SNDT Women’s University

Centre for Distance Education

Mumbai - 400 049

Master of Commerce Part I

(New Course w.e.f. 2021-22)

Semester - I

Course Title: Management of Finance

Course Code: 110051

Course Writers

Dr. Sunita Sharma, Dr. Ram Sable, Dr. G. Y. Shitole, Mr. Mukesh Kanojia

Mr. Ashok Mahadik, Mr. Subhash Ranshoor, Ms. Jyoti Thakur

1
 Centre for Distance Education
SNDT Women’s University
Vice Chancellor

Prof. Ujwala Chakradeo

Director

Dr. Smriti Bhosle

Co-ordinator – Course Material Writing

Ms. Neeta Kadam
(Asst. Professor)

Editor
Dr. G. Y. Shitole, Dr. Suryakant Lasune

@Centre for Distance Education, S.N.D.T Women’s University.

All rights reserved. No part of this work may be reproduced in any other means without
writtenpermission from Centre for Distance Education, S.N.D.T Women’s University.
Publishing year 2021.
Disclaimer:
Views expressed in the study material are of the individual authors.
The Center for Distance Education, SNDT Women’s University may or may not agree with the
same.
Printed by: Chintan Graphics, Ghatkopar (East), Mumbai

2
 Syllabus
Management of Finance
Module Topic Weightage
(%)
1. Financial Management – Meaning, nature and scope of 25
finance; financial goals: profit maximization, wealth
maximization; finance functions,- investment, financing and
dividend decisions, Organization of finance function: Role of
finance manager. Financial Mathematics: Concept &
relevance of time value of money, Application of the concept
of time value of money. Capital Structure: Factors
Determining Capital Structure, Capital Structure Theories
(Net Income, Net Operating Income, Traditional, and M.M
hypotheses) , Arbitrage Process Determining capital
structure in practice.
2. Financing decisions - Meaning and significance of cost of 25
capital – Calculation of cost of capital (debt, preference
capital, equity capital and retained earnings) – Combined
cost of capital (weighted) – Cost of equity and CAPM
(Including practical problems). Operating and Financial
Leverage – Measurement of leverage - Effects of operating
and financial leverage on profit – Analyzing alternate
financial plans – Combined / Composite Leverage [Including
practical problems]
3. Investment Decision: Nature and significance of investment 25
decisions, process; Project classification; Investment
evaluation criteria; Non-discounting criteria: Pay-back,
Accounting Rate of Return (Traditional method); Discounting
criteria: Internal Rate of Return, Net Present Value,
Profitability Index, NPV and IRR comparison, Capital
Rationing.
4. Working Capital And Dividend DecisionWorking Capital 25
Management: Meaning, need, determinants; estimation of
working capital need; management of cash; inventory &
receivables; Dividend Decision: Factors determining
Dividend Policy, Form of Dividends, Stability of Dividends,
Dividend models-Walter, Gordon & M.M. models.
Evaluation/ Assessment for all Modules:
• For English, each course will have 25% Internal Evaluation (i.e. assignments,
projects, seminar- papers, presentations, reports on field visits etc.) and 75%
External Evaluation.
• Minimum 40% marks are required in Internal and External assessment
• Separately for passing in each Course.
• Student needs to clear internal assessment to be eligible to appear for Semester
end(external) examination

3
Module 1

4
 Unit 1

Concept of Financial Management: Meaning & Scope

Table of Contents

1.0 Objectives:......................................................................................................................

1.1 Importance of Finance: .....................................................................................................

1.2 Meaning of Business Finance: ............................................................................................

1.3 Meaning of Financial Management: .....................................................................................

1.4 Objectives of Financial Management: ..................................................................................

1.5 Scope of Financial Management: ........................................................................................

1.6 Summary: .......................................................................................................................

1.7 Exercises: .......................................................................................................................

1.8 References: .....................................................................................................................

1.0 Objectives
At the end of this unit, you will be able to…
 Define the term financial management
 State what are the objectives of financial management
 Describe the scope and coverage of financial management
 Explain the three broad decision areas of a finance manager.

1.1 Importance of Finance

In the modern money-oriented economy, finance is regarded as the life blood of a
business enterprise. It is the master key which provides access to all the sources for
being employed in manufacturing and merchandizing activities. The business needs
money to make more money. However money begets more money, only when it is
properly managed. Hence, efficient management of every business enterprise is closely
linked with efficient management of its finances.

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1.2 Meaning of Business Finance
In general, finance may be defined as the provision of money at the time it is wanted.
However as a management function it has a special meaning. Finance function may be
defined as the procurement of funds and their effective utilization. Business finance can
broadly be defined as the activity concerned with planning, raising, controlling and
administering of the funds used in the business.

1.3 Meaning of Financial Management

Financial management is that managerial activity which is concerned with the planning
and controlling of the firm‟s financial resources. As a separate activity, it is of recent
origin. It was a branch of economics till 1890. Still today, it has no unique body of
knowledge of its own, and it draws heavily on economics for its theoretical concepts. The
management makes use of various financial techniques, devices, etc.., for administering
the financial affairs of the firm in the most effective and efficient way. Financial
management, therefore, means the entire gamut of managerial efforts devoted to the
management of finance- both its sources and uses- of the enterprise.

According to Soloman, “Financial management is concerned with the efficient use of

important economic resources, namely capital funds.”

Phillipatus has given a more elaborate definition of the term financial management.
According to him “Financial management is concerned with the managerial decisions that
result in the acquisition and financing of long-term and short-term credits for the firm. As
such it deals with the situations that require selection of specific assets (or combination
of assets), the selection of specific liability (or combination of liabilities) as well as the
problem of size and growth of an enterprise. The analysis of these decisions is based on
the expected inflows and outflows of funds and their effects upon managerial objectives.

Thus, financial management is mainly concerned with the proper management of funds.
The finance manager must see that the funds are procured in a manner that the risk,
cost and control considerations are properly balanced in a given situation and there is
optimum utilization of funds.

1.4 Objectives of Financial Management

Basic Objectives
 Traditionally, the basic objectives of financial management are the maintenance of
liquid assets and maximization of the profitability of the firm.
 Maintenance of liquid assets means that the firm has adequate cash in hand to
meet its obligations at all times.

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A business firm is a profit-seeking organization. Hence, profit maximization is all well
considered to be an important objective of financial management. However, the concept
of profit maximization has come under severe criticism in recent times on account of the
following reasons:

 It is vague:
It does not clarify what exactly does it mean. For example, which profits are to be
maximized, short-run or long-run, rate of profit or the amount of profit?

 It ignores timings:
The concept of profit maximization does not help in making a choice between projects
giving different benefits spread over a period of time. The fact that a rupee received
today is more valuable than a rupee received later, is ignored.

 It overlooks quality aspects of future activities:

The business is not solely run with the objective of earning highest possible profits. Some
firms place a high value on the growth of sales. They are willing to accept lower profits to
gain stability provided by a large volume of sales. Other firms use a part of their profits
to make contribution of socially productive purposes. Moreover, profit maximization at
the cost of social and moral obligations is a short-sighted policy even as a pragmatic
approach.

On account of the above reasons, these days profit maximization is not considered to be
an ideal criterion for making investment and financing decisions. Professor Ezra Soloman
has suggested that adoption of wealth maximization is the best criterion for the financial
decision making. He has described the concept of wealth maximization as follows:

“The gross present worth of a course of action is equal to the capitalized value of the flow
of future expected benefits, discounted (or capitalized) at the rate which reflects their
certainty or uncertainty. Wealth or net present worth is the difference between gross
present worth and the amount of capital investment required to achieve the benefits. Any
financial action which creates wealth or which has a net present worth above zero is a
desirable one and should be rejected. Any financial action which does not meet this test
should be rejected. If two or more desirable courses of action are mutually exclusive
(i.e., if only one can be undertaken), then the decision should be to do that which creates
most wealth or shows the greatest amount of net present worth. In short, the operating
objective for financial management is to maximize wealth or the present worth. Wealth
maximization is, therefore, considered to be the main objective of financial management.
This objective is also consistent with the objective of maximizing the economic welfare of
the shareholders of a company. The value of a company‟s shares depends largely on its
networth which itself depends on earning per share (EPS). The financial manager should,

7
therefore, follow a policy which increases the earning per share in the long run. This will
automatically lead to maximization of value of the shares of the company.

 Other Objectives:
Beside the above basic objectives, the following are the other objectives of financial
management:
o Ensuring a fair return to shareholders.
o Building up reserves for growth and expansion.
o Ensuring maximum operational efficiency by efficient and effective utilization of
finances.
o Ensuring financial discipline in the organization.

Q. 1 Fill in the blanks:

1. is the life blood of a business enterprise. (owner, staff, finance)
2. Maintenance of assets means that the firm has adequate cash in hand
to meet its obligations at all times (fixed liquid, tangible).
3. is the difference between gross present worth and the amount of capital
investment (wealth, profit, expenditure).
4. maximization is considered to be the main objective of financial
management (profit, social security, wealth).

1) Liquid 2) wealth 3) Wealth

1.5 Scope of Financial Management

Financial management as an academic discipline has undergone significant changes over
years as regards its scope and coverage. As such the role of finance manger has also
undergone fundamental changes over the years. In order to have a better exposition to
these changes, an attempt, in the following paragraphs has been made to explain both
the traditional approach and the modern approach to the finance function.

 Traditional Approach
The traditional approach, which was popular in the early part of this century, limited the
role of financial management to raising and administering of funds needed by the

8
corporate enterprises to meet their financial needs. It broadly covered the following of
these aspects:
o Arrangement of funds from financial institutions.
o Arrangement of funds through financial instruments, viz..shares, bonds, etc.
o Looking after the legal and accounting relationship between a corporation and its
sources of funds.

Thus, the traditional concept of financial management included within its scope the whole
gamut of raising the funds externally. The finance manager had also a limited role to
perform. He was expected to keep accurate financial records, prepare reports on the
corporation‟s status and performance and manage cash in a way that the corporation is
in a position to pay its bills in time. The terms “Corporation Finance” was used in place of
the present term “Financial Management‟.

The traditional approach found its first manifestation, though not very systematic, in
1897 in the book Corporation Finance written by Thomas Greene. It was given further
impetus by Edward Meade in 1910 in his book, Corporation Finance. However, it was
sanctified firmly by Arthur Dewing in 1919 in his book The Financial Policy of
Corporations. The book dominated the academics works in the field of corporation finance
for nearly three decades.

The traditional approach evolved during 1920 continued to dominate academic thinking
during the forties and through the early fifties. However, in the later fifties it started to
be severely criticized and later abandoned on account of the following reasons:

 Outsider –looking-in approach:

The approach equated finance function with the raising and administering of funds. It,
thus treated the subject of finance from the viewpoint of suppliers of funds, i.e.
outsiders, bankers, investors, etc. It followed an outsider-looking-in approach and not
the insider-looking-out approach since it completely ignored the viewpoint of those who
had to take internal financing decisions.

 Ignored routine problems:

The approach gave undue emphasis to episodic or infrequent happenings in the life of an
enterprise. The subject of financial management was mainly confined to the financial
problems arising during the course of incorporation, mergers, consolidations and
reorganization of corporate enterprise. As a result the subject did not give any
importance to day-to-day financial problems of business undertakings.

 Ignored non-corporate enterprises:

The approach focused attention only on the financial problems of corporate enterprises.
Non corporate industrial organizations remained outside its scope.

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  Ignored working capital financing:

The approach laid overemphasis on the problems of long term financing. The problems
relating to financing short-term or working capital were ignored.

 No emphasis on allocation of funds:

The approach confined financial management to issues involving procurement of funds. It

did not emphasize on allocation of funds. It ignored the following central issues of
financial management:
o Should an enterprise commit capital funds to certain purposes?
o Do the expected returns meet financial standards of performance?
o How should these standards be set and what is the cost of capital funds to the
enterprises?
o How does the cost vary with the mixture of financing methods used?
Traditional approach failed to provide answer to these questions. The modern approach,
as explained below, does provide answer to these questions.

 Modern Approach:

The traditional approach outlived its utility due to change business situations since mid-
1950. Technological improvements, widened marketing operations, development of a
strong corporate structure, keen and healthy business competition- all made it
imperative for the management to make optimum use of available financial resources for
continued survival.

The advent of computer in sixties made large quantum of information available to the
financial manager, based on which he could make sound decisions. Computers helped in
application of powerful techniques of operations research. The scope of financial
management increased with the introduction of capital budgeting techniques. As a result
of new methods and techniques, capital investments projects led to a framework for
efficient allocation of capital within the firm also. During the next two decades various
pricing models, valuation models and investment portfolio theories also developed.

