice, encouraging a proliferation of ‗instant‘ and frequently ephemeral new parties. It has
also been argued that the apparent inevitability of processes of economic globalization has diminished scope
for meaningful ideological differences between parties that could have helped them to develop a distinct
identity.

Finally globalization has been associated with striking developments in mass communications. In the west this
has contributed to the change from old style mass membership parties to ‗catch-all‘ or ‗electoral-professional‘
parties, with an increased focus on the personality of the party leader. In many developing countries the impact
has been The answer to this can be obtained if we analyze the period in which a party worker gestates in the
corridors of power. For this a little understanding of power structure in political parties is required. District
level unit is pivotal aggregate around which organizational structure of most political parties (with minor
variation) are build. Each district has a chief, who has a great say as far as the local affairs are concerned. The
second rung leaders and MLA aspirants of the particular district largely operate under the command of district
chief. MLA aspirants have to listen to the district chief‘s diktat and work, rather spend accordingly. It is the
district chief who recommends the name of probable contestants in a particular district to the party supreme or
parliamentary board or politburo or high command. The tasks of district chief mainly focuses on organizing
boisterous protests if the party is in the opposition ranks or stage propaganda campaigns to highlight the
‗achievements‘ of the government if they are ruling. This activity entails great deal of expenditure. District
chief delegates these jobs to the aspirants. They have to mobilize participants, provide food, organize musical
extravagances for entertainment before meet actually begins, and transport them back with some hard cash in
their hand for the effort expended. The state leadership keeps a close tab on activities of the leaders-leaders
who have the monetary wherewithal to spend obviously attracts the attention of the party vanguard.
Questions
1. Explain the main role of party development.
2. Find out the internal political process.

6.5 Summary
The political systems of the Arctic are the results of an historical development that was initiated by the
expansive colonial policies of the European and Euro-American states.
The most important type of political system in the modern world is the nation-state. The world today is
divided territorially into more than one ninety countries.
The government of these territories was generally more coercive than in the European colonies and more
concerned with protection and supervision of the commercial, industrial, and other exploitative interests of
the imperial power.
Political environment has a very important impact on every business operation no matter what its size, its
area of operation.
Commerce has a unique position in society, acting as the link between manufacturers and consumers.

6.6 Keywords
Political systems: The political systems are the results of an historical development that was initiated by the
expansive colonial policies of the European and Euro-American states.
Political environment: The political environment of international business includes any national or
international political factors
Democracy: Democracy is one of the basis form of political system. It refers to a political arrangement in
which the supreme power is vested in the people
Commerce: Commerce has a unique position in society, acting as the link between manufacturers and
consumers. Its overriding aim is to provide consumers with the products they want at the right time, at the
right place and at the best price.

6.7 Self Assessment Questions

1. Political environment has a very important impact on every business operation no matter what its size, its
area of operation.
(a) True (b) False

2. Political Environment dimensions have to be carefully analysed by an international marketer.

(a) True (b) False

3. Democracy is not one of the basis form of political system

(a) True (b) False

4. Parties are political institutions linking society and state.

(a) True (b) False
5. The problem of distributing the goods and services is not closely connected to the problem of production.
(a) True (b) False

6. Which of the following is not a part of the external marketing environment?

(a) Economic environment. (b) Competitive environment.
(c) Technological environment. (d) Political and legal environment.

7. Which of the following statements about company objectives is true?

(a) Company objectives should be stated in vague terms to provide flexibility to lower-level managers.
(b) Company objectives should be set by top management with no input from marketing managers.
(c) A good mission statement can substitute for more specific company objectives.
(d) Company objectives should be compatible with marketing objectives.

8. The economic environment.............................

(a) Has no relationship to the technological environment.
(b) Is not affected by the way all of the parts of the macro-marketing system interact.
(c) Is the same from country to country.
(d) Can change very rapidly.

9. Strategic business units:

(a) Are not treated as separate profit centres.
(b) Are organizational units within a larger company?
(c) Should receive an equal amount of attention and resources.
(d) Should never be dropped or sold.

10. At least 95 percent of party activists work at the

(a) National level (b) State level
(c) Local level (d) International level

6.8 Review Questions

1. Explain the three dimensions of political environment.
2. What are the principles of democracy?
3. Discuss about the political systems.
4. What do you know about the typologies of government?
5. What are the economic systems?
6. Describe the major political objective.
7. Explain the basis of the economic system.
8. Discuss about the socialist economic system.
9. What are the supranational political systems?
10. Briefly discuss the economic system versus economic science.

Answers for Self Assessment Questions

1. (a) 2.(a) 3.(b) 4.(a) 5.(b)
6. (b) 7.(d) 8.(d) 9.(b) 10.(c)
 7
Legal Environment
CONTENTS
Objectives
Introduction
7.1 Legal Environment
7.2 legal systems
7.3 Laws relating to IB
7.4 Market entry laws
7.5 Product liabilities
7.6 Warranties
7.7 Summary
7.8 Keywords
7.9 Self Assessment Questions
7.10 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain Legal Environment
Understand legal systems
Discuss Laws relating to IB
Describe Market entry laws
Understand Product liabilities
Explain Warranties

Introduction
The business community was largely free to organize its legal relations in any way it chose. But increasing
industrialization towards the end of the 19th century had given rise to labor unions, had led to increased
concentrations of economic power in the hands of huge trusts and robber barons, had led to increased injuries
in the workplace and to the demand for greater consumer protection and product liability. The scene was set
for Government to challenge the power of Business. What followed the passage of the 1895 Sherman Anti-
Trust Act was 30-40 years of constitutional wrangling over the power of the federal government to interfere in
the everyday life of businesses. The federal government won that first round just before the Second World
War, and what followed the war was half a century of developing federal administrative agency law. The
pervasiveness of federal regulation is impressive: we all recognize the alphabet soup - EPA, OSHA, the SEC,
NLRB, EEOC even NAFTA. But what has happened very recently - just in the last few years - is a sea change
in thinking about regulation and the federal government is giving ground both to businesses and to state
governments in some areas. It started under President Reagan, picked up speed after the 1994 Congressional
elections, and continues today under the current Bush Administration and the Supreme Court under Chief
Justice William Rehnquist.

We have also witnessed an amazing transformation in business in the last decade as a result of ―globalization‖
that has fundamentally altered the relations between Government and Business. One hundred multinationals
now control 20% of global assets. The sales of GM and Ford are bigger than the GDP of all of sub-Saharan
Africa. Wal-Mart has higher revenues than most East European nations. And corporations are using their
enormous muscle power to gain advantages. Borden Chemicals has had $15 million of corporate tax wiped
off its bill in Louisiana over the past decade in an effort by the state to keep the corporation domiciled there.
In Arkansas, the state spent $10 million to attract Frito Lay to Jonesboro in 1998, at a time when Arkansas is
not exactly the richest state in the country. Walmart pays no property taxes in Ohio. States (read local
people) find themselves begging corporations to set up home in their areas to provide jobs, and to do so, they
will waive property taxes that support the local school system, and lower corporate taxes that support the state
welfare program. If they do not, the corporation just goes elsewhere like Indonesia. Dominant corporations
are increasingly beyond the control of the traditional nation state and democratic institutions. They decide for
themselves where to invest, where to pay tax, and how much to pay. These are interesting times we live in:
the legal environment in which Business operates is changing all around us even as we study this subject.

7.1 Legal Environment

The set of rules and regulations to be abiding by law stimulating and surrounding the business is known as
legal environment. Among the many components of the marketers operating environment, there exists the laws
which governs business activities, which comprises the legal environment. Legal environment refers to the
legal system obtaining in a country. The legal system than refers to the rules and laws that regulates behaviour
of individuals and organisations. Failure to comply with the laws means that penalities will be inflicted by the
courts depending on the seriousness of the offence. The legal system of a country is of immense importance to
IB. A country‘s law regulate business practice, defines the manner in which business transactions are to be
carried out and set down the rights and obligations of those involved in business deals. It takes an added
importance for IB on the ground that since no single uniform international law governing business transactions
exist; hence a study of legal environment helps the marketer to explore the laws of each country individually
and makes him prepared to face the complex varied environments. The basic legal environment of business is
governed by state, country and international laws. This includes laws on what can or can not be produced or
sold, consumer and employee protection laws, tax and other financial laws, as well as many rules and
regulations with regards to business ethic

Did you know?

The world‘s largest economies, 51 are now corporations and only 49 are nation-states. One hundred
multinationals now control 20% of global assets.
7.2 legal systems
There are hundreds of legal systems in the world. At the global level, international law is of great importance,
whether created by the practice of sovereign states or by agreement among them in the form of treaties and
other accords. Some transnational entities such as the European Union have created their own legal structures.
At the national level there are over one eighty sovereign states in the United Nations Organization. Many of
these are federal or confederal, and their constituent parts may well have their own law. But, despite this great
variety, it is important to begin by emphasizing one great division: that into religious and secular legal
systems. Each side of this split holds quite different views as to law, in its source, scope, sanctions, and
function. The source of religious law is the deity, legislating through the prophets. Secular law is made by
human beings, and one of its most famous examples begins with the words ‗We, the people‘. It follows from
this difference in their source that religious laws are perceived to be eternal and immutable, while secular rules
can be changed by their makers. Religious law tells people what to believe as well as how to behave, whereas
secular law deals with our external actions as they affect others. In a religious legal system disputes are usually
adjudicated by an officer of that religion, so the same person is both judge and priest. In a secular system, by
contrast, the office of judge is separate, and is often reinforced by guarantees of judicial independence. A
further difference lies in the enforcement of the laws: in a secular system sanctions are imposed in this world,
and its severest punishment (the death penalty) amounts to forcible removal from the jurisdiction. The
sanctions and rewards of a religious system may also occur in this world, but are often to be felt most keenly in
the next.

Nowadays there are few countries whose legal system is exclusively religious, though some aspire to this. By
contrast a large number have secular systems, and this feature may be built into their legal structure, as in the
1958 French and the 1993 Russian constitutions, or the very first words of the First Amendment to the
American Constitution, which came into force in 1789: ‗Congress shall make no law respecting an
establishment of religion‘. A number of other countries have ‗dual‘ systems in which religious rules govern,
and religious courts adjudicate on, such matters as marriage, divorce, family relationships and possibly family
property, while a secular system with state courts covers the wider fields of public and commercial law. This
was the position in England until the 1850s, and is the case today in Israel, India, and Pakistan, whiles in some
African countries these more private areas are ruled by local ethnic and religious custom. In these dual
jurisdictions, the proportion of human activity governed by one or the other system may well depend on the
stage of economic and political development of the country in question. This leads to a difficult area of
enquiry, of which all that can be said in this context is that in some countries a sophisticated secular system
may well exist, but only on paper. A word should be added here about the place of law in human relations, for
different peoples and different epochs have taken very different views on the matter. For some law is an
aspiration, for others a blight. Some societies are proud to proclaim ‗the rule of law‘ it as fit only for
barbarians and put their trust in the ethical or customary matrix of the community. For instance, this seems to
have been true of China both under the Emperors and in the years of the Cultural Revolution. What follows
deals with positive legal systems, and not with the views of a given time or people as to the place of law within
society. Such matters are proper to a study of comparative ideology, politics or sociology.

7.2.1 Property Rights

One of the most fundamental requirements of a capitalist economic system and one of the most misunderstood
concepts is a strong system of property rights. For decade‘s social critics in the United States and throughout
the Western world have complained that ―property‖ rights too often take precedence over ―human‖ rights, with
the result that people are treated unequally and have unequal opportunities. Inequality exists in any society.
But the purported conflict between property rights and human rights is a mirage. Property rights are human
rights. The definition, allocation, and protection of property rights comprise one of the most complex and
difficult sets of issues that any society has to resolve, but one that must be resolved in some fashion. For the
most part, social critics of ―property‖ rights do not want to abolish those rights. Rather, they want to transfer
them from private ownership to government ownership. Some transfers to public ownership (or control, which
is similar) make an economy more effective. Others make it less effective. The worst outcome by far occurs
when property rights really are abolished. A property right is the exclusive authority to determine how a
resource is used, whether that resource is owned by government or by individuals. Society approves the uses
selected by the holder of the property right with governmental administered force and with social ostracism. If
the resource is owned by the government, the agent who determines its use has to operate under a set of rules
determined, in the United States, by Congress or by executive agencies it has charged with that role. Private
property rights have two other attributes in addition to determining the use of a resource. One is the exclusive
right to the services of the resource. Thus, for example, the owner of an apartment with complete property
rights to the apartment has the right to determine whether to rent it out and, if so, which tenant to rent to; to
live in it himself; or to use it in any other peaceful way. That is the right to determine the use. If the owner
rents out the apartment, he also has the right to all the rental income from the property. That is the right to the
services of the resources (the rent).
Finally, a private property right includes the right to delegate, rent, or sell any portion of the rights by
exchange or gift at whatever price the owner determines (provided someone is willing to pay that price). The
three basic elements of private property are:
(1) Exclusivity of rights to choose the use of a resource
(2) Exclusivity of rights to the services of a resource
(3) Rights to exchange the resource at mutually agreeable terms.

