ACHARYA INSTITUTE OF TECHNOLOGY

Soladevanahalli, Bangalore – 560107

FINANCIAL MANAGEMENT
(22MBA22)

Prof. Rohith B
Assistant professor, Department of MBA
Acharya Institute of Technology
Soladevanahalli, Bangalore – 560107
 TABLE OF CONTENTS

Module Nos Module Page Nos

1 Introduction to Financial Management 01 to 25

2 Time Value of Money 26 to 30

3 Long Term Sources of Funds & Cost of Capital 31 to 51

4 Capital Structure & Dividend Decisions 52 to 66

5 Long Term Investment Decisions (Capital Budgeting) 67 to 73

6 Working Capital Management 74 to 84

Numerical Problems 85 to 108

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MODULE 1: INTRODUCTION TO FINANCIAL MANAGEMENT

INTRODUCTION

Finance is a term for matters regarding the management, creation and study of money and investments. It
involves the use of credit and debt, securities and investment to finance current projects using future
income flows. Every enterprise, whether big, medium or small, needs finance to carry on its operations
and to achieve its targets. Finance is so indispensable today that it is rightly said to be the lifeblood of an
enterprise. The subject of finance has been classified into three classes:

(1) Public Finance – deals with finances of government institutions and governments.
(2) Corporate Finance – deals with finances of business firms.
(3) Personal Finance – deals with finances of an individual.

Managing finance in a systematic way is essentially required for organizations and also for individuals.
Organization may be public entity or private entity having sound financial management plan is necessary
to achieve organization goals and profits. Even small financial decision may cause heavily for
organizations either positively or negatively. Thus, managing the finance is challenging task for any
organization.

Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. In simple words, financial management is
that managerial activity which is concerned with the planning and controlling of the firm‘s financial
resources.

Finance Manager is a person who forecasts, budgets, supervises documents and manages a company‘s
cash flow to maximize profits.

Definitions

According to Weston and Brigham, ―Financial Management is an area of financial decision making,
harmonising individual motives and enterprise goals‖

According to Howard and Upon, ―Financial Management is the application of the planning and
controlling functions to the finance function‖.

J.F. Bradley defines financial management as, ―The area of the business management devoted to a
judicious use of capital and careful selection of sources of capital in order to enable a spending unit to
move in the direction of reaching its goals‖.

Guthman and Dougal defines ―Financial management is the activity concerned with planning, raising,
controlling and administering of funds used in the business.‖

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SCOPE OF FINANCIAL MANAGEMENT

To understand the scope of financial management we have two approaches,

1. Traditional Approach
2. Modern Approach

Traditional Approach

Traditional approach of financial management was widely using at the beginning of 20th century.
Corporate finance was the layman‘s term using at that period, enveloping today‘s financial management
objectives. This initial stage of corporate finance or financial management is the traditional approach to
financial management.

According to this approach, the scope of the finance function is restricted to procurement of funds by
corporate enterprise to meet their financial needs. Traditional approach to financial management focused
on maintaining financial stability and maximizing profits through cost control. As traditional approach
limited the role of financial management to acquisition and administration of funds it covers three major
aspects.

 Collect funds from capital market.

 Gather and connect with sources of finance from various services or products.
 Maintain accounting and legal relationships between investors (source of funds) and the firm.

Thus the traditional concept of financial management included the whole exercise of raising funds
externally. The finance manager had a limited role to perform. He was expected to keep accurate financial
records, prepare reports on the financial performance and manage cash in a way that the corporation is in
a position to pay bills in time.

In later fifties traditional approach started to be severely criticized and later abandoned on account of the
following reasons.

 The traditional approach to financial management offers an outsider‘s perspective. As a result,

internal decision making processes are not adequately acknowledged.
 There is no planning to execute the allocation of funds which is essential in today‘s financial
management.
 The traditional approach mainly focuses on addressing specific problems rather than everyday
issues.
 Traditional approach does not give much importance to the allocation of working capital.

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Modern Approach

Critics pointed out many drawbacks of traditional approach because of which traditional approach
outlived its utility due to changed business situations since mid-1950. Technology improvements,
innovative marketing operations, development of strong corporate structure, keen business competition,
all made it imperative for the management to make optimum use of available to the financial manager,
based on which he could make sound decisions.

The modern approach emphasizes the creation of shareholder value as the primary objective of financial
management. Value-based management involves aligning financial decisions with the organization's
strategic objectives and measuring financial performance based on value creation.

Unlike the traditional approach, modern financial management considers the procurement and effective
utilization of funds. It takes into consideration the internal parties and problems that affect an
organization. Modern approach mainly focuses on three questions to overcome the shortcomings of
traditional financing they are:

What is the total quantum of funds that a company needs to commit?

What assets should a company acquire?
What initiatives should a company take to finance the required funds?

A finance manager makes the below mentioned decisions in favour of the company by following the
modern financing approach.

 Investment Decisions: Investment decisions are nothing but the selection of assets that
businesses invest in, whether for a long or short period of time. Capital budgeting is the process
by which financial planners choose and invest in assets which bear long term benefits. The
modern financial approach also encourages finance managers of firms to deal with the assets that
have high liquidity.

 Financing Decisions: The scope of modern approach also allows firms to consider ways to
increase the company‘s cash flow. This is a crucial decision making process addressing a firm‘s
need for funds as and when required.

 Dividend Decisions: This is a major decision that a finance manager must undertake for a firm.
Here, the team considers the company‘s net income to evaluate investor‘s dividends while
simultaneously retaining profit for themselves.

The introduction of modern approaches, globalization of trade and increased use of IT are some of the
most popular trends of the 21st century. Business owners and executives need to study and implement
these trends to get new chances of reducing risk and increasing revenue for a firm. Today most businesses
follow the modern finance approach for long term growth.

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OBJECTIVES OF FINANCIAL MANAGEMENT

Financial management is concerned with procurement and use of funds. Its aim is to use of funds. Its
main aim is to use business funds in such a way that the firm‘s value/earnings are maximized. There are
various alternatives available for using business funds. Each alternative course has to be evaluated in
detail. The pros and cons of various decisions have to look into before making a final selection. Financial
management provides a framework for selecting a proper course of action and deciding a viable
commercial strategy. The main objective of a business is to maximize the owner‘s economic welfare. This
objective can be achieved by:

1. Profit Maximization
2. Wealth Maximization

Profit Maximization

A business firm is profit-seeking organization. Hence, profit maximization is well considered to be an

important means for achieving the objective of maximizing the owners‘ economic welfare. No business
can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profits also
serve as a protection against risks which cannot be ensured. The accumulated profits enable a business to
face risks like fall in prices, competition from other units, adverse government policies etc., thus, profit
maximization is considered as the main objective of business.

The following arguments are advanced in favor of profit maximization as the objective of business:

i) When profit earning is the aim of business then profit maximization should be sole objective.
ii) Profitability is a barometer for measuring efficiency and economic prosperity of a business
enterprise.
iii) Economic and business conditions do not remain same at all the times. There may be adverse
business conditions like recession, depression, severe competition etc., in such cases
businesses will survive by past earnings.
iv) Profits are the main sources of finance for the growth of business. So, business should aim at
profit maximization.
v) Profits contribute for socio-economic welfare, so concentrating on profit maximization is
necessary for business.

However, profit maximization objective has been criticized on many grounds. A firm pursuing the
objective of profit maximization starts exploiting workers and the customers. Hence, it is immortal and
leads to a number of corrupt practices.

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Let us look at some criticisms for this objective.

i) The term profit is vague; it does not clarify what exactly it means. It conveys a different
meaning to different people. For example, profit may be short term or long term period; is it
total profit or rate of profit.
ii) Profit maximization ignores time value of money and does not consider the magnitude and
timing of earnings. It treats all earnings as equal though they occur in different periods. It
ignores the fact that cash received today is more important than the same amount of cash
received after some years.
iii) It does not take into consideration the risk of the prospective earnings stream. Some projects
are more risky than others. The earning streams will also be risky in the former than the latter.
Two firms may have same expected earnings per share, but the weak earnings stream of one
is more risky than other and the value of same is comparatively less.
iv) Profit maximization concept is narrow it fails to take into account the social considerations as
also the obligations of workers, consumers, society, as well as ethical trade practices. If
company ignores those factors it won‘t survive in a long run.

Wealth Maximization

Wealth Maximization objective is also known as ―Value Maximization‖ or ―Net Present worth
Maximization.‖ This objective is considered appropriate for decision making. Wealth means the wealth of
shareholders. The wealth of shareholders is determined by the market value of shares. Financial theory
asserts that wealth maximization is the single substitute for a stockholder‘s utility. When the firm
maximizes the stockholder‘s wealth, the individual stockholder can use this wealth to maximize his
individual utility.

Wealth maximization is a strategy for companies that seek to maximize profits while meeting the needs of
all stakeholders. It also helps a business build reserves for future growth, recognize the value of regular
dividends, and retain a fair market price for its stock. While companies can make any number of decisions
to increase profits, wealth maximization is the best strategy for decisions that affect the interests of
shareholders.

Wealth also signifies Net Present Value (NPV) which is the difference between the present value of cash
inflows and the present value of cash outflows. In this way, wealth maximization objective considers the
time value of money and assign different values to cash inflows occurring at different point of time. So,
according to the wealth maximization objective, investments should be made in such a way that it
maximizes Net Present Value.

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Wealth Maximization is supported because:

1. It is superior: This objective is superior to profit maximization as its main aim is to maximize
shareholder‘s wealth.
2. It is precise and unambiguous: It is based on the concept of cash flows rather than profit. The
concept of profit in the profit maximization objective is vague and ambiguous.
3. Considers time value of money: Wealth maximization objective takes into account the time value
of money as it considers timing of cash inflows. The cash flows occurring at different period of
time are discounted with appropriate discount rate.
4. Considers risk: This objective also considers future risk associated with occurrence of cash flows.
This is done with the help of discounting rate. Higher the discount rate, higher the risk and vice-
versa.
5. Ensures efficient allocation of resources: Resources are allocated wisely to increase shareholder‘s
wealth.
6. Ensures economic interest of society: When wealth of shareholder is maximized, it ultimately
upholds economic interest of society.

Wealth Maximization is also criticized because:

1. Creates owner-management problem: The concept of wealth maximization creates owner-

management problem as owners want to maximize their profits and management want to
maximize shareholder‘s wealth.
2. Ignores other stakeholders: This objective has been criticized on the ground that it is inclined
towards wealth maximization of shareholders only and ignores other stakeholders such as
creditors, suppliers, employees etc.
3. Criteria of market value are not fair: The criteria of wealth maximization are based on market
value of shares which is not a correct measure. Because value of shares could increase or
decrease due to other economic factors which are beyond the control of the firm.
4. It is just another form of profit maximization: Ultimate aim is to earn maximum profits. Without
earning profits wealth cannot be maximized.
5. Conflicts between management and ownership: Wealth maximization may also face difficulties
when ownership and management are separated as is the case in most of the large corporate form
of organizations.

In spite of all the criticism, we are of the opinion that wealth maximization is the most appropriate
objective of a firm and the side costs in the form of conflicts between the stockholders and debenture
holders, firm and society, stockholders and managers can be minimized.

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FINANCE MANAGER

Meaning

Finance manager is person who oversees the financial health of an organization and helps ensure financial
sustainability. They supervise many important functions such as monitoring cash flow, managing
expenses, producing accurate financial data, and strategizing for profit.

Definitions

According to Myers,‖ Financial manager refers to anyone who is responsible for significant investment
or financing decision.

According to Canadian Human Resources Division,‖ Financial managers are those who plan, organize,
direct, control and evaluate the operation of financial and accounting departments.‖

Roles of financial manager

The role of a financial manager is rapidly increasing due to advance technology which has significantly
reduced the amount of time that was occupied to produce financial reports.

 They analyze market trends to find opportunities for expansion or for acquiring companies.
 They have to do some tasks that are specific to their organization or industry
 They manage company credit
 Make some dividend pay-out decisions
 Keep in touch with the stock market if the company is listed
 Appreciate the financial performance concerning return investments
 They maximize the wealth for company shareholders
 To handle financial negotiations with banks and financial institutions

Types of Financial Managers

 Controllers: They direct the preparation of financial reports that summarize and forecast the
organization's financial reports such as income statements, balance sheets, etc.

 Treasures and finance officers: These officers direct their organization's budgets to meet its
financial goals to oversee the investment of funds.

 Credit managers: They manage the organization's credit business.

 Cash managers: They monitor the flow of the cash that comes in and goes out of the company to
meet the investment needs of an organization.

 Risk managers: They control financial risk by using strategies to limit the probability of a
financial loss.

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Functions of Finance Manager

1. Financial Forecasting and Planning: A financial manager has to estimate the financial needs of
a business. How much money will be required for acquiring various assets? The amount will be
needed for purchasing fixed assets and meeting working capital needs. He has to plan the funds
needed in the future. How these funds will be acquired and applied is an important function of a
finance manager.
2. Raising of Funds: In order to meet the obligation of the business it is important to have enough
cash and liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of
a financial manager to decide the ratio between debt and equity. It is important to maintain a good
balance between equity and debt.
3. Allocation of Funds: Once the funds are raised through different channels the next important
function is to allocate the funds. The funds should be allocated in such a manner that they are
optimally used. In order to allocate funds in the best possible manner the following point must be
considered (1) The size of the firm and its growth capability (2) Status of assets whether they are
long-term or short-term (3) Mode by which the funds are raised. These financial decisions
directly and indirectly influence other managerial activities. Hence formation of a good asset mix
and proper allocation of funds is one of the most important activities.
4. Profit Planning: Profit earning is one of the prime functions of any business organization. Profit
earning is important for survival and sustenance of any organization. Profit planning refers to
proper usage of the profit generated by the firm. Profit arises due to many factors such as pricing,
industry competition, state of the economy, mechanism of demand and supply, cost and output. A
healthy mix of variable and fixed factors of production can lead to an increase in the profitability
of the firm.
5. Understanding Capital Markets: Shares of a company are traded on stock exchange and there
is a continuous sale and purchase of securities. Hence a clear understanding of capital market is
an important function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore a financial manger understands and calculates
the risk involved in this trading of shares and debentures.
6. It’s on the discretion of a financial manager as to how to distribute the profits. Many
investors do not like the firm to distribute the profits amongst share holders as dividend instead
invest in the business itself to enhance growth. The practices of a financial manager directly
impact the operation in capital market.
7. Maintain Proper Liquidity: Every concern is required to maintain some liquidity for meeting
day-to-day needs. Cash is the best source for maintaining liquidity. It is required to purchase raw
materials, pay workers, meet other expenses etc., a finance manager is required to determine the
need for liquid assets and then arrange liquid assets in such a way that there is no scarcity of
funds.
8. Risk management: Each and every business is vulnerable to risks. Natural disasters like floods,
fire, cyclone, or change in the rates of interests, uncertainties in the prices of commodities and
shares, fluctuation of foreign exchange rates, etc., all lead to risks for a business. But, it is
possible to cope with these risks in the form of insurance purchases or by hedging.

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INTERFACE OF FINANCIAL MANAGEMENT WITH OTHER FUNCTIONAL AREAS

Without financing, the business most likely would not exist, to say nothing of other business functions.
Financing is what enables the purchase of the equipment, the leasing of the property, the buying of
materials, employee's salaries, marketing, etc. The relationship between financial management and other
functional areas can be defined as follows:

Financial Management and Production Department: The financial management and the
production department are interrelated. The production department of any firm is concerned with
the production cycle, skilled and unskilled labour, storage of finished goods, capacity utilization,
etc. and the cost of production assumes a substantial portion of the total cost. The production
department has to take various decisions like replacing machinery, installation of safety devices,
etc. and all the decisions have financial implications.

Financial Management and Material Department: The financial management and the material
department are also interrelated. Material department covers the areas such as storage,
maintenance and supply of materials and stores, procurement etc. The finance manager and
material manager in a firm may come together while determining Economic Order Quantity,
safety level, storing place requirement, stores personnel requirement, etc. The costs of all these
aspects are to be evaluated so the finance manager may come forward to help the material
manager.

Financial Management and Personnel Department: The personnel department is entrusted

with the responsibility of recruitment, training and placement of the staff. This department is also
concerned with the welfare of the employees and their families. This department works with
finance manager to evaluate employees‘ welfare, revision of their pay scale, incentive schemes,
etc.

Financial Management and Marketing Department: The marketing department is concerned

with the selling of goods and services to the customers. It is entrusted with framing marketing,
selling, advertising and other related policies to achieve the sales target. It is also required to
frame policies to maintain and increase the market share, to create a brand name etc. For all this
finance is required, so the finance manager has to play an active role for interacting with the
marketing department.

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INDIAN FINANCIAL SYSTEM

The financial system is abrader term which brings under its fold the financial markets and the financial
institutions which support the system. The financial system enables lenders and borrowers to exchange
funds. India has a financial system that is controlled by independent regulators in the sectors of insurance,
banking, capital markets and various services sectors.

Thus, a financial system can be said to play a significant role in the economic growth of a country by
mobilizing the surplus funds and utilizing them effectively for productive purposes.

Indian Financial System is a combination of financial institutions, financial markets, financial instruments
and financial services to facilitate the transfer of funds. Financial system provides a payment mechanism
for the exchange of goods and services. It is a link between saver and investor.

Structure of Indian Financial System

Indian Financial System comprises of four major components.

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FINANCIAL INSTRUMENTS / FINANCIAL ASSETS

The products which are traded in the Financial Markets are called Financial Assets/Financial
Instruments. Based on the different requirements and needs of the credit seeker, the securities in
the market also differ from each other.

Financial Assets are of two types:

1. Marketable assets
2. Non-marketable assets

Marketable Assets

Marketable assets are those which can be easily transferred from one person to another without much
hindrance. Examples: Shares of listed companies, Government securities, Bonds, Debentures etc.,

Non Marketable Assets

If the assets cannot be transferred easily, they come under this category. Examples: Bank deposits,
provident funds, pension funds, national saving certificates, insurance policies etc.,

FINANCIAL MARKETS

Financial market refers to a market for the creation and exchange of financial assets. In simple words,
financial market is those centre and arrangements which facilitate buying and selling of financial,
claims and services. Sometimes, we do find the existence of a specific place or location for a
financial market as in the case of stock exchange.

Classification of Financial Markets

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Unorganized Markets:

In these markets there are a number of money lenders, indigenous bankers and traders etc., who lend
money to the public. Indigenous bankers also collect deposits from the public. There are also private
finance companies, chit funds etc., whose activities are not controlled by the RBI.

Organized Markets:

In the organized markets, there are standardized rules and regulations governing their financial dealings.
There is also a high degree of institutionalization and instrumentalization. These markets are subject to
strict supervision and control by the RBI or other regulatory bodies.

Organized markets are of two types:

 Capital Markets
 Money Markets

MONEY MARKETS

It refers to a market which deals in short-term securities and whose maturity is less than one
year. The assets in the money market can be regarded as very close substitutes for money.
Accordingly, they are also called ‗near money instruments‘. Money market instruments are of
high liquidity.

Features of Money Market

 Money Market instruments have maturity period of less than a year.

 Money market is a market of unsecured but low risk and highly liquid short term instruments.
 Helps raising funds for meeting temporary cash shortages and obligations.
 Participants in money market include banks and other financial corporations like RBI,
Commercial Bank, NBFCs, State Government, Large Corporate Houses and Mutual Funds.

Money Market Instruments

Treasury Bills

It is a short-term borrowing instrument of the Government of India. It is a promissory note having a

maturity period of less than one year. It is issued by the Reserve Bank of India on behalf of the central
government and is a highly liquid instrument. It is available for a minimum of Rs 25,000 and in multiples
thereof. This instrument is also known as Zero-Coupon Bond which is issued at discount and redeemed
at par. It has very low risk and offers an assured return. The maturity period of treasury bills varies from
14 days to 364 days.

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Call Money

It is a money market instrument which is used by commercial banks for interbank transactions. These
instruments are used by commercial banks for meeting their cash reserve requirements, i.e. commercial
banks borrow from each other to fulfill any shortage of funds required to maintain the cash reserve ratio
through call money. It has a maturity period of less than fifteen days. Interest is paid on the call money,
which is called the call rate. This rate is highly variable, varying from day to day. An inverse relationship
exists between the call rate and money market instruments such as commercial papers and certificates of
deposit. When the call money rate rises, other instruments of the money market become comparatively
cheaper and thereby their demand increases.

Commercial Paper

It is a short-term unsecured money market instrument introduced in India in 1990. Basically, it is a

promissory note which is negotiable and transferable. It has a maturity period ranging from a minimum
of 15 days to a maximum of one year. These are primarily used by large and creditworthy companies for
bridge financing, i.e. used as an alternative to borrowing from banks and the capital market. Companies
pay an interest rate lower than the market rates. Commercial papers are used for purposes such as to meet
the flotation cost on long-term borrowings from the capital market.

Certificate of Deposit

These are negotiable, unsecured instruments presented in the bearer form. These instruments are issued
by commercial banks and financial institutions to individuals, corporations and companies. It is used
during periods of tight liquidity by commercial banks to meet the demand for credit. Maturity period of
these instruments range from 91 days to 1 year. Banks are not allowed to discount these instruments.

Commercial Bill

It is a source of financing credit sales by companies for the short term. It is used by companies to finance
their working capital requirements. It is a negotiable instrument. A seller (drawer) draws a commercial
bill and gives it to a buyer (drawee) who accepts it. After the buyer‘s acceptance, it becomes a tradable
instrument. The seller can discount it with a commercial bank even before the bill matures. This is known
as discounting of a bill.

CAPITAL MARKETS

It refers to the market or medium through which long-term funds both debt and equity are raised and
invested. Typically the maturity period is more than a year. It comprises channels through which the
savings of the community are made available for the business sector and the public in general. The
capital market consists of development banks, commercial banks and stock exchanges. Instruments used
in the capital market are shares, debentures, bonds, mutual funds and public deposits.

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Capital Market is further divided into three types

Industrial securities markets

Government securities markets
Long term loan markets

Industrial Securities Markets

Primary Market
Secondary Market

Primary market (or) new issue market: The primary market deals with those securities which are issued
to public for the first time. In other words new issue market deals with raising of fresh capital by
companies. In primary market, borrowers exchange new financial securities for long term funds. Thus the
primary market facilitates capital formation.

There are three ways by which a company may raise capital in a primary market.
(1) Public Issue (2) Rights Issue (3) Private Placement

Secondary market: Secondary market is a market for secondary sale of securities. In other words
securities which have already passed through new issue markets are traded in this market.
Features:
 Stock exchange is a market for old securities.
 These securities are purchased and sold continuously among investors without involvement of
companies.
 It also makes continuous evaluations of share traded in the market.
 All stock exchanges are recognized by government of India and regulated by securities contracts
(regulations act 1956).

Long term Loans Market

Development banks and commercial banks plays are important rules in supplying long term
loans to corporate customers. Long term loans markets provide term loans, mortgage markets,
guarantee loans.

Government Securities Markets

It is also gilt edged securities market it is a market where long term government securities are traded. In
India, there are many kinds of government securities. These government securities issued by the central
government, state governments, semi government authorities such as city corporations, port trusts etc.,
These are issued in denominations of Rs 100/- and interest is paid half yearly and they carry tax
exemptions tax. They are generally in form of Stock certificates, Promissory notes and Bearer bonds
They are sold through public debt office of RBI.

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DIFFERENCES BETWEEN MONEY MARKET AND CAPITAL MARKET

Money Market Capital Market

A random course of financial institutions, bill brokers, A kind of financial market where the company or
money dealers, banks, etc., wherein dealing on short- government securities are generated and patronized
term financial tools is being settled is referred to as with the intention of establishing long-term finance to
Money Market. coincide with the capital necessary is called Capital
Market.
Money markets are informal in nature. Capital markets are formal in nature.
Instruments are Commercial Papers, Treasury Instruments are Bonds, Debentures, Shares, Asset
Certificate of Deposit, Bills, Trade Credit etc. Secularization, Retained Earnings, Euro Issues etc.
Investors are Commercial banks, non-financial Investors are Stockbrokers, insurance companies,
institutions, central bank, chit funds etc. Commercial banks, underwriters etc.
Money markets are highly liquid. Capital markets are comparatively less liquid.
Money markets have low risk. Capital markets are riskier in comparison to money
markets.
Instruments mature within a year. Instruments take longer time to attain maturity.
Purpose is to achieve short term credit requirements of Purpose is to achieve long term credit requirements of
the trade. the trade.
Increasing liquidity of funds in the economy. Stabilizing economy by increase in savings.
ROI is usually low in money market. ROI is comparatively high in capital market.

