Notes on

Basics of Financial Management

 Contents
Generic Basics of Finance Management
Page
SECTION(S) Topics Number
A INTRODUCTION TO FINANCE MANAGEMENT 1-49
A.1 What is Finance 1
A.1.1 Field of Finance 1
A.1.2 Organization Of Finance Function In A Muti-Divisional Indian 3
Company
A.2 Financial Management 5
A.2.1 Definitions 5
A.2.2 Objectives of Financial Management 5
A.2.3 Scope of Financial Management 7
A.2.4 Aims of Financial management 10
A.2.5 Functions of Finance 11
A.2.6 Interrelations of Finance 15
A.2.7 Liquidity Vs Profitability 16
A.2.8 Role of Finance Man 19
A.3 Time Value of money 21
A.3.1 Need for time value of money 22
A.3.2. Time Preference Rate and 22
Required Rate of Return
A.3.3 PVF: Present Value Factor 23
A.3.4 Future Value Factor: 25
A.3.5 Compounding: 28
A.4 Objectives of firm 33
A.4.1 Profit maximization 33
A.4.2 Wealth Maximization 34
Practical Sums 35
Exercise 44
B COST OF CAPITAL & VALUATION 50-83
B.1 Introduction 50
B.1.1 Meaning of Cost of Capital: 50
B.1.2 Assumptions of Cost of Capital 50
B.1.3 Importance of Cost of Capital 51
B.1.4 Classification of Cost 52
B.1.5 Risk-Return Relationship between various securities 54
B.2 Computation of Cost of Capital 55
B.2.1 Cost of Equity 55
B.2.2 Cost of Debt 59
 B.2.3 Cost of Preference Share Capital 62
B.2.4 Cost of Retained Earnings 64
B.2.5 Measurement of overall cost of capital 64
Practical Sums 67
Exercise 78
C Capital Budgeting 84-128
C.1 Fundamentals 84
C.1.1 Introduction 84
C.1.2 Definitions 84
C.1.3 Characteristics of capital budgeting 85
C.1.4 Need and importance of capital budgeting 85
C.1.5 Capital Budgeting Process 86
C.2 Methods of Capital Budgeting of Evaluation 88
C.2.1 Pay Back Period 89
C.2.2 Accounting Rate of Return 91
C.2.3 Net Present Value 93
C.2.4 Internal Rate of Return 97
C.3 Ratios 103
C.3.1 Debt Service Coverage Ratio 103
C.3.2 Interest Service Coverage Ratio 105
C.3.3 Earning before Interest, tax, depreciation and amortization 106
C.4 Leverages 107
C.4.1 Degree of Operating Leverage 108
C.4.2 Degree of Financial Leverage 110
Practical Sums 111
Exercise 122
D Working capital management 129
D.1 Working Capital 129
D.1.1 Definitions 129
D.1.2 Concept of Working Capital: 130
D.1.3 Needs of Working Capital 131
D.1.4 Causes and consequences of having excessive working capital. 132
D.1.5 The causes and repercussions of insufficient working capital 132
D.1.6 Types of Working Capital: 132
D.1.7 Factors determining working capital requirements 134
D.1.8 Working capital Management Policy 136
D.1.9 Sources of Working Capital: 137
D.2 Working Capital Requirements: 137
D.3 Receivable days 139
D.4 Accounts Payable days: 140
D.5 Inventory days 141
 D.6 Operating Cycle: 142
D.7 C2C Cycle 145
D.7.1 Days of Inventory Outstanding (DIO) 145
D.7.2 Days of Sales Outstanding (DSO) 146
D.7.3 Days of Payables Outstanding (DPO) 146
D.7.4 Cash Conversion Cycle 146
Practical Sum 147
Exercise 151
E SOURCES OF FUND 157-181
E.1 Demand of funding 157
E.1.1 Long term financial needs or fixed capital requirement: 157
E.1.2 Short term financial needs or working capital requirement 157
E.2 SOURCES OF FINANCE 158
E.2.1 Based of period 158
E.2.2 Based on ownership 159
E.2.3 Based on source of generation 159
E.3 Sources of funds 160
E.3.1 Retained Earnings: 161
E.3.2 BANK LOANS 163
E.3.3 COMMERCIAL PAPER 164
E.3.4 DEBENTURES 166
E.3.5 EQUITY SHARES 170
E.3.6 PREFERENCE SHARE CAPITAL 172
E.3.7 Other Funding Sources 175
Exercise 177
F APPLICATIONS OF FUNDS 182
F.1 Introduction 182
F.1.1 Investment Avenues 182
F.1.2 History of The Term "Fund" 184
F.1.3 Concept of funds 186
F.1.4 Sources of fund 186
F.1.5 IS DEPRECIATION A SOURCE OF FUNDS? 188
F.1.6 APPLICATION OR USES OF FUNDS 189
F.2 Fixed Assets 190
F.2.1 The Role of Fixed Assets in Financial Statements 190
F.2.2 Applications of Fixed Assets 191
F.2.3 Conclusion 194
F.3 Application of Stocks 194
F.3.1 Understanding Stocks 195
F.3.2 Stock Market Exchanges 195
F.3.3 Reasons for Investing in Stocks 195
 F.3.4 Strategies for Stock Investing 197
F.3.5 Implications of Stock Investing 198
F.3.6 Conclusion 198
F.4 Trade receivables 199
F.4.1 Key Concept 199
F.4.2 Definition and Nature of Trade Receivables 200
F.4.3 Importance of Trade Receivables 201
F.4.4 Managing Trade Receivables 201
F.4.5 Risks Associated with Trade Receivables 202
F.4.6 Reporting Trade Receivables 202
F.4.7 Analysis and Decision-Making 202
F.4.8 Conclusion 202
F.5 Application of Funds Kept as Cash or in Banks 203
F.5.1 Understanding Cash and Bank Accounts 203
F.5.2 Importance of Cash and Bank Funds 203
F.5.3 Strategies for Managing Cash and Bank Funds 203
F.5.4 Implications of Cash and Bank Funds Management 204
F.5.5 Reporting and Financial Decision-Making 205
F.5.6 Reasons for Maintaining Cash and Bank Balances 205
F.5.7 Conclusion 206
F.5.8 Investment Options for Excess Funds 206
F.6 Application of Funds from Investments 207
F.6.1 Understanding Investment 207
F.6.2 Types of Investments 208
F.6.3 Investment Strategies 208
F.6.4 Risk Management 209
F.6.5 Implications of Investments 209
F.6.5 Conclusion 210
F.7 Fund Flow Statement 210
F.7.1 Utility Of Funds Flow Statement To Different Parties 210
F.7.2 Procedure for knowing whether a transaction finds a place in 211
funds flow statement
F.7.3 Preparation of funds flow statement 213
Practical Sums 219
F.7.4 Difference Between Income Statement, Balance Sheet And 235
Funds Flow Statements
F.7.5 Limitations Of Funds Flow Statement 236
Exercise 236
Bibliography 242
 A.INTRODUCTION TO FINANCE MANAGEMENT

A.1.What is Finance?
The term "financing" refers to the management of financial resources, which includes activities such as
budgeting, forecasting, borrowing, lending and investing.

A person or organization's finances are strategically planned and managed as part of finance management
in order to better match their financial situation with their aims and objectives. Finance management
aims to maximize shareholder value, produce profit, reduce risk, and protect the company's long- and
short-term financial health depending on the size of the business. Planning for retirement, college savings,
and other personal assets may be involved while dealing with individuals in the field of finance
management.

A.1.1.Field of finance

a) Public Finance
The method of managing public funds in the economy that is most crucial to the development and
expansion of the country both domestically and globally is known as public finance. Every stakeholder in
the nation, whether a citizen or not, is likewise impacted. The assessment of desired results is computed
in accordance with the public finance economics, which takes into account the government's revenue and
expenditures. For eg., tax system of the country, annual expenditures, budget procedures, debt
instruments etc.

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 b) Corporate Finance
Corporate finance departments are in charge of overseeing the financial operations and capital
investment choices of their respective companies. These choices include whether to proceed with a
suggested investment and whether to finance it through equity, debt, or both. For eg., When a company
has surplus profit, option 1: Expansion of business, Option 2: Increasing the salary of employees, Option
3: Repayment of debt/ debentures/ loans, Option 4: Investment in another business Option 5: Distribution
of dividend to shareholders etc.

c) Personal Finance
Managing your personal and family finances, accepting responsibility for your current and future financial
circumstances, and creating financial objectives are all included in personal finance. It also involves
managing one's personal finances and setting aside money for emergencies. For eg., Investment in Share
market/ mutual fund for retirement, buying house by the year 2030, preparing finance for kids higher
studies, marriage etc.

d) Social Finance
Social finance is a category of financial services that aims to attract private capital to meet challenges in
the areas of social and environmental needs.

Source: https://upload.wikimedia.org/wikipedia/commons/5/5d/Social_finance_market_structure.png

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 e) Behavioural Finance
Behavioural finance tries to explain how people make financial decisions in the real world and why their
choices cannot always seem rational and have unforeseen results. The financial decisions of investors are
often biased due to various factors and make their decisions irrational.

A.1.2 ORGANISATION OF FINANCE FUNCTION

IN A MUTI-DIVISIONAL INDIAN COMPANY

Structure Chart:
Basically, there are two most important functions – the accounting and finance functions. The accounting
functions are performed by Controller while the Treasurer performs the finance functions. Both these
functionaries work under the close supervision of vice-president (Finance).

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The organisation chart shows that the Vice-President (Finance) is supported by two deputies known as:

1. Controller or Comptroller (Accounts Manager)

2. Treasurer (Finance Manager)

Controller’s Functions:

Controller’s functions, basically, include accounting function, inventory management, planning and
budgeting, payroll, all types of tax administration, statutory and internal audit, preparation of annual and
financial reports, economic appraisal and reporting and internal control. In some organisations, he is
designated as Accounts Manager.

Treasurer’s Functions:

The major duties of Treasurer include forecasting of financial needs, present and future, both long-term
and short-term and arranging required funds, at economic cost, in time. The main function of treasurer is
to plan, provide the needed capital and working capital funds and their management. Additionally, he
assumes responsibility for cash management and administering the flow of cash, management of
receivables, retirement benefits, cost control and protecting funds and securities. He is to coordinate with
banks and financial institutions. The treasurer is also designated as Finance Manager.

It may be stated that controller’s functions are concerned with the assets side of the balance sheet, while
treasurer’s functions relate to the liability side in a firm.

Capital Expenditure Decisions:

Looking to the importance of capital expenditure, the function is in direct control of Vice-President
(Finance). Decisions relating to capital expenditure are taken through Finance Committee, presided by
the President, where all the functional heads are the members.

It is interesting to note that the controller does not control the finances. He utilises the information
relating to finance for planning and management control. The routine functions are always delegated to
the officers, working under their supervision.

Additional functions may be assigned to the finance division. But, the culture, of late, has been to allow
the finance chief to concentrate on the finance functions, alone, as finance has been considered a very
important function, demanding full time attention to maintain the efficiency of the organisation. Earlier,
Government reporting and insurance functions used to be handled by the finance. Now, they are handled
by the Company Secretary to enable the Vice-President (Finance) to concentrate on the management of

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the financial resources. His duties are not compounded with the other duties, generally, in large
companies.

A.2. Financial Management

Financial management means planning, organizing, directing and controlling the company's financial
activities, such as acquisition and the use of funds. This means applying general management principles
to the company's financial resources.

A.2.1.Definitions:
“Financial management is the activity concerned with planning, raising, controlling and administering of
funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of capital and a
careful selection of the source of capital in order to enable a spending unit to move in the direction of
reaching the goals.” – J.F. Brandley

“Financial management is the operational activity of a business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient operations.”- Massie

“Financial Management is concerned with the efficient use of an important economic resource, namely,
Capital Funds” - Solomon

“Financial Management is concerned with the managerial decisions that result in the acquisition and
financing of short-term and long-term credits for the firm” - Phillioppatus

“Business finance is that business activity which is concerned with the conservation and acquisition of
capital funds in meeting financial needs and overall objectives of a business enterprise” - Wheeler

A.2.2.Objectives of

Financial Management
▪ Investing in fixed assets is one type of investment decision (also known as capital budgeting).
Investment choices referred to as working capital choices can include investments in current
assets.
▪ Financial decisions: These have to do with the decision of what type of source, how long the
financing will last, how much it will cost, and what returns will result from the financing.
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 ▪ The finance manager must make a judgement regarding the dividend in relation to the distribution
of net profit. Net profits are typically split into two categories.
Dividend for shareholders—A dividend must be declared, along with its rate.
Retained earnings: The amount of retained profits must be decided, and it will rely on the
company's intentions for growth and diversification.

a) Financial Objectives
The goals or targets relating to a company's financial success are known as financial objectives. They are
the objectives that businesses establish for development and success.
There are six main types of financial objectives:
● Revenue objectives,
● Cost objectives,
● Profit objectives,
● Cash flow objectives,
● Investment objectives,
● Capital structure objectives.
a.1. Revenue objectives
The most typical objectives employed by all different types of businesses are revenue objectives.
There are three types of revenue objectives:
1. Revenue growth (percentage or value). For example, aiming to grow total revenues by 30%, reaching
£1 million in annual revenue.
2. Sales maximization. For example, maximizing total sales no matter whether they are profitable or not.
3. Market share. For example, growing market share to 40%.
a.2. Cost objectives
Cost objectives simply seek to reduce costs while maintaining the quality of a good or service. lowering
variable costs, for instance, to £50 per unit.
a.3. Profit objectives
Revenue and cost objectives are frequently used to support profit objectives. An organisation will
produce a bigger profit, for instance, while increasing income and reducing expenses.
There are four types of profit objectives:
● Specific level of profit. For example, achieving an operating profit of £1 million.
● Rate of profitability. For example, achieving an operating profit margin of 15%.

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 ● Profit maximisation. For example, maximising the total profit for the year.
● Exceed industry or market profit margin. For example, growing the gross or operating profit
margin higher than the competitors.
a.4. Cash flow objectives
Small companies and start-ups that are not yet profitable frequently utilise cash flow objectives. The
goals are centred on increasing cash flow.
One can accomplish this by:
▪ decrease in borrowing,
▪ reducing interest expenses,
▪ lowering credit and inventory sales,
▪ minimising seasonal fluctuations in cash flow.
a.5. Investment objectives
Increasing return on investment is one of the investment goals.
There are two types of investment objectives:
Capital expenditure level
It establishes a fixed dollar amount or a fixed percentage of revenues. investing £1 million, or 5% of annual
income, as an illustration.
Investment yield
It is a desired rate of return. 20% ROCE, as an illustration (return on capital employed). (Read more about
financial ratios in the article.)
a.6. Capital structure objectives
The goals of the capital structure have to do with how a company is financed and how its capital is
organised.
There are two types of capital structure objectives:
Increased equity.
It is typically employed by start-ups and businesses that are exempt from dividend obligations.
Greater degree of debt.
When profits are large and interest rates are low, it is employed.

F.2.3 Scope of Financial Management

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Financial management is concerned with optimum utilisation of resources. Resources are limited,
particularly in developing countries like India. So, the focus, everywhere, is to take maximum benefit, in
the form of output, from the limited inputs.
Financial management is needed in every type of organisation, be it public or private sector. Equally, its
importance exists in both profit oriented and non-profit organisations. In fact, need of financial
management is more in loss-making organisations to turn them to profitable enterprises. Study reveals
many organisations have sustained losses, due to absence of professional financial management.
Financial management has undergone significant changes, over the years in its scope and coverage.
Approaches: Broadly, it has two approaches:
Traditional Approach-Procurement of Funds
Modern Approach-Effective Utilisation of Funds

a) Traditional Approach
The scope of finance function was treated, in the narrow sense of procurement or arrangement of funds.
The finance manager was treated as just provider of funds, when organisation was in need of them. The
utilisation or administering resources was considered outside the purview of the finance function. It
was felt that the finance manager had no role to play in decision making for its utilisation. Others used
to take decisions regarding its application in the organisation, without the involvement of finance
personnel. Finance manager had been treated, in fact, as an outsider with a very specific and limited
function, supplier of funds, to perform when the need of funds was felt by the organisation.
As per this approach, the following aspects only were included in the scope of financial management:
(i) Estimation of requirements of finance,
(ii) Arrangement of funds from financial institutions,
(iii) Arrangement of funds through financial instruments such as shares, debentures, bonds and loans, and
(iv) Looking after the accounting and legal work connected with the raising of funds.
Limitations

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The traditional approach was evolved during the 1920s and 1930s period and continued till 1950. The
approach had been discarded due to the following limitations:
(i) No Involvement in Application of Funds:
The finance manager had not been involved in decision-making in allocation of funds. He had been treated
as an outsider. He had been ignored in internal decision making process and considered as an outsider.
(ii) No Involvement in day to day Management:
The focus was on providing long-term funds from a combination of sources. This process was more of one
time happening. The finance manager was not involved in day to day administration of working capital
management. Smooth functioning depends on working capital management, where the finance manager
was not involved and allowed to play any role.
(iii) Not Associated in Decision-Making Allocation of Funds:
The issue of allocation of funds was kept outside his functioning. He had not been involved in decision-
making for its judicious utilisation.
Raising finance was an infrequent event. Its natural implication was that the issues involved in working
capital management were not in the purview of the finance function. In a nutshell, during the traditional
phase, the finance manager was called upon, in particular, when his speciality was required to locate new
sources of funds and as and when the requirement of funds was felt.
The following issues, as pointed by Solomon, were ignored in the scope of financial management, under
this approach:
(A) Should an enterprise commit capital funds to a certain purpose?
(B) Do the expected returns meet financial standards of performance?
(C) How does the cost vary with the mixture of financing methods used?
The traditional approach has outlived its utility in the changed business situation. The scope of finance
function has undergone a sea change with the emergence of different capital instruments.

b) Modern Approach
Since 1950s, the approach and utility of financial management has started changing in a revolutionary
manner. Financial management is considered as vital and an integral part of overall management. The
emphasis of Financial Management has been shifted from raising of funds to the effective and judicious
utilisation of funds. The modern approach is analytical way of looking into the financial problems of the
firm. Advice of finance manager is required at every moment, whenever any decision with involvement
of funds is taken. Hardly, there is an activity that does not involve funds.

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In the words of Solomon “The central issue of financial policy is the use of funds. It is helpful in achieving
the broad financial goals which an enterprise sets for itself”.
Nowadays, the finance manger is required to look into the financial implications of every decision to be
taken by the firm. His Involvement of finance manager has been before taking the decision, during its
review and, finally, when the final outcome is judged. In other words, his association has been continuous
in every decision-making process from the inception till its end.

F.2.4 AIMS OF FINANCE FUNCTION

The following are the aims of finance function:

a) Acquiring Sufficient and Suitable Funds:

The primary aim of finance function is to assess the needs of the enterprise, properly, and procure funds,
in time. Time is also an important element in meeting the needs of the organisation. If the funds are not
available as and when required, the firm may become sick or, at least, the profitability of the firm would
be, definitely, affected.
It is necessary that the funds should be, reasonably, adequate to the demands of the firm. The funds
should be raised from different sources, commensurate to the nature of business and risk profile of the
organisation. When the nature of business is such that the production does not commence, immediately,
and requires long gestation period, it is necessary to have the long-term sources like share capital,
debentures and long term loan etc. A concern with longer gestation period does not have profits for some
years. So, the firm should rely more on the permanent capital like share capital to avoid interest burden
on the borrowing component.

b) Proper Utilisation of Funds:

Raising funds is important, more than that is its proper utilisation. If proper utilisation of funds were not
made, there would be no revenue generation. Benefits should always exceed cost of funds so that the
organisation can be profitable. Beneficial projects only are to be undertaken. So, it is all the more
necessary that careful planning and cost-benefit analysis should be made before the actual
commencement of projects.

c) Increasing Profitability:

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Profitability is necessary for every organisation. The planning and control functions of finance aim at
increasing profitability of the firm. To achieve profitability, the cost of funds should be low. Idle funds do
not yield any return, but incur cost. So, the organisation should avoid idle funds. Finance function also
requires matching of cost and returns of funds. If funds are used efficiently, profitability gets a boost.

d) Maximising Firm’s Value:

The ultimate aim of finance function is maximising the value of the firm, which is reflected in wealth
maximisation of shareholders. The market value of the equity shares is an indicator of the wealth
maximisation.

F.2.5.FUNCTIONS OF FINANCE
Finance function is the most important function of a business. Finance is, closely, connected with
production, marketing and other activities. In the absence of finance, all these activities come to a halt. In
fact, only with finance, a business activity can be commenced, continued and expanded. Finance exists
everywhere, be it production, marketing, human resource development or undertaking research activity.
Understanding the universality and importance of finance, finance manager is associated, in modern
business, in all activities as no activity can exist without funds.
Financial Decisions or Finance Functions are closely inter-connected. All decisions mostly involve finance.
When a decision involves finance, it is a financial decision in a business firm. In all the following financial
areas of decision-making, the role of finance manager is vital. We can classify the finance functions or
financial decisions into four major groups:
(A) Investment Decision or Long-term Asset mix decision
(B) Finance Decision or Capital mix decision
(C) Liquidity Decision or Short-term asset mix decision
(D) Dividend Decision or Profit allocation decision

a) Investment Decision:
Investment decisions relate to selection of assets in which funds are to be invested by the firm. Investment
alternatives are numerous. Resources are scarce and limited. They have to be rationed and discretely
used. Investment decisions allocate and ration the resources among the competing investment
alternatives or opportunities. The effort is to find out the projects, which are acceptable.

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Investment decisions relate to the total amount of assets to be held and their composition in the form of
fixed and current assets. Both the factors influence the risk the organisation is exposed to. The more
important aspect is how the investors perceive the risk.
The investment decisions result in purchase of assets. Assets can be classified, under two broad
categories:
(i) Long-term investment decisions – Long-term assets
(ii) Short-term investment decisions – Short-term assets

a.1.Long-term Investment Decisions:

The long-term capital decisions are referred to as capital budgeting decisions, which relate to fixed assets.
The fixed assets are long term, in nature. Basically, fixed assets create earnings to the firm. They give
benefit in future. It is difficult to measure the benefits as future is uncertain.
The investment decision is important not only for setting up new units but also for expansion of existing
units. Decisions related to them are, generally, irreversible. Often, reversal of decisions results in
substantial loss. When a brand new car is sold, even after a day of its purchase, still, buyer treats the
vehicle as a second-hand car. The transaction, invariably, results in heavy loss for a short period of owning.
So, the finance manager has to evaluate profitability of every investment proposal, carefully, before funds
are committed to them.

a.2.Short-term Investment Decisions:

The short-term investment decisions are, generally, referred as working capital management. The finance
manger has to allocate among cash and cash equivalents, receivables and inventories. Though these
current assets do not, directly, contribute to the earnings, their existence is necessary for proper, efficient
and optimum utilisation of fixed assets.

b) Finance Decision
Once investment decision is made, the next step is how to raise finance for the concerned investment.
Finance decision is concerned with the mix or composition of the sources of raising the funds required by
the firm. In other words, it is related to the pattern of financing. In finance decision, the finance manager
is required to determine the proportion of equity and debt, which is known as capital structure. There are
two main sources of funds, shareholders’ funds (variable in the form of dividend) and borrowed funds
(fixed interestbearing). These sources have their own peculiar characteristics. The key distinction lies in
the fixed commitment. Borrowed funds are to be paid interest, irrespective of the profitability of the firm.
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Interest has to be paid, even if the firm incurs loss and this permanent obligation is not there with the
funds raised from the shareholders. The borrowed funds are relatively cheaper compared to
shareholders’ funds, however they carry risk. This risk is known as financial risk i.e. Risk of insolvency due
to non-payment of interest or non-repayment of borrowed capital.
On the other hand, the shareholders’ funds are permanent source to the firm. The shareholders’ funds
could be from equity shareholders or preference shareholders. Equity share capital is not repayable and
does not have fixed commitment in the form of dividend. However, preference share capital has a fixed
commitment, in the form of dividend and is redeemable, if they are redeemable preference shares.
Barring a few exceptions, every firm tries to employ both borrowed funds and shareholders’ funds to
finance its activities. The employment of these funds, in combination, is known as financial leverage.
Financial leverage provides profitability, but carries risk. Without risk, there is no return. This is the case
in every walk of life!
When the return on capital employed (equity and borrowed funds) is greater than the rate of interest
paid on the debt, shareholders’ return get magnified or increased. In period of inflation, this would be
advantageous while it is a disadvantage or curse in times of recession.

Return on equity (ignoring tax) is 20%, which is at the expense of debt as they get 7% interest only.
In the normal course, equity would get a return of 15%. But they are enjoying 20% due to financing by a
combination of debt and equity.
This area would be discussed in detail while dealing with Leverages, in the later chapter.
The finance manager follows that combination of raising funds which is optimal mix of debt and equity.
The optimal mix minimises the risk and maximises the wealth of shareholders.

c) Liquidity Decision

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Liquidity decision is concerned with the management of current assets. Basically, this is Working Capital
Management. Working Capital Management is concerned with the management of current assets. It is
concerned with short-term survival.
Short term-survival is a prerequisite for long-term survival. When more funds are tied up in current assets,
the firm would enjoy greater liquidity. In consequence, the firm would not experience any difficulty in
making payment of debts, as and when they fall due. With excess liquidity, there would be no default in
payments. So, there would be no threat of insolvency for failure of payments. However, funds have
economic cost. Idle current assets do not earn anything. Higher liquidity is at the cost of profitability.
Profitability would suffer with more idle funds. Investment in current assets affects the profitability,
liquidity and risk. A proper balance must be maintained between liquidity and profitability of the firm.
This is the key area where finance manager has to play significant role. The strategy is in ensuring a trade-
off between liquidity and profitability. This is, indeed, a balancing act and continuous process. It is a
continuous process as the conditions and requirements of business change, time to time. In accordance
with the requirements of the firm, the liquidity has to vary and in consequence, the profitability changes.
This is the major dimension of liquidity decisionworking capital management. Working capital
management is day to day problem to the finance manager. His skills of financial management are put to
test, daily.

d) Dividend Decision
Dividend decision is concerned with the amount of profits to be distributed and retained in the firm.
Dividend:
The term ‘dividend’ relates to the portion of profit, which is distributed to shareholders of the company.
It is a reward or compensation to them for their investment made in the firm. The dividend can be
declared from the current profits or accumulated profits.
Which course should be followed – dividend or retention? Normally, companies distribute certain amount
in the form of dividend, in a stable manner, to meet the expectations of shareholders and balance is
retained within the organisation for expansion. If dividend is not distributed, there would be great
dissatisfaction to the shareholders. Non-declaration of dividend affects the market price of equity shares,
severely. One significant element in the dividend decision is, therefore, the dividend payout ratio i.e. what
proportion of dividend is to be paid to the shareholders. The dividend decision depends on the preference
of the equity shareholders and investment opportunities, available within the firm. A higher rate of
dividend, beyond the market expectations, increases the market price of shares. However, it leaves a

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small amount in the form of retained earnings for expansion. The business that reinvests less will tend to
grow slower. The other alternative is to raise funds in the market for expansion. It is not a desirable
decision to retain all the profits for expansion, without distributing any amount in the form of dividend.
There is no ready-made answer, how much is to be distributed and what portion is to be retained.
Retention of profit is related to
• Reinvestment opportunities available to the firm.
• Alternative rate of return available to equity shareholders, if they invest themselves.

F.2.6.INTER-RELATIONSHIP OF

FINANCE FUNCTIONS OR DECISIONS

All the major functions or decisions – Investment function, Finance function, Liquidity function and
Dividend function, are inter-related and inter-connected. They are inter-related because the goal of all
the functions is one and the same. Their ultimate objective is only one – achievement of maximisation of
shareholders’ wealth or maximising the market value of the shares.
All the decisions are also inter-connected or inter-dependent also. Let us illustrate, both these aspects
with an example.
Example:
If a firm wants to undertake a project requiring funds, this investment decision can not be taken, in
isolation, without considering the availability of finances, which is a finance decision. Both the decisions
are inter-connected.
If the firm allocates more funds for fixed assets, lesser amount would be available for current assets. So,
financing decision and liquidity decision are inter-connected.
The firm has two options to finance the project, either from internal resources or raising funds, externally,
from the market. If the firm decides to meet the total project cost only from internal resources, the profits,
otherwise available for distribution in the form of dividend, have to be retained to meet the project cost.
Here, the finance decision has influenced the dividend decision.
So, an efficient financial management takes the optimal decision by considering the implications or impact
of all the decisions, together, on the market value of the company’s shares. The decision has to be taken
considering all the angles, simultaneously.
No Function is Superior:

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All the functions are important. Importance of the function depends on the situation of the firm. If a firm
has adequate investment opportunities but experiences difficulty to raise funds, then the finance function
is superior to the firm, at that juncture. It does not mean that investment decision is less important
compared to finance decision, always.
The essence is no financial function or decision is superior to others.

F.2.7. Liquidity vs profitability

(risk–return trade-off)
In the course of performance of duties, a finance manager has to take various types of financial decisions
– Investment Decision, Finance Decision, Liquidity Decision and Dividend Decision, as detailed above, from
time to time. In every area of financial management, the finance manger is always faced with the dilemma
of liquidity vs. profitability. He has to strike a balance between the two.
Liquidity means that the firm has:
(A) Adequate cash to pay bills as and when they fall due, and
(B) Sufficient cash reserves to meet emergencies and unforeseen demands, at all time.
Profitability goal, on the other hand, requires that the funds of the firm be so utilised as to yield the
highest return.

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Liquidity and profitability are conflicting decisions. When one increases, the other decreases. More
liquidity results in less profitability and vice versa. This conflict finance manager has to face as all the
financial decisions involve both liquidity and profitability.
Example:
Firm may borrow more, beyond the risk-free limit, to take the advantage of cheap interest rate. This
decision increases the liquidity to meet the requirements of firm. Firm has to pay committed fixed rate of
interest, at fixed time, irrespective of the return the liquidity (funds) gives. Profitability suffers, in this
process of decision, if the expected return does not materialise. This is the risk the organisation faces by
this financial decision.
Risk:
Risk is defined as the variability of the expected return from the investment.
Return:
Return is measured as a gain or profit expected to be made, over a period, at the time of making the
investment.
Example:
If an investor makes a deposit in a nationalised bank, carrying an interest of 7% p.a., virtually, the
investment is risk free for repayment, both principal and interest. However, if a similar amount is invested
in the equity shares, there is no certainty for the amount of dividend or even for getting back initial
investment as market price may fall, subsequently, at the time of sale. The expected dividend may or may
not materialise. In other words, the dividend amount may vary or the company may not declare dividend,
at all. A bank deposit is a safe investment, while equity shares are not so. So, risk is associated with the
quality of investment.
The relationship between risk and return can be expressed as follows:

Risk free rate is a compensation or reward for time and risk premium for risk. Risk and return go hand in
hand. Higher the risk, higher the required return expected. It is only an expectation, at the time of
investment. There is no guarantee that the return would be, definitely, higher. If one wants to make an
investment, without risk, the return is always lower. For this reason only, deposit in a bank and post office
carry lower returns, compared to equity shares.
So, every financial decision involves liquidity and profitability implications, which carries risk as well as
return. However, the quantum of risk differs from one decision to another. Equally, the return from all
the decisions is not uniform and also varies, even from time to time.
Basics of Finance Management Page 17 of 242
Relationship between Liquidity & Profitability and Risk & Return:
Example:
If higher inventories are built, in anticipation of an increase in price, more funds are locked in inventories.
So, organisation may experience problems in making other payments, in time. If the expected price
increase materialises, firm enjoys a boost in profits due to the windfall return the decision yields. The
expected increase in price is a contingent event. In other words, the increase in price may or may not
happen. But, firm suffers liquidity problems, immediately. This is the price firm has to pay, which
otherwise is the risk the firm carries.
It may be emphasised risk and return always go together, hand in hand. More risk, chances of higher
return exist. One thing must be remembered, there is no guarantee of higher returns, with higher risk.
The classical example is lottery. There is a great risk, if one invests amount in a lottery. There is no
guarantee that you would win the lottery. However, liquidity and profitability are conflicting decisions.
There is a direct relationship between higher risk and higher return. In the above example, building higher
inventories, more than required, is a higher risk decision. This higher risk has created liquidity problem.
But, the benefit of higher return is also available. Higher risk, on the one hand, endangers liquidity and
higher returns, on the other hand, increases profitability.
Liquidity and Profitability are conflicting while Risk and Return go together. The pictorial presentation is
as under:

Balanced Approach:

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A finance manager can not avoid the risk, altogether, in his decisionmaking. At the same time, he should
not take decisions, considering the returns aspect only. At the time of taking any financial decision, the
finance manger has to weigh both the risks and returns in the proposed decision and optimise the risk
and returns, at the same time. A proper balance between risk and return should be maintained by the
finance manager to maximise the market value of shares. A particular combination where both risk and
return are optimised is known as Risk–Return Trade-off.
Basic objective of Finance Manager:
An efficient finance manager fixes that level of operations, where he can achieve maximisation of the
shareholders’ wealth. Such a level is termed as risk-return trade off. Every finance manager attempts to
achieve that trade-off in every finance decision. At this level, the market value of the company’s shares
would be maximum. To achieve maximum return, funds flowing in and out of the firm are to be constantly
monitored to ensure their safety and proper utilisation.

F.2.8. Role of Finance manager

The finance manager handles finance. The role of finance manager is pivotal. He can change the fortunes
of the organisation with proper planning, monitoring and timely guidance. Equally, if the manager is not
competent, even a profitable organisation may dwindle or even sink. The finance manger is, now,
responsible in shaping the fortunes of the enterprise. The role of finance manager, in a modern business,
is pervasive in all the activities of business firm, including production and marketing.
It has been rightly said, money begets money. Business needs money to make more money. However,
business can make money, when it is properly managed. The financial history is replete with stories how
even the profitable organisations were wound up, when the management of finance had turned bad due
to mismanagement of financial affairs.
It is misunderstood, in some corners, that the role of finance manager is important only in private
organisations. It is not so. His role is important, both in private and public sector. He has a positive role to
play in every type of organisation. Even in non-profit making organisations, his role exists as long as there
is involvement of funds.
Influences Fortunes of Firm:
The history of failures of organisations is interesting. Many firms have failed, not because of inefficiency
of production, inability in marketing or non-availability of funds but due to the absence of competent
finance manager. In many public sector undertakings, in particular, state government undertakings,
importance is given to the appointment of peons, more than adequately, but not to the appointment of

Basics of Finance Management Page 19 of 242

competent professional manager in finance, even after lapse of several years. That is the real secret of
numerous loss-making organisations, in public sector! Over the years, the picture has been changing, but
only after the real damage has already occurred in those public sector undertakings, due to the non-
appointment of professional finance managers, at the time of formation of those undertakings. In several
public sector undertakings, the presence of competent finance manager is often found inconvenient. A
finance manager can not play any significant role in the public sector, unless he is allowed to play.
Exists Everywhere:
The role of finance manager, in modern times, can be well said, universal and pervasive. Hardly, we find
any activity, which does not involve finance. Even entertainment in a firm requires financial management
due to financial implications. In modern business, no decision is taken without the consultation of finance.
Even in recruitment, the presence of finance representative has been a normal feature manager. Only the
level of finance representative changes, dependant upon the status of position for which recruitment is
held. At times, people working in other departments feel that the finance manager has been interfering
in all matters, unconnected to him. It is due to inadequate understanding of the role and expectations
expected of him in modern business. The finance manager can, definitely, contribute to the overall
development of the organisation provided he is competent and allowed to perform his functions,
independently.
In his new role, the finance manager must find answers for the following three questions, again in the
words of Solomon:
• How large should an enterprise be, and how fast should it grow?
• How should the funds be raised?
• In what form, should the firm hold its assets?
To sum up, finance functions or decisions include the following important areas, where the finance
manager has to contribute:
• Investment decision or long term asset-mix decision
• Finance decision or capital-mix decision
• Liquidity decision or short-term asset mix decision
• Dividend decision or profit allocation decision.
The main objective of all the above decisions is to increase the value of the shares, held by the equity
shareholders. The finance manager has to strive for shareholders’ wealth maximisation.
While discharging the functions, the finance manager has to focus his attention on the following aspects
to maximise the shareholders’ wealth:

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1. Procuring the funds as and when necessary, at the lowest cost,
2. Investing the funds in those assets, which are more profitable, and
3. Distributing the dividends to the shareholders to meet their expectations and facilitate expansion to
achieve the long-term goals of organisation.