The U.S. Supreme Court has vacillated about this third aspect of property rights. But no matter what words the
justices use to rationalize such decisions, the fact is that such limitations as price controls and restrictions on
the right to sell at mutually agreeable terms are reductions of private property rights. Many economists believe
that most such restrictions on property rights are detrimental to society. Here are some of the reasons why.
Under a private property system the market values of property reflect the preferences and demands of the rest
of society. No matter who the owner is, the use of the resource is influenced by what the rest of the public
thinks is the most valuable use. The reason is that an owner who chooses some other use must forsake that
highest-valued use and the price others would pay him for the resource or for the use of it. This creates an
interesting paradox although property is called ―private,‖ private decisions are based on public, or social,
evaluation. The fundamental purpose of property rights, and their fundamental accomplishment, is that they
eliminate destructive competition for control of economic resources. Well-defined and well-protected property
rights replace competition by violence with competition by peaceful means.

The extent and degree of private property rights fundamentally affect the ways people compete for control of
resources. With more complete private property rights, market exchange values become more influential. The
personal status and personal attributes of people competing for a resource matter less because their influence
can be offset by adjusting the price. In other words, more complete property rights make discrimination more
costly. Consider the case of a black woman who wants to rent an apartment from a white landlord. She is
better able to do so when the landlord has the right to set the rent at whatever level he wants. Even if the
landlord would prefer a white tenant, the black woman can offset her disadvantage by offering a higher rent. A
landlord who takes the white tenant at a lower rent anyway pays for discriminating. But if the government
imposes rent controls that keep the rent below the free-market level, the price the landlord pays to discriminate
falls, possibly to zero. The rent control does not magically reduce the demand for apartments. Instead, it
reduces every potential tenant‘s ability to compete by offering more money. The landlord, now unable to
receive the full money price, will discriminate in favour of tenants whose personal characteristics such as age,
sex, ethnicity, and religion he favours. Now the black woman seeking an apartment cannot offset the
disadvantage of her skin color by offering to pay a higher rent. Competition for apartments is not eliminated
by rent controls. What changes is the ―coinage‖ of competition. The restriction on private property rights
reduces competition based on monetary exchanges for goods and services and increases competition based on
personal characteristics. More generally, weakening private property rights increases the role of personal
characteristics in inducing sellers to discriminate among competing buyers and buyers to discriminate among
sellers. The two extremes in weakened private property rights are socialism and ―commonly owned‖ resources.
Under socialism, government agents those whom the government assigns exercise control over resources. The
rights of these agents to make decisions about the property they control are highly restricted. People who think
they can put the resources to more valuable uses cannot do so by purchasing the rights because the rights are
not for sale at any price. Because socialist managers do not gain when the values of the resources they manage
increase, and do not lose when the values fall, they have little incentive to heed changes in market-revealed
values.

Similarly, common ownership of resources whether in the former Soviet Union or in the United States gives
no one a strong incentive to preserve the resource? A fishery that no one owns, for example, will be
overfished. The reason is that a fisherman who throws back small fish to wait until they grow is unlikely to get
any benefit from his waiting. Instead, some other fisherman will catch the fish. The same holds true for other
common resources whether they be herds of buffalo, oil in the ground, or clean air. All will be overused.
Indeed, a main reason for the spectacular failure of the 1980s and early 1990s economic reforms in the former
Soviet Union is that resources were shifted from ownership by government to de facto common ownership.
How? By making the Soviet government‘s revenues de facto into a common resource. Harvard economist
Jeffrey Sachs, who advised the Soviet government, once pointed out that when Soviet managers of socialist
enterprises were allowed to open their own businesses but still were left as managers of the government‘s
businesses, they siphoned out the profits of the government‘s business into their private corporations.
Thousands of managers doing this caused a large budget deficit for the Soviet government. The resource that
no manager had an incentive to conserve was the Soviet government‘s revenues. Similarly, improperly set
premiums for U.S. deposit insurance gave banks and S&Ls an incentive to make excessively risky loans and to
treat the deposit insurance fund as a ―common‖ resource.

Private property rights to a resource need not be held by a single person. They can be shared, with each person
sharing in a specified fraction of the market value while decisions about uses are made in whatever process the
sharing group deems desirable. A major example of such shared property rights is the corporation. In a limited
liability corporation, shares are specified and the rights to decide how to use the corporation‘s resources are
delegated to its management. Each shareholder has the unrestrained right to sell his or her share. Limited
liability insulates each shareholder‘s wealth from the liabilities of other shareholders, and thereby facilitates
anonymous sale and purchase of shares. In other types of enterprises, especially where each member‘s wealth
will become uniquely dependent on each other member‘s behaviour, property rights in the group endeavour
are usually salable only if existing members approve of the buyer. This is typical for what are often called joint
ventures, ―mutuals,‖ and partnerships. While more complete property rights are preferable to less complete
rights, any system of property rights entails considerable complexity and many issues that are difficult to
resolve. Therefore, a person does not effectively have enforceable private property rights to the quality and
condition of some parcel of air. The inability to cost-effectively monitor and police uses of our resources
means ―our‖ property rights over ―our‖ land are not as extensive and strong as they are over some other
resources such as furniture, shoes, or automobiles. When private property rights are unavailable or too costly
to establish and enforce, substitute means of control are sought. Government authority, expressed by
government agents, is one very common such means. Hence the creation of environmental laws. Depending on
circumstances, certain actions may be considered invasions of privacy, trespass, or torts. The complexities and
varieties of circumstances render impossible a bright-line definition of a person‘s set of property rights with
respect to resources. Similarly, the set of resources over which property rights may be held is not well defined
and demarcated. Ideas, melodies, and procedures, for example, are almost costless to replicate explicitly (near-
zero cost of production) and implicitly (no forsaken other uses of the inputs). Accompanying and conflicting
with the desire to secure private property rights for one is the desire to acquire more wealth by ―taking‖ from
others. This is done by military conquest and by forcible reallocation of rights to resources (also known as
stealing). But such coercion is antithetical to rather than characteristic of a system of private property rights.
Forcible reallocation means that the existing rights have not been adequately protected. Private property rights
do not conflict with human rights. They are human rights. Private property rights are the rights of humans to
use specified goods and to exchange them. Any restraint on private property rights shifts the balance of power
from impersonal attributes toward personal attributes and toward behaviour that political authorities approve.
That is a fundamental reason for preference of a system of strong private property rights: private property
rights protect individual liberty. Private property rights do not conflict with human rights. They are human
rights. Private property rights are the rights of humans to use specified goods and to exchange them. Any
restraint on private property rights shifts the balance of power from impersonal attributes toward personal
attributes and toward behaviour that political authorities approve. That is a fundamental reason for preference
of a system of strong private property rights private property rights protect individual liberty.

7.3 Laws Relating to IB

International business law is a large body of case law, statutory law, administrative law and contract law that
governs international business transactions. It often comprises the law of multiple countries and can therefore
require skilled legal counsel. Many lawyers are skilled in general business law but only a few are skilled and
experienced specifically in international business law. Among the issues that become involved in international
business matters are laws related to treaties and international conventions, such as the World Intellectual
Property Organization. Also, matters relating to import and export, tariffs and international trade regulations
are implicated by international business transactions. International business law attorneys can advise our
business on a wide range of issues before we engage in commerce, often saving thousands of dollars, assuring
against violation of international treaties and conventions and protecting against corrupt practices. The
strategic decision to enter a foreign market presents an executive management team with a challenging set of
critical decisions which often alters dramatically a firm‘s culture and business prospects. Matters such as
understanding thoroughly the served foreign market, its competitive landscape, cultural differences, product
positioning, comparative law issues, and of course, the structure of and the financial valuation of the chosen
business collaboration all come to bear upon a cross border market entry.

The Firm‘s cross border services encompass the entire foreign market entry process, ranging from an initial
onshore market entry to the establishment of a stable and far reaching permanent business operation. The
Firm‘s services derive from its extensive experience with complex international law and business matters as
well as assisting with critical post-acquisition integration matters. The Firm routinely calls upon its extensive
network of contacts in business, government, and technology sectors across the globe. The Firm‘s sensitivity
to and knowledge of various foreign cultures and business practices are of significant value in the
establishment of successful cross border alliances. The Firm has represented U.S and foreign enterprises
engaged in cross border trade in over 40 countries across five continents. Our international services encompass
the entire range of cross border development from market entry to establishment of permanent operations to
post-acquisition transition management. For this purpose, the Firm assists its clients with respect of the
following key aspects of international business operations and strategic investments:

If we plan to do any international business, it is very important that we familiarize our self with international
business law. As much as this concept may sound a whole lot like the natural common sense to many, there are
still so many people that do not make this obvious choice in their preparation for taking on their international
business accounts. International business law will allow us to make sure that we operating our international
business dealings in the appropriate manner. By studying international business law, we will be able to learn
how to properly carry out any type of transaction that we choose to partake in, be it sales, investments,
governmental, or even private international business. Understanding international business law is also very
advantageous if we are planning on doing international business with more than one nation on a regular basis.
Even if we are planning on executing one transaction, but it involves the involvement of several different
nations, we definitely want to familiarize our self with the international business law. Once a business has
reached a certain level of success, it is not at all unnatural that the business will want to venture out and
conduct international business. That seems to be the natural progression to want to expand and grow even
further and conduct international business, but most companies that reach this height and decide that they
would now like to operate on this level, first learn international business law, then they seek out the services of
an attorney that can help them in this effort.

The first thing that one should note about international business law is the fact that it is going to be different in
some way, or sometimes many ways, then the domestic business laws that our business follows. Many find
that conducting international business takes a lot more time and effort that our average domestic transaction to
pursue. we have to be willing and able to take on the responsibilities that come along with partaking in
international business in order to obtain the level of success that we would like to achieve.

The second thing that we need to know about international business law is that its unique set of methods,
procedures, and practices will let we know if this is the ideal route for our business. International business is
vastly different, so as we begin to study international business law, we will be able to determine if this is
something that we would like to pursue on a permanent basis. We will be able to see if international business
is going to be the path in which we want our business to spend time focusing on for the long haul.

Did You Know?

In 1995, the World Trade Organization, a formal international organization to regulate trade, was established.
It is the most important development in the history of international trade law.
7.4 Market Entry Laws
Entry into a market is always in some way possible yet also constrained in some ways except in purely
theoretical descriptions. The two extremes are described by a state-supported absolute monopoly on the one
hand and a market on the other hand where entry has zero cost . In actual practice, barriers to entry are always
present to a new entrant in the very nature of things: some investment is always required, however minimal it
may be. If the market already exists, some unusual effort to convince existing customers to buy, and channels
to carry the goods will be required. The subject of barriers, therefore, in academic or policy contexts, turns on
the concept of maintaining a healthy degree of competition or, in international contexts, fair access to markets.
Economic theory asserts that competition holds down prices and thus contributes to the common good. The
natural tendency of competitors in the market is to limit competition in order to raise profits to a maximum. A
conflict is inherent. Given the great complexity of markets and the presence of all manner of historical,
locational, technical, and other advantages, sorting out ―natural‖ and ―artificial‖ barriers to entry or
international trade is a never-ending activity.

Barriers In To Market Entry Laws

The major categories that translate into barriers are cost, capital, know-how, location, and state power. These
factors are complexly intertwined. To give a few examples: A company with an absolute cost advantage may
have acquired it by investing large amounts of capital, by ownership of patents no one can use except at a high
cost, by being located in a region of extremely low labor cost, or because it is highly subsidized by the state.
Know-how is often based on patents; patent protection is provided under state laws. A current controversy
concerning growing Chinese imports involves very low wage rates in China and Chinese governmental
manipulations of currency to keep costs in the U.S. low. These actions are said to create barriers to entry into
markets by American entrepreneurs who have high labor costs.
Absolute cost advantages enjoyed by the incumbent,
Economies of scale, 3) product differentiation,
The degree of firm concentration,
Capital requirements to enter a market,
Customers' cost of switching,
Access to distribution channels, and
Government policy.

