FM – (Al Jamia Arts and Science College, Poopalam)

FINANCIAL MANAGEMENT proper administration of finance

In the modern world every organization, is necessary. This is facilitated only if there
private and public runs on money. Money is an efficient FM.
touches everything we do. Finance is the  Co-ordination of functional
life blood of every business. activities –
Meaning- simply financial management is FM controls and co-ordinate all other
the process of managing financial activities. functions in the enterprise like marketing,
financial management is the planning, production etc.
organizing, directing and controlling of  Decision making
financial activities in a business enterprise. various financial tools are available for
FM is concerned with the management of evaluating alternatives and for choosing the
finance for the smooth running and best alternatives.
successful achievement of the objectives.  Determination of business success
Definition – PG Hastings defines “ financial FM plays an important role in the success of
management is the art of raising and organization
spending money”  Solution to financial problems –
Archer and Ambrossio defines “ FM is the efficient FM helps the top management by
application of the planning and control providing solutions to the various financial
functions to the finance function” problems faced by it.
Features or nature Objectives or goals of FM
 Management of money –  Maintain liquidity of the firm
FM is essentially an art and science of liquidity is the ability of firm to convert the
management of money. resources into cash quickly. An important
 Financial planning and control objective of FM is to keep the liquidity of
FM is concerned with planning and control the firm to such that the firm shall be able
of finance. to easily meet its financial obligations
 Determination of business success without any delay and difficult.
–  Maximization of profit;
FM plays an important role in the success of maximization of profit is generally
organization regarded as main aim of business. The main
 Focus on decision making – objective of the FM is to safeguard the
it gives analysis of data which facilitate economic interest of the persons who are
decision making directly or indirectly connected with the
 Centralized in nature – company. All these must get maximum
in finance function decentralization is not profit for their contributions. This is
possible. possible only when the firm earns
 Continuous function – maximum profit. Thus, the claim of the FM
it is a continuous administrative function. is to earn maximum rate of profit on capital
Importance of FM employed.
 Base for expansion –  Maximization of wealth
sound financial plan is very necessary for the ultimate goal of the FM is maximization
the success of a business enterprise. In the of owners’ wealth or firms’ value.
absence of a sound FM, it is not possible to According to this view, the proper goal of
prepare a sound financial plan. FM is maximization of wealth of equity
 Smooth running of business – for shareholders. Wealth maximization here
the smooth running of the business, means maximization of market price per
share in the long run.
 FM – (Al Jamia Arts and Science College, Poopalam)
Responsibility of FM or financial  Modern approach –
manager the modern approach views the term FM in
 Financial planning – a broad sense. According to
the main responsibility of FM is to forecast modern approach , the finance function
the need and source of finance then to plan covers both acquisition of funds as
for them. well as their allocations. According
 Raising necessary fund modern approach, FM covers three
before deciding to raise funds from a broad areas, namely investment
particular source, a cost-benefit analysis of decision, financial decision and dividend
various alternatives sources must be made. decision.
 Controlling the use of fund –  Investment decision
optimum and proper use or utilization of the investment decision relates to the
fund selection of assets in which funds will be
 Appropriation of profit- invested by the firm. That means how much
Finance manager is to advice the top is to spend for acquiring long term or fixed
management as to how much is to be assets and how much is to be allocated for
retained in the business and how much is current assets. The financial decision
to be distributed among the shareholders. making with regard to long term asset is
 Responsibility to owners called capital budgeting and financial
maximization of profit and wealth decision making with reference to short
of shareholders by maximizing the term asset is called working capital
market price of shares in the long run. management.
 Responsibility to employees  Financial decision –
provide up to date and regular payment to this decision is concerned with financing
them. mix or capital structure or leverage. The
 Responsibility to customers finance decision of a firm relates to
provide good quality of products the choice of the proportion of
and honestly deals with customers different sources to finance the
regarding the payments. investment requirements. There must
 Responsibility to suppliers be proper balance between equity and
 Legal obligation – tax matters debt. This is necessary to have a trade off
Scope of FM between risk and return to shareholders.
The approach to the scope of FM is divided  Dividend decision –
into three broad categories. this decision is related with the
 Traditional approach – appropriation of profit. That means what
Earlier the term FM is known as proportion of profit is to be retained
corporation finance. In the initial stages of and how much is to be distributed
its evolution the scope of FM was treated in among the shareholders.
the narrow sense of procurement of funds Function of FM or finance
by companies to meets their financial manager Executive or managerial
needs. functions
 Transitional approach -  Financial forecasting and planning
in this approach, greater emphasis was it is necessary to forecast the both short
being placed on the day to day problems term and long term financial requirements.
faced by financial managers in the areas of The financial planning should be done in
funds analysis, planning and control. such a way as to ensure the availability of
adequate finance and avoid excess funds
 FM – (Al Jamia Arts and Science College, Poopalam)
 Procurement of funds – Routine functions
after making financial planning the next  Record keeping and reporting
step is to identify the funds. There are a  Preparation of financial statements
number of sources of funds such as shares,  Management of cash balances
debentures, loan etc. the finance manager  Cash planning and credit
has to select the best sources. management
 Investment decision  Safe keeping of valuable papers
the investment decision relates to the and documents
selection of assets in which funds will be Basic principles of FM
invested by the firm. That means how much  Risk and return –
is to spend for acquiring long term or fixed every financial decision has two aspects –
assets and how much is to be allocated for these are return and risk. every decision
current assets. involved a risk. Financial decisions are
 Management of income – taken to maximize returns through the
finance manager has to decide what calculations of risk and return.
proportion of profit is to be retained and  Time value of money –
how much is to be distributed among the every financial manager has to take in mind
shareholders. the time value money while taking financial
 Management of cash – decision.
cash must be managed for the benefit of  Cash flow concept –
owners. The finance manager should see FM focuses on inflows and outflows of cash.
that an adequate supply of cash is available It does not deal with non cash items like
at proper time for the smooth running of depreciation.
business.  Incremental cash flow analysis –
 Deciding upon borrowing policy – the investment decision are taken on the
it is the duty of finance manager is to basis of incremental cash flow analysis.
decide the limit or extend of funds This concept helps in judging whether the
borrowed from the outside new project is good for the firm or not.
parties through issuing  Wealth maximization –
debentures and taking loans. the ultimate goal or aim of FM is
 Analysis and interpretation to maximize the wealth of shareholders
of financial by maximizing the market value of shares.
performance – So every finance manager should take
the finance manager is required to analyze, all decision on the light of this concept.
check and evaluate the financial Capital budgeting
performance. For this various financial Capital budgeting or capital
statements are prepared, analyzed and investment decision means a
then necessary guidelines are set for future. decision about capital expenditure.
 Advising the top management Capital expenditure simply refers to
advice the top management on all financial investment in fixed assets and other
matters and to suggest various alternative development projects.
solutions for any financial difficulty. The term capital budgeting is a
 Co-ordination and control combination of two terms namely, capital
– finance co- ordination and control and budgeting. Capital refers to the amount
 Helping in valuation decision allocated for investment in fixed assets or
a finance manager is supposed to assist
management in making valuation.
 Tax administration – legal matters
 FM – (Al Jamia Arts and Science College, Poopalam)
projects. Budgeting is the process of  Most difficult decision-
planning projected inflows and outflows of these decisions involve forecasting of
cash during a specific future period. future conditions for estimating the future
Thus capital budgeting refers to the cash flows. And cost of different projects. So
decision to invest the current funds of a it involve greater difficult.
business concern most effectively in fixed  Cost control –
assets and projects in anticipation of an in capital budgeting there is a regular
expected flow of future benefits of over a comparison of budgeted and actual
series of years. expenditures. Therefore cost control
Features or nature is facilitated through capital budgeting.
 There is an investment of funds in  Wealth maximization –
long term activities the basic objective of FM is to maximize the
 It involves large outlays wealth of the shareholders. Capital
 Current funds are exchanged budgeting helps to achieve this basic
for future benefits objective.
 The future benefits are expected Steps in capital budgeting
over a number of years in future.  Project generation –
 High risk the capital budgeting process begins with
 It is irreversible generation or identification of investment
 Gestation period is long. proposals. This involves a continuous
Role and importance of search for investment opportunities which
capital budgeting are compatible with the firm’s objectives.
 Huge investment –  Project screening -
capital budgeting decision involve huge each proposal is then subject to a
investment in permanent asset. So it preliminary screening process in order to
requires careful planning and appraisal. assess whether it is technically feasible,
 Long term implications – resources are available and the expected
capital budgeting decisions have long term return are adequate to compensate for the
effects on the future profitability and cost risks involved.
structure of the firm.  Project evaluation –
 Irreversible decision – after screening the project ideas
capital budgeting decision once made or investment proposals the next step is
cannot be reversed easily.so careful to evaluate the profitability of each
dealings should be made. proposal.
 Risk –  Project selection –
capital budgeting involve greater risk and after evaluation the next step is the
uncertainty. The longer is the period of selection and approval of best proposal.
project, the greater may be the risk.  Project execution and
 Growth – implementation –
the capital budgeting decisions affect the after selection, funds are allocated for them
rate and direction of growth of a firm. and a capital budget is prepared.
 Impact on firms’ competitive  Performance review – follow up
strength – Factors affecting capital budgeting
the capital budgeting decisions affect the decision
capacity and strength of a firm to face  Availability of fund
competition.  Utilization of fund
 FM – (Al Jamia Arts and Science College, Poopalam)
 Urgency of the project outflows and benefits are denoted as cash
 Expectation of future earnings inflows.
 Intangible factors Types of cash flows
 Risk and uncertainty a) Initial cash flows(initial
 Minimum rate of return investment) –
on investment investment required for beginning a new
Approaches to capital project. Eg – cost of new assets, initial
budgeting decisions – working capital etc
 Disaster approach – b) Operating cash flows –
in many cases, the capital expenditure regular cash outflow and inflows ( profits)
decisions are taken by management only c) Terminal cash flows-
when a disaster occurs.eg – a plant break’s it is the cash inflows for the last or terminal
down. Thus this approach is a situation of year of the project.
management by crisis. 2. Required rate of return –
 Passive approach – the expected rate of return from a proposal
under this approach, the emphasis is only is required in order to A) adjust the future
on present needs, it is a situation of cash flows of a project B) determining the
“manage as we go”. profitability of the proposal or project. An
 Dynamic approach – investment proposal is accepted when the
this is the most modern and effective return from it is more the required rate of
approach to capital budgeting. In this return.
approach, the emphasis is on long range 3. Other information –
planning. In this case the capital budgeting a) economic life of project b)
decisions are taken on the basis of market available funds c) risk
research, technological changes etc. METHODS OF
Limitations of capital budgeting PROFITABILITY
 The benefits from investment are APPRAISAL (PROJECT APPRAISAL)
received in future which is uncertain. Traditional or non-discounting
 Some factors affecting investment techniques
proposals cannot be expressed in  Urgency method
money value.  Pay back method
 It is difficult to estimate the period  Post pay back method
for which investment is to be made  Average rate of return method
and income will generate. Modern methods or discounting criteria
 It is difficult to estimate the rate of  Discounted pay back method
return, because future is uncertain.  Net present value method
 It is difficult to estimate the cost of  Benefit cost ratio
capital.  Internal rate of return method
Information required for capital  Net terminal value method
budgeting TRADITIONAL METHODS-
1. Cash flows – traditional methods do not take into
in capital budgeting decision, the cost and consideration the time value of money.
benefit of a project are measured in terms Important traditional methods may be
of cash flows. Cash flow may be cash inflow discussed below.
or outflow. cost are referred to as cash  URGENCY METHOD
Urgency is a method used to justify
the acceptance of projects on the
basis of emergency requirements. In short
most
 FM – (Al Jamia Arts and Science College, Poopalam)
urgent project is taken up first. inflows generated from a project during its
ADVANTAGES working life are taken into account. The
 Simple technique post payback profitability is calculated as
 It useful in case of short term under.
projects Post payback profitability = total cash
DISADVANTAGES inflows in life – initial cost
 It is not based on scientific analysis  AVERAGE RATE OF RETURN
 Does not consider time value METHOD (ARR)
 A project even though it is profitable, This method is also known as accounting
will not be accepted for the very rate of return method or return on
simple reason that it can be investment method or unadjusted rate of
postponed. return method. Under this method average
 PAY BACK METHOD annual profit is expressed as percentage of
Payback period is the length of time investment. ARR is found by dividing
required to recover the initial cost or average income by the average investment.
investment of the project. It is the period DECISION RULE
required to recover the cost of investment. The higher the ARR, the better the project.
It is also called pay off method, pay out The project with the highest ARR is
method etc,. the payback period is selected.
computed by dividing the initial investment ADVANTAGES
by net annual cash inflows.  Simple to understand
DECISION RULE (SELECTION CRITERIA)  Easy to apply
According to pay back criterion, the shorter  Take in account the earnings over
the pay back, the better the project. This  the entire life
means project having shorter payback  Consider profitability
period is chosen.  Project of different character can
ADVANTAGES be compared
 Simple to understand DISADVANTAGES
 Easy to apply  Does not consider time value of
 Important for cash money
forecasting, budgeting  It is based on profit, not cash flow
 Can be used profitably for short term  It consider only rate of return & not
project the life of the project
 It take into consider liquidity.  It ignore the fact that profit can be
DISADVANTAGES reinvested
 Ignore time value of money  It does not differentiate between the
 Completely ignore cash inflows after size of the investment required
pay back for each project.
 Does not measure profitability DISCOUNTED CASH FLOW TECHNIQUES
 Does not measure rate of return Unlike traditional methods it consider &
 POST PAY BACK METHOD take it account the time value of money.
As pointed out earlier, under payback The important discounted cash flow
method the profitability after payback is techniques are as follows
ignored. The post pay back method has  DISCOUNTED PAYBACK PERIOD
evolved to overcome this limitation. Under A major shortcoming of the conventional
post payback method, the entire cash payback period is that it does not consider
FM – (Al Jamia Arts and Science College, Poopalam)
time value money. To overcome this  It involve complicated calculations
limitation the discounted payback period  BENEFIT COST RATIO
method is suggested. In this modified Two projects having different investment
method, cash flows are first converted into cannot be compared by net present value
their present values and then added to method. In such a situation, benefit cost
ascertain the period of time require to ratio should be applied. It is also called
recover the initial cost of investment. profitability index or present value index.
 NET PRESENT VALUE Benefit cost ratio is computed by dividing
METHOD (NPV) present value of cash inflow with present
This method is used only when the rate of value of cash outflow.
return on investment is predetermined by DECISION RULE
the management. Under the NPV method, Accept the project if its benefit cost ratio is
all cash outflows & inflows are converted in more than one and reject the project if
to present values (values of future cash index is less than one. Higher the
flows at the present time). The NPV is profitability index better is the project.
obtained by deducting the present value of ADVANTAGES
cash outflow from the present value cash  Scientific and logical
inflows.  Consider fair rate of return
Computation procedure of NPV  Consider profitability
A. Determination of minimum rate of  Useful to compare projects having
return different investments
B. Computation of PV of cash inflows &  It consider all cash flows during the
outflows life of project.
C. Computation of NPV DISADVANTAGES
DECISION RULE  Not based on accounting methods
Accept the project which have highest NPV. & principles
If the project’s NPV is zero or positive  Comparatively difficult to
,accept it and if the NPV is negative reject it. understand Follow
ADVANTAGES  Difficult to estimate the effective life
 Consider time value of money of project
 It consider the cash flow over entire  Cannot be used for comparing those
life of project. projects having unequal lives
 It focus attention on objective of  INTERNAL RATE OF RETURN (IRR)
wealth maximization Net present value method indicates
 Suitable when cash flows are not the net present value of the cash flows of a
uniform project at a pre-determined interest rate.
 This method is generally preferred But it does not indicate the rate of return. In
by economists order to find the rate of return, estimated
DISADVANTAGES net cash inflows of each year discounted at
 may not provide satisfactory in case various rates till a rate obtained at which
of two projects of different useful the present value of cash inflow is equal to
life. the initial investment.
 This method is not suitable in case of Thus internal rate of return is the
projects involving different amount rate of return at which total present value
of investment. of future cash inflow is equal to initial
 Different discount rate give different investment.
present value