DIFFERENCES BETWEEN PRIMARY MARKET AND SECONDARY MARKET

Primary Market Secondary Market

A marketplace for new shares A marketplace where formerly issued securities are
traded
IPO and FPO Shares, debentures, warrants, derivatives, etc.
Buying and selling takes place between the company Buying and selling takes place between the
and investors investors
Underwriters are the middle men Brokers are the middle men
Price levels remains Fixed Price level fluctuates with variations in demand and
supply
The purchase process happens directly in the primary The company issuing the shares is not involved in
market the purchasing process
The beneficiary is the company The beneficiary is the investor
A company issues shares and the government There is no involvement of the government in the
interferes in the process process.

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FINANCIAL INSTITUTIONS

Financial Institutions are business organizations that act as mobilizers and depositories of savings and as
creators of credit and finance. Also provide various financial services to the community. They differ from
non-financial (industrial and commercial) business organizations. These institutions deal with deposits,
loans, securities and so on.

Financial Institutions are classified into two types

Banking Institutions
Non-Banking Financial Corporation (NBFCs)

Banking Institutions

Banking financial institutions are in the business of taking deposits from the public and making loans. In
addition, they provide other services such as investment banking, foreign exchange, and safe deposit
boxes. These institutions are heavily regulated by governments to protect consumers and ensure that the
banking system is stable.

Banks are of two types:

 Commercial Banks
 Cooperative Banks

COMMERCIAL BANKS

A commercial bank is a financial institution which performs the functions of accepting deposits
from the general public and giving loans for investment with the aim of earning profit. In fact,
commercial banks, as their name suggests, axe profit-seeking institutions, i.e., they do banking
business to earn profit. They generally finance trade and commerce with short-term loans. They
charge high rate of interest from the borrowers but pay much less rate of Interest to their
depositors with the result that the difference between the two rates of interest becomes the main
source of profit of the banks.

Functions of Commercial Banks

It accepts deposits: A commercial bank accepts deposits in the form of current, savings and fixed
deposits. It collects the surplus balances of the Individuals, firms and finances the temporary
needs of commercial transactions. The first task is, therefore, the collection of the savings of the
public. The bank does this by accepting deposits from its customers. Deposits are the lifeline of
banks.

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It gives loans and advances: The second major function of a commercial bank is to give loans
and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is, in
fact, the main source of income of the bank. A bank keeps a certain portion of the deposits with
itself as reserve and gives (lends) the balance to the borrowers as loans and advances in the form
of cash credit, demand loans, short-run loans, overdrafts.
Discounting bills of exchange or bundles: A bill of exchange represents a promise to pay a fixed
amount of money at a specific point of time in future. It can also be encashed earlier through
discounting process of a commercial bank. Alternatively, a bill of exchange is a document
acknowledging an amount of money owed in consideration of goods received. It is a paper asset
signed by the debtor and the creditor for a fixed amount payable on a fixed date.
Overdraft facility: An overdraft is an advance given by allowing a customer keeping current
account to overdraw his current account up to an agreed limit. It is a facility to a depositor for
overdrawing the amount than the balance amount in his account.

Types of Commercial Banks

Public Sector Banks: Public sector banks or nationalized banks are those in which the government has
retained a majority of its share with the primary aim of public interest. After independence, the
government of India started the nationalization of the Imperial Bank of India in 1955 to enter the banking
business. There are 12 public sector banks in India currently.

Private Sector Banks: Private sector banks are banks where the majority of the bank's equity is owned by
a private company or a group of individuals. They comply with the central bank's guidelines yet have a
unique financial system.

Regional Rural Banks: Regional Rural Banks are government owned scheduled commercial banks of
India that operate at regional level in different states of India. These banks are under the ownership of
Ministry of Finance, Government of India. Regional Rural Banks were set by the state government and
sponsoring commercial banks with the objective of developing the rural economy. Regional rural banks
provide banking services and credit to small farmers, small entrepreneurs in the rural areas. The regional
rural banks were set up with a view to provide credit facilities to weaker sections. They constitute an
important part of the rural financial architecture in India. There were 43 RRBs in 2023 from 196 RRBs at
the end of June 2002, as compares to 107 in 1981 and 6 in 1975.

Foreign Banks: Foreign banks are those banking companies which open a branch in a different nation
than the headquarters. They have their registered office in one country. These foreign banks open a
branch in other countries. It is to provide better services and convenience to multinational customers.
Foreign banks have been in India from British days. Foreign banks as banks that have branches in the
other countries and main head quarters in the home country. With the deregulation (Elimination of
Government Authority) in 1993, a number of foreign banks are entering India.

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COOPERATIVE BANKS

Cooperative bank is a type of banking service that is provided by a cooperative, which is a financial
institution that is owned and controlled by its members. Cooperative banks are founded by collecting
funds through shares, accepting deposits and granting loans. A co-operative bank is a small-sized,
financial entity, where its members are the owners and customers of the Bank. They are regulated by the
Reserve Bank of India (RBI) and are registered under the States Cooperative Societies Act.

These Banks have been opened with the motto of ‗no-profit-no-loss‘ and thus, do not seek for profitable
ventures and customers only. As the name suggests, the main objective of Co-operative Banks is mutual
help.
An important segment of the organized sector of Indian banking is the co-operative banking. The segment
is represented by a group of societies registered under the Acts of the states relating to cooperative
societies. In fact, co-operative societies may be credit societies or non-credit societies.

Different types of co-operative credit societies are operating in Indian economy. These institutions can be
classified into two broad categories:

(a) Rural credit societies which are primary agriculture,

(b) Urban credit societies which are primarily non-agriculture.

NON BANKING FINANCIAL INSTITUTION / CORPORATION (NBFCS)

The non-banking financial institutions are the organizations that facilitate bank-related financial services
but do not have banking licenses. NBFC stands for Non-Banking Financial Company. They are financial
institutions that provide financial services to customers but do not hold a banking license. This means that
NBFIs cannot accept deposits from the general public, which is one of the key functions of a traditional
bank.

NBFIs offer various financial services, such as providing loans, managing investments, and facilitating
financial transactions. Some common examples of NBFIs include insurance companies, leasing
companies, factoring companies, investment companies, and microfinance institutions. Overall, NBFIs
play an important role in the financial sector by providing various financial services to customers who
may not have access to traditional banking services.

A Non-Banking Financial Companies (NBFC) is a firm that engages in activities such as obtaining loans
and credit facilities, buying bonds, stocks, or shares, leasing property, financing assets, providing
insurance, exchanging currencies, operating hedge funds, engaging in chit transactions, etc. The Reserve
Bank of India defines a non-banking financial company as registered under the Companies Act 1956.

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Features of NBFIs

 Non Banking Financial Institutions (NBFIs) is a financial institution that does not have a full
banking license and cannot accept demand deposits from the public.
 They facilitate alternative financial services, such as investment (both collective and individual),
risk pooling, financial consulting, brokering, money transmission, and check cashing.
 NBFIs are a source of consumer credit and are engaged in the lending and advance business, as
well as the acquisition of shares, government or local authority securities, and other marketable
securities.
 Any institution whose principal business is agricultural, industrial activity, buying or selling any
goods or related services (excluding securities), or building immovable property is not considered
an NBFC.
 Licensing of banks and NBFC differ. A bank‘s license standards are more strict than those of an
NBFC.

Types of NBFCs

Insurance companies: These companies sell insurance policies to individuals and businesses. The
policies can provide coverage for things like car accidents, medical expenses, or property damage.

Investment banks: These banks help companies raise money by issuing and selling securities. They also
provide advice on mergers and acquisitions, and they trade stocks and bonds.

Pension funds: These funds provide retirement income for workers. The money is invested in stocks,
bonds, and other assets.

Mutual funds: These funds pool money from investors and invest it in a portfolio of stocks, bonds, and
other assets.

Hedge funds: These funds are private investment partnerships that use a variety of investment strategies
to make money.

Private equity firms: These firms invest in private companies and help them grow. They may also take
the companies public.

Venture capital firms: These firms invest in early-stage companies with high growth potential.

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FINANCIAL SERVICES

Efficiency of emerging financial system largely depends upon the quality and variety of financial services
provided by financial intermediaries. The term financial services can be defined as ―activities, benefits,
and satisfactions, connected with the sale of money that offers to users and customers financial related
value. Within the financial services industry the main sectors are banks, financial institutions, and non-
banking financial companies.

Kinds of Financial Services

Asset based / fund based services.

Fee based / advisory services.

ASSET BASED / FUND BASED FINANCIAL SERVICES

Asset-based finance is a specialized method of providing companies with working capital and term loans
that use accounts receivable, inventory, machinery, equipment, or real estate as collateral.

In other words, An asset-based loan or line of credit may be secured by inventory, accounts receivable,
equipment, or other property owned by the borrower. The asset-based lending industry serves business,
not consumers. It is also known as asset-based financing.

Some of the asset based financial services are:

1. Equipment Leasing/ Lease Financing

Leasing is a arrangement that provides a firm with the use and control over assets without buying
and owning the same. It is a form of renting assets. However, in making an investment, the firm
need not own the asset. It is basically interested in acquiring the use of the asset. Thus, the firm
may consider leasing of the asset rather than buying it. In comparing leasing with buying, the cost
of leasing the asset should be compared with the cost of financing the asset through normal
sources of financing, i. e. debt and equity. Since payment of lease rentals is similar to payment of
interest on borrowings and lease financing is equivalent to debt.

2. Hire Purchase and Consumer Credit

Hire purchase is an arrangement for buying expensive goods, where the buyer makes an initial
down payment and pays the balance plus interest in installments. In other words,
Hire purchase means a transaction where goods are purchased and sold on the terms that,
1. Payment will be made in installments.
2. The possession of the goods is given to the buyer immediately.
3. The property ownership in the goods remains with the vendor till the last installment is paid.
4. The seller can repossess the goods in case of default in payment of any installment.
5. Each installment is treated as hire charges till the last installment is paid..

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3. Venture Capital

In the real sense, venture capital financing is one of the most recent entrants in the Indian capital
market. There is a significant scope for venture capital companies in our country because of
increasing emergence of technocrat entrepreneurs who lack capital to be risked. These venture
capital companies provide the necessary risk capital to the entrepreneurs so as to meet the
promoters‘ contribution as required by the financial institutions. In addition to providing capital,
these VCFS (venture capital firms) take an active interest in guiding the assisted firms.

4. Insurance Services

Insurance is a contract where by the insurer e. insurance company agrees/ undertakes, in

consideration of a sum of money (premium) to make good the loss suffered by the insured (policy
holder) against a specified risk such as fire or compensate the beneficiaries (insured) on the
happening of a specified event such as accident or death. The document containing the terms of
contract, in black and white, between the insurer and the insured is called policy. The property
which is insured is the subject matter of insurance. The interest which the insured has in the
subject matter of insurance is known as insurable interest. Depending upon the subject matter,
insurance services are divided into (i) Life (ii) General.

5. Factoring

Factoring, as a fund based financial service provides resources to finance receivables as well as it
facilitates the collection of receivables. It is another method of raising short - term finance
through account receivable credit offered by commercial banks and factors. A commercial bank
may provide finance by discounting the bills or invoices of its customers. Thus, a firm gets
immediate payment for sales made on credit. A factor is a financial institution which offers
services relating to management and financing of debts arising out of credit sales.

FEE BASED ADVISORY SERVICES

1. Merchant Banking

Fee based advisory services includes all these financial services rendered by Merchant Bankers.
Merchant bankers play an important role in the financial services Sector. The Industrial Credit
and Investment Corporation of India (ICICI) was the first development finance institution to
initiate such service in 1974. After mid - seventies, tremendous growth in the number of
merchant banking organizations les taken place. These include banks financial institutions, non -
banking financial companies (NBFCS), brokers and so on. Financial services provided by these
organizations include loan syndication portfolio management, corporate counseling project
counseling debenture trusteeship, mergers acquisitions.

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2. Credit Rating

Credit rating is the opinion of the rating agency on the relative ability and willingness of the
issuer of debt instrument to meet the debt service obligations as and when they arise. As a fee
based financial advisory service, credit rating useful to investors, corporates (borrowers), banks
and financial institutions. For the investors, it is an indicator expressing the underlying credit
quality of a (debt) issue programme. The investor is fully formed about the company as any
effect of changes in business/ economic conditions on the agency company is evaluated and
published regularly by the rating agency.

3. Stock – Broking

Prior to the setting up of SEBI, stock exchanges were being supervised by the Ministry of
Finance under the Securities Contracts Regulation Act (SCRA) and were operating more or less
self-regulatory organizations. The need to reform stock exchanges was felt, when malpractices
crept into Trading and in order to protect investor's interests, SEBI was set up to ensure that
stock exchange perform their self - regulatory role properly. Since then, stock broking has
emerged as a professional advisory service Stockbroker is a member of a recognized stock
exchange who buys, sells or deals in shares/ securities. It is mandatory for each stockbroker to
get him / herself registered with SEBI order to act as a broker. SEBI is empowered to impose
conditions while granting the certificate of registration.

EMERGING AREAS IN FINANCIAL MANAGEMENT

There are several areas in financial management which is dominating and crucial at present time.

RISK MANAGEMENT

Risk management is the identification, evaluation, and prioritization of risks followed by coordinated and
economical application of resources to minimize, monitor, and control the probability or impact of
unfortunate events or to maximize the realization of opportunities.

In other words, Risk management is the process of identification, analysis, and acceptance or mitigation
of uncertainty in investment decisions. Put simply, it is the process of monitoring and dealing with the
financial risks associated with investing.

Financial risk management is the practice of protecting economic value in a firm by managing exposure
to financial risk - principally operational risk, credit risk and market risk, with more specific variants as
listed aside.

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Types of Risks

General Financial Risk

1. Systematic Risk - It is a financial risk that cannot be predicted or avoided due to several factors.
For example, a pandemic, political climate, and so on that result in inflation, increased interest
rates, and increased market volatility.
2. Non-systematic Risk - Is a financial risk that befalls a person, organization, or group due to an
event. For example loss, illness, or death.

Personal / Individual Financial Risk

1. Income Risk - Income risk is a variety of risks that affect a person's ability to earn income.
Examples include physical disabilities that make it difficult to work, getting laid off or losing
your job and death.
2. Expenditure Risk - Expenditure risk is the risk that arises when we use the money to meet needs
but the existing expenditure is greater than income, the existing income is not sufficient to meet
the needs, are experiencing an emergency condition that requires spending a lot of money. For
example accidents, vehicle damage, home renovations due to an incident, and much more.)
3. Asset / Investment Risk - Asset or investment risk is the risk that arises because the investment
instrument or assets owned experience several obstacles. These include loss of investment assets,
theft or damage to assets you own, asset values depreciating or depreciating in value, insufficient
savings to continue investing, and others.
4. Credit Risk - Credit risk includes several points including the inability to pay debts, financial
penalties, being trapped in debt with high-interest rates, and others.

Financial Risk Based on Time Period

1. Short-Term Financial Risk - This type of financial risk arises at an unexpected and relatively
short time. For example, a vehicle that suddenly breaks down due to a punctured tire, so you need
to spend some money to handle it. Another example is pain. When we get sick suddenly and are
required to go to the doctor, then there will be some unexpected funds that we need to prepare.
2. Long-Term Financial Risk - As the name implies, which is long-term, this one financial risk
has a fairly serious impact on your finances in the long term. For example, if death that befell the
backbone of a family, when this happens the family left behind will experience difficulties in the
form of loss of the main source of income.

Financial Risk Based on Impact

1. Pure Risk and Speculative Risk - Pure risk is a risk that has a direct impact. For example, your
vehicle broke down in the morning. This strike has an impact on your delay in getting to the
office on time. Speculative risk is the risk that arises due to the acquisition of a small profit that it
has the potential to cause losses.
2. Specific Risk or Fundamental Risk - Specific risk is a risk whose impact can only be felt by the
individual or other people related to the individual. For example, a house fire in a complex.
3. Static Risk and Dynamic Risk - Static risk is the risk that occurs due to the loss of assets or
property due to an incident. An example is a fire. However, this risk will not have an impact on a
person's finances.

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Techniques to mitigate risks

 Avoidance - Risk avoidance is the elimination of hazards, activities and exposures that can
negatively affect an organization and its assets.
 Retention - Risk retention is the planned acceptance of losses by deductibles, deliberate
noninsurance, and loss-sensitive plans where some, but not all, risk is consciously retained rather
than transferred.
 Spreading - The extent to which an insurance company by selecting diversified and independent
risks that are fairly uniform in size and sufficiently large in number can predict the losses thereon
with reasonable accuracy by the law of averages.
 Loss Prevention and Reduction - Risk reduction is one of the four main risk management
techniques to be used in conjunction with other techniques to help an individual or organization
effectively manage the risk of loss.
 Transfer - Risk transfer is a risk management and control strategy that involves the contractual
shifting of a pure risk from one party to another

BEHAVIOURAL FINANCE

The study of the influence of psychological processes on the behaviour of financial practitioners and the
effect on the market is known as behavioural finance. Investors' market behaviour, according to
behavioural finance, is based on psychological decision-making concepts that explain why people
purchase and sell certain class of assets. Behavioural finance is concerned with how investors interpret
and act on data to make financial decisions.

Further, behavioural finance emphasizes investor behaviour, which leads to a variety of market
anomalies. The study of investors' psychology when making financial decisions is known as behavioral
finance. Due to the use of emotions in financial decision-making, investors fall prey to their own and
occasionally others' blunders. Therefore, it is the study of the effects of psychology on investors and
financial markets. It focuses on explaining why investors often appear to lack self-control, act against
their own best interest, and make decisions based on personal biases instead of facts.

FINANCIAL ENGINEERING

Financial engineering involves utilization of mathematical techniques in solving financial problems. This
process uses tools and knowledge from the fields of economics, statistics, applied mathematics and
computer science. These tools not only assist in solving the prevailing financial issues but also help in
devising innovative financial products. Financial engineering is also known as quantitative analysis.
Investment banks, commercial banks and insurance agencies use this technique.

The term financial engineering together can be explained as the process of using engineering tools and
techniques of mathematics, statistics, computer science to solve the financial problems of the
organizations, investors, government etc. It helps in simplifying the activities related to investment or we
can say it is the application of scientific principles to the art of investment.

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DERIVATIVES

Derivatives are financial contracts, set between two or more parties that derive their value from an
underlying asset, group of assets, or benchmark. These contracts can be use to trade any number of assets
and carry their own risks. These financial securities are commonly used to access certain markets and
may be traded to hedge against risk.

Types of Derivatives

Forwards - A forward contract is a derivative contract that derives its value from an underlying asset. It is
a contract between two parties to buy or sell an asset at a predetermined price on a future date. A forward
contract is physically settled, which means it is considered to be fulfilled when the goods are exchanged.
Forward contract is not secured as it is settled over the counter.

Futures - Futures contract is one such financial instrument wherein a contract or agreement is formed
between a buyer (the one with the long position) and seller (the one with the short position) and the buyer
agrees to purchase a derivative or index at a specified time in the future for a fixed price. These contracts
are traded on listed stock exchange.

Options - Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell
an underlying asset at an agreed-upon price and date.

Options are of two types:

 Call Option - Call options are a type of derivative contract that gives the holder the right but not
the obligation to purchase a specified number of shares at a predetermined price, known as the
"strike price" of the option.

 Put Option – Put options are a type of derivative contract that gives the holder the right but not
the obligation to sale a specified number of shares at a predetermined price, known as the "strike
price" of the option.

Swaps - Swaps in derivatives is a contract or agreement between two parties where they can exchange
liabilities or cash flows from two different financial instruments. Most swaps involve cash flows based on
a notional principal amount on bonds or loans.

There are many types of swaps such as interest rate swaps, currency swaps, inflation swaps, equity swaps
etc.,

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MODULE 2: TIME VALUE OF MONEY

The time value of money (TVM) is the concept that a sum of money is worth more now than the same
sum will be at a future date due to its earnings potential in the interim. The time value of money is a core
principle of finance. A sum of money is a core principle of finance. A sum of money in the hand has
greater value than the same sum to be paid in the future.
The basic principle of time value of money is that a rupee today is worth more than a rupee tomorrow.

The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum
of money now rather than an identical sum later. It may be seen as an implication of the later-developed
concept of time preference.

Money deposited into a savings account earns interest. Over time, the interest is added to the principal,
earning more interest. That's the power of compounding interest. If it is not invested, the value of the
money erodes over time. For example, Rs 100 saved in the bank today will earn Rs 10 in the form of rate
of interest (if the interest rate is 10%) and will become Rs 110 tomorrow. Here, Rs 100 today became
equal to Rs 110 in one year later.

There are four variables of TVM; they are

 Present value (PV)

 Time as stated as the number of periods (n)
 Interest rate (r)
 Future value (FV)

Simple Interest and Compounding Interest

SIMPLE INTEREST

Simple Interest is the cost of borrowing. It is the interest only on the principal amount as a percentage of
the principal amount. Borrowers will benefit from simple interest as they have to pay interest only on
loans taken. In other words, simple interest is the amount that one pays to the borrower for using the
borrowed money for a fixed period.

COMPOUND INTEREST

Unlike simple interest, which gains interest only on the principal sum, compound interest (CI) earns
interest on the previously earned interest. The interest is added to the principal amount. CI is simply
Interest on Interest. The whole principle revolves around generating high returns by compounding the
interest received on the principal sum.

In other words, CI has the potential to earn more return than just the simple interest from an investment.
The investments grow exponentially with compound interest because it is based on the principal power of
compounding.

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FUTURE VALUE OF SINGLE CASH FLOW

Future value of a single cash flow refers to how much a single cash flow today would grow to over a
period of time if put in an investment that pays compound interest.

To explain the concept of the future value of a single amount, let's start with the below example,

Year Principal at start of the year Annual Interest Accumulated at the end of year
@ rate 12% PA
1 Rs. 10,000 Rs. 1,200 Rs. 11,200
2 Rs. 11,200 Rs. 1,344 Rs. 12,544
3 Rs. 12,544 Rs. 1,505.28 Rs. 14,049.28

In this table, we see what the future amount of Rs. 10,000 invested at 12% annual interest for three years
would be, given a certain compounding pattern. This is an example of determining the future value of a
single amount. There were no additional investments or interest withdrawals. These future value or
compound interest calculations are important in many personal and business financial decisions.

Formula to calculate future value of single cash flow

Where,

Shorter Compounding Period

( )

NOMINAL AND EFFECTIVE RATE OF INTEREST

The nominal interest rate does not take into account the compounding period. The effective interest rate
does take the compounding period into account and thus is a more accurate measure of interest charges.

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EIR Formula:

( )

DOUBLING PERIOD

Doubling time refers to the time period required to double the value or size of investment and is
calculated by dividing the log of 2 by the product of number of compounding per year and the natural log
of one plus the rate of periodic return.
In finance, the rule of 72 and the rule of 69.3 are methods for estimating an investment's doubling time.

Rule of 72

Rule of 69

The future value of an annuity is a calculation that measures how much a series of fixed payments would
be worth at a specific date in the future when paired with a particular interest rate. The word ―value‖ in
this term is the cash potential that a series of future payments can achieve.

FUTURE VALUE OF AN ANNUITY

An annuity is a series of periodic cash flows (payments or receipts) of equal amounts.

 When the cash flows occur at the end of each period the annuity is called is regular annuity or
deferred annuity.
 When the cash flows occur at the beginning of each period the annuity is called is regular annuity
due.

The future value of an annuity is a calculation that measures how much a series of fixed payments would
be worth at a specific date in the future when paired with a particular interest rate. The word ―value‖ in
this term is the cash potential that a series of future payments can achieve.

