Karnataka State Open University

Mukthagangothri, Mysuru - 570 006

[email protected] II SEMESTER M.COM
FINANCIAL MANAGEMENT
COURSE CODE:MCOSC2.2A/D

Department of Studies and Research in Commerce

BLOCK
1

Page No.

UNIT - 1: FINANCIAL MANAGEMENT 1-19

UNIT - 2: FINANCIAL PLANNING AND CONTROL 20-39

UNIT - 3: TIME VALUE OF MONEY 40-65

UNIT - 4: COST OF CAPITAL 66-96

 Credit Page
Programme : M.Com Year/Semester: Second Block No : I
Course : Financial Management Credit : 03 Units No :1-4
Course Design Expert Committee
Prof. Vidyashankar Chairman
Vice-Chancellor,
Karnataka State Open University,
Mukthagangotri, Mysuru – 570 006.
Prof. Ashok Kamble Member
Dean (Academic),
Karnataka State Open University,
Mukthagangotri, Mysuru – 570 006.
Dr.Mahesha V. Member
BOS Chairman,
DOS&R in Commerce, KSOU, Mysuru.
Dr. Sukanya R. Member
Assistant Professor and Course Designer,
DOS&R in Commerce, KSOU, Mysuru.
Smt. Usha C. Member Convener
Chairperson,
DOS&R in Commerce, KSOU, Mysuru
Course Writer Course Editor
Dr. Sukanya R. Smt. Usha C.
Assistant Professor, Chairperson,
DOS&R in Commerce, DOS&R in Commerce,
KSOU, Mysuru. KSOU, Mysuru.
Editorial Committee
Dr.Mahesha V. Chairman
BOS Chairman,
DOS&R in Commerce,KSOU, Mysuru.

Prof. Venkatesh S. External Member

Professor, Department of Commerce,
Kuvempu University, Shivamogga.
Dr. Sukanya R. Internal Member
Assistant Professor, DoS & R in Commerce,
Karnataka State Open University, Mysuru.

Smt. Usha C. Member Convener

Chairperson,
DOS&R in Commerce, KSOU, Mysuru. .
Copy Right
Registrar,
Karnataka State Open University, Mukthagangothri, Mysuru - 570006.
Developed by the Department of Studies and Research in Commerce, KSOU, under the guidance of Dean
(Academic) , KSOU, Mysuru.Karnataka State Open University, October -2022.
All rights reserved. No part of this work may be reproduced in any form, or any other means, without permission in
writing from the Karnataka State Open University.Further information on the Karnataka State Open University
Programmes may obtained from the University’s office at Mukthagangothri, Mysuru-570006.
Printed and Published on behalf of Karnataka State Open University. Mysuru-570006 by Registrar (Administration)-
2022.
 Karnataka State Open University
Mukthagangothri, Mysuru - 570 006
Preface

Dear Learner,

This study material provides you with key principles that you can apply throughout
your career to help you build financial insight. The principles of finance provide a unified
perspective of the most crucial financial ideas, which you can use in all of your financial
decisions. Financial management has emerged as an interesting and exciting area for
academic studies as well as for managing finance practically. All decisions taken by an
individual or a business that have financial implications fall under the category of financial
management. The financial implications of choices are assessed in terms of maximising the
value of the firm, whether the business is organised as a company, where ownership and
management are seperate, or in another way. As a result, the decision-making process is
focused on the goal of maximising shareholder’s wealth as shown by the market price of a
share. The curriculum makes an effort to address how a business organisation makes
financial decisions. An easy way to understand financial management is to apply the
theoretical concepts to real-life problems being faced by financial managers. The course
writer has tried to use practical illustrations to explain and analyse the different ideas in the
course ‘Financial Management’ in second semester M.Com.

The study material is in interactive mode which is developed by experienced

academicians in the field of finance. The course is designed to acquaint students and
professionals with the contents and tools of financial management. You may refer to
various text books relevant to the course, which are provided at the end of each unit. Feel
free to send feedback to the department for further improvements, and you may contact the
course writer for any clarifications.

With best wishes,

Smt. Usha C.
Chairperson
 BLOCK – I
INTRODUCTION

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise. It means
applying general management principles to financial resources of the enterprise. However,
Financial Planning is the process of estimating the capital required and determining its
competition. It is the process of framing financial policies in relation to procurement,
investment and administration of funds of an enterprise. The process begins at financial
planning, many times in the form of cash flow and forecasting balance sheet.

Money has time value. The time value of money is a basic financial concept that
holds that money in the present is worth more than the same sum of money to be received
in the future. This is true because money that you have right now can be invested and earn a
return, thus creating a larger amount of money in the future.

Cost of capital is the minimum rate of return or profit a company must earn before
generating value. It’s calculated by a business’s accounting department to determine
financial risk and whether an investment is justified. Company leaders use cost of capital to
gauge how much money new endeavours’ need to generate to offset upfront costs and
achieve profit. They also use it to analyse the potential risk of future business decisions.
Cost of capital is extremely important to investors and analysts. These groups use it to
determine stock prices and potential returns from acquired shares

This block consists of 4 units, they are:

Unit -1: Introduction to Financial Management

Unit -2: Financial Planning and Control

Unit -3: Time Value of Money

Unit -4: Cost of Capital

 BLOCK - I

UNIT -1 FINANCIAL MANAGEMENT

Structure:
1.0 Objectives

1.1 Introduction

1.2 Meaning and Definitions of Financial Management

1.3 Nature of Financial Management

1.4 Scope of Finance

1.5 Objectives of Financial Management

1.6 Finance Functions

1.7 Financial Goals

1.8 Profit Maximisation vs Wealth Maximisation

1.9 Role of Financial Manager in India

1.10 Financial Decisions

1.11 Challenges in Global Era

1.12 Check Your Progress

1.13 Keywords

1.14 Summary

1.15 Questions for Self-Study

1.16 References

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1.0 OBJECTIVES
After Studying this unit, you will be able to;

 Bring out the objectives of financial management.

 Discuss the role of financial manager in the present arena.
 Distinguish between profit maximisation vs wealth maximisation.
 Analyse the challenges in the global arena.
1.1 INTRODUCTION
Finance is defined as the provision of money at the time when it is needed. Every
enterprise, whether big, medium, small, needs finance to carry on its business activities. Any
kind of business activity depends on the finance, without adequate finance, no enterprise can
possibly accomplish its objectives. Hence, Finance is called as the lifeblood of business
organization. Therefore,

1.2 MEANING AND DEFINITIONS OF FINANCIAL MANAGEMENT

According to Khan and Jain, “Finance is the art and science of managing money”.

Financial Management deals with procurement of funds and their effective utilization in
the business. Financial management may be defined as “acquisition of fund at optimum cost and
its utilization with minimum financial risk.” Financial management refers to that part of the
management activity, which is concerned with the planning, organizing, directing and
controlling of firm’s financial resources. It deals with finding out various sources for raising
funds for the firm.

Financial management as given by S.C. Kuchal is that “financial management deals

with procurement of funds and their effective utilization in the business”.

According to Howard and Upton, financial management “as an application of general

managerial principles to the area of financial decision-making”.

According to Joseph & Massie, “financial management “is the operational activity of a
business that is responsible for obtaining and effectively utilizing the funds necessary for
efficient operations.

Financial management is practiced by many corporate firms and can be called corporate
finance or business finance.

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1.3 NATURE OF FINANCIAL MANAGEMENT
Finance management is a long term decision making process and requires planning. The
following are the nature of financial management.

 Estimates capital requirements

Financial management helps in forecasting capital required for carrying out business
activities, by estimating working capital and fixed capital requirements.

 Decides capital structure

Financial management helps to decide optimum capital structure, capital structure

decision involves deciding the proper balance between different type of securities like equity,
preferred share equity and debt. Optimal capital structure helps to achieve better profits by
minimizing the cost of capital.

 Select sources of fund

Source of fund are one crucial decision in every organisation. Financial management
helps to choose various sources of funds like shares, bonds, debentures, venture capital,
financial institutions, retained earnings, owner investment, etc. Financial management helps to
analyse all sources of funds available and helps to choose those funds which involve minimum
risk and in the cheapest form.

 Raises shareholders’ value

Financial management helps to raise the overall value of shareholders wealth. It aims to
increase return on investment to shareholders by reducing the cost of operations and increasing
profits.

 Management of cash

Financial management monitors all cash movements in the company. The supervision of
cash inflows and cash outflows is done properly. Thereby ensures there is no deficiency or
surplus of cash in an organization.

1.4 SCOPE OF FINANCE

Financial management is one of the important parts of overall management, which is
directly related with various functional departments like personnel, marketing and production.

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Financial management covers wide area with multidimensional approaches. The scope of
financial management is explained below:

 Financial Management and Economics

Financial economics is one of the emerging areas, which provides immense

opportunities to finance and economical areas. Using macro and micro economics concepts
for financial management approach is the recent trend.

Financial managers use investment decisions, micro and macro environmental

factors, money value discount factor, economic order quantity and other factors.

 Financial Management and Accounting

In olden days, both financial management and accounting were treated as same and
merged, but now-a-days, both are separated and interrelated.

 Financial Management and Mathematics

Latest approach of financial management applied large number of mathematical and

statistical tools and techniques called econometrics.

 Financial Management and Production Management

Production process need finance, because the expenses of production like raw
material, machinery wages, operating expenses and other direct expenses are carried out by
finance department and appropriate funds are allotted to each stage of production.

 Financial Management and Marketing

The finance manager or department is responsible to allocate the adequate funds to

marketing department by which goods will be sold by innovative and modern approaches.

 Financial Management and Human Resources

Financial manager should carefully evaluate the requirement of manpower in

respective departments and allocates finance to human resource department in the form of
wages, salary, bonus and other monetary benefits.

1.5 OBJECTIVES OF FINANCIAL MANAGEMENT

The main objective of a business is to maximize the owner’s economic welfare.
Financial management provides a framework for achieving the objectives of a business;
Objectives of financial management may be broadly divided into two parts: (i) Profit
maximization (ii) Wealth maximization.
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(i) Profit Maximization
Profit is the main aim of every economic activity. A business being an economic
institution should earn profit to cover its costs and provide funds for growth. Business
cannot survive without earning profit. Profit maximization is traditional and narrow
approach, which aims at, maximizes the profit of the concern.
Profit maximization consists of the following important features.
1. Profit maximization leads to maximize the business operation.
2. Ultimate aim of the business concern is earning profit, hence, it considers all the
possible ways to increase the profitability of the concern.
3. Profit is a measure of efficiency of a business enterprise. it shows the entire position of
the business concern.
4. Profit maximization also serves as a protection against the risk of the business
concern.
Arguments in favour of Profit Maximization
1. When profit earning is the main aim of the business, then the profit maximization
should be the obvious objective.

2. Profitability is the barometer for measuring the efficiency and economic prosperity of
a business concern, thus profit maximization is justified on the ground of rationality.

3. Profits are the main source of finance for the growth of the business. So a business
should aim at maximization of the profits for enabling its growth and development.

4. Profitability is essential for fulfilling the social goals also. A firm by pursuing the
objectives of profits maximization also maximizes the socio economic welfare.

5. Profit maximization serves as a protection against the risk of the business concern, a
business concern will be able to survive under unfavourable condition only if it had
some past earnings to rely upon.

6. Profit is the main internal sources of finance.

Arguments against Profit Maximization

1. The term ‘Profit’ is vague and it cannot be precisely defined. It means different things
for different people. It creates some confusion regarding earning habits of the
business concern. For instance, the confusion on maximising the short term profit or
long term profit? Total profit or earning per share? Profit before tax or after tax?
operating profit or profit available for the shareholders?.
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 2. It ignores the time value of money: Profit maximization does not consider the time
value of money or the net present value of the cash inflow. It treats all the earnings as
equal though they occur in different time periods. It leads to certain differences
between the actual cash inflow and net present cash flow during a particular period.

3. It ignores risk: It does not take into consideration the risk of the prospective earnings
stream. Risk may be internal or external which will affect the overall operation of the
business concern. Some projects are riskier than others, if the earning stream is riskier
the market nature of its share will be comparatively less.

4. Profit maximization objectives leads to inequalities among the different type of stake
holders such as customers, suppliers, public, shareholders, etc. In case, earnings per
share is the only objective then the enterprise may not think of paying dividends at all
because it retains profits in the business or investing them in the market may satisfy
this aim.

5. Profit maximization may lead to exploitation of workers and consumers.

6. In order to earn maximization of a profits business concern may indulge in immoral

practices such as corrupt practice, unfair trade practice and many others.

(ii) Wealth Maximization

Wealth maximization objective is also known as “Value Maximization” or “Net

Present worth Maximization.” Wealth maximization is one of the modern approaches to
financial management. The term wealth means shareholder wealth or the wealth of the
persons those who are involved in the business concern. When the firm maximizes the
shareholder’s wealth, the individual stakeholders can use this wealth to maximize his
individual utility. It means that by maximizing stakeholder’s wealth, the firm is operating
consistently toward maximizing stakeholder’s utility.
Arguments in favour of Wealth Maximization

1. Wealth maximization is superior to profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the
shareholders. Wealth maximization objective not only serves the interest of the
shareholder’s by increasing the value of their holdings but also ensures the security to
the lenders.

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 2. Wealth maximization takes into account both time value of money and risk of the
business concern as it considers timing of cash inflows. The cash flows occurring at
different period of time are discounted with appropriate discount rates.

3. Wealth maximization guides the management in framing the consistent strong

dividend policy to reach maximum returns to the equity holders, which ultimately
upholds economic interest of the society.

4. The concept of wealth maximization is universally accepted, because it takes care of

interest of financial institution, owners, employees and society at large.

5. Wealth maximization provides efficient allocation of resources. Resources are

allocated wisely to increase shareholder’s wealth.

Arguments against Wealth Maximization

1. Wealth maximization objective may face difficulties when ownership and

management are separated, as is the case in most of the corporate form of
organizations. It creates ownership-management problem as owners want to maximize
their profits and management want to maximize shareholder’s wealth.

2. The objective of wealth maximization is inclined towards wealth maximization of

shareholders and ignores other stakeholders such as creditors, suppliers, employees
and others.

3. Wealth maximization is another form of profit maximization. Wealth maximization

can be achieved only with the help of the profits, without earning profits, wealth
cannot be maximized. The ultimate aim of the wealth maximization is to maximize
the profit.

1.6 FINANCE FUNCTIONS

Finance function is one of the major parts of business organization, it reflects the
entire operational and profitability position of the concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance function.
His position is highly critical and analytical to solve various problems related to finance. A
financial manager has to concentrate on the following areas of the finance function.

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1. Forecasting financial requirements

The primary role of a finance manager is to meet the financial requirements of his
business. For this purpose, he should estimate the financial requirements of his business.
Funds are needed to meet working capital requirements, to acquire fixed assets and to meet
the short term and long-term needs of his business concern. A financial plan has to be
prepared for present as well as future. The estimation should be based on the sound
financial principles so that neither there are inadequate or excess funds with the concern.
The inadequacy will affect the working of the concern and excess funds may tempt a
management to indulge in extravagant spending.
2. Deciding capital structure

Capital structure is the composition of the capital employed by the firm from
different sources of finance, which is a mix of owner’s capital (that is, equity
capital and preferred capital) and loan (debt) from outsiders and is used to finance its
overall operations and investment activities.
The financial manager has to establish an optimum capital structure. Decision about various
sources of funds should be linked to cost of raising funds. If cost of rising funds is high,
then such sources may not be useful. A decision about the kind of the securities to be
employed and the proportion in which these should be used is an important decision which
will influence the profitability of the concern.
3. Selecting a source of finance

After preparing a capital structure, a finance manager has to identify an appropriate

source from which finance may be raised. He may issue different types of securities and
debentures. He may borrow from a number of financial institutions and the public. The
selection of a suitable source of funds will influence the profitability of the concern. A
finance manager has to be very careful and cautious in approaching different sources.
4. Selecting a pattern of investment

The selection of investment pattern is related to the use of the funds. The financial
manager must carefully select best investment alternatives and consider the reasonable and
stable returns from the investment. The finance manager must concentrate on principles of
safety, liquidity, profitability and leverage while investing capital. He must be well versed
in the field of capital budgeting techniques to determine the effective utilization of
investment.

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5. Administrating the allocation of funds

Once funds are allocated on investment opportunities, it is the basic responsibility of

the finance manager to watch the performance of each rupee that has been invested. He has
to adopt the close supervision and marking of flow of funds. This helps the management to
increase efficiency by reducing the cost of operations and earn fair amount of profits out of
these investments.

6. Proper cash management

Cash management plays a major role in the area of finance. The financial manager
has to assess the various cash needs at different times and then make arrangements for cash.
The cash management should be such that neither there is shortage of it nor it is idle. Any
shortage of cash will damage the creditworthiness of the enterprise. The idle cash with the
business means that it is not properly used. Proper cash management is not only essential
for effective utilization of cash but it also helps to meet the short-term liquidity position of
the concern. Cash flow statement helps to figure out various sources and applications of
cash.
7. Cost-volume-profit analysis

The finance manager has to ensure that the income of the firm should cover its
variable costs. Moreover, a firm will have to generate an adequate income to cover its fixed
costs as well. The finance manager has to find out the break-even-point-that is, the point at
which there is no-profit, no-loss. He has to try to shift the activity of the firm as far as
possible from the break-even point to ensure company’s survival against seasonal
fluctuations.
8. Dividend policies

Dividend is the reward of the shareholder for investments made by them in the
shares of the company. The investors are interested in earning maximum return on their
investments whereas management may try to improve its internal financing for future
expansion. A finance manager has to decide the percentage of profit to be distributed as
dividend among the shareholders and how much to retain for further requirement. This
aspect of financial management is dealt under dividend policy. The dividend policy of a
firm depends on a number of financial considerations, the most critical among them being
profitability. Thus, there are different dividend policy patterns which a firm may choose to
adopt, depending upon their suitability for the firm and its stockholders.
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9. Proper use of surpluses

The utilization of profits or surpluses is also an important factor in financial

management. A judicious use of surpluses is essential for the expansion and diversification
plans and also protecting the interest of the shareholders.
The ploughing back of profit is the best policy of further financing. A balance should
be struck in using the funds for paying dividends and retaining earnings for financing
expansion plans.
1.7 FINANCIAL GOALS
The goals of financial management can be classified in many ways, official goals,
operative goals and operational goals. Official goals are the general aims of the
organization. Maximization of return on investment and market value per share may be
termed as official goals of financial management. Operative goals indicate what the
organization is really attempting to do. They are focused and help in choice
making. Expected return on investment, cost of capital, debt-equity norms and others done.
dong with time horizon are specified or their acceptable ranges/limits are static keeping in
view the official goals. The operational goals of financial management are more directed,
quantitative and verifiable. The scale, mix and timing of specific form of finance are
detailed. The official, operative and operational goals are structured with a pyramidal shape,
the official goals at the top (concerned with the top executives), operative goals at the
middle (concerned with middle management) and operational goals at the base.

The financial management goals can also be classified in a functional way. Return
related goals, solvency related goals, liquidity related goals, valuation related goals, risk
related goals, cost related goals and so on. Return related goals refer to the aims on
minimum, average and maximum returns. What should be the minimum return from a
project in order to accept the same? What should be average return the firm should settle for
and what is the maximum return possible (for risk increases with return)? Similarly, goals
as to solvency, liquidity, market value and other goals can be thought of. Financial
managers should state to what extent the stated goal factor is important? and be actively
pursued/and the extent of the goal factor required; the minimum, average and the maximum
levels be specified.

1. Profit Maximization

Profit maximization is a stated goal of financial management. Profit is the excess of

revenue over expenses. Profit maximization is therefore maximizing revenue given the
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expenses or minimizing expenses given the revenue or a simultaneous maximization of
revenue and minimization of expenses. Profit maximization is possible through pricing and
scale strategies. By increasing the selling price, one may achieve revenue maximization,
assuming demand does not fall by a commensurate scale. By increasing quantity sold by
exploiting the price-elasticity of the demand factor, revenue can be maximized. Expenses
minimization depends on variability of costs with volume, cost consciousness and market
conditions for inputs. So, a mix of factors is called for profit maximization.

This objective of financial management is a favoured one for the following reasons:

1. Profit is a measure of success in business. Higher the profit, greater is the degree of
success.

2. Profit is a measure of performance. Performance efficiency is indicated by the

quantum of profit.

3. Profit making is essential for the growth and survival of any undertaking. Only
profit making business can think of tomorrow and beyond. It can only think of
renewal and replacement of its equipment and can go for modernization and
diversification. Profit is an engine doing away the odds threatening the survival of
the business.

4. Profit making is the basic purpose of business. It is accepted by the society. A losing
concern is a social burden. As we know, the sick business undertakings cause a
heavy burden to all concerned. So, profit criterion leads to operational inefficiency.
Therefore, the organisation cannot conceal its inefficiency, if profit is made the
criterion of efficiency.

5. Profit making is not a sin. Profit motive is a socially desirable goal, as long as your
means are good.

2. Profitability Maximization

1. Profit as an absolute figure conveys less and conceals more. Profit must be related
to sales, capacity utilization, production or capital invested. Profit when expressed
in relation to the above size or scale factors it acquires greater meaning. When so
expressed, the relative profit is known as profitability. Return on sales, profit per
unit production, return on investment and many other profits are more specific.
Hence, the superiority of this goal to the profit maximization goal.

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 2. Further, profit per rupee investment or return on investment (ROI) is a
comprehensive measure. ROI = Return or Profit / Average Capital invested.
3. Profit divided by sales measures the return on sales and sales divided by investment
measures the number of times of capital turnover. The former is an index of profit
earning capacity and the latter is an index of activeness of the business.
Maximization of profitability is possible through either the former or the latter or
both.
3. EPS Maximization

Maximization of Earnings Per Share (EPS) involves maximizing earnings after tax
given the number of outstanding equity shares. This goal is similar to profitability
maximization in respect of merits and demands. It is very specific both as to the type of
profit and the base to which it is compared. One disadvantage is that EPS maximization
may lead to value depletion too, because effect of dividend policy on value is totally
discarded.

4. Liquidity Maximization

Liquidity refers to the ability of a business to honour its short-term liabilities as and
when these become due. This ability depends on the ratio of current assets to current
liabilities, the maturity patterns of currents assets and current liabilities, the composition of
current assets, the quality of non-cash current assets; the relations with the short-term
creditors; the relations with bankers and the like. A higher current ratio, a perfect match
between the maturity of current assets and current liabilities, a well-balanced composition
of current assets, healthy and ‘moving‘ current assets, that is, those can be converted into
liquid assets with much ease and no loss, understanding creditors and ready to help bankers
in maintaining a high-liquidity level for a business. All these are not easy to obtain and
these involve costs and risks.

1.8 PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION

Profit Maximization Wealth Maximization

It is defined as the management of It is defined as the management of financial
financial resources aimed at increasing the resources aimed at increasing the value of the
profit of the company. stake holders of the company

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Focuses on increasing the profit of the
Focuses on increasing the value of the
company in short term. stakeholders of the company in the long term.
It does not consider the risk and
It considers the risk and uncertainty inherent
uncertainty inherent in the business model
in the business model of the company.
of the company.
Profit Maximization ignores the time Wealth Maximization considers the time value
value of money. of money.

1.9 ROLE OF FINANCIAL MANAGER IN INDIA

Finance manager is a person who heads the departments of finance. He groups
activities in such a way that areas of responsibility and accountability are clearly defined.
His focus is on profitability of the firm. It is his primary objectives, to maximise the value
of the firm to its stockholders.
The responsibilities of financial management or finance manager vary widely from
one business unit to another, in the light of this wide diversity of organizational practices. It
is not surprising to find that in most of the company financial officer is responsible for the
routine finance functions.

The main responsibilities of the finance manger are as follows:

1. Financial planning: The main responsibility of the financial manager in an enterprise

is to forecast the needs and sources of finance and ensure the adequate supply of cash at
proper time for the smooth running of the business. The finance manager is also to see
that there is no surplus money in the business which earns nothing.

2. Rising of necessary funds: The second main responsibility of the financial manager is
to see the nature of the need, that is, whether finances are required for long term or for
short term. He must assess the alternative sources of supply of finance taking into view
the cost of raising funds, its effect on various concerned parties, includes, shareholders,
creditors, employees and the society, control and risk in financing and elasticity in
capital structure and much more.

3. Controlling the use of funds: The finance manager is also responsible for the proper
utilization of funds. Assets must be used effectively so as to earn higher profits, inflow
and outflow of cash must be controlled in a manner so as to meet current as well as
future obligations.

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4. Disposition of profits: Appropriation of profits is one of the main responsibilities of
the finance manager He is to advise the executive as to how much of the profits should
be retained in the business as reserves for future expansion, how much funds are used
for repaying the debts and how much funds to be distributed to the shareholders as
dividend.

5. Responsibilities to owners: Shareholders or stockholders are the real owners of the

concern. The finance manager has the prime responsibility to those who have
committed funds to the enterprise. He should not only maintain the financial health of
the enterprise but should also help to produce a rate of earning that will reward the
owners adequately for the risk capital they provide.

6. Legal obligations: Financial manager is also under an obligation to consider the

enterprise in the light of its legal obligations. A host of laws, taxes and rules and
regulations cover nearly every move and policy. Good financial management helps to
develop a sound legal framework.

7. Responsibilities of employees: The financial manager must try to produce a healthy

going concern capable of maintaining regular employment at satisfactory rate of pay
under favourable working conditions. The long-term financial interests of management,
employees and owners are common.

8. Responsibilities to customers: In order to make the payments of its customer’s bill, the
effective financial management is necessary. Sound financial management ensures the
creditors continued supply of raw material.

9. Wealth maximization: Prof. Solomon of Stanford University has argued that the main
goal of the finance function is wealth maximization. The other goals may be achieved
automatically.

10. Maintaining liquidity: Liquidity of a firm increases the borrowing capacity. Expansion
and diversification activities can be comfortably executed. Increase in liquidity builds
the firm’s ability to meet short term obligations towards creditors or bankers.

1.10 FINANCIAL DECISIONS

Financial decisions refer to decisions concerning financial matters of a business
firm. Financial decisions will affect the entire business operations, as it has direct
relationship with various department functions such as marketing, production, personnel,

14
and other functions of the various departments. Financial management helps to take sound
financial decision in the business concern.
Financial decision may be broadly classified in to four types. They are,

1. Financing decision

2. Investment decision

3. Dividend decision

4. Working Capital Decision

1. Financing Decision:

Financing decision involves selecting appropriate sources of funds for raising

money is also called us capital structure that is, combination of debt and equity mix. It is a
major challenge for financial executive, because the source of finance selected should aim
in maximizing the returns of the investors. The different alternative sources available for
mobilizing funds are,

i) Only Equity;
ii) Debt and equity;
iii) Equity and preference;
iv) Equity, Preference and debt.
2. Investment Decision (Capital Budgeting):

This decision includes all activities involved in deciding the pattern of investment.
This decision involves both short term and long term investment on both capital and current
assets. This decision involves allocation of huge financial resources. Long term investment
decision also popularly termed as capital budgeting decision, require comparison of cost
against benefit over a long period.

3. Dividend Decision:

The dividend decision of the firm is of crucial importance for the financial manager,
since it determines the amount of profit to be distributed among shareholders and the
amount of profit to be retained in the business for financing its long term growth. While
taking dividend decision, the management will obviously take into account the effect of the
decision on the maximization of shareholder’s wealth.

15
4. Working Capital Decision:

The financial manager should also manage the current assets to have liquidity in the
business. Involvement of current assets resulting in reduction of dividend to shareholders.
Short term investment decision is called as ‘working capital management’. It includes
management of cash, accounts receivables and inventory.

1.11 CHALLENGES IN GLOBAL ERA

As businesses become global, financial managers needs to have a global perspective
and experience. They have to understand how their business can operate and survive in
different cultures, regions, in different regulatory context in order to provide a valuable
input of the finance function in the overall business.
Risk management is a major challenge of global financial management. The role of
the financial manager is not limited only to cost savings. In a highly volatile environment,
financial managers have to be proactive to diverse risks in order to safeguard the business
assets, cash availability and shareholder return. The balance between risk and return is
crucial in fast changing environment.
The wave of globalization is bringing enormous changes on the operation of
organizations. It is clear indication that globalization is inevitable. Therefore, organizations
need to be in the fore front by making adjustments in all relevant areas, for them to cope
with the changing environment. There is need for them to be working hard in developing
capabilities to help these organizations in coping with the trends in the finance functions.

Increasingly, financial managers will be tasked with overseeing the finance sections
of the organization. They assume these roles which entail creation of harmonious existence
between the different departments of the organization. The financial managers confront a
wide range of issues. They must ensure that their planning and operation takes into account
the micro and macro environments. This will automatically improve the quality of solutions
to financial problems.

Driving competitive financial functions is not an easy task. The finance department
is a core function. Being a core function entails devising of mechanisms to evaluating the
critical decisions intended to bring changes in the organization. The main objective of any
organization is growth. For them to grow there is a need to develop strategies which will
help the organization progress in the face of rapid changes of the environment it operates.
Therefore, effective decision making and planning are prerequisites for organizational
growth. The choice of the strategies is a catalyst for thriving of the businesses in the face of
16
the caveats presented by internal and external environments. The organizations growth has
to be achieved in the cost effective way. On account of this entails that the financial
managers play a fundamental role in any organization.

The finance function should run a competitive operation. They have critical role of
ensuring that other departments run competitive operations. Risk management is among the
vital functions of the finance departments. In overall, financial managers provide support to
the business activities by enabling cost effective operations to be conducted. Therefore,
employment of all the value addition strategies enables a firm to gain a competitive
advantage over those of rivals. The organizations which the finance managers represent
operate in global environment, which not only presents challenges to them, but also
compels them in identifying new opportunities. Opportunity cannot be dealt with in
isolation with challenges. The modern finance manager is a catalyst of change in the
organization. These personnel are required to act in collaboration with other departments,
through integration of all the activities of the organization. In this direction the finance
manager therefore acts as a catalyst of change.

The main challenges that hinder the proper functioning of the finance section, are
mainly attached to be originating from the working of the global economy. A cross
examination of the impediments has proved that greater uncertainty of the global economy,
fluctuating energy prices due to distortion of supply and demand conditions, fluctuation of
foreign exchange rates, changes in commodity prices, environmental caveats, inflation and
government deficits are the main challenges facing finance managers. An outlook on these
challenges shows that many are associated with the changing trends of the global economy.
These changing macroeconomic conditions have both individual and joined significance in
influencing the work of financial managers. The conditions also influence priorities and
strategy development by the management. Lastly they dictate the choice of strategy which
would be chosen to compete on a global context.

This is the global environment in which the future of finance managers thrives. This
macroeconomic environment provides both opportunities and challenges which would be
confronted by finance function. Therefore, this unit performs an analysis of the priorities
with an aim to understand the future of finance managers and finance function.

1.12 CHECK YOUR PROGRESS

Fill in the blanks with suitable answers:

1. ______is considered as the life blood of an organisation.

17
 2. ______, ______ and ______ are the three main functions of financial management.
3. ______ relates to the allocation of fund as among cash and equivalents, receivables and
inventories.
4. ______ is the process of making investment decision in capital expenditure.
5. ______refers to the ability of a business to honour its short-term liabilities as and when
these become due.
Answer to Check Your Progress

1. Finance

2. Investment, Financing and Dividend

3. Working Capital

4. Capital Budgeting

5. Liquidity

1.13 KEY WORDS

Profit Maximization : Maximizing firms profit.
Wealth Maximisation : Maximization of the market price per share of the
firms common stock.
Liquidity : Ready convertibility into cash.
EPS : Earnings after taxes divided by the number of
common shares outstanding.
Agents : Individuals authorized by another person, called the
principal, to act in the latter’s behalf.
1.14 SUMMARY
So far in this unit, we have discussed the important basic concepts of financial
management. Financial management deals with procurement of funds and their effective
utilization in the business. Financial management may be defined as “acquisition of fund at
optimum cost and its utilization with minimum financial risk.” Financial management
refers to that part of the management activity, which is concerned with the planning,
organizing, directing and controlling of firm’s financial resources. It deals with finding out
various sources for raising funds for the firm. Financial management is mainly concerned
with the acquisition, financing and management of assets with some overall goals in mind.
There are different opinions as to what this goal should be. Frequently, profit maximisation
is said to be the proper objective of the firm. This objective is criticized on the grounds that
there is no clarity as to what constituted profit. It could be maximizing of earnings after tax
18
or can be maximising earnings per share. Earnings after tax can be maximized even by
investing the proceeds of new issue of shares outside.

1.15 QUESTIONS FOR SELF STUDY

1. What are the objectives of financial management?
2. Compare and contrast wealth maximisation vs profit maximisation
3. Discuss the role of a financial manager in the present scenario
4. Discuss the challenges faced by a financial manager in the present global era.
5. What are the three main decisions to be taken in financial management?

1.16 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill- Tenth
Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh
edition-2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-
Eleventh Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya
Publishing House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and
Sons-Fifteenth Edition-2019.

19
UNIT -2 FINANCIAL PLANNING AND CONTROL
Structure:
2.0 Objectives

2.1 Introduction

2.2 Meaning and Importance of Financial Planning

2.3 Steps in Financial Planning

2.4 Meaning and Importance of Financial Control

2.5 Major Tools of Financial Control

2.6 Advantages and Limitations of Financial Control

2.7 Check Your Progress

2.8 Keywords

2.9 Summary

2.10 Questions for Self-Study

2.11 References

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2.0 OBJECTIVES
After studying this unit, you will be able to;

 Analyse the importance of financial planning and control.

 Explain the steps involved in financial planning.
 Examine the advantages and limitations of financial control.
 Identify the major tools of financial control.

2.1 INTRODUCTION
As you are aware, we have discussed the basic concepts of financial management.
Let us look into the financial planning and control aspects in this unit. Financial planning is
part of a larger planning system in the firm. The planning process begins with the firm’s
mission. Given its mission, management sets goals which are defined in quantitative terms.
Goals in turn form strategy which is a plan to gain competitive edge over rival firms. To
support this strategy, policies and budgets are developed in various areas such as research
and development, production, marketing, personnel, and finance. These then get translated
into the financial plan.

Financial Planning addresses all the concerns of an organisation relating to its long-
term growth, profitability, investment decisions and financing decisions. Whatever a
business is trying to achieve, to be successful, business must develop plans for future in a
systematic way. Finance lies at the very heart of the planning process. A business must
allocate its limited resources carefully.

2.2 MEANING AND IMPORTANCE OF FINANCIAL PLANNING

Meaning of Financial Planning:

Financial planning means deciding in advance the course of action to be undertaken

in future with respect to the financial management of a business enterprise. This function is
mainly concerned with the procurement and profitable use of funds. It involves the
determination of objectives, policies, and procedures relating to the finance function.

Financial planning is the process of estimating the capital required and determining
its competition. It is the process of framing financial policies in relation to procurement,
investment and administration of funds of an enterprise.

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 Financial planning is a systematic approach whereby the financial planner helps the
organization to maximize existing financial resources by utilizing financial tools to achieve
its financial goals.

In simple words, a financial plan is a statement estimating the amount of capital

and determining its composition.

The importance of financial planning can be outlined as follows:

1. Optimum fund: Financial planning avoids under or over capitalization of funds,

financial planning helps to figure out capital needs and ensures adequate funds
2. Financial stability: Financial planning helps in ensuring a reasonable balance
between outflow and inflow of funds so that stability is maintained.
3. Gains investor confidence: Financial planning will make it easier for you to attract
investors. Investors want to know and to understand how your business is taken care
by Financial Planning
4. Capital structure: Organizations raise short, medium, and long-term funds from
various sources. Financial planning is determining how to raise the money for the
various stages. Generally, long-term funds are contributed by shareholders and
debenture holders. For medium term funds, business will approach financial
institutions and for short term funds they approach commercial banks.
5. Smooth operational activities: success or failure in the production or distribution
process largely depends on financing decisions. If proper financial plans are not
made, the smooth working in different departments will be disrupted, which will
cause loss to business.
6. Uncertainties: Financial planning ensures business concern have cash reserves even
in bad times. Because financial planning anticipates and determines the financial
requirements of a business, it will be able to manage uncertainties.
7. Business expansion: Financial planning helps in forecasting the capital required for
the future expansion of a business. It helps to combat financial difficulties. The
growth and expansion of firms is needed due to change in internal and external
circumstances, which is essential for the long- term survival of the company.
8. Liquidity: Liquidity is related to the debt paying capacity of the business in short-
term. In a financial plan, adequate provision of funds is made for the payment of
these debts in time.

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 9. Reduces uncertainties: Planning helps in reducing the uncertainties which can be a
hindrance to growth of the company. This helps in ensuring stability and
profitability in concern.
2.3 STEPS IN FINANCIAL PLANNING
The financial planning process is a logical, six-step procedure:

 Determining the current financial situation

 Developing financial goals
 Identifying alternative courses of actions
 Evaluating alternatives
 Creating and implementing a financial action plan
 Re-evaluating and revising the plan.

1. Determining the current financial situation means determination of the situation with
regard to income, costs, liabilities, loans and receivables.

2. Developing financial goals - firstly, an analysis should be performed and the need for
achieving what is wanted should be determined and it is followed by specifying goals and
determining how the current income will be spent in order to provide funds for investments
for securing the future financial security.

3. Identifying alternative courses of actions means determining the factors which will
affect the continuity of actions, expansion of the current situation, new courses of actions,
the creativity in decision making and considering the possible alternative solutions which
can lead to more effective decisions.

4. Evaluating alternatives means taking into consideration the conditions in which the
business activities will be performed, the values of the organization and current economic
conditions in the environment. It needs to be evaluated where the assets will be invested,
what kind of costs will be made for production, also to evaluate the risks and which
information will be used in order to make relevant decisions.

5. Creating and implementing a financial action plan means to develop a plan, that is, to
choose ways to achieve the financial goals. The financial action plan needs to be
implemented by all employees, to provide assets, to invest, to maintain inventory, to
provide shares or bonds or mutual funds.

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6. Re-evaluating and revising the plan means dynamic following of the plan
implementation, assessing the financial decisions and adapting to the new changes of
personal, social and economic factors. The review of the implementation of the financial
plan enables priority adjustments which will enable the organization to achieve its financial
goals

2.4 MEANING AND IMPORTANCE OF FINANCIAL CONTROL

Financial control has now become an essential part of any organization. Financial
controls are the means by which an organization’s resources are directed, monitored, and
measured. It ensures the accuracy of reporting, eliminating fraud and protecting the
organization’s resources, both tangible and intangible.

Meaning of Financial Control:

Financial control is a mechanism which helps in controlling the financial activities

of an organisation with the help of certain tools like Ratio Analysis, Budgetary Control,
Break-Even Analysis, and any other financial tolls with a view to ensure the accuracy of
reporting, eliminating fraud and protecting the organisation’s resources in order to achieve
organisational objectives.

Financial control refers to the policies and procedures framed by an organization to

monitor and control the direction, allocation and usage of its financial resources. In other
words, they indicate those tools and techniques adopted by a firm to control its various
financial matters.

Financial control helps in judging whether current financial activities of an

organisation are in line with planned financial operations. Eventually, financial control
helps in the formulation of future plans also.

Importance of Financial Control:

1. Cash flow maintenance

Financial control contributes to efficient cash flow maintenance by keeping adequate
supervision on the inflow and outflow of resources. When overall cash flows are
monitored and planned, this results in efficient operations.
2. Resource management
Financial resources are crucial in order to ensure all other resources required for
operating a business. Effective financial control is essential to ensure resource
management in an organization.
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 3. Operational efficiency
An effective financial control ensures overall operational efficiency in an
organization.
4. Profitability
Ensuring an organization’s overall operational efficiency leads to the smooth
functioning of different departments of an organization which, increases
productivity, leading to cost reduction and increased profit. Hence, proper financial
control increases the earnings of the company.
5. Creditworthiness
Financial control helps in maintaining a proper balance between the debt collection
period and the creditors’ payment period; thereby ensuring proper liquidity exists in
a firm; it enhances the creditworthiness of the firm.
6. Fraud prevention
Financial control serves as a preventive measure against fraudulent activities in an
organization. It can help prevent any undesirable activities such as employee fraud,
online theft and many others by monitoring the inflow and outflow of financial
resources.
7. Prevention and elimination of wastage
Financial control helps in judging whether current financial activities of an
organisation are in line with planned financial operations. It helps in prevention and
elimination of wastage of financial resources.
8. Reformulating financial plans
It helps in reformulating financial plans when the results are not satisfactory.
9. Improvement in financial strength
Financial control supervises an organization’s financial resources which helps in
improving the financial strength of the organization.
10. Identifying deviations and corrective actions:
Financial control identifies deviations, and helps in examining the reasons for such
deviations and to take appropriate remedial measures.
2.5 MAJOR TOOLS OF FINANCIAL CONTROL
Finance is needed for each and every activity of business. Since activities requiring
finance are different in nature, different tools and techniques are required for controlling
such activities. Some major tools of financial control are:

1. Budgetary Control
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 2. Return on Investment
3. Break-Even Analysis
4. Ratio Analysis
5. Zero-Based Budgeting
1. Budgetary Control

Budgetary control is “systematic control of an organization’s operations through

establishment of standards and targets regarding income and expenditure, and a continuous
monitoring and adjustment of performance against them.”

Brown and Howard defines budgetary control is “a system of controlling costs

which includes the preparation of budgets, co-ordinating the departments and establishing
responsibilities, comparing actual performance with the budgeted and acting upon results to
achieve maximum profitability.”

Budgetary control is a system of controlling cost through preparation of budgets

whereby actual results are compared with budgets to find out deviations (if any) and to take
remedial measures as per requirement for the purpose of achieving organisational
objectives. Planning, coordinating and controlling are the three main objectives of
Budgetary Control. It is a control technique that aids management in allocating authority
and responsibility.

Meaning of budget: Budget is a financial and quantitative statement, prepared prior

to a defined period of time, of the policy to be pursued during that period for the purpose of
attaining a given objective.

Advantages of Budgetary Control:

1. Profit Maximisation: Budgetary control aims at profit maximisation by exercising

proper control both on revenue and capital expenditure.
2. Defining responsibilities: Budgetary control clearly defines responsibilities and
targets for each department, individual, etc. It then compares the budgeted
performance with the actual ones. As a result, everyone knows what is expected
from him.
3. Evaluating performance: It facilitates comparison of actual performance with
budgeted targets and helps in finding out the deviation, if any, between the
two.

26
 In this way, budget control serves as an effective tool in performance evaluation and
aids in suggesting remedial measures.
4. Optimum resource utilisation: It ensures optimum use of available resources
which promotes operational efficiency which helps in reduction of wastages.
5. Coordination: It fosters coordination of various activities of the business. The
budget committee acts as the co-ordinator of production, sales and other
departments. It facilitates centralised regulation of diversified operations.
6. Cost control: Budgetary control aids in cost control. There is control over costs,
revenue and capital expenditures. It fixes cost budgets for all departments of
business. Departments need to maintain their expenditure within the planned budget
and should not exceed it.
7. Cost consciousness: It creates cost consciousness among managers and restricts
expenditure to the minimum. Thus, unnecessary expenditure is avoided and
expenditure beyond the budgeted figure is not incurred without prior approval of the
higher authority.
8. Forecasting credit needs: The budgets of cash expenditure and cash receipts make
it possible for the financial manager to forecast the future credit needs and arrange
in advance.
9. Improved credit worthiness: It enhances the standing and credit worthiness of the
undertaking because an efficient cost control technique is followed.

Disadvantages of Budgetary Control:

The following are the disadvantages of budgetary control:

1. Costly: The introduction and implementation of a budgetary control system is

expensive. It requires huge expenditure on the part of organization to formulate
budgets after doing various researches and forecasting. Budget involves heavy
expenditure which small business concerns may not afford.
2. Conflict: Budgetary control can lead to departmental conflict over resource
allocation. Every department tries to get the maximum allocation of funds and this
raises conflict among different departments.
3. Estimate-based: Budgets are prepared for the future, which is always uncertain.
Despite best estimates made for the future, may or may not actually come out to be
true. In the future, conditions may change, which will upset budgets. Thus, future
uncertainties minimize the utility of the budgetary control system.

27
 4. Rigidity: Since, budgetary limits are regarded as final and little scope is left for
initiative. In practice, budgets often tend to become rigid. It becomes difficult to
make changes in budgets to suit the changing circumstances. Rigidity in budgetary
control makes it unsuitable in changing conditions.
5. Time consuming: Budgetary control is a time-consuming process. It requires huge
time for preparing budgets and implementing them in an organization. Employees
working within the organization also take time to get familiar with the budgeting
system and working in accordance with it.
6. Problem of co-ordination: Efficiency of budgetary system mainly depends upon
better co-ordination among different departments of organization. Performance of
one department affects the performance of other departments and overall
organization. It is difficult to bring proper co-ordination among various departments
of organizations. Lack of co-ordination can create problems and results in poor
performance.

2. Return on Investment

Return on Investment (ROI) is an important tool of financial control. Return on

Investment (ROI) is the money an investor in a business earns from the invested capital.
Return on investment measures the ability of an investment to generate income. In simple
words, return on investments estimates what you receive back as compared to what you
invest. ROI is generally expressed as the percentage used to analyse an organisation’s profit
or the earnings from different investments. ROI tells investors the profitability of
investments. By calculating the ROI, an investor can determine whether an investment is
worthwhile. It tells you how well an investment is performing. The ratio is used to compare
alternative investment choices, as well as to determine if an existing investment represents
an efficient use of resources.

Advantages of Return on Investment:

Return on Investment has certain advantages which are listed as follows:

1. Simplicity: It is a relatively simple, easy-to-use financial control tool. The

calculation is very simple. It does not involve any huge data as well as a
complicated system.
2. Applicability: It can be applied to the entire organisation or to different
departments of the organisation as per requirement. It helps the company to evaluate
the performance of a division or region by using ROI. They will be able to decide
28
 whether to sell or expand the operation of those business units by looking at
potential earnings or growth.
3. Completeness: It is a complete financial control technique. ROI helps to evaluate
the business's financial performance. Knowing the ROI keeps the company on track
by demonstrating whether the business is earning profit above or below its average.
It is a good reminder for companies to maintain a standard for their finances.
4. Understand ability: It is easily understood across functional organisations and
industries. Return on investment is a universally understood concept, so if one uses
the metric in conversation, then people will know what one is talking about.
5. Resource allocation: ROI is significant in measuring the performance of
investment, which focuses on earning maximum profit and making appropriate
decisions regarding acquisition and disposal of capital assets. It helps in proper
resource allocation and it also facilitates rational use of resources.

Disadvantages of Return on Investment:

Return on investment suffers from certain limitations which are listed as follows:

1. Dependence on profit: If profit is not accurately computed then ROI will also be
misleading because the calculation of ROI is based on profit. The ROI of a project
or venture does not account for the non-financial benefits of an investment.
2. Inaccuracy: To calculate an accurate ROI, a firm need to grasp future business
expenses. If there is no accurate numbers for future expenses, or if the numbers
comprising the calculation are variable, such as interest rates that may change, the
ROI may be inaccurate.
3. Narrow focus: It can produce a narrow focus on divisional profitability at the cost
of profitability for the organisation. ROI may influence a divisional manager to
select only investments with high rates of return that is, rates which are in line or
above his target ROI). Other investments that would reduce the division’s ROI but
could increase the value of the business may be rejected by the divisional manager.
4. Emphasizing short-term interest: When adopting the ROI model, managers’ will
consider only the short-term over the company’s long-term benefit. Only short-term
ROI will impact their current performance, while the long-term project takes too
long to show the results. So they will sacrifice the long-term company benefit over
the short-term one.

29
 5. Problem in standard setting: Difficulty in setting the standard rate of return on
investment.

2. Break-Even Analysis

Break-Even analysis is a financial control technique that analyses the inter-

relationship between production, cost and profit to formulate planning.
The Break-Even Analysis is a method adopted by firms to determine how much should be
produced or sold at a minimum to ensure that the project does not lose money. Simply, the
minimum quantity at which loss can be avoided is called a break-even point.

The Break-even point is the point where your total expenses match the total
revenue, a point without any profit or loss. To put it in simple terms, the point where you
finally recover all the capital costs borne to set up the business.

Break-even is usually expressed in terms of the number of units which need to sell
or how much revenue that need to generate. Here, expenses are divided into two
categories—fixed cost and variable cost.

Fixed costs:

Fixed costs are costs that do not change when sales or production volumes increase
or decrease. This is because they are not directly associated with manufacturing a product
or delivering a service. Fixed costs include rent, salaries, taxes, interest, labour,
depreciation, and other operational costs. These costs are free from production and must be
incurred even in the absence of production.

Variable costs:

Variable costs are expenses that directly relate to the volume of production.
Variable costs vary in proportion to the volume of goods or services that a company
produces. In other words, they are costs that vary depending on the volume of activity. The
costs increase as the volume of activities increases and decrease as the volume of activities
decreases. Variable costs include raw materials, packaging, transportation, and other
expenses related to production.

Formula of Break Even Analysis

Break-even point (BEP) can be arrived at by using the following formula:

1. BEP (in units) = Fixed Cost / Contribution per unit

2. Contribution per unit = Selling price per unit – Variable cost per unit
30
 3. BEP (in sales value) = Fixed Cost / P/V Ratio
4. P/V Ratio = Contribution / Sales

Advantages of Break-Even Analysis

The advantages of Break-Even Analysis are listed as follows:

1. Decision-making: It guides managerial decision making. Decisions pertaining to

make or buy, shut-down point, acceptance of an order and other decisions. are taken
on the basis of this analysis.
2. Determination of profit: Profit at different levels of activity can be easily
determined with the help of break-even analysis.
3. Fixing selling price: It aids in fixation of the selling price of the products or
services. Break-even analysis gives you a much more solid basis from which to
price your products. Look at the current financial situation, it is necessary to check
how business afford to be when it comes to reaching the break-even point.
4. Setting revenue targets: Break-even analysis can be a great tool for setting
concrete sales targets. Once the break-even analysis is complete, then the price can
be fixed to sell the product to earn profit. With break – even analysis, it is easier to
decide upon revenue targets.
5. Profit planning and budget preparation: It helps in profit planning and budget
preparation.
6. Cost control: It can be used as a tool of cost control.

Disadvantages of Break-Even Analysis

1. Assumption-based: Certain assumptions like fixed cost remains constant; variable

cost varies proportionately with production and many more on which this analysis is
based are unrealistic. Because of so many restrictive assumptions underlying the
analysis, calculation of BEP is considered an approximation rather than a reality.
2. Unrealistic assumption about the nature of the firm: The nature of the firm (that
is, whether the firm is growing or declining) is ignored in this analysis. Here, it is
assumed that the firm always remains constant.
3. Limited applicability: This technique cannot be appropriately used for
multiproduct firms.
4. Not a decision-making tool: It should be viewed as a planning aid and not as a
decision-making tool.

31
 5. Ignoring capital employed: It does not take into consideration the amount of
capital employed in the business. But capital employed is an important determinant
of the profitability of a concern.
6. Ignore provision for taxation: The simple form of a break-even chart makes no
provisions for taxes, particularly corporate income tax.

2. Ratio Analysis

A ratio is an expression of the relationship between numbers. It involves selecting

two critical figures from the financial statements and expressing the relationship.

Ratio analysis is an important tool of financial control that is used to obtain a quick
indication of a firm’s financial performance in several key areas. It is a quantitative analysis
of information contained in the financial statements. It is often used to evaluate the
operating and financial performance of an organization like liquidity, solvency efficiency,
profitability and others.

Ratio analysis is defined as the systematic use of ratios to interpret the financial
statements so that the strengths and weaknesses of a firm, as well as performance and
current financial condition, can be determined. In simple words, ratio analysis refers to the
analysis of various pieces of financial information in the financial statements of a business.

There are numerous financial ratios that are used for ratio analysis, and they are
grouped into the following categories:

a. Liquidity Ratios

These ratios evaluate a business’ efficiency to settle its debts as and when they
become due, with its revenues or assets in the disposal. Liquidity ratios cover quick ratio,
current ratio, and the working capital ratio.

b. Solvency Ratio

Solvency ratios are also referred to as financial leverage ratios. Solvency ratios
measure a company’s long-term financial viability. These ratios will compare an
organisation’s level of debt with assets, earnings and equity in order to determine the
possibility of an organization to stay in operation over an extended period of time by
settling all its short and long-term debts and by paying coupon/interest regularly. Solvency
ratios include interest coverage ratios, debt-asset ratios, and debt-equity ratios.

32
c. Profitability ratios

Profitability ratios measure a business’ ability to earn profits, relative to their

associated expenses. It indicates how efficiently a business will be able to generate
revenues and profits through its operations. Profit margins, return on equity, return on
assets, gross margin ratios and return on capital employed are good examples of
profitability ratios.

d. Efficiency ratios

Efficiency ratios are also called as the activity ratios. Efficiency evaluates how
efficiently a company uses its assets and liabilities to generate sales and maximize profits.
Some of the important efficiency ratios include the asset turnover ratio, inventory turnover,
payables turnover, working capital turnover, fixed asset turnover, and receivables-turnover
ratio.

Advantages of Ratio Analysis

Ratio analysis has the following advantages:

1. Decision-making: It aids in managerial decision making. Ratio analysis helps to

take decisions like whether to supply goods on credit to a firm, whether bank loans
will be made available and much more.
2. Simplifies complex accounting: ratio analysis helps in simplifying the complex
accounting statements and financial data into simple ratios of efficiency ratios,
solvency ratios and other ratios.
3. Determining financial performance: Ratio analysis helps in determining
financial performance such as liquidity, solvency and profitability of a firm.
4. Signal of the sickness: It can give a signal of the sickness of a firm in advance, so
that proper measures can be taken in time to prevent the occurrence of such
sickness.
5. Facilitating inter-firm and intra-firm comparisons: Ratio analysis enables to
make comparisons between the financial performances of two or more businesses,
even if they are of different sizes or from different industries, by converting
financial numbers into standardized form using pre-defined formulas.
6. Financial forecasting: It aids in preparing financial estimates for the future
(financial forecasting). Ratio analysis helps in identifying the trends of various
items like cost, profit and sales. It calculates the relevant accounting ratios with the

33
 help of past financial data, which helps in forecasting and planning business
activities.
7. Communication of information regarding the position and progress:
Ratios are effective means of communication and play a vital role in informing the
position of and progress made by the business concerned to the owners or other
parties. Through evaluating the financial statements, it depicts the true financial
condition of a business to owners, creditors, bankers, and investors.
8. Trend analysis: It helps in trend analysis involving the comparison of
performance of a single company over a period.

Disadvantages of Ratio Analysis:

1. Limitations of financial statements: Since ratios are calculated from financial

statements, the inherent limitations of financial statements also exist in ratio
analysis.
2. Problem of single ratio: It is not possible to come to a conclusion from a single
ratio in most of the cases. Supporting ratios are required to predict an incident.
3. Use of historical data: Information used for computing ratios is historical and is
based on past results. It does not consider current changing conditions which
therefore have little relevance for the future.
4. Ignoring qualitative factors: Ratio analysis takes into account only quantitative
aspects and ignores all qualitative aspects of the business. Sometimes qualitative
aspects are quite important and affect the functioning of a business to a great level.
5. Caution needed in application: In case of seasonal business (like Umbrella
Company) ratio analysis should be used with caution because there is a huge
difference in demand for such products in seasons and out-of-seasons.
6. Ignoring external factors: External factors (like the worldwide recession) are not
considered in ratio analysis.
7. Irrelevant in case of application of different accounting policies: Differences in
accounting policies make accounting ratios of two firms non-comparable.
8. Inability to provide solution: Ratios can provide clues to solutions but cannot
provide solutions.

5. Zero-Based Budgeting

Zero-Based Budgeting (ZBB) was developed by Peter A Pyre and gained

popularity during the early 1970s. It is used as a managerial tool to control costs. Zero-
34
Based Budgeting (ZBB) is a method of budgeting in which all expenses need justification
for each new period. It starts from the scratch with a ‘zero base’ and every function or
activity is analyzed for its needs and costs. Only new expenses are analyzed in traditional
budgeting, whereas ZBB calls for a justification of old, recurring, and new expenses. In
simple words, ZBB is the process of creating a budget from nothing without using the prior
year’s budget, or spending numbers. No activities are assumed to be untouchable. All
expenses are judged and must be justified in order to remain in the budget.

Essentially, management must start from scratch and look at every operation and
every activity to determine whether it is worth spending the company’s money.
Management must also set completely new spending goals. But it should not be used
indiscriminately. If applied intelligently, ZBB is a useful tool to curb unnecessary
expenditure.