A.3. Time value of money

The value of money changes over time. The value of money today is considerably more than that of future.
We have often heard from our grandparents or parents that their first salary was Rs 200 or Rs 1000. But
can imagine the life today with the same salary? No, right so the value of money has decreased over time.
So the things that we can buy now will be expensive in the future. A sum of money, once invested, rises
with time, therefore investors prefer to receive money today rather than the same amount of money in
the future. For instance, interest is paid on funds deposited into savings accounts. As the principal
increases over time, the interest also increases. That is compound interest at work. The calculation of the
same is termed as Time Value of Money.

The most basic time value of money formula takes into account the following factors: future value of
money, present value of money, interest rate, number of interest periods per year and number of years.

A.3.1. Need for time value of money

a) Uncertainty and risk

Future is always a source of uncertainty and risk. We have control over outflows because we are
responsible for making payments to others. Future financial inflows cannot be predicted with accuracy.
The ease of others determines how much money comes in. People would rather obtain something right
away than wait for an uncertain tomorrow.

b) Current requirements are more significant:

People typically favour current consumption. Even a little youngster prefers an ice cream now over
tomorrow.

c) Opportunity to invest:
A person or business can put money into an investment to get profits. An investor may successfully use a
rupee obtained today to increase the value of a rupee to be received tomorrow or at a later date.

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 d) Greater Purchasing Power in an Inflationary
Economy:
In an inflationary economy, the rupee has greater purchasing power now than it would have in the future.

It is clear from the above that money received today has a higher value than money that may be received
in the future. If the economy is experiencing a time of inflation, one can spend today, put money into an
investment for a return, or purchase more items. Comparing inflows and outflows can be challenging for
people or businesses because they take place across varying time periods.

Recognising the temporal value of money and accounting for it appropriately is the reasonable course of
action. In the absence of this, poor financial judgement is probably going to happen. Making the right
financial decision requires careful consideration of time worth of money.

A.3.2. Time Preference Rate and

Required Rate of Return

The time preference of money is usually expressed as an interest rate: This interest rate is positive even
when there is no risk. If no incentive is offered, no one will be willing to share a current preference for
future acceptance. If a person is offered the opportunity to receive 100 rupees today or 110 rupees at the
end of the year, a premium is offered for the time of sharing the money. Here it is 10% return for time,
not risk. An individual is indifferent between receiving Rs. 100 today and Rs. 110 at the end of the year,
because he considers these two sums to be of equal value.

a) Risk factor:
But there is also risk in sharing money, because there is uncertainty about time the receipt of money or
even the actual return. So compensation is expected for the risk taken. The higher the risk, the higher the
expected return. So the required performance must compensate both because of time and risk. It can be
expressed

Required Rate of Return = Risk free Rate + Risk premium

b) The risk-free rate compensates for time while risk

premium compensates for risk:

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The opportunity cost of capital with equivalent risk is another name for the needed rate of return. In other
words, a higher risk premium results from a higher risk. This is the reason why a higher interest rate is
applied when lending money to a film producer since making a movie is very hazardous, and the amount
of money returned also depends on whether the film is successful or not. The intent behind money's use
affects interest rates as well. This explains why speculative businesses must pay more interest than solid
businesses do.

c) Time Preference rate is based on no risk,

compensation for time only:
The traditional example is a bank deposit, where there is no chance of getting your money back. The
required rate of return includes time and risk compensation. An illustration would be lending money to a
third party, when remuneration is needed for both the time spent and the risk taken.

A.3.3. PVF: Present Value Factor

The present value factor, which is based on the time value of money, is a factor that is used to calculate
the present value of money that will be received in the future. This PV factor, or the number of periods
over which payments are to be made, is always less than one and is calculated by one divided by one plus
the rate of interest to the power.

The element that is used to determine the current value of a sum of money that will be received at a later
time is the present value factor. The foundation of this computation is the time value of money theory.
As a result, it demonstrates that the money acquired today is worth more than the money received
tomorrow because it can be invested in a present source of capital.

The factor for cash flows that will be received soon is often higher than the factor for cash flows that will
be received later. This indicates that receiving money sooner will increase its value. Printing or tabular
presentation of these elements or data is used. The table of present value factors includes a mix of interest
rates and time periods.

Analyses of annuities also make use of these variables. The present value factor for calculating annuities
aids in determining whether it is more lucrative to accept a lump sum payment at the present time or
annuity payments over a longer period of time. But first, it's crucial to understand the total sum and its
duration.

PV Factor = 1 .
Basics of Finance Management Page 23 of 242
 ( 1 + r)n

Whereas, r = rate of return

n = number of years

Present Value = Future Value x PV Factor

OR

Present Value = FV . (FV = Future Value )

( 1 + r)n

Sums:

1. ABC International has received an offer to be paid $100,000 in one year, or $95,000 now. ABC's
cost of capital is 8%.

Solution: PV Factor = 1 .

(1 + r)n

= 1 . (r = 8% = 8 / 100, n = 1 year)

(1 + 0.08)1

= 0.9259

Present Value = Future Value x PV Factor

= $ 1,00,000 x 0.9259

= $ 92590.

Here, we have 2 options, so choice of selecting $ 95,000 is profitable option for ABC.

2. PQR have the choice of being paid $2,000 today earning 3% annually or $2,200 one year from
now. Which is the best option?

Solution: PV Factor = 1 .

(1 + r)n

= 1 . (r = 3% = 3 / 100, n = 1 year)
(1 + 0.03)1
= 0. 9708

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 Present Value = Future Value x PV Factor

= $ 2200 x 0.9708

= $ 2135.76

Hence, Accepting the offer of getting paid $ 2200 one year from now is best option.

3. John is expected to receive $ 1,000 after 4 years. Determine the present value of the sum today
if the discount rate is 5 %.

Solution: FV = $ 1,000

r=5%

n = 4 years

Present Value = FV .

( 1 + r)n

= $ 1000 .

( 1 + 0.05)4

= $ 1000 .

1.2155

= $ 822.70

A.3.4. Future Value Factor:

The future value interest factor, or FVIF for short, is a factor that aids in estimating the future value of a
cash flow that will be received at some point in the future. The future cash flow could come in the form
of a single payment or a series of payments (as in the case of an annuity). Simply said, this factor, which
is based on the time value of money principle, aids us in figuring out the impact of compounding a single
cash flow or numerous cash flows (that occur at regular intervals) in the future, per dollar of their present
value.

Future value (FV) is the value of a current asset at a future date based on an assumed rate of growth. The
future value is important to investors and financial planners, as they use it to estimate how much an
investment made today will be worth in the future.

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Investors can forecast the potential profit from various investments with differing degrees of precision
using the future value computation. The future value equation is used to assess various possibilities since
the growth produced by holding a given amount in cash will probably differ from that produced by
investing that same amount in equities.

Depending on the type of asset, estimating its future worth can be challenging. Additionally, a constant
growth rate is assumed for the estimation of future value. When money is deposited in a savings account
with a guaranteed interest rate, it is simple to calculate the future value with accuracy.

FV=PV (1+ i_ )n×t

n
whereas,

FV=Future value of money

PV=Present value of money

i=Interest rate

n=Number of compounding periods per year

t=Number of years

FV=I×(1+R)T

Whereas,

I=Investment amount

R=Interest rate

T=Number of years

a) Merits of Future Value

Future worth may be helpful in some circumstances. The computation has limitations, though, and in
some circumstances it might not be appropriate.

a.1. Future value allows for planning:

A business or investor may be aware of their current situation and be able to make certain predictions
about what will occur in the future. People can plan for the future as they comprehend their financial
situation by merging this information. Future value, for instance, can be used to estimate how long it will
take a property buyer to save $100,000 for a down payment.
Basics of Finance Management Page 26 of 242
 a.2. Future value makes comparisons easier

Let's imagine that a potential investor is weighing his or her options. One calls for a $5,000 investment
that will yield 10% over the following three years. The other takes a $3,000 investment and yields 5% in
the first year, 10% in the second year, and 35% in the third year. Only by projecting future values and
comparing the results will an investor be able to determine which investment has the potential to yield
the highest returns.

a.3. Future value is easy to calculate due to estimates.

Future value does not require complex or accurate maths. Anyone can use future value in hypothetical
circumstances because it relies so heavily on estimates. For the property buyer attempting to save
$100,000, for instance, using the projected monthly savings, estimated interest rate, and estimated length
of savings, this person can determine the future value of their savings.

b) Demerits of Future Value

b.1. Future value usually assumes constant growth.

Only one interest rate is utilised in the aforementioned formulae. Even though variable interest rates can
be used to assess future value, the calculations become more difficult and illogical. A situation might have
unrealistic parameters in exchange for a streamlined formula that just considers rate because growth isn't
always linear or constant year over year.

b.2. Future value assumptions may not actually happen.

The calculations are merely estimates because future value is predicated on assumptions about the
future, which may or may not be accurate. For instance, a trader may have predicted the market will
return 8% annually when calculating the future value of their portfolio. The previous computation of
future value is useless if the market is unable to generate that anticipated return.

b.3. Future value may fail at comparisons.

Future value merely provides a final cash amount representing what something will be valued in the
future. In order to compare two projects, there are some restrictions. Consider the following scenario: An
investor has the option of investing $10,000 for a predicted return of 1% or $100 for a predicted return
of 700%. The first alternative would seem preferable when considering solely future value because it is
higher; however, this ignores the initial investment's starting place.

Basics of Finance Management Page 27 of 242

 4. A sum of $10,000 is invested for one year at 10% interest compounded annually. Calculate future
value of money.

Solution:

FV=PV (1+ i_ )n×t

n
FV= $ 10,000 (1+ 10 %_ )1×1
1
= $ 11,000

5. Calculate future value, if the present value (PV) of an investment is $5 million, and the amount is
invested at a rate of return of 10% for one year.

Solution:

FV=PV (1+ i_ )n×t

n
FV= $ 50,00,000 (1+ 10%_ )1×1
1
= $ 5,50,000

A.3.5. Compounding:
Compounding is the process through which earnings from an asset, such as interest or capital gains, are
reinvested to produce more earnings over time. The investment will produce earnings from both its initial
principal and the accumulated earnings from prior periods, which are calculated using exponential
functions.

Since only the principal earns interest each cycle in linear growth, compounding varies from that method.

Thus, compounding can be thought of as interest on interest, with the result that returns on interest are
magnified over time, or the so-called "miracle of compounding."

Compounding can happen with investments, making money increase faster, or with debt, increasing the
balance owing even when payments are being made.

Savings accounts automatically experience compounding, and some dividend-paying investments may
also gain from it.

a) Simple Interest
When interest is determined solely on the initial principle sum, this is referred to as simple interest.
Basics of Finance Management Page 28 of 242
With simple interest, neither the basis for calculating interest nor the amount of interest earned each
period change.

b) Compound Interest
When interest is calculated on both the initial principal and the accrued interest, this is referred to as
compound interest.

With compound interest, interest is computed on an ever-increasing base, and the total amount of
interest collected rises over time.

Difference between simple interest and compound interest can be understood by following example.

6. Mr Patel invests $ 100 for 50 year at the rate of 5 % p.a. Calculate the amount he will receive using
simple interest method and compound interest method.

Year Beginning balance Simple Interest Ending balance

1 $ 100 $ 100 x 5 % = $ 5 100 + 5 = 105

2 $ 105 $ 100 x 5 % = $ 5 $ 110

3 $ 110 $ 100 x 5 % = $ 5 $ 115

4 $ 115 $ 100 x 5 % = $ 5 $120

5 $ 120 $ 100 x 5 % = $ 5 $125

6 $ 125 $ 100 x 5 % = $ 5 $ 130

50 $ 345 $ 100 x 5 % = $ 5 $350

Year Beginning balance Simple Interest Ending balance

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1 $ 100 5 105

2 $ 105 5.25 110.25

3 $ 110 5.5125 115.7625

4 $ 115 5.788125 121.5506

5 $ 120 6.07753 127.6281

6 $ 125 6.381405 134.0095

50 $1092.13 54.6065 1146.737

7. A sum of $10,000 is invested for one year at 10% interest compounded annually. Calculate
future value of money.
i. Quarterly compounded
ii. Monthly compounded
iii. Daily compounded

Solution:

Quarterly compounded

FV=PV (1+ i_ )n×t

n
FV= $ 10,000 (1+ 10_% )4×1
4
= $ 11,038

Monthly compounded

FV=PV (1+ i_ )n×t

n
FV= $ 10,000 (1+ 10_% )12×1
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 12
= $ 11,047

Daily compounded

FV=PV (1+ i_ )n×t

n
FV= $ 10,000 (1+ 10 %_ )365×1
365
= $ 11,052

8. Calculate future value if compounded quarterly, the present value (PV) of an investment is $10
million, and the amount is invested at a rate of return of 10% for one year.

Solution:

FV=PV (1+ i_ )n×t

n
FV= $ 10,000,000 (1+ 10_% )4×1
4
= $ 11,038,128

9. A company has offered the following two options to pick from:

Option 1: Receive $225,000 in Year 4

Option 2: Receive $50,000 from Year 1 to Year 4

Solution:

Option 1

Future Value : $ 225,000

Present Value = FV .
( 1 + r)n

= $ 225,000

(1 + 10 %)4

= $ 225000

1.46

= $ 1,54,109
Basics of Finance Management Page 31 of 242
Option 2

Present Value = FV . (50,000 received at the beginning of 1st year)

( 1 + r)n
= 50,000 .
( 1 + 10%)4

= $ 34,326

Present Value = FV . (50,000 received at the beginning of 2nd year)

( 1 + r)n
= 50,000 .
( 1 + 10%)3
= 50,000 .
1.331

= $ 37,565

Present Value = FV . (50,000 received at the beginning of 3rd year)

( 1 + r)n
= 50,000 .
( 1 + 10%)2
= 50,000 .
1.21
= $41,322
Present Value = FV . (50,000 received at the beginning of 4th year)
( 1 + r)n
= 50,000 .
( 1 + 10%)1
= 50,000 .
1.1
= $ 45,454
Total cash inflow = $ 34,326 + $ 37,565 + $41,322 + $ 45,454
= $ 1,58,667

Option 2 is comparatively more profitable

Basics of Finance Management Page 32 of 242

 A.4. Objectives of firm
Financial resources are used by the business concern properly when they are procured and used
effectively. It is the financial manager's most important component. Therefore, the financial manager
must decide what the fundamental goals of financial management are. The goals of financial management
can be roughly classified into two categories, namely

1. Profit maximization
2. Wealth maximization.

A.4.1. Profit maximization

Profit is the primary goal of all economic activities. A company firm also operates primarily in order to
make money. Profit is the metric used to gauge a company's operational effectiveness. Another common
and limited strategy is profit maximisation, which tries to increase a company's profit as much as possible.
The following significant characteristics are involved in profit maximisation.

1. Profit maximisation is often referred to as "maximising cashing per share." It results in maximising
corporate operations for maximising profit.
2. The corporate concern's primary goal is to make a profit; as a result, it analyses every avenue open
to it to boost profitability.
3. Profit is the metric used to gauge how effectively a corporation is operating.
4. Thus, it depicts the company's overall status.
5. Profit maximisation goals assist in lowering business risk.

a) Favourable Arguments for Profit Maximisation

The business concern's goals of profit maximisation are supported by the following crucial points:

o The primary goal is to make money.

o The business operation's criterion is profit.
o Profit lowers the risk of the business concern .
o Profit is the primary source of funding .
o Profitability also satisfies social demands.

b) Unfavourable Arguments for Profit Maximization

Important considerations that go against the goals of profit maximisation include:
Basics of Finance Management Page 33 of 242
 o Profit maximisation results in the exploitation of customers and employees.
o Profit maximisation breeds immoral behaviours including dishonest business practises and unfair
trade practises, among others.
o The pursuit of profit maximisation results in disparities across stake holders, including customers,
suppliers, public shareholders, etc.

c) Drawbacks of Profit Maximization

Important factors that are opposed to profit maximisation goals include:

⮚ Profit maximisation leads to the exploitation of clients and workers.

⮚ Profit maximisation encourages unethical activity, such as unfair trade practises and dishonest
commercial practises.
⮚ The quest of profit maximisation leads to differences across stakeholder groups, including clients,
vendors, public shareholders, etc.

A.4.2. Wealth Maximization

One of the modern strategies that incorporates the newest advancements and enhancements in the
sphere of commercial concern is wealth maximisation. The term "wealth" refers to shareholder money or
the personal wealth of those involved in the firm.

Value or net present worth maximisation are other names for maximising wealth. In the sphere of
business, this purpose is a widely acknowledged idea.

a) Favourable Arguments for Wealth Maximization

● Wealth maximisation is preferable to profit maximisation since, in accordance with this notion,
the primary goal of the business concern is to increase the value or wealth of the shareholders.
● Wealth maximisation takes into account the value vs cost of the corporate enterprise. overall value
derived from all expenses involved in running the firm. It gives the company concern's extract
value.
● Wealth maximisation takes into account the business concern's time and risk.
● The effective allocation of resources is achieved through wealth maximisation.
● It protects society's economic interests.

b) Unfavourable Arguments for Wealth Maximization

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 ● Wealth maximisation produces prescriptive business ideas, however they might not be
appropriate for today's business activity.
● Wealth maximisation is merely another name for profit maximisation, which is what it actually is.
● Ownership-management disputes are brought on by wealth maximisation.
● Certain advantages are only enjoyed by management.
● Maximising profits is the ultimate goal of wealth maximisation aims.
● The lucrative position of the business concern is the sole way to enable wealth maximisation.

Calculations:

1. Basu were to receive $1000 after 2 years, calculated with a rate of return of 5%. Now, the term
or number of periods and the rate of return can be used to calculate the PV factor for this sum
of money with the help of the formula described above.

Solution: PV Factor = 1 .

(1 + r)n

= __1___

(1+0.05)2
= 0.907

Now, multiplying the sum of $1000 to be received in the future by this PV factor, we get:

$1000 x 0.907 = $907

This means that $907 is the current equivalent of the sum of $1000 to be received after two
years with a rate of return of 5%, and it could be possible to reinvest this sum of $907
somewhere else to receive greater returns.

2. Company Z has sold goods to Company M for Rs. 5000. Company M offered Company Z that
either Company M pays Rs. 5000 immediately or pay Rs. 5500 after two years. Discounting rate
is 8%.

Solution: Now, to understand which of either deal is better i.e. whether Company Z should take Rs.
5000 today or Rs. 5500 after two years, we need to calculate a present value of Rs. 5500 on the current
interest rate and then compare it with Rs. 5000, if the present value of Rs. 5500 is higher than Rs. 5000,
then Company Z should take money after two years otherwise take Rs. 5000 today.

PV = FV * 1 .

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 (1 + r)n

PV = 5500 * [ 1 / (1+8%) 2 ]

PV = Rs. 4715

As the present value of Rs. 5500 after two years is lower than Rs. 5000, Company Z should take Rs. 5000
today.

3. Calculate the compound value when Rs.10,000 is invested for 3 years and interest 10% per
annum is compounded on quarterly basis.
Solution: The formula to calculate the compounded value is:
A = P (1+ i/m)m x n
A = 10,000(1+ 0.10/4)3x 4
= 10,000(1 + 0.025)12
= Rs. 13, 448.89
4. Calculate the compound value when Rs.10,000 is invested for 3 years and interest 10% per
annum is compounded on quarterly basis.
Solution: The formula to calculate the compounded value is:
A = P (1+ i/m)m x n
= 10,000(1+ 0.10/4)3x 4
= 10,000(1 + 0.025)12
= Rs. 13, 448.89
5. Mr. X deposits Rs. 1,000 at the end of every year for 4 years and the deposit earns a compound
interest of 10% per annum. Calculate the amount at the end of 4th year?

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 6. Annuity received is Rs. 500 per annum. Calculate the present value for the annuity received for
four years, if the discounting factor is 10%

7.Given the uneven streams of cash flows shown in the following table, answer parts (a) and (b):

Cash Flow Stream

End of Year AB
1 $ 50,000 $10,000
2 40,000 20,000
3 30,000 30,000
4 20,000 40,000
5 10,000 50,000
Undiscounted
Total $150,000 $150,000
a. Find the present value of each stream, using a 15 percent discount rate
Given the uneven streams of cash flows shown in the following table, answer parts (a) and (b):
Cash Flow Stream
End of Year AB
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1 $ 50,000 $10,000
2 40,000 20,000
3 30,000 30,000
4 20,000 40,000
5 10,000 50,000
Undiscounted
Total $150,000 $150,000
a. Find the present value of each stream, using a 15 percent discount rate

b. Compare the calculated present values, and discuss them in light of the fact that the undiscounted
total cash flows amount to $150,000 in each case.
b. compare the calculated present values and discuss them in light of the fact that the undiscounted
total cash flows amount to $ 150,000 in each case.
Solution:

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8 You plan to invest $ 2,000 in an individual retirement arrangement today that pays a stated annual
interest rate of 8 %, which is expected to apply to all future years.
a. How much you have in the account at the end of 10 years if interest us compounded as follows?
1. Annually
2. Semiannually
3. Monthly
b. What is the effective annual rate for each conpounding frequency in part a?
Solution: (1) Annual Compounding
FV10 = $2,000 x (1.08)10
= $4,317.85
(2) Semiannual Compounding
FV10 = $2,000 x (1+0.08/2)2*10
= (1+0.04)2
FV10 = $4,382.25
(3) Monthly Compounding
FV10 = $2,000 x (1+0.08/12)12*10
FV10 = $4,439.28
c. b. (1) Annual Compounding
EAR = (1 + .08/1)1 –1
EAR = (1 + .08)1 - 1
EAR = (1.08) – 1
EAR = .08 = 8%
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 (2) Semiannual Compounding
EAR = (1 + .08/2)2-1
EAR = (1 + .04)2 - 1
EAR = (1.0816) - 1
EAR = .0816 = 8.16%
(3) Monthly Compounding
EAR = (1 + .08/12)12 – 1
EAR = 0.083
= 8.3%
9. You have $10,000 to invest today. Find the annual rates of return (interest rates) required to do the
following. Assume annual compounding.
a. Double the investment in 4 years (so that you have $20,000 in four years)
b. Triple the investment in 10 years
Solution:
a. Double the investment in 4 years (so that you have $20,000 in four years)
P.V = __A___
( 1 + r )n
P.V = __20,000___
( 1 + 10% )4
P.V = __20,000___
1.4641
P.V = 13,660
b. Triple the investment in 10 years
P.V = __A___
( 1 + r )n
P.V = __30,000___
( 1 + 10% )10
P.V = __30,000___
2.5937
P.V = 11,566

10. A sum of Rs. 500 is to be received after 4 years and we have to find its present worth or present
value with interest rate at 10%?
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 P= A__
(1 + i)t
= 500
(1 + 0.10)4
= 500
(1.10) 4
= 500
1.4641
= Rs 341.50
11. A sum of Rs. 500 is to be received after 4 years and we have to find its present worth or present
value with interest rate at 12%?
P= A__
(1 + i)t
= 500
(1 + 0.12)4
= 500
(1.12) 4
= 500
1.5735
= Rs 317.76
12. If Mr X gets an Annuity Payment of Rs. 5,000 for 5 years. What would the amount of money he will
get at the end of 5 years at interest of 10 % p.a. compounded annually ?
Solution:

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13. A firm wants to open a new coal mine. The price of coal is very volatile and the projected profits
over the next five years are : Rs. 100,000 , Rs. 250,000 , Rs. 10,000 , Rs. 200,000 and Rs. 50,000
respectively. After that profits will be a constant Rs. 150,000 per year for next 20 years at which time
the mine closes. If 7% is the appropriate discount rate for the first five years and is 8% after that, what
is the present value of the mine?
Solution:
PV5 = 100,000 + 250,000 + 10,000 + 2,00,000 + 50,000
(1 + 0.07)1 (1 + 0.07)2 (1 + 0.07)3 (1 + 0.07)4 (1 + 0.07)5

PV5 = 93,457.9439 + 218,359.6821 + 8162.9788 + 152,579.0424 + 35,649.3090

= 508,208.96
PV An = CCF ( PVIFA,i,n)
PV A20 = 150,000 (9.8181)
= 14,72,715
PV5 = 14,72,715
(1 + 0.07)5

PV5 = 1050025.44
Total present value = 508,208.96 + 1050025.44
= 1558234.4
14. Happy Harry has just bought a scratch lottery ticket and won €10,000. He wants to finance the future
study of his newly born daughter and invests this money in a fund with a maturity of 18 years offering
a promising yearly return of 6%. What is the amount available on the 18th birthday of his daughter?
(1) Calculate future value or present value or annuity ?
(2) Future value = PV * (1+ i)n
Items: -
PV = €10,000 –
i = 6%
n = 18 years
Solution:
FV = €10,000 * 1.0618
= €10,000 * 2.854339

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 = €28,543.39
15. Rudy will retire in 20 years. This year he wants to fund an amount of €15,000 to become available
in 20 years. How much does he have to deposit into a pension plan earning 7% annually?
(1) Calculate future value or present value or annuity ?
(2) Present value = FVn
(1 + i)n
Items: -
FV = €15,000 –
i = 7% -
n = 20 years
Solution:
PV = €15,000 * (1/1.0720)
= €15,000 * 0.258419
= €3,876.29
16. The National Savings Fund promises a monthly 0.75% return if you deposit €100 per month for 15
consecutive years. What amount will be accumulated after those 15 years?
Calculate future value or present value or annuity?
Items: -
Annuity = €100
n = 15 years
i = 0.75% p/m
Solution:

FVAN = €100 * (1.0075180 – 1)

0.0075
= €100 * 378.40577
= €37,840.58

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Q1. Choose the Correct answer
1.Time value of money indicates that
a)A unit of money obtained today is worth more than a unit of money obtained in future
b)A unit of money obtained today is worth less than a unit of money obtained in future
c)There is no difference in the value of money obtained today and tomorrow
d)None of the above

2.Time value of money supports the comparison of cash flows recorded at different time period by
a)Discounting all cash flows to a common point of time
b) Compounding all cash flows to a common point of time
c) Using either a or b
d) None of the above.

3.If the nominal rate of interest is 10% per annum and there is quarterly compounding, the effective
rate of interest will be:
a) 10% per annum
b) 10.10 per annum
c) 10.25%per annum
d) 10.38% per annum

4.Relationship between annual nominal rate of interest and annual effective rate of interest, if
frequency of compounding is greater than one:
a) Effective rate > Nominal rate
b) Effective rate < Nominal rate
c) Effective rate = Nominal rate
d) None of the above

5.If nominal rate of return is 10% per annum and annual effective rate of interest is 10.25% per
annum, determine the frequency of compounding:
a) 1
b) 2
c) 3
d) None of the above

6.An investment is said to be “risky” because

Basics of Finance Management Page 44 of 242

a) it is dangerous
b)it has low returns
c)its returns are uncertain
d)its raw material is unavailable

7.Which finance refers to overseeing the financial operations and capital investment choices of their
respective companies
a)public finance
b)private finance
c)social finance
d)corporate finance
8.The factor for cash flows that will be received soon is often _______than the factor for cash flows
that will be received later
a)Higher
b)Lower
c)Same
d)Negative
9.Expansion of business, increasing the salary of employees are example of _________ finance.
a)public finance
b)corporate finance
c)private finance
d)social finance
10.Investment in Share market/ mutual fund for retirement are examples of __________ finance.
a)public finance
b)corporate finance
c)personal finance
d)social finance
11.___________is the process through which earnings from an asset, such as interest or capital gains,
are reinvested to produce more earnings over time.
a)Simple interest
b)Present value
c)Future value
d)Compounding
Basics of Finance Management Page 45 of 242
12.Generally, the main objective of firm is _________.
a)Profit maximisation
b)Wealth maximisation
c)Both a and b
d)None of the above
13.Social finance is a category of financial services that aims to attract private capital to meet
challenges in the areas of __________needs.
a)Social and environmental
b)Personal
c)Firm’s
d)Private investors
14.Net profits of firm are split into ________ categories.
a)Dividend distribution
b)Retained earnings
c)Both a and b
d)None of the above
15.The financial decisions of investors are often biased due to various factors and make their
decisions _________.
a)Rational
b)Irrational
c)Personal choice
d)None of the above
16._________is the metric used to gauge a company's operational effectiveness
a)Assets
b)Liabilities
c)Profit
d)None of the above
17. Investors can forecast the potential profit from various investments with differing degrees of
precision using the _______computation
a) Present value
b) Future value
c) Compounding

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d) None of the above
18.Profit lower the ______ of business
a) Risk
b) Profitability
c) Liquidity
d) None of the above
19. When interest is determined solely on the initial principle sum is termed as __________.
a) Simple interest
b) Compound interest
c) Present value
d) Future value
20. _________ are the financial objectives of the firm
a) Investing objectives
b) Cash flow objectives
c) Cost objectives
d) All the above

Q.2 Fill in the blanks

1. The value of money changes over ________.

2. The method of managing public funds in the economy is called ________.
3. _________is the primary goal of all economic activities.
4. Required Rate of Return = _________+ Risk premium.
5. __________means planning, organizing, directing and controlling the company's financial
activities
6. __________is a category of financial services that aims to attract private capital to meet
challenges in the areas of social and environmental needs.
7. ___________tries to explain how people make financial decisions in the real world and why their
choices cannot always seem rational and have unforeseen results.
8. ________ refers to shareholder money or the personal wealth of those involved in the firm.
9. _______ is needed for planning.
10. __________is the process through which earnings from an asset, such as interest or capital gains,
are reinvested to produce more earnings over time.

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Q.3 Answer in one or two sentences.

1. What is public finance?

2. What is corporate finance?
3. What is behavioral finance?
4. What is financial management?
5. What is future value?
6. What is personal finance?
7. State the financial objectives.
8. Write the formula to find future value
9. Write the formula to find future value.
10. What is time value of money.

Q.4.Answer the following in brief

1. Explain the categories of finance?

2. What is profit maximization? Write down the characteristics of profit maximization?
3. Explain the need for time value of money
4. What is future value? Explain its merits and demerits.
5. What is present value? Explain in detail.

Q.5 Answer in detail

1. Write a note on profit maximization.
2. Write a note on wealth maximization.
3. What is compounding? State the difference between simple interest and compounding.
4. Define financial management. Explain the objectives of financial management.
5. Explain in detail the

Answer

Choose the correct answer

1.a 2.c 3.d 4. a 5.b 6.c 7.d 8.a 9.b 10.c
11.d 12.c 13.a 14.c 15.b 16.c 17.b 18.a 19.a 20.d

Fill in the blanks

1. Time

Basics of Finance Management Page 48 of 242

 2. Public finance
3. Profit
4. Risk free Rate
5. Financial management
6. Behavioral finance
7. Social finance
8. Wealth
9. Future value
10. Compounding

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 B.COST OF CAPITAL & VALUATION
B.1. Introduction
The cost of capital must be carefully considered by the finance management when the organization is
employing several sources of funding because it is directly related to the firm's worth and its ability to
generate income.

Because it is used to assess the merit of investment proposals made by business concerns, cost of capital
is a crucial component of investment decision-making. When calculating the present value of future cash
flows linked to capital projects, it serves as a discount rate. The terms cut-off rate, target rate, hurdle rate,
and needed rate of return are all variations of the term "cost of capital."

B.1.1 Meaning of Cost of Capital:

The cost of capital is the rate of return a company needs to achieve on its project investments in order to
keep its market value high and draw in investors.

The required rate of return on an organization's stock, debt, and retained profit investments is known as
the cost of capital. The market value of the shares would decline and the overall wealth of the
shareholders will decrease if a company does not generate returns at the anticipated rate.

The following important definitions are commonly used to understand the meaning and concept of the
cost of capital.

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

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

According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for the allocation of
capital to investment of projects. It is the rate of return on a project that will leave unchanged the market
price of the stock”.

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

B.1.2. Assumptions of Cost of Capital:

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While calculating and measuring the cost of capital, several assumptions are made that are closely related.
There are three fundamental ideas that should be taken into account:

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

2. It is the minimum rate of return.

3. It consists of three important risks such as zero risk level, business risk and financial risk.

Cost of capital can be measured with the help of the following equation.

K=rj + b + f.

Where, K = Cost of capital.

rj = The riskless cost of the particular type of finance.

b = The business risk premium.

f = The financial risk premium.

B.1.3. Importance of Cost of Capital

Calculating the cost of capital is a crucial step in financial management when choosing the capital structure
for a company.

a) Importance to Capital Budgeting Decision

The cost of capital for each source is a key factor in capital budget decisions. The present value of cash
inflow must be greater than the present value of cash outflow in accordance with the net present value
technique. Consequently, capital budgeting decisions are based on cost of capital.

b) Importance to Structure Decision:

Capital structure is the mix or proportion of the different kinds of long term securities. So the company
selects the best capital structure which is suitable for the firm. Therefore, the cost of capital influences
the choice of structure

c) Importance to Evolution of Financial Performance:

One of the key factors that influences the capital budgeting, capital structure, and business value is the
cost of capital. As a result, it is useful to assess the company's financial performance.

d) Importance to Other Financial Decisions:

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In addition to the aforementioned uses, the cost of capital is also utilized in other contexts, such as share
market value and the earning potential of securities. Consequently, it has a significant impact on financial
management.

B.1.4. Classification of Cost of Capital

Cost of capital may be classified into the following types on the basis of nature and usage:

• Explicit and Implicit Cost.

• Average and Marginal Cost.

• Historical and Future Cost.

• Specific and Combined Cost.

a) Explicit and Implicit Cost.

Explicit expenditures, often known as out-of-pocket expenses for an organisation, are expenses that
require an immediate monetary outlay from the organisation.

All fees spent to finish the production, such as those for land, labour, power, supplies, stationery, and
postage, are included in this category of costs. In essence, the explicit cost includes all expenses incurred
while the business is operating that are paid to third parties. Since these costs are recorded as they occur,
it is quite simple to record and report explicit costs indefinitely.

It is essential to record explicit expenses since doing so facilitates decision-making, cost control, reporting,
and other processes that are necessary for calculating profit.

Implicit costs are the expenses associated with the potential that a business is unable to take advantage
of because it is hidden from the public.

Implicit costs, to put it simply, are the costs associated with resources that the company already has but
could have used in another way. An organization's owner, for instance, could work at a job and make
money from it. Implicit costs do not necessarily require a cash outflow from the company.

Implicit costs are not reported or recorded in the books of accounts. Determining the implicit cost is done,
among other things, to assist in decision-making on the replacement of any asset. Expenses that are
incurred on self-supplied factors but for which no payment in cash or on credit is made are referred to as
implicit costs.

b) Average and Marginal Cost

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The overall cost of the items divided by the entire quantity of the goods, we get average cost. The average
cost is often referred to as the unit cost. Calculate the average cost using the formula below.

