FINANCIAL MANAGEMENT

MCO-07
SUGGESTIONS FOR TEE JUNE 2024
MCOM (IGNOU)
(NUMERICALS INCLUDED)

Santosh K. Sharma
(MCOM / BED / MBA)
WhatsApp: 9830034252
Email: sirsantoshsharma@[Link]
 Contents

Units Topics Page No.

1 Financial Management: An Overview 2

2 Time Value of Money 5
3 Valuation of Securities 6
4 Risk & Return 8
5 Cost of Capital 11
6 Capital Budgeting - I 12
7 Capital Budgeting – II 14
8 Sources of Long-Term Finance 16
9 Capital Market 18
10 Lease Financing 21
11 Project Financing 23
12 International Business Finance 25
13 Leverage: Operating, Financial and Total 29
14 Capital Structure Decision 31
15 Dividend Policy Decision 33
16 Working Capital 35
17 Cash Management 38
18 Inventory Management 39
19 Receivables Management 42
20 Numericals 45

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 Unit-1: Financial Management, An Overview
What is financial management? Discuss the nature of financial management.
Financial management simply means management of finance or funds. Finance is said to be the lifeblood of
business. Financial management is also called as managerial finance or corporate finance. Financial management
is the process of planning, organising, directing and controlling the financial activities of a firm. It answers the
following questions:
• How to procure funds?
• What are the sources of raising funds?
• Where to invest?
• How to manage and control funds?

Nature of Financial Management

The nature of financial management can be understood by the financial decisions taken by it. We can divide the
financial decisions into three categories such as:
1. Investment decisions
2. Financing decisions
3. Dividend decisions
1. Investment decisions: It relates to decisions regarding investments in different assets like securities, fixed
assets, instruments, bonds etc. Investment decisions generally involve the following decisions:
• Management of working capital.
• Buying of fixed assets.
• Capital budgeting decisions.
• Analysis of securities.
• Managing these investments and merger.
2. Financing decisions: It relates to raising finance through equity and debt capital. The important decisions
relating to financing are:
• Identifying the sources of finance.
• Cost of raising finance.
• Analysis of interest rates, taxes and depreciation.
• Requirement of funds.
• Amount of working and fixed capital required.
3. Dividend decisions: It relates to how much dividend should be paid to the shareholders out of the profits
earned. The important decisions relating to dividends are:
• How much dividend should be paid to the shareholders?
• How much funds are to be taken out of profits?
• Determining the market value of present equity shares.

Critically evaluate the goals of financial management.

1. Maximization of profit.
2. Maximization of return on capital.
3. Growth in the market value of shares.
4. Identification of the sources of finance at minimum cost.
5. Minimum cost of capital
1. Maximization of shareholders wealth: When the value of shares of a firm increase, it results in
maximization of shareholders wealth. The economic value of the shareholders wealth is the market price of

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 the shares which is the present value of all future dividends and benefits expected from the firm. Wealth and
profit maximization is also possible through proper financial management.
2. Maximization of return on capital: Every investor expects maximum return on his investment. The
shareholders of a company also expect good return on their investment. Therefore, the main object of financial
management is to maximise the return on capital employed by the investors. So that, they would invest more
with confidence in future.
3. Market value of shares: The growth of a company is reflected by the market value of its shares. If the market
value of the shares is increasing that means the company is making a steady growth. It increases the goodwill
and credit-worthiness of a company. Therefore, a firm aims at growing the market value of shares.
4. Optimum level of leverage: There are different types of leverages like financial leverages, operating leverage
and mixed leverages. In simple words, it is the earning per share. The amount of return on investment is
termed as leverage. Therefore, a company always tries to maximise the leverage.
5. Minimum cost of capital: A company can raise funds through debt capital or equity capital. A firm should
consider the cost of capital before raising funds through various sources. Cost of capital is the cost of raising
funds. A firm has to take decision on the sources of raising capital at the minimum cost.

What is the role of a Financial Manager in a modern organisation? Discuss the challenges faced by him in
India.
1. To estimate the funds required by the company.
2. To prepare appropriate capital structure of the company.
3. To take investment decisions.
4. To take financing decisions.
5. To take dividend decisions.
6. To look after the allocation of funds in the organization.
7. To evaluate ROI (Return on Capital)
8. To do financial negotiations with banks and financial institutions regarding raising funds.
9. To maintain good relationship with stock exchanges.
10. To increase profit of the firm and wealth of the shareholders.

Challenges for Financial Manager

Financial management is not easy task. There are many problems encountered by a financial manager while carrying
out his functions. Some of them are:
1. Shareholders value creation: Shareholders are more satisfied with increasing sales and profits. They want
growth of return on investment. Therefore, the financial manager has to concentrate not only on earning per
share but also on increasing market value of its shares.
2. Psychology of investors: It is a challenge for a financial manager to have a good understanding of the
psychology of the investors. These investors may be individual or institutional. For example, nowadays,
investors have shifted their focus more on mutual funds the rather than equity. So, he has to prepare the
different types of market securities which attract investor’s attention.
3. Increasing risk: The market has been increasingly risky nowadays with the onset of liberalisation,
privatisation and globalization. A financial manager should have sound interpersonal and communication
skills and overall organizational knowledge to deal with such risks.

A short note on Risk-Return Trade-off.

The risk return trade-off is the principle of investment. It states that higher the risk, higher will be the reward. Risk
is directly proportional to reward. By using this principle, an investor takes his financial decisions. It helps him to
compare the amount of risk associated with investments. It depends on factors like how much risk an investor can

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sustain and which stocks can be replaced? A proper balance between risk and return should be maintained to
maximise the market value of the investments.

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 Unit-2: Time value of money
Explain “Time value of money”
The time value of money is a basic financial concept that holds that money in the present is worth more than the
same sum of money to be received in the future. This is true because money that we have now can be invested to
earn a good return and thus creating a larger amount of money in the future. The time value of money is sometimes
referred to as the net present value (NPV) of money. Investors are willing to spend their money now only if they
expect a favourable return on their investment in the future. Time value of money problems involve the net value
of cash flows at different points in time.
For example, if we deposit ₹1000 in a bank at 10% interest rate per year. After one year, we will get ₹1,100. This
is equal to the principal amount of ₹1000 and interest of ₹100 which we have earned during the year. Hence ₹1,100
is the future value of ₹1000 invested for one year at 10%. It means that ₹1000 today is worth ₹1,100 in one year,
given that 10% is the interest rate.
The formula used to calculate the future value open single amount for a single period:
FV = PV (𝟏 + 𝐢)𝒏
Whereas,
FV = Future value
PV = Cash flow
I = Rate of interest
n = Number of years

Question: What will be the future value of Rs.1000, invested for 5 years @10%?
Here, PV = 1000, i = 10%, n= 5 years, FV =?
FV = 1000 X 1.611 {(1 + 10)5 = 1.611, see Annuity Table)
FV = 1611

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 Unit-3: Valuation of Securities
Write a short note on Basic Valuation Model of valuation of securities.
Any investor would take two steps before making an investment decision such as risk and return of the security. An
investor also considers factors like cost, benefit and uncertainty of securities before making an investment.
According to basic valuation model, an asset derives its value from the cash flow associated with it. The value of
an asset is equal to the present value of its expected cash flows. The formula used to calculate the value of an asset
in this model is:
𝑐𝑓1 𝑐𝑓2 𝑐𝑓3 𝑐𝑓𝑛
𝑉0 = 1 + 2 + 3 +⋯+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛
Whereas,
𝑉0 = Value at time 0
Cf = cash flow during a year
I =rate of interest
n= no of years

Explain the various approaches used to value Equity Shares?

Valuation of equity shares is rather difficult as the cash flows are not stable and measurable. The two important
methods to value equity shares are:
1. Dividend Capitalization Approach.
2. Earning Capitalization Approach

1. Dividend Capitalization Approach

This approach assumes that dividends do not grow in futures rather dividends grow at a constant rate or
multiple rates in future. This approach can again be subdivided into two parts such as single period and
multiple periods.
𝐷1 +𝑃1
Single period valuation assumes as one year and the formula is: 𝑃0 = 1+𝑟
P0 = = current price of shares,
D1 == Expected dividends
P1 == Expected price after one year
r= required rate of return

In multiple period valuation, it is assumed that equity shares have no maturity period. They are paid
dividend for an indefinite period of time. therefore, the formula is:
𝐷1 𝐷2 𝐷3 𝐷𝑛
𝑃0 = (1+𝑟)1 + (1+𝑟)2 + (1+𝑟)3 +……………..+ (1+𝑟)𝑛

2. Earning Capital Approach:

In this approach three factors are considered such as future earnings, growth rate and P/E ratio.
P/E is the ratio between price and earning per share. The greater the expected growth rates, higher will be the
P/E ratio. If normal price earnings ratio exceeds P/E ratio, then shares are under-priced and vice versa.
Average P/E ratio should be less than 20 which provides good investment opportunities. Lower the PE ratio
better will be the investment. The formula to calculate P/E ratio is:
P/E Ratio = Price per share / Earning per share

Write a short note on Valuation of Bonds

Bonds are the debts of a company. Its face value is also known as power value. It has a certain rate of interest called
coupon rate. Its maturity varies from 5 to 20 years. Realizable value or economic value of a bond is equal to the
present value of the expected cash flows. The formula to find the value of a bond is:
I TV
PV = (1+r)t + (1+r)n whereas,
PV= Present value at time 0.
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 I= Interest or Coupon rate
TV= Terminal value at maturity
R= Required rate of return
N= Number of years

• If rate of return = Coupon rate (Bond value = Par value)

• If rate of return > Coupon rate (Bond value < Par value)
• If rate of return < Coupon rate (Bond value > Par value)

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 Unit-4: Risk and Return
Explain the concept of Risk and Return. What are the various statistical techniques available to measure
risk?
Risk is the possibility of adverse happening. If a situation is deviated largely from the expectation, risk arises. There
are three states of possibilities such as certainty, uncertainty and risk. Certainty is a happening of an event with zero
deviation. Uncertainty is the happening of an event with large deviation. Risk lies between certainty and uncertainty.
There are some statistical tools to measure risks such as:
1. Standard deviation: The standard of deviation is a measure of the amount of variation or dispersion of a
set of values. A low S.D means the values are close to the mean whereas, a high S.D means the values are
spread out over a wide range. The S.D is approximately equal to the range of the data divide by 4. The
standard deviation is the most widely used and important measure of variation. S.D is also known as Root
Mean Square Deviation. The square of the standard deviation is called variance. The standard deviation and
variance become larger as the square of the data becomes greater. S.D is denoted by a Greek word and
symbol- SIGMA (σ).
2. Coefficient of variation: The coefficient of variation (CV) is the ratio of the standard deviation to the
mean. It is generally expressed as a percentage. The higher the CV, the greater is the level of dispersion
around the mean. It is useful for comparing the degree of variation from one data series to another. It shows
the extent of variability of data in relation to mean of a sample data. The formula to calculate coefficient of
variation is:
S.D σ
C.V = Mean x 100, or ̅ x 100
X
3. Skewness: Skewness, in statistics, is the degree of asymmetry observed in a probability distribution. The
measure of skewness tells us the direction of the distribution. Symmetry means the variables are equidistant
from the average on both sides. Skewness can be of three types such as, positive, negative and zero.
Negative skew refers to a longer or fatter tail on the left side of the distribution, while positive skew refers
to a longer or fatter tail on the right. Zero skewness (Bell curve) is a balanced distribution.
4. Probability distribution: A probability distribution is a mathematical function that describes the
probability of different possible values of a variable. These distributions are often depicted using graphs or
probability tables. In other words, it is a statistical function that describes all the possible values and
likelihoods that a random variable can take within a given range. This range will be bounded between the
minimum and maximum possible values, but precisely where the possible value is likely to be plotted on
the probability distribution depends on a number of factors. These factors include the distribution’s mean
(average), standard deviation, skewness, and kurtosis. A probability distribution can be of two types, such
as: i) Discrete Probability Distribution and ii) Continuous Probability Distribution.

Explain the various types of risks in financial management.

No risk, no gain. Risk may be of two types such as:
1. Systematic risk
2. Unsystematic risk

1) Systematic Risk
This type of risk is caused by external factors such as change in economic conditions, political uncertainty and
social conditions. It affects the whole economy and is also known as market risk. Systematic risks can be
classified into four categories such as:
a. Interest rate risk: In this type of risk, the government changes the rate of interests. These risks are not
under the control of a firm. These risks are applied to the whole economy.
b. Market risk: This type of risk is associated with stock market. It arises due to the change in attitude of
the investors. In other words, this risk arises due to change in demand and supply of securities,
international environment, domestic conditions, etc.