FM – (Al Jamia Arts and Science College, Poopalam)

DECISION RULE  More suitable for cash budgeting
The calculated IRR is compared with the DISADVANTAGES
desired minimize rate of return. If IRR is  It is difficult to project the future rate
equal to or greater than the desired of interest
minimize rate of return, then the project is  Comparative evaluation is not
accepted. If it is less than minimum rate of considered
return then the project is rejected. Capital rationing
ADVANTAGES When funds are limited, it cannot
 This method consider all the cash undertake all profitable projects. The need
flows over the entire life of the of capital rationing arises here. Due to
project. limited funds the firms limit their capital
 Consider time value of money budget with in limit. In this situation, the
 Cost of capital need not be calculated firm will have to ration the available funds
 IRR gives a true picture of the among the most profitable projects.
profitability of the project. The situation in which the firm is not
 Projects having different degrees of able to finance all the profitable investment
risk can easily compared. opportunities due to limits on available
DISADVANTAGES funds is called capital rationing. It is the
 Difficult to understand process of allocating or rationing the
 Complicated calculations limited capital to various projects ranked
 It is applicable mainly in according to profitability.
large projects Selection process under capital
Difference between NPV and IRR rationing
 Rank projects according
to profitability
 Select projects in the descending
NPV IRR order of profitability until the
The minimum The minimum available funds are exhausted.
desired rate of desired rate of Types of capital rationing
return is assumed return is to be  Soft capital rationing – this refers to
to be known. determined situations where the firm internally
It gives absolute It gives imposes a budget ceiling on the
return percentage return amount of capital expenditure.
The NPV of The IRRs of  Hard capital rationing – this refers to
NET TERMINAL VALUE METHOD
different projects different projects(NTV situations where the amount of
METHOD)
can be added cannot be added capital investment is restricted
This method is based on the assumption because of external constraints.
that each annual cash inflow is received at Projects with unequal
the end of year and is reinvested in another lives ANNUAL NPV
asset at a certain rate of return from the METHOD -
moment it is received till the termination of To make the economic life comparable, the
the project. annualized NPV is calculated. This is
ADVANTAGES calculated by dividing the NPV by the
 Simple technique present value annuity factor for the given
 Simple to understand discount factor and time period. Select the
 It avoids influence of cost of capital project which have highest ANPV.

FM – (Al Jamia Arts and Science College, Poopalam)

REPLACEMENT CHAIN METHOD –  Can be used along both with NPV
Under this method the project with shorter and IRR
life is made to have a similar cash flow  It takes the risk averse attitude of
sequence in the extended period. investors.
Project appraisal under risk and Demerits –
uncertainty  No scientific way of determining risk
If an investment proposal has high premium
profitability, the risk associated with it will  Personal judgment and bias
also be high. If the risk is high then  It does not adjust the future
investors’ money is unsafe. Therefore it cash flows.
becomes very essential to make risk Decision rule- the risk adjusted rate
analysis of investment proposals before the discount can be used both NPV and IRR. If
management goes ahead with the project. NPV is used, the project with higher NPV
Meaning of risk – risk is the variation that should be selected. In case of IRR, the
is likely to occur in future between project with IRR greater than the risk
estimated and actual returns. If the adjusted rate of return are selected.
variation is high w say that the risk CERTAINTY EQUIVALENT METHOD
involved in the investment proposal is high Under this method the risk involved in the
and vice versa. In short, risk is the degree of project is taken into consideration by
uncertainty about an income. adjusting the expected cash flows and not
Risk analysis – the discount rate. First the cash flows are
A firm should consider while estimating the conservatively estimated under the
required rate of return on a project. There assumption of normal risk for various years
is positive correlation between risk and during the life of the project. Then risk free
return. If the return is high, the risk is also cash flows are reduced to a certain level by
high and vice versa. Before accepting the using the correlation factor or risk
projects, their risk and return should be adjustment factor. This correction factor is
analyzed. The best project is one which has called “ certainty equivalent coefficient”.
highest return and lowest risk. Thus certainty equivalent co-efficient is the
Methods or techniques of risk ratio of riskless cash flow to risky cash flow.
analysis General or traditional The risk free cash flow is always lesser than
methods the risky cash flow. Therefore certainty
RISK ADJUSTED DISCOUNT RATE – equivalent coefficient will be less than 1.
Under risk adjusted discount rate Steps in Certainty equivalent coefficient
techniques some adjustment will be made method
in the discount rate. This is done according  Calculate the Certainty equivalent
to the degree of risk associated with the coefficient for each year
project. If the risk is high the discount rate  Calculate the risk adjusted cash flow
is raised(adding risk premium to discount of a project for each year
rate). In short, project which are more risky  Find the present value of risk
should be discounted at a higher rate than adjusted cash flow for each year.
those which are less risky.  Obtain the total present value of all
Merits years. This give total PV of the
 It is simple to understand project.
 Easy to operate  Find the NPV of the project.
 Provide compensation for the risk  Select the project
factor

FM – (Al Jamia Arts and Science College, Poopalam)