Efficient allocation of capital on suitable criterion became an important area of study

under Financial Management. Eighties witnessed an era of high inflation. This caused the
interest rates to rise dramatically. Thus, raising loan on suitable terms also became
specialized art and more important became the aspect of efficient utilization of these
scarce funds. In the new volatile environment capital investment and financing decisions
became more risky than ever before. These environmental changes enlarged the scope of
finance. The concept of managing a firm as a system emerged. External factors now no
longer could be evaluated in isolation. Decision to arrange funds was to be seen to
consonance with their efficient and effective use. This total approach to study of finance
is being termed as Financial Management.

10
Thus, according to modern concept, financial management is concerned with both
acquisitions of funds as well as their allocation. The new approach views the financial
management in a broader sense. In this sense, the central issue of financial policy is the
wise use of funds and the central process involved is a rational matching of advantages
of potential uses against the cost of alternative potential uses so as to achieve the broad
financial goals which an enterprise sets for itself.

The modern approach is an analytical way of looking at the financial problems of a firm.
The main contents of the new approach are as follows:
o What specific assets should an enterprise acquire?
o What is the total volume of funds an enterprise should commit?
o How should the funds required be financed?

The above questions relate to three broad decision areas of financial management, viz.,
investment decision, financing decision and dividend decision. These decisions, which can
also be termed as functions, outline the scope of financial management.

Q.1 Explain the traditional approach v/s. modern approach to the finance function.

Q.1 Say True or False. If false give the correct answer:

1. Capital budgeting is the financial decision making with reference to short term
assets.
2. Capital budgeting decisions relate only to the purchase of new assets.
3. Working capital management decision is a trade-off between profitability and risk
(liquidity).

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 1. False, Working Capital management is the financial decision making with reference
to short term assets.

2. False, Capital budgeting decisions relate to financial decisions making with

reference to long term assets which can either be new or old / existing ones.
3. True

Q.1 Fill in the blanks:

1. refers to the preparation of debt and equity capital (working capital,
current assets, capital structure).
2. is what proportion of net profits is paid to the shareholders. (retained
earnings, dividend payout ratio, reserves.)

1) Capital Structure 2) Dividend Payout Ratio

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1.6 Summary

So friends let‟s sum up what we have discussed till now

 Finance function may be defined as the procurement of funds and their effective
utilization.
 The role of finance manager has undergone fundamental changes over the years,
which can be explain with reference to traditional approach and the modern
approach to the finance function.
 The traditional approach limited the role of financial management to raising and
administering of funds needed by the corporate enterprises.
 According to modern concept, financial management is concerned with both
acquisition of funds, as well as their allocation.
 The financial management in the modern sense can be broken into three major
decisions. (i) The investment decision, (ii) The financing decision and (iii) The
dividend policy decision.
 Investment decision relates to the selection of assets in which funds will be
invested by a firm.
 The financing decision of a firm relates to the choice of the proportion of debt and
equity, to finance the investment requirements.
 The dividend decision is the decision as to what proportion of net profits should be
paid out to the shareholders.
 A finance manager takes the above three decisions in the light of objective of
maximization of shareholders wealth. This requires a tradeoff between risk and
return.
 A particular combination of risk and return where both are optimized is known as
Risk-Return Tradeoff.

1.7 Exercise

Q1.Explain the meaning of financial management. What are its objectives?

Q2.“Financial management has undergone significant changes over years, as
regards its scope”. Explain.
Q3.What are the basic financial decisions? How do they involve risk-return trade-
off?

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1.8 References

Chandra, Prassana. “Financial Management: Theory and Practice”, Tata McGraw-

Hill Publishing Co. Ltd.

Kucchal, S.C. “Financial M nagement:

a An Analytical & Conceptual Approach”,
Chaitanya Publishing House.

Maheshwari, S.N. “Fundame ntal of Financial Management”, Sultanchand & Sons.

Pandey, I.M. “Financial Management”, Vikas Publishing House Pvt. Ltd.

Rustagi, R.P. “Financial Management: Theory, Concepts and Problems”, Galgoita

Publishing Co.

Symonds, Curtis W. and Jain P.K. “Basic Financial Management”, D.B. Tarporevala
Sons & Co. Pvt. Ltd.

14
 Unit 2

Capital Structure Theories

Table of Contents

2.0 Objectives:..........................................................................................................................

2.1 Introduction: .......................................................................................................................

2.2 Capital Structure Theories: ....................................................................................................

2.2.1 Assumptions: ................................................................................................................

2.2.2 Notations Used: .............................................................................................................

2.3 Net Income Approach-Capital Structure Matters:......................................................................

2.4 Net Operating Income Approach: Capital Structure Does Not Matter:..........................................

2.5 Traditional Approach: A Practical View Point: ...........................................................................

2.7 Summary: ...........................................................................................................................

2.8 Exercise: .............................................................................................................................

2.9 Reference: ..........................................................................................................................

2.0 Objectives
At the end of this unit, you will be able to…

 Explain the concept of the value of the firm.

 Explain the Net Income Approach.
 Explain the Net Operating Income Approach.
 Justify the Traditional Approach as a practical viewpoint.

2.1 Introduction
The firm should select such a capital structure which will maximize the expected Earnings
Per Share (EPS). This is the basic objective of financial management; therefore all
financial decisions in any firm should be taken in the light of this objective. In this unit an
attempt has been made to analyze the relationship between capital structure and the
value of the firm as explained in different theories on the subject matter.

2.2 Capital Structure Theories

Different theories of capital structure can be studied and analyzed by grouping them into:
15
  The capital structure matters for the valuation of the firm

 The capital structure does not matter for the valuation of the firm, and

 A more pragmatic approach between the two above.

The following assumptions are made to understand this relationship.

2.2.1 Assumptions:
 There are only two sources of funds i.e, the equity and the debt, which is having
fixed interest.

 The total assets of the firm are given and there would be no change in the
investment decisions of the firm.

 The firm has a policy of distributing the entire profits among the shareholders,
implying that there is no retained earnings.

 The operating profits of the firm are given and are not expected to grow.

 Business risk complexion of the firm is given and is constant; it is not affected by
financial mix.

 There is no corporate or personal taxes and

 The investors have the same subjective probability distribution of expected

operating profits of the firm.

In light of these assumptions, the theories of capital structure are discussed as follows:
In discussing the theories of capital structure, the following notations have been used.

2.2.2 Notations Used:

E = Total Market Value of the Equity

D = Total Market Value of the Debt
V = Total Market Value of the Firm, i.e. D+E
I = Total Interest Payment
NOP = Net Operating Profit i.e, EBIT
NP = Net Profit or Profit after Tax (PAT)
Do = Dividend paid by the Company at Time 0
D1 = Expected Dividend at the end of year 1
Po = Current Market Price of the share
P1 = Expected market Price of the share after 1 year.
Kd = After Tax Cost of Debt i.e. I/D
Ke = Cost of Equity i.e., D/P
Ko = Overall Cost of Capital i.e, WACC

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 Match the Column:

Column A Column B

Value of the firm depends on Earning Per Share

EBIT Cost of Debt

Lower the Cost of Capital Higher the Value of the Firm

EPS Firms Investment Decision

Kd Earning Before Interest and Taxes

1) d 2) e 3) c 4) a 5) b

2.3 Net Income Approach-Capital Structure Matters

The Net Income (NI) approach to the relationship between Leverage, cost of capital and
value of the firm is the simplest in approach and explanation. This theory states that
there is a relationship between capital structure and the value of the firm and therefore
the firm can affect its value by increasing or decreasing the debt proportion in the overall
financing mix. This approach makes the following additional assumptions:

2.2.2.1 The total capital requirements of the firm are given and remain constant.

2.2.2.2 Kd is less than Ke.

2.2.2.3 Both Kd and Ke remains constant and increase in financial leverage does not affect
the risk perception of the investors.

This approach states that change in financing mix of a firm will lead to change in WACC,
Ko of the firm resulting in the change in value of the firm. As Kd is less than Ke the
increasing use of cheaper debt (and simultaneous decrease in equity proportion) in the
capital structure will result in the magnified returns to the shareholders. The increased
returns to the shareholders will increase the total value of the equity and thus increase
the total value of the firm. The WACC, Ko will decrease and the value of the firm will
increase. On the other hand, if the financial leverage s reduced by the decrease in the
debt financing, the WACC, Ko of the firm will increase and the total value of the firm will

17
decrease. The NI approach which shows the relationship between leverage, cost of
capital has been presented in the figure 2.1 graphically.

Cost of Capital %

ke

Ko

kd

Leverage (degree)

Figure 2.1: Net Income Approach to Cost of Capital

Fig 2.1 shows that the Kd and Ke are constant for all levels of leverage i.e, levels of debt
financing. As the debt proportion or the financial leverage increase, the WACC, decreases
as the Kd is less than Ke. This result in the increase in value of the firm. In the figure 2.1
it can be seen that Ko will approach Kd as the debt proportion is increased. However Ko
will never touch Kd, as there cannot be 100% debt firm. Some element of equity must be
there. However, if the firm is 100% equity firm, then the K o is equal to Ke. The rate of
decline in Ko depends upon the relative position of Kd and Ke.

Under NI approach, the firm will have the maximum value capital structure at a point
where Ko is minimized. With a judicious use of the debt and equity, a firm can achieve an
optimal capital structure. This optimal capital structure is one at which the WACC, Ko is
minimum, resulting in the maximum value of the firm. The NI approach may be
illustrated with the help of example 2.1.

Example 2.1

The expected EBIT of a firm is Rs.4,00,000. It has issued Equity Share Capital
with Ke 10% and 6% Debt of Rs.5,00,000/-. Find out the value of the firm and
overall cost of capital WACC.

EBIT Rs. 4,00,000

-Interest - 30,000

Net Profit 3,70,000

Value of Equity E (3,70,000 X 100/10) 37,00,000

Value of Debt D 5,00,000

Total Value of the firm V 42,00,000

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WACC (Ko) = 4,00,000 X 100 = 9.52%

42,00,000

Now if the firm has issued 6% Debt of Rs. 7,00,000 instead of Rs.5,00,000, the position
will be as follows:

EBIT Rs. 4,00,000

-Interest - 42,000

Net Profit 3,58,000

Value of Equity E (3,58,000 X 100/10) 35,80,000

Value of Debt D 7,00,000

Total Value of the firm V 42,80,000

WACC (Ko) = 4,00,000 X 100 = 9.34%

42,80,000

So when the 6% Debt is increased from Rs.5,00,000 to Rs. 700,000 the value of the firm
increases from Rs. 42,00,000 to Rs. 42,80,000 and WACC decreased from 9.52% to
9.34%

A firm has issued 6% debt of Rs. 2,00,000. The expected EBIT of the firm is Rs.
2,00,000. Ke of the firm is 10%, Find out the value of the firm and overall cost of capital,
WACC.

1) V-Rs. 20,80,000, Ko= 9.6%

The effect of changing proportions of debt on the market price of the share can also be
analyzed. Presently the value of equity. E is Rs. 37,00,000 and the firm has 1,00,000
equity shares outstanding. So, the market price of the share would be Rs.37. Now, if the
firm increase the debt proportion from Rs. 5,00,000 to Rs. 7,00,000 and uses it to retire
5405.40 shares (Rs.200,000/Rs.37) of the firm. In this case, the total value of the equity
is Rs.35,80,000 (already calculated) represented by 94594.60 shares or the market price
of Rs.37.84 per share (35,80,000/94594.60).

Thus, the market price of the share also moves in line with the value of the firm in
response to the variations in debt proportion of the capital structure.

19
Conclusion:

The NI approach, though easy to understand, it is too simple to be realistic. It ignores,

the most important aspects of leverage, that the market price depends upon the risk
which varies indirect relation to the changing proportion of debt in the capital structure.

Fill in the blanks:

1. As per NI approach, use of cheaper dept in the capital structure will result in
to equity shareholders.
a) same returns b) magnified returns c) decrease in returns.

2. If the firm is 100% equity firm then _.

a) Ko>Ke b) Ko=Ke c) Ko<Ke.

3. Under NI approach, the firm will have the maximum value, at a point where
.
a) Ko is minimum, b) Ko is maximum.

1) b 2) b 3) a

2.4 Net Operating Income Approach: Capital Structure Does Not

Matter:
The Net Operating Income (NOI) approach is opposite to the NI approach. According to
this approach, the market value of the firms depends upon the net operating profit or
EBIT and overall cost of capital, WACC. The financing mix/capital structure is irrelevant
and does not affect the value of the firm.

The NOI approach makes the following assumptions:

 The investors see the firm as a whole and thus capitalize the total earnings of the
firm.

20
  The overall cost of capital Ko, of the firm is constant and depends upon the
business which is assumed to be unchanged.

 The cost of debt, Kd is taken as constant.

 The use of more and more debt in the capital structure increase the risk of
shareholders and thus result in the increase of equity capital i.e. Ke.