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 c. Exchange rate risk: This type of risk arises due to devaluation of domestic currency in the international
market. There are many reasons for devaluation like unfavourable balance of payment, depression of the
domestic economy, etc. Those firms which are engaged in foreign trade are prone to such risks.
d. Political risk: This type of risk arises due to instable government, riots, wars, frequent elections and
instable government. This type of risk is quite common in India and badly affect the working of business
enterprises.

2) Unsystematic Risk
This type of risk arises due to internal events in the organization. The firm has control over such risks.
Examples of unsystematic risks are equipment failure, power cut, labour problem, change in top management
etc. A systematic planning of procedures can reduce the effect of such risks.

Distinguish between systematic and unsystematic risks.

Systematic Risk Unsystematic Risk
These risks arise due to external factors. These risks rise due to internal factors.
External factors include change in economic Internal factors include labour problems, equipment
conditions, political conditions and social failure, over management etc.
conditions.
The main components of systematic risk are market These risks are also known as specific risk.
risk, interest rate risk and income risk.

Write a short note on Capital Asset Pricing Model (CAPM)

This model tells us the relationship between risk and return. According to this model greater the risk of a security,
greater will be the return. There is an implied equilibrium relationship between risk and return. More the
unavoidable risk more will be the return on investment. Returns is directly proportional to risk. The risk averse
investors will not hold risky assets, unless they are adequately compensated for the risks, they bear. This model can
be used for pricing of the securities. It also helps to assess whether a security is over-priced, under-priced or
correctly priced. This model has two basic components such as:
a. Risk-free Rate
b. Risk Premium
The formula to find the relation between risk and expected return is: 𝐄𝐑 𝐢 = 𝐑 𝐟 + 𝛃𝐢 [ 𝐄(𝐑 𝐦 ) − 𝐑𝐟 ]
Whereas, ER i = Expected rate of return on asset i
R f = Risk free rate
βi = beta co-efficient of stock i
E(R m ) = Expected return of the market

Assumptions of the CAPM model

1. Investors make their decisions only on the basis of expected return and risk associated with the security.
2. An investor cannot influence the price of the stock in the market.
3. Investors can lend or borrow funds add the riskless rate of interest.
4. There are no transaction costs involved in buying and selling of stocks.
5. There is no personal income tax.

Explain in brief the ideas of Arbitrage Pricing Theory

This model was developed by Stephen Ross. Arbitrage is a process of earning profit by taking advantage of
differential pricing for the same asset. This process generates riskless profit. According to this model, security
should be sold at a high price and simultaneously we should purchase the security at relatively lower prices. The
difference between the high price and low price gives us the maximum return on investment. According to this
model, profit can be earned through arbitrage or riskless process. According to this model, returns on the securities

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are influenced by a number of macro economic factors such as industrial growth rate, rate of inflation, interest rates
etc.

Assumptions
• The investors have homogeneous expectations.
• The investors are risk takers and want to maximise returns.
• There is perfect competition in the market.
• There is no transaction cost.

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 Unit-5: Cost of Capital

What is Cost of Capital? Discuss the various uses of cost of capital.

As we know, a firm needs capital to grow and expand its business. The cost of raising funds is known as cost of
capital. Cost of capital is the minimum rate of return the firm must earn from investment so that the market value
of equity shares does not fall. It is the weighted average cost of their different sources of financing. In simple words,
the minimum rate of return required from investment is known as cost of capital.
Cost of capital is defined as “the rate of return the firm requires from investment in order to increase the value of
the firm in the market place.”
Some of the characteristics of cost of capital are:
i) Cost of capital is a rate of return; it is not a cost as such.
ii) Return is calculated on the basis of actual cost of different components of capital.
iii) It refers to minimum rate of return on investment.
iv) It is related to long-term capital funds.
v) Cost of capital consists of three main components, such as:
a. Return at Zero Risk Level.
b. Premium for Business Risk
c. Premium for Financial Risk

Uses of Cost of Capital

1. It helps to evaluate new investment proposals.
2. It helps to determine the optimal capital structure.
3. It helps to formulate appropriate dividend policy.
4. It helps to frame appropriate working capital policy.
5. It helps to evaluate the financial decisions of the management.

Describe the different types of Cost of Capital.

1. Explicit cost of capital & Implicit cost of capital: Explicit cost of capital is the present value of the funds
received by the firm. In simple words, explicit cost refers to raising of funds. On the other hand, implicit cost
refers to the rate of return associated with the best investment opportunity for the firm. In simple words,
implicit cost refers to the usage of funds.

2. Specific cost of capital and combined cost: Specific cost of capital refers to the individual component of
capital whereas, combined cost of capital is the average cost of capital. Combined cost of capital is mostly
used by a company while taking decisions regarding accepting or rejecting a proposal.

3. Average cost and Marginal cost: The average cost is the weighted average of the cost of each component of
funds. On the other hand, marginal cost of capital is the weighted average cost of new funds raised by a firm.

4. Future cost and historical cost future cost is also known as expected cost of funds to finance a project. It
includes all the expected costs associated with the project. On the other hand, historical cost refers to the past
costs which were incurred while executing a project.

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 Unit-6: Capital Budgeting-I
What is Capital budgeting decision? What are the processes involved in capital budgeting decisions?
It is a process of making capital investment decisions. Capital investment expenditures include expenditures on
plant and machinery, equipment, land and building, and all other fixed assets. These expenses are generally of
higher amounts. The decisions taken on capital expenditures are not reversible. These decisions are generally long-
term decisions taken by the company. Capital budgeting decisions are taken after analysing the initial outflow of
funds compensated by future inflow of funds. This is a very complex and critical decision taken by the finance
manager because future is uncertain. It is very difficult to predict the cost and benefit associated with a given project.

Processes of Capital Budgeting

1. Generation of idea: The whole process of capital budgeting decision starts with an idea. The owner or the
top executive of a company identifies the business opportunity and then ask their subordinates to gather
information about the opportunity.
2. Estimating cash flows: The next step is to estimate the cash flows of the project. In this step the cost of the
whole project including different types of costs are calculated and estimated.
3. Evaluating cash flows: Then evaluation of cash flows is done carefully. It is done to find out the certainty
and future value of the project. This is one of the most complex functions of the finance manager.
4. Selecting a project: The next step is to select the appropriate project or the most suitable project among the
various alternatives. Pros and cons of the projects are properly analysed before taking the final decision.
5. Execution of the project: Finally, the execution of the project it has to be started by a team of engineers,
financial experts, marketing experts under the leadership of the owner or the executive. Proper monitoring of
the implementation process is very important to avoid time and cost vestige.

What are the different types of Projects Investment? Also explain the requirements of a good method of
capital budgeting decision making?
The different types of project investments are as follows:
1. New project: It refers to expenditure on creation of new assets. For example, setting up a new factory or
building. These projects are generally of big size and takes a long time for completion.
2. Expansion of existing project: In this type of project the existing project is expanded and developed. More
investment is done on the existing project rather than new project.
3. Renewal project: It refers to the renovation of the projects. Here expenditure is done to replace old
machineries and plants. New machinery is installed and new technology is adopted.
4. Research and development project: Research and development projects are those projects in which present
expenditure is being incurred to get a new product or design in future. this type of project takes a long time
for completion and there is a degree of uncertainty too.
5. Exploration Projects: Those projects in which new resources are explored are known as exploration projects.
Expenditure incurred on these projects are capital in nature which means the benefits will be available in
future. For example, oil exploration, mining, etc.

Requisites of a good Investment Appraisal.

• It should be based on cash flows rather than on profits or expenditure.
• Cash should be covered for the entire expected life of the asset rather than few years only.
• It should give the absolute value of gain or loss.
• It should consider time value of money.
• It should show relative profitability between different alternative projects to make a better comparison analysis.
• It should indicate the degree of risk associated with the investment.

Explain the various methods of Capital Budgeting Decision. Also write the merits and demerits of each
method.
The following are the different methods of capital budgeting

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 1. Payback Period
2. Accounting Rate of Return (ARR)
3. Discounted Payback

1) Payback Period
It is the time duration required to recover the initial cash outflows or expenditures. This is also known as pay
off or capital recovery period method. Payback. Is calculated by initial cash outflow / annual cash inflow. For
example, if a company spends ₹50,000 on any project and expects that within two years it will get back the
amount, then the payback. Is 2 years. Shorter the payback, higher will be the ranking of the investment
proposal.
Advantages
a. This method is easy to understand and use.
b. This is one of the most popular methods widely used for initial screening of the project.
c. The risk associated with the project can be easily calculated.
d. This method is quite suitable for small projects.
Limitations
a. It takes into account only early cash flows and ignores the future cash outflows.
b. This method ignores time value of money.
c. This method is considered only a measure of capital recovery and it is not a perfect measure for
profitability.

2) Accounting Rate of Return (ARR)

It is the average of the rate of return for different years for the whole life of an asset. It is a ratio between the
Net Profit After Tax (PAT) and initial investment.
Advantages of ARR
a. It is a simple method involving the calculation of averages.
b. It is easy to understand because easy accounting information like EBIT, PAT, depreciation, investment
etc. are considered.
Disadvantages of ARR
a. It is not properly defined because we do not know whether to use EBIT or PAT.
b. Accounting information itself are not very accurate and subject to many assumptions.
c. It ignores time value of money and hence not suitable for scientific decision making.

3) Discounted Payback
In this method, the discounted cash flows of different years are considered to calculate the payback period. In
other words, the number of periods taken to recover the investment is calculated on the basis of present value
of the cash outflows. Obviously, this method takes a longer time to calculate payback.
Advantages
a. This method is more accurate and reliable.
b. It considers the time value of money.
Limitations
a. This method is too lengthy and takes a lot of time to calculate payback period.
b. This method is not very popular because it is a very complex method and involves a lot of mathematical
calculations.

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 Unit-7: Capital Budgeting-II
Describe the various methods of investment appraisal stating the advantages and disadvantages of each
method.
There are basically three scientific methods of investment appraisal. These are:
1. Net present Value Method.
2. Profitability Index Method.
3. Internal Rate of Return Method.
1. Net Present Value Method (NPV)
NPV is the net present value of all cash flows that occur during the entire life span of a project. The total cash
flows occurred during the completion of a project is called Net Present Value. The outflows will have negative
values while the inflows will have positive values. If the cash inflow is greater than outflow, then NPV is
positive. If cash inflow is less than cash outflow, there is a negative NPV.
Advantages of NPV
a. It is quite scientific technique of capital budgeting.
b. It considers time value of money.
c. It is an absolute value.
d. NPV of two or more projects can be added up.
Limitations of NPV
a. Comparison of two or more different projects is a complex process.
b. NPV is not applicable in case of change in rate of interest.

2. Profitability Index Method

It is a ratio between present value of inflows and present value of outflows. If profitability index is greater
than 1, the project should be accepted. If the profitability index is less than 1, the project should be rejected.
This method is also known as benefit-cost ratio method.
Advantages
a. It is a more scientific method and reliable.
b. It considers the time value of money.
c. It gives a relative measure of a project’s profitability.

3. Internal Rate of Return Method (IRR)

IRR is the rate of discount at which NPV is zero. It shows the relationship between the rate of discount and
the NPV. There is always an inverse relationship between NPV and discount rate. If discount rate increases,
NPV decreases and vice versa. Therefore, IRR is the rate when NPV is zero. It is also known as marginal rate
of return. If IRR is greater than the discount rate or cost of capital, the project should be accepted. A project
with higher IRR should be ranked higher than other projects.
Advantages of IRR
a. It considers the entire cash flows of a project. Therefore, it is more reliable and accurate.
b. It takes into account time value of money.
c. It is useful in ranking of projects because it is a rate and not any absolute value.
d. It is not dependent of any external rate.
e. It is useful to assess the margin of safety in a project.
f. It is more scientific in terms of cost and return.

Distinguish between NPV and IRR

NPV IRR
NPV discounts the stream of expected cash flows IRR calculates the percentage rate of return at which
associated with a proposed project to their current cash flows will result in a net present value of zero.
IRR is defined as that discount rate that equates the

SANTOSH K. SHARMA 14
 value, which presents a cash surplus or loss for the PV of projects expected cash inflows with its initial
project. cost or the present value of the outflow.

Here cash inflows are conventional. Here cash inflows are unconventional.
The cost of capital is considered discount rate at the The discount rate is calculated by trial-and-error
NPV method. method.
It is easy than IRR. It is difficult than NPV.
It is the absolute value of a gain or loss. It is the rate of return from a given investment and
thus, more accurate for project appraisal.