Merits the probabilities are assigned to cash
 Simple and easy to apply flows and expected values are found.
 Reduce uncertainty The expected values are ascertained
 It takes risk into consideration by multiplying cash inflows, with
 Superior to risk adjusted discount the probability assigned. The probabilities
rate. to be assigned depend upon the
Demerits expectation of realization of cash flows.
 Difficult to calculate Then the expected values are discounted
 It does not directly use to compute the PV. From the total PV,
the probability distribution cost is deducted to get NPV. The project
Decision rule – the Certainty equivalent which gives highest NPV may be accepted.
coefficient lies 0 to 1. The higher the risk, STANDARD DEVIATION METHOD
the lower is the coefficient. After converting In order to determine the
the uncertain cash flows to certain cash precise value of risk involved in budgeting ,
flows by using certainty coefficient, these we use methods like standard
are multiplied with the discount factor. deviation and coefficient of variation.
Now we get PV. Then NPV is found. Project It measures deviation of possible cash
with highest NPV is selected. flows of different projects from their
Modern or statistical respective mean or expected values.
techniques SENSITIVITY S.D method measures the degree of risk
ANALYSIS involved in the capital expenditure
Sensitivity analysis examines how decision. A project having a larger standard
sensitive the NPV is to changes in key deviation will be more risky
variables such as capital cost, sales volume when compared to a project having
etc. if a small change in one factor result in lower standard deviation.
major change in the profitability of an Steps in S.D method
investment proposal, the project is  Compute the mean values of the
considered sensitive to that factor and possible cash flows
more risky. Generally, less sensitive is  Calculate deviations
better than more sensitive ones. The  Square the deviations and obtain the
sensitivity analysis can be used through total
NPV and IRR. Sensitivity analysis is also  Apply the formula
called “what if” analysis. COEFFICIENT VARIATION METHOD
Cash flow estimates are made under S.D method is not suitable
three different situations. A) pessimistic B) for comparison particularly when cost
most likely C)optimistic. Pessimistic cash of projects are different. In such a case it
flows are estimate under negative is better to calculate the relative measure
conditions of the future. Most likely cash of dispersion. Co-efficient of variation is
inflows are projected under normal one of such measures.
circumstances. Optimistic cash flow are The higher the coefficient
estimated under positive conditions of the of variation, higher is the risk involved in
future. These cash flows are discounted by the project.
discount rate and NPV is calculated. If the SIMULATION TECHNIQUES
NPVs under these situations differ widely, In this process, random values for each
it indices that the risk is high and vice variables such as number of units to sold,
versa. selling price etc are identified. These values
PROBABILITY ASSIGNMENT METHOD.
Under probability assignment method
 FM – (Al Jamia Arts and Science College, Poopalam)
are processed to compute the NPV. This it is the systematical investigation rational
process of identifying the random values decision making in the context of
and calculating NPV is repeated many uncertainty concerning the move of
times. I the end, a mean and S.D of the competitors. The game theory can be
calculated NPVs is ascertained. The mean applied in making investment decision
show returns and the S.D shows the risk. under the conditions of uncertainty for
DECISION TREE ANALYSIS maximizing the returns from investments.
It is a mathematical tool that enables a WORKING CAPITAL
decision maker to consider various Working capital is the capital
alternative courses of action and select the required for the day to day working of an
best alternative. It is a graphical enterprise. It is required for the purchase of
representation of alternative courses of raw materials and for meeting the day to
action and the possible outcomes and risks day expenditure on salaries, wages, rents,
associated with each action. It is the advertisement etc. it is needed for holding
branching diagram, which represents the some convertible assets such as stock, book
relationships of the present decision with debts, bills receivables and cash. It is the
future events and decisions. The final shape capital required for the operation of
of the inter relationship of all possible working of an enterprise. It consist of funds
outcomes resembles to a tree with invested in current assets.
branches. That is why it is called decision Definition
tree method. According to shubin “working capital is the
Definition amount of funds necessary to cover the cost
According to Mc Farland “ a decision tree is of operating the enterprise”.
graphic method by which a decision maker Concepts of working capital
can more readily visualize the courses of  Gross concept –
action open to him together with the risks, according to gross concept working capital
possible outcomes, information needs refers to the amount of funds invested in
involved in a problem”. current assets. Thus working capital is
Construction of a decision tree in capital equal to total current assets. The working
budgeting capital as per gross concept is called
 Identify the investment proposals gross working capital
 Ascertain the different alternative  Net concept –
courses of action. according to net concept, working capital
 Drawing the decision tree showing refers to excess of current assets over
the decision points, decision current liabilities. To be more clearly,
branches and other data. Entering on working capital is equal to total current
the branches relevant data assets minus total current liabilities. The
 Evaluating the results working capital as per net concept is called
GAME THEORY net working capital.
Game theory is used to determine  Operating cycle concept –
the optimum strategy in a competitive according this concept, the working capital
situation. It provide a basis for is required because of time gap
determining, under certain specific between the sale and their actual
conditions, the particular strategy that will realization in cash. This time gap is
result in maximum gain or minimum loss technically termed as “operating cycle” of
no matter what opponents do or do not do. the business.
 FM – (Al Jamia Arts and Science College, Poopalam)
Operating cycle concept consist maintained to meet unforeseen
 Conversion of cash in to raw contingencies or to finance special
materials operations.
 Conversion of raw materials in to Dangers of deficiency of working capital
work in progress  It may leads to business failure
 Conversion of work in progress in to  The firm cannot take the advantage
finished goods and accounts of new opportunities
receivables.  Trade discount will be lost
 Conversion of accounts receivables  Cash discount will be lost
in to cash.  Financial reputation is lost
Components of working capital  Creditors may apply to court for
 Current assets- such as cash, bank, winding up
debtors etc  Rate of return on investment falls
 Current liabilities – such as creditors,  It affects dividend policy adversely
bills payable etc.  The company cannot utilize its fixed
TYPES OF WORKING CAPITAL assets properly.
Permanent working capital: Permanent Dangers of excess working capital
working capital is the minimum working  Idle fund, means no profit
capital which is continuously required by  Value of shares may fall due to lower
the business enterprise to carry out its rate of return
normal business operations. It is also called  Efficiency of management is
fixed working capital. ineffective
Initial working capital :The  Adversely affect dividend policy
working capital which is needed in Advantages of adequate working capital
the initial stage of business is called  Can avail cash discount
initial working capital.  Enhance liquidity
Regular working capital : It is the  Enhance solvency and
amount needed for continuous creditworthiness
operations of the business. It is the  Possible to meet unforeseen
amount of working capital required contingencies
after the project has been established  Improve morale of the executives
Variable working capital  Good relation with bank
Any amount over and above the fixed or  Possible to utilize fixed assets
permanent working capital is called properly
variable or temporary working capital. It is  Increase profitability
the working capital which varies with factors affecting working capital
volume of business. This is the additional requirement
capital needed to meet seasonal and special  Nature of business:
needs. Manufacturing or trading firms may require
Seasonal working capital :It is the more working capital than service firms.
working capital which is needed to  Production cycle :
meet the seasonal needs of the firm. The longer the production cycle, the larger
It refers to the additional working will be the requirement of working capital
capital required during busy seasons.  Size of business :
Special working capital : This Large size business requires more working
refers to the extra working capital to capital than small.
be
 FM – (Al Jamia Arts and Science College, Poopalam)
 Turnover : versa. Thus additional capital results in the
Turnover means the speed with which the decline in the cost of capital.
resources are converted into sales. If the  Principle of equity position:
turnover is high, working capital According to this principle, the amount of
requirement will be lesser. working capital invested in each
 Terms of purchase & sales : component should be adequately justified
If the most of sales are for cash, working by a firm’s equity position. Every rupee
capital requirement will be lesser and if the invested in the working capital should
most of the sales are for credit, working contribute to the worth or value of the firm.
capital requirement will be higher. In case  Principles of maturity of payment:
of purchase it is just opposite of sales There should be the least disparity between
terms. the maturities of a firm’s short term debt
 Nature and value of product : instruments and its flow of internally
If the cost of raw material is a larger generated funds.
proportion of the total cost of the finished Financing or approaches of
product, working capital required will be working capital mix
larger. It is crucial what should be the mix of
 Seasonal variations : short term funds and long term funds for
More working capital is required in busy the purpose of financing the working
seasons capital. the use of short term funds will
 Importance of labour: have Favourable impact on profitability. On
If the firm id more labour intensive, then the other hand the use of long term funds is
the working capital required will be larger favoured on the grounds that they are
due to payment of remuneration to them. If provide a liquidity for a long period of time.
the firm is capital intensive, working capital There are three basic approaches
required will be lesser. to determine working capital mix.
 Expansion of business –  Hedging approach –
need more working capital at the time of when the firm follows matching or hedging
expanding business concept, the permanent working capital
 Cyclical fluctuations requirements should be financed by
 Company policies long term funds, while the
Principles of working capital temporary or seasonal working capital
management. requirements should be financed out of
 Principles of risk variation – short term funds.
if the level of working capital increases, the  Conservative approach –
amount of risk decreases. The size of this approach emphasis upon
working capital is depends upon the safety. According to this
attitude of management. A conservative approach, all requirements of
management prefers to minimum risk by working capital fund should be met
holding a higher level of working capital. from long term sources. The short term
But liberal management assumes greater sources should be used only during
risk by reducing this level. emergency times.
 Principle of cost of capital  Aggressive approach –
Different sources of finance have different Under this approach, the firm relies more
costs. It can be seen that the cost of capital on short term sources than on long term
moves inversely with risk. If the risk is sources to finance its current assets. In
higher, the cost is lower and vice other words, the entire amount of current
asset is financed from short term sources.
 FM – (Al Jamia Arts and Science College, Poopalam)
SOURCES OF working  Depreciation –
capital Long term sources depreciation charged on fixed assets, and
 Share capital- the real sense is that the amount charged as
this is long term source of finance. There depreciation does not going to outside of
are two types of shares the business. So it can be used as a source
 Equity shares- of finance.
this represents contribution made by Working capital management
equity share holders. Their dividend is not Simply working capital management
fixed. is managing working capital of business
 Preference shares- enterprise. Widely working capital
represents the contribution made by management is the efficient planning and
preference shareholders. They enjoy controlling of working capital for smooth
preferential right in the payment of running of day to day operations of the
dividend & repayment of capital. enterprise.
 Debenture capital- Working capital management consist-
this is borrowings of the company.  Management of inventory
Debentures are instruments for raising  Management of cash
debt capital  Management of receivables
 Term loans-  Factoring management
in addition to the raising of funds through Management of inventory
shares, debentures firms may also raise Meaning of inventory- inventory means
term loans for meeting their working stock of goods. In accounting language
capital requirements. inventory means stock of raw materials,
 Retained earnings stock of work in progress and stock of
This is an internal source of finance. It finished goods.
represent the undistributed profit and Types of inventory
retained for meeting financial  Raw material inventory – inputs
requirements.  Work in progress – semi finished
Short term sources  Finished goods – final products
 Commercial banks – Inventory management
short term loans from commercial banks Simply inventory management
 Public deposits – means managing inventory or stocks of
these are the fixed deposits accepted by a business enterprise. Widely it means
business enterprise directly form public. efficient planning and controlling of
 Indigenous bankers inventories.
– private money lenders Objectives of inventory management
 Factoring –  To ensure that adequate inventories
factors are the agents who collect money are available
from the customers for the business on  To minims the investment of funds in
commission. Besides, they also lend inventories
advance amount to the firms. So it becomes  Minimize cost ordering and
a source of fund. carrying inventories
Transactional sources –  Maximize wealth of shareholders
 Trade creditors –  Avoid cash crisis
purchase the goods on credit and then we  Avoid over stocking and under
can use that amount for other purpose. stocking
 FM – (Al Jamia Arts and Science College, Poopalam)
 Minimize wastage and pilferage  VED analysis
 Ensure quality of products  Aging schedule of inventories
Motives of holding inventories  Perpetual inventory system
 Transaction motive –  JIT inventory system
every firm has to maintain some level of Economic Order Quantity (EOQ)
inventory to meet day to day requirement The EOQ enables the firm to
of sales. determine the optimum level of inventory.
 Production motive – EOQ can be defined as the quantity which is
a firm should keep some inventory for most economical to order at a time. It is the
unforeseen circumstances. ordering quantity which minimizes the
 Speculative transaction – total cost of inventory. The total inventory
the firm may keep some inventory in order comprises ordering cost and carrying costs.
to capitalize an opportunity of making If the ordering quantity is less, then
profit. the ordering cost will be high and the
Benefits of inventories – carrying cost will be lesser and vice versa. It
 Uninterrupted production – is because of more number of order to
continuous flow of production be placed. Therefore, the ordering
 Efficient purchase – bulk purchase quantity should be fixed at that level where
may lead to trade and cash discounts the total cost of inventory is lowest. This is
 Independent sales – maintain possible when the ordering cost is equal to
minimum level of stock of finished carrying cost. Thus EOQ is that quantity at
goods to avoid flow sales. which the total inventory cost is minimum.
 Goodwill with customers – in order Assumptions of EOQ
to provide goods on demand.  The demand for material is known
Costs of inventory  Consumption rate is constant
 Ordering cost –  Purchase price of material is fixed
these are cost of placing an orders. This  Carrying or storage cost per unit is
cost depends on number of orders. It fixed
includes preparation of purchase order,  Ordering cost per unit is fixed.
cost of receiving order, transport costs, etc.  The quantity of material ordered is
 Carrying cost – received immediately. The lead
these are the cost incurred in keeping time is zero
inventory. These includes storage Classification and codification of
costs(rent, lighting), handling costs, materials
insurance, security cost, damage etc. For efficient storage,
 Stock out cost – proper classification and codification of
a stock out is a situation when the firm is material is necessary . classification of
not having items in store but there is a materials refers to grouping of materials
demand for the same. according to their nature in suitable
Techniques of inventory management categories. Codification of material is the
 Economic order quantity (EOQ) process of giving distinct numbers or
 Classification and codification letters or symbols to each time of material
 Stock levels to facilitate easy identification.
 Safety of stocks Advantages of classification and
 Inventory turnover ratio codification
ABC analysis  Easy identification of materials
 Maintain secrecy of materials
 Accounting purpose
 FM – (Al Jamia Arts and Science College, Poopalam)
 Ensure clarity consumed during a given period to the
 Reduce clerical work average stock during that period. It
 Speedy movement of materials indicates the speed with which the raw
 Material control material have been consumed in
Stock levels production. It gives the number of times in
In order to avoid overstocking and a year stock is used up and replenished. In
under stocking inventory management short, it shows the rate of consumption of
should fix the levels of stocks such as materials.
maximum level, minimum levels, etc ABC analysis
 Maximum level – In the case of large concerns large
maximum stock is the upper level of number of items are kept in the stores.
inventory. It is the maximum quantity of Therefore, it is practically impossible to
items of material that can be held in stock concentrate on each and every item. In
at any time. This is the level above which such situations, ABC analysis is used with
stock should not be maintained. view to exercise better control over
 Minimum level – materials. Under ABC analysis all
minimum stock level is the minimum materials are classified into three
quantity of stocks that should be held at all categories. A, B and C according to value.
times. It is that level below which stock Category A include high value of materials,
should not normally be allowed to fall. category B includes medium value of
 Reorder level (ordering level): materials and category C consist lower
This is the level at which order is placed for value materials. According to this technique
further supply of materials. When stock of a greater or strict control is exercised over
material reaches this level, the storekeeper category A, moderate control is exercised
should initiate action for the purchase of over category and relatively lesser degree
material. of control over category C materials.
 Average stock level – Advantages of ABC analysis –
this is the average stock held by a business  Ensure strict control over costly
enterprise. materials
 Danger level –  Can use working capital bitterly
this is the level of stock below which the  Reduction in costs
stock should never be allowed to fall. If the  Reduce clerical costs
stock level falls below the minimum level is  Maintain high stock turnover ratio
called the danger level. VED analysis
 Reorder period.- According to this parts are classified
the term reorder period refers to the time in to Vital, Essential and Desirable. Vital
required to obtain new materials. spares are those which are very critical
Safety of stocks production. If these are out of stock, it will
A safety of stock is an addition lead to immediately production stoppage.
supply of inventory that is carried all the Essential spares are those which are very
time to be used when normal stocks run important. Without these, production can
out. It is the minimum additional inventory be done only for few hours or day. If they
to serve as a safety margin or buffer or are out of stock for a long
cushion to meet an unanticipated increase period, production will stop. Desirable
in usage. parts are those which are required for
Inventory turnover ratio – production, but factory can manage
It is the ratio of cost of material without them for some time, say a week
or even more. While exercising control,
greater attention should be paid on vital
 spares.