The payments in a typical annuity are distributed at the end of a pay period. An example of this would be
a company that pays out dividends at the end of a fiscal quarter where its earnings allowed them to pay
proceeds to shareholders. This is not to be confused with an annuity due, where payments are distributed
at the beginning of a pay period.

Future value of annuity is calculated by,

…………. +A OR [ ]

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Where,

PRESENT VALUE OF SINGLE AMOUNT

The present value of a single amount is an investment that will be worth a specific sum in the future.

Formula to calculate present of single amount,

[ ]
Where,

PRESENT VALUE OF ANNUITY

The present value of an annuity is the cash value of all of your future annuity payments. The rate of return
or discount rate is part of the calculation. An annuity's future payments are reduced based on the discount
rate. Thus, the higher the discount rate, the lower the present value of the annuity is.

Formula to calculate present value of an annuity,

PVA = [ ] OR [ ]

Where,

PRESENT VALUE OF PERPETUITY

The present value of perpetuity is determined by simply dividing the amount of the regular cash flows by
the discount rate.

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Formula to calculate present value of perpetuity, PV = C / (r – g)

C = Amount of continuous cash payment.
r = Interest rate or yield.
g = Growth Rate.

LOAN AMORTIZATION SCHEDULE

The loan amortization schedule is a record of your loan payments that shows the principal amounts and
the interest included in each payment. The schedule shows all payments until the end of the loan term.
Each payment should be the same per period, however; you will owe interest for the majority of the
payments. The bulk of each payment will be the loan‘s principal. The last line should show the total
interest you paid and your principal payments for the full term of the loan.

EQUATED MONTHLY INSTALMENT

An equated monthly installment (EMI) is a fixed payment made by a borrower to a lender on a specified
date of each month. EMIs are applied to both interest and principal each month so that over a specified
time period, the loan is paid off in full.

[ ]
Formula to calculate EMI, {[ ]
}
Where,

P - Principal Amount
R - Prevailing Interest Rate
N - Tenure in months

CAPITAL RECOVERY FACTOR

A capital recovery factor is the ratio of a constant annuity to the present value of receiving that annuity
for a given length of time.

Where,

i - Interest rate
n - Number of years

***********

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MODULE 03: LONG TERM SOURCES OF FINANCE & COST OF CAPITAL

PART – I: LONG TERM SOURCES OF FUNDS

INTRODUCTION

Normally the methods of raising finance are also termed as the sources of finance. But, as a matter of fact
the methods refer only to the forms in which the funds are raised, and hence may or may not include the
sources from, or through which the funds are raised. Hence, we must also have an idea about the sources
of finance. Long-term sources fulfil the financial requirements of a business for a period more than 5
years. It includes various other sources such as shares and debentures, long-term borrowings and loans
from financial institutions. A long-term investment is an account on the asset side of a company's balance
sheet that represents the company's investments, including stocks, bonds, real estate, and cash. Long-term
investments are assets that a company intends to hold for more than a year.

LONG TERM SOURCES OF FUNDS

The sources of long-term finance refer to the institutions or agencies from, or through which finance for a
long period can be procured. Long term source of funds for business includes,

Shares
Debentures
Term Loans

SHARES

A share represents a unit of equity ownership in a company. Shareholders are entitled to any profits that
the company may earn in the form of dividends. They are also the bearers of any losses that the company
may face.

A shareholder is a person, company, or institution that owns at least one share of a company's stock or in
a mutual fund. Shareholders essentially own the company, which comes with certain rights and
responsibilities. This type of ownership allows them to reap the benefits of a business's success.

EQUITY SHARES

Equity shares are long-term financing sources for any company. These shares are issued to the general public
and are non-redeemable in nature. An equity share, normally known as ordinary share is a part ownership
where each member is a fractional owner and initiates the maximum entrepreneurial liability related to a
trading concern. These types of shareholders in any organization possess the right to vote.

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Features of Equity Shares

 Equity share capital remains with the company. It is given back only when the company is closed.
 Equity Shareholders possess voting rights and select the company‘s management.
 The dividend rate on the equity capital relies upon the obtain ability of the surfeit capital.
However, there is no fixed rate of dividend on the equity capital.
 Equity shares have the potential to generate significant returns to the shareholders. However,
these are risky investment options. In other words, equity shares are highly volatile.
 Equity shares are highly liquid investments. The shares are trade on the stock exchanges. As a
result, you can buy and sell the share anytime during trading hours. Therefore, one doesn‘t have
to worry about liquidating their shares.
 A loss of a company makes doesn‘t affect the ordinary shareholders. In other words, the
shareholders are not liable for the company‘s debt obligations. The only effect is the decrease in
the price of the stocks. This will have an impact on the return on investment for a shareholder.

Types of Equity Shares

 Initial Public Offerings – IPOs: An initial public offering (IPO) refers to the process of offering
shares of a private corporation to the public in a new stock issuance for the first time. It is the
largest source of funds with long or indefinite maturity for the company. An IPO is an important
step in the growth of a business. It provides a company access to funds through the public capital
market.
 Rights Issues: A right issue is when a company offers its existing shareholders the chance to buy
additional shares for reduced price. A company would offer a rights issue in order to raise capital.
If current shareholders did choose to buy the additional shares, a company could use the funding
to clear its debt obligations, acquire assets, or facilitate expansion without having to take bank
loan from a bank.
 Bonus Issue: A bonus issue is an offer given to the existing shareholders of the company to
subscribe for additional shares. Instead of increasing the dividend payout, the companies offer to
distribute additional shares to the shareholders. Bonus shares are issued to the shareholders free of
cost instead of dividend.
 Sweat Equity: Sweat equity shares are discounted shares issued by a company to its employees
or directors the shares are given in exchange for a value-add by an employee or director. Sweat
equity shares are essential when creating a startup with low amounts of funding.

Advantages of Equity Shares

 High Returns: Equity shares have the potential to generate high returns as they are high-risk
investments. Higher the risk, the higher the reward. The shares are highly volatile, and the prices
fluctuate owing to many factors.
 Voting Rights: Equity shareholders enjoy voting rights. They can vote for or against corporate
policies and business decisions.

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 Limited Obligations: Though equity shareholders own a part of the company, they have limited
legal liabilities.
 Liquidity: These shares trade on the stock exchange. Buying and selling them is quite easy.

Disadvantages of Equity Shares

 Company’s Performance: The performance of the share largely depends on the company‘s
performance. When the company is not performing and is unable to make profits, the equity
shareholder will not receive any dividends.
 Capital Loss: Since equity shares are high-risk, high-reward investments, the probability of
capital loss is also high. Due to many internal and external factors, the share price fluctuates. A
negative impact may lead to a capital loss for the investors.
 Volatility: Volatility in share prices can be for many reasons. The market sentiments drive the
share prices up and down. Timing the markets is an impossible strategy to adopt. The share prices
fluctuate within seconds and microseconds.

PREFRENCE SHARES

Preference shares are defined as those shares which are given priority over other equity shares in terms of
the payment of dividends. Preference shares are held by preference shareholders who are the first to
receive pay-outs in case the company decides to pay its investors any dividends.

Types of preference shares

Cumulative preference share & Non – cumulative preference shares

These shares come with a provision that entitles shareholders to receive dividends in arrears. So,
when a company does not make enough profits in a year to pay dividends, they pay cumulative
dividends in the following year.

These shares do not accumulate dividends. It is mostly because non-cumulative preference

shareholders are paid from the current year‘s net profits. So, if a company is met with loss in a
particular year, the outstanding dividends cannot be claimed by shareholders from future profits.

Participating preference shares & Non-Participating preference shares

Participating shares extend the right to partake in surplus profit during liquidation once the
company in question has paid its other shareholders. The participating preference shareholders
receive a fixed rate of dividend and also have a share in the company‘s extra earnings. Most
individuals invest in participating preference shares of those companies which are more likely to
generate robust profits.

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Non-participating preference shareholders do not have a share in the extra earnings or surplus
assets during the liquidation of a company. This type of share entitles its shareholders to receive
only the pre-fixed dividends.

Redeemable preference shares & Irredeemable preference shares

Redeemable preference shares are also known as callable preferred stock and serve as one of the
most effective ways to finance big companies. These shares come with a blend of equity and debt
financing and are readily traded on stock exchange. Typically, a company has the right to
repurchase the shares it had issued to satiate its own purpose. Consequently, the redeemable
preference shares are repurchased at a fixed rate on a fixed date or by announcing the same in
advance. Notably, redeemable preference shares come in handy for cushioning the impact of
inflation and the decline of monetary rate.

Irredeemable share cannot be redeemed or repaid during the active lifetime of a company. To
elaborate, shareholders will have to wait until the company decides to wind up its current
operations or liquidate the venture altogether to initiate the same. It makes the shares a perpetual
liability for the company.

Convertible preference shares & Non-convertible preference shares

Convertible shares are fundamentally those shares which enable holders to get them converted
into equity shares at a fixed rate. Notably, these shares can only be converted after the expiry of a
specified time and within a given period, as stated in the memorandum. Ideally, these shares are
considered to be beneficial for those investors who intend to receive preferred share dividends. It
also proves rewarding for those who wish to partake in the change in the price of equity shares.

Non-convertible shareholders cannot convert their shares into equity shares. Regardless, they
enjoy the preferential benefit when it comes to accruing dividends or during company‘s
dissolution.

Adjustable-Rate Preference Shares

The rate of dividend paid on this share is floating in nature and is heavily dependent on the
prevailing market rates. It directly influences the amount of dividend received by the shareholders
throughout the investment.

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Difference between equity and preference shares

Basis of Comparison Equity Shares Preference Shares

Equity shares are ordinary shares of a Preference shares are ones that carry
Definition company that represent ownership of the preferential rights in terms of dividend payment
company. and repayment of capital.
In the case of equity shares, the dividend
rate is not fixed. The board of directors
Preference shareholders receive dividends at a
decide dividend rates for equity
Rate of Dividends fixed rate predefined at a standard share price
shareholders after analysing the
value.
company's performance in the past
financial year.
Equity shareholders are entitled to Preference shareholders are not entitled to
Bonus Shares
receive bonus stocks from the company. receive bonus shares.
Equity shareholders enjoy the right to
Preference shareholders do not have voting
Voting Rights vote and participate in the company's
rights.
decision-making process.
Preference shares can be redeemed after a
Equity stocks cannot be redeemed
Redemption certain period or after the company successfully
throughout the company‘s lifetime.
achieves desired goals.
Equity shareholders receive capital
repayment at the time of liquidation of Preference shareholders receive their capital
Capital Repayment
the company and are the last ones to repayment before equity shareholders.
receive it.
Equity shareholders are at high risk in In comparison to equity shareholders, the risk is
Risk
comparison to preference shares. low in the case of preference shareholders.
Equity shareholders are part owners and
Preference shareholders do not enjoy any
Role in Management have the right to participate in company
advantage in terms of role in management.
management.
Equity shares cannot be converted into Preference shares are convertible and can be
Convertibility
preference shares. converted into equity shares.
Lower costs of equity shares make them The price range of preference shares is higher,
Cost easily accessible to any investor, making them accessible only to medium and
specifically small investors. large investors.
Preference shareholders can avail arrears of
Equity shareholders cannot claim arrears
Arrears of Dividend dividends along with dividends of the current
of dividends.
year.
In the case of equity shares, there is a Preference shares have a relatively lesser
Capitalisation
high chance of over-capitalisation. chance of over-capitalisation.
Equity shares serve as means for long- Preference shares serve as means for mid-term
Financing Terms
term financing. and long-term financing.
Most preference shares come with high
Investment Denomination Equity shares have lower denominations.
denominations.
It is mandatory for companies to issue It is not mandatory for every company to issue
Mandate to Issue
equity share capital. preference share capital.
Payment of equity dividends is optional Payment of preferred dividends is an obligation
Financing Burden
and depends on the company's profit. for the company.

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DEBENTURES

A debenture is a long term debt instrument issued by corporate entities which not secured by any
collateral. It is funding option for companies with solid finances that want to avoid issuing shares and
diluting their equity. The debentures usually have a term greater than 10 years.

Features of Debentures

1. Promissory Note: It is a written promise by the issuing company that owes the specified money
to the holder.
2. Face Value: There should be a face value for debenture, which can be issued at par or discount.
The face value of debenture is generally the high denomination of Rs.100 or in the multiples of
Rs.100
3. Maturity Date: It is a debt instrument that the company issues with a maturity date mentioned in
the certificate. Basically, it provides the time of repayment of the principal amount and interest on
the maturity date.
4. Interest Rate: The holders receive a fixed rate of interest payment periodically, either half-yearly
or annually. The rate of interest of this instrument varies depending on the company, the current
market conditions and the nature of business operations.
5. Assurance: As per the deed, this long term debt instrument carries an assurance of repayment on
the specified due date. Also, they can be redeemed at par, premium or discount.

Types of Debentures

Registered vs. Bearer

The details of registered debenture holders are registered in the company‘s records. Suppose a
debenture holder wants to change the ownership of such debentures. In that case, the transfer or
trading must be organized through a clearing facility, which then alerts the issuer about the changes in
ownership so that the interest can be paid to the right bondholder.

Unregistered debentures are also called bearer debentures. These debentures are issued by a company
that does not require its holders to maintain records. In the case of unregistered debentures, the
company pays the principal amount and the debenture‘s bearer, irrespective of its name. Unregistered
debentures are easily transferable.

Redeemable vs. Irredeemable

Redeemable debentures are redeemable as per the mentioned redeemable date on the company‘s
debenture certificate. Once the redemption date arrives, the company is bound to return the principal
amount to the debenture holder.

Irredeemable debentures are the opposite of redeemable debentures and have no fixed date for the
debenture holder‘s payment. These are only redeemable when the company goes through liquidation.

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Convertible vs. Nonconvertible

The investors‘ debenture holdings can convert these types of debenture into equity shares of the
company. At the time of the issuance of the convertible debentures, the rights of the debenture
holders, the trigger date for conversion, and the conversion date are mentioned.

The investors cannot convert the non-convertible debentures into equity shares. So, when choosing
this type of asset, the investor will always be remunerated according to the pre-, post-fixed, or hybrid
profitability.

Government vs. Corporate Debentures

Debentures that issued by government and government authorities are termed as government
debentures.

Debentures issued by corporate entities are termed as corporate debentures.

Incentivized Debentures

Also called infrastructure debentures, these bonds are issued by businesses that carry out strategic
activities for the country‘s development. Usually, they are from priority sectors such as logistics,
transport, basic sanitation, and energy. A significant benefit of incentivized debentures is that they are
tax-exempted.

BONDS

A Bond is a fixed income instrument that represents a loan made by an investor to a borrower. In simpler
words, bond acts as a contract between the investor and the borrower. Mostly companies and Government
Issue bonds and investors buy those bonds as a savings and security option.

Features of Bonds

1. Face Value: There should be a face value for a bond because that is the price at which the bond
issuer originally sells the bonds.
2. Date of Maturity: Ensure that you check the maturity period of the bond and invest in something
where you can earn more with a shorter time duration
3. Coupon Rate: The rate of interest at which a bond is issued and the Company is liable to pay the
Investor is called the coupon rate. Research and look for Bond options which offer high coupon rate.
4. Coupon dates: are the dates on which the bond issuer will make interest payments. Payments can be
made in any interval, but the standard is semi-annual payments.
5. Tax free: When the government and government authorities issue the bonds they were completely
tax free and taxable when these are issues by corporate entities.

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Types of Bonds

Corporate Bonds: are issued by companies. Companies issue bonds rather than seek bank loans for
debt financing in many cases because bond markets offer more favorable terms and lower interest
rates.
Municipal Bonds: are issued by states and municipalities. Some municipal bonds offer tax-free
coupon income for investors.
Government Bonds: Government bonds issued by national governments may be referred to as
sovereign debt.
Agency Bonds: are those issued by government-affiliated organizations.
Callable Bond: When the issuer of the bond calls out his right to redeem the bond even before it
reaches its maturity is called a Callable Bond.
Puttable Bond: When the investor decides to sell their bond and get their money back before the
maturity date, such type of bond is called a Puttable bond.
Fixed-Rate Bonds: When the coupon rate remains the same through the course of the investment, it is
called Fixed-rate bonds.
Floating Rate Bonds: When the coupon rate keeps fluctuating during the course of an investment, it
is called a floating rate bond.
Mortgage Bond: The bonds which are backed up by the real estate companies and equipment are
called mortgage bonds.
Zero-Coupon Bond: When the coupon rate is zero and the issuer is only applicable to repay the
principal amount to the investor, such type of bonds is called zero-coupon bonds.
Serial Bond: When the issuer continues to pay back the loan amount to the investor every year in
small instalments to reduce the final debt, such type of bond is called a Serial Bond.
Extendable Bonds: The bonds which allow the Investor to extend the maturity period of the bond are
called Extendable Bonds.
Convertible Bonds: are debt instruments with an embedded option that allows bondholders to
convert their debt into stock (equity) at some point in time based in market value of share price.

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Difference between debentures and bonds

Basis of Debentures Bonds
Difference
Definition Debentures are debt financial Bonds are debt financial instruments issued
instruments issued by private by large corporations, financial institutions
companies, but any collaterals or and government agencies that are backed
physical assets do not back them up. up by collaterals or physical assets.
Owner The owner of a debenture is called a The owner of a bond is called a bondholder.
debenture holder.
Collateral Debentures do not get secured by the Bonds get secured by the collateral or
collateral or physical assets of the physical assets of the issuing company.
issuing company. Lenders purchase
these instruments solely based on the
reputation of the issuing company.
Tenure Debentures are generally short to Bonds are long term investments and their
medium term investments and their tenure is generally higher than debentures.
tenure is usually lower than bonds.
Issuer Private companies generally issue Large corporations, financial institutions
debentures for their immediate capital and government agencies issue these bonds
requirements. for their long term capital requirements.
Rate of The debentures carry a fixed or floating The bonds carry a fixed or floating interest
Interest interest rate that is generally higher than rate that is generally lower than debentures
bonds because they are less stable in because they are more stable in terms of
terms of repayment, and they are also repayment, and they get backed by
not backed by collateral. collateral of the issuing company.
Priority If the company is on the verge of If the company is on the verge of
During liquidation, the debenture holders are liquidation, the bondholders are given
Liquidation given second priority over bondholders priority over debenture holders for
for repayment of capital and interest repayment of capital and interest amount.
amount.
Payment The payment of interest for debentures The payment of interest for bonds is on an
Structure is done on a periodical basis and accrual basis. The issuing company pays
depends on the company‘s performance. this amount on a monthly, half-yearly or
yearly basis and this payment is not
dependent on the performance of a
company.
Risk Debentures are riskier than bonds Bonds are less riskier than debentures
because they do not have the security of because they have the security of the
the physical assets of the issuing physical assets of the issuing company.
company.

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TERM LOANS

A term loan provides borrowers with a lump sum of cash upfront in exchange for specific borrowing
terms. Borrowers agree to pay their lenders a fixed amount over a certain repayment schedule with either
a fixed or floating interest rate.

Term loans are commonly used by businesses to purchase fixed assets, such as equipment or a new
building. Borrowers prefer term loans because they offer more flexibility and lower interest rates. Short
and intermediate-term loans may require balloon payments while long-term facilities come with fixed
payments.

Features of term loan

1. Regardless of the company's (borrower's) financial status, the loan must be repaid over the
specified term.
2. The term loan interest rates are based on the risk of the proposal, the amount of the loan that is
asked for, and the tenure for which the loan has been taken. A default can be issued if the loans
are not paid on time.
3. You have to pay the principal amount after a period of 1 to 2 years for long-term loans.
4. Commercial loans are repayable in equal quarterly instalments whereas financial institutions‘
term loans are repayable in equal semi-annual instalments.
5. Servicing burden of the loan declines over time.
6. The interest will be less, and the principal repayment will remain constant.

Types of term loans

Short-term loans: These types of term loans are usually offered to firms that don't qualify for a
line of credit. They generally run less than a year, though they can also refer to a loan of up to 18
months.
Intermediate-term loans: These loans generally run between one to three years and are paid in
monthly instalments from a company‘s cash flow.
Long-term loans: These loans last anywhere between three to 25 years. They use company
assets as collateral and require monthly or quarterly payments from profits or cash flow. They
limit other financial commitments the company may take on, including other debts, dividends or
principals' salaries, and can require an amount of profit set aside specifically for loan repayment.

DEFERRED CREDIT

A deferred credit is cash received that is not initially reported as income, because it has not yet been
earned. In most cases, a deferred credit is caused by the receipt of a customer advance. This is a
situation where a customer pays the seller before the seller has provided it with an offsetting amount
of services or merchandise. Generally, deferred credits are classified as liability or owner's equity
depending on how the company accounts for them. For instance, deferred tax liabilities are generally
classified as a liability while stock options are considered part of owner's equity.

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LEASE FINANCING

Lease financing is one of the important sources of medium-and long-term financing where the owner of
an asset gives another person, the right to use that asset against periodical payments. The owner of the
asset is known as lessor and the user is called lessee. The periodical payment made by the lessee to the
lessor is known as lease rental. Under lease financing, lessee is given the right to use the asset but the
ownership lies with the lessor and at the end of the lease contract, the asset is returned to the lessor or an
option is given to the lessee either to purchase the asset or to renew the lease agreement. Different Types
of Leases Depending upon the transfer of risk and rewards to the lessee, the period of lease and the
number of parties to the transaction.

Lease financing can be classified into two categories.

1. Finance Lease: It is the lease where the lessor transfers substantially all the risks and rewards of
ownership of assets to the lessee for lease rentals. In other words, it puts the lessee in the same
condition as he/she would have if he/she had purchased the asset. Financial lease has two phases: The
first one is called primary period. This is non-cancellable period and in this period, the lessor recovers
his total investment through lease rental. The primary period may last for indefinite period of time.
The lease rental for the secondary period is much smaller than that of primary period.

2. Operating Lease: Lease other than finance lease is called operating lease. Here risks and rewards
incidental to the ownership of asset are not transferred by the lessor to the lessee. The term of such
lease is much less than the economic life of the asset and thus the total investment of the lessor are
not recovered through lease rental during the primary period of lease. In case of operating lease, the
lessor usually provides advice to the lessee for repair, maintenance and technical knowhow of the
leased asset and that is why this type of lease is also known as service lease.

Advantages of lease financing

For Lessor

1. Regularly Assured Income: Lessors receive lease rentals by leasing an asset for the duration of
the lease, which is a guaranteed and consistent source of income.
2. Ownership Preservation: In a finance lease, the lessor transfers all risk and rewards associated
with ownership to the lessee without transferring asset‘s ownership, so the lessor retains
ownership.
3. Tax Advantage: Because the lessor owns the asset, the lessor receives a tax benefit in the form
of depreciation on the leased asset.
4. Profitability is high: Leasing is a highly profitable business because the rate of return on lease
rentals is much higher than the interest paid on the asset‘s financing.
5. Growth Possibilities: There is a lot of room for growth here. Because leasing is one of the most
cost-effective forms of financing, demand for it is steadily increasing. Even amid a depression,

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economic growth can be maintained. As a result, leasing has a much higher growth potential
than other types of businesses.

For Lessee

1. Capital Goods Utilization: A business will not have to spend a lot of money to acquire an asset,
but it will have to pay small monthly or annual rentals to use it. The business can use its funds
for other productive purpose.
2. Tax Advantages: Lease payments can be deducted as a business expense, allowing a company
to benefit from a tax advantage.
3. Cheaper: Leasing is a form of financing that is less expensive than almost all other options.
4. Technical Support: Regarding the leased asset, the lessee receives some form of technical
support from the lessor.
5. Friendly to Inflation: Leasing is inflation-friendly because the lessee is required to pay a fixed
amount of rent each year, even if the asset‘s cost rises.
6. Ownership: After the primary period has expired, the lessor offers the lessee the opportunity to
purchase the assets for a small fee.