A short note on Capital Rationing

• It is a process of imposing restrictions on the number of new investments or projects undertaken by a
company.
• The project is to ensure that capital has been used properly and there will not be any shortage of funds.
• It is a management function of allocating funds to various investment projects.
• It helps to achieve optimal use of available capital. It is a situation when there is some ceiling of funds.
• A firm has to choose the best project due to limited availability of funds.

SANTOSH K. SHARMA 15
 Unit-8: Sources of Long-Term Finance

What are the sources of Long-term Finance and to what uses can they be put?
Long-term finance can be defined as any financial instrument with maturity exceeding one year. For example, bank
loans, bonds, lease finance, etc. The different types of long-term finance are:
1. Retained earnings
2. Equity capital
3. Preference capital
4. Debentures and bonds
5. Term loans
6. Venture capital

i) Retained Earnings
These are the earnings of a company for the current accounting year after distribution of dividends. It also
includes accumulated profits of the past periods like reserve fund. Retained earnings are those earnings that
are kept as reserves in the form of various reserve accounts. They are shareholders’ funds and are used for
the purpose of capital or revenue expenditure of the company. They may be distributed as bonus shares to the
existing equity shareholders. Have retained earnings can be used for buying back shares, have reinvesting for
growth, paying off the debts, etc. It is one of the best sources of long-term finance for a company.

ii) Equity Capital

The stock or shares of a company issued to investors is called equity capital. It is of two types such as equity
shares and preference shares. Equity capital is divided into a number of equal parts known as shares having
a specified nominal value. Dividends on equity shares is paid after paying dividends to the preference
shareholders. Whenever a company needs finance, it can issue equity capital to raise money. It is one of the
major sources of long-term finance. It has no maturity and as long as the company exists its equity capital
also exists.

iii) Preference Capital

Preference shares have preferential rights to receive dividends at fixed rate and repayment of capital at the
time of winding up of a company. They carry a fixed rate of dividend. Preference shares may be of different
types such as cumulative and non-cumulative preference shares, redeemable and irredeemable preference
shares, convertible and non-convertible preference shares. Preference shareholders are less risky. They don’t
have voting rights in the management of a company.

iv) Debentures or Bonds

Debenture is a document acknowledging a loan made by a company. A fixed rate of interest is paid on
debentures. Debentures are also transferable like equity shares. These are also of different types such as
transferable and non-transferable debentures, redeemable and irredeemable debentures. It is also one of the
major sources of raising funds buyer company.

v) Term Loans
These are loans taken from banks and financial institutions to purchase fixed assets. The period of loan may
vary from 3 years to 10 years. The borrower has to pay a fixed amount at regular intervals of time. Term loans
carry a fixed or floating interest rate. These loans are generally taken by small business organisations. The
borrower may need to pay down payment or keep mortgage to avail such loans. These are the primary sources
of income for banks and financial institutions. Term loans may be of 3 types such as short-term loans, medium
term loans and long-term loans. Short term loans are generally for less than one year. Medium term loans are
generally between 1 to 3 years. Long term loans are taken up to 30 years.

SANTOSH K. SHARMA 16
vi) Venture Capital
It is an equity capital seeking investment in new companies, new ideas, new production, new processes or
new services that offer the potential of high returns on investment. Venture capital is used to finance high risk
ventures. The ventures are generally new and sunshine industries but may also be old and risky ones. These
enterprises have a high mortality rate and therefore do not find finance from banks or private sector
companies. It does not look into current income but returns off future expectations. Venture capitalists finance
new, young and rapidly growing or changing companies. They help to invent or produce new products and
services. They take high risks with the expectation of higher rewards. They have a long-term investment plan.
Venture capitalist also work actively with the management of the company and frames strategy.

SANTOSH K. SHARMA 17
 Unit-9: Capital Market

What purpose do Capital Market serve?

Capital markets are a part of financial markets where financial assets are purchased or sold. The main participants
in these markets are households, business firms, governments etc. In other words, it is a marketplace for investments
that have a lock-in period greater than a year, or their maturity period is at least more than one year. The capital
market involves the sale and purchase of both equity and debt instruments, including equity shares, debentures,
preference shares, secured premium notes, and zero-coupon bonds. Capital market maybe of 2 types such as primary
capital market and secondary capital market.

Purposes of Capital Markets

1) Mobilize savings: Financial market helps to utilize the savings of the people. The investors can invest their
hard-earned savings to earn healthy returns. Their investment is put in the productive work which may yield
heavy profits.
2) Price fixing: Financial market helps to determine the prices of financial securities. In other words, the
exchange rates of shares and debentures are automatically fixed due to interaction of suppliers of funds and
demand of funds.
3) Liquidity of financial assets: Financial market acts as a place for buying and selling of securities. Thus,
financial assets can be converted into cash as and when required.
4) Economical: It helps to save time, effort and money of both buyers and sellers of assets. It provides a platform
where they can interact with each other to do a transaction.

Differences between Capital Market and Money Market

Capital Market Money Market
The main participants are companies, banks and The main participants are RBI, commercial banks and
public. no public.
The main instruments traded are shares, debentures The main instruments trade is Treasury Bills,
and bonds. Commercial Paper, Certificate of Deposits, etc.
Investments can be made in small amounts. Investment is made in huge amounts.
It deals in long term securities. It deals in short term securities.
This market is risky for the investors. This market is safe for the investors as the duration is
short.
Return on investment is generally very high. Return on investment is low.

Differences between Primary Markets and Secondary Markets

Primary Market Secondary Market
It is a place where new securities of the companies It is a place where existing securities of the companies
are bought & sold. are bought and sold.
Securities are traded between companies and Securities are exchanged between investors only.
investors directly.
Prices are determined by the management of the Prices are determined by the action of demand &
companies. supply of securities in the market.
Here securities are only bought. Securities are bought & sold.
These markets do not have fixed geographical These markets have fixed geographical locations.
location.

Explain the different ways of issuing IPO by a company.

A company can raise cash by placing their securities for sale in a number of ways such as:
1. Direct sale
2. Sale through firms

SANTOSH K. SHARMA 18
 3. Secondary Stock issue
4. Securities Auction
5. Transfer of shares
a) Direct Sale: Companies can directly sell their securities to the existing shareholders or to the new shareholders.
It is done when company offers IPO (Initial Public Offering) for the first time. The firms must provide detailed
information about its financial condition to the shareholders because the company is new to the shareholders.
b) Sale through firms: Normally, a company planning to issue an IPO will hire a professional firm to sell their
stocks. These hiring firms are called underwriters who help the company to issue new shares by extending
their certification which is more acceptable to the public. Since they go to the market frequently, they need to
protect their reputations. They may also buy the shares at discounted issue prices and takes the risk of selling
them later to the investors at a higher price. The underwriter undertakes an analysis of the company and then
estimates the price range for the stock.
c) Secondary Stock Issue: In this case, a company hires is security firm to sell its shares. Because the company
already has shares in the market. It can monitor the market price to anticipate the price at which it should sell
new shares. Companies are more willing to issue new stock when the market price of their outstanding shares
is relatively high.
d) Securities Auction: In auctions of securities, the participants are often required to submit sealed bids. The two
most common auction mechanisms are, i) discriminatory auction and ii) uniform price auction. In uniform
price auctions the winning bidders pay the same price equal to the lowest winning bid. In the discriminatory
auction the winning bidders pay the prices the bid.
e) Transfer of Shares: As we know, the ownership of shares is transferable from one person to another. Thus, a
company can transfer its new shares to the existing shareholders, if they agree. It is done through the stock
broker and transfer agent who brings the buyer and seller together.

Why is a Stock Exchange an important institution of the capital markets?

Stock Exchange is a place or institution where securities are bought and sold. It controls, regulates and helps in
trading of securities.
Functions or role of a Stock Exchange
1) Provides liquidity
Liquidity here means buying and selling of securities. A stock exchange helps to buy and sell securities. This
is the place where people can invest their savings in buying share and debentures of the companies. There are
authorised brokers who guide the investors in buying or selling securities.
2) Pricing of securities
The prices of shares are determined by the action of demand and supply forces in a stock exchange. It is the
place where people can get immediate information about the prices of securities. Prices of securities fluctuate
every hour on a stock exchange.
3) Safety
Stock exchanges are regulated and controlled by SEBI, which is a government department. So, there is very
less possibility of fraud and cheating in a stock exchange. Public money is safe and all the transactions are
genuine.
4) Economic growth
A stock exchange helps to mobilize the savings of the people into the most productive uses. This helps to
multiply the savings of the people. They can earn more and have high purchasing power. All these things lead
to overall economic growth of the economy.
5) Speculation
A stock exchange encourages healthy speculation within the controlled limits. All the speculative activities
are done within the provisions of law.

What means are employed to regulate Stock Exchanges in India?

SANTOSH K. SHARMA 19
Indian Capital Markets are regulated and monitored by the Ministry of Finance. The Ministry of Finance regulates
through the Department of Economic Affairs - Capital Markets Division. The division is responsible for formulating
the policies related to the orderly growth and development of the securities markets as well as protecting the interest
of the investors. The main institutions that regulate stock exchanges in India are:
A. SEBI (The Securities and Exchange Board of India)
B. The RBI (The Reserve Bank of India).
C. NSE (National Stock Exchange)

A. Securities & Exchange Board of India (SEBI): The Securities and Exchange Board of India (SEBI) is the
regulatory authority established under the SEBI Act, 1992 and is the principal regulator for Stock Exchanges
in India. SEBI’s primary functions include protecting investor interests, promoting and regulating the Indian
securities markets. All financial intermediaries permitted by their respective regulators to participate in the
Indian securities markets are governed by SEBI regulations, whether domestic or foreign. The important
functions of SEBI are:
1. The SEBI has been empowered to conduct inspection of stock exchanges. The SEBI has been inspecting
the stock exchanges once every year since 1995-96.
2. During these inspections, a review of the market operations, organisational structure and administrative
control of the exchange is made.
3. It ensures that the exchange provides a fair, equitable and growing market to investors.
4. It should also ensure that the exchange’s organisation, systems and practices are in accordance with the
Securities Contract Act.
5. The SEBI should see that the exchange has implemented the directions, guidelines and instructions
issued by it from time to time.
6. The exchange has complied with the conditions, if any, imposed on it at the time of renewal/ grant of its
recognition.

B. Reserve Bank of India (RBI): The Reserve Bank of India (RBI) is governed by the Reserve Bank of India
Act, 1934. The RBI is responsible for implementing monetary and credit policies, issuing currency notes, being
banker to the government, regulator of the banking system, manager of foreign exchange, and regulator of
payment & settlement systems while continuously working towards the development of Indian financial
markets. The RBI also regulates financial markets and systems through different legislations. It regulates the
foreign exchange markets through the Foreign Exchange Management Act, 1999.

C. National Stock Exchange (NSE): In the role of a securities market participant, NSE is required to set out and
implement rules and regulations to govern the securities market. These rules and regulations extend to member
registration, securities listing, transaction monitoring, compliance by members to SEBI / RBI regulations,
investor protection etc. NSE has a set of Rules and Regulations specifically applicable to each of its trading
segments. NSE as an entity regulated by SEBI undergoes regular inspections by them to ensure compliance.

SANTOSH K. SHARMA 20
 Unit-10: Lease Financing
What is Lease financing? Explain the advantages and disadvantages of lease financing.
A lease is a contract whereby the owner of the asset grants to another party the exclusive right to use the asset,
usually for an agreed period of time, in return for the payment of rent. The lease contract may vary from few hours
to the entire life of an asset. The lessee pays fixed rent in instalments over period of time. In the lease agreement,
options may be given to lessee to renew the lease for another lease period or to purchase the asset after the
termination of the agreement. The owner of the asset is called lessor and the user is known as lessee.

Benefits of Lease Financing.

1. Risk of ownership of asset is avoided: When a firm purchases machinery, it has to bear the risk that the
machinery may become obsolete before the completion of its service life. However, this risk can be avoided
by taking the machinery on lease.
2. Convenience of payment: Leasing enables the lessee firm to make full use of the asset without making
immediate payments of the purchase price which it would otherwise have been required to pay.
3. Tax advantage: Leasing can provide the tax advantages to the lessee. When a company acquires an asset on
lease, the full amount of the lease payments is deductible for tax purposes.