FM – (Al Jamia Arts and Science College, Poopalam)

Aging schedule of inventories Motives for holding cash
A schedule in which inventories are  Transaction motive –
classified according to the period of their cash is necessary for business operation. It
holding in the store is called aging schedule is required for financing transactions.
of inventory. It shows the age of inventories  Precautionary motive –
or the period for which inventories are cash inflows and outflows
lying on stock together with the percentage are unpredictable. Therefore, firms
of each inventory of total inventory. It helps need to hold some cash to meet
to identify the rate at which various unforeseen needs
inventories are consumed. This will help in  Speculative motive –
identifying slow moving inventories. a firm sometimes hold cash to
Perpetual inventory system take advantage of unexpected
The system of material control on opportunities. It is called speculative
continuous basis while the material is in motive of holding cash.
storage is called perpetual inventory  Compensation motive –
system. Under this system the actual stock to obtain a loan or other banking services
is taken continuously and is compared with the firm will be required to hold a
the stock as shown by the material records. minimum balance of cash in the bank.
It is a method of recording stores balance Factors affecting cash level or cash
after every receipt and issue, to facilitate needs
regular checking to avoid closing down of  Credit policy –
factory for stock taking. if the credit policy liberal the cash level will
JIT(Just In Time) inventory technique be higher and vice versa.
The system aims at minimizing  Distribution channel –
inventories of raw material and work in if the distribution channel is long, the level
progress. It also aims at eliminating waste cash may be higher.
from every aspect of manufacturing and its  Nature of product –
related activities. The term JIT refers to the level of cash holding in case of
producing only what is needed, when it is necessities and comforts will differ from
needed, in just the quantity needed. the level of cash in case of luxury items.
Management of cash  Size of the firm –
Cash is a critical asset. If finance larger the firm, higher will be the cash level.
department of a firm is heart, cash is its  Working capital cycle –
lifeblood. if working capital cycle is long, cash level
Meaning of cash – cash is the most liquid will be greater.
asset that a business owns. It is defined as
 Policy of disbursement of salary
demand deposits plus currency. The term
if salaries are paid fortnightly or below,
cash in narrow sense means currency and
then the cash need will be higher and vice
equivalents of cash such as cheques, drafts
versa.
etc. in a broad sense cash include cash
Cash management
assets such as marketable securities and
It is the efficient managing of cash and cash
demand deposit in banks.
related items of business enterprise. It
Nature of cash
means efficient planning, organizing and
 Cash is essential for the smooth
controlling cash and cash equivalents items.
running of business
It is the process of forecasting, collecting,
 Liquid asset
disbursing, investing planning for the cash
 Not available in abundance
for the smooth running of enterprise.
 Cash is in itself unproductive

FM – (Al Jamia Arts and Science College, Poopalam)

Scope of cash management. Accelerate cash receipts
 Cash planning – planning cash The financial manager should take
inflows and outflows steps for speedy recovery from debtors. For
 Managing the cash outflows – this purpose, proper internal
outflows of cash should be made as control system should be installed in
late as possible. the firm. Periodic statements should be
 Managing optimum cash balance – prepared to show the outstanding
the firm should determine the bills. Incentives offered to the customers
optimum level of cash balance. for early payment should be well
 Investing cash – surplus cash if any, communicated to them. Once the
should be properly invested in short cheque / DD received from customers,
term investment to earn additional no delay should be there in depositing
profit these receipts with the banks. There are
Functions of cash management certain techniques to reduce the time lag
 Planning cash inflows and outflows in collection of receivables.
 Controlling cash inflows  Lock box system –
and outflows Under this system the firm establishes a
 Investing surplus funds post office box near customers’ area. The
 Improving investment image firm then orders its debtors to send their
 Maintaining relationship with banks. cheques to the post office rather than to the
Advantages of cash management firm’s headquarters. The payments are
 Smooth running of business collected by local banks, which are
 Maintain optimum working capital authorized to do so. The banks open the
 Ensures liquidity and solvency box several times a day and collects the
 Helps to frame sound debt policy cheques from the lock box. Then the bank
 Regularize cash flows deposits these cheques in the firm’s
Techniques of cash management account.
 Synchronize cash flows  Concentration banking –
 Accelerate cash collections firms that have many branches and at
 Delay cash disbursement different places can collect their account
 Balance surplus and deficit of cash receivables quickly by applying a
Synchronizing cash flows concentration banking system. This system
If a firm pays it bill on a weekly basis works on a decentralized manner. Under
but collects its payments biweekly, we say this system, multiple collection points are
the firm has a lack of cash flow made to collect the funds. This reduces
synchronization. The firm can reduce the mailing time. Collection centres are set up
needed cash balance if it can move the cash in different geographical centres. The
disbursements and cash collections into the company has a central account called
same cash flow cycle. Sometimes such concentration banking. When the customer
synchronization is not possible. At that deposit his payment to the local collection
times it is accompanied by additional costs. center. It gets transferred to the central
The management should consider the office.
benefits and the cost of synchronization  Automated clearing houses –
before deciding whether it is worthwhile to this is an electronic network. It sends data
achieve. from one bank to another. No paper
cheques are sent. Hence this avoids mail
time delay. ACH guarantees one-
day clearing regardless of the bank’s
location.
 FM – (Al Jamia Arts and Science College, Poopalam)
 Zero balance accounts – float management are to increase the
under this system a firm does not keep any payment float as much as possible and
cash balance in the bank account. Cash is decrease the receipt float.
transferred only when the cheque is Optimum cash balance
presented for the payment to the bank. The optimum level of cash is that
Only an amount sufficient to cover day’s level of cash at which there is a trade off
cheques is deposited. Idle cash balance is between cost of maintaining the cash
thus minimized. surplus and cost of deficit financing. The
 Wholly owned collection centre – optimum cash level should be adequate
under this method, a firm sets up its own enough to manage the contingencies and
collection centres in the cities where there basic cash requirements of the firm.
are majority of its customers. Management of receivables
The customers mail their payments, Meaning of receivables – receivables
processes them and record the are assets created out of credit sales. These
transactions in the books of accounts. If are the assets created as a result of
then deposits the cheques with the sale of goods and services in the
authorized banks and transmits payment ordinary course of business. Receivables
to the central office. are also known as accounts receivables,
 Pre authorized cheques – book debts etc.
customers deposit with the pre signed Definition – according to O.M Joy “the term
cheques. The date of the receivables is defined as debt owed to the
cheque corresponds to the date firm by customers arising from sale of
when payment is due. The supplier goods or services in the ordinary course of
deposits the cheques on the appointed business”.
date and the amount is credited to his Receivables = debtors + bills
account. receivables Meaning of receivables
Managing outflows or disbursements management
Finance manager should try to slow down Receivables management
the payments as much as simply refers to management of
possible. However, care must be receivables. It refers to planning and
taken that goodwill and credit rating of the controlling of receivables of a firm. It is
firm is not affected. For managing the process of making decisions relating
outflows the following techniques to investment in trade debtors.
are used. Objectives of receivables management
 Centralized cash payments –  To increase sales
in this technique all receipts are  To increase profit
transferred from subsidiaries to central  To increase market value of shares
office. The central office in turn accepts and  To increase customer base
pays the creditors’ bill direct to the parties.  Evaluate and control receivables
 Avoidance of early payments – Scope of receivables management
the debt should not be paid before due date 1) Determining credit policy
because it has no special advantage except A suitable credit policy is essential
earnings cash discount. for the proper management of debtors. If
 Float management – there is no proper credit policy,
when a firm receives or make cheques outstanding balances in the debtors
there is usually a time gap between the account and risk bad debt will increase. The
time the cheque is written and when it is term credit policy is that decides how much
cleared. This time gap is called float. These credit be extended to a customer and on
can be used by a prompt and careful float what terms. The credit policy may be liberal
management. The goal of or aggressive(loose or tight). when a firm