Average Cost = Total Cost / Number of Produced Units.

The average cost drops as the number of things rises since it is inversely related to both the number of
goods and their total cost. Fixed cost and variable cost are its two halves. The average cost tries to evaluate
how a change in output level may affect overall unit costs.

The cost of producing a single additional unit of a good or service rises due to marginal cost. Upon the
change in output that alters the quantity of production, marginal cost changes in the overall cost of
production. An key element in deciding the output is variable cost.

In other words, when the quantity produced increases by one unit, the total cost changes called marginal
cost. The derivative of the total cost regarding quantity is how the marginal cost function is stated. The
marginal cost is the price of the following unit produced at each production level, albeit it may vary
depending on volume. The following formula can be used to express marginal cost:

Marginal Cost = Change in Total Cost / Change in Quantity

Change in Total Cost = Total Cost of Production including additional unit – Total Cost of Production of a
normal unit

Change in quantity = Total quantity product including additional unit – Total quantity product of normal
unit

c) Historical and Future Cost.

It is the price that has already been paid to finance a specific project. Based on actual expenses incurred
for the prior project. Using the historical cost technique, the assets of the company are recorded in the
books of accounts at the original purchase price. The initial cost at the time of a transaction is often what
is meant by the terms cost and historical cost. The historical cost approach is the most used accounting
technique since it is simple for a business to determine how much was spent for an asset.

Forecasts are the basis of future costs. Forecasts of future costs or comparisons of future circumstances
serve as the relevant expenses for the majority of managerial choices. a quantification of a potential
expense's size that is estimated. Cost projections are necessary for budgeting, estimating future income
statements, evaluating capital expenditures, choosing new projects and programs for expansion, and
pricing. It represents the estimated expense of financing the suggested project. Calculating expected cost

Basics of Finance Management Page 53 of 242

is based on prior experience. It plays a significant role in project planning and choosing how much money
will be committed in the future. These are helpful for making financial decisions when comparing the
expected future cost of capital with the overall present cost of capital.

d) Specific and Combined Cost.

A specific cost of capital is the price associated with each type of capital source, including loans, debt,
retained earnings, and stock. Finding each and every individual source of capital is highly helpful.

All capital sources are pooled to form the combined or total cost of capital.

It is additionally known as the total cost of capital. It is utilized to comprehend the complete cost related
to the firm's overall financing.

B.1.5.Risk-Return Relationship
between various securities.
Investors have a wide range of investment options. They have various risks and returns. Return and risk
are inextricably linked. Why is the return on a postal deposit less than a debenture's interest rate?
Debentures carry risk, whereas postal deposits are not. When compared to a postal deposit, a debenture's
return is higher because the risk is higher. Because the risk is greater than both the postal deposit and the
debenture, the return on an equity share is still significant.

It is clear that any security's needed return is made up of two rates: a riskfree rate and a risk premium. As
compensation for time value, a risk-free rate will have a zero risk premium.

Examples of risk-free securities are bank deposits and government securities. On risky securities, investors
anticipate a larger return. A security's risk increases with its risk premium, which in turn raises the needed
rate of return.

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Source:(C.Paramasivan & T.Subramanian, n.d.)

B.2. Computation of Cost of Capital:

Computation of cost of capital consists of two important parts:

1. Measurement of specific costs & Measurement of overall cost of capital

2. Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:

• Cost of equity

• Cost of debt

• Cost of preference share

• Cost of retained earnings

B.2.1. Cost of equity

When determining a company's share value, investors discount the expected dividends of the company
at a certain rate, known as the cost of equity capital.

Cost of Capital (Ke) defined as “Minimum rate of return that a firm must earn on the equity financed
portion of an investment project in order to leave unchanged the market price of the shares”.

Cost of equity can be calculated from the following approach:

• Dividend price (D/P) approach

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• Dividend price plus growth (D/P + g) approach

• Earning price (E/P) approach

• Realized yield approach

a) Dividend price (D/P) approach

The expected dividend rate that will keep the current market price of equity shares constant will be the
cost of equity capital.

The dividend price approach describes an investor's view before investing in stocks. Under this approach,
investors already have a certain minimum expectation of receiving a dividend before buying shares. The
investor calculates the current market price of the stock and the dividend rate.

Dividend price approach can be calculated with the help of the following formula:

Ke = D___
Np

Whereas, Ke = Cost of equity capital

D = Dividend per equity share

Np= Net proceeds of equity share

1. A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. The company has
been paying 25% dividend to equity shareholders for the past five years and expects to maintain
the same in the future also. Compute the cost of equity capital. Will it make any difference if the
market price of equity share is Rs. 175?

Solution: Ke = D___
Np
Ke = 25__ x 100 (D= Rs 25, Np= 100 + 10%= 110)
110
= 22.72 %
If the market price of equity share is Rs 175
Ke = D___
Np
Ke = 25__ x 100
175
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 Ke= 14.28 %

b)Dividend Price Plus Growth Approach

The predicted dividend rate per share and dividend growth are used to calculate the cost of equity.
Dividend growth is the annual percentage growth rate that a particular stock's dividend experiences over
a period of time. Many mature companies try to pay dividends to their investors regularly. Knowing the
dividend growth rate is a key input to stock valuation models known as dividend discount models. It can
be calculated using the following formula:
Ke = D__ + g
Np

Whereas, Ke = Cost of equity capital

D = Dividend per equity share

Np= Net proceeds of equity share

g = growth in expected dividend

2. (a) A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation costs are
expected to be 4% of the share price. The company pays a dividend of Rs. 12 per share initially and
growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares.
(b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity
share capital.
Solution : (a) Ke = D__ + g
Np
Ke = 12____+ 5 = 17.76%
100 – 4
(b) Ke = D__ + g
Np
= 12__ + 5 = 10 + 5 = 15%
120
3. The current market price of the shares of A Ltd. is Rs. 95. The floatation costs are Rs. 5 per share
amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You are required to calculate the cost
of equity share capital.
Solution : Market price Rs. 95

Basics of Finance Management Page 57 of 242

 Dividend Rs. 4.50
Growth 7%.
Ke = D__ + g
Np
= 4.50_ + 7%
95
= 4.73 % + 7%
= 11.73 %

c) Earning Price Approach:

The market price of the shares is determined by the cost of equity. It is predicated on the equity's potential
for future earnings. The price-to-earnings approach indicates that the cost of equity depends on the size
of the fixed income of the organization. According to the price-earnings approach, the investor assumes
that the organization must generate a certain amount of profit.

Investors do not always expect an organization to pay dividends regularly. Sometimes they prefer the
organization to invest the dividend amount in additional projects to generate profit. In this way, the profit
of the organization would increase, which in turn would increase the value of its shares in the market.
This method uses the following calculation to determine the cost of equity:

Ke = E_

Np

Whereas, Ke = Cost of equity capital

Np= Net proceeds of equity share

E = Earning per share

4. A firm is considering an expenditure of Rs. 75 lakhs for expanding its operations. The relevant
information is as follows :
Number of existing equity shares =10 lakhs
Market value of existing share =Rs.100
Net earnings =Rs.100 lakhs
Compute the cost of existing equity share capital and of new equity capital assuming that new
shares will be issued at a price of Rs. 92 per share and the costs of new issue will be Rs. 2 per share.

Solution: Cost of existing equity shares: Ke = E_

Basics of Finance Management Page 58 of 242
 Np
E = Earning per share = Net Earnings = 100 lakhs = Rs 10
Number of existing equity shares 10 lakhs

Ke = E_

Np

Ke= 10_ x 100 = 10 %

100

Cost of equity capital = Ke = E_

Np

= 10_ x 100

92 – 2

= 11.11%

d) Realized Yield Approach:

It is a simple way to figure out the cost of equity capital. This method bases the cost of equity calculation
on the actual return that an investor in a company has received on their equity investment. Realized yield
is the actual income earned on the investment during the holding period. This can include dividends,
interest and other cash. The term realized yield can be used for a bond or dividend-paying security sold
before maturity. Generally, the bond's realized yield includes the coupon payments received during the
holding period plus or minus the change in the value of the original investment, which is calculated
annually.

Ke = PVf x D

Whereas, Ke = Cost of equity capital

PVf = Present Value of discount factor

D = Dividend per share

B.2.2. Cost of Debt:

Basics of Finance Management Page 59 of 242
The after-tax cost of borrowing long-term cash is known as the cost of debt. The cost of debt is the total
interest cost of the debt. Simply put, the cost of debt is the actual interest rate or the total amount of
interest that a business or individual owes on all debts, such as bonds and loans. This cost can relate to
either pre-tax or post-tax debt costs. The amount of debt costs depends entirely on the creditworthiness
of the borrower, so higher costs mean the riskiness of the borrower. Debt may be perpetual or
redeemable and may be issued at par, premium, or discount.

a) Debt issued at Par:

Debt issued at par means, debt is issued at the face value of the debt. Par value, also known as face value
or initial value, is the face value of a bond or the value of a share certificate as stated in the company's
articles of association.

The share certificates issued for the purchased shares show the nominal value. The par value or stated
value per share is the lowest legal price at which a company sells its shares.

A bond or interest-bearing instrument must have a face value and indicate its maturity value and the
dollar value of the coupon or interest payable to the bond holder. It may be calculated with the help of
the following formula.

Kd = (1 – t) R

Whereas, Kd = Cost of debt capital

t = Tax rate

R = Debenture interest rate

b) Debt Issued at Premium or Discount:

When debt is issued at a price lower than its face value, then it is termed as Debt issued at discount. For
eg., if the debenture or bond of Rs 10 is issued at Rs 8 and will be redeemed at Rs 10 then it is termed as
debt issued at discount. When the debt is issued at a price higher than it’s face value and will be redeemed
at face value is termed as the debt issued at premium. Here the rates of interest is considerably high as
compared to debt issued at discount. For eg., if the shares are issued at Rs 12 having face value of Rs 10
then it will be termed as debt issued at premium. If the debt is issued at premium or discount, the cost of
debt is calculated with the help of the following formula.

Kd = I__(1-t)

Np
Basics of Finance Management Page 60 of 242
Whereas, Kd = Cost of debt capital

I = Annual interest payable

Np = Net proceeds of debenture

t = Tax rate

5. (a) A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate applicable to the company is
50%. Compute the cost of debt capital.
(b) B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate applicable to the
company is 60%. Compute the cost of debt capital.
(c) A Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute the
cost of debt capital.
(d) B Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%.
The tax rate applicable is 50%.
Compute the cost of debt-capital. In all cases, we have computed the after-tax cost of debt as the
firm saves on account of tax by using debt as a source of finance

Solution: (a ) Kd = I__(1-t)

Np

Kd = _80,000_ (1-50%)

10,00,000

= _80,000_ (0.50)

10,00,000

=4%

OR

Kd = (1 – t) R

= ( 1 – 50%) 8 %

= ( 0.50 ) 8 %

=4%

(b) Np = Face value + Premium = Rs 1,00,000 + Rs 10,000 = Rs 1,10,000

Basics of Finance Management Page 61 of 242

 Kd = I__(1-t)

Np

Kd = _8000__ (1- 0.60)

1,10,000

Kd = 2.91 %

(c) Np = Face Value – Discount = Rs 1,00,000 – Rs 5,000 = Rs 95,000

Kd = I__(1-t)

Np

Kd = 8,000__(1-0.60)

95,000

Kd = 3.36 %

(d) Np = Rs 10,00,000 + Rs 1,00,000 = Rs 11,00,000 – 2 % = Rs 10,78,000

Kd = I__(1-t)

Np

Kd = I__(1-t)

Np

Kd = 90,000__ (1 – 0.50 )

10,78,000

Kd = 4.17 %

B.2.3. Cost of Preference Share Capital:

Cost of preference share capital is the annual preference share dividend by the net proceeds from the
sale of preference share. The cost of preference share capital is that part of the cost of capital, in which
we consider the amount paid to preference shareholders as a fixed interest dividend. Even the payment
of dividend to the preferred shareholder is made at the request of the board of the company, and the
preferred shareholder cannot press the payment of the dividend.

There are two types of preference shares irredeemable and redeemable.

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Cost of redeemable preference share capital is calculated with the help of the following formula:

Kp = Dp___
Np

Whereas, Kp = Cost of preference share capital

Np= Net proceeds of preference share

Dp = Fixed dividend of preference share

6. XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per share.
Calculate cost of preference share capital if these shares are issued (a) at par, (b) at a premium of
10% and (c) of a discount of 6%.

Solution: Cost of preference share capital = Kp = Dp___

Np
(a) Dp= 20,000 x 100 = Rs 20,00,000 x 8 % = Rs 1,60,000
Np= Rs 20,00,000 – (20,000 x 2) = Rs 20,00,000 – Rs 40,000 = Rs 19,60,000
Kp = Dp___
Np
= Rs 1,60,000 x 100
Rs 19,60,000
= 8.16 %
(b) Np= Rs 20,00,000 + Rs 2,00,000 – (20,000 x 2) = Rs 22,00,000 – Rs 40,000 = Rs 21,60,000
Kp = Dp___
Np
Kp = Rs 1,60,000 x 100
Rs 21,60,000
Kp = 7.40 %
(c) Dp= 20,000 x 100 = Rs 20,00,000 x 8 % = Rs 1,60,000
Np= Rs 20,00,000 – 1,20,000 - (20,000 x 2) = Rs 18,80,000 – Rs 40,000 = Rs 18,40,000
Kp = Dp___
Np
Kp = Rs 1,60,000___ x 100

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 Rs 18,40,000
Kp = 8.69 %

B.2.4. Cost of Retained Earnings:

One of the sources of funding for investment proposals is retained earnings; this source differs from
others like debt, equity, and preference shares. The cost of retained earnings, as determined by the cost
of equity capital, is equal to the cost of an equivalent fully subscripted issue of extra shares. The following
formula can be used to determine the cost of retained earnings:

Kr = Ke ( 1 – t ) ( 1 – b )

Whereas, Kr = Cost of retained earnings

Ke = Cost of equity

t = tax rate

b = brokerage cost

7. A firm’s Ke (return available to shareholders) is 10%, the average tax rate of shareholders is 30%
and it is expected that 2% is brokerage cost that shareholders will have to pay while investing their
dividends in alternative securities. What is the cost of retained earnings?

Solution: Cost of retained earnings: Kr = Ke ( 1 – t ) ( 1 – b )

Ke = 10 %

t = 30 %

b=2%

Kr = Ke ( 1 – t ) ( 1 – b )

= 10 % ( 1 – 30% ) ( 1 – 2% )

= 4.9 %

B.2.5. Measurement of Overall Cost of Capital

Total cost of capital means the weighted average of the costs of each capital component. It represents
the combined cost of capital from various sources such as debt, equity, equity and retained earnings.

Ko = Kd .Wd + Kp .Wp + Ke .We + Kr .Wr

Whereas, Ko = Overall cost of capital

Basics of Finance Management Page 64 of 242
 Kd = Cost of debt

Kp = Cost of preference share

Ke = Cost of equity

Kr = Cost of retained earnings

Wd= Percentage of debt of total capital

Wp = Percentage of preference share to total capital

We = Percentage of equity to total capital

Wr = Percentage of retained earnings

Weighted average cost of capital is calculated in the following formula also:

Kw = ∑XW
∑W

Whereas, Kw = Weighted average cost of capital

X = Cost of specific sources of finance

W = Weight, proportion of specific sources of finance.

8. A company has on its books the following amounts and specific costs of each type of capital.

Type of Capital Book Value Market Value Specific Costs (%)

Debt 4,00,000 3,80,000 5

Preference 1,00,000 1,10,000 8

Equity 6,00,000 9,00,000 15

Retained Earning 2,00,000 3,00,000 13

13,00,000 16,90,000

Determine the weighted average cost of capital using:

(a) Book value weights, and

(b) Market value weights.

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How are they different? Can you think of a situation where the weighted average cost of capital would be
the same using either of the weights?

Solution: Computation of Weighted Average Cost of Capital

(a) Book Value

Type of Capital Book Value Specific Costs (%) Weighted Cost

Proportion x Cost (XW)

Debt 4,00,000 5 20,000

Preference 1,00,000 8 8,000

Equity 6,00,000 15 90,000

Retained Earning 2,00,000 13 26,000

13,00,000 1,44,000

Kw = ∑XW

∑W

Kw = 1,44,000 x 100

13,00,000

= 11.1 %

(b) Market Value

Type of Capital Market Value Specific Costs (%) Weighted Cost

Proportion x Cost (XW)

Debt 3,80,000 5 19,000

Preference 1,10,000 8 8,800

Equity 9,00,000 15 1,35,000

Retained Earning 3,00,000 13 39,000

Basics of Finance Management Page 66 of 242

 16,90,000 2,01,800

Kw = ∑XW

∑W

Kw = 2,01,800 x 100

16,90,000

= 11.1 %

Practical Sums:
1. A Co. Ltd issued 10% debentures of Rs 500000 at par. Compute the cost of debt if the applicable
rate on the company is
a) 50%
b) 40%
c) 45%

Solution: Tax rate = 50%

Cost of Debt = (kd) = I__(1-t)

Np
Basics of Finance Management Page 67 of 242
 = 50,000 ( 1 – 50%)
5,00,000
= 5 x 0.5
50
=5%

Tax rate = 40%

Cost of Debt = (kd) = I__(1-t)

Np
= 50,000 ( 1 – 40%)
5,00,000
= 5 x 0.6
50
=6%

Tax rate = 45%

Cost of Debt = (kd) = I__(1-t)

Np
= 50,000 ( 1 – 45%)
5,00,000
= 5 x 0.55
50
= 5.5 %
2. X.Co Ltd issued 12 % debenture of Rs 2,00,000, face value of the debenture is Rs 100. Compute
cost of debenture if
i. Issued at par, tax rate is 20 %
ii. Issued at 10 % premium, tax rate is 30 %
iii. Issued at 10 % discount, tax rate is 40 %

Solution: In order to separate the tax adjustment, cost of debt are computed before tax adjustment and
after tax adjustment

Basics of Finance Management Page 68 of 242

 3. A company has issued 10,000 equity shares of Rs 100 each. Company has been paying dividend
to equity shareholders at 25% p.a. from last three years and expected to maintain the same. The
market value of the shares is Rs 180. Compute cost of equity.

Solution: Ke = D___
Np
Ke = 25___ x 100
180
Ke = 13.89 %
4. ABC Co. Ltd wants to issue 20,000 new shares of Rs 100 each at par. The flotation cost is expected
to 5 %. The company has paid dividend of Rs 15 in last year and it is expected to grow by 7 %.
Compute the cost of equity
i. In case of new equity shares
ii. For existing shareholder assuming market price of the share is Rs 160

Solution: Cost of equity to existing shareholders

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 5. The cost of various types of capital of Shiv Co. Ltd is given below along with target market
proportions. Compute WACC from the following

Solution:

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 6. What would be your opinion if company wants to change WACC approach from book value to
market approach? In market approach, the price of equity share is Rs 250 per share instead of
Rs 100 in book value. Compute WACC under market approach.

Solution:

In market value approach, the retained earnings are automatically covered under equities as these
are valued at market price which takes reserves of the companies in to account while valuing firm’s
security.

14. Calculate the cost of capital in the following cases:

X Ltd. issues 12% Debentures of face value Rs. 100 each and realizes Rs. 95 per Debenture. The
Debentures are redeemable after 10 years at a premium of 10%.
Y. Ltd. issues 14% preference shares of face value Rs. 100 each Rs. 92 per share. The shares are repayable
after 12 years at par.
Note: Both companies are paying income tax at 50%.
Solution
Cost of Debt
kd = [Int + (RV – SV) / N] (1 – t)
Basics of Finance Management Page 71 of 242
 (RV + SV) / 2
Int = Annual interest to be paid i.e. Rs. 12
t = Company’s effective tax rate i.e. 50% or 0.50
RV = Redemption value per Debenture i.e. Rs. 110
N = Number of years to maturity = 10 years
SV = issue price per debenture minus floatation cost i.e. Rs. 95
kd =[12 + (110 – 95) / 10] (1 – .5)
(110 + 95) / 2
= [12 + 2.5](0.5)
97.50
= 7.25
97.50
= 7.43%
(ii) Cost of preference capital
Kp= D + (RV – SV) / N
(RV + SV) / 2
Where, D = Dividend on Preference share i.e. Rs. 14
SV = Issue Price per share minus floatation cost Rs. 92
N = No. of years for redemption i.e. 12 years
RV = Net price payable on redemption Rs. 100
= 14 (100 – 92) / 12
(110 + 95) / 2
= 14 + .67
95
= 15.28%
15a) A company raised preference share capital of Rs. 1,00,000 by the issue of 10% preference share of
Rs. 10 each. Find out the cost of preference share capital when it is issued at
(i) 10% premium, and
(ii) 10% discount.
b) A company has 10% redeemable preference share which are redeemable at 6the end of 10th
year from the date of issue. The underwriting expenses are expected to 2%. Find out the effective cost
of preference share capital.

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c) The entire share capital of a company consist of 1,00,000 equity share of Rs. 100 each. Its current
earnings are Rs. 10,00,000 p.a. The company wants to raise additional funds of Rs. 25,00,000 by
issuing new shares. The flotation cost is expected to be 10% of the face value. Find out the cost of equity
capital given that the earnings are expected to remain same for coming years.
Solution:
(a) Cost of 10% preference share capital
(i) When share of Rs. 10 is issued at 10% premium
Kp = D / P0
= 10 / 11 x 100
= 9.09%
(ii) When share of Rs. 10 is issued at 10% discount
kp = PD / P0
= 10 / 9 x 100
= 11.11%
(b) The cost of preference share (face value = Rs. 100) may be found as follows:
kp = D + (RV – SV) / N
(RV+ SV) / 2
In this case
D = 10
RV = 100
SV = 100 – 2 = Rs. 98
kp =10 + (100 – 98) / 10
(100 + 98) / 2
= 10.3%
(c) In this case,
the net proceeds on issue of equity shares are Rs. 100 – 10 = Rs. 90
and earnings per share is Rs. 10.
Cost of new equity is: ke = D1 / p0
= 10 / 90
= 11.%
16. A company is considering raising of funds of about Rs. 100 lakhs by one of two alternative
method, viz., 14% institutional term loan or 13% non-convertible debentures. The term loan option

Basics of Finance Management Page 73 of 242

would attract no major incidental cost. The debentures would have to be issued at a discount
of 2.5% and would involve cost of issue of Rs. 1,00,000.
Advise the company as to the better option based on the effective cost of capital in each case.
Assume a tax rate of 50%.
Solution
Effective cost of 14% loan:
In this case, there is no other cost involved and the company has to pay interest at 14%.
This interest after tax shield @ 50% comes to 7% only.
Effective cost of 13%
NCD : In this case, Annual Interest, I = Rs. 13
SV = 100 – 2.50 – 1.00
= 96.50
kd =13 (1 – 5)
96.50%
= 6.74%
The effective cost of capital is lesser in case of 13% NCD.
17. The following figures are taken from the current balance sheet of Delaware & Co.
Capital Rs. 8,00,000
Share Premium 2,00,000
Reserves 6,00,00
Shareholder’s funds 16,00,000
12% irredeemable debentures 4,00,00
An annual ordinary dividend of Rs. 2 per share has just been paid. In the past, ordinary dividends have
grown at a rate of 10 per cent per annum and this rate of growth is expected to continue. Annual
interest has recently been paid on the debentures. The ordinary shares are currently quoted at Rs. 27.5
and the debentures at 80 per cent. Ignore taxation.
You are required to estimate the weighted average cost of capital (based on marker values) for
Delaware & Co.
Solution
In order to calculate the WACC, the specific cost of equity capital and debt capital are to be calculated as
follows:
ke =D1 + g

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 P0
= Rs. 2 x 1.10 = + 10
Rs. 27.50
= 18%
The market value of equity is 80,000 x Rs. 27.50 = Rs. 22,00,000
kd = I__
SV
=Rs. 12
Rs. 80
= 15%
The market value of debt is 4,00,000 x .80 = Rs. 3,20,000.
Now, the WACC is
(22,00,000 / 25,20,000) x .18 + (3,20,000/25,20,000) x .15
= .176
= 17.6%
Note: In this case, the dividend of Rs. 2 has just been paid.
So, D0 = Rs. 2 and the D1, i.e. dividend expected after one year from now will be
D0 x (1 + g)
= Rs. 2 x 1.10.
18. The following information has been extracted from the balance sheet of Fashions Ltd. as on 31-12-
1998:
Rs. in Lacs
Equity share capital 400
12% debentures 400
18% term loan 1,200
a) Determine the weighted average cost of capital of the company. It had been paying dividends at a
consistent rate of 20% per annum.
b) What difference will it make if the current price of the Rs. 100 share is Rs. 160?
c) Determine the effect of Income Tax on the cost of capital under both premises (Tax rate 40%).
Solution
a) Weighted average cost of capital of the company is as follows:

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Sources of capital Cost of capital Proportion of total Weighted cost of capital
Equity share capital 20% 4/20 4.00
12% debenture 12% 4/20 2.40
Term loan 18% 12/20 10.80
WACC 17.20
Therefore, weighted cost of capital (without consideration of the market price of Equity and not taking
into consideration the effect of Income Tax) is = 17.2% per annum.
b) When market price of equity shares is Rs. 160 (Face value Rs. 100), the cost of capital is:
ke = D1
p
= 20
160
= 12.5%
Weighted average cost of capital will therefore be:
Sources of capital Cost of capital Proportion of total Weighted cost of capital
Equity share capital 12.5% 4/20 2.5%
12% debenture 12% 4/20 2.4%
18% Term loan 18% 12/20 10.8
WACC 15.7%
The above WACC is without taking into consideration the effect of Income Tax.
c) As interest on debenture and loans is an allowable deductible expenditure for arriving at taxable
income, the real cost to the company will be interest charges less tax benefit (assuming that the
company earns taxable income).
So, interest cost will be : Rate of interest (1 – t)
12% Debenture : 12 x 0.60 = 7.2%
18% Term loan : 18 x 0.60 = 10.8%
The cost of capital after tax benefit (as per premises – a):

Sources Cost Proportion Weighted cost (Rs.)

Equity 20% 4/20 4.00
12% debenture 7.2% 4/20 1.44
18% Term loan 10.8% 12/20 6.48

Basics of Finance Management Page 76 of 242

WACC 11.92
The cost of capital after tax benefit (as per premises – b):
Sources Cost Proportion Weighted cost (Rs.)
Equity 12.5% 4/20 2.50
12% debenture 7.2% 4/20 1.44
18% Term loan 10.8% 12/20 6.48
Weighted average cost= 10.42

Basics of Finance Management Page 77 of 242

Q1.Choose the correct answer
1.The cost of equity share or debt is known as __________.
a. The specific cost of capital
b. The related cost of capital
c. The burden on the shareholder
d. None of the above

2.In weighted average cost of capital, an organisation can affect its cost of capital through
____________.
a. The policy of investment
b. The policy of capital structure
c. The policy of dividends
d. All of the above

3.What is Marginal Cost?

a. It is the cost of raising an additional unit of capital
b. It is the additional cost of capital when the company decides to raise finance for its operations
c. It is the weighted average cost of raising finance
d. All of the above

4.Which of the following factors affecting the cost of capital can be controlled by the firm?
a. Tax rates
b. Dividend policy
c. Level of interest rates
d. All of the above

5._________ is the cost that is used to raise the common equity of a firm by reinvestment of the
internal earnings.
a. Cost of reserve assets
b. Cost of stocks
c. Cost of mortgage
d. Cost of common equity

6.Which of the following factors affects the determination of the cost of capital for a firm?
a. Operating and financing decisions

Basics of Finance Management Page 78 of 242

 b. General economic factors
c. Market conditions
d. All of the above

7.The cost of equity share capital is greater than the cost of debt because __________.
a. Equity shares carry a higher risk than debts
b. The face value of equity shares is lower than the face values of debentures in most cases
c. Equity shares do not provide a fixed dividend rate
d. Equity shares are not easily saleable

8.In which of the following method cost of equity capital is computed by dividing the dividend by
market price per share or net proceeds per share?
a. Price Earning Method
b. Adjusted Price Method
c. Adjusted Dividend Method
d. Dividend Yield Method
9.……….. is the rate of return associated with the best investment opportunity for the firm and its
shareholders that will be forgone if the projects presently under consideration by the firm were
accepted.
a. Explicit Cost
b. Future Cost
c. Implicit Cost
d. Specific Cost
10. The cost of equity share or debt is called specific cost of capital. When specific costs are combined,
then we arrive at –
a. Maximum rate of return
b. Internal rate of return
c. Overall cost of capital
d. Accounting rate of return
11. Interest rates, tax rates and market risk premium are factors which –
a. Industry cannot control
b. Industry can control

Basics of Finance Management Page 79 of 242

 c. Firm must control
d. Firm cannot control
12.…….. is the rate that the firm pays to procure financing.
a. Average Cost of Capital
b. Combine Cost
c. Economic Cost
d. Explicit Cost
13. In weighted average cost of capital, rising in interest rate leads to –
a. Increase in cost of debt
b. Increase the capital structure
c. Decrease in cost of debt
d. Decrease the capital structure
14. ………… is the cost which has already been incurred for financing a particular project
a. Future Cost
b. Historical Cost
c. Implicit Cost
d. Opportunity Cost
15. Overall cost of capital is called as –
a. Composite cost of capital
b. Combined cost of capital
c. Both (A) and (B)
d. Neither (A) nor (B)
16. Type of cost which is used to raise common equity by reinvesting internal earnings is classified
as………
a. Cost of common equity
b. Cost of mortgage
c. Cost of stocks
d. Cost of reserve assets
17. Which of the following factor affects the determination of cost of capital of the firm?
a. General economic conditions
b. Market conditions

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 c. Operating and financing decisions
d. All of the above
18. A firm’s overall cost of capital:
a. varies inversely with its cost of debt.
b. is unaffected by changes in the tax rate.
c. is another term for the firm’s internal rate of return.
d. is the required return on the total assets of a firm.
19. For which of the following costs is it generally necessary to apply a tax adjustment to a yield
measure?
a. Cost of debt
b. Cost of preferred stock
c. Cost of common equity
d. Cost of retained earnings
20. While calculating WACC on market value basis which of the following is not considered –
a. After tax cost of debt
b. Reserve and surplus
c. Weight of each fund in capital structure
d. Cost of term loan

Q.2 Fill in the blanks

1. _____________is the rate of return a company needs to achieve on its project investments in
order to keep its market value high and draw in investors.
2. Explicit expenditures is also known as ________expenses
3. __________ cost is hidden cost
4. Average cost is ________ related to total cost and number of units produced.
5. ____________ is actual cost incurred on prior projects
6. _______projections are necessary for budgeting, estimating future income statements, evaluating
capital expenditures, choosing new projects and programs for expansion, and pricing.
7. __________is utilized to comprehend the complete cost related to the firm's overall financing.
8. __________cost of capital is the price associated with each type of capital source, including loans,
debt, retained earnings, and stock.
9. The cost of producing a single additional unit of a good or service called _________cost.
10. Cost of Capital is denoted by _______.
Basics of Finance Management Page 81 of 242
Q.3 Answer in one or two sentences.

1) What is cost of capital?

2) State the difference between historical cost and future cost?
3) What is debt issued at discount?
4) What is debt issued at premium?
5) What is combined cost?
6) What is overall cost of capital?
7) What is average cost?
8) What is marginal cost?
9) State 4 assumptions of cost of capital?
10) State 4 importance of cost of capital?

Q.4.Answer the following in brief

1. Explain the importance of cost of capital

2. Rani Ltd’s shares are currently trading at a price of Rs.70 with outstanding shares of 5,00,000.
Their expected profit after tax for the coming year is Rs. 84 lakhs. Calculate the cost of capital
based on price/ earning method.
(Ke=24 %)
3. What is cost of debt? Explain in detail.
4. Discuss cost of preference share capital and retained earnings in detail.
5. Define cost of capital and discuss its assumptions.

Q.5 Answer in detail

1. (a)ABC Ltd. has disbursed dividend of Rs. 25 on each equity share of Rs. 10. The current market price of
equity share is Rs. 60. Calculate the cost of equity as per dividend yield method. (Ke=41.67 %)
(b)XYZ LTD’s shares are quoted in stock exchange trading at Rs. 120 each. Next year’s dividend is expected
to be Rs.30 per share and the subsequent dividends are expected to grow at an annual rate of 5% of the
previous year’s dividend. What is the cost of Equity shares? (K e=30 %)

2. What is cost of equity? Explain different methods to find the cost of equity.

3.The following is the capital structure of XYZ ltd.

Source Amount Interest rate
Equity share capital 25,000 11%

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 Preference share capital 20,000 10%
Retained earnings 10,000 8%
Debentures 20,000 10%

Tax rate is 50%. Calculate the overall cost of capital.

(WACC = 8.73%
Note: Interest payable on debentures is 10%. However, tax-rate is 50%. So, the after-tax cost is 5%.)
4.Discuss the risk and return relationship between various securities.

5. Discuss average and marginal cost in detail.

Answers:

Q1. Choose the correct answer

1.a 2.d 3.a 4. b 5.d 6.d 7.a 8.d 9.c 10.c

11.d 12.d 13.a 14.b 15.c 16.a 17.d 18.d 19.a 20.b

5. historical
Q.2 Fill in the blanks
6. Cost
1. Cost of capital
7. Total cost
2. out-of-pocket
8. Specific
3. implicit
9. Marginal
4. inversely
10. K

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 C. CAPITAL BUDGETING
C.1.Fundamentals
C.1.1.Introduction
The term "capital" refers to a company's overall investment in cash, tangible assets, and intangible assets.
In contrast, budgeting as described by "Rowland and William" might be considered the art of creating
budgets. Budgets are the expression in amounts and methods of a plan and an activity. A company's
investment choices are typically referred to as capital budgeting or capital expenditure choices. The goal
of capital budgeting is to allocate the company's limited financial resources to long-term initiatives whose
benefits will accrue in the future.

Capital expenditure instances include:

1. Purchasing fixed assets like real estate, buildings, machinery, and goodwill.

2. The cost associated with the expansion, improvement, and modification of fixed assets.

3. Changing out fixed assets.

4. A project for research and development.

C.1.2. Definitions:
According to the definition of Charles T. Hrongreen, “Capital budgeting is a long-term planning for making
and financing proposed capital out lays.”

According to the definition of G.C. Philippatos, “Capital budgeting is concerned with the allocation of the
firms source financial resources among the available opportunities. The consideration of investment
opportunities involves the comparison of the expected future streams of earnings from a project with the
immediate and subsequent streams of earning from a project, with the immediate and subsequent
streams of expenditure”.

According to the definition of Richard and Green law, “Capital budgeting is acquiring inputs with long-
term return”.

According to the definition of Lyrich, “Capital budgeting consists in planning development of available
capital for the purpose of maximizing the long-term profitability of the concern”

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The concepts above provide a clear explanation of how a firm's limited financial resources are used to
take advantage of the opportunities that are presented. The company's primary goals are to increase
earnings and cut costs as much as possible.

C.1.3. Characteristics of
capital budgeting:
● Exchange of current assets for future benefits.
● Investment of funds in non-flexible and long-term assets or activities.
● Huge Funds are involved.
● Future benefits or cash flows occur over a series of years.
● Decisions are irreversible.
● Significant impact on the profitability of the concern.