Advantages of Zero-Based Budgeting

The advantages of zero-based budgeting are briefly listed as follows:

1. Efficient resource allocation: Zero-based budgeting starts from scratch each year
and hence it can eliminate the unnecessary activities/expenses that traditional
budgeting often results in. This improves resource allocation and profitability of
the organization.
2. No scope for inflating the budget: Since every line item is to be justified, zero-
based budget overcomes the weakness of incremental budgeting of budget
inflation.
3. Removing redundant activities: It assists in the identification of redundant
activities and consequent removal of all the unproductive or redundant activities.
4. Cost reduction: Zero-based budgeting makes every department relook at each and
every item of the cash flow and compute their operating costs. This is to some
extent helps in cost reduction as it gives a clear picture of costs against the desired
performance.
5. Focusing on goals: Zero-based budgeting encourages to determine the
departmental goals and priorities, while evaluating the expenses.
6. Eliminating non-key activities: By forcing managers to identify critical activities
ZBB helps in eliminating non-key activities.

35
Disadvantages of Zero-Based Budgeting:

The following are the disadvantages of zero-based budgeting:

1. Time-consuming: Zero-based budgeting is a very time-intensive exercise for a

company to do every year as against incremental budgeting, which is a far easier
method.
2. Manpower requirement: Making an entire budget from scratch may require
additional staff, which in turn increases the cost for the organization. May not be
suitable for small-sized firms with limited funding.
3. Costly: Implementing a zero-based budget requires qualified and specialized
managers at all levels of the organization, which can be costly.
4. Requires skill, expertise and training: To prepare ZBB proper training needs to be
given to staff and to the managerial person as it requires an understanding of the
activities performed and cost structure associated. It again comes with some cost
and time.
5. It is tough to justify all the expenses for considering the same in budgeting.
Sometimes few expenses cannot be justified, but still they play an important role for
the prospects of the business.
2.6 ADVANTAGES AND LIMITATIONS OF FINANCIAL CONTROL
Financial control system has many advantages:

1. Financial discipline: Financial control ensures proper financial discipline.

2. Proper utilization of resources: It ensures optimal utilization of resources, which
promotes operational efficiency
3. Prevention and elimination of wastage: It helps in prevention and elimination of
wastage of financial resources.
4. Selecting appropriate source of finance: It aids in selecting appropriate source of
finance.
5. Bringing in confidence: It brings in confidence amongst the stakeholders.
6. Cost reduction: It can help in achieving cost reduction.
7. Accomplishing organizational objectives: It helps in achieving organizational
objectives.
8. Co-ordination: It facilitates co-ordination of financial activities.
9. Creditworthiness: It enhances creditworthiness of the organization.
10. Financial decisions: It aids management to take appropriate financial decisions.
36
 11. Reformulating financial plans: It helps in reformulating financial plans when the
results are not satisfactory.
12. Self-control: It inspires employees to apply ‘self-control’.

Limitations of Financial Control system are as follows:

1. Difficulty in standard setting: Setting the standard for an activity is a difficult task.
2. Problem of improper measurement: Improper measurement of actual financial
performance makes the task of comparison difficult.
3. Rigidity: The rigidity of the standards makes it useless in changed situation.
4. Expensive: It involves lots of money. So all organizations are not in a position to
implement it.
5. Unsuitable for controlling external financial activities: It can control internal
financial activities. But controlling external financial activities is outside its scope.
6. Limitations of tools and techniques: Tools and techniques used in financial control
have their own limitations. As a result, financial control also suffers from those
limitations.
7. More emphasis on cure: It is often used as a curative measure than a preventive
measure. As such, the loss already suffered is beyond its control.
8. Manipulation of data: Strict financial control may motivate managers to manipulate
data by way of insufficient provision for bad debts or by means of providing
inaccurate information.
9. Focus on short-term profit performance: It is often oriented towards short-term
profit performance ignoring the long-term prospects.
10. Ignoring non-financial attributes: Important non-financial attributes like product
quality, customer service, motivation of employees and other attribute are not taken
into consideration.
11. Information overload: Information overload may act as a barrier to financial control.
2.7 CHECK YOUR PROGRESS
Fill in the blanks with suitable answers:

1. ______ are the three main objectives of budgetary control.

2. ______ is a mechanism which helps in controlling the financial activities of an
organisation.
3. ______ is the money an investor in a business earns from the invested capital.
4. Zero-Based Budgeting (ZBB) was developed by ______.
37
 5. ______ is a Financial Control technique that analyses the interrelationship between
production, cost, and profit to formulate planning.

Answers to Check Your Progress

1. Planning, coordinating and controlling

2. Financial Control
3. Return on Investment (ROI)
4. Peter A Pyre
5. Break-Even Analysis

2.8 KEYWORDS
Financial Planning : Deciding in advance about the future course of
action pertaining to financial management.

Financial Control : A mechanism which helps in controlling the

financial activities of an organisation.

Budgetary Control : It is a system of controlling cost through

preparation of budgets whereby actual results
are compared with the standard budgets to find
out deviations.

Ratio : It is an expression of the relationship between

numbers.

Break-Even Point : It is the point where your total expenses match

the total revenue, a point without any profit or
loss.

2.9 SUMMARY
Financial planning is part of a larger planning system in the firm. The planning
process begins with the firm’s mission. Given its mission, management sets goals which are
defined in quantitative terms. Goals in turn form strategy which is a plan to gain
competitive edge over rival firms. To support this strategy, policies and budgets are
developed in various areas such as research and development, production, marketing,
personnel, and finance. These then get translated into the financial plan.

Financial control is a mechanism which helps in controlling the financial activities

of an organisation with the help of certain tools like Ratio Analysis, Budgetary Control,
38
Break-Even Analysis, and other financial tools with a view to ensure the accuracy of
reporting, eliminating fraud and protecting the organisation’s resources in order to achieve
organisational objectives.

Financial control refers to the policies and procedures framed by an organization to

monitor and control the direction, allocation, and usage of its financial resources. In other
words, they indicate those tools and techniques adopted by a firm to control its various
financial matters.

2.10 QUESTIONS FOR SELF STUDY

1. Discuss the importance of financial planning and control.
2. What are the benefits of financial planning?
3. Examine the advantages and limitations of financial control.
4. Explain the major tools of financial control.
5. What do you mean by Break-even Point? Examine its advantages and limitations.

2.11 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill- Tenth
Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh
edition-2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-
Eleventh Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya
Publishing House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and
Sons-Fifteenth Edition-2019.

39
UNIT-3 TIME VALUE OF MONEY
Structure:
3.0 Objectives

3.1 Introduction

3.2 Simple Interest

3.3 Compound Interest

3.4 Present Value

3.5 Present Value of an Annuity

3.6 Future Value

3.7 Check Your Progress

3.8 Keywords

3.9 Summary

3.10 Questions for Self-Study

3.11 References

40
3.0 OBJECTIVES
After studying this unit, you will be able to;

 Sketch out the concept of principal and interest.

 Compute the interest using the simple interest formula and compound interest formula.
 Differentiate between simple interest and compound interest.
 Compute the present value and present value of an annuity of series of uniform cash
inflows.
 Compute the future value of a single cash flow and series of cash flows of unequal
amounts.

3.1 INTRODUCTION
In our day to day activities we may have heard the terms like principal, borrower, lender
and interest. Let us get familiar with these terms. Individuals and institutions borrow money for
various reasons. The individual or institution borrowing money is known as the borrower. The
amount borrowed is called the principal. The person or institution which provides money is
called the lender. The borrower is expected to pay a certain amount to the lender for the use of
money in addition to the repayment of principal. The additional money so paid is called the
interest. Therefore, in this unit we will be concentrating on computation of simple interest,
compound interest, present value, present value of an annuity and further value.

3.2 SIMPLE INTEREST

When the interest is calculated only on the original principal, it is called simple interest.
Simple interest is calculated using the following formula

𝑷𝑻𝑹
𝑺𝑰 =
𝟏𝟎𝟎

Where,

SI = Simple Interest

P = Principal

T = Time

R = Rate of Interest

Amount = Simple Interest + Principal

41
3.2.1 ILLUSTRATION
A. CALCULATION OF SIMPLE INTEREST (SI)

1. Calculate the simple interest on ₹ 1, 200 for 2 years at 8% p.a.

Solution: SI = PTR/100 = (1,200 X 2 X 8)/100 = ₹ 192

2. Calculate the simple interest on ₹ 8, 000 for 2½ years at 12% p.a.

Solution: SI = PTR/100 = (8,000 X 2.5 X 12)/100 = ₹ 2, 400

3. Find the simple interest on ₹15,450 for 3 years 6 months 73 days at the rate of 5% p.a.

Solution: T= 3 years 6 months 73 days = 3 + 6/12 + 73/365 = 3 + 0.5 + 0.2 = 3.7

SI = PTR/100 = (15,450 X 3.7 X 5)/100 = ₹ 2,858.25

4. Find the amount receivable on ₹300 at 8% p.a. for 14 weeks.

Solution: T = 14/52

SI = PTR/100 = 0.269

= (300 X 14 X 8)/ (100 X 52) = ₹ 6.46

Amount = Principal + Interest

= 300 + 6.46

= ₹ 306.46

5. Find the simple interest on ₹4,000 from January 3rd 2013 to 17th March 2013 at the
rate of 12% p.a.

Solution: T = From 3rd January 2013 to 17th March 2013 which indicates 28 days
of January, 28 days of February and 17 days of March. Therefore, total
number of days is 28+28+17=73 days. So T can be taken as 73/365 = 0.2

SI = PTR/100 = (4000 X .2 X 12)/100 = ₹ 96

6. Find the simple interest and amount on ₹570 for 2½ years at 3% p.a.

Solution: SI = PTR/100
= (570 X 2.5 X 3)/100 = ₹ 42.75
Amount = Principal + Interest
= 570 + 42.75
=₹ 612.75

42
 7. Find the simple interest on ₹1, 00,000 at 8% for 1 year 1 month 6 days.

Solution: T= 1 year 1 month 6 days = 1 + 1/12 + 6/365 = 1 + 0.083 + 0.0164 =

1.0994

SI = PTR/100 = (1, 00,000 X 1.0994 X 8)/100 = ₹ 8,795.2

B. CALCULATION OF PRINCIPAL AMOUNT (P)

8. Find out the principal if the simple interest for 3 years at the rate of 5% is ₹ 240.

Solution: SI = PTR/100 Given:

240 = (P X 3 X 5)/100 SI= ₹ 240
P=?
24,000 = 15 P T = 3 years
R = 5%
P = 24,000/15 = ₹1, 600

9. What sum will produce ₹112.80 in 4½ years at 3½% p.a.

Solution: SI = PTR/100 Given:

SI= ₹ 112.80
112.80 = (P X 4.5 X 3.5)/100 P=?
T = 4.5 years
11,280 = 15.75 P
R = 3.5% p.a.
P = 11,280/15.75 = ₹ 716

10. The simple interest for 73 days at 5½% is ₹35.20. Find the principal?

Solution: SI = PTR/100 Given:

SI= ₹ 35.20
35.20 = (P X 0.2 X 5.5)/100 P=?
T = 73 days=73/365=0.2
3,520 = 1.1 P
years years
P = 3,520/1.1 = ₹3, 200 R = 5.5%

11. What sum will produce ₹21 in 4 years at 3½% p.a?

Solution: SI = PTR/100 Given:

SI= ₹ 21
21 = (P X 4 X 3.5)/100
P=?
2,100 = 14 P T = 4 years
R = 3.5%
P = 2,100/14 = ₹ 150

43
C. CALCULATION OF RATE OF INTEREST

12. At what rate of simple interest, ₹ 750 yields an interest of ₹ 337.50 in 3 years.

Solution: SI = PTR/100 Given:

SI= ₹ 337.5
337.50 = (750 X 3 X R)/100
P = ₹ 750
33,750 = 2,250 R T = 3 years
R=?
R = 33,750/2,250 = 15%

13. At what rate of S.I, will ₹800 amounts to ₹836 in 9 months.

(a) Calculation of Simple Interest (SI)

Solution: Amount = Principal + Interest

Given:
836 = 800 + Interest SI= ?
P = ₹ 800
836 - 800 = Interest
T = 9 months= 9/12=0.75
₹ 36 = Interest. R=?

(b) Calculation of rate of interest (R)

Solution: SI = PTR/100

36 = (800 X 0.75 X R)/100

3,600 = 600 R

R = 3,600/600 = 6%

14. At what rate of simple interest, ₹15, 000 yields an interest of ₹9,900 in 5½ years.

Solution: SI = PTR/100 Given:

9,900 = (15,000 X 5.5 X R)/100 SI= ₹ 9,900
P = ₹ 15,000
9, 90,000 = 82,500 R
T = 5.5 years
R = 9, 90,000/82,500 = 12% R=?
D. CALCULATION OF TIME (IN YEARS)

15. In what time a ₹ 30,000 earns a simple interest of ₹7,500 at 6¼% p.a.

Solution: SI = PTR/100 Given:

SI= ₹ 7,500
7,500 = (30,000 X T X 6.25)/100
P = ₹ 30,000
7,50,000 = 1,87,500 T T=?
1
R = 6 4% = 6.25% p.a.
44
 T = 7,50,000/1,87,500 = 4 Years
16. In what time will a sum of ₹ 2,000 amounts to 2,240 at the rate of 4% p.a. S.I

(a) Calculation of simple interest

Solution: Amount = Principal + Interest Given:

SI= ?
2,240 = 2,000 + Interest
P = ₹ 2,000
2,240 – 2,000 = Interest T=?
R = 4 % p.a.
240 = Interest

(b) Calculation of time in years (T)

SI = PTR/100

240 = ( 2000 X T X 4)/100

24,000 = 8,000 T

T = 24,000/8,000 = 3 Years

17. A sum of money at simple interest amounts to ₹5,600 in 2 years and ₹6,500 in 5
years. Interest for 3 years is ₹900. Find the principal and the rate of interest for 2 years.

Solution: Amount in 5 years = ₹6,500

Given:
Amount in 2 years = ₹5,600 Amount in 5 years: ₹6,500
Amount in 2 years: ₹5,600
Interest for 3 years = ₹900 Int for 3 years= ₹900
(a) Calculation of interest for 2 years.

If interest for 3 years amounted to ₹900 then,

Interest for 2 years would be --------- ?

 (2 X 900)/3 = ₹ 600
(b) Calculation of principal

Principal = Amount after 2 years - Interest for 2 years

= 5,600 - 600

= ₹ 5,000

(c) Calculation of Rate of Interest for 2 years.

SI = PTR/100

45
 600 = (5,000 X 2 X R)/100

60000 = 10,000 R

R = 60,000/10,000 = 6%

3.4 COMPOUND INTEREST

In case of compound interest, interest at the end of each period is added to the
principal and the amount thus obtained is taken as the principal for interest calculation in
the subsequent period. The formula used for calculating compound interest is as follows:
t
CI =P(1+R/100) - P

CI = Compound Interest

P = Principal

R = Rate of interest

t = Time in years

To calculate the amount after n number of years under compound interest, the
following formula is used:

Amount = P (1+ R/100)t

3.4.1 ILLUSTRATIONS
A. Ascertainment of Compound Interest (CI)

1. Find the compound interest on ₹10, 000 at 12% p.a. for a period of 6 years.
Solution:

CI = P (1+ R/100)t - P
Given:
= 10,000 (1+ 12/100)6 -10,000 CI= ?
P = ₹ 10,000
= 10,000(1+.12) 6 - 10,000
T = 6 years
R = 12% p.a.
= 10,000 (1.12) 6 - 10,000

= 10,000 (1.9738) - 10,000

= 19,738 - 10,000

= ₹ 9,738

46
2. What is the amount on ₹ 30,000 at 15% compound interest for a period of 2 years
if

(a) The interest is payable half yearly

(b) The interest is payable quarterly

(c) The interest is payable annually

Solution:

(a) If the interest is payable half yearly:

Since the interest is payable half yearly, which states 2 times a year, therefore, rate
will be divided by 2 and time will be multiplied by 2.

P = 30,000 R = 15/2 = 7.5% t = 2 X 2 = 4 years

Amount = P (1+ R/100) t

= 30,000 (1+ 7.5/100)4

= 30,000 (1+.075)4

= 30,000 (1.075)4

= 30,000 (1.3355)

= ₹ 40,065

(b) If the interest is payable quarterly yearly:

Since the interest is payable quarterly yearly, which states 4 times a year, therefore,
rate will be divided by 4 and time will be multiplied by 4.

P = 30,000 R = 15/4 = 3.75% t = 2 X 4 = 8 years

Amount = P (1+ R/100)t

= 30,000 (1+ 3.75/100)8

= 30,000 (1+.0375) 8

= 30,000 (1.0375) 8

= 30,000 (1.3425)

= ₹40,275

47
 (c) If the interest is payable yearly

P = 30,000 R = 15% T = 2 years

Amount =P (1+ R/100)t

= 30,000 (1+ 15/100)2

= 30,000 (1+.15) 2

= 30,000 (1.15) 2

= 30,000 (1.3225)

= ₹ 39,675

3. Find the compound interest on ₹10,000 for 2 years at the rate of 4% p.a payable half
yearly.

Solution:

Calculation of compound interest if the interest is payable half yearly

since the interest is payable half yearly, which states 2 times a year,
therefore, rate will be divided by 2 and time will be multiplied by 2.

P = 10,000 T = 2X2 = 4 years

CI = P (1+ R/100)T

= 10,000 (1+ 2/100)4 - 10,000

= 10,000(1+0.02) 4 - 10,000

= 10,000 (1.02) 4 - 10,000

= 10,000 (1.0824) - 10,000

= 10,824 - 10,000

= ₹ 824

48
B. ASCERTAINMENT OF PRINCIPAL AMOUNT

4. What sum amounts to ₹12, 155 in 4 years at 5% compound per annum?

Solution:

Amount = P (1+ R/100)t

Given:
Amount = ₹ 12,155
12,155 = P (1+ 5/100)4
P=?
12,155 = P (1+.05) 4 T = 4 years
R = 5%
12,155 = P (1.05) 4

12,155 = P (1.2155)

Principal = 12,155/1.2155 = ₹ 10,000

5. What sum amounts to ₹3,258 at 5% compound per annum at the end of 10 years?

Solution:

Amount = P (1+ R/100)t

Given:
3,258 = P (1+ 5/100)10 Amount = ₹ 3,258
P=?
3,258 = P ( 1+ 0.05 )10 T = 10 years
R = 5%
3,258 = P (1.05)10

3,258 = P (1.6289)

Principal = 3,258/1.6289 = ₹ 2,000

C. ASCERTAINMENT OF TIME ( IN YEARS)

6. In how many years will ₹2,000 amounts to ₹2,432 at 4% p.a. compound interest at
4% p.a.
Solution:
Amount = P (1+ R/100)t Given:
Amount = ₹ 2,432
2,432 = 2,000 (1+ 4/100)t
P = ₹ 2,000
2,432 / 2,000 = (1+ 0.04)t T=?
R = 4%
1.216 = (1.04) t

(1.04) 5 = (1.04) t
t = 5 Years
49
 7. In what time will ₹1,200 amounts to ₹1,323 compound interest at 5%p.a.

Solution:
Given:
Amount = P (1+ R/100)T Amount = ₹ 1,323
1,323 = 1,200 (1+ R/100)T P = ₹ 1,200
T=?
1,323 / 1,200 = ( 1+ 0.05 ) T R = 0.05%
1.1025 = (1.05) T

(1.05) 2 = (1.05) T
T = 2 Years
D. ASCERTAINMENT OF RATE OF INTEREST

8. A man borrowed ₹15,000 and repaid ₹17,496 after 2 years. Find the rate?

Solution:
Given:
Amount = P (1+ R/100)t
Amount = ₹ 17,496
P = ₹ 15,000
17,496 = 15,000 (1+ R/100)2
T=2
R=?
17,496 / 15,000 = (1+ R/100)2

Multiplying the powers of both the sides by ½

(1.1664)½ = (1 + R/100) 2 x ½

Note: Any number to the power ½ can be written as root of that number

√1.1664 = 1+ R/100

1.08 = 1+ R/100

1.08 - 1 = R/100

0.08 = R/100

R=8%

50
9. A man borrowed 12,500 from a bank and after 2 years paid back 13,520 in full
settlement of his debt. What is the rate of compound interest charged by the bank?
Solution:
Given:
Amount = P (1+ R/100)t
Amount = ₹ 13,250
13,520 = 12,500 (1+ R/100)2 P = ₹ 12,500
T = 2 years
13,520/12,500 = (1+ R/100)2 R=?
1.0816 = (1+R/100)2
Multiplying the powers of both the sides by ½

(1.0816) ½= (1+ R/100) 2x½

Note: Any number to the power ½ can be written as root of that number

√1.0816 = 1+ R/100

1.04 = 1+ R/100

1.04 - 1 = R/100

0.04 = R/100

R=4%

10. At What rate of compound interest will ₹400 amounts to ₹ 441 in 2 years?

Solution:
Given:
Amount = P (1+ R/100)t Amount = ₹ 441
P = ₹ 400
441 = 400 (1+ R/100)2 T = 2 years
441 / 400 = (1+ R/100)2 R=?

Multiplying the powers of both the sides by ½

(1.1025) ½ = (1+ R/100) 2x½
Note: Any number to the power ½ can be written as root of that number

√1.1025 = 1+ R/100

1.05 = 1+ R/100

1.05 - 1 = R/100

0.05 = R/100

R=5%
51
3.5 PRESENT VALUE
Introduction and Meaning:

The present value concept is based on the fact that a rupee in hand today is worth
more than a rupee to be received after sometime. It is true because the cash in hand at
present may be invested to earn a return.

In business this concept is mainly used in evaluating the capital projects. Investment
to be made in the project is termed as cash outflow and the revenues received over a period
from the project are called as cash inflows.

The expected cash flows from a project are discounted at the expected rate of return
to know the present value of the cash inflows from the project. The present value of the
cash inflows is compared with the investment to be made in that project. If the present value
of the cash inflow is greater than the cash outflow or investment, the project is accepted.
Otherwise, it is rejected. In other words, if the net present value is positive, the project is
judged as profitable.

Net present value = Present value of future cash inflows - Present value of cash
outflows.

Where,

Cash in inflows = Earnings/profits/Returns

Cash outflows=Investment

The formula to calculate the present value of cash inflow is given as follows:

PV of Cash flows = C / (1+ r) n

Where:

PV = Present Value = 1/(1+r)n

C = Cash inflow

r = Expected rate of return

n = Period

52
3.5.1 ILLUSTRATIONS
Illustration-1:

A project requires an investment of ₹ 10,000 at present. The cash flows of this project at the
end of first year and second year are ₹ 7,000 and ₹ 5,000 respectively. If the expected rate
of return is 10%, can the project be accepted?

Solution:

P V of Cash inflows = C/(1+ r)n = 7,000/(1+ 0.1) 1+ 5,000/(1+ 0.1) 2

= 7,000/(1.1) 1+5,000/(1.1) 2

= 7,000/1.1 + 5,000/1.21

=6363.6 + 4132.2
= ₹ 10,495.8
Net present value = Present value of future cash inflows – Cash outflow
= 10,495.8-10,000
= ₹ 495.8
Conclusion: Since NPV is positive, the project can be accepted.

Illustration-2:

A project involves an investment of ₹ 1,20,000. The expected cash inflow at the end of 1st,
2nd, 3rd and 4th year are ₹ 30,000, ₹ 40,000, ₹ 50,000 and ₹ 60,000 respectively. What is the
net present value, if the expected rate of return is 15%.

Solution:

P V of Cash inflows = C/(1+ r) n

= 30,000/(1+ 0.15) 1 + 40,000/(1+ 0.15) 2 + 50,000/(1+ 0.15) 3 + 60,000/(1+ 0.15) 4

= 30,000/(1.15) 1+ 40,000/(1.15) 2+ 50,000/(1.15)3s + 60,000/(1.15) 4

= 30,000/1.15 + 40,000/1.3225 + 50,000/1.5209 + 60,000/1.7490

=26,087 + 30,246 + 32,875 + 34,305

=1, 23,513
Net present value = Present value of future cash inflows – Cash outflow
= 1, 23,513 - 1, 20,000

= ₹ 3,513
53
Conclusion: Since NPV is positive, the project can be accepted.

Illustration-3:

The details of two investment proposals are given below:

Particulars Proposal A Proposal B

Investment 60,000 80000

Cash inflows:

First year 10,000 40000

Second year 20,000 40000

Third Year 45,000 15000

If the expected rate of return is 10%, evaluate the projects.

Solution:

Evaluation of Proposal A

C
PV of cash inflow =
(l + r)n

10,000 20,000 45,000

PV = + +
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3

10,000 20,000 45,000

= + +
(1.10)1 (1.10)2 (1.10)3

10,000 20,000 45,000

= + +
1.1 1.21 1.331

= 9,090 + 16,529 + 33,809 = ₹ 𝟓𝟗, 𝟒𝟐𝟖

Net present value = Present value of future cash inflows – Cash outflow

= 59,428 - 60,000

= ₹ - 572

54
Evaluation of Proposal B:

C
PV of Cash inflow =
(l + r)n

40,000 40,000 15,000

PV = + +
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3

40,000 40,000 15,000

= 1
+ 2
+
(1.10) (1.10) (1.10)3

40,000 40,000 15,000

= + +
1.1 1.21 1.331

= 36,364 + 33,058 + 11,269

= ₹ 𝟖𝟎, 𝟔𝟗𝟐

Net present value = Present value of future cash inflows – Cash outflow

= 80,692 - 80,000

= ₹ 692

Conclusion: The proposal A shows negative net present value and the proposal B shows
the positive net present value. Therefore, it is advisable to select Proposal B
which is judged as profitable.

Illustration-4:

Two projects having the same investment of ₹ 16, 00,000 are expected to yield the
following revenues.

Cash inflows Project P Project Q

1st year 7,20,000 3,20,000

2nd year 6,40,000 4,80,000

3rd year 5,60,000 7,60,000

4th year 4,80,000 9,40,000

The company can take up only one project. The expected rate of return is 15%.
Advise the company as to which project can be accepted?

55
Solution:
Evaluation of Project P
𝐂
𝐏𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 =
(𝐥 + 𝐫)𝐧
7,20,000 6,40,000 5,60,000 4,80,000
= 1
+ 2
+ 3
+
(1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15)4

7,20,000 6,40,000 5,60,000 4,80,000

= + + +
(1.15)1 (1.15)2 (1.15)3 (1.15)4

7,20,000 6,40,000 5,60,000 4,80,000

= + + +
1.15 1.3225 1.5209 1.7490

= 6, 26,087 + 4,83,932 + 3,68,203 + 2,74,443

= ₹ 𝟏𝟕, 𝟓𝟐, 𝟔𝟔𝟓

Net present value = Present value of future cash inflows – Cash outflow
= ₹ 17, 52,665 - 16,00,000
= ₹ 1,52,665
Evaluation of Project Q

𝐂
𝐏𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰 =
(𝐥 + 𝐫)𝐧
3,20,000 4,80,000 7,60,000 9,40,000
= 1
+ 2
+ 3
+
(1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15)4
3,20,000 4,80,000 7,60,000 9,40,000
= + + +
(1.15)1 (1.15)2 (1.15)3 (1.15)4
3,20,000 4,80,000 7,60,000 9,40,000
= + + +
1.15 1.3225 1.5209 1.7490
= 2,78,261 + 3,62,949 + 4,99,704 + 5,37,450
= ₹ 𝟏𝟔, 𝟕𝟖, 𝟑𝟔𝟒

Net present value = Present value of future cash inflows – Cash outflow
= 16,78,364 - 16,00,000
= ₹ 78,364
Conclusion: Both the project shows positive net present value, which indicates that both
the projects are profitable. But the company has an option offered to invest in
only one project. Therefore, out of the above mutually exclusive profitable
projects, it is advisable to investment in project P, because it gives higher Net
Present Value.
56
Illustration-5:

A project involves an investment of ₹ 1,00,000. The expected cash inflow at the end of 1st
,2nd, 3rd , and 4th year are ₹ 20,000, ₹ 15,000, ₹ 25,000 and ₹ 50,000 respectively. What is the
net present value if the expected rate of return is 10%?

Solution:

C
PV of Cash inflow =
(l + r)n

20,000 15,000 25,000 50,000

= 1
+ 2
+ 3
+
(1 + 0.1) (1 + 0.1) (1 + 0.1) (1 + 0.1)4

20,000 15,000 25,000 50,000

= 1
+ 2
+ +
(1.1) (1.1) (1.1)3 (1.1)4

20,000 15,000 25,000 50,000

= + + +
1.1 1.21 1.331 1.4641

= 18,182 + 12,397 + 18,783 + 34,151

= 𝟖𝟑, 𝟓𝟏𝟑

Net present value = Present value of future cash inflows – Cash outflow
= 83,513 - 1,00,000
= ₹ -16,487
Conclusion: Since NPV of project is negative, hence it is advisable not to accept he project.
Illustration- 6:

The details of 2 investment proposals are given below:

Particulars Proposal A Proposal B

Investment 80,000 80,000

Cash inflows:

First year 30,000 35,000

Second year 35,000 30,000

Third Year 50,000 10,000

If the expected rate of return is 10%, evaluate the projects.

57
Solution:

Evaluation of Proposal A

C
PV of cash inflow =
(l + r)n

30,000 35,000 50,000

= 1
+ 2
+
(1 + 0.10) (1 + 0.10) (1 + 0.10)3

30,000 35,000 50,000

= + +
(1.10)1 (1.10)2 (1.10)3

30,000 35,000 50,000

= + +
1.1 1.21 1.331

= 27,273 + 28,926 + 37,566

= ₹ 𝟗𝟑, 𝟕𝟔𝟓

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

= ₹93,765 − ₹ 𝟖𝟎, 𝟎𝟎𝟎

= ₹ 𝟏𝟑, 𝟕𝟔𝟓

Evaluation of Proposal B

𝐂
𝐏𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰 =
(𝐥 + 𝐫)𝐧

35,000 30,000 10,000

= + +
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3

35,000 30,000 10,000

= 1
+ 2
+
(1.10) (1.10) (1.10)3

35,000 30,000 10,000

= + +
1.1 1.21 1.331

= 31,818 + 24,793 + 7,513

= ₹ 𝟔𝟒, 𝟏𝟐𝟒

Net present value = Present value of future cash inflows – Cash outflow

= 64,124 - 80,000

= - 15,876

58
Conclusion: The proposal B shows negative net present value and the proposal A shows the
positive net present value. Therefore, it is advisable to select Proposal A which is
judged as profitable.

3.6 PRESENT VALUE OF AN ANNUITY

An annuity is defined as a series of uniform receipts and payments occurring over a
specified number of years. When receipts or revenues from a project are uniform over a
specified period, the present value is calculated by using the following formula:

Present Value of an Annuity = A 1 - 1 / (1+ r) n

r
Where,

P= Present value of each annuity payment

A = Annuity received

n = Number of years

r = Rate of return

3.6.1 ILLUSTRATIONS
Illustration-1:

Find the present value of an annuity of ₹1,000 for four years at 10% p.a.

1 − 1/(1+ r) n
Present Value of an Annuity (A) =p
r

1 − 1/(1 + 0.10)4
= 1,000
0.10

1 − 1/(1.1)4
= 1,000
0.10

1 − 1/1.4641
= 1,000
0.10

1 − 0.6830
=1,000
0.10

0
=1,000 .317
0.10

= ₹ 3,170
59
Illustration-2:

Find the present value of an annuity of ₹5,000 for 5 years at 12% p.a.

Solution:

1 − 1/(1 + r) n)
Present Value of an Annuity (A) =p
r

1 − 1/(1 + 0.12)5
= 5,000
0.12

1 − 1/(1.2)5
= 5,000
0.12

1 − 1/1.7623
= 5,000
0.12

1 − 0.5674
=5,000
0.12

= 5,000 x 3.605

= ₹ 18,025

3.7 FUTURE VALUE

It is the value of cash flow at the end of a specified period. It is also known as terminal
value. In order to find the future value of the cash flow, the following formula can be used:

Future Value of cash flow = P ( 1 + r ) n

Where,

F V = Future Value = (1+r)n

P = Present value

r = Rate of Interest

n = Period

3.7.1 ILLUSTRATIONS
Illustrartion-1:

Present outlay is 10,000. It is invested for 4 years. The rate of interest is 10% p.a.

Calculate the future value of 10,000 after 4 years.

60
Solution:

Future Value = P (1+7)n

=10,000 ( 1 +0.10 ) 4

=10,000 ( 1.1 ) 4

=10,000 ( 1.4641 )

=₹ 14,641

Illustration-2:

Calculate the future value of ₹ 20,000, if

a. Received at the end of one year

b. Received at the end of eight years
c. Received at the end of fifteen years

Assume 9% rate of interest.

Solution:

a. Future value of 20,000, if received after one year

Future Value of Cash flow = P (1 + r) n

=20,000 (1 + .09) 1

=20,000 (1.09) 1

=20,000 (1.09)

=₹ 21,800

b. Future value of 20,000, if received after eight years

Future Value of Cash flow = P (1 + r) n

=20,000 (1 + 0.09) 8
=20,000 (1.09) 8

=20,000 (1.9925)

=₹ 39,851

c. Future value of 20,000, if received after fifteen years

Future Value of Cash flow = P (1 + r) n

61
 =20,000 (1 + .09) 15

=20,000 (1.09) 15

=20,000 (3.64255)

=₹ 72,850

Illustration-3:

Mr. A invests ₹1,000 at the end of first year, ₹ 2,000 at the end of second year and ₹3,000 at the
end of third year at an interest of 10% per annum. Calculate the future value of the investment at
the end of 3 years compounded annually.

Solution:

Future Value of Cash flow =P(1+r)n

=1,000 ( 1 + .10 ) 3 + 2,000 ( 1 + .10 ) 2 + 3,000 ( 1 + .10 ) 1

1,000 ( 1.1 ) 3 + 2,000 ( 1.1 ) 2 + 3,000 ( 1.1 ) 1

1,000 ( 1.331 ) + 2,000 ( 1.21 ) + 3,000 ( 1.1 )

=1,331 + 2,420 + 3,300

=₹ 7,051

Note: The investment for 1st year will remain for 3 years, the investment for 2nd year will
remain for 2 years and the investment for 3rd year is only for one year.

Illustration-4:

Present outlay is 15,000. It is invested for 3 years. The rate of interest is 12% p.a.

Calculate the future value of 15,000 after 3 years.

Solution:

Future Value of Cash flow = P (1+r) n

= 15,000 (1 + .12) 3

= 15,000 (1.12) 3

= 15,000 (1.4049)

= ₹ 21,074.

62
3.8 CHECK YOUR PROGRESS
Fill in the blanks with suitable answers:

1. ₹1,000 in hand today is worth ______ than a ₹ 1000 to be received after sometime.

(a) More (b) Same (c) Less (d) None

2. If the net present value of cash inflow is more than the cash out flow then the project can be
______.

(a) Rejected (b) can't say (c) partially rejected (d) accepted

3. An annuity is a series of ______ receipts and payment occurring over a number of years
cash flow at the end of a specified period is called ______.

4. Today's value of the payment to be received in the future is called ______.

Answers to Check Your Progress

1. (a)

2. (d)

3. Uniform

4. Future value

3.09 KEY WORDS

Present Value : Today’s value of a payment to be received in the
future.

Future Value : Value of cash flow at the end of a specified

period.

Annuity : Uniform receipts and payments occurring over a

specified number of years.

3.10 SUMMARY
Perhaps, in this unit we have discussed and understand the computation of present value
and future value of cash flows. Present value and future value are measures of worth based on
the concept of time value of money and discounted cash flow. Present value is today's value of a
payment to be received in the future. It is the value today of a future payment or series of
payments, discounted at the appropriate discount rate. Present value answers the questions of

63
how much money would have to be set aside today and invested in order to accumulate the
target amount by the payment date.

Future value is the amount of money that an investment made today will grow to some
future date. It refers to a method of calculating how much the present value of cash will be worth
at a specific time in the future.

3.12 QUESTIONS FOR SELF STUDY

1. For an investment of ₹15,000 the expected revenues are as follows: At the end of the first
year ₹ 6,000, at the end of the second year ₹ 7,000 at the end of the third year ₹ 5,000

Find whether the project can be accepted at 12% expected return.

2. Two projects having the same investment of ₹ 16, 00,000 are expected to yield the
following revenues.

Cash inflows Project P Project Q

1st year 7,10,000 3,30,000

2nd year 6,50,000 5,05,000

3rd year 5,75,000 7,95,000

4th year 4,45,000 9,20,000

The company can take up only one project. The expected rate of return is 15%. Advise
the company as to which project can be accepted ?

3. Find the present value of an annuity of ₹ 15,000 for 4 years at 12% p.a.

4. Present outlay is ₹ 25,000. It is invested for 5 years. The rate of interest is 10% p.a.

Calculate the future value of ₹ 25,000 after 5 years .

5. Calculate the future value of ₹40,000, if

(a) Received at the end of one year

(b) Received at the end of five years
(c)Received at the end of ten years
(d) Received at the end of twelve years. Assume 12% rate of interest.

64
 6. Mr. Smart invests 10,000 at the end of first year 20,000 at the end of second year 30,000 at
the end of third year and 40,000 at the end of fourth year at an interest of 12% per annum.
Calculate the future value of the investment at the end of 4 years compounded annually.

3.13 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill- Tenth
Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh
edition-2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-
Eleventh Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya
Publishing House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and
Sons-Fifteenth-Edition-2019.

65
UNIT 4 COST OF CAPITAL
Structure:

4.0 Objectives

4.1 Introduction

4.2 Meaning and Definitions of Cost of Capital

4.3 Importance of Cost of Capital in Financial Management

4.4 Components of Cost of Capital

4.5 Factors Affecting for Financing Costs

4.6 Determination of Cost of Capital

4.6.1 Cost of Debt

4.6.2 Cost of Preference Share Capital

4.6.3 Cost of Equity Share Capital

4.6.4 Cost of Retained Earnings

4.7 Weighted Average Cost of Capital (WACC)

4.8 Check Your Progress

4.9 Keywords

4.10 Summary

4.11 Questions for Self-Study

4.12 References

66
4.0 OBJECTIVES
After studying this unit, you will be able to;

 Sketch out the importance of cost of capital in financial decision making.

 Analyze the problems on cost of debt, cost of equity shares and cost of preference
shares.
 Analyze the problems on weighted average cost of capital.
 Examine the various components of cost.

4.1 INTRODUCTION
The cost of capital represents the rate of return which the company must pay to the
suppliers of capital for the use of their funds. This would be the minimum rate of return that a
project must yield to keep the value of the enterprise intact.

It has also been observed that cost of capital and plays vital role in accept-reject
decisions criterion. A cost of capital is shown in per cent value. Now question arises, how to
determine cost of capital and what does it actually represent? In earlier discussion on sources
of finance, we have also learnt that there are various types of sources of finance, like long-
term, short-term, equity and debt.

Let’s take the example of debt to understand the cost of capital. A company issues
debt security at 10% interest per annum is under two obligations, first, to pay interest and
second to pay-back the principal amount on the maturity of debt. It means, raising and using
debt is not free, rather it bears some cost, that is, interest and principle amount. The raised
funds (from debts) will be used to make an investment in capital assets in order to generate
revenues. Now company is required to generate revenues, at least, equal or more than ten per
cent. The required percentage of return is ‘rate of return’ or cost of capital. Thus, this unit,
chapter, we will learn various types of cost of capital in detail with some illustrations.

4.2 MEANING AND DEFINITIONS OF COST OF CAPITAL

The role of cost of capital is very important in decision making process of financial
management. The cost of capital is used for two purposes, , firstly, a comparison of
alternative sources of funds may be made to select one which has least cost and maximum
contribution to wealth maximisation, secondly, to evaluate investment proposals, as it
provides a benchmark to yield a minimum return. A few definitions on cost of capital are
given below.

67
 As per J. C. Van Horne, “cost of capital is a cut-off rate for the allocation of capital
to investments of projects. It is the rate of return on a project that will leave un-changed the
market price of the stock” .

According to Lawrence J. Gitman,’ “the cost of capital of the rate f returns a firm
earn on its investment for the market value of the firm to remain unchanged. It can also be
thought of as the rate of return required by the market suppliers of capital in order to attract
needed financing at all reasonable price”.

According to H.Kent Baker and Gray E. Powell, “the cost of capital is the rate that
the firm has to pay, explicitly or implicitly, to investors for their capital or the minimum rate
of return required by the suppliers of capital, thus, ignoring taxes and floatation costs, the cost
of capital represents two sides of the same coin- the cost to issuers is the return to investors”.

I.M.Pandey, defined cost of capital as, “the project’s cost of capital is the minimum
required rate of return on funds committed to the project, which depends on the riskiness of
its cash flows”.

J.Berk, Peter D., and A.Thampy, defines, “cost of capital is the expected return
available on securities with equivalent risk and term to a particular investment”.

According to Hunt, Willian and Donaldson, “cost of capital may be defined as the
rate of that must be earned on the net proceeds to provide the cost elements of the burden at
the time, they are due”.

In view of Hampton, John J.,”cost of the capital is the rate of return the firm
required from investment in order to increase the value of the firm in the market place”.

Form the above definitions, the following characteristics of the cost of capital may be drawn.

1. Cost of capital is a rate of return, generally, expressed in per cent value

2. It is the minimum required rate of return to offset the effect of risk associated with
business and to maintain profitability in order to maximise the wealth of
shareholders.
3. Cost of capital has role in maintaining market value of the firm. The value of a
firm will decline if a firm uses capital at a higher cost than its return on assets.
4. Arranging sources of finance at rate of return (called cost of capital), and
allocating them in investments are the two sides of same coin. The amount so

68
 invested must yield return equal to or more than a rate at which sources are
arranged to fund such investments.
5. Cost of capital involves implicit as well as explicit cost; therefore, it takes future
risk into account.
4.3 IMPORTANCE OF COST OF CAPITAL IN FINANCIAL MANAGEMENT
The cost of capital has a central role in financial management because it provides a
way to link investment and financing decisions of a firm. An interrelationship exists between
capital budgeting and cost of capital. For example, to determine the size of the capital budget,
managers need information about both the returns on investment opportunities and the cost of
capital. It helps in two ways, first, assist in identify the discount rate to be used to evaluate
proposed capital investment, second, to serve as guideline in developing capital structure and
evaluating financial alternatives. The key usages of cost of capital in financial management
are discussed below:

1. Cost of capital in capital budgeting: The cost capital is the fundamental

requirement of capital budgeting technique especially based on discounted cash
flows. The acceptance and rejection of a proposal depends upon cost of capital
associated with it. A proposal with higher rate of return have lesser net present
value in comparison of another proposal with lesser cost of capital, therefore,
more chances to reject the proposal with higher cost of capital. Since, the cost of
capital represents the minimum rate of return to be earned on an investment, thus,
a costly source of finance expects higher rate of return from assets to be funded
from such source of finance. Net present value, profitability index, discounted
payback period method and many more are based on cost of capital to discount the
cash flows. Hence, the cost of capital is very useful in capital budgeting decision.
2. Cost of capital in determination of capital structure: Every source of fund has
own features, few are costly in comparison to others and some are easily
available. A firm commonly uses both equity and debt as a mix in its total
financing. The cost of debt is considered at lower rate in comparison to equity. At
the same, there is tax advantage on debt security but not on equity capital.
Therefore, an optimum mix of debt and equity is helpful in determination of
average cost of capital. In designing an optimal capital structure, the management
has to keep in mind the objective of maximising the value of the firm which
makes cost of capital important in financial planning of the firm.

69
 3. Cost of capital and financial performance of the firm: The average cost of
capital of a firm represents risk and return of the firm. A firm with high cost of
capital exposed to high rate of risk and impact firm’s profitability. If the actual
profitability of a proposal is more than the projected and actual cost of capital, the
performance may be said to be satisfactory, vice-versa.
4. Cost of capital and financial decisions: Cost of capital has more usages in
financial decision making, in valuation of retained earnings, dividend policy,
capitalisation or profit also. Cost of capital involves business risk as well as
financial risk; therefore, it recognises the time value of money in optimum
manner. Moreover, cost of capital also taken explicit and implicit cost into
account, thus, opportunity cost is also considered in financial decision making
when the decision is taken on the basis of cost of capital.
5. Cost of capital and external users: Cost of capital is useful in decision making
for internal as well as external users. A potential investor, banking institution,
short-term lender, creditors also interested to know the cost of capital of the firm.
A firm with higher cost of capital, generally, operates at higher risk, thus, lender
may have less favour to advance money to such firm. Sometimes, government
also provide financial assistance to companies in danger, but of national or social
importance, due to high cost of capital by way of announcing special packages.
4.4 COMPONENTS OF COST OF CAPITAL
The prime components of cost of capital are: (i) cost, and (ii) capital. A combination
of different types of capital and cost components determine cost of capital which may vary
form case to case. A detail classification of components of cost of capital is displayed below:

70
 Components of Cost of Capital

Cost Capital
Before tax or after tax

Historical, Future, Average

External Internal
Flotation, Marginal Cost

Explicit and Implicit Cost Equity Retained

Capital Earnings

Depreciation

Preference Depreciation
Capital

Debt

Figure 6.1: Components of Cost of Capital

Components of Capital

Capital components are funds that come from investors. There are three major long-
term components in the capital structures are debts, preference share capital and equity
shares. Although some firms can finance their operations totally with equity share capital,
most rely on other capital components. In actual practice, firms raise capital from several
sources in an effort to reduce the average required rate of return on the firm’s overall capital.
Thus, their cost of capital should be the weighted averages of the various types of funds they
use. Since, the retained earnings are also a source of funds to a firm therefore, valuation of
retained earnings is also important. Depreciation is also treated as source of funds and
component of cost of capital.

Components of Cost:

The major components of cost are discussed below:

71
 1. Before Tax or After Tax: Although the corporate tax effects associated with
financing can be incorporated in determination of cost of capital and most of firms do
the same. Therefore, analysts should focus on after-tax costs. Taxes only affect the
cost of debt because of interest an expense that reduces taxes but not dividend.
2. Historical Cost or Future Cost: The decision-making process of financial
management generally depends upon accounting information which is historical in
nature, but the use of future cost or estimated cost is much relevant than historical
cost. At the same point of time, it is emphasized that future cost can’t be generated
without the base of historical cost.
3. Average, Marginal, Floating Cost: The role of average cost and marginal cost has
wider application in cost of capital. Average cost of capital is the combined cost of all
components of capital. The average cost refers to weighted average cost of capital.
Marginal cost is an additional cost to raise additional funds. Both, average costs and
marginal costs are used in determining cost of capital depending upon case to case.
Two distinct opinions are there on floating cost; some authors are in view that floating
costs are relevant when a firm raises new financing. Another approach threats
floatation costs as an additional outflow that increases the initial cash outlay of an
investment. There is disagreement on how to appropriately handle floatation costs.
4. Explicit Cost and Implicit Cost: Explicit cost is the cost which is directly connected
with the subject matter, whereas implicit cost refers to opportunity cost. On the other
hand if retained earnings are used in business then the implicit cost of such retained
earnings is the opportunity cost, that is, implicit cost of such retained earnings is the
rate of return available to shareholders by investing the funds elsewhere.
5. Depreciation: For many firms, depreciation is the internally generated source of
funds. The cost of funds generated through depreciation depends on how the firm will
use the funds. If the firm plans to use these funds as a part of the capital expenditure
process, the cost of depreciation will be weighted average cost of capital before
issuing new equity. Thus, using depreciation in total cost increases the weighted
average cost of capital unreasonably, therefore including depreciation in cost is
unnecessary.

4.5 FACTORS AFFECTING FOR FINANCING COSTS

The cost of capital is measured under the assumption that both the business and
financial risk of the firm are fixed and that the investor’s disposition towards risk remains

72
unchanged, the only factor that affects the various specific costs of financing is demand and
supply of operating in the market for long-term funds. It is the risk-free cost of funds that
under these circumstances is of key importance in assessing financing cost. Regardless of the
type of financing uses, the following general relationship should prevail.

K i = r1 + bp + fp

Where,

K i = the specific cost of the various types of long-term financing.

r1 = the risk-free cost of the given type of financing.

bp = business risk premium

fp = financial risk premium

Above equation shows that cost of each type of capital depends on the risk-free cost
of that type of funds, the business risk of the firm and the financial risk of the firm. The
business risk is related to the response of the firm’s earnings before interest and taxes (EBIT)
or operating profit, to changes in sales. The financial risk related to the response of the firm’s
EPS to changes in EBIT. Though, both affect capital structure of the company, but in
determination of cost of capital, these are assumed to be constant. It means only one factor
remain open, that is, relationship of demand and supply of a particular fund.

4.6 DETERMINATION OF COST OF CAPITAL

The cost of capital is measured at a given point of time; it must reflect the cost of
funds over the long-run, based upon the best information available. This section describes the
procedure for measuring the costs of specific sources. First, the cost of capital of each source
of fund will be measured individually, then followed by weighted average cost of capital.

4.6.1 COST OF DEBT

The cost of long-term debt has two basic components. One is the annual interest and
the other arises from the amortization of discounts given or premiums received when the debt
is initially issued. In order to simplify the calculations in this section annual interest payments
on debts are only taken into account.

(i) Cost of debt, issued at par, before tax affect

I
Kd =P

K d = Cost of debt before tax;

73
 I = Interest;

P = Principal amount.

(ii) Cost of debt raised at premium or discount.

In case of premium, face value will be increased by premium and in case of discount
principal amount will be face value less discount amount.

I
Kd =
NP

NP=Net proceeds on issue of debt.

In case of debt issued at premium, NP=Face value+ Premium, in case of discount, NP=Face
Value-Discount Value.

(iii) Cost of debt considering tax affect

The payment of interest on debt is a statutory obligation. On profit, firstly interest is deducted
then tax is paid on remaining earnings. Thus, interest on debt has tax advantage. In this case
cost of debt is:

I
Kd = (1 − t)
P

Where,

K d =cost of debt after tax, and

I= interest

T= rate of tax

NP=net proceeds

Illustration 1:

A Co. Ltd. Issued 10% debenture of ₹ 5, 00,000 at par. Compute the cost of debt if the
applicable tax rate on the company is (i) 50%, (ii) 40%, (iii) 45%.

Solution:

Computation of cost of Debt if,

(i) Tax Rate = 50 %

I
Cost of debt (K d ) = NP (1 − t)

74
 50,000
=5,00,000 (1 − 0.5)
5
=50 X 0.5
𝟏
=𝟏𝟎 𝐗 𝟎. 𝟓 = 𝟓%

(ii) Tax Rate= 40 %

I
Kd = (1 − t)
NP
50,000
= 5,00,000 (1 − 0.4)

1
=10 X 0.6 = 6%

(iii) Tax Rate = 45%

1
Kd = 10 (1 − 0.45)
1
=10 X 0.55

= 𝟓. 𝟓%
Illustration 2:

X Co. Ltd issued 12% debenture of ₹ 2,00,000, face value of the debenture is ₹ 100. Compute
cost of debenture if:

(i) Issued at par, tax rate is 20%

(ii) Issued at 10% premium, tax rate is 30%
(iii) Issued at 10% discount, tax rate is 40%.
Separate the tax adjustment of each case.
Solution: In order to separate the tax adjustment, costs of debt are computed (i) before tax
adjustment and (ii) after tax adjustment.

Before Tax Adjustment After Tax Adjustment

(i) At Par I
Kd = (1 − t)
NP
I 12
Kd = = = 12% 12
NP 100 = (1 − 20)
100
12
= X0.80 = 9.6%
100

75
 (ii) At Premium 12
= (1 − 0.30)
110
I 12
Kd = = = 10.9% 12
NP 110 = X0.70 = 7.63%
110
NP=Face value + Premium

(iii) At Discount 12
= (1 − 0.40)
90
I 12
Kd = = = 13.33% 12
NP 90 = X0.60 = 7.9%
90

Thus, cost of debt has tax advantage as it declines when the rate of tax increases.

Illustration 3:

Z Co. Ltd issues 9% debenture of ₹ 6,00,000, face value of the debenture is ₹ 100 at par
value. It spent ₹ 20,000 as floating expense on issue of debenture. Compute cost of debt, if
tax rate is 40%.

Solution:
I
K d = NP(1-t)

NP = Principal amount- Expenses on issue

= 6,00,000-20,000

= 5,80,000
54,000
K d = 5,80,000 (1-0.40)

= 0.0931 x 0.6

=5.59%

(iv) Cost of Redeemable Debt (Short-Cut Method)

When debts are issued for a predetermined period and have to redeem on maturity called
redeemable debt. The cost of redeemable debt is measured as follows:
1
I+ (P−NP)
n

Kd = 1 (1-t)
(P+NP)
2

76
Where,

n = Number of years in which debt is to be redeemed.

P = Principal amount

NP = Net proceeds

t = Tax rate

Illustration 4:

Compute the cost of capital of 12% debentures issued by Vikas (P) Ltd., face value of ₹100,
amount of ₹ 2,00,000, in following situations. The life of debenture is 7 years.

(i) Redeemable at par, tax rate is 20%

(ii) Redeemable at 10% premium, tax rate is 30%.
(iii) Redeemable at 10% discount, tax rate id 40%.
Solution:

12% Debenture of ₹ 2,00,000. Face value ₹ 100, Debenture issued at par, Tax rate 20%
1
I+ (P−NP)
n
Kd = 1 (1-t)
(P+NP)
2

Where, I = 24000; n= 7 years; P = 100; NP = 100; t = 20%.

1
24,000+ (2,00,000−2,00,000)
7
Kd = 1 (1-0.20)
(2,00,000+2,00,000)
2
24,000+0
= x 0.80
4,00,000/ 2
24,000
= X 0.80
2,00,000
= 9.6%
(ii) Debenture redeemable at premium (10%), tax rate is 30%
1
24,000+ (2,00,000−2,20,000)
7
Kd = 1 (1-0.3)
(2,00,000+200000)
2
1
24,000+ (−20,000)
7
Kd= 1 x 0.7
(4,20,000)
2
21,142
Kd= x 0.7
2,10,000

𝐊 𝐝 = 7.05 %

77
(iii) Debenture issued at discount (10%)
1
24,000+ (20,000)
7
Kd = 13,80,000 x (1-0.60)
2

24,000+2,857
Kd= 1,90,000
x 0.60

𝐊 𝐝 = 8.48 %

Short-Cut method has a limitation that this method gives only approximated result, it
does not consider the repayment and the annual compounding.

4.6.2 COST OF PREFERENCE SHARE CAPITAL

There is fixed percent of payment on preference share capital, whenever the dividend
is paid to them. The payment of dividend to preference shareholder is dependent upon the
discretion of the Board of Directors, but it does not mean that preference share capital has no
cost. Since dividend is paid out of profit after tax, thus, there is no tax advantage on cost of
capital of preference share capital.

As per the Companies Act, 2013, in India, preference shares have a defined life,
therefore, these have to be redeemed as and when maturity period arises. Secondly, no share
can be issued at discount, thus, preference shares will be issued either at par or premium.
Thus, net proceeds will not be less than the face value in any case. However, any expenditure
incurred on issue of such shares may be deducted from the face value, hence exception. The
cost preference share capital is computed as follows:

1
D + n (RV − NP)
kp =
1
2 (RV + NP)

Where,

k p = Cost of preference share capital

D = Dividend (annual)

RV= Redemption Value

NP= Net Proceeds (face value + premium) or (face value-floatation cost)

n= number of yours

78
Illustration-1:

Harshita Co. Ltd. issued 12% Redeemable Preference Share Capital of ₹ 5,00,000, face value
each share is ₹ 10. Calculate the cost of capital if shares are issued (i) at par, (ii) at a 10%
premium. Assuming the shares will be redeemed on 10th year at a premium of 10%.

Solution:

Competition of cost of preference share capital

(i) Issue at par, redemption at premium

1
D + n (RV − NP)
Kp = X 100
1
2 (RV + NP)

1
60,000 + 10 (5,50,000 − 5,00,000)
= X 100
1
2 (5,50,000 + 5,00,000)

1
60,000 + 10 (50,000)
= X 100
10,50,000/2

60,000+5,000
= X 100
5,25,000

= 𝟏𝟐. 𝟑𝟖%

(ii) Issued at premium, Redemption at premium

1
D + n (RV − NP)
Kp = X 100
1
(RV + NP)
2
1
60,000 + 10 (5,50,000 − 5,50,000)
= X 100
1
2 (5,50,000 + 5,50,000)
60,000+0
= X 100
5,50,000

= 10.91%

79
Illustration-2:

Kishore (P) Ltd. issued 10% preference shares, face value ₹ 10 each, redeemable after 8
years. Total numbers of shares issued are 50,000. Preference shares are to be redeemed at
20% premium. The cost of issue of such shares is 50 paise per share. Compute cost of capital
of preference shares.

