FINANCIAL MANAGEMENT

(Unit – I)

Meaning
Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise.
According to Dr. S. N. Maheshwari,
"Financial management is concerned with raising financial resources and their effective
utilization towards achieving the organizational goals."
Thus, financial management means:
 To collect finance for the company at a low cost and
 To use this collected finance for earning maximum profits.
It is clear that financial management is that specialized activity which is responsible for
obtaining and affectively utilizing the funds for the efficient functioning of the business and,
therefore, it includes financial planning, financial administration and financial control.

Finance Functions
Finance functions can be divided into three major decisions, which the firm must make, namely
investment decision, finance decision, and 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 -
Investment Decision
One of the most important finance functions is to intelligently allocate capital to long term assets.
This activity is also known as capital budgeting. It is important to allocate capital in those long
term assets so as to get maximum yield in future. Following are the two aspects of investment
decision -
a. Evaluation of new investment in terms of profitability.
b. Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return.
Along with uncertainty comes the risk factor which has to be taken into consideration. Therefore
while considering investment proposal it is important to take into consideration both expected
return and the risk involved.
Investment decision not only involves allocating capital to long term assets but also involves
decisions of using funds which are obtained by selling those assets which become less profitable
and less productive.
Financial Decision
Financial decision is yet another important function which a financial manger must perform. It is
important to make wise decisions about when, where and how should a business acquire funds.
Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an
equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s
capital structure.
A firm tends to benefit most when the market value of a company’s share maximizes this not
only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand
the use of debt affects the risk and return of a shareholder. It is more risky though it may increase
the return on equity funds. A sound financial structure is said to be one which aims at
maximizing shareholders return with minimum risk. In such a scenario the market value of the
firm will maximize and hence an optimum capital structure would be achieved.
Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the key function a
financial manger performs in case of profitability is to decide whether to distribute all the profits
to the shareholder or retain all the profits or distribute part of the profits to the shareholder and
retain the other half in the business. It’s the financial manager’s responsibility to decide an
optimum dividend policy which maximizes the market value of the firm. Hence an optimum
dividend payout ratio is calculated.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders?
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e., funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of Financial requirements: A finance manager has to make estimation with
regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis.
This will depend upon the proportion of equity capital a company is possessing and
additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible. It can be –
 a) Capital Budgeting Decision – It is related to selection of long-term assets in which
investments will be made by the company. Investment decisions are related to future and
involve risk, that’s why these should be evaluated in terms of expected risk and return.
b) Working Capital decision – It is concerned with management of current assets. It is an
important function of financial manager since short –term survival of the firm is a pre-
requisite for long term success.
5. Disposal of surplus: The net profits decision has to be made by the finance manager. This
can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other benefits like
bonus.
b. Retained profits - The volume has to be decided which will depend upon expansion,
innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many techniques
like ratio analysis, financial forecasting, cost and profit control, etc.

Scope of Financial Management

1. Traditional Approach
The traditional approach to the scope of financial management refers to its subject matter in
the academic literature in the initial stages of its evolution as a separate branch of study.
According to this approach, the scope of financial management is confined to raising of
funds. Hence, the scope of finance was treated by traditional approach in narrow sense of
procurement of funds by corporate enterprise to meet their financial needs. Since the main
emphasis of finance function at that period was on procurement of funds, the subject was
called corporation finance till mid-1950's and covered discussion on financial instruments,
 institutions and practices through which funds are obtained. Further, as the problem of
raising funds is more intensely felt at certain episodic events such as merger, liquidation,
consolidation, reorganization and so on. These are the broad features of subject matter of
corporation finance, which has no concern with the decisions of allocating firm's funds.
But the scope of finance function in the traditional approach has now been discarded as it
suffers from serious criticisms -
 Outsider-looking - The emphasis in the traditional approach is on procurement of funds
by the corporate enterprises, which was woven around the viewpoint of suppliers of funds
such as investors, financial institutions, investment bankers, etc, i.e. outsiders. It implies
that the traditional approach was the outsider-looking-in approach.
 Confined to Episodic events - The second criticism leveled against this traditional
approach was that the scope of financial management was confined only to the episodic
events such as mergers, acquisition, reorganizations, consolation, etc.
 Focus on Long-term problems - Another serious lacuna in the traditional approach was
that the focus was on the long-term financial problems thus ignoring the importance of
the working capital management. Thus, this approach has failed to consider the routine
managerial problems relating to finance of the firm.
During the initial stages of development, financial management was dominated by the
traditional approach as is evident from the finance books of early days. It over emphasized
long-term financing lacked in analytical content and placed heavy emphasis on descriptive
material. Thus, the traditional approach omits the discussion on the important aspects like
cost of the capital, optimum capital structure, valuation of firm, etc.

2. Modern Approach
After the 1950's, a number of economic and environmental factors, such as the technological
innovations, industrialization, intense competition, interference of government, growth of
population, necessitated efficient and effective utilization of financial resources. The
emphasis shifted from episodic financing to the managerial financial problems, from raising
of funds to efficient and effective use of funds. Thus, the broader view of the modern
 approach of the finance function is the wise use of funds. Since the financial decisions have a
great impact on all other business activities, the financial manager should be concerned about
determining the size and nature of the technology, setting the direction and growth of the
business, shaping the profitability, amount of risk taking, selecting the asset mix,
determination of optimum capital structure, etc. The new approach is thus an analytical way
of viewing the financial problems of a firm.
According to the new approach, the financial management is concerned with the solution of
the major areas relating to the financial operations of a firm, viz., investment, and financing
and dividend decisions. The modern financial manager has to take financial decisions in the
most rational way. These decisions have to be made in such a way that the funds of the firm
are used optimally.

Profit Maximization v/s Wealth Maximization

It is clear from the above discussion that the modern approach to financial management is to give
answers for three questions: where to invest and in what amount; how to raise; and when to pay
dividends. It is generally agreed that the financial objective of the firm should be the
maximization of owners' economic welfare. However, there is a disagreement as to how the
economic welfare of the owners can be maximized. The two well known and widely discussed
criteria in this respect are:
1) Profit Maximization
According to this concept, actions that increase the firm's profit are undertaken while those
that decrease profit are avoided. The profit can be maximized either by increasing output for
a given set of scarce input or by reducing the cost of production for a given output. The
modern economics states that the profit maximization is nothing but a criterion for economic
efficiency as profits provide a yardstick by which economic performances can be judged
under condition of perfect competition. Besides, under perfect competition, profit
maximization behavior by firms leads to an efficient allocation of resources with maximum
social welfare. Since, the capital is a scarce material; the financial manager should use these
capital funds in the most efficient manner for achieving the profit maximization. It is,
 therefore, argued that profitability maximization should serve as the basic criterion for the
ultimate financial management decisions.
The profit maximization criterion has been criticized on the following grounds:
 Vagueness - One practical difficulty with profit maximization criterion is that the term
profit is vague and ambiguous as it is amenable to different interpretations, like, profit
before tax or after tax, total profit or rate of return, etc. If profit maximization is taken to
be the objective, the problem arises, which of these variants of profit to be maximized?
 Ignores the timing of benefits - A more important technical objection to profit
maximization is that it ignores the differences in the time pattern of the cash inflows from
investment proposals. In other words, it does not recognize the distinction between the
returns in different periods of time and treat them at a par which is not true in real world
as the benefits in earlier years should be valued more than the benefits received in the
subsequent years.
 Ignores risk – It ignores the degree of certainty/ risk with which benefits can be obtained.
As a matter of fact, the more certain the expected return, the higher the quality of the
benefits. Conversely, the more uncertain the expected returns, the lower the quality of
benefits, which implies risk to the investors. Generally, the investors want to avoid risk.
Therefore, from the above discussion, it clear that the profit maximization concept is
inappropriate to a firm from the point of view of financial decisions, i.e. investment, finance and
dividend policies. It is not only vague and ambiguous but also it does not recognize the two basic
aspects, i.e., risk and time value of money.

2) Wealth Maximization
The most widely accepted objective of the firm is to maximize the value of the firm for its
owners. The wealth maximization goal states that the management should seek to maximize the
present value of the expected returns of the firm. The present value of future benefits is
calculated by using its discount rate (cost of capital) that reflects both time and risk. The discount
rate is the rate that reflects the time and risk preferences of the suppliers of capital.
The next feature of wealth maximization criterion is that it takes; both the quantity and quality
dimensions of benefits along with the time value of money. Other things being equal, income
with certainty are valued more than the uncertain ones. Similarly, the benefits received in earlier
period should be valued more than the benefits received in later period.
It is quite clear that the wealth maximization is, no doubt, superior to the profit maximization
objective. The wealth maximization objective involves a comparison of present value of future
benefits to the cash outflow. If the activity results in positive net present value, i.e. the present
value of future stream of cash flows exceed the present value of outflows, reflecting both time
and risk, it can be said to create wealth.
The objective of wealth maximization can also be explicitly defined by short-cut method
symbolically as under:

Where, A1, A2 ... A represent the stream of benefits (cash inflows) expected to occur on the
investment project;
Co = cost of the project
k = the discount factor / capitalization rate
W = the net wealth of the firm (the difference between the present value of stream of
expected benefits and the present value of cash outflow).
It is abundantly clear from the above discussion that the wealth maximization criterion
recognizes the time value of money and also tackles the risk, which is ascertained by the
uncertainty of the expected benefits. That is why, it is rightly said that maximization of wealth is
more useful than minimization of profits as a statement of the objective of most business firms.

Liquidity v/s Profitability

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 trade-off between
liquidity and profitability; gaining more of one ordinarily means giving up some of the other.
Liquidity: Having enough money in the form of cash, or near-cash assets, to meet your financial
obligations. Alternatively, how easily assets can be converted into cash.
Profitability: A measure of amount by which a company's revenues exceed its relevant expenses.
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. 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.

Organization of Finance Function

Since the finance function is a major functional area, the ultimate responsibility for carrying out
the financial management functions lies with the top management: Board of directors / Managing
director / chief executive / committee of the Board. However, the exact nature of the
organization of the finance function differs from firm to firm depending upon the factors such as
size of the firm, nature of the business, ability of the financial executive etc. Similarly, the
designation of the chief executive of the finance department also differs widely in case of
different firms. In some cases, they are known as finance managers while in others as vice-
president (Finance), or Director (Finance), or financial controller etc.
Under the chief executive, there are controllers, treasurers, who will be looking after the sub
functions viz., accounting and control; and financing activities in the firm. The functions of
treasurer includes obtaining finance; maintaining relations with investors, banks, etc., short-term
financing, cash management, credit administration while the controller is related to the functions
like financial accounting; internal audit; taxation, management accounting and control,
budgeting, planning and control, economic appraisal, etc.