C.1.4. Need and Importance

of Capital Budgeting:
The importance and need for capital budgeting are as follows:

a) Huge investments:
Since large financial investments are necessary for capital budgeting yet there are only a finite amount of
funds available, the company plans and controls its capital expenditures prior to investing in projects.

b) Long term:
Long-term or permanent expenditures are capital expenditures. Consequently, there are greater financial
risks associated with the investing decision. If there are greater risks involved, rigorous capital budgeting
planning is required.

c) Irreversible:
The decisions made on capital investments cannot be changed back. Once the choice to buy a permanent
asset has been made, selling that item without suffering significant losses can be quite challenging.

d) Long-term effect:
By avoiding excessive or inadequate investment, capital planning not only lowers costs but also boosts
long-term income and significantly alters the company's profit. Overinvesting results in underutilizing

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assets or overusing fixed assets. Therefore, rigorous preparation and in-depth project research are
essential before making the investment.

C.1.5. Capital Budgeting Process:

The process of investing the money that are available is called capital budgeting. The benefit won't be
realized until the very near future, but that future is unknown. The procedure could be simpler if the
subsequent steps are taken for capital budgeting:

Identification of Various investments

Screening or matching the available

resources

Evaluation of Proposals

Fixing property

Final Approval

Implementation

a) Identification of Various investments:

There may be a variety of investment suggestions in the capital budgeting. The top management may
determine the investment opportunities, or it may even come from a lower rank. The heads of several
departments will evaluate the numerous investment choices and choose suggestions to be presented to
the competent authority's planning committee.

b) Screening or matching the available

resources:
The planning committee will review and examine the various screenings and ideas. The chosen proposals
are evaluated in light of the concern's resources. The financial portion of the proposal is referred to here
as resources. The difference between resources and investment costs is narrowed as a result.

Basics of Finance Management Page 86 of 242

 c) Evaluation of Proposals:
After being screened, the proposals are assessed using a variety of techniques, including the payback
period proposal, the net discovered present value approach, the accounting rate of return, and risk
analysis. The proposals are evaluated by.

(a) Independent proposals

(b) Contingent of dependent proposals

(c) Partially exclusive proposals.

Independent proposals may be accepted or rejected without comparison to other proposals. While the
adoption of higher proposals is dependent on one or more other proposals. For instance, the construction
of new buildings and the hiring of more workers follow the expansion of plant machinery. Projects that
are mutually exclusive are ones that had to compete with other plans in order to implement them after
weighing risk and reward, market demand, etc.

d) Fixing property
The planning committee will forecast which projects will receive more profit or economic consideration
after the evolution. The initiatives are rejected without taking into account the proposals' other
characteristics if they are not acceptable for the concern's financial situation.

e) Final Approval
The following factors assist the planning committee in approving the final proposals:

a) Profitability,
b) Economic components,
c) Financial vulnerabilty, and
d) Market conditions etc.

The budget is created by the planning committee and submitted to management.

f) Implementation:
The money is spent and the suggestions are put into action by the responsible authority. As the proposal
is implements the recommendations, responsibilities is to assigned for seeing that they are completed
within the specified time and at the lowest possible cost. The network methods, including PERT and CPM

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are included for project completion. It aids management in keeping an eye on and restricting the
application of the recommendations.

g) Performance review of feedback:

Actual results and standard results are compared when the capital planning process comes to a close.
Identifying and removing the project's many challenges were the negative or undesirable results. For the
proposals' long-term benefit.

C.2.Methods Of Capital Budgeting Of Evaluation

By matching the projects with the resources that are available, it can be invested. The money are always
available as living funds. Environment and economic conditions are just two of the many factors taken
into account when making investment decisions.
The methods of evaluations are classified as follows:
(A) Traditional methods
(i) Pay-back Period Methods
(ii) Post Pay-back Methods
(iii) Accounts Rate of Return
(B) Modern methods
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method

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 C.2.1.Pay back period:
The duration needed to recover an investment's cost is referred to as the payback period. Simply
described, it is the period of time it takes for an investment to break even. Longer payback times are
unfavourable, while shorter paybacks make investments more appealing. The payback period is a factor
that account and fund managers consider when deciding whether to proceed with an investment. The
payback period's disregard for the time value of money is one of its drawbacks.
Pay-back period = Initial investment
Annual cash inflows
a) Merits of Payback period:
● Payback period method is easy to understand and calculate. It does not include any complicated
and difficult calculations.
● This method provides further improvement than accounting rate of return.
● Payback period method helps in reducing the risk of losses due to being obsolesce

b) Demerits of Payback period

● Payback period method does not consider the impact of time value of money on cash inflows.
● Payback period method does not consider the inflow of cashflow after the payback period.
● It is also considered as one of the misleading concepts of capital budgeting.
1. Project cost is Rs. 50,000 and the cash inflows are Rs. 15,000, the life of the project is 7 years.
Calculate the pay-back period.

Solution: Pay-back period = Initial investment

Annual cash inflows
= Rs 50,000
Rs 15,000
= 3.33 years.
2. A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 12½%
but before tax at 50%. Calculate the pay-back period.

Solution: Calculation of Cash inflow

Cash Inflow 3,00,000

Tax 50% (1,50,000)
1,50,000
Depreciation 2,50,000
20,00,000 x 12½%

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 Net Cash inflow 4,00,000

Pay-back period = Initial investment

Annual cash inflows
= Rs 20,00,000
Rs 4,00,000
= 5 years
3. ABC projects require an initial cash outflow of Rs. 35,000. The cash inflows for 6 years are Rs. 5,000,
Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000.

Solution:
Year Cash Inflows (Rs) Cumulative Cash Inflows (Rs)
1 5,000 5,000
2. 8,000 13,000
3. 10,000 23,000
4. 12,000 35,000
5. 7,000 42,000
6. 3,000 45,000

Here in above calculation it shows that the Amount of investment is recovered in 4 years. So the payback
period is 4 years.
4. Adani projects require an initial cash outflow of Rs. 25,000. The cash inflows for 6 years are Rs.
5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000.

Solution:
Year Cash Inflows (Rs) Cumulative Cash Inflows (Rs)
1 5,000 5,000
2. 8,000 13,000
3. 10,000 23,000
4. 12,000 35,000
5. 7,000 42,000
6. 3,000 45,000
Here, the amount of Rs 23,000 was recovered in 3 years and remaining Rs 2,000 was recovered within
Rs 12000 recovered in 4th years. The calculation of payback period will be as follows;

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Payback period : 3 years + 2000 / 12,000 x 12 months
: 3 years + 2 months
: 3 years 2 months

C.2.2.Accounting Rate of Return or

Average Rate of Return:
The average annual amount of cash flow produced over the course of an investment is the average rate
of return. This rate is derived by adding up all anticipated cash flows and dividing it by the anticipated
lifespan of the investment. Investors frequently use it to choose whether to invest in a particular asset.
The average rate of return refers to the profit or return that is taken into account when evaluating a
project. One of the established techniques for assessing project proposals is this one.

a) Merits of Accounting Rate of Return:

✔ It is very easy to understand and simple to calculate unlike IRR and NPV.
✔ ARR does not require cashflows but considers accounting data which is true reflection of
company’s performance.
✔ It considers all the total benefits associated with the project.
✔ It is not based on time value of money.

b) Demerits of Accounting Rate of Return:

✔ It ignores the time value of money.
✔ It ignores the reinvestment potential of a project.
✔ Different methods are used for accounting profit. So, it leads to some difficulties in the calculation
of the project.

Average rate of return = Average Annual Profit

Cost of investment
5. A company has two alternative proposals. The details are as follows:
Proposal 1 Proposal 2

Automatic Machine Ordinary machine

Cost of machine Rs 2,20,000 Rs 60,000

Estimated life 5½ years 8 years

Estimated sales p.a. Rs 1,50,000 Rs 1,50,000

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Costs: Material 50,000 50,000

Labour 12,000 60,000

Variable overheads 24,000 20,000

Compute the profitability of the proposals under the return on investment method .
Solution: Profitability Statement
Automatic Machine Ordinary machine

Cost of machine Rs 2,20,000 Rs 60,000

Estimated life 5½ years 8 years

Depreciation= Cost of Machine 2,20,000 / 5½ = Rs 40,000 60,000 / 8 = Rs 7,500

Estimated life

Estimated sales p.a. (A) Rs 1,50,000 Rs 1,50,000

Costs: Material 50,000 50,000

Labour 12,000 60,000

Variable overheads 24,000 20,000

Depreciation 40,000 7,500

Total Cost (B) Rs 1,26,000 Rs 1,37,500

Profit (A – B) Rs 24,000 Rs 12,500

Return on Investment= = 24,000 / 2,20,000 x 100 = 12,500 / 60,000 x 100

Average Profit / original = 10.90 % = 20.83%
Investment x 100

Ordinary machine is more profitable than automatic machine.

6. A machine costs Rs 1,00,000 and is expected to give profit of Rs 60,000 in next 3 years. Calculate
the average rate of return.
Solution: Cost of Machine = Rs 1,00,000
Profit in next 3 years = Rs 60,000
Average profit per year = Total profit

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 No. of years
= Rs 60,000
3 years
= Rs 20,000.

Average rate of return = Average Annual Profit

Cost of investment
= Rs 20,000 x 100
Rs 1,00,000
= 20%
Hence, the average rate of return on investment is 20%.

C.2.3.Net Present Value:

The term "net present value," or "NPV," refers to a financial metric that determines the value of an
investment or project by measuring the difference between its present value of cash inflows and outflows.
When comparing a project or investment to other options, the net present value (NPV) is used to assess
its profitability and viability. The time value of money, which states that money today is worth more than
money in the future since it may be invested and produce interest, is taken into consideration by NPV. By
applying a discount rate that reflects the opportunity cost of capital or the lowest acceptable rate of
return, NPV also captures the risk associated with an investment.
To calculate NPV, you need to estimate the future cash flows of the project or investment, and discount
them to their present value using the appropriate discount rate. Then, you subtract the initial investment
or cost from the total present value of cash flows. If the NPV is positive, it means that the project or
investment will generate more cash than it costs, and it may be a good option to pursue. If the NPV is
negative, it means that the project or investment will cost more than it will generate, and it may be better
to reject it.

a) Merits of Net Present Value:

● It considers the time value of money, which is important for long-term projects or investments.
● It considers the cash flows over the entire life of the project or investment, not just the initial or
final values.
● It provides a clear decision criterion: accept projects or investments with positive NPV, and reject
those with negative NPV.
● It allows risk factors to be incorporated into the calculation by adjusting the discount rate
accordingly.
Basics of Finance Management Page 93 of 242
 ● It can be used to rank projects or investments based on their NPV, and choose the one with the
highest NPV.

b) Demerits of NPV:
● It requires an estimate of the required rate of return or discount rate, which may be difficult to
determine or vary over time.
● It cannot be used to compare projects or investments of different sizes, durations, or risk levels,
unless they are mutually exclusive.
● It may not capture some hidden costs or benefits that are not reflected in the cash flows, such as
environmental or social impacts.
● It may be sensitive to changes in assumptions or estimates of cash flows, discount rate, or
inflation rate.

7. From the following information, calculate the net present value of the two project and suggest
which of the two projects should be accepted a discount rate of the two.

Project X Project Y

Initial Value Rs 20,000 Rs 30,000

Estimated Life 5 years 5 years

Scrap value Rs 1,000 Rs 2,000

The profits before depreciation and after taxation (cash flows) are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

Project X Rs 5,000 Rs 10,000 Rs 10,000 Rs 3,000 Rs 2,000

Project Y Rs 20,000 Rs 10,000 Rs 5,000 Rs 3,000 Rs 2,000

Note: The following are the present value factors @ 10% p.a.
Year 1 2 3 4 5 6

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Factor 0.909 0.826 0.751 0.683 0.621 0.564

Solution:
Cash Inflows Present value of net cash flow
Year Project X Project Y Present Value @10% Project X Project Y
1 5000 20,000 0.909 4545 18180
2 10,000 10,000 0.826 8260 8260
3 10,000 5,000 0.751 7510 3755
4 3,000 3,000 0.683 2049 2049
5 2,000 2,000 0.621 1242 1242
Scrap Value 1,000 2,000 0.621 621 1242
Total Present Value 24227 34728
Initial Value 20,000 30,000
Net Present Value 4,227 4,728

Here the present value of Project Y is higher. So it should be selected.

8. The following are the cash inflows and outflows of a certain project.

Year Outflow Inflow

0 1,75,000 -
1 50,000 35,000
2 - 45,000
3 - 65,000
4 - 85,000
5 - 50,000
The scrap value at the end of 5 years is Rs. 50,000. Taking the cutoff rate as 10%, calculate net present
value.

Year 1 2 3 4 5

P.V 0.909 0.826 0.751 0.683 0.621

Solution:

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 Year Cash Inflows Present Value Present Value of Cash Inflows
1 35,000 0.909 31815
2 45,000 0.826 37170
3 65,000 0.751 48815
4 85,000 0.683 58055
5 50,000 0.621 31050
5 ( Scrap Value) 50,000 0.621 31050
Total Present Value of Cash Inflows 237955

Calculation of Net Present Value:

Total Present Value of Cash Inflows 237955
Less: Total Present value of Cash outflows
Cash outflow at the beginning (A) 1,75,000
Cash outflow at the end of first year
50,000 x 0,909 (B) 45,450
Total value of outflows (A + B) 220450
Net Present Value 17,505

9. The information about tax and depreciation is given as follows:

Initial cash outflow : Rs 2,00,000

Estimated Life : 5 years
Scrap Value : Rs 20,000
Year 1 2 3 4 5

Profit after Tax 12,000 28,000 48,000 32,000 NIL

At the end of
year

Solution:

Year 1 2 3 4 5

P.V 0.909 0.826 0.751 0.683 0.621

Depreciation = Initial Value – Scrap Value

Estimated life of project

= 2,00,000 - Rs 20,000
Basics of Finance Management Page 96 of 242
 5 Years

= Rs 36,000

Year Profit after Tax Depreciation Total Cash Inflow

1 12000 36000 48000
2 28000 36000 64000
3 48000 36000 84000
4 32000 36000 68000
5 NIL 36000 36000

Total Cash
Year Inflow Discount Factor Present value of Cash Inflow
1 48000 0.909 43632
2 64000 0.826 52864
3 84000 0.751 63084
4 68000 0.683 46444
5 36000 0.621 22356
Total present value of cash inflows 228380

Total present value of cash inflows = Rs 228380

Total value of cash outflows = Rs 200000
Net Present Value = Rs 28380.

C.2.4.Internal Rate of Return:

In financial analysis, the internal rate of return (IRR) is a statistic used to calculate the profitability of
possible investments. IRR is a discount rate that, in a discounted cash flow analysis, reduces all cash flows'
net present values (NPV) to zero.
The same formula is used for NPV calculations and IRR calculations. Remember that the project's true
financial value is not represented by the IRR. The annual return is what brings the NPV to a negative value.
It can be calculated by the following formula:
Cash inflow
Initial investment
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Steps to be followed:
Step 1: Find out the factor
Factor is calculated as follows:
F = Cash Outlay (or) initial investment
Cash inflow
Step 2: Find out positive net present value
Step 3: Find out negative net present value
Step 4: Find out formula net present value
Base factor :
Positive discount rate
DP : Difference in
percentages

a) Merits of internal rate of return

● It considers the time value of money, which means that money today is worth more than money
tomorrow.
● It is simple to understand and use.
● It does not require a hurdle rate or a required rate of return, which may be difficult to estimate or
vary over time.
● It does not use the concept of the required rate of return.

b) Demerits of internal rate of return

● It does not consider the project’s size, duration, or future costs, which may affect the profitability.
● It may give multiple or no solutions for some projects with unconventional cash flows.
● It may lead to incorrect ranking of mutually exclusive projects with different initial investments or
cash flow patterns.
● It involves complicated computation rate.
● It produces multiple rates which may be confusing for taking decisions.
● It is assume that all intermediate cash flows are reinvested at the internal rate of return.

The NPV and IRR are closely related investment criteria.

Superiority of IRR over NPV:

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In the following respects, IRR may be considered to be superior to NPV for the following reasons:
1. Basis:
IRR gives the percentage result, while NPV gives the result in absolute amount.
2. Required Rate of Return:
For calculating IRR, the required rate of return is not a prerequisite while it is a must to NPV. Superiority
of NPV over IRR:
NPV is superior to IRR for the following reasons:
1. NPV shows the expected increase in the wealth of the shareholders.
2. The NPV of different projects are additive while the IRRs can not be added.
3. NPV gives better ranking as compared to IRR.
Comparison between NPV and IRR:
Both are modern techniques of capital budgeting and take the time value of money into account. Still,
there are certain basic differences between them.

Similarity between NPV and IRR:

It must be remembered that both NPV and IRR methods show the same results in respect of independent
investment proposals, which do not compete with one another.
Different Results:
In case of mutually exclusive projects, both the projects compete with each other and acceptance of one
project, automatically, excludes the acceptance of the other. Both may give contradictory results when
evaluating mutually exclusive projects for the following reasons:
(A) Requirement of cash outlays for the projects may be different. One project may require more funds
while the other may demand less.
(B) The projects have unequal lives.
(C) The projects have different patterns of cash flows.

10. A company has to select one of the following two projects:

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 Project A Project B

Cost Rs 22,000 Rs 20,000

Cash Inflows

Year 1 12,000 2,000

Year 2 4,000 2,000

Year 3 2,000 4,000

Year 4 10,000 20,000

Solution:

F = Cash outlay
Cash Inflow
Cash Inflow = Total Cash inflow
No. of years

= 28,000
4

= 7000.
F = Cash outlay
Cash Inflow

= 22000 = 3.14
7000

Present Value @ 10 %
Year Cash Inflow Discount factor @ 10% Present Value
1 12,000 0.909 10908
2 4,000 0.826 3304
3 2,000 0.751 1502
4 10,000 0.683 6830
Total Cash inflow 22544
Initial Cash flow 22000
Net present value 544

Present Value @ 15 %
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 Year Cash Inflow Discount factor @ 15% Present Value
1 12,000 0.87 10440
2 4,000 0.756 3024
3 2,000 0.658 1316
4 10,000 0.572 5720
Total Cash inflow 20500
Initial Cash flow 22000
Net present value -1500

IRR = Base Factor + Positive Net Present Value x DP

Difference in positive and negative net present value
Here, Base factor = 10
Positive Net Present Value= 544
Difference in positive and negative net present value = 544- (-1500) = 544 + 1500 = 2044
DP = 15 – 10 = 5
IRR = Base Factor + Positive Net Present Value x DP
Difference in positive and negative net present value
= 10 + 544 x 5
2044
= 10 + 1.33
= 11.33 %.
Project B:
Present Value @ 10 %
Discount factor @
Year Cash Inflow 10% Present Value
1 2,000 0.909 1818
2 2,000 0.826 1652
3 4,000 0.751 3004
4 20,000 0.683 13660
Total Cash inflow 20134
Initial Cash flow 20000

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 Net present value 134

Present Value @ 15 %

Year Cash Inflow Discount factor @ 10% Present Value

1 2,000 0.87 1740
2 2,000 0.756 1512
3 4,000 0.658 2632
4 20,000 0.572 11440
Total Cash inflow 17324
Initial Cash flow 20000
Net present value -2676
Here, Base factor = 10
Positive Net Present Value= 134
Difference in positive and negative net present value = 134- (-2676) = 134 + 2676 = 2806
DP = 15 – 10 = 5
IRR = Base Factor + Positive Net Present Value x DP
Difference in positive and negative net present value
= 10 + 134 x 5
2806
= 10 + 0.2387

= 10.24%.

The internal rate of return of project A is higher than project B.

11. A project costs Rs. 16,000 and is expected to generate cash inflows of Rs. 4,000 each 5 years.
Calculate the Interest Rate of Return.

Solution:

F = Cash outlay
Cash Inflow

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F = 16000
4000
=4

Year Cash inflow Discount factor @ 5% (5 year) Present Value

5 4000 4.329 17,316
Initial Cash Flow 16,000
Net Present Value 1,316

Year Cash inflow Discount factor @ 10% (5 year) Present Value

5 4000 3.791 15,164
Initial Cash Flow 16,000
Net Present Value (- 836)
Here, Base factor = 5 %
Positive Net Present Value= 1,316
Difference in positive and negative net present value = 1,316 - (-836) = 1316 + 836 = 2152
DP = 10 - 5 = 5
IRR = Base Factor + Positive Net Present Value x DP
Difference in positive and negative net present value
= 5 + 1,316 x 5
2152
= 5 + 3.057
= 8. 057

C.3.Ratios:
C.3.1.Debt Service Coverage Ratio:
The debt service ratio (DSCR) measures a company's available cash flow to pay its current debt obligations.
DSCR tells investors and lenders whether a company has enough revenue to pay its debts. The ratio is
calculated by dividing net income by debt service, including principal and interest.

Debt service ratio (DSCR) is an amount of cash flow available to pay current debt obligations.

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A DSCR ratio of less than one indicates that the company cannot pay its debts with current income and
that it is not an established company.

A high DSCR ratio indicates that the business has a higher probability of getting a loan and a better chance
of getting a lower interest rate and the business is thriving.

DSCR = Net Operating Income

Total Debt Service

Whereas, Net operating income = Revenue – Total debt service

12. A real estate owner wants to take out a loan from a local bank. The lender will then first want to
calculate the DSCR to determine the borrower's ability to repay the loan. A real estate developer
discloses that his operating income is $200,000 per year and he has to pay $70,000 in annual
interest on a loan. Therefore, the lender calculates the DSCR to decide whether to lend to the
property owner.

Solution: Here, operating income : $ 2,00,000

Total debt service : $ 70,000

DSCR = Net Operating Income

Total Debt Service

= $ 2,00,000
$ 70,000

= 2.85
A debt service coverage ratio of 2.85 is good to provide loan to real estate developer.
13. Calculate DSCR from the following information:

Particulars Amount in Millions

Sales 1,00,000
Cost of goods sold 80,000
Gross Profit 20,000
Selling, general and admin expenses 5,000
Research and development expenses 2,000

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Operating profit 13,000
Interest expenses 5,000
Profit before tax 8,000
Provision for income tax 4,000
Net Income 4,000

DSCR = Net Operating Income

Total Debt Service
= 13,000
5,000
= 2.6

C.3.2.Interest Service Coverage ratio:

ISCR stands for Interest Service Coverage Ratio. It is a financial ratio that measures the ability of a
borrower to pay the interest on their debts. It is calculated by dividing the earnings before interest and
taxes (EBIT) by the interest expense. A higher ISCR means the borrower has more cash flow to cover their
interest payments. A lower ISCR means the borrower may struggle to pay their interest obligations.
Lenders, creditors, and investors frequently use the interest coverage ratio calculation to determine the
risk associated with lending money to a certain company. It also aids in determining how profitable the
aforementioned business is.

Interest Service Coverage ratio = _____EBIT______

Interest Expenses
OR
= _____EBIT + Non – cash expenses______
Interest Expenses

Whereas,
EBIT = Earnings before Interest and taxes
Non – cash expenses = Depreciation and amortisation
Interest expenses = Interest paid on loan, amortisation, bond etc.
14. Calculate Interest Service Coverage Ratio

Firm Particulars 2015 2016 2017 2018 2019

EBIT 10,000 12,000 13,000 15,000 18,000

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 Deep Bro’s Interest 2500 2800 2900 3000 3200
and Co.
Shyam Bro’s EBIT 10,000 12,000 13,000 15,000 18,000
and Co. Interest 2500 3000 3500 4000 5000

Solution: Deep Bro’s and Co.

Interest Service Coverage

Year EBIT Interest Expenses Ratio= EBIT/ Interest
Expenses

2015 10000 2500 4

2016 12000 2800 4.28

2017 13000 2900 4.48

2018 15000 3000 5

2019 18000 3200 5.625

Shyam Bro’s and Co.

Interest Service Coverage
Year EBIT Interest Expenses Ratio= EBIT/ Interest
Expenses
2015 10000 2500 4
2016 12000 3000 4.
2017 13000 3500 3.71
2018 15000 4000 3.75
2019 18000 5000 3.6

As per the outcome, it is determined that Deep bro’s co has increased its ISCR in the given period and
remains stable throughout. Whereas, Shyam Bro’s and Co. shows a decrease in its iscr, indicates problems
regarding to liquidity and stability.

C.3.3.Earning Before Interest, tax,

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 depreciation and amortisation:
EBITDA means earnings before interest, taxes, depreciation and amortization. It measures a company's
operations and cash flow. To calculate it, non-cash depreciation and amortization costs are added to net
income, and interest and tax costs are subtracted. The focus shifts to a company's ability to generate cash
flow, regardless of how they choose to finance their business, how high the tax rate is or how quickly their
assets lose value.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
OR
EBITDA = Operating Income + Depreciation + Amortization
15. Calculate EBITDA from the following information.

Net Income Rs 4,60,700

Interest expenses Rs 15,000
Taxes Rs 2,000
Depreciation Rs 12,000
Amortization Rs 4,000

Solution: EBITDA can be calculated by the following formula

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
= Rs 4,60,700 + Rs 15,000 + Rs 2,000 + Rs 12,000 + Rs 4,000
= Rs 4,93,700.

C.5. Leverages
Every company's finance manager has a responsibility to determine how much money is needed and to
find a cost-effective way to get it. There are other additional sources of funding available. Since there are
numerous sources, charges also vary. If the same amount is raised in the form of share capital, the return
to shareholders varies while the firm must pay fixed costs for some funds, such as interest on debentures.
The optimal combination of these funds must be chosen, or the capital structure of the company must be
decided, by the financial manager. The ultimate structure selected affects the risk and return to the
company. Business organisations use leverage analysis as a technique to quantify the risk-return
connection of various forms of alternative capital structure.
The definition of "leverage" according to the dictionary is "an increased means for accomplishing some
purpose." Leverage, for instance, enables humans to move heavy objects that would otherwise be
Basics of Finance Management Page 107 of 242
impossible. A heavy stone can be pushed in a different direction with a tiny amount of force in one
direction, but not with the same force applied directly. Utilising leverage, we were able to move the heavy
stone. Leverage is a real notion in business as well. The definition of the word "leverage" is "To improve
or enhance."
Leverage is generally thought of as the relative change in profits brought on by a change in sales. When
there is a high level of leverage, profits change significantly for only a little change in sales.
The word "leverage" has a particular meaning in the world of finance. Leverage is a term used to
characterise a company's capacity to use fixed-cost resources or capital to increase returns to owners,
or equity shareholders.
James Horne has defined leverage as “the employment of an asset or funds for which the firm pays a
fixed cost or fixed return”.

C.4.1. Degree of Operating Leverage:

The operating leverage ratio (DOL) is a multiplier that measures how much a company's operating
performance changes as a result of a change in sales. Companies with a ratio of fixed costs (or costs that
do not change with production) to variable costs (costs that change with production volume) have higher
operating leverage.
The DOL ratio helps analysts determine the effect of a change in sales on a company's profit or bottom
line. Operating leverage measures how much a company's operating result changes as a result of changes
in sales. The DOL ratio helps analysts determine the effect of a change in sales on a company's profits.

Degree of operating leverage = % change in EBIT

% change in Sales
Whereas,
EBIT=earnings before income and taxes
Degree of operating leverage= __Changes in operating income
Change in sales
OR
Degree of operating leverage=Contribution margin
Operating income
OR

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 Degree of operating leverage= sales – variable costs
sales – variable costs – fixed costs
OR
Degree of operating leverage= contribution margin percentage
operating margin
Contribution = Sales – Variable Cost
EBIT = Contribution – Fixed Cost.
16. Calculate DOL from the following information

Year Sales Operating expenses

2021 5,00,000 1,00,000
2022 7,00,000 1,50,000

Solution:
EBIT = Sales – Operating Expenses
2021 = Rs 5,00,000 – Rs 1,00,000
= Rs 4,00,000
2022 = Rs 7,00,000 – Rs 1,50,000
= Rs 5,50,000
% Change in EBIT = EBIT (2022) - 1
EBIT (2021)
= Rs 5,50,000 - 1
Rs 4,00,000
= 1.375 – 1
= 0.375 x 100
= 37.5 %
% Change in Sales = Sales (2022) - 1
Sales (2021)
=Rs 7,00,000 - 1
Rs 5,00,000
= 1.4 – 1
= 0.4 x 100
= 40 %
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Degree of operating leverage = % change in EBIT
% change in Sales
= 37.5 %
40 %
= 0.9375

C.4.2.Degree of financial leverage:

Degree of Financial Leverage (DFL) is a leverage ratio that measures the sensitivity of a company's earnings
per share (EPS) to changes in operating profit due to changes in capital structure. The financial debt ratio
(DFL) measures the percentage change in EPS for a unit change in operating profit, also known as earnings
before interest and payments (EBIT).
This relationship shows that the higher the leverage, the more volatile the result. Because interest is
usually a fixed cost, leverage increases earnings and EPS. This is good when operating income is growing,
but can be a problem when operating income is under pressure.
DFL= %change in EPS
%change in EBIT
OR
DFL= __EBIT______
EBIT − Interest

17. A company has operating income of Rs 10,00,000 in 1st year and interest expense of Rs 1,00,000
and 10,00,000 share are outstanding . In 2nd year, there is 20% increase in the operating profit,
interest expense remains unchanged. Find the Degree of financial leverage.

Solution:
DFL= __EBIT______
EBIT – Interest
= ___Rs 10,00,000________
Rs 10,00,000 – Rs 1,00,000

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 = Rs 10,00,000
Rs 9,00,000

= 1.11
The DFL of year 2 is as follows:
DFL= __EBIT______
EBIT – Interest

= ___Rs 12,00,000________
Rs 12,00,000 – Rs 1,00,000

= Rs 12,00,000
Rs 11,00,000

= 1.09

Practical Sums
1. The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000,
$25,000, and $10,000 over four years.

The first step is to calculate the present value and profitability index.
Year Cash Inflows Present Value Factor Present Value
$ @10% $
1 20,000 0.909 18,180
2 15,000 0.826 12,390
3 25,000 0.751 18,775
4 10,000 0.683 6,830
Total 56,175

Total present value = $56,175

Less: initial outlay = $50,000
Net present value = $6,175

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Profitability Index (gross) = Present value of cash inflows / Initial cash outflow
= 56,175 / 50,000
= 1.1235
Given that the profitability index (PI) is greater than 1.0, we can accept the proposal.
Net Profitability = NPV / Initial cash outlay
= 6,175 / 50,000 = 0.1235
N.P.I. = 1.1235 - 1 = 0.1235
Given that the net profitability index (NPI) is positive, we can accept the proposal.

2. A company is considering whether to purchase a new machine. Machines A and B are

available for $80,000 each. Earnings after taxation are as follows:

Year Machine A Machine B

$ $
1 24,000 8,000
2 32,000 24,000
3 40,000 32,000
4 24,000 48,000
5 16,000 32,000

Required: Evaluate the two alternatives using the following:

(a) payback method,
(b) rate of return on investment method, and
(c) net present value method. You should use a discount rate of 10%.

Solution

(a) Payback method

24,000 of 40,000 = 2 years and 7.2 months
Payback period:
Machine A: (24,000 + 32,000 + 1 3/5 of 40,000) = 2 3/5 years.
Machine B: (8,000 + 24,000 + 32,000 + 1/3 of 48,000) = 3 1/3 years.
According to the payback method, Machine A is preferred.

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(b) Rate of return on investment method

Particular Machine A Machine B

Total Cash Flows 1,36,000 1,44,000

Average Annual Cash Flows 1,36,000 / 5 = $27,000 1,44,000 / 5 = $28,800

Annual Depreciation 80,000 / 5 = $16,000 80,000 / 5 = $16,000

27,200 - 16,000 = 28,800 - 16,000 =

Annual Net Savings
$11,200 $12,800

Average Investment 80,000 / 2 = $40,000 80,000 / 2 = $40,000

ROI = (Annual Net Savings /

(11,200 / 40,000) x 100 (12,800 / 40,000) x 100
Average Investments) x 100

= 28% = 32%

According to the rate of return on investment (ROI) method, Machine B is preferred due to the higher ROI
rate.

(c) Net present value method

The idea of this method is to calculate the present value of cash flows.

Year Discount Factor Machine A Machine B

(at 10%) Cash Flows ($) P.V ($) Cash Flows ($) P.V ($)

1 .909 24,000 21,816 8,000 7,272

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 2 .826 32,000 26,432 24,000 19,824

3 .751 40,000 30,040 32,000 24,032

4 .683 24,000 16,392 48,000 32,784

5 .621 16,000 9,936 32,000 19,872

1,36,000 1,04,616 1,44,000 1,03,784

Net Present Value = Present Value - Investment

Net Present Value of Machine A: $1,04,616 - $80,000 = $24,616
Net Present Value of Machine B: $1,03,784 - 80,000 = $23,784
According to the net present value (NPV) method, Machine A is preferred because its NPV is greater
than that of Machine B.
3.At the beginning of 2015, a business enterprise is trying to decide between two potential investments.
Required: Assuming a required rate of return of 10% p.a., evaluate the investment proposals under: (a)
return on investment, (b) payback period, (c) discounted payback period, and (d) profitability index.
The forecast details are given below.
Proposal A Proposal B
Cost of Investment $20,000 $28,000
Life 4 years 5 years
Scrap Value Nil Nil
Net Income (After depreciation and tax)
End of 2015 $500 Nil
End of 2016 $2,000 $3,400
End of 2017 $3,500 $3,400
End of 2018 $2,500 $3,400
End of 2019 Nil $3,400

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It is estimated that each of the alternative projects will require an additional working capital of $2,000,
which will be received back in full after the end of each project.
Depreciation is provided using the straight line method. The present value of $1.00 to be received at the
end of each year (at 10% p.a.) is shown below:
Year 1 2 3 4 5
P.V. 0.91 0.83 0.75 0.68 0.62

Solution:
Calculation of profit after tax

Year Proposal A $ 20,000

Net Income Dep Cash Inflow

$ $ $

2015 500 5,000 5,500

2016 2,000 5,000 7,000

2017 3,500 5,000 8,500

2018 2,500 5,000 7,500

2019 - - -

Total 8,500 20,000 28,500

Year Proposal B $ 28,000

Net Income Dep Cash Inflow

$ $ $

2015 - 5,600 5,600

2016 3,400 5,600 9,000

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 2017 3,400 5,600 9,000

2018 3,400 5,600 9,000

2019 3,400 5,600 9,000

Total 13,600 28,000 41,600

Return on investment

Proposal A Proposal B

Investment 20,000 + 2,000 = 22,000 28,000 + 2,000 = 30,000

Life 4 years 5 years

Total Net Income $8,500 $13,600

Average Return ($) 8,500 / 4 = 2,125 13,600 / 5 = 2,720

Average Investment ($) (22,000 + 2,000) / 2 = (30,000 + 2,000) / 2 =

12,000 16,000

Average Return on Average

(2,125 / 12,000) x 100 (2,720 / 16,000) x 100
Investment ($) = 17.7% = 17%

Payback period

Proposal A Cash Inflow ($)

2015 5,500
2016 7,000

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2017 7,500 (7,500 / 8,500 = 0.9)
20,000

Payback period = 2.9 years

Proposal B Cash Inflow

2015 5,600

2016 9,000

2017 9,000

Payback period = 3.5 years

(c) Discounted payback period

Proposal A Proposal B

P.V. of Cash Inflow P.V. of Cash Inflow

Year $ Year $

2015 5,005 2015 5,096

2016 5,810 2016 7,470

2017 6,375 2017 6,750

2018 2,810 (2,810 / 5,100 = 0.5) 2018 6,120

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 2019 2,564 (2,564 / 5,580 = 0.4)

20,000 28,000

Discounted Payback Period = 3.5 years Discounted Payback Period = 4.4 years

(d) Profitability index method

Proposal A Proposal B

(22,290 / 20,000) x 100 (31,016 / 28,000) x 100

Gross Profitability Index
= 111.45% = 111.08%

(2,290 / 20,000) x 100 (3,016 / 28,000) x 100

Net Profitability Index
= 11.45% = 10.8%

4. Consider the following data of ABC Company

Selling price per unit 60
Variable cost per unit 40
Fixed Cost 3,00,000

Interest burden 1,00,000

Tax Rate 50%

Preference Dividend 50,000

Calculate the leverages if the number of units sold are 1,00,000.