 There is no tax.

The NOI approach, argues that for a given value of EBIT, the value of the firm remains
the same irrespective of the capital composition and instead depends on the overall cost
of capital. The value of the equity may be found by deducting the value of debt from the
total value of the firm i.e.,

V= EBIT

Ko

and E= V-Dz

and the cost of equity capital, Ke, is

Ke =EBIT – Interest

V-D

Thus, the financing mix is irrelevant and does not affect the value of the firm. The value
remains the same for all types of Debt-Equity mix, since there will be change in risk of
the shareholders as a result of change in Debt-Equity mix, therefore, the Ke will be
changing linearly with change in debt proportions. The NOI approach to the relationship
between the leverage and cost of capital has been presented in the Figure 1.2

ke

Cost of Capital %

ko

kd

Leverage (degree)

Figure 2.2: The NOI Approach to Cost of Capital

Figure 2.2 shows that the cost of debt, Kd, and the overall cost of capital, Ko, are
constant for all levels of leverage. As the debt proportion or the financial leverage
increases, the risk of the shareholders also increases and thus the cost of equity capital,

21
Ke also increases. However the overall cost of capital remains constant because increase
in Ke is just sufficient to offset the benefits of cheaper debt financing.

The NOI approach considers Ko to be constant and therefore, there is no optimal capital
structure rather every capital structure is as good as any other and so every capital
structure is an optimal one. The NOI approach can be explained with the help of example
2.2.

Example 2.2

A firm has an EBIT of Rs.4,00,000 and belongs to a risk class of 10%. What is the value
& cost of equity capital if it employs debt to the extent of 30%, 40% or 50% of the total
capital of Rs. 10,00,000.

Solution:

The effect of changing debt proportion on the cost of equity capital can be analyzed as
follows:

30% Debt 40% Debt 50% Debt

EBIT Rs. 400,000 Rs. 400,000 Rs.

400,000

Ko 10% 10% 10%

Value of firm, V 40,00,000 40,00,000 40,00,000

Value of 6% debt, D 3,00,000 4,00,000 5,00,000

Value of equity, (E=V-D) 37,00,000 36,00,000 35,00,000

Net Profit (EBIT-Interest) 3,82,000 3,76,000 3,70,000

Ke (NP/E) 10.32% 10.44% 10.57%

Thus, the above calculations testify that the benefit of employment of more and more
debt in the capital structure is offset by the increase in equity capitalization rate, Ke.

A firm has an EBIT of Rs.2,00,000 and belongs to a risk class of 10%. What is the value
and cost of equity capital if it employs 6% debt to the extent of 30%, 40% or 50% of the
total capital of Rs. 20,00,000.

22
 1) 11.71%, 12.67%, 14%

2.5 Traditional Approach: A Practical View Point

The NI and the NOI approach hold extreme views on the relationship between the
leverage, cost of capital and the value of the firm. In practical situations, both these
approaches are unrealistic. The traditional approach takes a compromising view between
the two and incorporates the basic philosophy of both. It takes a mid way between the NI
approach (that the value of the firm can be increased by increasing the leverage) and the
NOI approach (that the value of the firm is constant irrespective of the degree of
financial leverage).

As per the traditional approach, a firm should make a judicious use of both debt and
equity to achieve a capital structure which may be called the optimal capital structure.
At, this capital structure, the overall cost of capital, WACC, of the firm will be minimum
and the value of the firm maximum. The traditional view point states that the value of
the firm increase with the increase in financial leverage, but up to a certain limit only.
Beyond this limit, the increase in leverage will increase its WACC also and hence the
value of the firm will decline.

Under the traditional approach, the cost of debt, Kd, is assumed to be less that cost of
equity, Ke. In case of 100% equity firm, Ko is equal to Ke but when (cheaper) debt is
introduced in the capital structure and the financial leverage increases, the Ke remains
same as the equity investors expect a minimum leverage in every firm. The Ke does not
increase even with increase in leverage. Ke remains unchanged upto a particular degree
of leverage, because of the interest charge may not be large enough to pose a real treat
to the dividend payable to the shareholders. The constant Ke and Kd makes the Ko to fall
initially. Thus, it shows that the benefits of cheaper debts are available to the firm. But
this position does not continue when leverage is further increased.

The increase in leverage beyond a limit increase the risk of the equity investors also and
Ke starts increasing. However, the benefits of use of debt may be so large that even after
offsetting the effects of increase in Ke, the Ko may still go down or may become constant
for the same degree of leverages.

However, if the firm increases the leverage further, then the risk of the debt investor
may also increase and consequently the Kd, also starts increasing. The already increasing
Ke, and the now increasing Kd makes the Ko to increase. Therefore the use of leverage
beyond a point will have the effect of increase in the overall cost of capital of the firm
and thus resulting in the decrease in value of the firm.

23
Thus, there is a level of financial leverage in any firm, up to which it favorably affects the
value of the firm, but thereafter if the leverage is increased further, then the effect may
be adverse and the value of the firm may decrease. There may be a particular leverage
or a range of leverage which separates the favorable leverage from the unfavorable
leverage. The traditional view point has been shown in the Figure 2.3

Cost of Capital % Ke Cost of Capital % Ke

Ke ke

Ke
ke

1O Leverage Degree O P Leverage Degree

Optimal Capital Structure Range Optimal Capital Structure

(Part A) (Part B)

Figure 2.3: Traditional View on the Relationship Between Leverage, Cost of Capital and
the Value of the Firm

The figure 2.3 shows that there can either be a particular financial leverage (as in Part A)
or a range of financial leverage (as in Part B) when the overall cost of capital, Ko is
minimum. The figure in Part A shows that at the financial leverage level O, the firm has
the lowest Ko, and therefore, the capital structure at that financial leverage is optimal.
The Part B of the figure shows that, there is not one optimal capital structure, rather
there is a range of optimal capital structure from leverage level O to level P. Every capital
structure over this range of financial leverage is an optimal capital structure.

Thus, as per the traditional approach, a firm can be benefited from a moderate level of
leverage when the advantages of using debt (having lower cost) outweigh the
disadvantages of increasing Ke (as a result of higher financial risk). The overall cost of
capital Ko, therefore is a function of the financial leverage. The value of the firm can be
affected therefore, by the judicious use of debt and equity in the capital structure.

24
Example 2.3

XYZ Ltd. having an EBIT of Rs.1,50,000 is contemplating to redeem a part of the capital
by introducing debt financing. Presently, it is a 100% equity firm with the equity
capitalization rate, Ke, of 16%. The firm is to redeem the capital by introducing debt
financing up to Rs. 3,00,000 i.e., 30% of total funds or up to Rs. 5,00,000 i.e., 50% of
total funds. It is expected that for the debt financing up to 30%, the rate of interest will
be 10% and the Ke will increase to 17%. However, if the firm opts for 50% debt
financing, then interest will be payable at the rate of 12% and Ke will be 20%. Find out
the value of the firm, and its WACC under different levels of debt financing.

Solution:

The total funds of the firm is Rs.10,00,000 (whole of which is provided by the equity
capital) out of which 30% or 50% i.e., Rs. 3,00,000 or Rs. 5,00,000 may be replaced by
the issue of debt bearing interest at 10% or 12% respectively. The value of the firm and
its WACC will be:

0% Debt 30% Debt 50% Debt

Total Debt - Rs. 3,00,000

Rs.5,00,000

Rate of Interest - 10% 12%

EBIT Rs.1,50,000 Rs. 1,50,000 Rs.

1,50,000

(-) Interest - Rs. 30,000 Rs. 60,000

Profit Before Tax Rs. 1,50,000 Rs. 1,20,000 Rs. 90,000

Equity Capitalization rate Ke .16 .17 .20

Value of Equity Rs. 9,37,500 Rs. 7,05,882 Rs.

4,50,000

Value of debt - Rs. 3,00,000 Rs.

5,00,000

Total Debt Rs.9,37,500 Rs. 10,05,882

Rs.9,50,000

Ko (EBIT / Total Value) .16 .149 .158

25
In the above example given, what will be the value of the firm and WACC, if firm raises
Rs. 6,00,000/- (60% ) debt, bearing interest 10% and Ke is 17%.

1) V = Rs. 11,29,412, Ko = 13.28%

The example 2.5 shows that with the increase in leverage from 0 to 30% the firm is able
to reduce its WACC from 16% to 14.9% and the value of the firm increases from Rs.
937,500 to Rs. 10,05,882. This happens as the benefits of employing cheaper rate debt
are available and the Ke does not rise too much. However, when the leverage is
increased further to 50%, the debt as well as the cost of equity, both rise to 12% and
20% respectively. The equity investors have increased the equity capitalization rate to
20% as they are now finding the firm to be risky (as a result of 50% leverage). The
increase in cost of debt and the equity capitalization has increased the Ko and hence
value of the firm has reduced from Rs. 10,05,882 to Rs. 9,50,000 and Ko has increased
from 14.9% to 15.8%.

Thus, the above example shows that the value of the firm increases up to particular level
of leverage only and any further increase would reduce the value of the firm. So, by a
judicious use of the financial leverage, the firm can optimize its value.

Conclusion:

Thus, the traditional approach seems to be a workable position on the theoretical

grounds. The Kd and Ke, both may be expected to increase beyond a particular level of
leverage. However the traditional approach is criticized on the point that the value of the
firm is a factor of its profitability than its financial mix.

26
2.6 Summary:

So friends let‟s sum up what we have discussed till now.

 The value of the firm depends on the earnings of the firm and the cost of capital.

 The financial leverage helps in increasing EPS, for a given level of EBIT. The EPS
affects the market value of the share and hence affects the value of the firm.

 The firm can change its WACC by changing the financing mix and can thus affect
the value of the firm.

 Different views on the relationship between leverage cost of capital and the value of
the firm, are known as theories of capital structure.

 According to NI approach, as the debt proportion or financial leverage increases,

the WACC, decreases. This results in the increase in the value of the firm. The firm
will have the maximum capital structure at a point where Ko is minimum.

 The NOI approach is opposite to the NI approach. According to the NOI approach,
the market value of the firm depends upon the net operating profit / EBIT and
overall cost of capital, WACC. The financing mix is irrelevant and does not affect the
value of the firm.

 The Traditional Approach takes a midway between the NI approach and the NOI
approach. The view point states that the value of the firm increases with the
increase in financial leverage, but up to a certain limit only. Beyond this limit, the
increase in the leverage will increase its WACC and the value of the firm will decline.

2.7 Exercise:

Now let us check what we have learnt so far.

Justify: Role of TRAI of India is of great importance.

Q1.Explain the concept of value of the firm.

Q2.Compare Net Income Approach with Net Operating Income Approach.

Q3.How does cost of equity behave with leverage under Traditional Approach?

Q4.Describe the Traditional View on Optimal Capital Structure. Compare and Contrast
this view with the NOI Approach and NI Approach.

27
2.8 Reference:

Chandra, Prassana. “Fina cial

n Management: Theory and Practice”, Tata McGraw-Hill
Publishing Co. Ltd.

Kucchal, S.C. “Financial M anagement: An Analytical & Conceptual Approach”, Chaitanya

Publishing House.

Maheshwari, S.N. “Fundamental of Financial Management”, Sultanchand & Sons.

Pandey, I.M. “Financial Management”, Vikas Publishing House Pvt. Ltd.

Rustagi, R.P. “Financial Management: Theory, Concepts and Problems”, Galgoita

Publishing Co.

Symonds, Curtis W. and J ain P.K. “Basic Financial Management”, D.B. Tarporevala Sons
& Co. Pvt. Ltd.

28
 Unit 3
Traditional & M.M Hypothesis without Taxes & With
Taxes

Table of Contents

3.0 Objectives .......................................................................................................................

3.1 Introduction: ...................................................................................................................

3.2 Assumptions ....................................................................................................................

3.3 MM Model: Extension of the NOI Approach ..........................................................................

3.4 MM Model without Taxes: ..................................................................................................

3.5 MM Model with Corporate Taxes: ........................................................................................

3.6 Critical Evaluation of MM Model:.........................................................................................

3.7 Summary: .......................................................................................................................

3.8 Exercise: .........................................................................................................................

3.9 Reference: ......................................................................................................................

3.0 Objectives
At the end of this unit, you will be able to…
 Understand the Modigliani-Miller Model
 Explain the Arbitrage Process
 Describe the impact on the value of the firm under MM model without corporate
taxes.
 Justify the impact on the value of the firm under MM Model with corporate taxes.
 Explain the limitations of the application of MM Model

3.1 Introduction:
The Modigiliani-Miller (MM) model studies the relationship between the leverage, cost of
capital and the value of the firm. It maintains that under a given set of assumptions, the
capital structure and its composition has no effect on the value of the firm. The theory
argues that the financial leverage does not matter and the cost of capital and value of
firm are independent of the capital structure. There is nothing which can be called as the

29
optimal capital structure. MM Model, in fact, has restated the NOI approach and has
added to it the behavioral justification. It is based on the following assumptions.