Economies of scale are another form of cost advantage, specifically lower acquisition costs for raw materials
and lower overhead Product differentiation, similarly, represents the consequences of investment in new and
specialized products. Firm concentration is another way of saying that oligarchic structures prevent entry. In
such cases, often, access to distribution channels is also difficult. The cost of switching customers occurs
frequently in modern industrial times in which highly integrated technical products play a role. It is difficult,
for example, to cause a customer to replace a well-established computer system with a new one. The cost
savings must be very high. Anyone who has ever installed a new operating system will understand. Karakaya
also conducted his own survey of executives, concentrating on industrial enterprises. His survey disclosed
similar but slightly different rankings.
The first eight barriers cited by his respondents were :
Absolute cost advantages,
Capital requirements,
Incumbents with superior production processes,
Capital intensity of the market,
Incumbents with proprietary product technology,
 Customer loyalty advantage held by the incumbent,
Incumbents with economies of scale, and
Amount of sunk cost involved in entering the market.

7.5 Product Liabilities

The product liability practice members represent a Canadian and international client base that includes
manufacturers, distributors, wholesalers, retailers, suppliers, end users and their respective insurers. The
members bring a wide range of experience to the practice, including defending class action product liability
claims, major tort claims, single product claims, designing recalls and drafting product warnings. This
experience allows our practitioners to aggressively defend large complex matters, including particularly claims
that may threaten the reputation, or even future prospects, of affected clients. In addition to litigation, our
product liability lawyers counsel clients regarding the preventative measures they should take to avoid liability
claims and provide advice on regulatory compliance, e-commerce and jurisdiction, defective design,
advertising and media, insurance issues, and product labelling and warnings.

Through our national network of offices our practice members defend class action lawsuits across Canada for a
number of diverse industry sectors, such as:
Construction;
Manufacturing plants;
Industrial equipment;
Oil and gas facilities;
Consumer products;
Pet food;
Pharmaceutical;
Medical devices;
Food and beverage;
Aviation; and
Automotive.

Members of the product liability practice have extensive trial and appellate experience and are regularly
retained to act in a wide range of proceedings, from motions and applications to complex trials and appeals at
all levels of provincial and federal courts. Members appear regularly before various regulators, boards,
tribunals, arbitration panels, commissions of inquiry and the governing bodies of a range of institutions and
professional disciplines.

Product Liability Forum

The Product Liability Forum allows the practical application of policy and developments in product liability
and safety law to be considered by leading lawyers in private practice, industry, academia, regulatory bodies
and senior business managers, consumer representatives, public servants, public affairs professionals and other
specialist practitioners. Its role is to analyse and improve the conduct of policy and practice in the spheres of
Product Liability, Product Safety and Mass Torts. The academic credentials of the Product Liability Forum set
it apart from other bodies. It is not designed as a lobby group, nor is it to be identified with any particular
perspective or sector. The Product Liability Forum will share the reputation enjoyed by the British Institute of
International and Comparative Law for independence, even-handedness and academic rigour.
International Product Liability Law
Product liability litigation, specific to more than 50 countries around the globe. These 50-plus countries
represent the major economies and strategically important markets across six continents. This volume offers
succinct summaries of the product liability laws, modern statutes and traditional theories of recovery, insight
into the legal and litigation systems, within which these laws operate, and a risk analysis of product liability
lawsuits by the most respected and experienced product liability lawyers living and working in each of these
countries. Each chapter is written by a senior product liability partner from a law firm in that country. This
desk reference is designed to serve as an essential tool for a select group of Corporate Counsel and legal
specialists, including: Corporate in-house counsel responsible for the management of product liability risks
and lawsuits on a global or regional basis International legal practitioners (solicitor, barrister, avocet,
abogado, etc.) who represent product manufacturers on a regional or global basis

Miscellaneous other legal professionals including in-house counsel in the liability and casualty insurance
arena, law professors specializing in product liability law, as well as a variety of other practitioners and
specialists the unique nature of each country‘s product liability law - to facilitate comparison between
countries on both specific points, as well as broad areas of the law (e.g., a country-by-country survey as to
whether punitive or exemplary damages are permitted). Additionally, each chapter begins with a "Country.

Did You Know?

Advising various pharmaceutical companies on product liability issues, including several successful
judgements obtained between 2003 and 2008 in the context of an €80m dispute.

7.6 Warranties
A product or service warranty is a promise, from a manufacturer or seller, to stand behind the product or
service. It is a statement about the integrity of the product and about the seller‘s commitment to correct
problems should the product or service fail. Product and service warranties have become standard practice in
most U.S. industries, although opinions vary somewhat regarding their impact on sales. But misleading
language in these guarantees has the capacity to spark significant legal troubles for small businesses that run
afoul, however inadvertently, of legal guidelines. Consumers can ask the courts to enforce warranties, whether
they are express, implied, written, verbal, or given in any other way. Federal, state, and local government
entities establish the regulatory basis upon which warranties are judged. The Federal Trade Commission (FTC)
is the ultimate arbiter of warranty law in the United States. The FTC‘s primary tool in monitoring product and
service guarantees is the Magnuson-Moss Consumer Warranty Act.

Due to the public expectation of better road performance accompanied by economic development and
population growth over the past decades, state highway agencies have been under intense pressure for
continuous improvement in the quality and cost efficiency of transportation projects. To meet these challenges,
state highway agencies must seek innovative approaches to deliver highway projects, including outsourcing
some of the agency‘s functions and shifting maintenance responsibilities to contractors. Many states have
implemented alternative contracting methods in project programming and execution to provide lasting and
functional roadways at the optimum life-cycle cost to the public. The performance warranty is one of the
innovative practices that has been declared operational by the Federal Highway Administration since 1996.
Use of warranties in some states has required changes to state legislation and agency regulations. This paper
discusses the laws and regulations needed to successfully incorporate performance warranties into current
contracting practices and avoid litigation. The state of Alabama is used as an example of a state considering
the use of performance warranties. Proposals for laws and regulations will be outlined.
Warranty law
Warranties may be either express or implied. Express warranties are created by affirmative acts of the seller
that are an affirmation of fact or promise made by the seller which relates to the goods and becomes part of the
basis of the bargain. Express warranties can be created when the seller describes the goods or furnishes
samples. Express warranties create strict liability for the seller, so that negligence need not be proven. In
general, express warranties are based on factual statements rather than opinions about the future. An exception
is made when it is a professional opinion which can create a warranty. Under the Uniform Commercial Code
(UCC), which has been adopted in some form by almost all states, liability for breach of warranty is based on
seller status. Manufacturer, distributor, and retailer could all be jointly and severally liable, so that the full
amount of damages could be collected from one or any of them. The distributor and retailer may be able to
escape liability if the manufacturer is not bankrupt. Purchasers, consumers, users, and even bystanders are
entitled to sue in most states for breach of warranty. Implied warranties are part of every UCC contract unless
disclaimed by the seller. Implied warranties are often disclaimed, which is legal as long as the disclaimers are
conspicuous, such as in bold face print. Warranty disclaimers have been held a material alteration, such that
they would not be part of the contract if the term was added in the acceptance. Although a seller cannot
disclaim an express warranty, he can disclaim implied warranties.

Caution
The integrity of the product and about the seller‘s commitment to correct problems should the product or
service fail

Case Study-Contract Law

Big store Furniture Ltd (―Big store‖) is a retailer of household furniture. The company announced its summer
sale on 1 July 2009 by placing the following advertisement in several national daily newspapers in the UK.
Big store‘s Summer Mega sale!
Prices cut by up to 70%!
Special offer! Anyone purchasing an Italia leather three-seater sofa by cash or credit card at the reduced price
of £750 will receive an Italia leather two-seater sofa priced at £500 in the sale absolutely free of charge!
This offer is available at all our stores until 31st August 2009. (The advertisement concluded by listing in
small print all the company‘s stores throughout the country.) On 5 August 2009 Susan took a copy of the
advertisement with her and called at her local big store to inspect the Italia sofas. She spoke to Ben, the Sales
Manager, and told him that she had decided to purchase the sofas subject to first talking this over with her
husband. Ben told Susan that the company only had a limited number of two-seaters so it was agreed that she
would leave £100 in return for his agreement to hold the sofas for 48 hours. Ben told her that he would deduct
the £100 from the purchase price if Susan went ahead with the purchase within that time period. On 7 August
2009 Susan called at the store to purchase the sofas and spoke to Ben who was very apologetic but explained
that his staff had forgotten to reserve the sofas for her. He explained that in any event the two-seaters were
―subject to availability‖ (as stated in various notices around the store), and the company had now run out of
them. Ben also said that ―obviously the two-seaters were a free gift and were subject to availability.‖ He
pointed out that the Italia three-seater sofa was still available but the price had now gone back up to £2,500.
Questions
1. What is mega sale offer?
2. What is the importance‘s of Retailing?

7.7 Summary
 The set of rules and regulations to be abiding by law stimulating and surrounding the business is known as
legal environment.
There are hundreds of legal systems in the world. At the global level, international law is of great
importance, whether created by the practice of sovereign states or by agreement among them in the form
of treaties and other accords.
International business law is a large body of case law, statutory law, administrative law and contract law
that governs international business transactions.
The product liability practice members represent a Canadian and international client base that includes
manufacturers, distributors, wholesalers, retailers, suppliers, end users and their respective insurers.
The Product Liability Forum allows the practical application of policy and developments in product
liability and safety law to be considered by leading lawyers in private practice, industry, academia,
regulatory bodies and senior business managers.

7.8 Keywords
FTC: The Federal Trade Commission is the ultimate arbiter of warranty law in the United States. The FTC's
primary tool in monitoring product and service guarantees is the Magnuson-Moss Consumer Warranty Act.
International business law: International business law is a large body of case law, statutory law,
administrative law and contract law that governs international business transactions. It often comprises the law
of multiple countries and can therefore require skilled legal counsel.
Product liability: The product liability practice members represent a Canadian and international client base
that includes manufacturers, distributors, wholesalers, retailers, suppliers, end users and their respective
insurers.
Legal Environment: The set of rules and regulations to be abiding by law stimulating and surrounding the
business is known as legal environment
Property Rights: One of the most fundamental requirements of a capitalist economic system and one of the
most misunderstood concepts is a strong system of property rights

7.9 Self Assessment Questions

1. The set of rules and regulations to be abiding by law stimulating and surrounding the business is known as
legal environment.
(a) True (b) False

2. The legal system of a country is not of immense importance to IB.

(a) True (b) False

3. The basic legal environment of business is governed by......................

(a) State (b) country
(c) International laws (d) All of these

4. There are hundreds of legal systems in the world. At the global level.
(a) True (b) False

5. International business law is a large body of........................

(a) Case law (b) statutory law
(c) Administrative law (d) All of these
6. The Firm has represented U.S and foreign enterprises engaged in cross border trade in over.............
(a) 50 countries (b) 30 countries
(c) 40 countries (d) 60 countries

7. The major categories that translate into barriers are.......................

(a) Cost (b) capital
(c) Location (d) All of these

8. The product liability practice members represent a Canadian and international client base that
includes.................................................
(a) Manufacturers (b) Wholesalers
(c) Retailers (d) All of these

9. Product liability litigation, specific to more than .......................around the globe

(a) 10 countries (b) 20 countries
(c) 50 countries (d) 60 countries

10. The Federal Trade Commission (FTC) is the ultimate arbiter of warranty law in the United States.
(a) True (b) False

7.10 Review Questions

1. What do you know about the business community?
2. Discuss about the legal environment.
3. Discuss about the international business law.
4. If we plan to do any international business? What should we do?
5. Discuss about the market entry law.
6. What are the barriers in to market entry laws?
7. What do you know about the product liabilities?
8. Explain the international product liability law.
9. What do you understand by legal system?
10. Explain the Property Rights.