Limitations of lease financing

To Lessor

1. In the event of inflation, it is unprofitable: Every year, the lessee receives a fixed amount of
lease rental, which they cannot increase even if the asset‘s cost rises. So, it is unprofitable
during inflation.
2. Taxation twice: It is possible to be charged sales tax twice: The first is when the asset is
purchased, and the second is when the asset is leased.
3. Greater Risk of Asset Damage: As the ownership is not transferred, the lessee treats the asset
carelessly, and there is a great chance that it will not be usable after the primary lease period
ends.

To Lessee

1. Compulsion: Finance leases are non-cancellable, and lessees must pay lease rentals even if
they do not intend to use the asset.
2. Ownership: Unless the lessee decides to purchase the asset at the end of the lease agreement,
the lessee will not become the owner of the asset.
3. Costly: Lease financing is more expensive than other types of financing because the lessee is
responsible for both the lease rental and the expenses associated with asset ownership.
4. Asset Understatement: As the lessee is not the owner of the asset, it cannot be included in the
balance sheet, resulting in an understatement of the lessee‘s asset.

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HYBRID FINANCING

Hybrid Financing is the financial instrument that partakes some characteristics of debt and some
characteristics of equity. Simply, it is the financial security that possesses the characteristics of both the
debt and equity. The debt and equity are the two extreme points and in the midpoint lies the hybrid
financing that offers the investors the benefits of both the equity and debt. Equity gives the right to have a
residual claim on the cash flows and assets of the firm and have control over the management. Whereas,
the debt represents the fixed claim over the cash flows and the assets of the firm, but generally, do not
give the right to control the management.

Hybrid financing includes:-

1. Preference Stocks: Holders of preference stocks are meant to receive dividends before the
holders of the common stocks. In this regard, it is important to highlight the fact that preferred
stocks are considered to be a mixture of both, fixed income streams as well as variable income
streams. Preference Stocks tend to be similar to Fixed Income Components in the sense that upon
maturity, the share price might not necessarily be equivalent to the price that they initially paid
for the share. In the same manner, they also include a variable component, because they are
entitled to a fixed rate of dividend every year. Regardless of the volume of profit that the
company generates, Preference Stocks are entitled to the fixed rate of dividend that they receive.
Therefore, preference stocks are considered to be a classic example (and type) of hybrid
financing, because they include both the relevant components.

2. Convertible Debentures: Convertible Debentures can be termed as another example of hybrid

financing. In addition to the normal debenture features, it can be seen that convertible debentures
tend to include the option to convert debentures into equity, contingent on certain terms and
conditions. Up till the point where these debentures are converted into equity, they continue to be
treated as debt instruments, and therefore, they incur a periodic, agreed-upon interest rate.
However, after they have converted into equity shares, the return rate of the equity shares then
changes.

3. Warrants: Warrants are considered a type of hybrid security that gives the right to buy and sell
shares at a particular price on or before a particular date. However, they do not obligate him to do
the same. Warrants are similar to the call options in the manner in which they function. However,
they are different because warrants are sold between investors and the company issuing the
warrant. This is different from the call option because the call option involves options being
exchanged between investors. In the same manner, they are also cheaper as compared to other
call options. They are considered as a source of hybrid financing because they constitute of both,
the fixed component, and the variable component.

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VENTURE CAPITAL

Venture capital (VC) is a type of financing that investors provide to start-up companies and small
businesses that are believed to have long-term growth potential. Venture capital generally comes from
well-off investors, investment banks, and any other financial institutions. Venture capitalists can provide
backing through capital financing, technological expertise, and/or managerial experience. VC can be
provided at different stages of their evolution, although it often involves early and seed round funding.
Venture capital funds manage pooled investments in high-growth opportunities in start-ups and other
early-stage firms and are typically only open to accredited investors.

ANGEL INVESTING

Angel investors are wealthy private investors focused on financing small business ventures in exchange
for equity. Unlike a venture capital firm that uses an investment fund, angels use their own net worth.
Compared to venture capitalists, angels may also be more patient with entrepreneurs and open to
providing smaller dollar amounts for a longer time period. But they do want to see an exit strategy at
some point where they can pocket their profits, typically through a public offering or an acquisition.

PRIVATE EQUITY

Private equity (PE) is a form of financing where money, or capital, is invested into a company. Typically,
PE investments are made into mature businesses in traditional industries in exchange for equity, or
ownership stake. PE is a major subset of a larger, more complex piece of the financial landscape known
as the private markets. PE is an alternative asset class alongside real estate, venture capital, distressed
securities, and more. Alternative asset classes are considered less traditional equity investments, which
mean they are not as easily accessed as stocks and bonds in the public markets.

CROWD FUNDING

Crowd funding is the use of small amounts of capital from a large number of individuals to finance a
new business venture. Crowd funding makes use of the easy accessibility of vast networks of people
through social media and crowd funding websites to bring investors and entrepreneurs together, with the
potential to increase entrepreneurship by expanding the pool of investors beyond the traditional circle of
owners, relatives, and venture capitalists.

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PART – II: COST OF CAPITAL

INTRODUCTION

Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and the
debt-holders) to the business as a compensation for their contribution to the total capital. When an
entity (corporate or others) procured finances from either sources as listed above, it has to pay
some additional amount of money besides the principal amount. The additional money paid to
these financiers may be either one off payment or regular payment at specified intervals. This
additional money paid is said to be the cost of using the capital and it is called the cost of capital.
This cost of capital expressed in rate is used to discount/ compound the cash flow or stream of
cash flows.

MEANING

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its
market value and attract funds. Cost of capital is the required rate of return on its investments
which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected
rate, the market value of the shares will fall and it will result in the reduction of overall wealth of
the shareholders.

DEFINITION

According to the definition of John J. Hampton, ―Cost of capital is the rate of return the firm
required from investment in order to increase the value of the firm in the market place‖.

According to the definition of Solomon Ezra, ―Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure‖.

According to the definition of William and Donaldson, ―Cost of capital may be defined as the
rate that must be earned on the net proceeds to provide the cost elements of the burden at the
time they are due‖.

Assumption of Cost of Capital Cost of capital is based on certain assumptions which are closely
associated while calculating and measuring the cost of capital. It is to be considered that there are
three basic concepts:

1. It is not a cost as such. It is merely a hurdle rate.

2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk and financial risk.
Cost of capital can be measured with the help of the following equation.

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IMPORTANCE / SIGNIFICANCE OF COST OF CAPITAL

 Evaluation of investment options: The estimated benefits (future cash flows)

from available investment opportunities (business or project) are converted
into the present value of benefits by discounting them with the relevant cost of
capital. Here it is pertinent to mention that every investment option may have
different cost of capital hence it is very important to use the cost of capital
which is relevant to the options available.
 Financing Decision: When a finance manager has to choose one of the two
sources of finance, he can simply compare their cost and choose the source which
has lower cost. Besides cost he also considers financial risk and control.
 Designing of optimum credit policy: While appraising the credit period to be
allowed to the customers, the cost of allowing credit period is compared against
the benefit/ profit earned by providing credit to customer of segment of
customers. Here cost of capital is used to arrive at the present value of cost and
benefits received.

Formula of Cost of Capital

K - Cost of capital.
- The riskless cost of the particular type of finance.
b - The business risk premium.
f - The financial risk premium.

COMPONENTS OF COST OF CAPITAL

1. Cost of Debt
2. Cost of Preference Shares
3. Cost of Equity
4. Weighted Average Cost of Capital (WACC)

COST OF DEBT

External borrowings or debt instruments do no confers ownership to the providers of finance. The
providers of the debt fund do not participate in the affairs of the company but enjoys the charge on the
profit before taxes. Long term debt includes long term loans from the financial institutions, capital from
issuing debentures or bonds etc.

The cost of debt is the effective rate that a company pays on its debt, such as bonds and loans. The key
difference between the pre-tax cost of debt and the after-tax cost of debt is the fact that interest expense is
tax-deductible. Debt is one part of a company‘s capital structure, with the other being equity.

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Cost of debentures sis calculated based on the below types

1. Cost of redeemable debenture

2. Cost of irredeemable debenture

Cost of Irredeemable Debentures

Where,
= Cost of debenture
P = Current Market Price
I = Interest Payment
T = Tax Rate

Cost of Redeemable Debenture

Where,
= Cost of debenture
RV = Redemption value
P = Current Market Price
I = Interest Payment
T = Tax Rate
N = Remaining life of preference share

Yield-To-Maturity

Yield to maturity is the total rate of return that will have been earned by a bond or debenture when it
makes all interest payments and repays the original principal. YTM is essentially a bond's internal rate of
return if held to maturity. Formula to calculate YTM,

Where,

C = Coupon Payment / Annual Interest

F = Face value of the bond
P = Current market price of the bond
n = Years to maturity

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COST OF PREFERENCE SHARES

The preference share capital is paid dividend at a specified rate on face value of preference shares.
Payment of dividend to the preference shareholders are not mandatory but are given priority over the
equity shareholder. The payment of dividend to the preference shareholders are not charged as
expenses but treated as appropriation of after tax profit. Hence, dividend paid to preference shareholders
does not reduce the tax liability to the company. Like the debentures, Preference share capital can be
categorised as redeemable and irredeemable. Accordingly cost of capital for each type will be discussed
here

Cost of Irredeemable Preference Share

Where,
= Cost of Preference Share
P = Issue Price
PD = Annual Preference Dividend

Cost of Redeemable Preference Share

Where,
= Cost of Preference Share
RV = Redemption value
P = Issue Price
PD = Annual Preference Dividend
T = Tax Rate
N = Remaining life of preference share

COST OF EQUITY SHARES

The cost of equity is the return that a company requires to decide, if an investment meets capital return
requirements. Cost of equity share capital is that part of cost of capital which is payable to shareholder.
Every shareholder gets shares for getting return on it. Firms often use it as a capital budgeting threshold
for the required rate of return. A firm‘s cost of equity represents the compensation that the market
demands in exchange for owning the asset and bearing the risk of ownership.

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There are different methods to calculate the cost of equity, they are

 Dividend Approach
 Dividend Growth Approach
 Earning Approach
 CAPM

Dividend Price Approach

The dividend price approach describes the investors' view before investing in equity shares. According to
this approach, investors have certain minimum expectations of receiving dividend even before purchasing
equity shares. An investor calculates present market price of the equity shares and their rate of dividend.

Formula,

Where,

= Cost of Equity
D = Expected Dividend
P = Market Price of Share

Dividend Growth Approach

It‘s an approach that assumes dividends grow at a constant rate in perpetuity. The value of the stock
equals next year's dividends divided by the difference between the required rate of return and the assumed
constant growth rate in dividends.

Formula,

Where,

= Cost of Equity
D1 = Next Expected Dividend
G = Growth Rate
P = Market Price of Share

Earning Price Approach

The earnings price ratio approach suggests that cost of equity capital depends upon amount of fixed
earnings of an organization. According to the earnings price ratio approach, an investor expects that a
certain amount of profit must be generated by an organization.

Formula,

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Where,

= Cost of Equity
E = Earnings per Share
P = Market Price of Share

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, or the
general perils of investing, and expected return for assets, particularly stocks. It is a finance model that
establishes a linear relationship between the required return on an investment and risk. The model is
based on the relationship between an asset's beta, the risk-free rate (typically the Treasury bill rate), and
the equity risk premium, or the expected return on the market minus the risk-free rate. CAPM evolved as
a way to measure this systematic risk. It is widely used throughout finance for pricing risky securities
and generating expected returns for assets, given the risk of those assets and cost of capital.

The CAPM model bases its predictions on the following assumptions:

 Investors are given the same amount of time to assess the information.
 Investments can be broken up into countless shapes and sizes.
 By nature, all investors are risk-averse.
 Risk and reward are correlated linearly.
 Taxes, inflation, and transaction costs do not exist.
 At the risk-free rate of return, limitless capital is available for borrowing.

Where,

= Cost of Equity
= Risk free return
β = Beta coefficient
= Market risk premium

Advantages of CAPM

1. It solely takes into account systematic risk, reflecting that most investors have diversified portfolios in
which unsystematic risk has been completely removed.
2. The needed return and systematic risk have a theoretically determined relationship that has frequently
been empirically investigated and tested using the CAPM method.
3. Since it expressly considers a company's level of systematic risk in relation to the entire stock market,
it is widely regarded as a much superior approach to determining the cost of equity than the dividend
growth model (DGM).

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Drawbacks of CAPM

1. First, certain questionable assumptions are made by CAPM. For instance, the formula is only valid if
we believe that the market is dominated by rational individuals who only consider investment returns
when making decisions.
2. CAPM exclusively uses historical data. The use of historical data is a problem with a lot of financial
models and one that is quite difficult to solve. The previous price fluctuations of a stock are
ultimately insufficient to assess the overall risk of an investment according to the capital asset pricing
model.

COST OF RETAINED EARNINGS

The cost of retained earnings is the cost to a corporation of funds that it has generated internally. If the
funds were not retained internally, they would be paid out to investors in the form of dividends. Most of
the times cost of retained earnings is equal to that of cost of equity.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Weighted average cost of capital (WACC) represents a firm‘s average after-tax cost of capital from all
sources, including common stock, preferred stock, bonds, and other forms of debt. WACC is the average
rate that a company expects to pay to finance its assets.

WACC is a common way to determine required rate of return (RRR) because it expresses, in a single
number, the return that both bondholders and shareholders demand to provide the company with capital.
A firm‘s WACC is likely to be higher if its stock is relatively volatile or if its debt is seen as risky
because investors will require greater returns.

WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant
weight by market value, then adding the products together to determine the total.

WACC is also used as the discount rate for future cash flows in discounted cash flow analysis.

The weighted average cost of capital is the average of a company's cost of equity and cost of debt,
weighted by their respective proportions of the company's total capital. The main advantage of using the
WACC is that it takes into account the different risks associated with equity and debt financing. The
disadvantage of using the WACC is that it is a long-term average and may not be representative of the
company's current cost of capital.

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MODULE 4: CAPITAL STRUCTURE AND DIVIDEND DECISIONS

PART – I: CAPITAL STRUCTURE

INTRODUCTION

Capital Structure is combination of capitals from different sources of finance. Capital structure is the
particular combination of debt and equity used by a company to finance its overall operations and
growth. 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 part of the capital
structure.

Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance
sheet, are purchased with debt or equity. Capital structure can be a mixture of a company's long-term
debt, short-term debt, common stock, and preferred stock. A company's proportion of short-term debt
versus long-term debt is considered when analysing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity (D/E)
ratio, which provides insight into how risky a company's borrowing practices are. Usually, a company
that is heavily financed by debt has a more aggressive capital structure and therefore poses a greater risk
to investors. This risk, however, may be the primary source of the firm's growth.

PLANNING THE CAPITAL STRUCTURE

Planning the capital structure is nothing but deciding on the structure of capital required by the company
inform of both ownership and debt. There are two approaches to design capital structure they are

EBIT-EPS ANALYSIS (Profitability approach to capital structure)

It is needless to say that if we want to examine the effect of leverage, we are to analyse the relationship
between the EBIT (earnings before interest and tax) and EPS (earnings per share).Practically, it requires
the comparison of various alternative methods of financing under various alternative assumptions relating
to Earnings Before Interest and Taxes. Financial leverage or trading on equity arises when fixed assets are
financed from debt capital (including preference shares). When the same gives a return which is greater
than the cost of debt capital, the excess will increase the EPS (Earnings Per Share) and the same is also
applicable in case of preference share capital.

But there are some disagreements to this approach because of the following reasons

(a) Interest on debt capital is an allowable deduction as per Income-Tax rule while calculating profit,
(b) Usually the cost of preference share is more costly than the cost of debt.

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However, while planning capital structure of a firm, the effect of leverage, EPS, are to be given due
consideration. In order to increase the shareholders‘ fund, a firm can effectively use its high level of EBIT
against the high degree of leverage. It is already stated above that the effect of leverage can be examined
if we analyse the relationship between the EBIT and the EPS.

CASH FLOW ANALYSIS (Liquidity approach to capital structure)

In order to meet the fixed service charge of a firm, analysis of cash flow is very important. It indicates the
ability of the firm to meet its various commitments including the fixed service charges, which includes
fixed operating charges and interest on debt capital.

Thus, the analysis of the cash flow ability of the firm to service fixed charges is no doubt an important
tool while analysing financial risk in addition to EBIT-EPS analysis in capital structure planning. We
know that if the amount of debt capital increases, there is a corresponding increase in the amount of
uncertainty which a firm must face to meet its obligation in the form of fixed charges.

Because, if a firm borrows more than its capacity and if it fails to meet its maturing obligation at a future
date, the creditors will acquire the assets of the firm for their unsatisfied claim which brings financial
insolvency. So, before taking any additional debt capital, analysis of expected future cash flows must
carefully be considered as the fixed interest charges are paid out of cash.

That is why analysis of cash flow presents very significant information in this regard. If there is greater
and stable expected future cash flow, a firm should go for a higher degree of debt which can be used as a
source of finance. Similarly, if the expected future cash flows are unstable and smaller, a firm should
avoid any fixed charge securities which will be considered a very risky proposition.

Cash flow analysis helps in capital structure because of the following reasons

(i) Cash flow analysis highlights the solvency and liquidity position of a firm at the time of
adverse condition;
(ii) It records the various changes made in Balance Sheet and other cash flow which do not
exhibit in Profit and Loss Account;
(iii) It takes the financial trouble in a dynamic context over a number of years.

GUIDELINES FOR PLANNING CAPITAL STRUCTURE

The capital structure decision is a difficult decision that involves a complex trade off among several
considerations like income, risk, flexibility, control, timing, and so on. Given the over - riding objective
of maximising the market value of a firm, bear in mind the following guidelines while hammering out the
capital structure of the firm.

Avail of the Tax Advantage of Debt: Interest on debt finance is a tax - deductible expense. Hence
finance scholars and practitioners agree that debt financing gives rise to tax shelter which enhances
the value of the firm.

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Preserve Flexibility: The tax advantage of debt should not persuade one to believe that a firm should
exploit its debt capacity fully. By doing so, it loses flexibility. And loss of flexibility can erode
shareholder value. So, a firm should preserve a certain degree of financial flexibility.
Ensure that Total Risk Exposure is Reasonable: While examining risk from the point of view of the
investor, a distinction is made between systematic risk (also referred to as the market risk or non -
diversifiable risk) and unsystematic risk (also referred to as the non - market risk or diversifiable
risk). We now dwell on the distinction between business risk and financial risk.
Know the Norms of Lenders and Credit Rating Agencies: Financial institutions and banks are often
the principal providers of debt capital. They are more comfortable in lending against stable, tangible
assets like plant and machinery, but not inclined to support intangible items like outlays on Research
and Development or market development. Hence, if your firm has stable, tangible assets you may be
able to borrow more. On the other hand, if your firm has risky, intangible assets you may not be able
to borrow much.
Issue Innovative Securities: Instead going for traditional securities try issuing new securities so that
capital structure is not much affected and company hold edge over ownership. The important
securities innovations have been as follows: floating rate bonds (or notes ), collateralized mortgage
obligations, dual currency bonds, extendable notes, medium term notes, pass through certificates,
puttable bonds, zero coupon bonds, adjustable rate preferred stock, auction rate preferred stock, liquid
yield option notes, puttable convertible bonds and puttable common stocks.
Widen the range of financing sources: In a dynamically evolving financial environment, traditional
sources of financing may diminish in importance. They may not be adequate or optimal. Hence, it
behoves on a firm to employ newer an opportunity presents itself, tap different markets and
instruments.

IMPORTANCE OF CAPITAL STRUCTURE

 Assessing company growth: Your financial risk declines as your company grows from a start-
up to a functioning business. Your operations become more predictable and profitable, improving
access to new income sources such as debt financing. You can assess the growth of your business
through capital structure.
 Ownership and interest: Equity financing means investors have ownership rights in your
company and receive a portion of the earnings. If the company earns nothing, the investors also
earn nothing. Debt financing means you own your company, but you‘ll have to pay the money
borrowed back to lenders, including an interest rate, even if your company fails. Each has risks
and rewards, and a capital structure helps you manage these options.
 Seeking investors: Growth means your company has a higher market value and stock prices,
attracting more dependable lending providers with lower interest payments. If your company has
more debt than equity, investors will see it as a more significant financial risk. Your company‘s
capital structure guides you in terms of when and from whom to seek investments. Get Starbucks
CEO Howard Shultz‘s tips for finding business investors.

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OPTIMUM CAPITAL STRUCTURE

An optimal capital structure is the best mix of debt and equity financing that maximizes a company‘s
market value while minimizing its cost of capital. Minimizing the weighted average cost of capital
(WACC) is one way to optimize for the lowest cost mix of financing. The optimal capital structure of
a company refers to the proportion in which it structures its equity and debt. It is designed to maintain the
perfect balance between maximising the wealth and worth of the company and minimising its cost of
capital.

The objective of a company is to determine the lowest weighted average cost of capital (WACC) while
deciding on its capital structure. The WACC is the weighted average of its cost of equity and debt. It is
not mandatory for a company to take any debt.

A company can have a capital structure that is all-equity, or a structure with minimal debt. It also
depends on the industry the company belongs to because standard capital structures vary from industry to
industry and whether the company is a private or public company.

Things to be considered in while designing the optimum capital structure,

1. Maximise the company's wealth: An optimal capital structure will maximise the company's net
worth, wealth, and market value. The wealth of the company is calculated in terms of the present value of
future cash flows. This is discounted by the WACC.

2. Minimise the cost of capital: The lower the cost of the capital, the lower is the risk of insolvency.
Companies in industries that have uncertain future cash flows should keep their cost of financing
minimal. The lower the cost of capital, the higher will be its present value of future cash flows.

3. Simple: It should be simple to structure and understand. A complicated capital structure will only
create confusion.

4. Maintain Control: An optimal capital structure maintains the owners' rights and control. It is also
flexible and gives scope for future borrowing whenever necessary, without losing control.

DETERMINATION OF CAPITAL STRUCTURE

There are several factors that determine the capital structure some of them are:

1. Cost of capital: It is the cost that is incurred in raising capital from different fund sources. A firm
or a business should generate sufficient revenue so that the cost of capital can be met and growth
can be financed.
2. Degree of Control: The equity shareholders have more rights in a company than the preference
shareholders or the debenture shareholders. The capital structure of a firm will be determined by
the type of shareholders and the limit of their voting rights.

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3. Trading on Equity: For a firm which uses more equity as a source of finance to borrow new
funds to increase returns. Trading on equity is said to occur when the rate of return on total
capital is more than the rate of interest paid on debentures or rate of interest on the new debt
borrowed.
4. Government Policies: The capital structure is also impacted by the rules and policies set by the
government. Changes in monetary and fiscal policies result in bringing about changes in capital
structure decisions
5. Flexibility of financial plan: In an enterprise, the capital structure should be such that there is
both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the
time requires.
6. Choice of investors: The company‘s policy generally is to have different categories of investors
for securities. Therefore, a capital structure should give enough choice to all kind of investors to
invest. Bold and adventurous investors generally go for equity shares and loans and debentures
are generally raised keeping into mind conscious investors.
7. Capital market condition: In the lifetime of the company, the market price of the shares has got
an important influence. During the depression period, the company‘s capital structure generally
consists of debentures and loans. While in period of boons and inflation, the company‘s capital
should consist of share capital generally equity shares.
8. Period of financing: When company wants to raise finance for short period, it goes for loans
from banks and other institutions; while for long period it goes for issue of shares and debentures.
9. Stability of sales: An established business which has a growing market and high sales turnover,
the company is in position to meet fixed commitments. Interest on debentures has to be paid
regardless of profit. Therefore, when sales are high, thereby the profits are high and company is
in better position to meet such fixed commitments like interest on debentures and dividends on
preference shares. If company is having unstable sales, then the company is not in position to
meet fixed obligations. So, equity capital proves to be safe in such cases.
10. Sizes of a company: Small size business firms capital structure generally consists of loans from
banks and retained profits. While on the other hand, big companies having goodwill, stability and
an established profit can easily go for issuance of shares and debentures as well as loans and
borrowings from financial institutions. The bigger the size, the wider is total capitalization.