Solution:

 RV= (50,000x10) + (50,000x10x20%) =5,00,000 + 1,00,000 = ₹ 6,00,000

 NP= 50,000 x (10-0.5) = 50,000 x 9.5= ₹ 47,50,000
 D = 5,00,000 x 10% = ₹ 50,000
1
D + n (RV − NP)
Kp = X 100
1
(RV + NP)
2
1
50,000 + 8 (6,00,000 − 4,75,000)
= X 100
1
2 (6,00,000 + 4,75,000)

50,000 + 15,625
= X 100 = 12.21%
5,37,500

Cost of Preference Share in Respect to Market Value

4.6.3 COST OF EQUITY SHARE CAPITAL

The cost of equity share is not as easy to calculate as the cost of debt or the cost of
preference share. The difficulty arises from the definition of the cost of equity share, which is
based on the premise that the value of a share of stock in a firm is determined by the present
value of all future dividends expected to be paid on the stock. But, payment of dividend to
equity shareholders is not a legal binding on a company, moreover, there is no any fixed
percent at which dividend to be paid to equity shareholders. But this does not make cost of
capital of equity share capital free of cost. Of course, there is no explicit method, but with the
help of implicit method, that is, opportunity cost, cost of equity capital (Ke) can be
determined.

The probability of getting dividend and to remain the market price of the equity share
unchanged is the first expectation of equity shareholders. With the help of following
methods, cost of equity share capital can be ascertained.

80
(i) Dividend Yield Method

This method is also known as Dividend/Price Ratio method. According to this method, the
cost of equity capital is the discount rate that equates the present value of expected future
dividend per share with the current market price of a share. The basic assumptions of this
method are:

(a) Investors give prime importance to dividend.

(b) Risk of the firm remains unchanged.
(c) There is no growth in future dividend.
(d) It does not consider the retained earnings.
The formula to compute cost of equity is given below:
D
Ke = MP

Where,
Ke = Cost of equity capital
D = Dividend per share (expected)
MP = Market price per share
Illustration-1:

A company has issued 10000 equity shares of ₹ 100 each. Company has been paying
dividend to equity shareholders at 25% p. a. from last three years and expected to maintain
the same. The market value of the share is ₹ 180. Compute cost of equity.

Solution:
D
Ke = MP

25
Ke = x 100
180

K e = 13.89%
(ii) Dividend Growth Method

Under this method, the assumption of earlier method, that is, there is no growth in dividend
has been revoked, and it is considered that there is an expected growth in divided of equity
share in comparison to previous year. The formula to compute ‘ke’ is given below.
D
Ke = +g
MP

Where,
D1 = dividend of last year

81
 g = growth in dividend (in %)
This method can be computed for existing shareholders as well in case of issuing right
shares. In case of exiting shares, the denominator is market price, whereas in case of right
shares, denominator is net proceeds on new issue.

Illustration-2:

ABC Co. Ltd. wants to issue 20,000 new shares of ₹ 100 each at par. The flotation cost is
expected to 5%. The company has paid dividend of ₹ 15 in last year and it is expected to
grow by 7%. Compute the cost of equity (i) in case of new equity shares, (ii) for existing
shareholder assuming market price of the share is ₹ 160 per share.

Solution:

(i) Cost of equity to existing shareholders

D1
Ke = +g
MP

Net proceeds = Face value – Flotation cost

= 100 – 5 = 95 per share
15
Ke = + 0.07
95
= 22.79%
(ii) In case of existing shareholders
15
Ke = + 0.07
160
= 16.375%

(iii) Earning Yield Method

This method is also known as earning/price ratio method. This method adheres the basis
relationship between earnings and market price of the security. According to this method, the
cost of equity capital is the discount rate that equates the present values of expected future
earnings per share with the net proceeds (or current market value), presented below:

Earnings per Share

Ke =
Market Price per Share

82
Illistration-3:

Kapil Co. Ltd. has proposal to expand its business operations for what it needs fresh equity
capital of ₹ 20,00,000. On the basis of following information, determine the cost of equity
capital for existing shareholders as well as new equity shareholders.

Issue price of new share is ₹ 200, no issuing charges

Number of existing equity shares, 2,00,000
Market value of existing share ₹ 300
Net earnings 100 lakh
Solution:
Cost of Capital for existing shareholders
Net Earnings 100,00,000
EPS = = = 50
Number of Shares 2,00,000

EPS 50
Ke = = X 100 = 16.67%
MP 300

Cost of Capital for New Share Capital

EPS 50
Ke = = X 100 = 25%
Net Proceeds 200

4.6.4 COST OF RETAINED EARNINGS

The cost of retained earnings is closely related to the cost of equity share capital. If
earnings were not retained, they would be paid out to the equity shareholders as dividends.
Retained earnings are often looked on as fully subscribed issue of additional equity share
capital, since they increase the stockholder’ equity in the same way as a new issue of the
equity shares. The cost of retained earnings must therefore be viewed as the opportunity cost
of the forgone dividends to the existing equity shareholders.

If a firm is unable to earn as much on its retained earnings as other firms with a
comparable level of risk, it is assumed that shareholders will prefer to receive these earnings
in the form of dividends so they can invest in other firms. In contrary case, where company’s
internal growth is more, and it is expected that company’s internal source of fund (retained
earnings) gives more return than making investment in other opportunities, in such a case
shareholders prefer to retain profit than distribution in the form of dividend.

83
 If retained earnings are viewed as a fully subscribed issue of additional equity share,
the firm’s cost of retained earnings ‘kr’, can be assumed to be equal to the cost of equity share
as given in following equation.

kr = ke
Further, in case, the retained earnings are distributed as dividend and shareholders
want to reinvest amount so received after tax has to pay additional charges like brokerage,
commission, and other. to purchase securities in a new company. Thus, retained earnings also
have advantages that payment of tax, or additional brokerage is not required. To make
adjustment of this advantage, existing equation on ‘kr’ can be updated as follows:

kr = ke (1 – t) x (1 – b)
Where,
t = rate of tax
b = brokerage charges
4.7 WEIGHTED AVERAGE COST OF CAPITAL (WACC)
As we have learnt that in the capital structure of a company there are different
combination of securities viz., equity, preference, and debt. Their different combination leads
to make variation in total cost of the company. In the preceding section, we also learnt about
the cost have been calculated, they are multiplied by the proportions of the respective sources
of capital to obtain the weighted average cost of capital (WACC). WACC is also known as
composite cost of capital, overall cost of capital. WACC is found by weighting the cost of
each specific type of capital by its proportion in the firm’s capital structure. The proportions
of capital must be based on target capital structure.

It is emphasized that WACC follows weighted average not simple average method. A
simple average method may distort the whole objective of WACC. However, there are two
common schemes on the bass of which weight can be assigned to particular cot. These are
Book Value vs. Market Value and Historic vs. Target schemes.

Book Value vs. Market Value: Book value weights are based on the use of accounting
values to assess the proportion of each type of capital in the firm’s structure. Market value
weights measured the proportion of each type of financing at its market value. The weights
under book value are mostly criticized as the book values do not reveals the opportunity costs
and involves only historical value than economic value. Market value approach is
theoretically more appealing, since the market values of securities are closely related with

84
actual value. It seems only reasonable to use market value weights. However, it is more
difficult to calculate the market values of a firm’s sources of finances than book value. The
market value may fluctuate due to any reason beyond to the scope of firm level. Thus, book
value is preferred over market value.

Historic vs. Target: Under second approach, the weight may be assigned on the basis of
historic weights or target weights. The historic weights are based on actual data and target
weights are based on book plus desire capital structure proportions. Firms using target
weights establish these proportions on the basis of the optimal capital structure they wish to
achieve. From a strict theoretical point of view, the preferred scheme is target market value
proportions.

WACC is performed by multiplying the specific cost of each form of financing by its
proportion in the firm’s capital structure and summing the weighted values. Thus WACC.
‘Ka’ can be presented as given below.

k 0= Wd k d + Wp k p + We k e

Where,

k 0 = WACC

Wd =Weight for cost of debt securities k d

Wp =weight for cost of preference share capital k p

We =Weight for cost of equity capital k e

Wr = Weight for cost of retained earnings K r

∑ WK
Ka =
∑W

Or

Where,

K= cost of specific source of finance.

W= weight of specific source of finance.

Two important points should be noted:

1. The sum of the weights must be equal to 1 (or 100%). Simply, stated, all capital
structure components must be accounted for.

85
 2. The firm’s equity share capital weight ‘We ’is multiplied by either the cost of retained
earnings, Kr or the cost of new equity share capital.
Illustration-1:

A firm has the following capital structure and after-tax costs for the different sources of funds
used:

After-tax
Amount Proportion
Sources of Funds Cost
₹ %
%

Debentures 15,00,000 25 5

Preference Shares 12,00,000 20 10

Equity Shares 18,00,000 30 12

Retained Earnings 15,00,000 25 11

Total 60,00,000 100

You are required to compute the weighted average cost of capital.

Solution:

Sources of Funds Amount(₹) Proportion After tax Cost Weighted Cost

Proportion X Cost
(1) (2) (w) (k)
(5=3x4) (WK)
(3) (4)

Debentures 15,00,000 0.25 5% 1.25%

Preference Shares 12,00,000 0.20 10% 2.00%

Equity Shares 18,00,000 0.30 12% 3.60%

Retained Earnings 15,00,000 0.25 11% 2.75%

Total 60,00,000 9.60%

86
Weighted average cost of capital (Ko) = 9.60%

Illustration-2:

From the following capital structure of a company, calculate the overall cost of capital using
a) book value weight b) market value weights

Particulars Book value Market Value

Sources ₹ ₹

Equity Share Capital (₹ 10 shares) 45,000 90,000

Retained earning 15,000 -

Preference share capital 10,000 10,000

Debentures 30,000 30,000

The after tax cost of different sources of finance is as follows:

Equity share capital: 14%

Retained Earnings: 13%

Preference share capital: 10%

Debentures: 5%

Solution:

a) Computation of weighted average cost of capital using book value weights

Source Amount Proposition After tax

Weighted Cost
(₹) cost
(5=3X4)
(1) (2) (3) (4)

Equity Share Capital 45,000 0.45 14% 6.3%

Preference Share 15,000 0.15 13% 1.95%

Capital

Retained earning 10,000 0.10 10% 1%

87
 Debentures 30,000 0.30 5% 1.5%

Total 1,00,000 10.75

Weighted Average Cost of Capital:

WACC (Ko) = 10.75%

b) Computation of weighted average cost of capital based on market value weights

Source Amount After tax

Proposition Weighted Cost
(₹) cost
(3) (5=3X4)
(1) (2) (4)

Equity Share Capital 90,000 0.692 14% 9.688%

Preference Share 10,000 0.077 10% 0.770%

Capital

Debentures 30,000 0.231 5% 1.155 %

Total 1,30,000 11.613%

Weighted average cost of capital is

WACC (Ko) = 11.613%

3. ABC Company limited has the following capital structure

Particulars Amount
Equity Share Capital (2, 00,000 shares) ₹ 40, 00,000
6% Preference Shares 10, 00,000
8% Debentures 30, 00,000
80,00,000

The market price of the company’s equity share is ₹ 20. It is expected that the
company will pay a current dividend of ₹ 2 per share which will grow at 7 percent forever.
The tax rate may be presumed at 50 percent. You are required to compute the following.

88
(a) A weighted average cost of capital based on existing capital structure
(b) The new weighted average cost of capital if the company raises an additional amount of ₹
20, 00,000 debt by issuing 10 per cent debentures. This would result in increasing the
expected dividend to ₹ 3 and leaves the growth rate unchanged but the price of the share
will fall to ₹ 15 per share.
Solution:

(a) Computation of weighted average cost of capital based on existing capital

structure

Step 1:

The cost of equity shares is

Ke=D/MP + g

Ke=₹ 2/₹20 +0.07

Ke=0.10+0.07

Ke=0.17

Step 2:

After tax cost of Debentures is

k d =Before tax cost of debentures (1-tax)

k d =8 %(1-0.50)

k d =8/100(0.50)

𝐤 𝐝 (After tax cost of debentures) =0.04

Statement showing weighted average cost of capital based on the existing capital structure

Source Amount Proposition After tax cost Weighted

Cost
(1) (₹) (3) (4)
(5=3X4)
(2)

Equity Share Capital 40,00,000 0.50 0.17 0.085

Preference Share Capital 10,00,000 0.125 0.06 0.0075

89
Debentures 30,00,000 0.375 0.04 0.015

Total 80,00,000 0.1075

Weighted average cost of capital =0.1075x100

WACC=10.75%

b. Computation of Weighted average cost of capital for the proposed capital structure

Step – 1:

Computation of Cost of Equity

Ke=D/MP + g

Ke=₹ 3/₹15 +0.70

Ke=0.20+0.07

Ke=0.27

Statement showing weighted average cost of capital based on proposed capital structure.

Amount
Source Proposition After tax cost Weighted Cost
(₹)
(1) (3) (4) (5=3X4)
(2)

Equity Share Capital 40,00,000 0.40 0.27 0.108

6% Preference Share 10,00,000 0.10 0.06 0.006

Capital

8% Debentures 30,00,000 0.30 0.08 0.024

10% Debentures 20,00,000 0.20 0.10 0.020

Total 1,00,00,000 0.158

Weighted average cost of capital =0.158x100

WACC =15.8%

90
Illustration – 4:
Kushal company has the following capital structure as on 1st July 2021.
Source Amount (₹)

Equity Shares (4,00,000) 80,00,000

10% Preference Shares 20,00,000
14% Debentures 60,00,000
Total 1,60,00,000

The share of a company currently sells for ₹ 25. It is expected that the company will
pay a dividend of ₹ 2 per share which will grow at 10 per cent forever. Assume a 50% tax
rate. You are required to compute a weighted average cost of capital on the existing capital
structure.
Solution:
Cost of Debt (after tax)
kd=Cost of Debt before tax (1- tax rate)
kd=14(1-0.50)
kd=14(0.50)
kd=7%
Cost of Equity
D
Ke= +g
MP
2
= +0.1
25
=0.08+0.1
= 0.18
Statement showing weighted average cost of capital.

91
 Source Amount (₹) Proposition After tax cost Weighted Cost

(1) (2) (3) (4) (5=3X4)

Equity Share Capital 80,00,000 0.500 0.18 0.09

10% Preference 20,00,000 0.125 0.10 0.009

Share Capital

14% Debentures 60,00,000 0.375 0.07 0.02625

160,00,000 0.12875

Weighted average cost of capital is

WACC(k o )=0.12875 x 100 = 12.875%
Illustration – 5:
ABC Company has the following capital structure as on December 31st 2020
Particulars Amount (₹)
Equity Share Capital (5,000 shares of ₹ 100 each) 5,00,000
9% Preference Shares 2,00,000
10% Debentures 3,00,000

The equity shares of the company are quoted at ₹ 102 and the company is expected to
declare a dividend of ₹ 9 per share for the next year. The company has registered a dividend growth
rate of 5% which is expected to be maintained.
a) Assuming the tax rate applicable to the company at 30%. Calculate the weighted average
cost of capital
b) Assuming that the company can raise additional term loan at 12% for ₹ 5,00,000 to finance
its expansion. Calculate the revised WACC. The company’s expectation is that the business
risk associated with new financing may bring down the market price from ₹ 102 to ₹ 96.
Solution:
(a) Computation of WACC for the existing capital structure.
The present WACC may be calculated as follows:
Cost of Equity
ke=D/MP + g
ke=₹ 9/₹102 +0.05

92
 ke=0.088+0.05

ke=0.138

ke=13.8%

Cost of Debt (after tax)

kd=Cost of Debt before tax (1- tax rate)
kd=10(1-0.30)
kd=10(0.70)
kd=7%
Statement showing WACC based on existing capital structure.

Source Amount (₹) Proposition After tax cost Weighted Cost

(1) (2) (3) (4) (5=3X4)

Equity Share Capital 5,00,000 0.5 0.138 0.069

9% Preference Share 2,00,000 0.2 0.09 0.018

Capital

10% Debentures 3,00,000 0.3 0.07 0.021

10,00,000 0.108

Weighted average cost of capital is 0.108x100

WACC=10.8%
b. Computation of Revised Weighted average cost of Capital

Cost of Equity

ke=D/MP + g
ke=₹ 9/₹96 +0.05

ke=0.093+0.05

ke=0.143

ke=14.3%

93
 Cost of Debt (after tax)
kd=Cost of Debt before tax (1- tax rate)
kd=10(1-0.30)
kd=10(0.70)
kd=7%

Cost of Loan (after tax)

kd=Cost of Loan before tax (1- tax rate)

kd=12(1-0.30)
kd=12(0.70)
kd=8.4%
Statement sharing weighted average cost of capital for the proposed capital structure.

Source Amount (₹) Proposition After tax cost Weighted Cost

(1) (2) (3) (4) (5=3X4)

Equity Share Capital 5,00,000 0.33 0.143 0.0472

9% Preference Share 2,00,000 0.133 0.09 0.012

Capital

10% Debentures 3,00,000 0.20 0.07 0.0140

12% Loan 5,00,000 0.33 0.084 0.0277

15,00,000 0.1009
Revised weighted average cost of capital is 0.1009x100
WACC=10.09%
4.8 CHECK YOUR PROGRESS
Fill in the blanks with suitable answers:

1. ______ represents the rate of return which the company must pay to the suppliers of capital for
the use of their funds.

2. For many firms, ______ is the internally generated source of funds

3. ______ method is also known as earning/price ratio method.

4. Explicit cost is the cost which is ______ connected with the subject matter
94
 5. The cost of ______ is closely related to the cost of equity share capital

Answers to Check Your Progress

1. Cost of capital
2. Depreciation
3. Earning Yield Method
4. Directly
5. Retained earnings
4.9 KEYWORDS
Cost of Capital : It represents the rate of return which the company must pay to
the suppliers of capital for the use of their funds.

Average cost of capital : It is the combined cost of all components of capital.

Marginal Cost : It is an additional cost to raise additional fund.

4.10 SUMMARY
The cost of capital is an important element in the capital expenditure management. In
operational terms, the cost of capital is a discount rate that is used in determining the present value
of the future cash flows. Conceptually, it is the minimum rate of return that a firm must earn on its
investments to keep its market value unchanged. The cost of capital can be explicit or implicit. The
explicit cost of capital is associated with the raising of funds. When funds are internally used, the
cost is known as implicit cost in terms of the opportunity cost of the forgone alternatives.
The computation of cost of capital involves two steps (1) Computation of individual sources
of finance like equity shares, preference shares, debt cost and retained earnings (2) the calculation
of the weighted average cost by combining the specific costs into the composite costs.

4.11 QUESTIONS FOR SELF STUDY

1. What do you mean by cost of capital?

2. Examine the different approaches to the calculation of cost of debt

3. Discuss the different methods of computation of cost of equity

4. What is weighted average cost of capital? Examine the rationale behind the use of weighted
average cost of capital.

5. XYZ Company Ltd has the following book value capital structure:

95
 Particulars Amount

Equity Capital (in shares of ₹10 each ,fully paid up at par) 15,00,000

Retained earnings 20,00,000

13.5% Debentures of ₹ 100 each 10,00,000

15% Term Loans 12,50,000

The next expected dividend on equity shares per share is ₹ 3.60; the dividend per share is
expected to grow at a rate of 7%. The market price per share is ₹ 40.

Compute the weighted average cost of capital using the book value weights.

4.12 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill- Tenth
Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh
edition-2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-
Eleventh Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya
Publishing House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and
Sons-Fifteenth Edition-2019.

96
Karnataka State Open University
Mukthagangothri, Mysuru - 570 006
[email protected] II SEMESTER M.COM
FINANCIAL MANAGEMENT
COURSE CODE:MCOSC2.2A/D

Department of Studies and Research in Commerce

BLOCK
2

Page No.

UNIT - 5: CAPITAL STRUCTURE AND LEVERAGES 1-42

UNIT - 6: CAPITAL STRUCTURE THEORIES 43-57

UNIT - 7: CAPITAL BUDGETING 58-122

UNIT - 8: RISK ANALYSIS IN CAPITAL BUDGETING 123-146

 Credit Page
Programme : M.Com Year/Semester: Second Block No :II
Course : Financial Management Credit : 03 Units No :5-8
Course Design Expert Committee
Prof. Vidyashankar Chairman
Vice-Chancellor,
Karnataka State Open University,
Mukthagangotri, Mysuru – 570 006.
Prof. Ashok Kamble Member
Dean (Academic)
Karnataka State Open University,
Mukthagangotri, Mysuru – 570 006.
Dr.Mahesha V. Member
BOS Chairman,
DOS&R in Commerce,KSOU, Mysuru.
Dr. Sukanya R. Member
Assistant Professor and Course Designer,
DOS&R in Commerce, KSOU, Mysuru.
Smt. Usha C. Member Convener
Chairperson,
DOS&R in Commerce, KSOU, Mysuru.
Course Writer Course Editor
Dr. Sukanya R. Dr. Chaya R.
Assistant Professor, Assistant Professor,
DOS&R in Commerce, DOS&R in Commerce,
KSOU, Mysuru. KSOU, Mysuru.
Editorial Committee
Dr.Mahesha V. Chairman
BOS Chairman,
DOS&R in Commerce,KSOU, Mysuru.

Prof. Venkatesh S. External Member

Professor,Department of Commerce,
Kuvempu University, Shivamogga.
Dr. Sukanya R. Internal Member
Assistant Professor, DoS & R in Commerce
Karnataka State Open University, Mysuru.

Smt. Usha C. Member Convener

Chairperson,
DOS&R in Commerce, KSOU, Mysuru. .
Copy Right
Registrar,
Karnataka State Open University, Mukthagangothri, Mysuru - 570006.
Developed by the Department of Studies and Research in Commerce, KSOU, under the guidance of Dean
(Academic) , KSOU, Mysuru.Karnataka State Open University, October -2022.
All rights reserved. No part of this work may be reproduced in any form, or any other means, without permission in
writing from the Karnataka State Open University.Further information on the Karnataka State Open University
Programmes may obtained from the University’s office at Mukthagangothri, Mysuru-570006.
Printed and Published on behalf of Karnataka State Open University. Mysuru-570006 by Registrar (Administration)-
2022.
 Karnataka State Open University
Mukthagangothri, Mysuru - 570 006
Preface
Dear Learner,

This self-learning material provides you with key principles that you can apply throughout
your career to help you to build financial insight. The principles of finance provide a unified
perspective of the most crucial financial ideas, which you can use in all of your financial
decisions. Financial management has emerged as an interesting and exciting area for academic
studies as well as for managing finance practically. All decisions taken by an individual or a
business that have financial implications fall under the category of financial management. The
financial implications of choices are assessed in terms of maximising the value of the firm,
whether the business is organised as a company, where ownership and management are seperate,
or in another way. As a result, the decision-making process is focused on the goal of maximising
shareholder’s wealth as shown by the market price of a share. The curriculum makes an effort to
address how a business organisation makes financial decisions. An easy way to understand
financial management is to apply the theoretical concepts to real-life problems being faced by
financial managers. The course writer has tried to use practical illustrations to explain and analyse
the different ideas in the course ‘Financial Management’ in second semester M.Com.

The study material is in interactive mode which is developed by experienced academicians

in the field of finance. The course is designed to acquaint students and professionals with the
contents and tools of financial management. You may refer to various text books relevant to the
course, which are provided at the end of each unit. Feel free to send feedback to the department
for further improvements, and you may contact the course writer for any clarifications.

With best wishes,

Smt. Usha C.
Chairperson
 BLOCK – II
INTRODUCTION

The most crucial component of starting a business is capital. It acts as the foundation of
the company. Debt and Equity are the two primary types of capital sources for a business. Capital
structure is defined as the combination of equity and debt that is put into use by a company in
order to finance the overall operations of the company and for its growth.

Leverage is an investment strategy of using borrowed money specifically, the use of

various financial instruments or borrowed capital to increase the potential return of an investment.
Leverage can also refer to the amount of debt a firm uses to finance assets.

Capital budgeting as a concept affects our daily lives. The term ‘Capital Budgeting’ refers
to the long term planning for proposed capital outlays and their financing. Thus, it includes both
raising of long term funds as well as their utilisation. Ideally, an organization would like to invest
in all profitable projects but due to the limitation on the availability of capital an organization has
to choose between different projects/investments.

Risk is the variability in terms of actual returns comparing with the estimated returns.
Most common techniques of risk measurement are Standard Deviation and Coefficient of
variations. There is a thin difference between risk and uncertainty. In case of risk, probability
distribution of cash flow is known. When no information is known to formulate probability
distribution of cash flows, the situation is referred as uncertainty.

This block consists of 4 units, they are:

Unit - 5 : Capital Structure and Leverages

Unit - 6 : Capital Structure Theories

Unit - 7 : Capital Budgeting Decisions

Unit - 8 : Risk Analysis in Capital Budgeting

 BLOCK –II

UNIT-5 CAPITAL STRUCTURE AND LEVERAGES

Structure:

5.0 Objectives

5.1 Introduction

5.2 Meaning of Capital Structure

5.3 Features of an Appropriate Capital Structure

5.4 Factors Determining Optimum Capital Structure

5.5 EBIT – EPS Analysis

5.6 Illustration on EBIT- EPS Analysis

5.7 Point of Indifference

5.8 Meaning of Leverages

5.9 Types of Leverages

5.10 Illustration on Computation of Financial Leverage, Operating Leverage and

Combined Leverage

5.11 Trading on Equity

5.12 Check Your Progress

5.13 Summary

5.14 Keywords

5.15 Questions for Self-Study

5.16 References

1
5.0 OBJECTIVES
After Studying this unit, you will be able to;

 Analyse the factors determining the capital structure decisions of a firm.

 Examine the features of an appropriate capital structure.
 Compute problems on leverages and EBIT- EPS.
 Examine the importance of trading on equity.

5.1 INTRODUCTION
In order to run and manage a company, funds are needed. Right from the promotional
stage up to end, finance plays an important role in a company’s life. If funds are inadequate, the
business suffers and if the funds are not properly managed, the entire organisation suffers. It is,
therefore, necessary that correct estimate of the current and future needs of capital be made to
have an optimum capital structure which shall help the organisation to run its work smoothly and
without any stress.

A firm can make use of different sources of financing whose costs are different, that is,
funds which carry a fixed rate of return (debentures and preference shares) and those with variable
returns (equity shares). The term capital structure refers to the composition of the long term
sources of funds, with an optimum debt and equity mix, where the cost of capital is minimum and
the market price per share is maximum.

5.2 MEANING OF CAPITAL STRUCTURE

According to Gersternberg, “capital structure of a company refers to the composition of
its capitalization and it includes all long term capital sources viz., loans, reserves, shares and
bonds.”

According to Schwartz, “the capital structure of business can be measured by the ratio of
various kinds of permanent loan and equity capital to total capital”.

Capital structure is referred to as the ratio of different kinds of securities raised by a firm
as long-term finance. The capital structure involves two decisions:

a. Type of securities to be issued is equity shares, preference shares and long term
borrowings (debentures).
2
 b. Relative ratio of securities can be determined by process of capital gearing. On this basis,
the companies are divided into two-

i. Highly geared companies: Those companies whose proportion of equity

capitalization is small.

ii. Low geared companies: Those companies whose equity capital dominates total
capitalization.

For instance, there are two companies A and B. Total capitalization amounts to be ₹ 2, 00,000 in
each case. The ratio of equity capital to total capitalization in company A is ₹ 50,000, while in
company B, ratio of equity capital is ₹ 1,50,000 to total capitalization, that means, in Company A,
proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered
to be a highly geared company and company B is low geared company.

A firm’s capital structure may be in any of the following patterns mentioned below:

1. Capital structure with equity shares only.

2. Capital structure with both equity and preference shares.
3. Capital structure with equity shares and debentures.
4. Capital structure with equity shares, preference shares and debentures.

5.3 FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE

1. Profitability: The capital structure of the company should be most profitable. The most
profitable capital structure is one that minimizes the cost of financing and maximizes the
earnings per equity share within the constraints.
2. Solvency: The use of excessive debt threatens the solvency of the company. So the financial
planning should be devised to ensure that the risk of insolvency does not threaten the firm.
3. Flexibility: The capital structure of a firm should be flexible to change according to the
changing market conditions.
4. Conservatism: The capital structure should be conservative, in the sense that the debt capacity
should not be exceeded.
5. Control: An appropriate capital structure should preserve the control of the firm in the hands
of equity shareholders.

3
5.4 FACTORS DETERMINING OPTIMUM CAPITAL STRUCTURE

Size of the company

Financial Leverage Nature of the industry

Risk
Investors
Growth & Stability
Factors
Cost of flotation
Retaining Control influencing
capital Legal requirement
Cost of Capital structure
Period of finance
Cash Flows
Level of interest rate
Flexibility

Purpose of Finance

Asset Structure
Fig.5.1 Shows factors affecting Capital Structure

Factors affecting capital structure are mainly classified into two factors

A. Internal factors

B. External factors.

A. Internal Factors:

1. Financial Leverage
The use of fixed income bearing securities, such as debt and preference capital along with
owners’ equity in the capital structure is described as financial leverage or trading on
equity. This decision is most important from the point view of financing decisions.
2. Risk
Ordinarily, debt securities increases the risk, while an equity security reduces it, risk can
be measured to some extent by the use of ratio, measuring gearing and time – interest
earned. The risk attached to the use of leverage is called “financial risk”.
3. Growth and Stability
In the initial stages, a firm can meet its financial requirements through long-term sources,
particularly by raising equity shares. Once the company starts getting good response and

4
 cash inflow capacity is increased through sales, it can raise debt or preference capital for
growth and expansion programmes of the company.
4. Retaining control
The attitude of the management towards retaining control over the company will have
direct impact on the capital structure. If the existing shareholders want to continue the
same holding on the company, they may not encourage the issue of additional equity
shares.
5. Cost of capital
The cost of capital is the expectation of suppliers of funds. The objective of knowing the
cost of capital is to increase the returns on investments, so that, a firm should earn
sufficient profits to repay the interest and instalment of principal to the lenders.
6. Cash flows
Cash flow ability of a company will have direct impact on the capital structure. Cash flow
generation capacity of a firm increases the flexibility of the financial manager in deciding
the capital structure.
7. Flexibility
Flexibility is the firms’ ability to adopt its capital structure to the needs of changing
conditions; its capital structure should be flexible, so that, without much practical
difficulties, a firm can change the securities in capital structure.
8. Purpose of finance
The purpose of finance is another factor that influences the capital structure. If a firm is
engaged in business transactions, it can make use of Debt and Equity mix or can enjoy
leverage benefits.
9. Asset structure
Funds are needed to make investments on fixed assets and current assets.
B. External factors:
1. Size of the company
If the size of business is small, the requirement of finance is too little. If the size of the
business of a firm is large, large amount of capital is required.

5
2. Nature of Industry
The nature of industry, method of production, type of product, etc., will also influence the
capital structure.
3. Investors
In the recent past, the behaviours of the investors have changed. Now the investors are
cautious over the investments. Political, socio-economic factors of the country made the
investors to be very alert in their portfolio management.
4. Cost of flotation
The cost of flotation is the expenses a firm incurred during the process of public issues.
Advertising, printing of the application forms, fees of merchant bankers, underwriting
commission, brokerage, etc.
5. Legal requirements
The legal and statutory requirement of the Government will also influence the capital
structure. SEBI guidelines on investors protection, maintaining Debt-Equity ratio and
current ratio, promoter contribution etc., will have direct bearing impact on capital
structure.
6. Period of finance
Funds are required for different period for different purposes i.e. for short term, medium
term and long term.
7. Level of interest rate
The rate of interest will have a direct impact on borrowed funds. If the expectation of the
banker or financial institution is more to get high percentage of interest, a firm can
postpone the mobilization of funds or can make use of retained earnings.
8. Level of business activity: The availability of money in the capital and money market
will directly influence the company financial structure. Free flow of money in the
economy encourages a corporate to raise funds through securities without much difficulty.
9. Taxation policy: High corporate tax, high tax on dividend and capital gains directly
influence the decision of capital structure.
10. Level of stock prices: If the general price levels of stocks or raw materials are constant
over a period of time, management prefers to invest such funds either through equity or
preference capital.
6
5.5 EBIT – EPS ANALYSIS
EBIT analysis is a method through which the effect of leverage can be studied, it
essentially involves comparison of different method of financing the capital composition under
different assumptions of EBIT.

A firm can raise the funds by different means viz.,

(a) Only through equity,

(b)Only through debt,
(c) Only through preference share,
(d)Combination of all the alternatives with different proportions.

The choice of different methods of financing must facilitate the company to earn more to
the equity shareholders. The EPS indicates the earnings available to the equity shareholders after
meeting all the obligations of the company. The evaluation is done by taking different level of
earnings before interest and taxes.

5.6 ILLUSTRATIONS ON EBIT-EPS ANALYSIS

Illustration – 1:

B Ltd has a share capital of ₹ 1, 00,000 divided into equity shares of ₹ 10each. It has to invest
₹ 50,000 in new machinery. The management is considering the following alternatives for raising
this amount.

1. To issue 5,000 equity shares of ₹ 10 each

2. To issue 5,000 preference shares of ₹ 10 each at 12%
3. To issue debentures for ₹ 50,000 at 10%.

The Company’s present EBIT is ₹ 40,000 per annum. Corporate tax rate is 50%

You are required to calculate the effect of the above mentioned alternatives of financing on EPS
if,
a) EBIT continues to be the same even after expansion.
b) EBIT increase by ₹ 10,000 after expansion, and

7
Solution:
Case-1: Statement showing EPS, if EBIT is ₹ 40,000
Proposed Capital Structure
1 2 3
Particulars All Preference Debentures
equity Shares at 12% at 10%
(₹) (₹) (₹)

EBIT 40,000 40,000 40,000

Less: Interest (50,000x10%) - - 5,000

EBT 40,000 40,000 35,000

Less: Tax (50% on EBT) 20,000 20.000 17,500

EAT 20,000 20,000 17,500

Less: Preference Dividend (50,000x12%) - 6,000 -

A. Earnings available to equity

20,000 14,000 17,500
shareholders

B. Number of equity shareholders 15,000 10,000 10,000

EPS (A/B) 1.33 1.40 1.75

Working Note:
50
1. Tax = 40,000 x = ₹ 20,000
100

(It is given that tax rate is 50%)

12
2. Preference dividend = 50,000 x = ₹ 6,000
100
10
3. Debentures = 50,000 x = ₹ 5,000
100

4. Number of equity shares

1,00,000
Present capital structure = = 10,000
10

8
Proposed Capital Structure:
1st alternative = 10,000 + 5,000 = 15,000
2nd & 3rd alternatives = 10,000, because 2nd alternative is using additional preference shares, and
the 3rd alternative is using debentures. Therefore, number of equity shares is 10,000, that is, the
present number of equity shares.
Case – 2: Statement showing EPS, if EBIT is ₹ 50,000
Particulars Proposed Capital Structure
All Preference Debentures
equity Shares at at 10%
12% (₹)
(₹) (₹)
EBIT 50,000 50,000 50,000
Less: Interest (50,000x10/100) - - 5,000
EBT 50,000 50,000 45,000
Less: Tax (50% on EBT) 25,000 25,000 22,500
EAT 25,000 25,000 22,500
Less: Preference Dividend - 6,000 -
(50,000x12/100)
Earnings available to equity shareholders 25,000 19,000 22,500
Number of equity shares 15,000 10,000 10,000
EPS = Earnings available to Equity 1.67 1.9 2.25
shareholders/Number of Equity shares

Interpretation
1. EPS is maximum when the firm is using the 3rd alternative. So the machinery has to be
purchased by issuing debentures.
2. If the EBIT is ₹ 50,000, then also alternative using debentures is giving the highest EPS. So,
for buying the machinery it is advisable to raise ₹ 50,000 through debentures.

9
Illustration – 2:

A firm has an all equity capital structure consisting of 1, 00,000 ordinary shares of ₹ 10 per share.
The firm wants to raise ₹ 2, 50,000 to finance its investment and is considering three alternative
methods of financing.

1. To issue 25,000 equity shares at ₹ 10 each.

2. To borrow ₹ 2, 50,000 at 8% rate of interest.
3. To issue 2,500 preference shares of ₹ 100 each at 8% rate of dividend.
Calculate the effect of EPS under the three financing options if EBIT after additional investment
is,
a) ₹ 3, 12,500
b) ₹ 75,000

Assume tax rate is 50%.

Solution:
8
1. Debenture Interest = 2,50,000 x = ₹ 20,000
100
8
2. Preference Dividend = 2,50,000 x = ₹ 20,000
100

3. Number of equity shares, Present position 1,00,000 shares and as per the proposed capital
structure
1st alternative- 1, 00,000 + 25,000 = 1, 25,000
2ndalternative- 1, 00,000 because capital is raised through preference shares and debentures.
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
4. EPS =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

10
 Case-1: Computation of on EPS if the EBIT is ₹ 3, 12,500
Proposed Capital Structure
Equity Preference Debt
Particulars
(₹) (₹) (₹)
EBIT 3,12,500 3,12,500 3,12,500
Less: Debenture Interest (25, 00,000X8%) - - 20,000
EBT 3,12,500 3,12,500 2,92,500
Less: Tax 1,56,250 1,56,250 1,46,250
EAT 1,56,250 1,56,250 1,46,250
Less: Preference Dividend (2,50,000X8%) - 20,000 -
A. Earnings available to equity share
1,56,250 1,36,250 1,46,250
holders
1,25,000 1,00,000 1,00,000
B. Number of equity shares
EPS (A/B) 1.25 1.36 1.46

Case- 2: Computation of EPS if EBIT is ₹ 75,000

Proposed Capital Structure

Particulars Equity Preference Debt
(₹) (₹) (₹)
EBIT 75,000 75,000 75,000
Less : Debenture Interest - - 20,000
EBT 75,000 75,000 55,000
Less :Tax 37,500 37,500 27,500
EAT 37,500 37,500 27,500
Less: Proposed Dividend - 20,000 -

11
 A. Earnings available to equity share
37,500 17,500 27,500
holders
1,25,000 1,00,000 1,00,000
B. Number of equity shares
0.3 0.175 0.275
EPS (A/B)

Illustration – 3:

Gurudatta Ltd has equity share capital of ₹ 5, 00,000 divided into shares of ₹ 100 each. It wishes
to raise further ₹ 3, 00,000 for modernization plans. The company plans the following financing
schemes:

a) All equity shares

b) ₹ 1, 00,000 in equity shares and ₹ 2, 00,000 in debt at the rate of 10 percent per annum.
c) All debt at 10 percent per annum
d) ₹ 1, 00,000 in equity shares and ₹ 2, 00,000 in preference shares, with dividend at 8 percent
per annum.

The Company’s estimated EBIT is ₹ 1,50,000. The corporate tax rate is 50 percent.
Calculate EPS in each case.

Solution:
1) Debenture Interest
10
a. 2,00,000 x 100 = ₹ 20,000 (For the second financing plan)
10
b. 3,00,000 x 100 = ₹ 30,000 (For the 3rd financing plan)
8
2) Preference dividend = 2,00,000 x 100 = ₹ 16,000

3) Number of equity shares,

5,00,000
Present position = = 5,000 shares
100
3,00,000
a) For the first financing plan = 3,000 shares
100

5,000 + 3,000 = 8,000 shares

(existing equity + new issue of equity)

1,00,000
b) For the second financing plan = 1,000 shares
100

12
 5,000 + 1,000 = 6,000 shares

(existing equity+ new issue of equity)

c) For the third financing plan, 5,000 shares

1,00,000
d) For the fourth financing plan = 1,000 shares
100

5,000 + 1,000 = 6,000 shares

(existing equity + new issue of equity)
Statement Showing Effect on EPS under Different Financial Plans
Different Financing Plans
Equity + Equity +
Particulars All Equity All Debt
Debt Preference
(₹) (₹)
(₹) (₹)
EBIT 1,50,000 1,50,000 1,50,000 1,50,000
Less: Debenture Interest - 20,000 30,000 -
EBT 1,50,000 1,30,000 1,20,000 1,50,000
Less: Tax 75,000 65,000 60,000 75,000
EAT 75,000 65,000 60,000 75,000
Less: Preference Dividend - - - 16,000
Earnings available to ES (A) 75,000 65,000 60,000 59,000
Number of Equity shares (B) 8,000 6,000 5,000 6,000
EPS (A/B) 9.37 10.83 12 9.83
Interpretation:

1. EPS is maximum for the third financing plan, so ₹ 3, 00,000 has to be collected as debt at 10
percent interest per annum.
2. Another advantage of accepting debt capital is that it will not result in dilution of control. Debt
holders will not get controlling rights in the company.

Illustration – 4:

E Ltd needs ₹ 10, 00,000 to build a new factory which will yield an EBIT of ₹ 1, 50,000 per year.
The company has to choose between two alternative financing plans. 75 per cent equity and 25 per
cent debt, or 50 per cent equity and 50 per cent debt. As per the first plan shares can be sold at ₹
50 per share and the interest on debt will be 14%. Under the second plan, the shares can be sold

13
 for ₹ 40 per share and the interest rate on debt will be 16 per cent. Determine the EPS for each
plan assuming a 50 per cent tax rate?

Solution:
Computation of on EPS under Different Financing Plans
Particulars I Option II Option
(₹) (₹)

1,50,000 1,50,000
EBIT
35,000 80,000
Less :Debenture Interest
1,15,000 70,000
EBT
57,500 35,000
Less: Tax (50%)
57,500 35,000
Earnings available to equity shareholders
15,000 12,500
Number of equity shares
3.833 2.8
EPS
Working Note:

1. Interest Calculation
14
a) For the first plan 2,50,000 x 100 = ₹ 35,000
16
b) For the second plan 5,00,000 x 100 = ₹ 80,000

2. Number of equity shares

7,50,000
a) For the first plan = 15,000 shares
50
5,00,000
b) For the second plan = 12,500 shares
40

(Because as per the second plan, share value is ₹ 40)

Illustration – 5:

It is proposed to start a business requiring a capital of ₹ 10, 00,000 and an assured return of 15%
on investment. Calculate the EPS, if EBIT is 1,50,000 and

a) The entire capital is raised by means of ₹ 100 equity shares and

b) If 50% is raised from equity shares and 50% capital is raised by means of 10%
debentures?

14
Solution:
Computation of EPS under different financing plans
1st Plan 2nd Plan
Particulars
(₹) (₹)
1,50,000 1,50,000
EBIT
- 50,000
Less: Debenture Interest
1,50,000 1,00,000
EBT
75,000 50,000
Less: Tax (50%)
A. Earnings available to equity 75,000 50,000
shareholders
10,000 5,000
B. Number of equity shares
7.5 10
EPS (A/B)
CALCULATION
10
1. Debenture Interest 5,00,000 x 100 = ₹ 50,000

2. Number of equity shares

10,00,000
a) First plan = 10,000 shares
100
5,00,000
b) Second plan = 5,000 shares
100

3. It is assumed that the tax rate is 50%.

Interpretation
a) EPS is highest when the firm is using the second financial plan. So that second plan has to be
adopted.
b) Another advantage of second plan is that, it is 50 percent equity and 50 percent debt. The debt
can be redeemed within 10 years and the debt holders will not get any controlling rights in the
firm. Here the number of equity shares holders is 5,000 compared to 10,000 as per the first
plan.

5.7 POINT OF INDIFFERENCE

Point of indifference refers to the level of EBIT at which EPS remain the same irrespective of
debt-equity mix. It is also called as Break Even Point. This situation would emerge for all types of

15
financial plans. The return as capital employed will be equal to the interest as debt capital. It is
also known as Break Even Level of EBIT for alternative financial plans.

The Point of indifference can be calculated with the help of the following formula:

(𝑬𝑩𝑰𝑻 − 𝑰𝟏 )(𝟏 − 𝑻) − 𝑷𝑫 (𝑬𝑩𝑰𝑻 − 𝑰𝟐 )(𝟏 − 𝑻) − 𝑷𝑫

=
𝑬𝑺𝟏 𝑬𝑺𝟐

Where EBIT= Earnings before interest and taxes

I1 = Interest under the financial plan 1

I2 = Interest under the financial plan 2

ES 1 = No. of equity shares under the plan1

ES2 = No. of equity shares under the plan2

T = Tax rate

PD = Preference Dividend

Illustration – 1:

XYZ Ltd is considering three financial plans for which the information is as below:

(a) Total investment to be raised ₹4, 00,000.

(b) Plans of Financing Proportion

Plans Equity Debt Preference share

A 100% - -

B 50% 50% -

C 50% - 50%

1. Cost of debt 8%
2. Cost of preference share 8%
3. Tax Rate 50%
4. Equity shares of the face value of ₹10 each will be issued at a premium of ₹ 10 per share.
5. Expected EBIT is ₹ 1,60,000

16
Determine for each plan:

(i) Earnings per share (EPS)

(ii) Financial break- even point.
(iii) Compute the EBIT range among the plans for point of indifference.

Solution:

(i) Computation of Earnings per share (EPS) for each plan

Plan A Plan B Plan C

Particulars
₹ ₹ ₹

Earnings Before Interest Tax (EBIT) 1,60,000 1,60,000 1,60,000

Less: Interest on Debt at 8% 0 16,000 0

Earnings Before Tax 1,60,000 1,44,000 1,60,000

Less: Tax at 50% 80,000 72,000 80,000

Earnings After Tax 80,000 72,000 80,000

Less: Preference Dividend at 8% 0 0 16,000

Earnings available for equity shareholders 80,000 72,000 64,000

20,000 10,000 10,000

Number of Equity Shares
4,00,000 2,00,000 2,00,000
(10+10 = ₹ 20 face value)
20 20 20

Earnings per share (EPS) ₹4.00 ₹7.20 ₹6.40

17
(ii) Financial Break – Even Point for Each Plan:

P D
Financial Break – Even Point = 1 + (1−t)

Where, I = Fixed Interest Charges

DP = Preference Dividend
T = Tax Rate
Plan A: As it does not involve any fixed financial charges, the financial break – even point
for Plan A is zero.

Plan B: As there are fixed interest charges of ₹ 16, 000. The financial break – even point for
Plan B is ₹ 16,000.
16,000
Plan C: 0 + = ₹ 32,000.
1−0.5

(iii) Computation of EBIT Range among the plans for Point of Indifference Between
(a) Plan A and B:

(𝐗 − 𝐈𝟏 ) (𝟏 − 𝐓) − 𝐏𝐃 (𝐗 − 𝐈𝟐 ) (𝟏 − 𝐓) − 𝐏𝐃
=
𝐒𝟏 𝐒𝟐

Where, X = Point of Indifference or Range of Earnings.

I1 = Interest under plan 1

I2 = Interest under plan 2

T = Tax Rate

PD = Preference Dividend

S1 = Number or Amount of shares under plan1

S2 = Number or Amount of shares under plan2

(X − 0) (1 − 0.5) − 0 (X − 16,000) (1 − 0.5) − 0

=
20,000 10,000
0.5X 0.5X − 8000
=
20,000 10,000
10,000 (0.5𝑋) = 20,000 (0.5 𝑋 − 8,000)
0.5X = 2 (0.5 𝑋 − 8,000)
18
 0.5X = 𝑋 − 16,000
16,000 = X − 0.5X
16,000 = 0.5X
16,000
=X
0.5
X=32,000

(Thus, the range of earnings is ₹ 32, 000) Between Plan A and B

(b) Between Plan A and C

(X − 0) (1 − 0.5) − 0 (X − 0) (1 − 0.5) − 16000

=
20,000 10,000

0.5X 0.5X − 16000

=
20,000 10,000

0.5X = X − 32,000

32,000 = X − 0.5 X

32,000 = 0.5 X

32,000/0.5=X

X=64,000

(Thus Point of indifference between plan A and C is ₹ 64,000)

(c) Between Plan B and C

(X − 16,000) (1 − 0.5) − 0 (X − 0) (1 − 0.5) − 16000

=
10,000 10,000

0.5X − 8,000 = 0.5X − 16,000

0.5 X-0.5 X=-16000+8000

Thus, there is no point of indifference between plan B and C.

19
5.8 MEANING OF LEVERAGES
Leverage has been defined as “the action of a lever and mechanical advantage gained by
it”. A lever is a rigid price that transmits and modifies force or motion where forces are applied at
two points and turns around a third.

In simple words, it is a force applied at a particular point to get the desired result. In
business, leverage is the means which a business firm can increase the profits. The force will be
applied on debt; the benefit of this is reflected in the form of higher returns to equity shareholders.
It is termed as “Trading on Equity”.

Christy and Roden defined leverage as the tendency for profits to change at a faster rate
than sales. It is a relationship between equity share capital and securities and creates fixed interest
and dividend charges. It is also known as “gearing”.

SPECIMEN FORMAT TO CALCULATE THE LEVERAGE

Amount
Particulars
(in ₹)
Sales XXX
Less: Variable Cost XXX
Contribution XXX
Less: Fixed Cost XXX
Operating Profit / Earnings before interest and tax [EBIT] XXX
Less: Interest XXX
Earnings before tax [EBT] XXX
Less: Tax XXX
Earnings after Tax XXX
Less: Preference dividend XXX
Earnings available to Equity shareholders XXX

5.9 TYPES OF LEVERAGE

Leverage can be divided into three types are as follows:

1. Operating Leverage

20
 2. Financial Leverage
3. Combined Leverage
1. Operating Leverage

The operating leverage occurs when a firm has fixed costs which must be recovered
irrespective of sales volume. The fixed costs remaining same, the percentage change in
operating revenue (EBIT) will be more than the percentage change in sales. This is known as
operating leverage.

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑜𝑟 𝐸𝐵𝐼𝑇

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑜𝑟 𝐸𝐵𝐼𝑇

𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠

Significance of operating leverage:

Higher the fixed operating costs, the higher the firm’s operating leverage and its operating
risk. High operating leverage is good when sales revenue is high and bad when it is falling.
Operating risk is the risk of the firm not being able to cover its fixed operating costs. The
larger the fixed operating costs, the larger should be the sales volume to cover all fixed
operating costs.

2. Financial Leverage

Financial leverage is the second type of leverage. It is related to the financing activities
of the firm. Financial leverage results from the presence of fixed financial charges in the
firm’s income stream. These fixed charges do not vary with the earnings before interest and
taxes [EBIT].

Financial leverage may be defined as “the ability of a firm to use fixed financial
charges to magnify the effect of changes in EBIT, on the firm’s earnings per share.

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠 𝐸𝐵𝐼𝑇

𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 = or
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠 𝐸𝐵𝑇

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆

𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

21
Significance of Financial Leverage

High fixed financial costs increase the firm’s financial risk. The financial risk refers to the
risk of the fir not being able to cover its fixed financial costs. EBIT should be sufficient to cover
the fixed charges; otherwise it may force the company into liquidation.

3. Combined or Composite Leverage

The operating leverage measures the degree of operating risk and it is measured by percentage
change in operating profit due to percentage change in sales. The financial leverage measures
the financial risk by measuring the percentage change in taxable profit or EPS with the
percentage change in operating profit or EBIT. Both these leverages are closely concerned
with the firm's capacity to meet the fixed costs.

Composite leverage expressed the relationship between revenue on account of sales

(Contribution) and the taxable income (PBT) on account of change in sales. The composite
ratio is calculated as follows:

𝐂𝐨𝐦𝐩𝐨𝐬𝐢𝐭𝐞 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 𝐱 𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞

Contribution
𝐂𝐨𝐦𝐩𝐨𝐬𝐢𝐭𝐞 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 =
EBT
Percentage Change in EPS
𝐃𝐞𝐠𝐫𝐞𝐞 𝐨𝐟 𝐂𝐨𝐦𝐛𝐢𝐧𝐞𝐝 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 =
Percentage Change in Sales

Significance of Combined Leverage:

CL measures the percentage changes in EPS due to percentage change in sales. It will
be favourable when sales increases and unfavourable when sales decreases.

Note: OP= Operating Profit ie. EBIT(Earnings before Interest and Tax)

22
5.10 COMPUTATION OF FINANCIAL LEVERAGE, OPERATING LEVERAGE
AND COMBINED LEVERAGE
Illustration – 1:

From the following details calculated operating leverage

1. Selling price per unit ₹ 20

2. Variable cost per unit ₹ 12
3. Actual sales 200 units
4. Installed capacity 300 units in each of the following two situations.
(i) When fixed costs are ₹ 1,000
(ii) When fixed costs are ₹ 800.

Solution:
Statement showing computation of operating leverage

When fixed cost is When fixed cost is

Particulars ₹ 1,000 ₹ 800
₹ 4,000
Sales ₹ 4,000
₹ 2,400
Less: Variable Cost ₹ 2,400
₹ 1,600
Contribution ₹ 1,600
₹ 800
Less: Fixed Cost ₹ 1,000
₹ 800
Earnings before Interest and Tax ₹ 600
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 1600
1600 =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 800
= 600
𝐸𝐵𝐼𝑇
= 2.67 =2

Illustration – 2:

The following are the details:

a) Selling Price Per Unit ₹ 20

b) Variable Cost per unit ₹ 12
c) Actual Sales 200 units
d) Fixed cost 1000

Calculate degree of operating leverage when sales will be (a) 150 units (b) 250 units (c) 300 units.

23
Solution:

Computation of degree of operating leverage

Present
(i) (ii) (iii)
Position

Sales in units 200 150 250 300

Sales in ₹ 4,000 3,000 5,000 6,000

Less: Variable cost 2,400 1,800 3,000 3,600

Contribution 1,600 1,200 2,000 2,400

Less: Fixed cost 1,000 1,000 1,000 1,000

EBIT 600 200 1,000 1,400

Degree of Operating Leverage -2.67 2.68 2.66

If a firm has a high degree of operating leverage, small change in sales will have large
effect on operating income. Similarly, the operating profits of such a firm will suffer loss as
compared to decrease in its sales. There will not be any operating leverage, if there are no fixed
costs.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠

Case-1:

( 200 − 600 )𝑥100

𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 600
(3,000 − 4,000)𝑥 100
4,000

(−400 )
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 600 𝑥100
(−1,000)
4,000 𝑥100

−66.67
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
−25

24
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = −2.668

Case 2:

( 1,000 − 600 )𝑥100

𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 600
(5,000 − 4,000)𝑥 100
4,000

(400 )
𝑥100
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 600
(1,000)
4,000 𝑥100

66.67
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
25

𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 2.67

Case 3:

( 1,400 − 600 )𝑥100

𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 600
(6,000 − 4,000)𝑥 100
4,000

(800 )
𝑥100
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 600
(2,000)
4,000 𝑥100

133.33
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
50

𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 2.67

Illustration – 3:

From the following information relating to the operating and financial structure of DTS Ltd,
calculate the operating and financial leverage under situations A, B and C, and financial plans, I,
II and III respectively. Also find out the combinations of operating and financial leverage, which
will give the highest value, and the least value.

Installed Capacity = 12, 000 units

Actual production and sales = 800 units

25
 Variable cost per unit = ₹ 100
Selling Price per unit = ₹ 150
Fixed Expenses
Situation A = ₹ 10,000
Situation B = ₹ 20,000
Situation C = ₹ 30,000
Financial
Capital Structure
Particulars
II III
I
Equity 75,000 50,000 25,000

Debt 25,000 50,000 75,000

Cost of debt 12%

Solution:
Statement Showing Operating Leverage
Particulars Situation Situation Situation
A B C

Sales revenue 1,20,000 1,20,000 1,20,000

80,000 80,000 80,000
Less :Variable Cost
Contribution 40,000 40,000 40,000

Less : Fixed Cost 10,000 20,000 30,000

Operating Profit (EBIT) 30,000 20,000 10,000

C 1.33 2 4
OL = OP

Statement Showing Financial Leverage

Situation-A: When EBIT = ₹ 30,000

Particulars Plan I Plan II Plan III

30,000 30,000 30,000

Operating Profit (EBIT)
3,000 6,000 9,000
Less: Debenture Interest @ 12%
27,000 24,000 21,000
EBT

26
 OP 1.11 1.25 1.429
FL =
EBT

Statement Showing Financial Leverage

Situation – B: When EBIT = ₹ 20,000

Particulars Plan I Plan II Plan III

20,000 20,000 20,000

Operating Profit
3,000 6,000 9,000
Less: Debenture Interest @ 12 %

17,000 14,000 11,000

EBT
OP 1.176 1.429 1.82
FL = EBT

Interpretation:
In order to calculate the combined leverage, or the total risk, multiply OL with FL values
in each column.
For example, (1.33 x 1.11, 1.33 x 1.25, 1.33 x 1.429). See table next page.
Statement Showing Financial Leverage
Situation – C: When EBIT = ₹ 10,000
Particulars Plan I Plan II Plan III
Operating Profit 10,000 10,000 10,000
Less :Debenture Interest 3,000 6,000 9,000
EBT 7,000 4,000 1,000
OP
FL = EBT 1.429 2.5 10

Statement Showing Combined Leverage

(OL X FL = CL)
Situation Situation Situation
Particulars A B C
1.33 2 4
Operating Leverage
Financial Leverage:
1.11 1.176 1.429
Plan I

27
 1.25 1.429 2.5
Plan II
1.429 1.82 10
Plan III

Working Note:
1. Sales revenue = 800 x 150 = ₹ 1,20,000
2. Variable expenses = 800 x 100 = ₹ 80,000
3. Debenture Interest
12
Plan I = 25,000 x 100 = ₹ 3,000
12
Plan II = 50,000 x 100 = ₹ 6,000
12
Plan III = 75,000 x 100 = ₹ 9,000

Conclusion:
1. Most risky situation 4 x 10 = 40, that is situation C and financial plan III
2. Least risky position 1.33 x 1.11 = 1.4763, that is, Situation A and Financial Plan I.