Answers for Self Assessment Questions

1. (a) 2.(b) 3.(d) 4.(a) 5.(d)
6. (c) 7.(d) 8.(d) 9.(c) 10.(a)
 8
Global Economic Environment
CONTENTS
Objectives
Introduction
8.1 Decision concerning global manufacturing
8.2 materials management
8.3 Summary
8.4 Keywords
8.5 Self Assessment Questions
8.6 Review Questions

Objectives
After studying this chapter, you will be able to:
Describe the Decision concerning global manufacturing
Explain the materials management

Introduction
The global economy is at a turning point since the U.S. economy, which led global economic growth and
promoted economic development in emerging economies throughout the globalization process, is in the
correction phase. Various environmental factors such as economic environment, socio-cultural environment,
political, technological, demographic and international, affect the business and its working. Out of these
factors economic environment is the most important factor. A global economy is characterized as a world
economy with a unified market for all goods produced across the world. It thus gives domestic producers an
opportunity to expand and raise capacity according to global demands Likewise; it also provides an
opportunity to domestic consumers to choose from a vast array of imported goods. A global economy aims to
rationalise prices of all products globally. A computer or a cup of coffee would cost the same amount of
money in both the USA and India in real terms if identical units of both the goods are purchased. With the
reduction in the level of tariffs and quotas under new WTO (World Trade Organization) restrictions, free flow
of goods between the developed and the developing countries has become a distinct possibility. The
emergence of Trans National Companies or Multi National Companies has been due to the direct impact of
globalization. Globalisation has boosted productivity and capacity of these companies to astronomical highs
because of the stiff competition at the international level. Improvement in technology in the developed
countries such as USA and Japan has permeated to those of the less developed economies of Asia, Africa and
Latin America. This has enabled the people of the developing countries acquire requisite technical skills and
knowledge for operating sophisticated equipments. These skills percolate throughout the economy and
improve the general productivity of the labour in these countries thereby raising the income levels. While a
global economy or globalization has the distinct advantage of raising world productivity and incomes and
bringing about an improvement in the standards of living for all people at a global level, it has the dangerous
side effect of growth with inequality. This has been evidenced in the less developed economies of India, China
and Brazil where the benefits of globalization have not percolated to the lowest levels. This has brought about
a wide divide between the have-nots and the have-lots. A Global Economy also leads to a shifting of jobs from
the developed countries to the Third World Countries as wage rates are much lower here. This allows
companies of the advanced nation to grow exponentially. For example, we might find computer chips
produced in China be exported to USA for designing which may be subsequently used in Japanese computers
supplied across the world. This process is called ―outsourcing‖ and leads to exploitation of workers in Third
World economies where income inequalities already exist. Nonetheless, a global economy may be beneficial
for the world at large. This may result in the economies of the world fighting issues such as global warming,
climate change and environmental degradation collectively and effectively.

8.1 Decision Concerning Global Manufacturing

Accurate inventory records are essential to not only controlling the inventory costs, but also for the analysis of
the cost effectiveness.
Manufacturing Typology
Manufacturing companies differ in the way they meet their demand. Some deliver products to their clients
from finished goods inventories as their production anticipates customers' orders, others, however manufacture
only in response to customers' orders. Time competition being a driving issue requires an emphasis on time
that should not be wasted and is supported by fewer and faster activities being performed. On the other hand,
customization means performing some activities according to the unique requirements of an individual
customer. Competition in terms of time and customization is reflected in the most popular classification of
manufacturing types, namely: make-to-stock (MTS), assembly-to-order (ATO), make-to order (MTO) and
engineer-to-order (ETO).

8.1.1 Manufacturing Planning

Manufacturing strategy requires that clear goals are formed and understood by all members of the
organization. Some plans must be determined in order to reach the projected goals. Strategic goals enable the
formulation of strategic, tactical and operational plans. Tactical and operational plans are closely tied to the
management of the production processes while strategic plans have a considerable impact on the companies‘
future. In the opinion of Hodgetts and Kuratko ―strategic planning can contribute to performance by generating
relevant information, by creating a better understanding of the important environment, and by reducing
uncertainty‖. There is empirical evidence indicating a positive relationship between long-term formal
planning, frequency of plan‘s modifications and the obtained performance level. Research indicates that the
time horizon of plans for high performers is longer than of plans for low performers whilst frequent plan
revisions allow for a timely and thus cost-efficient adaptation of plans and strategies in case of a deviation
between current and anticipated data.

8.1.2 Accuracy of Plant Records

The accuracy of manufacturing records is the basis for maintaining an effective performance level. Lack of
inventory accuracy often results in discrepancies which may ultimately lead to higher than preferred inventory
levels and the costs associated with the quantity and value of inventory stored. Conversely, accurate inventory
records results in lower inventory investment and are the foundation for forecasting, ordering, tracking, vendor
evaluation, and dead stock administration programs. Therefore, accurate inventory records are essential to not
only controlling the inventory costs, but also for the analysis of the cost effectiveness. Product data accuracy
entails data accuracy of the bill of material (BOM) and accuracy of routing file. According to Chen and Wang
―the generic BOM provides an efficient way to describe a large number of variants with limited amount of
data‖

8.1.3 Performance Efficiency of Manufacturing Practices

Efficient production is a primary concern for manufacturing companies. This performance can be affected by
manufacturing technology, labour, capital investment, etc. Traditionally business performance is considered to
be the result of efficiency which means doing all the activities in the process using the least possible resources,
whether these are people, equipment or the inventory. Many researchers have studied and identified variation
in manufacturing processes that reduce product quality and increase the overall costs of operation.
Subsequently, several indices were presented to assess the efficiency of the manufacturing process. Maull et al.
argue that the value of the products/items affects the volume by value of the items being phased-out, and, thus,
the potential scrap costs. General manufacturing scrap embraces the following manufacturing process
characteristics: materials supply scrap level, manufacturing scrap level and final product scrap level. They are
used to assess the performance manufacturing efficiency. The other performance dimension often linked to the
manufacturing efficiency is productivity. It is the ratio of actual output to input over a period of time. Inputs
might include transforming and transformed resources, such as staff and equipment. Outputs are goods and
services In its simplest form, labour productivity could be defined as the hours of work divided by the units of
work accomplished. Another productivity dimension or metric is the productivity of manufacturing facilities.
The equipment productivity metric assesses internal efficiencies and is a measure of the value that is by
equipment in a manufacturing process. In this paper labour and equipment productivity are measured as an
index comparing the current productivity to that of two years prior to the survey response

8.1.4 Manufacturing Strategy

Skinner was the first to observe that a company‘s manufacturing function could do more than simply produce
and ship the products. Manufacturing strategy generally refers to exploiting certain properties of the
manufacturing function as a competitive weapon. In the literature, manufacturing strategy is seen as that part
of the operations management area that focuses on the strategic consequences of investments at the operational
level. Berry, Hill, and Klompmaker speak of the choice of a firm‘s investments in processes and infrastructure
that enable it to make and supply its products to chosen markets. The crucial question preceding any decision
on manufacturing investments is: how do products qualify and how do they win orders in the marketplace? In
addition to price, quality and product features, there is also the matter of delivery speed and dependability,
design, technical support and after-sales support. These are all aspects that influence location decisions on
production and distribution facilities. We will now discuss these issues for companies with international
manufacturing activities.

8.1.5 Global Markets

Publications on manufacturing strategy do not generally deal with concepts associated with international
business. One exception is De Toni, Filippini and Forza, who present a framework for discussing and
classifying a number of problems, decisions and opportunities occurring in the global market. The discussion
is centred on the operation value chain, consisting of four phases: design, purchase, production and
distribution. Three groups of strategic decision categories are distinguished: organization and management;
management systems, and technologies, each of which has implications for the value chain. Only in the
clarification of the category ―organization and management‖ are global issues addressed. The competitive
advantages of configuration and co-ordination are mentioned rather than defined and analysed. A further
observation is that, in fact, only co-ordination is discussed in any detail, specifically in the context of
centralization/de concentration of activities in the global value chain. With reference to the operation value
chain, De Toni et al state that the co-ordination of decentralized units is crucial in obtaining competitive
advantages. These advantages relate more to how the company manages the various activities than where they
are located. For example, coordination among development centres (design phase) allows for an exchange and
increase of know-how, while co-ordination in the purchase of materials makes it possible to obtain economies
of scale. The transfer of experience can also be considered a form of co-ordination. Finally, in the discussion
of technologies, the authors mention that modern information and communication systems enhance greater
integration among phases of the operation value chain and more efficiently operating decentralized units.
In general, the article by De Toni et al is concerned with manufacturing strategy in global markets, although
the framework they propose does not have international features. Second, the discussion addresses co-
ordination rather than configuration issues.

We now turn to a contribution by McGrath and Bequillard in which international features are more easily
discerned. The authors define international manufacturing strategy as the overall plan for how the company
should manufacture products on a worldwide basis to satisfy customer demand. Moreover, they come up with
an extensive number of issues together referred to as the international manufacturing infrastructure. However,
the proposed issues are interrelated and sometimes even (partly) overlapping.
They can be regrouped, and summarized, as follows:
International supply/demand management. The complete order process, including inventory replenishment
and production decisions takes place in an international environment. Customer service, capacity
utilization, and inventory objectives must therefore be balanced internationally. How is this global pipeline
managed? How are customer orders with international multi-plant requirements scheduled? How is
interplant demand scheduled?
Global versus local purchasing. The inputs of a factory, manufactured goods as well as raw materials, can
be procured abroad or from a source close to that factory. What are the trade-offs between global and local
(perhaps just-in-time) purchasing? And how should international procurement take place, centrally or by
specialized plants?
Decomposition of overall manufacturing strategy. The international manufacturing strategy of the
company as a whole must be broken down and translated into specific goals for each of the factories.
Which aspects of manufacturing (for instance, applied production processes) need to be standardized
across international plants? What is needed to maintain consistency within the overall international
manufacturing strategy? How should product development and introduction be organized on a worldwide
basis?

These topics are co-ordination oriented: they refer to the question of how to link or integrate production
facilities. Together, they embody a framework for international co-ordination, which will be applied later on,
in the practical part of the paper. The next section is devoted to international business, in which the
configuration dimension of international manufacturing and location decisions is presented.

Did you know?

The global era of trading in between 1970 and 1999 for materials management increased.

8.2 Materials Management

Every organization, big or small, depends on materials and services from other organizations to varying
extents. These materials and services are obtained through exchange of money and the physical arrangement of
it all is called Materials Management or even Material Management. Various materials used as inputs, such as
raw materials, consumables and spares, are required to be purchased and made available to the shops / users as
and when needed to ensure uninterrupted production. Therefore, efficient management of input materials is of
paramount importance in a business organization for maximizing materials productivity, which ultimately adds
to the profitability of the organization.

8.2.1 Nature and Scope of Materials Management

Nature and scope of materials management are:

Scope of Materials Management

Materials management is typically comprised of four basic activities:
Anticipating materials requirements.
Sourcing and obtaining materials.
Introducing materials into the organization.
Monitoring the status of materials as a current asset.

Functions performed by materials managers include purchasing, inventory control of raw materials and
finished goods, receiving, warehousing, production scheduling, and transportation. The definition of materials
management views the activity as an organizational system with the various functions as interrelated,
interactive, subsystems. The objectives of materials management are to solve materials problems from a total
company viewpoint by coordinating performance of the various materials functions, providing a
communications net work, and controlling materials flow. The specific objectives of materials management
are closely tied to the firm‘s main objectives of achieving an acceptable level of profitability or return on
investment (ROI), and remaining competitive in an increasingly competitive marketplace. The major
objectives of materials management are low costs, high levels of service, quality assurance, low level of tied-
up capital, and support of other functions.
Materials management encompasses a variety of logistics activities. The primary differences between the
process of materials management and that of finished goods distribution are that the items handled in materials
management are incoming finished goods, raw materials, component parts, and subassemblies to be further
processed or sorted before being received by the final customer. The recipient of the materials management
effort is the production or manufacturing group and oilier internal customers, not the final customer. Integral
aspects of materials management include purchasing and procurement, production control, inbound traffic and
transportation, warehousing and storage, management information system (MIS) control, inventory planning
and control, and salvage and scrap disposal. BY MACDONALD CHIBUZOR NWAOHA
Material management is an approach for planning, organizing, and controlling all those activities principally
concerned with the flow of materials into an organization. With this introduction, we can say that material
management requires professional planning and is exclusive in nature. Materials handling section is
responsible for the transport of materials to various departments.
There are four basic traffic activities:
Selecting common or charter carriers and routings for dispatch / shipments as required. Tracing in-bound
shipments of material in short supply as requested by production control or purchasing.
Auditing invoices from carriers and filing claims for refunds of excess charges or for damaged shipments
when required.
Developing techniques to reduce transportation cost. This may involve negotiation with competing
shippers, special studies n selecting the most advantageous plant location for new products, analysis of
tariffs, and negotiation of any number of special arrangements for handling certain traffic.
The activity includes packaging of finished product, labeling and loading of end products in the trades.
 Finally the disposal of scrap and surplus must be done periodically to release the capital locked in those
item

The salient features which highlight the nature of management are as follows:
Management is goal-oriented: Management is not an end in itself. It is a means to achieve certain goals.
Management has no justification to exist without goals. Management goals are called group goals or
organizational goals. The basic goal of management is to ensure efficiency and economy in the utilization
of human, physical and financial resources. The success of management is measured by the extent to
which the established goals one achieved. Thus, management is purposeful.
Management is universal: Management is an essential element of every organised activity irrespective of
the size or type of activity.
Wherever two or more persons are engaged in working for a common goal, management is necessary. All
types of organizations, e.g., family, club, university, government, army, cricket team or business, require
management. Thus, management is a pervasive activity. The fundamental principles of management are
applicable in all areas of organized effort. Managers at all levels perform the same basic functions.
Management is an Integrative Force: The essence of management lies in the coordination of individual
efforts in to a team. Management reconciles the individual goals with organizational goals. As unifying
force, management creates a whole that is more than the sum of individual parts. It integrates human and
other resources.
Management is a Social Process: Management is done by people, through people and for people. It is a
social process because it is concerned with interpersonal relations. Human factor is the most important
element in management. According to Apply, ―Management is the development of people not the direction
of things. A good manager is a leader not a boss. It is the pervasiveness of human element which gives
management its special character as a social process‖.
Management is multidisciplinary: Management has to deal with human behavior under dynamic
conditions. Therefore, it depends upon wide knowledge derived from several disciplines like engineering,
sociology, psychology, economics, anthropology, etc. The vast body of knowledge in management draws
heavily upon other fields of study.
Management is a continuous Process: Management is a dynamic and an on-going process. The cycle of
management continues to operate so long as there is organized action for the achievement of group goals.
Management is Intangible: Management is an unseen or invisible force. It cannot be seen but its presence
can be felt everywhere in the form of results. However, the managers who perform the functions of
management are very much tangible and visible.
Management is an Art as well as Science: It contains a systematic body of theoretical knowledge and it
also involves the practical application of such knowledge. Management is also a discipline involving
specialized training and an ethical code arising out of its social obligations.