Solution:
Contribution per unit = 60-40 =20
Total contribution = 20 × 1,00,000
= 20,00,000
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EBIT = Contribution – Fixed Cost
= 20,00,000 – 3,00,000
= 17,00,000
Operating Leverage =Contribution
EBIT
Operating leverage = 20,00,000
17,00,000
= 1.18
Financial Leverage = EBIT
Profit before tax
EBIT = 17,00,000
Interest = –1,00,000
16,00,000
*Less Preference
Dividend = 1,00,000
Profit before tax = 15,00,000

Financial Leverage = 17,00,000

15,00,000
= 1.1
5. An investor made an investment of $500 and got $570 next year. Calculate the internal rate of return
on the investment.

Solution:
Given:
Invested amount, CF00 = -$500 (negative, because money went out)
Cash inflow after 1 year, CF11 = $570
Using internal rate of return formula,

0 = CF0+ CF1
(1+IRR)1
0 = -$500 + 570
(1+IRR)1
500 + 500 × IRR = 570
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IRR = 70/500
IRR = 0.14 = 14%
Therefore, the internal rate of return on the investment = 14%.

6. Sam bought a house for $250,000. He plans on selling the house 1 year later for $350,000, after
deducting any realtor's fees and taxes. Calculate the internal rate of return on the complete
transaction.
Solution:
Given
Invested amount, CFo = -$250,000 (negative, because money went out)
Cash inflow after 1 year, CF11 = $350,000
Using internal rate of return formula,
0 = CF0+ CF1
(1+IRR)1
0 = -$250,000 + 350,000
(1+IRR)1
250,000 + 250,000 × IRR = 350,000
IRR = 100,000/250,000
IRR = 0.4 = 40%
Therefore, the internal rate of return on the investment = 40%.

7. Josie made an investment of $700 and got $800 the next year. Calculate the internal rate of return on
the investment.
Solution:
Given:
Invested amount, CF00 = -$700 (negative, because money went out)
Cash inflow after 1 year, CF11 = $800
Using internal rate of return formula,
0 = CF0+ CF1
(1+IRR)1
0 = -700 + 800
(1+IRR)1
700 + 700 × IRR = 800
IRR = 100/700
IRR = 0.1428 = 14%
Therefore, the internal rate of return on the investment = 14%.

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 7. A machine purchased six years ago for Rs. 1,50,000 has been depreciated to a book value of Rs.
90,000. It originally had a projected life of 15 years and zero salvage value. A new machine will
cost Rs. 4,30,000 and result in a reduced operating cost of Rs. 30,000 per year for the next nine
years. The older machine could be sold for Rs. 50,000. The cost of capital is 10%. The new machine
will be depreciated on a straight line over nine year’s life with Rs. 25,000-salvage value. The
company’s tax rate is 55%. Decide whether the old machine should be replaced?
Solution:
Solution: Incremental Net Investment or Net Initial outflow:
Cost of the Proposed Machine = 4,30,000
– Current scrap value of existing machine = 50,000
Incremental net investment 3,80,000
(Net outflow)
Incremental annual cash inflows:

NPV of the proposal (cost of capital 10%)

= Present value of inflows–Present value of outflow

C1 and C2 = Net cash inflows in year 1 and 2 ...n

k = Appropriate discount rate (cost of capital)

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Q1. Choose the correct answer
1.Capital Budgeting is a part of:
(a) Investment Decision
(b) Working Capital Management
(c) Marketing Management
(d) Capital Structure
2.Capital Budgeting Decisions are:
(a) Reversible
(b) Irreversible
(c) Unimportant
(d) All of the above
3. In capital budgeting, the term Capital Rationing implies:
(a) That no retained earnings available
(b) That limited funds are available for investment
(c) That no external funds can be raised
(d) That no fresh investment is required in current year
4. Capital Budgeting deals with:
(a) Long-term Decisions
(b) Short-term Decisions
Basics of Finance Management Page 122 of 242
(c) Both (a) and (b)
(d) Neither (a) nor (b)
5. The values of the future net incomes discounted by the cost of capital are called –
(a) Average capital cost
(b) Discounted capital cost
(c) Net capital cost
(d) Net present values
6.The decision to accept or reject a capital budgeting project depends on –
(a) an analysis of the cash flows generated by the project
(b) cost of capital that are invested in business/project.
(c) Both (a) and (b)
(d) Neither (a) nor (b)
7. .………………. is the discount rate which should be used in capital budgeting.
(a) Cost of capital (Ko)
(b) Risk free rate (Rf)
(c) Risk premium (Rm)
(d) Beta rate (β)
8. Which of the following represents the amount of time that it takes for a capital budgeting project to
recover its initial cost?
(a) Maturity period
(b) Payback period
(c) Redemption period
(d) Investment period
9. The shorter the payback period –
(a) the more risky is the project.
(b) the less risky is the project.
(c) less will the NPV of the project.
(d) more will the NPV of the project
10. Which of the following is demerit of payback period?
(a) It is difficult to calculate as well as understand it as compared to accounting rate of return method.
(b) This method disregards the initial investment involved.

Basics of Finance Management Page 123 of 242

(c) It fails to take into account the timing of returns and the cost of capital.
(d) None of the above
11. Which of the following is demerit it of accounting rate of return (ARR) method?
(a) It does not take into accounting time value of money.
(b) It fails to measure properly the rates of return on a project even if the cash flows are even over the
project life.
(c) It is biased against short-term projects in the same way that payback is biased against longer term
ones.
(d) All of the above
12. The term Leverage in general refers to a ……………
(a) Relationship between fixed cost and profit.
(b) Relationship between sales and fixed cost.
(c) Relationship between two interrelated variables.
(d) Relationship between two unrelated variables.
13. ………….. is the ratio of net operating income before fixed charges to net operating income after
fixed charges.
(a) Financial Leverage
(b) Operating Leverage
(c) Operation Leverage
(d) Fiscal Leverage
14. Degree of ………… is the ratio of the percentage increase in earning per share (EPS) to the
percentage increase in earnings before interest and taxes (EBIT).
(a) Operating Leverage
(b) Combined Leverage
(c) Working Capital Leverage
(d) Financial Leverage
15. EBIT is usually the same thing as: …………
(a) Funds provided by operations
(b) Earnings before taxes
(c) Net income
(d) Operating profit

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16. Measure of business risk is –
(a) Operating leverage
(b) Financial leverage
(c) Combines leverage
(d) Working capital leverage
17. Operating leverage is directly ………. to business risk.
(a) Proportional
(b) Not proportional
(c) Unrelated
(d) Not related
18. Where a company has large amount of fixed interest charges, the financial leverage will be
(a) High
(b) Low
(c) Negative
(d) Unreliable
19. The difference between the present value of cash inflows and the present value of cash outflows
associated with a project is known as:
(a) Net present value of the project
(b) Net future value of the project
(c) Net historical value of the project
(d) Net salvage value of the project
20. If present value of cash outflow is equal to present value of cash inflow, the net present value will
be:
(a) Positive
(b) Negative
(c) Zero
(d) Infinite
Q.2 Fill in the blanks

1. _________ refers to a company's overall investment in cash, tangible assets, and intangible assets.
2. _________ refers to a financial metric that determines the value of an investment or project by
measuring the difference between its present value of cash inflows and outflows.

Basics of Finance Management Page 125 of 242

 3. __________is a multiplier that measures how much a company's operating performance changes
as a result of a change in sales.
4. Purchasing of fixed assets is a _________ expenditure.
5. The duration needed to recover an investment's cost is referred to as _________.
6. __________measures a company's available cash flow to pay its current debt obligations.
7. The average annual amount of cash flow produced over the course of an investment is
_____________.
8. __________ is a financial ratio that measures the ability of a borrower to pay the interest on their
debts.
9. The process of investing the money that are available is called ___________.
10. ______________ is the difference between sales and variable cost.

Q.3 Answer the following questions in one or two sentences.

1. What is degree of operating leverage?
2. What is degree of financial leverage?
3. What is Net Present Value?
4. What is Payback period?
5. What is leverage?
6. What is pay back period?
7. What is IRR?
8. Write the full form of ARR.
9. What is capital budgeting?
10. List down the methods of capital budgeting.
Q.4.Answer the following in brief
1. What is leverages? Explain the types of leverages in detail.
2. Write the meaning of Payback Period. Explain its merits and demerits.
3. Write down the meaning of Net Present Value. Explain its merits and demerits.
4. Define Capital Budgeting and explain the features of capital budgeting.
5. Write the meaning of Accounting rate of return. Explain its merits and demerits.
Q.5 Answer in detail
1. Define Capital Budgeting. Discuss the need and importance of Capital budgeting.
2. Explain the process of capital budgeting.
3. Explain methods of capital budgeting evaluation.
Basics of Finance Management Page 126 of 242
4. The ABC company is planning to purchase a machine known as machine X. Machine X would cost
$25,000 and would have a useful life of 10 years with zero salvage value. The expected annual cash inflow
of the machine is $10,000. Compute payback period of machine X and conclude whether or not the
machine would be purchased if the maximum desired payback period of ABC company is 3 years.
(Payback period = 2.5 years)
5.Calculate operating leverage, financial leverage and combined leverage under situation 1 and 2 in
financial plans A & B from the following information relating to the operation and capital structure of a
company.
Installed capacity – 2,000 units
Actual production and sales – 50% of the capacity
Selling price ₹20 per unit
Variable Cost ₹10 per unit
Fixed Cost Rs 4000
Capital structure Financial Plan A

Equity 5,000

Debt 15,000

(Operating leverage = 1.67

Financial leverage =1.33)
Answer
Choose the correct answer

1.a 2.b 3.b 4. a 5.d 6.c 7.a 8.b 9.b 10.c

11.d 12.d 13.d 14.d 15.d 16.a 17.a 18.a 19.a 20.c

Fill in the blanks

1. Capital
2. Net present value
3. Operating leverage ratio
4. Capital
5. Payback period
6. Debt service ratio
Basics of Finance Management Page 127 of 242
 7. Average rate of return
8. Interest service coverage ratio
9. Capital budgeting
10. Contribution

Basics of Finance Management Page 128 of 242

 D. WORKING CAPITAL MANAGEMENT
Introductions
One of the crucial aspects of financial management is working capital management. It focuses on the
business's short-term financing, which is a closely associated trade between profitability and liquidity.
Effective management of working capital results in enhancing the business's operational efficiency and
aids in supplying short-term financing. As a result, studying working capital management is not only
crucial of financial management, but they also oversee the entire operation of the company.
Working capital is defined as non-fixed but more prevalent capital. One way to think about the working
capital is as the difference between the book value of current resources and liabilities.

Fixed capital is defined as money set aside for a company's long-term investments. for instance, investing
in long-term assets. Typically, it comprises of one-time events.
Another type of cash that is necessary to support a business's ongoing needs is known as working capital.
For instance, it typically comprises of recurrent in nature, such as paying creditors, paying workers'
salaries, buying raw materials, etc. It is simple to convert it to money. Therefore, it is sometimes referred
to as short-term capital.

D.1. Working Capital:

D.1.1.Definitions

According to the definition of Mead, Baker and Malott, “Working Capital means Current Assets”.
According to the definition of J.S.Mill, “The sum of the current asset is the working capital of a business”.
According to the definition of Weston and Brigham, “Working Capital refers to a firm’s investment in
short-term assets, cash, short-term securities, accounts receivables and inventories”.
Basics of Finance Management Page 129 of 242
According to the definition of Bonneville, “Any acquisition of funds which increases the current assets,
increase working capital also for they are one and the same”.
According to the definition of Shubin, “Working Capital is the amount of funds necessary to cover the cost
of operating the enterprises”.
According to the definition of Genestenberg, “Circulating capital means current assets of a company that
are changed in the ordinary course of business from one form to another, for example, from cash to
inventories, inventories to receivables, receivables to cash”.

D.1.2.Concept of Working Capital:

Working capital in detail can be understood by two important concepts. The two important concepts are
as follows:
1. Gross Working Capital
2. Net Working Capital

a) Gross Working Capital:

The money invested in all of the company's current assets is its gross working capital.
Gross Working Capital = Current Assets

b) Net Working Capital:

The precise concept known as "Net Working Capital" takes the company's current liabilities as well as its
current assets into account.
The difference between the company's current assets and liabilities at a given time is its net working
capital.
Positive working capital is defined as when current assets exceed current obligations; the opposite is
described as negative working capital. Working capital deficit
Net Working Capital = Current Assets – Current Liabilities
Working capital is made up of several current assets and liabilities. The following chart serves as an
example of this.

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Cash in hand Bills Payable
▪ Cash at bank Sundry Creditors
▪ Bills receivable Provision for taxation
▪ Sundry Debtors Outstanding Expenses
▪ Short-term loans advance Short term loans and advances
▪ Inventories Dividend Payable
▪ Prepaid expenses Bank Overdraft
▪ Accrued Income

D.1.3.Needs of Working Capital

Working capital is a crucial component of any firm. Every business concern needs to keep a certain
amount of working capital on hand to cover short-term obligations as well as daily needs.
Working Capital is needed for the following purpose.

a) Purchase of raw materials and spares

Raw materials are the foundational component of the manufacturing process, along with spare parts.
According to the requirements of the business concern, it should make regular purchases. As a result,
every business concern keeps a certain amount on hand as working capital to buy supplies like raw
materials and spare parts.

b) Wage and salary payments

The final component of working capital is the payment of labour and workers' wages and salaries.
Employees who receive periodic payments are always at the top of their game. Therefore, a business
concern maintains a sufficient level of operating capital to pay wages and salaries.

c) Daily costs
A business concern must cover a variety of costs related to operations on a daily basis, including fuel,
power, office expenses, etc.

d) Provide Credit Obligations

To fulfil short-term obligations and give credit facilities to the consumer, a business concern is liable.
Therefore, the company must offer enough working capital.

e) Working Capital Position/

Basics of Finance Management Page 131 of 242
 Balanced Working Capital Position
To increase the effectiveness of corporate operations and effective management of finances, a business
concern must maintain a sound working capital position. Both much and insufficient working capital
contribute to a number of issues for the business.

D.1.4. Causes and consequences of

having excessive working capital.
(i) An excessive amount of working capital causes a needless buildup of raw materials, parts, and spares.
(ii) Excess Working Capital is locked up as a result of being excessive.
(iii) It lengthens collection timeframes, produces bad debts, etc.
(iv) It causes the profits to drop.

D.1.5. The causes and repercussions

of insufficient working capital
(i) A lack of working capital prevents an organization from purchasing its needs in bulk.
(ii) It becomes more challenging to put operating strategies into action and activate the company's profit
aim.
(iii) It becomes impossible to use fixed assets effectively.
(iv) The rate of return on investments decreases as working capital is scarce.
(v) It scales back the firm' overall operations.

D.1.6. Types of Working Capital:

Working Capital may be classified into three important types on the basis of time.

Basics of Finance Management Page 132 of 242

Source:(C.Paramasivan & T.Subramanian, n.d.)

a) Permanent Working Capital:

It is also known as Fixed Working Capital. It is the capital; the business organization must always keep a
minimum quantity of capital on hand. The amount of permanent capital required varies on the type of
enterprise. Regardless of time or sales volume, permanent or fixed working capital won't change.

Source: (C.Paramasivan & T.Subramanian, n.d.)

b) Temporary Working Capital:

It is often referred to as variable working capital. To meet seasonal demands and other unique objectives,
a certain amount of money is needed. Additional categories include seasonal working capital and special
working capital.
Seasonal working capital is the money needed to cover a company's cyclical financial needs. The money
needed to cover any extra costs, such launching large-scale marketing campaigns or funding research, etc.

Basics of Finance Management Page 133 of 242

Source: (C.Paramasivan & T.Subramanian, n.d.)

c) Semi Variable Working Capital:

Up to a certain point, a particular amount of working capital is allocated at the field level, and then it
increases in accordance with changes in sales or the passage of time.

Source: (C.Paramasivan & T.Subramanian, n.d.)

D.1.7.Factors determining working

capital requirements
The amount of working capital needed depends on a number of variables. The working capital
requirements of a business concern cannot be determined using a set of guidelines or a formula. The
following are the main variables that affect how much working capital is needed.

a) Nature of Business:
The nature of the business has a big impact on how much working capital a company needs. Business
concerns might retain less working capital if they adhere to strict credit policies and only accept cash
payments for their items. While a construction business retains a bigger amount of working capital, a
transport company maintains less.

b) Production cycle:

Basics of Finance Management Page 134 of 242

The amount of working capital is based on how long the cycle is. They need to keep less working capital
on hand if the production cycle is short. If not, a significant quantity of working capital must be
maintained.

c) Business cycle:
Business variations result in cyclical and seasonal changes in the state of the company, which have an
impact on the need for working capital. Working capital requirements increase during periods of
economic expansion and decrease during periods of economic contraction. The need for working capital
increases as business performance improves.

d) Production strategy:
This is another element that determines how much working capital a company needs to operate. If the
business keeps to its policy of continuous manufacturing, regular working capital is required. Working
Capital requirements will depend on the circumstances set forth by the company if the production policy
of the company is based on the scenario or conditions.

e) Credit policy:
Sales and purchase credit policies have an impact on how much working capital a business needs. The
corporation must keep more working capital if it maintains a lax credit policy to recover payments from
its consumers. The corporation will maintain cash on hand and in the bank if it pays the debts before the
deadline.

f) Growth and expansion:

When a business is growing and expanding, more working capital is needed because these phases involve
greater initial costs and a need for additional working capital.

g) Raw material accessibility:

A significant portion of the working capital requirements are heavily dependent on raw material
accessibility. The fundamental elements of the industrial process are raw materials. The production stops
if the raw material is not easily accessible. In order to maintain an appropriate supply of raw materials,
the company needs invest some working capital.

h) Earning capacity:
If a company has a high level of earning potential, it can use its operating cash flow to generate extra
working capital. One of the things that affects how much money a corporation needs in working capital is
earning potential.

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 D.1.8.Working capital Management Policy:
In order to manage and handle working capital effectively, working capital management formulates three
rules that are based on the relationship between sales and working capital.
1. Conservative Working Capital Policy.
2. Moderate Working Capital Policy.
3. Aggressive Working Capital Policy.

a) Conservative Working Capital Policy.

Conservative working capital policy refers to reducing risk by keeping a higher amount of working capital.
This kind of working capital policy is appropriate to handle the manufacturing operation's seasonal
fluctuations.

b) Moderate Working Capital Policy.

A moderate working capital policy is one that maintains a modest amount of working capital in accordance
with a moderate level of sales. It indicates that a shift of one percent in working capital, or working capital
equal to sales, is meant.

c) Aggressive Working Capital Policy.

This strategy, which maintains a low level of aggressive working capital against a high level of sales in a
business concern over a specific time period, is one of the most dangerous and profitable strategies.

Source:(C.Paramasivan & T.Subramanian, n.d.)

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 D.1.9.Sources of Working Capital:
Working capital needs can be normalized from both short- and long-term sources. Each source will have
advantages and disadvantages up to a certain extract. Depending on the stage, many things can be done
using working capital.

Source:(C.Paramasivan & T.Subramanian, n.d.)

D.2.Working Capital Requirements:

1. The board of directors of Aravind mills limited request you to prepare a statement showing the
working capital requirements for a level of activity of 30,000 units of output for the year. The cost
structure for the company’s product for the above mentioned activity level is given below

Cost per unit(Rs)

Raw Materials 20
Direct Labour 5
Overheads 15
Total 40
Profit 10
Selling price 50

(a) Past experience indicates that raw materials are held in stock, on an average for 2 months.
(b) Work in progress (100% complete in regard to materials and 50% for labour and overheads) will be
half a month’s production.

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(c) Finished goods are in stock on an average for 1 month.
(d) Credit allowed to suppliers: 1 month.
(e) Credit allowed to debtors: 2 months.
(f) A minimum cash balance of Rs 25,000 is expected to be maintained.
Prepare a statement of working capital requirements.
Solution:
Output per annum = 30,000 units
Output per annum = 12% of 30,000 = 2,500 units
Raw materials p. m. Rs. 20×2500 = 50,000
Labour p. m. Rs. 5×2,500 = 12,500
Overheads p. m. Rs. 15×2,500 = 37,500
1,00,000
Solution:
Statement of Working Capital
Particulars Rs Rs
Current Assets
Stock of raw materials (2 months) 50,000 x 2 1,00,000
Work-in-progress (1/2 months)
Raw materials = 50,000 x ½ 25000
Labour = 12,500 x ½ x 50/100 3,125
Overheads = 37,500 x ½ x 50/100 9,375 37,500
Stock of finished goods (1 month) 1, 00,000 x 1 1,00,000
Debtors (2 month) 1,00,000 x 2 2,00,000
Cash balance required 25,000
Total Current Assets 4,62,500
Less: Current Liabilities
Creditors (1 month) 50,000 x 1 50,000
Working Capital Required 4,12,500

2. Prepare an estimate of working capital requirement from the following information of a trading
concern. Projected annual sales 10,000 units
Selling price Rs. 10 per unit
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 Percentage of net profit on sales 20%
Average credit period allowed to customers 8 Weeks
Average credit period allowed by suppliers 4 Weeks
Average stock holding in terms of sales requirements 12 Weeks
Allow 10% for contingencies

Solution:
Statement of Working Capital
Particulars Rs
Current Assets
Debtors (8 weeks) 80,000 x 8 12,307
52
Stocks (12 weeks) 80,000 x 12 18,462
52
Total Current Assets 30770
Less Current Liability
Credits (4 weeks) 80,000 x 4 6,154
52
24,616
Add 10% for contingencies 2,462
Working Capital Required 27078

Working Notes:
Sales = 10000×10 = Rs. 1,00,000
Profit 20% of Rs. 1,00,000 = Rs. 20,000
Cost of Sales=Rs.1,00,000 – 20,000 = Rs. 80,000
As it is a trading concern, cost of sales is assumed to be the purchases.

D.3 Receivable days

The average period of time it takes a client to reimburse a company for goods or services is known as the
accounts receivable days (A/R days). This statistic aids businesses in estimating their cash flow and
budgeting for upcoming immediate expenses. A business can determine whether or not its credit and
collection operations are effective by measuring the A/R days. For instance, if a sizable proportion of

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customers miss payments but finally pay, it's time to make the collection procedure more proactive. A
better credit management process is required if the company's bad debt is mounting.
Accounts Receivable Days = Accounts Receivable x 365
Total Revenue
1. Company A has made a revenue of $5 million at the end of a year and has pending accounts
receivable of $500,000.
Total Revenue = $5,000,000
Accounts Receivable = $500,000
Accounts Receivable Days = Accounts Receivable x 365
Total Revenue
= 500,000 x 365
5,000,000
= 0.1 x 365
= 36.5 days
2. Find Accounts Receivable days, if a company has an average accounts receivable balance of
$200,000 and annual sales of $1,200,000.
Solution:
Accounts Receivable Days = Accounts Receivable x 365
Total Revenue

= $2,00,000 x 365
$12,00,000
= 60.8 days.

D.4 Accounts Payable days:

Accounts payable days is also referred to as AP days or days payable outstanding (DPO). It is a financial
ratio that displays the typical length of time it takes a company over a given period of time to pay its
vendors. The AP process's overall effectiveness is determined by this ratio.
Accounts Payable Days = Average Accounts Payable × 365 Days
Cost of Goods Sold

3. The financial analyst at XYZ wants to perform the accounts payable days calculation for the
previous fiscal year. The starting accounts payable balance was Rs. 400,000, and by the end of the
year, it increased to Rs. 600,000. During the year, the total sales were Rs. 3,000,000.

Basics of Finance Management Page 140 of 242

Solution:
Accounts Payable Days = Average Accounts Payable × 365 Days
Cost of Goods Sold
Average Accounts Payable = Opening Accounts Payable + Closing Accounts Payable
2
= 4,00,000 + 6,00,000
2
= 5,00,000
Accounts Payable Days = Average Accounts Payable × 365 Days
Cost of Goods Sold
= 5,00,000 x 365
30,00,000
= 60.83 days.
4. Company A reported cost of goods sold of $113,555 . Accounts payable at the beginning and end
of the year were $12,555 and $25,121, respectively. The company wants to measure how many
times it paid its creditors over the fiscal year.
Solution:
Average Accounts Payable = Opening Accounts Payable + Closing Accounts Payable
2
= 12,555 + 25,121
2
= 18,838.
Accounts Payable Days = Average Accounts Payable × 365 Days
Cost of Goods Sold
= 18,838 x 365
113555
= 60.55 days.

D.5 Inventory days

The average number of days a corporation retains its goods before selling it is called days in inventory.
Some businesses refer to it as inventory days of supply or days of outstanding inventory. Days in inventory,
which indicate how quickly a company can sell its inventory, can provide information about a company's
operational and financial effectiveness.
Basics of Finance Management Page 141 of 242
 Days in Inventory = Average Inventory x Period Length
Cost of Goods Sold
A low number for days in inventory might be a sign that a business is efficiently running and promptly
swapping its goods for money. When a business experiences delayed sales conversion, this might highlight
the areas that may require more support, such as brand image development or revision or industry change
adaptation.

5. All Smiles Dental Suppliers sells dental supplies to practices in its area. The company has an
average inventory of $1,000 and a cost of goods sold of $40,000 for the year. What is its days in
inventory result for a one-year period?

Solution:
Days in Inventory = Average Inventory x Period Length
Cost of Goods Sold
= $1000 x 365
$40,000
= 9.13 days
6. Robert's Repairs offers repair services and sells spare parts to mechanics. Its average inventory is
$5,000, and its cost of goods sold for the year is $71,000. What is its days in inventory result for a
one-year period?

Solution:
Days in Inventory = Average Inventory x Period Length
Cost of Goods Sold
= $ 5,000 x 365
$ 71,000
= 25.7 days

D.6. Operating Cycle:

The amount of working capital needed depends on the business's operational cycle. Raw material
procurement marks the start of the operating cycle, which concludes with receivables collection.
Operating cycle consists of the following important stages:
1. Raw Material and Storage Stage, (R)
2. Work in Process Stage, (W)
Basics of Finance Management Page 142 of 242
3. Finished Goods Stage, (F)
4. Debtors Collection Stage, (D)
5. Creditors Payment Period Stage. (C)

Source :
https://gfgc.kar.nic.in/punjalakatte/FileHandler/199-488f5be2-8adb-487e-9c8a-871c1afb8615.pdf
Operating Cycle = R + W + F + D – C
Each component of the operating cycle can be calculated by the following formula:
R= Average Stock of Raw Material
Average Raw Material Consumption Per Day
W = Average Work in Process Inventory
Average Cost of Production Per Day
F = Average Finished Stock Inventory
Average Cost of Goods Sold Per Day
D = Average Book Debts
Average Credit Sales Per Day
C= Average Trade Creditors
Average Credit Purchase Per Day
7. From the following information extracted from the books of a manufacturing company, compute
the operating cycle in days and the amount of working capital required:

Period Covered 365 days.

Average period of credit allowed by suppliers 16 days.
Average Total of Debtors Outstanding 480.
Raw Material Consumption 4,400
Total Production Cost 10,000

Basics of Finance Management Page 143 of 242

 Total Cost of Sales 10,500.
Sales for the year 16,000.
Value of Average Stock maintained:
Raw Material 320
Work-in-progress 350
Finished Goods 260
Solution:
Computation of Operating Cycle:
i. Raw Material held in stock: Average Stock of Raw Material
Average Raw Material Consumption Per Day
= ___320_x 365__
4400
= 26.5 days = 27 days
- Average credit period granted by suppliers - 16 days
11 days
ii. Work in progress = Average Work in Process Inventory
Average Cost of Production Per Day
= __350___
10,000/365
= 350 x 365
10,000
= 12.775 = 13 days

iii. Finished Goods Stage= Average Finished Stock Inventory

Average Cost of Goods Sold Per Day
= __260_____
10,350 / 365
= 260 x 365
10,350
= 9.16 = 9 days
iv. Debtors Collection Stage = Average Book Debts
Average Credit Sales Per Day
= __480_____
16,000 / 365
=480 x 365

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 16,000
= 10.95 = 11 days
Total operating cycle period: (i) + (ii) + (iii) + (iv) = 44 days
Number of Operating cycles in a year = 365/44 = 8.30
Amount of Working Capital required = Total operating cost
Number of operating cycles in a year
= 10,500/8.3 = Rs. 1,265
Alternatively, the amount of working capital could have also been calculated by estimating the
components of working capital method, as shown below:
Value of Average Stock Maintained
Raw Material 320
Work-in-progress 350
Finished Goods 260
Average Debtors Outstanding 480
1,410
Less: Average Creditors Outstanding 145
1265

D.7.C2C Cycle
The cash conversion cycle measures how long it takes a business to turn money spent on production and
sales into cash. It is a gauge of how effectively a business uses its working capital.
The CCC measures the speed at which a business may turn its original capital investment into cash.
Businesses with low CCCs frequently have the best management.
The cash conversion cycle (CCC) is one statistic among many that managers use to evaluate how well they
utilize working capital. Working capital refers to the funds utilized for daily activities. This metric gauges
how quickly a business turns money used for operations into cash.
In order to build inventory, sell things, and collect money from customers, the CCC uses average timings.
In general, the shorter this period, the better for the business.

D.7.1.Days of Inventory Outstanding (DIO)

DIO is how many days it takes to sell the entire inventory. The smaller the number, the better.

Basics of Finance Management Page 145 of 242

To calculate it, you first need to determine average inventory:
Average Inventory = (Beginning Inventory + Ending Inventory)
2
Days of Inventory Outstanding = Average Inventory x number of days in period
Cost of Goods Sold

D.7.2.Days of Sales Outstanding (DSO)

DSO is days sales outstanding or the number of days a company takes to collect on sales.
Days of Sales Outstanding = Accounts Receivable x Number of Days in Period
Annual Revenue

D.7.3.Days of Payables Outstanding (DPO)

DPO is days payable outstanding. This metric reflects the company's payment of its own bills or accounts
payable (AP). If this can be maximized, the company holds onto cash longer, maximizing its investment
potential. Therefore, a longer DPO is better.
Days of Payables Outstanding =Average Accounts Payable
(Cost of Sales / Number of Days)

D.7.4. Cash Conversion Cycle

Cash Conversion Cycle= Days inventory outstanding + Days sales outstanding - Days payables outstanding
8.

Item Fiscal Year 2020 Fiscal Year 2021

Revenue 9,000 10,000
COGS 3,000 4,000
Inventory 1,000 2,000
Accounts Receivable 100 90
Accounts Payable 800 900
Solution:
Average Inventory = (Beginning Inventory + Ending Inventory)
2
= (1000 + 2000)

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 2
= 1,500
Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable)
2
= 100 + 90
2
= 95
Average Accounts Payable = (Beginning Accounts Payable + Ending Accounts Payable)
2
= 800 + 900
2
= 850
Days of Inventory Outstanding = Average Inventory
Cost of Goods Sold
= 1500 x 365
3000
= 182.5 days
Days of Sales Outstanding = Accounts Receivable x Number of Days in Period
Annual Revenue
= 95 x 365
9000
= 3.9 days
Days of Payables Outstanding =Average Accounts Payable
(Cost of Sales / Number of Days)
= 850 x 365
3000
= 103.4 days
Cash Conversion Cycle= Days inventory outstanding + Days sales outstanding - Days payables outstanding
= 182.5 + 3.9 days - 103.4 days
= 83 days

Practical Sums:
Basics of Finance Management Page 147 of 242
The following information is available for Swagat Ltd.: (`. ‘000)
Average stock of raw materials and stores 200

Average WIP inventory 300

Average finished goods inventory 180

Average accounts receivable 300

Average accounts payable 180

Average raw materials and stores purchase on credit and consumed per day 10

Average WIP value of raw materials committed per day 12.5

Average cost of goods sold per day 18

Average sales per day 20

You are require to calculate:

(i) Duration of raw material stage
(ii) Duration of WIP stage
(iii) Duration of Finished goods stage
(iv) Duration of accounts receivable stage
(v) Duration of accounts payable stage, and
(vi) Duration of operating cycle.
Solution:
Duration of Raw Materials Stage = Average stock of raw materials and stores
Average materials and stores purchased per day
= 200
10
= 20 days
Duration of work in progress Stage = Average work in progress inventory
Average work in progress committed per day
= 300
Basics of Finance Management Page 148 of 242
 12.5
= 24 days
Duration of finished goods Stage = Average finished goods inventory
Average cost of goods sold per day
= 180
18
= 10 days
Duration of accounts receivable Stage = Average accounts receivable
Average credit sales per day
= 300
20
= 15 days
Duration of accounts payable Stage = Average accounts payable
Average credit purchase per day
= 180
10
= 18 days
Duration of operating cycle= Duration of Raw Materials Stage + Duration of work in progress Stage +
Duration of finished goods Stage + Duration of accounts receivable Stage - Duration of accounts payable
Stage
= 20 days + 24 days + 10 days + 15 days - 18 days
= 51 days
2.From the following information extracted from the books of a manufacturing company,
compute the operating cycle in days and the amount of working capital required:
Period Covered 365 days
Average period of credit allowed by suppliers 16 days
Average Total of Debtors Outstanding 480
Raw Material Consumption 4,400
Total Production Cost 10,000
Total Cost of Sales 10,500
Sales for the year 16,000
Value of Average Stock maintained:

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Raw Material 320
Work-in-progress 350
Finished Goods 260
Calculation of operating cycle:
Raw material held in stock = Average stocks of raw material held
Average consumption per day
= ___320 x 365___ = 27 days
4400
Less: average credit period granted by suppliers = 16 days
11 days

Work in progress = Average work in progress maintained

Average cost of production per day
= 350
10,000 / 365
= 13 days

Finished goods held in stock = Average finished goods maintained

Average cost of goods sold per day
= 260
10,500 / 365
= 9 days
Credit period allowd to debtors = Average total of outstanding debtors
Average credit sales per day
= __480_____
16000/365
= 11 days
Total operating cycle period: Raw material held in stock + Work in progress + Finished goods held in stock
+ Credit period allowd to debtors
= 44 days
Number of operating cycles in a year: 365 / 4
= 8.30 times

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Amount of working capital required= total operating cost
Number of operating cycles in a year
= 10,500
8.30
= Rs 1265
Q1.Choose the correct answer
1. Which of the following physical capital is working capital?