Illustration – 4:

XYZ Ltd is considering the proposal for a new production process which is highly capital
intensive. The units of production are 50,000 units. It will double the fixed costs, at the same time
reducing variable costs to ₹ 4 per unit. The new process can be financed with debt, which will
increase the interest charges by ₹ 70,000. As an alternative if equity financing is used, the number
of shares will go up by 20,000. If the sales remain constant, find out for each financing method.

a) Operating Leverage.
b) Financial Leverage, and
c) Combined Leverage.
An analytical statement of XYZ Ltd is as follows
Sales revenue 10,00,000
Less :Variable expenses 4,00,000
Contribution 6,00,000
Less: Fixed expenses 2,00,000
EBIT 4,00,000

28
 Less :Interest 1,25,000
EBT 2,75,000
Less: Tax 1,10,000
Earnings available to equity 1,65,000
Shareholders
Number of equity shares 1,00,000
EPS ₹ 1.65

SOLUTION:
Computation of Leverages for the existing structure
C 6,00,000
OL = = = 1.5
OP 4,00,000
OP 4,00,000
FL = = = 1.455
EBT 2,75,000
C 6,00,000
CL = = = 2.182
EBT 2,75,000

Or CL = OL X FL = 1.5 X 1.455 = 2.182

II. Statement Showing Leverages for new proposal
Sales revenue 10,00,000

2,00,000
Less :Variable expenses
8,00,000
Contribution
4,00,000
Less: Fixed expenses
4,00,000
EBIT
C 8,00,000
OL = OP = 4,00,000 = 2

Particulars Equity Debt

Financing financing
4,00,000 4,00,000
EBIT
1,25,000 1,95,000*
Less: Interest

29
 2,75,000 2,05,000
EBT
EBIT 1.455 1.9512
FL = EBT
C 2.909 3.90
CL = EBT

Working Note:
1. Variable expenses = 50,000 x 4 = ₹ 2,00,000
2. Fixed expenses doubled, so that it is ₹ 4,00,000
3. * If equity financing is used, interest charges will be ₹ 1,25,000 and if debt financing is used
interest charges will be ₹ 1,25,000 + 70,000 = ₹ 1,95,000

Illustration – 5:

A Company has sales of ₹ 1 lakh. The Variable costs are 40% of the sales while fixed operating
costs amount to ₹ 30,000. The amount of interest on long term debt is ₹ 10,000. You are required
to calculate the composite leverage and illustrate its impact, if sales increase by 5%?

Solution:
Statement Showing the Calculation of Composite Leverages
Sales revenue 1,00,000
40,000
Less :Variable expenses
60,000
Contribution
30,000
Less: Fixed expenses
30,000
Operating Profit
10,000
Less : Debenture Interest
20,000
EBT
C 60,000
CL = EBT = =3
20,000

The composite leverage 3 indicates that, with every one rupee increase in sales, the
earnings available to the equity shareholders will increase by ₹ 3. This can be verified by the
following computation:
Computation of Composite Leverage when there is 5% increase in Sales.
Sales revenue 1,05,000

30
 Less : Variable expenses
40
(1,05,000 x 100 ) 42,000
63,000
Contribution
30,000
Less: Fixed expenses
33,000
Operating Profit
10,000
Less: Debenture Interest
23,000
EBT
C 63,000
CL = EBT = 23,000 = 2.7391

% change in EPS
Degree of Composite Leverage = % change in sales

Here preference capital is not mentioned, therefore EBT = Earnings available to equity
shareholders.
23,000−20,000
% Change in EPS = x 100 = 15%
20,000

% Change in Sales = 5%
15%
DCL = =3
5%

So it is proved that 1% change in sales would bring 3% change in EPS, in the direction of
the change in sales.
Illustration – 6:
The capital structure of P Company consists of an ordinary share capital of ₹ 10,00,000, (shares of
₹ 100 par value) and ₹ 10,00,000 of 10% debentures. Sales increased by 20% from 1,00,000 units
to 1,20,000 units, and the selling price is ₹ 10 per unit. Variable cost amounts to ₹ 6 per unit, fixed
expenses amounted to ₹ 2, 00,000. The income tax rate is assumed to be 50 percent.
You are required to calculate the following:
1. The percentage increase in Earnings per Share.
2. The degree of financial leverage at 1, 00,000 units and 1, 20,000 units.
3. The degree of operating leverage at 1, 00,000 units and 1, 20,000 units.
Comment on the behaviour of operating and financial leverages in relation to increase in
production, from 1, 00,000 units to 1, 20,000 units?

31
Solution:
The effect on EPS at Various Levels of Sales

Plan – 1 Plan - 2
Particulars 1,00,000 1,20,000
Units Units

10,00,000 12,00,000
Sales revenue
6,00,000 7,20,000
Less :Variable expenses
4,00,000 4,80,000
Contribution
2,00,000 2,00,000
Less :Fixed expenses
2,00,000 2,80,000
EBIT
1,00,000 1,00,000
Less :Debenture interest
1,00,000 1,80,000
EBT
50,000 90,000
Less: Tax 50%
A. EAT ( Earnings available to equity 50,000 90,000
shareholders)
10,000 10,000
B. Number of equity shares
5 9
EPS (A/B)
CALCULATION
1. Sales revenue = 1,00,000 x 10 = ₹ 10,00,000
2. Variable expenses = 1,00,000 x 6 = ₹ 6,00,000 (Plan – 1)
= ₹ 7, 20,000 (Plan – 2)
10
3. Debenture Interest = 10,00,000 x 100 = ₹ 1,00,000
10,00,000
4. Number of equity shares = 10,000 shares
100
9−5
5. Percentage increase in EPS = X 100 = 80%
5

6. Percentage increase in sales = 20% (given)

2,80,000−2,00,000
7. Percentage increase in EBIT = x 100 = 40%
2,00,000
% Change in EBIT 40%
8. DOL = = =2
% Change in Sales 20%
% Change in EPS 80%
9. DEL = = 40% = 2
% Change in EBIT

32
 % Change in EPS 80%
10. DCL = = =4
% Change in Sales 20%

Interpretation

1. DOL is 2, it means that for every one percent change in sales, there will be a 2% change in
EBIT, in the same direction in which the sales change.
2. DFL is 2, it means that a one percent change in EBIT, will cause a 2 percent change in the
EPS, in the same direction (that is, the increase or decrease) in which the EBIT changes.
3. DCL is 4, it means that for one percent change in sales, there will be a 4% change in EPS, in
the direction of the change in sales.
Illustration – 7:
A firm has sales of ₹ 10, 00,000, Variable cost of ₹ 7, 00,000 fixed cost of ₹ 2,00,000 and debt of
₹ 5, 00,000 at 10% rate of interest. What are the operating, financial and combined leverages?
If the firm wants do double its EBIT, how much of a rise in sales would be needed on a
percentage basis?

Solution:
Statement Showing Profitability
Sales revenue 10,00,000
7,00,000
Less: Variable expenses
70
(100 𝑋 10,00,000)
3,00,000
Contribution
2,00,000
Less :Fixed expenses
1,00,000
OP
50,000
Less debenture Interest
10
(50,000 x = Rs. 50,000)
100
50,000
EBT

C 3,00,000
OL = = =3
OP 1,00,000
OP 1,00,000
FL = = =2
EBT 50,000
33
 C 3,00,000
CL = = =6
EBT 50,000
Or CL = OL x FL = 3 x 2 = 6

Working backwards to get the required sales if the EBIT doubles (1, 00,000 x 2=2, 00,000)
Operating Profit=2, 00,000
Fixed Expenses= 2, 00,000
Contribution = Operating Profit +Fixed Expenses
Contribution=2, 00,000+2, 00,000
Contribution=4, 00,000
70
Variable Expenses = 100(𝑥)

Sales=x
Contribution =4, 00,000
Sales-Variable Cost= Contribution
70
x- 100 x=4,00,000

30x=4, 00,000 x 100

30 x= 4, 00, 00,000
4,00,00,000
X= 30

X=13, 33,333.33 Sales= 13, 33,333.33

70
Variable Cost =100 𝑥 13,33,333.33

Variable Cost= 9, 33,333.33

Let us prove the calculation:
Required sales 13,33,333.333

Less variable expenses

70
1333333.333 x 9,33,333.333
100
4,00,000
Contribution
2,00,000
Less fixed expenses
2,00,000
Operating Profit

34
Illustration – 8:
An analytical statements of XY Company is shown below
Sales revenue 9,60,000
5,60,000
Less: Variable cost
4,00,000
Contribution
2,40,000
Less: Fixed costs
1,60,000
EBIT
60,000
Less :Interest
1,00,000
EBT
50,000
Less tax (50%)
50,000
Net Income
Calculate
1. Operating leverage,
2. Financial leverage and
3. Combined leverage
Solution:
C 4,00,000
1. Operating Leverage = OP = 1,60,000 = 2.5
OP 1,60,000
2. Financial Leverage = EBT = 1,00,000 = 1.6
C 4,00,000
3. Combined Leverage = EBT = 1,00,000 = 4

Or CL = OL x FL = 2.5 x 1.6 = 4

Illustration – 9:

Calculate
1. Operating Leverage
2. Financial Leverage and
3. Combined Leverage from the following data:
a) Sales 1,00,000 units at the rate of ₹ 2 per unit is ₹ 2,00,000
b) Variable cost per unit at the rate of ₹ 0.70,
c) Fixed cost ₹ 1, 00,000 and
d) Interest charges ₹ 3,668.

35
Solution:
Statement Showing the Profitability
Sales revenue 2,00,000
70,000
Less: Variable expenses
1,30,000
Contribution
1,00,000
Less: Fixed expenses
30,000
Operating Profit (OP)
3,668
Less :Interest charges
26,332
EBT
C 1,30,000
1. Operating Leverage = OP = = 4.33
30,000
OP 30,000
2. Financial Leverage = EBT = 26,332 = 1.1393
C 1,30,000
3. Combined Leverage = EBT = = 4.93695
26,332

Or CL = OL x FL = 4.33 x 1.1393 = 4.93317.

Illustration – 10:
Calculate Operating Leverage, Financial Leverage and Combined Leverage, for the following
firms and interpret the results.

Particulars P Q R
3,00,000 75,000 5,00,000
Output (units)
3,50,000 7,00,000 75,000
Fixed costs (₹)
1.00 7.50 0.10
Unit variable cost (₹)
25,000 40,000 Nil
Interest charges (₹)
3.00 25.00 0.50
Unit Selling Price (₹)
Solution:
Calculation for Firm P
1. Sales revenue = 3,00,000 x 3 = ₹ 9,00,000
2. Variable expenses = 3,00,000 x 1 = ₹ 3,00,000
Similarly these values are calculated for firms Q and R. Calculation is explained in the following
table.

36
 Particulars P Q R
9,00,000 18,75,000 2,50,000
Sales revenue
3,00,000 5,62,500 50,000
Less: Variable expenses
6,00,000 13,12,500 2,00,000
Contribution
3,50,000 7,00,000 75,000
Less: Fixed expenses
2,50,000 6,12,500 1,25,000
Operating Profit (OP)
25,000 40,000 -
Less : Interest
2,25,000 5,72,500 1,25,000
EBT
C 6,00,000 13,12,500 2,00,000
OL = OP
2,50,000 6,12,500 1,25,000
= 2.4 = 2.14 = 1.6
OP 2,50,000 6,12,500 1,25,000
FL = EBT
2,25,000 5,72,500 1,25,000
= 1.111 = 1.07 =1
13,12,500 2,00,000
Combined Leverage 6,00,000
5,72,500 1,25,000
C 2,25,000
= EBT
=2.29 =1.6
= 2.67

2.4 x 1.111 2.14 x 1.06986 1.6 x 1

Or CL = OL x FL
= 2.67 = 2.2926 =1.6

Interpretation:
The most risky situation is for firm P (the highest composite leverage) and the least risky
situation is for the firm R, due to least combined leverage.
Illustration – 11:
ABC Ltd, has an EBIT of ₹ 1, 60,000. Its capital structure consists of the following securities.
10% debentures = ₹ 5, 00,000
12% Preference shares = ₹ 1, 00,000
Equity shares of ₹ 100 each = ₹ 4, 00,000
The company is in the 55% tax bracket. You are required to determine. (1) the company’s
EPS (2) the percentage change in EPS associated with 30% increase and 30% decrease in EBIT.
(3) The degree of financial leverage.

37
Solution:
Statement showing the effect on EPS at various levels of EBIT
Particulars Case II Base Case I

(- 30%) (+30%)

1,12,000 1,60,000 2,08,000

EBIT
50,000 50,000 50,000
Less :Debenture interest
62,000 1,10,000 1,58,000
EBT
34,100 60,500 86,900
Less :Tax
27,900 49,500 71,100
EAT
Less: Preference
12,000 12,000 12,.000
Dividend
A. Earnings available to
15,900 37,500 59,100
equity share holders

4,000 4,000 4,000

B. Number of equity shares
3.975 9.375 14.775
EPS
OP 1,12,000 1,60,000 2,08,000
FL = =
EBT 62,000 1,10,000 1,58,000

= 1.8065, 1.4545, 1.3165

CALCULATION:
30
1. EBIT, 30% decrease = 1,60,000 – 1,60,000 x 100 = ₹ 1,12,000
30
2. EBIT, 30% Increase = 1,60,000 + 1,60,000 x 100 = ₹ 2,08,000
10
3. Debenture Interest = 5,00,000 x 100 = ₹ 50,000 (Same for all cases)
12
4. Preference dividend = 1,00,000 x 100 = ₹ 12,000 (Same for all cases)
4,00,000
5. Number of equity shares = = ₹ 4,000 shares (Same for all cases)
100
55
6. Income tax = 1,10,000 x 100 = ₹ 60,500

7. Percentage change in EPS associated with 30% increase in

38
 14.775−9.375
EBIT = x 100 = + 57.6%
9.375

8. Percentage change in EPS associated with 30% decrease in

3.975−9.375
EBIT = x 100 = - 57.6%
9.375
% Change in EPS + 57.6
9. DFL = % Change in EBIT = = 1.92
+ 30
2,08,000−1,60,000
% Change in EBIT = x 100 = 30%
1,60,000

5.11 TRADING ON EQUITY

A company may raise funds either by issue of shares or by debentures. Debentures carry a
fixed rate of interest and this interest has to be paid irrespective of profits. Of coure, preference
shares are also entitled to a fixed rate of divided but the payment of dividend depends upon the
profitability of the company. In case the rate of return (ROI) on the total capital employed
(shareholder’s funds plus long term borrowed funds) is more than the rate of interest on
debentures or the rate of dividend on preference shares, it is said that the company is trading on
equity.

For example, the total capital employed in a company is a sum of ₹ 2,00,000 The capital
employed consists of equity shares of ₹ 10 each. The company makes a profit of ₹ 30,000 every
year. In such a case the company cannot pay a dividend of more than 15% on the equity share
capital. However, if the funds are raised in the following manner and other things remain the
same, the company may be in a position to pay a higher rate of return on equity shareholders’
funds.

(a) ₹ 1 lakh is raised by issue of debentures, carrying interest at 10% p.a.

(b) ₹ 50,000 is raised by issue of preference shares, carrying dividend at 12%.
(c) ₹ 50,000 is raised by issue of equity shares.

In the above case out of the total profits of ₹ 30,000, ₹ 10,000 will be used for paying interest
while ₹ 6,000 will be used for paying preference dividends. A sum of ₹ 14,000 will be left for
paying dividends to the equity shareholder Since the amount of equity capital is ₹ 50,000, the
company can give a dividend of 28% .Thus, the company can pay a higher rate of dividend than
the general rate of earning on the total capital employed. This is the benefit of trading on equity.

39
5.12 CHECK YOUR PROGRESS
Fill in the blanks with suitable answers

1. ______is a method through which the effect of leverage can be studied.

2. ______measures the percentage changes in EPS due to percentage change in sales.
3. The formula to compute Financial Leverage is ______.
4. ______ has been defined as “the action of a lever and mechanical advantage gained by it”.
5. The formula to compute EPS is ______.

Answers to Check Your Progress

1. EBIT analysis
2. Combined Leverage
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠 𝐸𝐵𝐼𝑇
3. Financial Leverage = or
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠 𝐸𝐵𝑇

4. Leverage
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
5. EPS = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

5.13 SUMMARY
Capital Structure refers to the specific mix of debt and equity used to finance a company’s
assets and operations. From a corporate perspective, equity represents a more expensive,
permanent source of capital with greater financial flexibility.

Equity capital arises from ownership shares in a company and claims to its future cash
flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the
form of common stock, preferred stock or retained earnings. Short term debt is also considered to
be a part of the capital structure.

A company may raise funds either by issue of shares or by debentures. Debentures carry a
fixed rate of interest and this interest has to be paid irrespective of profits. Of course, preference
shares are also entitled to a fixed rate of divided but the payment of dividend depends upon the
profitability of the company. In case the Rate of Return (ROI) on the total capital employed
(shareholder’s funds plus long term borrowed funds) is more than the rate of interest on

40
debentures or the rate of dividend on preference shares, it is said that the company is trading on
equity.

5.14 KEYWORDS
Highly Geared Companies : Companies whose proportion of equity
capitalization is small.

Low Geared Companies : Companies whose equity capital dominates total

capitalization.

Capital Structure : Composition of capitalization and it includes all

long term capital sources of a firm.

Leverage : Use of debt (borrowed capital) in order to

undertake an investment or project.

5.15 QUESTIONS FOR SELF-STUDY

1. A firm has an all equity capital structure consisting of 1,00,000 ordinary shares of ₹10 per
share. The firm wants to raise ₹ 2,50,000 to finance its investment and is considering three
alternative methods of financing.
a. To issue 25,000 equity shares at ₹10 each.
b. To borrow ₹2,50,000 at 8% rate of interest.
c. To issue 2,500 preference shares of ₹ 100 each at 8% rate of interest.

Calculate the effect of EPS under the three financing options if EBIT after additional
investment is, (a) ₹ 3,12,500, (b) ₹ 75,000 and (c) ₹ 2,00,000.

2. G Company has currently an ordinary share capital of ₹ 25 lakhs consisting of ₹ 25,000 shares
of ₹ 100 each. The management is planning to raise another ₹ 20 lakhs to finance a major
program of expansion through one of the four possible financing plans. The options are;
a. Entirely through ordinary shares.
b. ₹ 10 lakhs through ordinary shares (equity shares) and ₹ 10 lakhs through long term
borrowings at 8% interest p.a.
c. ₹5 lakhs through ordinary shares and ₹ 15 lakhs through long term borrowings at 9%
interest p.a.

41
 d. ₹10 lakhs through ordinary shares and ₹ 10 lakhs through preference shares with 5%
dividend.

The company’s expected earnings before interest & tax will be 8 lakhs. Assuming a
corporate rate of tax is 10%. Determine the Earnings per share (EPS) in each alternative and
comment on the implications of financial leverage.

3. From the following calculate financial, operating and combined leverage.

Sales 10,000 units ₹ 25 per unit as the selling price, Variable cost ₹ 5 per unit, Fixed Cost
₹30,000 and interest cost ₹ 15,000.
4. A firm has sales of ₹ 10, 00,000, variable cost ₹ 7,00,000, fixed cost ₹ 2,00,000 and debt
₹ 5,00,000 at 10% rate of interest. What are the operating and financial leverages?

5.16 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill- Tenth
Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh edition-
2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-Eleventh
Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya Publishing
House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and Sons-
Fifteenth Edition-2019.

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UNIT 6 CAPITAL STRUCTURE THEORIES
Structure:

6.0 Objectives

6.1 Introduction

6.2 Net Income (NI) Approach

6.3 Net Operating Income (NOI) Approach

6.4 Optimum Capital Structure

6.5 Modigliani –Miller Approach

6.6 Traditional Approach

6.7 The Trade-off Theory

6.8 Agency Cost Theory

6.9 The Signalling Theory

6.10 Check Your Progress

6.11 Summary

6.12 Keywords

6.13 Questions for Self-Study

6.14 References

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6.0 OBJECTIVES
After Studying this unit, you will be able to;

 Analyse the importance of capital structure theories.

 Bring out the assumptions of net income approach and net operating income approach.
 Discuss the relevance of agency cost theory.
 Identify the need for trading on equity.
6.1 INTRODUCTION
In order to achieve the goal of identifying an optimum debt-equity mix, it is necessary for the
finance manager to be conversant with the basic theories underlying the capital structure of corporate
enterprises. In this unit, we are reviewing major theories of capital structure and trying to develop a
unified theory of capital structure. However, it will be seen that the existence of optimum capital
structure is not accepted by all. There exist extreme views. There is a viewpoint that strongly supports
the argument, the financing or debt-equity mix has a major impact on the shareholders wealth. There
are many theories explaining the relationship between capital structures, cost of capital and value of
the firm they are; Net Income (NI) Approach, Net Operating Income (NOI) Approach, Modigliani
Miller (MM) Approach, Traditional Approach, Trade off theory, Signalling Theory and Agency cost
theory.

Theories of capital structure

NI NOI M-M Traditional Trade-off Agency Signaling

Approach Approach Approach Approach Approach Cost Theory
Theory

Assumptions:

The following assumptions are been made in order to present the analysis in a simple and intelligible
manner:

1. The firm employs only two types of capital –debt and equity. There are no preference shares.
2. There are no corporate taxes. This assumption has been removed later
3. The firm pays 100% of its earning as dividend. Thus there are no retained earnings.

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 4. The firm’s total assets are given and they do not change. In other words the investment decisions
are assumed to be constant.
5. The firms total financing remains constant. The firm can change its capital structure either by
redeeming the debentures or by issue of shares or by raising more debt and reduce the equity
share capital.
6. The operating earnings (EBIT) are not expected to grow.
7. The business risk remains constant and is independent of the capital structure and the financial
risks.
8. All investors have the same subjective probability distribution of the future expected operating
earnings (EBIT)for a given firm.
9. The firm has perpetual life.

6.2 NET INCOME (NI) APPROACH

This approach has been suggested by Durand. According to this approach, capital structure
decision is relevant to the valuation of the firm. In other words, a change in the capital structure causes
a corresponding change in the overall cost of capital as well as the total value of the firm.

According to this approach, higher debt content in the capital structure will result in decline in
the overall or weighted average cost of capital. This will cause increase in the value of the firm and
consequently increase in the value of equity shares of the company. Reverse will happen in a converse
situation.

The following are the assumptions of Net Income Approach

1. There are no corporate taxes

2. The cost of debt is less than cost of equity or equity capitalisation rate

3. The debt content does not change the risk perception of the investors

The value of the firm on the basis of Net Income Approach can be ascertained as follows;

𝐕=𝐒 + 𝐁

Where

V=Value of the firm

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S= Market value of Equity

B=Market value of Debt

Market value of equity can be ascertained as follows

𝐒 = 𝐍𝐈/𝐤𝐞

NI=Earnings available for equity shareholders

Ke=Equity Capitalisation rate.

Illustration – 1:

X Ltd is expecting an annual EBIT of ₹ 1lakh.The company has ₹ 4 lakh in 10% debentures. The cost
of equity capital or capitalisation rate is 12.5%. You are required to calculate the total value of the firm
and also state the cost of capital of the firm.

Solution::

Statement showing value of the firm

Particulars ₹
Earnings before Interest and Tax( EBIT) 1,00,000

Less: Interest @10% on ₹ 4,00,000 ( Debentures) 40,000

Earnings available to equity share holders(NI) 60,000

Equity Capitalization Rate (Ke) 12.5%

Market Value of Equity

𝑁𝐼 60,000 4,80,000
S= = 𝑥 100
𝑘𝑒 12.5

Market value of Debt ( B) 4,00,000

Total Value of the Firm (V=S+B) 8,80,000
Overall cost of capital
𝐸𝐵𝐼𝑇
𝑘= 𝑉
1,00,000
𝑘= 𝑥 100 = 𝟏𝟏. 𝟑𝟔%
8,80,000

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Illustration 2:
X Limited is expecting an annual EBIT of ₹ 1, 00,000.The company has ₹ 4, 00,000 in 10%
debentures. The equity capitalisation rate is 12%. The company decides to raise ₹ 1, 00,000 by
issue of 10% debentures and use the proceeds thereof to redeem equity shares.
You are required to calculate the total value of the firm and also the overall cost of capital.

Statement showing value of the firm

Particulars ₹
Earnings before Interest and Tax( EBIT) 1,00,000
Less: Interest @10% on ₹ 5 ,00,000 ( Debentures) 50,000
Earnings available to equity share holders(NI) 50,000
Equity Capitalization Rate (ke) 12%
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑆)
NI 50,000 4,16,667
S= = 𝑥 100
Ke 12
Market value of Debt ( B) 5,00,000
Total Value of the Firm(V=S+B) 9,16,667
Overall cost of capital
𝐸𝐵𝐼𝑇
𝑘=
𝑉
1,00,000
𝑘 = 9,16,667 𝑥 100 = 𝟏𝟎. 𝟗𝟏%

The above table shows that raising of additional debt has increased the total value of the
firm and reduced the overall cost of capital structure.

Decrease in value: Similarly, the value of the firm according to NI approach will get
decreased in case the amount of debt is decreased by issuing additional equity shares.

Illistrarion 3:
X Limited is expecting annual EBIT of ₹ 1,00,000. The company has ₹ 4,00,000 in 10%
debentures. The equity capitalisation rate is 12.5 %. The company capitalisation rate is 12.5%. The
Company desires to redeem debentures ₹ 1,00,000 by issuing additional equity shares of ₹
1,00,000.

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 You are required to calculate the value of the firm and the overall cost of capital.

Statement showing value of the firm

Particulars ₹
Earnings before Interest and Tax( EBIT) 1,00,000
Less: Interest @10% on ₹ 3 ,00,000 ( Debentures) 30,000
Earnings available to equity share holders(NI) 70,000
Equity Capitalization Rate (ke) 12.5%
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝑁𝐼 70,000 5,60,000
𝑆= = 𝑥 100
𝑘𝑒 12.5

Market value of Debt ( B) 3,00,000

Total Value of the Firm (V=S+B) 8,60,000
Overall cost of capital
𝐸𝐵𝐼𝑇
𝑘=
𝑉
1,00,000
𝑘= 𝑥 100 = 𝟏𝟏. 𝟔%
8,60,000

6.3 NET OPERATING INCOME (NOI) APPROACH

This approach has also been suggested by Durand. This is just the opposite of Net Income
Approach. According to this approach, the market value of the firm is not at all affected by the
capital structure changes. The market value of the firm is ascertained by capitalising the net
operating income at the overall cost of capital (k) which is considered to be constant. The market
value of equity is ascertained by deducting the market value of the debt from the market value of
the firm.
Assumptions:
The Net Income Approach is based on the following assumptions
i. The overall cost of capital (k) remains constant for all degrees of debt equity mix or
leverage.

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 ii. The market capitalises the value of the firm as a whole and therefore, the split between
debt and equity is not relevant.
iii. The use of debt having low cost increases the risk of equity shareholders, this result in
increase in equity capitalisation rate. Thus, the advantage of debt is set off exactly by
increase in the equity capitalisation rate.
iv. There are no corporate taxes.

Value of the firm: According to the Net Operating Income approach, the value of the firm can be
determined by the following equation

𝑬𝑩𝑰𝑻
𝑽=
𝒌

Where,

V=Value of the firm

k= Overall cost of capital

EBIT= Earnings before interest and tax

Value of equity: The value of equity is a residual value, which is determined by deducting the
total value of debt (B) from the total value of firm (V). Thus the value of equity(S) can be
determined by the following equation

S=V-B

Where,

S=Value of equity

V=Value of firm

B=Value of debt

6.4 OPTIMUM CAPITAL STRUCTURE

According to the Net Operating Income (NOI) approach, the total value of the firm
remains constant irrespective of the debt equity mix or the degree of leverage. The market price of
equity shares will therefore not change on account of the change in debt –equity mix. Hence, there

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is nothing like optimum capital structure. Any capital structure will be optimum according to this
approach.

In those cases where corporate taxes are presumed, theoretically there will be optimum
capital structure when there is 100% debt content. This is because with every increase in debt
content ‘k’ declines and the value of the firm goes up. However, due to legal and other provisions,
there has to be a minimum equity. This means that the optimum capital structure will be at a level
where there can be maximum possible debt content in the capital structure.

Illustration – 1:

XYZ Limited has an EBIT of ₹ 1,00,000. The cost of debt is 10% and the outstanding debt
amounts to ₹ 4,00,000. Presuming the overall capitalisation rate as 12.5%, calculate the total value
of the firm and the equity capitalisation rate.

Solution:

Statement showing value of the firm

Particulars ₹
Earnings before Interest and Tax( EBIT) 1,00,000
Overall Capitalization rate (k) 12.5%
Market value of the firm(V) 8,00,000
1,00,000
𝑉= 𝑋100
12.5
Total Value of Debt (B) 4,00,000
Market Value of Equity (S) 4,00,000
(S=V-B)
Equity Capitalization rate (ke)
𝐸𝐵𝐼𝑇−𝐼
𝑘𝑒 = 𝑋 100
𝑉−𝐵
1,00,000−40,000 15%
ke= 8,00,000−4,00,000 x 100
60,000
= 4,00,000 𝑥100
=15%
The validity of the NOI approach can be verified by calculating the overall cost of capital
𝑩 𝑺
k=kd (𝑽)+ ke(𝑽)

Where,
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k= Overall cost of capital

kd= Cost of debt

B=Total debt

V=Total value of firm

ke=Cost of equity capital

S=Market value of equity

4,00,000 4,00,000
𝑘 = 10% ( ) + 15% ( )
8,00,000 8,00,000
1 1
=10%(2)+15% (2)

=5%+7.5%

=12.5%

Increase in Debt: In case the firm raises the debt content for reducing its equity content, the total
value of the firm would remain unchanged; however the equity capitalisation rate would go up.
This is clear with the following illustration.

Illustration – 2:

ABC Company has an EBIT of ₹ 1,00,000. It cost of debt is 10% and the outstanding debt
amounts to ₹ 4,00,000. The overall capitalisation rate is 12.5% .The Company decides to raise a
sum of ₹ 1,00,000 through debt @10% and uses the proceeds to pay off the equity shareholders

You are required to calculate the total value of the firm and also the equity capitalisation rate.

Solution:

Statement showing the value of the firm

Particulars Amount

Earnings before Interest and Tax (EBIT) ₹ 1,00,000

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 Overall capitalization Rate (k) 12.5%

1,00,000 8,00,000
Market value of the firm (V) V= x 100
12.5

Total Value of Debt(B) 5,00,000

Market value of Equity (S) 3,00,000

(S=V-B)

Equity Capitalization Rate (ke) 16.67%

𝐸𝐵𝐼𝑇 − 𝐼
𝑘𝑒 = 𝑋 100
𝑉−𝐵
1,00,000−50,000
=8,00,000−5,00,000 𝑋 100

50,000
=3,00,000 𝑋100

The overall cost of capital as per NOI approach can now be verified as follows
𝑩 𝑺
k=kd (𝑽)+ ke(𝑽)

5,00,000 3,00,000
𝑘 = 10% ( ) + 16.67% ( )
8,00,000 8,00,000

5 3
𝑘 = 10% ( ) + 16.67% ( )
8 8

K=6.25%+6.25%

=12.50%

6.5 MODIGLIANI –MILLER APPROACH

The Modigliani-Miller (MM) approach is similar to the Net Operating Income (NOI)
approach. In other words, according to this approach, the value of the firm is independent of its
capital structure. However, there is a basic difference between the two. The NOI approach is
purely definitional or conceptual. It does not provide operational justification for irrelevance of the
capital structure in the valuation of the firm. While the MM Approach supports the NOI approach
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providing behavioural justification for the independence of the total valuation and the cost of
capital of the firm from its capital structure. In other words, MM approach maintains that the
average cost of capital does not change with the change in the debt weighed equity mix or the
capital structure of the firm. It also gives operational justification for this and not merely states
only a proposition.

Assumptions:

The three main propositions of MM approach are

1. The overall cost of Capital (k) and the value of the firm (v) are independent of the capital
structure. In other words, k and v are constant for all leverages of debt-equity mix. The total
market value of the firm is given by capitalising the expected net operating income (NI) by
the rate appropriate for that risk class.

2. The cost of equity (ke) is equal to capitalisation rate of a pure equity stream plus a premium
for the financial risk. The financial risk increases with more debt content in the capital
structure. As a result, ke increases in a manner to offset exactly the use of a less expensive
source of funds represented by debt.

3. The cut-off rate for investment purposes is completely independent of the way in which an
investment is financed.

6.6 TRADITIONAL APPROACH

We have learnt about the Net Income Approach, Net Operating Income Approach and
Modigliani – Miller Approach. According to the NI approach, the debt content in the capital
structure affects both the overall cost of capital and the total valuation of the firm while in case of
NOI approach the capital structure is totally irrelevant so far as the total valuation of the firm is
concerned. The MM approach supports the NOI approach. However, the limitations of the MM
approach shows that MM approach with its assumptions is of doubtful validity. The traditional
approach or the intermediate approach is a mid-way between the two approaches. It partly
contains the features of both NI and NOI approaches as given below:

1. The traditional approach is similar to the NI Approach to the extent that it accepts that the
capital structure or leverage of the firm affects the cost of capital and its valuation.

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 However, it does not subscribe to the NI approach that the value of the firm will
necessarily increase with all degree of leverages.
2. It subscribes to the NOI approach that beyond a certain degree of leverage, the overall cost
of capital increases resulting in decrease in the total value of the firm. However, it differs
from NOI approach in the sense that the overall cost of capital will not remain constant for
all degree of leverages.

6.7 THE TRADE-OFF THEORY

The trade- off theory of capital structure says the cost of debt is always lower than the cost
of equity because tax can be deducted from the interest on debt. Debt may be cheaper but it carries
with it the risk of not being able to make payments on time, which could result in insolvency.

Debt holders have first hold on the company’s assets .If it goes bankrupt as the firm can
only pay shareholders after meeting its debt obligations. Ultimately, the company has to find an
optimal capital structure that minimises the cost of financing while also minimising the risk of
bankruptcy

6.8 AGENCY COST THEORY

The agency theory is based on the notion that managers will not always act in the best
interest of the shareholders. Jensen and Meckling further elaborate on this concept by identifying
two main conflicts between parties to a company, firstly, between the managers and shareholders,
and secondly, between the shareholders and the creditors. In the first instance, managers are
tempted to pursue the profits of the firms they manage to their own personal gain at the expense of
the shareholders. In the latter instance, debt provides shareholders with the incentive to invest sub-
optimally.

Harris and Raviv argue that if an investment yields returns higher than the face value of
the debt, the benefits accrue to the shareholders. Conversely, if the investment fails, the
shareholders enjoy limited liability by exercising their right to walk away. This leaves the debt
holders with a firm whose market value is less than the face value of the outstanding debt. Another
potential agency cost of debt is pointed out by Myers. He notes that when firms are on the verge
of bankruptcy, there is no incentive for shareholders to invest more equity capital, even if positive
NPV projects are available. This is because the value derived from the projects will accrue mainly

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to the debt holders. The implication is that high debt levels may result in the rejection of value
increasing projects.

6.9 THE SIGNALLING THEORY

The signalling theory emanates from information asymmetries between firm management
and shareholders. If managers believe that their firms are undervalued, they will issue debt first
and then issue equity as a last resort. Conversely, if management believes that their firm is
overvalued, they will issue equity first. The signalling theory was first coined by Ross who
suggests that if managers have inside information, their choice of capital structure will signal
information to the market. Leverage may well be influenced by the theoretical premise that
increases in debt are a positive sign that managers are confident about future earnings. Debt
contracts are a commitment by managers to make future interest payments. Failure to repay debt
could lead to bankruptcy. This signals confidence to the market that the firm will have sufficient
cash flows to service debt. The shareholders of a firm are the residual claimants to the firm’s cash
flows. This is because promised interest payments are an obligation and have priority over
dividends. As a consequence, share prices are more sensitive to financial structure announcements
than bond prices. If managers are optimistic about their firm’s future prospects, the firm’s share
price will appear more undervalued than bond prices.

The implication of the signalling theory is that corporate managers will attempt to time
equity issues based on the market’s assessment of their shares.

6.10 CHECK YOUR PROGRESS

Fill in the blanks with suitable answers:

1. The Net Income approach has been suggested by ______.

2. According to the Net Income approach the value of the firm can be found out using the
equation ______.

3. According to the Modigliani and Miller approach, the value of the firm is ______ of its
capital structure.

4. The signalling theory emanates from information asymmetries between ______ and ______

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 5. The ______ theory is based on the notion that managers will not always act in the best
interest of the shareholders.

Answer to Check Your Progress

1. Durand
𝑬𝑩𝑰𝑻
2. 𝑉 = 𝒌

3. Independent
4. Firm management and shareholders
5. Agency Cost

6.11 SUMMARY
In financial management, capital structure theory refers to a systematic approach to
financing business activities through a combination of equities and liabilities. There are several
competing capital structure theories, each of which explores the relationship between debt
financing, equity financing and the market value of the firm slightly differently.

The capital structure theory helps the company in deciding an optimal capital structure and
in determining its effect on the value of the firm. The capital structure theories explore the
relationship between your company’s use of debt and equity financing and the value of the firm.

6.12 KEYWORDS
Capital Structure : The specific mix of debt and equity used to
finance a company’s assets and operations.

Equity Capitalisation Rate : The rate that reflects the relationship between the
income of the property and the equity of the
investor.

EBIT : Earnings before interest and tax.

Debt-Equity Mix : It indicates how much debt and equity a company

uses.

Overall Cost of Capital : Combined cost of capital of various sources such

as debt, preference, equity and retained earnings.

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6.13 QUESTIONS FOR SELF STUDY
1. Give a critical appraisal of the traditional approach.
2. Sketch out the various assumptions of capital structure theories.
3. Is the MM Approach realistic with respect to capital structure and the value of the firm? If not
what are its main weaknesses?
4. What are the assumptions of Net Income and Net Operating Income Approach
5. Discuss about the relevance of trading on equity.

6.14 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill- Tenth
Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh edition-
2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-Eleventh
Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya Publishing
House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and Sons-
Fifteenth Edition-2019.

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UNIT - 7 CAPITAL BUDGETING
Structure:

7.0 Objectives

7.1 Introduction

7.2 Need and Importance of Capital Budgeting

7.3 Difficulties in Capital Budgeting

7.4 Techniques of Capital Budgeting

7.4.1 Traditional Techniques

A. Pay Back Period

B. Accounting Rate of Return

7.4.2 Modern Techniques

A. Discounted Pay Back Period

B. Net Present Value Method

C. Profitability Index Method

D. Internal Rate of Return Method

7.5 Check Your Progress

7.6 Summary

7.7 Keywords

7.8 Questions for Self-Study

7.9 References

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7.0 OBJECTIVES
After studying this unit, you will be able to;

 Examine the need and importance of capital budgeting

 Compute problems on discounted and non-discounted cash flow techniques
 Ascertain the techniques of accepting and rejecting project by using various capital
budgeting.
 Compare Net Present Value Method vs Internal Rate of Return Method.

7.1 INTRODUCTION
The investment decision is the most important of the firms three major decision when it
comes to the value creation. Investment decision related to the determination of total amount of
assets to be held in the firm.

Investment decision can be broadly classified into two groups,

1. Long term investment decision or capital budgeting

2. Short term decision or working capital decision.
The term ‘Capital Budgeting refers to the long term planning for proposed capital outlays
and their financing. Thus, it includes both raising of long term funds as well as their utilisation. It
may thus be defined as the firm’s formal process by which the firms evaluate the purchase of
major fixed assets. It involves firm’s decision to invest its current funds for addition, disposition,
modification and replacement of long term or fixed assets. However, it should be noted that
investment in current assets necessitated on account of investment in a fixed assets, is also to be
taken as a capital budgeting decision. For example, a new distribution system may call for both a
new warehouse and an additional investment in inventories. An investment proposal of this nature
must be taken as a capital budgeting decision and evaluated as a single package, not as an
investment in a fixed asset and in a current asset separately.
Capital budgeting is a many sided activity. It includes searching for new and more
profitable investment proposals, investigating engineering and marketing considerations to predict
the consequences of accepting the investment and making economic analysis to determine the
profit potential of each investment proposal. Its basic features can be summarised as follows.
1. It has the potentiality of making large anticipated profits

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 2. It involves a high degree of risk
3. It involves a relatively long time period between the initial outlay and the anticipated
return.

7.2 NEED AND IMPORTANCE OF CAPITAL BUDGETING

The importance of capital budgeting can be well understood from the fact that an unsound
investment decision may prove to be fatal to the very existence of the concern.
1. Large Investments: Capital budgeting decision, generally, involve large investment of
funds. But the funds available with the firm are always limited and the demand for funds
far exceeds the resources. Hence, it is very important for a firm to plan and control its
capital expenditure.
2. Long-term Commitment of Funds: Capital expenditures involves not only large amount
of funds but also funds for long term or more or less on permanent basis. The long term
commitment of funds increases the financial risk involved in the investment decision.
Greater the risk involved, greater is the need for careful planning of capital expenditure
3. Irreversible Nature: The capital expenditure decisions are of irreversible nature. Once the
decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of
these assets without incurring heavy losses.
4. Long Term Effect on Profitability: Capital budgeting decisions have a long term and
significant effect on the profitability of a concern. Not only the present earnings of the firm
are affected by the investments in capital assets but also the future growth and profitability
of the firm depends upon the investment decisions taken today. An unwise decision may
prove disastrous and fatal to the very existence of the concern. Capital budgeting is of
utmost importance to avoid over investment or under investment in fixed assets.

7.3 DIFFICULTIES IN CAPITAL BUDGETING

Capital budgeting is hardly an exact science. If it were, companies would never make bad
decisions about expansions, product development, equipment upgrades and other capital
projects. The fact that companies do make various kinds of mistakes. Let us discuss the
limitations of capital budgeting.

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Cash Flow:

The single most important step in capital budgeting is to get the right forecasting of the
cash flows a project will produce. Capital budgeting is simply the process of determining
whether the increased revenue from a project justifies the investment required, but that future
revenue is only your best estimate. Even up-front costs, which are more immediate and therefore
easier to forecast, are still only estimates at this stage. Overestimate revenue or underestimate
costs, and a project that looks profitable could become a money-loser. Underestimate revenue or
overestimate costs, and you might end up rejecting a project that would have proved profitable.

Time Horizon:

Forecasting cash flows gets increasingly difficult the farther into the future you go. You
can make predictions based only on what you know right now. As you expand the time horizon
for a capital project, the likelihood rises that between the time you get started and the time you
expect to be reaping the benefits, some disruptive event will change your operating
environment. Unforeseen competition, legal and regulatory changes or technological
innovations can affect the ultimate success of your project. Yet they may be impossible to
consider in your capital budgeting process. At the same time the most ambitious projects the
ones that truly can take your company to the next level may take years to develop. As is often
the case in finance, getting the reward requires taking the risk.

Time Value:

One of the most common capital budgeting methods, particularly among small
businesses, is the payback period method. It simply requires that a project's forecast cash flows
repay its investment within a set amount of time. For instance, you require payback within five
years. If a project has ₹ 45,000 in up-front costs and estimates cash flows of ₹ 10,000 for five
years, this project meets your criteria. The problem is that this method doesn't account for the
time value of money the fact that equal sums of money at different points in time have different
values based on a number of factors. If you had to borrow the money for the project at 4 per cent
annual interest, for example, you actually would lose money, and inflation would add losses on
top of that. Other capital budgeting methods consider these issues, but they, too, have
limitations.

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Discount Rates

Capital budgeting methods that attempt to account for the time value of money do so by
figuring your cost of capital, the annual rate it will cost you to finance a project, either by
borrowing the money and paying interest or using your own money and not earning a return on
it somewhere else. Figuring the proper discount rate, as it is called, is yet another challenge.
Even if you peg it fairly accurately, there is always a chance that interest rates will rise or
something else will happen to increase your cost of capital down the road, reducing the real
value of those future cash flows. If you get the discount rate wrong to start with, your yes-or-no
decision on pursuing a project will be based on a flawed assumption.

7.4 TECHNIQUES OF CAPITAL BUDGETING

In the view of the significance of capital budgeting decisions, it is absolutely necessary that
the method adopted for appraisal of capital investment proposals is a sound one. Any appraisal
method should provide for the following.

(i) Basis of distinguishing between acceptable and non-acceptable projects.

(ii) Ranking of projects in order of their desirability.
(iii) Choosing among several alternatives.
(iv) A criterion which is applicable to any conceivable project.
(v) Recognising the fact that bigger benefits are preferable to smaller ones and early
benefits are preferable to later ones.

There are several methods for evaluating and ranking the capital investment proposals. In
case of all these methods, the main emphasis is on the return which will be derived on the capital
invested.

62
Types of the Traditional or the Conventional Approach:

1. Payback Period Method

2. Accounting rate of return method

Types of Non-traditional or the Discounted Cash Flow Technique :

1. Discounted payback period method

2. Net present value method

3. Internal rate of return method

4. Profitability index method

7.4.1 TRADITIONAL TECHNIQUES:

Traditional techniques are also called as non-discounted cash flow technique as it does not
consider the time value of money. Let us discuss in detail of each types of traditional techniques of
Capital budgeting.

A. PAYBACK PERIOD METHOD [PBP]

It refers to the period to recover on investment. The term PBP refers to the period in which
the project will generate the necessary cash to recover the initial investment. In simple , it id the
period in which the amount of investment is recovered back.

𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒐𝒓 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒇𝒍𝒐𝒘

𝑷𝑩𝑷 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘 𝒐𝒓 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘 𝒑. 𝒂

63
B. Decision criteria

Case-1: When there is an only one asset

Accept the asset if payback period is less than the life of the asset (or) reject the asset when
payback period is more than life of the asset.

Case-2: When there is an alternative

Accept the asset which has less payback period among the available alternatives.

Advantages:

1. It is a traditional and old method.

2. It involves simple calculation.

3. Selection or rejection of the project can be made easily.

4. It is the best method for evaluating high risk projects.

Disadvantages:

1. It is based on the principles of value of money.

2. It does not recognize the importance of time value of money.

3. It does not consider the profitability of economic life of project.

4. It does not recognize the pattern of cash flows and its timing.

*Note: In case of Payback period method Cash Inflows after tax but before
depreciation should be considered.

ILLUSTRATIONS ON PAYBACK PERIOD

Even cash flows:

Illustration – 1:

A project costs ₹ 1, 00,000 and yield annual cash inflow of ₹ 20,000 for 8 years. Calculate the
pay-back period.

64
Solution:

The payback period for the project is as follows:

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑟 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤
𝑃𝐵𝑃 = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 𝑜𝑟 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 𝑝.𝑎

1,00,000
𝑃𝐵𝑃 = = 5 years
20,000

𝐔𝐧𝐞𝐯𝐞𝐧 𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬

In the above example, we have presumed that the annual cash inflows are uniform.
However, it may not always be so. The cash flows of each year may be different. In such a case
cumulative cash inflows will be calculated and by interpolation, the exact pay-back period can be
calculated.

Illustration – 2:

A project requires an initial investment of ₹ 20,000 and the annual cash inflows for 5 years are ₹
6,000, ₹ 8,000, ₹ 5,000, ₹4,000 and ₹ 4,000 respectively, Calculate the payback period.

Solution:

Cash Cumulative
Year Flows Cash Flows
₹ ₹

1 6,000 6,000

2 8,000 14,000

3 5,000 19,000

4 4,000 23,000

5 4,000 27,000

The above table shows that in three years ₹ 19,000 has been recovered. ₹ 1,000 are left out of the
initial investment (Unrecovered cost). In the fourth year, the cash inflow is ₹ 4,000. It means the
payback period is between three to four years, which is ascertained as follows:

Unrecovered cost
PBP = Year before full recovery of cost +
Cash flow during the next year
65
 1,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 3 𝑦𝑒𝑎𝑟𝑠 +
4,000

Payback Period=3.25 years

Illustration – 3:
Determine the payback period for a project which requires a cash outlay of ₹ 10,000 and generates
cash inflows of ₹ 2,000, ₹ 4,000, ₹ 3,000 and ₹ 2,000 in the first, second ,third and fourth year
respectively.
Solution:

Cash Cumulative
Year Flows Cash Flows
₹ ₹

2,000 2,000
1

4,000 6,000
2

3 3,000 9,000

2,000 11,000
4
1,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 3 𝑦𝑒𝑎𝑟𝑠 + 2,000

Payback Period=3.5 years

Illustration – 4:

There are two projects Project X and Project Y. Each project requires an investment of ₹ 20,000.
You are required to rank these projects according to the payback period method.

Net cash inflows after tax and before depreciation are given below

Project X Project Y
Years
₹ ₹
1 1,000 2,000
2 2,000 4,000

66
 3 4,000 6,000
4 5,000 8,000
5 8,000 -

Solution:

Cumulative Cumulative
Project X Project Y
Years Cash Flows Cash Flows
₹ ₹
₹ ₹
1 1,000 1,000 2,000 2,000
2 2,000 3,000 4,000 6,000
3 4,000 7,000 6,000 12,000
4 5,000 12,000 8,000 20,000
5 8,000 20,000 - -
The above table shows that in case of Project X, it takes 5 years to recover the original
investment of ₹ 20,000 whereas in case of Project Y, it takes 4 years to recover the original
investment of ₹ 20,000.

Hence, Project Y should be preferred, since the payback period is shorter i.e., 4 years.

Illustration – 5:

A company has an investment opportunity costing ₹ 40,000 with the following expected net cash
flows after tax and before depreciation are:

From Year 1 to 5- ₹ 7,000 each year

From Year 6 to 9- ₹ 8,000 each year
Determine the payback period
Solution:
Here the cash inflows are cash inflows after tax and before depreciation and hence it is in the
required format. Here the Cash inflows are uneven, so the calculations are as follows-

67
 Cash Flow Before
Cumulative
Depreciation and
Year Cash Inflow
After Tax
₹
₹
1 7,000 7,000
2 7,000 14,000
3 7,000 21,000
4 7,000 28,000
5 7,000 35,000
6 8,000 43,000
7 8,000 51,000
8 8,000 59,000
9 8,000 67,000

5,000
Payback period =5 +
8,000

=5.625 years

Illustration – 6:

ABC and company is considering the purchase of a machine .Two machines X and Y each costing
₹ 50,000 are available, cash flows are expected to be as under. Calculate the payback period

Year Machine X Machine Y

1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Solution:

Here cash flows are uneven, the calculations are explained below:

68
 Machine X Machine Y
Year Cash Cumulative Cash Cumulative
Inflows Inflows Inflows Inflows
1 15,000 15,000 5,000 5,000
2 20,000 35,000 15,000 20,000
3 25,000 60,000 20,000 40,000
4 15,000 75,000 30,000 70,000
5 10,000 85,000 20,000 90,000
Payback period:
15,000
Machine X =2 𝑌𝑒𝑎𝑟𝑠 + 25000

=2.6 years
10,000
Machine Y=3 𝑌𝑒𝑎𝑟𝑠 + 30,000

=3.33 years.
B. AVERAGE RATE OF RETURN METHOD (ARR METHOD)
The accounting rate of return (ARR) method is also known as the Return on Investment
Method (ROI) method. This method uses accounting information as revealed by the financial
statements, to measure the profitability of an investment. The Average Rate of Return (ARR) is
calculated using the following equations.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

a) 𝐴𝑅𝑅 = 𝑥 100
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Or

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

b) 𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Where ,

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑇𝑜𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑡𝑎𝑥
=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

69
 𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 =
𝟐

c) When working capital and scrap value is given

When working capital and scrap value is given

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
(𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 − 𝐒𝐜𝐫𝐚𝐩 𝐯𝐚𝐥𝐮𝐞 )
= + 𝐀𝐝𝐝𝐢𝐭𝐢𝐨𝐧𝐚𝐥 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 + 𝐒𝐜𝐫𝐚𝐩 𝐯𝐚𝐥𝐮𝐞
𝟐

According to this method, the capital investment proposals are judged on the basis of their
relative profitability. For this purpose, the capital employed and related income is determined
according to commonly accepted accounting principles and practices over the entire economic life
of the project and then the average yield is calculated.
Decision criteria

Case-1: When there is only one asset

Accept the asset if ARR is more than the expected return, reject the asset if ARR is less than
expected rate of return.

Case-2: When there is an alternative

Accept the alternative which has the highest ARR.

Advantages:

1. It is very simple to understand and use.

2. This method is taken into account savings over the entire economic life of the project.
3. This method through the concept of “net earnings”, ensures a compensation of expected
profitability of the projects.
4. It can readily be calculated by using accounting data.

Disadvantages:

1. It ignores the time value of money.

2. It does not consider the length of life of the project.

70
 3. It ignores the fact that the profits earned can be reinvested.

*Note: In case of Average Rate of Return Method Cash Inflows after Depreciation and
after Tax should be considered.

Illustration – 1:

A limited company is considering investing in a project requiring a capital outlay of ₹ 2, 00,000.

The forecasted annual income after depreciation but before tax is as follows.
Year ₹
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000

Depreciation may be taken as 20% on original cost and taxation @50% of net income
You are required to calculate the Average rate of return for the project.
Solution:
Cash Inflows Cash Inflows
After Less
After
Depreciation Tax
Depreciation and
Year and Before Tax @50%
After Tax
(a) (b)
(a-b)
₹
₹ ₹

1 1,00,000 50,000 50,000

2 1,00,000 50,000 50,000
3 80,000 40,000 40,000
4 80,000 40,000 40,000
5 40,000 20,000 20,000

For computation of Average rate of return we need to take Average cash inflows after tax
and after depreciation.

71
 Cash inflows after
tax and after
Year
depreciation
₹
1 50,000
2 50,000
3 40,000
4 40,000
5 20,000
Total 2,00,000

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Where,

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 =

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠
2,00,000
=
5

= ₹ 40,000

𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
2
2, 00,000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
2

Average Investment =₹ 1, 00,000

40,000
 𝐴𝑅𝑅 = 𝑋 100
1,00,000

ARR= 40%

72
Illustration – 2:
X company Limited is considering the purchase of a machine. Two machines are available E and
F. The cost of each machine is ₹ 60,000. Each machine has an expected life of 5 years. Net profits
after depreciation and before tax during the expected life of the machines are given below.
Year Machine E Machine F

1 15,000 5,000

2 20,000 15,000

3 25,000 20,000

4 15,000 30,000

5 10,000 20,000

Total 85,000 90,000

Following the method of Average return on average investment, ascertain which of the
alternatives will be more profitable. The average rate of tax may be taken as 50%

Solution:

Computation of Average Rate of Return for Machine E

Cash
Net Profits
Inflows
After
Tax After
Depreciation
@50% Depreciation
Year and
(b) and After
Before Tax
₹ Tax
(a)
(a-b)
₹
₹
1 15,000 7,500 7,500
2 20,000 10,000 10,000
3 25,000 12,500 12,500
4 15,000 7,500 7,500
5 10,000 5,000 5,000
Total 42,500

73
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐴𝑅𝑅 = X 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Where,
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑇𝑜𝑡𝑎𝑙 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

42,500
= 5

= ₹ 8,500
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
2
60,000
=
2
=₹ 30,000
𝑅𝑠 8,500
𝐴𝑅𝑅 = 𝑅𝑠 30,000 X100

ARR=28.33%

Computation of Average rate of return for Machine F

Net Profits
Cash Inflows
After Less
After
Depreciation Tax
Depreciation
Year and Before @50%
and After Tax
Tax (b)
(₹)
(a) (₹)
(a-b)
(₹)
1 ₹ 5,000 2,500 2,500
2 15,000 7,500 7,500
3 20,000 10,000 10,000
4 30,000 15,000 15,000
5 20,000 10,000 10,000
Total 45,000
74
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Where,
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

45,000
=
5

= ₹ 9,000.

𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
2
60,000
=
2

= ₹ 30,000

₹ 9,000
𝐴𝑅𝑅 = X100
₹ 30,000

ARR=30%

Suggestion:

Machinery E Machinery F

ARR 28.33% 30%

Average Rate of Return on Machine F is more profitable compared to Machine E.