GOVERNANCE OF EQUITY AND DEBT

When running a business, utilising and controlling debt effectively is a key factor for success. While
it‘s true there are ‗good‘ types of debt, all liabilities require frequent and regular attention. Small
businesses operating under a company structure should be aware that the directors have a legal duty
to ensure that debts of the company can be paid as and when they fall due, and those tra ding from an
unincorporated structure are ultimately personally liable for debts of the business. Debt can benefit
your business when it‘s managed well. Neglected or mismanaged, debt can sink the business.

 Rework Business Budget: A business budget should identify business income sources, variable
expenses and fixed costs. It is also a good idea to include a cash flow budget to take into
account expected transactions outside of the profit & loss including loan repayments, ATO

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obligations and returns to owners. A budget should help business to establish the helpful habit
of laying money aside to pay suppliers, creditors, your landlord, the ATO and other predictable
expenses.

 Review and Prioritise Debts: It is important to be aware that certain liabilities may have highly
adverse consequences for late payment – for instance, employer Super Guarantee contributions
are generally due to be paid to each employee‘s chosen fund by 28 days after the end of each
quarter and there are significant ATO penalties that apply for missing this deadline by even 1
day.

 Review Loan Terms & Consider Refinancing: Interest rates are at historic lows so now is a
good time to review business loans and ensure business is getting a competitive deal – the
savings could be significant. Refinancing can also provide an opportunity to restructure debt in
various ways e.g. by consolidating multiple loans into a more manageable single facility,
changing loan durations or optimising tax deductibility of debt.

 Increase of Sales: In addition to improving your budget and cash flow, prioritising your debts
and reviewing your loans, you might look to understand the profit drivers in your business and
focus your energy on increasing sales in the most lucrative areas of the business. Many business
owners get too focused on top-line revenue and don‘t realise that in some cases they may in fact
be losing money on some products, services or customers!

 Make Timely Payments: Timely payments are the key factor that comes in governance of debt.
Timely payment attracts variety of investors and financial institutions to provide a competitive
deal. This in turn improves the credit worthiness of the business.

Equity Governance is the process of creating and managing ownership in the company. It involves:

 Tracking and reporting changes in ownership on your cap table.

 Updating equity documents like your stock option plan and stock purchase agreements and
communicating changes with stakeholders.
 Consulting your board of directors and, if applicable, obtaining requisite approvals from
stockholders.
 Staying compliant with various regulatory and accounting obligations.

CapTable

A cap table is a record of all your company‘s securities—including stock, convertible notes, warrants,
options, and other equity grants—as well as who owns them. The more securities company issues, the
more complex your cap table tends to be.

Equity Governance includes:

 Shareholder management: Updating your employees and investor stakeholders on the growth of
the company is one part of managing equity. With more knowledge about your company, they are

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more likely to invest. Keeping them in this loop requires technology and time. Additionally,
regular investor updates are a must after issuing electronic certificates. These updates should
consist of key metrics, customer wins, hires, and the company‘s trajectory. When needed
alongside update management can also ask for an introduction or additional funding.
 Record and track company equity transactions: It is essential to keep a record and track all the
shares of the company. This is also in the main tasks that the admin needs to address.
 Cap table management: The capital table is a record of all the organization‘s securities such
as warrants, convertible notes, equity grants, and stock. They also state who owns them. The cap
table gets more complicated as the company keeps issuing securities. The equity admin is
responsible for issuing the board approved equity to processing exercises and stakeholders. They
also maintain the table by updating it after every finance, liquidity, or material event.
Additionally whenever changes are made they send the updated copy to the stakeholders.
 Company valuations (409a valuation): If your company wants to offer equity then you need to
get an appraisal done called a 409A valuation. This helps you qualify for an IRS safe harbor. The
main aim of this is to determine the fair market value of the common stock of your company.
This sets the price of each stock. Generally, you will need to get an appraisal done every 12
months or when a material event happens.
 Maintaining compliance: The equity admin has the responsibility of enforcing the set rules
when they issue and report equity. They should also abide by the GAAP rules. In the U.S they
will have to also follow ASC 718. When reporting an employee stock-based compensation on an
income statement, this is a set of accounting standards that they will have to abide by. If your
corporation issues equity to its international employees, then they will also have to address
the IFRS and adhere to its rules and regulations.

LEVERAGE

In finance, leverage is a strategy that companies use to increase assets, cash flows, and returns, though it
can also magnify losses. There are two main types of leverage:

 Financial Leverage
 Operating Leverage

Financial Leverage

Financial leverage results from using borrowed capital as a funding source when investing to expand the
firm's asset base and generate returns on risk capital. 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.

Financial Leverage calculated by using the below formula,

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High Financial Leverage Vs. Low Financial Leverage

High degree of financial leverage means the company is using more debts. High degree of leverage
indicates higher financial risk.

A lower financial leverage ratio is usually a mark of a financially responsible business with a steady
revenue stream.

Operating Leverage

Operating leverage measures a company‘s fixed costs as a percentage of its total costs. It is used to
evaluate the breakeven point of a business, as well as the likely profit levels on individual sales. The
following two scenarios describe an organization having high operating leverage and low operating
leverage.

Operating Leverage calculated by using the below formula,

High Operating Leverage Vs. Low Operating Leverage

If a business has a high degree of operating leverage, it's a reliable indication that its proportion of fixed
to variable costs is high.

A company with low operating leverage has a large proportion of variable costs—which means that it
earns a smaller profit on each sale, but does not have to increase sales as much to cover its lower fixed
costs.

Combined Leverage

Combined leverage is a leverage which refers to high profits due to fixed costs. It includes fixed operating
expenses with fixed financial expenses. It indicates leverage benefits and risks which are in fixed
quantity. It represents a company‘s total risk related to operating leverage, financial leverage, and the net
effect on the EPS. Combined Leverage calculated by using the below formula,

OR

Combined Leverage = Financial Leverage × Operating Leverage

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EBIT AND EPS ANALYSIS

The EBIT-EPS analysis gives the best ratio of debt-to-equity which the businesses can use to find an
optimum balance in their debt and equity financing. The analysis shows the effect of the balance sheet‘s
structure on the company‘s earnings.

Earnings Before Interest and Taxes (EBIT)

Earnings before interest and taxes (EBIT) measures a company's net income before income tax and
interest expenses are deducted. EBIT is used to analyse the performance of a company's core operations.
EBIT is one of the subtotals used to indicate a company's profitability. It can be calculated as the
company's revenue minus its expenses, excluding tax and interest. In some cases, EBIT is also referred to as
operating profit, operating earnings, or profit before interest and taxes. EBIT is essential when the business is
looking to share its performance with creditors and investors, which makes it a valuable measure of your
business' overall performance.

EBIT = Revenue – Cost of Goods Sold – Operating Expenses

Earnings Per Share (EPS)

Earnings per share (EPS) is an important financial measure, which indicates the profitability of a
company. It is calculated by dividing the company's net income with its total number of outstanding
shares. EPS is the portion of a company‘s profit that is allocated to every individual share of the stock. It
is a term that is of much importance to investors and people who trade in the stock market. The higher the
earnings per share of a company, the better is its profitability. While calculating the EPS, it is advisable to
use the weighted ratio, as the number of shares outstanding can change over time.

Limitations of EBIT-EPS Analysis

Although EBIT-EPS analysis is a good way to check the earning sensitivity of a company, it has certain
limitations too.

 No Consideration of Risk: The EBIT-EPS analysis does not consider the risk associated with a
business project. It simply shows whether the earnings are enough for a corporation. It is not
needed in case of a profit larger than returns, but it can be hurting if the opposite situation is
there. When the profits are low, but the interest is high, then businesses may be in turmoil.
 Contradictory Results: When new equity shares are not considered in a different alternative
financial plan, the results arising out of this can get erroneous. The comparison of plans also
becomes difficult when the number of alternatives increases.

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 Over-capitalization of Funds: This analysis ignores the over-capitalization of the funds. Beyond
a certain point, additional capital should not be employed to generate a return in excess of the
payments that should be made for its use. The analysis does not address such cases.

RETURN ON INVESTMENT (ROI)

Return on investment (ROI) is the key measure of the profit derived from any investment. It is a ratio
that compares the gain or loss from an investment relative to its cost. It is useful in evaluating the current
or potential return on investment, whether you are evaluating your stock portfolio's performance,
considering a business investment, or deciding whether to undertake a new project.

In business analysis, ROI and other cash flow measures—such as internal rate of return (IRR) and net
present value (NPV)—are key metrics that are used to evaluate and rank the attractiveness of a number
of different investment alternatives. Although ROI is a ratio, it is typically expressed as a percentage
rather than as a ratio.

Profit = Current Value – Cost of Investment

RETURN ON EARNINGS/EQUITY (ROE)

Return on equity (ROE) is the measure of a company's net income divided by its shareholders' equity.
ROE is a gauge of a corporation's profitability and how efficiently it generates those profits. The higher
the ROE, the better a company is at converting its equity financing into profits.

ROE indicates a company‘s profitability by measuring how much the shareholders earned for
their investment in the company. It exhibits how well the company has utilised the shareholders‘ money.
ROE is calculated by dividing net profit by net worth. If the company‘s ROE turns out to be low, it
indicates that the company did not use the capital efficiently invested by the shareholders. Generally, if a
company has ROE above 20%, it is considered a good investment.

Share Holders Equity = Total Assets – Total Liabilities

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PART II: DIVIDEND DECISIONS & POLICIES

DIVIDEND DECISION

The dividend is that portion of the profit that is distributed to the shareholders. The decision involved
here is how much of the profit earned by the company after paying the taxes is to be distributed to the
shareholders. It also includes the part of the profit that should be retained in the business. When the
current income is re-invested, the retained earnings increase the firm‘s future earning capacity. This
extent of retained earnings also influences the financing decision of the firm. The dividend decision
should be taken keeping in view the overall objective of maximizing shareholders‘ wealth.

DIVIDEND POLICY

A dividend policy is a policy a company uses to structure its dividend payout. Put simply, a dividend
policy outlines how a company will distribute its dividends to its shareholders. These structures detail
specifics about pay-outs, including how often, when, and how much is distributed.

FACTORS AFFECTING DIVIDEND DECISION POLICY

1. Amount of Earnings: Dividends are paid out of the current and previous year‘s earnings. More
earnings will ensure greater dividends, whereas fewer earnings will lead to the declaration of a low
rate of dividends.
2. Stability of Earning: A company that is stable and has regular earnings can afford to declare
higher dividend as compared to those company which doesn‘t have such stability in earnings.
3. Stability of Dividend: Some companies follow the policy of playing a stable dividend because it
satisfies the shareholders and helps in increasing companies reputation. If earning potential is high,
it is declared as a high dividend, whereas if the earning is temporary or not increasing, then it is
declared as a low or normal dividend.
4. Growth Opportunities: Companies with growth opportunities prefer to retain more money out of
their earnings to finance the new project. So, companies that have growth prospects in near future
will declare fewer dividends as compared to companies that don‘t have any growth plan.
5. Cash flow Position: Payment of dividends is related to the outflow of cash. A company may be
profitable, but it may have a shortage of cash. In case the company has surplus cash, then the
company can pay more dividends, but during a shortage of cash, the company can declare a low
dividend.
6. Taxation Policy: The rate of dividends also depends on the taxation policy of the government. In
the present taxation policy, dividend income is tax-free income to the shareholders, so they prefer
higher dividends. However, dividend decision is left to companies.
7. Stock market reaction: The rate of dividend and market value of a share are directly related to
each other. A higher rate of dividends has a positive impact on the market price of the shares.
Whereas, a low rate of dividends may hurt the share price in the stock market. So, management
should consider the effect on the price of equity shares while deciding the rate of dividend.

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8. Management Attitude: Some companies use internal sources to finance expansion programs
because issuing new shares would alter the control of the company. When debentures are issued to
finance expansion, this runs the risk of causing the earnings of existing members to fluctuate.
9. Ability to Borrow: A company that can borrow from external sources at a cheap rate can borrow
from the outside. In such cases, the cost of borrowed capital and retained earnings can be compared.
10. Past Dividend Rate: While deciding on a dividend policy, managers and the board of directors
should pay attention to the dividend rate in previous years.

TYPES OF DIVIDEND POLICY

The policy of the dividend distribution of a company dictates the number of dividends and the frequency
at which the company pays to shareholders. The company can follow different types of policies related to
the dividend. When the company earns profits, it has to decide how and where that profit will be utilized.
The company can either retain profits earned or choose to distribute the same in the form of dividends to
its shareholders.

The four most prevalent types of dividend policy are –

1. Regular Dividend Policy

2. Stable Dividend Policy
3. Irregular Dividend Policy
4. No Dividend Policy

Regular Dividend Policy

Under this type of dividend policy, the company follows the procedure of paying out a dividend to its
shareholders every year. If the company earns abnormal profits, then it retains the extra profit. Whereas, if
it remains in loss any year, it also pays its shareholders a dividend. This type of policy is adopted by the
company with stable earnings and steady cash flow. In the eyes of investors, a company paying regular
dividends is low risk despite the fact the quantum of regular dividend might be small. Under this policy,
the investors get dividends at a standard rate.

The class of investors putting their investments into these companies is generally risk-averse. They
mainly belong to the retired or weaker section of the society and aim at regular income. The company can
only adopt this policy if it has a regular income. The main demerit of this policy is that investors cannot
expect an increase in dividends, even if the market is relatively booming. This type of policy helps in
creating confidence among the shareholders. It also helps stabilize the market value of shares, which
increases the company‘s goodwill.

Stable Dividend Policy

Under this type of dividend policy, the company pays out a fixed percentage of profits as dividends
yearly. For example, suppose a company sets the payout rate at 10%. Then this profit percentage will be

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paid out as dividends every year regardless of the quantum of profit. Whether a company makes a less
profit or more profit, a fixed dividend rate will be paid out to the shareholders. In the eyes of investors, a
company adopting this policy is risky. The reason being the amount of dividend fluctuates with the level
of profit.

In it, the company makes three components for their dividends. One part is a constant dividend per share,
and the other is a constant payout ratio. Last is a stable rupee dividend plus extra dividends. The reserve
fund created for this purpose pays a constant dividend per share. The actual company volatility is not
verifiable through the dividend payout. The target payout ratio defines a stable dividend policy. It also
helps stabilize the market value of shares in the same line as the regular dividend policy.

Irregular Dividend Policy

Under this type of dividend policy, the company states that it has no obligation to pay a dividend to the
shareholders. The board of directors will decide the quantum and rate of dividend. They will decide in
respect of action taken with the earned profit. Their action concerning paying a dividend has nothing to do
with the company‘s scenario of earning a profit or coming into a loss. It depends on the decision of
the board of directors. The board might decide to distribute profit despite having low or no profit. It gains
investors‘ confidence, and they will invest more in the company, and the company‘s liquidity will
increase.

In the eyes of Investors Company, paying periodic dividends is considered risky. On the other hand, the
company might retain all or significant amounts of profit and distribute no or fewer dividends. The
company may do this to increase the growth by using retained earnings. Moreover, companies with
irregular cash flow and a lack of liquidity adopt this policy. The class of investors who are risk lovers
prefers investing in this type of company.

No Dividend Policy

Under this type of dividend policy, the company pays no dividend to the shareholders irrespective of its
profit or loss scenario. The payout ratio will be 0%. The company will retain the total earnings. It will
reinvest into the company‘s business model to expand it further with an increased rate and without
hurdling into issues like liquidity. The company gets funds through the earnings for shareholders, which
is the cheaper cost of financing, increasing profit.

These policies are adopted by the company that is generally a startup or company (like Google or
Facebook) who have already established trust among the investors. For startups, it helps expand their
business, which will result in the overall growth of the business. The shareholders invest in the
company‘s following no dividend policy with the aim that their total value of an investment will increase
with the company‘s growth. For them, appreciation in share price is more important than the regular
dividend. The class of investors investing in these companies generally belongs to younger or middle ages
that are not more bent on a regular income.

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FORMS OF DIVIDEND

1. Cash dividends: These are the most common type of dividends, paid out in cash. A company
pays out a certain portion of its profits as dividends to shareholders. This would mean each
shareholder would receive a certain dividend amount, depending on how much stock they own.
The advantages and disadvantages of cash dividends depend on the company's financial situation.
On the one hand, shareholders can benefit from receiving a dividend payment in the form of cash;
on the other hand, companies have less money to reinvest in their businesses, which can limit
growth potential. Cash dividends provide an immediate return but also mean less money for
companies to reinvest and grow.

2. Stock dividends: As the name suggests, stock dividends are paid out as additional shares instead
of cash. The advantage of stock dividends is that they can increase a shareholder's potential
returns without them having to invest more money. Additionally, companies won't have to part
with their profits as they do with cash dividends. On the downside, they also don't provide
immediate benefits and tend to carry more risk than cash dividends. The market value of the new
shares could be lower or higher than when the original investment was made.

3. Property dividends: These various forms of dividend are paid out as assets instead of cash or
shares. This could be anything from real estate to antiques and can even include intangible assets
such as patents or copyrights. The advantage of property dividends is that they can diversify an
investment portfolio and may provide more tax benefits than other types of dividends. On the
downside, there is always a risk that the value of these types of assets may decline over time,
limiting potential returns.

4. Scrip dividends: Scrip dividends are similar to stock dividends, but instead of receiving
additional shares directly from the company, shareholders receive a scrip or voucher that can be
exchanged for shares on the market. The advantage of scrip dividends is that they can provide
more flexibility to investors as it allows them to decide when and how much of their dividend
money should be used for reinvestment. On the downside, there is always a risk that the value of
these types of assets may decline over time, limiting potential returns.

5. Liquidating dividends: Liquidating dividends are paid out to shareholders when a company is
winding down its operations, and there isn't enough money left to pay out other different types of
dividends. The advantage of liquidating dividends is that they can provide a return for
shareholders even if the business has failed. On the downside, it typically means that all
remaining assets will be sold off to pay the dividend, and the company will cease to exist.

6. Special Dividend: A special dividend is a non-recurring payment made by a company to its

shareholders, along with regular dividend payments. Unlike recurring or regular payments, it is a
one-time payment. A company exercises this type of dividend when they have excess cash or are
willing to distribute a part of it to its shareholders. Unlike regular dividends, special dividends are
not guaranteed and can vary widely in terms of the amount paid and the timing of the payment.
They can also be a one-time event without expecting future special dividend payments.

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7. Interim Dividend: An interim dividend is a dividend payment made before a company's annual
general meeting and before the release of final financial statements. This declared dividend
usually accompanies the company's interim financial statements and are paid out monthly or
quarterly. The company's Board of Directors declares the interim dividend, but the final approval
must be given by the shareholders.

BONUS ISSUE

A bonus issue is an offer given to the existing shareholders of the company to subscribe for additional
shares. Instead of increasing the dividend payout, the companies offer to distribute additional shares to the
shareholders. For example, the company may decide to give out one bonus share for every ten shares
held.

STOCK SPLIT

A stock split happens when a company increases the number of its shares to boost the stock's liquidity.
A stock split lowers its stock price but doesn't weaken its value to current shareholders. It increases the
number of shares and might entice would-be buyers to make a purchase.

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MODULE 5: LONG TERM INVESTMENT DECISIONS (CAPITAL BUDGETING)

INTRODUCTION

Capital budgeting is the planning of expenditure whose return will mature after a year or so. Thus, it is a
process of deciding whether or not to commit resources to a project whose benefit would be spread over
the years. The objective of capital budgeting is to rank the various investment opportunities according to
the expected earnings they will yield. The total capital (long/short term) of a company is used in fixed
assets and current assets of the firm. In the case of fixed assets, these refer to assets that are not intended
for resale. Examples include land and buildings, plant and machinery, and furniture. It is a challenging
task for management to make a judicious decision regarding capital expenditure (i.e., investment in fixed
assets).

In particular, the amount invested in fixed assets should ideally not be locked up in capital goods, which
may have a far-reaching effect on the success or failure of an enterprise. A capital asset, once acquired,
cannot be disposed of without substantial loss. If these are acquired on a credit basis, a
continuous liability is incurred over a long period of time. It is, therefore, required to exercise long-range
planning when making decisions about investments in capital expenditure. This is known as capital
budgeting. Capital budgeting is the art of deciding how to spend your company‘s money wisely.
Basically, it is the process of evaluating potential long-term investment opportunities to determine which
ones will generate the most profit for a business. It involves analysing future cash flows, considering the
time value of money, and assessing risks. Ultimately, the goal is to choose investments that will help the
business grow and thrive.

NEED FOR CAPITAL BUDGETING

1. Heavy investment: All capital expenditures are long-term investments and also involve huge
sums that are collected from various external and internal sources. Thus, these funds pose a
serious problem for capital investment planning.
2. Permanent commitment of funds: Capital budgeting is a long-term decision that has far-
reaching effects. A poor capital expenditure decision may lead to unnecessarily heavy operating
costs.
3. Guard against risk and uncertainty: Capital expenditure decisions are more sophisticated and
carry more risk and uncertainty compared to acquiring capital assets, which is a continuous
process. Therefore, management must always be judicious.
4. Irreversible decisions: Capital expenditure not only involves heavy investment but also
irreversible decisions. In particular, the amount invested cannot be taken back without heavy
financial loses.
5. Ranking investment programmes: Capital expenditure requires substantial investment, which is
not easy to procure. Careful cash forecasts are needed to ensure that financial requirements are
met at the right time.

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6. Wealth maximization: Capital expenditure is a long-term financial planning activity that

benefits the interest of shareholders. It guards against over- and under-investment in fixed assets.
7. Useful for sound depreciation policy: Capital expenditure planning is a useful technique in
depreciation policy and the replacement of fixed assets.
8. Cost Reduction: Capital budgeting is useful for cost reduction. The most modern machine is
purchased whose capacity is greater than the old one, which means that the per-unit cost of output
falls.

IMPORTANCE OF CAPITAL BUDGETING

1. Calculation of future cash flows: Capital Budgeting process takes into account the expected
future cash inflows and the expected future cash outflows of the project by taking into account the
discounted rate of return and following the various techniques like calculation of net present
value, considering the internal rate of return, payback period, profitability index, and accounting
rate of return Thus, the organization get the idea about present investment‘s future total value and
the net profitability by using the process of capital budgeting.
2. Helps in the long term goals of the organization: Capital Budgeting process helps the
organization for the long term decision making as well as in making the long term goals as it
provides the idea of future costs and growth taking into account the expected future cash flows.
The making of long term goals is the most important and sensitive area for any organization and
any wrong decision taken in this area can adversely affect the long term profitability of the
organization.
3. Control of Expenditure: The capital budgeting process gives the idea of the expected future
cash inflows as well as expected future cash outflows. It takes into account the investment cost
for the project considering the other related expenditures like Research & Development costs,
running costs of the project, etc. So, with this information, the organization can monitor the total
costs and have control of its future costs. The proper management and control of the total costs is
a very important factor for the growth and efficiency perspective of the company.
4. Helps in Permanent Decision Making: Generally, the Capital related decisions are the
permanent decisions taken by the organization as it involves the large amount of investments and
funds. Such decisions cannot be reversed back in the future once they are taken. Hence, the
process of capital budgeting helps in effective decision making for such permanent decisions of
the organization.
5. Wealth Maximization: The interest and the investment decisions of the shareholders in the
company depend on its long term investment decisions. If the investments in the capital or other
long term investments are done by the company in the proper and planned manner, the confidence
of the shareholders gets boost up and thus they become more interested in investing in the
company thus resulting in the company‘s wealth maximization.
6. Flow of information within the departments: The entire process of capital budgeting involves
numerous steps and ideas and a number of decisions are taken by the different levels of the
company. This allows the flow and exchange of information within the various departments and
thus increases the connectivity between them.
7. Protection to the large funds involved: As discussed above, there involves a large amount of
funds by the company in the acquisition of the capital assets. Thus with the process of capital

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budgeting, that large financial investment or a large amount of funds invested by the company
gets protected to a certain extent against any uncertainty in future.
8. Protection against future risks: There are various risks that are associated with capital
acquisitions by the company as they all are related to some future events and uncertainty. Thus,
the capital budgeting process helps the organization in the advance assessment of those risks
involved, and the management of the company plans for the protection of such risks well in
advance to minimize its impact.
9. New Opportunities in the market: With the introduction of the new project in the market, there
arises many job opportunities for the new employees as well as the existing ones. This gives rise
to the economic growth of the country along with boosting up the morale of personals.
10. Understanding the Complications of the projects: With the help of the Capital budgeting
process, the management of the company can have the idea of different types of complications or
Complexities that can be faced or arise during the development of the project. Hence, the
management can have ready and advance strategies for dealing with such future complexities
arising from the project.