Finance and Related Disciplines

There is an inseparable relationship between finance on the one hand and other related
disciplines and subjects on the other. It draws heavily on related disciplines and fields of study.
The most important of these are accounting and economics, but the subjects like marketing,
production, quantitative methods, etc. also have an impact on the finance field -
 Finance and Accounting
The relationship between finance and accounting has two dimensions:
a. They are closely related to the extent that accounting is an important input in financial
decision making;
b. There are certain differences between them.
Accounting is a necessary input into finance function. It generates information through financial
statements. The data contained in these statements assists the financial managers in assessing the
past performance and future directions of the firm. Thus, accounting and finance are functionally
inseparable.
The key differences between finance and accounting are as under:
a. Treatment of funds: The measurement of funds in accounting is based on the accrual
concept. For instance, revenue is recognized at the point of sale and not on collection of
credit. Similarly, expenses are recognized when they are incurred but not at the time of actual
payment of these expenses. Whereas in case of finance the treatment of funds is based on
cash flows. That means here the revenue is recognized only when actually received or
actually paid in cash.
b. Decision Making: The purpose of accounting is collection and presentation of financial data.
The financial manager uses these data for financial decision-making. It does not mean that
accountants never make decisions or financial managers never prepare data. But the primary
focus of accountants is collection and presentation of data while the financial manager's
major responsibility relates to financial planning, controlling and decision-making. Thus, the
role of finance begins, where the accounting ends.
 Economics and Finance
The development of the theory of finance began in the 1920s as an offshoot of the study of the
theory of the firm in economic theory. The financial manager uses microeconomics when
developing decision models that are likely to lead to the most efficient and successful modes of
operation within the firm. Further, the marginal cost and revenue concepts are used in making
the investment decisions, managing working capital, etc in the finance field.
 Finance and Production
Finance and production are also functionally related. Any changes in production process may
necessitate additional funds which the financial managers must evaluate and finance. Thus, the
production processes, capacity of the firm are closely related to finance.
 Finance and Marketing
Marketing and finance are functionally related. New product development, sales promotion plans
new channels of distribution; advertising campaign etc. in the area of marketing will require
additional funds and have an impact on the expected cash flows of the business firm. Thus, the
financial manager must be familiar with the basic concept of ideas of marketing.
 Finance and Quantitative Methods
Financial management and Quantitative methods are closely related such as linear programming,
probability, discounting techniques, present value techniques etc. are useful in analyzing
complex financial management problems. Thus, the financial manager should be familiar with
the tools of quantitative methods. In other way, the quantitative methods are indirectly related to
the day-to-day decision making by financial managers.
 Finance and Costing
Cost efficiency is a major advantage to a firm, and will contribute towards its competitiveness,
sustainability and profitability. A finance manager has to understand, plan and manage cost,
through appropriate tools and techniques including budgeting and activity based costing.
 Unit II
Time Value of Money
Money has time value. Money that you hold today is worth more because you can invest it and
earn interest. 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. 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. It can
be used to compare investment alternatives and to solve problems involving loans, mortgages,
leases, savings, and annuities.
For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate
$1.06 at the end of the year. You can say that the future value of the dollar is $1.06 given a 6%
interest rate and a one-year period. It follows that the present value of the $1.06 you expect to
receive in one year is only $1.
Reasons for Time Value of Money
Money has time value because of the following reasons:
1. 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.
2. 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.
3. Consumption: Individuals generally prefer current consumption to future consumption.
4. 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 is given an alternative either to receive 10,000 now or after one
year, he will prefer 10,000 now.

Techniques of Time Value of Money

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.
1. 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 per cent
interest per year. If you reinvest your interest income, your investment will grow as follows -
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 end (1100 + 10%) 1210
Third year: Principal at the end (1210 + 10%) 1331
This process of compounding will continue for an indefinite time period.
 Compound/ Future Value of a Single Amount (Lump sum) -
A generalized procedure for calculating the future value of a single amount compounded
annually is as follows:
Formula: FVn = PV (1 + r) n
 Where, FVn = 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.
FVn = PV (1 + r) n
= 1,000 (1.10)3 = 1331/-
To solve future value problems, compound value interest factor (CVIF) table i.e. Table A-1 can
be used. The table shows the future value factor for certain combinations of periods and interest
rates. To simplify calculations, this expression has been evaluated for various combinations of ‘r’
and ‘n’.
Illustration 1: If you deposit 55,650 in a bank which is paying a 12 per cent rate of interest on a
ten-year time deposit, how much would the deposit grow at the end of ten years?
Solution: FVn = PV (1 + r) n or FVn = PV (CVIF 12%, 10 yrs)
FVn = 55650 (1.12)10 (Using Table A-1)
= 55650 × 3.106 = 172848.90
 Multiple Compounding Periods -
Interest can be compounded monthly, quarterly and half-yearly. If compounding is quarterly,
annual interest rate is to be divided by 4 and the number of years is to be multiplied by 4.
Similarly, if monthly compounding is to be made, annual interest rate is to be divided by 12 and
number of years is to be multiplied by 12.
Formula: FVn = PV (1+ r/m) m*n
Where, FVn = Future value after ‘n’ years
PV = Cash flow today
r = Interest rate per annum
m = Number of times compounding is done during a year
 Compound Value of an Annuity –
Sometimes, a person may desire to deposit annually a sum of money that is known as annuity.
The compound value of an annuity can be calculated through compound value Table A-2.
Compound Value = Annuity amount * Compound Value Annuity Factor (CVAF)
Illustration 2: A person invests Rs. 5000 every year at the same time at an interest rate of 10%
Calculate the sum of money he will receive after 5 years?
Solution: Annuity amount = 5000/-
Compound Value = 5000 * (FVAF 10%, 5 years)
CVAF (10%, 5 years)= 6.105
Compound Value = 5000 * 6.105 = Rs 30525/-

2. Present Value Technique

Present Value describes the process of determining what a cash flow to be received in the future
is worth in today's dollars. Therefore, the Present Value of a future cash flow represents the
amount of money today which, if invested at a particular interest rate, will grow to the amount of
the future cash flow at that time in the future. The process of finding presen values is called
discounting and the interest rate used to calculate present values is called the discount rate.
For Example, The Present Value of $100 to be received one year from now is $90.91 if the
discount rate is 10% compounded annually.
The following equation can be used to find the Present Value of a Cash Flow stream.

Where, PV = the Present Value of the Cash Flow Stream,

CFt = the cash flow which occurs at the end of year t,
r = the discount rate,
t = the year, which ranges from zero to n, and
n = the last year in which a cash flow occurs.
Or, It can be calculated by using present value of Rs.1 table i.e. Table A-3.
 Present Value of Semi Annual/ Quarterly/ Monthly Cash Flows -
A person may select monthly, quarterly and half-yearly discounting. If discounting is done
quarterly, annual interest rate is to be divided by 4 and the number of years is to be multiplied by
4. Similarly, if monthly discounting is to be made, annual interest rate is to be divided by 12 and
number of years is to be multiplied by 12.
Formula PV = FV / (1+ r/m) m*n
:
Where, FV = Future value after ‘n’ years
PV = Present Value
r = Interest rate per annum
m = Number of times discounting is done per year
 Present Value of an Annuity
The Present Value of an Annuity is equal to the sum of the present values of the annuity
payments. This can be found in one step through the use of the following equation:

Where, PVA = Present Value of the Annuity

PMT = Annuity Payment
r = Interest or Discount Rate
t = Number of Years (also the Number of Annuity Payments)
OR
It can be calculated by using present value of an annuity table i.e. Table A- . It is similar to
compound value of an annuity the only difference is Table A-4 is used instead of Table A-2.
PV = Annuity Amount * PVAF (Rate, No. of years)
Illustration 3: Using same data given in Illustration 2, Calculate the Present value of annuity.
Solution: Annuity amount = 5000/-
Present value = 5000 * PVAF (10%, 5 years)
PVAF (10%, 5 years) = 3.791
Present value = 5000 * 3.791 = Rs. 18955/-
 CAPITAL BUDGETING

INTRODUCTION
A firm incurs two types of expenses i.e.
Revenue expenditure – The benefits of which are supposed to be exhausted within the year
concerned and their planning and control is done through various functional departments.
Capital expenditure – The benefits of which are expected to be received over long period a
series of years in future like building, plant, machinery or to undertake a program on -
 Research and development of a product
 Diversification in to a new product line
 Replacement of a machine
 Expansion in production capacity
 Promotional campaign
Capital expenditure involves investment of substantial funds for longer period and the benefits of
such investment are in the form of increasing revenues or decreasing costs. Wrong decision
under this head may affect future earnings, employment capacity, quantity and quality of
production. Hence, long term planning and right decision to incur or not to incur such
expenditure is a crucial responsibility of management. The techniques used by management to
carry out this responsibility is known as capital budgeting.
Definitions
According to Milton “Capital budgeting involves planning of expenditure for assets and return
from them which will be realized in future time period”.
According to I. M. Pandey, “Capital budgeting refers to the process of generating, evaluating,
selecting, and follow up of capital expenditure alternatives.”

NATURE / FEATURES OF CAPITAL BUDGETING DECISIONS

(1) Long term effect - Such decisions have long term effect on future profitability and influence
pace of firm’s growth. A good decision may bring good returns and wrong decision may
endanger very survival of firm.
(2) High degree of risk - decision is based on estimated return. Changes in taste, fashion,
research and technological advancement leads to greater risk in such decisions.
(3) Huge funds – large amount/funds are required and sparing huge funds is problem and hence
decision to be taken after proper care/analysis
(4) Irreversible decision – Reverting back from a decision is very difficult as sale of high value
asset would be a problem.
(5) Most difficult decision – decision is based on future estimates/uncertainty. Future events are
affected by economic, political and technological changes taking place.
(6) Impact on firms future competitive strengths – These decisions determine future profit/
cost and hence affect the competitive strengths of firm.
(7) Impact on cost structure – Due to this vital decision, firm commits itself to fixed costs such
as supervision, insurance, rent, interest etc. If investment does not generate anticipated profit,
future profitability would be affected.

OBJECTIVES OF CAPITAL BUDGETING

(1) Share holder’s wealth maximization. In tune with objectives of financial management, its
aim is selecting those projects that maximize shareholders wealth. The decision should avoid
over/under investment in fixed assets.
(2) Evaluation of proposed capital expenditure – Capital budgeting helps in evaluating
expenditure to be incurred on various assets to measure validity of each expenditure
(3) Controlling costs - by evaluating expenditure costs can be controlled.
(4) Determining priority – arranging projects in order of their profitability enabling the
management to select most profitable project.

FACTORS AFFECTING CAPITAL BUDGETING DECISIONS

(1) Technological changes – Before taking CBD, management will have to undertake in-depth
study of cost of new product /equipment as well productive efficiencies of new as well as old
equipment.
(2) Demand forecast – Analysis of demand for a long period will have to be undertaken
before taking any capital budgeting decision.
(3) Competitive strategy – If a competitor is going for new machinery /equipment of high
capacity and cost effective, we may have to follow that.
(4) Type of management – If management is innovative, firm may go for new equipments/
investment as compared to conservative management.
(5) Cash flow – cash flow statement or cash budget helps a firm in identifying time when a firm
can make investment in CBD.
(6) Other factors- Like fiscal policy (tax concessions, rebate on investments) political salability,
global situation etc.

TECHNIQUES OF CAPITAL BUDGETING

Capital budgeting decision may be thought of as a cost-benefit analysis. We are asking a very
simple question: "If I purchase this fixed asset, will the benefits to the company be greater than
the cost of the asset?" In essence, we are placing the cash inflows and outflows on a scale
(similar to the one above) to see which is greater.
A complicating factor is that the inflows and outflows may not be comparable: cash outflows
(costs) are typically concentrated at the time of the purchase, while cash inflows (benefits) may
be spread over many years. Therefore, before we can place the costs and benefits on the scale,
we must make sure that they are comparable. We do this by taking the present value of each,
which restates all of the cash flows into "today's dollars." Once all of the cash flows are on a
comparable basis, they may be placed onto the scale to see if the benefits exceed the costs.