8.2.2 Organization of Material Function

The overall objectives of an organization tend to be achieved most efficiently when the organization is
structured by grouping similar activities together. The process begins by dividing the total operation into its
basic functional components. Each component, in turn, is divided into a number of sub-functions. The process
is continued until each individual job encompasses a reasonable number of related tasks. The basic aim is to
have a system that is functionalized, has proper control over the activities and is well co-ordinate. Materials
Management provides an integrated systems approach to the co-ordination of the materials activities and the
control of total material costs. Obviously, the MM organization is derived from its fundamental objectives.
Since Materials management function ranges from receiving the material requisition to placement of purchase
orders and then on the other hand to receiving the material and making it available to the users, a commonly
seen organization of materials management is divided into integrated sections as:

Purchasing
The Purchasing function is a real-time, decision support application designed to help manage the entire
procurement cycle. This cycle includes requesting, competitive bidding, buying, receiving, and inspecting.
Purchasing agents' day-to-day decision-making is fully supported with tools and information on-line to
manage the supplier base and service the purchasing function for the State in a timely and efficient manner.
The participants and tasks in the Purchasing or Competitive Sourcing and Vendor Selection processes,
respectively

Purchasing Financial Functions

The State‘s purchasing policies and strategies are the basis for the system and are incorporated into a policy
hierarchy. The policy hierarchy consists of rules that define how to handle purchasing functions within the
government environment. The most general purchasing policies represent the highest level of the hierarchy,
and each successive level below the general policy defines further levels of detail to the general policy.
As requisitions and purchase orders are processed, the policy hierarchy ensures that the majority of the
purchasing activity is handled automatically and within the required purchasing guidelines. If a particular
situation does not fit the general rules, a purchaser may change the hierarchy default to fit the situation;
however, the system tracks in detail the full procurement process from requisition to payment.

The Purchasing Function Provides:

Full integration with Accounts Payable, Inventory, Budgetary Control, and General Ledger;
Real-time encumbering of funds and confirmation of funds availability;
A centrally-controlled item file that ensures a consistent statewide purchasing history database;
Common policy files for Purchasing and Accounts Payable;
A state-wide central vendor file that is shared by both Purchasing and Accounts Payable;
Funds checking at each decision point (requisition, purchase order, and Accounts Payable);
Buyer tools (on-line buyer split requisition worksheet);
Document preparation for requisitions, purchase orders, and requests for quotes (RFQs) with standard
phrases available to expedite the preparation process;
Flexible purchase order generation to support blanket order purchases, services, and purchases of goods;
An integrated receiving function;
Documentation and tracking of purchase order quotes;
On-line real-time requisition approval and rejection; and
Continuous building of financial data throughout the Purchasing and Accounts Payable functions.

8.2.3 Purchasing Reporting Functions

Reporting within the Purchasing function supports:
Daily purchasing decisions through buyer action reports and buyer exception reports, and
Central management requirements for the Division of Purchase and Contract (P&C) HUB reporting and
recycled goods reporting.

Accounts Payable: The Accounts Payable function provides an effective and efficient cash management
process by automatically calculating the discount due date, discount amount, and payment due date according
to standard vendor terms or system policy, thus maximizing cash availability. For inventory transactions, the
Accounts Payable function recognizes price variances, and automatically posts the adjustments to the General
Ledger. For clarity and completeness, a flow of the Current Receiving Process is also presented in. The
Receiving process contains multiple decision points necessary to bring a receipt to the point where the
Accounts Payable staff are involved and pay for the items.

Administrative: Purchasing administration involves all the tasks associated with the management process, with
emphasis on the development of policies, procedures, controls and the mechanics for coordinating purchasing
operations with those of other departments.

Expediting: This is basically the order follow up activity involving various types of vendor relationship work.

Special Projects (Non Routine): In order to facilitate smooth purchasing in a highly competitive business
environment , purchasing authorities have to keep building the capacity to do better by taking up as special
projects activities such as vendor development, vendor registration, value analysis, market studies, system
studies et.

Routine: Purchasing process or procedure involving routine or every day activities such as dealing specific
purchase file , placing orders, maintaining records of commodities, vendors etc.

8.2.4 Materials Planning

Material requirements planning is based on future sales quantities that exist in the form of planned independent
requirements, sales orders, material reservations, and so on. We can use the material forecast to plan the total
requirements or we can use it as an aid for calculating unplanned additional requirements or the safety stock.
For materials that are produced in-house, the system calculates dependent requirements for assemblies and
components during BOM explosion using the requirements for the finished product. MRP is usually used for
planning finished products and important assemblies and components (A parts).

Master Production Scheduling

In master production scheduling, parts or products that greatly influence company profits or which take up
critical resources are marked as master schedule items and are planned with extra attention. Master schedule
items may be finished products, assemblies, or even raw materials. MPS is a special form of material
requirements planning meaning that this planning run also bases the calculation of requirement quantities on
future sales quantities. Parts that have been given the MRP type ―Master production scheduling‖ are planned
in a separate planning run where they are first planned with no BOM explosion. This means that the MRP
controller can plan the master plan for master schedule items first before the lower BOM levels of dependent
parts are in any way affected. MRP is only started once the MRP controller is satisfied with the master plan for
these MPS parts.

Consumption-Based Planning
Consumption-based planning includes simple and easy-to-use procedures for materials planning which are
used to achieve planned targets with relatively little effort. In consumption-based procedures, historical data is
used as a starting point for planning. Future requirements are forecast using the information from these past
consumption values. This planning procedure is mainly used in areas with no in-house production or for
planning B and C parts.

8.2.5 Quality Control

The quality of the product manufactured by the organization depends upon the quality of the materials used to
manufacture that product. It is a very important and necessary Materials Management function of materials
management to purchase the right quality of materials. The inspection, quality control, simplification,
specification, and standardization are the activities which are to be followed for the measurement of quality of
the materials. The quality assurance is decided by inspection and checking. The various properties of materials
as per their specifications and standard. The size and dimensional measurements within tolerance limits
assures the interchange ability and reliability of components and parts. Quality is largely determined by
consumer taste and liking. The market is under buyer‘s control. Customer decides the quality of the product.
Material quality control aims at delivering product at higher and higher quality at lower cost. The product will
be specified not only bytes dimensional accuracy but its quality standards, durability and dependability, high-
performance, reliability and aesthetic value. Each of this factor aids cost to the product. In order to achieve
high quality, the materials input to the product should be of high quality, which will have higher cost. The
performance decides the reliability, which is obtained through high quality production. The performance is
checked by quality inspection and accuracy. This also aids cost to the product. The quality of the materials also
decides the selection of vendors and the relationship between buyers and suppliers. The specifications, size
and quality of materials must be referred and if possible the standard should be followed for specifications and
sizes. The types of tests required for assuring the quality should be specified and conducted to establish the
standards.

8.2.6 Quality Control in Business

Quality control, ensuring products are of high and consistent value is a major part of materials management.
The creation of material standards, inspections, and a returns process is a primary responsibility of employees
at a company. All parts and materials must be tested to ensure that a specific level of quality is met. This is
typically completed before a payment is issued to a supplier, ensuring that the supplier has met the conditions
of their contract.

8.2.7 Quality Control Process

Our division of the quality control process into three separate processes ensures that specialized expertise is
applied to each stage of our operation. This system also provides the redundancy necessary to prevent any
quality problem from evading detection.

8.2.8 Incoming Quality Control

It is the job of the IQC process to conduct inspections and handle quality problem before the assembly process
starts.

Specific Tasks Of IQC Include:

Perform approved vendor list check;
Evaluate supplier quality records;
Perform sampling of incoming materials based on the MIL-STD-105E standard;
Assess dimension, visual and functional inspection of material samples;
Monitor quality control chart of inspected properties and alert engineering staff of significant deviations;
Continuously enhance the IQC process.

8.2.9 Process Quality Control

Our IPQC process governs the quality systems during the assembly process, to detect and handle problems that
may arise as a result of assembly.

Specific Tasks Of IPQC Include:

Perform inspections on assembled and in-process materials according to IPC-A-610D standards;
 Conduct in-line automated and manual inspections (see our Testing Equipment page for details);
Utilize statistical control techniques and watch for significant deviations;
Perform in-process audits to ensure processes are up to standard, and to identify factors needing
improvement.

8.2.10 Outgoing Quality Assurance

OQA is the last process before products ship to customers, and hence is every important to ensure our
shipment is defect-free. Numerous redundancies with IQC and IPQC are performed here to ensure the validity
of previous processes.

Specific tasks of OQA include:

Perform visual and functional inspection;
Verify first-article inspection;
Repeat approved vendor list check;
Apply sampling based on the MIL-STD-105E standard;
Conduct reliability testing;
Submit failure analysis reports and alert engineering staff.

Caution
It should be noted that the conceptual framework itself does not designate features specific to globally
operating companies.

Did You Know?

The Board of Industrial and Financial Reconstruction (BIFR) came into existence in 1987.

Case Study-Customer Centric Materials Management -A Case Study of ECIL

Electronics Corporation of India Ltd. (ECIL) is a Public Enterprise under the Department of Atomic Energy
established with the purpose of supporting India‘s Nuclear Power Programmer and helps the country achieve
self-reliance in professional electronics. Over the years the company evolved itself into a multi-product and
multi-disciplinary organization with focus on Computers, Control Systems and Communications. In the post-
liberalization scenario, the compulsions of global competition on local soil guided its Vision, Mission and
Objectives as follows:

Vision
To help the country achieve self-reliance in Strategic Electronics.

Mission
To strengthen the status as a valued national asset in the area of Strategic Electronics meeting the requirements
of Atomic Energy, Defence, Space, Civil Aviation, Security and such other sectors of strategic importance.

Objectives
To strengthen the technology base and thereby the capability to combat technology denials
To promote creativity and innovation and realize higher levels of operational efficiency through actionable
learning
To attain and maintain world-class competitiveness by pursuing global benchmarks
To lay down plans and programmers for effective succession at senior management level
 To consistently ensure a customer-centric organizational culture
To achieve steady growth in business performance and generate reasonable internal resources
The operations are therefore focused towards meeting the requirements of Strategic Electronics in the Nuclear,
Defence, Security and such other sectors of National Importance.

The Crisis
The post-liberalization period of 90s was characterized by intense competition from both the MNCs and
private sector. The impact of the globalization process and the sanctions in the wake of Pokhran-11
experiments has brought the company to the brink of sickness in 1998-99. ECIL suffered a loss of $500 crore
in 1997-98 and a substantial loss of $600crore in 1998-99. The net worth of the company was badly eroded
and ECIL had to be reported to BIFR.

The Initiatives in Materials Management

The company had to initiate a number of innovative measurers to tide over the crisis. Material costs
constituting around 55-60 % of the total cost, it became imperative for the company to introduce a host of
innovative practices in the area of materials management. These initiatives need to be in consonance with the
nature of global electronics business characterized by high rate of obsolescence, falling prices, high quality
inputs and global sourcing. More over the business environment of ECIL is different even from other PSUs as
there is no assured market, customer-driven requirements and threat of denials. It is against this background
that the entire supply chain is addressed and briefed below are the salient aspects of this process.