Disadvantages of lease financing

1. Expensive: Leasing may prove to be costlier than a straight purchase particularly in the case of leveraged
leasing where the lessor is only the financial intermediary who has obtained finance from banks and has added
to the cost his own profit.
2. Strict actions against defaulters. If the lessee fails to pay the lease rent regularly strict actions are taken
against him. The asset may be taken back from him. He is always in a pressure situation to pay the rent on
regular intervals of time.
3. Lessor loses the economic value: The asset may be useless and obsolete at the end of lease term. The lessee
may not maintain the asset properly and thereby the value of the asset decreases rapidly.
4. Risk of obsolescence: After the expiry of the lease agreement, the equipment may be obsolete and not usable
anymore. therefore, the asset loses its economic value add utility. Because technology is rapidly changing and
the asset may prove to be a useful.
5. Competition: With rising competition, the major players are diverting their activities to other activities. It has
been reported that the rate of interest is 13% to 14% only which is below the average cost of capital.
6. Lack of qualified personnel: In India, the concept of leasing business is a recent one and naturally it is very
difficult to get the right person to deal with the problems of this new business. The leasing companies have to
develop expertise in handling new types of business.

Difference between Leasing and Hire Purchase

Leasing Hire Purchase
The user of the asset or lessee is not the owner of The hirer is deemed to be the owner of the asset.
the asset.
A lessee cannot claim depreciation on asset. Depreciation can be claimed by the hirer.
Lessee cannot charge depreciation to profit and A hirer may charge depreciation to profit and loss
loss account. account.
The rent paid by lessee is a tax-deductible expense.
In hire purchase, the interest paid on loan is considered
as a revenue expenditure and hence tax deductible.
The asset is not shown in the balance sheet of the The asset is shown in the balance sheet of the hirer.
lessee.
It is done usually for industrial equipment. It is generally done for vehicles.

Explain the different types or forms of Lease Finance

Generally, leases are classified into:

SANTOSH K. SHARMA 21
 1. Financial lease
2. Operating lease
3. Direct leasing
4. Sale and leaseback
5. Leveraged leasing

1. Financial lease
In this type of lease, the lease period is generally equal to the expected economic life of the assets. The lease
agreement cannot be cancelled. The lessee has to pay fixed rents until the lease period expires. The lessee has
the exclusive right to use the asset for a period of time. The lessee may purchase the equipment after the
expiry of the agreement. This type of lease is more popular in costly equipment like locomotives, earthmoving
equipment, office equipment, plant and machinery, textile machinery, etc.
2. Operating lease
In this type of lease, the lease period is less than the expected economic life of the assets. The lease contract
can be cancelled with proper prior notice. The lessor is expected to maintain the assets in good working
conditions. It is also known as short term or maintenance lease because the lease period is usually for a short
period which may stretch from one day to 5 years. The lease rent is generally higher. This type of leases is
more suitable for highly sensitive equipment like computers, automobiles, office equipment, etc.
3. Direct leasing
In this type of leasing, accompany acquires the right to use an asset which it did not own previously. The
manufacturers sell the asset to the lessor, who in turn, leases it to the lessee. The lessee firm may also lease
the asset from the manufacturer directly. The important lessor may be manufacturers, finance companies,
banks, etc.
4. Sale and leaseback
In this type of lease, a firm, that owns a given asset sells it to the leasing company and gets it back on lease.
Usually, the asset is sold at the market value. The lessee receives the sale price in cash and the economic use
of the asset. The lessee has to pay lease rent periodically. The lessee pays all the maintenance expenses,
property taxes, insurance, etc. The lessee may purchase the property after the termination of the agreement.
This type of leasing is more popular in retail stores, office buildings, multipurpose industrial buildings, etc.
5. Leveraged leasing
This type of leasing has been popular in recent years. There are 3 parties involved in leveraged leasing such
as the lessee, the lessor and the lender. The lessor acquires the asset and finances the asset in part by an equity
investment. The remaining part is financed by a long-term lender. The lessor is the borrower in this type of
lease. This loan is secured by a mortgage on the asset. This type of leasing is more popular in aircraft, railroad,
coal mining, electric power plants, pipeline, ships, etc.

SANTOSH K. SHARMA 22
 Unit-11: Project Financing
Give an overview of Project financing and distinguish it from corporate finance.
Project financing is the most popular form of financing large infrastructure projects. Project financing is financing
of a project as an independent economic unit. Cash flows from the project is used to recover the investments made
by the sponsors. It is a source of raising funds through loans for mega projects in power, telecommunication, roads,
railways, oil and gas etc. A special purpose vehicle (SPV) is created for the project. For example, the construction
of Konkan railways project, Konkan Railway Corporation limited was created as SPV. The funding of long-term
infrastructure, projects and public services is known as project financing arrangements. The loan is repaid from
cash flows after the completion of the project.

Distinguish between Corporate Finance and Project Finance.

Corporate finance Project Finance
The board of directors monitors and control the The special purpose vehicle is appointed to manage
overall performance of corporate finance. project finance.
The debt ratio is generally very low. The debt ratio is generally very high.
A company can raise finance quickly in case of In case of project financing, it is highly structural and
corporate finance. involve a lot of transaction costs.
The company is a going concern that means it has The SPV has a specific life and comes to an end once the
perpetual succession. concession period is over.
The board of directors take decisions regarding cash The SPV cannot take such decisions regarding distribution
flows to be paid as dividends and reinvestment. of profits and cash flows.
The lenders have interest in the balance sheet of a The lenders decide on the strength of the project assets and
company. future cash flows expected to be generated by the project.
All the projects undertaken buy a corporate are Each project has a separate legal entity and therefore have
reported together in the balance sheet. separate balance sheet.

Discuss the criteria for successful project financing.

The following factors should be considered for a successful project financing:
1. Environmentally friendly technology: The technology used for the project should be latest and
environmentally friendly which is the demand of the day. For this purpose, the opinions of consultants and
engineering firms should be taken.
2. The project should have economic value: The project should be completed within the stipulated date. It
should start generating cash immediately after the completion of the project. It is very important to recover the
investments which has been done on the project. This is possible only when the project has economic value.
3. Availability of factors of production: It should be ensured that raw materials and labour should be available
near the site of the project. This will help to save transportation and other costs. Factors of production include
raw-materials, labour, machinery, power, etc.
4. Professional management: The project must have competent management in order to ensure successful
execution of the project. It should be properly designed by engineers and the task of completion can be given
to Special Purpose Vehicle (SPV) who are specialised in the project.

Explain the various risks associated with Project Financing.

There are different types of risks associated with project financing. These are as follows:
1. Completion risk
2. Technological risk
3. Raw material risk
4. Maintenance risk
5. Economic value risk
6. Financial risk
7. Political risk

SANTOSH K. SHARMA 23
 8. Environmental risk

1) Completion Risk: It refers to the risk of completing the project within stipulated time. If the project does not
get completed in time, it will affect the lenders the most. Because they expect return on their investments as
quickly as possible. There are many factors which may cause delays in completing the project such as
availability of raw-materials, labour, environmental factors, etc.
2) Technological Risk: As we know, technology has been changing very fast. There is every chance of change
in technology during the completion of the project. The project may not meet the desired quality specifications
if it fails to use latest technology.
3) Raw-material Risks: The quality and quantity of resources availability is critical to the project success.
Availability of resources ensures smooth operation of the project and results in completion within the stipulated
time period.
4) Maintenance Risk: The ability of the management of the SPV who successfully operate and maintain the
plant after its implementation is important for the project to be successful. The economic value of the project
depends on the management and maintenance by the SPV.
5) Economic value Risk: The economic risks refer to the market demand for the project output and its market
price. The demand for the project may not be sufficient in order to recover the investments of the sponsors.
The prices may be very competitive making the project margins very low.
6) Financial Risk: Generally, there is a very high debt ratio in case of project finance. If the debt carries floating
rate of interest, there is a possibility of rising interest rates which may affect the profitability of the project.
7) Political Risk: There may be a change in the government policies towards the execution of the project. If there
are frequent elections in the country and has an environment of political instability, it will badly affect the
execution of the project. Because every government has its own ideologies.
8) Environmental Risk: When the environmental impact causes a delay in the completion of the project it creates
environmental risk. Therefore, a proper assessment of the environment must be made before the start of the
project.

SANTOSH K. SHARMA 24
 Unit-12: International Business Finance

What are the various functions of Foreign Exchange Markets (FOREX)?

Foreign exchange market is a market where foreign currencies are bought and sold. The traders include firms,
foreign exchange brokers, banks, financial institutions, etc. In other words, the foreign exchange market is a
financial institution that facilitates the exchange of one country’s currency for that of another. Foreign exchange
markets are the oldest and most traditional financial marketplaces. Banks, dealers, commercial companies,
investment management firms, and hedge funds make up the foreign exchange markets. The foreign exchange rate
is the price at which one currency may be exchanged for another currency. The forex market has no physical address.
It is an electronically linked network.

Function of Foreign Exchange Market

1. Transfer of money: The primary purpose of the foreign exchange market is to make it easier to convert one
currency into another or to make buying power transfers between nations. A number of credit instruments,
such as telegraphic transfers, bank draughts, and foreign bills, are used to transmit purchasing power. The
foreign exchange market performs the transfer function by making international payments by clearing debts
in both directions at the same time, similar to domestic clearings.
2. Provides credit: Another important role of the foreign exchange market is to facilitate international trade by
providing credit, both domestic and international. When foreign bills of exchange are used in overseas
payments, a credit of around three months is necessary before they mature. The FOREX provides importers
with short-term loans in order to promote the flow of goods and services between countries. The importer can
fund international imports with his own credit.
3. Hedging Function: Hedging foreign exchange risks is a third function of the foreign exchange market.
Hedging is the process of avoiding foreign currency risk. When the exchange rate, or the price of one currency
in terms of another currency changes in a free exchange market, the party involved may earn or lose money.
If there are large amounts of net claims or net liabilities that must be satisfied in foreign currency, a person
or a company takes on a significant exchange risk.

Explain the different types of Foreign Exchange Market in India?

The following are the various types of FOREX markets exist in India;
1. Spot Market: In this, transaction involving currency pairs happen quickly. In the spot market, transactions
require immediate payment at the current exchange rate, also known as the 'spot rate.' The traders on the
spot market are not exposed to the FOREX market's uncertainty, which increases or lowers the price between
trade and agreement.
2. Futures Market: Future market transactions, as the name implies, require future payment and distribution
at a previously negotiated exchange rate, also known as the future rate. These agreements and transactions
are formal, which ensures that the terms of the agreement or transaction are set in stone and cannot be
changed. Traders who conduct major FOREX transactions and pursue a consistent return on their assets
prefer future market transactions.
3. Forward Market: Forward market deals are identical to future market transactions. The main difference is
that in a forward market, the parties will negotiate the terms. The terms of the agreement can be negotiated
and adapted to the needs of the parties concerned. Flexibility is provided by the forward market.

Describe the various risks which an exporter faces while dealing in foreign currency or financial market
Foreign exchange risks refer to a situation where a trader is affected due to fluctuations of the exchange rates. These
risks can be divided into 3 categories:
1. Transaction Risks
2. Economic Risks
3. Translation Risks

1. Transaction Risks
SANTOSH K. SHARMA 25
 These types of risks arise when there is a change in exchange rate before the settlement of the transaction.
Transaction Risk is the exposure to uncertainty factors that may impact the expected return from a deal or
transaction. It can include but is not limited to foreign exchange risk, commodity, and time risk. It essentially
encompasses all negative events that can prevent a deal from happening. A deal with a high transaction risk
will typically require a higher return. Therefore, it is important to consider such risk when evaluating a
prospective investment. Some of the most common transaction risks that can affect the deal or transaction
value include the following:
a. Foreign Exchange Risk: Foreign exchange risk is the unforeseen fluctuation of foreign exchange,
which can affect the expected transaction value. This risk is especially important to consider for cross-
border transactions or deals with countries that have relatively high currency volatility. Foreign
Exchange Risk is also called economic exposure.
b. Commodity Risk: Similar to foreign exchange, commodity risk considers the unexpected fluctuation
of commodity prices. While commodity fluctuation affects all sectors, it is a primary consideration in
the Oil & Gas and Mining sectors.
c. Interest Rate Risk: It examines how interest rate fluctuation can affect transaction value. Depending
on the changes in rates, this risk can affect the ability of the purchasing party to raise the necessary
capital for the transaction and can impact the debt obligations of the selling party. For companies that
engage in debt covenant agreements with financial institutions, interest rate fluctuation can impact the
company’s ability to meet its obligations established in the covenant.
d. Time Risk: As market conditions and companies change with time, there is a higher probability that
the initial transaction agreement conditions will become unfavourable the longer the negotiation
process is extended. As a result, deals can fall through due to the favourable conditions no longer being
present for both parties. The longer a deal takes to finalize, the longer the transaction is exposed to the
other risks.
e. Counterparty Risk: When engaging in transactions, there is a risk that the counterparty will not
complete their contractual obligations agreed upon in the transaction. In instances where counterparties
default on their contractual obligations, it is often due to the effects of the previously stated transaction
risks.