The Major Capital Budgeting Techniques

A variety of measures have evolved over time to analyze capital budgeting requests. The better
methods use time value of money concepts. Older methods, like the payback period, have the
deficiency of not using time value techniques and will eventually fall by the wayside and are
replaced in companies by the newer, superior methods of evaluation.

1. PAYBACK PERIOD
It is the length of time that it takes to recover your investment.
For example, to recover $30,000 at the rate of $10,000 per year would take 3.0 years. Companies
that use this method will set some arbitrary payback period for all capital budgeting projects,
such as a rule that only projects with a payback period of 2.5 years or less will be accepted. (At a
payback period of 3 years in the example above, that project would be rejected.) The payback
period method is decreasing in use every year and doesn't deserve extensive coverage here.

2. PROFITABILITY INDEX (PI)

It is also known as profit investment ratio (PIR), is the ratio of payoff to investment of a
proposed project. It is a useful tool for ranking projects because it allows you to quantify the
amount of value created per unit of investment. The ratio is calculated as follows-
PI = Present Value of Cash Inflows
Present Value of Cash Outflows
Assuming that the cash flow calculated does not include the investment made in the project, a
profitability index of 1 indicates breakeven. Any value lower than ‘one’ indicates that the
project's PV is less than the initial investment. As the value of the profitability index increases,
so does the financial attractiveness of the proposed project.
Rules for selection or rejection of a project:
If PI > 1 then accept the project
If PI < 1 then reject the project

3. ACCOUNTING RATE OF RETURN

It is also known as the Average rate of return. ARR is a financial ratio used in capital
budgeting. The ratio does not take into account the concept of time value of money. ARR
calculates the return, generated from net income of the proposed capital investment. The ARR is
a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven
cents out of each dollar invested.
If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is
less than the desired rate, it should be rejected. When comparing investments, the higher the
ARR, the more attractive the investment. Over one-half of large firms calculate ARR when
appraising projects.
ARR = Average Profit / Average Investment

4. NET PRESENT VALUE

Using a minimum rate of return known as the hurdle rate, the net present value of an investment
is the present value of the cash inflows minus the present value of the cash outflows. A more
common way of expressing this is to say that the net present value (NPV) is the present value of
the benefits (PVB) minus the present value of the costs (PVC) NPV = PVB - PVC
If the NPV is: Benefits vs. Should we expect to earn at Accept the
Costs least
investment?
our minimum rate of return?
Positive Benefits > Costs Yes, more than Accept
Zero Benefits = Costs Exactly equal to Indifferent
Negative Benefits < Costs No, less than Reject
The purpose of the capital budgeting analysis is to see if the project's benefits are large enough to
repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of
return that adequately compensates the company for the risk found in the cash flow estimates.
Therefore, if the NPV is:
 Positive, the benefits are more than large enough to repay the company for (1) the asset's
cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates
the company for the risk found in the cash flow estimates.
 Zero, the benefits are barely enough to cover all three but you are at breakeven - no profit
and no loss, and therefore you would be indifferent about accepting the project.
 Negative, the benefits are not large enough to cover all three, and therefore the project should
be rejected.

5. INTERNAL RATE OF RETURN

The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn on the
investment. Technically, it is the discount rate that causes the present value of the benefits to
equal the present value of the costs. The IRR method is actually the most commonly used
method for evaluating capital budgeting proposals. This is probably because the IRR is a very
easy number to understand because it can be compared easily to the expected return on other
types of investments (savings accounts, bonds, etc.).
If the internal rate of return is greater than the project's minimum rate of return, we would tend to
accept the project. The calculation of the IRR, however, cannot be determined using a formula; it
must be determined using a trial-and-error technique.

6. MODIFIED INTERNAL RATE OF RETURN

The Modified Internal Rate of Return (MIRR) is an attempt to overcome the above two
deficiencies in the IRR method. The person conducting the analysis can choose whatever rate he
or she wants for investing the cash inflows for the remainder of the project's life.
For example, if the analyst chooses to use the hurdle rate for reinvestment purposes, the MIRR
technique calculates the present value of the cash outflows (i.e., the PVC), the future value of the
cash inflows, and then solves for the discount rate that will equate the PVC and the future value
of the benefits. In this way, the two problems mentioned previously are overcome:
1. The cash inflows are assumed to be reinvested at a reasonable rate chosen by the analyst, and
2. There is only one solution to the technique.

CONTRAST BETWEEN NPV AND IRR

The NPV is better than the IRR. It is superior to the IRR method for at least two reasons:
1. Reinvestment of Cash Flows: The NPV method assumes that the project's cash inflows are
reinvested to earn the hurdle rate; the IRR assumes that the cash inflows are reinvested to
earn the IRR. Of the two, the NPV's assumption is more realistic in most situations since the
IRR can be very high on some projects.
2. Multiple Solutions for the IRR: It is possible for the IRR to have more than one solution. If
cash flows experience a sign change (e.g., positive cash flow in one year, negative in the
next), the IRR method will have more than one solution.
When this occurs, we simply don't use IRR method to evaluate the project, since no one value of
IRR is theoretically superior to the others. The NPV method does not have this kind of problem.

PRACTICAL PROBLEMS
Q.1 Project has the following patterns of cash flows:

Year Cash Flow (Rs. In Lacs)

0 (10)
1 5
2 5
3 3.08
4 1.20

What is the IRR of this project?

Solution:
To determine the IRR, we have to compare the NPV of the project for different rates of interest
until we find that rate of interest at which the NPV of the project is equal to zero.
Step 1 Find the average annual net cash flow based on given future net cash inflows. = (5 + 5 +
3.08 + 1.20)/4 = 3.57
Step 2 Divide the initial outlay by the average annual net cash inflows i.e. 10/3.57 = 2.801
Step 3 From the PVIFA table, it is found that interest rate is nearly equal to 2.801 in 4 years i.e.
the duration of the project. In this case the rate of interest will be equal to 15%.
We use 15% as the initial value for starting the hit and trial process and keep trying at
successively higher rates of interest until we get an interest rateat
which the NPV is zero. NPV at r = 15% will be equal to: = -10 + (5*.0870) +
(5*.756) + (3.08*.658) + (1.2*.572) = 0.84 NPV at r = 16 % will be equal to: = -10 + (5*.862) +
(5*.743) + (3.08*.641) + (1.2*.552) = .66 NPV at r = 18% will be equal to: = -10 + (5*.848) +
(5*.719) + (3.08*.0609) + (1.2*.516) = .33 NPV at r = 20% will be equal to: = -10 + (5*.833) +
(5*.694) + (3.08*.609) + (1.20*.482) = 0
We find that at r= 20%, the NPV is zero and therefore the IRR of the project is 20%.
 COST OF CAPITAL

MEANING
Cost of capital is the minimum required rate of return a project must earn in order to cover the
cost of raising fund being used by the firm in financing of the proposal. It may be defined in two
phase i.e. operational term and economic term. As per operational term, it refers to the discount
rate that would be used in determining the present value of the estimated future cash proceeds
and eventually deciding whether the project is worth undertaking or not.

CLASSIFICATION OF COST
The various concepts of cost of capital are not relevant for all-purpose of decision-making.
Therefore for a proper understanding of the application of the cost of capital in financial
decision-making various concept of cost should be distinguished. These concepts are -
Future Cost and Historical Cost
Future cost of capital refers to the expected cost of funds to be raised to finance a project while
historical cost represents cost incurred in the past in acquiring fund. In financial decision future
cost of capital is relatively more relevant and significant while evaluating viability of a project
historical cost is taken into consideration.
Specific Cost and Composite/Overall Cost
Cost of each component of capital such as equity, debenture and preference share etc. is known
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, or combined or weighted cost of capital.
Average Cost and Marginal Cost
Average cost of capital is weighted average of cost of each component of funds employed by the
firm, while the marginal cost of capital is average cost of new or incremental funds raised by the
firm. For capital budgeting & financing decisions marginal cost of capital is more important.
Explicit Cost and Implicit Cost
Explicit cost of capital of any source is the discount rate that equates the present value of each
inflow with present value of its incremental cash inflows. It arises when the firm considers
alternative uses of the funds raised. Implicit cost is also known as opportunity cost. It is the rate
of return associated with the best investment opportunity for the firm and its shareholders that
will be forgone if the project presently under consideration by the firm were accepted.

FACTORS AFFECTING COST OF CAPITAL

The elements in the business environment that cause a company's cost of capital to be high or
low determine the cost of capital of any firm. These factors are:
1. General Economic Conditions
The general economic conditions determine the demand for and supply of capital within the
economy as well as the level of expected inflation. This economic variable is reflected in the risk
less rate of return. This rate represents the rate of return on risk free investments such as the
interest rate on short-term government securities.
2. Risk and Cost of Capital
High-risk investments only make the investors attractive to purchase the security. The risk
elements are composed of five aspects that are closely intertwined. These are -
(a) Financial Risk- refers to the proportion of debt and equity with which a firm is financed.
(b) Business Risk- refers to the variability in return of assets and is affected by the company's
investment decision.
(c) Purchasing Power Risk- refers to the change in purchasing power of money measured by
price level changes.
(d) Money Rate Risk- refers to the premium in the yield demanded by suppliers of capital to
cover the risk of an increase in future interest rate.
(e) Market/Liquidity Risk- refers to the ability of a supplier of fund to sell his holding quickly.
3. Floating Cost
Floating cost is the cost of marketing new securities. It includes legal fees, printing expenses,
underwriting commission etc. They are called floating because they incurred in floating new
securities. It is also called underwriting cost or issuance cost. These costs directly influence the
cost of capital. High floating cost leads to higher cost of capital.

COMPONENTS OF COST OF CAPITAL

The overall cost of capital of a firm is comprised of the cost of the various components of
financing, techniques to determine the specific cost of each of these sources such as debt,
preference share, retained earning, and equity share. The measurement of cost of capital is the
process of determines the cost of fund to the firm. The method of measuring cost of capital of
different components is given as under: -

COST OF DEBENTURES AND BONDS

The cost of capital for debenture/bond is the rate of return i.e. interest that potential investors or
holders require on the firm’s debt securities. The debenture holders receive a fixed rate of
interest on their investment. The interest on debentures is tax deductible so, the after tax interest
rate will be lower. For calculation we can divide the debenture into two categories i.e. Perpetual
Debt and Redeemable Debt.
1. Perpetual Debt/ Irredeemable Debt
The debenture availed by the firm on a regular basis is called perpetual debt. The cost of capital
of such type of debt may be ascertained as under: -

Where - Ki = Cost of debenture capital (Before Tax)

I = Annual interest
Bo = Net proceeds
Tax Adjustment
Interest on debenture is tax deductible. It works as a tax shield and the tax liability of a firm is
reduced. Thus the effective cost of debenture is lower than the interest paid to investor but it
depends on tax rate. The real cost of debt is determined after considering tax shield, as follows -
Kd = Ki (1-t)
Where - Kd = Cost of debenture capital (after tax)
T = tax rate
The tax benefit is not available, to firms having loss or no tax-paying situation. In this condition
Kd will be equal to Ki.
2. Redeemable Debenture
To calculate the cost of capital of redeemable debenture, it can be divided into two categories
such as (a) If redemption is made after a certain period
(b) If redemption is made gradually in installment.
(a) If redemption is made after a certain period
Kd = I (1 - t) + (RV – NP) / N
(RV + NP) / 2
Where: RV = Redemption value of debenture
N = Life of Debenture
NP = Net Proceeds
(b) If redemption is made gradually in installment