Supplier Communication
It was ensured that the requirements of the customers of ECIL are clearly communicated to the suppliers, thus
making the latter jointly responsible for ensuring customer satisfaction. This is done through constant touch
with the suppliers to indicate the priorities through written and verbal means and by hosting vendor meets
Vendor Development and Quality Assurance. The suppliers were continuously provided all the support during
product development and engineering, prototype testing, evaluation, qualification and guidance in the
implementation of ISO 9000 Quality Management system and other industry standards and practices.
Emphasis was on prevention rather than detection and correction. Suppliers are encouraged to imbibe the
culture of ‗Ownership of Quality‘ as?

Inventory Control
The scheduling of placement of orders and receipt of materials was streamlined to ensure efficient inventory
management covering such requirements as timely availability of material, minimization of waste and surplus
due to obsolescence etc.

Negotiations and Payments

Suppliers are involved right from the tender stage to offer the most competitive terms to the customers in terms
of quality, cost and delivery. Mutually beneficial payment terms are negotiated and strictly adhered to.

Implementation of IT
All the processes involved in Integrated Materials Management are fully computerized for speedy disposal of
material requisitions, resulting in substantial reductions in lead times across various operations.

The Results
These simple initiatives were implemented effectively resulting in incredible results that culminated in the
historic turnaround of the company that brought wide recognition and national awards like SCOPE award for
Outstanding Performance and Contribution to Public Sector Management. Specifically the following
achievements were realized.

Between 1998-99 and 2002-03

Turnover shot up from $50 crore to $100 crore
Profitability reversed from a loss of $ 60 crore to a profit of $ 130 crore
Net worth increased from $7 crore to $60 crore
Loans Outstanding and Statutory Outstanding became nil
Inventory levels and Sundry Debtors demonstrated efficient Working Capital Management
Substantial cost Reductions were realized through negotiations and improved quality levels across various
processes
Procurement lead-times reduced substantially from about 60 days to 30 days Customer Satisfaction
Index improved phenomenally from 66% to 95%
MoU rating of ‘Excellent‘ has been achieved and is maintained
Image of the company enhanced remarkably.

Future Plans
The multi-disciplinary competencies and capabilities of ECIL coupled with the Strategic Sectors it has chosen,
is bound to give the company a competitive advantage to succeed in the national market but explore avenues in
the international market. Many of its products have been identified for export promotion and the brilliant
performance of the Electronic Voting Machines in the recent general elections established its export
worthiness with many countries evincing interest in the product. While all the processes under materials
management are fully computerized, plans are underway to install a fully IT enabled Supply Chain
Management including e-procurement. The company is fully aware of the competitive global environment
surrounding it in the high technology electronics and is focusing continuously on enhancing its technology
base and enriching its skill base to strengthen its status as a valued national asset.

Question
Briefly discuss about initiatives in materials management.
Explain the inventory control.

8.3 Summary
A global economy is characterized as a world economy with a unified market for all goods produced
across the world
Manufacturing companies differ in the way they meet their demand. Some deliver products to their clients
from finished goods inventories as their production anticipates customers' orders, others, however
manufacture only in response to customers' orders
Materials management is a total concept having its definite organization to plan and control all types of
materials, its supply, and its flow from raw stage to finished stage.
Integrated waste management is a systematic approach that uses multiple methods to control and dispose
of waste
Just-in-Time (JIT) manufacturing is a philosophy rather than a technique. By eliminating all waste and
seeking continuous improvement
Inventory generally refers to the materials in stock. It is also called the idle resource of an enterprise.
8.4 Keywords
Global economy: It has the distinct advantage of raising world productivity and incomes and bringing about an
improvement in the standards of living for all people at a global level, it has the dangerous side effect of
growth with inequality
Manufacturing: It is the production of goods for use or sale using labour and machines, tools, chemical and
biological processing, or formulation.
Materials management: It can deal with campus planning and building design for the movement of materials,
or with logistics that deal with the tangible components of a supply chain
Productive efficiency: It occurs when the economy is utilizing all of its resources efficiently.
Purchasing: It refers to a business or organization attempting to acquiring goods or services to accomplish the
goals of its enterprise.

8.5 Self Assessment Questions

1. Which of the following information forms available to the marketing manager can usually be accessed more
quickly and cheaply than other information sources?
(a).Marketing intelligence (b).Marketing research
(c).Customer profiles (d).Internal databases

2. All of the following are considered to be drawbacks of local marketing EXCEPT:

(a).it can drive up manufacturing and marketing costs by reducing economies of scale.
(b).it can create logistical problems when the company tries to meet varied requirements.
(c).it can attract unwanted competition.
(d).it can dilute the brand‘s overall image.

3. Cognitive dissonance occurs in which stage of the buyer decision process model?
(a).Need recognition (b).Information search
(c).Evaluation of alternatives (d).Post purchase behaviour

4. That the company that overlooks new and better ways to do things will eventually lose customers to another
company that has found a better way of serving customer needs is a major tenet of:
(a).innovative marketing. (b).consumer-oriented marketing.
(c).value marketing. (d).sense-of-mission marketing.

5. The biggest or greatest amount of involvement in a foreign market comes through which of the following?
(a).Exporting (b).Joint venturing
(c).Licensing (d).Direct investment

6. A is a good offered either free or at low cost as an incentive to buy a product.

(a).patronage reward (b).spiff
(c).price pack (d).premium

7. Setting call objectives is done during which of the following stages of the selling process?
(a).Prospecting (b).Preapproach
(c).Approach (d).Handling objections
8. Pricing to cover variable costs and some fixed costs, as in the case of some automobile distributorships that
sell below total costs, is typical of which of the following pricing objectives?
(a).Current profit maximization (b).Product quality leadership
(c).Market share leadership (d).Survival

[Link] determining sales force size, when a company groups accounts into different size classes and then
determines the number of salespeople needed to call on them the desired number of times, it is called the:
(a).key-size approach. (b).work-load approach.
(c).product-need approach. (d).call-service approach.

10. are products bought by individuals and organizations for further processing or for use in conducting a
business?
(a).Consumer products (b).Services
(c).Industrial products (d).Specialty products

8.6 Review Questions

1. What are economic environment?
2. Define the global manufacturing.
3. What is the manufacturing strategy?
4. Explain about global markets.
5. Discuss to nature and scope of materials management.
6. Explain the organization of material function.
7. What is quality control?
8. Explain the quality control in business.
9. Explain the process quality control.
10. Write short notes on:
(a) Master production scheduling
(b) Purchasing reporting functions

Answers for Self Assessment Questions

1. (d) 2.(c) 3.(d) 4.(a) 5.(d)
6. (d) 7.(b) 8.(d) 9.(b) 10.(c)
 9
Global Supply Chains
CONTENTS
Objectives
Introduction
9.1 Managing global supply chains
9.2 product and branding decisions
9.3 Summary
9.4 Keywords
9.5 Self Assessment Questions
9.6 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain about managing global supply chains
Describe the product and branding decisions

Introduction
The existing trend toward the globalization of supply chains renders many managers confused as to what
globalization really earnings. Often, the term is little more than a battlefield of semantics, of little value to the
individual tasked with managing value creation and cost reduction processes in the movement of goods.
Obviously, globalization infers the cross-border movement of goods and the emergence of global competitors
and opportunities across competing supply chains within an industry. Managers, however, often question the
differences between a global market and a single market, in that many of the same conditions exist in both.
Although this may be true, the complexities of cross-border operations are exponentially greater than in a
single country, and the ability to compete in the global environment often depends on understanding the
subtleties that emerge only in cross border trade that is, in GSCM. The fierce competition in today‘s markets is
led by advances in industrial technology, increased globalization of demand and supply sources, marvellous
improvements in information availability, plentiful venture capital, and creative business designs (Bovet and
Sheffi 1998). In highly competitive markets, the simple pursuit of market share is no longer sufficient to
ensure profitability, and thus, companies focus on redefining their competitive space or profit zone (Bovet and
Sheffi 1998). For example, companies pursue cooperative relationships to capture lifetime customer share (as
opposed to mass market share) through systematic development and management of cooperative and
collaborative partnerships (Gruen 1997). Markets have been changed by factors such as power shifts from
corporate buyers to end users, the requirement for mass customization, emergence of global consumer
segments, time- and quality-based competition, improvements in communications and information technology,
increasing knowledge intensity, and changing government policies. Power in a broad spectrum of supply
chains has shifted downstream toward the customer or end user (LaLonde 1997), and as a result, customer
satisfaction becomes the ultimate goal of a company. As the customer increasingly is in charge in the
marketplace, interim cooperation is critical to satisfy customers. Manufacturers and their intermediaries must
be nimble and quick or face the prospect of losing market share, and thus, relationships and predictable
performance become very important in a supply chain. Mass customization provides a tremendous increase in
variety without sacrificing efficiency, effectiveness, or low costs (Pine 1993). In other words, customers want
low cost with high levels of service and customization with availability (Bovet and Sheffi 1998). Pine (1993),
therefore, argues that mass customization can be achieved only through the committed involvement of
employees, suppliers, distributors, retailers, and end customers. Firms are competing in a global economy, and
thus, the unit of business analysis is the world, not just a country or region. The communications revolution
and globalization of consumer culture will not tolerate hand-me-down designs or excessive delivery times
(Bovet and Sheffi 1998). In this context, Kotler (1997) states, ―As firms globalize, they realize that no matter
how large they are, they lack the total resources and requisites for success. Viewing the complete supply chain
for producing value, they recognize the necessity of partnering with other organizations‖

Time- and quality-based competition focuses on eliminating waste in the form of time, effort, defective units,
and inventory in manufacturing-distribution systems (Larson and Lusch 1990; Schonberger and El-Ansary
1984; Schultz 1985). In addition, there has been a significant trend to emphasize quality, not only in the
production of products or services but also throughout all areas in a company. LaLonde and Powers (1993)
suggest that the most profound and influential changes that directly affect companies are information
technology and communications. With the advent of modern computers and communications, monolithic
companies, which had become highly bureaucratic, started eroding. Fast communication that links all members
of a company decreased the need for multiple

9.1 Managing Global Supply Chains

Supply chains are increasingly global and complex, as companies aspire to support a variety of strategies, such
as entering new markets, increasing speed to customers, and lowering costs. In this survey, we asked
operations and other senior executives from around the world about their companies‘ supply chain strategies,
the factors that influence those strategies, and the ways their companies act on these factors. We also explored
how well executives think their companies are meeting their goals, how they manage their supply chains, and
the challenges involved in running a global supply chain. The results show that supply chain risk is rising
sharply. Executives point to the greater complexity of products and services, higher energy prices, and
increasing financial volatility as top factors influencing their supply chain strategies. Relatively few
respondents, however, say that their companies are translating the importance they place on these factors into
corporate action. Nor do executives express confidence that their companies are meeting the top strategic
goals: reducing costs, improving customer service, and getting products to market faster. In addition, for all the
public attention paid to environmental concerns, including global warming, executives report that such issues
have little influence on supply chain strategies. What‘s more, our results suggest that most companies tend
toward centralisation, not local management, in running their supply chains and that this tendency has
increased in recent years.

9.1.1 Forces at work

More than three-quarters of the respondents say the degree of supply chain risk their companies face has
increased in the past five years, up from almost two-thirds two years ago. Executives in general-management
positions are slightly less likely to say it had increased than executives in operational roles (74 per cent
compared with 86 per cent), perhaps because operations executives are closer to supply chain processes and
the day-to-day challenges of managing them. The increasing complexity of products and services tops the list
of global factors that executives say most influence their supply chain strategies. That focus seems persistent:
seven in ten respondents who choose this factor say it was also important five years ago. By contrast, among
the global executives who say that the rising price of energy is one of the most influential factors today, fully
three-quarters indicate that it wasn‘t five years ago hardly surprising, given the recent spike in oil prices.
Despite the importance respondents place on these trends, relatively few say that their companies are acting on
them. For example, only 35 and 16 per cent of the executives say that their companies have acted in response
to the increasing complexity of products and services and to rising energy prices, respectively.
The most common responses to the trends influencing supply chain strategies are increasing the efficiency of
supply chain processes (71 per cent of executives), actively managing risks along the supply chain (56 per
cent), and sourcing more inputs from low-cost countries (47 per cent). The degree of attention paid to supply
chain processes seems prudent, as process improvements are an effective way to manage increasing
complexity.

9.1.2 Supply chain priorities

Reducing costs is even more important for companies in developing markets; perhaps companies in countries
such as China are trying to anticipate the effect of rising costs (including labour costs and appreciating
currencies) on the competitive advantages they currently enjoy as low-cost manufacturers. Respondents in
areas other than operations are upward of twice as likely as operations executives to say that getting new
products to market faster is a top priority. The disparity may reflect functional differences between executives
such as marketers, who tend to focus on targets like margins and market share (where speed to market is
essential), and operations executives, who generally stress costs and customer service. Executives, whatever
the goals of their companies, say that those companies are not meeting them well. Indeed, fewer than half of
the executives in our survey indicate that their companies completely or almost completely meet any strategic
goal involving supply chains.