CAPITAL BUDGETING PROCESS

The process includes the following steps

1. Identification of Investment Opportunities

2. Estimation of Cash Flows
3. Evaluation of Cash Flows
4. Selection of Projects
5. Implementation of Projects
6. Review and Monitoring

1. Identification of Investment Opportunities: The process of identifying potential investment

opportunities for a company‘s capital budget. The organization‘s capital budgeting committee must
identify the expected sales shortly. After that, they recognize the investment opportunities keeping in
mind the sales target set up by them. One must consider some points before searching for the best
investment opportunities. It includes regularly monitoring the external environment to get an idea
about new investment opportunities.

2. Estimation of Cash Flows: The process of forecasting the expected cash inflows and outflows of a
potential investment. A company invests in capital projects in order to increase stockholder value by
investing in projects that generate cash flows in the future whose present value exceeds the present
value of the cash flows needed to make the investment. When it invests in new capital projects, it
expects the future cash flows to be greater than without this new investment. Hence, in estimating a
project's cash flows, the focus is on incremental cash flows.

3. Evaluation of Cash Flows: The process of assessing the quality and profitability of a potential
investment based on its expected cash flows. t mainly consists of selecting all criteria necessary for
judging the need for a proposal. In order to maximize market value, it has to match the company's mission. It
is crucial to consider the time value of money here. In addition to estimating the benefits and costs, you

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should weigh the pros and cons associated with the process. There could be a lot of risks involved with the
total cash inflows and outflows. This needs to be scrutinized thoroughly before moving ahead.

4. Selection of Projects: The process of selecting the most appropriate investment opportunities based
on their evaluation. Since there is no ‗one-size-fits-all‘ factor, there is no defined technique for selecting a
project. Every business has diverse requirements and therefore, the approval over a project comes based on
the objectives of the organization. After the project has been finalized, the other components need to be
attended to. These include the acquisition of funds which can be explored by the finance department of the
company. The companies need to explore all the options before concluding and approving the project.
Besides, the factors like viability, profitability, and market conditions also play a vital role in the selection of
the project.

5. Implementation of Projects: The process of executing and managing approved projects. Once the
project is implemented, now come the other critical elements such as completing it in the stipulated time
frame or reduction of costs. Hereafter, the management takes charge of monitoring the impact of
implementing the project.

6. Review and Monitoring: The process of evaluating completed projects and monitoring their on-
going performance. This involves the process of analysing and assessing the actual results over the
estimated outcomes. This step helps the management identify the flaws and eliminate them for future
proposals.

CAPITAL BUDGETING TECHNIQUES

PAYBACK PERIOD (PBP)

The payback period is a capital budgeting technique used to determine the amount of time required for a
project to generate enough cash flow to recover the initial investment. To calculate the payback period,
you need to divide the initial investment by the expected annual cash inflows until the investment is fully
recovered.

Advantages of PBP

 Simple and easy to understand.

 Useful for evaluating short-term projects.
 Provides a quick assessment of the project‘s risk and liquidity.
 Can help avoid investments that take too long to recoup their costs.
 Does not require estimating future cash flows or discount rates.

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Limitations of PBP

 Ignores the time value of money.

 Does not consider cash flows beyond the payback period.
 Ignores profits earned after the payback period.
 Ignores the risk associated with future cash flows.
 Cannot be used to compare projects with different lifespans.

NET PRESENT VALUE (NPV)

The Net Present Value (NPV) method is a capital budgeting technique used to determine the value of an
investment by comparing the present value of its expected cash inflows to the initial investment cost.

Advantages of NPV

 Considers the time value of money.

 Accounts for all expected cash inflows and outflows.
 Provides a measure of the investment‘s profitability.
 Can be used to compare multiple investment opportunities.

Limitations of NPV

 Requires accurate estimates of future cash flows and discount rates.

 Can be complex and time-consuming to calculate.
 Does not consider non-financial factors such as environmental impact or social responsibility.

INTERNAL RATE OF RETURN (IRR)

The Internal Rate of Return (IRR) method is a capital budgeting technique that determines the expected
rate of return of an investment. It is the discount rate that makes the net present value of the project‘s
expected cash inflows equal to the initial investment cost. IRR is calculated by finding the discount rate
that makes the present value of cash inflows equal to the initial investment.

( )

Advantages of IRR

 Considers the time value of money.

 Accounts for all expected cash inflows and outflows.
 Provides a measure of the investment‘s profitability.
 Can be used to compare multiple investment opportunities.

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Limitations of IRR

 Requires accurate estimates of future cash flows and discount rates.

 May lead to incorrect decisions when evaluating mutually exclusive projects.
 May result in multiple IRR values for some projects.

PROFITABILITY INDEX (PI)

The Profitability Index (PI) method technique is used to evaluate investment opportunities by calculating
the ratio of the present value of cash inflows to the initial investment cost.

Advantages of PI

 Considers the time value of money.

 Accounts for all expected cash inflows and outflows.
 Provides a measure of the investment‘s profitability.
 Can be used to compare multiple investment opportunities.

Limitations of PI

 May lead to incorrect decisions when evaluating mutually exclusive projects.

 May not always lead to the best investment decisions when budgets are limited.

MODIFIED INTERNAL RATE OF RETURN (MIRR)

The Modified Internal Rate of Return (MIRR) method is a capital budgeting technique used to determine
the rate of return on investment by considering both the cost of the investment and the reinvestment rate
of future cash flows.

( )

Advantages of MIRR

 Considers the reinvestment of future cash flows.

 Accounts for the time value of money.
 Provides a measure of the investment‘s profitability.

Limitations of MIRR

 Requires accurate estimates of future cash flows and reinvestment rates.

 Can be complex and time-consuming to calculate.
 May not be appropriate for investments with uneven cash flows.

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CAPITAL RATIONING

Capital Rationing technique is used when a company has limited funds and must prioritize its investment
opportunities based on the availability of capital. The capital rationing method of capital budgeting is not
based on a single formula like the other methods. Instead, it involves setting a fixed budget for capital
investments and then selecting the combination of projects that maximizes the overall value of the firm
within that budget constraint. Therefore, the capital rationing method involves a complex decision-
making process that considers multiple factors such as project profitability, risk, and liquidity. The
decision-making process often involves using quantitative and qualitative criteria to evaluate each
project‘s potential impact on the firm‘s financial performance.

Advantages of capital rationing

 Enables a company to prioritize investments based on available funds.

 Helps avoid over-committing to investments.
 Encourages better financial management.

Limitations of capital rationing

 May limit a company‘s ability to pursue all profitable investments.

 May result in missed opportunities.
 Can be difficult to determine the optimal allocation of capital.

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MODULE 6: WORKING CAPITAL MANAGEMENT

INTRODUCTION

Every venture needs capital to meet all the business needs, be it gathering the resources or injecting
capital into day-to-day activities. The capital required by a business or venture to meet its day-to-day
expenses is known as the working capital. Working capital is often also known as short-term capital
decisions. Working capital revolves around two important components of a business, which are, current
assets and current liability. The assets that is capable of being converted into cash within one year.
Moreover, are extremely liquid, are called current assets of the business. For instance, bank balance, cash
in hands, short-term investments, debtors, and prepaid expenses. Another component of the working
capital is the current liability. Current liabilities are the sum of amounts due to be paid within the span of
a year. For instance, bank overdrafts, outstanding expenses, etc.

The proper management of working capital may bring about the success of a business firm. The
management of working capital includes the management of current assets and current liabilities. A
number of companies for the past few years have been finding it difficult to solve the increasing problems
of adopting seriously the management of working capital.

A firm may exist without making profits but cannot survive without liquidity. The function of working
capital management in an organization is similar that of the heart in a human body. Also it is an important
function of financial management. The financial manager must determine the satisfactory level of
working capital funds and also the optimum mix of current assets and current liabilities. He must ensure
that the appropriate sources of funds are used to finance working capital and should also see that short
term obligation of the business are met well in time.

Meaning

In simple words ―Working Capital is the excess of Current assets over current liabilities.‖

The difference received after deducting the current liabilities from the current assets is known as the net
working capital of the business. Working Capital is the measure of a venture's liquidity. It also denotes
the operational efficiency of a venture. The better the working capital, the better is the business‘ short-
term financial health.

Definitions

According to quantitative concept, the amount of working capital refers to ‗total of current assets‘.
Current assets are considered to be gross working capital in this concept.

The qualitative concept gives an idea regarding source of financing capital. According to qualitative
concept the amount of working capital refers to ―excess of current assets over current liabilities.‖

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L.J. Guthmann defined working capital as ―the portion of a firm‘s current assets which are financed from
long–term funds.‖ The excess of current assets over current liabilities is termed as ‗Net working capital‘.
In this concept ―Net working capital‖ represents the amount of current assets which would remain if all
current liabilities were paid.

CURRENT ASSETS AND CURRENT LIABILITIES

Current assets – It is rightly observed that ―Current assets have a short life span. These type of assets are
engaged in current operation of a business and normally used for short– term operations of the firm
during an accounting period i.e. within twelve months. The two important characteristics of such assets
are, (i) short life span, and (ii) swift transformation into other form of assets. Cash balance may be held
idle for a week or two; account receivable may have a life span of 30 to 60 days, and inventories may be
held for 30 to 100 days.

Current liabilities – The firm creates a Current Liability towards creditors (sellers) from whom it has
purchased raw materials on credit. This liability is also known as accounts payable and shown in the
balance sheet till the payment has been made to the creditors. The claims or obligations which are
normally expected to mature for payment within an accounting cycle (1 year) are known as current
liabilities. These can be defined as ―those liabilities where liquidation is reasonably expected to require
the use of existing resources properly classifiable as current assets, or the creation of other current assets,
or the creation of other current liabilities.‖

TYPES OF WORKING CAPITAL

 Gross Working Capital: Gross working capital refers to total investment in current assets. The
current assets employed in business give the idea about the utilization of working capital and idea
about the economic position of the company. Gross working capital concepts is popular and
acceptable concept in the field of finance.

 Net Working Capital: Net working capital means current assets minus current liabilities. The
difference between current assets and current liabilities is called the net working capital. If the net
working capital is positive, business is able to meet its current liabilities. Net working capital
concept provides the measurement for determining the creditworthiness of company.

SOURCES OF WORKING CAPITAL

A company has various sources of working capital. Depending upon its condition and requirements, a
company may use any of these sources of working capital. These sources may be spontaneous, short-term,
or long-term.

1. Spontaneous Sources: The sources of capital created during normal business activity are called
spontaneous sources of working capital. The amount and credit terms vary from industry to
industry and depend on the business relationship between the buyer and seller. The main

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characteristic of spontaneous sources is ‗zero-effort‘ and ‗negligible cost‘ compared to traditional

financing methods. The primary sources of spontaneous working capital are trade credit and
outstanding expenses.
2. Short-term Sources: The sources of capital available to a business for less than one year are
called short-term sources of working capital.
3. Long-term Sources: The sources of capital available to a business for a longer period, usually
more than one year, are called long-term sources of working capital.

SHORT TERM SOURCES OF WORKING CAPITAL

Short-term sources of capital may further be divided into two categories – Internal Sources and External
Sources.

The short-term internal sources of working capital include provisions for tax and dividends. These are
essentially current liabilities that cannot be delayed beyond a point. All companies make separate
provisions for making these payments. These funds are available with the company until these payments
are made. Hence, these are called the internal sources of working capital. However, this value is relatively
small and thus not that significant.

On the other hand, the short-term external sources of working capital include capital from external
agencies like banks, NBFCs, or other financial entities. Some of the primary sources of short-term
external sources of working capital are listed below:

 Loans from Commercial Banks: Businesses, mostly MSMEs, can get loans from commercial
banks with or without offering collateral security. There is no legal formality involved except
creating a mortgage on the assets. Repayment can be made in parts or lump sum at the time of
loan maturity. At times, banks may offer these loans on the personal guarantee of the directors of
a country. They get these loans at concessional rates; hence it is a cheaper source of financing for
them. However, the flip side is that getting this loan is a time-consuming process.

 Public Deposits: Many companies find it easy and convenient to raise funds for meeting their
short-term requirements from public deposits. In this process, the companies invite their
employees, shareholders, and the general public to deposit their savings with the company. As per
the Companies Act 1956, companies can advertise their requirements and raise money from the
general public against issuing shares or debentures. The companies offer higher interest rates than
bank deposits to attract the general public. The biggest of this source of financing is that it is
simple and cheaper. However, its drawback is that it may not be available during the depression
and financial stringency.

 Trade Credit: Companies generally source raw materials and other items from suppliers on
credit. The amount payable to these suppliers is also treated as a source of working capital.
Usually, the suppliers grant their buyers a credit period of 3 to 6 months. Thus, they provide, in a
way, short-term finance to the purchasing company. The availability of trade credit depends on
various factors like the buyer‘s reputation, financial position, business volume, and degree of

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competition, among others. However, when a business avails trade credit, it stands to lose the
benefit of cash discount, which it would earn if they make the payment within 7 to 10 days of
making the purchase. This loss of cash discount is treated as an implicit cost of trade credit.

 Bill Discounting: Just as business buys goods on credit, they offer credit to their buyers. The
credit period may vary from 30 days to 90 days and sometimes extends, even up to 180 days.
During this period, the company funds get blocked, which is not good. Instead of waiting that
long, sellers prefer to discount these bills with a bank or NBFC. The financial entity charges some
amount as commission, called a ‗discount‘, and makes the balance payment to the sellers. This
discount compensates them for the time gap between disbursing and collecting the money on the
maturity of the bill. This ‗discount‘ charged by the bank is treated as the cost of raising funds
through this method. Businesses widely use this method for raising short-term capital.

 Bank Overdraft: Some banks offer their esteemed customers and current account holders a
facility to withdraw a certain amount of money over and above the funds held by them in their
current account with the bank. The bank charges interest on the amount overdrawn and the period
it is withdrawn. The overdraft facility is also granted against securities. The bank sets this limit
and is subject to revision anytime, depending upon the customer‘s creditworthiness.

 Advances from Customers: One effortless way to raise funds to meet the short-term
requirement is to ask customers for some payment in advance. This advance confirms the order
and gives much-needed cash to the business. No interest is payable to the customer for this
advance. Even if any business pays interest, it is very nominal. Hence, this is one of the cheapest
sources of raising funds to meet companies‘ short-term working capital requirements. However,
this is possible only when the customers do not choose the terms of the sellers.

LONG TERM SOURCES OF WORKING CAPITAL

When the companies require funds for more than one year, it makes sense to go for long-term sources, as
they are generally cheaper than short-term sources.

Like short-term sources, long-term sources may also be classified as internal and external sources.
Retained profits and accumulated depreciation are internal sources wholly earned and owned by the
company itself. These funds are available to a company without any direct cost.

The external sources of long-term sources of working capital are listed below:

 Share Capital: The Company may raise funds by offering the prospective shareholders a stake in
their business. These shares may be held by the general public, banks, financial institutions, or
even other companies. The response depends on several factors, including the company‘s
reputation, perceived profit potential, and general economic condition. In return, the company
offers dividends to their shareholders, which along with the floating cost, is treated as the cost of
sourcing. However, the company is not legally bound to pay this dividend. Also, no rule
prescribes how much dividend is to be given. All this makes this a very cheap source of working
capital. But, in reality, most companies do not use this for meeting their working capital needs.

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 Long-term Loans: Also called Working Capital Loans, these long-term loans may be temporary
or long-term. The long-term here is generally 84 months (7 years) or more. This loan is not taken
for buying long-term assets or investments and is used to provide working capital to meet a
company‘s short-term operational needs. Experts advise using long-term sources for permanent
needs and short-term sources for temporary working capital needs.
 Debentures: Like shares, debentures also include generating money from the general public,
financial institutions, and other companies. However, unlike shares, in the case of debentures, the
company has to declare the interest they will pay to their lenders openly. The company is legally
bound to pay the agreed interest. So, here, if the funds are unused or even if the company runs
into losses, they have to pay the lenders.

FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

1. Nature of Companies: The composition of an asset is a function of the size of a business and the
companies to which it belongs. Small companies have smaller proportions of cash, receivables and
inventory than large corporation. This difference becomes more marked in large corporations. A
public utility, for example, mostly employs fixed assets in its operations, while a merchandising
department depends generally on inventory and receivable. Needs for working capital are thus
determined by the nature of an enterprise.
2. Demand of Creditors: Creditors are interested in the security of loans. They want their obligations to
be sufficiently covered. They want the amount of security in assets which are greater than the
liability.
3. Cash Requirements: Cash is one of the current assets which are essential for the successful
operations of the production cycle. A minimum level of cash is always required to keep the operations
going. Adequate cash is also required to maintain good credit relation.
4. Nature and Size of Business: The working capital requirements of a firm are basically influenced by
the nature of its business. Trading and financial firms have a very less investment in fixed assets, but
require a large sum of money to be invested in working capital. Retail stores, for example, must carry
large stocks of a variety of goods to satisfy the varied and continues demand of their customers. Some
manufacturing business, such as tobacco manufacturing and construction firms also have to invest
substantially in working capital and a nominal amount in the fixed assets.
5. Time: The level of working capital depends upon the time required to manufacturing goods. If the
time is longer, the size of working capital is great. Moreover, the amount of working capital depends
upon inventory turnover and the unit cost of the goods that are sold. The greater this cost, the bigger
is the amount of working capital.
6. Volume of Sales: This is the most important factor affecting the size and components of working
capital. A firm maintains current assets because they are needed to support the operational activities
which result in sales. They volume of sales and the size of the working capital are directly related to
each other. As the volume of sales increase, there is an increase in the investment of working capital-
in the cost of operations, in inventories and receivables.
7. Terms of Purchases and Sales: If the credit terms of purchases are more favourable and those of
sales liberal, less cash will be invested in inventory. With more favourable credit terms, working

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capital requirements can be reduced. A firm gets more time for payment to creditors or suppliers. A
firm which enjoys greater credit with banks needs less working capital.
8. Business Cycle: Business expands during periods of prosperity and declines during the period of
depression. Consequently, more working capital required during periods of prosperity and less during
the periods of depression.
9. Production Cycle: The time taken to convert raw materials into finished products is referred to as the
production cycle or operating cycle. The longer the production cycle, the greater is the requirements
of the working capital. An utmost care should be taken to shorten the period of the production cycle
in order to minimize working capital requirements.
10. Liquidity and Profitability: If a firm desires to take a greater risk for bigger gains or losses, it reduces
the size of its working capital in relation to its sales. If it is interested in improving its liquidity, it
increases the level of its working capital. However, this policy is likely to result in a reduction of the
sales volume, and therefore, of profitability. A firm, therefore, should choose between liquidity and
profitability and decide about its working capital requirements accordingly.
11. Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable working capital.
Often, the demand for products may be of a seasonal nature. Yet inventories have got to be purchased
during certain seasons only. The size of the working capital in one period may, therefore, be bigger
than that in another.

CURRENT ASSET POLICY

The financial executives must decide the most advantageous level of current assets so that the worth of
shareholders is maximized. A company requires fixed and current assets to maintain a pre-decided level
of output. However, to maintain the same level of production, the company is able to contain various
levels of current assets. As the company‘s production and sales increases, the requirement for current
assets also goes upward.

Generally, current assets does not increase in direct proportion to production level, current assets may
increase in inverse proportion to production level. This relationship is based upon the concept that it takes
a larger relative outlay in current assets when only a small number of units of production are
manufactured than it does afterward when the company can utilize its current assets more efficiently and
effectively.

The level of the current assets can be computed by dividing amount of current assets by amount of fixed
current assets which gives CA/FA ratio. Keeping high level of CA/FA ratio shows conservative current
assets practices and a lesser CA/FA ratio means aggressive current assets practices assuming other factors
to be unchanged. A conservative policy depicts high level of liquidity and lesser risk; whereas an
aggressive policy depicts higher risk and low level of liquidity.

CURRENT ASSET FINANCING POLICY

After establishing the level of current assets, the firm must determine how these should be financed. What
mix of short term and long term debt should the firm employ to support its current assets? Working
capital can be financed by different source like – long term sources, short term sources or transactionary

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sources (like credit allowances, outstanding labour and other expenses). In general, the short term assets
should be financed through short term funds and long term assets through long term funds. As far as
financing of working capital is concerned it depends on the policy of the firm that what sources (and mix)
of finance the firm want to use. Several strategies are available to a firm for financing its working capital
requirement.

1. Conservative Approach: Long term financing is used to meet fixed asset requirement as well as peak
working capital requirement. In case the WC requirement is less than the peak value, the surplus will
be invested in liquid assets like cash and marketable securities. Here the firm do not want to take any
risk. Larger the portion of long term sources used to finance the working capital, more conservative
the firm will be.
2. Moderate Approach: Long term financing is used to meet fixed asset requirements, permanent WC
requirement and a portion of fluctuating WC. During seasonal upswings, short term financing is used;
during seasonal downswing, surplus is invested in liquid assets.
3. Hedging Approach / Matching Approach: According to this approach, the maturity of sources of
financing should match the maturity of assets being financed. Thus, long-term financing is used to
meet fixed asset requirement and permanent working capital requirement. Short-term financing is
used to meet fluctuating WC requirement.
4. Aggressive Approach: Long term financing is used to meet fixed asset requirement and a part of
Permanent WC requirement. Rest of the part of PWC and all fluctuating WC will be financed by
short term financing. This policy seeks to minimize excess liquidity while meeting short term
requirement. The firm may accept even greater risk of insolvency in order to save cost of long term
financing.

OPERATING CYCLE

An operating cycle is essentially the amount of time it takes for a company to acquire inventory, sell that
inventory and receive cash from customers in exchange for the inventory sold. The length of a company's
operating cycle indicates its true liquidity, or total liquid assets in the form of cash. A short operating
cycle is ideal as this means a company realizes its profit quickly and can use the available cash to make
investments. A long operating cycle means it takes a company more time to turn purchases into cash for
sales.

Companies with short operating cycles are more likely to attract investors and are often able to expand
their businesses at a faster rate. To shorten the operating cycle, businesses often sell inventory at a faster
rate, reduce the time period on payment terms and implement a stricter credit policy.

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Operating cycle determined by using the below formula,

Operating Cycle = IP+ARP-APP (For trading firm)

Operating Cycle = RMCP+WIPCP+FGCP+ARP – APP (For manufacturing firm)

 Inventory Period (IP)

 Raw Material Conversion Period (RMCP)
 Work-In-Progress Conversion Period (WIPCP)
 Finished Goods Conversion Period (FGCP)
 Accounts Receivable Period (ARP)
 Accounts Payable Period (APP)

Where,

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CASH CYCLE

A cash cycle, also known as a cash conversion cycle represents the number of days it takes for a company
to convert resources into cash. The cash cycle is a calculation of the amount of time a company's dollars
are being used for production or sales purposes before being converted into cash. Just like the operating
cycle, a short cash cycle is often indicative of success. A company's cash cycle has three distinct parts:

1. Days inventory outstanding: A company's DIO represents the current inventory level and how long
it may take to sell that inventory.
2. Days sales outstanding: A company's DSO represents its current sales and the amount of time it
takes to collect cash from these sales.
3. Days payable outstanding: A company's DPO represents the amount of money owed to its current
vendors or suppliers and when the company expects to pay it.