Where: COP = Regular/ Periodical cash outflow in installments

Bo = Net proceeds

COST OF PREFERENCE SHARE

It represents the rate of return that must be earned on the preference shares financed investments
to keep earning available to the residual stockholders unchanged. The rate of dividend is
predetermined but the preference dividend is not entitled for tax benefit. It is of two types i.e.
redeemable and irredeemable.
Irredeemable Preference Shares
The preference shares which cannot be redeemed in company’s life time are known as
irredeemable or perpetual preference shares. The firm has to pay dividend at a fixed rate on these
shares, the calculation of cost is as under -
Kp = PD/ PO
Where: PD = Annual Preference dividend
Po = Net Proceeds

Redeemable Preference Shares

If the preference shares are redeemable at the end of a specific period than the cost of capital can
be calculated through the following equation: -

Where: Pn = Amount payable at the time of redemption

n = Redemption period of preference shares i.e No. of years
Kp = cost of preference shares

COST OF EQUITY CAPITAL

It is generally argued that the equity capital is free of cost. But it is not true: The reason behind
this argument is that there is no legal binding on company to pay dividend to the equity
shareholders. The objective of management is to maximize shareholders wealth and
maximization of market price of share is operational substitute of wealth maximization.
Therefore the required rate of return, which equates the present value of expected dividends with
the market value of shares, is cost of equity capital. The cost of equity may be defined as
"The minimum, rate of return that a firm must earn on the equity-finance portion of an
investment project in order to leave unchanged the market price of the shares". Thus the
expected rate of return in equity share is just equal to the required rate of return of investors. This
can be calculated by various approaches which are as follows –
1. Dividend Approach
According to this approach cost of equity is the rate of dividend expected by equity shareholders
from the firm.

Where: MP = Market Price per share (if not given, then net proceeds)
DP = Dividend per share
In case of Dividend Growth Rate, the cost of equity will be -

Where: G = Annual Growth Rate of dividend

2. Earning Price Approach
Earning price approach takes into consideration the earning available to equity shareholders
rather than dividend distributed.

Where: EPS = Earning per share

3. Capital Asset Price Method (CAPM)

CAPM is an alternative method to measure the cost of equity share capital other than dividend
method, which is directly based on risk consideration. Risk is the variability of returns inherent
in the type of security while return defined as total economic return obtained from it. Under this
method total risk associated with the security can be divided into unsystematic and systematic.
Calculation of cost of equity share capital under this method is given as under: -
Ke = Rf +B (Rm - Rf)
Where: Rf = Risk free interest rate
B = beta factor (measure of non-diversifiable risk)
Rm = expected cost of capital of the market portfolio
The cost of equity capital will be high if the beta factor is high. The B (beta factor) indicates the
systematic risk of firm’s securities. It shows the sensitivity of firm security to market portfolio.

COST OF RETAINED EARNING

If the entire earning is not distributed and the firm retains a part then these retained earnings are
available within the firm. Companies are not required to pay any dividend on retained earnings,
so it is generally observed that this source of finance is cost free, but it is not true. If earnings
were not retained, they would have been paid out to the ordinary shareholders as dividend. This
dividend forgone by the equity shareholders is opportunity cost. The firm has required to earn on
retained earnings at least equal to the rate that would have been earned by the shareholders if
they were distributed to them. So the cost of retained earning may be defined as opportunity cost
in term of dividends forgone by withholding from the equity shareholders.
WEIGHTED AVERAGE COST OF CAPITAL
In order to evaluate a capital expenditure project, overall or average cost of capital is required.
The overall cost of capital is the rate of return that must be earned by the firm in order to satisfy
the requirements of different investors. It is the minimum rate of return on the asset of the firm,
so it is preferably calculated as weighted average rather than the simple average.
 UNIT – 3
SOURCES OF FINANCE

A company might raise new funds from the following sources:

• The capital markets
- new share issues, e.g., by companies acquiring a stock market listing for the first time
- rights issues
• Loan stock
• Retained earnings
• Bank borrowing
• Government sources
• Business expansion scheme funds
• Venture capital
• Franchising.

ORDINARY (EQUITY) SHARES

Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value,
typically of $1 or 50 cents. The market value of a quoted company's shares bears no relationship
to their nominal value, except that when ordinary shares are issued for cash, the issue price must
be equal to or be more than the nominal value of the shares.

Deferred ordinary shares

These are a form of ordinary shares, which are entitled to a dividend only after a certain date or if
profits rise above a certain amount. Voting rights might also differ from those attached to other
ordinary shares.

Ordinary shareholders put funds into their company:

a) By paying for a new issue of shares
b) Through retained profits.

Simply retaining profits, instead of paying them out as dividends, offers an important, simple
low-cost source of finance, although this method may not provide enough funds, for example, if
the firm is seeking to grow.
New shares issues
A company seeking to obtain additional equity funds may be:
a) an unquoted company wishing to obtain a Stock Exchange quotation
b) an unquoted company wishing to issue new shares, but without obtaining a Stock Exchange
quotation
c) a company which is already listed on Stock Exchange wishing to issue additional new shares.

Rights Issues
A rights issue provides a way of raising new share capital by means of an offer to existing
shareholders, inviting them to subscribe cash for new shares in proportion to their existing
holdings.
For example, a rights issue on a one-for-four basis at 280c per share would mean that a company
is inviting its existing shareholders to subscribe for one new share for every four shares they
hold, at a price of 280c per new share.
A company making a rights issue must set a price which is low enough to secure the acceptance
of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid
excessive dilution of the earnings per share.

PREFERENCE SHARES
Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary
shareholders. As with ordinary shares a preference dividend can only be paid if sufficient
distributable profits are available, although with 'cumulative' preference shares the right to an
unpaid dividend is carried forward to later years. The arrears of dividend on cumulative
preference shares must be paid before any dividend is paid to the ordinary shareholders.
From the company's point of view, preference shares are advantageous in that:
• Dividends do not have to be paid in a year in which profits are poor, while this is not the case
with interest payments on long term debt (loans or debentures).

• Since they do not carry voting rights, preference shares avoid diluting the control of existing
shareholders while an issue of equity shares would not.
• Unless they are redeemable, issuing preference shares will lower the company's gearing.
Redeemable preference shares are normally treated as debt when gearing is calculated.
• The issue of preference shares does not restrict the company's borrowing power, at least in
the sense that preference share capital is not secured against assets in the business.
• The non-payment of dividend does not give the preference shareholders the right to appoint a
receiver, a right which is normally given to debenture holders.
However, dividend payments on preference shares are not tax deductible in the way that interest
payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of
payment needs to be higher than for interest on debt to compensate for the additional risks.
For the investor, preference shares are less attractive than loan stock because:
• they cannot be secured on the company's assets
• the dividend yield traditionally offered on preference dividends has been much too low to
provide an attractive investment compared with the interest yields on loan stock in view of
the additional risk involved.

LOAN STOCK
Loan stock is long-term debt capital raised by a company for which interest is paid, usually half
yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company.
Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a
stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the
coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive
$10 interest each year. The rate quoted is the gross rate, before tax.
Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt
incurred by a company, normally containing provisions about the payment of interest and the
eventual repayment of capital.
Debentures with a floating rate of interest

These are debentures for which the coupon rate of interest can be changed by the issuer, in
accordance with changes in market rates of interest. They may be attractive to both lenders and
borrowers when interest rates are volatile.
Security
Loan stock and debentures will often be secured. Security may take the form of either a fixed
charge or a floating charge.
a) Fixed charge; Security would be related to a specific asset or group of assets, typically land
and buildings. The company would be unable to dispose of the asset without providing a
substitute asset for security, or without the lender's consent.
b) Floating charge; With a floating charge on certain assets of the company (for example, stocks
and debtors), the lender's security in the event of a default payment is whatever assets of the
appropriate class the company then owns (provided that another lender does not have a prior
charge on the assets). The company would be able, however, to dispose of its assets as it chose
until a default took place. In the event of a default, the lender would probably appoint a receiver
to run the company rather than lay claim to a particular asset.
The redemption of loan stock
Loan stock and debentures are usually redeemable. They are issued for a term of ten years or
more, and perhaps 25 to 30 years. At the end of this period, they will "mature" and become
redeemable (at par or possibly at a value above par).

RETAINED EARNINGS
For any company, the amount of earnings retained within the business has a direct impact on the
amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as
a dividend. The major reasons for using retained earnings to finance new investments, rather than
to pay higher dividends and then raise new equity for the new investments, are as follows:
1) The management of many companies believes that retained earnings are funds which do not
cost anything, although this is not true. However, it is true that the use of retained earnings as
a source of funds does not lead to a payment of cash.

2) The dividend policy of the company is in practice determined by the directors. From their
standpoint, retained earnings are an attractive source of finance because investment projects
can be undertaken without involving either the shareholders or any outsiders.
3) The use of retained earnings as opposed to new shares or debentures avoids issue costs.
4) The use of retained earnings avoids the possibility of a change in control resulting from an
issue of new shares.
Another factor that may be of importance is the financial and taxation position of the company's
shareholders. If, for example, because of taxation considerations, they would rather make a
capital profit (which will only be taxed when shares are sold) than receive current income, then
finance through retained earnings would be preferred to other methods.
A company must restrict its self-financing through retained profits because shareholders should
be paid a reasonable dividend, in line with realistic expectations, even if the directors would
rather keep the funds for re-investing. At the same time, a company that is looking for extra

funds will not be expected by investors (such as banks) to pay generous dividends, nor over-
generous salaries to owner-directors.

BANK LENDING
Borrowings from banks are an important source of finance to companies. Bank lending is still
mainly short term, although medium-term lending is quite common these days.
Short term lending may be in the form of:
a) an overdraft, which a company should keep within a limit set by the bank.
b) a short-term loan, for up to three years.
Medium-term loans are loans for a period of from three to ten years. The rate of interest charged
on medium-term bank lending to large companies will be a set margin, with the size of the
margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed
rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted
every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.
Lending to smaller companies will be at a margin above the bank's base rate and at either a
variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a
variable rate of interest is sometimes referred to as a floating rate loan.

CAPITAL STRUCTURE

INTRODUCTION
Capital structure means the pattern of capital employed in the firm. It is a financial plan of the
firm in which the various sources of capital are mixed in such proportions that those provide a
distinct capital structure most suitable for the requirement of the firm.
Capital structure represents the mutual proportion between long term sources of capital which
includes equity shares, preference shares, reserve & surplus and long term debts.
According to Weston and Brigham:-
“Capital structure is the permanent financing of the firm, represented by long-term debt,
preferred stock and net-worth.”
Financial structure: - refers to the way, the company’s assets are financed. It is the entire left
hand side of balance sheet which includes all the long term and short-term sources of capital.
Asset Structure: - Asset structure refers to total assets and their components. It includes all
types of assets of the company i.e. fixed assets and current assets.
Capitalization:- Capitalization is a quantitative concept indicating the total amount of long-term
finance required to carry on the business capitalization comprises a corporation’s ownership
capital and its borrowed capital, as represented by its long - Term indebtedness.

OPTIMUM CAPITAL STRUCTURE

The optimal or the best capital structure implies the most economical and safe ratio between
various types of securities. A capital structure of security mix that minimizes the firm’s cost of
capital and maximizes firms’ value is called optimal capital structure.