9.1.3 How Companies Manage Global Supply Chains

Although a majority of the respondents say that their companies manage both sourcing and logistics outside
the home country, these activities are run by corporate employees, not vendors. When the respondents were
asked how supply chain management has changed over the past five years, 56 per cent of those at large
companies (with annual revenues greater than $1 billion) say that it has become more centralised. This finding
is consistent with our experience: when possible, companies seek to maximise economies of scale in the
supply chain, and many companies treat it as a shared utility of the broader organisation not only to take
advantage of synergies, but also to strengthen their operational expertise. The challenges that respondents
associate with managing supply chain talent reflect talent-related concerns that executives have expressed in
other research. The top-rated challenge is the ability to share knowledge effectively across different
manufacturing and sourcing locations. When executives are asked to reflect on the greatest management
challenge their companies face as supply chains become more global, they highlight the total resources
required, followed by the recruitment and retention of sufficient local talent and the integration of the IT
systems of companies and their vendors. Such challenges reflect perennial concerns; talent, for example, was
the top supply chain risk two years ago. Creating transparency across a company‘s supply chain involves
thorny challenges as well, both technological (multiple vendors processing a single transaction, for example)
and risk based (such as trade-offs in how much visibility a company‘s vendors should have into proprietary IT
systems that may represent a source of its competitive advantage).
9.1.4 Looking Ahead
Against a backdrop of sharply rising supply chain risk, including the prospect of higher energy prices,
companies are likely to take a harder look at their manufacturing and supply footprints. In some cases,
companies could even consider localising elements of their operations now managed in remote including
offshore locations. Moreover, our experience suggests that successful cross-functional collaboration will
increasingly differentiate companies that meet the full range of their strategic goals from those that do not.
Companies that can ensure closer partnerships between operations and groups such as sales and marketing, for
example, will be able to respond more quickly to changing trends and will have the edge in turning strategic
trade-offs (say, speed versus cost) into sources of advantage. Finally, while environmental concerns,
particularly a company‘s carbon footprint, are of increasing interest to consumers and executives, they are not
yet major strategic considerations for supply chains. That will probably change. Trade-offs between emissions
and profitability may lead companies to explore new kinds of supplier relationships, including the transfer of
best practices to supply chain partners.

Did you know?

In the 1980s, the term Supply Chain Management (SCM) was developed to express the need to integrate the
key business processes, from end user through original suppliers

9.2 Product and Branding Decisions

9.2.1 International Marketing
International Marketing mix
The international marketing mix consists of 4 Ps viz.
Product
Price
Place
Promotion

1. Product & Branding Decision

A product is something both tangible and intangible. The tangible products can be described in terms of
physical attributes like shape, dimension, components, form, colour etc. The intangible products include
various services like merchant banking, mutual funds, insurance, consultancy, air travel etc. However,
sometimes both tangibles and intangible are combined to give a total product. The global markets must see the
total product which includes tangible and intangible.
The study of product in the international market includes:
1: Product Development
2: Product Life-cycle
3: Branding Decisions
4: Packaging Decisions

Market Segmentation: The main purpose of the market segmentation is to satisfy the customer needs more
precisely. Market segmentation helps to enter the foreign markets in a phased manner

Product Positioning: Product positioning attempts to occupy an appealing space in a consumer‘s mind in
relation to the space occupied by other competitive products.

Product Adoption: Product to be adopted in a foreign market must demonstrate five factors.
They are:
Relative advantage over existing alternatives.
Products cleanliness and sanitation are accepted in rich countries.
Compatible with local customs and habits:
Observes: If the product is used publicly the others can observe the product.
Complexity: If the product‘s qualities are difficult to understand then other product has slow market
acceptance.

2. Product Life Cycle

International Product Life Cycle
International product life cycle model is based on empirical actual pattern of trade. I this model explains the
relationship among the product life cycle trade and investment.

International product life cycle model explains:

(1) High-income, mass-consumption countries initially export, and later import the product as they lose their
export markets.
(2) Later, the other advanced countries shift from an importing country to an exporting country.
(3) After some time, even the less developed countries shift from the status of importing country.

New products are initially introduced in high-income countries/markets as the latter offer high potential
demand
. Initially products are produced where they are sold.
Mostly product inventions take place in high-income countries.
Entrepreneurs in middle-income countries take the advantage of low cost of labour and other factors of
production in the production of the new products.
Market stabilises when the product reaches maturity, the design, technology and markets stabilise.
Production from low income countries displaces the production of the high income countries due to the
cost advantage.
Companies of high-income countries shift to low-income countries to take the advantage of low cost
factors of production.
These companies gain the ownership and control over the production of low-income countries.
The producers of low-income countries produce and sell higher volumes due to the low cost of production
and price. Further, these producers also export in higher volumes due to heavy demand, consequent upon
low cost of factors.
Low-income countries export to high-income countries and compete with the industries of high-income
countries that enjoyed monopoly at the initial stage of the cycle.
With this stage, cycle completes its turn. Textiles are an example of this cycle. This product has gone
through the complete cycle for the investing country (UK), other developed countries and finally the
developing countries. Similarly, electronics industry passed through all the stages. This product shifted
from USA to Japan to Korea to India.

Stages of International Product Life Cycle

Stages of international product life cycle include:
Stage Zero: Local Innovation: The product in this stage is a familiar product in the local market. Product
innovations take place mostly due to the changing wants of the local people .
Stage 1: Overseas Innovation: After a product is successful in the domestic market, the producer desires
exporting it to the foreign markets due to excess production compared to its demand in the domestic country.
Stage 2: Maturity: The development of the product reaches the peak stage even in foreign markets. The
producer modifies it and develops it based on taste and preference of the customers in foreign markets. The
producer exports the products even to less developed countries in this stage.
Stage 3: Worldwide Imitation: The local manufacturers in various foreign countries start to imitate the popular
foreign products. They modify those products slightly based on the local needs and produce the same at less
cost and sell them at cheaper prices.
Stage 4: Reversal: Competitive advantage of innovative or original manufacturer disappear sat this1stage as
producers in many foreign countries imitate the product, develop it further and produce it at less cost. This
stage also results in product standardisation and competitive disadvantage. The product at this stage does not
have to be either capital intensive or technology intensive, but it becomes labour intensive - a strong
competitive advantage possessed by developing countries.

9.2.2 International Branding Decision

A trademark in USA according to the Lauham Trademark Act, 1947, ―includes any word, name, symbol or
device or any combination thereof adopted and used by manufacturer or merchant to identify his goods, and
distinguish them from those manufactured or sold by others.‖

Branding Decision
Generic or No Brand: The first decision regarding branding is whether to brand or not. The trend towards non-
branding products is increasing world-wide. In fact, the scales of non-branded products is increasing
particularly in retail stores. The increase in demand for non-brand products is due to the availability of these
products at fewer prices. In addition, non-brand products are available - In a number of sizes and models.

Branded Products: Most of the global companies go for branding. The customers of different countries find it
easy to identify the branded products and they are aware of the ingredients and utility of the branded products.
For example" the customers throughout the world are aware of the products of Colgate-Palmolive, Pepsi or
Coke etc. The global company can get better price and profits through branded products.

Private Brand: Most of the exporting companies go for dealer‘s brand or private brand. The advantages of
private branding include: easy in giving dealer‘s acceptance, possibility of getting larger market share, less
promotional expenses etc. Private branding is more appropriate for the small companies who export to various
foreign countries.

Manufacturer’s Brand: The manufacturer sells the products in his own brand. The advantages of
manufacturer‘s brand include: better control of products and features, better price due to more price in
electricity, retention of brand loyalty and better bargaining power.

Single Brand: The global company go for a single brand for all its exports to the same country (or Single
Brand): The advantages of single brand in single market include: better impact on marketing, permittmg more
focussed marketing; brand receives full attention, reduction in cost of promotion etc.

Multiple Brands: The marketing conditions and the features of the customers vary widely from one region to
the other, in the same country. Therefore, the exporter uses multiple branding decisions in such cases. Multiple
branding enables the exporter to meet the needs of all segments. The other advantages of multiple branding
include: creation of excitement among employees, gaining of more shelf space, avoidance of negative
connotation of existing brand etc.
Local Brands: Global companies have started widely using the local brands in order to give the impression of
cultural compatibility of the local market. The advantages of local branding include: elimination of difficulty
in pronunciation, elimination of negative connotations, avoidance of taxation on international brand etc.
World Wide Brand/Global Brand: Exporters normally go for global brand. The advantages of global brand
include: reduction of advertising costs, elimination of brand confusion, better marketing impact and focus,
status for prestigious brands and for well-known designs etc.

9.2.3 Strategies for Branding Decisions

If the product has production consistency and salient attributes which can be differentiated, then it would
be better for the manufacturer to go for branding otherwise better to sell the product without any brand.
If the manufacturer is least dependent person, it would be feasible to go for the manufacturer‘s own brand
otherwise; it would be feasible to go for a private brand.
If there are inter market differences like demographic and psychological, it would be feasible for having a
local brand. Otherwise, it would be better to go for global brand.
If there are inter market differences like demographic and psychological, it would be feasible for
multiband. Otherwise it would be feasible to go for single brand.

Caution
Brands should be seen as more than the difference between the actual cost of a product and its selling price
they represent the sum of all valuable qualities of a product to the consumer

Did You Know?

The oldest generic Brand, which is in continuous use in India, since Vedic period, 9000–10000 years ago is
known as 'Chyawanprash‘.

Case Study-Supply chain whirl

While the 2001 global overhaul of Whirlpool's supply chain systems remains a work in progress today,
managers say its success to date is encouraging the remaining systems work The supply chain at Whirlpool in
2000 was broken. Indeed, a manager there at the time quipped that among the four major appliance makers in
the U.S., Whirlpool ranked fifth in delivery performance. ―We had too much inventory, too little inventory,
wrong inventory, right inventory/wrong place, any combination of those things,‖ says J.B. Hoyt, who was then
supply chain project director. He says a sales vice president approached him one day and said he'd accept even
worse performance from supply systems if they would just be consistent rather than wildly bouncing back and
forth between good and poor production and shipping plans. So in 2001, Whirlpool embarked on a
multiproject global overhaul of its supply chain systems. The megaprojects remain a work in progress today,
with a number of systems yet to be rolled out and some major technical issues to be resolved. But managers at
Whirlpool say its success to date - including huge improvements in customer service and reduced supply chain
costs - is providing the psychological and financial impetus to drive the remaining systems work.

Get the latest IT news on the Australian government and businesses in Computerworld's Business &
Government newsletter Whirlpool CIO Esat Sezer says that by 2000, the company had grown by acquisition
and geographic expansion to the point that old systems, stitched together by spreadsheets and manual
procedures, could not cope with the exploding complexity. ―Our supply chain was becoming a competitive
disadvantage for us,‖ he says. Availability the percentage of time a product is in the right place at the right
time -- was an unacceptably low 83 percent, even as inventories remained too high overall. The home-grown
supply systems were primitive and not well integrated with the company's SAP ERP system, which had been
installed in 1999, or with a legacy production scheduling system, Sezer says. And they were not integrated
with the systems of major wholesale customers or suppliers of parts and materials. ―The plans we were
creating were not linking back into reality,‖ he says. In particular, Sezer says, supply chain systems were not
fine-grained enough, nor were they very good at juggling priorities and constraints except through slow and
cumbersome manual methods. Often, they would optimize locally -- a single product line at one location, for
example -- but not for the supply chain as a whole.

Here's what Whirlpool was using for its North American supply chain in 2000:
A home-grown production scheduling system, the Whirlpool Manufacturing Control System (WMCS),
which was developed in the mid-1980s and extensively modified over the years.
SAP's R/3 ERP system, which was installed in 1999 and used for transaction-processing applications such
as accounting and order processing.
I2 Technologies' Demand Planner (now called Demand Manager), which was installed in 1997 and used
for demand forecasting.
A system for distribution planning that was custom-developed for Whirlpool in the 1980s that used
optimization software from ILOG.