A. Buildings
B. Tools
C. Machines
D. Raw materials
2. The major current assets are _____
A. cash and marketable securities
B. accounts receivable (debtors)
C. inventory (stock)
D. All of the above
3. The basic current liabilities are _____
A. accounts payable and bills payable
B. bank overdraft
C. outstanding expenses.
D. All of the above
4. There are two concepts of working capital – gross and ____
A. Zero
B. Net
C. Cumulative
D. distinctive
5. Working capital is also known as___ capital.
A. current asset
B. Operating
C. projecting
D. Operation capital
6. ______ working Capital refers to the firm’s investment in current assets.
Basics of Finance Management Page 151 of 242
A. Zero
B. Net
C. Gross
D. Distinctive
7. In finance, “working capital” means the same thing as _______ assets.
A. Current
B. Fixed
C. Total
D. All of the above
8. A _______ net working capital will arise when current assets exceed current liabilities.
A. Summative
B. Negative
C. Excessive
D. Positive
9. A ______ net working capital occurs when current liabilities are in excess of current assets.
A. Positive
B. Negative
C. Excessive
D. Zero
10. _______ varies inversely with profitability.
A. Risk
B. Assets
C. Liquidity
D. Revenue
11. ______ cycle analyzes the accounts receivable, inventory, and accounts payable cycles in terms
of a number of days?
A. Business
B. Current asset
C. Operation
D. Operating
12. Operating cycle is also called as _____
A. Working cycle

Basics of Finance Management Page 152 of 242

B. Business cycle
C. Current asset cycle
D. Working capital cycle
13. A positive working capital means that –
(A)the company is able to pay-off its long-term liabilities.
(B) the company is able to select profitable projects.
(C) the company is unable to meet its short-term liabilities.
(D) the company is able to pay-off its short-term liabilities.
14. Working capital =………….
(A) Core current assets less current liabilities
(B) Core current assets less core current liabilities
(C) Liquid assets less current liabilities
(D) Current assets less current liabilities
15. Contingencies are – ………..
(A) Added to gross working capital
(B) Deducted from gross working capital
(C) Contingencies are not considered in financial management; it is considered in accounts only
(D) None of the above
16. A negative working capital means that -………..
(A)the company has no current assets at all
(B) the company currently is unable to meet its short-term liabilities
(C) the company has negative earnings before interest and tax
(D) the company currently is able to meet its short-term liabilities
17. Initial Working Capital -…………
(A)supplies the funds necessary to meet the current working expenses.
(B) is used to raise the volume of production by improvement or extension of machinery.
(C) is required at the time of the commencement of business
(D) represents the amount utilized at the time of contingencies.
18. One of the important objective(s) of working capital management is/are –
(A) To maintain the optimum levels of investment in current assets.
(B) To reduce the levels of current liabilities.

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(C) Improve the return on capital employed.
(D) All of the above
19. Fluctuating Working Capital is also called as —
(A) Reserve Margin Working Capital
(B) Temporary Working Capital
(C) Permanent Working Capital
(D) Variable working capital
20. Capital which is needed to meet the seasonal requirements of the business –
(A)Gross Working Capital
(B) Reserve Margin Working Capital
(C) Net working capital
(D) Fluctuating Working Capital
Q.2 Fill in the blanks
1. _________capital is defined as money set aside for a company's long-term investments.
2._________ includes only current assets.
3.______________ is also known as fixed working capital.
4. Seasonal needs for capital is met by _________.
5.__________ is the crucial aspects of business.
6.___________policy refers to reducing risk by keeping a higher amount of working capital.
7.The average period of time it takes a client to reimburse a company for goods or services is known as
the _____________.
8.___________is a financial ratio that displays the typical length of time it takes a company over a given
period of time to pay its vendors.
9.___________ measures how long it takes a business to turn money spent on production and sales into
cash.
10.___________ indicate how quickly a company can sell its inventory, can provide information about a
company's operational and financial effectiveness.
Q.3 Answer in one or two sentences.
1. What is working capital?
2. What is accounts receivable days?
3. What is accounts payable days?
4. What is cash conversion cycle?

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5. What is inventory days?
6. What is gross working capital?
7. What is net working capital?
8. What is operating cycle?
9. Write the components of operating cycle.
10. Write down sources of working capital.
Q.4.Answer the following in brief
1. Define working capital and explain the types of working capital.
2. Explain working capital management policy.
3. Write down the meaning of working capital. List down the sources of working capital.
4. Calculate Accounts receivable days
2020 2021 2022
Net Revenue 1,00,000 1,20,000 1,50,000
Accounts Receivable 20,000 22,000 26,000

(Accounts Receivable 2021= 64 days

Accounts Receivable 2022= 58 days)
5. A toy company has the reputation for paying its suppliers on time. It has an ending Account Payable
of Rs 40,000. Its cost of goods sold is Rs 375,000. Calculate Accounts payable days.
(Accounts Payable days = 38 days)
Q.5 Answer in detail
1. Explain in detail the needs of capital.
2.Prepare an estimate of working capital requirement from the following information’s of a trading
concern.
Projected annual sales Rs. 6,50,000
Percentage of net profit on sales 25%
Average credit period allowed to debtors 10 Weeks
Average credit period allowed by creditors 4 Weeks
Average stock holding in terms of sales requirements 8 Weeks
Allow 20% for contingencies

(Net working capital required=1,68,000)

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 3. Company A reported a $1,000 beginning inventory and $3,000 ending inventory for the fiscal year
ended 2018 with $40,000 cost of goods sold. Company A reported $4,000 in beginning accounts
receivable and $6,000 in ending accounts receivable for the fiscal year ended 2018, along with
credit sales of $120,000. Company A posted $1,000 in beginning accounts payable and $2,000 in
ending accounts payable for the fiscal year ended 2018, along with $40,000 in cost of goods sold.
Calculate Cash Conversion cycle.

(Cash conversion cycle =20 days)

4. Calculate operating cycle.

Item Opening Closing

Inventory 23,00,000 35,00,000

Accounts Receivable 17,50,000 23,00,000

Accounts payable 7,00,000 9,00,000

Net Sales 1,30,00,000

Cost of Goods Sold 85,00,000

(Operating cycle= 182 days)

5. Explain accounts receivable days, accounts payable days and inventory days with formula.

Answer

1.d 2.d 3.d 4. b 5.b 6.c 7.a 8.d 9.b 10.c

11.d 12.d 13.d 14.d 15.a 16.b 17.c 18.d 19.d 20.d

Fill in the blanks

1) Fixed 6) Conservative working capital
2) Gross working capital 7) Accounts receivable days
3) Permanent working capital 8) Accounts payable days
4) Temporary working capital 9) Cash conversion cycle
5) Working capital 10) Inventory days

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 E SOURCES OF FUND
INTRODUCTION:
Finance is the lifeblood of business because it is involved in all activities carried out by a group of
companies. In the human body, if the circulation is not normal, bodily functions cease. Therefore, if the
financing is not properly organized, the company the system stops. Arranging the necessary finance for
each business department the concern is very complex and requires careful judgment. The amount of
funding can be depending on the nature and situation of the company. But the demand of funding can be
broadly divided into two parts:

E.1.Demand of funding
The financial requirements of the company differ from company to company and the nature of the activity
depending on the conditions or duration of the financial need, it can be long-term and short-term financial
needs.

E.1.1.Long term financial needs or

fixed capital requirement:
Long-term financial need means the financing needed to acquire land and building for business purposes,
purchase of equipment and machinery and other fixed expenses. Long-term financial needs are also called
working capital requirements. The fixed capital is capital used to buy fixed assets such as land and
buildings for businesses, furniture and fixtures, equipment and machinery, etc. That is why it is also called
capital expenditure.

E.1.2.Short term financial needs or

working capital requirement:
In addition to business investment, businesses should require certain expenses such as procurement of
raw materials, payment of salaries, daily expenses, etc. These costs must be covered by short-term
financial needs. which covers the operating costs of companies. Short-term financing needs are usually
called working capital

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 E.2 SOURCES OF FINANCE:
Sources of financing refer to the mobilization of various financial conditions for the use of industry.
Sources of financing tell how companies get financing to meet their needs. Businesses are existing or
new that require a certain amount to meet long-term and short-term needs (e.g. fixed purchases) real
estate, office building, procurement of raw materials and daily expenses. Funding sources can be classified
into different categories accordingly the following important heads:

E.2.1.Based on period:
Funding sources can be classified into different categories based on time period.

a) LONG-TERM SOURCES
Funds can be mobilized both long-term and short-term. If a large amount is raised and repaid over a period
of more than five years, it can be considered a long-term source. This source of financing includes equity
capital, bonds, long-term loans from financial institutions and commercial banks. A long-term source of
financing must cover the capital costs of businesses, such as the purchase of fixed assets, land and
buildings, etc.
Long term sources of finance are
Equity share
Preference Shares
Debentures
Long term
Fixed Deposits

b) SHORT TERM SOURCES

In addition to a long-term source of financing, companies can finance through loans and advances from
short-term sources such a commercial banks, moneylenders, etc. The short-term funding source must
cover the company's operating costs.
Short term sources of finance are
Bank Credit
Short term loan
Trade credit
Public deposits
Money market instruments
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Customer Advances

E.2.2.Based on Ownership:
Sources of Finance may be classified under various categories based on the ownership are as follows:

a) AN OWNERSHIP SOURCE OF FINANCE

The term "owner's funds" refers to money given by entrepreneurs who can be individual proprietors,
partners, or corporation shareholders. Apartment money, as well as earnings, are reinvested in the
company. The owner's capital is invested in the firm for a long period and is not recoverable during the
company's life.
This capital serves as the foundation upon which owners gain control and possession. The issuance of
shares and the retention of earnings are two major sources of money for the owner.
An ownership source of fund are:
Share Capital, Earnings
Retained earnings
Surplus and Profits

b) BORROWED CAPITAL
On the other hand, "borrowed funds" refer to funds obtained through loans or borrowings. Sources are a
collection of loans from commercial banks, loans from financial institutions, number bonds, public
deposits, and business credit. Such sources provide funding at a specific time, subject to specified rules
and requirements, and must be reimbursed beyond the deadline. Fixed-rate borrowers must pay interest
on such money. It sometimes requires a lot of charge to the organisation as payment interesting though
income is little or if a loss occurs. Borrowed money are typically used to secure some fixed assets.
Borrowed capital are
Debenture
Bonds
Public deposits
Loans from bank and financial institutions

E.2.3.Based on Source of Generation:

Sources of Finance may be classified into various categories based on the generation:

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Another factor to consider when categorising funding sources is whether the funds come from within the
institution or from outside sources.

a) Internal Source Of Fund

Internal sources of funding are funds created within the firm. A company, for example, can generate funds
internally by speeding receivables collection, disposing of excess inventory, and reinvesting profits.
Internal money can only meet a limited number of the business's needs.
Internal Source of fund are
Retained Earnings
Depreciation funds
Surplus

b) External Source Of Funds

External sources of finances are those that exist outside of an organisation, such as suppliers, lenders, and
investors. When a substantial sum of money needs to be raised, it is usually done through the use of
outside sources. External finances may be more expensive than those obtained internally.
When a business needs money from outside sources, it may need to mortgage its assets as security.
Some examples of common external sources of funding used by corporate entities include issuing
debentures, borrowing from commercial banks and financial organisations, and receiving public deposits.
External source of funds are:
Share capital
Debenture
Public deposits
Loans from bank and financial institutions

E.3.Sources of funds:
Different forms of funding are available to businesses. To choose the finest source of funding, it is
necessary to fully comprehend the distinctive qualities that each source possesses. For all organisations,
there isn't a single optimum source of funding.
One may decide on the source to be used based on the circumstance, goal, cost, and associated risk. For
instance, long-term funds may be needed if a corporation wishes to raise money to meet fixed capital
requirements. These funds can be obtained through either owned or borrowed funds. Similar to this,
short-term sources may be used if the goal is to meet daily business requirements. An overview of the
several sources, along with their merits and demerits are discussed below:

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 E.3.1.Retained Earnings:
In most cases, a corporation does not pay out all of its profits in dividends to its shareholders. The
corporation may decide to keep some of its net earnings for potential future usage.
These are referred to as retained earnings. It serves as a means of internal funding, self-financing, or
"ploughing back profits."
The amount of money that can be reinvested in an organisation relies on a variety of variables, including
net income, the dividend schedule, and the organization's age.

a) Features of Retained Earnings

● Retained earnings are seen as a cushion of security since they offer assistance during trying times
when it becomes challenging for a company to collect money from other ventures.
● Retained earnings are a frequent source of capital for the funding of innovative and risky
initiatives. These are typically utilised for research projects, growth initiatives, etc.
● Retained earnings are used for medium-term and long-term financing since they are regarded as
ownership money.
● Conversion into Ownership Securities: By issuing bonus shares, excess retained earnings may be
converted into ownership funds. The issuance of bonus shares doesn't involve any cash outlays.
The unfettered issuance of shares benefits investors as well.

b) Merits of Retained Earnings are:

The merits of retained earnings are as follows:
b.1. Most Reliable Source:
Since retained earnings are an internal source, they are a more reliable and long-lasting source of funding
than outside sources of capital. This is due to the fact that all external sources are dependent on factors
such as market conditions, creditors' preferences, etc.
b.2. No Explicit Cost:
Using retained earnings entails no costs because there are none to be expended for prospectus issuance,
advertising, floatation charges, etc.
b.3. No Fixed Liability:
Since retained earnings are a company's own funds, there is no fixed obligation to pay dividends or
interest on this source of funding.
b.4. No Interference:
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A corporation does not have to issue new shares when using its retained profits. There is therefore no
chance of control being diluted within the organisation.
b.5. Lack of Security:
Unlike debentures, there is no charge placed on the company's assets. As a result, the business is free to
use its assets in the future to raise financing.
b.6. Goodwill:
Retained earnings improve the company's financial stability and reputation. Businesses may easily
respond to any crisis or unanticipated event thanks to large reserves. The market price of equity shares
may rise as a result of retained earnings.
b.7. Absorbs Unexpected Losses:
A company is in a position to absorb unexpected losses if it has retained earnings.

c) Demerits of Retained Earnings are:

The following are the drawbacks of retained earnings:
c.1. Disappointment:
When profits are excessively reinvested, or when a significant portion of the profits are held as reserves,
shareholders may be dissatisfied with the decreased dividend payments made to them.

c.2. Uncertainty:
Because a company's profits constantly change, using retained earnings as a source of funding is quite
risky.
c.3. Opportunity Cost:
Many businesses frequently ignore or occasionally fail to recognise the opportunity cost connected with
the use of retained profits, which results in less-than-ideal use of the cash.
c.4. Less Productivity:
Growth is unbalanced because profits from one industry are not spread to others. A lot of businesses
overlook the potential cost related to these finances. The money are thus used less effectively as a result.
c.5. Debt Capital:
Debt capital is money that a business or organisation raises by taking out loans with interest from banks
or investors. Debt capital is an excellent source of funding for firms and can be applied for a variety of
goals, including working capital, expansion, and acquisition.

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 E.3.2.BANK LOANS:
The simplest way to obtain financing is through bank loans. A bank loan is a credit line extended to a client
or business; it must be repaid with interest.
Bank loans are a means for acquiring operating capital, money for business expansion, and financing the
purchase of inventory and equipment. These loans are a tried-and-true source of funding for small
businesses, but banks frequently only work with companies who have strong collateral and a proven track
record, and the terms they give are frequently very severe. Business owners should compare the benefits
and drawbacks of bank loans to alternative sources of funding.

a) Merits of Bank loan:

a.1. Flexibility:
As long as payments are made on time and on schedule, a bank loan can be repaid at the borrower's
leisure. As opposed to an overdraft, where the entire credit is taken out at once. Or a credit card for
individuals where the maximum limit cannot be used all at once.
a.2. Cost Effectiveness:
In terms of interest rates, bank loans are typically less expensive than overdraft and credit card options.

a.3. Profit Retention:

You must distribute earnings to shareholders when raising capital through equity. With a bank loan, you
are not required to split earnings with the bank.
a.4. Tax benefit:
When a loan is taken out for business purposes, the government allows the interest that is due to be
deducted from taxes.
a.5. Management Control:
A bank will lend money to a company if it believes the business will be able to repay the loan with timely
and full payments. Banks do not acquire any ownership stake in enterprises, in contrast to equity financing
where the business issues shares. Additionally, bank employees are not involved in any part of managing
a company to which they have provided a loan. This implies there will be no outside interference and you
will maintain complete management and control of your company.

a.6. Financial obligation is limited to Principal and interest:

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Unless the business borrower wants to take out another loan, there is no longer any responsibility to or
interaction with the bank lender once a loan has been repaid. through contrast, through equity financing,
the corporation may pay dividends to shareholders for the duration of the business.

b) Demerits of bank loan:

b.1. Hard Prerequisite:
Most fledgling enterprises would find it difficult to finance the operations through bank loans because
large financing from a bank is predicated on collateral.
b.2. Uneven Payment Amounts:
The interest rate on a long-term loan paid back in monthly instalments may fluctuate. This indicates that
the EMI will vary depending on how the market affects the interest rate that is applicable rather than
remaining constant.
b.3. Tough to obtain:
Bank loans have one of the biggest drawbacks in that they are very hard to get unless a small business has
a strong track record or expensive collateral like real estate. Banks take care to only lend to companies
that can clearly pay back their loans and to ensure that they have the financial reserves to sustain losses
in the case of failure. In the case that a business fails and is unable to repay all or a portion of a loan,
personal assets of the borrower may be seized. Business borrowers may be required to give personal
guarantees.
b.4. High interest rates:
The interest rates on bank loans for small businesses can be fairly high, and the amount of bank funding
that a business is eligible for is sometimes insufficient to fully satisfy its needs. When a business does
acquire finance, the high interest rate it pays frequently prevents it from growing since it must cope with
both servicing the loan and finding new capital to offset money that the bank does not supply. The terms
of loans insured by the U.S. Small Business Administration are better than those of other loans, however
there are stringent qualifications to be eligible for these subsidised bank loans.

E.3.3.COMMERCIAL PAPER:
Commercial Paper (CP) is a type of promissory note that is an unsecured money market instrument. It was
first launched in India in 1990 to give highly rated corporate borrowers the opportunity to diversify their
sources of short-term borrowings and to give investors another tool. In order to help them fulfil their
short-term funding needs for their operations, principal dealers and all-India financial institutions were
Basics of Finance Management Page 164 of 242
subsequently given permission to also issue CP. Investments in CPs can be made by individuals, financial
institutions, other corporate entities (registered or incorporated in India), unincorporated bodies, Non-
Resident Indians (NRIs), Foreign Institutional Investors (FIIs), etc.

a) Features of Commercial Paper:

● This short-term debt product has a predetermined maturity date.
● It is typically an unsecured debt where the business does not commit any assets but yet qualifies for it
based on their company's financial strength, ability to generate income, and accomplishments.
● The issuer of the commercial paper guarantees or promises to pay the subscriber the predetermined sum
in cash in the future.
● This document may be used as an unsecured debt certificate.

b) Types of Commercial Paper:

There are 2 types of commercial paper:

b.1. Secured Commercial Paper:

These are frequently referred to as Asset-backed commercial papers (ABCP), and they are backed by real
assets like trade receivables, among other things.
b.2. Unsecured Commercial Paper:
These are the standard commercial documents, which are distributed without any kind of security.

b.3. Draft:
Draft is a three-party document that attests to the payment. The drawee is the person to whom the order
to pay is provided in this instance, whereas the drawer is the party who provides the order to pay. It is a
letter from one person to another (often a bank) requesting payment of a specific amount to a third party.
The process involves a drawer, drawee, and acceptor.
b.4. Promissory notes:
Promissory notes is an agreement in writing to pay money. The maker of the note, who also guarantees
payment to the bearer, makes the promise. Anyone who has the promissory note in their possession, or
the person specifically mentioned in the note, is the payee.
b.5. Cheques:
Cheques are drew against a bank. It is either payable to the holder on demand or to a specific individual
upon demand.

b.6. Certificate of Deposits:

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Certificate of Deposits is the bank's approval for the purchase of a particular amount of money from a
depositor for a specific period of time. After maturity, the bank guarantees to pay back the money plus
interest. In the case of a CD, the person making the deposit is the payee, and the bank serves as both the
maker and the drawee.

c) Merits of Commercial Paper:

The advantages of commercial paper are as follows:
c.1. Contributes Additional Funds –
Because the cost of the paper to the issuing company is less than the loans from the commercial bank, it
contributes additional funds.
c.2. Flexible –
It is more flexible due to its high liquidity value and wide maturity range.
It is quite dependable and devoid of any limiting conditions.
c.3. Spend Less –
By using commercial paper, businesses can spend less money while still making a profit.
c.4. Lasting Source of Funds –
The maturity range may be adjusted to meet the needs of the company, and matured papers may be
reimbursed by the sale of new commercial paper.

E.3.4.DEBENTURES:
A bond or other sort of financial instrument that is secured by collateral is referred to as a debenture.
Debentures must rely on the issuer's trustworthiness and reputation for support because they lack a
collateral underpinning. Debentures are commonly issued by both businesses and governments to raise
cash or money. It is a document the business issues with its seal that acknowledges a debt.
According to the Companies Act 1956, “debenture includes debenture stock, bonds and any other
securities of a company whether constituting a charge of the assets of the company or not.”

a) Features of Debentures:
a.1 Maturity Period:
Debentures have a fixed, long-term maturity time. Debentures typically have a maturity length of 10 to
20 years and are repayable with the principal investment at the end of the period.
a.2 Residual Claims in Income:

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Holders of debentures are entitled to a predetermined rate of interest at the conclusion of each
accounting period. Debenture holders have precedence over equity and preference shareholders in their
claims to the company's income.
a.3 Residual claims on assets:
Holders of debentures take precedence over equity and preference shareholders in their claims on the
company's assets. The holders of the debt instruments may request either a fixed change in the company's
assets or a floating adjustment. Debenture holders who own specific changes are regarded as secured
creditors, whereas those who hold floating changes are regarded as unsecured creditors.

a.4 No Voting Rights:

Debenture holders do not have voting rights because they are regarded as the company's creditors.
Therefore, they are not allowed to vote. Holders of debt instruments are unable to influence how a
company operates.
a.5 Fixed Rate of Interest:
Debentures have a set rate of interest that remains the same until maturity. Therefore, the operation
won't have an impact on the debenture's yield.

b) Types of debentures:
The types of debentures are as follows:
b.1 Secured Debentures:
Debentures with security are backed by the company's assets. Due to the fact that these debentures are
issued in exchange for any mortgages on the company's assets, they are also known as mortgaged
debentures.
b.2 Unsecured Debentures:
Debentures that are not secured by assets of the corporation are not given any security. Additionally, it is
known as basic or naked debentures. When the firm is wound up, these form of debentures are treated
as unsecured creditors.
b.3 Redeemable Debentures:
These debentures must be redeemed when a specific time period has passed. Periodically, interest is paid,
and following the predetermined maturity period, the initial investment is refunded.
b.4 Irredeemable Debentures:

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Throughout the existence of the business concern, certain types of debentures cannot be redeemed. It
can only be redeemed when the company goes into liquidation.
b.5 Convertible Debentures:
These debentures can be converted by the investors' holdings into equity shares of the business. The
rights of the holders of convertible debentures, the conversion trigger date, and the conversion date are
all indicated at the time of issuance.
b.6 Non- Convertible Debentures:
The non-convertible debentures cannot be converted by the investors into equity shares. Therefore, the
investor will always be compensated in accordance with the pre-, post-fixed, or hybrid profitability when
selecting this form of asset.
b.7 Registered Debentures:
The company's records contain information about registered debenture holders. Let's say a debenture
holder wants to modify the debentures' ownership. The transfer or trade must then be coordinated
through a clearing house, which notifies the issuer of the ownership changes so that the proper
bondholder will get the interest.
b.8 Unregistered Debentures:
These bonds are also known as bearer bonds. The firm that issued these debentures does not require its
holders to keep any records. In the case of unregistered debentures, the corporation pays the holder of
the debenture, regardless of its name, as well as the principal amount. Debentures that are not registered
are easily transferred.
b.9 Other types:
Debentures can also be classified into the following types. Some of the common types of the debentures
are as follows:
Collateral Debenture
Guaranteed Debenture
First Debenture
Zero Coupon Debenture
Zero Interest Bond/ Debenture

c) Merits of Debenture:
Debenture is one of the major part of long term financing. The merits of debentures are as follows:
c.1 Long-term sources:
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Debentures are one of the company's long-term sources of funding. The maturity time is typically longer
than that of other sources of funding.
c.2 Fixed rate of interest:
Since fixed rates of interest are paid to debenture holders, they are best suited for businesses that
generate bigger profits. The interest rate is typically lower than those of other long-term financing
options.
c.3 Trade on equity:
By include debentures in its capital structure, a corporation can trade on equity and raise its earnings per
share. When a corporation uses the concept of trade on equity, capital costs will go down and company
value will rise.
c.4 Deduction for income taxes:
The total profit of the company may be reduced by interest paid on debentures. Consequently, it aids in
lowering the company's tax liability.
c.5 Protection:
A number of clauses in the debenture trust deed and the rules issued by the SEB1 safeguard the debenture
holder's interests.

d) Demerits of Debentures:
The demerits of Debentures are as follows:
d.1 Fixed interest rate:
Debentures include fixed interest rates that are payable on securities. The set rate of interest must be
paid to debenture holders even while the company is not making a profit, hence it is not appropriate for
businesses with highly variable earnings.
d.2 No voting rights:
Holders of Debentures are not permitted to vote. As a result, they are unable to influence how the
company is run.
d.3 The company's creditors:
Holders of debentures are only the company's creditors, not its owners. They are not entitled to any of
the company's excess profits.
d.4 High risk:

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Because debenture holders have larger expectations, each successive issue of debentures is riskier and
more expensive. Because of the elevated financial risk, raising money through debentures is also more
expensive and has a high cost due to the high stamp duty.
d.5 Limitations on future issues:
Because the company's debentures are secured by assets that have already been mortgaged to debenture
holders, it is not possible to obtain more funds through them.

E.3.5.EQUITY SHARES
Other than preference shares, equity shares are sometimes referred to as ordinary shares.
The actual proprietors of the business are equity stockholders. They have some influence over how the
business is run. If the company makes money, dividends can be paid to equity investors. In the course of
the company's existence, equity share capital cannot be redeemed. The unpaid share value represents
the equity stockholders' liabilities.

a) Features of Equity Shares:

The features of equity shares are as follows:
a.1. Shares' maturity:
Equity shares are perpetual securities with no set maturity date. It is not redeemable while the company
is still in existence.
a.2 Residual claim on Income:
Equity owners have a claim to any income that remains after paying preference shareholders a fixed rate
of dividend. The profit after tax less the preference dividend is the earnings or income that is accessible
to the shareholders.
a.3 Remaining claims on assets:
If the firm was dissolved, the remaining claims on assets would go to the equity or common shareholders.
Only equity stockholders are eligible to exercise these rights.
a.4 Right to control:
The actual owners of the corporation are the equity shareholders. As a result, they have the authority to
decide everything related to how the firm is run and to govern the company's management.
a.5 Voting rights:

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Equity shareholders have the ability to amend or repeal any business decision at a meeting of the company
by using their voting rights. Equity shareholders can designate a proxy to attend and vote in place of the
shareholder at company meetings. Equity shareholders only have voting rights in the company meeting.
a.6 Pre-emptive shares:
Equity shareholder pre-emptive rights are a pre-emptive right. The existing shareholders have a legal right
known as the pre-emptive right. The corporation confirms that it will buy more equity shares at the first
available opportunity in proportion to their present holding capacity.
a.7 Limited liability:
Equity shareholders' liability is capped at the cost of the shares they purchased. The shareholders have
no obligations if their shares are completely paid up.

b) Merits of Equity Share Capital:

The most popular and widely used shares to raise capital for the company are equity shares. The benefits
of equity share capital are as follows:
b.1 Long-term permanent sources of funding:
Equity share capital is a type of long-term permanent source of funding and can be utilised to meet the
long-term or fixed capital needs of a business concern.
b.2 Voting privileges:
Equity shareholders, who are the true owners of the business, are entitled to vote. The only people who
can take advantage of this benefit are equity shareholders.
b.3 No fixed dividend:
Owning equity shares exempts you from any contractual obligations to pay a predetermined dividend
rate. Equity shareholders can get dividends if the company is profitable, but they cannot do so if the
company is losing money.
b.4 Less expensive capital:
The cost of capital is the main factor influencing the company's worth. Because share capital has a lower
cost of capital (Ke) than other types of funding, it must be used more frequently if a company wishes to
expand its value.
b.5 Retained earnings:
When a company has a larger share capital, retained earnings are an appropriate source of funding since
they are less expensive than other sources of funding.

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 c) Demerits of Equity Share Capital:
The drawbacks of equity share capital are as follows:
c.1 Irredeemable:
Equity shares are irredeemable and cannot be redeemed while the business is in operation. The riskiest
aspect of overcapitalization is this. Only when the firm goes into liquidation the investor can redeem it.
c.2 Obstacles in Management:
Management difficulties can be created through manipulation and self-organization by equity
shareholders. Because they have the authority to challenge any decision that is detrimental to the
shareholders' wealth.
c.3 Encourages speculation:
Equity share transactions on the stock market encourage secularism during affluent times. The
speculators try to take the advantage of market during uncertainty in the market.
c.4 Limited income to investor:
Equity shares are not appealing to investors who want to invest in safe securities with a guaranteed
dividend. Only risk takers are interested in investing their money in equity share capital as the return is
uncertain and risky.

c.5 No trading on equity:

A corporation cannot benefit from trading on equity if it raises cash solely through the sale of shares. As
the concentration of shares decreases in the management so the control also decreases. So the firm need
to look into alternative source of income to keep the concentration of equity.

E.3.6.PREFERENCE SHARE CAPITAL:

Preference shares, also known as preferred stock, are shares of a company's stock that pay dividends to
shareholders ahead of dividends on regular stock.
Preferred stockholders are entitled to payment from firm assets before common stockholders in the event
of bankruptcy. Common stocks often do not carry a fixed dividend, while the majority of preference shares
do. Additionally, holders of preferred stock often do not have voting rights; holders of common stock
typically do.

a) Types of Preference Share:

a.1 Cumulative Preference Share:

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The owner of cumulative preference shares is entitled to dividend payments even while the company is
losing money. As the name implies, the business pays shareholders their proper dividends when it is
profitable. Preference shareholders must be paid out before common shareholders may receive their
payments. The owners of these preference shares occasionally receive an additional dividend.
a.2 Non-Cumulative Preference Share:
These are the shares on which the firm has the discretion to determine whether or not the shareholders
will receive omitted or pending dividends. The right to receive dividends does not belong to the
shareholders. Dividends are paid out of profits.
a.3 Redeemable Preference Share:
These preference shares, sometimes referred to as callable preferred stock, are one of the most efficient
methods for financing large corporations. These shares are easily traded on stock markets and have a
combination of equity and loan funding.
A firm typically has the right to buy back the shares it has issued to further its own objectives. Therefore,
the redeemable preference shares are bought back at a set price on a set date or by declaring it
beforehand. Particularly useful for mitigating the effects of inflation and the fall in the money supply are
redeemable preference shares.
a.4 Irredeemable Preference Share:
Throughout the active lifetime of a corporation, this particular share cannot be redeemed or returned.
Shareholders won't be able to take the same action until the company decides to stop its current
operations or liquidate the venture altogether, to elucidate. As a result, the firm has a perpetual duty for
the shares.
a.5 Participating Preference Share:
In this scenario, if the dividend paid to the common shareholders is higher than the set amount, the
shareholders may seek an excess on the dividend. The Participating Preference Shareholder has the right
to claim a portion of any excess profits made in the event that the firm is liquidated.
a.6 Non-Participating Preference Share:
These preference shares' owner will only get predetermined dividends. They won't receive a cut of the
extra money.
a.7 Convertible Preference Share:

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Fundamentally, convertible shares are those that can be converted into equity shares at a certain price
by their owners. It should be noted that according to the memorandum, these shares can only be
converted when a specific amount of time has passed and within a certain window of time.
These shares are ideally thought to be advantageous for investors who want to obtain preferred share
dividends.
a.8 Non-Convertible Preference Share:
Shareholders who are non-convertible preference shares are unable to convert their shares into equity
shares. In any case, they get the preferred treatment when it comes to receiving dividends or when the
firm is dissolved.

b) Features of Preference Shares:

The following are the features of preference shares
b.1 Maturity Period:
Except in the case of redeemable preference shares, preference shares typically do not have a defined
maturity period. Preference shares are only redeemable at a company's liquidation.
b.2 Residual income claims:
Owners of preferential shares have a residual income claim. The preferred stockholders are entitled to a
fixed rate of dividend.
b.3 Remaining claims on assets:
At the moment of liquidation, the preference shareholders receive first preference. If there are any extra
assets, they should be given to equity shareholders.
b.4 Management Control:
Preference shareholders do not have voting privileges. As a result, they are unable to influence how the
company is run.

c) Merits of Preference Share Capital:

The merits of Preference Share Capital:
c.1 Fixed dividend:
For preference shares, the dividend rate is set. Because it offers investors a fixed rate of income, it is
known as a fixed income security.
c.2 Cumulative dividends:

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Another benefit of preference shares is something called cumulative dividends. If the business has not
made a profit in any previous years, the dividend for future periods may be cumulative.
c.3 Redemption:
Preference Shares, with the exception of irredeemable preference shares, may be redeemed after a set
time period. The initial investment will be repaid over a set length of time.

c.4 Participation:
After the surplus profit has been distributed to the equity shareholders, holders of participatory
preference shares may take part in it.
c.5 Convertibility:
Convertibility preference shares can be converted into equity shares when the articles of association
provide such conversion.

d) Demerits of Preference Share Capital:

The demerits of preference share capital are as follows:
d.1 Expensive sources of finance:
Preference shares have high expensive source of finance while compared to equity shares.
d.2 No voting right:
Generally preference shareholders do not have any voting rights. Hence they cannot have the control over
the management of the company.
d.3 Fixed dividend only:
Preference shares can get only fixed rate of dividend. They may not enjoy more profits of the company.
d.4 Permanent burden:
Cumulative preference shares become a permanent burden so far as the payment of dividend is
concerned. Because the company must pay the dividend for the unprofitable periods also.
d.5 Taxation:
From a tax perspective, the dividend on preference shares is not a tax-deductible expense. However,
interest is a tax-deductible cost. As a result, from the perspective of a tax deduction, it is disadvantageous.

E.3.7.Other Funding Sources:

a) Depreciation Funds:

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The majority of internal sources of finance used to meet the working capital needs of the business concern
are depreciation funds. Depreciation is the term used to describe a loss in asset value brought on by
damage, ageing, obsolescence, exhaustion, and accidents.
Depreciation is typically adjusted annually at a preset rate against the company's fixed assets.
Depreciation is used to replace assets after their useful life has passed. It is a specific type of financial
provision that is required to lower the company's tax liability and increase overall profitability.

b) Short term Advance:

Commercial banks offer their clients advances with or without securities. It is one of the most popular and
commonly used short-term methods of financing, which is required to cover the company's working
capital needs.
In the form of a pledge, mortgage, hypothecation, and discounted and rediscounted bills, it is a cheap
source of financing.

c) Cash Credit:
In a cash credit agreement, a bank permits a customer to borrow money up to a predetermined level in
exchange for the security of a commodity.

d) Overdraft:
An agreement with a bank known as an overdraft allows a current account holder to withdraw more
money than is to his credit up to a certain limit without putting up any collateral.