Essentials of Optimum Capital Structure:-

1. Simplicity:- The capital structure should not complicated. Therefore, it is essential that in the
beginning only equity shares or preference shares should be issued and afterwards debentures
may be issued
2. Flexibility:- The capital structure should suit to the requirement of the firm in both short-term
and long-term.

3. Minimum Cost:- A sound capital structure must ensure the minimum cost of capital
therefore, while determining the capital structure, such a mix of different securities should be
selected in which the cost in minimum.

4. Minimum Risk:- The capital structure should be heart risky. Therefore, sound capital
structure attempts at a perfect trade-off between return and risk.

5. Maximum Return:- The appropriate capital structure would be one that is most profitable to
the company. It is possible when the cost of financing is minimum and the firm earns stables
and adequate income regularly.

6. Maximum Control:- The capital structure should be designed to preserve the control of the
company’s management in the hands of existing shareholders. Therefore, additional funds be
raised through debentures and preference shares.

7. Safety:- Debt should be used to the extent that the burden of fixed charges does not create the
danger of insolvency.

8. Adequate Liquidity:- The capital structure should be determined in such a way the it may
always provide adequate liquidity.

9. Alternative Rules:- The capital structure should be that which provides different sights to the
securities holder such as return, voting power, redemption, transfer etc. are more and more
attractive.
10. Fulfill Legal Requirements:- The capital structure should fulfill certain rules framed in
companies and other acts regarding the ratios of various types of securities in the capital
structure of business concerns.

FACTORS DETERMINING CAPITAL STRUCTURE

All the factors which affect its capital structure should be considered at the time of its formation.
Generally factors affecting capital structure are divided in two categories, namely (A) Internal
factors, and (B) External Factors.
 Factors Affecting Capital Structure
Internal factors External Factors
- Size of business - Capital Market Conditions
- Nature of business - Nature of Invertors
- Regularity of Income - Policy of financial Institutions
- Assets Structure - Taxation Policy
- Age of Firm - Government Control
- Attitude of Management - Cost of Capital
- Freedom of Working - Seasonal Nature
- Desire to control - Economic Fluctuations
- Future plans - Nature of competition
- Period and Purpose of Financing
- Operating Ratio
- Trading on Equity

POINT OF INDIFFERENCE
Point of indifference is a level of earnings before interest and tax where earnings per share
remain constant irrespective of the debt equity mix. The policy of trading on equity increases the
earnings per shares but it is beneficial to a certain point after which it can proves to be disastrous.
Hence till the rate of intent is lower than the return on assets, trading on equity is beneficial, but
when both becomes equal which is called the point of indifference, more use of debt capital will
be harmful.
Thus with the help of EBIT-EPS analysis keeping in view the point of indifference an optimal
capital structure can be determined. The point of indifference of EBIT can be ascertained by
using the following algebraic formula:
(X-R ) (1-T) – PD = (X-R ) (1-T) – PD
1 2
N N
1 2

Where,
X = EBIT at Indifference Point
R = Interest in option I
1
R = Interest in option II
2
T = Tax Rate
PD = Preference Dividend
N = No. of Equity Shares in Option I
1
N = No. of Equity Shares in Option II
2

TRADING ON EQUITY
Gestenberg defines trading on equity in these words: “When a person or corporation used
borrowed capital as well as owned capital in the regular conduct of its business then it is said to
be trading on equity.”
Trading on equity is an arrangement under which a company makes use of borrowed capital
carrying a fixed rate of interest or dividend in such a way as to increase the return on equity
shares. The policy of trading on equity can be adopted only when the management is confident
that he will earn profits more than the interest to be paid on debt capital. In other words, trading
on equity is advantageous when the rate of interest on debt is less than average rate of return.
Utility of Trading on Equity:-
The basic philosophy behind trading on Equity is to use debt capital to earn more than their cost
and to raise the rate of return on equity share capital. This policy leads higher dividend rate for
equity shares, improvement of the goodwill of the firm and increase in the market price of equity
shares. All these factors make it easy to get more lean from market at a lower rate of interest.
Limitations of Trading on Equity:
1. The firm should not follow the policy of trading on equity if there is no certainty and stability
of income of the firm.
2. Increasing rate of interest of future loans as the risk of successive creditors increases due to
prior lien of the existing creditors on the assets of the firm.
3. Sometimes the management, despite of strong financial position or the capacity to raise loans
by issuing debentures at favorable terms, does not prefer the policy of trading on equity.
4. There is a limit of carrying on business with the use of borrowed funds. After that limit, there
is a fear of over capitalization.
5. There are some legal and contractual difficulties without the fulfillment of those the
management cannot follow the policy of trading on equity.
6. There are some other limitations like increasing burden of interest, interference of creditors in
management and falling goodwill of the firm. For More Detail: - http://www.gurukpo.com
THEORIES OF CAPITAL STRUCTURE
The theories of capital structure are as follows:-
1. Net Income theory.
2. Net Operating Income theory.
3. Traditional theory.
4. Modigliani – Miller theory.

Net Income (NI) Theory:-

This theory was propounded by David Durand. According to this theory a firm can increase the
value of the firm and reduce the overall cost of capital by increasing the proportion of debt in its
capital structure to the maximum possible extent.
As debt is cheaper source of finance, it results in a decrease in overall cost of capital leading to
an increase in the value of the firm as well as market value of equity shares.
Assumptions:
1. The cost of debt is cheaper than the cost of equity
2. Income tax has been igored
3. The cost of debt capital and cost of equity capital remains constant i.e. with the increase in
debt capital the risk perception of creditors and equity investors does not change.
4. Total value of firm = Market value of Equity + market value of debt. Or V = S +D
Market Value of share (S);
S= _NI_ Or _(EBIT-I)_
Ke Ke
Where;
NI = Earnings available for equity shareholders
EBIT = Earnings before interest and Tax
Ke = Cost of Equity Capital.
 The overall cost of capital or capitalization ratio:
Ko = EBIT
V
Ko = Overall cost of capital

Net Operating Income (NOI) Theory

This theory has also been propounded by David Durand. This theory is just opposite that of Net
Income Theory. According to this theory, the total market value of the firm (v) is not affected by
the change in the capital structure and the overall cost of capital (Ko) remains fixed irrespective
of the debt-equity mix. According to this theory there is nothing like optimum capital structure.
Assumptions:-
1. The split of total capitalization between debt and equity is not essential or irrelevant.
2. At every level of capital structure business risk is constant; therefore, the rate of
capitalization also remains constant.
3. The rate of debt capitalization remains constant.
4. There are no corporate taxes.
5. With the use of debt funds which are cheaper, the risk of shareholders increases, which in
turn results to increase in the equity capitalization rate. Hence debt capitalization rate remains
constant.
Computation:-
Value of the Firm = _EBIT_ Or V = S + D
Ko Or S = V – D
Cost of Equity Capital = Ke = EBIT - I (where, I = Interest on debt)
S

Modigliani – Miller Theory:-

This theory was propounded by Franco Modigliani and Merton Miller (generally referred to as
M-M) who are Nobel Prize winners in financial economies. They have discussed their theory in
two situations:
(i) When there are no corporate taxes, and
(ii) When there are corporate taxes.
(i) In the Absence of Corporate taxes:-
As per Modigliani – Miller if there are no corporate taxes than the changes in the capital
structure of any firm do not bring any change in the overall cost of capital and total value of firm.
The reason is that though the debt is cheaper to equity with increased use of debt as a source of
finance, the cost of equity increases and the advantage of low-cost debt is offset equally by the
increased cost of equity. According to this theory, two identical firms in all respect, except their
capital structure, cannot have different market value or cost of capital due to arbitrage processes.
For example, suppose the capital structure of company comprises of equity share capital of Rs
10, 00, 00 and 6% debentures of Rs 20, 00, 00. If the average rate of return on total capital
employed is 10%, the company will earn a profit of Rs. 30,000 (10% on 30, 00, 00). Out of this
profit, the company will have to pay leaving a balance of (1800/10,0,0x100) Which is the
company succeeds in paying more dividend on equity shares capital with the use of borrowed
capital such a situation in any business is known as ‘trading on equity’.
Assumptions:-
1. The capital market is perfect.
2. There is no transaction cost.
3. All the firms can be divided in hom0geneous risk classes.
4. There is no corporate tax.
5. All the profits of the firm are distributed.
6. Individual investors can easily get loans on the same terms and conditions as firm can.
(ii) When Corporate Taxes Exist:-
The basic theory of Modigliani- Miller that the changes in the capital structure do not affect the
total value of the firm and overall cost of capital is not true in the presence of corporate taxes.
Corporate taxes are reality; therefore, they changed their basic theory in the year 1963.
They accepted this fact that for corporate tax determination of interest is a deductible expenditure
than the cost of debt is low. Therefore if any firm uses debt in its capital structure it leads to
reduction in the overall cost of capital and increase in the value of the firm. They accepted that
the total value of a leveraged firm is high than the non-leveraged firm.
Computation:-
 Value of Unlevered firm (Vu) = Vu = EBIT (1 – T)
Ke
Where:Vu = Earning after tax but before Interest
Ke = After tax equity capitalization Rate

Value of levered firm (Vl) = Vl = Vu + DT or EBIT (1 - T) + DT

Ke
Where:D = Amount of Debt
T = Tax Rate

Traditional Theory:-
The traditional theory is a mid-path between Net Income theory and Net Operating Income
theory. According to this theory the cost of debt capital is lower than the cost of equity capital,
therefore a firm by increasing the proportion of debt capital in its capital structure to a certain
limit can reduce its overall cost of capital and can raise the total value of the firm. But after
certain limit the increase in debt capital leads to rise in overall cost of capital and fall in the total
value of the firm. A rational or appropriate mix of debt and equity minimizes overall cost of
capital and maximizes value of the firm. Thus this theory accepts the idea of existence of
optimum capital structure. Ezra Solomon has explained the effects of changes in capital structure
on the overall cost of capital (Ko) and the total value of firm (V) in the following stages:

First Stage: In the beginning the use of debt capital in the capital structure of the firm results in
fall of overall cost of capital and increases the total value of the firm because in the first stage
cost of equity remains fixed rises slightly and use of debt is favorably treated in capital market.

Second State: In this stage beyond a particular limit of debt in the capital structure, the
additional of debt capital will have insignificant or negligible effect on the value of the firm and
the overall cost of capital. It is because the increase in cost of equity capital, due to increase in
financial risk, offsets the advantage of using low cost of debt. Therefore during this second stage
the firm can reach to a point where overall cost of capital is minimum and the total value of the
firm is maximum.
 Third Stage: - If the proportion of debt capital in the capital structure of the firm increases
beyond an accepted limit this dead to increase in the overall cost of capital and fall in the total
value of the firm because the financial risk rises rapidly which results into higher cost of equity
capital which cannot be offset led by low debt capital cost. Hence, the total value of the firm will
decrease and the overall cost of capital will increase.

DIVIDEND POLICY

Dividend is divisible profit distributed amongst members/shareholders of a company in proportion to

shares in the manner as prescribed under law. A dividend cannot be declared unless:
1. Sufficient profit is there in a company.
2. It has been recommended by Board of Directors.
3. Its acceptance has been given by the shareholders in Annual General Meeting (AGM)

KIND OF DIVIDEND
I. Type of Security – Preference Dividend, Equity Dividend
II. Timings of Dividends – Interim Dividend, Regular Dividend
III. Mode of Payment – Cash, Stock dividend (Bonus), Script or Bond.