75
Illustration – 3:

A Limited Company has under consideration the following two projects. Their details are as
follows:

Project Project
Particulars
X Y

Investment ₹ 10,00,000 ₹ 15,00,000

Working Capital 5,00,000 5,00,000

Life of the machinery 4 6

Scrap value of the machinery 10% 10%

Tax rate 50% 50%

Income before depreciation and tax at the end of

Year 1 2 3 4 5 6

X 8,00,000 8,00,000 8,00,000 8,00,000 - -

Y 15,00,000 9,00,000 15,00,000 8,00,000 6,00,000 3,00,000

You are required to calculate the average rate of return and suggest which project is to be
preferred.

Solution:

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐿𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡

10
10,00,000− ( 𝑥 10,00,000)
100
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛= 4

10,00,000 − 1,00,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = ₹ 𝟐, 𝟐𝟓, 𝟎𝟎𝟎
4

76
 Computation of ARR for Project X

Cash Inflows
Cash Inflows Tax
After
Before Cash Inflows
Year Depreciation Depreciation @50%
Depreciation After
Before Tax (5=50% on
1 and Tax 3 Depreciation
4=2-3 column 4 and After Tax
2 values)

1 8,00,000 2,25,000 5,75,000 2,87,500 2,87,500

2 8,00,000 2,25,000 5,75,000 2,87,500 2,87,500

3 8,00,000 2,25,000 5,75,000 2,87,500 2,87,500

4 8,00,000 2,25,000 5,75,000 2,87,500 2,87,500

Total cash inflows after depreciation after tax 11,50,000

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

11,50,000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 = = ₹ 2,87,500
4

When working capital and scrap value is given

Average Investment

(Original Investment − Scrap value )

= + Additional Working Capital + Scrap value
2
(𝟏𝟎,𝟎𝟎,𝟎𝟎𝟎−𝟏,𝟎𝟎,𝟎𝟎𝟎 )
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 = + 𝟓, 𝟎𝟎, 𝟎𝟎𝟎 + 𝟏, 𝟎𝟎, 𝟎𝟎𝟎
𝟐

Average Investment =₹ 10, 50,000

77
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

2,87,500
𝐴𝑅𝑅 = 𝑋 100
10,50,000

ARR= 27.38 %

Project Y

Computation of ARR for Project Y

Solution:

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐿𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
10
15,00,000− ( 𝑥15,00,000)
100
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛=
6

15,00,000 − 1,50,000
Depreciation = = ₹ 2,25,000
6

Computation of ARR

Cash Inflows Cash Inflows

Tax @50%
Before After
Year Depreciation on Column 4
Depreciation and Depreciation
1 3 Values
Tax Before Tax
5
2 4
1 15,00,000 2,25,000 12,75,000 6,37,500
2 9,00,000 2,25,000 6,75,000 3,37,500
3 15,00,000 2,25,000 12,75,000 6,37,500
4 8,00,000 2,25,000 5,75,000 2,87,500
5 6,00,000 2,25,000 3,75,000 1,87,500
6 3,00,000 2,25,000 75,000 37,500
Total cash inflows after depreciation and after tax 21,25,000

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

78
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠
21,25,000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 = = ₹ 3,54,167
6

When working capital and scrap value is given

𝑨𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒 )
= + 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
2
+ 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
Scrap value =10% of Investment 10/100 x 15,00,000 =1,50,000
(15,00,000−1,50,000 )
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = + 5,00,000 + 1,50,000
2

Average Investment =₹ 13, 25,000

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

3,54,167
𝐴𝑅𝑅 = 𝑋100
13,25,000

ARR=26.72 %

Suggestion:

Project X Project Y

ARR 27.38% 26.72%

Conclusion: Project X must be accepted since project X has a higher Average rate of return.

79
7.4.2 DISCOUNTED CASH FLOW METHODS [MODERN TECHNIQUES]
Discounted cash flow methods or time adjusted techniques are an improvement over pay
back Method and ARR. Let us throw a light on important types of modern techniques in detail.

A. DISCOUNTED PAYBACK PERIOD METHOD

There are two steps involved in calculating the discounted payback period. First, we must
discount (i.e., bring to the present value) the net cash flows that will occur during each year of the
project.

Second, we must subtract the discounted cash flows from the initial cost figure in order to
obtain the discounted payback period. Once we have calculated the discounted cash flows for each
period of the project, we can subtract them from the initial cost figure until we arrive at zero.

Discounted Payback Period [DPBP]:

Decision criteria:

Case-1: When there is an only one project

Accept the project if the discounted payback period is less than life of the project and reject the
project if the discounted payback period is more than the life of the project

Case-2: When there are alternative projects

Accept the alternative which has the least Discounted Pay Back Period.

Advantages of Discounted Pay Back Period:

1. It considers the concept of time value of money.

2. It recognizes the pattern of cash flow and its timings.

3. It is the best method for evaluating high risk projects.

Disadvantages of Discounted Payback Period

One of the disadvantages of discounted payback period analysis is that it ignores the cash
flows after the payback period. Thus, it cannot tell a corporate manager or investor how the
investment will perform afterward and how much value it will add in total. It may lead to
decisions that contradict the NPV analysis.

80
 A project may have a longer discounted payback period but also a higher NPV than
another if it creates much more cash inflows after its discounted payback period. Such an analysis
is biased against long-term projects.

Practical Example

Illustration – 1:

SK Manufacturing Company uses the discounted payback period to evaluate the investments in
capital assets. The company expects the following annual cash flows from an investment of ₹
35,00,000. The following information is available:

Years Cash flows

0 35,00,000
1 9,00,000
2 9,00,000
3 9,00,000
4 9,00,000
5 9,00,000
6 9,00,000
7 9,00,000
8 9,00,000

Solution:

Given cost of the asset =₹ 35, 00,000

Year Cash Flows PV Factor @12 Present Value of Cumulative

% Cash Flows @12% Cash Inflows

1 9,00,000 0.893 8,03,700 8,03,700

2 9,00,000 0.797 7,17,300 15,21,000

3 9,00,000 0.712 6,40,800 21,61,800

81
 4 9,00,000 0.636 5,72,400 27,34,200

5 9,00,000 0.567 5,10,300 32,44,500

6 9,00,000 0.507 4,56,300 37,00,800

7 9,00,000 0.452 4,06,800 41,07,600

8 9,00,000 0.404 3,63,600 44,71,200

Unrecovered cost
DPBP = Year before full recovery of cost + x 12
Cash flow during the next year

DPBP= 4+ (35, 00,000-32, 44,500/ 4, 56,300) x12

DPBP=4+ (2, 55,500/4, 56,300) x 12

DPBP=4+ (0.55 x12)

4 years and 6 months is the discounted payback period.

Illustration – 2:

A company has to make a choice between two projects namely A and B. The initial capital outlays
of two projects are ₹ 1,35,000 and ₹ 2,40,000 respectively for A and B. Evaluate the projects
under discounted payback period if the cost of capital is 16%.

Year Project A Project B

1 - 60,000

2 30,000 84,000

3 1,32,000 96,000

4 84,000 1,02,000

5 84,000 90,000

82
Solution:

Computation of Discounted Payback Period for Project A

Original Cost of Project A is ₹ 1,35,000

PV of Cumulative
PV Factor
Year Project A Cash
@ 16% Cash Inflows
Inflows

1 - 0.862 0 0

2 30,000 0.743 22,290 22,290

3 1,32,000 0.641 84,612 1,06,902

4 84,000 0.552 46,368 1,53,270

5 84,000 0.476 39,984 1,93,254

Unrecovered cost
DPBP = Year before full recovery of cost + x 12
Cash flow during the next year

1,35,000−1,06,902
DPBP= 3+ X 12
46,368

28,098
DPBP= 3+ X 12
46,368

DPBP= 3years and 7 months.

83
 Computation of Discounted Payback Period for Project B

Original Cost of Project B is ₹ 2, 40,000

PV factor @ PV of cash Cumulative

Year Project A
16% inflows Cash inflows

1 60,000 0.862 51,720 51,720

2 84,000 0.743 62,412 1,14,132

3 96,000 0.641 61,536 1,75,668

4 1,02,000 0.552 56,304 2,31,972

5 90,000 0.476 42,840 2,74,812

Unrecovered cost
DPBP = Year before full recovery of cost + x 12
Cash flow during the next year

2,40,000−2,31,972
DPBP= 4+ X 12
42,840

8,028
DPBP= 4+ X 12
42,840

DPBP= 4 Years and 2 months

Interpretation:

The Discounted Payback period of Project A is 3 Years and 7 months whereas for Project B it is 4
years and 2 months. Hence Project A should be accepted since it has a lesser discounted payback
period compared to project B.

7.5.2 Net Present Value Method

Net present value (NPV) is the difference between the present value of cash inflows and
the present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyse the profitability of a projected investment or project. NPV is the
result of calculations used to find today’s value of a future stream of payments.

84
Positive vs. Negative NPV

A positive NPV indicates that the projected earnings generated by a project or investment
in present rupees exceed the anticipated costs, also in present rupees. It is assumed that an
investment with a positive NPV will be profitable.

An investment with a negative NPV will result in a net loss. This concept is the basis for
the Net Present Value Rule, which dictates that only investments with positive NPV values
should be considered.

Steps involved in computation of NPV:

(I) Forecasting of cash inflows of the investment project based on realistic assumptions
(II) Computation of cost of capital which is used as a discounting factor for conversion of
future cash inflows into present values
(III) Calculation of Present value cash flows using cost of capital as discounting rate
(IV) Finding out NPV by subtracting Present value of cash outflows from Present value of
cash inflows.
Decision criteria

Case-1: When there is an only one asset

Accept the asset if NPV is positive (or) reject the asset when NPV is negative.

Case-2: When there is an alternative

Accept the asset which has highest NPV among the available alternatives.

Advantages:

1. It recognizes the time value of money.

2. It considered the cash inflow of the entire project.

3. It estimates the present value of their cash flows using a discount rate equal to the cost
of capital.

4. It is consistent with the objective of maximizing the welfare of the owners.

85
Disadvantages:

1. NPV method is based on discount rate. In a real life situation its very difficult to
understand the concept of cost of capital.

2. It may not give reliable answers when dealing with alternative projects under the
conditions of unequal lives of projects.

*Note: In case of Net Present value method Cash Inflows after Tax and before
Depreciation should be considered.

Illustration – 1:
From the following information compute Net Present value of the project X The cost of the project
is ₹ 25,000 and it is expected that the project would generate annual cash inflows of ₹ 9,000, ₹
8,000, ₹ 7,000, ₹ 6,000 and ₹ 5,000. The cost of capital may be assumed @10% .Calculate the Net
present value of the project.
Solution:
Present
PV
Cash value of
Year factor @
inflows Cash
10%
Inflows
1 0.909 9,000 8181
2 0.826 8,000 6608
3 0.751 7,000 5257
4 0.683 6,000 4098
5 0.621 5,000 3105
27,249

Net present value = Total of the Present value of the cash inflows– Capital investment
Net present value = 27,249-25,000
NPV= ₹ 2249.

86
Illustration – 2:
ABC Company is planning to purchase machinery. Two alternative machines, Machine A and
Machine B are selected for evaluation, each costing ₹ 3, 00,000. The cash inflows after tax but
before depreciation tax are as follows.
Year Machine A Machine B
1 20,000 40,000
2 65,000 1,10,000
3 90,000 1,20,000
4 1,50,000 1,40,000
5 1,75,000 2,00,000

Evaluate the projects under NPV method by considering the cost of capital to be 10%

Solution:
Machine A
PV of
Cash Inflows After PV
Cash
Year Tax But Before Factor
Inflows
Depreciation @10%
@10%
1 20,000 0.909 18,180
2 65,000 0.826 53,690
3 90,000 0.751 67,590
4 1,50,000 0.683 1,02,450
5 1,75,000 0.621 1,08,675
Total of Present Value of Cash 3,50,585
Inflows @10%
Net present value = Total of the Present value of the cash inflows – Capital investment
Net present value = ₹3, 50,585-₹3,00,000
Net Present Value of Machine A = ₹ 50,585

87
 Machine B
Cash Inflows
After Tax But PV Factor PV of Cash
Year
Before @10% Inflows @10%
Depreciation
1 40,000 0.909 36360
2 1,10,000 0.826 90860
3 1,20,000 0.751 90120
4 1,40,000 0.683 95620
5 2,00,000 0.621 124200
Total of Present value of cash inflows @10% 4,37,160
Net present value = Total of the Present value of the cash inflows – Capital investment
Net present value = ₹ 4,37,160 – ₹ 3,00,000
Net present value of Machine B = ₹ 1, 37,160
Particulars Machine A Machine B
NPV ₹50,585 ₹1,37,160
Interpretation: Since Machine B has higher NPV, Machine B can be accepted
Illustration – 3:
Kushal Company Limited is considering the purchase of a new machine. Two alternative
machines A and B have been suggested, each costing ₹ 4,00,000. Cash inflows after tax and
before depreciation are to be as follows. The cost of Capital is assumed to be 10%.

Year Cash Flows

Machine A Machine B
₹ ₹
1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000

88
Considering the NPV method, which project can be accepted?
Solution:
Computation of NPV of Machine A
Cash Inflows
PV PV of Cash
After Tax But
Year Factor Inflows
Before
@ 10% @10%
Depreciation
1 40,000 0.909 36,360
2 1,20,000 0.826 99,120
3 1,60,000 0.751 1,20,160
4 2,40,000 0.683 1,63,920
5 1,60,000 0.621 99,360
Total 5,18,920
Net present value = Total of the Present value of the cash inflows – Capital investment
Net present value = ₹5, 18,920-₹4, 00,000
Net present value of Machine A = ₹ 1,18,920
Computation of NPV of Machine B
Cash Inflows
PV of cash
After Tax But PV factor
Year inflows
Before @ 10%
@10%
Depreciation
1 1,20,000 0.909 1,09,080
2 1,60,000 0.826 1,32,160
3 2,00,000 0.751 1,50,200
4 1,20,000 0.683 81,960
5 80,000 0.621 49 ,680
Total 5,23,080

Net present value = Total of the Present value of the cash inflows – Capital investment
Net present value = ₹5, 23,080 -₹4, 00,000
Net Present Value of Machine B =₹ 1,23,080

89
 Particulars Machine A Machine B
NPV ₹1,18,920 ₹1,23,080

Interpretation: NPV of Machine B is more than the NPV of Machine A, hence Machine A
can be accepted.
Illustration – 4:
Hitha Company Limited is considering making an investment in a project which requires a capital
outlay of ₹ 2,00,000.The forecasted annual income after depreciation but before tax are as follows:
Annual income after
Year depreciation but before tax
₹
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000

Compute NPV considering the cost of capital @10% and the tax rate to be taken as 50%.
Depreciation should to take as 20% on investment.
Solution:
Note: For computation of NPV, the cash inflows before depreciation and after tax are to be
considered
However the cash inflow after depreciation and before tax has been given hence calculations
should be made to bring it to the required format and then must proceed.
1. Depreciation=20% on Investment
Depreciation = 20/100 x 2, 00,000
=₹ 40,000

90
 Annual
Annual Income Annual Income
Tax@50% Income After
After Before
Year on Depreciation Depreciation
Depreciation Depreciation
1 Column and After 5
but Before Tax After Tax
3 Tax
2 6=4+5
4=2-3
1 1,00,000 50,000 50,000 40,000 90,000
2 1,00,000 50,000 50,000 40,000 90,000
3 80,000 40,000 40,000 40,000 80,000
4 80,000 40,000 40,000 40,000 80,000
5 40,000 20,000 20,000 40,000 60,000

Computation of NPV:

Annual Income Present

Discount
Before Value of
Year Factor
Depreciation Cash Inflows
1 at 10%
but After Tax @10%
3
2 4=2x3
1 90,000 0.909 81,810
2 90,000 0.826 74,340
3 80,000 0.751 60,080
4 80,000 0.683 54,640
5 60,000 0.621 37,260
Total Present Value Cash Inflows 3,08,130

Net present value = Total of the Present value of the cash inflows – Capital investment
Net present value = ₹3, 08,130- ₹ 2, 00,000
Net Present Value of the Project= ₹1, 08,130

91
7.5.3 PROFITABILITY INDEX METHOD OR BENEFIT COST RATIO METHOD.
It’s also time adjusted method of evaluating the investment proposals. PI Is the relationship
between present value of cash inflows and present value of cash out flows.

𝑷𝑽 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘
𝑷𝑰 =
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

*Note: In case of Profitability Index method Cash Inflows after Tax and before
Depreciation should be considered

Decision criteria

Case-1: When there is an only one asset

The proposal is accepted if the PI is more than one and it’s rejected in case of PI is less than one.

Accept the asset if Discounted Payback Period less than life of the asset and vice-versa.

Case-2: When there is an alternative

Accept the alternative which has the highest profitability index.

Advantages:

1. It considers the concept of time value of money.

2. It recognizes the pattern of cash flow and its timings.

3. It is the best method for evaluating high risk projects.

Illustration – 1:

The cost of a project is ₹ 50,000 and it generates cash inflows of ₹ 20,000, ₹ 15,000,₹ 25,000, and
₹10, 000 over four years. Compute NPV and Profitability Index for the project.

Solution:

The first step is to calculate the present value and profitability index

92
 Present
Present
Year Cash Inflows Value of ₹
Value
1@10%

1 20,000 0.909 18,180

2 15,000 0.826 12,390

3 25,000 0.751 18,775

4 10,000 0.683 6,830

Total present value 56,175

Total present value = ₹ 56,175

Less: Initial outlay = ₹ 50,000
Net present value = ₹ 6,175

𝑷𝑽 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘
𝑷𝑰 =
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

PI = 56,175 / 50,000
PI = 1.1235

Interpretation: Given that the profitability index (PI) is greater than 1.0, hence we can accept the
proposal.

Illustration – 2:

The initial investment of a project is ₹1,00,000 and it generates cash inflows of ₹ 40,000,₹ 30,000,
₹ 50,000 and ₹ 20,000. Assume a 10% rate of discount. Calculate the Profitability index.

93
Solution:

Present
Present
Year Cash Inflows Value of Re
Value
1@10%

1 40,000 0.909 36,360

2 30,000 0.826 24,780

3 50,000 0.751 37,550

4 20,000 0.683 13,660

Total present value 1,12,350

𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤
𝑃𝐼 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

1,12,350
PI=
1,00,000

PI=1.12 Units

7.5.4 INTERNAL RATE OF RETURN METHOD [IRR]:

IRR is the rate at which the sum of discounted cash inflows equals the sum of discounted
cash inflow. It is that rate at which the NPV of the investment is zero.

*Note: In case of Internal Rate of Return Method Cash Inflows before Depreciation
and after Tax should be considered

a. To calculate the internal rate of return when the cash inflows are uniform

I
F=
C

94
 Where F=Factor to be located

I=Initial Investment

C=Cash inflow per year

1. An equipment requires an initial investment of ₹ 6,000.The annual cash flow is estimated at ₹

2,000 for 5 years. Calculate the internal rate of return.

Solution:
I
F=C

₹ 6,000
𝐹=
₹ 2,000

F=3

b. Where cash inflows are not uniform

When cash inflows are not uniform, the internal rate of return is calculated by making trial
calculations in an attempt to compute the correct interest rate which equates the present value of
cash inflows with the present value of cash outflows. In the process, cash inflows are to be
discounted by a number of trial rates. The first trial rate may be calculated on the basis of the same
formula which is used for determining the internal rate of return when cash inflows are uniform.

After applying the first trial rate the second trial rate is determined when the total present
value the of the cash inflows is greater or less than the total present value of the cash outflows.

Decision criteria

Case-1: When there is an only one asset

Accept the asset if IRR is more than the minimum required rate of return, reject the asset if IRR is
less than minimum rate of return.

Case-2: When there is an alternative

Accept the alternative which has the highest IRR and higher than the cost of capital.

Advantages:

1. It considers the time value of money.

95
 2. Calculation of cost of capital is not a perquisite for adopting IRR.

3. IRR attempts to find the maximum rate of interest at which funds invested in the
project could be repaid out of the cash inflows arising from the projects.

4. It is not in conflict with the concept of maximizing the welfare of equity share holders.

5. It considered cash inflows throughout the life of the project.

Disadvantages:

1. Computation of IRR technical and difficult to understand.

2. Both NPV and IRR assume that the cash inflow can be reinvested at the discounting
rate in the new projects.

3. It may give result inconsistent with NPV method.

Illustration – 1:

A company has to select one of the following two projects.

Particulars Project A Project B

Cost ₹ 11,000 ₹ 10,000

Cash Inflows
Year
A B

Year 1 6,000 1,000

Year 2 2,000 1,000

Year 3 1,000 2,000

Year 4 5,000 10,000

Using the Internal Rate of Return Method suggest which project is preferable.

96
Solution:

Project A

Cash Present Value of

Inflows Discounting Cash Inflows at 10%
Year
Factor @ 10%
(₹) (₹)

1 6,000 0.909 5,454

2 2,000 0.826 1 ,652

3 1,000 0.751 751

4 5,000 0.683 3,415

Present value of Cash inflows @10% 11,272

The present value at 10% comes to ₹ 11,272. The initial investment is ₹ 11,000 .Internal
rate of return may be taken approximately at 10%. In case more exactness is required another trial
rate which is slightly higher than 10% (since at this rate the present value is more than initial
investment) may be taken. Taking a rate of 12%, the following results would emerge:

Present Value of
Cash inflows Discounting cash inflows at
Year 12%
(₹) factor @12%
(₹)

1 6,000 0.893 5,358

2 2,000 0.797 1,594

3 1,000 0.712 712

4 5,000 0.636 3,180

Present value of cash inflows @ 12 % 10,844

The Internal rate of return is thus more than 10% but less than 12%. The exact rate is thus
more than 10% but less than 12%. The exact rate may be calculated as follows:

97
 𝑪– 𝑶
𝑰𝑹𝑹 = 𝑨 + × (𝑩 – 𝑨)
𝑪−𝑫

Where,

A = Discount factor of lower trial rate.

B = Discount factor of higher trial rate.

C = PV of cash inflows at lower trial rate.

D = PV of cash inflows at higher trial rate.

O = Original outlay/ initial cash outlay.

C–O
IRR = A + × (B – A)
C−D

11,272−11,000
IRR = 10% + X (12-10)
11,272−10844

272
IRR = 10% + × (2)
428

IRR=11.3%

The exact internal rate of return can also be calculated as follows:

At 10% the present value is +272

At 12% the present value is -156

The internal rate would, therefore be between 10% and 12 % .

98
 Project B

Present Value of
Cash Inflows Discounting Factor @
Year Cash Inflow @
(₹) 15%
15% (₹)

1 1,000 0.870 870

2 1,000 0.756 756

3 2,000 0.658 1,316

4 10,000 0.572 5,720

Present value of Cash inflows @ 15% 8,662

Since present value at 15% comes only to ₹ 8,662, a lower rate of discount should be taken.
Taking a rate of 10%, the following will be the result.

Present Value of
Cash Inflows Discounting
Year Cash Inflow @ 10%
(₹) Factor @ 10%
(₹)

1 ₹ 1,000 0.909 ₹ 909

2 1,000 0.826 826

3 2,000 0.751 1,502

4 10,000 0.683 6,830

Present value of Cash inflows @ 10% 10,067

The present value at 10% comes to ₹ 10,067 which is more or less equal to the initial
investment. Hence, the interest rate of return may be taken as 10%

In order to have more exactness, the internal rate of return can be interpolated as done in
case of project A.

99
At 10% the present value is +67

At 15% the present value is -1,338

67
= 10% + 𝑥5
67 + 1.338

67
=10+ X5
67+1.338

=10+.24=10.24%

Or

C−O
 IRR =A+ =(B-A)
C−D
10,067−10,000
= 10% + (15-10)
10,067−8,662
67
= 10% + X5
1405

= 10%+0.24%

= 10.24%

Interpretation:

Thus, Internal Rate of Return in case of Project “A” is higher as compared to Project. Hence,
Project A is preferable.

Illustration – 2:
From the following details compute IRR.
A Limited Company is considering investing in a project requiring a capital outlay of ₹ 2, 00,000.
Forecasted annual incomes are as follows

100
 Year Cash Inflows
(₹)

1 90,000

2 90,000

3 80,000

4 80,000

5 60,000

Solution:

Since the annual cash inflows are not uniform, the factor will have to be located for determining
the approximate rate of return

I
F=
C

Where F=Factor to be located

I=Initial Investment

C=Average annual cash inflows

2,00,000
F= 80,000

F=2.5

When we look at PV table the factor rate of return in column for 5 years is 28% .Therefore the
present value at 28% is as follows:

Present Value
Cash Inflows Discount factor of Cash
Year
₹ @28% Inflows
₹

1 90,000 0.781 70,290

2 90,000 0.610 54,900

101
 3 80,000 0.477 38,160

4 80,000 0.373 29,840

5 60,000 0.291 17,460

Total Present Value of Cash Inflows 2,10,650

Less: Initial Investment 2,00,000

Net Present Value 10,650

At 28% discounting rate, the present value is higher by ₹ 10,650. Hence a higher discounting rate
should be taken. Taking it at 30%.

Present
Cash Inflows Discount Value of
Year Factor @ Cash Inflow
₹ 30%
₹

1 90,000 0.769 69,210

2 90,000 0.592 53,280

3 80,000 0.455 36,400

4 80,000 0.350 28,000

5 60,000 0.269 16,140

Total Present Value of Cash Inflows 2,03,030

Less: Initial Investment 2,00,000

Net Present Value 3,030

The present value at 30% is higher by ₹ 3,030. The internal rate of return will, therefore,
by slightly higher than 30% .Though exact interpolation can be done, it would not affect much the
management decision. Hence, the rate may be taken as 30%.

Judging from all angles, the investment in the new project seems to be fairly attractive.

102
 Illustration – 3:

A company is considering two mutually exclusive projects. Both requires an initial investment of
₹ 50,000 each and has a life of five years. The cost of capital of the company is 10% and tax rate
is 50% .The depreciation is charged on straight line method. The estimated net cash inflows
(before depreciation and tax) of the two projects are as follows:

Year Project A Project B

₹ ₹

1 20,000 30,000

2 22,000 27,000

3 28,000 22,000

4 25,000 25,000

5 30,000 20,000

Which project should be accepted as per NPV and IRR methods?

Solution:

Project A

For computation of NPV and IRR we need Cash inflows after Tax and before Depreciation

Computation of NPV of Project A

Cash Inflows Profit Profit After Profit After

Less Add
Before After Depreciatio Tax and
Depreciation Tax Depreciation
Depreciation Depreci n and After Before
Year (b) @50%
and Tax
₹
ation
(d)
Tax (f) Depreciation
(a) (c=a-b)
₹
(e=c-d) ₹ (g=e+f)
₹ ₹ ₹ ₹
1 20,000 10,000 10,000 5,000 5,000 10,000 15,000

2 22,000 10,000 12,000 6,000 6,000 10,000 16,000

103
3 28,000 10,000 18,000 9,000 9,000 10,000 19,000

4 25,000 10,000 15,000 7,500 7,500 10,000 17,500

5 30,000 10,000 20,000 10,000 10,000 10,000 20,000

Profit After Tax but Present Value of

Discount
Before Depreciation Cash Inflow @ 10%
@10%
₹ ₹

15,000 0.909 13,635

16,000 0.826 13,216

19,000 0.751 14,269

17,500 0.683 11,952,

20,000 0.621 12,420

Total Present Value of Cash inflows 65,492

Less: Initial Investment -50,000

Net Present Value (NPV) 15,492

104
 Project B

Computation of NPV of Project B

Profit
Cash Inflows Profit After After
Less
Before Less Profit After Depreciatio Add Tax but
Tax
Depreciation Depreciation Depreciation n and Depreciation Before
Year @50%
and Tax (b) (c=a-b) AFTER Tax (f) Depreci
(d)
(a) (₹) (₹) (e=c-d) (₹) ation
(₹)
(₹`) (₹) (g=e+f)
(₹)
1 30,000 10,000 20,000 10,000 10,000 10,000 20,000

2 27,000 10,000 17,000 8,500 8,500 10,000 18,500

3 22,000 10,000 12,000 6,000 6,000 10,000 16,000

4 25,000 10,000 15,000 7,500 7,500 10,000 17,500

5 20,000 10,000 10,000 5,000 5,000 10,000 15,000

Profit after tax but before Discount @10% Present Value of cash
depreciation inflow @ 10%

20,000 0.909 18,180.00

18,500 0.826 15,281.00

16,000 0.751 12,016.00

17,500 0.683 11,952.00

15,000 0.621 9,315.00

Total Present Value of Cash inflows 66,744.50

Less: Initial Investment -50,000.00

Net Present Value(NPV) 16,744.50

105
Interpretation:

Since NPV of Project B is higher than that of Project A, it is recommended to adopt Project B.

IRR Method

In order to determine IRR, it will be appropriate to ascertain the trial rate of return. This can be
done as follows:

I
F=
C

Where F=Factor to be located

I=Initial Investment

C=Average annual cash inflows

Project A

50,000
F=
17,500

F=2.86

On looking to table of Present values of Re 1 for ‘n’ years in the line of 5 years, the trial rate
comes to 22%

Project B:

I
F=
C
50,000
F=
17,500

F=2.87

In the case of project B the trial rate will also be 22%

106
 Net Cash Discounted Cash
Inflows Discount Factor Inflows
Year
@ 22%
₹ ₹

1 15,000 0.820 12,300

2 16,000 0.672 10,752

3 19,000 0.551 10,469

4 17,500 0.451 7,892

5 20,000 0.370 7,400

Present value of cash inflows @ 22% 48,813

At 22% the present value of cash inflows is less than ₹ 50,000 i.e., the initial investment.
Hence a lower rate of return should be used for discounting the cash flows. In case the rate is
taken at 18%, the discounted cash inflows will be as follows;

Discounted
Net Cash Discount
Cash
Year Inflows Factor@
Inflows
(₹) 18%
(₹)
1 15,000 0.847 12,705

2 16,000 0.718 11,488

3 19,000 0.609 11,571

4 17,500 0.516 9,030

5 20,000 0.437 8,740

PV of cash inflow @ 18% 53,534

At 22% Total present value of cash inflows =48,813

At 18% Total present value of cash inflows=53,534

107
 C– O
IRR = A + × (B – A)
C−D

Where,

A = Discount factor of lower trial rate.

B = Discount factor of higher trial rate.

C = PV of cash inflows at lower trial rate.

D = PV of cash inflows at higher trial rate.

O = Original outlay/ initial cash outlay.

53,534−50,000
IRR = 18% + × (22 − 18)
53,534−48,813

3,534
IRR = 18% + × (22 − 18)
4721

IRR=18%+2.994

IRR=20.99 i.e. 21%

a) Project B

Net Cash Discounted

Discount Factor@
Year Inflows Cash Inflows
22%
₹ ₹

1 20,000 0.820 16,400

2 18,500 0.672 12,432

3 16,000 0.551 8,816

4 17,500 0.451 7,892

5 15,000 0.370 5,550

Present value of cash inflows @22% 51,090

108
 At 22%, the Present value is higher than the initial investment, hence a higher trial rate say 25%
may be used.

Net Cash Discount Discounted

Year Inflows Factor@ Cash Inflows
₹ 25% ₹

1 20,000 0.800 16,000

2 18,500 0.640 11,840

3 16,000 0.512 8,192

4 17,500 0.410 7,175

5 15,000 0.328 4,920

Present value of cash inflows 48,127

@25%

C– O
IRR = A + × (B – A)
C−D

Where,

A = Discount factor of lower trial rate.

B = Discount factor of higher trial rate.

C = PV of cash inflows at lower trial rate.

D = PV of cash inflows at higher trial rate.

O = Original outlay/ initial cash outlay

51,090−50,000
IRR = 22% + × (25 − 22)
51,090−48,127

1,090
IRR = 22% + × (3)
2963

IRR=22%+1.104

IRR=23.10%

109
 Project A Project B

IRR 21% 23.1%

NPV 15,492 16,744.50

Since IRR of Project B is greater than Project A, Project B is preferable

Since NPV of Project B (16,744) is greater than NPV of Project A (15,492), Project B is
preferable.

Problems on different techniques of capital budgeting

Illustration – 1:

A Limited Company is considering investing in a project requiring a capital outlay of ₹ 2, 00,000.

The forecasted annual income after depreciation but before tax is as follows:

Year ₹

1 1,00,000

2 1,00,000

3 80,000

4 80,000

5 40,000

Depreciation may be taken as 20% on original cost and taxation at 50% of net income.

You are required to evaluate the project according to each of the following methods.

a) Payback Period Method

b) Average Rate of Return Method

c) Net Present Value Method @10%

d) Profitability Index Method.

110
Solution:

Note: For computation of Payback period, Net present value method, Internal Rate of Return
method and Profitability index method, the Cash inflows after tax and before depreciation should
be considered

In case of Average rate of return method, the Cash inflows after depreciation and after tax
should be considered.

Solution:

Cash Inflows
Cash Inflows Cash Inflows
Before
After Tax Add Before
Depreciation
Depreciation @50% Depreciation Depreciation
but After
Year and Before Tax and After Tax
(b) Tax (d)
(a) (e=c+d)
₹ (c=a-b) ₹
₹ ₹
₹

1 1,00,000 50,000 50,000 40,000 90,000

2 1,00,000 50,000 50,000 40,000 90,000

3 80,000 40,000 40,000 40,000 80,000

4 80,000 40,000 40,000 40,000 80,000

5 40,000 20,000 20,000 40,000 60,000

20
 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 100 𝑥 2,00,000

 Depreciation=40,000

111
1. Payback period

Cash Inflows After Tax Cumulative

Year and Before Depreciation Cash Inflows

₹ ₹

1 90,000 90,000

2 90,000 1,80,000

3 80,000 2,60,000

4 80,000 3,40,000

5 60,000 4,00,000

The above table shows that in two years ₹ 1, 80,000 have been recovered. ₹ 20,000 are left
out of the initial investment. In the third year, the cash inflow is ₹ 80,000. It means the payback
period is between second and third year, which is ascertained as follows:

20,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 2 𝑦𝑒𝑎𝑟𝑠 +
80,000

Payback Period=2.25 years

2. Net present value method

Cash Inflows
Discount Present
After Tax
Factor @ Value of
Year and Before
10% Cash Inflows
Depreciation
₹ ₹
₹

1 90,000 0.909 ₹ 81,810

2 90,000 0.826 74,340

3 80,000 0.751 60,080

112
 4 80,000 0.683 54,640

5 60,000 0.621 37,260

Present Value of Cash Inflows 3,08,130

Less: Initial Investment 2,00,000

Net Present Value ₹ 1,08,130

3. Profitability Index Method

PV of cash inflow
PI =
Initial Investment
3,08,130
PI =
2,00,000

PI=1.54 units

Illustration – 2:
Determine the average rate of return from the following data of two Machines A and B
Particulars Machine A Machine B

Original Cost 56,125 56,125

Additional investment in
net working capital 5,000 6,000
Estimated life in Years 5 5
Estimated salvage value 3,000 3,000
Average income tax rate 55% 55%
Annual estimate income
after depreciation and tax
1st Year 3,375 11,375
2nd Year 5,375 9,375
3rd Year 7,375 7,375
th
4 Year 9,375 5,375
5th Year 11,375 3,375
36,875 36,875

113
Depreciation has been charged on straight line basis.

Solution:
Machine A
Particulars Machine A

Annual estimate income

after depreciation and tax
3,375
1st Year
5,375
2nd Year
7,375
3rd Year
9,375
4th Year
11,375
5th Year
36,875
Total

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠
𝟑𝟔,𝟖𝟕𝟓
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒂𝒏𝒏𝒖𝒂𝒍 𝒑𝒓𝒐𝒇𝒊𝒕𝒔 𝒂𝒇𝒕𝒆𝒓 𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 = = ₹ 7,375
𝟓

When working capital and scrap value is given

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
(𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 − 𝑺𝒄𝒓𝒂𝒑 𝒗𝒂𝒍𝒖𝒆 )
=
𝟐
+ 𝑨𝒅𝒅𝒊𝒕𝒊𝒐𝒏𝒂𝒍 𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 + 𝑺𝒄𝒓𝒂𝒑 𝒗𝒂𝒍𝒖𝒆

(56,125 − 3000)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = + 5,000 + 3,000
2

Average Investment =53,125/2+5,000+3,000

Average Investment= 26,562.5+8,000
Average Investment= ₹ 34,562.50
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 ₹ 7,375
𝐴𝑅𝑅 𝑓𝑜𝑟 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐴 = x 100
₹ 34,562.50

ARR for Machine A =21.34%

Machine B
Particulars Machine B

Annual estimate income

after depreciation and tax
1ST Year 11,375
2nd Year 9,375
3rd Year 7,375
4th Year 5,375
5th Year 3,375

36,875

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠
𝟑𝟔,𝟖𝟕𝟓
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒂𝒏𝒏𝒖𝒂𝒍 𝒑𝒓𝒐𝒇𝒊𝒕𝒔 𝒂𝒇𝒕𝒆𝒓 𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 = = 7,375
𝟓

When working capital and scrap value is given

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
(𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 − 𝑺𝒄𝒓𝒂𝒑 𝒗𝒂𝒍𝒖𝒆 )
=
𝟐
+ 𝑨𝒅𝒅𝒊𝒕𝒊𝒐𝒏𝒂𝒍 𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 + 𝑺𝒄𝒓𝒂𝒑 𝒗𝒂𝒍𝒖𝒆
(𝟓𝟔, 𝟏𝟐𝟓 − 𝟑, 𝟎𝟎𝟎)
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 = + 𝟔, 𝟎𝟎𝟎 + 𝟑, 𝟎𝟎𝟎
𝟐

Average Investment =53,125/2+6,000+3,000

115
 = 26,562.5+9,000
= ₹ 35,562.5
₹ 𝟕,𝟑𝟕𝟓
𝐴𝑅𝑅 𝑓𝑜𝑟 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐵 = x 100
₹ 𝟑𝟓,𝟓𝟔𝟐.𝟓𝟎

ARR for Machine B =20.75%

Machine A Machine B

21.34% 20.75%
ARR

Illustration – 3:

A company has an investment opportunity costing ₹ 40,000 the following expected net cash flow
after taxes and before depreciation.

Net Cash Flow

Year
₹
1 7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 4,000
Using 10% as the cost of capital determine the following:

(a) Payback period

(b) Net present value at 10% discount factor
(c) Profitability index at 10% discount factor

116
Note:

Present value of
Year
Re 1 @ 10%

1 0.909

2 0.826

3 0.751

4 0.683

5 0.621

6 0.564

7 0.513

8 0.467

9 0.424

10 0.386

Solution:

a) Computation of payback period

Year Cash Cumulative

Flows Cash Flows
₹ ₹

1 7,000 7,000

2 7,000 14,000

3 7,000 21,000

4 7,000 28,000

5 7,000 35,000

6 8,000 43,000

117
 7 10,000 53,000

8 15,000 68,000

9 10,000 78,000

10 4,000 82,000

The above table shows that in five years ₹ 35,000 has been recovered. ₹ 5,000 are left out
of the initial investment. In the sixth year, the cash inflow is ₹ 8,000. It means the payback
period is between five to six years, which is ascertained as follows:

5,000
Payback Period = 5 years +
8,000

Payback Period=5 Years and 6 months

(b) Calculation of Net Present Value @10% Discount Rate

Net Cash Inflow Present Value of PV of Cash

Year
(col.2) Discount Rate of 10% Inflow
(col.1)
₹ (col.3) ₹
1 7,000 0.909 6,363
2 7,000 0.826 5,782
3 7,000 0.751 5,257
4 7,000 0.683 4,781
5 7,000 0.621 4,347
6 8,000 0.564 4,512
7 10,000 0.513 5,130
8 15,000 0.467 7,005
9 10,000 0.424 4,240
10 4,000 0.386 1,544
Total present value of cash inflow 48,961
Net Present Value = Total Present Value of Cash inflow - Initial investment
= ₹ 48,961 - 40,000 = 8,961

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 (c) Calculation of Profitability Index @10% Discount Rate

Present Value of Cash Inflows

Profitability Index = Initial investment

48,961
PI = = 1.22 units
40,000

7.6 CHECK YOUR PROGRESS

Fill in the blanks with suitable answers:

1. The term ______ refers to the long term planning for proposed capital outlays and their
financing.

2. The term PBP refers to the period in which the project will generate the necessary cash to
recover the ______.

3. The accounting rate of return (ARR) method is also known as the ______.

4. When working capital and scrap value is given average investment under ARR can be
computed by ______.

5. The formula to calculate Profitability Index =______.

Answer to Check Your Progress

1. Capital Budgeting
2. Initial investment
3. Return on Investment Method (ROI) method.
4. 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
(Original Investment−Scrap value )
+ Additional Working Capital + Scrap value
2
Present Value of Cash Inflows
5. Profitability Index = Initial investment

7.7 SUMMARY
Any business organisation has to face quite often the problem of capital investment
decisions. Capital investment refers to the investment in projects whose results would be available
only after a year. The investments in these projects are quite heavy and to be made immediately,
119
but the return will be available only after a period of time. The term ‘Capital Budgeting’ refers to
the long –term planning for proposed capital outlays and their financing. Thus, it includes both
raising of long –term funds as well as their utilisation. It may thus be defined as “the firm’s formal
process for the acquisition and investment of capital”. It is the decision making process by which
the firms evaluate the purchase of major fixed assets. It involves firm’s decision to invest its
current funds for addition, disposition, modification and replacement of long term or fixed assets.
However, it should be noted that investment in a fixed assets, is also to be taken as a capital
budgeting decision.

Capital budgeting is a many sided activity. It includes searching for new and more
profitable investment proposals, investigating engineering and marketing considerations to predict
the consequences of accepting the investment and making economic analysis to determine the
profit potential of each investment proposal.

7.8 KEYWORDS
Capital Budgeting : Long term planning for proposed capital outlays.

Payback Period : The time period in which a project will be able

to generate the necessary cash to recover the
initial investment.

Discount Rate : It is the interest rate used to determine the

present value of future cash flows in a
discounted cash flow (DCF) analysis.

Present Value : This concept states that an amount of money

today is worth more than that same amount in
the future.

Initial Investment : Original amount required to start a business or a

project.

7.9 QUESTIONS FOR SELF-STUDY

1. A project requires an initial investment of ₹100000 and yields annual cash inflow of ₹20000
for seven years. What is the payback period?

120
2. A project requires ₹250000 as initial investment. It will generate annual cash flow of
₹42000 for eight years. What is the payback period?
3. Determine the payback period for a project which requires a cash outlay of ₹ 1,00,000 and
generate cash inflow of ₹20,000 ₹40,000,₹30,000 and ₹20,000 in the first, second, third and
fourth year respectively.
4. A company is requiring a machine which requires an investment of ₹160000. the net income
before tax and depreciation is estimated as follows:
Year ₹

56,000
1
48,000
2
30,000
3
64,000
4
80,000
5

Depreciation is to be charges on straight line basis. The tax rate is 40%. Calculate ARR.
5. Calculate the average rate of return for projects A & B from the following:
Project Project
A B
Investments (₹) 20,000 30,000
Expected life (no salvage value) 4 years 5 years
Projected net income (after 5 5
interest, deprn & taxes)
1 2,000 3,000
2 1,500 3,000
3 1,500 2,000
4 1,000 1,000
5 - 1,000
6,000 10,000

121
6. The following two projects A & B require an investment of ₹200000 each. The income returns
after tax for these projects are as follows:

Project Project
Year A B
(₹) (₹)
80,000 20,000
1
80,000 40,000
2
40,000 40,000
3
20,000 40,000
4
- 60,000
5
- 60,000
6
Using the criteria, determine which of the projects is preferable:

1. ARR method
2. NPV, using PV approach if the company’s cost of capital is 10%.
3. Profitability Index Method.

7.10 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill- Tenth
Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh edition-
2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-Eleventh
Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya Publishing
House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and Sons-
Fifteenth Edition-2019.

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UNIT-8 RISK ANALYSIS IN CAPITAL BUDGETING
Structure:
8.0 Objectives

8.1 Introduction

8.2 Types of Risks

8.3 Techniques of Measuring Risk in Capital Budgeting

8.3.1. Statistical Techniques

8.3.2 Conventional Techniques

8.3.3 Other Techniques of Risk analysis in Capital Budgeting

8.4 Check Your Progress

8.5 Summary

8.6 Keywords

8.7 Questions for Self-Study

8.8 References

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8.0 OBJECTIVES
After studying this unit, you will be able to;

 Discuss the various types of risks involved in capital budgeting decisions

 Analyse the steps involved in decision tree analysis
 Examine the various techniques of measuring risk in capital budgeting
 Compute the problems on decision tree analysis

8.1 INTRODUCTION
While discussing the capital budgeting techniques in unit - 7, we have assumed that the
investment proposals do not involve any risk and cash flows of the project are known with
certainty. This assumption was taken to simplify the understanding of the capital budgeting
techniques. However, in practice, this assumption is not correct. Infact, investment projects are
exposed to various degrees of risk. There can be three types of decision making:

1. Decision making under certainty: When cash flows are certain

2. Decision making involving risk: When cash flows involve risk and probability can be
assigned.
3. Decision making under uncertainty: When the cash flows are uncertain and probability
cannot be assigned.

8.2 TYPES OF RISKS

Risk is the variability in terms of actual returns comparing with the estimated returns. Most
common techniques of risk measurement are Standard Deviation and Coefficient of Variations.
There is a thin difference between risk and uncertainty. In case of risk, probability distribution of
cash flow is known. When information is unknown to formulate probability distribution of cash
flows, the situation is referred as uncertainty. However, these two terms are used interchangeably.

Types of Risk

Risk arises from different sources, depending on the type of investment being considered,
as well as the circumstances and the industry in which the organization is operating. Some of the
sources of risk are as follows

124
1. Project-specific risk: Risks which are related to a particular project and affects the project’s
cash flows, it includes completion of the project in scheduled time, error of estimation in
resources and allocation, estimation of cash flows and soon. For example, a nuclear power
project of a power generation company has different risks than hydel projects.

2. Company specific risk: Risk which arise due to company specific factors like downgrading
of credit rating, changes in key managerial persons, cases for violation of intellectual
property rights (IPR) and other laws and regulations, dispute with workers and many others.
All these factors affect the cash flows of an entity and access to funds for capital
investments. For example, two banks have different exposure to default risk.

3. Industry-specific risk: These are the risks which affect the whole industry in which the
company operates. The risks include regulatory restrictions on industry, changes in
technologies and related risks. For example, regulatory restriction imposed on leather and
breweries industries.

4. Market risk: The risk which arise due to market related conditions like entry of substitute,
changes in demand conditions, availability and access to resources. For example, a thermal
power project gets affected if the coal mines are unable to supply coal requirements of a
thermal power company.

5. Competition risk: These are risks related with competition in the market in which a
company operates. These risks are risk of entry of rival, product dynamism and change in
taste and preference of consumers and many more.

6. Risk due to economic conditions: These are the risks which are related with macro-
economic conditions like changes monetary policies by central banks, changes in fiscal
policies like introduction of new taxes and cess, inflation, changes in GDP, changes in
savings and net disposable income and so on.

7. International risk: These are risks which are related with conditions which are caused by
global economic conditions like restriction on free trade, restrictions on market access,
recessions, bilateral agreements, political and geographical conditions etc. For example,
restriction on outsourcing of jobs to overseas markets.

125
8.3 TECHNIQUES OF MEASURING RISK IN CAPITAL BUDGETING

Probability

Statistical Variance or Standard

Techniques Deviation

Coefficient of Variation

Risk-adjusted discount rate

Conventional
techniques
Certainty equivalents

Sensitivity analysis
Others techniques
Scenario analysis

Fig 8.1: Techniques of Measuring Risk in Capital Budgeting

8.3.1 STATISTICAL TECHNIQUES
A. PROBABILITY

Probability is a measure about the chances that an event will occur. When an event is certain to
occur, probability will be 1 and when there is no chance of happening an event, probability will
be 0.

Illustration – 1:

From the given problem compute the expected Net Present Value.

Assumption Cash Flows Probability

A 3,00,000 0.3

B 2,00,000 0.6

C 1,20,000 0.1

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In the above example chances that cash flow will be 3, 00,000, 2, 00,000 and 1, 20,000 are 30%,
60% and 10% respectively.

Solution:

Computation of Expected Net Cash Flows

Expected cash flows are calculated as the sum of the likely cash flows of the Project multiplied
by the probability of cash flows. Expected cash flows are calculated as below:

Cash Flows Probability Expected cash flow

(2) (3) 4=2X3

A 3,00,000 0.3 3,00,000×0.3 = 90,000

B 2,00,000 0.6 2,00,000×0.6 =1,20,000

C 1,20,000 0.1 1,20,000×0.1 = 12,000

Expected Net Cash Flow (ENCF) 2,22,000

Illustration – 2: Expected Net Present Value- Single period

Possible net cash flows of Projects A and B at the end of first year and their probabilities are given
as below. Discount rate is 10 per cent. For both the project initial investment is ₹ 10,000. From the
following information, calculate the expected net present value for each project. State which
project is preferable?

Project A Project B
Possible Cash Flow Probability Cash Flow Probability
Event ₹ ₹

A 8,000 0.10 24,000 0.10

127
 B 10,000 0.20 20,000 0.15

C 12,000 0.40 16,000 0.50

D 14,000 0.20 12,000 0.15

E 16,000 0.10 8 ,000 0.10

Solution:

Note: In the above problem the probabilities for net cash flows all the period are given separately.

Calculation of Expected Value for Project A and Project B

Project A Project B
Net Cash Expected Cash Expected
Possible
Flow Probability Value Flow Probability Value
Event
(₹) (₹) (₹) (₹)
A 8,000 0.10 800 24,000 0.10 2,400

B 10,000 0.20 2,000 20,000 0.15 3,000

C 12,000 0.40 4,800 16,000 0.50 8,000

D 14,000 0.20 2,800 12,000 0.15 1,800

E 16,000 0.10 1,600 8,000 0.10 800

ENCF 12,000 16,000

(Expected Net Cash flow)

Since the discount rate is 10% the present value of Re1 @ 10% for one year is 0.909

Net Present Value= PV of Cash inflows – Cash outflow

NPV for Project A = (₹12,000X0.909) - ₹10,000=₹908

NIV for Project B = (₹16,000X0.909) – 10,000 = ₹ 4,544

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Illustration – 3: Expected Net Present Value- Multiple Period

Probabilities for net cash flows for 3 years of a project are as follows:

Year 1 Year 2 Year 3

Cash Cash Cash

Flow Probability Flow Probability Flow Probability
(₹) (₹) (₹)

2,000 0.1 2,000 0.2 2,000 0.3

4,000 0.2 4,000 0.3 4,000 0.4

6,000 0.3 6,000 0.4 6,000 0.2

8,000 0.4 8,000 0.1 8,000 0.1

Calculate the expected net cash flows. Also calculate net present value of the project using
expected cash flows using 10 per cent discount rate. Initial Investment is ₹ 10,000.

Solution:

Year 1 Year 2 Year 3

Cash Cash Cash Expected

Expected Expected
Flow Probability Flow Probability Flow Probability Value
Value (₹) Value (₹)
(₹) 2 (₹) 5 (₹) 8 (₹)
3=1x2 6=4x5
1 4 7 9=7x8

2,000 0.1 200 2,000 0.2 400 2,000 0.3 600

4,000 0.2 800 4,000 0.3 1,200 4,000 0.4 1,600

6,000 0.3 1,800 6,000 0.4 2,400 6,000 0.2 1,200

8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800

129
 ENCF 6,000 4,800 4,200

The net present value of the expected value of cash flow at 10 per cent discount rate has been
determined as follows:

Year PV values ENCF PV of CF

1 0.909 6,000 5,454

PV of Re
1 @ 10%
2 0.826 4,800 3,965

3 0.751 4,200 3,154

Net Present Value 12,573

B. VARIANCE

Variance is a measurement of the degree of dispersion between numbers in a data set

from its average. In very simple words, variance is the measurement of difference between the
averages of the data set from every number of the data set .Variance measures the uncertainty of a
value from its average. Thus, variance helps an organization to understand the level of risk it
might face on investing in a project. A variance value of zero would indicate that the cash flows
that would be generated over the life of the project would be same. This might happen in a case
where the company has entered into a contract of providing services in return of a specific sum.

A large variance indicates that there will be a large variability between the cash flows of
the different years. This can happen in a case where the project being undertaken is very
innovative and would require a certain time frame to market the product and enable to develop a
customer base and generate revenues.

A small variance would indicate that the cash flows would be somewhat stable throughout
the life of the project. This is possible in case of products which already have an established
market.

130
C. STANDARD DEVIATION

Standard Deviation is a degree of variation of individual items of a set of data from its average.
The square root of variance is called Standard Deviation. For capital budgeting decisions, standard
deviation is used to calculate the risk associated with the estimated cash flows from the project.

Problems on computation of Variance and Standard Deviation.

Illustration – 1:

From the following information calculate Variance and Standard Deviation

Project A Project B
Possible
Event Cash Flow Cash Flow
Probability Probability
(₹) (₹)

A 8,000 0.10 24,000 0.10

B 10,000 0.20 20,000 0.15

C 12,000 0.40 16,000 0.50

D 14,000 0.20 12,000 0.15

E 16,000 0.10 8,000 0.10

Solution:

Calculation of Expected Value for Project A and Project B

Project A Project B

Net Cash Expected Cash Expected

Possible
Flow Probability Value Flow Probability Value
Event
(₹) (₹) (₹) (₹)

131
 A 8,000 0.10 800 24,000 0.10 2,400

B 10,000 0.20 2,000 20,000 0.15 3,000

C 12,000 0.40 4,800 16,000 0.50 8,000

D 14,000 0.20 2,800 12,000 0.15 1,800

E 16,000 0.10 1,600 8,000 0.10 800

ENCF 12,000 16,000

Formula to calculate Variance (σ2) :

Variance (σ2) = (𝑵𝑪𝑭𝟏 − 𝐄𝐍𝐂𝐅) 2 𝒑𝒓𝒐𝒃𝟏 + (𝑵𝑪𝑭𝟐 − 𝐄𝐍𝐂𝐅) 2 𝒑𝒓𝒐𝒃𝟐

+ (𝑵𝑪𝑭𝟑 − 𝐄𝐍𝐂𝐅) 2 𝒑𝒓𝒐𝒃𝟑 + (𝑵𝑪𝑭𝟒 − 𝐄𝐍𝐂𝐅) 2 𝒑𝒓𝒐𝒃𝟒

+ ------------------------+ (𝑵𝑪𝑭𝐧 − 𝐄𝐍𝐂𝐅) 2 𝒑𝒓𝒐𝒃𝒏

Project A

Variance (σ2) = (8,000 – 12,000)2 × (0.1) + (10,000 -12,000)2 × (0.2) + (12,000 –

12000)2 × (0.4) + (14,000 – 12,000)2 × (0.2) + (16000 – 12,000)2 × (0.1)

= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000

Standard Deviation (σ) = Variance = 48, 00,000 = 2,190.90

Project B:

Variance (σ2) =

(24,000 – 16,000)2 × (0.1) + (20,000 – 16,000)2 × (0.15) + (16,000 – 16,000)2 × (0.5) + (12,000 –
16,000)2 × (0.15) + (8,000 – 16,000)2 × (0.1)

= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000

132
Standard Deviation (σ) = 1, 76, 00,000 = 4195.23

D. THE COEFFICIENT OF VARIATION

The standard deviation is a useful measure of calculating the risk associated with the
estimated cash inflows from an investment. However, in capital budgeting decisions, the
management is several times faced with choosing between many investments avenues. Under such
situations, it becomes difficult for the management to compare the risk associated with different
projects using standard deviation as each project has different estimated cash flow values. In such
cases, the Coefficient of Variation becomes useful.

The Coefficient of Variation calculates the risk borne for every percent of expected return. It is
calculated as:

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐶𝑜 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑟 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

The Coefficient of Variation enables the management to calculate the risk borne by the
concern for every unit of estimated return from a particular investment. Simply put, the investment
avenue which has a lower ratio of standard deviation to expected return will provide a better risk –
return trade off.

Thus, when a selection has to be made between two projects, the management would
select a project which has a lower Coefficient of Variation.