3.2 Assumptions
 The capital markets are perfect. Complete information is available to all the
investors free of cost, and can borrow and lend funds at the same rate. The
investors can quickly move from one security to another without incurring any
transaction cost.
 The securities are infinitely divisible.
 Investors are rational and well-informed about the risk-return of all the securities.
 All the investors have same probability distribution about the expected future
earnings.
 The personal leverage and the corporate leverage are perfect substitute.

3.3 MM Model: Extension of the NOI Approach

The MM Model argues that if two firms are alike in all respect, except that they differ in
respect of their financing pattern and their market value, then the investors will develop
a tendency to sell the shares of the overvalued firm (creating a selling pressure) and to
buy the shares of the undervalued firm (creating a demand pressure). These buying and
selling pressures will continue till the two firms have same market values. The MM model
can be explained with the help of the following example.

Suppose, there are two firms, Jack & Co and Jill & Co. These two firms are alike and
identical in all respects except that the Jack & Co. is a levered firm and has 10% debt of
Rs.30,00,000 in its capital structure. On the other hand, Jill & Co. is an unlevered firm
and has raised funds only by the issue of equity share capital. Both these firms have an
EBIT of Rs.10,00,000 and the equity capitalization rate Ke of 20%. Under these
conditions, the total value and the WACC of both the firms will be:-

Jack & Co. Jill & Co.

EBIT Rs. 10,00,000 Rs. 10,00,000
-Interest Rs. 3,00,000 -
Net Profit Rs. 7,00,000 Rs. 10,00,000
Equity Capitalization rate, Ke .20 .20
Value of Equity Rs.35,00,000 Rs.50,00,000
Value of Debt Rs.30,00,000 -
Total Value, V Rs.65,00,000 Rs.50,00,000
WACC, Ko= EBIT/V 15.38% 20%

30
Though, both the Jack & Co. and Jill & Co. have same EBIT of Rs.10,00,000 and same Ke
of 20% and still the Jack&Co, the levered firm has a lower Ko and higher value as against
the Jill&Co., which is an unlevered firm. MM argues that this position cannot persist for a
long and soon there will be an equality in the values of the two firms. The arbitrage
mechanism is used to prove their hypothesis.

Q.1 AB Ltd is a levered firm and has 10% Debt of Rs. 60,00,000 in its capital structure.
The firm has EBIT of Rs.10,00,000 and the equity capitalization rate of Ke of 20%.
Calculate the total value of the firm and WACC.

1) V = 80,00,000, WACC = 12.5%

 The Arbitrage Process:

This refers to undertaking by a person of two related steps simultaneously in order to
derive some benefit e.g. buying by a speculator in one market and selling the same at
the same time in some other market; or selling one type of investment and investing the
proceed in some other investment. The profit or benefit from the arbitrage process may
be in any form: increased income from the same level of investment or same income
from lesser investment. Their arbitrage process has been used by MM to testify their
hypothesis of financial leverage, cost of capital and value of the firm.

In order to understand the working of the arbitrage process, the above example of Jack &
Co. etc may be taken. Suppose, an investor is a holder of 10% equity share capital of
Jack & Co. The value of his ownership right is Rs.3,50,000 i.e. 10% of Rs.35,00,000.
Further, that out of the total net profits of Rs.7,00,000 of Lev & Co, he is entitled to 10%
i.e. Rs. 70,000 per annum and getting a return of 20% , his Ke, on his worth. In order to
avail the opportunity of making a profit, he now decides to convert his holdings from Jack
& Co to Jill & Co. He disposes off his holding in Jack & Co. for Rs.3,50,000, but in order to
buy 10% holding of Jill & Co., he requires total funds of Rs. 5,00,000 whereas his
proceeds are only Rs. 3,50,000. So he takes a loan @ 10% of an amount equal to Rs.
3,00,000 (i.e. 10% of the debt of the Jack & Co.) and now he is having total funds of
Rs.6,50,000 (i.e., the proceeds of Rs. 3,50,000 and the loan of Rs.3,00,000).

31
Out of the total funds of Rs. 6,50,000, he invests Rs. 5,00,000 to buy 10% shares of Jill
& Co. still he has funds of Rs. 1,50,000 available with him. Assuming that the Jill & Co.
continues to earn the same EBIT of Rs.1,00,000, the net returns available to the investor
from Jill & Co, are:

Profit available from Jill & Co. Rs. 1,00,000

(being 10% of net profit)
- Interest payable @ 10% on Rs. 3,00,000 loan Rs. 30,000
Net Return Rs. 70,000

So, the investor is able to get the same return of Rs.70,000 from Jill & Co. also, which
he was receiving as an investor of Jack & Co., but he has funds of Rs. 1,50,000 left over
for investment elsewhere. Thus, his total income may now be more than Rs.70,000
(inclusive of some income on the investment of Rs. 1,50,000). Moreover his risk is the
same as before. Though his new outlet i.e. Jill & Co., is an unlevered firm (hence no risk)
but the position of the investor is levered because he has created a homemade leverage
by borrowing Rs.3,00,000 from the market. In fact, he has replaced the corporate
leverage of Jack & Co., by his personal leverage.

The above example shows that the investor who originally owns a part of the levered firm
and enter into the arbitrage process as above, will be better off selling the holding in
levered firm and buying the holding in unlevered firm using his home made leverage.

MM Model argues that this opportunity to earn extra income through arbitrage process,
will attract so many investors. The gradual increase in sales of the shares of the levered
firm, Jack & Co, will push its prices down and the tendency to purchase the shares of
unlevered firm, Jill & Co. will drive its prices up. These selling and purchasing pressures
will continue until the market values of the two firms are equal. At this stage, the value
of the levered and the unlevered firm and also their cost of capital are same; and thus
the overall cost of capital Ko, is independent of the financial leverage.

The arbitrage process described involves a transfer of investment from a levered firm to
unlevered firm. The arbitrage process will work in the reverse direction also, when the
value of the levered firm is less than the value of the unlevered firm, say, the total value
of Jack & Co. is Rs.45,00,000 (consisting of Rs.30,00,000 debt capital and Rs. 15,00,000
equity share capital. The value of Jill & Co. is the same as before i.e. Rs. 50,00,0000.
Now, the investor holding 10% share capital of Jill & Co. sells his ownership right for Rs.
5,00,000. Out of these proceeds, he buys 10% of share capital of Jack & Co for Rs.
1,50,000 and invests Rs. 7,00,000 (i.e., 10% of Rs.30,00,000) in 10% Government
Bonds. Still he will be having funds of Rs.50,000 with him and his position in respect of
incomes from two firms would be as under:

32
 Jill & Co. Jack & Co.
10% of Profits Rs. 1,00,000 Rs. 70,000
10% Interest on Bonds - Rs. 30,000
Total Income Rs. 1,00,000 Rs. 1,00,000

Thus, by performing the arbitrage process, the investor will not only be able to maintain
his income level, but also be having additional cash flows of Rs. 50,000 at his disposal.
The prices of the share of Jill & Co. and Jack & Co. must adjust until the values of both
the firms are equal.

Q.1 Explain the Arbitrage Process?

3.4 MM Model without Taxes:

Relationship between the cost of equity and the leverage (as measured by the Debt-
Equity ratio i.e., D/E): When the leverage is increased will increase, but the cost of
equity will also increase as a result of increase in financial risk. The benefits of increasing
leverage are completely off set by the increase in cost of equity capital and consequently
the market value of the firm remains same. As per the MM model, the cost of equity
capital, Ke, is

Ke = Ko+(Ko-Kd) D/E
i.e, Ke for the given risk class is equal to the fixed overall cost of capital, Ko, plus a
premium for the financial risk. Kd is the cost of debt of levered firm. As there is an
assumption of no corporate taxes, Kd is equal to the rate of interest on debt employed by
the firm.

For example Apple Co Ltd has raised equity capital of Rs. 60,00,000 and 10% debt of
Rs.40,00,000. It belongs to a risk class having overall cost of capital, Ko of 18%. The
cost of equity capital, Ke, for the firm is

33
Ke = Ko+(Ko-Kd) D/E
.18+(.18-.10) (40,00,000/60,00,000)
.18+.053 = .233 or 23.3%

If however the company issues additional debt of Rs. 20,00,000, the debt equity ratio will
be 1:1 and Ke will be
Ke = .18+ (.18-.10) (1/1) = .26 or 26%
So, overall cost of capital, Ko, remains same, but with the increase in financial leverage,
the risk premium of equity shareholders has increased.

Q.1 XYZ Ltd. has raised equity capital of 20,00,000 and 5% Debt of Rs.10,00,000. The
overall cost of capital, Ko is 15%. The cost of equity capital Ke, for the firm is?

1) .20 or 20%

3.5 MM Model with Corporate Taxes:

MM agrees that leverage may increase the value of the firm. The effect of corporate
taxes on the value of the firm can be explained with the help of an example. A Ltd and B
Ltd both alike in all respect, except that out of total capital fund of Rs.10,00,000. B Ltd.
has raised Rs. 5,00,000 by issue of 10% debentures. Both firms have to pay tax @ 30%.
The position of their EBIT will be
A Ltd B Ltd
EBIT Rs. 1,50,000 Rs. 1,50,000
Less Interest - Rs. 50,000
EBT Rs. 1,50,000 Rs. 1,00,000
Tax (30%) Rs. 45,000 Rs. 30,000
Profit after Tax Rs. 1,05,000 Rs. 70,000
Total cash flow for
Debt and equity shareholders Rs. 50,000
Rs. 1,05,000 Rs. 1,20,000

From above table can be seen that A Ltd (unlevered firm) has tax liability of 45,000/-
whereas B Ltd. (levered firm) having same level of EBIT Rs. 150,000 has to pay Rs.

34
30,000 taxes. Therefore use of leverage reduces the portion of EBIT going out as taxes,
who collectively determine the total value of the firm, also receives a larger share of EBIT
in case of levered firm than the share in unlevered firm.

The excess cash flow available to the investors of a levered firm can be calculated as:
Interest charges X tax rate i.e, 50,000 X .30 = Rs. 15,000. This is difference between the
cash flows from levered firm and unlevered firm (1,20,000 – 1,05,000). This difference of
Rs. 15,000/- is also known as Interest Tax Shield.

The total market value of a firm increases with leverage as the cash flow available to
total investors also increases with increase in leverage. Higher the leverage used by a
firm, the large will be the cash available to investors and higher will be the value of the
firm. The value of the levered and unlevered firm will differ only with respect to the
interest tax-shield which will be available to the investor of the levered firm.

VL

Value Interest Tax Shield

(Rs.) Vu

Leverage Degree

Fig. 3.1 MM Model with Corporate Taxes

The value of Levered firm under MM Model (after incorporating the corporate taxes) will
be higher than the value of the unlevered firm. If market value of the firm increase with
leverage than it means that overall cost of capital Ko, will fall. The MM Model with
corporate taxes has been graphically presented as:

Ke
Cost
Of
Capital KO

Kd
Leverage Degree

Fig. 3.2: MM Model with Corporate Taxes

35
Thus the value of the levered firm under MM Model a (after incorporating the corporate
tax) will be higher than the value of the unlevered firm. If the market value of the firm
increases with leverage than it follows that overall cost of capital Ko will fall.

So, with reference to corporate taxes, the value of the leveraged firm is more than the
value of the unlevered firm even under MM Model. So the introduction of tax benefit of
debt financing in the financing decision undercuts the conclusion that capital mix is
irrelevant.

3.6 Critical Evaluation of MM Model:

If the financing decision is relevant as shown by the MM Model, then the financial
analysis relating to financial decision is so simplified. The overall cost of capital, which is
the weighted averaged of the cost of debt and cost of equity, is unaffected by the
changes in the proportion of debt and equity. As per the MM model, any benefits arising
by substituting cheaper debt for more expensive equity are offset by increase in both the
costs. This is shown in Fig. 3.3

Cost Ke
Of
Capital Ko

Kd

Leverage (Degree)
Fig: 3.3: The Cost of Capital Cost of Debt and the Cost of Equity in the MM Model.

The value of the firm is unaffected by the amount of leverage it has. Thus, if firm is
valued as an all-equity firm, its value will be unchanged if it is valued with any debt ratio.
So, the investment decisions can be made independently of the financing decisions,
under the MM model. In other words, if a project is a bad project when evaluated as an
all-equity project, it will remain so using any other financing mix.

Theoretically speaking, therefore as per MM model, there is no relationship between the

leverage and the value of the firm, seems to be good enough in the light of the
assumptions underlying the model. However, most of these assumptions are unrealistic
and untenable.