Cash conversion cycle determined by using the below formula,

Cash Conversion Cycle = DIO + DSO – DPO

Where,

 DIO stands for Days Inventory Outstanding

 DSO stands for Days Sales Outstanding
 DPO stands for Days Payable Outstanding

DIO Formula,

DSO Formula,

DPO Formula,

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ESTIMATION OF WORKING CAPITAL REQUIREMENT OF A FIRM

Working capital requirement of the firm is estimated by using five major methods they are:

1. Percentage of Sales Method: This method of estimating working capital requirements is based
on the assumption that the level of working capital for any firm is directly related to its sales
value. If past experience indicates a stable relationship between the amount of sales and working
capital, then this basis may be used to determine the requirements of working capital for future
period.
2. Regression Analysis Method (Average Relationship between Sales and Working Capital):
This method of forecasting working capital requirements is based upon the statistical technique of
estimating or predicting the unknown value of a dependent variable from the known value of an
independent variable. It is the measure of the average relationship between two or more variables,
i.e.; sales and working capital, in terms of the original units of the data.
3. Cash Forecasting Method: This method of estimating working capital requirements involves
forecasting of cash receipts and disbursements during a future period of time. Cash forecast will
include all possible sources from which cash will be received and the channels in which payments
are to be made so that a consolidated cash position is determined.
4. Operating Cycle Method: This method of estimating working capital requirements is based
upon the operating cycle concept of working capital. The cycle starts with the purchase of raw
material and other resources and ends with the realization of cash from the sale of finished goods.
It involves purchase of raw materials and stores, its conversion into stock of finished goods
through work-in-process with progressive increment of labour and service costs, conversion of
finished stock into sales, debtors and receivables, realization of cash and this cycle continues
again from cash to purchase of raw material and so on. The speed/time duration required to
complete one cycle determines the requirement of working capital – longer the period of cycle,
larger is the requirement of working capital and vice-versa.
5. Projected Balance Sheet Method: Under this method, projected balance sheet for future date is
prepared by forecasting of assets and liabilities by following any of the methods stated above.
The excess of estimated total current assets over estimated current liabilities, as shown in the
projected balance sheet, is computed to indicate the estimated amount of working capital
required.

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FORMAT OF WORKING CAPITAL REQUIREMENT COMPUTATION

Notes:

1. If payment is received in advance, the item should appear under CL.

2. If advance payment is to be made to creditors, the item should appear under CA.
3. The same will be the treatment for advance payment of wages and overheads.
4. Depreciation: An important point in estimating the working capital requirement is the depreciation
on fixed assets. The depreciation on the fixed assets is not considered in working capital estimation.
The depreciation is a non-cash expense and there is no funds locked up in depreciation therefore, it is
ignored. Depreciation is neither included in valuation of work-in- progress nor in finished goods. The
working capital calculated by ignoring depreciation is known as cash cost basis working capital. In
case, depreciation is included in working capital calculations, such estimate is known as total cost
basis working capital.
5. Safety Margin: Sometimes, a firm may also like to have a safety margin of working capital in order
to meet any contingency. The safety margin may be expressed as a % of total current assets or total
current liabilities or net working capital. The safety margin, if required, is incorporated in the working
capital estimates to find out the net working capital required for the firm.
6. Additional assumptions: In the absence of information, it is assumed that
 All sales and purchases are made on credit basis.
 Production during the current year will be maintained at the same level as in the previous year.
 There is no change in inventory and credit terms.
 Production is evenly carried out throughout the year.

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PROBLEMS ON TIME VALUE OF MONEY

Doubling Period

1. If you deposit Rs. 20,000 today @12% rate of interest, in how many years will this amount grow
to Rs. 80,000? Work out this problem using Rule of 72 & 69.
2. If you deposit Rs. 10,000 today at 12% rate of interest, in how many years will this amount grow to
Rs.120, 000? Work out this problem by using the Rule of 72 & 69.
3. If you deposit Rs. 5000 today @6% rate of interest, in how many years will this amount getdoubled?
Work out this problem using Rule of 72 & 69.
4. A finance company offers to give Rs 8,000 after 12 years in return for Rs 1,000 deposited today.Using
the rule of 72 & 69, figure out the approximate interest rate offered.
5. If we deposit Rs. 1,00,000 at 7% interest rate in how many years amount will be double accordingto
rule 69 & 72.

Interest Rates

1. A company offers to pay you Rs. 5,002 annually for 6 years, if you deposit Rs. 20,000 today with
the company. What interest rate do you earn on the deposit?
2. An investment company offers to pay Rs. 60,965 at the end of 15 years to investors who deposit
annually Rs. 1,000. What interest rate is implicit in the offer?
3. Mr. A offers to pay you Rs. 12,000 after 15 years in exchange of Rs. 1,000 today. What interest
rate is implicit in the offer?
4. A finance company advertises that it will pay a lump sum of Rs 10,000 at the end of 6 years to
investors who deposit annually Rs 1,000. What interest rate is implicit in this offer?
5. Someone promises to give you Rs 5,000 after 10 years in exchange for Rs 1,000 today. What
interest rate is implicit in this offer?
6. Suppose someone offers you the following financial contract. If you deposit Rs 20,000 with him
he promises to pay Rs 4,000 annually for 10 years. What interest rate would you earn on this
deposit?

Future Value

1. Calculate the future value of Rs. 20,000 invested now for a period of 5 years at a time preference
rate of 8%.
2. Calculate the value 5 years hence of a deposit of Rs 1,000 made today if the interest rate is –
(a)8 % (b) 10 % (c) 12 % (d) 15 %
3. An investment company pays 12% rate of interest and compound it quarterly. If Rs. 5000
is deposited initially, how much shall it grow in 5 years?
4. Mr. Raghu deposits Rs 10,000 in a bank now. The interest rate is 10 per cent and
compounding isdone semi-annually. What will the deposit grow to after 10 years? If the
inflation rate is 8 per cent per year, what will be the value of the deposit after 10 years in
terms of the current rupee?
5. Suppose you deposit Rs. 1000 today in a bank which pays 10% interest compounded
annually.How much will it grow after 8 years and 12 years?
6. Calculate the future value of an investment of Rs. 10,000 compounded semi annually for 10
yearsat interest rate of 10% PA.
7. Mr. X makes deposit of Rs. 10,000 in a bank which pays 8% interest compounded annually
for 8years. What is the sum he can receive at the end of 8 years?
8. Calculate the future value of Rs. 15,000 at end of 3 years at 12% interest rate, when interest
rate calculated on the basis of yearly, half yearly and quarterly and monthly.

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9. You can save Rs 2,000 a year for 5 years, and Rs 3,000 a year for 10 years thereafter. What will
these savings cumulate to at the end of 15 years, if the rate of interest is 10 per cent?
10. Determine the future value at the end of 5 years of the following series of payments at 5% rate of
interest : At the end of the 1st year = Rs.1000, 2nd year = Rs.2000, 3rd year = Rs.3000, 4th year =
Rs.4000, 5th year = Rs.5000
11. A person invests Rs. 5000 at the end of the each year at 10% rate of interest per year. State what
amount he will receive at the end of 4 years.
12. Mr. X deposits Rs. 5000 at the end of every year for 5 years and the deposit earns a compound
interest @8% p.a. Determine how much money he will have at the end of 5 years?
13. Ms. Sujatha deposits Rs. 5000 at the end of every year for 6 years and the deposit earns a
compound interest @6% p.a. Determine how much money he will have at the end of 6 years?
14. If the interest rate is 12 per cent how much investment is required now to yield an income of Rs
12,000 per year from the beginning of the 10th year and continuing thereafter forever?
15. You have a choice between Rs 5,000 now and Rs 20,000 after 10 years. Which would you choose?
What does your preference indicate, if interest you earn on Rs. 5000 is 10%?
16. Mr. Vinay plans to send his son for higher studies abroad after 10 years. He expects the cost of these
studies to be Rs 100,000. How much should he save annually to have a sum of Rs 100,000 at the end
of 10 years, if the interest rate is 12 per cent?
17. A company has issued debentures of Rs 50 lakh to be repaid after 7 years. How much should the
company invest in a sinking fund earning 12 per cent in order to be able to repay debentures?
18. A company needs Rs. 10, 00,000 after 5 years from now on for replacement of its fixed assets. It has
established a Sinking Fund for the purpose. The investments are to be made at the end of each year.
What annual payment must be made to ensure the needed Rs. 10, 00,000 after 5 years? Assume 10%
interest per year on investments.

Present Value

1. Calculate the present value of Rs.10, 00,000 to be received after 5 years from now assuming 6%
time preference for money.
2. Calculate the present value of the following cash flows assuming a discount rate of 8%.
Year 1 – 10,000 Year 2 – 20,000 Year 3 – 10,000 Year 4 – 5,000
3. Mr. A has to receive Rs. 5000 per year for 6 years. Calculate the present value of the annuity
assuming that he can earn interest on his investment at 12% p.a.
4. Mr. Rajan is to receive Rs. 5000 after five years from now. His time preference for money is 10%
p.a. calculate its present value, if the discount factor is 0.621.
5. A payment annuity of Rs. 5000 will begin 7 years hence. What is the value of this annuitynow
if the discount rate is 12%?
6. Mr. X is to receive from Indira Vikas Patra Rs. 20,000 after 5 years from now. His time
preference for money is 10% p.a. Calculate its present value if the discount factor is 0.621.
7. X deposits Rs. 1, 00,000 on retirement in a bank which pays 10% annual interest. How much canhe
withdraw annually for a period of 10 years if PVgFA 10% is 6.145?
8. What is the present value of an income stream which provides Rs 1,000 at the end of year on Rs
2,500 at the end of year two, and Rs 5,000 during each of the years 3 through 10, if the discount rate
is 12 per cent?
9. What is the present value of an income stream which provides Rs 2,000 a year for the first five
years, and Rs 3,000 a year forever thereafter, if the discount rate is 10 per cent? [Present value for
the a perpetual annuity]
10. What amount must be deposited today in order to earn a perpetual annual income of Rs 5,000
beginning from the end of 15 years from now? The deposit earns 10 per cent per year.
11. What is the present value of Rs 2,000 receivable annually for 30 years? The first receipt
occurs after 10 years and the discount rate is 10 per cent.

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12. What is the present value of the following cash flow streams? The discount rate is 12 per cent
Year 1 2 3 4 5 6 7 8 9 10
Stream A 100 200 300 400 500 600 700 800 900 1000
Stream B 1000 900 800 700 600 500 400 300 200 100
Stream C 500 500 500 500 500 500 500 500 500 500

13. Mr. Rakesh receives a sum of Rs. 2,00,000 as provident fund on his retirement. He deposits it in a
bank which pays 12% interest. If he withdraws annually Rs. 29,364, how long can he do so?
14. At the time of his retirement Mr. X is given a choice between two alternatives; An annual pension Rs.
10,000 as long as he lives and A lump sum payment of Rs. 60,000. If Mr. X expects to live for 15
years and rate of interest is 15%, which alternative should he select?

EMI & Loan Amortization

1. Determine the amount of equal payment to be made for a loan of Rs. 2, 00,000 taken for a period
of 4 years at 10% rate of interest.
2. Shyam takes a housing loan of Rs. 10, 00,000 carrying interest of 1% per month. The loan to be
repaid over 180 months. Calculate the EMI.
3. Mr. Ram is borrowing Rs. 50,000 to buy a motorcycle. If he pays equal instalments for 25 years
and 4% interest on the outstanding balance, what is the amount of instalment? What will be amount
of the instalment if quarterly payments are requested to be made?
4. A debt of Rs.10, 00,000 is amortized by making equal payments at the end of every six months for
three years, and interest is 6% compounded semi-annually. Construct an amortization schedule.
5. Xavier has borrowed a 3 year loan of Rs. 10,000 at 9% from a bank to buy a motor cycle. Draw a
loan amortization schedule.
6. Phoenix company borrows Rs. 5,00,000 at an interest rate of 14%. The loan to be paid in 4 equal
instalment payable at end of next 4 years. Prepare loan amortization schedule.
7. Prepare loan amortization schedule from the information: Loan amount – 15,00,000 , rate of
interest - 20%, loan tenure – 5 years.
8. Mr. Laxman borrow Rs. 10,00,000 at an interest rate of 15% and loan is to be repaid in 5 equal
instalments payable at end of each year for next 5 years. Prepare the loan amortization schedule.
9. Mr. Sharma borrows Rs. 1,60,000 for a musical system at monthly interest rate of 2.5% . The
loan is to be repaid in 12 equal monthly instalments. Prepare the loan amortization schedule.
10. A company borrows a loan of Rs. 5,00,000 at 12% PA. The loan has to be repaid in 10 annual
instalments. Compute instalment amount.

************

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PROBLEMS ON COST OF CAPITAL

PROBLEMS ON COST OF DEBT

1. X Ltd., issues 12% debentures of face value of Rs. 100 each and realizes at Rs. 95 per debenture. The
debenture is redeemed after 10 years at premium of 10%. Tax rate is 50%.
2. A Co Ltd., issued 10% debenture of Rs. 5,00,000 at par. Compute the cost of debt, if tax rate applicable is
(i) 50% (ii) 40% (iii) 45%
3. Sodexo Ltd., issued debenture 12% debenture of Rs. 2,00,000 – face value of the debenture is Rs. 100 –
Compute cost of debenture, if
(a) Issued at par, tax rate is 20%
(b) Issued at 10% premium, tax rate is 30%
(c) Issued at discount 10%, tax rate is 40%
4. Zen Co Ltd., issues 9% debenture of Rs. 6,00,000 – face value of debenture is Rs. 100 at par value. It
spent Rs. 20,000 as floating expenses on issue of debenture. Compute tax of debt, if the tax rate is 40%.
5. Compute the cost of debt of 12% debentures issued by Vishal Ltd., face value of Rs. 100 each amount to
Rs. 2,00,000 in the following situations. The life of debenture is 7 years
(a) Issued at par, redeemable at par.
(b) Issued at 10% premium.
(c) Issued at 10% discount.
6. Abacus Limited issued 15 year, 14% bonds five years ago. The bond which has a face value of Rs. 100 is
currently selling for Rs. 108.
 What is the pre – tax cost of debt?
 What is the after – tax cost of debt? (Assume a 35% tax rate.)
7. A company has 15% perpetual debt of Rs. 1,00,000 – the tax rate is 35% Determine cost of debt (both
after tax and before tax) assuming the debt is issued at (i) par (ii) 10% premium and (iii) 10% discount.
8. Five years ago, Sona Limited issued 12 per cent irredeemable debentures at Rs. 103, at Rs. 3 premium to
their par value of Rs. 100. The current market price of these debentures is Rs. 94. If the company pays
corporate tax at a rate of 35 per cent calculate its current cost of debenture capital?
9. A company issued 10,000 10% debentures of Rs. 100 each at premium of 10% on 01.04.2018 and will
going to mature on 01.04.2023 The debenture will be redeemed on maturity. Compute the cost of debt.
Tax rate applicable is 40%
10. A company issued 10,000 12% debentures of Rs. 100 each on 01.04.2013 which is going to be mature on
01.04.2023. The company want to know the cost of its existing debt as on 01.04.2018 when market value
of the debenture is Rs. 80. Calculate the cost of existing debentures, if tax rate is 35%.
11. ABC Limited issues 15% debentures of face value of Rs. 100 each, redeemable at the end of 7 years. The
debentures are issued at a discount of 5% and floatation cost is estimated to be 1%. Find out the cost of
capital if tax rate is 50%.
12. Suguna Ltd., Zero Coupon Bonds with face value of Rs. 100 each at 40% discount for Rs. 3,00,000 the
bonds are to be redeemed at face value after 5 years. Find out the cost of debt.
13. Calculate the explicit cost of debt for each of the situations:- Coupon Rate - 15%, Face Value – Rs. 100
Maturity – 10 Years, Tax Rate – 35%.
 Debentures are sold at par and floatation costs are 5% of issue price
 Debentures sold at discount of 5% and floatation cost of 5% of issue price
 Debentures sold at premium of 10% and floatation cost of 5% of issue price.

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14. A company‘s debentures of the face value Rs. 100 bear 8% coupon rate. Debentures of this type currently
yield 10%. What is market price of the debentures? What would happen to the market price of debentures
if interest rate rises to 16% and drips to 12%

YIELD TO MATURITY PROBLEMS

1. A bond issued by Diana Ltd., has a market price of Rs. 850 and that the bond comes with a face value
of Rs.1,000. On this bond, yearly coupons are $150. The coupon rate for the bond is 15% and the
bond will reach maturity in 7 years.
2. Compute the yield to maturity of a 2-year coupon bond with a principal of Rs.100, currently selling at
Rs. 95 and a coupon rate of 4.25%. Assume annual coupon payments.
3. A bond issued by Karthikeya ltd., is currently selling at Rs. 940, with the face value of the bond at
Rs.1000. The annual coupon rate is 8%, with a maturity of 12 years. You are required to calculate the
yield to maturity.
4. Calculate the YTM by using the following information:
 Face Value of Bond (FV) = Rs. 1,000
 Annual Coupon Rate (%) = 6.0%
 Number of Years to Maturity = 10 Years
 Market Price of Bond (PV) = Rs.1,050
5. A 4 year bond with 10% coupon rate of Rs. 1000, is currently selling at Rs. 900. Compute its YTM.
6. A bond pays 10% interest annually and currently selling at Rs. 835. It has 6 years left to maturity and
a par value of Rs. 1000. Compute the YTM.

PROBLEMS ON COST OF PREFERENCE CAPITAL

1. XYZ Ltd., has issued 15% preference shares of the face value of Rs. 100 each. To be redeemed after
10 years. Floatation cost expected to be 4%. Determine the cost of preference shares.
2. A company has 10% redeemable preference shares which are redeemable at the end of 10th year from
the date of issue. The underwriting expenses expected to be 2% & face value of debenture is Rs. 100.
Find out the effective cost of preference shares.
3. Superior Cement Limited issues Rs. 100 face value preference shares carries 12% dividend. The
preference capital is repayable in two equal instalments at the end of 10th and 12th year respectively.
The net amount realised per preference share is Rs. 95. What is the cost of capital?
4. Harshitha Company Limited issued 12% redeemable preference shares of Rs. 5,00,000 and face value
of the same is Rs. 10. Calculate the cost of capital if shares are issued (i) at par and (ii) at 10 premium
assuming the shares are redeemed at 10th year for premium of 10%.
5. Kishore Pvt Ltd., issued the 10% preference shares of face value of Rs. 10 each which is redeemable
after 8th years. Total number of shares issued is 50,000. And these shares redeemed at 20% premium.
The cost of such issue is 50 paisa per share. Compute the cost of preference capital.
6. XYZ Ltd., issues 2,000 10% preference shares of Rs. 100 each at Rs. 95 each. The company proposes
to redeem preference shares at the end of 10th year from the date of issue. Calculate the cost of capital.
7. A Ltd. Issued 40,000 8% preference shares of Rs. 500 each at a premium of 6%. These preference
shares are Redeemable after 8 years at a premium of 10 %. The cost of issue is ₹ 1,00,000. calculate
Cost of preference share capital before tax , if income tax is 25 %

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8. Reliance Energy Ltd., is issuing preferred stock at Rs. 100 per share, with a stated dividend of Rs. 12
and flotation cost is 3% then, calculate the cost of preference share.
9. A company issues 14% irredeemable preference of the face value of Rs. 100 each. Flotation costs are
estimated at 5% of the expected sale price. What is the cost of preference capital, if preference shares
issued at (i) par (ii) 10% premium and (iii) 5% discount.
10. A company issues 10 % irredeemable preference shares. The face value per share is Rs. 100, but the
issue price is Rs. 95. What is the cost of preference shares? What is cost if the price is Rs. 105?
11. A company has 1,00,000 shares of Rs. 100 at par of preference share outstanding at 9.75% of
dividend rate. The current market price is Rs. 80. What is its cost?
12. A company is planning to issue 9% preference shares expected to sell at Rs. 85 per share. The costs of
issuing and selling the shares are expected to be Rs. 3 per share. Find out the cost of preference share
capital.

PROBLEMS ON COST OF EQUITY

1. A company has issued 10,000 equity shares of Rs. 100 each. Company has been paying a dividend to
equity shareholders at 25% p.a. from last three years and expected to maintain the same. Market value
of the equity share is Rs. 180. Compute the cost of equity.
2. M ltd. has issued equity shares of Rs10 each at a premium of 10% after incurring a floatation cost of
4% of the issue price. In keeping with the dividend paid by similar companies, shareholders expect a
dividend of 15% per share. Determine the cost of equity capital.
3. A company has paid a dividend of Re. 1 per share (of face value of Rs. 10 each) last year and
expected grow by 10% next year. Calculate the cost of equity if the market price is Rs. 55.
4. ABC Company Ltd., want to issue 20,000 new equity shares of Rs. 100 each at par. The flotation cost
is expected to 5%. The company has paid the dividend of Rs. 15 in last year and it is expected grow
by 7%. Compute the cost of equity (i) in case of new equity shares (ii) for existing shareholders
assuming the market price of the share is Rs. 160 per share.
5. A company is about to pay a dividend of Rs. 1.40 per share having a market value of Rs. 19.50 – The
expected future growth in dividends is estimated at 12%. Calculate the cost of capital.
6. The current market price of shares of A Ltd. Is Rs. 95 – The flotation costs are Rs. 5 per share.
Dividend per share amounts to Rs. 4.50 and is expected to grow at the rate of 7%. You are required to
calculate the cost of equity.
7. XY Company‘s share is currently quoted in market at Rs. 60. The expected dividend is Rs. 3 per
share and investors expect a growth rate of 10% per year. You are required to calculate:
(i) The company‘s cost of equity capital.
(ii) The indicated market price per share, if anticipated growth rate is 12%.
(iii) The market price, if the company‘s cost of equity capital is 12%, anticipated growth rate is
10% p.a., and dividend of Rs. 3 per share is to be maintained.
8. The current market price of a share is Rs. 100. The firm needs Rs. 1,00,000 for expansion and the
new shares can be sold at only Rs. 95. The expected dividend at the end of the current year is Rs. 4.75
per share with a growth rate of 6%. Calculate the cost of capital of new equity.
9. Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a stock exchange at a market price of
Rs. 28. A constant expected annual growth rate of 6% and a dividend of Rs. 1.80 per share has been
paid for the current year. Calculate the cost of equity share capital.
10. A company‘s share is currently quoted in the market at Rs. 20. The company pays a dividend of Rs. 2
per share and the investors expect a growth rate of 5% per year. You are required to calculate
(i) Cost of equity capital of the company, and
(ii) The market price per share, if the anticipated growth rate of dividend is 7%.

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11. The share capital of a company is represented by 10,000 Equity Shares of Rs. 10 each, fully paid. The
current market price of the share is Rs. 40. Earnings available to the equity shareholders amount to
Rs. 60,000 at the end of a period. Calculate the cost of equity share capital using Earning/Price ratio.
12. A company plans to issue 10,000 new Equity Shares of Rs. 10 each to raise additional capital. The
cost of floatation is expected to be 5%. Its current market price per share is Rs. 40. If the earnings per
share is Rs. 7.25, find out the cost of new equity.
13. The Xavier Corporation, a dynamic growth firm, anticipates long run level of future earning of Rs. 7
per share. The current price of Xavier shares is Rs. 55.45 flotation costs for sale of equity shares
would average about 10% of the price of the shares. What is the cost of new equity capital to Xavier?
14. Kapil Company Limited has a proposal to expand business operations for which it needs fresh equity
capital of Rs. 20,00,000. On the basis of the following information determine the cost of equity
capital:
 Issue price of new share is Rs. 200 – No Issue charges
 Number of existing equity shares – 20,000
 Market value of existing shares – Rs. 300
 Net earnings – 100 Lakh
PROBLEMS ON CAPM & COST OF RETAINED EARNINGS

1. You expect a return on the market of 15% on a stock of Zen Ltd., and risk-free rate is 3%. The beta of
Zen Ltd., is 0.89 and it is priced to return 14%, Is Zen Ltd., stock is fairly priced? Will you buy extra
shares or will you sell the existing shares in this case?
2. The risk-free rate is 15% and market risk premium is 10%. The beta of stock is 1.4 and its standard
deviation is 30%. What is the expected rate of return on the stock as per CAPM?
3. ABC Company provides the following details: D – 4.19 P – Rs. 50 G – 5% - Calculate the cost of
retained earnings as per DCF.
4. Vistara Ltd., provides the following details calculate the cost of retained earnings as per CAPM.
Risk Free Rate is 7%. Market Risk Premium is 13% Beta is 1.20
5. Y Ltd., retains Rs. 7,50,000 out of its current earnings. The expected rate of return to the
shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 3% and shareholders
come in 30% tax bracket. Calculate the cost of retained earnings.