Illustration-1:

Calculate Coefficient of Variation based on the following information:

Project A Project B
Possible
Event Cash Flow Cash Flow
Probability Probability
(₹) (₹)

A 10,000 0.10 26,000 0.10

B 12,000 0.20 22,000 0.15

133
 C 14,000 0.40 18,000 0.50

D 16,000 0.20 14,000 0.15

E 18,000 0.10 10,000 0.10

Solution:

Calculation of Expected Value for Project A and Project B

Project A Project B

Possible Net Cash Probability Expected Cash Probability Expected

Event Flow Value Flow (₹) Value (₹)
(₹) (₹)

A 10,000 0.10 1,000 26,000 0.10 2,600

B 12,000 0.20 2,400 22,000 0.15 3,300

C 14,000 0.40 5,600 18,000 0.50 9,000

D 16,000 0.20 3,200 14,000 0.15 2,100

E 18,000 0.10 1,800 10,000 0.10 1,000

ENCF 14,000 18,000

Project A

Variance (σ2) = (10,000 – 14,000)2 × (0.1) + (12,000 -14,000)2 × (0.2) + (14,000 –

14,000)2 × (0.4) + (16,000 – 14,000)2 × (0.2) + (18,000 – 14,000)2 × (0.1)

= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000

Standard Deviation (σ) = √ Variance = √48, 00,000 = 2,190.90

134
Project B:

Variance (σ2) = (26,000 – 18,000)2 × (0.1) + (22,000 – 18,000)2 × (0.15) + (18,000 –

18,000)2 × (0.5) + (14,000 – 18,000)2 × (0.15) + (10,000 – 18,000)2 × (0.1)

= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000

Standard Deviation (σ) = √ 1, 76, 00,000 = 4,195.23

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐶𝑜 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑟 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

Coefficient of Risk Expected

Projects
Variation (SD) Value

A 2,190.90 Less Less

=0.1565
14,000

B 4,195.23 More More

=0.2331
18,000

In project A risk per rupee of cash flow is ₹ 0.15 while in project B it is ₹ 0.23.

Therefore Project A is better than Project B.

8.3.2 CONVENTIONAL TECHNIQUES

A. RISK ADJUSTED DISCOUNT RATE

The use of risk adjusted discount rate (RADR) is based on the concept that investors
demands higher returns from the risky projects. The required rate of return on any investment
should include compensation for delaying consumption plus compensation for inflation equal to
risk free rate of return, plus compensation for any kind of risk taken. If the risk associated with
any investment project is higher than risk involved in a similar kind of project, discount rate is
adjusted upward in order to compensate this additional risk borne.

A risk adjusted discount rate is a sum of risk free rate and risk premium. The risk premium
depends on the perception of risk by the investor of a particular investment and risk aversion of
the investor.
135
So Risks Adjusted Discount Rate = Risk Free Rate+ Risk Premium

Risk Free Rate: It is the rate of return on Investments that bear no risk. For example, government
securities yield a return of 6 % and bear no risk. In such case, 6 % is the risk-free rate.

Risk Premium: It is the rate of return over and above the risk-free rate, expected by the investors
as a reward for bearing extra risk. For high risk project, the risk premium will be high and for low
risk projects, the risk premium would be lower.

Advantages of Risk-adjusted discount rate

1) It is easy to understand.

2) It incorporates risk premium in the discounting factor.

Illustration – 1:

An enterprise is investing ₹ 100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the management is 7%. The life of the project is 5 years. Following are the
cash flows that are estimated over the life of the project.

Year Cash flows

(₹ in lakhs)

1 25

2 60

3 75

4 80

5 65

Calculate Net Present Value of the project based on Risk free rate and also on the basis of Risks
adjusted discount rate.

Solution:
136
 The Present Value of the Cash Flows for all the years by discounting the cash flow at 7%
is calculated as below:

Cash flows Discounting Present value of Cash

Year
₹ in lakhs Factor @7% Flows (₹)

1 25 0.935 23,38,000

2 60 0.873 52,38,000

3 75 0.816 61,20,000

4 80 0.763 61,04,000

5 65 0.713 46,35,000

Total of present value of Cash flow 2,44,35,000

Less: Initial investment 1,00,00,000

Net Present Value (NPV) 144.35

Now when the risk-free rate is 7% and the risk premium expected by the Management is 7%.

So the risk adjusted discount rate is 7% + 7% =14%.

Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:

Year Cash flows Discounting Present Value of Cash

₹ in Lakhs Factor@14% Flows ₹ in lakhs

1 25 0.877 21,93,000

2 60 0.769 46,14,000

3 75 0.675 50,63,000

4 80 0.592 47,36,000

5 65 0.519 33,74,000

Total of present value of Cash flow 1,99,80,000

Less: Initial investment 1,00,00,000

137
 Net present value (NPV) 99,80,000

B. CERTAINTY EQUIVALENT (CE) METHOD FOR RISK ANALYSIS

As per CIMA terminology, “An approach to dealing with risk in a capital budgeting
context. It involves expressing risky future cash flows in terms of the certain cash flow which
would be considered, by the decision maker, as their equivalent, that is the decision maker would
be indifferent between the risky amount and the (lower) riskless amount considered to be its
equivalent.”

The certainty equivalent is a guaranteed return that the management would accept rather
than accepting a higher but uncertain return. This approach allows the decision maker to
incorporate his or her utility function into the analysis. In this approach a set of risk less cash flow
is generated in place of the original cash flows.

8.3.3 OTHER TECHNIQUES OF RISK ANALYSIS IN CAPITAL BUDGETING

A. SENSITIVITY ANALYSIS

As per CIMA terminology, “A modeling and risk assessment procedure in which changes
are made to significant variables in order to determine the effect of these changes on the planned
outcome. Particular attention is thereafter paid to variables identifies as being of special
significance”

Sensitivity analysis put in simple terms is a modeling technique which is used in capital
budgeting decisions which is used to study the impact of changes in the variables on the outcome
of the project. In a project, several variables like weighted average cost of capital, consumer
demand, price of the product, cost price per unit and other variables. operate simultaneously. The
changes in these variables impact the outcome of the project. It therefore, becomes very difficult
to assess change in which variable impacts the project outcome in a significant way. In Sensitivity
Analysis, the project outcome is studied after taking into change in only one variable. The more
sensitive is the NPV, the more critical is that variable. So, sensitivity analysis is a way of finding
impact in the project’s NPV (or IRR) for a given change in one of the variables.

B. DECISION TREE ANALYSIS

138
 Decision tree technique is a method to evaluate risky proposals. A decision tree shows the
sequential outcome of a risky decision. The decision tree approach gets its name because of
resemblance with a tree having number of branches. A capital budgeting decision tree shows the
cash flows and net present value of the project under differing possible circumstances.

Steps in Decision Tree Analysis:

1. Identifying the investment: It is the first step at which the investment is identified.
2. Identification of decision alternatives: The identified investment will have two or more
alternatives. For example, a company is planning to construct a building for starting a new
business; it may buy water for constructing a building or to dig a bore well.
3. Drawing the decision tree: The decision tree should be drawn indicating the decision points,
chance points and other data.
4. Specification of data: Once drawing the decision tree is over and then the evaluator has to
specify probabilities and monitor values for each alternative.
5. Evaluate the alternatives: Having drawn the decision tree and specified the data, then the
next step is to evaluate the alternatives.
6. Selection of the best alternative: This is the last step in decision tree analysis in which the
evaluator selects a profitable alternative, thereby rejecting other alternatives.

Merits of Decision Tree Analysis

 Easy to Understand
 Clearly brings out the implicit assumptions and calculations for all to see, question
and revise

Limitations of Decision Tree Analysis

 Decision tree becomes more complex when the alternatives increases

 It is consuming
 It needs enormous information

139
Problems on Decision Tree Analysis:

Illustration – 1:

Venkat Intel Company provides the following estimates of the present values of the future
expected cash flows after taxes associated with investment proposal relating to the plant
expansion.

Without Expansion Probability

With expansion
2,00,000 0.2
4,50,000
3,50,000 0.3
7,00,000
5,00,000 0.5
5,00,000

The plant expansion costs ₹ 4, 00,000. You are required to advise Venkat Intel Company
regarding the financial feasibility on the investment with the use of decision tree approach.

Solution:

CFAT(₹)
Probability
With Without
Expansion Expansion

4,50,000 2,00,000 0.2

7,00,000 3,50,000 0.3

5,00,000 5,00,000 0.5

The plant expansion cost ₹ 4, 00,000. You are required to advise Venkat Intel Company
regarding the financial feasibility on this investment with the use of decision tree approach.

140
Solution:

In the above illustration, PV of CFs is available

Computation of NPV (₹ )

Pro
PV OF CFAT TPV (₹)

Expand Plant ₹4,50,000 0.2 90,000

₹7,00,000 0.3 2,10,000

₹ 4, 00,000 ₹5,00,000 0.5 2,50,000

5,50,000
DT (-)Cash outflow 4,00,000

NPV 1,50,000

₹2,00,000 0.2 40,000

No
₹3,50,000 0.3 1,05,000
Expansion
₹5,00,000 0.5 2,50,000
3,95,000

Decision: Proposed expansion is feasible, Since the NPV is positive, i.e. ₹ 1, 50,000

Illustration 13:

Dream Well Co. Ltd. has an investment proposal that requires an investment of ₹ 2, 50,000. The
following information is available.

Year 1

CF's
Event Probability
(₹)
A 1,00,000 0.2
B 1,25,000 0.4
C 1,80,000 0.4

141
 Year 2: CFAT Possibilities depend on the happening in a year 1 CFAT

(₹) 1,00,000 (₹) 1,25,000 (₹) 1,80,000

Event CFAT
CFAT (₹) Pro. CFAT (₹) Pro. Pro.
(₹)
A 45,000 0.2 1,40,000 0.2 1,90,000 0.3
B 1,20,000 0.3 1,80,000 0.6 2,10,000 0.3
C 1,80,000 0.5 1,90,000 0.2 2,60,000 0.4

You are required to advise the company regarding the financial feasibility of the project
using decision tree approach. Company’s cost of capital is 10 percent.
Solution:
Joint Expected
Year Year Path NPV of
Year Pro. NPV (₹)
0 1 and Prob. 2 and Prob. CF's (₹)
(₹) 45000 1 -1,21,930 0.04 -4,877.20*
0.2
(₹) 1,00,000 (₹) 1,20,000 2 -59,980 0.06 -3,598.80
A 0.2 0.3
(₹) 1,80,000 3 -10,420 0.10 -1,042.00
0.5
(₹) 1,40,000 4 -25,280 0.08 -2,022.40
0.2
Cash
B (₹) 1,25,000 (₹) 1,80,000 5 7,760 0.24 1,862.40
Out Flow
0.4 0.6
₹ 2,50,000
(₹) 1,90,000 6 16,020 0.08 1,281.60
0.2
(₹) 1,90,000 7 70,560 0.12 8,467.20
0.3
C (₹) 1,80,000 (₹) 2,10,000 8 87,080 0.12 10,449.60
0.4 0.3
(₹) 2,60,000 9 1,28,380 0.16 20,540.80
0.4 NPV 31,061.20

142
 Decision: The investment is feasible, since its NPV is positive

*Note: Computation of NPV

Cash
Possible Year 1 Year 2 Total NPVs
Outflow
DF% DF% Cash
events CFs PV(₹) CFs PV(₹) PV(₹) (₹)
10% 10% inflows
A1 1,00,000 0.909 90,900 45,000 0.826 37,170 1,28,070 2,50,000 -121,930

A2 1,00,000 0.909 90,900 1,20,000 0.826 99,120 1,90,020 2,50,000 -59,980

A3 1,00,000 0.909 90,900 1,80,000 0.826 1,48,680 2,39,580 2,50,000 -10,420

B4 1,20,000 0.909 1,09,080 1,40,000 0.826 1,15,640 2,24,720 2,50,000 -25,280

B5 1,20,000 0.909 1,09,080 1,80,000 0.826 1,48,680 2,57,760 2,50,000 7,760

B6 1,20,000 0.909 1,09,080 1,90,000 0.826 1,56,940 2,66,020 2,50,000 16,020

C7 1,80,000 0.909 1,63,620 1,90,000 0.826 1,56,940 3,20,560 2,50,000 70,560

C8 1,80,000 0.909 1,63,620 2,10,000 0.826 1,73,460 3,37,080 2,50,000 87,080

C9 1,80,000 0.909 1,63,620 2,60,000 0.826 2,14,760 3,78,380 2,50,000 1,28,380

8.4 CHECK YOUR PROGRESS

Fill in the blanks with suitable answers:
1. ______ are related with conditions which are caused by global economic conditions like
restriction on free trade, restrictions on market access etc.
2. ______is a modeling technique which is used in Capital Budgeting decisions to study the
impact of changes in the variables on the outcome of the project.
3. A ______shows the sequential outcome of a risky decision.
4. A risk adjusted discount rate is a sum of ______.
5. ______risk arises due to market related conditions like entry of substitute, changes in
demand conditions, availability and access to resources.

143
Answer to Check Your Progress

1. International risk
2. Sensitivity analysis
3. Decision tree
4. Risk free rate and risk premium
5. Market

8.5 SUMMARY
In the preceding unit we have examined the various techniques for evaluating capital
investment proposals. Our basic assumption was that these proposals did not involve any kind of
risk or irrespective of the proposal selected; there would not be any change in the business risk
complexion of the firm as perceived by the supplier of capital. However, this seldom happens in
the real world situations. Decisions are made on the basis of forecasts which themselves depend
upon the future events whose occurrence cannot be anticipated with absolute certainty because of
economic, social, fiscal, political and other reasons. Thus, risk is linked with business decisions.
Of course, it varies from one investment proposal to another. Some proposals may not involve any
risk for example, investment in Government securities which assure a return at a fixed rate. Some
may be less risky like expansion of the existing business, while others may be more risky, such as
Taking up a new venture, etc. Any firm has to take into consideration the risk factor while
determining return\cash flows from a project or capital budgeting decisions. However,
incorporation of risk factor in capital budgeting decisions is a difficult task. However, many
techniques of analysing capital budgeting risks are available which can be used appropriately to
analyse and manage the risk.

8.6 KEYWORDS
Risk Free Rate : It is the rate of return on Investments that bear
no risk.

Risk Premium : It is the rate of return over and above the risk-
free rate, expected by the Investors as a reward
for bearing extra risk.

144
Variance : It is a measurement of the degree of dispersion
between numbers in a data set from its average.

Probability : It is a measure about the chances that an event

will occur.

Coefficient of Variation : Calculates the risk borne for every percent of

expected return.

8.7 QUESTIONS FOR SELF STUDY

1. Explain the various techniques used for incorporating risk factor in capital budgeting
decisions.
2. Define risk. Differentiate between certain, uncertain and risky situations.
3. What is “Decision Tree Analysis”? Explain the steps you take for construction of a decision
tree.
4. “Risk analysis of Capital Investments is one of the most complex, controversial and slippery
areas in finance”- Comment.
5. Explain Certainty Equivalent Coefficient.
6. A project requires an investment of ₹ 50,000. It is expected to generate cash flows at the end
of each year as given below
Year Cash Flows
1 ₹ 25,000
2 20,000
3 10,000
4 10,000
Ascertain by NPV Method whether the project will be accepted in each of the following situations
1. The project is risk free and the expected returns is 10%
2. The project is risky and the expected return is 15%

7. Arun Company provides the following estimates of the present values of the future expected
cash flows after taxes associated with investment proposal relating to the plant expansion.

145
 With expansion Without Expansion Probability

4,00,000 0.2
9,00,000
7,00,000 0.3
14,00,000
10,00,000 0.5
10,00,000

The plant expansion costs ₹ 8, 00,000. You are required to advise Arun Company regarding
the financial feasibility on the investment with the use of decision tree approach.

8.8 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill- Tenth
Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh edition-
2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-Eleventh
Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya Publishing
House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and Sons-
Fifteenth Edition-2019.

146
Karnataka State Open University
Mukthagangothri, Mysuru - 570 006
[email protected] II SEMESTER M.COM
FINANCIAL MANAGEMENT
COURSE CODE:MCOSC2.2A/D

Department of Studies and Research in Commerce

BLOCK
3

Page No.

UNIT - 9: DIVIDEND DECISIONS 1-18

UNIT - 10: DIVIDEND THEORIES 19-41

UNIT - 11: WORKING CAPITAL MANAGEMENT 42-71

UNIT - 12: INVENTORY MANAGEMENT, RECEIVABLES

MANAGEMENT AND CASH MANAGEMENT 72-103

 Credit Page
Programme : M.Com Year/Semester: Second Block No :III
Course : Financial Management Credit : 03 Units No :9-12
Course Design Expert Committee
Prof. Vidyashankar Chairman
Vice-Chancellor,
Karnataka State Open University,
Mukthagangotri, Mysuru – 570 006.
Prof. Ashok Kamble Member
Dean (Academic),
Karnataka State Open University,
Mukthagangotri, Mysuru – 570 006.
Dr.Mahesha V. Member
BOS Chairman,
DOS&R in Commerce,KSOU, Mysuru.
Dr. Sukanya R. Member
Assistant Professor and Course Designer,
DOS&R in Commerce, KSOU, Mysuru.
Smt. Usha C. Member Convener
Chairperson,
DOS&R in Commerce, KSOU, Mysuru.
Course Writer Course Editor
Dr. Sukanya R. Dr. Chaya R.
Assistant Professor, Assistant Professor,
DOS&R in Commerce, DOS&R in Commerce,
KSOU, Mysuru. KSOU, Mysuru.
Editorial Committee
Dr.Mahesha V. Chairman
BOS Chairman,
DOS&R in Commerce,KSOU, Mysuru.

Prof. Venkatesh S. External Member

Professor,Department of Commerce,
Kuvempu University, Shivamogga.
Dr. Sukanya R. Internal Member
Assistant Professor, DoS & R in Commerce,
Karnataka State Open University, Mysuru.

Smt. Usha C. Member Convener

Chairperson,
DOS&R in Commerce, KSOU, Mysuru. .
Copy Right
Registrar,
Karnataka State Open University, Mukthagangothri, Mysuru - 570006.
Developed by the Department of Studies and Research in Commerce, KSOU, under the guidance of Dean
(Academic) , KSOU, Mysuru.Karnataka State Open University, October -2022.
All rights reserved. No part of this work may be reproduced in any form, or any other means, without permission in
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Printed and Published on behalf of Karnataka State Open University. Mysuru-570006 by Registrar (Administration)-
2022.
 Karnataka State Open University
Mukthagangothri, Mysuru - 570 006
Preface

Dear Learner,

This study material provides you with key principles that you can apply throughout
your career to help you build financial insight. The principles of finance provide a unified
perspective of the most crucial financial ideas, which you can use in all of your financial
decisions. Financial management has emerged as an interesting and exciting area for
academic studies as well as for managing finance practically. All decisions taken by an
individual or a business that have financial implications fall under the category of financial
management. The financial implications of choices are assessed in terms of maximising
the value of the firm, whether the business is organised as a company, where ownership
and management are seperate, or in another way. As a result, the decision-making process
is focused on the goal of maximising shareholder’s wealth as shown by the market price of
a share. The curriculum makes an effort to address how a business organisation makes
financial decisions. An easy way to understand financial management is to apply the
theoretical concepts to real-life problems being faced by financial managers. The course
writer has tried to use practical illustrations to explain and analyse the different ideas in the
course ‘Financial Management’ in second semester M.Com.

The study material is in interactive mode which is developed by experienced

academicians in the field of finance. The course is designed to acquaint students and
professionals with the contents and tools of financial management. You may refer to
various text books relevant to the course, which are provided at the end of each unit. Feel
free to send feedback to the department for further improvements, and you may contact the
course writer for any clarifications.

With best wishes,

Smt. Usha C.
Chairperson
 BLOCK – III
INTRODUCTION

Dividend refers to the part of corporate net profits distributed among shareholders
as a reward for contributing capital in the firm. Dividend decision relates to how much of
the company's net profit is to be distributed to the shareholders and how much of it should
be retained in the business for meeting the investment requirements. This decision should
be taken keeping in mind the overall objective of maximising shareholders' wealth.

The dividend theories relates with the impact of dividend on the value of the firm.
According to one school of thought the dividends are irrelevant and the amount of
dividends paid does not affect the value of the firm while the other theory considers that
the dividend decision is relevant to the value of the firm. Thus there are conflicting
theories on dividends are Irrelevance Theory of Dividend and Relevance Theory of
Dividend.

Working capital management us a very important decision for any business

because a company cannot operate without having sufficient working capital. Working
capital id regarded as the life blood of a business enterprise. Woking capital us the excess
of current assets over current liabilities.

Inventors constitute a very important component of a business concern. It services

as a link between the production and distribution process. Inventory management is
essential to allow a firm to take advantage of the opportunities to improve profitability.

This block consists of 4 units, they are:

Unit 9 : Dividend Decisions

Unit 10 : Dividend Theories

Unit 11 : Working Capital Management

Unit 12 : Inventory Management, Receivables Management and Cash Management

 BLOCK-III

UNIT – 9 DIVIDEND DECISIONS

Structure:
9.0 Objectives

9.1 Introduction

9.2 Meaning of Dividend

9.3 Types of Dividend

9.4 Dividend Policies

9.5 Types of Dividend Policies

9.6 Procedural and Legal Requirements involved in Payment of Dividend

9.7 Factors influencing Dividend Policy

9.8 Bonus Shares and Stock Splits

9.9 Buyback of Shares

9.10 Check Your Progress

9.11 Summary

9.12 Keywords

9.13 Questions for Self-Study

9.14 References

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9.0 OBJECTIVES
After studying this unit, you will be able to;
 Discuss the various factors influencing dividend policy.
 Examine the procedural and legal requirements involved in payment of dividend.
 Explain the various types of dividends.
 Analyse the benefits of a stable dividend policy.
9.1 INTRODUCTION
Dividend decisions are decisions relating to deciding upon the extent of profits to
be distributed to the owners or shareholders of the company. The financial manager must
take careful decisions on how the profit should be distributed among shareholders. Like
financing decisions and investment decisions, dividend decisions are also a major part of
the financial management. When business concerns decide dividend policy, they have to
consider certain factors such as retained earnings and the nature of shareholders of the
business concern. The firm has to choose between distributing the profits to shareholders
and ploughing them back into the business, called retained earnings. The firm should use
net profits to pay dividends to shareholders if the payment would lead to
the maximisation of the wealth of the owners. If not, the firm should rather retain them to
finance investment programmes. The relationship between dividends and the value of the
firm, therefore, is a very important and crucial part of the business concern, because these
decisions are directly related to the value of the business concern and the shareholder’s
wealth.

9.2 MEANING OF DIVIDEND

A dividend is the part of the divisible profit which is distributed among the
shareholders as a return on their investment in the company in the form of share capital.

Dividend refers to that part of the profit of a business concern that is distributed by
the company among its shareholders. It is the reward of shareholders for investments made
by them in the shares of the company. In short, dividends refer to that portion of a firm’s
net earnings which are paid out to shareholders.

Dividends refer to the share of profits distributed by a company to its shareholders.

The profits after tax of a company are available for either distribution among owners or for
further use in business. Profits retained in business for further use are called retained
earnings, and the share of profits distributed among shareholders is called dividends.

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 According to the Institute of Chartered Accountant of India, dividend is defined as
“a distribution to shareholders out of profits or reserves available for this purpose”

9.3 TYPES OF DIVIDEND

Though dividend must necessarily be a part of the profits earned by an
organisation, it can be distributed among the shareholders through different means. These
different types of dividends are discussed below.

Cash Dividend:

When dividend is paid in the form of cash to shareholders, it's called cash dividend.
Cash dividends are the common and popular type of dividend distribution followed by the
majority of business concerns. Though shareholders always prefer cash dividend, a
company needs to consider a number of factors before paying dividends in cash. These
include the working capital position of the company, the immediate need for liquid cash,
etc. Cash dividend results in outflow of funds and reduces both total assets and
shareholders’ fund and hence has an immediate impact on the balance sheet.
Stock Dividend:
Stock dividend is the distribution of bonus shares to existing shareholders in lieu of
a cash dividend. Normally, it's paid in the form of additional shares proportionately to
shareholders. If a company doesn't have liquid resources, it's better to declare a stock
dividend. Under this type, cash is retained by the business concern. Stock dividend
amounts to the capitalization of earnings and distribution of profits among the existing
shareholders without affecting the cash position of the firm. The bonus
dividend doesn't have any immediate impact on the balance sheet as the total shareholders’
fund remains the same and only the composition is changed. However, it's relatively costly
to administer.
Script or Bond Dividend:
Bond dividend is also known as script dividend. When a company pays dividend by
issuing long-term debt securities among the shareholders, it is called Bond Dividend. In
case company doesn't have sufficient funds to pay dividends in cash, it may issue notes or
bonds for the amount due to shareholders. The objective of the script dividend is to
postpone the immediate payment. A script dividend bears interest and is accepted as a
collateral security. The company promises to pay shareholders at a future specific date with
the help of the issue of bonds or notes.

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Property Dividend:
Property dividends are paid in the form of some assets other than cash among the
shareholders in the form of dividend, it is called property dividend. Here, property may
include any financial assets like shares or debentures of investee company or even products
produced (i.e., stock) by the company.
Composite Dividend:
When dividends include partly cash and partly any other asset or security, they
are referred to as composite dividend.

9.4 DIVIDEND POLICIES

Dividend policies refer to the policy or practice adopted by a company towards
dividend payments. It refers to the policy concerning the quantum of profits to be
distributed as dividend. A company’s dividend policy influences the division of its net
earnings into two parts: retained earnings and dividend. What amount is to be retained and
how much is to be distributed is the essence of dividend policy.

9.5 TYPES OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and
profitable position. The various types of dividend policies are discussed as follows:

a. Regular dividend policy

b. Stable dividend policy
c. Irregular dividend policy
d. No dividend policy.

a. Regular Dividend Policy:

Payment of dividend at the usual rate is termed as regular dividend. Shareholders get a
fixed amount of dividend every year, whether the company is making profit or loss. Under
the regular dividend policy, the company pays out dividends to its shareholders every year,
irrespective of the company making profit or loss. If the company makes abnormal profits
(very high profits), the excess profits will not be distributed to shareholders but are
withheld by the company as retained earnings. If the company makes a loss, shareholders
will still be paid a dividend under the policy. This type of policy is suitable for small
investors, retired persons and other economically weaker people who prefer to get regular
dividends.

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Advantages of regular dividend policy:

(i) It establishes a profitable record of the company.

(ii) It creates confidence amongst the shareholders.
(iii) It stabilizes the market value of shares.
(iv) The ordinary shareholders view dividends as a source of funds to meet their
day-to-day living expenses.
However, it must be remembered that regular dividends can be maintained only by
companies of long standing and stable earnings.

b. Stable Dividend Policy:

The term 'stability of dividends' means consistency in the stream of dividend

payments. In more precise terms, it means payment of a certain minimum amount of
dividend regularly. In this type of dividend policy, investors receive dividends consistently,
although the amount of dividend may vary from year to year. Basically, the companies
decide to distribute a certain portion of the profit to shareholders every year in the form of
dividends.
Forms of stable Dividend Policy:

A stable dividend policy may be established in any of the following three forms:

(i) Constant dividend per share: In this policy, a company pays a fixed amount of
dividend per share every year irrespective of the profit generated by it. Such firms
usually create a "Reserve for Dividend Equalization" to enable them to pay the
fixed dividend even in years when the earnings are not sufficient.

(ii) Constant pay-out ratio: Constant pay-out ratio means payment of a fixed
percentage of net earnings as dividends every year. The amount of dividend in
such a policy fluctuates in direct proportion to the earnings of the company.

(iii) Stable rupee dividend plus extra dividend: In this policy, a company pays a
relatively lower rate of dividend per share plus an extra dividend in the years of
high profits. This policy helps to avoid instances of no dividend payment in the
case of weak financial performance. Such a policy is also suitable for firms having
fluctuating earnings from year to year.

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Advantages of Stable Dividend Policy:
(i) It is sign of continued normal operations of the company.
(ii) It stabilizes the market value of shares
(iii) It creates confidence among the investors, improves credit standing and makes
financing easier
(iv) It provides a source of livelihood to those investors who view dividends as a
source of fund to meet day-to-day expenses
(v) It meets the requirements of institutional investors who prefer companies with
stable dividend .

c. Irregular Dividend Policy:

When companies are facing constraints on earnings and unsuccessful business

operations, they may follow irregular dividend policies. It is one of the temporary
arrangements to deal with financial problems. In this type of dividend policy, there is no
certainty of receipt of dividend to the shareholders of the company. The company is under
no obligation to share the amount or share of profits with the shareholders. The board of
directors can decide what to do with the profits. If they make an abnormal profit in a
certain year, they can decide to distribute it to shareholders or not pay out any dividends at
all and instead keep the profits for business expansion and future projects. For
shareholders, it can be highly risky to invest in a company as there is a risk of not receiving
any dividend in any given year.
d. No Dividend Policy:
Under the no dividend policy, the company follows the procedure of paying no
dividend to the shareholders irrespective of its profit or loss scenario. It is because any
profits earned are retained and reinvested into the business for future growth. Companies
that don’t give out dividends are constantly growing and expanding, and shareholders
invest in them because the value of the company’s stock appreciates. For the
investor, the share price appreciation is more valuable than a dividend pay-out. The
company may follow no dividend policy because of its unfavourable working capital
position or on account of requirements of funds for future expansion and growth.

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9.6 PROCEDURAL AND LEGAL REQUIREMENTS INVOLVED IN
PAYMENT OF DIVIDEND
The declaration of dividend of a company is governed by the Companies Act,
judgments of courts in leading cases, contractual restrictions, provisions of the Income Tax
Act, etc. The following are the legal aspects relating to the declaration of dividend.

1. Under the provisions of the Companies Act of 1956, dividends can be paid by a
company either out of the profits earned during the current financial year or out of
the undistributed profits of the previous financial years or out of both.

2. Dividend cannot be paid out of capital.

3. Dividend cannot be paid out of capital profits or capital reserves such as securities
premium, capital redemption reserve, revaluation reserve, etc.

4. Dividends can be paid out of the profits of the current financial year only after
providing for depreciation and after transferring to reserves.

5. Dividend must be paid only in cash except when the company decides to capitalize
reserves or profits by issuing bonus shares.

6. The rights of the creditors must be protected before dividends are declared.

7. The right to declare dividend is the prerogative of the board of directors. As such
the board of directors must in a formal board meeting, pass a resolution to pay the
dividends.

8. The resolution of the board of directors to pay the dividend has to be approved by
the shareholders in the annual general meeting.

9. The dividend is payable only to those shareholders whose names appear in the
register of Members as on the date of declaration of dividend.

10. Once the dividend is declared, dividend warrants must be posted to the
shareholders within 30 days from the date of declaration of dividend.

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9.7 FACTORS INFLUENCING DIVIDEND POLICY

The following factors influencing dividend policy are:

Stability of earnings

Financing policy of the company

Liquidity of funds

Dividend policy of competitive concerns

FACTORS
Past dividend rates
INFLUENCING
DIVIDEND Debt obligation
POLICY
Ability to borrow

Growth needs of the company

Profit rates

Legal requirements

1. Stability of Earnings: Stability of earnings is one of the important factors

influencing the dividend policy. If earnings are relatively stable, a firm is in a better
position to predict what its future earnings will be and such companies are more
likely to pay out a higher percentage of its earnings in dividends than a concern
which has fluctuating earnings.

2. Financing policy of the company: Dividend policy may be affected and

influenced by the financing policy of the company. If the company decides to meet
its expenses from its earnings, then it will have to pay less dividend to shareholders.
On the other hand, if the company feels, that outside borrowing is cheaper than
internal financing, then it may decide to pay higher rate of dividend to its
shareholder. Thus, the internal financing policy of the company influences the
dividend policy of the business firm.

3. Liquidity of funds: The liquidity of funds is an important consideration in

dividend decisions. Although the dividend is paid out of profits, a cash dividend
only is paid from money in the bank. Payment of dividend means a cash outflow

8
 and hence the greater the cash position and liquidity of the firm is determined by
the firm’s investment and financing decisions.

4. Dividend policy of competitive concerns: Another factor which influences is the

dividend policy of other competitive concerns in the market. If the other competing
concerns are paying higher rate of dividend than this concern, the shareholders may
prefer to invest their money in those concerns rather than in this concern.

5. Past dividend rates: If the firm already exists, the dividend rate may be decided on
the basis of dividends declared in the previous years. It is better for the concern to
maintain stability in the rate of dividend and hence generally the directors will have
to keep in mind the rate of dividend declared in the past.

6. Debt obligations: A firm which has incurred heavy indebtedness is not in a

position to pay higher dividends to shareholders. Earning retention is very
important for such concerns which are following a programme of substantial debt
reduction. On the other hand, if the company has no debt obligations, it can afford
to pay higher rate of dividend.

7. Ability to borrow: Every company requires finance for expansion programmes as

well as for meeting unanticipated expenses. Hence the company has to borrow from
the market, well established and large firms have better access to the capital market
than new and small firms and hence they can pay higher rate of dividend. The new
companies generally find it difficult to borrow from the market hence they cannot
afford to pay higher rate of dividend.

8. Growth needs of the company: Another factor which influences the rate of
dividend is the growth needs of the company. In case the company has already
expanded considerably, it does not require funds for further expansions. On the
other hand, if the company has expansion programmes, it would need more money
for growth and development. Thus when money for expansion is not needed, then it
is easy for the company to declare higher rate of dividend.

9. Profit rate: Another important consideration for deciding the dividend is the profit
rate of the firm. The internal profitability rate of the firm provides a basis for
comparing the productivity of retained earnings to the alternative return which
could be earned elsewhere. Thus, alternative investment opportunities also pay an
important role in dividend decisions.

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 10. Legal requirements: While declaring dividend, the board of directors will have to
consider the legal restriction. The Indian Companies Act 1956 prescribes certain
guidelines in respect of declaration and payment of dividends and they are to be
strictly observed by the company for declaring dividends.

11. Policy control: If the company feels that no new shareholders should be added,
then it will have to pay less dividend. Hence if maintenance of existing control is an
important consideration, the rate of dividend may be lower so that the company can
meet its financial requirements from its retained earnings without issuing additional
shares to the public.

12. Corporate taxation policy: Corporate taxes affect the rate of dividend of the
concern. High rates of taxation reduce the residual profits available for distribution
to shareholders. Hence the rate of dividend is affected.

13. Tax position of shareholders: The tax position of shareholders is another

influencing factor on dividend decisions. In a company if a large number of
shareholders have already high income from other sources, they will not be
interested in high dividends because the large part of the dividend income will go
away by way of income tax. Hence instead of receiving the dividend in the form of
cash, the shareholders would like to get shares and increase their holding in the
form of shares. This has certain benefits to shareholders.

14. Effect of trade cycle: Trade cycle also influences the dividend policy of the
concern. For example, during the period of inflation, funds generated from
depreciation may not be adequate to replace the assets. Consequently there is a
need for retained earnings in order to preserve the earning power of the firm.

15. Attitude of the interested group: a concern may have certain group of interested
and powerful shareholders. These people have certain attitude towards payment of
dividend and have a definite say in policy formulation regarding dividend
payments.

9.8 BONUS SHARES AND STOCK SPLITS

BONUS SHARES:
Bonus Shares are the distribution of additional shares to existing shareholders. A
company can pay bonus to its shareholders either in cash or in the form of shares. Bonus
Shares are paid in the form of additional shares proportionately to shareholders. In other

10
words, Bonus Shares are the shares which are issued to the existing shareholders, by way
of the capitalization of the reserves of the company. Bonus shares can be issued only out of
free reserves built out of genuine profits or share premium collected in cash only.
Many a times, a company is not in a position to pay bonus in cash in spite of
sufficient profits because of an unsatisfactory cash position or because of its adverse
effects on the working capital of the company. In such cases, if the articles of association
of the company provide, it can pay bonus to its shareholders in the form of shares, either
by making partly paid shares as fully paid, or by issuing fully paid bonus shares. The issue
of bonus shares in lieu of dividend is not allowed as, according to the Companies Act, no
dividend can be paid except in cash. It cannot be termed as a gift because it only represents
the past sacrifice of shareholders. When a company accumulates huge profits and reserves,
its balance sheet does not reveal a true picture of the capital structure of the company, and
the shareholders do not get a fair return on their capital. Thus, if the Articles of Association
of the company so permit, the excess amount can be distributed among the existing
shareholders of the company by way of the issue of bonus shares.
The effect of the bonus issue:
(i) It amounts to a reduction in the amount of accumulated profits and reserves.
(ii) There is a corresponding increase in the paid up share capital of the company.
(iii) In the event of the issue of the bonus shares, the proportional ownership of the
shareholders remains unchanged.
(iv) But then, the book value per share, as also the earnings per share, and the market
price per share decrease, correspondingly, as the number of shares increases.

Objectives of Bonus Issue:

a) To reduce the abnormally high dividend rate on its capital in order to avoid labour
problems such as wage inflation and to limit the entry of new entrepreneurs attracted by
the allure of abnormal profits.
b) To pay a bonus to the company's shareholders without affecting the company's liquidity
or earning capacity.
c) To make the nominal value and the market value of the shares of the company
comparable.
d) To correct the balance sheet so as to give a realistic view of the capital structure of the
company.

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e) The issuance of bonus shares increases the number of shares available for sale and
purchase on stock exchanges. Thus, it promotes active trading in these shares. It also
increases the volume and value of transactions involving these shares on the stock
exchanges.

Regulation of Bonus Issues:

The following are the main regulatory provisions, governing the issue of bonus shares:
a) The bonus shares can be issued only out of the free reserves, built out of the genuine
profits of the company, or share premium, collected by it, but only in cash.
b) Further, remaining (residual) free reserves, after the proposed capitalisation of the free
reserves, by way of issuance of the bonus shares, should be at least 40 per cent of the
increase paid-up capital (increased due to the issuance of the bonus shares).
c) A bonus issue cannot be made in lieu of dividend payment.
d) A bonus issue cannot be made on partly paid up shares.
e) A company should not be in default of servicing fixed deposits, debentures, and
statutory dues if it wants to issue bonus shares.
f) The articles of association of the company should authorise a bonus issue.

Advantages of Issue of Bonus Shares:

Advantages from the viewpoint of the company

1. It makes available capital to carry a larger and more profitable business.
2. When a company pays bonus to its shareholders in the value of shares and not in cash,
its liquid resources are maintained and the working capital of the company is
not affected.
3. It enables a company to make use of its profits on a permanent basis and increases the
credit worthiness of the company.
4. It is the cheapest method of raising additional capital for the expansion of the business.
5. An abnormally high rate of dividend can be reduced by issuing bonus shares, which
enables a company to restrict the entry of new entrepreneurs into the business and
thereby reduces competition.
6. The balance sheet of the company will reveal a more realistic picture of the capital
structure and the capacity of the company.

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Advantages from the viewpoint of investors or shareholders:
1. The bonus shares are a permanent source of income to the investors.
2. Even if the dividend rate falls, the total amount of dividend may rise as the investor
receives dividends on a greater number of shares.
3. If investors so desire, they can easily sell these shares and receive immediate cash.

Disadvantages of Bonus Shares:

1. The issue of bonus shares leads to a drastic fall in the future rate of dividend as it is only
the capital that increases and not the actual resources of the company.
2. Earnings do not usually increase with the issuance of bonus shares.
3. The fall in the future rate of dividend results in the fall of the market price of
shares considerably. This may cause unhappiness· among the shareholders.
4. The reserves of the company after the bonus issue decline and leave lesser security to
investors.

STOCK SPLITS:

In a stock split, the par value per share is reduced and the number of shares is
increased proportionately. A stock split involves issuing a substantial number of additional
shares and reducing the par value of the stock on a proportional basis. In the case of a stock
split the face value (par value) per share of the company is reduced and, consequently, the
number of shares of the company is increased proportionately (the total value of
the its fully paid-up shares remains unchanged). In simple terms, a share split is a method
to increase the number of shares outstanding, with a proportional reduction in the par value
of the shares. Suppose the par value of the share is ₹ 10 and the outstanding shares are
10,000 resulting in a capital structure of ₹ 1,00, 000. When the par value share is divided
into two, the par value becomes ₹ 5 and the number of outstanding shares increases to
20,000. There is no change in the share capital amount of ₹ 1,00,000.
A stock split is often prompted by a desire to reduce the market price per share,
which will make it easier for small investors to purchase shares.
Reasons for Share Split:
The following are the reasons for the split of shares
1. To make shares attractive: When the price of a share is too high, only the wealthy
can afford to invest in a company. When the share is split, the price level would be
within the range of many to buy.

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 2. Indication of Higher Future Profits: The share splits are used by the management
of the company to communicate to investors that the company is expected to earn
higher profits in the future.

BONUS SHARE V/S SPLIT SHARE

Bonus Share Split Share

1. The par value (face value) of the 1. The par value (face value) of the shares is
shares remains unchanged. reduced.

2. A part of the reserves is capitalized 2. There is no capitalization of the reserves.

3.The shareholders proportional 3.The shareholders’ proportional ownership

ownership remains unchanged. remains unchanged in this case also.

4. The book value per share, the 4. The book value per share, the earnings per
earnings per share, and the market price share, and the market price per share decline
per share decline. in this case also.

5. Issue of bonus share increases the 5. In split share, share capital amount remains
share capital amount. the same.

6. In case of bonus share, the balance in 6. Split share does not affect the balance in the
the profit and loss account, reserves profit and loss account, reserves and even
decreases, with a similar increase in the share capital amount.
share capital account.

Reverse Stock Split: A reverse stock split is the opposite of a stock split. It involves
increasing the par value and decreasing the number of shares proportionately. A reverse
stock split is done when the stock is quoting too low.
9.9 BUYBACK OF SHARES
Buy-Back is a corporate action in which a company buys back its own shares
from the existing shareholders, usually at a price higher than the market price. When it
buys back shares, the number of shares outstanding in the market reduces. A buyback
allows companies to invest in themselves. By reducing the number of shares outstanding

14
on the market, buybacks increase the proportion of shares a company owns. In other
words, a buyback is when the issuing company pays shareholders the market value per
share and re-absorbs that portion of its ownership that was previously distributed among
public and private investors. Until recently, the buyback of shares by companies in India
was prohibited. But these have since been permitted under law, with certain restrictions.
In India, the buyback of shares is generally done by the tender method or the open
market purchase method. When companies decide to opt for the open market mechanism to
repurchase shares, they can do so through the secondary market. A company buys from the
stock market through brokers. The company fixes the maximum price for the open market
purchase, stipulates the number of shares it plans to buy, and specifies the closing date of
the offer. On the other hand, those who choose the tender offer can avail the same by
submitting or tendering a portion of their shares within a given period. In the tender
method, a company offers to buy back shares at a fixed price, which is usually higher than
the prevailing price. It determines the maximum number of shares it is willing to buy and
specifies an outer time limit for accepting the offer.

The reasons for buy-back:

1. To improve earnings per share.

2. To improve return on capital and return on net worth, as well as to increase long-
term shareholder value.
3. To provide an additional exit route to shareholders when shares are undervalued or
are thinly traded.
4. To prevent unwelcome takeover bids.
5. To return surplus cash to shareholders.
6. To achieve optimum capital structure.
7. To support share price during periods of sluggish market conditions.

Advantages of Buyback of shares:

The advantages arising from a stock repurchase include the following:

(1) If market price per share goes up as a result of the repurchase, stockholders can
take advantage of the capital gain deduction.
(2) If management is holding stock, they would favour a stock repurchase rather than a
dividend because of the favourable tax treatment.

15
 (3) It is an alternative mode of reduction in capital without requiring approval of the
Court.
(4) To provide an additional exit route to shareholders when shares are undervalued or
thinly traded.
(5) To prevent unwelcome takeover bids.

Disadvantages of Buyback of shares:

1. The market price of stock may benefit more from a dividend than a stock
repurchases.
2. Treasury stock may be bought at an excessively high price to the detriment of the
remaining stockholders. A higher price may occur when share activity is limited or
when a significant amount of shares is reacquired.
3. If investors feel that the company is engaging in a repurchase plan because its
management does not have alternative good investment opportunities, a drop in the
market price of stock may ensue.
4. If the reacquisition of stock makes it appear that the company is manipulating the
price of its stock on the market.

9.10 CHECK YOUR PROGRESS

Fill in the blanks with suitable answers:
1. Dividend decisions are decisions relating to deciding upon the extent of ______ to be
distributed to the owners or shareholders of the company.
2. When dividend is paid in the form of cash to shareholders, it's called ______.
3. In a ______ the par value per share is reduced and the number of shares is increased
proportionately.
4. Bonus Shares are the distribution of ______ to existing shareholders.
5. A reverse stock split is the opposite of a ______.
Answer to Check Your Progress:

1. Profits
2. Cash dividend
3. Stock split
4. Additional shares
5. Stock split

16
9.11 SUMMARY
The term dividend refers to that part of the profits of a company which is
distributed amongst its shareholders. It may, therefore be defined as the return that a
shareholder gets from the company, out of its profits, on his shareholdings. It may,
therefore, be defined as the return that a shareholder gets from the company, out of its
profits on his shareholdings. According to the Institute of Chartered Accountants of India,
dividend is “distribution to shareholders out of profits or reserves available for this
purpose”.

The term dividend policy refers to the policy concerning quantum of profits to be
distributed as dividends. The concept of dividend policy implies that the companies
through their Board of Directors evolve a pattern of dividend payments which has a
bearing on the future action. Of course, in practice many companies do not have a dividend
policy in this sense. They rather take each dividend decision independent of every other
such decision. This is not a sound practice but the financial manager cannot do much about
it since he works only in an advisory capacity and the power to declare dividends vests
completely with the Board of Directors of the company.

9.12 KEYWORDS
Dividend : It is the part of the divisible profit which is
distributed among the shareholders as a return
on their investment in the company in the
form of share capital.
Bonus Shares : They are the distribution of additional shares
to existing shareholders.
Buy-back of Shares : It is a corporate action in which a company
buys back its own shares from the existing
shareholders, usually at a price higher than the
market price.
Reverse Stock Split : It involves increasing the par value and
decreasing the number of shares
proportionately.

17
9.13 QUESTIONS FOR SELF STUDY
1. What are the factors that determine the dividend policy of a company?

2. Examine the importance of a stable dividend policy.

3. What are the different forms of dividends?

4. Explain the reasons for buyback of shares.

5. Discuss the various advantages and disadvantages of buyback of shares.

9.14 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill-
Tenth Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh
edition-2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-
Eleventh Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya
Publishing House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and
Sons-Fifteenth Edition-2019.

18
UNIT – 10 DIVIDEND THEORIES
Structure:

10.0 Objectives

10.1 Introduction

10.2 Irrelevance Theory of Dividend

10.2.1 Modigliani Miller Approach

10.3 Relevance Theory of Dividend

10.3.1 Walter’s Model

10.3.2 Problems on Walter’s Model of Dividend Decisions

10.3.3 Gordon’s Model

10.3.4 Problems on Gordon’s Model of Dividend Decisions

10.4 Check Your Progress

10.5 Summary

10.6 Keywords

10.7 Questions for Self-Study

10.8 References

19
10.0 OBJECTIVES
After studying this unit, you will be able to;

 Examine the various dividend theories.

 Analyse the assumptions of Modigliani and Miller approach.
 Compute the problems on Walters Model and Gordon’s Model of dividend decisions.
 Discuss the assumptions and implications of Walter’s relevance theory of dividend.
10.1 INTRODUCTION
Dividend theories attempt to explain the relationship between dividend payment
and market price of shares. In other words, they explain whether payment of dividend can
affect the market price of share of the company in any way. There are conflicting views
regarding the impact of dividend decision on the valuation of the firm. According to one
school of thought, dividend decision does not affect the share-holders' wealth and hence
the valuation of the firm. On the other hand, according to the other school of thought,
dividend decision materially affects the shareholders' wealth and also the valuation of the
firm. Hence, these approaches can broadly be divided into two groups—relevance
approach and irrelevance approach.

10.2 IRRELEVANCE THEORY OF DIVIDEND

Irrelevance approach suggests that dividend payment has no effect on the share
price of the company. There is no relation between the dividend rate and value of the
firm. Hence companies need not design dividend policies keeping in mind its potential
impact on share price. Modigliani and Miller contributed a major approach to prove the
irrelevance dividend concept.

This theory regards dividend decision merely as a part of financing decision

because the earnings available may be retained in the business for re-investment. But, if the
funds are not required in the business they may be distributed as dividends. This theory
assumes that investors do not differentiate between dividends and retentions by the firm.
Their basic desire is to earn higher return on their investment. In case the firm has
profitable investment opportunities giving a higher rate of return than the cost of retained
earnings, the investors would be content with the firm's retaining the earnings to finance
the same. However, if the firm is not in a position to find profitable investment
opportunities, the investors would prefer to receive the earnings in the form of dividends.

20
Thus, a firm should retain the earnings if it has profitable investment opportunities,
otherwise it should pay them as dividends.

10.2.1 MODIGLIANI MILLER APPROACH

Modigliani and Miller Approach (MM Model): According to M-M hypothesis,
the dividend policy of the firm is irrelevant. It has no effect on the wealth of shareholders;
rather the value of the firm is determined by the earning capacity of the firm or the
profitability of its investment policy. The splitting of earnings between retentions and
dividends may be in any manner the firm likes, and does not affect the value of the firm.

As observed by M.M., "Under conditions of perfect capital markets, rational

investors, absence of tax discrimination between dividend income and capital appreciation,
given the firm's investment policy, its dividend policy may have no influence on the
market price of the shares."

Assumptions of MM Hypothesis:

MM approach is based on the following important assumptions:

1. The firm operates in a perfect capital market.

2. Information is available to all market participants without any cost.
3. The absence of any transaction and the cost of floatation
4. No investor is large enough to affect the market price of shares.
5. There are no taxes, or there are no differences in the tax rates applicable to dividends
and capital gains.
6. The investment policy of the firm is fixed. Hence, financing new projects through
Retained earnings or by raising new capital does not change the operating risk of the
firm.
7. All investors are rational, i.e. they have no preference for dividends over capital gain.
8. All investors are perfectly certain about the future investment programmes and future
profits of the firm.
9. No risk or uncertainty.
The argument given by MM in support of their hypothesis is that whatever increase
in the value of the firm results from the payment of dividend, will be exactly off set by the
decline in the market price of shares because of external financing and there will be no
change in the total wealth of the shareholders. For example, if a company, having
investment opportunities, distributes all its earnings among the shareholders, it will have to

21
raise additional funds from external sources. This will result in the increase in number of
shares or payment of interest charges, resulting in fall in the earnings per share in the
future. Thus whatever a shareholder gains on account of dividend payment is neutralized
completely by the fall in the market price of shares due to decline in expected future
earnings per share. To be more specific, the market price of a share in the beginning of a
period is equal to the present value of dividends paid at the end of the period plus the
market price of the shares at the end of the period. This can be put in the form of the
following formula:

Formula for MM approach:

MM approach can be proved with the help of the following formula:

𝐃𝟏 + 𝐏𝟏
𝐏𝟎 =
(𝟏 + 𝐊 𝐞 )

Where,

P0= Prevailing market price of a share.

Ke = Cost of equity capital.

D1 = Dividend to be received at the end of period one.

P1 = Market price of the share at the end of period one.

P1 can be calculated with the help of the following formula:

P1 = Po (1+Ke) – D1

The number of new shares to be issued can be determined by the following formula:

M × P1 = I – (X – nD1)

Where,

M = Number of new share to be issued.

P1 = Price at which new issue is to be made.

I = Amount of investment required.

X = Total net profit of the firm during the period.

nD1= Total dividend paid during the period.

22
Criticism of MM Approach:

1. Prefect capital market does not exist in reality

2. Information about the company is not available to all the persons.
3. The firms do not follow a rigid investment policy.
4. The investors have to pay brokerage, fees, etc. while doing any transaction.
5. Shareholders may prefer current income as compared to further gains.
6. MM approach assumes that tax does not exist. It is not applicable in the practical life
of the firm.
7. MM approach assumes that, there is no risk and uncertain of the investment. It is
also not applicable in present day business life.
8. MM approach does not consider floatation cost and transaction cost. It leads to affect
the value of the firm.
9. MM approach assumes that, investor behaves rationally. But we cannot give
assurance that all the investors will behave rationally.

10.3 RELEVANCE THEORY OF DIVIDEND

Relevance theory of Dividend: According to this concept, dividend payment has a
significant bearing on the share price and hence, the dividend policy should be designed to
maximise the share price. Under the relevance approach, we have theories like Walter’s
Model and Gordon’s Model.

According to them, dividends communicate information to the investors about the

firms' profitability and hence, dividend decisions become relevant those firms which pay
higher dividends will have greater value as compared to those which do not pay dividends
or have a lower dividend pay-out ratio.

10.3.1 WALTER’S MODEL AND GORDON’S MODEL

According to Professor James E. Walter, the dividend policy of a firm should be
designed to maximise the shareholders’ value or market capitalisation. This is required as
the choice of dividend policies has a significant bearing on determining the market price of
shares. According to Walter, the investment policy of a firm cannot be separated from its
dividend policy, and both are interlinked. The choice of an appropriate dividend policy
affects the value of an enterprise.

Walter model is based on the relationship between the following important factors:

23
• Rate of return or return on investment, i.e., (r)

• Cost of capital or required rate of return, i.e. (k)

The firm would have an optimum dividend policy, which would be determined by
the relationship of r and k. If the firm earns a higher rate of return on its investment than
the required rate of return, the firm should retain the earnings. Such firms are termed as
growth firms and the optimum pay-out would be zero in their case. That is to say, the firm
should plough back the entire earnings within the firm. As a result, the market value of the
shares will be maximised. In case of declining firms which do not have profitable
investments, i.e., where r < k, the shareholders would stand to gain if the firm distributes
its earnings. For such firms, the optimum pay-out would be 100%, and the firms should
distribute the entire earnings as dividends. In case of normal firms, where r = k, the
dividend policy will not affect the market value of shares as the shareholders will get the
same return from the firm as expected by them. For such firms, there is no optimum
dividend pay-out and the value of the firm would not change with the change in dividend
rate.

Thus, Walter’s model relates the distribution of dividends (retention of earnings) to

available investment opportunities.

Assumptions of Walter's Model

1. The investments of the firm are financed through retained earnings only and the firm
does not use external sources of funds.
2. Earnings and dividends do not change while determining the value.
3. The firm has a very long life.
4. The firm does not issue any new share or debt.
5. The firm either distributes its entire earnings as dividend or re-invests immediately as
additional capital into the business.
6. Its Internal Rate of Return (r) and Cost of Capital (k) remain constant so that the
business risk is unchanged with additional investment proposals.
7. Firms beginning EPS and DPS are constant and given.
Walter’s formula for determining the value of a share:

(𝐄 + 𝐃)
𝐃+𝐫
𝐏= 𝐊𝐞
𝐊𝐞

24
Where,

P = Price of Equity Share

D = Initial dividend per share

Ke = Cost of Equity capital

r = Internal rate of return

E = Earnings per share

Criticism of Walter's Model

The following are some of the important criticisms against Walter model:

1. Walter model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
2. There is no possibility of constant return. Return may increase or decrease,
depending upon the business situation. Hence, it is not applicable.
3. According to Walter model, it is based on constant cost of capital. But it is not
applicable in the real life of the business.
4. Walter ignores the fact that market price of shares depends on many factors other
than dividend expectation of the shareholders. In reality, market price fluctuates
more because of the changes in industry structure and other macroeconomic
variables rather than dividend alone.
10.3.2 PROBLEMS ON WALTER’S MODEL OF DIVIDEND DECISIONS
r
D + K (E − D)
e
P=
Ke

Where,

P=Market price of an equity share

D=Dividend per share

r= Internal rate of return

E=Earnings per share

K e =Cost of equity capital

25
Illustration 1:

Venkat Company Ltd. has capitalization rate (Ko) of 10 per cent. Its earning per share is
₹ 20. The company declares ₹ 10 as dividend. You are required to calculate share price
assuming 20 per cent returns on investment.

Solution:
r
D + K (E − D)
e
P=
Ke

Where,

P=Market price of an equity share

D=Dividend per share

r= Internal rate of return

E=Earnings per share

K e =Cost of equity capital

0.20
₹10+ (20−10)
0.10
= = ₹ 300
0.10

Therefore the Market price of equity shares is ₹ 300

Illustration 2:

From the following data determine price per share and comment.

Particulars ABC Co. XYZ Co.

Earnings per share (₹) 10 10

Cost of Capital (%) 12 12

Return on investment (%) 15 15

Dividends per share (₹) 8 5

26
Solution:

Market Price of Equity share:

0.15
8+ (10−8)
0.12
ABC Co. = = ₹ 87.5
0.12

0.15
5+ 0.12(10−5)
XYZ Co. = = ₹ 93.75
0.12

Comment: According to Walter’s model, value of share price is maximized when

r > k0, with low dividend pay-out ratio.

In the above illustration both firms have same information except variation in the
dividend per share variation. Company XYZ has maximized share price with low dividend
payment.