The arbitrage process which provides the behaviors to justification for the model. In the
real life as the perfect competition is never found and the transaction costs are

36
inevitable. The validity of the model, on practical considerations, can be examined as
follows:

 Non-substitutability of Personal and Corporate Leverages:

Under the MM Model, the arbitrage mechanism operates on the assumption that the
personal leverage of the investor and the corporate leverage are perfect substitute. This
is not true in real life. There may be difference in the effects of personal leverage and the
corporate leverage, and it may be sustained as follows:

o Different Borrowing Rates for the Corporate and the Individuals: The
arbitrage process presupposes that an individual investor is able to borrow funds
at the same rate at which the leverage firm can and hence the personal home
made leverage of the individual investor is a perfect substitute of the corporate
leverage. However, in practice neither the interest rates for different categories of
investors are same. An individual cannot borrow or lend funds at same rate at
which a corporate firm can. A corporate entity having better credit standing in the
market can definitely borrow at rates lower than the rates which an individual has
to pay.

o Personal Gearing versus Corporate Gearing: In the arbitrage process, when

an investor takes a personal loan, he creates a personal gearing and then
purchases shares of unlevered firm. So, as a result, the gearing has shifted from
the corporate leverage to the personal leverage of the investor. These two
gearings are not a perfect substitute of each other. When an investor borrow
funds in his personal capacity, he in fact incurs an unlimited liability only to the
capital subscribed irrespective of the level of borrowings by the firm. So, the
personal leverage is not a substitute of the corporate gearing.

o Leverage Capacity: The firms usually have a higher leverage capacity as

compared to the leverage capacity of the individuals. The creditors may not lead,
to an individual, beyond a particular level.

o Inconveniences of Personal Leverage: Borrowings either by firms or by an

individual involve a lot of formalities and inconveniences. An individual investor
may have a preference for corporate borrowing, because in this case, he will
remain an outsider to the act of borrowing. Thus, the personal leverage may not
at all be sufficient replacement for corporate leverage.

So, the above factors point out that the personal leverage is not a perfect substitute of
corporate leverage. Hence the MM Model in general, is questionable.

37
 Transaction Costs:
o Transaction Costs: The assumption of no transaction costs of the MM model is
also imaginary. The buying and selling of shares by the investors will surely
involve some transaction costs which will make the arbitrage process to stop short
of completion. Though, the quantum of transaction costs will generally be small,
yet the efficiency of the arbitrage process will be affected.

o Institutional Investor: If an institution or a firm is a shareholder in a levered

firm which is valued higher in the market, can this institutional investor take
benefit by the arbitrage mechanism? Generally, it cannot. The reason being that
the institutional investors may not be allowed to create a „Personal‟ leverage and
them to buy the shares of unlevered firm.

o Availability of Complete Information: In real life, the assumption that all the
investors have complete information is also illusory. However, this assumption is
compulsory otherwise the very emergence of the arbitrage process will become
impossible. The arbitrage process requires that the investors have complete
information about the levered and unlevered firm.

o Corporate taxes: The MM Model is based on the assumption that there is no

corporate tax. This assumption is also unrealistic and the tax aspects of the
levered firm are very significant in practice. Out of two alike firms differing only in
respect of leverage, the levered firm will definitely have higher cash profits to be
distributed among the shareholders as compared to an unlevered firm. This is
particularly due to the fact that the interest is tax deductible. This will result in
higher value of the levered firm than the value of the unlevered firm.

3.7 Summary:

The result of the analysis of MM Model can be summarized as follows:

MM MODEL WITHOUT TAXES:

 Firm‟s capital structure is irrelevant
 The WACC is the same no matter what mixture of debt and equity is used to finance
the firm.
 The value of the levered firm is equal to the value of the unlevered firm, and
 Cost of equity Ke = Ko + (Ko-Kd) D/E. It implies that the cost of equity rises as the
firm increases its use of debt.

38
MM MODEL WITH TAXES:
 The value of the levered firm is equal to the value of unlevered firm + the present
value of the interest tax shield i.e. VL = Vu+ D (t). So debt financing is
advantageous

 The WACC of the firm decreases, as the firm relies more and more on debt
financing.

 The cost of equity, Ke = Ko + (Ko-Kd) D/E (l-t) where Ko is the WACC of the
unlevered firm. So, with reference to corporate taxes, the value of the leveraged
firm is more than the value of the unleveraged firm under MM Model. So, the

 Introduction of tax benefit of debt financing is the financing decisions undercuts the
conclusion that capital mix is irrelevant.

3.8 Exercise:

Now let us check what we have learnt so far.

Q1. MM Model is an extension of the NOI Approach‟ Explain

Q2.Explain MM Hypothesis of Capital Structure with following premises
- Without corporate taxes
- With corporate taxes
Q3.Explain ”The assumptions underlying the MM Model are unrealistic and
untenable”

39
3.9 Reference:

Chandra, Prassana. “Financial Management: Theory and Practice”, Tata McGraw-Hill

Publishing Co. Ltd.

Kucchal, S.C. “Financial Management: An Analytical & Conceptual Approach”,

Chaitanya Publishing House.

Maheshwari, S.N. “Funda mental of Financial Management”, Sultanchand & Sons.

Pandey, I.M. “Financial Management”, Vikas Publishing House Pvt. Ltd.

Rustagi, R.P. “Financial Management: Theory, Concepts and Problems”, Galgoita

Publishing Co.

Symonds, Curtis W. and Jain P.K. “Basic Financial Management”, D.B. Tarporevala
Sons & Co. Pvt. Ltd.

40
 Unit 4

Determining Capital Structure in Practice

Table of Contents

4.0 Objectives .......................................................................................................................

4.1 Introduction: ...................................................................................................................

4.2 Features of an Appropriate Capital Structure: ......................................................................

4.3 Determinants of the Capital Structure:................................................................................

4.4 Summary ........................................................................................................................

4.5 Exercise: .........................................................................................................................

4.5 Reference: ......................................................................................................................

4.0 Objectives
At the end of this unit, you will be able to…
 Identify various factors considered for capital structures decisions
 Prepare Capital Structure of an Organization

4.1 Introduction:
Capital structure refers to the mix of long term sources of funds, such as debentures,
long-term debt, preference share capital and equity share capital including retained
earnings. Some companies do not plan their capital structure, it develops as a result of
the financial decisions taken by the financial manager without any formal planning. There
companies may survive in short run, but they may fail to economize the use of their
funds. Thus a company should plan its capital structure to maximize the use of the funds,
and to be able to adapt more easily to the changing conditions.

Theoretically, the financial manager should plan an optimum capital structure for his
company. The optimum capital structure is obtained when the market value per share is
maximum. The value will be maximized when the marginal real cost of each source of
funds is the same.

41
4.2 Features of an Appropriate Capital Structure:
The financial manager of a company should develop an appropriate capital structure,
which is most advantageous to the company. This can be done only when all those
factors which are relevant to the company‟s capital structure decision are properly
analyzed and balanced.

Q.1 Fill in the blanks:

1. Capital structure refers to mix of sources of funds. (Long term,
short term, liquid).
2. Optimum capital structure is obtained when the market value per share is
(minimum, maximum, average).
3. Market value of share will be maximized when the marginal real cost of each source
of funds is (Maximum, same, minimum).

1) Long-term 2) Maximum 3) Same

The equity shareholders are the ultimate owners of the company, however, the interests
of other groups, such as employers, customers, creditors, society and government,
should also be given reasonable consideration. Thus, while developing an appropriate
capital structure for its company, the financial manager should aim at maximizing the
long-term market price per share. Theoretically, there is a precise point or range within
which the market value per share is maximum. In practice for most companies within an
industry there would be a range of an appropriate capital structure within which there
would not be great differences in the market value per share.

A sound capital structure should have the following features:

 Profitability: The capital structure of the company should be most advantageous,
within the constraints; maximum use of leverage at a minimum cost should be
made.
 Solvency: The use of excessive debt threatens the solvency of the company. To
the point, debt does not add significant risk it should be used, otherwise its use
should be avoided.

42
  Flexibility: It should be possible for a company to adapt its capital structure with
a minimum cost and delay if warranted by a changed situation.
 Conservation: The capital structure should be conservative in the sense that the
debt capacity of the company should not be exceeded. It should have enough cash
to pay creditor‟s fixed charges and principal sum.
 Control: The capital structure should involve minimum risk of loss of control of the
company.

The above listed are the general features of an appropriate capital structure.

4.3 Determinants of the Capital Structure:

The initial capital structure should be designed very carefully. The financial manager has
also to deal with an existing capital structure. The company needs funds to finance its
activities continuously. Every time when the funds have to be procured, the financial
manager weigh pros and cons of various sources of finance and select most
advantageous sources keeping in view the target capital structure. Thus the capital
structure decision is a continuous one and has to be taken whenever a firm needs
additional finances.

The following factors should be considered whenever a capital structure decision has to
be taken:

4.3.1 Trading On Equity - Effect on Earnings per Share:

This is also known as Earnings before Interest and Taxes – Earning Per Share (EBIT-EPS)
Analysis. The use of fixed cost sources of finance, such as debt and preference share
capital to finance the assets of the company is known as financial leverage or trading on
equity. If the assets financed with the use of debt yield a return greater than the cost of
debt, the earnings per share increase without an increase in the owners investment. The
earnings per share also increase when the preference share capital is used to acquire
assets. But the leverage impact is more pronounced in case of debt because (i) the cost
of debt is usually lower than the cost of preference share capital and (ii) the interest paid
on debt is tax deductible.

Because of its effect on the earnings per share, financial leverage is one of the important
considerations in planning the capital structure of a company. The companies with high
level of the earnings before interest and taxes can make profitable use of the high degree
of leverage to increase return on the shareholders equity one common method of
examining the impact of leverage is to analyse the relationship between EPS and various
possible levels of EBIT under alternative method of financing.

43
Illustration:
A firm has an all equity capital structure consisting of 1,00,000 ordinary shares @ Rs. 10
per share. The firm wants to raise Rs.2,50,000 to finance its investments, the firm is
considering three alternative methods of financing.
1. to issue 25000 equity shares at Rs.10 each.
2. to borrow Rs.250,000 at 6% rate of interest (ROI)- Debentures
3. to issue 2500 preference shares of Rs.100 each at 6% ROI.

The tax rate is 50 percent, effect on the earnings per share under the three financing
alternative s will be as follows if the EBIT of the firm is Rs.2,00,000/-

Table 4.1
Equity Financing Debt financing Preference
Financing
EBIT 2,00,000 2,00,000 2,00,000
less Interest - _ 15,000 -
Profit Before Tax (PBT) 2,00,000 1,85,000 2,00,000
Less Taxes (50%) 1,00,000 92,500 1,00,000
Profits After Taxes (PAT) 1,00,000 92,500 1,00,000
Less Preference Dividend - _ - _ 15,000
Equity share holders 1,00,000 92,500 85,000
Earnings available to
equity shareholders 1,00,000 = .800 92,500= .925 85,000 = .85
1,25,000 1,00,000 1,00,000

The above illustration shows that the firm is able to maximize the earnings per share
when it uses debt financing. Though the rate of preference dividend is equal to the rate
of interest, EPS is high in case of debt financing because interest charges are tax
deductible while preference dividends are not with increasing levels of EBIT, EPS will
increase at a faster rate with a high degree of leverage. However, if a company is not
able to earn a rate of return on its assets higher than the interest rate (or the preference
dividend rate), debt (or preference financing) will have adverse impact on EPS.

Q.1 Solve the above question assuming the earnings of the firm go down to the
Rs.40,000/-

44
The effect on the earnings per share under the three financing alternatives will
be:
Equity Financing Debt financing Preference Financing
Earnings Per Share .16 .125 .05

It is obvious that, under unfavorable conditions i.e., when the rate of return on total
assets is less than the cost of debt or preference, the earnings per share will fall with the
degree of leverage. Thus the finance manager has to consider the EBIT and examine the
impact on EPS under different financial plans. If returns on firm‟s assets are less than
cost of debt than the firm should not employ debt.

EPS is one of the most widely used measures of the company‟s performance, however, it
has some serious limitations as a financing-decision criterion. The major shortcoming of
the variability about the expected value of EPS. The belief that investors would be just
concerned with the expected EPS is not well founded. Investors in valuing the shares of
the company consider both expected value and variability.

4.3.2 Financial Risk:

The risk attached to the use of leverage is called financial risk. Financial risk is added
with use of debt because of (a) the increased variability in the shareholder‟s earnings and
(b) the threat of insolvency. A firm can avoid financial risk altogether if it does not
employ any debt in its capital structure. But then the shareholders will be deprived of the
benefit of the expected increase in EPS. Therefore, a company should employ debt to the
extent the financial risk perceived by shareholders does not exceed the benefit of
increased EPS. If a company increases its debt beyond a point, the expected EPS will
continue to increase, but the value of the company will fall because of the greater
exposure of shareholders to financial risk in the form of financial distress.