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Q1 Choose the correct answer.
1. ___________ is called the lifeblood of any business.
a) Profit
b) Loss
c) Finance
d) Assets
2. The funds which are required to purchase land, building and furniture comes under:

a) Fixed capital requirement

b) Working capital requirement
c) Further capital requirement
d) Finance capital requirement
3. Preference shares and debentures comes under the category of:
a) Short term funds
b) External source of funds
c) Long term funds
d) Both B and C
4. Which of the following comes under the category of owner’s funds:
a) Equity shares
b) Retained earning
c) Both A and B
d) None of the above
5. Owner’s fund remain invested in the business for a_______duration:
a) Short
b) Very short
c) Long
d) None of the above
6. ________not required to be refunded during the lifetime of the business:
a) Owner’s fund
b) Borrowed funds
c) Both of these
d) None of these
7. Funds raised through loans or borrowings are called:
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 a) Owner’s fund
b) Borrowed funds
c) Both of these
d) None of these
8. Borrowed funds include which of the following
a) Retained earnings
b) Trade credit
c) Equity shares
d) None of these
9. The capital raised by issuing shares is called________:
a) Debentures
b) Public deposits
c) Share capital
d) Bank loans
10. The person holding the shares of the company are called as ________ of the company.
a) Shareholder
b) Debenture holders
c) Debtors
d) Creditors
11. The liability of equity shareholders is:
a) Unlimited
b) Limited
c) Partially unlimited
d) Partially limited
12. ________holders do not receive a fixed amount of dividend, whereas________holders receive a
fixed amount dividend:
a) Equity share; preference share
b) Preference share; equity share
c) Debenture; equity shares
d) Preference shares; debenture
13. Portion of net earnings retained in the business for future use:

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a) Retained earnings
b) Savings
c) Debentures
d) Assets
14. Debentures represent ______.
(a) Fixed capital of the company
(b) Permanent capital of the company
(c) Fluctuating capital of the company
(d) Loan capital of the company
15. Funds required for purchasing current assets is an example of ______.
(a) Fixed capital requirement
(b) Ploughing back of profits
(c) Working capital requirement
(d) Lease financing
16. Internal sources of capital are those that are _____.
(a) Generated through outsiders such as suppliers
(b) Generated through loans from commercial banks
(c) Generated through an issue of shares
(d) Generated within the business
17. Investor who want steady income may not prefer ______.
(a) Bonds
(b) Equity shares
(c) Debentures
(d) None of the above
18. Sources of finance can be classified as ______.
(a) Generation basis
(b) Period basis
(c) Ownership
(d) All of the above
19. Which of the following has fixed rate of interest?
(a) Equity share
(b) Preference share

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(c) Debenture
(d) All of the above
20. Convertible debenture can be converted into______.
(a) Equity share
(b) Partial equity and debenture
(c) Equity and preference share
(d) All of the above
Fill in the blanks
1. Dividend is only paid on _________.
2. __________ is the term used to describe a loss in asset value brought on by damage, ageing,
obsolescence, exhaustion, and accidents.
3. __________sources of finances are those that exist outside of an organisation.
4. _____________ is also know as “ploughing back of profit”
5. ___________is a credit line extended to a client or business; it must be repaid with interest.
6. Fixed deposit is a __________ source of finance.
7. The preference share that can be redeemed after a specific period of time is called ___________.
8. ______________ debentures are also known as bearer bonds/ debentures.
9. Preference shareholders have _______ voting rights.
10. Expense incurred to buy machine, land or building for business is called _________ expenditure.
Answer the following question in one or two sentences (2 Marks each)
1. What is voting right?
2. What is Cash Credit?
3. What is Retained Earnings?
4. What is Commercial Paper?
5. What is Depreciation fund?
6. State 4 short term source of finance.
7. What is Internal source of finance?
8. What is external source of finance?
9. State 4 long term source of funds.
10. What is overdraft?
Answer the following in brief (5 Marks each)
1. List down and explain the types of Debentures.

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 2. Classify and discuss in detail the sources of fund.
3. State and explain other sources of finance.
4. Classify and discuss the types of preference share capital.
5. What is long term financing need? Explain with example.
Answer in detail (10 Marks each)
1. Write a short note on Preference share capital.
2. What is debenture? Explain its merits and demerits.
3. Explain Merits and Demerits of Equity Share Capital.
4. Explain in detail Retained earnings.
5. Write a note on Commercial paper.
Answer Key:

1.c 2.a 3.d 4. c 5.c 6.a 7.b 8.b 9.c 10.a

11.b 12.a 13.a 14.d 15.c 16.d 17.b 18.d 19.c 20.d

Fill in the blanks

1. Shares
2. Depreciation
3. External
4. Retained earnings
5. Bank loan
6. Long term
7. Redeemable preference share
8. Unregistered Debentures
9. No
10. Capital

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 F. APPLICATIONS OF FUNDS
Introduction:
There is a wide array of investment options available to individuals and organizations, each with its own
characteristics, risk-return profiles, and purposes. Here are some of the most common types of
investments:

F.1.1 Investment Avenues

a) Stocks (Equities):
Stocks represent ownership in a company. When you buy a stock, you become a shareholder and have a
claim on the company's assets and earnings. Stocks offer the potential for capital appreciation and often
pay dividends.

b) Bonds (Fixed-Income Securities):

Bonds are debt instruments issued by governments, municipalities, or corporations. When you invest in
bonds, you are essentially lending money to the issuer in exchange for periodic interest payments and the
return of the principal amount at maturity.

c) Real Estate:
Real estate investments involve purchasing physical properties, such as residential or commercial real
estate, with the aim of generating rental income and capital appreciation. Real estate can be owned
directly or through real estate investment trusts (REITs).

d) Mutual Funds:
Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or
other securities. They are managed by professional portfolio managers and offer diversification and
professional management.

e) Exchange-Traded Funds (ETFs):

ETFs are similar to mutual funds but trade on stock exchanges like individual stocks. They track specific
indices or asset classes and offer liquidity and flexibility.

f) Certificates of Deposit (CDs):

CDs are time deposits offered by banks with fixed terms and interest rates. They are considered low-risk
investments and provide guaranteed returns if held until maturity.

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 g) Money Market Funds:
Money market funds invest in short-term, highly liquid securities like Treasury bills and commercial paper.
They offer safety and liquidity, making them suitable for preserving capital and short-term cash
management.

h) Commodities:
Commodities include physical goods like gold, oil, and agricultural products. Investors can buy
commodities directly or invest indirectly through commodity futures contracts or commodity-focused
funds.

i) Collectibles:
Some investors choose to invest in collectibles like art, antiques, rare coins, or vintage cars. These
investments can be highly specialized and illiquid.

j) Peer-to-Peer (P2P) Lending:

P2P lending platforms connect borrowers with individual or institutional lenders. Investors can earn
interest by lending money to individuals or small businesses.

k) Options and Derivatives:

Options and derivatives are financial contracts that derive their value from an underlying asset, such as
stocks or commodities. They are often used for hedging or speculative purposes.

l) Cryptocurrencies:
Digital currencies like Bitcoin and Ethereum have gained popularity as alternative investments. They are
highly speculative and volatile, with the potential for significant gains or losses.

m) Retirement Accounts:
Retirement accounts, such as 401(k)s and IRAs, offer tax advantages for long-term retirement savings.
They can hold various types of investments, including stocks, bonds, and mutual funds.

n) Startups and Private Equity:

Investing in startups or private companies through venture capital or private equity funds allows investors
to participate in early-stage growth opportunities.

o) Hedge Funds:
Hedge funds are investment vehicles that pool capital from accredited investors to employ various
strategies, including long/short equity, arbitrage, and distressed debt investing.

p) Savings Accounts:
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Traditional savings accounts offered by banks provide a safe place to store money and earn interest,
although the interest rates are typically lower than other investments.

q) Government Securities:
Investments in government securities, such as U.S. Treasuries, are considered low-risk and provide fixed
interest payments. They are often used for capital preservation.

r) Foreign Exchange (Forex):

Forex trading involves the exchange of one currency for another with the aim of profiting from currency
exchange rate fluctuations.

s) Peer-to-Peer Real Estate:

Platforms exist that allow individuals to invest in real estate projects or loans, often with lower minimum
investments than traditional real estate.

t) Education and Professional Development:

Investing in education and professional development, such as acquiring new skills or certifications, can
also be considered an investment in one's future earning potential.
It's important to note that each type of investment carries its own set of risks, rewards, and
considerations. Diversification, risk assessment, and alignment with financial goals are crucial factors to
consider when building an investment portfolio. Additionally, consulting with a financial advisor can help
individuals and organizations make informed investment decisions.

F.1.2 History of The Term "Fund"

The term "fund" has a long history, and its usage has evolved over time to encompass various financial
and investment-related meanings. Here is a brief history of the term "fund":
Etymology: The word "fund" has Latin origins. It comes from the Latin word "fundus," which means
"bottom" or "foundation." This root concept of something foundational or providing support laid the
groundwork for its financial usage.

a) Early Usage:
In the 17th century, the term "fund" began to be used in a financial context to refer to money or assets
set aside for a particular purpose. For example, governments and organizations established funds for
specific projects or initiatives, such as building infrastructure or supporting charities.

b) Mutual Funds:

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The modern concept of a mutual fund emerged in the 18th century. The Dutch merchant Adriaan van
Ketwich is often credited with launching the first recorded mutual fund in 1774. This fund allowed
investors to pool their money, which was then invested in various securities, and they shared in the profits
and losses.

c) Investment Funds:
As financial markets developed, investment funds became more prevalent in the 19th and early 20th
centuries. These funds were created to offer diversified investment opportunities to a broader range of
investors. Investment funds included open-end mutual funds and closed-end investment trusts.

d) Hedge Funds:
Hedge funds, a type of investment fund, began to gain prominence in the mid-20th century. They were
originally created to "hedge" against market downturns by using various strategies, including short selling
and derivatives trading. Hedge funds are known for their flexibility and alternative investment
approaches.

e) Exchange-Traded Funds (ETFs):

ETFs, a modern financial innovation, gained popularity in the late 20th century. ETFs are investment funds
that are traded on stock exchanges like individual stocks. They offer investors the opportunity to gain
exposure to a wide range of asset classes and investment strategies.

f) Venture Capital and Private Equity Funds:

In the world of venture capital and private equity, the term "fund" refers to pools of capital raised from
institutional and individual investors to invest in private companies. These funds play a crucial role in
financing startups and facilitating mergers and acquisitions.

g) Sovereign Wealth Funds:

Sovereign wealth funds, typically created by governments, manage large pools of capital derived from a
nation's reserves or income from commodities. These funds are often established to preserve and grow
wealth for future generations or to support a country's economic development.
Today, the term "fund" encompasses a wide range of financial instruments and vehicles, from traditional
mutual funds and ETFs to specialized funds like hedge funds, private equity funds, and sovereign wealth
funds. Funds have become a fundamental part of the global financial landscape, offering diverse
investment opportunities and serving various financial purposes.
In the world of finance and accounting, fixed assets represent a crucial component of a company's balance
sheet. These tangible assets play a significant role in the operations, growth, and financial stability of a
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business. In this chapter, we will explore the various applications of fixed assets and how they impact a
company's financial health and strategic decisions.

F.1.3. Concept of funds

The term ‘Funds’ has been defined in a number of ways. They are:
(A) In the Narrow sense: Here, the term ‘funds’ refer to cash only. Transactions that involve cash only are
taken. Cash Flow Statement is prepared, in this approach, where only cash receipts and disbursements
are included. It is a summary of cash transactions.
(B) In the Popular sense: ‘Funds’ refer to working capital, the excess of current assets over current
liabilities. Total resources of a business are invested in fixed assets and working capital, the later is partly
in the liquid form .This is the most popular form of ‘Statement of Changes in Financial Position’. Sources
and Application of Funds is prepared on this basis.
(C) In the Broader sense: The term ‘Funds’ refer to financial resources, in whatever form, they may exist.
Statement of Total Financial Resources is prepared as per this approach. This is a comprehensive
statement involving cash and non-cash transactions.
Transactions involving money, materials, machinery and others are included. When machinery or building
is purchased, in exchange of shares, it is not reported both in cash flow statement and Sources and
Application of Funds. However, this type of transaction involves financial resources and so finds place in
the Statement of Total Financial Resources.
All types of transactions involving financial resources are included in this statement. The working capital
concept of funds is the most popular one, as already stated, amongst the different ways of defining the
term ‘Funds’. In this chapter, when we discuss Sources and Application of funds, the term ‘funds’ refer to
working capital only.

F.1.4. Sources of fund

These are the sources through which funds come into the business of the firm.

a) Funds from operations:

Profits from business is the main source of funds. Profit does not mean the amount that is shown in the
profit and loss account. When profit and loss account is prepared, several operating and non-operating
expenses are debited. Similarly, operating and non-operating incomes are also credited. Non-operating
item is one, which is not connected with the conduct of the business such as loss on sale of assets;

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preliminary expenses written off and rent from building, not connected to the business. Adjustment is
necessary to arrive at the correct profit from business operations. To arrive at operating income, non-
operating expenses are to be added and nonoperating income is to be deducted from the amount of profit
shown in profit and loss account. Profit from operations is the source as funds are received into the
business.

b) Sale of Fixed Assets:

If any fixed asset such as land, building, plant and machinery is sold, the total sale proceeds are a source.
Sale of fixed assets increases the working capital. However, if one non-current asset (Fixed asset) is
exchanged for another non-current asset, it does not constitute inflow of funds, as there is no change in
working capital.

c) Issue of Shares and Debentures:

When shares and debentures are issued to be public and cash is received, the amount of cash received is
a source. The important point is if cash is received then only it is a source. In the following instances, it is
not to be treated as source:
(A) Issue of shares and debentures for consideration other than current assets
(B) Conversion of debentures and loans into shares
(C) Issue of bonus shares or making partly paid shares as fully paid shares out of the accumulated profits
The reason is simple. Such above instances do not increase the working capital.

d) Increase in Long-term Loans:

Long-term loans from financial institutions and banks are a source as the amount increases the availability
of funds.

e) Decrease in Working Capital:

If the working capital at the end of the period is decreased compared to the amount at the beginning of
the period, it is a source. This can happen due to reduction of current assets or increase of current
liabilities. If stock Rs.60,000 is reduced to Rs.40,000, working capital is decreased by Rs.20,000 and the
decrease is a source. Similarly, creditors may increase from Rs.10,000 to Rs. 15,000 and the effect is
reduction of working capital by Rs.5,000. Decrease of working capital is a source of funds.

f) Non-Trading Receipts:
Non-trading receipts like dividend and rent are also credited to profit and loss account. These items are
deducted from the net profit to arrive at profit from business operations. So, these items are to be shown,

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separately, in the Funds Flow Statement, as they are also sources of funds, not included in the funds from
operations.

F.1.5. IS DEPRECIATION A
SOURCE OF FUNDS?
Depreciation means decrease in the value of an asset due to wear and tear, passage of time, obsolescence,
exhaustion and accident. It is a part of capital cost of fixed asset spread over the life of the asset.
Depreciation is taken as an operating expense while arriving at true profits of a business. Depreciation is,
simply, a book entry to arrive at book profits. Depreciation is a non-cash item.
It is myth depreciation is a source. People misunderstand depreciation as a source as it is added to net
profits to calculate funds from operations. Funds (Working capital or cash) are provided by revenues, but
not by depreciation. Depreciation does not affect current assets or current liabilities. Preliminary expenses
and goodwill written off are also added to net profits as these transactions do not result in any outflow of
cash with them. The same treatment is extended to depreciation, while adding back to net profits to arrive
at funds from operations.
Depreciation is neither a direct source nor application of funds. To quality to be a source, depreciation
should increase quantum of working capital. This is not happening. As depreciation is not decreasing
working capital, it is also not an application of funds.
Another dimension is depreciation does not generate funds, but it saves funds. For example, if the firm
takes the assets on hire, it has to pay rent for them. Payment of rent is avoided by owning assets, which
would have otherwise gone in the outflow of funds. So, ownership of assets has only saved funds but not
generated any new funds.
Depreciation is not a direct source of funds. Then, is it an indirect source of funds? The answer is both YES
and NO. When it is an indirect source? If so, to what extent? These are the questions to be answered.
Depreciation can be taken as an indirect source of funds — in a limited sense. It depends upon
circumstances. If the firm is in profits, depreciation acts as a tax shield in helping the firm for reducing tax
liability. Income tax permits depreciation as an admissible expenditure to the extent it is provided as per
its rules. As a result, taxable profits are reduced and tax liability is reduced. So, to that extent, depreciation
is a source. In consequence, depreciation is a source to the extent tax liability is reduced. Due to
depreciation, profits available for distribution of dividend get reduced. But, more funds would be available
to the business for expansion. In these circumstances, depreciation is a source. But, when the firm is in

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loss, question of tax payment does not rise. In those circumstances, depreciation is not a source. It can be
said, with certainty, that depreciation is not a source of funds, directly. Depreciation is only an indirect
source to a limited extent, under certain circumstances.
The above point can be understood with a simple example:
Case I Case II
Income before depreciation 80,000 80,000
Depreciation provided (A) --- 20,000
Taxable income 80,000 60,000
Income Tax Rate, say 50% 40,000 30,000
Net income after tax (B) 40,000 30,000
Net flow of funds after tax (A+B) 40,000 50,000
In case of II, funds from operations are Rs.50,000 while they are only Rs.40,000 in case of I. In case of II,
depreciation is a source to the extent of Rs. 10,000 and these funds are, additionally, available to the firm
for future expansion.

F.1.6. APPLICATION OR USES OF FUNDS

a) Loss from Operations:
Result from trading operations may be a loss in a year. Such loss of funds in trading amounts to an
application or outflow of funds. Working capital would be the first casualty when the firm sustains loss.

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 b) Redemption of Preference Share Capital:
If preference shares are redeemed during a year, redemption decreases the funds and so it is an
application. Where redemption happens at premium or discount, the net amount (including premium or
after deducting discount) is the use. However, if preference shares are redeemed in exchange of some
type of shares or debentures, it does not constitute as outflow of funds as no fund is involved in the
transaction.

c) Repayment of loans or redemption of debentures:

Similar to redemption of preference shares, repayment of loan and redemption of debentures are also
uses.

d) Purchase of Fixed or non-current Asset:

Purchase of fixed assets such as machinery or building results in application of funds. However, purchase
of fixed assets in consideration of issue of shares, debentures or loans is not use as no funds are involved.

e) Payment of Dividend and Tax:

Payment of dividend (including interim dividend) and tax are applications. The important point is their
actual payment, and then only they become uses. Mere declaration of dividend and provision of tax are
not uses.

f) Any other non-trading payments:

Any other non-trading payments are also uses as they involve outgo of funds. Examples are loss of cash
or theft in business

F.2 Fixed Assets

Fixed assets, often referred to as property, plant, and equipment (PP&E), are long-term tangible assets
that a company acquires for the purpose of generating revenue and supporting its operations. These
assets typically have a useful life of more than one accounting period and are not intended for resale.
Examples of fixed assets include land, buildings, machinery, vehicles, and office equipment.

F.2.1 The Role of Fixed Assets in

Financial Statements
a) Balance Sheet

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Fixed assets are prominently featured on a company's balance sheet. They are recorded at their historical
cost (the initial purchase price plus any necessary costs to get them ready for use) and are subject to
depreciation or amortization to allocate their cost over their useful life. The balance sheet equation can
be represented as:
Assets = Liabilities + Equity Assets = Liabilities + Equity
Fixed assets contribute to the total asset value and have a direct impact on the owner's equity. A well-
managed fixed asset portfolio can enhance a company's financial standing.

b) Income Statement
While fixed assets do not directly affect the income statement, their depreciation or amortization
expenses do. These expenses reduce a company's net income, which in turn affects the retained earnings
portion of the equity section in the balance sheet. Proper accounting for depreciation or amortization is
essential for accurately assessing a company's profitability.

F.2.2 Applications of Fixed Assets

a) Operational Efficiency
Fixed assets are critical for a company's day-to-day operations. For instance, manufacturing companies
rely on machinery and equipment to produce goods efficiently. Retailers depend on store buildings to
showcase products to customers. Maintaining and upgrading these assets is essential to ensure smooth
operations and stay competitive in the market.

b) Strategic Decision-Making
Fixed assets can also influence strategic decisions. For instance, expanding by acquiring new facilities or
machinery can increase a company's production capacity and market reach. Conversely, disposing of
underutilized or outdated assets can free up capital for more strategic investments.

c) Valuation and Financing

Fixed assets contribute to a company's overall value, which can be crucial when seeking financing or selling
the business. Lenders and investors often evaluate the quality and condition of a company's fixed assets
to assess its creditworthiness or investment potential.

d) Tax Implications
Fixed assets can have significant tax implications. Governments often provide tax incentives or
depreciation deductions to encourage businesses to invest in assets. Properly managing fixed asset data
and depreciation schedules can help optimize tax planning and reduce a company's tax burden.
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 e) Risk Management
Effective management of fixed assets can mitigate various risks. For example, proper maintenance can
prevent accidents and equipment breakdowns. Insurance coverage is often tied to the valuation of fixed
assets, so accurate records are essential for risk management.
Let’s study the application of fixed assets in detail:

a) Operational Efficiency
a.1 Production and Manufacturing
Fixed assets play a central role in the production and manufacturing processes of many companies.
Machinery, equipment, and specialized tools are essential for producing goods efficiently and meeting
customer demand. For example, in an automobile manufacturing plant, assembly line equipment and
robotic machinery are critical fixed assets. These assets are essential for maintaining a competitive edge
by increasing production capacity, reducing production costs, and improving product quality.
b.2 Retail and Real Estate
In the retail industry, the fixed assets primarily include physical store locations and their associated
infrastructure. The location of retail stores can significantly impact foot traffic and sales. For instance, a
strategically located retail store in a high-traffic area can boost revenue. Fixed assets like store interiors,
shelves, and point-of-sale systems also contribute to the shopping experience and operational efficiency.
In real estate, fixed assets encompass land, buildings, and other property-related assets. For real estate
companies, these assets are not only sources of rental income but also appreciating assets. Proper
maintenance and management of these assets are crucial for maximizing rental income and ensuring that
properties retain their value over time.
c.3 Information Technology
In today's digital age, information technology (IT) infrastructure is a vital category of fixed assets.
Computers, servers, data centers, and networking equipment are integral to the functioning of
businesses, especially those in the tech sector. Ensuring the reliability and scalability of IT assets is
essential for maintaining business continuity and supporting growth.

b) Strategic Decision-Making
b.1 Expansion and Growth
Fixed assets often play a pivotal role in a company's growth strategy. When a business plans to expand, it
may acquire additional fixed assets such as new facilities, machinery, or vehicles to support increased

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production or reach new markets. Expansion through the acquisition of fixed assets can help a company
capture market share, diversify its product offerings, or enter new geographic regions.
b.2 Cost Reduction and Efficiency Improvement
Companies frequently invest in fixed assets to streamline their operations and reduce long-term costs.
For example, upgrading to more energy-efficient manufacturing equipment can lower utility bills and
reduce the environmental footprint. Similarly, investing in automated systems can reduce labor costs and
increase production efficiency.
b.3 Asset Optimization
Proper management of fixed assets includes optimizing their usage. This involves assessing whether assets
are being used to their full potential or if there are underutilized resources. Asset optimization may lead
to decisions such as redistributing assets to higher-demand areas or divesting assets that are no longer
contributing to the company's objectives.

c) Valuation and Financing

c.1 Asset-Backed Financing
Fixed assets can serve as collateral for loans and financing. Lenders often consider the value and condition
of fixed assets when extending credit. Asset-backed financing can include options like secured loans or
sale-leaseback arrangements, where a company sells its fixed assets to a lender and leases them back,
providing an immediate infusion of capital.
c.2 Mergers and Acquisitions
When companies engage in mergers and acquisitions (M&A) activities, fixed assets can be a significant
point of interest. Acquiring companies assess the value and condition of the target company's fixed assets
as part of the due diligence process. Accurate valuation of fixed assets is essential for determining the
purchase price and negotiating the terms of the deal.
c.3 Investor Relations
Investors and stakeholders often review a company's fixed asset portfolio as part of their analysis. They
look at the company's investment in long-term assets to gauge its growth prospects and financial stability.
Companies with well-maintained and strategically managed fixed assets are more likely to attract
investors and maintain a positive reputation in the financial markets.

d) Tax Implications
d.1 Depreciation for Tax Purposes
Depreciation, which represents the allocation of a fixed asset's cost over its useful life, has significant tax
implications. Tax codes often allow businesses to deduct depreciation expenses from their taxable
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income, reducing their tax liability. Properly managing depreciation schedules can help businesses
optimize their tax planning and cash flow.
d.2 Tax Credits and Incentives
Governments may offer tax credits and incentives to encourage businesses to invest in certain fixed assets
that promote economic growth or environmental sustainability. These incentives can range from tax
breaks for renewable energy investments to deductions for purchasing energy-efficient equipment.
Businesses need to stay informed about these opportunities to reduce their tax burden.

e) Risk Management
e.1 Asset Maintenance and Safety
Effective risk management involves maintaining fixed assets to ensure they operate safely and efficiently.
Poorly maintained assets can lead to accidents, production downtime, and increased repair costs. Regular
inspections, preventive maintenance programs, and employee training are essential components of asset
risk management.
e.2 Insurance Coverage
The value and condition of fixed assets are crucial factors in determining insurance coverage and
premiums. Adequate insurance coverage can protect a company from financial losses resulting from asset
damage, theft, or other unforeseen events. Accurate asset valuation ensures that the insurance coverage
is appropriate and cost-effective.

F.2.3. Conclusion
In summary, fixed assets are integral to nearly every aspect of a business, from daily operations to
strategic planning, financial management, and risk mitigation. Recognizing the multifaceted applications
of fixed assets and managing them effectively is essential for achieving long-term success, optimizing
financial performance, and adapting to changing market conditions. Companies that prioritize the
acquisition, maintenance, and strategic utilization of fixed assets are better positioned to thrive in a
competitive business environment.

F.3 Application of Stocks

Stocks, also known as equities, represent ownership in a company and are traded on stock exchanges
worldwide. Investing in stocks is a common way for individuals and institutions to allocate funds. In this
chapter, we will delve into the intricate details of the application of funds in stocks, including various
aspects of stock investing, strategies, and the broader implications.

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 F.3.1 Understanding Stocks
a) Types of Stocks
a.1 Common Stocks:
Common stocks are the most prevalent type of equity ownership. When you hold common stock, you
have voting rights in the company and are entitled to a share of its profits through dividends, if the
company chooses to distribute them. Common stockholders also have the potential for capital
appreciation if the stock's value increases over time.
a.2 Preferred Stocks:
Preferred stocks are another form of equity ownership but differ from common stocks in several ways.
Preferred stockholders typically do not have voting rights in the company but have a higher claim on the
company's assets and dividends. They receive dividends before common stockholders and may have other
preferences, such as cumulative dividends.

F.3.2 Stock Market Exchanges

Stocks are traded on various stock market exchanges, such as the New York Stock Exchange (NYSE) and
the Nasdaq. These exchanges provide a platform for buying and selling stocks, and each exchange may
have its own listing requirements and regulations.

F.3.3 Reasons for Investing in Stocks

a) Capital Appreciation
One of the primary reasons individuals invest in stocks is the potential for capital appreciation. As
companies grow and become more profitable, the value of their stocks can increase. Investors aim to buy
stocks at a lower price and sell them at a higher price, thus realizing a capital gain.

b) Dividend Income
Many investors seek dividend income from their stock investments. Companies that generate profits
often distribute a portion of those profits to shareholders in the form of dividends. Dividend income can
provide a steady stream of cash flow, making it attractive to income-focused investors, such as retirees.

c) Diversification
Stocks offer investors a means of diversifying their investment portfolios. Diversification involves
spreading investments across different asset classes and industries to reduce risk. By holding a mix of
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stocks from various sectors, investors can mitigate the impact of poor performance in any single stock or
industry.

d) Hedge against Inflation

Stocks have historically been considered a hedge against inflation. Unlike fixed-income investments, such
as bonds, which may lose purchasing power during periods of inflation, stocks have the potential to
appreciate in value and outpace inflation.

e) Long-Term Wealth Building

Investing in stocks with a long-term perspective can lead to wealth accumulation. Compound growth,
where earnings are reinvested, can significantly increase the value of an investment over time. Stocks are
well-suited for investors with a horizon of several years or more.

f) Active Trading
Some investors use stocks for active trading, buying and selling stocks frequently to capitalize on short-
term price movements. Traders use various strategies, including technical analysis and momentum
trading, to make short-term gains.

g) Passive Investing:
Passive investors use stocks as part of a long-term, buy-and-hold strategy. They often invest in index funds
or exchange-traded funds (ETFs) that track market indices, allowing them to gain exposure to a broad
market or specific sector without actively managing individual stocks.

h) Ownership of Blue-Chip Stocks:

Blue-chip stocks are shares in well-established, reputable, and financially stable companies. Investors
often hold blue-chip stocks as a safe and reliable investment, providing stability and potential dividends.

i) Strategic Investing:
Some investors buy stocks strategically to gain influence or control in a company. They may purchase a
significant number of shares to have a say in corporate governance or advocate for specific changes in the
company's direction.

j) Asset Allocation:
Institutional investors, such as pension funds and mutual funds, use stocks as part of their asset allocation
strategy. They allocate a portion of their portfolios to stocks to achieve specific investment goals and
balance risk and return.

k) Tax Benefits:
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Stocks may offer tax benefits, such as long-term capital gains tax rates, which are often lower than
ordinary income tax rates. Tax-efficient investment strategies can help investors minimize their tax
liability.

l) Liquidity:
Stocks are generally considered liquid assets because they can be bought and sold on stock exchanges.
This liquidity allows investors to easily convert their holdings into cash when needed.

m) Financial Planning:
Individuals and financial advisors use stocks as part of their financial planning and retirement strategies.
Investing in stocks can help individuals build wealth over time and achieve their long-term financial goals.

In summary, stocks serve various purposes, including wealth creation, income generation, risk
management, and strategic investments. The specific use of stocks depends on the investor's financial
objectives, risk tolerance, and investment strategy.

F.3.4 Strategies for Stock Investing

a) Fundamental Analysis
Fundamental analysis involves evaluating a company's financial health and prospects. Investors examine
financial statements, assess factors like revenue growth, profitability, and debt levels, and consider
competitive positioning to determine whether a stock is a sound investment. They may also analyze a
company's management team and its industry.

b) Technical Analysis
Technical analysis relies on historical price and trading volume data to identify trends and patterns.
Technical analysts use charts, indicators, and statistical tools to make predictions about future stock price
movements. This approach is primarily focused on market psychology and short-term trading.

c) Value Investing
Value investors seek stocks that are trading at a discount to their intrinsic value. They look for companies
with strong fundamentals but undervalued stocks. Value investing often involves a longer investment
horizon, as it may take time for the market to recognize the true value of a stock.

d) Growth Investing

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Growth investors focus on companies with high growth potential. They are willing to invest in stocks with
higher valuations in the hope that future growth will justify the price. Growth investing often requires
patience and a tolerance for volatility.

F.3.5 Implications of Stock Investing

a) Risk
Stock investing carries inherent risks. Stock prices can be volatile and subject to market sentiment and
economic conditions. Investors may experience losses, especially in the short term. Risk management and
diversification are essential strategies to mitigate these risks.

b) Liquidity
Stocks are generally considered liquid assets because they can be bought and sold on stock exchanges.
However, the liquidity of specific stocks can vary, and investors should consider the ease of trading when
building their portfolios.

c) Taxes
Stock investments can have tax implications. Capital gains on stocks may be subject to capital gains tax
when sold, and dividend income may be taxed at different rates depending on the country's tax laws. Tax-
efficient investing strategies can help investors minimize their tax liability.

d) Research and Due Diligence

Successful stock investing requires thorough research and due diligence. Investors should stay informed
about the companies they invest in, monitor market trends, and make informed decisions based on their
investment goals and risk tolerance.

F.3.6 Conclusion
Investing in stocks offers a range of opportunities, from capital appreciation to dividend income and long-
term wealth building. However, it is not without risks, and investors should approach stock investing with
careful consideration, a long-term perspective, and a well-thought-out strategy. Understanding the
reasons for investing in stocks, adopting suitable investment strategies, and staying informed about
market conditions are key to making informed investment decisions in the stock market. Stock investing
can be a powerful tool for building wealth when approached prudently and as part of a diversified
investment portfolio.

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 F.4 Trade receivables
Trade receivables, often referred to as accounts receivable, are a crucial component of a company's
working capital and balance sheet. They represent the amounts owed to a company by its customers or
clients for goods or services that have been delivered but not yet paid for. Understanding trade
receivables is essential for managing a company's cash flow, assessing its liquidity, and evaluating its
financial health.

F.4.1 Key Concept:

a) Recognition and Recording:
Trade receivables are recognized on a company's balance sheet when revenue is recognized, typically
when goods are delivered or services are performed.
Companies record trade receivables as assets because they represent the right to receive cash in the
future.

b) Types of Transactions:
Trade receivables arise from credit sales, where a company extends credit terms to its customers. This
allows customers to pay for products or services at a later date, usually within a specified credit period.

c) Significance for Cash Flow:

Trade receivables have a direct impact on a company's cash flow. As customers make payments, cash is
collected, which can be used to fund operations, repay debt, or invest in the business.

d) Valuation and Impairment:

Companies need to assess the collectability of trade receivables and may need to make provisions for bad
debts or impairment. This ensures that receivables are stated at their net realizable value, reflecting the
portion expected to be collected.

e) Aging Analysis:
Companies often conduct aging analyses of trade receivables to categorize them based on the length of
time they have been outstanding. This helps identify accounts that may be at risk of becoming
uncollectible.

f) Managing Credit Risk:

Managing credit risk is crucial in trade receivables management. Companies establish credit policies,
monitor customer creditworthiness, and may use credit insurance to protect against potential losses.
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 g) Collections and Accounts Receivable Turnover:
The speed at which a company collects its receivables is an important metric. Accounts receivable
turnover measures how many times, on average, a company collects its accounts receivable during a
specific period.

h) Financial Ratios and Analysis:

Trade receivables are often analyzed in conjunction with other financial metrics to assess a company's
financial health and liquidity. For example, the accounts receivable turnover ratio and the days sales
outstanding (DSO) are used for this purpose.

i) Disclosure in Financial Statements:

Companies are required to disclose information about trade receivables in their financial statements. This
includes the amount of receivables, any allowances for bad debts, and any significant concentrations of
credit risk.

j) Impact on Working Capital:

Trade receivables are considered a component of current assets and have a direct impact on a company's
working capital. Managing receivables effectively can help optimize working capital and ensure that the
company has sufficient liquidity.
In summary, trade receivables are a critical aspect of a company's financial operations. Effectively
managing trade receivables is essential for maintaining cash flow, minimizing credit risk, and ensuring the
financial stability and sustainability of a business. Proper valuation, monitoring, and collection efforts are
key components of trade receivables management.
Trade receivables, often referred to as accounts receivable, are a critical component of a company's
balance sheet and represent amounts owed by customers for goods or services that have been delivered
but not yet paid for. These receivables are a form of short-term assets and are considered a valuable
resource for a business. Let's explore trade receivables in more detail:

F.4.2 Definition and Nature

of Trade Receivables:
Definition: Trade receivables are amounts owed to a company by its customers or clients as a result of
credit sales. These amounts are typically expected to be collected within a short period, usually within
one year.

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Nature: Trade receivables arise from the company's primary revenue-generating activities, such as selling
products or providing services to customers on credit terms. They represent the company's claims or
rights to receive cash in the future.

F.4.3 Importance of Trade Receivables:

a) Working Capital:
Trade receivables are a vital component of a company's working capital. They represent funds that the
company expects to receive in the near future, which can be used to cover operational expenses, invest
in growth, or pay off short-term debts.

b) Revenue Generation:
Trade receivables often result from credit sales, which can boost a company's sales revenue and market
competitiveness by providing customers with flexibility in payment terms.

c) Recording Trade Receivables:

Initial Recording: When a company makes a credit sale, it records the transaction by debiting accounts
receivable (increasing the receivables) and crediting sales revenue.
Subsequent Adjustments: Over time, the company may need to adjust the amount of trade receivables
due to factors like bad debts (uncollectible accounts), customer returns, or discounts offered for early
payment.