Then, in 2001, Whirlpool began to implement an advanced planning and scheduling (APS) system. It included
a suite of supply chain integration and optimization tools from i2 -- Supply Chain Planner for Master
Scheduling, Deployment Planning and Inventory Planning. Those three modules, the heart of Whirlpool's
efforts to fix its supply chain, went live in three phases over 2001 and 2002. In mid-2002, Whirlpool installed
the i2 Trade Matrix Collaborative Planning, Forecasting and Replenishment (CPFR) system, a Web-based
collaboration tool for sharing and combining the sales forecasts of Whirlpool and its major trade partners --
Sears, Roebuck and Co., Lowe's and Best Buy Co. The rollout of a component for Web-based collaboration
with suppliers, based on SAP's Inventory Collaboration Hub, is just getting under way. And Whirlpool
continues to use the old WMCS for production scheduling but plans to replace that with SAP's Production
Planning module.

It is available
By all accounts, the supply chain overhaul was a smashing success for the US$13 billion company. CPFR cut
forecasting errors in half. APS boosted availability in North America from 83 percent to 93 percent (97 percent
today), reduced finished-goods inventories by more than 20 percent and trimmed 5 percent from freight and
warehouse costs. Whirlpool declined to discuss the cost of the projects. Managers at Whirlpool give much of
the credit for the success of these projects to a close partnership between the IT department and the business
units. We said the tool had to do x, y and z. We did the requirements analysis together." Whirlpool considered
standardizing completely on SAP for all ERP and supply chain systems in North America, but i2 ultimately
got the nod for the APS system, the critical part needed to fix the company's availability and inventory
problems. ―There was a lot of back and forth, but after a long harangue and discussion of our business
requirements, we settled on the i2 tool set in North America,‖ Hoyt says. But while i2 was seen as being more
capable than SAP for handling the fine-grained optimization, constraint-based planning and prioritization that
the business units wanted, it was far from ideal from an IT perspective. The APS system would cost IT, whose
budget is about US$190 million, more than an all-SAP supply chain because there would be less integration,
more systems interfaces and more skills to maintain in-house. Plus, IT was worried about i2's deteriorating
financial condition.
Whirlpool had already standardized on IBM AIX application servers and series mainframe database servers for
supply chain systems and had put systems for all its global operations in a single data center in Benton Harbor.
Now it was time to standardize on software. So in 2001, a mandate came from the CIO, via Whirlpool's
Executive Committee, that supply chain modernizations henceforth would be based entirely on SAP. In
particular, new systems planned for Europe for 2003 and Latin America would use SAP's Advanced Planner
and Optimizer rather than the more capable but costly i2-based APS system used in North America. And they
were to use SAP's Net Weaver for Web collaboration with suppliers and trade partners rather than North
America's Trade Matrix CPFR. Vivek Mehta, a lead supply chain analyst at Whirlpool, says SAP may catch up
with i2 in its optimization capabilities, but in the meantime, i2's financial condition is worrisome. ―There were
10 guys at i2 that we interacted with, and some of them are gone now,‖ he says. ―There is lack of continuity.‖

―We have this challenge, where the IT organization is pushing for everything to be SAP, but the business, on
the other hand, is going for whatever brings them value,‖ Mehta says. ―They are now used to the optimal plan,
the high service levels, the lower inventories. So if we bring in something and say their availability will go
down by a couple of points, no way will they buy that.‖ Sezer says Whirlpool will probably replace i2 with
SAP ―eventually‖ but is in no hurry. ―We would like to get the return out of that investment before making any
platform decisions,‖ he says. Sezer says that in the four years since Whirlpool standardized on IBM and SAP
as ―strategic partners,‖ revenue has increased on average US$1 billion per year and IT expenses have fallen 6
percent per year. He says there are several joint development projects under way involving all three
companies. But for the time being, the combination of SAP and i2 works well for Whirlpool, far better than the
legacy tools of a few years ago. Sezer says the company's supply chain is now a competitive advantage.

Think globally, act locally

When the time came for Whirlpool Europe to overhaul its supply chain, the company decided not to go with i2
optimization products, as North America had done, but with SAP's Advanced Planner and Optimizer (APO)
for demand and supply-network planning. Vivek Mehta, a lead supply chain analyst involved in both projects,
says Europe was starting from a more primitive systems base, with even more manual procedures and less-
integrated systems than had been the case in North America. So for Europe, ―APO was a huge step forward,‖
he says. The integration of Whirlpool Europe's supply chain systems around APO, though not quite complete,
has already boosted inventory availability from less than 80 percent to more than 90 percent, says Walter
Manfred, supply chain director in Whirlpool‘s Comerio, Italy, operations center. ―Today, our supply chain is
integrated -- processes and systems,‖ he says. ―Now, demand from a trade partner or customer is integrated
into production planning. We can look into production plans and see if this item for this date in this quantity is
for this customer. So we can now give priority depending on the type of demand.‖ For example, he says,
priority is always given to production orders earmarked for specific customers -- for which availability is now
97 percent -- over orders to simply replenish stock. Still, improvements need to be made, especially at the level
of individual factories, Manfred says. Some factory managers, in an attempt to tweak system rules and
parameters to optimize their operations, make the systems so complex that they become maintenance
nightmares. And, he adds, attempts by factories to optimize their own performance can be at odds with
optimizing the European supply chain overall. Finally, Manfred says, while production can be varied daily by
altering system rules and parameters, some production modifications require workforce changes or changes in
line and equipment capacities, which can take weeks to accomplish. ―That's very difficult,‖ he notes.
Questions
1. Explain about whirlpool europe‘s supply chain systems
2. Discuss the advanced planner and optimizer (APO).

9.3 Summary
In this survey, we asked operations and other senior executives from around the world about their
companies‘ supply chain strategies, the factors that influence those strategies, and the ways their
companies act on these factors.
 The fierce competition in today‘s markets is led by advances in industrial technology, increased
globalization of demand and supply sources, tremendous improvements in information availability,
plentiful venture capital, and creative business designs.
Firms are competing in a global economy, and thus, the unit of business analysis is the world, not just a
country or region
The challenges that respondents associate with managing supply chain talent reflect talent-related concerns
that executives have expressed in other research
When executives are asked to reflect on the greatest management challenge their companies face as supply
chains become more global, they highlight the total resources required, followed by the recruitment and
retention of sufficient local talent and the integration of the IT systems of companies and their vendors
The intangible products include various services like merchant banking, mutual funds, insurance,
consultancy, air travel etc

9.4 Keywords
Branded Products: The global company can get better price and profits through branded products.
Market Segmentation: The main purpose of the market segmentation is to satisfy the customer needs more
precisely.
Maturity: The development of the product reaches the peak stage even in foreign markets. The producer
modifies it and develops it based on taste and preference of the customers in foreign markets.
Product Positioning: It attempts to occupy an appealing space in a consumer‘s mind in relation to the space
occupied by other competitive products.
Supply chains: These increasingly global and complex, as companies aspire to support a variety of strategies,
such as entering new markets, increasing speed to customers, and lowering costs.

9.5 Self Assessment Questions

1. Which of the following descriptions best describe the role of a supply chain?
(a) The logistics of an organization‘s distribution strategy.
(b) Physical distribution and payment collection.
(c) The role varies based on the nature of the environment, but can include physical ownership, payment
collection, and the inclusion of after-sales service, but never involves risk or responsibility for the product.
(d) The role varies based on the nature of the environment, but can include sourcing, production, marketing,
sales, after-sales service, and the acceptance of risk and responsibility for the product.

2. There are a number of key influences on the selection of distribution strategy. Which of the following is
generally recognized as a key influence?
(a) Buyer behaviour (b) Producer‘s needs
(c) Product type (d) All of the above

3. Which of the following statements about the selection of an intermediary would be typically TRUE in
respect of the distribution of fast moving consumer goods?
(a) Market coverage and approach to order processing and fulfilment are important but the depth and width of
lines carried by the intermediary and whether or not competitor lines are carried is irrelevant.
(b) Market coverage, approach to order processing and fulfilment, and the depth and width of lines carried by
the intermediary are important, but it is irrelevant whether or not competitor lines are carried.
(c) Market coverage, approach to order processing and fulfilment, the depth and width of lines carried and
whether or not competitor lines are carried by the intermediary are all important factors.
(d) Market coverage, approach to order processing and fulfilment and whether or not competitor lines are
carried by the intermediary are important, but the depth and width of lines carried are irrelevant...

4. An organization embarks on an international product strategy depending on a decision on a number of

factors, which include:
(a) The overall market objectives (b) Market and customer expectations
(c) Marketing mix support (d) all of the above

5. Which stage of the product lifecycle is marked by falling costs and rising revenues?
(a) Introduction stage (b) Growth stage
(c) Maturity stage (d) Saturation stage

6. At which stage in the International Trade Cycle does a country usually import foreign goods?
(a) Introduction stage (b) Growth stage
(c) Maturity stage (d) Saturation stage

7. To have value, a brand must offer which one of the following?

(a) A simple product range with a defined set of features.
(b) A complex product range with a defined set of features.
(c) Consistency, a reduced level of perceived risk for the buyer, and a range of functional and emotional
attributes which are of value to buyers.
(d) An identity through which the customer can trace the party responsible for supplying the product.

8. Choosing a suitable international brand name is an important, but often difficult, part of the process that
creates a strong and distinctive brand. Which of the following statements about choosing a name for a new soft
drink is UNTRUE?
(a) The name should be memorable and easy to pronounce.
(b) The name must be checked by experts to ensure it does not infringe on another company‘s brand name.
(c) The name should have positive associations with the benefits and features of the product.
(d) The brand name must be modern and contemporary.

9. The usual source for new products is:

(a) Marketing research
(b) R&D
(c) Accidental discoveries
(d) A variety of sources including customers, competitors, serendipity and formal processes

10. One approach to branding is to use the same brand name for everything a company produces. However
there are several drawbacks to this approach. Which of the following is not an identified drawback to this
approach?
(a) It is more expensive as the company has to spend money promoting all its product and also itself.
(b) It can confuse the values of the brand where products within the branded range are too diverse.
(c) One poorly performing product can tarnish all products carrying the name.
(d) It can make it difficult for a company to dispose of a division or product line as the main value of a product
is often the brand name.
9.6 Review Questions
1. What are supply chains? Explain about ménage.
2. Define the supply chain priorities.
3. How companies manage global supply chains?
4. Define product & branding decision.
5. What are factors of product adoption?
6. Explain the product life cycle?
7. Explain about the international branding decision?
8. Describe the branded products and private products?
9. Explain the strategies for branding decisions.
10. Write short notes on:
(a) Looking ahead
(b) Forces at work

Answers for Self Assessment Questions

1. (d) 2.(d) 3.(c) 4.(d) 5.(b)
6. (a) 7.(c) 8.(d) 9.(d) 10.(a)
 10
Distribution Channels
CONTENTS
Objectives
Introduction
10.1 International promotion mix and pricing decisions
10.2 Counter trade
10.3 Summary
10.4 Keywords
10.5 Self Assessment Questions
10.6 Review Questions

Objectives
After studying this chapter, you will be able to
Understand the International promotion mix and pricing decisions
Explain the counter trade

Introduction
Distribution plays an important role in the implementation of the international marketing programme as it
enables the products and services to reach the ultimate customer. And international marketing firm has the
option of managing its distribution function either directly or indirectly through middleman or a suitable
combination of the two.
 Figure 10.1: Examples of International Distribution Channels.

Due to physical distance, and also the differences in geographical, cultural and market characteristics of the
trading countries, use of middlemen is found quite prevalent in international marketing. In fact, distribution is
one such primary functions of marketing which makes use of the services of external independent agencies
that bind the firm in a long term relationship. Distribution has two elements, the institutional and the physical.
Physical distribution aspects cover transport and warehousing. The longer the channel, the more likely that
producer's profits will be indirectly reduced. This is because the end product‘s price may be too expensive to
sell in volume, sufficient for the producer to cover costs. Yet cutting channel length may be impossible, as
country infrastructure requirements may dictate they being there. As already mentioned international
marketers have the options of organizing distribution of their goods in foreign markets through the use of
indirect channels, i.e. using intermediaries, direct channels or a combination of the two in the same or different
markets.

1. Indirect Distribution
Indirect channels are further classified based on whether the international marketer makes use of domestic
intermediaries. An international marketer therefore, can make use of the following types of intermediaries for
distribution in foreign markets.
a) Domestic Overseas Intermediaries
• Commission buying agents
• Country-controlled buying agents
• Export management companies (EMCs)
• Export merchants
• Export agents
• Piggy backing
b) Foreign Intermediaries
• Foreign Sales Representatives
• Foreign Sales Agents
• Foreign Stocking and Non-Stocking Agents
• State Controlled Trading Companies

2. Direct Distribution
The options available to international marketer in organizing direct distribution include sending missionary
skies representatives abroad from the headquarter, setting up of local sales/branch office in the foreign country
or for a region, establishing a subsidiary abroad, entering into a joint venture or franchising agreement.