FM – (Al Jamia Arts and Science College, Poopalam)

adopt liberal credit policy, sales and profit from slow payers and reducing losses on
will increase, but there is an chance of account of bad debts. Collection policy
increase in bad debt and decrease in refers to the collection procedures such as
liquidity. On the other hand aggressive letters, phone calls, and other follow up
credit policy will create benefit of decrease mechanism to recover the amount due from
in bad debt and increase in liquidity, but debtors.
there will be a problem of decrease in sales The following techniques can be adopted by
and profit. So FM should implement an a company for the collection.
optimum credit policy to manage its  Polite requesting collection letters
receivables.  Telephone calls, fax etc
2) Determining credit terms  Computer contacts
The credit terms refers to the set of  Personal visits
stipulation under which the credit is  Using collection agencies
granted to the customers. The credit terms  Warning letters
include:  Legal action
 Credit period- 5) Control and analysis of receivables
it is the length of time for which the firm The next important aspect of
grants credit. A firm should determine the receivables management is to analyze the
credit period to ensure better receivables size of investment in receivables from time
management. to time. For this purpose, the following
 Discounts – ratios may be helpful
discounts are given for early or prompt  Debtors turnover ratio –
payment. It is an effective tool to manage this ratio indicates the speed with which
accounts receivables. cash is collected from debtors
 Credit standards – or receivables.
credit standards refers to the required  Average collection period –
financial strength of acceptable customers this ratio indicates the period for which
to whom credit is to be granted. These are debtors or receivables are outstanding.
the criteria of extension of credit to  Ageing schedule of debtors –
customers. It is the process of checking to keep track of its receivables situation,
paying capacity of customers. the firm prepares an ageing schedule. An
3) Evaluating the credit applicants aging schedule shows ages of unpaid
A firm cannot follow the policy of treating accounts and what percentage of total value
all the customers equal for the purpose of of receivables those accounts represent.
granting credit. Each case is to be decided The older the receivables, the lower quality
in its own merits. It includes: and greater the probability of a default(bad
 Collecting credit information debt).
of customers Cost and benefits of
 Evaluating the credit capacity receivables Cost of receivables
of customers  Administration cost – collection
 Credit analysis(credit limit) cost, staff cost etc.
 Collection procedures determination  Capital cost – interest paid on
4) Evaluating collection policies and outsiders fund (outside fund needed
methods - when there will be credit sales)
The firm should formulate an  Delinquency cost – opportunity cost
effective collection policy. The collection for the delayed period.
policy should aim at accelerating collections  Default cost – bad debts

FM – (Al Jamia Arts and Science College, Poopalam)

Benefits of receivables  Find out additional or incremental
 Increase in sales cost of sales
 Increase in profit o Calculate the total cost under
 Extra profit – sell price which is present policy and proposed
higher than cash sales policy
 Increase in market share- attract o Calculate the
new customers average investment in
Decision regarding tightening credit debtors under both situation.
policy – o Calculate increase in
In receivables management, the investment in debtors
management has to decide whether adopt a o Find out additional
liberal credit policy or a tightened credit or incremental cost on the
policy. In arriving at a decision, the basis of firm’s rate of return.
following steps are required.  Find out the increase in profit
 Find out reduction or saving in o Find out profit of present and
cost of sales proposed policy
o Calculate the total cost under o Find out increase in profit
present policy and proposed  Compare incremental cost with
policy increase in profit
o Calculate the average  Take decision –
investment in debtors under if incremental cost less than increase in
both situation. profit, the proposal shall be accepted and
o Calculate reduction in rejected the proposal if incremental cost is
investment in debtors more than increase in profit.
o Find out reduction or saving in Factoring service
cost on the basis of firm’s rate Meaning – factoring simply refers to selling
of return. the receivables by a firm to another party.
 Find out the reduction in profit The buyer of the receivables is called the
o Find out profit of present and factor. The factor can be commercial bank
proposed policy or a financial company. When receivables
o Find out reduction in profit are factored, the factor takes possession of
 Compare reduction in cost with the receivables and generally becomes
reduction in profit responsible for its collection. It also
 Take decision – undertake administration of credit. Factors
if reduction cost more than reduction in work for commission.
profit, the proposal shall be accepted and Procedures of factoring
rejected the proposal if reduction cost is The firm having receivables enters
less than reduction in profit. into an agreement with a factoring agency.
Decision regarding liberalizing credit The client delivers all orders and invoices
policy and send the invoice copy to the factor. The
When a firm adopt liberal credit policy, factor pays around 80 % of the invoice
sales and profit will increase, but there is value as advance(determined as per
an chance of increase in bad debt and agreement). The balance amount is paid
decrease in liquidity. In arriving at a when factor collects complete amount of
decision whether the credit policy is money due from customers. Against all
liberalized or not, the following steps are these services, the factor charges some
required. amount as service charges. In certain cases
the client sells its receivables at discount

FM – (Al Jamia Arts and Science College, Poopalam)