2. Economic Risk
These types of risks arise when there is a change in market value of product due to change in its demand and
supply. These risks can be of three types:
i) Sovereign Risk: This type of economic risk is one of the most critical risks that can have a direct impact
on the investment. Sovereign Risk arises when a government cannot repay its debt and default on its
payments. When a government becomes bankrupt, it directly impacts the businesses in the country.
Sovereign Risk is not limited to a government defaulting but also includes the political unrest and change
in the policies made by the government.
ii) Unexpected swing in exchange rate: This can be due to speculation or the news that can cause a fall
in demand for a particular product or currency. Oil prices can significantly impact the market movement
of other traded products. Change in inflation, interest rates, import-export duties, and taxes also impact
the exchange rate. Since this directly impacts trade, exchange rates risk seeming to be a significant
economic risk.
iii) Credit risk: This type of sovereign risk is the risk that the counterparty will default in making the
obligation it owes. Credit risk is entirely out of control since it depends on another entity’s worthiness
to pay its debts. The counterparty’s business activities need to be monitored on a timely basis so that the
business transactions are closed at the right time without the risk of counterparty default to make it
payments.

3. Translation Risks
These risks occur when a company does business outside the country but its financial performance is
measured in domestic currency. Translation risk arises when foreign financial statements of a company is
SANTOSH K. SHARMA 26
 converted into domestic currency. This risk may adversely affect firm’s reported financial statements, or
related financial ratios or borrowing covenant compliance, resulting from changes in the rates at which foreign
currency denominated assets and liabilities are translated into the reporting currency. Translation risk
commonly applies to the translation of monetary assets and liabilities. This risk may also apply to the
consolidation of overseas subsidiaries into group financial statements.

What are the various types of International Bonds traded in FOREX markets.
International bonds are bonds issued by a country or company that is not domestic for the investor. The international
bond market is quickly expanding as companies continue to look for the cheapest way to borrow money. By issuing
debt on an international scale, a company can reach more investors. It also potentially helps decrease regulatory
constraints.

Types of International Bonds

There are three general categories for international bonds: domestic, euro, and foreign. The categories are based on
the country (domicile) of the issuer, the country of the investor, and the currencies used.
1. Domestic bonds: As the name implies, these bonds are traded in the domestic markets. These are issued,
underwritten and then traded with the currency and regulations of the borrower’s country.
2. Eurobonds: A Eurobond is a long-term bond. It is issued and sold outside the country where it has been
denominated. Although the implication from the name indicates that Europe is involved, any country can
create a Eurobond. If an organization is based in the United States, it can issue a bond that is denominated in
dollars, then sold to the investors in the United Kingdom, then it would be qualified as a Eurobond. The same
would be true if that company sold that bond to South-Korean investors. Multi-national companies often issue
Eurobonds as a way to finance their global operations. It is very common to issue a Eurobond from one
country where they have a presence, then sell it to another country where there are offices as well.
3. Foreign bonds: Issued in a domestic country by a foreign company, using the regulations and currency of
the domestic country. A foreign bond is a long-term bond that can be issued by governments or companies
which are outside of their home country. If a U.S. company were to issue a bond that was denominated in
Canadian dollars, then sold to investors in Canada, then a foreign bond would be issued. It is usually
denominated in the currency of where it is expected to be sold. Many companies issue foreign bonds in the
U.S. Dollar because they seek out investors from the United States to fuel their operations. Foreign bonds
may be subject to disclosure requirements, trading regulations, and securities regulations as they are traded
on national markets.

Explain the different instruments traded in International Financial Market.

1. Foreign Exchange: In international financial market, currencies of various countries are bought and sold
against each other. The foreign exchange market is an over-the-counter market. It is one of the largest
markets in the world.
2. Derivative Products: A derivative is a financial instrument whose value depends on other more basic,
underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold
or copper. Derivatives have become increasingly important in the field of finance.
3. International Currency Market: Since the 1960s various banks started forming international syndicates.
Multinational banks are responsible for huge international transfers of capital not only for investment
purposes but also for hedging and speculating against exchange rate changes.
4. Eurocurrency Market: This represents the money market in which Eurocurrency, that is currency held in
banks outside of the country where it is legal tender, is borrowed and lent by banks in Europe.
5. Money Market Instruments: The money market is the securities market dealing in short-term debt and
monetary instruments. Money market instruments are forms of debt that mature in less than one year and
are very liquid and relatively risk free. The important instruments traded here are:
i) Treasury bills make up the bulk of the money market instruments.

SANTOSH K. SHARMA 27
ii) Commercial Paper: This is an unsecured, short-term instrument issued by a corporation, typically
for financing accounts receivables and inventories. It is usually issued at a discount reflecting
prevailing market interest rates. Maturities on commercial paper are usually up to a maximum
maturity 270 days.
iii) Euro commercial Paper: This is an unsecured, short-term paper issued by a bank or corporation
in the international money market, denominated in a currency that differs from the corporation’s
domestic currency.
iv) Certificate of Deposit: This is a savings certificate entitling the bearer to receive interest. A
Certificate of Deposit bears a maturity date, a specified interest rate and can be issued in any
denomination. CDs are generally issued by commercial banks.
v) Banker’s Acceptance: This is a short-term credit investment created by a non-financial firm and
guaranteed by a bank. Such acceptances are traded at a discount from face value on the secondary
market.
vi) Bond and Note Issues A note is a debt security, usually maturing in one to 10 years. In comparison,
bills mature in less than one year and bonds typically mature in more than 10 years. Often the terms
‘notes’ and ‘bonds’ are used interchangeably.

SANTOSH K. SHARMA 28
 Unit-13: Leverage- Operating, Financial and Total

What is Leverage? What are the different types of leverages explaining the uses of each.
The term ‘leverage’ is used to describe the ability of a firm to use fixed cost assets or funds to increase the return
to its equity shareholders. In other words, leverage is the employment of fixed assets or funds for which a firm has
to meet fixed costs or fixed rate of interest obligation—irrespective of the level of activities attained, or the level of
operating profit earned. Leverage occurs in varying degrees. The higher the degree of leverage, the higher is the
risk involved in meeting fixed payment obligations i.e., operating fixed costs and cost of debt capital. But, at the
same time, higher risk profile increases the possibility of higher rate of return to the shareholders.

Types of Leverage
Leverage are the three types:
1. Operating leverage
2. Financial leverage
3. Total or Combined leverage

1) Operating Leverage
Operating leverage may be defined as the “firm’s ability to use fixed operating cost to magnify effects of
changes in sales on its earnings before interest and taxes”. Operating leverage refers to the use of fixed
operating costs such as depreciation, insurance of assets, repairs and maintenance, property taxes etc. in the
operations of a firm. But it does not include interest on debt capital. Higher the proportion of fixed operating
cost as compared to variable cost, higher is the operating leverage, and vice versa. It is calculated by the
following formula:
Contribution
O.L = , whereas, Contribution = Sales Revenue – Variable Cost, EBIT = Earning before Interest
EBIT
& Tax

The importance of Operating Leverage:

i) It gives an idea about the impact of changes in sales on the operating income of the firm.
ii) High degree of operating leverage magnifies the effect on EBIT for a small change in the sales volume.
iii) High degree of operating leverage indicates increase in operating profit or EBIT.
iv) High operating leverage results from the existence of a higher amount of fixed costs in the total cost
structure of a firm which makes the margin of safety low.
v) High operating leverage indicates higher number of sales required to reach break-even point.
vi) Higher fixed operating cost in the total cost structure of a firm promotes higher operating leverage and its
operating risk.
vii) A lower operating leverage gives enough cushion to the firm by providing a high margin of safety against
variation in sales.
viii) Proper analysis of operating leverage of a firm is useful to the finance manager.

2) Financial Leverage
Financial leverage is a technique of using debt instead of equity to acquire assets and projects. It is also known
as trading on equity. Companies should maintain a proper balance between debt and equity. They must
generate a higher rate of return than the rate of interest to be paid on debts. Financial leverage is suitable for
companies which are in profits. There are many types of leverage ratios to determine the financial health of a
firm such as debt-capital ratio, debt-equity ratio etc. Financial leverage can be found out by using the following
formula:
EBIT
F.L = , whereas, EBT = Earning before Tax
EBT

SANTOSH K. SHARMA 29
 The importance of Financial Leverage
i) It helps the financial manager to design an optimum capital structure. The optimum capital structure
implies that combination of debt and equity at which overall cost of capital is minimum and value of
the firm is maximum.
ii) It increases earning per share (EPS) as well as financial risk.
iii) A high financial leverage indicates existence of high financial fixed costs and high financial risk.
iv) It helps to bring balance between financial risk and return in the capital structure.
v) It shows the excess of return on investment over the fixed cost.
vi) It is an important tool in the hands of the finance manager while determining the amount of debt in the
capital structure of the firm.

3) Total or Combined Leverage

Operating leverage shows the operating risk and is measured by the percentage change in EBIT due to
percentage change in sales. The financial leverage shows the financial risk and is measured by the percentage
change in EPS due to percentage change in EBIT. Both operating and financial leverages are closely concerned
with ascertaining the firm’s ability to cover fixed costs or fixed rate of interest obligation, if we combine them,
the result is total leverage and the risk associated with combined leverage is known as total risk. It measures
the effect of a percentage change in sales on percentage change in EPS. The combined leverage can be
measured with the help of the following formula:
Combined Leverage = Operating leverage x financial leverage

The importance of combined leverage is:

a) It indicates the effect change in sales on EPS.
b) It shows the combined effect of operating leverage and financial leverage.
c) A combination of high operating leverage and a high financial leverage is very risky situation because
the combined effect of the two leverages is a multiple of these two leverages.
d) A combination of high operating leverage and a low financial leverage indicates that the management
should be careful as the high risk involved in the former is balanced by the later.
e) A combination of low operating leverage and a high financial leverage gives a better situation for
maximising return and minimising risk factor, because keeping the operating leverage at low-rate full
advantage of debt financing can be taken to maximise return. In this situation the firm reaches its BEP
(Breakeven point) at a low level of sales with minimum business risk.
f) A combination of low operating leverage and low financial leverage indicates that the firm losses
profitable opportunities.

SANTOSH K. SHARMA 30
 Unit-14: Capital Structure Decision
What do you mean by Capital Structure? Explain the essentials of an appropriate capital structure.
The composition of capital with equity, preference, debenture, bonds, etc. is termed as capital structure. There are
two main sources of raising capital, such equity capital and debt capital. Equity is one the major sources of raising
capital because the cost of capital is less. On the other hand, debt capital is raised in the form of debentures and
loans. A business enterprise must maintain a proper balance between equity and debt capital.

Features of Appropriate Capital Structure

1. Flexibility
2. Profitability
3. Solvency
4. Control
1) Flexibility: The capital structure of the firm should be flexible and dynamic. That means it can be changed
according to time and situation. If new growth opportunity comes in future, the company should be capable of
getting easy finance for the same.
2) Profitability: The main object of the firm is to have the capital structure which ensures maximum returns to
the shareholders. Therefore, the amount of capital structure and its size should be properly designed.
3) Solvency: An appropriate capital structure should have the features of solvency. A firm should have proper
control over its capital structure. Its size should be big enough to create market value in the market so that a
company can easily raise money from the public.
4) Control: The choice of capital structure should consider that it should not result in dilution of control of the
existing management. Therefore, the firm should raise more debt capital for an appropriate capital structure.

Explain the important assumptions of Net Operating Income Theory of Capital structure.
Durand proposed the theory of the Net Income Approach. According to this theory, a firm can increase its value by
decreasing the overall cost of capital which is measured in terms of the (WACC) Weighted Average Cost of Capital.
This can be done by raising more of debt capital than equity capital. Because debt capital is a cheaper source of
capital. Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts, where the
weights are the amount of capital raised from each source.
According to Net Income Approach, a change in the financial leverage of a firm will lead to a corresponding change
in the Weighted Average Cost of Capital (WACC) and the company’s value. The Net Income Approach suggests
that with the increase in leverage (proportion of debt), the WACC decreases, and the firm’s value increases.