PROBLEMS ON WACC

1. From the following capital structure of G Ltd., calculate the overall cost of capital using book value
weights and market value weights.

Source Book Value Market Value

Equity Share Capital (Rs. 10 Per Share) Rs. 45,000 Rs. 90,000
Retained Earnings Rs. 15,000 NIL
Preference Share Capital Rs. 10,000 Rs. 10,000
Debentures Rs. 30,000 Rs. 30,000
The after tax cost of different source of finance is as follows: Equity 14%, RE 13%, Pref 10%, Debt
5%.

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2. GHCL Ltd., has on its books the following amounts and specific costs of each type of capital.
Book Value Market Value Specific Cost
Source (Rs.) (Rs.) (%)
Debt 4,00,000 3,80,000 5
Preference Shares 1,00,000 1,10,000 8
Equity Shares 6,00,000 12,00,000 (R+E) 15
Retained Earnings 2,00,000 NIL 13
Determine the weighted average cost of capital using: - Book Value Weights & Market Value
Weights

3. The following is the capital structure of the firm:

Source Amount (Rs.) Proportion (%) After Tax Cost (%)
Equity Shares 4,50,000 45 18
Retained Earnings 1,50,000 15 18
Preference Shares 1,00,000 10 11
Debt 3,00,000 30 8
Calculate the weighted average cost of capital.

4. The PQR company has the following capital structure in 31st March 2023
Ordinary Shares (2,00,000
Shares) 40,00,000
10% Preference Shares 10,00,000
14% Debentures 30,00,000
Total 80,00,000
The share of company sells for Rs. 20. It is expected that company will pay next year a dividend of Rs. 2
per share which will grow at 7% forever. Assume 50% tax rate. You are required to
- Compute WACC using existing capital structure.
- Compute the new WACC if the company raises an additional of Rs. 20,00,000 by issuing 15%
debentures. This would result in increasing the expected dividend to Rs. 3 and leave the growth rate
unchanged, but process of share will fall to Rs. 15 per share.

5. A firms after tax cost of capital of the specific sources is as follows:

i. Cost of debt – 8%
ii. Cost of preference shares (including dividend tax) – 14%
iii. Cost of equity funds -17%
The following is the capital structure.
Source Amount (Rs.)
Debt 3,00,000
Preference Shares 2,00,000
Equity Shares 5,00,000
Retained Earnings 2,00,000
Calculate the weighted average cost of capital using book value and market value, if debt market
value is Rs. 2,70,000, Preference Capital is Rs. 2,30,000 and Equity is Rs. 7,50,000.

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6. Compute the weighted average cost of capital under each of the following three financing plans: If

Plans WEC WPC WDC

1 0.50 0.30 0.20
2 0.30 0.40 0.30

7. The following is the capital of Nyka ltd., Calculate WACC if market value of equity is Rs. 20

Source Book Value Cost of Capital

Equity Share Capital (45,000 shares of Rs. 10 each) 4,50,000 14%
Retained Earnings 1,50,000 14%
Preference Share Capital 1,00,000 10%
Debentures @ 9% 3,00,000 4.5%

8. Following is the capital structure details of VFX limited. Compute the WACC by using book value
and market value.

Source of Capital Book Value Market Value COC

Debentures 80,000 76,000 10%
Preference Shares 20,000 22,000 15%
Equity Shares 1,20,000 1,80,000 30%
Retained Earnings 40,000 60,000 15%

9. Anand Limited has following capital structure:

 Equity expected dividend 12% Rs. 20,00,000

 10% Preference shares Rs. 10,00,000
 8% Debt Rs. 30,00,000

You are required to determine the weighted average cost of capital using book value weights and
market value weights.

10. Following information is the capital structure of Woods limited.

Source of Capital Book Value COC

Debentures 12,00,000 5%
Preference Shares 4,00,000 10%
Equity Shares 8,00,000 15%
Retained Earnings 16,00,000 12%

You are required to calculate weighted average cost of capital (WACC).

PROBLEMS ON CAPITAL STRUCTURE

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PROBLEMS ON LEVERAGES

1. Calculate operating leverage, financial leverage and combined leverage under situation 1 and 2 in
financial plans A & B from the following information relating to the operation and capital structure of
a company.
 Installed capacity – 2,000 units
 Actual production and sales – 50% of the capacity
 Selling price Rs. 20 per unit
 Variable Cost Rs.10 per unit
 Fixed Cost: Under Situation I Rs. 4,000, Under Situation II Rs. 5,000
 Interest Payment is Rs. 2,500
2. Calculate operating leverage and financial leverage for Maruthi Limited from the following
information
 Number of Units Produced 50,000
 Selling Price per Unit is Rs. 50
 Variable Cost per Unit is Rs. 20
 Fixed Cost per Unit at Current Level of Sales is Rs. 15
 Interest on Debentures Rs. 1,50,000
3. A firm sells its only product at Rs. 12 per unit. Its variable cost is Rs. 8 per unit. Present sales are
1,000 units. Calculate the operating leverage in each of the following situations.
 When fixed cost is Rs. 1,000
 When fixed cost is Rs. 1,200
 When fixed cost is Rs. 1,500
4. Calculate the financial leverage from the below details, assume that the company is in 50% bracket.
 Equity share capital Rs. 1,00,000
 10% preference share capital Rs. 1,00,000
 8% Debentures Rs. 1,25,000
 The present EBIT is Rs. 50,000.
5. The following is the data given by ABC Inc.,
 Selling Price – Rs. 120 per unit
 Variable Cost – Rs. 70 per unit
 Fixed cost – Rs. 2,00,000
a) What is operating leverage when ABC Inc., produces and sells 6,000 units?
b) What is the percentage change that will occur in the EBIT, if the output increases by 5%?
c) Calculate revised operating leverage
6. The following is the balance sheet of Delta Corporation as on 31.03.2023.
Liabilities Rs. Assets Rs.
Equity Capital Rs. 10 / Share 1,80,000 Fixed Assets 4,50,000
10% Debentures 2,40,000 Current Assets 1,50,000
Retained Earnings 60,000
Current Liability 1,20,000
6,00,000 6,00,000
The company‘s total asset turnover is 2.5 times. The fixed operating cost are Rs. 2,00,000 and
variable operating cost is 40%. If income tax rate is 50%, Compute
 Operating Leverage
 Financial Leverage
 Combined Leverage
7. The capital structure of the Progressive Ltd, consists of ordinary share capital of Rs. 10,00,000 (share
of Rs 100 each) and Rs. 10,00.000 of 10% debenture. The selling price is Rs. 10 per unit, variable

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costs amounts to Rs 6 per unit and fixed expenses amount to Rs. 2,00,000. The income tax rate is
assumed to be 50%. The sales level is expected increase from 1,00,000 units to 1,20,000 units. You
are required to calculate Financial and Operating leverage at (1,00.000 units and 1,20,000 units).
8. Calculate operating, financial and combined leverage from the following data:
 Sales (1,00,000 units) – Rs. 2,00,000
 Variable cost per unit – Rs. 0.70
 Fixed cost – Rs. 65,000
 Interest charges – Rs. 15,000
9. The Gama co ltd., consists of sales 1,50,000 units @ 1.50 per unit then they want to increase sales to
2,00,000 units. Variable cost is 0.50 paisa per unit. Fixed expenses amounted to Rs. 40,000 interest is
Rs. 5,000 and income tax is 50%. You are required compute all three leverages.
10. A firm has sales of Rs.10,00,000 , variable cost Rs.7,00,000 , fixed cost Rs.2,00,000 and
Rs.5,00,000 debt at 10% interest. What are the operating, financial and combined leverages?

PROBLEMS ON EPS CALCULATION

1. Galaxy Ltd., currently has capital structure which consists of equity shares of 15,000 of Rs. 100 each.
The management of the company is planning to raise another Rs. 25,00,000 to finance a major
expansion and is considering three alternative methods of financing.
 To issue 25,000 – 8% debentures of Rs. 100 each
 To issue 25,000 equity shares of Rs. 100 each
 To issue 25,000 – 8% preference shares of Rs. 100 each
The company‘s expected earnings before interest and tax will be Rs. 8,00,000 – Assuming the
corporate tax at 50%, Determine the earnings per share in each alternative and comment which
alternative is best and why?
2. A Ltd. Has a share capital of Rs .1,00,000 divided into share of Rs. 10 each. It has a major expansion
program requiring an investment of another Rs. 50,000. The Management is considering the
following alternatives for raising this amount :
 Issue of 5,000 equity shares of Rs. 10 each
 Issue of 5000, 12% preference shares of Rs. 10 each
 Issue of 10% debentures of Rs. 50,000
The company‘s present Earnings Before Interest and Tax (EBIT) are Rs. 40,000 per annum subject to
tax @ 50%. You are required to calculate the effect of the above financial plan on the earnings per
share presuming: (a) EBIT continues to be the same even after expansion (b) EBIT increases by Rs.
10,000
3. From the following prepare the income statement and calculate the EPS for both companies.
Particulars Company A Company B
Financial Leverage 4:1 5:1
Interest Rs. 6,00,000 Rs. 7,00,000
Operating Leverage 3:1 4:1
Variable Cost to Sales 66.67% 50%
Tax Rate 30% 40%
No. of equity shares 1,00,000 70,000

4. Oriental Ltd. Currently as an ordinary share capital of Rs.25 lakhs, consisting of 25,000 shares of
Rs.100/- each. The management is planning to raise another Rs.20 lakhs to finance major expansion
programme, through one of four possible financial plans,
 Entirely through ordinary shares.
 Rs.10 lakhs through ordinary shares and Rs.10 lakhs in 8% long term loan.
 Rs.5 lakhs through ordinary shares and Rs. 15 lakhs through 9% loan (LT)

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 Rs.10 lakhs through ordinary shares and Rs.10 lakhs through preference shares with 5%
dividend.
The company‘s expected earnings before interest and taxes (EBIT) will be Rs.8 lakhs. Assuming a
corporate tax rate of 50% determine the EPS in each alternative and comment, which alternative is
best and why?
5. XYZ Ltd., is an established company which requires a further sum of Rs 30,00,000 for expansion
scheme. Apart from the original equity capital of Rs 30,00,000 of Rs 100 each. The directors have the
following plan for expansion:
 Whole amount to be raised through equity shares.
 Rs 10,00,000 in equity shares and balance amount in 8% debentures.
 All in debentures @ 8%.
 Rs 10,00,000 in 12% preference shares and balance in equity.
The expected EBIT is Rs 8,00,000 and tax rate applicable is 50%. Analyse the options and select the
best option.
6. M/s Tejaswini Ltd., needs Rs 10 lakh. For expansion is expected to yield 16% on investment (Before
interest and the tax payment). Firm is planning to raise funds through debt and equity and the
objective is to maximize the EPS. If the firm borrows in excess of Rs 4,00,000, the cost of debt would
go up to 12% from 10% and the market price would drop from Rs 25 to Rs 20. The tax rate applicable
is 50%.
Determine the EPS in three alternatives of financing mix
 Rs 3.00.000 debt
 Rs 5,00,000 debt
 Rs 7,00,000 debt in the capital structure.
7. A firm‘s sale, variable costs and fixed costs amount to Rs.75,00,000, Rs.42,00,000 and Rs.6,00,000
respectively. It has borrowed Rs.45,00,000 at 9% and its equity capital totals Rs.55,00,000.
1. What is the firm‘s ROI?
2. Does the firm have favourable financial leverage?
3. If the firm belongs to an industry whose asset turnover is 3, does it have a high or a low asset
leverage?
4. What are the operating, financial and combined leverages?
5. If the sales drop to Rs.5000000, what will be the new EBIT?
6. At what levels, will the EBT of the firm equal to zero?
8. A B Ltd. Needs Rs. 10,00,000 for expansion. The expansion is expected to yield an annual EBIT of
Rs.160000. In choosing a financial plan, AB Ltd. Has an objective to maximize the EPS. It is
considering the possibility of issuing equity shares and raising debt of Rs.100000 or Rs.400000. The
current market price per share is Rs.25. Funds can be borrowed at the rate as below: (a) Up to
Rs.1,00,000 @8% (b) Above 1,00,000 @ 12% Assume tax rate @ 50%. Determine EPS for both
alternatives.
9. The following key information pertains to Ashika Ltd. For the year 2013-14
Rs. In Lakhs
Sales 82.50
Variable Cost 46.20
Fixed Cost 6.60
9% Debentures 50.00
Equity Shares (Rs. 100 each) 60.00
Corporate Tax 35%

You are required to answer the following questions:

1. What is the Company‘s ROI?
2. Does it have favourable financial leverage?

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3. If the firm belongs to an industry whose asset turnover is 3, does it have high or low asset
leverage?
4. What is the operating, financial and combined leverage of the firm?
5. What is the Company‘s EPS?
6. What will be the expected EPS if the Sales of Ashika Ltd. Increase by 10% in the next year and
cost structure as well as financial structure remains same?

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PROBLEMS ON CAPITAL BUDGETING

1. An Industry is considering investing in a project which cost Rs 12.00,000. The cash flows are Rs
2,40,000 , Rs 2,80,000 , Rs 3,60,000 , Rs 4,00,000 and Rs 5,00,000. Calculate Payback period.

2. From the following information relating to Ambuja Ltd, compute payback period and discounted
payback period. Cost of the project - 50,000
Year PAT PV Factor @ 10%
1 5,000 0.909
2 20,000 0.826
3 30,000 0.751
4 30,000 0.683
5 10,000 0.621

3. A firm has an initial investment of Rs. 1,00,000 and cash inflows shown below. Compute NPV.
Year Cash Inflow PV Factor @ 10%
1 50,000 0.909
2 40,000 0.826
3 30,000 0.751
4 10,000 0.683

4. A Company intends to replace an old machine with a new machine. From the following information,
you are required to determine the Net cash outflow for such replacement:
Particulars Amount
Cost of old machine 50000
Life of the old machine 5 years
Depreciation method followed Original cost
Remaining useful life 2 years
Cost of new machine 70000
Installation charges 10000
Additional working capital required 5000
Amt. realized on sale of old machine 25000
Income tax 50%
Capital gain tax 30%
Investment allowance on new machine purchased 20%

5. Sensera Ltd has to select one of the two alternative projects whose particulars are given below:

Project A Project B
Initial
Outlay 1,18,720 1,00,670
Year Cash Flows
1 1,00,000 10,000
2 20,000 10,000
3 10,000 20,000
4 10,000 1,00,000

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The company's cost of capital is 8%. Compute the NPV and IRR for each project and comment on the
results.
6. Madan Lal Dhingra is determining the cash flow for a project involving replacement of an old
machine by a new machine. The old machine bought a few years ago has a book value of Rs 400000
and it can be sold to realize a post-tax salvage value of Rs 300000. It has a remaining life of five
years after which its net salvage value is expected to be Rs 160000. It is being depreciated annually at
a rate of 25% under the written down value method. The working capital required for the old machine
is Rs 400000. The new machine costs 16,00,000. It is expected to fetch a net salvage of Rs 5,00,000.
After 5 years when it will be no longer be required. The depreciation rate applicable to it is 25%
under WDV method. The net working capital required for the new machine is Rs 5,00,000.
Installation charges of the new machine is Rs 100,000. The new machine is expected to bring a
savings of Rs 3,00,000 annually in manufacturing costs (other than depreciation). The tax rate
applicable to the firm is 40%. As a Financial Advisor of the company, you should suggest whether the
old machine be replaced by the new machine. (Assuming cost of capital to be: 10%)

Year 1 2 3 4 5
PVIF 0.909 0.826 0.751 0.683 0.621
7. A Company is considering an investment proposal to install a new machine. The project will cost Rs
50,000 and will have a life of 5 years and no salvage value. Tax rate is 50%. Straight Line method of
depreciation of providing depreciation is followed. Estimated Net Income before depreciation and tax
from the proposed investment are:
Year Net Income before Depreciation
and Tax (Rs)
1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Evaluate Project Using (i) NPV @ 10% (ii) PI @ 10%
8. Naveen Enterprises is considering a capital project about which the following information is
available.
- The investment outlay on the project will be Rs.100 million. This consists of Rs.80 million on
plant and machinery and Rs.20 million on net working capital. The entire outlay will be incurred
at the beginning of the project.
- The project will be financed with Rs.45 million of equity capital, Rs.5 million of preference
capital, and Rs.50 million of debt capital. Preference capital will carry a dividend rate of 15%,
debt capital will carry an interest rate of 15%.
- The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will fetch a net
salvage value of Rs.30 million whereas net working capital will be liquidated at its book value.
- The project is expected to increase the revenues of the firm by Rs.120 million per year. The
increase in costs on a/c of the project is expected to be Rs.80 million per year. (This included all
items cost other than depreciation, interest and tax). The effective tax rate will be 30%.
- Plant and machinery will be depreciated at the rate of 25%. Per year as per the written down
value method. Hence, the depreciation charges will be.
 First year: Rs.20.00 million
 Second year: Rs.15.00 million
 Third year: Rs.11.25 million
 Fourth year: Rs.8.44 million
 Fifth year: Rs.6.33 million
Given the above detail, prepare the project cash flows.

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9. A company plans to undertake a project for placing a new product in the market. The company cut off
rate is 12%. It was estimated that the project would cost 40,00,000 in plant and machinery in addition
to working capital 10,00,000 at the end of life of the project. Scrap value - 10%. After tax, profits
were estimated as follows:
Year 1 2 3 4 5
PAT (Rs.) 3,00,000 8,00,000 13,00,000 5,00,000 4,00,000
DF @ 12% 0.893 0.797 0.712 0.636 0.567

10. The expected cash flows of a project are as follows:

Year Cash flow
0 -1,00,000
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
If cost of capital is 12%. Calculate modified internal rate of return.
11. ABC Ltd is evaluating a project that has the following cash flow stream associated with it.
Year 0 1 2 3 4 5 6
Cash Outflow 120 80 - - - - -
Cash Inflow - - 20 60 80 100 120
Calculate modified rate of return. The cost of capital of ABC ltd is 15%.
12. The expected cash flows of a project are as follows:
Year 0 1 2 3 4 5
Cash flow 1,00,000 20,000 30,000 40,000 50,000 30,000
The cost of capital is 12%. Calculate the following:
a) Net Present Value
b) Profitability Index
c) Payback Period
d) Discounted Payback Period
13. A Company is currently considering modernization of a machine originally costing Rs 1,00,000 that
has current book value of zero. However, it is in good working condition and can be sold for Rs
50,000. Two choices are available one is to rehabilitate the existing machine at a total cost of Rs
3,60,000 and the other is to replace the existing machine with a new machine costing Rs 4,20,000 and
requiring Rs 60,000 to install. The rehabilitated machine as well as the new machine would have a six
year life and no salvage value. The Firm's projected after tax profits under various alternatives are as
follows:

The Firm is taxed at 55% of income. The Company uses Straight line depreciation. The company's
cost of capital is 12%. Advise the Company, whether, it should rehabilitate the existing machine or
replace it with a new machine by using Net Present Value Method.

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14. A firm whose cost of capital is 10% is considering two project X and Y each cost Rs 1,00,000
respectively. Following are the cash inflows:

Compute the NPV@ 10% and IRR for two projects separately, Project X by 20 and 29% and Project
Y by 9 and 15%.
15. Aryan and Co. is considering the purchase of 2 machines. Each Rs 50,000. Cash inflows are expected
to be as under. Calculate discounted payback period using 10% discount.

16. SLS Trading Company prepares to increase the production of the company. They are willing to
purchase a new machine. There are 3 types in the market. The following details are available.

Taxation is 50% of the profit. you are required to advice the management which type of the machine
should be purchased under PBP method and post PBP.
17. A company is considering to install new machine at a cost of Rs.10,00,000. The life expectancy of the
machine is 5 years and no salvage value. The tax rate is 30%. Firm uses straight line method of
depreciation. The estimated cash inflows before depreciation and tax are as follows:

Compute: i) PBP ii) ARR iii) NPV iv) PI. Consider discount rate of 10%.
18. PQR Ltd., is considering a purchase of machinery. Two alternatives machinery 1, 2 are suggested
each costing Rs 5,00,000 cash inflow are expected to be as follows:

Calculate NPV and PI.

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PROBLEMS ON WORKING CAPITAL MANAGEMENT

1. The following information is available in respect of a trading firm. ;

 On an average, debtors are collected after 15 days, inventories have an average holding period
of 25 days and creditors' payment period on an average is 10 days.
 The firm spends a total of Rs 40 lakh annually at a constant rate.
 It can earn 10% on investment.
For the above information, compute
a) The cash cycle
b) Cash turn over and
c) Minimum amount of cash to be maintained to meet payments as they become due
d) Savings by reducing the average inventory holding period by 10 days.
2. Calculate the operating cycle of Anand Ltd., The enterprise gets 30 days credit from its suppliers. All
sales based on credit. Assume 365 days in a year.

3. Zenith has provided the following data

What is the length of operating cycle and cash cycle? Assume 360 days in a year.
4. From the following date compute operating and cash cycle. Assume 360 days in a year.

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5. A proforma cost sheet of a company provided the following particulars:

6. While preparing a project report on behalf of a client you have collected the following facts. Estimate
the net working capital required for the project. Add 10% to your computed figure to allow
contingencies.

Additional information:

Selling price Rs.200 per unit, level of activity 104000 units of production p.a., raw materials in stock,
average 4 weeks, finished goods in stock average 4 weeks, WIP (assume 50% completion stage in
respect of conversion costs and 100% completion in respect of materials), average 2 weeks. Credit
allowed by suppliers, average 4 weeks, credit allowed to debtors, average 8 weeks lag in payment of
wages, average 1.5 weeks, cash at bank is expected to Rs. 25,000. You may assume that production is
carried on evenly throughout the year (52 weeks) and wages and overheads accrue similarly, all sales
are on credit basis only.
7. From the following details you are required to make an assessment of the average amount of working
capital requirement of AB Ltd.,

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It is assume that all expenses and incomes were made at even rate for the year and minimum cash
balance of Rs. 1,00,000 to be maintained.

8. A company is currently operating at 60 % level, producing 36,000 units of a product and proposes to
increase in capacity utilization in the coming year by 33.33% over the existing level of production.
The following data has been supplied.
Overhead Costs Amount (Per Unit)
Raw Materials 80
Wages (variables) 40
Overheads (variables) 40
Fixed overheads 20
Profit 60
Selling price 240
Additional Information:
a. Raw materials will remain in stores for 1 month before being issued for production. Materials
will remain in process for further one month. Supplier grant 3 months credits to the company.
b. Finished goods remain in stores for 1 month.
c. Debtors are allowed credit for 2 month.
d. Average time lag in payment of wages and overheads is 1 month and these expenses accrue
evenly throughout the production cycle.
e. Selling price is estimated to be increased by 10%.

You are required to prepare:

1) Projected profitability statement.

2) A statement showing working capital requirements at the new level assuming minimum cash
balance of ₹ 50,000.

9. While preparing the project report on behalf of a client you have collected the following facts. With
the help of the same estimate working capital requirements:

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10. The management of Arun Ltd has called for a statement showing the working capital needed to
finance a level of activity of 3,00,000 units of output for the year. The cost structure for the
company's product, for the above mentioned activity level, is detailed below :

a) Past experience indicates that raw materials are held in stock, on an average for two months.
b) Work-in-progress (100% complete is regard to materials and 50% for labour and overheads) will
approximately be to half a month's production.
c) Finished goods remain in warehouse, on an average for a month.
d) Suppliers of materials extend a month's credit.
e) Two months credit is allowed to debtors, calculation of debtors may be made at selling price.
f) A minimum cash balance of Rs 25,000 is expected to be maintained.
g) The production pattern is assumed to be even during the year.

Prepare the statement for working capital requirements.

11.

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12. From the following data, compute the duration of operating cycle and cash cycle of X Ltd., by
assuming 360 days in a year.

13.

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14.

15. Miss spoorti paper mills provided the following details and requested you to calculate cash
conversion cycle.

16.

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17.

18.

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