The EPS criterion does not consider the long-term perspectives of financing decisions. It
fails to deal with the risk-return trade-off. A long-term view of the effects of financing
decisions will lead one to a criterion of wealth maximization rather than EPS
maximization. The EPS criterion is an important performance measure but not a decision
criterion. A long-term view of the effect of the alternative financial plans on the value of
the shares should be taken. If management opts for a financial plan which will maximize
value in the long run, but has an adverse impact on near term EPS the reasons must be
communicated to investors.

45
Q.1 Fill in the blank:
1. Risk attached to the use of leverage is called risk. (Business, Financial).
2. EPS criterion is a measure. (performance, decision).
3. If the company increases its debt beyond optimum point, the value of the company
will .

1) Financial 2) Performance 3) Fall

4.3.3 Growth and Stability of Sales:

The magnitude of the EPS variability with sales will depend on the degree of its sales.
The magnitude of the EPS variability with sales will depend on the degree of operating
and financial leverage employed by the company. The firms with stable sales will have
stable EPS and thus, can employ a high degree of leverage as they will not face difficulty
in meeting their fixed commitments. The likely fluctuations in sales increase the business
risk. A small change in sales can lead to dramatic change in EPS of the company‟s fixed
cost and debt are high. As a result, the shareholders perceive a high degree of financial
risk if debt is employed by such companies. Sales of the consumer goods industries show
wide fluctuations, therefore, they do not employ a large amount of debt. On the other
hand, the sales of public utilities are quite stable and predictable. Public utilities employ a
large amount of debt to finance their asset.

The expected growth in sales also affects the degree of leverage. The greater the
expectation of growth, the greater the amount of the external financing needed since it
may not be possible for the firm to cope up with growth through retained earnings. The
cheapest source of external financing is debt. The growth firms, may usually employ a
high degree of leverage. Companies with declining sales should not employ debt or
preference share capital in their capital structures as they would find difficulty in meeting
their fixed obligations. Non-payment of fixed charges can force a company into
liquidation. Sales, growth and stability is just one factor in the leverage decision. There
are many other factors listed below which would dictate the decision.

46
4.3.4 Cost of Capital and Valuation:
The cost of a source of finance is the minimum return expected by its suppliers. The
expected return depends on the degree of risk assumed by investors. A high degree of
risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate
of interest is fixed and the company is legally bound to pay interest whether it makes
profit or not. For shareholders, the rate of dividends is not fixed and the board of
directors has no legal obligation to pay dividends even if the profits are made by the
company. The loan of the debt-holders is returned within a prescribed period, while
shareholder will have to share the residue only when the company is wound up. This debt
is cheaper source of funds than equity. The tax deductibility of interest charges further
reduces the cost of debt. The preference share capital is also cheaper than equity capital,
but it is not cheap as debt is. Thus, using the cost of capital as a criterion for financing
decisions, a firm would always like to employ debt since it is the cheapest source of
funds. However a point or range is reached beyond which debt becomes more expensive
because of the increased risk of excessive debt to creditors, as well as to shareholders
(increase in financial risk).

The excessive amount of debt makes the shareholders‟ position very risky. This has the
effect of increasing the cost of equity. Thus, up to a point the overall cost of capital
decreases with debt, but beyond that point the cost of capital would start increasing and
therefore, it would not be advantageous to employ debt further. So, there is a
combination of debt and equity which minimizes the firm‟s average cost of capital and
maximizes the market value per share. In practice there is generally a range of debt-
equity ratio within which the cost of capital is minimum or the value is maximum.

The cost of equity includes the cost of new issue of shares and the cost of retained
earnings. The cost of debt is cheaper than the costs of both these sources of equity
funds. Between the cost of new issue and retained earnings, the latter is cheaper. The
cost of retained earnings is less than the cost of new issues because the personal taxes
have to be paid by shareholders, while no taxes are paid to retained earnings, also no
flotation costs are incurred when the earnings are retained. As a result, between the two
sources of equity funds, retained earnings are preferred. In internal funds are not
sufficient to meet the investment outlays, firms go for external finance, issuing the safety
security first. They start with debt, than possibly hybrid securities such as convertible
debentures, then perhaps equity as a last resort. Excessive debt will reduce the share
price, and thereby lower the overall return to shareholders, despite the increase in EPS.
The return of shareholders is made of dividends and appreciation in share prices, not of
EPS. Thus a trade-off between cost of capital and EPS, set the maximum limit to the use
of debt.

47
Q.1 Match the Column:

Column A Column B
1. Shareholders a. High degree of leverage
2. Fluctuating sales b. Increase in cost of equity
3. Stable Sales c. Minimum leverage
4. Excessive Debt d. Owners of the company

1) d 2) c 3) a 4) b

4.3.5 Cash Flow Analysis:

Conservatism is one of the important features of a sound capital structure. It relates to

fixed charges created by the use of debt or preference capital in the capital structure and
the firm‟s ability to generate cash to meet these fixed charges. In practice, appropriate
debt-equity mix is one, at which the firm is able to service debt without any threat and
operating inflexibility.

The fixed charges of a company include payment of interest preference dividend and
principal and they depend on both the amount of senior securities and the terms of
payment. The amount of senior securities and the terms of payment. The amount of fixed
charges will be high, if the company employs a large amount of debt or preference
capital with short-term maturity. Whenever a company thinks of raising additional debt,
it should analyze its expected figure cash flows to meet the fixed charges. If a company
is not able to generate enough cash to meet its fixed obligation, it may have to face
financial insolvency. It is not the average cash inflows but the yearly cash inflows which
are important to determine the debt capacity of a company. Fixed financial obligations
must be met when due, not on an average and not in most years but always. This
requires a full cash flow analysis. A company should borrow only if it can service debt
without any problem. It should examine the impact of alternative debt policies on the
firm‟s cash flow ability, and should choose the debt policy it can service.

4.3.6 Marketability and Timing:

Marketability means the readiness of investors to purchase a security in a given period of

time. It does not influence the initial capital structure, but it is an important consideration
to decide about the appropriate timing of security issues. Due to the changing market

48
sentiments, the company has to decide whether to raise funds with a common shares
issue or with a debt issue. The alternative methods of financing should, therefore, be
evaluated in the light of general market conditions and the internal conditions of the
company.

If the share market is depressed, the company should not issue common shares, but
issue debt and wait to issue common shares till the share market revive. During boom
period in the share market, it may be advantageous for the company to issue shares at
high premium. This will help to keep its debt capacity utilized. The internal conditions of a
company may also dictate the marketability of securities. For example, a highly levered
company may find it difficult to raise additional debt. Similarly, when restrictive
covenants in existing debt agreements preclude payment of dividends on common
shares, convertible debt may be the only source to raise additional funds. A company
may find difficulty to issue any kind of security in the market merely because of its small
size. The heavy indebtedness, low payout, small size, low profitability, high degree of
competition etc cause low rating of the company, which would make it difficult for the
company to raise external finance at favorable terms.

4.3.7 Flotation Costs:

Flotation costs are incurred only when the funds are externally raised. Generally the cost
of floating a debt is less than the cost of floating an equity issue. This may encourage a
company to use debt than issue common shares. If the owners capital is increased by
retaining the earnings no flotation costs are incurred.

Flotation costs as a percentage of funds raised will decline. Therefore, it can be an

important consideration in deciding the size of a security issue. The company will save in
terms of flotation costs if it raises funds through large issues of securities. But a large
issue can curtail company‟s financial flexibility. Also, the company should raise only that
much of funds which can be employed profitability.

Q.1 Match the Column:

Column A Column B
1. Fixed Charges a. External Funds
2. Flotation Costs b. Low rating
3. Depressed share market c. Interest
4. Heavy indebtedness and low payout d. Issue Debt

49
 1) c 2) a 3) d 4) b

4.3.8 Control:

In designing the capital structure, sometimes the existing management is governed by

its desire to continue control over the company. This is particularly so in the case of the
firms promoted by entrepreneurs. The existing management team not only wants control
and ownership but also to manage the company, without any outside interference.

The ordinary shareholders elect the directors of the company. If company issues new
shares, there is risk of dilution of control. This is not a very important consideration in
the case of a widely-held-company. The shares of such company are widely scattered.
Most of the shareholders are not interested in taking active part in the company‟s
management. Nor do they have time and money to attend the meetings. They are
interested in dividends and capital gains. If they are not satisfied, they will sell their
shares. Thus, the best way to ensure control and to have the confidence of the
shareholders is to manage company most efficiently and compensate shareholders in the
form of dividends and capital gains. The risk of loss of control can be reduced by
distribution of shares widely and in small lots.

The consideration of maintaining control may be significant in case of a closely-held,

small company. A shareholder or a group of shareholders can purchase all or most of the
new shares and control the company. Even if the majority shares are held by the owner
managers, their freedom to manage the company will be curtailed when they go public
for the first time. Fear of sharing control and being interfered by others often delays the
decision of the closely held companies to go public. To avoid the risk of loss of control,
small companies may slow their rate of growth or issue preference shares or raise debt
capital. If the closely-held companies can ensure a wide distribution of shares, they need
not worry about the loss of control so much.

The holders of debt do not generally have voting rights. Therefore, it is suggested that a
company should use debt to avoid the loss of control. However, when a company uses
large amount of debt, a lot of restrictions are put by the debt-holders, specifically the
financial institutions in India since they are the major providers of loan capital to the
companies, on company to protect their interest. These restrictions curtail the freedom of
the management to run the business. A very excessive amount of debt can also cause
serious liquidity problem and ultimately render the company sick, which means a
complete loss of control.

50
4.3.9 Flexibility:
Flexibility is one of the most serious considerations in setting up the capital structure.
Flexibility means the firms‟ ability to adapt its capital structure to the needs of the
changing conditions. The company should be able to raise funds, without undue delay
and cost, whenever needed to finance the profitable investments. It should also be in a
position to redeem its preference capital or debt whenever warranted by the future
conditions. The financial plan of the company should be flexible enough to change the
composition of the capital structure as warranted by the company‟s operating strategy
and needs. It should also be able to substitute one form of financing for another to
economize the use of funds.

Restrictive covenants are commonly included in long-term loan agreements and

debentures. These restriction curtail the company‟s freedom in dealing with the financial
matters and put it in an inflexible position. Covenants in loan agreements may include
restrictions to distribute cash dividends, to incur capital expenditure, to raise additional
external finances or to maintain working capital at a particular level. These restrictions
may be quite reasonable from the point of view of creditors as they are meant to protect
their interests, but they reduce the flexibility of company to operate freely and may
become burdensome if conditions change. Therefore, a company while issuing
debentures or accepting other forms of long-term debt, should ensure that a minimum of
restrictive clauses, that circumscribe its financial action in future, are included in debt
agreements.

The flexibility of the capital structure also depends on the company‟s debt capacity. The
greater the debt capacity and the greater the availability of unused debt capacity, the
greater the degree of flexibility. If a company borrows to the limit of its capacity, it will
not be in a position to borrow additional funds to finance unforeseen and unpredictable
demands except at restrictive and unfavorable terms. Therefore, a company should not
borrow to the limit of its capacity, but keep available some unused capacity to raise
funds in future to meet some sudden demand for finances.

Although flexibility is most desirable it is achieved at a cost. A company trying to obtain

loans at easy terms will have to pay interest at a higher rate. Also, to obtain the right of
refunding, it may have to compensate creditors by paying higher interest. Therefore, the
company should compare the benefits and costs of attaining the desired degree of
flexibility and balance them properly.

4.3.10 Size of the Company:

The size of a company may influence the availability of funds from different sources. A
small company finds great difficulties in raising long-term loans. If it is able to obtain
some long-term loan, it will be available at a higher rate of interest and inconvenient
terms. The highly restrictive covenants in loan agreement in case of small companies

51
make their capital structures very inflexible and management cannot run business freely
without any interference. Small companies, therefore, depend on share capital and
retained earnings for their long-term funds. It is quite difficult for small companies to
raise share capital in the capital markets. Also, the capital base of most small companies
is so small that they are not allowed to be registered in the stock exchanges. Those small
companies which are able to approach to the capital markets, the cost of issuing shares
is generally more for them than the large ones. Further, resorting frequently to ordinary
share issues to raise long-term funds carries a greater danger of the possible loss of
control to a small company than to a large company. The shares of a small company are
not widely scattered and the dissident group of a shareholders can be easily organized to
get control of the company. The small companies, therefore, sometimes limit the growth
of their business to what can easily be financed by retaining the earnings.