Assumptions of Net Operating Income Approach

The Net Income Approach makes certain assumptions which are as follows.
a. The increase in debt will not affect the confidence levels of the investors.
b. There are only two sources of finance; debt and equity. There are no other sources of finance like
Preference Share Capital and Retained Earnings.
c. All companies have a uniform dividend pay-out ratio; it is 1.
d. There is no flotation cost, no transaction cost, and corporate dividend tax.
e. The capital market is perfect; it means information about all companies is available to all investors,
and there are no chances of overpricing or under-pricing of security. Further.
f. All investors are rational and want to maximize their return by minimizing risk.
g. All sources of finance are for infinity. There are no redeemable sources of finance.

Write a short note on Net Income Approach of Capital Structure.

SANTOSH K. SHARMA 31
Net income approach was introduced by Durant. According to this theory, the market value of a company can be
increased by decreasing the cost of capital and increasing the debt capital. Cost of capital is measured by weighted
average cost of capital (WACC). Debt capital is a cheaper source of capital as compared to equity capital.

Assumptions of Net Income Approach

1. There are only two sources of capital such as debt capital and equity capital.
2. The market value of a firm is not affected by an increase or decrease of debt capital.
3. All companies have uniform dividend pay-out ratio of 1:1.
4. There are no transaction costs, taxes etc.
5. There is perfect competition in the market which means all the companies are known to investors.
6. Investors are rational that means they want maximum returns on their investments.

Explain the important assumptions of Modigliani and Miller Proposition or Approach (MM Proposition).
Franco Modigliani and Merton Miller received the Nobel Prize in 1950 for their important contributions to
understanding the relationship between a firm's capital structure, value, and cost of capital. The main idea of them
is that the capital structure of a company doesn’t affect its overall value. According to them, in the absence of taxes,
firm capital structure is irrelevant and with taxes, a firm's cost of capital can be lowered through issuing debt. There
are two parts of this theory. The first proposition is without taxes and suffered from a lot of limitations. But the
second proposition was with taxes, transaction costs and bankruptcy costs.
Assumptions of MM Proposition
a. There are no taxes.
b. There are no transaction costs.
c. Both individuals and corporations can borrow at the same rate.

1. MM Proposition I: According to this proposition, the company’s capital structure doesn’t impact its value.
Since the value of a company is calculated as the present value of future cash flows, the capital structure
cannot affect it. The value of levered firm is equal to value of unlevered firm plus present value of infinite
stream of tax advantage of interest on debt. It assumes that companies operating in perfectly efficient market
do not pay any taxes and transaction costs.

2. MM Proposition II: According to this proposition, the company’s cost of capital is directly proportional to
the company’s leverage level. It assumes that the company pay taxes and transaction costs. This proposition
is widely accepted and more practical than the first proposition. The cost of debt is generally less than the
cost of equity. If a company increases borrowing to get the cheaper rate, it will also increase the amount it
will have to pay on equit. So, in effect, you cannot lower your cost of capital by exchanging debt for equity.

SANTOSH K. SHARMA 32
 Unit-15: Dividend Policy Decision

Why do firms pay dividends?

Dividend is the return on investment made by shareholders. In simple words, it is the income of shareholders
received for taking risks. A company can only pay dividends when it makes sufficient profits during the year.
Moreover, it depends on the policy of the company whether to distribute a part of profit among the shareholders or
not. It may not issue dividends if it wants to reinvest the profits in a profitable venture. But there are many companies
that pay dividends due to the following reasons:
Advantages of paying dividends
1. Investors like dividends: Number of investors in India prefer dividends for behavioural reasons. The
payment of dividends resolves uncertainty about the firm’s performance in the minds of the investors. If the
firm is continuously paying growing dividend per share, it builds confidence amongst the investors.
2. Information signal: Dividend decision of the management conveys information to the market as to how the
company is likely to perform in the future competitive environment.
3. A tool for changing firms financing mix: The firm used dividend policy to change its debt to total capital
ratio. If the firm increases dividend payments, it will result in increase in debt ratio and increased use of
financial leverage. The management can use dividends as a vehicle to shift the value to shareholders from
lenders. the lenders generally put a condition at the time of granting loans that dividend payments cannot
exceed their particular level. if management wants to pay more dividends it has to first retire the debt and
then it can pay more dividends.
4. Reduces management discretion: The management of firm may pursue a goal of maximising sales and
investing in assets but this growth may not be profitable to the shareholders. This growth may have a required
rate of return greater than the rate of return it generates.
5. It builds confidence among shareholders that the firm has good financial position.
6. It increases the demands for their stocks.
7. It increases the market value of their shares.
8. The company has stable growth.
9. It increases the market worthiness and the company can get loans from the market easily.
10. Regular dividend acts as a source of income for few shareholders.

What are the factors that determine the Dividend Pay-out Ratio of a company?
1. Availability of growth opportunities
2. Liquidity position of the firm
3. Debt market conditions
4. Control considerations
5. Other considerations

1) Availability of growth opportunities: Generally, matured firms pay most of their earnings as dividends.
Their pay-out ratio is high. The dividend pay-out ratio of growing firm is low because the firm has
opportunities available.
2) Liquidity position of the firm: The payment of dividends involved cash outflows. Hence the liquidity
position of the firm has an impact on the firm’s dividend policy. The firm may be profitable but may not have
adequate cash available to pay dividends as the profits are reinvested or used for paying debts hence may
have low dividend pay-out ratio. This is possible in case of highly profitable but rapidly growing firms.
3) Debt market conditions: If the debt market is flushed with the funds and firm has financial flexibility, the
firm may like to distribute its earnings as dividends and raise resources in the debt market to encash the

SANTOSH K. SHARMA 33
 growth opportunity. On the other hand, if the firm has not so good credit ratings it will be compelled to use
internally generated funds for growth and we will have low dividend pay-out ratio.
4) Control considerations: If a firm pays dividends and raises fresh equity to invest in the growth opportunity,
it incurs transaction cost and results in dilution of control. The dilution of control means the managements
controlling stake is reduced by fresh equity and firm becomes vulnerable to takeover.
5) Other considerations: The other considerations for determining dividend pay-out ratio may be cost and
availability of alternative forms of financing, legal rules, inflation, access to capital market, tax policy and
desire of the shareholders.

Explain briefly the various types of Dividend Policies practised by companies.

Generally, a firm can have two types of dividend policy such as:
1. Stable Dividend Policy
2. Residual Dividend Policy

1) Stable Dividend Policy

In this type of dividend policy, the investors receive dividends consistently, although the amount of dividend
may vary from year to year. Basically, the companies decide to distribute a certain portion of the profit to the
shareholders every year in the form of dividends. These companies are mostly matured and don’t intend to
pursue any strong growth strategy. Further, the policy is best suited for investors for whom a steady source
of income today is more important than capital appreciation.
2) Residual Dividend Policy
According to residual dividend policy, the equity earnings of the firm are first applied to provide for its
investment needs. The surplus if any, left after the meeting of the investment needs is distributed as dividend
to the shareholders. In other words, dividends are only to be paid out of residual profit.
Residual dividend policy has approaches such as pure residual dividend policy approach, fixed dividend pay-
out approach and smooth residual dividend approach.
In this type of dividend distribution, the company pays dividend based on the amount of left-over earnings.
In residual dividend policy, a company pays dividends only after ensuring that all the planned investments
have been done. This policy reduces the need for raising external funds to a large extent.

What is the rationale behind Buy backing of Shares?

Buyback of shares refers to repurchase of shares by a company which it had issued earlier to the shareholders. It is
done by paying the shareholders back at market values either in the open market or directly.
Advantages of Buyback of Shares
1. It helps to reduce excess share capital not required by the company at present.
2. It helps to increase the reserves of a company.
3. It helps to protect against unfriendly takeovers from other companies.
4. It increases earning per share and P/E ratio.
5. It increases the market value of shares of the company.
6. If a company thinks that its share prices are low as expected it can go for buyback of shares.
7. It results in saving taxes.
8. It boosts the prices of shares.
9. A company can use excess amount of cash for its growth and expansion of business.

SANTOSH K. SHARMA 34
 Unit-16: Working Capital
What are the factors influencing that influence Working Capital requirement?
Working capital refers to the capital used to meet day to day operations of a company. Working capital is the
difference of current assets and current liabilities. The following are the important factors that influence working
capital needs;
1) Nature of business: A manufacturing company needs more working capital than a trading company. Because
it has to keep a stock of raw-materials, payment of wages to labourers, factory rent, warehousing charges, etc.
whereas, a trading company just needs to have a stock of inventory according to the orders.
2) Scale of the unit: If the size or scale of business is large, it requires large amount of fixed capital. Because its
large economies of scale and capable of producing goods at lower cost. So, large companies may not require
huge amount of working capital.
3) Method of production: A capital intensive organisation requires more working capital than labour intensive
organisation. A capital-intensive firm uses latest methods of production and technology for which it has to
incur a large amount of capital for procuring them. On the other hand, a labour-intensive firm uses more of
labour and less of machines, so they need less working capital comparatively.
4) Technology: If an organisation uses modern technology, it needs more working capital. Whereas if an
organisation uses old technology, it needs less capital. To operate new technology, it needs services of expert
persons, for which it needs have sufficient amount of working capital.
5) Growth prospects: Higher growth of an organisation generally requires higher investment in fixed assets. If
a firm wants to grow and expand its business, it needs more and more of capital.

Explain the different approaches of working capital policy. Or, explain the different formal and informal
credit arrangements?
There are two methods to finance working capital requirements such as:
A. Informal Credit
B. Formal Credit
A. Informal Credit: These sources of credit include:
1. Trade credit
2. Stretching accounts payable
3. Accrued expenses and deferred income
1) Trade credit: When firms purchase goods and services on credit terms, it is known as trade credit. It
is generally given on open account basis. The supplier evaluates the creditworthiness of the buyer
before giving trade credit. This method is more attractive and not very difficult and therefore firms
prefer this method of credit.
2) Stretching accounts payable: It is also a very attractive source of credit. The firm may have to pay
interest on the extra credit period.
3) Accrued expenses at deferred income: Expenses which are due but not paid are called accrued
expenses. Deferred income consists of payment received from customers for goods and services yet
to be delivered.

B. Formal Credit: These credit sources include:

1. Commercial paper
2. Bank credit
3. Line of credit
4. unsecured and secured borrowing
5. Inventory loans
1) Commercial paper: It is a short term unsecured promissory note issued by large corporations. The
maturity could range from days to months. Commercial paper is typically bought by large corporations
and banks with surplus funds to invest. This is not very reliable form of funding and may not be
available to corporations at all points of time because they are dependent on external market conditions.

SANTOSH K. SHARMA 35
 2) Bank credit arrangements: It is available in several different forms such as working capital term loan,
cash credit, overdraft, bill discounting, etc. each of these options have interest and maturity.
3) Line of credit: It is an agreement between the bank and the borrower wherein, the bank promises a
certain line of credit permitting the company to borrow up to that limit during a specified period. It is
available when the company needs it and it is quite flexible.
4) Unsecured and secured borrowing: These unsecured borrowings refer to the borrowings in which
there is no mortgage or security kept by a company. This source of credit has high rate of interest and
requires creditworthiness of the borrower. Whereas, secured borrowings can be undertaken by keeping
assets mortgage for security.
5) Inventory loans: These loans can be taken from financial institutions and banks on the basis of stocks
or inventory they have. These inventories act as collateral or mortgage for short term borrowings.

Define Money Market. Explain its characteristics.

Money Market is a financial market where short-term financial assets having liquidity of one year or less are traded
on stock exchanges. The securities or trading bills are highly liquid. Also, these facilitate the participant’s short-
term borrowing needs through trading bills. The participants in this financial market are usually banks, large
institutional investors, and individual investors.
Objectives of Money Market
1. Providing borrowers such as individual investors, government, etc. with short-term funds at a reasonable
price.
2. Lenders will also have the advantage of liquidity as the securities in the money market are short-term.
3. It also enables lenders to turn their idle funds into an effective investment. In this way, both the lender and
borrower are at a benefit.
4. RBI regulates the money market. Therefore, in turn, helps to regulate the level of liquidity in the economy.
5. Since most organizations are short on their working capital requirements. The money market helps such
organizations to have the necessary funds to meet their working capital requirements.
6. It is an important source of finance for the government sector for both national and international trade. And
hence, provides an opportunity for the banks to park their surplus funds.

Characteristics of Money Market

1. It is a financial market and has no fixed geographical location.
2. It is a market for short term financial needs, for example, working capital needs.
3. Its primary players are the Reserve Bank of India (RBI), commercial banks and financial institutions like
LIC, etc.,
4. The main money market instruments are Treasury bills, commercial papers, certificate of deposits, and call
money.
5. It is highly liquid as it has instruments that have a maturity below one year.
6. Most of the money market instruments provide fixed returns.