Illustration 3:

The following information is available in respect of a firm:

Earnings per Share (EPS) ₹ 40

Capitalization rate (Ko or Ke) 10 %

Assumed rate of return on investment (r) is

(a) 13 %

(b) 10 %

(c) 8 %

Calculate the Market Price of Shares using Walter’s model, when dividend payout ratio is

(a) 0 %

(b) 25 %

(c) 37.5 %

(d) 50 %

(e) 75 %

(f) 100 %

27
Solution:

Dividend Policy: Value of Share Price

r > Ko r = Ko r < Ko

r = 13 % r = 10% r = 8%

(a) When DPR 0%

0.13 0.10 0.08
₹0+ (40−0) ₹0+ (40−0) ₹0+ (40−0)
P= 0.10
= ₹ 520 P= 0.10
=₹ 400 P= 0.10
= ₹ 320
0.10 0.10 0.10

(b) When DPR 25%

0.13 0.10 0.08
₹10+ (40−10) ₹10+ (40−10) ₹10+ (40−10)
P= 0.10
= ₹ 490 P= 0.10
= ₹ 400 P= 0.10
= ₹ 340
0.10 0.10 0.10

(c) When DPR 37.5%

0.13 0.10 0.08
₹15+ (40−15) ₹15+ (40−15) ₹15+ (40−15)
P= 0.10
= ₹ 475 P= 0.10
= ₹ 400 P= 0.10
= ₹ 350
0.10 0.10 0.10

(d) When DPR 50%

0.13 0.10 0.08
₹20+ (40−20) ₹20+ (40−20) ₹20+ (40−20)
P= 0.10
= ₹ 460 P= 0.10
= ₹ 400 P= 0.10
= ₹ 360
0.10 0.10 0.10

(e) When DPR 75%

0.13 0.10 0.08
₹30+ (40−30) ₹30+ (40−30) ₹30+ (40−30)
P= 0.10
= ₹ 430 P= 0.10
= ₹ 400 P= 0.10
= ₹ 380
0.10 0.10 0.10

(f) When DPR 100%

0.13 0.10 0.08
₹40+ (40−40) ₹40+ (40−40) ₹40+ (40−40)
P= 0.10
= ₹ 400 P= 0.10
= ₹ 400 P= 0.10
= ₹ 400
0.10 0.10 0.10

28
Interpretation:

The following are the conclusions from the above illustration:

(a) When the firm’s return on investment (r) is greater than the required rate of return
(K0), the share price or value declines with increase in dividends per share. From
the above illustration, we can observe that the value of share price is highest at
“zero” dividends per share thus; optimum dividend pay-out ratio is “zero” for
growth firms.
(b) When r = K0, the share price remains (stable) unaffected by increase in dividend
pay-out (DPR) ratio. In other words, there is no difference between dividends and
retained earnings, when r = k0, thus there is no optimum pay-out ratio.
(c) When r < K0, the share price increase with the increase in dividend pay-out ratio.
Thus the optimum dividend pay-out ratio is 100 per cent.
Criticisms
Walter’s model has been criticized on the basis of assumptions.
 No External Financing: Walter’s model assumes that the firm’s profitable
investment are exclusively financed by internal funds (retention of earnings) and not
by external financing. But it is not true in the real world. Firms do raise funds by
issue of new issue of new shares or bonds whenever they are in need of additional
funds.
 Constant rate of return on investment (r): The model assumes the return on
investment is constant. But in reality ‘r’ may increase with increased investment on
profitable projects. Thus ‘r’ changes.
 Constant cost of capital: The assumption that cost of capital remains constant does
not hold good, because firm’s risk pattern does not always remain constant.
Illustration – 4:

Following are the details regarding three companies A Ltd, B Ltd and C Ltd

A Ltd B Ltd C Ltd

r=15% r=5% R=10%

Ke=10% Ke=10% Ke=10%

E=₹ 8 E=₹ 8 E= ₹ 8

29
Calculate the value of equity shares of each of these companies applying Walter’s formula
when dividend payment ration (D/P Ratio) is

a) 50%

b) 75%

c) 25%

What conclusions do you draw?

Solution:

Value of an Equity Share According to Walters Formula

A Ltd B Ltd C Ltd

(i) When Dividend Payout Ratio is 50%

r
D + K (E − D)
e
P=
Ke

0.15
4+0.10(8−4) 0.05 0.10
4 + 0.10 (8 − 4) 4 + 0.10 (8 − 4)
P= P= P=
0.10 0.10 0.10

P = ₹ 100 P = ₹ 60 P = ₹ 80

(ii) When the Dividend Payout Ratio is 75%

0.15
6+0.10(8−6) 0.05 0.10
6 + 0.10 (8 − 6) 6 + 0.10 (8 − 6)
P= P= P=
0.10 0.10 0.10

P = ₹ 90 P= ₹ 70 P= ₹ 80

(iii) When Dividend Payout Ratio is 25%

2+
0.15
(8−2) 0.05 0.10
0.10 2 + 0.10 (8 − 2) 2 + 0.10 (8 − 2)
P= P= P=
0.10 0.10 0.10

P = ₹ 110 P = ₹ 50 P = ₹ 80

30
Conclusion:

A Ltd

The company may be characterized as a “growth firm”. In case of this company,

the internal rate of return is higher than the cost of capital (𝑟 > 𝐾𝑒). In such a situation, the
company can between to retain the earnings rather than distributing it in terms of
dividends, for maximizing the equity shareholders wealth. The value of the shares is
highest (₹ 110) when D/P Ratio is lowest i.e. 25%.

B Ltd

This company may be characterized as a “declining firm”. In case of this company

the internal rate of return is lower than the cost of capital (r< Ke).It will therefore be
appropriate for this company to distribute the earning among its shareholders rather than
retaining them with itself, for maximizing the shareholders wealth. As will be seen, the
value of share of this company goes on declining with every increase in the earnings
retained by it.It is the highest (₹70) when the retained earnings ratio is at its lowest (ie. D/P
ratio is at 75%).

C Ltd

This may be characterized as “normal firm”. In case of this company r=Ke. Hence
D/P ratio does not have any impact on the value of the company’s shares. The value of
share continues to be ₹ 80 in all three situations.

Illustration – 5:

Following are the details regarding three companies A Ltd, B Ltd and C Ltd

A Ltd B Ltd C Ltd

r=15% r=10% R=8%

Ke=10% Ke=10% Ke=10%

E=₹ 10 E=₹ 10 E= ₹ 10

Calculate the value of equity shares of each of these companies applying Walter’s
formula when dividend payment ration (D/P Ratio) is,

31
 a) 20%

b) 50%

c) 0%

d) 100%

Solution:

Value of an Equity Share According to Walters Formula

A Ltd B Ltd C Ltd

(i) When Dividend Payout Ratio is 20%
r
D + K (E − D)
e
P=
Ke

0.15
2+0.10(10−2) 0.10 0.08
2 + 0.10 (10 − 2) 2 + 0.10 (10 − 2)
P= P= P=
0.10 0.10 0.10

P = ₹ 140 P = ₹ 100 P = ₹ 84

(ii) When the Dividend Payout Ratio is 50%

0.15
5+0.10(10−5) 0.10 0.08
5 + 0.10 (10 − 5) 5 + 0.10 (10 − 5)
P= P= P=
0.10 0.10 0.10

P = ₹ 125 P = ₹ 100 P = ₹ 90

(iii) When Dividend Payout Ratio is 0%

0.15
0+0.10(10−0) 0.10 0.08
0 + 0.10 (10 − 0) 0 + 0.10 (10 − 0)
P= P= P=
0.10 0.10 0.10

P = ₹ 150 P= ₹ 100 P= ₹ 80

(iv) When Dividend Payout Ratio is 100%

10+
0.15
(10−10) 0.10 0.08
0.10 10 + (10 − 10) 10 + (10 − 10)
P= P= 0.10 P= 0.10
0.10 0.10 0.10

P = ₹ 100 P = ₹ 100 P = ₹ 100

32
Comment:

Company A is a growth firm,

Company B is a normal firm and

Company C is a declining firm

Illustration – 6:
From the following information, compute market price of the company share as per
Walter’s Model, if it can earn a return of (i) 20; (ii) 15 and (iii) 10 per cent on its
investments.
Earnings per share - ₹ 10
Dividends pay-out Ratios is (a) 25% (b) 50% (c) 75% (d) 100 %
The Company’s capitalization is 15 per cent.
Solution:
Dividend Policy and Value of Share as per Walter ‘S’ Model
r > K0 r = K0 r < K0
r = 0.2, k= 0.15 r = 0.15, k= 0.15 r = 0.2, k= 0.15
(a) DP Ratio 25%
0.2 0.15 0.10
2.5+ ( 10−2.5) 2.5+ ( 10−2.5) 2.5+ ( 10−2.5)
0.15 0.15 0.15
P= P= P=
0.15 0.15 0.15
P = ₹ 83.33 P = ₹ 66.67 P = ₹ 50
(b) DP Ratio 50%
0.2 0.15 0.10
5+ ( 10−5) 5+ ( 10−5) 5+ ( 10−5)
0.15 0.15 0.15
P= P= P=
0.15 0.15 0.15
P = ₹ 77.78 P = ₹ 66.67 P = ₹ 55.66
(c) DP Ratio 75%
0.2 0.15 0.10
7.5+ ( 10−7.5) 7.5+ ( 10−7.5) 7.5+ ( 10−7.5)
0.15 0.15 0.15
P= P= P=
0.15 0.15 0.15
P = ₹ 72.22 P = ₹ 66.67 P = ₹ 61.11
(d) DP Ratio 100%
0.2 0.15 0.10
10+ ( 10−10) 10+ ( 10−10) 10+ ( 10−10)
0.15 0.15 0.15
P= P= P=
0.15 0.15 0.15
P = ₹ 66.67 P = ₹ 66.67 P = ₹ 66.67

Note: When Dividend payout ratio is given Dividend = Earnings x dividend payout ratio.

33
10.3.3 GORDON’S MODEL
This is another popular model which argues that dividends are relevant, and
dividend decision of a firm affects its value. It was proposed by Gordon Myron. According
to this model a firm’s share price is dependent on dividend pay-out ratio. The model uses
stock valuation using dividend capitalization approach.
Assumptions
Gordon’s model is based on the following assumptions.
(i) The firm is all – equity firm and it has no debt
(ii) All investment projects are financed by exclusively retained earnings. In other
words, no external financing is available;
(iii) The rate of return (r) on firm’s investment is constant;
(iv) The cost of capital (K0) of the firm remains constant; and it is greater than growth
rate (K0 > b.r)
(v) The firm’s stream of earnings is perpetual;
(vi) The firm has perpetual life;
(vii) The retention ratio (b), once decided upon is constant. Thus, the growth rate,
(g = b.r) is also constant;

(viii) There are no corporate taxes.

Market price per share

Gordon’s Market value per share is determined by the following formulae
𝐄 ( 𝟏−𝐛)
P=
𝐊 𝐞−𝐛𝐫
Where:
P = Price per share
E = Earnings per share
b = Retention ratio
(1 – b) = Proportion of earnings of the firm distributed as dividends or Divided Payout
Ratio;
Ke = Capitalization rate or cash of capital or required return by equity shareholders
r = Rate of returns earned on investment made by the firm
g = b r = growth rate
From the above formula, it can be understood that the market value of the share is
equal to the present value of an infinite stream of dividends.

34
The implications of Gordon's basic valuation model may be summarized as below:

1. When r > k, the price per share increases as the dividend pay-out ratio decreases. Thus,
growth firm should distribute smaller dividends and should retain maximum earnings.

2. When r = k, the price per share remains unchanged and is not affected by dividend
policy. Thus, for a normal firm there is no optimum dividend pay-out.

3. When r < k, the price per share increases as the dividend pay-out ratio increases. Thus,
the shareholders of declining firm stand to gain if the firm distributes its earnings. For
such firms, the optimum pay-out would be 100%.

Notes: Though initially Gordon argued that a normal firm may adopt any dividend policy,
he later modified his proposition under the given context. Gordon assumed that
under situation of uncertainty:

● The shareholders (investors) are risk averse

● The shareholders (investors) prefer certain return to uncertain return.

Because of these two assumptions, under situation of uncertainty, the Cost of

Capital (k) of normal firm subsequently increases over r. As a result, dividend payment
becomes inevitable.

Gordon’s Argument: Assumptions of Gordon’s model are all similar to those of Walter’s
model. Walter and Gordon models argue that dividends affect a firm’s value. But Gordon’s
model is based on the two main arguments. (i) Investors are risk averse, and (ii) They put a
premium on a certain return for uncertain returns.
Investors are risk averse: Here risk refers to the possibility of not getting a return on
investment. It can be avoided by payment of current dividends. Investors are rational, they
want to avoid risk. Thus, they prefer current dividend. It is also known as bird in hand
argument. In other words, investors attach more risk to retained earnings; therefore, share
price would be adversely affected.
Criticism of Gordon’s Model

Gordon’s model consists of the following important criticisms:

1. Gordon model assumes that there is no debt and equity finance used by the firm. It is
not applicable to present day business.
2. Ke and r cannot be constant in the real practice.

35
 3. According to Gordon’s model, there are no taxes paid by the firm. It is not practically
applicable.
10.3.4 PROBLEMS ON GORDON’S MODEL
Illustration 1:
A firm has given the following information and requested you to determine share price
using Gordon’s model of dividend decisions.
Earnings per share ₹ 10
Retention ratio = 40 per cent
Given:
Capitalization rate = 15 per cent
Returns on investment = 14 per cent E = ₹ 10
b = 4% = 0.4
Solution: k e = 15% = 0.15
E ( 1−b) ₹10 ( 1−0.4) r = 14% = 0.14
P= = = ₹ 63.83 br = 0.4 x 0.14
k−g 0.15−0.056 br = 0.056
Illustration 2:
From the following information of Sai Co. Ltd., calculate company share value by using
Gardon’s Model.
Earnings per share ₹ 10
Cost of capital = 15 per cent
Rate of return on investment (r) 16 per cent (b) 15 per cent (c) 14 per cent
i ii iii iv v vi
Dividend Payment Ratio (1-b) 10 20 30 40 50 80
Retention Ratio 90 80 70 60 50 20

Solution:
Computation of Market Price Per Share using Gordon’s Model
r > K0 r = K0 r < K0
r = 16%, k= 15% r = 15%, k= 15% r = 14%, k= 15%
(i) D/P Ratio 10% (Retention ratio 90%)
10 ( 1−0.9) 10 ( 1−0.9) 10 ( 1−0.9)
P= P= P=
0.15−(0.9 x 0.16) 0.15−(0.9 x 0.15) 0.15−(0.9 x 0.14)

P = ₹ 166.67 P = ₹ 66.67 P = ₹ 41.67

36
 (ii) DP Ratio (Retention 80%)
10 ( 1−0.8) 10 ( 1−0.8) 10 ( 1−0.8)
P= P= P=
0.15−(0.8 x 0.16) 0.15−(0.8 x 0.15) 0.15−(0.8 x 0.14)

P = ₹ 90.91 P = ₹ 66.67 P = ₹ 52.63

(iii) DP Ratio 30% (Retention 70%)
10 ( 1−0.70) 10 ( 1−0.70) 10 ( 1−0.70)
P= P= P=
0.15−(0.7 x 0.16) 0.15−(0.7 x 0.15) 0.15−(0.7 x 0.14)

P = ₹ 78.95 P = ₹ 66.67 P = ₹ 57.69

(iv) DP Ratio 40% (Retention 60%)
10 ( 1−0.60) 10 ( 1−0.60) 10 ( 1−0.60)
P= P= P=
0.15−(0.6 x 0.16) 0.15−(0.6 x 0.15) 0.15−(0.6 x 0.14)

P = ₹ 74.07 P = ₹ 66.07 P = ₹ 60.61

(iv) DP Ratio 50% (Retention 50%)
10 ( 1−0.50) 10 ( 1−0.50) 10 ( 1−0.5)
P= P= P=
0.15−(0.5 x 0.16) 0.15−(0.5 x 0.15) 0.15−(0.5 x 0.14)

P = ₹ 71.4 P = ₹ 66.67 P = ₹ 62.50

(vi) DP Ratio 80% (Retention 20%)
10 ( 1−0.20) 10 ( 1−0.2) 10 ( 1−0.2)
P= P= P=
0.15−(0.2 x 0.16) 0.15−(0.2 x 0.15) 0.15−(0.2 x 0.14)

P = ₹ 67.80 P = ₹ 66.67 P = ₹ 65.57

Interpretation: The following are the conclusions from the above illustrations:
 When the firms r > K0 the share price decreases with decrease in retention ratio or
increase in dividend pay-out ratio. Therefore, the optimal dividend pay-out ratio is
‘zero’.
 When r = Ko the share price remains unaffected with decrease in retention ratio or
increase in dividend pay-out ratio. Therefore, there is no optimal dividend pay-out
ratio.
 When r < Ko the share price increases with decreases in retention ratio and increase in
dividend pay-out ratio. Therefore, the optimum dividend pay-out ratio is 100 per cent.
Illustration – 3:

The following information is available

Earnings per share - ₹ 5

Cost of Capital – 15 per cent

37
Return on investment (a) 20 per cent (b) 15 per cent (c) 10 per cent
Compute value of share using Gordon’s Model assuming the following.
DP Ratio (%) 100 75 50 30
Retention Ratio - 25 50 70
Comment on share price
Solution:
Dividend Policy and Share Price as per Gordon’s Model
r > K0 r = K0 r < K0
r = 20% , K=15% r = 15%, K = 15% r = 10%, K = 15%
(a) D/P Ratio 100% Retention ratio ‘0’
5 ( 1−0) 5 ( 1−0) 5 ( 1−0)
P= P= P=
0.15−(0x0.20) 0.15−(0x0.15) 0.15−(0x0.10)

P = ₹ 33.33 P = ₹ 33.33 P = ₹ 33.33

(b) DP Ratio 75% Retention ratio 25%
5 ( 1−0.25) 5 ( 1−0.25) 5 ( 1−0.25)
P= P= P=
0.15−(0.25x0.20) 0.15−(0.25x0.15) 0.15−(0.25x0.10)

P = ₹ 37.5 P = ₹ 33.33 P = ₹ 30
(c) DP Ratio 50% Retention ratio 25%
5 ( 1−0.5) 5 ( 1−0.5) 5 ( 1−0.5)
P= P= P=
0.15−(0.5x0.20) 0.15−(0.5x0.15) 0.15−(0.5x0.10)

P = ₹ 50 P = ₹ 33.33 P = ₹ 25
(d) DP Ratio 30% Retention ratio 70%
5 ( 1−0.7) 5 ( 1−0.7) 5 ( 1−0.70)
P= P= P=
0.15−(0.70x0.20) 0.15−(0.70x0.15) 0.15−(0.70x0.10)

P = ₹ 150 P = ₹ 33.33 P = ₹ 18.75

Comment:
 When the r > ko Share price increases as the dividend pay-out ratio decreases.
 When the r = ko share price remains constant in response to variations in dividend
pay-out ratio.
 When the r < ko share price decreases as the dividend pay-out ratio decreases.

10. 4 CHECK YOUR PROGRESS

Fill in the blanks with suitable answers:

1. According to M-M hypothesis, the dividend policy of the firm is ______.

2. Gordon’s Market value per share is determined by the following formulae ______.

38
 3. The formula to compute the Market price of an equity share by using Walter’s
model is ______.
4. Gordon’s model is based on the assumption that a firm has all – equity and it has no
______.
5. When a company has the internal rate of return higher than the cost of capital (r>
ke), then such a firm is termed as ______.
6. When the company has lower internal rate of return than the cost of capital (r<ke),
then such a firm is termed as ______.

Answer to Check Your Progress:

1. Irrelevant.
E ( 1−b)
2. P = K0−b.r
r
D+ (E−D)
Ke
3. P = Ke

4. Debt
5. Growth firm
6. Declining firm

10.5 SUMMARY
On the issues pertaining to the relationship between the dividend policy and the
share value of the firm, different viewpoints have been expressed by financial experts
Modigliani and Miller have an advanced view regarding the value of a firm. He opines that
the value of a firm depends solely on the earning power and is not influenced by the
manner in which its earnings are split between dividends and retained earnings. The view
is referred to as the “dividend irrelevance theory.”

However, as per Walters’s theory of dividend:

(1) When the rate of return on investments exceeds the cost of capital, the price per
share increases as the dividend pay-out ratio decreases.
(2) When the rate of return on investment is equal to the cost of capital, the price per
share does not vary with changes in the dividend pay-out ratio.
(3) When the rate of return on the investment is less than the cost of capital, the price
per share increases as the dividend pay-out ratio increases.

39
10.6 KEYWORDS
Dividends : A share in the profits of the company distributed to
the shareholders of the Company.

Perfect Capital Market : A market that has complete access to all financial
information.

Earnings Per Share (EPS) : Total Earnings available to the equity shareholders /
No of shares.
Retention Ratio : It is the proportion of earnings kept back in the
business as retained earnings.

10.7 QUESTIONS FOR SELF-STUDY

1. The following information is available

Earnings per share - ₹ 10

Cost of Capital – 15 per cent
Return on investment (a) 20 per cent (b) 15 per cent (c) 10 per cent
Compute value of share using Gordon’s Model assuming the following.
DP Ratio (%) 100 75 50 30
Retention Ratio - 25 50 70
Comment on share price
2. What are the assumptions of MM Hypothesis?

3. XYZ Ltd. has capitalization rate (Ko) of 10 per cent. Its earnings per share are ₹ 40. The
company declares ₹ 10 as dividend. You are required to calculate share price assuming
20 per cent returns on investment.

4. Discuss the Irrelevance theory of Dividend.

5. Explain Gordon’s Model.

10.8 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill-
Tenth Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh
edition-2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-
Eleventh Edition-2016.

40
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya
Publishing House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and
Sons-Fifteenth Edition-2019.

41
UNIT - 11 WORKING CAPITAL MANAGEMENT
Structure:

11.0 Objectives

11.1 Introduction

11.2 Meaning and Definitions of Working Capital

11.3 Types of Working Capital

11.4 Working Capital Management

11.5 Meaning and Definitions of Working Capital Management

11.6 Objectives of Working Capital Management

11.7 Working Capital Cycle/ Operating Cycle

11.8 Stages in Operating Cycle

11.9 Determining Working Capital Requirement of a Firm

11.10 Adequacy and Excessive Working Capital

11.10.1 Problems of Excessive Working Capital

11.10.2 Problems of Inadequate Working Capital

11.11 Illustration Estimation of Working Capital Requirements

11.12 Check Your Progress

11.13 Summary

11.14 Keywords

11.15 Questions for Self-Study

11.16 References

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11.0 OBJECTIVES
After studying this unit, you will be able to;

 Examine the need and importance of working capital

 Discuss the operating cycle
 Highlight the factors influencing working capital decisions in a firm
 Arrive at the proper mix of short term and long term financing of current assets
 Compute the problems on ascertainment of net working capital

11.1 INTRODUCTION
Working Capital is an important decision for any business, because a company
cannot operate if it does not have working capital. Working capital may be regarded as the
lifeblood of a business enterprise. It is closely related to the day-to-day operations of the
business. Every business needs funds for two purposes of loans term and short term. Long-
term funds are required for the creation of production facilities. Investment in these assets
represents that part of a firm’s capital, which is permanently blocked on a permanent or
fixed basis and is called fixed capital. The form of these assets does not change, in the
normal course. Short-term funds are also needed for the purchase of raw materials,
payment of wages and other day-to-day expenses etc. These funds are known as working
capital. Funds invested in these assets keep revolving, fast and on a continuous basis.
These assets are converted into cash and, again, cash is converted into current assets. So,
working capital is also called revolving or circulating capital.

11.2 MEANING AND DEFINITIONS OF WORKING CAPITAL

In simple terms, Working Capital refers to the capital required for the day-to-day
working of a business enterprise. In other words, working capital refers to that part of the
firm’s capital, which is required for financing short-term or current assets such as cash,
debtors, inventories, and marketable securities etc.

Working Capital is the excess of Current Assets over Current Liabilities. Working
Capital is also known as ‘circulating capital’ or ‘revolving capital’ or ‘fluctuating capital’
or ‘short-term capital’ since it circulates within the organisation in a cyclical manner. This
cycle has the following steps: (1) The process begins with the purchase of raw materials,
(2) raw materials are converted into work-in-progress, (3) work-in-progress is converted to
finished goods, (4) finished goods are sold to debtors and (5) cash is collected from debtors
and the next process begins with the purchase of raw materials and the process continues.

43
Working Capital is a vital component of a business, and its management is important to
ensure the smooth functioning of the business.

Definitions:

According to Shubin: “Working Capital is the amount of funds necessary to cover the
cost of operating the enterprises.”

According to Genestenberg: “Working Capital means current assets of a company that

are changed in the ordinary course of business from one form to another as for e.g. Cash to
inventories, inventories to receivables and receivables to cash”.

Hampton has defined Working Capital as “Working Capital refers to the firm’s Current
Assets.” Working Capital = Current Assets – Current Liabilities

11.3 TYPES OF WORKING CAPITAL

Working Capital can be divided into two categories on the basis of time:

1. Permanent Working Capital

2. Temporary or Variable Working Capital

Permanent working capital

This refers to that minimum amount of investment in all current assets which is required at
all times to carry out minimum level of business activities. In other words, it represents the
current assets of business activities. In other words, it represents the current assets required
on a continuing basis over the entire year. Tandon Committee has referred to this type of
working capital as “core current assets”.

The following are the characteristics of this type of working capital

1. Amount of permanent working capital remains in the business in one form or

another. This is particularly important from the point of view of financing. The
suppliers of such working capital should not expect its return during the life time of
the firm.
2. It also grows with the size of the business. In other words greater the size of the
business, the greater is the amount of such working capital and vice versa.
Permanent working capital is permanently needed for the business and therefore its
should be financed out of long term funds.

44
Temporary working capital

The amount of such working capital keeps on fluctuating from time to time on the
basis of business activities. In other words, it represents additional current assets required
at different times during the operating year. For example, extra inventory has to be
maintained to support sales during peak sales period. Similarly, receivable also increase
and must be finance during period of high sales. On the other hand investment in
inventories, receivables etc. will decrease in periods of depression

Suppliers of temporary working capital can expect its return during off season when
it is not required by the firm. Hence, temporary working capital is generally financed from
short-term sources of finance such as bank credit.

11.4 WORKING CAPITAL MANAGEMENT

Management of Working Capital is also an important part of financial management.
Working capital management policies of a firm have a great effect on its profitability,
liquidity and structural health of the organisation. The main objective of Working Capital
Management is to manage the current assets and current liabilities effectively so that a
satisfactory level of working capital is maintained in such a way that it's neither inadequate
nor excessive. Both inadequate as well as excessive working capital positions are bad for
any business. Management of Working Capital is the management of key components of
working capital such as cash, inventories, and receivable is critical because these assets
hold the majority of working capital.

11.5 MEANING AND DEFINITIONS OF WORKING CAPITAL

MANAGEMENT
Working capital management refers to the management and control of gross current
assets. such as cash in hand, cash in bank as well as cash in transit, sundry debtors and
inventories (comprising raw materials, consumables, spares, work-in-process and finished
goods).

Working capital management is an act of planning, organizing and controlling the

components of working capital like cash, bank balance inventory, receivables, payables,
overdrafts and short-term loans.

In other words, application of the management functions for managing Working

Capital is known as working capital management. Working Capital represents the liquidity
position of a business, i.e. its ability to meet the day-to-day operations. Hence, Working

45
Capital management is of utmost importance as it indicates the probability that the firm
will be unable to meet its financial commitments.

Working Capital Management Comprises of the following:

1. Estimation of Working Capital Requirement.

2. Sources of Working Capital.
3. Approaches to Working Capital Financing or Working Capital Policies.
4. Components of Working Capital Management.
5. Receivables Management.
6. Inventory Management.
7. Cash Management.
Definitions:

According to Smith K.V, “Working capital management is concerned with the problems
that arise in attempting to manage the current asset, current liabilities and the
interrelationship that exist between them”.

According to Weston and Brigham, “Working capital generally stands for excess of
current assets over current liabilities. Working capital management therefore refers to all
aspects of the administration of both current assets and current liabilities”.

11.6 OBJECTIVES OF WORKING CAPITAL MANAGEMENT

Working Capital management is essential to maintain a satisfactory level of
working capital in order to avoid a financial crisis. Both excess and inadequate working
capital exerts an evil influence on the health of a company. So, neither excess nor
inadequate working capital is desirable. The objectives of Working Capital management
are as follows:

1. Management of current assets and liabilities:

The prime objective of working capital management is the management of

Current Assets and Current Liabilities so that there is neither excess Working
Capital nor inadequate Working Capital, i.e. there's a satisfactory level of
Working Capital.

46
 2. Assessing liquidity and profitability:
There should be a proper balance between liquidity and profitability and hence,
working capital management targets should be to balance profitability and
liquidity by maintaining a satisfactory level of working capital.
3. Proper balance among different components:
To ensure a proper balance between different components of working capital like
cash, bank balance inventory, receivables, payables, overdrafts, and short-term
loans.
4. Maintain optimum cash level:

The optimum level of cash balance should be maintained so that there is neither
excessive cash in hand or at the bank nor insufficient cash in hand or at the bank,
because excessive cash in hand or at the bank indicates the inability of the firm to
utilise resources for profitable and productive purposes, whereas insufficient cash
indicates a fund crisis. So, management of Working Capital is essential.
5. Examine the soundness of the company:
Working Capital management in an effective and efficient manner ensures higher
profitability, a balanced liquidity position and the sound health of the company.
6. Forecasting:
Working Capital management forecasts, the Working Capital needs of each
component of Current Assets—determining the amount to be invested in Current
Assets, examining each component of Working Capital.
11.7 WORKING CAPITAL CYCLE/ OPERATING CYCLE
Working Capital cycle refers to the time period required for the conversion of cash
back into cash again. Working Capital cycle is also known as Operating Cycle. In other
words, Operating Cycle is the time gap between the outflow of cash and the inflow of cash
of a firm. It is an important determinant of the working capital requirement. Operating
Cycle starts with the purchase of raw materials and ends with cash realisation from sales.

The first stage of Operating Cycle is procurement of raw materials by cash. Raw
materials can be procured on credit also, but cash is required for labour and overhead
expenses to carry out production process. Raw materials procured in combination
with labour and overhead are converted into finished goods— this process of conversion of
raw materials into finished goods is known as production. Raw materials are converted into
finished goods by adding some value to it. These finished goods are sold in the market

47
either for cash or credit. For credit sales, cash is realized from debtors after the expiry of
the credit period allowed to debtors by the company. The time it takes to complete one
cycle, from cash procurement of raw materials to cash realisation from sales, is referred to
as the Operating Cycle or Working Capital Cycle.

The time that elapses between the purchase of raw materials and the collection of
cash for sales is referred to as the operating cycle (Operating Cycle is also known as Gross
Operating Cycle), whereas the time length between the payment for raw material purchases
and the collection of cash for sales is referred to as the cash cycle (Cash cycle is also
known as Net Operating Cycle).
Accounting Research Bulletin No. 43 defines Operating Cycle as ‘The average
time intervening between the acquisition of materials or services entering this process and
the final cash realisation constitutes an Operating Cycle.’

K. V. Smith defines Operating Cycle as ‘the continuing flow from cash to

suppliers, to inventory, to accounts receivable and back into cash is what is called
Operating Cycle. ‘So, the operating cycle is the length of time between the company's
outlay on raw materials, wages and other expenses and inflow of cash from sale of goods.

11.8 STAGES IN OPERATING CYCLE

1. Procurement of raw materials

2. Conversion of raw materials in work-in-progress

3. Conversion of work-in-progress into finished goods

4. Sale of finished goods

● For cash sales (Operating Cycle ends)

● For credit sales

5. Conversion of receivables into cash or realization of debtors into cash.

48
 Purchase of Raw
Materials

Cash Operating Cycle Work - in - Progress

OR (labour + overhead
Working Capital Cycle + raw materials)

Accounts Receivables
Finished Goods
(Debtors + Bills
Stock
Receivables)
+ raw materials)
+ raw materials)
Fig. 11.1: Stages in Operating Cycle

11.9 FACTORS DETERMINING WORKING CAPITAL REQUIREMENT OF A

FIRM
There are no set rules or formulae to determine the working capital requirements.
The factors that influence the requirements vary from time to time. They cannot be ranked
in the order of importance as the importance of each factor differs, over time. However, the
following is the description of the factors, which, generally, influence the requirement of
working capital.

1. Nature of Business:
The working capital requirements of a firm are closely related to the nature of its
business. For those organisations providing services, working capital requirement
is less as compared to manufacturing organisations. Because the requirement of
working capital is greater in the case of manufacturing organisations, since they
have to maintain a huge stock of raw materials and finished goods. Their working
capital requirement is limited, while they abundantly invest in fixed assets. If
business concerns follow a rigid credit policy and sell goods only for cash, they
can maintain a lesser amount of Working Capital.
2. Size of Business:
The working capital requirements are largely determined by the size of the unit or
scale of operations. If the enterprise is big, the requirements are large and for a

49
 small firm, the requirements are low. In some cases, even small units may require
more working capital due to inefficient utilisation of funds, high overhead
charges, and other economic disadvantages.
3. Business Cycle:
Business fluctuations cause cyclical and seasonal changes in the business
condition, which affect the working capital requirements. Working Capital
requirements depend on the business cycle, i.e., in a period of recession, the
demand for working capital is lower, whereas in a boom period, the demand for
working capital is higher since the volume of production is higher in the boom
period. Better business results lead to increasing the working capital requirements.
4. Production Cycle:
The amount of working capital depends upon the length of the production cycle. If
the production cycle is longer, in that case the amount of Working Capital
requirement is higher as the funds remain blocked for a longer period of time. If
it is not, they have to maintain a lesser amount of working capital. The production
cycle starts with the purchase of raw materials to production of finished goods.
The longer the period, the higher the requirement of working capital.
5. Sales Volume:
The working capital needs of a firm are directly related to sales. The firm has to
build inventory before sales are expected. For higher sales volume, a higher
amount of investment in Working Capital is required, but for lower sales volume
the amount of investment in Working Capital is lower. Additional current assets
are needed to match the increased volume of production and sales. So, firms need
more working capital, when sales are higher and demand for the product is high.
6. Credit Policy:
Credit policy is an important factor in determining the requirement for working
capital. if the credit policy is stringent, i.e. customers are allowed lower credit
periods, in that case. Working Capital requirement is lower but in case of a liberal
credit policy where customers are allowed higher credit period, in that case
working capital requirement is higher. A company that purchases its supplies on
credit and sells its goods and services in cash requires less working capital. On the
other hand, a concern buying its requirement for cash and allowing credit to its
customers will need larger amounts of working capital as very huge amounts of
funds are bound to be tied up in debtors or bills receivables.

50
7. Operational Efficiency:
Efficient firms can manage with lower working capital. The operating efficiency
of a firm relates to its optimum utilisation of resources available, whether in any
form of factor of production, say, capital, labour, materials, machines etc. If a
company is able to effectively operate its costs, its operating cycle is accelerated
and requires a relatively smaller amount of working capital. On the other hand, if
a firm is not able to utilise its resources properly, it will have a slow operating
cycle and naturally require a higher amount of working capital.
8. Production Policy:
Production could be kept either steady by accumulating inventories during slack
periods with the view of meeting high demand during the peak season or
production could be curtailed during the slack season and increased during the
peak season. Depending on the production policy, the requirement for working
capital varies. In the case of a steady production policy, the requirement for
working capital is higher since production is to be carried out throughout the
year. However, in the case of seasonal production policies, the amount of working
capital required is minimal.
9. Inventory Policy:
If the amount of funds blocked in inventory is higher, higher will be the
requirement for working capital. Whereas if the amount of funds blocked in
inventory is lower, lower will be the requirement for working capital.
10. Variable Production Competencies:
When the industry is able to produce alternative products, it can manufacture its
core product during periods of high demand while manufacturing other products
during periods of low demand, enabling the industry to use its manufacturing
capacity more equally. Firms can have a consistent working capital requirement
throughout the year as a result of this.
11. Availability of Credit:
When a business is confident in its ability to obtain further funding from banks, it
can operate with much less working capital than companies that do not have that
facility or backing. Similarly, businesses with easy financing may not require a lot
of working capital. They do have the option of selling for cash or on credit.

51
12. Price Level:
Price level is also another determinant of Working Capital requirement. The
anticipation of future price level changes is necessary to avoid their effects on the
working capital of the firm. Generally, rising price levels will require a company
to demand more working capital because the same level of current assets requires
a higher amount of working capital due to increased prices. The increasing shifts
in price levels result in an increased requirement for working capital, if the firm is
not able to revise the selling prices immediately.
13. Rate of Stock Turnover:
The amount of working capital and the velocity or speed with which sales are
influence have a strong inverse relationship. A company with a high rate of stock
turnover will require less working capital than one with a low rate of turnover.
14. Availability of Raw Materials:
The availability of raw materials influences the Working Capital requirements. If
raw materials are readily available throughout the year, then there is no
requirement to maintain a huge inventory. When raw materials are not readily
available, they lead to production stoppages. As a result, the company must keep
enough raw materials on hand for that reason. They will need to spend a certain
amount of Working Capital.
15. Dividend Policy:
The dividend policy of a firm is also an important determinant of working capital
requirements. The higher the amount of dividend paid in cash, the higher the
requirement of Working Capital, and the lower the amount of dividend paid lower
will be the Working Capital requirement. A consistent dividend policy may affect
the size of working capital. When some amount of working capital is financed out
of the internal generation of funds, such an effect will be there.

16. Earning Capacity:

If the business concern consists of high level of earning capacity, they can
generate more Working Capital, with the help of cash from operation. Earning
capacity is also one of the factors which determine the Working Capital
requirements of the business concern.

52
 17. Working Capital Cycle:
The longer the Working Capital or Operating Cycle, higher the requirement for
Working Capital. Working capital cycle starts with the procurement of raw
materials and ends with cash realisation. It is evident that the longer the operating
cycle, the greater the need for working capital.
18. Growth and Expansion:
If a firm wants to expand its business, then additional Working Capital is
required. If a firm plan for further expansion in future, in that case the Working
Capital requirement will be higher compared to a firm which doesn't want to
expand its business in future. It is the tendency of any business organization to
grow further and further till its saturation point, if any. Such growth may be
within existing units by increased activities. Similarly, business concerns will
expand their organisation by establishing new units. In both cases, the need for
working capital requirements increases as the organisation increases.
11.10 ADEQUACY AND EXCESSIVE WORKING CAPITAL
A firm must have adequate working capital, i.e., is much as needed by the firm. It
should neither be excessive nor inadequate. Both situations are dangerous. Excessive
working capital means the firm had idle funds which earn no profits for the firm.
Inadequate working capital means the firms does not have sufficient funds for running its
operations which ultimately results in production, interruptions and lowering down the
profitability.

It will be interesting to understand the relationship between working capital, risk and
return. In a manufacturing concern, it is generally accepted that higher levels of working
capital decrease the risk and decrease the profitability too. While lower levels of working
capital increase the risk but have the potentiality of increasing the profitability also. This
principle is based on the following assumptions:

1. There is direct relationship between risk and profitability -higher is the risk, higher
is the profitability, while lower is the risk, lower is the profitability.
2. Short term funds are less expensive than long term funds
3. Current assets are less profitable than fixed assets
On account of the above principle, an increase in the ratio of current assets to total assets
will result in the decline in the profitability of the firm. This is because investment in

53
current assets, as stated above is less profitable than that of in fixed assets. However, this
will increase the risk of the firm becoming technically insolvent on account of its possible
inability of meeting its commitments in time due to shortage of funds.

11.10.1 Problems of excessive working capital

1. Excess of working capital may result in unnecessary accumulation of inventories.

2. It may lead to offer too liberal credit terms to buyers and very poor recovery system
and cash management.

3. It may make management complacent leading to its inefficiency.

4. Over-investment in working capital makes capital less productive and may reduce
return on investment.

11.10.2 Problems of inadequate working capital management

1. Growth may be stunted. It may become difficult for the enterprise to undertake
profitable projects due to non-availability of working capital.

2. Implementation of operating plans may become difficult and consequently the

profit goals may not be achieved.

3. Cash crisis may emerge due to paucity of working funds.

4. Optimum capacity utilization of fixed assets may not be achieved due to non-
availability of the working capital.

5. The business may fail to honor its commitment in time, thereby adversely affecting
its credibility. This situation may lead to business closure.

6. The business may be compelled to buy raw materials on credit and sell finished
goods on cash. In the process it may end up with increasing cost of purchases and
reducing selling prices by offering discounts. Both these situations would affect
profitability adversely.

7. Non-availability of stocks due to non-availability of funds may result in production

stoppage.

8. While underassessment of working capital has disastrous implications on business,

over assessment of working capital also has its own dangers.

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11.11 ILLUSTRATION ON ESTIMATION OF WORKING CAPITAL
REQUIREMENT
Illustration - 1:

Prepare an estimate of working capital requirement from the following information of a

trading concern.

1. Projected annual sales 10,000 units

2. Selling price ₹ 10 per unit
3. Percentage of net profit on sales 20%
4. Average credit period allowed to customers 8 Weeks
5. Average credit period allowed by suppliers 4 Weeks
6. Average stock holding in terms of sales requirements 12 Weeks
7. Allow 10% for contingencies
Solution:

Statement of Working Capital Requirements

Current Assets `

Debtors (8 weeks) (at cost of sales) (80,000 × 8/52) 12,308

Stock (12 weeks) (80,000×12/52) 18,463

Total Current Assets 30,770

Less: Current Liability

Credits (4 weeks) (80,000 × 4/52) ( 6,154)

Net Working Capital = Current Assets – Current Liabilities 24,616

Add: 10% for Contingencies 2,462

Working Capital Required 27,078

Working Notes:

Sales = 10000×10 = ₹ 1, 00,000

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Profit 20% of ₹ 1, 00,000 = ₹ 20,000

Cost of Sales = ₹1, 00,000 – 20,000 = ₹ 80,000

As it is a trading concern, cost of sales is assumed to be the purchases

Illustration – 2:

Prepare an estimate of working capital requirement from the following information of a

trading concern.

Projected annual sales ₹ 6, 50,000

Percentage of net profit on sales 20%

Average credit period allowed to debtors 10 Weeks

Average credit period allowed by creditors 4 Weeks

Average stock holding in terms of sales requirements 8 Weeks

Allow 20% for contingencies

Solution: Statement of Working Capital Requirements

Current Assets ₹
Debtors (10 weeks) (at cost) (5,20,000 × 10/52) 1,00,000
Stock (8 weeks) (5,20,000 × 8/52) 80,000
Total Current Assets 1,80,000
Less: Current Liability
Creditors (4 weeks) (5,20,000 × 4/52) (40,000)
Net Working Capital = Current Assets – Current Liabilities 1,40,000
Add: 20% for Contingencies 28,000
Working Capital Required 1,68,000

Working Notes

Sales = ₹ 6, 50,000

Profit 20/100 of ₹ 6, 50,000 = ₹ 1, 30,000

Cost of Sales = ₹ 6, 50,000 – 1, 30,000 = ₹ 5, 20,000

As it is a trading concern, cost of sales is assumed to be the purchases.

Illustration – 3:

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The Board of directors of Aravind Mills Ltd. request you to prepare a statement showing
the working capital requirements for a level of activity of 30,000 units of output for the
year. The cost structure for the company’s product for the above mentioned activity level is
given below. Compute working capital based on monthly turnover. Compute working
capital based on monthly Turnover.

Cost per Unit (₹)

Raw materials 20

Direct labour 5

Overheads 15

Total 40

Profit 10

Selling Price 50

(a) Past experience indicates that raw materials are held in stock, on an average for 2
months.

(b) Work in progress (100% complete in regard to materials and 50% for labour and
overheads) will be half a month’s production.

(c) Finished goods are in stock on an average for 1 month.

(d) Credit allowed to suppliers: 1 month.

(e) Credit allowed to debtors: 2 months.

(f) A minimum cash balance of ₹ 25,000 is expected to be maintained.

Prepare a statement of working capital requirements.

Solution

Output per annum = 30,000 units

Output per month = 30,000/12 =2,500 units

Raw materials ( ₹ 20 × 2500 ) 50,000

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 Labour ( ₹ 5 × 2,500 ) 12,500

Overheads ( ₹ 15 × 2,500 ) 37,500

1,00,000

Statement of Working Capital Requirements

Particulars ₹

a)Stock of raw materials (2 months)

(₹ 50,000 x 2 months) 1,00,000

b) Work-in-progress (1/2 months)

Raw materials = (₹50,000 x ½ months) 25,000

Labour = (₹12,500 x ½ months x 50/100) 3,125

Overheads=(₹37,500 x ½ months x 50/100) 9,375

37,500

c)Stock of finished goods (1 month)

(₹ 1, 00,000 x 1 months) 1,00,000

d)Debtors (2 month) 2,00,000

(₹ 1,00,000 x 2 months)

e) Cash balance required 25,000

Total Current Asset 4,62,500

(a+b+c+d+e)

Less: Current liability

Creditors (1 month) (₹ 50,000 x 1 month) 50,000

Net Working Capital = Current Assets – 4,12,500

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 Current Liabilities

Illustration – 4:

ABC Ltd sells its products on a gross profit of 20% on sales. The following information is
extracted from the annual accounts for the year ended 31st December 2020:

Particulars ₹
Sales(3 month credit) 40,00,000
Raw materials 12,00,000
Wages(15days in arrears) 9,60,000
Manufacturing expenses(one month in arrears) 12,00,000
Administration expenses (one month in arrears) 4,80,000
Sales promotion expenses (payable half yearly in advance) 2,00,000

The company enjoys one month’s credit from the suppliers of raw materials and maintains
2 months stock of raw materials and one and a half months finished goods. Cash balance is
maintained at ₹ 1, 00,000 as a precautionary balance. Assuming a 10% margin, find out the
working capital requirements of ABC Ltd.
Solution:
Statement of Working Capital Requirement
Current Assets ₹
Stock of raw materials (₹ 12,00,000 x 2/12) 2,00,000
Stock of finished goods at stock 4,00,000
(₹ 40,00,000 x 80/100 x 1.5/12)
Debtors at cost 8,00,000
(40,00,000 x 80/100 x 3/12)
Advance payment of sales promotion expenses
(2,00,000 x 6/12) 1,00,000
Cash balance 1,00,000
Total Current Assets 16, 00,000
Current Liabilities
Creditors for raw materials (`12,00,000 x 1/12) 1,00,000
Wages outstanding (` 9,60,000 x 0.5/12) 40,000

59
 Manufacturing expenses outstanding (12,00,000 x 1/12) 1,00,000
Administration expenses outstanding (4,80,000 x 1/12) 40,000
Total Current Liabilities 2, 80,000
13,20,000
Net Working Capital = Current Assets – Current Liabilities
1,32,000
Add: 10% Margin for contingencies
Working Capital Requirements 14,52,000
Illustration – 5:
Raju Brothers Private Limited sells goods on a gross profit of 25%. Depreciation is taken
into account as part of cost of production. The following are the annual figures given to
you:

Particulars Amount

Sales( two months credit) 18,00,000

Material Consumed ( one month credit) 4,50,000

Wages ( One month lag in payment) 3,60,000

Cash manufacturing expenses ( one month lag in payment) 4,80,000

Administration expenses(One month lag in Payment) 1,20,000

Sales promotion expenses (paid currently in advance) 60,000

Income tax payable in 4 installments of which one lies in next year 1,50,000

The company keeps one month’s stock of each raw material and finished goods. It also
keeps ₹ 1,00,000 in cash. You are required to estimate the working capital requirements of
the company assuming 15% safety margin.
Solution:
Statement of Working Capital Requirements
Current Assets
Stock of raw materials (4,50,000 x 1/12) 37,500
Stock of finished goods at cost (18,00,000x75/100x1/12) 1,12,500
Advance payment of sales promotion expenses 60,000
Debtors at cost (18,00,000 x 75/100 x 2/12) 2,25,000
Cash 1,00,000

60
 Total Current Assets 5,35,000
Current Liabilities
Creditors for materials (4,50,000 x 1/12) 37,500
Wages outstanding (3,60,000 x 1 /12) 30,000
Cash Manufacturing expenses outstanding (4,80,000x1/12) 40,000
Administration expenses outstanding (1,20,000 x 1/12) 10,000 (1,17,500)
Net Working Capital = Current Assets – Current Liabilities 4,17,500
Add:15% Safety Margin 62,625
Working Capital 4,80,125

Note:
1. Profit has been ignored and the debtors have been taken at cost. The profit has been
ignored because this may or may not be used as a source of working capital.
2. Income tax has also been ignores as it is charged on profits.
Illustration – 6:

Calculate the amount of working capital requirement of SRCC Ltd. from the
following information:

Particulars Amount
Per Unit
₹
Raw material 80
Direct Labour 30
Overheads 60

Total cost 170

Profit 30

Selling Price 200

1. Raw materials are held in stock on an average for one month.

2. Materials are in process on an average for half – a – month. The materials
are in 50 % completion stage.
3. Finished goods are in stock on average for one month.
4 . Credit allowed by suppliers is one month and credit allowed to debtors is
Two months.

61
 5. Time lag in payment of wages is 1½ week.
6. Time lag in payment of overhead expenses is one month.
7. One fourth of the sales are made on cash basis.
8. Cash in hand and at the bank is expected to be ₹ 3, 65,000 and expected
level of production amounts to 1, 04,000 units for a year of 52 weeks.
You may assume that production is carried on evenly throughout the year and a
time period of four weeks is equivalent to a month.
Solution:
Statement of Working Capital Requirements
Current Assets `
Stock of materials for 1 month (1,04,000 units x 80 x4/52) 6,40,000
Work in Progress for half a month
a) Material (1,04,000 units x 80 x 2/52 x 0.50) 1,60,000
b) Labour (1,04,000 units x 30 x 2/52 x 0.50) 60,000
c) Overheads (1,04,000 units x 60 x 2/52 x0.50) 1,20,000
Finished goods for 1 month (1,04,000x 170x4/52) 13,60,000
Debtors for 2 months (78,000 x 170 x8/52) 20,40,000
Cash in hand and at Bank 3,65,000
Total Current Asset 47,45,000
Current Liabilities
Creditors – 1 month’s purchases of raw materials (1,04,000x80x4/52) 6,40,000
Average time lag in payment of expenses
a) Overheads (1,04,000 x 60 x4/52) 4,80,000
b) Labour (1,04,000x 30 x 1.5/52) 90,000
Total Current Liabilities (12,10,000)
Net Working Capital = Current Assets – Current Liabilities 35,35,000

Working notes and assumptions:

1. 26,000 units have been sold for cash. Therefore, credit sales pertain to 78,000 units only
[that is, 1,04,000x ¾]

2. One year has 52 weeks.

Illustration- 7:

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Calculate the amount of working capital requirement for Fireworks Company Ltd. from
the following information:

(Per Unit)
Particulars `

Raw Material 160

Direct Labour 60

Overheads 120

Total cost 340

Profit 60

Selling price 400

1. Raw materials are held in stock on an average for one month.

2. Materials are in process on an average for half-a-month.

3. Finished goods are in stock on an average for one month. The materials are in 50%
completion stage.

4. Credit allowed by suppliers is one month and credit allowed to debtors is two months.

5. Time lag in payment of wages is 1½ weeks.

6. Time lag in payment of overhead expenses is one month.

7. One fourth of the sales are made on cash basis.

Cash in hand and at the bank is expected to be ` 50,000 and expected level of
production amounts to 2, 00,000 units for a year of 52 weeks.
You may assume that production is carried on evenly throughout the year and a
time period of four weeks is equivalent to a month.

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Solution:

Statement of Working Capital Requirements

Current Assets `
Stock of materials for 1 month (2,00,000 x 160 x4/52) 24,61,538.46
Work in Progress for 0.5 months
d) Material (2,00,000 x 160 x 2/52 x 0.50) 6,15,384.61
e) Labour (2,00,000 x 60 x 2/52x 0.50) 2,30,769.23
f) Overheads (2,00,000 x 120 x 2/52 x0.50) 4,61,538.46
Finished goods for 1 month(2,00,000 x 340 x4/52) 52,30,769.23
Debtors for 2 months (1,50,000 x 340 x8/52) 78,46,153.84
Cash in hand and at Bank 50,000.00
Total Current Asset 1,68,96,153.83
Current Liabilities
Creditors – 1 month’s purchases of raw materials
(2,00,000x160x4/52) 24,61,538.46
Average time lag in payment of expenses
c) Overheads (2,00,000 x120 x4/52) 18,46,153.84
d) Labour (2,00,000x 60 x 1.5/52) 3,46,153.84
Total Current Liabilities 46,53,846.14
Net Working Capital = Current Assets – Current Liabilities 1,22,42307.69

Working Note:

1. Computation of Debtors: Since 1/4 th of Sales in based on Cash the remaining

3/4th is based on credit. Hence (2, 00,000 x 3/4 = 1, 50,000) is the value of debtors.
2. One year has 52 weeks.

Illustration – 8:

The Product cost sheet of Sheetal Company Ltd is as follows:

60
Raw materials
30
Direct Labour
50
Overheads

64
 140
Total
20
Profit
160
Selling Price

 Average raw material in stock is for one month.

 Work in progress is for half month.
 On an average all units in work in progress are 50% complete.
 Credit allowed by suppliers: One month:
 Credit allowed to debtors: One month.
 Average time lag in payment of materials is 30 days.
 Average time lag in payment of wages: 10 days
 Average time lag in payment of overheads is 30 days.
 25% of the sales are on cash basis.
 Cash balance expected to be ₹ 1, 00,000.
 Finished goods lie in the warehouse for one month.

You are required to prepare a statement of the working capital needed to finance a level of
activity of 54,000 units of output. Compute the working capital based on the monthly
turnover. Production is carried on evenly throughout the year and wages and overheads accrue
similarly. State your assumptions, if any.

Solution:

The annual level of activity is given at 54,000 units, it means that the monthly turnover
would be 54,000/12=4,500 units. The working capital requirements for this monthly turnover
can now be estimated as follows:

Estimations of Working Capital Requirement

Amount Amount
Particulars
₹ ₹
Current Assets:
1. Raw material (4500 units x 60 x 1 months) 2,70,000
2. Work in Progress
Materials (4,500 units x 60 x 50/100 x ½) 67,500
Wages (4,500 units x 30 x 50/100 x ½) 33,750

65
 Overheads (4,500 units x 50 x 50/100 x ½) 56,250
3. Finished Goods (4,500 units x 140 x 1 month) 6,30,000
4. Debtors (4,500 units x 140 x 75% x 1 month) 4,72,500
5. Cash Balance 1,00,000
Gross Working Capital 16,30,000
Current Liabilities
1. Lag in Payment of Materials (4,500x60X30/30) 2,70,000
2. Lag in payment of wages (4,500x30x10/30) 45,000
3. Lag in payment of overheads(4,500x50X30/30) 2,25,000
Total Current Liabilities ( 5,40,000)
Net Working Capital 10,90,000

Working Note:

1. Since 25% of the transaction is on cash basis. It implies that 75 % of the transaction
is on credit basis.

Illustration – 9:

A company has provided the following information

Cost per unit

Particulars
52.00
Raw materials
19.50
Direct Labour
39.00
Overheads

Total Cost 110.50

19.50
Profit
130.00
Selling Price

The following additional information is available:

1. Average raw materials in stock-one month

2. Average materials in process: Half a month
3. Average finished goods in stock : One month
4. Credit allowed by supplier : One month
5. Credit allowed to debtors: Two month
6. Time lag in the payment of wages: one and a half weeks

66
 7. Overheads: One month
8. One fourth of sales are on cash basis
9. Cash balance is expected to be ₹ 1,20,000

You are required to prepare a statement showing the working capital needed to
finance a level of activity of activity of 70,000 units of annual output. The production is
carried throughout the year on even basis and wages and overheads accrue similarly
(Calculation be made on the basis of 30 days a month and 52 weeks a year)

Solution:

Amount
Particulars Amount ₹
₹
Current Assets
Stock of Raw material (70,000 x 52 x 30/360) 3,03,333
Work in progress
Raw materials (70,000 units x 52 x 15/360) 1,51,667
Direct labour ( 70,000 units x 19.50 x 30/360 x 1/4) 28,437
Overheads (70,000 units x 39 x 30/360 x 1/4) 56,875 2,36,979
Stock of finished goods (70,000 units x 110.50 x 30/360) 6,44,583
Debtors (70,000 units x 3/4 110.50 x 60/360) 9,66,875
Cash balance 1,20,000
A. Total Current Assets 22,71,770
Current Liabilities
Lag in payment of raw material (70,000 units x 52 x30/360) 3,03,333
Lag in payment of wages (70,000 units x 19.50 x 1.5/52) 39,375
Lag in payment of overheads(70,000 units x 39 x 30/360) 2,27,500
B. Total Current Liabilities 5,70,208
Net Working Capital (A-B) 17,01,562

11.12 CHECK YOUR PROGRESS

Fill in the blanks with suitable answers:

1. _______management refers to the management and control of gross current assets.

2. Both _______and _______working capital exerts an evil influence on the health of a
company.
3. The formula to compute Net Working Capital =_______.