A large company has relative flexibility in designing its capital structure. It can obtain
loans at easy terms and sell common shares, preference shares and debentures to the
public. Because of the large size of issues, its cost of distributing a security is less than
that for a small company. A large issue of ordinary shares can be widely distributed and
thus, making the loss of control difficult. The size of the firm has an influence on the
amount and the cost of funds raised.

To conclude, the capital structure decision is a continuous one and has to be taken
whenever a firm needs additional finances. The above listed factors should be considered
whenever a capital structure decision has to be taken in practice.

4.4 Summary

So friends let‟s sum up what we have discussed till now.

 The companies which do not plan their capital structure, may survive in short-run,
but in long-run will not be able to economize the use of their funds.
 The financial manager of a company should develop an appropriate capital
structure
 A sound / appropriate capital structure should have the following features –
Profitability, Solvency, Flexibility, Conservation and Control.

 Every time when the funds have to be procured the financial manager weighs pros
and cons of various sources of finance and selects most advantageous sources,
keeping in view the target capital structure.

 The finance manager has to consider the EBIT and examine the impact on EPS,
under different financial plans. If return‟s on firm‟s assets are less than the costs
of debt, than the firm should not employ debt.

52
  Financial Risk is added with use of debt.

 Firm with stable sales will have stable EPS and thus can employ a high degree of
leverage

 The growth firms may usually employ high degree of leverage.

 There is generally a range of debt-equity ratio, within which the cost of capital is
minimum and the value of the firm is maximum.

 If a company is not able to generate enough cash to meet its fixed obligation, it
may have to face financial insolvency.

 Alternative methods of financing should be evaluated in the light of general

market conditions and internal conditions of the company.
 The cost of floating a debt is less than the cost of floating an equity issue.

 The risk of loss of control can be reduced by distribution of shares widely and in
small lots

 The financial plan of the company should be able to substitute one form of
financing for another to economise the use of funds.

 The cost of issuing shares is generally more for small companies than the large
ones.

 The capital structure decision is a continuo one and has to be taken whenever a
firm needs additional finances.

4.5 Exercise:

Now let us check what we have learnt so far.

Q1.Define Capital Structure. What are its features and determinants?

53
4.6 Reference:

Chandra, Prassana. “Financial Management: Theory and Practice”, Tata McGraw-Hill

Publishing Co. Ltd.

Kucchal, S.C. “Financial Management: An Analytical & Conceptual Approach”,

Chaitanya Publishing House.

Maheshwari, S.N. “Fundamental of Financial Management”, Sultanchand & Sons.

Pandey, I.M. “Financial Management”, Vikas Publishing House Pvt. Ltd.

Rustagi, R.P. “Financial Management: Theory, Concepts and Problems”, Galgoita

Publishing Co.

Symonds, Curtis W. and Jain P.K. “Basic Financial Management”, D.B. Tarporevala
Sons & Co. Pvt. Ltd.

54
 Unit 1
Financial Management
Nature of Financial Management

Finance is termed as the backbone of every business and is required for carrying out
each and every activity.

Financial Management means applying management principles to manage the financial

resources of an organization. It simply involves planning, organizing, directing, and
controlling financial operations to manage the finance of an organization efficiently.

Financial Management is a methodology that a business implements to monitor and

govern its revenue, expenses, and assets in order to maximize profitability and ensure
sustainability.

Financial Management is Science as well as Art. It is neither pure science nor an art. It
deals with various methods and techniques which can be adopted, depending on the
situation of business and the purpose of the decision.

As a science it uses various statistical and mathematical models and computer

applications for solving the financial problems relating to the firm.

For example - capital investment appraisal, capital allocation and rationing, optimising
capital structure mix, portfolio management etc.

Along with the above, a Finance Manager is required to apply his analytical skills in
decision making. Hence, Financial Management is both a science as well as an art.

According to Soloman, "Financial management is concerned with the efficient use of an

important economic resource, namely, Capital Funds."

According to Phillippatus, "Financial management is concerned with the managerial

decisions that result in the acquisition and financing of long-term and short-term credits
for the firm. As such it deals with the situations that require selection of specific assets
(or combination of assets), the selection of specific Liability (or combination of liabilities)
as well as the problem of size and growth of an enterprise. The analysis of these
decisions is based on the expected inflows and outflows of funds and their effects upon
managerial objectives."

In short, financial management is concerned with efficiently planning the procurement of

funds and the utilization of these funds in the business. It ensures availability of funds in
business from different sources and also it earns the best return on its investments.

Following Are the Nature of Financial Management

1. Estimates Capital Requirements

Financial management helps in anticipation of funds required for running the business. It
estimates working and fixed capital requirements for carrying out all business activities.

2
The finance manager prepares a budget of all expenses and revenues for a particular
time period on the basis of which capital requirements are determined.

2. Decides Capital Structure

Deciding optimum capital structure for an organization is a must for attaining efficiency
and earning better profits. It involves deciding the proper portion of different securities
like equity, preference shares, debentures, bonds etc. The proper balance between debt
and equity should be attained which minimizes the cost of capital.

3. Select Sources of Fund

Every business should properly analyze different sources of funds available and choose
one which is cheapest and involves minimal risk. Because choosing the source of funds is
one of the crucial decisions for every organization. There are various sources available
for raising funds like shares, bonds, debentures, venture capital, financial institutions,
retained earnings, owner investment, etc.

4. Selects Investment Pattern

After raising funds, it is important to allocate them among profitable investment

avenues. This means risk and return associated with every business proposal should be
properly evaluated. The investment proposal should be properly analyzed regarding its
safety, profitability, and liquidity.

5. Raises Shareholders Value

Financial management works towards raising the overall value of shareholders. It aims
at increasing the amount of return to shareholders by reducing the cost of operations
and increasing the profits. The finance manager focuses on raising cheap funds from
different sources and invests them in the most profitable avenues.

6. Management of Cash

Financial management monitors all funds movement in an organization. Finance

managers supervise all cash movements through proper accounting of all cash inflows
and outflows. They ensure that there is no situation like deficiency or surplus of cash in
an organization.

7. Apply Financial Controls

Implying financial controls in business is a beneficial role played by financial

management. It helps in keeping the company's actual cost of operation within the limit
and earning the expected profits. There are various processes involved in this like
developing certain standards for business in advance, comparing the actual cost or
performance with pre-established standards, and taking all required remedial measures.

Thus, financial management is mainly concerned with the proper management of funds.
The finance manager must see that the funds are procured in a manner that the risk,
cost and control considerations are properly balanced in a given situation and there is
optimum utilisation of funds.

3
Financial Goals: Profit Maximization, Wealth Maximization

Profit Maximisation Wealth Maximisation

1. Meaning The management of financial The management of financial
resources aimed at increasing resources aimed at increasing the
the profit of the company. value of the stakeholders of the
company.
2. Approach Profit maximization is the Wealth maximization is the
traditional approach. universal approach.
3. Focus It is focused on increasing the It is focused on increasing the
profit of the company. value of the company’s
stakeholders.
4. Time It ignores the time value of Wealth maximization considers the
Value of money. In profit time value of money.
Money maximization, money
receivable today is more
valuable than the money
received in future.
5. Duration It is the short-term process. It is the long-term process.
6. Risk Profit maximization ignores Wealth maximization considers the
the risk & uncertainty. risk & uncertainty.
7. Under profit maximization, Under wealth maximization,
Discretionary immediate increase of profit management always pays for
Expenditures is the main object. So, discretionary expenditures. Such
management never allowed as advertising, research, and
discretionary expenditures. maintenance.
8. Product’s When a company wants to Wealth-oriented companies focus
Pricing maximize profits, it prices on maintaining product price
strategy products as high as possible over the long-term.
in order to increase
margins.

Profit maximisation is a process business firms undergo to ensure the best output and
price levels are achieved in order to maximise its returns.

But, it can be a bad thing for the stakeholders if company fully focuses on profit making.

Example – To make more profit company used lower-quality materials or not adopts
advance technology.

The concept of profit maximisation has come under severe criticism in recent times on
account of the following reasons -

(i) It is vague – Profit maximization policy does not clarify a goal of profit ratio.
(ii) It ignores timings - The concept of profit maximisation does not help in making a
choice between projects giving different benefits spread over a period of time. The
fact that a rupee received today is more valuable than a rupee received later is
ignored.
(iii) It overlooks quality aspects of future activities – The business is not solely run
with the objective of earning highest possible profits. Some firms place a high value
on the growth of sales. They are willing to accept lower profits to gain stability

4
 provided by a large volume of sales. Other firms use a part of their profits to make
contributions for socially productive purposes. Moreover, profit maximisation at the
cost of social or moral obligations is a short-sighted policy even as a pragmatic
approach.
(iv) Ignore Quality - The most challenging part of profit maximisation as a goal is that it
neglects the intangible benefits such as quality, image, technological advancements
etc.

On account of the above reasons, profit maximisation is not considered to be an ideal

criterion for making investment and financing decisions.

In recent times, adoption of wealth maximisation is the best criterion for financial
decision making.

What is Wealth Maximization?

Wealth maximization means maximization of the shareholder’s wealth as a result of

increase in share price thereby increasing the market capitalization of the company.
Share price increase is a direct function of how competitive the company is, its
positioning, growth strategy and how it generates profits.

Advantages -

• The concept of wealth maximization is universally accepted.

• It is more related to cash flow than profits.
• Present value of cash flow taken into consideration.
• It considers the factors of risk and uncertainty while taking into consideration the
discounting rate which reflects both the time and risk.
• It considers the concept of time value of money. The present value of cash inflows
and outflows helps the management to achieve the overall objective of a company.
• It is more long term focused as compared to profit maximization which has a short
term focus. Profit maximization is easy to attain because managers may adopt
unethical ways to bring short term profits based on long term sustainability.

Criticism of Wealth Management

The wealth maximization objective has been criticized by certain financial theorists
mainly on the following accounts:

• It is a prescriptive idea. This means not describing the actual activities do for wealth
maximization.
• The objective of wealth management is not necessarily socially desirable.
• There is some controversy as to whether the objective is to maximize the
stockholders wealth or the wealth of the firm which includes other financial
claimholders such as debenture holders, preferred stockholders etc.

5
• When managers act as agents of the real owners (equity shareholders), there is a
possibility for a conflict of interest between shareholders and the managerial
interests.

In spite of all the criticism, wealth maximization is the most appropriate objective of a
firm and the side coast in the form of conflicts between the stockholders and debentures
holders, firm and society and stockholders and managers can be minimized.

Finance Function - Investment, Financing and Dividend decisions

Introduction

Finance is the life blood of a business. Financial management is the study of the process
of procuring and judicious use of financial resources with a view to maximizing the value
of the organisation. It improves the value of the owners. i.e. Maximum monetary
benefits to equity shareholders in a company.

Traditional view of Financial Management looks into the following functions that a
Finance Manager of a business firm will perform –

• Arrangement of short term and long term funds from financial institutions.
• Mobilisation of funds through financial instruments like Equity shares, Preference
shares, Debentures, Bonds etc.
• Orientation of Finance functions with the Accounting function and compliance of
legal provision relating to funds procurement, utilisation of fund and allocation of
fund.

With the increase in complexity of modern business situations, the role of a Finance
Manager is not just confined to procurement of funds, but his area of functioning is
extended to judicious and efficient use of funds available to the company, keeping in
view the objectives of the company and expectations of the providers of funds.

Modern Approach to Financial Management

In view of modern approaches, financial management is concerned with both acquisition

of funds as well as their allocation.

Technological improvements widened marketing operations, development of a strong

corporate structure & healthy business environment support to modern approach in
financial management.

Finance Manager is expected to analyse the firm with following aspects -

• Total funds requirement of the company

• Assets to be acquired
• Pattern of financing the assets

6
The Finance Manager of a modern business company will generally involves the three
types of decisions - Investment decisions, Finance decisions & Dividend decisions.

A] Investment Decisions-

Investment decisions relate to –

a) Careful selection of viable and profitable investment proposals

b) Allocation of funds to the investment proposals
c) Consider investment proposals with a view to obtain net present value of the future
earnings of the company & to maximize its value.

It is the function of a Finance Manager to carefully analyse the different alternatives of

investment, determination of investment levels in different assets. i.e. fixed assets and
current assets.

The finance manager has to evaluate different capital investment proposals and select
the best keeping in view the overall objective of the company.

Situations based Examples -

• The investment in current assets will depend on the credit and inventory policies
pursued by the enterprise.
• The credit policy is determined with the need for growth in sales and the availability
of finance.
• The inventory policy will be set up taking into account the requirements of
production, the market trend of the price of raw materials and the availability of
funds.