Explain the various types of Money Market Instruments traded in money market.
The important instruments traded in money market are:
1. Treasury Bills
2. Certificate of Deposits
3. Commercial Paper
4. Repo & Reverse Repo Transactions
5. Banker’s Acceptance

SANTOSH K. SHARMA 36
1) Treasury Bills (T-Bills): T-bills are issued by the Central Government. These are known to be one of the
safest money market instruments available. Treasury bills are zero risk instruments. Therefore, the returns one
gets on them are not attractive. Treasury bills come with different maturity periods like 3-month, 6-month and
1 year and are circulated by primary and secondary markets. Treasury bills are issued by the Central
government at a lesser price than their face value. Currently, there are 3 types of treasury bills issued by the
Government of India via auctions, which are 91-day, 182-day and 364-day treasury bills.
2) Certificate of Deposits (CDs)
A Certificate of Deposit or CD, functions as a deposit receipt for money which is deposited with a financial
organization or bank. However, a Certificate of Deposit is different from a Fixed Deposit Receipt in two
aspects. The first aspect of difference is that a CD is only issued for a larger sum of money. Secondly, a
Certificate of Deposit is freely negotiable. First announced in 1989 by RBI, Certificate of Deposits have
become a preferred investment choice for organizations in terms of short-term surplus investment as they carry
low risk while providing interest rates which are higher than those provided by Treasury bills and term
deposits. CDs are also issued at a discounted price and their tenor ranges between a span of 7 days up to 1
year. They can be issued to individuals (except minors), trusts, companies, corporations, associations, funds,
non-resident Indians, etc.
3) Commercial Papers (CPs)
Commercial Papers can be compared to an unsecured short-term promissory note which is issued by highly
rated companies with the purpose of raising capital to meet requirements directly from the market. CPs usually
feature a fixed maturity period which can range anywhere from 1 day up to 270 days. Highly popular in
countries like Japan, UK, USA, Australia and many others, Commercial Papers promise higher returns as
compared to treasury bills and are automatically not as secure in comparison. Commercial papers are actively
traded in secondary market.
4) Repo & Reverse Repo Transactions
Repurchase Agreements, also known as Reverse Repo or simply as Repo, loans of a short duration which are
agreed upon by buyers and sellers for the purpose of selling and repurchasing. These transactions can only be
carried out between RBI approved parties Repo / Reverse Repo transactions can be done only between the
parties approved by RBI. Transactions are only permitted between securities approved by the RBI like treasury
bills, central or state government securities, corporate bonds and PSU bonds.
5) Banker's Acceptance (BA)
Banker's Acceptance or BA is basically a document promising future payment which is guaranteed by a
commercial bank. Similar to a treasury bill, Banker's Acceptance is often used in money market funds and
specifies the details of the repayment like the amount to be repaid, date of repayment and the details of the
individual to which the repayment is due. Banker's Acceptance features maturity periods ranging between 30
days up to 180 days.

SANTOSH K. SHARMA 37
 Unit-17: Cash Management
Explain the motives of holding cash. Also explain the important functions of cash management.
Cash Management refers to the collection, handling, control and investment of the organizational cash and cash
equivalents, to ensure optimum utilization of the firm’s liquid resources. Money is the lifeline of the business, and
therefore it is essential to maintain a sound cash flow position in the organization.
Objectives of Cash Management
i) Fulfil Working Capital Requirement: The organization needs to maintain ample liquid cash to meet its
routine expenses which possible only through effective cash management.
ii) Planning Capital Expenditure: It helps in planning the capital expenditure and determining the ratio of debt
and equity to acquire finance for this purpose.
iii) Handling Unorganized Costs: There are times when the company encounters unexpected circumstances like
the breakdown of machinery. These are unforeseen expenses to cope up with; cash surplus is a lifesaver in
such conditions.
iv) Initiates Investment: The other aim of cash management is to invest the idle funds in the right opportunity
and the correct proportion.
v) Better Utilization of Funds: It ensures the optimum utilization of the available funds by creating a proper
balance between the cash in hand
vi) Avoiding Insolvency: If the business does not plan for efficient cash management, the situation of insolvency
may arise. It is either due to lack of liquid cash or not making a profit out of the money available.

Functions of Cash Management

Cash management is required by all kinds of organizations irrespective of their size, type and location. Following
are the multiple managerial functions related to cash management:
1. Investing Idle Cash: The company needs to look for various short-term investment alternatives to utilize
surplus funds.
2. Controlling Cash Flows: Restricting the cash outflow and accelerating the cash inflow is an essential
function of the business.
3. Planning of Cash: Cash management is all about planning and decision making in terms of maintaining
sufficient cash in hand and making wise investments.
4. Managing Cash Flows: Maintaining the proper flow of cash in the organization through cost-cutting and
profit generation from investments is necessary to attain a positive cash flow.
5. Optimizing Cash Level: The organization should continuously function to maintain the required level of
liquidity and cash for business operations.

Explain briefly the techniques of Cash Management.

The various techniques or tools used by the managers to practice cash flow management are as follows:
1. Accelerating Collection of Accounts Receivable: One of the best ways to improve cash inflow and
increase liquid cash by collecting the debts and dues from the debtors readily.
2. Stretching of Accounts Payable: In this technique, the company try to extend the payment of dues by
acquiring an extended credit period from the creditors.
3. Cost Cutting: The company must look for the ways of reducing its operating cost to main a good cash flow
in the business and improve profitability.
4. Regular Cash Flow Monitoring: In this method, a firm keeps an eye on the cash inflow and outflow,
prioritizing the expenses and reducing the debts to be recovered, makes the organization’s financial position
sound.
5. Wisely Using Banking Services: The services such as a business line of credit, cash deposits, lockbox
account and sweep account should be used efficiently and intelligently.
6. Upgrading with Technology: Digitalization makes it convenient for the company to use the cash flows
wisely.

SANTOSH K. SHARMA 38
 Unit-18: Inventory Management
What is Inventory Management? What is the purpose of holding inventories?
Inventory management is the process of ordering, storing and using inventory. The main object is to avoid
overstocking and understocking of inventory.
Objectives of Inventory Management
1. To ensure continuous supply of raw materials.
2. To avoid overstocking and understocking of inventory.
3. To maintain minimum working capital.
4. To reduce order costs, holding cost and transport cost.
5. It reduces wastages.
6. It helps to maintain systematic record of inventories.

Purpose of holding inventories

1. Meet variation in Production Demand: Production plan changes in response to the sales, estimates, orders
and stocking patterns. Accordingly, the demand for raw material supply for production varies with the
product plan in terms of specific SKU as well as batch quantities. Holding inventories at a nearby warehouse
helps issue the required quantity and item to production just in time.
2. Cater to Cyclical and Seasonal Demand: Market demand and supplies are seasonal depending upon
various factors like seasons; festivals etc and past sales data help companies to anticipate a huge surge of
demand in the market well in advance. Accordingly, they stock up raw materials and hold inventories to be
able to increase production and rush supplies to the market to meet the increased demand.
3. Economies of Scale in Procurement: Buying raw materials in larger lot and holding inventory is found to
be cheaper for the company than buying frequent small lots. In such cases one buys in bulk and holds
inventories at the plant warehouse.
4. Take advantage of Price Increase and Quantity Discounts: If there is a price increase expected few
months down the line due to changes in demand and supply in the national or international market, impact
of taxes and budgets etc, the companies tend to buy raw materials in advance and hold stocks as a hedge
against increased costs. Companies resort to buying in bulk and holding raw material inventories to take
advantage of the quantity discounts offered by the supplier. In such cases the savings on account of the
discount enjoyed would be substantially higher that of inventory carrying cost.
5. Reduce Transit Cost and Transit Times: In case of raw materials being imported from a foreign country
or from a faraway vendor within the country, one can save a lot in terms of transportation cost buy buying
in bulk and transporting as a container load or a full truck load. Part shipments can be costlier. In terms of
transit time too, transit time for full container shipment or a full truck load is direct and faster unlike part
shipment load where the freight forwarder waits for other loads to fill the container which can take several
weeks. There could be a lot of factors resulting in shipping delays and transportation too, which can hamper
the supply chain forcing companies to hold safety stock of raw material inventories.
6. Long Lead and High demand items need to be held in Inventory: Often raw material supplies from
vendors have long lead running into several months. Coupled with this if the particular item is in high
demand and short supply one can expect disruption of supplies. In such cases it is safer to hold inventories
and have control.

What are the different types of costs associated with inventory?

The different types of costs associated with inventory are: material cost, ordering cost, carrying cost and opportunity
costs. These costs are discussed below:
1. Material Cost: These are the costs of purchasing or procuring the goods for the purpose of production or
trading. These costs also include transportation and handling costs.
2. Ordering Cost: The ordering costs refer to the costs associated with the preparation of purchase order.
Manufacturing firms have to purchase raw materials for production. these costs include preparation of
purchase order, transportation of materials ordered, inspection and handling at the warehouse. These are
inversely related to the size of inventory. Lesser the size of the inventory lesser will be the ordering costs.
SANTOSH K. SHARMA 39
 3. Carrying Cost: These are the expenses related to storage of goods. these costs include insurance, rent,
depreciation of warehouse, salaries of store keeper and security personnel, spoilage, labour and accounting
costs. Carrying costs increase with the size of the inventory.
4. Opportunity cost: It is a part of carrying cost. Whenever a firm commits its resources to inventory it is using
funds that otherwise might be available for other purposes. The firm has lost the use of funds for other profit-
making purposes. This is known as opportunity cost.

Explain the different types of inventory management techniques employed by a firm.

The important techniques and methods of inventory management are:
1. Economic Order Quantity (EOQ)
2. Re-Order level (ROL)
3. ABC Analysis
4. Just-in-time Inventory Control (JIT)

1) Economic Order Quantity (EOQ): The economic order quantity is that quantity where the total cost of
inventory management is the minimum. The cost of inventory management includes the carrying cost and the
ordering cost. The order quantity should be such that the firm has economy of order cost and the number of orders
will be less during the year. Thus, the trade-off is between the ordering cost and the carrying cost. The firm generally
gets quantity discount if it places an order for large quantity. EOQ is calculated by the following formula
2 x Annual Material requirement quantity x Ordering Cost per order 0.5
EOQ = [ ]
Material Cost per unit x Carrying Cost %

Carrying cost = Average order quantity into cost per unit into carrying cost percent per annum = Q/2 × C × i%
Ordering cost = Number of orders placed during the year x Ordering cost per order = A/Q × O

Assumptions of EOQ Model

i) The ordering cost per order and carrying cost per unit per annum are fixed.
ii) The material cost per unit is constant.
iii) The material consumption level during the year is known in advance and is even throughout the year.
iv) No stock out occurs.

2) Re-Order level (ROL): The reorder level lies between the minimum stock level and the maximum stock level.
The reorder level is that stock level on reaching the same, the firm places and order for the economic order quantity.
It ensures that there is enough quantity available during the lead time to meet the normal production requirements
and minimum stock level. Lead time is the time taken to replenish the inventory levels. In other words, lead time
refers to the how long it will take the order to arrive. The firm places an order for fixed order quantity or economic
order quantity, once the reorder level is reached.
Reorder level = Minimum Stock Level + (Normal Lead Time × Normal Level of raw material consumption per unit
of time) or
Reorder level = Maximum Lead Time × Maximum Level of raw material consumption per unit of time

3) ABC Analysis of inventory control: ABC stands for “Always Best Control”. As the name implies, the
management should classify its inventories into three main categories such as, A, B and C.
Category-A: Low volume but high value
Category-B: Moderate volume and moderate value
Category-C: High volume but low value
The management should focus on low volume but high value items as far as application of inventory management
tools. The tools such as reorder level, economic order quantity and safety stock levels are applied to A-Category

SANTOSH K. SHARMA 40
items. The firm should order most of its requirement in respect of C-Category items to avail the benefit of quantity
discount.
Category-A Category-B Category-C
Stocks included in category A are These items are less important and These items are not risky
the most important and risky to risky.
handle.
Nearly about 70% of the value of These inventories cover only 20% of Value of inventory is about 10%
consumption is from category-A. the value of consumption.
Nearly 13% of the inventory is Nearly 30% of the inventory is Volume of inventory used is about
consumed from this category. consumed from this category. 57%
Strict control is required on these These items do not require strict They do not require much control.
stocks. control.
The items in category-A are These items are moderately This category contains items of
generally expensive. expensive. least value.