DIVIDEND POLICY
Policy followed by Board of Directors concerning quantum of profit to be distributed as dividend. It
also includes principal rules and procedure for planning and distributing dividend after deciding rate of
dividend.
• Stable: Long term policy without frequent changes i.e. long term policy which is not affected by
changes or quantum of profit.
• Lenient: Most of the profit is distributed amongst share holders and a very small part is kept as
retained earnings. Even 90% to 95% profit is distributed as dividend. This is generally done in initial
years to gain confidence of share holders.

FACTORS AFFECTING DIVIDEND POLICY

The main determinants of dividend policy of a firm can be classified into:
1. 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
optimum dividend policy should strike a balance between current dividends and future growth which
maximizes the price of the firm's shares. 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.
2. 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:
a. constant dividend per share
b. constant dividend payout ratio or
c. constant dividend per share plus extra dividend
3. 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. 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, financial requirements, availability of
funds, earnings stability and control.
4. 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.
5. 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.

6. 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.
7. Liquidity position: In tight liquidity position, instead cash dividend, bonus shares or
scripts/bonds are issued.
8. Trade Cycle: In boom conditions, higher profits are there and hence high dividend.
MODELS OF DIVIDEND (THEORIES)

Relevance and Irrelevance Dividend Theory - Dividend is that portion of net profits which is
distributed among the shareholders. The dividend decision of the firm is of crucial importance for the
finance manager since it determines the amount to be distributed among shareholders and the amount
of profit to be retained in the business.
A financial manager may treat the dividend decision in the following two ways:
1) As a long term financing decision: When dividend is treated as a source of finance, the firm will
pay dividend only when it does not have profitable investment opportunities. But the firm can also pay
dividends and raise an equal amount by the issue of shares.
2) As a wealth maximization decision: Payment of current dividend has a positive impact on the
share price. So to maximize the price per share, the firm must pay more dividends.

RELEVANT THEORY
If the choice of the dividend policy affects the value of a firm, it is considered as relevant. In that case a
change in the dividend payout ratio will be followed by a change in the market value of the firm. If the
dividend is relevant, there must be an optimum payout ratio. Optimum payout ratio is that ratio which
gives highest market value per share.
Walter’s Model (Relevant Theory)
Prof. James E Walter argues that the choice of dividend payout ratio almost always affects the value of
the firm. Prof. J. E. Walter has very scholarly studied the significance of the relationship

between internal rate of return (R) and cost of capital (K) in determining optimum dividend policy
which maximizes the wealth of shareholders.
The optimum dividend policy will have to be determined by relationship of r & k under following
assumptions.
a) Internal rate of return ® and cost of capital (k) are constant.
b) All new investment opportunities are to be financed through retained earnings and no external
finance is available to the firm.
c) A firm has perpetual or an infinite life
According to the theory, the optimum dividend policy depends on the relationship between the firm’s
internal rate of return and cost of capital. If R>K, the firm should retain the entire earnings, whereas it
should distribute the earnings to the shareholders in case the R<K. The rationale of R>K is that the firm
is able to produce more return than the shareholders from the retained earnings.
Gordon’s Model (Relevant Theory)
Another theory, which contends that dividends are relevant, is the Gordon’s model. This theory is
similar to that of Walter. This model is like Walters Model but a few extra assumptions are:
a) The firm operates its investment activity only through equity.
b) The retention ratio once decided is constant forever.
But Gordon goes one step ahead and argues that dividend policy affects the value of shares even when
R=K. According to Gordon, the rational investors prefer current dividend to future dividend. Retained
earnings are considered as risky by the investors. This behavior of investor is described as “Bird in
Hand Argument”.

IRRELEVANT THEORY
If the choice of the dividend policy does not affect the value of a firm, it is considered as irrelevant. In
that case a change in the dividend payout ratio will not change the market value of the firm.
Modigliani-Miller Model (Irrelevance theory)

According to MM, the dividend policy of a firm is irrelevant, as it does not affect the wealth of
shareholders. According to the theory the value of a firm depends solely on its earnings power resulting
from the investment policy and not influenced by the manner in which its earnings are split between
dividends and retained earnings.
The assumptions of this model are:
a) Perfect Capital Market
b) Investors are rational by nature.
c) In absence of tax, no discrimination between dividend income and capital appreciation
d) The firm’s investment policy is given.
If the company retains the earnings instead of giving it out as dividends, the shareholders enjoy capital
appreciation, which is equal to the earnings, retained.
 UNIT-4
MANAGEMENT OF WORKING CAPITAL

MEANING OF WORKING CAPITAL

It is a fund needed to fulfill the operating cost of a concern. Each and every business
concern should have adequate funds to meet its day-to-day expenses and to finance current
asset viz., debtors, receivables and inventories. The funds tied up in current assets are
known as working capital funds. The funds invested in these current assets keep revolving
and are being constantly converted into cash and this cash in again converted into current
assets.
Therefore, working capital is also known as circulating capital, ‘revolving capital,’ ‘short-
term capital’, or liquid capital.

WORKING CAPITAL MANAGEMENT

Working capital in that part of firms capital which is required for financing current assets
such as cash, debtors, receivables inventories, marketable securities etc. Funds invested in
such assets keep revolving with relative rapidity and are constantly converted in to cash.
Working capital is a financial metric which represents the amount of day-by-day operating
liquidity available to a business. Along with fixed assets such as plant and equipment,
working capital is considered a part of operating capital. It is calculated as current assets
minus current liabilities. A company can be endowed with assets and profitability, but short
of liquidity, if these assets cannot readily be converted into cash.

CLASSIFICATION OF WORKING CAPITAL

Gross working capital – Refers to firms investments in current assets which are converted
in to cash during an accounting year such as cash, bank balance, short term investments,
debtors, bills receivable, inventory, short term loans and advances etc.
Net working capital – Refers to difference between current assets and current liabilities or
excess of total current assets over total current liabilities.
Regular or permanent working capital – Refers to minimum amount which permanently
remain blocked and cannot be converted in to cash such as minimum amount blocked in raw
material, finished product debtors etc.
Variable or temporary working capital – Refers to amount over and above permanent
working capital i e difference between total working capital less permanent working capital.
Seasonal working capital - Refers to capital required to meet seasonal demand e.g. extra
capital required for manufacturing coolers in summer, woolen garments in winter. It can be
arranged through short term loans.
Specific working capital – Refers to part of capital required for meeting unforeseen
contingencies such as strike, flood, war, slump etc.

CONCEPTS OF WORKING CAPITAL

1. Quantitative concept /Gross working capital concept: - The gross working capital
refers to the firm’s investment in current assets. According to J.S. Milli, “The sum of
current assets is the working capital of the business.”
From the management point of view, this concept is more appropriate as the
management formulates all the plans on the basis of current assets and concentrates his
attention on the quantum of current assets and their profitability.
2. Qualitative or Net working capital concept: - The net working capital means the
difference between current assets and current liabilities. If the amount of current assets
and current liabilities is equal, it means that there is no working capital.
The net working capital is a qualitative aspect of working capital and it measures the
firm’s liquidity. It also indicates the extent to which working capital can be financed
with ling term funds. This concept is useful only for accountants, investors, creditors or
those persons who have interest in the liquidity and financial soundness of the firm.
3. Operating Cycle concept:- The amount of working capital required by a firm depends
upon the length of production process and the expenses needed for this purpose The
time required to complete the production process right from Purchase of raw material to
the realization of sales in cash is called the operating cycle or working capital cycle.
 This concept is more appropriate than the qualitative and quantitative approach because
in this case the fund required for carrying on the operational activities is treated as
working capital. It is also called circulating capital.

DETERMINANTS OF WORKING CAPITAL

The amount of working capital required depends upon a large number of factors and each
factor has his own importance, They also wary from time to time in order to determine the
proper amount of working capital of a firm, the following factors should be kept in mind :-
1. Nature of business: Firms dealing in luxury goods, construction business, steel industry
etc need more capital while those dealing in fast moving consumer goods (FMCG“s)
need less working capital.
2. Size of business: Working capital is influenced by size of the firm. Large size firms
need more working capital as compared to small size firms.
3. Level of technology: use of high level technology leads to fastening the process and
reduce wastage and in such case, less working capital would be required.
4. Length of operating cycle: longer is the operating cycle; higher would be the need of
working capital.
5. Seasonal nature: firms dealing in goods of seasonal nature, higher capital during peak
season would be required.
6. Credit policy: If credit policy followed is liberal more working capital would be
required and if the same is strict less working capital would be required.
7. Turnover of working capital: If rate of turnover is more, less working capital would be
required and this rate is less, more working capital would be required.
8. Dividend policy: If a firm retains more profit and distributes fewer amounts as
dividend, less working capital would be required.
9. Profit margin: If rate of margin of profit is more, less working capital would be
required.
10. Rate of growth: If growth rate is high and firm is continuously expending/ diversifying
its production & business, more working capital would be needed.
11. Business Cycle fluctuation
12. Banking relations
13. Taxation Policy
14. Production process and policies
15. Requirement of cash
16. Availability of raw material
17. Terms of Purchase and Sales

SIGNIFICANCE/IMPORTANCE OF ADEQUATE WORKING CAPITAL

 Prompt payment to supplies & benefit of cash/ trade discount.
 Increase in good will/ image
 Easy loans from banks
 Increase in the efficiency of employee’s executives/ directors.
 Increase in the productivity as well as profitability

Limitation of Inadequate Working Capital

 Stock out situation may arise
 Losing customers
 Less profit
 Down fall of good will / image

Limitations of Excess working capital

 Unnecessary piling of stock due to which loss of interest on amount blocked
 Loss due to theft, pilferage etc
 Lead to inefficiency of management
 Adversely affect production and profitability

METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS

1. Operating Cycle Method
2. Net Current Assets Forecasting
 3. Projected Balance Sheet Method
4. Adjusted Profit and Loss Method
CASH MANAGEMENT

INTRODUCTION
Efficient management of cash is crucial to the solvency of business. It implies making sure that
all business generated revenues are efficiently controlled and utilized in best possible manner to
result in gains to the organization. Cash management is concerned with optimizing amount of
cash available to the company & maximizing interest on spare funds not required immediately by
the company.

OBJECTIVES OF CASH MANAGEMENT

1. Ensuring availability of cash as per payment schedule
2. Minimize amount of idle cash
3. Effective control of cash (Maximizing interest on cash/funds not required immediately by the
firm).

MOTIVES OF HOLDING CASH

a. Transaction motive: - Refers to cash required for making payments like wages, operating
expenses, taxes, dividend, interest etc.
b. Precautionary motive: - To make payment for unpredictable contingencies like strike,
lockout, fire, sharp rise in prices etc.
c. Speculative motive: - To take advantages of unexpected opportunities e.g. purchase of raw
material at reduced prices on cash basis, buying securities at time when prices have fallen.

IMPORTANCE /ADVANTAGES OF EFFICIENT MANAGEMENT OF CASH

- firms goodwill is maintained by meeting obligations in time
- cash discount can be availed
- healthy relations can be maintained
 - Unforeseen events can easily by face.

Scope of cash management: -

1. Cash planning & forecasting
 Cash budget
 Cash flow statement
 Ratio analysis
2. Managing cash flows
 Inflows
 Out flows
3. Determining optimum level of cash
4. Investing surplus cash.