say, 10 %. This means the factor collects  Collection of receivables – factor
the full amount of receivables and pays 90 collect all the book debts for the
% of the receivables to the client. From the clients
discount, the factor meets it expenses and  Protection against risk- factor
losses. The balance is the profit. protect the firm from bad debt risks.
Types of factoring  Credit management – helps to fix
 Recourse factoring – credit limit, credit period etc
in this type of factoring, the factor manages  Advisory services –
the receivables without taking any risk like Advantages of factoring
bad debt etc. full risk is borne by the firm  Improves efficiency-
itself. improve overall efficiency of management
 Non recourse factoring –  Higher credit standing –
here the firm gets total credit protection it helps to increase credit standing by
because complete risk of total receivables providing advance. The firm can utilize that
is borne by the factor. advance amount for other purposes.
 Maturity factoring –  Reduces cost –
in this type, the factor does not pay any reduce cost of handling receivables
cash in advance. The factor pays clients  Additional source –
only when he receive funds. advance amount becomes an additional
 Advance factoring – source of fund.
here the factor makes advance payment  Advisory services –
about 80 % of the value to the client factors advice the clients regarding credit
 Invoice discounting – matters.
under this arrangement the factor advance  Accelerate of production cycle –
against receivables collects interest for the a firm can maintain liquidity. Hence it can
period extending from the date of advance accelerate its production cycle.
to the date of collection.  Adequate credit period for
 Undisclosed factoring – customers –
in this case the firm does not disclose customers gets adequate credit period for
identity of factor to the customers. They act payment of assigned debts.
as part of the firm and will do all the  Competitive terms to offer –
activities. able to improve competitive terms to its
Features of factoring buyer (discount). It will increase profit.
 Financial service Limitations of factoring
 Purchase credit from clients and  It create over confidence in
collects from customers the minds of firms.
 Risk  Lack of professionalism
 Act as an intermediary  Not suitable for small business
 Other services like advance payment, Committees on working
bad debt protection etc capital management
 Helps to solve financial problems (committees on bank
Functions of factor finance)
 Provision of finance – Bank provide finance to business
advance about 80% of concern to meet the requirements (working
invoices. capital). To regulate and control bank
 Administration of sales ledger – finance, RBI constitutes committees. These
maintain sales ledger of committees submit reports with findings
every customer. and recommendations to formulate the
 FM – (Al Jamia Arts and Science College, Poopalam)
finance policy of the banks. Important  Assess the need based credit of
committees are as follows: the borrower on the basis of
 Dehejia Committee their business plans.
 Tandon Committee  Bank credit would only
 Chore Committee supplementary to the borrower’s
 Marathe Committee resources. So bank should
Dehejia Committee not finance 100 % of working
National Credit Council (NCC) capital requirements
appointed a committee under the  Bank should ensure proper end-
chairmanship of sri V.T Dehajia in 1968. use of bank credit.
The purpose of constituting the committee  Working capital finance would be
was to determine the extent to which credit available on the basis of
needs of industry and to establish some industry wise norms for holding
norms for lending by commercial banks. different current assets
The recommendations of the committee  Credit would be available in the
are as follows: form of cash credit, bill
 Banks should finance industry on the purchased and discounted,
basis of a study of borrowers’ total working capital term loan etc.
operation rather than security basis.  Bank would require to them
 The total credit requirements of the to submit regular report of
borrower should be segregated into their financial operations.
“hard core” (minimum level of Norms
working capital) and “short term” The following norms are recommended
components. by the Tandon committee.
 Loans can be provided for meeting  Norms for inventory and
hard core working capital. receivables –
 A customer should be required to the committee has suggested norms for 15
confine his dealings to one bank major industries regarding inventory,
only. receivables and bills purchases.
Findings of Dehajia Committee The committee has suggested that the
The committee found that there was banks should follow these norms while
a tendency to take short term credit from granting loans.
banks and use it for purposes other than  Lending norms –
production. The committee pointed out in the committee introduced the concept of
its report that in the financing practice of “maximum permissible bank finance”. The
banks, there was no relationship between committee suggested that part of current
the optimum requirements for production assets should be financed by trade credit
and the bank loan. The committee also and current liabilities. The remaining
found that do not giv proper attention to part(working capital gap- difference
the financing pattern of their clients. between current assets and current
Tendon committee liabilities) should partly financed by
In 1974 a study group under the owners fund long term borrowings and
chairmanship of Sri P.L Tandon was formed partly by the short term credit. The
to examine the existing method of bank committee has suggested three alternative
lending and suggest changes. They methods for working maximum permissible
submitted a report which popularly known bank finance.
as Tandon Committee report. The following
are the recommendations:
 FM – (Al Jamia Arts and Science College, Poopalam)
First method – the borrower will Marathe Committee
contribute 25 % of the working capital gap In 1982, the RBI appointed a committee
from the owned fund and long term under the chairmanship of Sri Marathe to
borrowings and the remaining can be review the working of credit authorization
financed from bank borrowings. scheme and suggest measures for giving
Second method - the borrower will meaningful directions to the credit
contribute 25 % of the current assets from management function of RBI.
the owned fund and long term borrowings Recommendations
and the remaining can be financed from  Committee has declared the third
bank borrowings. method of lending as suggested by
Third method- in this method, the the Tandon Committee to be
borrowers’ contribution fund will be 100 % dropped. Banks would provide credit
of the core current assets and a minimum for working capital according to
of 25 % of the balance of current assets. second method.
The remaining can be met from the  The committee has suggested the
borrowings. Core current assets means introduction of the “Fast Track
minimum level of investment in current Scheme” to improve the quality of
assets. credit appraisal in banks. It
Chore Committee recommended that
The RBI appointed another committee commercial banks can release
under the chairmanship of K.B chore in without prior approval of the RBI
April 1979 to review the working of cash 50 % of the additional credit
credit system. required by the borrower, subject
Recommendations to the following requirements;
 The bank should obtain quarterly o Estimates in regards
statements from all borrowers to production, sales,
having working capital credit limit chargeable current assets,
of Rs. 50 lakhs and above. other current assets, current
 If borrower does not submit such liabilities, and net working
statements in time, banks may capital are reasonable.
charge penalty interest(1 %) o The classification of assets
 Bank should undertake a periodic and liabilities as current and
review of limit of Rs. 10 lakhs and non current is in conformity
above. with the guidelines issued
 Bank should not bifurcate cash credit by the RBI.
accounts into demand loans. o The projected current ratio
 While assessing the credit is not below 1.33 : 1.
requirements, the bank should o The borrower has to be
appraise and fix separate limits for submitted quarterly
normal non-peak level and peak statement.
level credit requirements. Dimensions of working capital
 Bank should take steps to convert management:
cash credit limit into bill limits for  Formulation of policies regarding
financing sales. profitability, risk and liquidity:
 Use of different types of advances, the greater the firm’s investment in current
namely, cash credit, bill purchases assets, the greater the firm’s liquidity and
and discounted. lowers the firm’s risk and profitability and
vice versa. Therefore, what is needed is a
 FM – (Al Jamia Arts and Science College, Poopalam)
trade off between profitability, risk and operations. Debt capital is the company’s
liquidity. Such a moderate policy should be long term borrowings. Equity capital is the
formulated for working capital by the long term funds provided by the
financial management. shareholders or owners of the company.
 Decision about the composition Definition : In the words of C.W
and level of current assets ;- Gerstenberg “Capital structure refers to the
It may be noted that the liquidity of a firm kind of securities that make up
does not depend upon the volume of capitalization”.
current assets, but on the composition level Difference between capital structure
of current assets. Even if the firm maintain and financial structure
large volume of current assets, sometimes Capital structure is the proportion of
its liquidity is weak (eg inventory). different sources of long term capital. It
Therefore, there should be a balance among excludes short term fund. Financial
the various components of current assets. structure refers to the way the company’s
 Decision about the composition assets are financed. It is the entire left hand
and level of current liabilities – side of the balance sheet. This represents
the FM has to decide the type of current all the long term sources of capital and
liabilities, their composition and the short term sources of capital. In short,
amount of each type of current liability. The financial structure shows the pattern of
management must determine the period up total financing. Thus capital structure only
to which the payment of current liabilities a part of financial structure.
can be delayed. However, while doing this, Importance of capital structure
it should be seen that the creditors are not  Capital structure affects the financial
dissatisfied and it will not affect the risk
reputation of the firm.  It affects the firm’s cost of capital
Zero working capital concept:  It affects the value of the firm
This is one of the latest trends in  It represent management attitude
working capital management. Zero working towards risk and return
capital concept was advocated by Capital structure planning
Kampouris (CEO of American Standard). Planning about capital structure is
Under this policy the working capital tends essential for the smooth running of
to be zero i.e. at all the time the current business. It is the process of determining or
assets shall equal to the current liabilities. designing capital structure. That means
Excess investment in current assets is how much is to be raised form equity and
avoided and firm meets its current how much is to be raised through debt
liabilities out of the matching current capital.
assets. As current ratio is 1 and quick ration The key factors which governs the capital
is below 1, there is a fear about the structure planning are
liquidity. But if all current assets are  Profitability
performing and recorded at their realizable  Liquidity
value, there is no place for these fears. The  Flexibility
firm saves opportunity cost on excess  Nature of industry
investment in current assets.  Control
Capital structure  Legal requirements
Capital structure simply refers to the  Nature of firm
make up of the capitalization of a firm. It is  Market conditions etc
the mix of debt and equity which a
company uses to finance its long term
 FM – (Al Jamia Arts and Science College, Poopalam)
Factors determining capital  Cost of financing –
structure Internal factors generally cost of financing by debenture is
 Size of business – cheaper than the financing by issue of
it is very difficult for small companies to equity shares.
raise long term debt. Hence they depend on  Legal requirements –
share capital and retained earnings. Large it should also take care of norms set by
company cannot be raised from single financial institutions, SEBI, stock exchanges
source of capital. etc.
 Nature of business –  Taxation policy –
manufacturing firms have more risk. So high tax discourages the issue of equity
these forms prefer equity capital and debt. shares and encourages the issue
On the other hand, trading firms can raise of debentures.
more fund through debt capital. They have  Attitude of
less risk compared to manufacturing. management optimum capital
 Regularity and certainty – structure
debt capital should be issued only when the The capital structure which maximizes the
company expects a high and regular value of the firm is called optimum capital
income. structure. Optimum capital structure
 Period and purpose of financing – simply refers to the best or most
equity shares are the best choice for funds economical capital structure. It is the mix of
required for permanent investment. debt and equity that maximizes the value of
 Trading on equity – the company and minimizes the cost of
the use of debentures, loans, preference capital.
share capital along with equity share When a company uses more debt, the
capital is known as trading on equity. When overall cost of capital will be less. This will
a firm want to enjoy the benefit of trading turn higher return and market value of
on equity they can raise funds through shares. But the equity holders will have to
equity as well as debt funds. bear higher risk. On the other hand When a
 Desire to retain control – company uses less debt, the overall cost of
if the management desires to retain control capital will be high. This will turn lower
over the company, it may raise additional return and market value of shares. But the
capital through debt capital. equity holders will have to bear only lower
 Asset structure – risk. Therefore, there should be a trade off
if the company has more fixed than current between risk and return.
assets, it will use more debentures and Essentials of optimal capital structure
preference shares and less equity shares.  Clarity of objectives –
External factors the capital structure of a company should
 Conditions in the capital market - be guided by clear cut objectives.
rate of interest on debentures, rate of  Balance –
dividend on preference shares should kept there should be a balance between different
in mind while determining types of ownership and creditor ship
capital structure. securities.
 Attitude of investors –  Economy –
attitude of investors are also affects the the capital structure should ensure the
determination of capital structure of a minimum cost of issue.
company.  Liquidity and solvency –
a sound capital structure should ensure
adequate liquidity and solvency.
 FM – (Al Jamia Arts and Science College, Poopalam)
 Flexibility – degree of leverage on the overall cost of
should be possible to repay when they are capital (Ko) and the value of the firm (V)
not required. can be explained in the following three
 Simplicity – stages.
should be easy to understand and simple to First stage: in the first stage, the use of
operate. debt in capital structure increases the value
 Safety – of the firm and decreases the overall cost of
an ideal capital structure should ensure capital. It happens because the cost of
safety of investment. equity (Ke) remains constant or rises
 Maximum return – slightly with debt, but it does not rise fast
an optimum capital structure should ensure enough to offset the advantages of low cost
maximum return of debt. On the other hand, the cost of debt
Patterns or forms of capital structure (Kd) remains constant or rises
 Equity shares only very negligibly because market views the
 Equity shares and preference shares use of debt within reasonable limits. In
 Equity shares and debentures short, in the first stage the value increases.
 Equity shares, preference shares and Second stage: in the second stage, the
debentures. increase in debt beyond a particular limit
In a going company, reserves and surplus has no effect on the value of the firm and
can also constitute an important part of the overall cost of capital. This happens
capital structure. because the increase in the cost of equity
Theories of capital structure (Ke) due to the increase in financial risk
The basic purpose of capital structure completely offsets the advantage of using
decision is to maximize the value of firm. the cheaper debt.
However, there is a difference of opinion Third stage: in the third stage, the further
regarding whether or not capital structure increases in debt in the capital structure
decision affects the value of firm. Number will increase overall cost of capital (Ko) and
of theories have been developed on capital reduces the value of the firm (V). this
structure to determine optimal capital happens due to (a) owing to increased
structure. The following are the important financial risk the cost of equity (Ke) rises
theories. substantially, (b) the creditors will also
 Traditional theory raise the interest rate on account of higher
 Modigliani Miller theory risk.
TRADITIONAL THEORY(APPROACH) MODIGLIANI MILLER THEORY (MM THEORY)
Traditional approach was suggested Franco Modigliani and Merton
by Soloman Ezra. According to this Miller developed a capital structure
approach, a firm can reduce the overall cost theory in 1958. They formulate theory
of capital (Ko) or increase the total value of under two situation (a) in the absence
the firm (V) by increasing the proportion of of corporate taxes(Irrelevance theory)
debt in the capital structure to a certain (b) when corporate taxes are assumed to
limit. Beyond this limit the additional doses exist.
of debts may result in a decrease in the In the absence of corporate
total value of the firm. The optimum capital taxes(Irrelevance theory)
structure is one at which the V is maximum According to this theory, a firm’s total value
and Ko is minimum. (V) and its overall cost of capital will be
According to the traditional same at all degrees of financial leverage.
approach, the effects of changes in the Modigliani and Miller have proved under
a given set of assumptions, the
capital structure and its composition have
 no effect

FM – (Al Jamia Arts and Science College, Poopalam)

on the value of the firm. In other words riskier than corporate leverage.
capital structure is irrelevant.  Transaction cost:
Assumptions of MM theory MM approach assumes no transaction cost.
 There is a perfect capital market In real life costs like brokerage etc have to
 The business risk of all the firms are be incurred.
homogenous  Institutional restrictions :
 There are no taxes (later withdrawn) certain institutional investors like LIC, UTI
 Investors are rational etc are not allowed to create personal
 There is no transactional cost leverage.
 All the investors anticipate the same  Corporate taxes :
percentage of firm’s EBIT. MM model is based on the assumption that
 All the earnings are distributed to there is no corporate tax. This assumption
the shareholders is unrealistic.
 Investors are free to buy and sell  Influence of share price :
securities share price cannot be influenced by a
In the opinion of Modigliani and Miller, two single individual.
identical firms in all respects, except their  Information access :
capital structure, cannot have different MM hypothesis expects every investors to
market value and cost of capital. This have complete information of all the
happens because of arbitrage process. companies.
Arbitrage process MM theory when corporate taxes
Arbitrage process refers to buying a assumed to exist
security which has low risk and selling it in MM published a follow up paper in
a high risk market. The investors will 1963 in which they had withdrawn the
develop a tendency to sell the shares of the assumption that there are no corporate
overvalued firm and to buy the shares of taxes. Interest on debt is a deductible
the undervalued firm. This buying and expense for a tax purpose. But dividend is
selling will continue till the two firms have not deductible. This encourages companies
same market values. It happens so because to use debt in their capital structure. Thus
the increased demand for undervalued due to the existence of tax, the overall cost
securities raises their prices and the of capital of the levered firm will be lower
increased supply of overvalued securities than that of an unlevered firm. Therefore
reduces their prices. Thus arbitrage the value of the levered firm will be more
process restores equilibrium. MM theory is than that of an unlevered firm even both
also known as arbitrary theory. are identical in respect. The optimal capital
Limitations of MM theory structure can be achieved by maximizing
 Discrepancy in lending and the debt mix in the equity of a firm.
borrowing rate of firm and COST OF CAPITAL
individuals : Meaning – cost of capital simply refers
MM approach assumes that individuals and to cost of obtaining funds. Cost of capital is
firms can borrow and lend at the same rate. the rate a firm pays to its investors for the
This assumption is wrong use of their money.
 Difference in personal and Definition: According to John J. Hampton
corporate leverage: “the cost of capital is the rate of return, the
MM approach assumes same risk with both firm requires from investment in order
personal and corporate leverage. But to increase the value of the firm in the
actually the personal leverage is more market place”.
To conclude, cost of capital is the minimum