4. Just-In-Time technique of inventory control: According to this technique, goods are ordered only when they
are needed. The main object is to control stocks of goods. It helps to reduce inventory wastage. It helps the producer
to concentrate more on production rather than handling stocks. It helps producers to produce good quality of
products. Producers are burden free. It needs small investments. This model is suitable for computer appliances,
electronics producing companies. Producers must have good relationship with the suppliers so that purchasing can
be done in time. There is no risk of overproduction. A firm can concentrate more on consumers satisfaction.

Write a short note on Safety Stock Level.

Safety stock is the inventory held by the firm during all the times irrespective of the order size. The safety stock is
that stock level where the total cost of inventory management is the minimum. The firm carries safety stock levels
to meet the contingencies of lead time. It is a cushion to avoid stock out situation. It is also called as minimum stock
level. It includes the expected stock out cost besides carrying cost and ordering cost. The maintenance of safety
stock has the benefit of avoiding loss of profits by meeting delivery schedules.
The formula to calculate safety stock level is:
Safety Stock Level = Reorder level (Normal Lead Time × Normal level of material consumption per unit of time)

Write a short note on Maximum stock level

It is the maximum level of inventory maintained by the firm at any point of time. The firms with conservative
approach will maintain the maximum stock level. It is to be ensured that the firm has necessary storage facilities
and funds to maintain this level. The formula to calculate maximum stock level is:
Reorder level + reorder quantity – (Minimum consumption × Minimum Lead Time)

SANTOSH K. SHARMA 41
 Unit-19: Receivables Management
What is Credit Policy? Discuss its objectives and variables.
Credit policy refers to the decisions on the maximum amount of credit that will be allowed to customers. In simple
words, amount of risk a firm is willing to undertake in its sales activities is called its credit policy. A credit policy
may be of two types such as liberal credit policy and rigid credit policy.
In liberal credit policy, a firm allows credit facilities freely without much hesitation. On the other hand, in rigid
credit policy, limited amount of credit is allowed to customers.

Objectives of Credit Policy

1. To increase sales: The most important object of a credit policy is to increase the sales and profits of a
company. some customers are unable to pay immediate cash so they opt for credit.
2. To increase profits: Profits are directly linked to sales. More the sales more will be the profit. A firm can
earn high profits in credit sales.
3. To maintain liquidity: Here, liquidity means converting stocks into cash immediately. There is no chance
of deadstock. A firm can dispose of with old stocks by selling them on credit.
4. To meet competition: A sound credit policy can challenge the competitors of the firm. A firm should have
a lucrative credit policy to beat its competitors.

Variables of Credit Policy

The financial manager must consider the following variables before framing credit policy:
1. Credit Standard
2. Credit Period
3. Cash Discount
4. Collection efforts
i) Credit Standard
This is the most important base to decide credit policy. Credit policy should be designed according to the
standard of customers. It should be well balanced. The factors that affect credit standard are:
a. Creditworthiness of a customer.
b. Capacity to pay.
c. Character of the customer.
d. Capital invested by the customer.
e. Collateral or security offered by the customers.
ii) Credit Period
The time period allowed to customers to pay for their purchases is known as credit. It directly affects
investments. Longer the credit period, longer will be the investments. Long credit periods increase the chances
of bad debts. Some factors should be considered while framing a proper credit period:
1. Buyers stock turnover.
2. Nature of commodity.
3. Profit margin.
4. Availability of funds.
5. Competitors policies.
iii) Cash Discount
The creditor grants cash discount to a debtor if he makes payment in or before credit. It is not a compensation
but a premium on payment of debts. Cash discount is beneficial to both creditor and debtor. It increases the
turnover rate of working capital and the firm can do higher volume of business with less investment in
working capital. Cash discount prevents debtors from using trade credit as a source of working capital.

SANTOSH K. SHARMA 42
 iv) Collection efforts: The collection policy should be speedy while collecting dues. If the speed is slow,
additional finance will be needed to sustain the production and sales. The objective should be to collect dues
and not to offend the customer. The firm may take efforts like sending a reminder or personal request on
phone or personal visits to customer or through collection agencies. Some of the firms employ muscle men
to recover payments which is absolutely a wrong policy. Court cases of recovery should be avoided as far as
possible because of court delays and expenses in India.

A short note on Factoring

It is a financial transaction in which a firm sells its accounts receivables or invoices to a 3rd party or factor at a
discount. It is done to meet immediate cash requirements of a business enterprise. There are 3 parties involved in
factoring such as seller, factor and debtor. A factor gets the right to collect from the debtors. It is also known as
invoice discounting. Factoring is more popular method used by exporters in international trade. Factoring provides
quick and convenient funding to growing companies who need capital to expand their business.
The factor enters into an agreement with the company for factoring receivables and the terms under which it is
ready to advance funds. The firms send the customer purchase order to the factor to do a credit verification and
approval. The factor confirms the willingness to advance funds based on the credit risk evaluation. Based on the
confirmation, the customer is informed that the receivables have been sold and that the payment must be made
directly to the factor. Factoring allows the firm to create cash flow for the growth and expansion of business.

What is Securitization? State its merits and demerits.

It is a process of converting debts or illiquid assets into securities which are traded to raise money. Securitization is
a process by which the future cash inflows of an entity are converted and sold as debt instrument through certificates
carrying a fixed rate of return to the holders. The originator of a typical securitization transfers a portfolio of
potential assets to a special purpose vehicle (SPV) commonly a trust. The SPV is basically funded by investors. In
return for the transfer, the originator gets cash up front on the basis of the mutually agreed valuation of the
receivables. The transfer value of the receivables is done in such a manner so as to give the lenders a reasonable
rate of return.
It helps to raise funds easily for working capital and in liquidity of assets. It also assures good return to investors.
The cash inflow from financial assets such as mortgage loans, trade receivables, credit card receivables, etc. become
the security against which borrowings are raised. Since the lender is assured of regular cash inflows there is an
advanced element of credit. This process involves 3 parties such as originator, special purpose vehicle (SPV) and
investors.

Merits of Securitization
a. It helps to raise funds easily to meet the working capital requirements.
b. The assets can be liquidated into cash immediately
c. Investors can earn good amount of profit from securitization.
d. It increases the total financial resources available to the firm without disturbing the traditional lines of credit.

Demerits of Securitization
a. The true picture of the originators financial position is not clear merely from the balance sheet.
b. The best assets of the company may be transferred to the SPV and the company may be left with substandard
assets on its books.
c. A company may have taken huge liabilities but that may not be apparent from the balance sheet of the
company.
d. If the receivables become bad the SPV will have the right to recover the dues from the originator.

A short note on Special Purpose Vehicle (SPV)

An SPV is an entity specially created for doing the securitization deal. It invites investment from investors, uses the
invested funds to acquire the receivables of the originator and then uses the realizations to pay the investors thereby
giving them a reasonable rate of return. The SPV may be a trust, corporation or any other legal entity.
SANTOSH K. SHARMA 43
The Important functions of SPV are:
1. Holding title to transfer financial assets.
2. Issuing beneficial interest in the form of debt securities or equity securities.
3. Collecting cash proceeds from assets held and reinvesting proceeds.
4. Distributing proceeds to the holders of the beneficial interests.

SANTOSH K. SHARMA 44
 Few important Numericals

1. A company issued 10% debentures of Rs.10000. The company is in 50% tax bracket. Find the cost of
debt capital i) at par, ii) 10% discount and iii) 10% premium.
Solution:
I (1−T)
Cost of Debt Capital (Kd) = np , Kd = Cost of capital, I = Interest, np = Net proceeds, t = tax
I = 10% of 10,000 = 1,000, np = 10,000, Tax (T) = 50% = 0.5

1000 (1−0.5)
i) Kd (at par) = 𝑥 100% = 5%
10000

1000 (1−0.5)
ii) Kd (at discount) = 𝑥 100% = 5.56%
9000

1000 (1−0.5)
iii) Kd (at premium) = 𝑥 100% = 4.54%
11000

2. A company issued Rs.100 face value Preference shares with 12% dividend repayable after 10 years.
The net amount realised is Rs.92. Find the cost of preference capital.
Solution:
(F−P)
D+ n
Formula to find Cost of preference share: Kp = P+F
2
Kp = Cost of preference capital
D = Dividend = 12
P = Redemption price = 92
n = no. of years = 10
F = Face Value = 100
(𝟏𝟎𝟎−𝟗𝟐)
𝟏𝟐+ 12+0.8
𝟏𝟎
Kp = 𝟗𝟐+𝟏𝟎𝟎 = = 0.133 x 100% = 13.3%
96
𝟐

3. Sales=7,50,000, Variable cost= 4,20,000, Fixed cost= 60,000, Debt= 4,50,000, Interest on debt= 9%,
Equity capital= 5,50,000, Find:
i) Operating Leverage
ii) Financial Leverage
iii) Total Leverage
iv) Rate of Return on investment
Solution:
Contribution = Sales – V.C = 7,50,000 – 4,20,000 = 3,30,000

EBIT (Earnings before interest & tax) = Contribution – F.C = 3,30,000 – 60,000 = 2,70,000

EBT (Earning before tax) = EBIT – Interest = 2,70,000 – 9% of 4,50,000 = 2,29,500

Contribution 3,30,000
i) Operating Leverage = = 2,70,000 = 1.22
EBIT

EBIT 2,70,000
ii) Financial Leverage = == = 1.17
EBT 2,29,500

iii) Total Leverage = O.L X F.L = 1.22 X 1.17 = 1.43

SANTOSH K. SHARMA 45
 EBIT 2,70,000
iv) Rate of Return = Total share capital+Debt capital = 5,50,000+4,50,000 = 0.27 x 100% = 27%

4. Given that Discount rate is 10%, Present value of Rs.1 for 1 st & 2nd year is 0.893 & 0.797, Find the
NPV for each project. Which project is to be selected and why?
Cash flows Project-A Project-B Project-C
𝐂𝟎 -25,000 -25,000 -25,000
𝐂𝟏 0 15,400 28,700
𝐂𝟐 33,050 15,400 0

Solution:
NPV of Project-A = (-25,000) + (0 X 0.893) + (33,050 X 0.797) = Rs.1,340.85

NPV of Project-B = (-25,000) + (0.893 x 15,400) + (0.797 x 15,400) = Rs. 1,026

NPV of Project-C = (-25,000) + (0.893 x 28,750) + (0.797 x 0) = Rs. 673.75

NPV of project-A is more profitable as its NPV is highest.

5. A company needs Rs. 5,00,000 for a new plant. The company issues 50,000 equity shares @ Rs.10. If
the company’s earnings before interest and tax are Rs.10,000, Rs.20,000, Rs.40,000, Rs.60,000 and
Rs.1,00,000 for 5 years. What is the earning per share? (Assuming that corporate tax is 50%)

Items 1st year 2nd year 3rd year 4th year 5th year
EBIT 10,000 20,000 40,000 60,000 1,00,000
Tax (50%) (5,000) (10,000) (20,000) (30,000) (50,000)
Total earning 5,000 10,000 20,000 30,000 50,000
No. of shares 50,000 50,000 50,000 50,000 50,000
EPS 0.1 0.2 0.4 0.6 1.0

6. A firm issued 100, 10% debentures each of Rs.100 at 5% discount. The debentures are to be redeemed
at the end of 10th year. The tax rate is 50%. Calculate the cost of debt capital.
Solution:
Interest = 10% of (100 x 100) = Rs.1000
Discount = 5% of (100 x 100) = Rs.500
Maturity Period (mp) = 10 years
Nominal value (p) = Rs.10,000
Net proceeds (np) = Rs. (10,000 – 500) = Rs.9500
Discount
I+
mp
Kd = P+np x 100 (1 − Tax)
2
500
1000+ 10 50
Kd = = 10000+9500 x 100 (1 − 100) = 5.385%
2

7. A company is considering a proposal to spend Rs.1,00,000 on a new project. The cash inflows are
expected as follows, Year-1 Rs.20,000, Year-2 Rs.30,000, Year-3 Rs.30,000, Year-4 Rs.40,000 and
Year-5 Rs.40,000. Calculate the payback period.

Solution:

SANTOSH K. SHARMA 46
 Year Cash inflow Cumulative Cash inflow
1 20,000 20,000
2 30,000 50,000
3 30,000 80,000
4 40,000 1,20,000
5 40,000 1,60,000

The company has an investment proposal of Rs.1,00,000, which lies in the cumulative figure between 3 rd
and 4th year. The 3rd year needs 20,000 to be added whereas, 4th year adds 40,000 in 80,000 to make it equal
to Rs.1,00,000 which is the initial investment.
So, the payback period is:
20,000 1
3 + 40,000 = 32 years

SANTOSH K. SHARMA 47