67
 4. Working Capital cycle is also known as _______.
5. Working capital cycle starts with _______ and ends with _______.
Answer to Check Your Progress:

1. Working capital
2. Excess and inadequate
3. Current Assets – Current Liabilities
4. Operating Cycle
5. Procurement of Raw Materials, Cash Realisation

11.13 SUMMARY
The interaction between current assets and current liabilities is the main theme of
the theory of working capital management. Management of current assets is similar to that
of fixed assets in the sense that, in both the cases form analyse their effects on its risk and
return. But there are differences also. The firm has a great degree of flexibility in managing
the current assets.The concept of working capital is of two types, gross working capital and
net working capital. The gross working capital is the total investment in current assets and
net working capital is the difference between current assets and current liabilities. The need
for working capital is mainly decided by its operating cycle. Two important issues of
working capital management are deciding the adequate amount of working capital and
deciding the way of financing working capital. There are three approaches of financing
working capital needs: matching approach or hedging approach, conservative approach and
aggressive approach. A trade-off between risk and return has to be made in order to arrive
at the optimum level of financing current assets.

11.14 KEYWORDS
Net Working Capital : It is the difference between the company’s current
assets and current liabilities.

Operating Cycle : The days required for a business to receive inventory,

sell the inventory and collect cash from the sale of
inventory.

Inventory : Refers to the goods and materials held by a business

for selling in the market with the intension of earning
profit.

68
Operational Efficiency : The ability of an organization to reduce waste in
time, effort and materials as much as possible, while
still producing a high quality service or product.

Gross Working Capital : Total Current Assets.

11.15 QUESTIONS FOR SELF-STUDY

1. Discuss the various factors affecting the working capital requirement of a firm.
2. “Working capital is the life blood of a business firm and there is always an operating
cycle involved in the cash to cash cycle”. Draw up the operating cycle and list out the
components of an operating cycle.
3. Examine the problems faced by an organization due to excess and insufficient
working capital.
4. Camellia Industries Ltd is desirous of assessing its working capital requirements for
the next year. The finance manager has given the following information for this
purpose.
Particulars Amount in ₹

90
Raw Materials
50
Direct Labour
40
Manufacturing and Administrative
Overheads (excluding Depreciation)
20
Depreciation
30
Selling Overheads
230
Total Cost

The following additional information is available

1. Average raw materials in stock :1 month

2. Average materials in process:1/2 a month
3. Average finished goods in stock :1 month
4. Credit allowed by suppliers: 1 month
5. Credit allowed to debtors:2 months
6. Time lag in payment of wages : one and half weeks
7. Overheads:1 month

69
 8. One fourth of the sales is on cash basis
9. Cash balance is expected to be ₹ 5,00,000

You are required to prepare a statement showing the working capital needed to
finance a level of activity of 1,00,000 units of annual output. The production is carried out
throughout the year on even basis and the wages and overheads accrue similarly. The
calculations can be made on the basis of 30 days in a month and 52 weeks in a year.

5. The management of Royal Industries has called for a statement showing the
working capital to finance a level of activity of 1,90,000 units of output for the year.
The cost structure for company’s product for the above mentioned activity level is
detailed below:

Particulars Amount
₹

Raw Material 20

Direct Labour 5

Overheads 15

Total Cost 40

Profit 10

Selling Price 50

Additional information:

1. Minimum desired cash balance is ₹ 20,000.

2. Raw materials are held in stock, on an average, for two months.
3. Work – in – progress (assume 50% completion stage) will approximate to half –
a – month production.
4. Finished goods remain in warehouse, on an average, for a month.
5. Suppliers of materials extend a month’s credit and debtors are provided two
month’s Credit.
6. Cash sales are 25% of total sales.
7. There is a time lag in payment of wages of a month; and half a month in the case
of overheads.

70
11.16 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill-
Tenth Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh
edition-2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-
Eleventh Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya
Publishing House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and
Sons-Fifteenth Edition-2019.

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UNIT – 12 INVENTORY MANAGEMENT, RECEIVABLES
MANAGEMENT AND CASH MANAGEMENT

Structure:

12.0 Objectives
12.1 Introduction
12.2 Inventory Management
12.2.1 Meaning of Inventory and Inventory Management
12.2.2 Motives of holding Inventory
12.2.3 Objectives of holding Inventory
12.2.4 Cost of Holding Inventory
12.2.5 Techniques of Inventory Control
12.3 Receivables of Management
12.3.1 Characteristics of Receivables Management
12.3.2 Objectives of Receivables Management
12.3.3 Factors Influencing Investment in Receivables
12.3.4 Credit Policy
12.3.5 Monitoring Accounts Receivables
12.4 Cash management
12.4.1 Motives of Holding Cash
12.4.2 Objectives of Holding Cash
12.4.3 Factors Determining Cash Needs of a Firm
12.4.4 Cash Planning
12.4.5 Cash Management Techniques
12.4.6 Cash Management Models
12.4.7 Miller’s Model and Baumol Model
12.5 Check Your Progress
12.6 Summary
12.7 Keywords
12.8 Questions for Self-Study
12.9 References

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12.0 OBJECTIVES
After studying this unit, you will be able to;

 Examine the motives of holding cash.

 Analyse the various techniques of Inventory Control.
 Identify the various factors influencing Investment in Receivables.

12.1 INTRODUCTION
Inventories constitute the most significant part of the current assets of the business
concern. It is also essential for the smooth running of business activities. It serves as a link
between production and distribution processes. Due to its major composition in current
assets, the management of inventories occupies a key role in working capital management.
Excessive investment affects liquidity. Inadequate investment makes the firm lose business
opportunities, which would be otherwise available. Profitability would be affected by
excessive or inadequate investment. So, inventory management is essential to allow the
firm to take advantage of the opportunities to improve profitability and, at the same
time does not impair its liquidity, with excessive or unproductive investment.

12.1 INVENTORY MANAGEMENT

12.2.1 Meaning of Inventory and Inventory Management

The term inventory refers to the stocks of the product a firm is offering for sale and
the components that make up the product. Inventory is stores of goods and stocks. This
includes raw materials, work-in-process, and finished goods. Raw materials consist of
those units or inputs which are used to manufacture goods that require further processing to
become finished goods. Finished goods are products ready for sale. The classification of
inventory and the levels of the components vary from organisation to organisation
depending upon the nature of the business. For example, steel is a finished product for a
steel industry, but a raw material for an automobile manufacturer. Thus, inventory may be
defined as "Stock of goods that has been held for future use".

Meaning of Inventory Management:

Inventory management means, management of raw materials and related items.

Inventory management considers what to purchase? how to purchase? how much to
purchase? from, where to purchase? where to store? and when to use for production? etc.

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 Inventory management refers to an optimum investment in inventories. It should
neither be too low to affect production adversely, nor too high to block funds
unnecessarily. Excess investment in inventories is unprofitable for the business. Both
excess and inadequate investments in inventories are not desirable. The firm should
operate within the two danger points. The purpose of inventory management is to
determine and maintain the optimum level of inventory investment.

12.2.2 MOTIVES OF HOLDING INVENTORY

Holding of inventories is expensive in the form of storage costs, interest charges,
deterioration of quality in holding stocks, theft and pilferage. There are three main
purposes for holding the inventories:

Transaction Motive:
This facilitates the continuous production and timely execution of sales orders. Sufficient
stocks of raw materials are to be maintained to facilitate uninterrupted production. There
is always a time lag between the date of placing the order and its actual receipt. There
could be delays due to strikes, lockout, and transport problems. Transaction motive takes
care of these contingencies.
Precautionary Motive:
This necessitates the holding of inventories to meet unpredictable changes in demand and
supply of materials. Holding of inventories is necessary to safeguard against unforeseen
changes in demand and supply forces and other factors that cannot be anticipated.
Production is dependent on demand for the finished product. If there is more demand for
the product, raw materials would be consumed. Consumption of raw materials cannot be
forecast, with absolute accuracy. Sufficient stocks are to be maintained to suit fluctuations
in demand. Similarly, problems in supply may arise. Here, stocks are to be kept to guard
against changes in demand and supply, which are not foreseen. Forces which could be
foreseen are taken care of by the transaction motive, while forces that cannot be foreseen
are guarded by the precautionary motive.
Speculative Motive:
This includes keeping inventories for taking advantage of price fluctuations, saving on
reordering costs and quantity discounts. The firm takes suitable decisions to change the
stock holding pattern depending on the increase or decrease in prices. Bulk order discounts
may be offered to attract higher purchases. Reordering costs may be another factor in
holding more quantities of inventories, than needed.

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12.2.3 OBJECTIVES OF HOLDING INVENTORY

The primary objective of inventory management is to maintain the right quantity of

stocks, in the right location, at the right time to ensure uninterrupted production and, at the
same time, minimize the investment in stock holding. The purpose of inventory
management is to keep the stocks in such a way that either there is over-stocking or under-
stocking. The main objectives of inventory management are Operational and Financial.

The operational objectives mean that the materials and spares should be available
in sufficient quantity so that the work is not disrupted for want of inventory.

The financial objectives mean that investment in inventories should not remain idle
and minimum working capital should be locked in it.

The following are the objectives of holding Inventory:

1. To ensure the continuous supply of raw materials, spares, and finished goods so
that production does not suffer at any time.
2. To avoid both over-stocking and under-stocking of inventory.
3. To maintain the investment in inventories at the optimum level as required in
the operational and sales activities.
4. To keep material costs under control so that they contribute to reducing the cost of
production and overall costs.
5. To eliminate duplication in ordering stocks. This is possible with the help of
centralised purchase.
6. To reduce losses due to pilferage, waste, and damage.
7. To ensure perpetual inventory control so that the material shown in the stock
ledgers actually lies in the stores.
8. To facilitate the furnishing of data for short-term and long-term planning and
control of inventory.
9. To ensure efficient and smooth production process.
10. To meet the seasonal demand of the products.
11. Reduce the carrying costs and lead time on supplies.
12. Maintain sufficient stocks of finished goods for smooth sales operations and
business opportunities are not lost.

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12.2.4 COST OF HOLDING INVENTORY
When a firm holds goods for future sale, it exposes itself to a number of risks and
costs. The effective management of inventory involves a trade-off between having too little
and too much inventory. In achieving this trade-off, the financial manager should realise
that risks and costs may be closely related. The costs of holding inventories are as follows:

1. Material Costs:
These are the costs of purchasing the goods plus transportation and handling. This
may be calculated by adding the purchase price (less any discounts), the delivery charges
and the sales tax (if any).
2. Order Costs:
These are the variable costs of placing an order for the goods. Each separate
shipment involves certain expenses connected with requesting and receiving materials.
Examples of these costs are the typing of the order and the inspection of the goods after
they arrive. The fewer the orders, the lower the order cost will be for the firm.
3. Carrying Costs:
These are the expenses of storing goods. Once the goods have been accepted, they
become part of the firm’s inventories. The following are the different kinds of carrying
costs.
a. Storage Costs: The firm must provide storage space, usually through the
operation of a warehouse or supply room. The firm must employ workers to
move, clean, count, record and protect goods. All of these activities dealing with
the physical holding of the goods are considered storage costs.
b. Insurance: Despite the best precautions taken, firms must be protected against
threats such as fire or warehouse accidents. Larger amounts of inventory
necessitate larger amounts of insurance. The insurance premiums represent a
carrying cost on inventory.
c. Damage or Theft: Although a firm makes every effort to protect goods against
damage and safeguard items against pilferage, goods are damaged and stolen. A
portion of these expenses are not covered by insurance and are losses to the firm.
Some businesses, particularly retail stores and firms producing luxury goods, face
this carrying cost.
d. Obsolescence and Spoilage: Obsolescence is the cost of being unable to sell
goods because of current market factors deriving from changes in styles, tastes or

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 other factors. If a product is no longer wanted, the firm must sell it at a fraction of
its value or destroy it. Spoilage occurs when a product is not saleable because of
deterioration during storage, such as foods that rot, plants that die, garments that
are attacked by moths, candles that discolour or chemicals that decompose.
4. Cost of Funds Tied Up in Inventory:
Holding inventories involves funds. Whenever a firm commits its resources to
inventory, it is using funds that otherwise might be available for other purposes. A portion
of the inventory is financed by trade credit from suppliers and involves no cost. The
balance of the inventory must be financed from the firm’s general funds and involves a
cost. If the firm is considering an expansion of inventory and plans to borrow to obtain
funds, the firm will have to pay interest on the additional debt. So, in both cases, the firm
incurs costs. In the case of own funds, it is opportunity cost, and in the case of
borrowings, it is interest cost.
5. Cost of Running Out of Goods:
When a company runs out of goods, it incurs costs. If the firm is unable to fill an
order, it risks losing a sale. If the firm runs out of raw materials, it may force a costly
shutdown of the production process. Adequate inventory helps reduce additional costs and
lost revenues due to shortages. Stock out of finished goods, however, may result in the
dissatisfaction of customers and the resultant loss of sales. These costs, however, are
somewhat intangible in nature, and consequently, difficult to assess quantitatively.
12.2.5 TECHNIQUES OF INVENTORY CONTROL
Efficient inventory management requires an effective control system. A proper
inventory control system helps the enterprise solve the problems of liquidity, eliminates
excessive stocks and achieves increased profits with a substantial reduction in working
capital.

The following are the important tools and techniques in inventory management and
control:

1. Determination of Stock Level

2. Determination of Economic Order Quantity
3. A.B.C. Analysis
4. V E D Analysis
5. Inventory Turnover Ratio
6. JIT Control System

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1. Determination of 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 an optimum level of stock to ensure the
smooth running of the business process. If the inventory level is too low, the firm will face
frequent stock outs involving heavy ordering costs, and if the inventory is too high, there
will be an unnecessary tie up of capital. Therefore, efficient inventory management
requires that a firm maintain an optimum level of inventory where inventory costs are at a
minimum. Different levels of stock can be determined based on the volume of the stock:
a. Minimum level:
This represents the quantity, which must be maintained in hand at all, times. If
stocks are less than the minimum level than the work will stop due to shortage of
material.
The following factors are taken into account while fixing the minimum stock level:
 Average rate of consumption of material.
 Average lead time
 Re-order level
 Nature of the item
 Stock-out cost
Formula:
Minimum Level = Re-order level – (Average usage ×Average lead time)
Lead-time: After placing the requisition for materials, sometime is needed to
process and place the order. After receipt of the order, supplier too takes some time
to execute the order. So, raw material holding is needed, during the process time
and execution time, so that production does not suffer, which is called ‘Lead Time.
Rate of Consumption: It is the average rate of consumption of raw materials in a
factory. This rate of consumption can be calculated based on the earlier period’s
consumption rate, past experience and future plans. If the capacity of the factory
enhances to match the increased production plans, the consumption rate also
enhances.

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b. Maximum Stock Level:
The maximum stock level is that quantity above which stocks should not normally
be allowed to exceed. If this level is exceeded, there would be blockage of working
capital, loss due to wastages, risk of obsolescence and more rent for storage space
etc.
The following factors are taken into consideration while fixing the maximum stock
level:
 Average rate of consumption of material
 Lead time
 Re-order level.
 Maximum requirement of materials for production at any time.
 Storage space available as cost of storage and insurance.
Formula:
Maximum Stock Level = Re-Ordering Level + Re-ordering Quantity -
(Minimum Consumption × Minimum Re-ordering Period)
C. Re-order Level:
When the stock level reaches the re-ordering level, the order is placed for
replenishment of stocks. This is the point fixed between the maximum and
minimum stock levels and at this time, it is essential to initiate purchase action for
fresh supplies of the material. In order to cover the abnormal usage of material or
unexpected delay in delivery of fresh supplies, this point will usually be fixed
slightly higher than the minimum stock level.
The following factors are taken into account while fixing the re-order level:
 Maximum usage of materials
 Maximum lead time
 Maximum stock level
 Minimum stock level
Formula:
Re-ordering Stock Level = Maximum Consumption per day × Maximum Re -
order period

D. Average Stock Level: The formula for calculating average stock is as under:

Formula:
Average Stock level = Minimum stock level + ½ of reorder quantity

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E. Danger Level:
This is the absolute minimum level, below which the stocks should not fall. When
the stock reaches this level, stock would be issued only to the emergency
requirements and just to maintain the machinery working, to avoid dry out
situation.
Formula:
Danger Level = Average Consumption × Maximum re-order Period for
Emergency Purchases
F. Stock:
Consumption of raw materials depends upon production level. Production changes
on the demand for the finished products. The demand for the finished product is not
always constant due to varying conditions. So, consumption of raw materials is not,
always, constant. There should be safety stock to take care of fluctuations in
consumption pattern of raw materials. The time taken for getting replenishment of
stocks may also vary, due to unforeseen problems of strikes or lockouts. So, every
firm has to maintain certain amount of stock as safety stock to take care of
unforeseen consumption pattern as well as time for procurement of materials.
Basically, safety stock is to meet unforeseen contingencies.
2. Determination of Economic Order Quantity
For effective inventory management, it is necessary to determine what should be the
quantity of stock that has to be ordered for replenishment periodically. The stock that
is ordered should be neither more nor less. To avoid accumulation of stock, if frequent
ordering of stock is made, more handling and ordering costs would be incurred. On the
other hand, a lower number of stock orders results in an accumulation of stocks, which
results in higher carrying costs. The basic EOQ model is one of the simplest inventory
models. The economic order quantity (EOQ) is the optimum amount of goods to order
each time an order is placed so that total inventory costs are minimized. The Economic
Order Quantity (EOQ) refers to the order size that will result in the lowest total order and
carrying costs for an item in the inventory. Determining an optimum level involves two
types of costs, such as ordering costs and carrying costs.
Ordering Costs: The costs that are associated with purchasing and placing an order are
called "ordering costs." These are also known as "buying costs," as they are incurred only
at the time of purchase.

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This cost includes:
a) The cost of staff posted for the purpose of ordering goods
b) Transportation expenses for purchased goods
c) Incoming material inspection costs
d) The cost of stationery, postage, and telephone charges
Carrying Costs: These are the costs associated with holding inventories. The higher the
stock holding, the greater the carrying costs and they would be lower if the
stocks are lower. Inventory may be high sometimes and low at other times. So, the carrying
cost is calculated on the average inventory.
This cost includes:
a) The Cost of Capital Invested in Inventories
b) The cost of storage
c) The cost of insurance
d) Cost of material spoilage during handling
e) The loss of material due to deterioration
The ordering and carrying costs of materials are high; an effort should be made to
minimize these costs. The quantity to be ordered should be large enough so that economies
may be made in transport costs and discounts may also be earned. By calculating an
Economic Order Quantity, the firm identifies the number of units to order that results in the
lowest total of these two costs. EOQ is the size of the lot to be purchased that is
economically viable. This is the quantity of the material, which can be purchased at
minimum cost.
Assumptions: While calculating EOQ, the following assumptions are made:
1. Demand is known: Although it is difficult to predict accurately the firm’s level of
sales for individual items, the marketing manager must provide a sales forecast.
Using past data and future plans, a reasonably accurate prediction of demand can
often be made. This is expressed in units sold per year.
2. Sales occur at a constant rate: This model may be used for goods that are sold in
relatively constant amounts throughout the year. A more complicated model is
needed for firms whose sales fluctuate in response to seasonal or other cyclical
factors.
3. Costs of running out of goods are ignored: Costs associated with shortages, delays or
lost sales are not considered. These costs are considered in the determination of
safety level in the reorder-point subsystem.

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 4. Safety stock level is not considered: The safety stock level is the minimum level of
inventory that the firm wishes to hold as a protection against running out. Since the
firm must always be above this level, the EOQ formula need not consider the costs of
maintaining the safety stock level.
5. The total usage of a particular material is known and the usage is even throughout the
year,
6. Material is readily available and there is no time lag between placing an order and
receiving the supplies,
7. Cost of carrying inventory is also fixed and uniform though out the period,
8. There are only two costs associated with the cost of holding, i.e. cost of ordering and
cost of carrying and The prices of the goods are stable.
Formula:
𝟐𝑨𝑺
𝐸𝑂𝑄 = √ 𝑰

where,
A = Annual consumption in rupees
S = Cost of placing an order
I = Inventory carrying cost of one unit
3. ABC Analysis
A-B-C analysis is a method of material control according to values. The basic principle is
that high-value items are more closely controlled than low-value items. The materials are
grouped according to the value and frequency of replenishment during a period.
‘A’ Class items: items having higher values
‘B’ Class items: items having medium values.
‘C’ Class items: items having low values
ABC Analysis is concerned with selective control of inventory management. If all
materials were given equal importance in terms of control, the result would be ineffective.
The essence of selective control of inventory management is to allocate the importance of
control to goods based on their cost composition. So, the organisation has to give more
concentration to the "A" category of items due to the higher cost composition in the total
inventory cost. As concentration is on fewer items, the result would be effective.
A-B-C analysis helps to concentrate more efforts on category A since the greatest
monetary advantage will come from controlling these items. Attention should be paid to
estimating the requirements, purchasing, maintaining the safety stocks, and properly

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storing the "A" Category material. These items are kept under constant review so that
substantial material costs may be controlled. The control of "C" items may be relaxed and
these stocks may be purchased for a year. A little more attention should be given towards
"B" category items, and their purchase should be undertaken at quarterly or half-yearly
intervals.
Method of Preparation: The method of preparation is as follows:
a) Determine the annual consumption of each item throughout the year.
b) Arrange the annual consumption of the various materials in descending order, with
the highest
c) value at the top and the lowest value at the bottom.
d) Determine each item's consumption as a percentage of total material consumption.
e) Determine the cumulative consumption in percentage terms.
f) When the total touches around 70%, the first group where concentration is needed,
is arrived at.
g) The following groups are to be calculated at 20% and 10%, respectively.
It may, however, be mentioned here that there are no fixed rules or rigid principles for
classifying items into the A, B, and C categories. In fact, it is a managerial decision and,
therefore, may vary from person to person. However, this does not imply that any
classification can be justified solely on the basis of managerial decision and discretion. It
may vary, but only marginally, as the principle and rationale of the selective approach to
inventory monitoring and control must always be borne in mind and taken full care of, in
order to justify the classification as acceptable and reasonable.
4. VED Analysis
The V-E-D analysis is generally used for spare parts. The requirements and urgency
of spare parts are different from those of material. Spare parts are classified as vital (V),
essential (E), and desirable (D). Here, cost is not of importance, but its necessity for
smooth production assumes importance. Vital spares are a must for running the concern
smoothly, and these must be stored adequately. The lack of spare parts will wreak havoc
on the company. The E-type spares are also necessary, but their stock may be kept at low
figures. Stocking of D-type spares may be avoided at times. If the lead time of these spares
is less, then stocking of these spares can be avoided. The classification of spares under
these three categories is an important decision. A wrong classification of any spare will
create difficulties for the production department. The classification should be left to the
technical staff because they know the need for urgency and use of these spares.

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5. Inventory Turnover Ratio
Inventory turnover ratios indicate the efficiency of using the inventory. The inventory
turnover ratio indicates the number of times the stock has turned over a period of one year.
The greater the number of times, the more efficient the organisation is. The inventory
conversion period shows the number of days the stock is blocked. The purpose is to ensure
the blocking of only the required minimum funds in inventory. This ratio is also known as
the "stock velocity ratio." The following ratios may be found to be helpful in effective
monitoring and control of inventory.

Formula:
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝
Inventory Turnover Ratio =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐚𝐭 𝐜𝐨𝐬𝐭

Where,

𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 + 𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

Average Inventory =
𝟐
𝐃𝐚𝐲𝐬 𝐢𝐧 𝐘𝐞𝐚𝐫
Inventory Conversion Period =
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐑𝐚𝐭𝐢𝐨

6. JIT Control System

Just in Time (JIT) inventory control system aims at eliminating wastage from every
aspect of manufacturing. This was first introduced in Japan in the 1950s. Toyota was the
first company to use this technique. There are two aspects to this. (i) Just-in-time
purchasing; and (ii) Just-in-time manufacturing. JIT wants to avoid materials for storage,
and they should be available only when they are needed to meet the requirements.
Just in time inventory control system involves the purchase of materials in such a
way that delivery of purchased materials is assured just before their use or demand. The
basic philosophy of JIT is to keep only a sufficient quantity of stock on hand to meet the
immediate production requirements. This concept relies on the suppliers to furnish "stock"
"just in time" as and when needed.
The primary goal of JIT is to reduce inventories to insignificant or zero levels.
When the carrying cost has gone up due to high interest rates and other associated costs,
the goal of JIT maintaining only essential stocks–is highly relevant. The focus of JIT is to
maintain relationships with suppliers to enable them to purchase the right quantities at the
right time. The major thrust is to purchase or produce in response to need, rather than as
per plan and forecasts.

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 Reduction in quality-related costs such as inspection, costs of delayed delivery,
early delivery, processing documents etc., resulting in an overall reduction in cost.
Objectives of JIT
1. Minimum (zero) inventory and its associated costs.
2. Elimination of non-value added activities and all wastes.
3. Minimum batch/lot size.
4. Zero breakdowns and continuous flow of production.
5. Maintain on-time delivery schedules both within and outside the firm.
6. Manufacturing the right product at the right time.
Advantages of the JIT Inventory Control System
1. The right quantities of materials are purchased or produced at the right time.
2. Investment in inventory is reduced.
3. Waste is eliminated.
4. Carrying or holding costs of inventory are also reduced because of the reduced
inventory.

12.3 RECEIVABLES MANAGEMENT

Introduction:

Accounts receivables or debtors are created, as and when goods are sold on credit.
Debtors occupy a predominant place, next to inventories, in current assets. When it is the
practise of the industry, as a whole, to sell on credit, it is not possible for an individual firm
to avoid credit sales. Receivables constitute a significant portion of the current assets of a
firm. But, for investments in the receivables, a firm has to incur certain costs. There is also
a risk of bad debts also. It is therefore, very necessary to have proper control and
management of receivables. Receivables represent amounts owed to the firm as a result of
credit sale of goods or services in the ordinary course of business. These are the claims of
the firm against its customers and form a part of the Current Assets. Hence, accounts
receivables are among the largest and most liquid assets of the total assets the companies
hold. Receivables are also known as accounts receivables; trade receivables, customer
receivables, debtors, etc. The ultimate goal of accounts receivable is to enhance the
Working Capital available with the firm.

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Meaning of Receivables:

The term receivable is defined as debt owed to the concern by customers arising
from sale of goods or services in the ordinary course of business. Receivables are also one
of the major parts of the current assets of the business concerns. It arises only due to credit
sales to customers, hence, it is also known as Account Receivables or Bills Receivables.

The period of credit and extent of Receivables depend upon the credit policy followed by
the firm. The purpose of maintaining or investing in Receivables is to meet competition,
and to increase the sale and profits of the business.

Meaning of Receivables Management:

Management of account receivables is defined as the process of making decisions

resulting in the investment of funds in these assets, which will result in maximising the
overall return on the investment of the firm. But at the same time, investment in this asset
involves cost consideration also. Further, there is always a risk of bad debt too. Thus, the
objective of receivables management is to make a sound decision as regards investment in
debtors. In the words of Bolton, S.E. "The objective of Receivables Management is to
promote sales and profits until that point is reached where the return on investment in
further funding of Receivables is less than the cost of funds raised to finance that
additional credit."

Accounts receivable management means managing the credit sales of the firm. The
credit sales result in accounts receivables, which may be converted to cash after the credit
period. Accounts receivable management can improve cash available to the firm and hence
lead to significant financial gain for the firm. An efficient management of accounts
receivable implies a lesser amount of outstanding account balances, which means lesser
bad debts for the company. Efficiently managed accounts receivable enhances the firm’s
cash inflow and thus creates large cash support for the firm’s cash requirements.

The costs associated with the extension of credit and accounts receivables are
identified as follows:

Collection Cost: This cost incurred in collecting the receivables from the customers to
whom credit sales have been made.

Capital Cost: This is the cost on the use of additional capital to support credit sales which
alternatively could have been employed elsewhere.

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Administrative Cost: This is an additional administrative cost for maintaining account
receivable in the form of salaries to the staff kept for maintaining accounting records
relating to customers, cost of investigation etc.

Default Cost: Default costs are the over dues that cannot be recovered. Business concern
may not be able to recover the over dues because of the inability of the customers.

12.3.1 CHARACTERISTICS OF RECEIVABLES MANAGEMENT

Receivables Management have three peculiar characteristics:

The first and most important feature is ‘risk’, they carry. If payment is not received,
sale turns into a bad debt, eroding the profitability of the firm. In other words, profit made
on other sales is at stake, till realization of proceeds of sale.
Second, the ‘economic value’ in the goods or services is transferred from the seller
to the buyer, immediate to the sale. After sale, seller stands at the convenience of the buyer
to receive payment.
The third characteristic is its ‘uncertainty’ feature. The seller receives payment, at a
later date. This future event of ‘receiving the payment’ is a contingent or uncertain event.
Payment depends on the willingness and capacity of the buyer, on the due date. This
picture cannot be foreseen, at the time of sale.
12.3.2 OBJECTIVES OF RECEIVABLE MANAGEMENT
The basic objective of accounts receivable management is to collect the funds due
and to help the management in meeting their cash flow requirements. An effective
accounts receivable management can help and support the management in achieving the
desired Cash Flow through the timely collection of outstanding debts.

The main objectives of receivable management are as follows:

1. Achieving Growth in Sales and Profits:

If a firm allows credit sales, it will usually be able to sell more goods or services than
if it insists on immediate cash payment. Similarly, additional sales normally result in
higher profits for the firm. This proposition will hold good only when the marginal
contribution or gross margin is greater than the additional costs associated with
administering the credit policy.
2. Meeting Competition:
To survive in a competitive market, businesses must adopt credit practises that are
similar to those of their competitors. As a result, by adapting its terms of trade to

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 industry norms, a company can prevent losing sales from customers who would
otherwise buy elsewhere if they didn't get the credit they expected.
3. Increasing Profits:
If maintaining receivables has the direct impact of increasing sales, the indirect result
is that the additional sales usually result in higher profits for the company.
4. To control the cost of receivables, cost of collection, administrative expenses, bad
debts and opportunity cost of funds blocked in the receivables.
5. To maintain the debtors at minimum according to the credit policy offered to
customers
6. To offer cash discounts suitably depending on the cost of receivables, bank rate of
interest and opportunity cost of funds blocked in the receivables.
7. The objectives of receivables management are to eliminate bad debts, and reduce
transaction costs incidental to maintenance of accounts and collection of sale
proceeds and, finally, enhance profits of the firm.

12.3.3 FACTORS INFLUENCING INVESTMENT IN RECEIVABLES

The level of investment in receivables is affected by the following factors:

1. Volume of Credit Sales:

Size of credit sale is the prime factor that affects the level of investment in receivables.
Investment in receivable increase when the firm sells major portion of goods on credit
base and vice versa. In other words an increase in credit sales, increase the level of
receivables and vice versa.

2. Credit Policy of the Firm:

There are two types of credit policies such as lenient and stringent credit policy. A firm
that is following lenient credit policy tends to sell on credit to customers very liberally,
which will increase the size of receivables. On the other hand, a firm that following
stringent credit policy will have low size of receivables because the firm is very selective
in providing of stringent credit. A firm that is providing string one credit, may be able to
collect debts promptly this will keep the level of receivables under control.

3. Trade Terms:

It is the most important factor (variable) in determining the level of investment in

receivables. The important credit terms are credit period and cash discount. If credit

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 period is more when compared to other companies/industry, then the investment in
receivables will be more. Cash discount reduces the investment in receivables because it
encourages early payments.

4. Seasonality of Business:

A firm doing seasonal business has to provide credit sales in the other seasons. When the
firm provides credit automatically the level of investment in receivables will increase with
the comparison of the level of receivables in the season; because in season firm will sell
goods on cash basis only. For example, refrigerators, air-cooling products will be sold on
credit in the winter season and on cash in summer season.

5. Collection Policy:

Collection policy is needed because all customers do not pay the firm’s bill on time. A
firm’s liberal collection policy will not be able to reduce investment in receivables, but in
future sales may be increased. On the other hand, a firm that follows stringent collection
policy will definitely reduce receivables, but it may reduce future sales. Therefore, the
collection policy should aim at accelerating collections from slow payers and reducing
bad debt base.

6. Bill Discounting and Endorsement:

Bill discounting and endorsing bill to the third party, which the firm has to pay, will reduce
the size of investment in receivables. If the bills are dishonoured on the due date, again the
investment in receivable will increase because discounted bills or endorsed bills have to
be paid by the firm.

12.3.4 CREDIT POLICY

A firm must establish its own credit policy for proper management of debtors
otherwise, it will lead to more outstanding balances in debtors’ accounts, and the risk of
bad debts Would increase. For efficient management of receivables, each firm has to
design its own credit policy. A firm should adopt receivables policies after carefully
considering both the benefits and costs of various policies. Credit policy involves decisions
on credit standards, length of credit periods, cash discounts, and discount periods. These
are discussed as follows:

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1. Credit Standards:
The term credit standards represent the basic criteria for the extension of credit to
customers. The credit standards of a firm are the minimal requirements for credit
extension to its customers. They emphasise the strictness of the credit policy of the firm
in a holistic view. Credit standards are said to be liberal or relaxed when credit policy
decision-making involves stretching of credit period and negligible monitoring of credit
collections, thus giving customers an ample stretch of time to make their payment as per
their convenience. On the other hand, they may become stringent or tightened as the
credit policy variables are tightened and strictly adhered to. Variable Credit Standards.
The credit should be liberalised only to the level where incremental revenue matches the
additional costs. This the optimum level of investment in receivables is achieved at a
point where there is a trade off between the costs, profitability, and liquidity. The levels
of sales and receivables are likely to be high if the credit standards are relatively loose,
as compared to a situation when they are relatively tight.
The firm’s credit standards are generally determined by the five "C's." Character,
Capacity, Capital, Collateral and Conditions.
Character - denotes the integrity of the customer, i.e., his willingness to pay for the
goods purchased.
Capacity - denotes his ability to manage the business.
Capital - denotes his financial soundness.
Collateral - refers to the assets which the customer can offer by way of security.
Conditions - refer to the impact of general economic trends on the firm or to special
developments in certain areas of the economy that may affect the customer’s ability to
meet his obligations.Information about the five C’s can be collected both from internal
and external sources. Internal sources include the firm’s previous experience with the
customer, supplemented by its own well-developed information system. External
resources include customers’ references, trade associations, and credit rating
organizations.
Credit standards of a given firm are evaluated based on the firm’s sales volume,
investment in accounts receivables and the amount of bad debt losses actually incurred
by it.
Volume of sales: Sales volume is directly proportional to the degree of relaxation of
credit standards for a normal firm. As the credit standards are tightened, the volume of
sales decreases and vice versa.

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 Investment in accounts receivables: The size of the receivables depends upon the
extent to which the credit policy is relaxed by the firm. Highly relaxed credit policy
implies large investments in receivable. Contrarily, when the credit policy becomes
strict, credit sales decreases and the investment in receivable also decreases.
Bad-debt losses: As the receivables increase, a chance of occurrence of bad debts also
increases and thus it reduces the total profits earned.
2. Length of Credit Periods:
The credit period is the length of time (say, thirty days, forty-five days, sixty days, etc.)
given to customers to pay the bill, which represents the cost of goods supplied on credit.
The credit period is the time allotted to the customer to make the payment. The length
of credit is influenced by the practise or custom prevalent in the industry. If a firm
extends credit at a lower limit than the credit period allowed by the rest of the firms, its
sales decline. So, by necessity, firms have to adopt similar practises to those followed
by the industry. To attract new customers, some firms may give more credit than their
competitors. In other words, the credit period is used as a marketing tool to increase
existing sales or to prevent sales from declining. Customers paying on time may also be
allowed certain cash discounts. There are no bindings on fixing the terms. The length of
the credit period and quantum of discount allowed determine the magnitude of the
investment in receivables. A firm may allow liberal credit terms to increase the volume
of sales. The lengthening of this period will mean the blocking of more money in
receivables, which could have been invested somewhere else to earn income. There may
be an increase in debt collection costs and bad debt losses too. If the earnings from
additional sales by length of credit period are more than the additional costs, then the
credit terms should be liberalised.

3. Cash Discounts:

The discount given to customers on early payments on the purchases made by them is
known as a "cash discount." A "Cash discount" is a discount given to consumers who
payment in full before the due date. A percentage of the cash payment that is to be made
by the customers is waived off by the firm. This difference in cash payment by the
customers is the cash discount. Cash discounts act as an incentive for credit customers
to pay on time. For example, if a firm allows 30-days of credit to its customers, plus a
discount of 5% if the payment is made within 15 days of the invoice date, and the
customer pays within 15 days of the invoice date, the customer gets a cash discount of

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 5% on the total cash payment. The finance manager should compare the earnings
resulting from released funds with the cost of the discount. The discount should be
allowed only if its cost is less than the earnings from additional funds. If the funds
cannot be profitably employed, then a discount should not be allowed.

4. Discount Periods:

Credit periods to be granted to customers may be extended to effect an increase in sales.

The additional period allowed for this facility may prompt some more customers to
avail of the discount and make payments. However, credit terms cannot be extended
arbitrarily. One has to compare additional profits (arising from an increase in sales due
to the extension of credit terms) with the costs associated with the decision. The average
debtor increases as the credit period is extended. Additional investment that has to be
made due to comparatively relaxed credit terms has to be determined. Then the cost of
additional investment in debtors has to be ascertained. In computing the costs of
additional investment in debtors or opportunity savings, either of the two approaches
that are generally followed may be adopted. The first is the appropriate required rate of
return for the level of risk in the investment of debtors. The second approach views the
cost of debt capital as the cost of financing investment in debtors. The decision rule can
be formulated so that the cost of additional investment in debtors or savings from
freeing funds should not exceed the expected additional contribution/profit when a
change in credit policy is to be accepted. Two assumptions are made in this approach to
credit extension decisions. First, volume and sales increases can be attained with
available capacity and resources. Second, an increase in sales volume will not have any
adverse effect on prices.

12.3.5 MONITORING ACCOUNTS RECEIVABLES

Managing receivables does not end with granting of credit as dictated by the credit
policy. It is necessary to ensure that customers make payment as per the credit term and in
the event of any deviation, corrective actions are required. Thus, monitoring the payment
behaviour of the customers assumes importance. There are several possible reasons for
customers to deviate from the payment terms. Three of these possible reasons and their
implications in credit management are discussed below:

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1. Changing Customer Business Characteristics
The customers, who have earlier agreed to make payment within a certain period of
time, may deviate from their acceptance and delay the payment. For example, economic
slowdown or slowdown in the industry of the customers’ business may force the
customers to delay the payment. In fact, the bills payable become discretionary cash
outflow item in economic recession. Thus, a close watch on the performance of
customer’s industry is required.
2. Inaccurate Policy Forecasts
A wide deviation from the credit terms and actual flow of cash flows show inaccurate
forecast and defective credit policy. It is quite possible that a firm uses defective credit
rating model or wrongly assesses the credit variable. For example, it is quite possible to
overestimate the collateral value and then lend more credit. If this is the reason for wide
deviation, it requires updating the model or training the employees.
3. Improper Policy Implementation
Often wide deviation is noticed in practice while implementing credit policy. This may
not be intentional but frequently in the form of accommodating special requests of the
customers. For example, a customer may not be eligible for credit or higher credit as per
the model in force. The customer may personally see the concerned manager and
request her/him to relax the credit restriction. If there is no policy in place to deal with
these types of request and ad hoc decisions are made, then wide deviation is possible.
Often these deviations become costly for the firm. Intervention of top officials and ad
hoc decisions are cited as major reasons for widespread defaults in many public
financial institutions. Thus, it is necessary to ensure that policies are implemented in
letter and spirit. Monitoring provides signals of deviation from expectations. There are
several 17 monitoring techniques available to the credit managers. The monitoring
system Management of Inventory begins with aggregate analysis and then move down
to account-specific analysis.
4. Investments in Receivables
The decision to supply on credit basis leads to investments in receivables. Credit policy
is designed in such a way that investment needs of receivables are optimised i.e. return
is greater than cost associated with investments. Credit monitoring starts with an
assessment of investment in receivables as a percentage of total assets. The investments
in receivables are then compared with the budget. Any deviation from budgeted value
shows delay in collection or managers deviating from the credit policy.

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5. Collection Period
Receivables can be related to sales in different ways. The simplest form of analysis is
comparing sales and receivables for different periods to know the trend. While this
analysis gives a reasonable understanding on how the receivables have moved over the
period, it fails to give an implication of the changes in the trend.
12.4 CASH MANAGEMENT
Introduction:

Cash is the lifeblood of every business. It is the most liquid current asset a firm can
hold. It is denominated in the currency of the nation in which the firm exists. Business
concern needs cash to make payments for acquisition of resources and services for the
normal conduct of business. Cash is one of the important and key parts of the current
assets.

Meaning:

Cash is the money which a business concern can disburse immediately without any
restriction. The term cash includes coins, currency, cheques held by the business concern
and balance in its bank accounts. In a narrow sense cash refers to coins, currency, cheques,
drafts and deposits in banks. The broader view of cash includes near cash assets such as
marketable securities and time deposits in banks. The reason why these near cash assets are
included in cash is that they can readily be converted into cash. Usually, excess cash is
invested in marketable securities as it contributes to profitability.

Cash is one of the most important components of current assets. Every firm should
have adequate cash, neither more nor less. Inadequate cash will lead to production
interruptions, while excessive cash remains idle and will impair profitability. Hence, there
is a need for cash management. Management of cash consists of cash inflow and outflows,
cash flow within the concern and cash balance held by the concern etc.

Cash management:

Cash management involves the efficient collection, disbursement and temporary

investment of cash. Cash management involves having the optimum, neither excessive nor
deficient, amount of cash on hand at the right time. In other words, efficient cash
management practice means an elaborate form of cash management, where the firm is able
to accurately assess its current cash position and make fairly reliable predictions at key
intervals about how much cash it requires to meet the company’s contingency and day-to-

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day expenses. Efficient cash management helps the company to remain healthy and strong.
Poor cash management may end up pushing the company to crisis. The objective of cash
management is to invest excess cash for a return while retaining sufficient liquidity to
satisfy future needs.

12.4.1 MOTIVES OF HOLDING CASH

Transaction Motive:

Cash facilitates the meeting of the day to day expenses and other payments on the
debts. Transaction Motive requires a firm to hold cash to conduct its business in the
ordinary course. The firm needs cash to make payments for wages, operating expenses,
purchases of raw materials, taxes, dividends and other payments etc. So firm should
maintain cash balance to make the required payment. If more cash is need for payments
than receipts, it may be raised through bank overdraft. On the other hand, if there are more
cash receipts than payments, it may be spent on marketable securities

Precautionary Motive:

Cash is also maintained by the firm to meet the unforeseen expenses at a future
date. Cash may be held to act as a safety net against unexpected events. There are
uncontrollable factors like government policies, competition, natural calamities, and labour
unrest that have a heavy impact on business operations. Such things as breakdowns must
be taken care of by the firm. In such situations, the firm may require cash to meet
additional obligations. Hence, the firm should hold cash reserves to meet such
contingencies. Such cash may be invested in short-term marketable securities, which may
provide the cash when necessary.

Speculative Motive:

Speculative cash balances may be defined as the cash balances that are held to
enable the firm to take advantage of any bargain purchases that might arise. To take the
advantage of unexpected opportunities, a firm holds cash for investment in profit making
opportunities. Such a motive is purely speculative in nature. For e.g. holding cash to rake
advantage of an opportunity to purchase raw material at the reduced price on the payment
of immediate cash or delay that purchase of material in anticipation of declining prices. It
may like to keep some cash balance to make profits by buying securities at the time when
their prices fall on account of tight money conditions.

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Compensating motive:

It is a motive for holding cash to compensate banks for providing certain services or
loans. Banks provide a variety of services to business firms, such as clearance of cheque,
supply of credit information, transfer of funds, and so on. While for some of these services
banks charge a commission or fee, for others they seek indirect compensation. Usually
clients are required to maintain a minimum balance of cash at the bank. Since this balance
cannot be utilised by the firms for transaction purposes, the banks themselves can use the
amount to earn a return. Such balances are compensating balances.
12.4.2 OBJECTIVES OF HOLDING CASH
1. Provide sufficient cash to each unit:
Adequate cash availability is critical for the business's existence. Effective cash
management provides each unit with sufficient cash.
2. There are no funds blocked in idle cash:
Idle cash is associated with high costs in terms of interest and opportunity costs. Every
company needs to maintain an optimal cash balance. Management should also consider
the factors that influence and determine cash balances at different points in time. To
identify the optimal level of cash balances, you need to balance the cost of excess cash
with the risk of inadequate cash.
3. Investment of excess cash:
The firm has to invest the excess or idle funds in short term securities or investments to
earn profits, as idle funds earn nothing. (Investment which can be easily diluted within
one financial year for normal growth of the firms). This is one of the important aspects
of the management of cash.
4. Management of cash flows:
This is another important aspect of cash management. The inflow and outflow of funds
are rarely synchronized. Sometimes, the cash inflows will be greater than the outflows
because of receipts from debtors and cash sales in huge amounts. In addition, cash flow
may exceed inflow due to payment of taxes, interest, dividends, etc. Therefore, you
need to manage your cash flow to improve your cash management. As a result, cash
flows must be handled in order to improve cash management.
5. Insolvency:
Effective cash management prevents insolvency or bankruptcy arising out of the
inability of a firm to meet its obligations.

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6. Uncertainty:
The firm can meet unanticipated cash expenditure with a minimum of strain during
emergencies, such as strikes, fires or a new marketing campaign by competitors.
12.4.3 FACTORS DETERMINING CASH NEEDS OF A FIRM
Maintenance of optimum level of cash is the main problem of cash management.
The level of cash holding differs from industry to industry, organisation to organisation.
The factors determining the cash needs of the industry is explained as follows:
1. Matching of cash flows:
The need for maintaining cash balances arises from the non-synchronisation of the
inflows and outflows of cash: if the receipts and payments of cash perfectly coincided or
balanced each other, there would be no need for cash balances. The need for cash
management, therefore, is due to the non-synchronisation of cash receipts and
disbursements. For this purpose, the inflows and outflows have to be forecast over a
period of time depending upon the planning horizon, which is typically a one-year
period with each of the 12 months being a sub period. The technique adopted is a cash
budget.
2. Short costs:
Another general factor to be considered in determining cash needs is the cost associated
with a shortfall in cash needs. The cash forecast presented in the cash budget would
reveal periods of cash shortages. In addition, there may be some unexpected shortfalls.
Every shortage of cash–whether expected or unexpected–involves a cost, ‘depending
upon the severity, duration, and frequency of the shortfall and how the shortage is
covered. Short costs are defined as the expenses incurred as a result of a shortfall in
cash. The shortfall costs include transaction costs associated with raising cash to
overcome the shortage, borrowing costs associated with borrowing to cover the
shortage, i.e. interest on loan, loss of trade-discount, penalty rates by banks to meet a
shortfall in cash balances, and costs associated with deterioration of the firm’s credit
rating, etc. which is reflected in higher bank charges on loans and a decline in sales and
profits
3. Cost of excess cash balances:
One of the important factors in determining cash needs is the cost of maintaining cash
balances, i.e., excess or idle cash balances. The cost of having excessively large cash
balances is known as the "excess cash balance cost." If large funds are idle, the
implication is that the firm has missed opportunities to invest those funds and has

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 thereby lost interest that it would otherwise have earned. This loss of interest is
primarily due to excess costs.
4. Procurement and Management:
The costs associated with establishing and operating cash management staff and
activities determining the cash needs of a business firm. They are generally fixed and
are mainly accounted for by salary, storage, handling of securities, and so on.
5. Uncertainty and Cash Management:
Finally, the impact of uncertainty on cash management strategy is also relevant as cash
flows cannot be predicted with complete accuracy. The first requirement is a
precautionary cushion to cope with irregularities in cash flows, unexpected delays in
collections and disbursements, defaults, and unexpected cash needs. The uncertainty can
be overcome through accurate forecasting of tax payments, dividends, capital
expenditure, etc. and the ability of the firm to borrow funds through an overdraft
facility.
12.4.4 CASH PLANNING
Cash planning is not just about avoiding a liquidity crisis. Along with a better
management of inventory, cash management is key to reducing working capital. As a
result, being able to accurately forecast net cash flows and quickly model different
scenarios, such as how fast to pursue growth initiatives without having to resort to external
funding, is a top priority for CFOs. Their objective is to ensure there are sufficient funds to
sustain the business, identify where lines of credit or external funding may be required to
fund expansion, and identify idle cash that can be invested externally.

How often cash flow forecasts need to be run will depend on the financial security
of the business. If it is struggling, it might be necessary to forecast the cash position on a
daily basis to ensure there is enough cash to compensate staff and suppliers. If the business
is stable, cash flow forecasting every week or month may be viewed as sufficient.
However, there are considerable benefits from automating the process and running it daily.
It will give earlier warning to negative variances that require attention, as well as reveal
pockets of cash that can be invested overnight to earn a return for the company.

Creating accurate cash flow and balance sheet forecasts means continually updating
models with data from disparate sources. This includes forecasting the company’s cash
receipts and disbursements. The receipts primarily come from the accounts receivable from
recent sales, but also include sales of assets, available loans, and external funding.

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 Disbursements include payroll, payment of accounts payable from recent
purchases, tax payments due, dividends, and interest on debt. For forecasting cash flow
over longer periods, less direct methods are used and typically model various assumptions
about the income and expenditure line items in a forecast profit and loss account.

12.4.5 CASH MANAGEMENT TECHNIQUES

The term cash management refers to the collection, concentration, and
disbursement of cash. In many ways, managing cash flow is the most important job for
business managers. If a company happens to miss paying an obligation due to lack of cash,
the company becomes insolvent, which is the primary cause of bankruptcy. Not only this,
but having a poorly managed cash flow leads to having no margin of safety in case of
unanticipated expenses, trouble finding funds for expansion, or difficulties in hiring and
retaining employees.

Typically, cash flow problems are the leading cause of business failures — so it is
important to make sure you understand every technique available to keep your business
afloat. To have a successful business, you need to be able to manage your cash flow well.
Here are some useful cash management methods to help you as you grow your business.

a. Monitoring of Cash Flow Regularly

Staying on top of one’s cash flow is the first and foremost important aspect of cash
management. To help with this, creating a cash flow budget is essential that charts
finances for shorter and longer terms. This will assist in understanding where ones
money will be going and how much is necessary, as well as to keep a track of what
finances you currently have and should be spending.
b. Billing Promptly and Accurately
The faster one mails an invoice, the sooner it will be paid. If your company's deliveries
or services do not automatically trigger an invoice, then it is necessary to establish a
weekly billing schedule to stay on top of things. Along with this, always include a
payment due date to encourage customers to pay quickly.
If payments are coming in at a rate that isn't beneficial to your company, it's time to
begin encouraging faster payments. There are options such as offering discounts for
early payment that can be used or other incentives that your company can offer. Be sure
to ensure that getting paid early is worth the loss, though. Too much of a discount could
only be more of a financial burden.

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c. Designate a Cash Flow Monitor
Choosing a trustworthy employee to monitor cash flow provides your business with
someone to watch and inform you when your company reaches a certain threshold. This
is an excellent way to stay on top of things efficiently without taking up too much of the
company's time and resources.
d. Cut cost where ever it is possible
To manage your cash well, it's important to make sure your company isn't spending
more than it can handle. Cutting costs such as subscriptions or services you no longer
need, cutting back on utilities, rent, or payroll, or renegotiating terms of outstanding
loans or leases are different ways to save your company money.
e. Delay your payment to vendors
To keep the cash in your account for as long as possible, wait to pay your vendors as
long as you can (without risking late fees). The only time that it is a better option to pay
early is if there is a worthwhile incentive available, otherwise, stick with waiting.
f. Use available Technology
There are different professional accounting software solutions available that will assist
you in your finances, as well as cash flow spread sheets in the cloud at sites such as
Drop box or One Drive. The benefits of these include being able to access your
financials from anywhere and at any time.
g. Use Bank Wisely
Banks can offer incredibly useful services such as overdrafts or credit that are great for
businesses, especially those that are just starting out. The First State Bank provides
services such as Business Online Banking, Merchant Card Services, Remote Deposit
Capture, and many others that are perfect cash management tools that will assist in
recognizing your cash flow and keeping track of it.
12.4.6 CASH MANAGEMENT MODELS
Several types of cash management models have been recently designed to help in
determining optimum cash balance. These models are interesting.Cash management
demands.
(i) To have an efficient cash forecasting and reporting systems,
(ii) To achieve optimal conservation and utilisation of funds.
The cash budget tells us the estimated levels of cash balances for the given period
on the basis of expected revenues and expenditures.

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 However, if there are shortfalls and surplus, how should these be arranged and what
should be done with surplus, are the questions which are not answered by the cash budget.
For such issues, there are cash management models.
1. Baumol Model
2. Miller and Orr model.
12.4.7 MILLER’S MODEL AND BAUMAL MODEL
A. Baumol Model
This model was suggested by William J.Baumol.It is similar to one used for the
determination of economic order quantity,According to this model ,optimum cash level is
that level of cash where the carrying costs and transaction costs are the minimum.
Carrying costs
This refers to the cost of holding cash, namely, the interest foregone on marketable
securities. They may also be earned as opportunity cost of keeping cash balance.
Transaction costs
This refers to the cost involved in getting the marketable securities converted into
cash. This happens when the firm falls short of cash and has to sell the securities resulting
in clerical, brokerage, registration and other costs.
There is however an inverse relationship between the two costs. When one
increases, the other decreases. Hence, optimum cash level will be at that point where these
two costs are equal.
B. Miller-Orr Model
Baumol model is not suitable in those circumstances where the demand for cash is
not steady and cannot be known in advance. Miller-Orr model helps in determining the
optimum level of cash in such circumstances. It deals with the cash management problem
under the assumption of random cash flows by laying down the control limits for cash
balances. These limits consist of an upper limit (h), lower limit (o) and return point
(z).When the cash balance reaches the upper limit ,a transfer of cash equal to “h-z” is
effected to marketable securities. When it touches the lower limit, a transfer equal to “z-
0”from marketable securities to cash is made. No transaction between cash to marketable
securities and marketable securities to cash is made during the period when the cash
balance stays between the high and low limits.

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12.5 CHECK YOUR PROGRESS
Fill in the blanks with suitable answers:
1. ______ constitute the most significant part of the current assets of the business
concern.
2. The ______includes keeping inventories for taking advantage of price fluctuations,
saving on reordering costs and quantity discounts. The firm takes suitable decisions
to change the stock holding pattern.
3. The term .______refers to the collection, concentration, and disbursement of cash.
4. ______starts with an assessment of investment in receivables as a percentage of total
assets.
5. Effective cash management prevents ______ arising out of the inability of a firm to
meet its obligations.

Answer to Check Your Progress

1. Inventories
2. Speculative Motive
3. Cash management
4. Credit monitoring
5. Insolvency or bankruptcy
12.6 SUMMARY
Inventories constitute the most significant part of the current assets of the business
concern. It is also essential for the smooth running of business activities. It serves as a link
between production and distribution processes. Due to its major composition in current
assets, the management of inventories occupies a key role in working capital management.
Excessive investment affects liquidity. Inadequate investment makes the firm lose business
opportunities, otherwise available. Profitability would be affected by excessive or
inadequate investment. So, inventory management is essential to allow the firm to take
advantage of the opportunities to improve profitability and, at the same time does
not impair its liquidity, with excessive or unproductive investment.

12.7 KEYWORDS
Inventory : It is the stores of goods and stocks.

Collection Cost : This cost incurred in collecting the receivables from

the customers to whom credit sales have been made.

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Capital Cost : This is the cost on the use of additional capital to
support credit sales which alternatively could have
been employed elsewhere.

Administrative Cost : This is an additional administrative cost for

maintaining account receivable in the form of salaries
to the staff kept for maintaining accounting records
relating to customers, cost of investigation etc.

Default Cost : Default costs are the over dues that cannot be
recovered. Business concern may not be able to
recover the over dues because of the inability of the
customers.

12.8 QUESTIONS FOR SELF-STUDY

1.Discuss the various techniques of Inventory Control.
2. Examine the factors determining the cash needs of the industry.
3 .Discuss the various Cost of holding inventory
4. What are the objectives of Just in Time Technique?
5. What are the advantages of the JIT Inventory Control System?
12.9 REFERENCES
1. Prasanna Chandra –Financial Management, Theory and Practice-Mc Graw Hill-
Tenth Edition-2019.
2. Pandey I.M. -Financial Management-Vikas Publishing House Limited- Eleventh
edition-2016.
3. Rustagi R.P. - Fundamentals of Financial Management- Taxmann’s Publication-
Eleventh Edition-2016.
4. Sudarsana Reddy G. - Financial Management, Principles and Practice- Himalaya
Publishing House-Third Edition- 2014.
5. Prasanna Chandra- Fundamentals of Financial Management-Tata Mc Graw Hill-Fifth
Edition-2012.
6. Maheshwari S.N. -Financial Management, Principles and Practice- Sultan Chand and
Sons-Fifteenth Edition-2019.

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