FM – (Al Jamia Arts and Science College, Poopalam)

rate of return that must be earned to Amount of finance required –for additional
maintain the market value per share. fund investors may ask for higher required
Classification of cost of capital rate of return.
 Historical cost and future cost :  Floatation cost –
Historical cost refers to the cost which it refers to the cost of marketing new
already been incurred. While future cost securities. When cost of floatation is
refers to the expected cost of funds to be incurred, the cost of capital will be
raised for financing a project. increased.
 Specific cost and composite cost :  Taxes –
specific cost refers to the cost of a specific it also a factor of determination on cost of
source of capital such as equity, debentures capital.
etc. composite cost of capital refers to the Determination of cost of capital
combined cost of various sources of capital. Before calculating overall cost of capital, an
 Average cost and marginal cost : attempt may be made to calculate the cost
average cost refers to the weighted average of each of the components such as:
cost of capital calculated on the basis of  Cost of debt
cost of each source of capital. Marginal  Cost of preference capital
cost of capital refers to the additional cost  Cost of equity capital
incurred due to additional source.  Cost of retained earnings
 Explicit cost and implicit cost :  Cost of weighted average cost
explicit cost refers to the discount rate of capital
which equates the present value of cash Cost of debt
inflows with the present value of cash Debt capital comprises of debentures and
outflows. Implicit cost refers to the rate of long term loans. Cost of debt capital means
return which can be earned by investing the payment of interest on debentures or
the funds in alternative investment. It is loans from financial institutions. For
the opportunity cost of capital. calculating cost of debt we need data
Importance of the concept of cost of regarding
capital  Net cash proceeds (the issue price)
 Useful in investment decision  Net cash out flows (interest paid
 Useful in designing capital structure and repayment of principal amount)
 Useful in deciding method Cost of irredeemable debt : irredeemable
of financing debt is known as perpetual debt. In this
 Useful in evaluation of performance case the time of maturity is not specified. In
of management case the debt is raised at premium or
 Useful in evaluation of expansion discount, NP is the net proceeds received
projects from the issue. It means premium should
 Optimum mobilization of resources added to face value and discount should be
Factors determining cost of capital deducted.
 General economic condition – Cost of redeemable debt: usually the debt
cost capital will change according to the is issues to be redeemed after a certain
inflation condition prevailing in the period during the life time of a firm.
economy Cost of preference share capital
 Risk Preference shares carry a fixed rate of
higher the risk, higher the cost of capital dividend. It is paid before equity dividend is
and vice versa. paid. The rate of dividend is determined at
the time of issue. The cost of preference

FM – (Al Jamia Arts and Science College, Poopalam)