F.4.4. Managing Trade Receivables:

a) Credit Policies:
Companies establish credit policies to assess the creditworthiness of customers before extending credit.
This includes evaluating credit histories, financial statements, and payment histories.

b) Credit Terms:
Clear credit terms, including payment due dates and interest rates for late payments, are communicated
to customers to ensure prompt payment.

c) Accounts Receivable Aging:

Companies often maintain an accounts receivable aging schedule that categorizes receivables by the
length of time they have been outstanding. This helps identify overdue accounts for follow-up and
collection efforts.

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 F.4.5. Risks Associated with Trade Receivables:
a) Bad Debts:
The risk of customers defaulting on payments can result in bad debts. Companies must estimate and
account for potential bad debts through allowances for doubtful accounts.

b) Liquidity Risk:
Relying too heavily on trade receivables can tie up cash that might be needed for other purposes.
Managing liquidity risk involves ensuring a balance between receivables and cash flow.

F.4.6. Reporting Trade Receivables:

a) Balance Sheet:
Trade receivables are reported as a current asset on the balance sheet under "Accounts Receivable" or a
similar heading. The balance represents the total amount owed to the company by customers.

b) Notes to Financial Statements:

Companies often provide additional information about trade receivables in the notes to their financial
statements, including the accounting policies used, any allowances for doubtful accounts, and significant
changes in receivables.

F.4.7. Analysis and Decision-Making:

a) Investors:
When analyzing a company's financial health, investors may examine the trend in trade receivables to
assess sales and collection efficiency. Rapidly increasing receivables might indicate strong sales growth
but also potential liquidity issues if collections lag.

b) Creditors:
Lenders and creditors evaluate trade receivables to assess a company's ability to meet its short-term
obligations and evaluate its creditworthiness.

F.4.8 Conclusion
In conclusion, trade receivables play a crucial role in a company's financial operations. Managing them
effectively is essential for maintaining healthy cash flow, ensuring revenue generation, and minimizing

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risks associated with credit sales. Proper accounting and reporting of trade receivables are essential for
transparency and financial decision-making.

F.5 Application of Funds Kept as Cash or in Banks

Funds held as cash or deposited in banks are a fundamental component of financial management for
individuals, businesses, and institutions. In this chapter, we will explore the various applications of funds
kept as cash or in bank accounts, highlighting their importance, strategies for optimizing their use, and
the implications of these decisions.

F.5.1 Understanding Cash and Bank Accounts

a) Cash on Hand
Cash on hand refers to physical currency and coins held by individuals or entities. It is the most liquid form
of money and is readily available for day-to-day transactions.

b) Bank Accounts
Bank accounts, on the other hand, involve depositing funds with financial institutions. These accounts
include:
b.1 Checking Accounts:
Designed for everyday transactions, checking accounts allow account holders to write checks, make
electronic payments, and access funds through ATM withdrawals.

b.2 Savings Accounts:

Savings accounts are typically used for holding funds that are not needed for immediate expenses. They
may offer interest on deposits, helping to grow the balance over time.
b.3 Certificates of Deposit (CDs):
CDs are time-bound savings instruments with fixed interest rates. They require account holders to commit
funds for a specified period, and in return, they earn higher interest rates than regular savings accounts.
b.4 Money Market Accounts (MMAs):
MMAs are interest-bearing accounts that combine elements of savings and checking accounts. They offer
higher interest rates than regular savings accounts and typically allow limited check writing.

F.5.2 Importance of Cash and Bank Funds

a) Liquidity
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Cash and bank funds provide liquidity, ensuring that individuals and entities can cover their immediate
financial needs and emergencies.

b) Transactional Convenience
Having funds in bank accounts offers transactional convenience, allowing individuals and businesses to
make payments, receive funds, and manage financial affairs efficiently.

c) Safety
Bank deposits are often insured up to a certain limit by government agencies, providing a level of security
for funds against theft, loss, or bank insolvency.

d) Earning Interest
Bank accounts, especially savings accounts and CDs, can earn interest income, allowing funds to grow over
time.

F.5.3 Strategies for Managing Cash

and Bank Funds
a) Cash Flow Management
Individuals and businesses use cash flow management strategies to ensure they have sufficient funds for
daily expenses, bills, and savings goals.

b) Emergency Funds
Maintaining an emergency fund in a highly liquid account provides a financial safety net for unexpected
expenses, such as medical bills or car repairs.

c) Investment Opportunities
Savvy investors use excess cash to explore investment opportunities, including stocks, bonds, real estate,
or starting a new business venture.

d) Debt Management
Funds in bank accounts can be used to pay down high-interest debts, reducing interest expenses over
time. Using excess cash to pay down high-interest debt can be a wise financial move. Reducing debt not
only saves on interest expenses but also improves financial health.

e) Capital Allocation

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Companies should carefully allocate excess cash for various purposes, such as research and development,
acquisitions, debt repayment, or returning value to shareholders through dividends or stock buybacks.

F.5.4 Implications of Cash and

Bank Funds Management
a) Opportunity Cost
Leaving excessive funds in low-interest savings accounts or as cash on hand may result in missed
investment opportunities and a lower return on investment.

b) Inflation
Failure to invest or earn interest on funds can lead to a decrease in purchasing power over time,
particularly when inflation outpaces interest rates.

c) Risk
Cash on hand is vulnerable to theft, and while bank deposits are generally insured, large uninsured
balances may be at risk in the event of a bank's financial troubles.

F.5.5 Reporting and

Financial Decision-Making
a) Financial Statements
Cash and bank balances are typically reported on financial statements. For individuals, this may be part
of personal financial statements, while businesses include this information in their balance sheets.

b) Budgeting
Individuals and businesses use budgets to plan and allocate funds effectively. Monitoring cash flow and
bank account balances is crucial for adhering to budgetary goals.

c) Investment Decisions
Investment decisions are influenced by the availability of funds in bank accounts. Investors must decide
whether to maintain liquidity, invest in financial markets, or allocate funds to various investment vehicles.

F.5.6 Reasons for Maintaining

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 Cash and Bank Balances
a) Liquidity Management
The primary reason for holding cash and bank balances is liquidity management. These funds serve as a
financial buffer to cover day-to-day expenses, unexpected emergencies, and short-term financial needs.
Adequate liquidity is essential to maintain financial stability and flexibility.

b) Working Capital Management

In the business context, cash and bank balances are vital for managing working capital. They ensure that
a company can meet its short-term obligations, such as paying suppliers, employees, and utility bills.
Proper working capital management prevents liquidity crises and helps a business operate smoothly.

c) Investment Opportunities
While cash and bank balances are highly liquid, they can also be strategically invested to earn a return.
Companies and individuals may consider short-term investment options such as money market funds or
Treasury bills to earn interest on idle funds while maintaining easy access to cash.

d) Financial Stability
Maintaining adequate cash reserves is essential for financial stability. It helps protect against unforeseen
events like economic downturns, unexpected expenses, or disruptions in cash flows. Having cash on hand
provides a safety net during challenging times.

F.5.6 Conclusion
The application of funds kept as cash or in bank accounts is essential for achieving financial goals,
managing daily expenses, and preparing for the future. The strategies employed to manage these funds
should align with financial objectives, balancing liquidity, safety, and return on investment. Moreover,
understanding the implications of cash and bank fund management is crucial for making informed
financial decisions and optimizing financial well-being.

F.5.7 Investment Options

for Excess Funds

a) Money Market Funds

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Money market funds invest in short-term, highly liquid securities. They offer competitive interest rates
and are considered a safe place to park excess cash.

b) Treasury Bills (T-Bills)

Treasury bills are government securities with short maturities, typically ranging from a few days to one
year. They are virtually risk-free and offer a fixed interest rate.

c) Certificates of Deposit (CDs)

CDs provide higher interest rates than regular savings accounts. They have fixed terms, ranging from a
few months to several years, and penalties for early withdrawals.

d) Short-Term Bonds
Investing in short-term corporate or municipal bonds can provide a slightly higher yield than traditional
savings accounts while still maintaining a degree of liquidity.

F.6 Application of Funds from Investments

Investing funds is a fundamental aspect of financial planning and wealth management. When funds are
invested, they are allocated to various assets or investment vehicles with the aim of generating returns
and achieving specific financial objectives. In this chapter, we will explore the application of funds that
have been invested, including investment strategies, asset allocation, risk management, and the broader
implications of investing.

F.6.1 Understanding Investment

a) Purpose of Investments
● Investing serves several purposes, including:
● Wealth Accumulation:
Investing can help individuals and organizations grow their wealth over time by generating returns
on invested capital.
● Income Generation:
Some investments, like dividend-paying stocks or bonds, provide a regular stream of income.
● Financial Goals:
Investments are often aligned with specific financial goals, such as retirement planning, buying a
home, funding education, or achieving financial independence.

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 F.6.2 Types of Investments
Investments can take various forms, including:

a) Stocks:
Ownership shares in companies, offering the potential for capital appreciation and dividends.

b) Bonds:
Debt securities issued by governments or corporations, providing regular interest payments and return of
principal at maturity.

c) Real Estate:
Investment in physical properties, such as residential or commercial real estate, with the potential for
rental income and property appreciation.

d) Mutual Funds:
Pooled investment vehicles that allow investors to diversify their holdings across various assets, managed
by professional portfolio managers.

e) Exchange-Traded Funds (ETFs):

Funds that trade on stock exchanges and typically track specific indices, offering diversification and
liquidity.

F.6.3 Investment Strategies

a) Risk Tolerance
Investment strategies should align with an individual's or organization's risk tolerance. Risk tolerance
reflects one's ability and willingness to endure market fluctuations and potential losses. Conservative
investors may prioritize capital preservation, while aggressive investors may seek higher returns but are
willing to tolerate higher volatility.

b) Asset Allocation
Asset allocation involves distributing investments across different asset classes, such as stocks, bonds,
real estate, and cash. The goal is to create a diversified portfolio that balances risk and return. The specific
allocation depends on an investor's goals, time horizon, and risk tolerance.

c) Investment Time Horizon

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Investors should consider their investment time horizon when developing strategies. Longer time horizons
may allow for greater exposure to growth assets like stocks, while shorter horizons may necessitate a
more conservative approach to preserve capital.

d) Active vs. Passive Investing

Active investing involves selecting individual securities or actively managed funds with the aim of
outperforming the market. Passive investing, on the other hand, involves investing in index funds or ETFs
that seek to replicate the performance of a specific market index. Both approaches have their merits, and
the choice depends on an investor's preferences.

F.6.4 Risk Management

a) Diversification
Diversification is a key risk management strategy. Spreading investments across different assets and asset
classes can reduce the impact of poor performance in any single investment. It helps mitigate the risk
associated with individual securities or sectors.

b) Risk Assessment
Investors should assess and understand the specific risks associated with their investments. These risks
may include market risk, credit risk, liquidity risk, geopolitical risk, and more. Understanding these risks
allows investors to make informed decisions and implement risk mitigation strategies.

c) Risk Tolerance Reassessment

Risk tolerance is not static; it can change over time due to changes in financial circumstances, goals, or
life events. Periodically reassessing risk tolerance ensures that investment strategies remain aligned with
an individual's or organization's evolving needs.

F.6.5 Implications of Investments

a) Tax Considerations
Investments can have tax implications. Capital gains on investments may be subject to capital gains tax,
and income from investments may be taxed differently based on the type of income and jurisdiction. Tax-
efficient investment strategies can help minimize tax liabilities.

b) Liquidity Needs

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Investors must balance the need for liquidity with the benefits of long-term investments. While long-term
investments may offer higher returns, they may not be readily accessible in emergencies. Having an
emergency fund or maintaining some liquid assets can address short-term liquidity needs.

c) Financial Planning
Investments are integral to financial planning. Investors should regularly review their investment
portfolios, assess progress toward financial goals, and adjust strategies as needed. Proper planning
ensures that investments continue to serve their intended purposes.

F.6.6 Conclusion
The application of funds through investments is a strategic and dynamic process that plays a vital role in
achieving financial objectives. It requires careful consideration of goals, risk tolerance, asset allocation,
and ongoing monitoring and adjustment. Effective investment strategies can help individuals and
organizations build wealth, generate income, and secure their financial future while managing and
mitigating risks.

F.7 Fund Flow Statement

F.7.1 Utility Of Funds Flow Statement
To Different Parties
The versatile utility of Funds Flow Statement to different parties can be summarised as follows:

a) Management:
The historical Funds Flow Statement (Statements of the earlier years) provides the information how the
funds were available and their use in the past. They provide the means to understand why the targets of
the earlier years were not achieved. That would be useful information to avoid recurrence, in future.
Funds Flow Statements can be prepared for future too. Planning can be more effective with their help.
They provide the necessary hints to the management whether it is necessary for them to review and
recast their plans, in a more realistic way, in case the future inflows are not adequate to meet the
anticipated outflows.

b) Financial Institutions:
Commercial banks require them to assess the working capital needs of the firm. Term-lending institutions
want to satisfy the repayment capacity of the firm. Funds Flow Statement provides the information how
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the firm used the funds, earlier. Instances of diversion of sanctioned working capital for acquisition of
fixed assets, contrary to the terms of sanction, would be known. The lenders would know firm’s style of
functioning. The borrowings may be secured by the assets, but the financial institutions want to satisfy
with the financial integrity of the borrower too. Financial institutions would know the ways the funds were
used, earlier, and future ways of use to judge their repaying ability.

c) Debenture holders:
Debenture holders too are long-term creditors of the firm. Their stake is similar to financial institutions.
They would get back their money after several years, dependant on the maturity period of the debentures.
Debenture holders look for redemption and projected Funds— Flow Statement shows the position of
availability of funds when the debentures fall due for repayment. To continue to hold the debentures till
such time or not, Funds Flow Statement is useful for them to take a suitable decision.

d) Trade Creditors:
They are the suppliers of goods and services and look for short-term liquidity for payment. Liquidity of the
firm and operating profits assure the repayment schedule. Statement of Working Capital Position
indicates how far the firm is liquid to meet the promised payment schedule to review their credit policy.

e) Shareholders:
Shareholders are basically interested about the financial position of the firm and their future investment
plans that generate operating profits. This holds well to the existing as well as potential shareholders.
Future investment plans and the operating profits that are likely to generate would be known from the
Funds Flow Statement.

F.7.2 Procedure for knowing whether a

transaction finds a place in

funds flow statement

1. Make out the journal entry and find out the accounts involved.

2. Decide whether the accounts concerned are current (concerned with current assets and current
liabilities) or non-current (concerned with non-current assets and non-current liabilities).

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3. If both the accounts involved are current i.e. either current assets or current liabilities, it does not result
in the flow of funds.

4. If both the accounts are non-current, i.e. either permanent assets or permanent liabilities, the
transaction still does not result in the flow of funds.

5. If one of the accounts is concerned with current and the other is non-current, the transaction results in
flow of funds. For the transaction to appear in Funds Flow Statement, it is necessary only one of the
accounts should be concerned with current assets or current liabilities.

Examples:

Impact of Opening Stock/Closing Stock on Funds:

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Opening stock appears on the debit side of the Profit and Loss Account. Opening stock reduces profit so
it is an application. Closing stock appears on the credit side of the profit and loss account and also appears
on the assets side of the balance sheet. Profit is a source. Due to closing stock, profit increases. So, closing
stock is a source. More so, working capital increases due to its inclusion in the current assets. This is also
another argument why closing stock is a source.

F.7.3. Preparation of funds flow statement

To prepare Funds Flow Statement, first identify transactions relating to funds, as explained above. Two
additional statements are required to be prepared. They are Statement of Changes in Working Capital and
Statement of Funds from Operations. All the information may not be readily available, always. Hidden
information has to be found out. The entire process of preparation of Funds Flow Statement can be
summarised, as under:

(A) Statement of Changes in Working Capital

(B) Calculation of Funds from Operations

(C) Finding out hidden information, if required

(D) Preparation of Funds Flow Statement

a) Statement of Changes in Working Capital

Working capital is the excess of current assets over current liabilities. Every current asset at the end of
the year is to be compared with the amount at the beginning of the year to find out the increase or
decrease of working capital. Increase or decrease of working capital is to be recorded in the relevant
column. The same procedure is to be repeated in respect of all current liabilities.
All other information is not relevant for preparation of Statement of Changes in Working Capital.
Working capital = Current Assets – Current Liabilities

Illustration 1: Prepare a Statement of Changes in Working Capital from the following Balance Sheets of
THEER & Co, Bhopal.

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Solution:
Statement of Changes in Working Capital

* Note: Out of the total Loan amount Rs. 40,000, only Rs.25,000 is repayable during the year 2007. Only
Rs. 25,000 is current liability, as it becomes payable within one year and so working capital is affected to
that extent only.
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 b) Calculation of Funds from Operations
The net profit seen in the Profit and Loss Account need not necessarily be the funds from operations.
Certain adjustments are to be made to get Funds from Operations.
Follow the steps as under:
1. Take the net profit figure in Profit and Loss Account as the BASE.
2. Depreciation:
Add back depreciation to the net profit, debited in the Profit and Loss Account, as it does not involve
outflow of funds. Depreciation is an expense to be taken into account to arrive at accounting profit, but
this has no relevance for calculation of funds from operations.
3. Intangible Assets written off:
Add back expenses like preliminary expenses, discount on issue of shares and debentures, goodwill
written off. These are intangible assets written off to arrive at profit but does not involve outflow of funds.
4. Incomes not related to Operations or Business:
These are the incomes that are not related to operations but considered in Profit and Loss Account to
arrive at net profit. These incomes – profit on sale of assets, income from investments and rent from
buildings, not connected to business – are to be deducted from net profits.
5. Non-operating Expenses:
Similarly, non-operating expenses like loss on sale of assets, loss on theft debited to Profit and Loss
Account are to be added back to net profit to arrive at Funds from Operations.
The intention of the exercise is to find out funds from operations. Instead of net profit, net loss may
appear in Profit and Loss Account. Simply, follow a reverse procedure to arrive at funds from operations
in case of loss shown in Profit and Loss Account.
Income Statement or Profit and Loss Account is not given:
If Income Statement or Profit and Loss Account is not given, information on net profit or loss may be,
indirectly, given. Increase in General Reserve and Profit and Loss Account, balances appearing between
opening and closing balance sheets, has to be taken as net profit i. e. increase in retained earnings.
Suitable adjustments are to be made for the dividend paid and issue of bonus shares, capitalising profits.
Funds from operations can be calculated by preparing Profit and Loss Adjustment Account.
Funds Flow Statement can be prepared in two types:
1. Report Form
2. T Form or Account Form or Self-Balancing Type.
Illustration No. 2
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From the following information extracted from the Balance Sheets of Theer & Tarkh Ltd. Calculate Funds
from Operations:

Bonus shares have been issued for Rs.20,000 during 2005-06 capitalising profits from Profit and Loss
Account. It is observed in the Profit and Loss Account that an income from sale of machinery Rs.6,000 has
been received.
Solution:
(Rs.)
Profit and Loss Account (as on 31st March, 2006) 1,00,000
+ Increase in share capital (Bonus issue)
Transferring from Profit and Loss A/c 20,000
+ Transfer to General Reserve 5,000
+ Provision for Depreciation 3,000
+ Goodwill written off 5,000
+ Preliminary Expenses written off 1,000
+ Patents written off 2,000
- Income from sale of machinery 6,000
1,30,000
- Balance in Profit and Loss Account 40,000
(As on 31st March, 2005)
Funds from Operations 90,000
The funds from operations can be found out in an alternative way by preparing Profit and Loss Adjustment
Account.

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 c) Finding out hidden information
While preparing the Funds Flow Statement, one has to analyse the Balance Sheets given. At the end of
balance sheets, certain information may be given as notes that give clues for the hidden information. The
hidden information may relate to provision and payment of tax, purchase/ sale of assets and issue/
redemption of shares and debentures.
1. Provision for Taxation: There are two ways of dealing with provision for Taxation.
(i) As a current liability
(ii) As an appropriation of profits
(i) As a Current Liability:
Provision for tax may be treated as current liability as tax, generally, is an immediate obligation of the
firm to pay to the Government. It is preferable to treat ‘Provision of tax’ as current liability as such
treatment is simple as nothing, further, is to be done. This approach is recommended for students if the
problem does not stipulate any specific treatment. When it is treated as current liability, provision for
taxation will appear in the Schedule of Changes in Working Capital like other current liabilities. No
further treatment is needed in respect of payment of tax and provision of tax made during the year.
There is no need to prepare provision for taxation account. In this case, payment of tax shall not be
shown as an application of funds. Provision for tax made during the year is not to be added back to the
profits to arrive at funds from operations. The simple rule is to treat provision for tax as current liability
and forget further treatment about this matter.
Illustration No.3
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The opening balance in the Provision for Taxation Account as on 1st January 2005 was Rs. 40,000 and
the closing balance as on 31st December 2005 was Rs. 50,000. The taxes paid during the year amounted
to Rs. 35,000. Show the treatment of the item in the Funds Flow Statement:
(i) As Current Liability
(ii) As Appropriation of Profit
Solution:
(i) When provision for taxation is treated as Current liability
Provision for taxation is treated as current liability and is shown in the schedule of changes in working
capital. No further effect on the Funds Flow Statement:

(ii) As Appropriation of Profit:

1. This item will not be shown in the Schedule of Changes in Working Capital.
2. Taxes paid during the year Rs. 35,000 is an Application of Funds and will appear on the application
side of Funds Flow Statement.

3. Provision for taxation made during the year Rs. 45,000 is calculated as below. This amount will be
added back to net profit for finding Funds from Operations.

OR

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Note: It is suggested to students to adopt ‘Prepare Account’ approach to find out the hidden information
so that double entry concept can be applied, conveniently. More so, account preparation leaves no
confusion about adding or subtracting the figures.

Practical Sums:
1. Prepare Statement Showing Changes in Working Capital and Source & Application of Funds from the
following information:

The following information was obtained:

(i) In 2006, a dividend of Rs. 84,000 was paid.
(ii) Assets of another firm were purchased at Rs. 1,00,000, payable in 10,000 shares of Rs. 10 each. The
assets included stock Rs. 10,000; fixed assets Rs. 30,000; and goodwill Rs. 60,000.
(iii) Income tax paid in 2006 was Rs. 10,000.
(iv) Net profit in 2006 was Rs. 28,000.
Solution:
Schedule of Changes In Working Capital (Rs.)

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Basics of Finance Management Page 220 of 242
Note:
Balance in Profit and Loss Account at the end of 31st March, 2005 is Rs. 84,000. The amount is totally paid
as dividend, hence shown as Application. There is no balance left out for the previous year’s profit. Net
Profit for the year 2006 is Rs.28,000 , which is the balance in the Profit and Loss Account at the end of
March, 2006.
*This represents the total value of shares acquired in consideration of stock Rs. 10,000 included the
current assets shown in Schedule of Changes in Working Capital and non-current assets acquired shown
as application
2. From the following balance sheets of Beta Limited, make out (i) Statement of changes in Working
capital and (ii) Funds Flow Statement:

Notes:
1. A piece of land has been sold out in the year 2002 and profits on sales have been carried to capital
Reserve.
2. A machine has been sold for Rs.10,000. The written down value of the machine was Rs.12,000.
Depreciation of Rs.10,000 is charged on plant account in the year 2002.
3. The investments are trade investments. Rs. 3,000 by way of dividend is received including Rs.1,000
from pre-acquisition of profit, which had been credited to investments account.
4. An interim dividend of Rs.20,000 has been paid in the year 2002.
Solution:

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Basics of Finance Management Page 222 of 242
Note:
1. Dividend received on Trade Investments is Rs.3,000. Out of Rs.3,000, only Rs.1,000 has been credited
to Trade Investments Account. The balance amount Rs.2,000 has been credited to Profit and Loss Account.
This is the interpretation of the problem. Many think Rs. 3,000 totally has been credited to Trade
Investments Account. But, this is not so. Many a time, students’ loose full marks, as answer would be
different for incorrect interpretation.
2. The second part is reasoning for crediting part of dividend to Trade Investments Account. When trade
investment is purchased on the basis of ‘cum dividend’, pre-acquisition dividend, subsequently received,
is to be credited to Investment Account, as investment should appear at cost only.
3. Dividend received on investments (Fixed assets, non-current assets) is not operating income and so it
is to be shown in Profit and Loss Adjustment account for calculating funds from operations. In other
words, dividend is not part of normal business income.
4. Proposed Dividend has not been treated as current liability. It has been treated as appropriation of
profit for better presentation. Interim dividend has been shown in application as the amount has been
paid during the year. Another alternative way is to show Proposed dividend as current liability. In that
event, both proposed and interim dividends are not to be shown as application

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3. In the following Balance Sheet, a part of machinery costing Rs.20,000 has been revalued at Rs.30,000
and transferred to Profit and Loss Account. Show the necessary accounts.

Solution:

4. You are given the Balance Sheets of Sandhya & Co. as at the end of 2005 and 2006 as under:

Equity shares were issued, at par, for redemption of debentures. A dividend of 10% on share capital, at
the end of the year, was paid.
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A plant purchased for Rs. 4,000 (Depreciation Rs. 2,000) was sold for cash for Rs. 800 during the year.
An item of furniture was purchased for Rs. 2,000. These were the only transactions concerning fixed
assets during 2006.
Treat Provision for Tax as non-current liability.
Solution:

The increase in Working capital in Schedule of Changes in Working Capital is confirmed with the increase
in working capital in Funds Flow Statement.
Note:
Shares for Rs. 20,000 were issued at par for redemption of debentures and this transaction does not find
a place in Funds Flow Statement and Schedule of Changes in Working Capita as both the items are non-
current.
Working:

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5. The following relevant information has been extracted from the following Balance Sheets:

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Additional Information:
1. Equity shares were issued during the year for purchase of Building for Rs.2,50,000.
2. 9% Preference Share Capital value Rs. 1,75,000 was redeemed during the year.
Prepare necessary accounts to find out Source/Application of Funds.
Solution:

1. Issue of Equity Shares against purchase of Building Rs. 2,50,000 is neither a source nor application of
funds. Issue of shares for Rs. 1,50,000 is a source.
2. Redemption of Preference Shares Rs. 1,75,000 is an application of funds.
3. Issue of Preference Shares Rs. 3,25,000 is a source of funds.
6. The following information has been taken from the Balance Sheet of Tarkh & Company, Indore.

The following additional information is also available:

(i) A machine costing Rs. 15,000 was purchased during the year by issue of equity shares.
(ii) On January 1st 2005, a machine costing Rs. 25,000 (with an accumulated depreciation of Rs. 10,000)
was sold for Rs. 22,000.
Find out sources/application of funds.
Solution:

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1. Purchase of Machinery for Rs.15,000 by issue of equity shares is neither a source nor an application of
funds.
2. Sale of Machinery Rs. 22,000 is a source of funds.
3. Funds from Operations Rs. 43,000 are a source of Funds.
4. Purchase of machinery by cash Rs. 1,80,000 is an Application of funds
7. The comparative Balance Sheets Kalyan & Kishore Ltd are indicated in a condensed form as under:

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Additional information:
1. The net profit for the year 2005-06 (after providing depreciation Rs. 40,000, writing off preliminary
expenses of Rs. 7,200 and making provision for tax Rs.32,000 ) amounted to Rs.58,000.
2. The company sold during the year, an old machinery costing Rs. 9,000 for Rs. 3,000. The accumulated
depreciation on the said machinery was Rs. 8,000.
3. A portion of company’s investments became worthless and was written off to General Reserve during
the year. The cost of such investment was Rs. 50,000.
4. During the year, the company paid an interim dividend of Rs. 10,000 and the directors have
recommended final dividend of Rs. 15,000 for the current year.
Treat proposed dividend as non-current liability and prepare the Schedule of Change in Working Capital
and the Funds Flow Statement.
Solution:

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Basics of Finance Management Page 230 of 242
Note:
1. Profit and Loss Adjustment Account has been prepared to show that interim dividend and proposed
dividend for the year 2006 have been appropriated.
2. The balance in the profit and loss account at the end of 2006 is after payment of interim dividend and
provision for proposed dividend for the year 2006. To confirm that the closing balance in the Profit and
Loss Account is after payment of interim dividend, Profit and Loss Adjustment Account is prepared and
the adjustments have been incorporated. So, no adjustment is needed for them, except showing them in
the application.
8. From the following Balance Sheets as on 31st March, 2005 and 31st March, 2006, prepare a Schedule
of Changes in the Working Capital and Funds Flow Statement in T Form (Account Form or Self-Balancing
Type) taking:
(i) the provision for tax and proposed dividend as current liabilities and
(ii) the provision for tax and proposed dividend as non-current liabilities

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Additional information:
1. Tax paid during 2006 Rs.2,500
2. Dividends paid during 2006 Rs.1,000
Solution:
(i) When provision for tax and proposed dividends are taken as current liabilities

(ii) When provision for tax and proposed dividends are taken as non-current liabilities:

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9. The opening balance in the Provision for Taxation Account as on 1st January 2005 was Rs. 40,000 and
the closing balance as on 31st December 2005 was Rs. 50,000. The taxes paid during the year amounted
to Rs. 35,000. Show the treatment of the item in the Funds Flow Statement:
(i) As Current Liability
(ii) As Appropriation of Profit

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Solution:
(i) When provision for taxation is treated as Current liability
Provision for taxation is treated as current liability and is shown in the schedule of changes in working
capital. No further effect on the Funds Flow Statement:

(ii) As Appropriation of Profit:

1. This item will not be shown in the Schedule of Changes in Working Capital.
2. Taxes paid during the year Rs. 35,000 is an Application of Funds and will appear on the application side
of Funds Flow Statement.

3. Provision for taxation made during the year Rs. 45,000 is calculated as below. This amount will be added
back to net profit for finding Funds from Operations.

OR

Note:

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It is suggested to students to adopt ‘Prepare Account’ approach to find out the hidden information so that
double entry concept can be applied, conveniently. More so, account preparation leaves no confusion
about adding or subtracting the figures

F.7.4 Difference Between Income Statement,

Balance Sheet And Funds Flow Statements
Funds flow statement is not a substitute of an income statement i.e. a profit and loss account and a
balance sheet. Their purposes are different. Funds flow statement is not competitive but complementary
to these financial statements.

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 F.7.5 Limitations Of Funds Flow Statement
Funds Flow Statement is an important tool for analysis and serves several useful purposes. However, its
limitations cannot be ignored and they are:
1. It is not an original statement. It is only a rearrangement of data taken from the financial statements
(Profit and Loss Account and Balance Sheet).
2. It is based on the financial statements and so the limitations of financial statement are equally
applicable to them.
3. It is essentially historic in nature and projected statement cannot be prepared with much accuracy.
4. Funds Flow Statement is not a substitute for basic financial statements like profit and loss account and
balance sheet. At best, it can be a supplementary statement to explain the changes in working capital.
Despite the above limitations, Funds Flow Statement serves the basic purpose of explaining the causes
for changes in the financial position of the firm between two periods
Q1 Choose the correct answer.
10. Which of these is not an investment avenue?
e) stocks

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 f) bonds
g) management
h) real estate
11. Money Market funds does not offer_______
a) liquidity
b) short term
c) safety
d) long term
12. _____________ shareholders does not have voting rights
a) Preference
b) Equity
c) debenture
d) Bank loan
13. Which of the following are sources of funds for an organisation?
a) Conversion of debenture into equity
b) Conversion of bank loan into equity
c) issue of shares against purchase of fixed assets
d) None of the above
14. Owner’s fund remain invested in the business for a_______duration:
a) Short
b) Very short
c) Long
d) None of the above
15. Reason for investing in stocks
a) capital appreciation
b) dividend income
c) diversification
d) all the above
16. __________ analysis involves evaluating a company's financial health and prospects.
a) Charts
b) technical

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 c) fundamental
d) None of these
17. Technical analysis relies on ……………..
a) Historical price
b) trading volume
c) charts
d) all of these
18. The capital raised by issuing shares is called________:
a) Debentures
b) Public deposits
c) Share capital
d) Bank loans
10. …………….. investors seek stocks that are trading at a discount to their intrinsic value
a) speculator
b) trader
c) value
d) hedge investor
11. ____________ are amounts owed to a company by its customers or clients as a result of credit
sales.
a) loan
b) trade receivable
c) trade payable
d) debtors
12. which of these are importance of trade receivables?
a) working capital
b) revenue generation
c) recording of transactions
d) all of these
13. factors that are managed for effective trade receivable
a) credit policy
b) credit period

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 c) account receivable aging
d) All of the above
14. _________ refers to physical currency and coins held by individuals or entities
(a) cash on hand
(b) bank balance
(c) shares
(d) loan
15.__________ is the most liquid form of money and is readily available for day-to-day transactions.
(a) bank balance
(b) bank over draft
(c) Cash Balance
(d) loan
16. reasons for maintaining cash and bank funds
(a) liquidity
(b) transactional convenience
(c) financial stability
(d) all the above
17. Investment option for excess funds
(a) money market funds
(b) treasury bills
(c) certificate deposits
(d) all the above
18. purpose of investment is _______
(a) wealth accumulation
(b) income generation
(c) attain financial goals
(d) All of the above
19. Which of the following is investment strategies
(a) risk tolerance
(b) asset allocation
(c) investment time horizon
(d) All of the above

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20. Investment in physical properties, such as residential or commercial is called as _______
(a) Equity share
(b) Real estate
(c) bonds
(d) debentures
Fill in the blanks
1. Assets = Liabilities + __________.
2. ________ shareholders have voting rights.
3. ________________involves selecting individual securities or actively managed funds with the aim
of outperforming the market
4. _________involves investing in index funds or ETFs that seek to replicate the performance of a
specific market index.
5. ______________ means spreading investments across different assets and asset classes can
reduce the impact of poor performance in any single investment
6. _________ have fixed terms, ranging from a few months to several years, and penalties for early
withdrawals.
7. Maintaining adequate _________is essential for financial stability.
8. The primary reason for holding cash and bank balances is ________management.
9. Trade receivables are reported as a current asset on the ________ side in balance sheet.
10. Companies establish ________to assess the creditworthiness of customers before extending
credit
Answer the following question in one or two sentences (2 Marks each)
1) What is fixed assets?
2) What is trade receivables?
3) What is trade payables?
4) What is application of fund?
5) What is risk associated with trade receivable?
6) State the purpose of investment.
7) State the types of investment.
8) Explain the risk management of investment.
9) What is treasury bills?
10) What is CDs (Certificate of Deposits)?

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Answer the following in brief (5 Marks each)
1) List down the strategies of stock investing.
2) Strategies for managing cash or bank balance.
3) Explain the strategies for investment.
4) Explain the reasons for maintaining cash and bank balances.
5) Explain the strategies for stock investing.
Answer in detail (10 Marks each)
1) Write application of fixed assets.
2) Write application of stocks
3) Explain application of funds kept as cash or bank.
4) Explain application of funds kept as stock
5) Explain application of funds kept as investment
Answer Key:

1.c 2.d 3.a 4. d 5.c 6.d 7.c 8.d 9.c 10.c

11.b 12.d 13.d 14.a 15.c 16.d 17.d 18.d 19.d 20.b

Fill in the blanks

1. Equity
2. equity
3. Active investing
4. Passive investing
5. Diversification
6. Certificate of Deposits
7. Cash Reserve
8. liquidity
9. asset
10. credit policies

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Bibliography:
https://www.financestrategists.com/accounting/management-accounting/capital-budgeting-important-
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