CASH BUDGET
A statement showing estimate of cash receipts, cash disbursement and net cash balance for a
future period of time. It is a time based schedule & covers a specific period. There are two
methods of preparing cash budget -
 Cash budget for a short period (up to one year) A statement projecting cash inflows and
flows for a firm over various interim periods (months, quarters). For each period, expected
cash inflows are put against expected out follows to find out if there is any surplus or
deficiency.
 Long term cash budget (3 to 7 years) under this method profit and loss account is adjusted to
know estimates of cash receipts/ payments
This cash budgets helps in
- planning for borrowings
- planning for repayment of loans
- distribution of dividends
- estimation of idle cash
- better coordination of timings of each inflows & out flows
 - identification of cash surplus position and planning for alternative investments in advance

COLLECTION AND DISBURSEMENT METHODS TO IMPROVE CASH

MANAGEMENT EFFICIENCY
(A) COLLECTION METHODS:
Concentration banking – improving flow of cash by establishing collection centers at different
places i.e. multiple collection centers instead of single centre. Even the local cheques received
are collected fast and amount is deposited in bank. The bank in the head office of firm is known
as concentration bank.
Lock Box system – A firm takes on rent post office boxes in selected areas and instructs the
customers to mail their payment in these boxes. The bank of the firm is authorized to open these
boxes, pick up mails and deposit cheques in the account of firm and sends a list of cheques
received for the record of firm.

(B) DISBURSEMENT METHODS –

1. Centralized disbursement centre – Establishing a centralized disbursement centre at head
office of firm and all payments only through this centre. This would help in consolidating all
funds in a single account and making a proper schedule of payments/ handling funds.
2. Payment on due date – all payment on their due dates (not early & not late) strictly
according to agreed terms so that there is no loss of cash/ trade discount and credit
worthiness of firm is maintained.
3. Proper synchronization of receipts and payments
4. Utilizing float – float indicates difference between bank balance and firm’s bank account &
bank pass book. It arises due to time gap between cheque written/issued and time when it is
presented or time gap between cheque deposited and time when credit is actually given by
the bank to the firm this float may be
 Postal float – Time required for receiving cheque from customers through post.
 Deposit float –Time required processing the cheques received and depositing them in bank.
 Bank float – Time required by banker to collect the payment from customer’s bank.
MODELS OF CASH MANAGEMENT
(i) Baumol Model: - It is like EOQ model of inventory control. According to this model,
optimum level of cash is one at which carrying cost of cash or cost of receiving cash is
minimum. Carrying cost of cash refers to interest for gone on marketable securities. This is also
called opportunity cost. Cost of receiving cash or transaction cost is the cost of converting
marketable securities in cash.
(ii) Hiller Orr model – This model is based on assumption that cash balance changes randomly
over a period of time in size. This model prescribes two levels i.e. upper limited and lower limit.
Optimum balance of cash lies between upper and lower limit. When cash balance reaches upper
limit, cash equal to difference between upper limit and optimum limit, it should be invested in
marketable securities. When cash balance reaches to lower limit, cash equal to difference
between optimum limit and lower limit, finance manager should immediately sell marketable
securities so that cash balance reaches normal level.

TREASURY MANAGEMENT (TM)

T.M mainly deals with working capital management and financial risk management. The
working capital management includes cash management and decide asset liability mix. Financial
risk includes forex and interest and interest rate management. Hence, key goal of TM is planning
organizing and controlling cash assets to satisfy financial objectives of organization. The goal is
to: - Maximize return on available cash - Minimize interest cost - Mobilize as much cash as
possible for corporate returns.
Key Responsibilities of T.M.
- Maintaining good relations with banks and other financing institutions
- Managing cost while earning optimum return from any surplus fund.
- Providing long term and short term funds for business at minimum cost.
- Managing interest rate risk in accordance with firms/groups policy
- Advising on all matters of corporate finance including capital structure, merger &
acquisitions etc.
Functions of a Treasury manager
1. Cash management: - efficient collection & payment of cash.
2. Fund management: - Planning and sourcing of short/medium/long term funds.
3. Currency management: - managing foreign currency risk in a multinational company by
T.M
4. Banking function: - negotiating with banks and maintaining good contact with banks.
 RECEIVABLES MANAGEMENT

MANAGEMENT OF RECEIVABLE
Receivables are created on account of credit sales. They are represented in the balance sheet in
the form of sundry debtors, trade debtors, and book debts, accounts receivable, bills receivable
etc. Receivables constitute around 15 to 20% of assets or around 1/3 of working capital in a big
organization and substantial amount of working is blocked in this asset. Hence, their efficient
management occupies great significance in financial management. Receivable Management
means matching the cost of increasing sales with the benefits arising out of increased sales and
maximizing return on investment of firm under this head.
Hence, the prime objective of receivables management is to:
▪ Optimize return on investment
▪ By minimizing costs associated with receivables

BENEFITS OF RECEIVABLES
1. Growth in sales- If a firm does not sell on credit, sales cannot grow.
2. Increase in profit– Growth in sales leads to increase in profit. At times, credit sales are at
a price more than price of cash sales
3. Enables to face competition in market

COSTS ASSOCIATED WITH RECEIVABLES

1. Carrying cost – cost of amount blocked in the form of
 Interest if amount is borrowed
 Opportunity cost if amount blocked is out of retained earnings.
2. Administrative costs – Cost incurred on maintaining staff, for keeping records and for
process of collecting amount from debtors. E.g.
 Salary to staff
 Cost of collecting information about debtors
 Record keeping
  Cost of collecting cheques
 Cost on phone calls, reminders follow up
 Cost on office space, equipments etc and expenditure on staff assigned the duty of
collection of amount from debtors.
3. Delinquency cost - cost on following up with delinquent debtors, reminders, site collection,
legal charges etc.
4. Default cost – cost of debtors becoming bad debts.

FACTORS EFFECTING INVESTMENTS IN RECEIVABLES

1. Level of sales – Higher the sales, high would be amount of credit sales & receivable would
also be high.
2. Nature and conditions of business – In competitive market, more credit sales in consumer
durables like furniture, refrigerators etc.
3. Credit policy of firm – If credit policy is liberal, more would be amount of receivables
4. Terms of credit - Terms of cash & trade discount and period in which payment is expected
from debtors.
5. Capacity of credit department
6. Scrutiny of orders placed by customers
7. Assessing creditworthiness for which collecting information from various sources
8. Timely collection of receivables from debtors

CREDIT POLICY
The firm's credit policy involves analysis of:
1. Opportunity cost of lost contribution.
2. Credit administration cost and risk of bad-debt losses.
There is a contrary relationship that exists between the two costs. If a company adopts stringent
credit policy, there occurs considerable reduction in the level of profitability by the liquidity
position stands story. However, the firm losses in terms of contribution due to higher opportunity
cost resulting form lost sales. Yet, the credit administrative cost & risk of bad debt losses are
quite low.
Contrary to this, a company resorting to liberal credit policy has it profitability rising above
liquidity but the problem of liquidity becomes evident as a result of heavy investment in
receivables due to increased sales. Besides this, the opportunity costs of such a firm declines as
the firm raptures lost contribution. But the credit administrative costs increase as more accounts
are to be handled and also there is rise in risk of bad debt losses.
In reality, it is rather a different task to establish an optimum credit policy as the best
combination of variables of credit policy is quite difficult to obtain. The important variables of
credit policy should be identified before establishing an optimum credit policy.
The three important decisions variables of credit policy are:
1. Credit terms,
2. Credit standards, and
3. Collection policy.

Credit Control - Credit control is a complex process, which costs both time and administrative
costs. Broadly, speaking, the function of credit control incorporates the following elements: -
1. Checking Customers Credit Worthiness - This step relates to applicants ability to pay for the
goods or services opted by him. The decision pertaining to credit grant and its volume largely
depends upon this assessment. The assessment can be done on the basis of financial
soundness, general behavior, past records, business habits and traits. Trade reference,
banker's records available with the geriatric etc. are a few of certain elements that provide
relevant information for conducting this assessment.
2. Prompt Invoicing and Follow-up - This is an executive action involving prompt issue of
invoice and equally close follow-up action. A continuous personal attention is required for
reviewing amounts of bills receivables. Methods are selected among the various possible
alternatives available to ensure that the time period is minimum between the realization of
payments and converting it into bank's credit account.
3. Credit Insurance - This point pertains to credit exports. As credit sales does not fall under any
credit insurance policy coverage in India. It is export credit guarantee department, which
 formulates appropriate rules and issues credit insurance policies for exports on payments of a
nominal premium. These facilities are of high importance for credit control of exports.
4. Financial Statements - Financial statement is an important document that presents desirable
sources of information to the seller regarding the financial position of customer for credit
control. For the companies carrying out seasonal business, interim statements instead of
financial statements are preferred. For acquiring authenticated information audited financial
statement should be favored rather than unaudited figures.
5. Use of Electronic Data Processing Equipment - In the modern world, the importance of
computers cannot be possibly denied. Electronic data processing equipment holds its own
individual importance in providing timely and accurate information pertaining to the status of
accounts. The computer can provide a vast array of detailed information, previously
impractical to obtain that may be useful not only to the credit manager but to other
management as well. In addition to processing data the computer can be programmed to
make certain routine credit decisions.
 INVENTORY MANAGEMENT

INTRODUCTION
Inventory means stock of goods in the form of raw material, stores or supplies, work in progress
and finished product waiting for sale.
Important features of inventory are.
▪ If accounts for large share of working capital
▪ Risk factor is high in holding inventory
▪ If involves many types of costs.
▪ It influences price and income of the firm as well as profitability.
▪ It involves almost all functional areas of management i.e. purchase, production,
marketing & finance.

TYPES OF RISKS ASSOCIATED WITH INVENTORY

 Risk of price fluctuation
 Risk of deterioration of quality of goods
 Risk of obsolescence
 Risk of pilferage & loss

INVENTORY MANAGEMENT
It means efficient management/ control of capital invested in inventory for obtaining maximum
return by keeping inventory costs at minimum.
OBJECTIVES OF INVENTORY CONTROL
There are two main objectives of inventory control, these are -
Operating objectives
a. Regular flow of material
b. Minimization of risks due to Stock out.
c. Avoid obsolescence of stored goods due to change in demand, technology etc.
Financial objective
 a. Minimum investment or maximization of returns on investments
b. Minimizing inventory costs.
KEY FUNCTIONS OF INVENTORY CONTROL
1) Effective use of financial resources
2) Economy in purchasing
3) Uninterrupted production of goods & services
4) Protection against loss of material
5) Prompt delivery of goods to customers
6) Eliminating redundant inventory
7) Providing information to management for decision making

DANGERS OF OVER STOCKING OF INVENTORY

1) Blocking of funds – If there is over stock of inventory, then it may lead to reduction in profit
due to interest cost or opportunity cost.
2) Increase in holding cost – besides interest, rent of space, insurance, loss on account of theft,
pilferage etc.
3) Loss of liquidity – as it is difficult to sell stores, woks in proposes as well as semi-finished
goods.
4) Dangers of under stocking of inventory/stock out/ shortage of inventory items
 Loss of profit due to loss of sales
 Loss of future sales as customers may go else where
 Loss of customer’s confidence resulting to loss of good will
 Loss of machine and men hours as they may remain idle which lead to frustration in
labour may force, unnecessary stoppage in production, extra costs in urgent
replenishment of items.