capital is the dividend expected by the This method is used in the following cases:
preference shareholders. It is found by  When the EPS is expected to remain
dividing annual preference dividend by the constant
net proceeds from the issue of preference  When the dividend payout ratio is
shares. 100 %
Cost of equity share capital  The share price is influenced by
The cost of equity capital is the most the EPS
difficult to measure. It is so because the Realized yield method :when future
rate of dividend is not fixed. It depends dividend and market price are uncertain, it
upon the profitability. However it does not is very difficult to estimate the rate of
mean that equity share capital is cost free. return on investment. In order to overcome
It also has certain cost. The cost of equity this difficulty, the average rate of return
capital is the minimum rate of return that actually realized in the past few years by
the company must earn on its equity share the investor is used to determine the cost of
capital. It is the return which the capital. Under this method, the realized
shareholder expects on his investment. yield is discounted at the present value
The cost of equity capital can be calculated factor and then compared with the value of
under six methods. investment.
 Dividend yield method Capital asset pricing model (CAPM):
 Dividend yield plus growth method under this method the cost of equity is
 Earning yield method divided into two components- (i) the near
 Realized yield method risk free return available on investing in
 CAPM government bonds and (ii) an additional
 Gordon dividend growth model risk premium for investing in a particular
Dividend yield method: this method is share or investment. This risk premium in
based on the assumption that turn comprises the average return on the
each shareholder, while investing his overall market portfolio and the beta factor
savings in the company, expects to receive (or risk) of the particular investment.
dividend at the current rate Gordon dividend growth model : this is
of return. Therefore, dividend yet another technique to determine cost of
received is capitalized by the market equity. This approach takes into account
value of shares to ascertain the cost of annual growth in dividend in perpetuity.
shares. This method is also known as The dividend and its growth is shown as
dividend price ratio method. To ascertain the ratio of expected rate of return plus
the cost of capital, dividend is divided by growth rate.
net proceeds. Cost of Retained Earnings
Dividend yield plus growth method : Generally, it is thought that retained
when the dividend expected to grow at a earnings do not involve any cost and it is a
constant rate and dividend payout ratio is cost free source of finance. It is true that
constant, this method may be used. Under there is no explicit cost of retained
this method the cost of equity is based on earnings. If a company does not retain any
the present rate of dividend and expected part of its profit and distributes the whole
growth rate of dividend. amount as dividend, the income of the
Earning yield method : according to this equity holders would have been increased
method, the cost of equity capital is the and they could earn a certain income by
discount rate that equates the present investing this amount. Thus the retained
value of expected future earnings per share earnings involve opportunity cost. So cost
with the current market price or net of retained earnings is the rate of return
proceeds per share.
 FM – (Al Jamia Arts and Science College, Poopalam)
which the shareholder is not receiving the  Difficult to assign weights
dividend. It refers to the rate of return LEVERAGE ANALYSIS
which shareholder can obtain by investing Leverage : generally the term leverage
the after tax dividend in other securities. means the relationship between two inter-
Weighted average cost of capital (WACC) related variables. In FM the term leverage
WACC simply refers to the average cost of means, by use of certain fixed costs, the
the various sources of finance. It is an firm increases its profitability.
average of the cost of all sources of funds in Types of leverages
the capital structure, properly weighted by  Financial leverage
the proportion of each source in the capital  Operating leverage
structure. It is also known as composite  Combined leverage
cost of capital or overall cost of capital. We Financial leverage: (FL)
use no simple average but weighted The use of borrowed money(debt) by
average. the firm to make more money is called
Steps involved in calculating WACC financial leverage. If a firm uses debt or
 Assigning of weights : first of all preference capital or both, it has financial
weights have to be assigned to each leverage and the firm is a leveraged firm.
source. It can be either book value
weights or market value weights. The impact of fixed charge securities
Book value weights : these are the relative on EPS(earning per share) is the result of
proportion of various sources of capital to FL. The FL analyze the effects of changes in
the total capital. EBIT(earnings before interest and tax)
Market value of weights: it may calculated on firm’s EPS due to the use of fixed
on the basis of the market value of the cost bearing sources.
different sources of capital. FL may favourable or unfavourable.
 Computation of specific cost of If the earnings by the use of fixed cost
each source : after assigning bearing securities is more than their fixed
weights, the next step is to calculate cost, it is known as favourable FL. It is also
the specific cost of each source. known as trading on equity. If the earnings
 Computation of WACC: after is less than their fixed cost, it is known as
ascertaining specific cost of each unfavourable FL.
source, the WACC is calculated. This Definition of FL: According to Gitmar “FL
is calculated by multiplying the cost is the ability of a firm to use fixed financial
of each source by its respective leverage to magnify the effect of change in
weights. EBIT and EPS”
Merits of WACC Impact or effect of FL
 Straight forward and  Effect on shareholders’ earnings:
logical approach if a company’s rate of earnings is higher
 Takes into consideration all changes than the rate of fixed charges, the financial
in the capital structure leverage has positive impact on EPS and
 More accurate when profit vice versa.
are normal  Effect on financial risk:
 Useful in budgeting decision. with the use of FL, financial risk increases.
Demerits of WACC Financial risk means the firm’s ability to
 Not suitable in case of excessive low cover the fixed financial cost. When the firm
cost debt fails to pay interest and other obligations
 Not suitable in case of low profits year after year, its creditors may demand
compulsory winding up of the company.
 FM – (Al Jamia Arts and Science College, Poopalam)
Degree of financial leverage: amount of fixed cost in the cost structure. In
The degree of FL measures the impact of a simple words, presence of fixed cost
change in EBIT on change in EPS. is known as operating leverage. If the
Characteristics of FL fixed costs are more as compared to
 Related with liability side of balance variable cost, the operating leverage will be
sheet high.
 Determines the mix of various OL measures the changes
methods of financing necessary in operating profit (EBIT) to changes in
assets. sales. Operating leverage may be defined
 It shows the effect of changes in EBIT as a firm’s ability to use fixed operating
on EPS costs to magnify the effect of changes in
 Involve financial risk sales on operating profit.
Importance of FL In case the contribution exceeds the fixed
 Planning of capital structure: cost, the OL is favourable and vice versa.
FL is concerned with judicious balance Degree of OL: Degree of OL measures
between debt and equity. For this, an how much is the effect of change in
optimum capital structure is determined. sales on change in operating profit.
 Profit planning : Degree of OL at any level of output is
FL affects EBIT or EPS. Therefore, the expressed as the ratio of the percentage
concept of FL is important for profit change in profit (EBIT) to percentage
planning. change in sales.
 Increase in shareholders’ income: Relationship between OL and BEP
higher dividends can be declared in case of There is a relationship between the
favourable FL. This will increase operating leverage and the BEP. As the OL
the goodwill of the firm. This leads to becomes higher, the BEP also becomes
increase in the market value of its shares. higher because of presence of high fixed
Limitations of FL costs. Hence greater is the impact on profits
 Double edged sword: of a given change in the sales.
it can successfully be used to increase the Characteristics of OL
EPS. If the rate of earning is less than fixed  OL is related to the asset side of the
interest and dividend, it will work balance sheet
adversely.  There is a direct relationship
 Increase risk: between BEP and degree of OL
the increase in debt increase in financial  Related to contribution
risk also.  OL magnifies profit as well as risk
 Beneficial to companies having Importance of OL
stable earnings  Profit planning –
 Restriction from OL is relevant for capital budgeting
financial decision. Capital budgeting is essential for
institutions : long term profit planning.
the financial institutions may impose  Capital structure-
restrictions on companies which have high Operating income is the basis for decision
degree of FL due to risk factor. about the capacity of the firm to bear the
Operating leverage (OL) burden of payment of interest on debts.
A main reason for change in EBIT is Thus OL influences the debt equity mix or
changes in the cost structure. All costs can capital structure planning.
be classified into two- fixed and variable.  Risk analysis –
Operating leverage refers to the a firm should try to operate at a level
sufficiently higher than break-even level
 FM – (Al Jamia Arts and Science College, Poopalam)
so that the chances of loss due to situation. If sales decreases, EPS also will
fluctuations in sales are minimized. decrease. This is an unfavourable situation.
Difference between OL and FL DIVIDEND POLICY
OL FL Meaning of dividend: the term dividend
It magnifies effect of It magnifies the refers to that portion of after-tax profits
changes in sales on effect of changes which is distributed among the
profit in operating profit shareholders of the company. Dividend is
on EPS the reward paid to the shareholders.
It establishes Establishes Definition: according to institute of
relationship relationship chartered accountants of India “ dividend is
between operating between a distribution to shareholders out of profits
profit and sales operating profit or reserves available for this purpose”.
and return on Types or forms of dividend
equity Cash dividend: dividend paid in cash. It
Relates to the asset Relates to the may two types
side of the balance liability side of  Regular or final dividend: it is the
sheet the balance sheet dividend declared and paid at
It influences EBIT It influences EAT the end of the financial year.
(earning after tax)  Interim dividend: dividend
Concerned with Concerned with declared before the declaration of
investment decision financial decision final dividend. The means between
two financial year.
It deals with It deals with
Stock dividend: dividend paid in the form
business risk financial risk
Impact of OL on profit shares by capitalizing its past profits or
If a firm has a high degree of OL, the reserves.
% change in EBIT will be more than change Scrip dividend: dividend paid in the form
in sales. This means a small % of increase of promissory note for a shorter maturity
in sales results in a larger % of increase in period.
EBIT. As operating income is affected, net Bond dividend : dividend paid in the form
income will also be affected. Similarly, of debentures or bonds for a long period
when the sales of a firm decrease, a smaller bearing interest at fixed rate.
% fall in sales results in a larger % of fall in Property dividend : dividend paid in the
operating income. form of assets.
Combined or total leverage MEANING OF DIVIDEND POLICY :
Combined leverage refers to the Dividend policy refers to the
combination of OL and FL. It is the policy which determines the allocation of
relationship between contribution and the earning into retained earnings and
taxable income. It is also known as dividend. Dividend policy represents the
composite or overall leverage. plan action to be followed whenever
Importance of combined leverage the dividend decision must be made.
A proper combination of OL and FL is What amount is to be retained and
a blessing for the company’s growth. A how much is to be distributed is the
company should try to have a balance of OL essence of the dividend policy.
and FL. Combined leverage enables to Definition :Weston and Brighem defines “
know the overall risk assumed by a firm. It Dividend policy determines the division
reflects a combined effect of operating risk of earnings between payments
and financial risk on EPS. If sales increases to shareholders and retained earnings”.
EPS will also increases. This is a favourable
 FM – (Al Jamia Arts and Science College, Poopalam)
Importance of dividend policy/  Legal requirements :
optimum dividend policy legal formalities also consider
An optimal dividend policy which while deciding dividend policy
maximizes the value of firm or its shares.  Corporate dividend tax rate : CDT
Determination of how much is to be should be paid on
distributed among shareholders and how dividend distributed among its
much is to retained in the business is very shareholders.
important for a company. Because it  General state of
certainly affect the overall market price of economy: uncertain economy
the shares. So dividend policy should be may leads to aggressive dividend
optimum. Liberal dividend policy may policy.
affect the liquidity of the business and  Conditions in the capital market:
aggressive dividend may affect the market liberal dividend policy can follow
value of shares. when there is a comfortable capital
Factors which affects dividend market.
policy Internal factors  Government policy:
 Stability and size of earnings: if Types of dividend policy
earnings is stable and large size, the 1) Stable dividend policy : Stable
company can distribute more among dividend policy is one that maintains
shareholders. regularity in paying some dividend
 Liquidity fund: while deciding even though the earning fluctuate
dividend policy liquidity of the firm year after year. In short stable
should be kept in mind. dividend means payment of certain
 Investment opportunities and minimum amount of dividend
shareholders’ preference: retained regularly. It may be in three types:
if there is a plan of new investment o Constant dividend
and also consider the preference of per share: paying a fixed
shareholders. amount of dividend per
 Attitude of management towards share every year.
control : if the management wants to o Constant percentage
retain the control in existing of earnings: paying a
shareholders, should retain adequate fixed percentage of net
fund for further necessary. profit as dividend every year.
 Past dividend rate : new dividend o Constant dividend per share
rate should not be below the past plus extra dividend :
rate for a new company. her fixed amount of dividend
 Ability to borrow: if the company per share plus extra
has high borrowing capacity, they dividend in the year of good
can distribute more among its profits.
shareholders. Advantages of stable dividend policy
 Need to repay debt: if the firm has  Increase confidence of the
more debt, they should retain shareholders.
adequate fund to repay it.  It meets expectation of investors
External factors  Attract new investors
 Trade cycle : during inflation,  Stabilizes market value of shares
companies can not declare more  Increase goodwill of the firm
dividend.  Helps in preparing financial planning
 Sign of continued normal operations
of the company
 FM – (Al Jamia Arts and Science College, Poopalam)
Dangers of stable dividend policy distributed to the shareholders as
 It is not easy to change dividends. In short, it is the ratio between
 If the company pays stable dividend dividend and earnings.
in its incapacity, it will be suicidal in Theories on dividend policy
the long run Modigliani and Miller theory
2) Regular and extra dividend policy: (irrelevancy theory)(MM theory)
Under this policy shareholders are According to this theory, dividend
paid a constant rupee dividend as a policy has no effect on the market price of
fixed percentage along with extra the shares and value of firm. It states that
dividends. when a firm pays dividend, the market
3) Regular stock dividend policy: this price of its shares increases. Hence
is the policy of distributing shares increases the value of firm. But due to
instead of cash dividend. payment of dividend, the cash balance
4) Regular dividend plus stock decreases. So companies want to found out
dividend policy: giving regular necessary funds. Company can raise
dividend in cash and extra dividend through equity capital and debt capital.
in shares. Issue of new equity shares leads to supply
5) Irregular dividend policy: paying of equity, then it leads to decrease in value
irregular dividend among the of share and hence decreases the value of
shareholders. firm. Thus increase in value of shares gets
Dividend policy and value of firms nullified due to increase in supply of shares.
There are two opinion about the On the other hand, if the firm raised fund
dividend policy and value of firms. Some through debt capital, firm’s financial risk
are argued that dividend policy is will increase. So cost of equity will also
irrelevant and some others are argued that increase. This will bring down the market
dividend policy id relevant. value. Finally total value of firm would
Irrelevance concept of dividend : reach its previous level.
according to this concept dividend policy Assumptions of MM theory
has no effect on the market price of the  There are perfect capital market
shares and value of firm and hence  Investors behave rationally
dividend policy is irrelevant. In their  No tax
opinion investors do not differentiate  No floatation and transaction costs.
between dividend and the capital gains.  Firm has a fixed investment policy
Solomon Ezra, Modigliani and miller  No investors is large enough to affect
believes this concept. the market price.
Relevance concept : according to this Criticism of MM theory
concept dividend policy has reasonable  Perfect capital market does not
effect on the market value of the shares and exist in reality
value of firm. Hence dividend policy is  While Issuing of shares the company
relevant. Those firms which pay higher will have to incur floatation and
dividends, will have greater value and vice transaction costs.
versa. M. Gordon, John Linter and James  Taxes do exist
Walter follow this concept.  Most of the shareholders
Dividend payout ratio prefer current income rather than
Dividend payout ratio is the future capital gains.
percentage of ratio of dividend to the  Firms need not follow a
earnings. In other words, it is the fixed investment policy.
percentage share of net earnings
 FM – (Al Jamia Arts and Science College, Poopalam)
Walter’s Dividend theory dividends are relevant and it will affect the
In this theory Walter argues market value shares and value of firm.
dividend decision of a firm is relevant. This Assumptions of Gordon model
means dividend policy has an impact on  The firm is an all equity firm
market price of shares. Thus dividend  Retained earnings are the only
policy affects the value of the firm. source of funds.
According to Walter, if the company has  Rate of return ( r ) is constant
investment opportunities to invest its  The growth rate ‘g’ is the product of
earnings, it does not pay dividend. That is it its retention ‘b’ and its rate of return
will invest earnings. On the other hand, if ‘r’. i.e. g = b x r
the company has no investment  Cost of capital ( k ) is constant and
opportunities, it will pay dividend. So the more than growth rate
dividend decision affects the market price  The firm has a long life
of the shares and value of the firm.  Corporate taxes do not exist
According to this theory a firm can Implications of Gordon’s Model
maximize the market price of its shares and  When r is greater than k, the market
value of the firm by adopting a dividend price of shares increases as
policy as follows the dividend payout ratio
 If r (rate of return) is greater than k decreases. Thus growth firms
(cost of equity), the payout ratio should distribute lower dividends
should be zero (100 % retention (payout ratio 0 %)
ratio)  When r is less than k, the market
 If r is less than k, the payout ratio price of shares increases as
should be 100 % (0 % retention the dividend payout ratio
ratio) increases. Thus declining firms
 If r= k, the dividend is irrelevant and should distribute higher dividends
the company can follow any dividend (payout ratio 100 %)
payout ratio.  When r = k, the market price of
Assumptions of Walter’s model shares remain unchanged.
 The firm does not use Residual theory :
external source of funds. The residual theory focuses on the firm’s
 The IRR (rate of earnings) and cost internal need for capital. This theory states
of capital (expected rate) are that if there are viable projects, earnings
constant. should be retained for funding the projects.
 Earnings and dividend are constant This means if there are investment
 The firm has a very long life. opportunities, company should pay less
 All earnings are distributed dividend or on dividend and vice versa.
or invested internally Smoothened residual theory:
immediately. The smoothened dividend policy is
Criticism of Walter’s Model the modified version of residual theory.
 External sources are used Under this theory, the dividends are
for additional funds varied gradually over a period of time. The
 The IRR and cost of capital do not level of dividend is so fixed that over the
remain constant planning period, the amount of dividend
 We cannot predict that the firm has a payment is equal to the total
very long life. earnings less the forecasted
Gordon’s Model investments.
M. Gordon has also given a model on
the line of Walter. He suggested that
 FM – (Al Jamia Arts and Science College, Poopalam)
Bird in hand theory:  Avoid frequent changes : negative
Graham, Dodd and Cottle states that one change in dividend should bring a
rupee of dividend is worth opportunity negative approach in the mind of
three rupees of retained cash flows. investors. So keep regular or
According to this, dividend are worth more positive change in dividend policy.
to investors than retained earnings because  Avoiding skipping dividend :
the purchaser of shares buys with the dividend payment should be regular.
expectation of future dividends.  Communication :
Tax differential theory: should
According to this theory, investors would communicate the dividend policy to
not prefer higher dividend because of the the shareholders of the company
higher tax. They prefer a low dividend
payout and a huge rate of earning retention MUHAMMED RIYAS . N
on the expectation of an appreciation in the ASST. PROF
capital value. Thus according to this theory, AL JAMIA ARTS AND SCIENCE COLLEGE
a firm should pay a low dividend. POOPALAM, PERINTHALMANNA
Dividend preference theory : PH: 9747799772
This theory was developed by Solomon E-mail: riyasmuhammed89@gm
Ezra. According to this theory, investors
prefer dividend payment rather than
retention, it is because of the following
three reasons
 Dividend payment provides first-
hand information to investors about
the firms profitability
 There is always a group of low
income shareholders that need
stable and cash dividend.
 Current dividend payment resolve
uncertainty in the minds of
investors.
Principles of dividend policy
 Increase in value : what-ever may
be the dividend policy, it should be
capable of increasing value of shares
and value of firms
 Balance between shareholders’
need and company’s need: there
should be balance between
shareholders’ need and company’s
need while deciding dividend policy.
 Long term perspective : dividend
policy should not aim at making
short term residual decision.
 Reduce speculative trading : the
dividend policy of a firm should aim
at reducing speculative trading in its
shares.
FM – (Al Jamia Arts and Science College, Poopalam)