DIFFERENT TYPES OF COSTS ASSOCIATED WITH INVENTORY

 Material cost – Which include cost of purchasing material/ Goods including transportation
cost, sales tax, octroi, handling cost (loading unloading) etc.
 Ordering costs: Clerical & administrative costs such as salary, postage, stationary telephone
etc associated with purchasing, cost of requisition of material for order, follow up,
receiving/evaluating quotations, checking of material when received (quality/quantity)
accounting costs such as checking of supplies against orders, making payment, maintaining
records of purchase etc. setup costs when items are manufactured internally.
 Carrying costs- storage cost e.g. Rent, lighting heating, refrigeration, labour costs in
handling material, store staff equipments, taxes, depreciation, insurance, product
deterioration obsolescence spoilage, breakage, pilferage, audit & accounting cost and lastly
interest cost on capital or opportunity cost.
 Stock out costs or shortage of material – Which include loss of profit due to loss of sale,
loss of future sales, loss of loosing goodwill in the eyes of customers and loss of man and
machine hours.

TECHNIQUE OF INVENTORY MANAGEMENT

EOQ - Optimum size of an order for replenishment of an item of inventory is called EOQ.
ROP - Re-ordering point is the level of inventory at which an order should be placed for
replenishment of on item of inventory.
Stock levels - Fixing levels like minimum, maximum, re-order and danger level.
ABC analysis – Always Better control. All items of inventory are divided in to three categories
i.e. „A“, „B“, & „C“.
Category A - Value 70% to 75%, where quantity is 5% to 10%
B - Value 20% to 25%, where quantity is 20% to 30%
C - Value 5% to 10%, where quantity is 65% to 70%
VED Analysis – Vital, Essential & Desirable (used for spare parts)
SDE Analysis
Scarce (items in short supply)
Difficult (items cannot be procured easily)
Easy (items which are easily available)
FSN Analysis
 Fast moving (stock to be maintained in large quantity)
Slow moving (not frequently required by production dept.)
Non-moving (items which are rarely required by production dept)

Introduction to A.B.C.
ABCis a selective inventory control technique which stand for Always Better Control.
ABC analysis is a technique for prioritizing the management of inventory. Inventories are
categorized into three classes- A, B, and C. Most management efforts and oversights are
expended on managing A items. C items get the least attention and B items are in-between
(moderate).
All three refer to categorization of various items, products and services into three groups
depending upon their importance and significance so that their handling is done accordingly.
1.2 Explanation of A.B.C.
This ABC analysis is based on economic principle of economist Vilfredo Pareto which
state that most of the economic productivity comes from only a small parts of the economy
i.e. in any large group there are “significant few” and “insignificant many”.

Classification of items Under A.B.C.

1.3.1 Category ‘A’
Most valuable and costly items are classified under ‘A’ category. Such items have large
investment but not much in number. For example 10 percent of items account for 70 percent
of total invested in inventory. So, more careful and strict control is needed for such items.
This category will be the smallest category in quantity but largest in monetary terms.
1.3.2 Category ‘B’
Category ‘B’ represents the middle parts of products between Category ‘A’ and Category
‘C’. They are larger in number than category ‘A’ but smaller in monetary term. These items
having average consumption value. 20 percent of the item in an inventory account 20 percent
for total investment. These ‘B’ items have less importance than ‘A’, so moderate control is
needed for them.
1.3.3 Category ‘C’
The items placed under category ‘C’ have the lowest consumption value.But, nearly 70 per
cent of inventory items account only for 10 percent of the total invested capital. So, these
are “trivial many” items which do not catch much strict management attention i.e. loose
control is needed for such items.
Now, this ABC analysis can be demonstrated with help of following graphs:
WhyA.B.C. Analysis:
• Ensures control over the costly items.
• Reduction in the storage expenses.
• Resource allocation.
• Increased economy.
1.5 Limitation of A.B.C. Analysis:
• ABCAnalysis does not permit precise consideration of all relevant problem of inven
tory control.
• If ABC Analysis is not updated and reviewed periodically the real purpose of control
may be defeated.
• Periodical consumption value is the basis for ABC classification not the unit value
Introduction to E.O.Q.
What is a EOQ model?
Economic Order Quantity (EOQ) is a model used in inventory management to determine the optimal
order quantity that a company should purchase to minimize the total cost of inventory. This model
takes into account the cost of ordering and holding inventory, as well as the cost of stockouts.

In order to understand the EOQ model, it is important to first understand the two main costs associated
with inventory: holding costs and ordering costs. Holding costs are the costs associated with storing
and maintaining inventory, such as warehouse space, insurance, and depreciation. Ordering costs are
the costs associated with placing an order for inventory, such as the cost of processing the order,
transportation costs, and any discounts or bulk purchasing costs.

The EOQ model uses these two costs to determine the optimal order quantity that minimizes the total
cost of inventory. The formula for EOQ is as follows:

EOQ = √(2DS/H)

Where:

D = Annual demand for the item

S = Cost of placing an order

H = Holding cost of one unit per year

The EOQ formula assumes that the demand for the item is constant and that the lead time for the item
is negligible. The model also assumes that the ordering and holding costs are constant, and that there is
no stockout cost.
Who it is important for?
The Economic Order Quantity (EOQ) model is important for any company or organization that
manages inventory. This includes businesses in a variety of industries such as retail, manufacturing,
healthcare, and logistics.

In retail, the EOQ model can help companies to minimize the total cost of inventory and improve
customer service by ensuring that they always have enough inventory on hand to meet customer
demand.

In manufacturing, the EOQ model can help companies to minimize the costs associated with ordering
and holding raw materials, and improve efficiency by ensuring that they always have the necessary
materials on hand to meet production needs.

In healthcare, the EOQ model can be used to manage the inventory of medical supplies, helping
hospitals and clinics to minimize costs and ensure that they always have enough supplies on hand to
meet patient needs.

In logistics, the EOQ model can be used to manage the inventory of shipping and packaging materials,
helping companies to minimize costs and ensure that they always have enough materials on hand to
meet shipping needs.

Overall, the EOQ model is important for any company or organization that needs to manage inventory
in an efficient and cost-effective manner. It can help companies to minimize costs, improve efficiency,
and ensure that they always have enough inventory on hand to meet customer demand.

Advantages of using EOQ model in inventory management

There are several advantages to using the Economic Order Quantity (EOQ) model in inventory
management. These include:

Minimizes total inventory costs: The EOQ model helps companies to minimize the total cost of
inventory by determining the optimal order quantity. By using the EOQ model, companies can reduce
the costs associated with ordering and holding inventory.
Improves customer service: By determining the optimal order quantity, companies can ensure that they
always have enough inventory on hand to meet customer demand. This can lead to higher customer
satisfaction and increased sales.
Easy to use: The EOQ model is a simple and easy-to-use tool for inventory management. The formula
for EOQ is straightforward and can be easily implemented in practice.
Can be used in conjunction with other inventory management techniques: The EOQ model can be used
in conjunction with other inventory management techniques, such as safety stock, reorder points, and
just-in-time inventory systems to provide a comprehensive inventory management strategy.
Helps to improve forecasting: By determining the optimal order quantity, companies can improve their
forecasting abilities by having a better understanding of their inventory needs.
Helps in setting inventory levels: EOQ model helps in determining the right inventory level that is
neither too high nor too low, thus, reducing the carrying cost and also the ordering cost.
Helps in determining the reorder point: EOQ model also helps in determining the reorder point, the
point at which an organization needs to place an order for new stock.
In conclusion, the EOQ model is a useful tool for inventory management that can help companies to
minimize the total cost of inventory, improve customer service, and assist in forecasting and setting
inventory levels. It is easy to use, and can be used in conjunction with other inventory management
techniques. However, it’s important to keep in mind that the EOQ model has some limitations and
should be used in conjunction with other inventory management techniques to provide a comprehensive
inventory management strategy.

Disadvantages of using EOQ model in inventory management

There are a few disadvantages to using the Economic Order Quantity (EOQ) model in inventory
management. These include:

Assumes constant demand: The EOQ model assumes that the demand for the item is constant, which
may not always be the case in the real world. If demand is not constant, the EOQ model may not
accurately reflect the optimal order quantity.
Neglects lead time: The EOQ model assumes that the lead time for the item is negligible, which may
not be the case for all items. This can lead to inaccuracies in the EOQ calculation if lead time is not
considered.
Constant costs: The model assumes that the ordering and holding costs are constant, which may not be
the case for all companies. If these costs vary, the EOQ model may not accurately reflect the optimal
order quantity.
No stockout cost: The model does not consider the cost of stockouts. In real world scenarios the cost of
stockouts can be significant and should be taken into account when determining the optimal order
quantity.
Only one item: EOQ model is applicable when the inventory system is dealing with only one item. If
the inventory system is dealing with multiple items, this model is not applicable.
Simplistic: EOQ model is relatively simplistic, it does not take into account all the possible
complexities that a real-world inventory system may have, such as demand uncertainty, multiple
products, multiple suppliers, and stochastic lead times.
It’s important to keep in mind that the EOQ model is just one tool that can be used in inventory
management. In practice, companies may use a combination of different inventory management
techniques and consider other factors such as lead time, demand variability, and supplier reliability
when determining their inventory strategy.

In summary, the Economic Order Quantity (EOQ) is a model that can help companies to minimize the
total cost of inventory by determining the optimal order quantity. By using the EOQ model, companies
can reduce the costs associated with ordering and holding inventory, and improve customer service by
ensuring that they always have enough inventory on hand to meet customer demand. However, it’s
important to remember that the EOQ model has some limitations and it’s important to use the EOQ
model in conjunction with other inventory management techniques.

Example of how to use EOQ

To illustrate the EOQ model let’s consider an example where the demand for an item is 1000 units per
year, the cost of placing an order is $50 and the holding cost of one unit per year is $2.

Using the EOQ formula:

EOQ = √(2DS/H) = √ (2100050/2) = √(100000) = 316.22

Therefore, the optimal order quantity would be 316.22 units.

Techniques based on the order quantity of Inventories
Order quantity of inventories can be determined with the help of the following techniques:
1. Stock Level:
Stock level is the level of stock which is maintained by the business concern at all times.
Therefore, the business concern must maintain optimum level of stock to smooth running of the
business process. Different level of stock can be determined based on the volume of the stock.
2. Minimum Level:
The business concern must maintain minimum level of stock at all times. If the stocks are less than
the minimum level, then the work will stop due to shortage of material.
3. Re-order Level
Re-ordering level is fixed between minimum level and maximum level. Re-order level is the level
when the business concern makes fresh order at this level.
Re-order level=maximum consumption × maximum Re-order period.
4. Maximum Level
It is the maximum limit of the quantity of inventories, the business concern must maintain. If the
quantity exceeds maximum level limit then it
will be overstocking. Maximum level = Re-order level + Re-order quantity –
(Minimum consumption × Minimum delivery period
5. Danger Level
It is the level below the minimum level. It leads to stoppage of the production process.
Danger level=Average consumption × Maximum re-order period for emergency purchase
6. Average Stock Level
It is calculated such as, Average stock level= Minimum stock level + ½ of re- order quantity
7. Lead Time
Lead time is the time normally taken in receiving delivery after placing order s with suppliers. The
time taken in processing the order and then executing it is known as lead time.
8. Safety Stock
Safety stock implies extra inventories that can be drawn down when actual lead time and/ or usage
rates are greater than expected. Safety stocks are determined by opportunity cost and carrying cost
of inventories. If the business concerns maintain low level of safety stock, it will lead to larger
opportunity cost and the larger quantity of safety stock involves higher carrying costs.