The investment decisions of a Finance Manager cover the following areas -

• Prioritisation of investment decisions

• Ascertainment of total volume of funds
• Appraisal and selection of capital investment proposals
• Measurement of risk and uncertainty in the investment proposals
• Funds allocation
• Securities analysis and portfolio management etc.
• Determination of levels of investments in current assets viz, inventory, cash,
marketable securities, receivables etc., and its management.
• Asset replacement decisions
• Restructuring, reorganization, mergers and acquisitions

7
B] Finance Decisions -

Finance decisions relates to –

• Cost of funds from various sources

• Determination of debt-equity mix
• Analyse debt component in the capital mix
• Monitoring the impact of taxation and depreciation in maximization of earnings per
share to the equity holders
• Observe the impact of interest & inflation rates on the company

Major goal of financial decisions is to optimize the financing mix, to improve return to
the equity shareholders and maximization of wealth of the firm and value of the
shareholders' wealth.

The Finance Manager is involved in following Finance Decisions -

• Determination of financing pattern of long term funds requirement

• Determination of financing pattern of medium and short term funds requirement
• Raising of funds through issue of financial instruments viz, Equity shares, Preference
shares, Debentures, Bonds etc.
• Arrangement of funds from Banks and Financial Institutions for long term, medium
term and short term needs.
• Arrangement of finance for working capital requirement
• Consideration of interest burden on the company
• Consideration of debt level changes and its impact on the company
• Taking advantage of interest and depreciation in reducing the tax liability of the
company
• Consideration of various modes of improving the earnings per share (EPS) and the
market value of the share
• Consideration of cost of capital of individual components and weighted average cost
of capital to the company
• Analysis of impact of different levels of gearing on the firm and individual
shareholder
• Portfolio management
• Consideration of impact of over-capitalisation and under-capitalisation on the firm's
profitability.
• Consideration of foreign exchange risk exposure of the firm and decisions to hedge
the risk.
• Study of impact of stock market and economic conditions of the country on modes
of financing
• Maintenance of balance between long term funds and short term funds.
• Evaluation of alternative use of funds
• Preparation of cash flow and funds flow statements and analysis of performance
through ratios to identify the problem areas and its correction, etc.

8
 • Determination of degree or level of gearing
• Setting of budgets and review of performance for control action.

C] Dividend Decisions -

It is mainly concerned with the decisions relating to the distribution of earnings of the
firm among its equity holders and the amounts to be retained by the company.

The Finance Manager will involve in taking the following dividend decisions -

• Determination of dividend and retention policies of the firm.

• Consideration of impact of levels of dividend and retention of earnings on the market
value of the share and the future earnings of the Company.

The dividend decision involves the determination of the percentage of profits earned by
the enterprise which is to be paid to its shareholders.

Theoretically, this decision should depend on whether the company or the shareholders
can make a more profitable use of the funds.

However, in practice, a number of other factors like the market price of shares, the trend
of earnings, the tax position of the shareholders, etc., play an important role in the
determination of dividend policy of a business enterprise.

Organization of Finance Function: Role of Finance Manager

In many organizations accounting and finance functions are clubbed and the finance
function is often considered as part of the functions of the Accountant. But, the finance
function is a distinct and separate function rather than simply an extension of the
accounting function.

Accounting function discharges the function of systematic recording of transactions

relating to the firm's transactions in books of account and summarizing the same for
presenting in financial statements viz, Profit and Loss Account and Balance Sheet, Funds
flow and Cash flow statements.

The Finance Manager will make use of the accounting information in analysis and review
of the firm's business position in decision making.

To analyze financial information available from the books of account and records of the
firm, a Finance Manager uses the advanced methods and techniques like Capital
budgeting techniques, Statistical and Mathematical models and Computer applications in
decision making to maximise the value of the firm's wealth and value of the owners'
wealth.

In the modern business world, finance manager’s decisions involve three aspects -
Investment decisions, Finance decisions & Dividend decisions. These decisions are

9
interrelated to each other. Therefore, the finance manager judges own decision with all
the three angles simultaneously.

The Important Functions of a Finance Manager in a Modern Business World

Consist Of the Following -

1. Estimate the capital requirement – Finance manager has to estimate the total
capital requirement of the company.
2. Determining Capital Structure – After determining the requirement of capital, the
finance manager has to determine the proper mix of equity and debt ratio. It is
positively reflect with minimum cost of capital and maximizes shareholders wealth.
3. Select sources of funds – Before the actual procurement of funds, the finance
manager has to decide the affordable sources of fund & report to top level
management.
4. Allocation of funds - After the funds are raised, the next important thing is to
allocate the funds. The best possible manner of allocating the funds:
a. Size of the organizations and their growth capability
b. Status of assets about long term or short term
c. The mode by which the funds are raised
5. Working capital decisions - Working capital decisions are concerned with
investment in current assets or current liabilities. It revolves around working capital
and short-term financing. Current assets include cash, inventories, receivables,
short-term securities, etc. whereas current liabilities include creditors, bank
overdraft, bills payable.
6. Ensures Liquidity - The finance manager ensures that there is a regular supply of
funds in an organization. He monitors all cash-inflows and cash-outflows and avoids
any underflow or overflow like situations. Ensuring the optimum level of liquidity in
an organization is one of the important scopes of financial management.
7. Credit and collections - To direct the granting of credit and the collection of
accounts due to the company, including the supervision of required special
arrangements for financing sales, such as time payment and leasing plans
8. Investments - To achieve the company's funds as required and to establish and co-
ordinate policies for investment in pension and other similar trusts.
9. Tax administration - Finance manager has to prepare and administer tax policies
and procedures.
10. Profit Management - The finance manager measures the cost of capital and
chooses cheap sources of capital by properly analyzing different sources available.
11. Dividend Decision - The finance manager should decide an optimum dividend
payout ratio out of available profit.
12. Evaluating and consulting - To consult with all segments of management
responsible for policy or action concerning any phase of the operation of the business
as it relates to the attainment of objectives and the effectiveness of policies,
organisation structure and procedures.

10
13. Controlling Activities - The financial performance of the various units of the
organisation is to be evaluated from time to time to detect any fault in the financial
policy and take the remedial action at appropriate time, if necessary.
14. Reporting and interpreting - Finance managers compare performance with
operating plans and standards, and to report and interpret the results of operations
to all levels of management.

Subsidiary Functions of Finance Manager

Apart from the above main functions, following subsidiary functions are also performed
by the finance manager:

(i) Protection of assets - Finance managers ensure protection of assets for the
business through internal control, internal auditing and proper insurance coverage.
(ii) Manage financial risk – Manage financial risk by using strategies to limit the
probability of a financial loss.
(iii) Government reporting - Finance manager has to supervise or co-ordinate the
preparation of statutory reports to Government agencies.
(iv) Relations with financial institutions – Finance managers have to maintain
professional relations with bankers and other financial institutions. It is necessary
for the company to obtain the funds at most favourable terms.

In conclusion - Financing decisions involve deciding how the required funds should be
raised from available long term or short term sources. A financial manager is required to
form a proper finance mix or optimum capital structure of the company to raise its value.
They are required to maintain a proper balance between equity and debt to provide
maximum return to shareholders.

Financial Mathematics: Concept & Relevance of Time Value of Money

Time Value of Money: Concept & Relevance

Time Value of Money (TVM) means that money received in the present is of higher
worth than money to be received in the future. This means money generate money. If
we invest todays received money, then it can generate cash flow in future in the way of
interest.

The value of money received today is different from the value of money received after
some time in the future. Time Value of Money is a concept that recognizes the relevant
worth of future cash flows arising as a result of financial decisions by considering the
opportunity cost of the funds. Since money tends to lose value over time, there is
inflation, which reduces the buying power of money.

However, the cost of receiving money in the future rather than now shall be greater

11
than just the loss in its real value on account of inflation. The opportunity cost of not
having the money right now also includes the loss of additional income, which could be
earned by simply having possession of cash earlier.

An important financial principle is that the value of money is time dependent. This
principle is based on the following four reasons -

1. Inflation - Under inflationary conditions the value of money, expressed in terms of

its purchasing power over goods and services, declines.
2. Risk - Rs. 1 now is certain, whereas Rs. 1 receivable tomorrow is less certain.
This 'bird-in-the-hand principle is extremely important in investment appraisal.
3. Personal Consumption Preference - Many individuals have a strong preference
for immediate rather than delayed consumption. The promise of a bowl of rice next
week counts for little to the starving man.
4. Investment Opportunities - Money like any other desirable commodity has a
price, given the choice of Rs. 100 now or the same amount in one year's time, it is
always preferable to take the Rs. 100 now because it could be invested over the
next year at (say) 18% interest rate to produce Rs. 118 at the end of one year. If
18% is the best risk-free return available, then you would be indifferent to receiving
Rs. 100 now or Rs. 118 in one year's time. Expressed another way, the present
value of Rs. 118 receivable one year hence is Rs. 100.

The Time Value of Money is also referred to as the Present Discounted Value. Money
deposited in a savings bank account earns a certain interest rate to compensate for
keeping the money away from them at the current point of time. Hence, if a bank
holder deposits Rs.100 in the account, the expectation will be to receive more than Rs.
100 after one year.

Time Value of Money Formula

The formula to calculate time value of money (TVM) either discounts the future value of
money to present value or compounds the present value of money to future value.

FV = PV x [1 + (I/ N)] (N*T)

Or

PV = FV x [1 + (I/ N)] (N*T)

FV = Future value of money

PV = Present value of money

i = Rate of interest or current yield on similar investment

t = Number of years

n = Number of compounding periods of interest per year

12
Time Value of Money Calculations

A] Future Value of a Single Amount

Future Value of Money = Value of money at present + Interest

Illustration - Suppose one invests Rs.1,000 for 2 years in a Savings account, which
pays 10% interest per year. If one allows the interest income to be reinvested, the
investment shall grow as follows:

Future Value at the End of First Year

Time Value of Money - Future Value a Principal at the beginning of the Rs. 1,000
year
Principal at the beginning of the year Rs.1,000 Interest for the year Rs. 100
(Rs. 1,000 * 0.10)
Principal at the end Rs. 1,100

Future Value at the End of Second Year

Time Value of Money - Future Value a Principal at the beginning of the Rs. 1,100
second year
Interest for the year (Rs. 1,100 * 0.10) Rs. 110
Principal at the end Rs. 1,210

Reinvestment

Reinvestment is the process of investing the returns received from investment in the
form of dividends, interest, or any type of cash reward to purchase additional shares
and reinvesting the gains; investors do not opt to check out cash benefits while they are
reinvesting their profits in their portfolio.

Reinvestment is mainly used by investors to increase the value of the portfolio by

concentrating all the funds into one particular investment; in the case where the price
of security surges, the value of the portfolio shoots up accordingly.

Reinvestment can also be used in the context where a business is reinvesting the profits
to further expand the company or investing in any technological advancements from a
long-term perspective.

Reinvestment can be done with any type of assets like stocks, mutual funds, bonds,
ETF, or any instrument which gives periodic returns, and the proceeds can be used to
reinvest.

Major two factors effect on reinvestment -

(i) Risk

There is always a risk of downside in any investment, and the investor won’t be able to
reinvest at the current rate of return.

13
A Portfolio of mixed instruments helps to reduce the reinvestment risk, like investing in
bonds with different maturities, bonds with different interest rates, and so on.

Fund managers assist in mitigating the risk and allocate the funds appropriately to the
respective investments. However, market risk and falling yields are some risks that are
totally unavoidable.

(ii)Interest Rate

Every other investment bear returns based on the interest rate, so the reinvestment
rate is the rate at which money can be earned by investing in another fixed-income
instrument other than the current one.

Anticipated interest rates for investment by any investor play a vital role; for instance,
if the interest rate increases, the price of the bond tend to fall, and the individual loses
the value of the principal and also makes less money than the current market rate, so a
person faces interest rate risk for his reinvestment.

A] Calculation of Future Value

Interest Rate – There are two kinds of interest

I] Simple Interest – It is the interest which accrues only on the amount originally
borrowed/lend. No interest accrues on the interest accrued previously.

Simple Interest = Money borrowed at present (P) * Rate of Interest (r) * Time Period
(t)

Simple Interest = P*r*t

Future value on simple interest basis = P + Prt

Principal (P) = FV / (1 + rt)

II] Compound Interest –

It is the interest on the original amount borrowed and an interest accrued previously
byt not paid or received. Compound interest is calculated as follows –

Compound Interest (CI) = Future Value (FV) – Money Borrowed at Present (P)

Future Value (FV) = Money borrowed at present (P) * [1 + Interest rate (r)] Time
Period (t)

FV = P (1+r)t

PV of money borrowed will be (P) = FV / (1 + r)t

Illustration – Calculate future value and compound interest on an amount of Rs.

100,000 borrowed at a compound interest of 10% p.a. for –

14
 i. 6 Months
ii. 1 Year
iii. 2 Years

6 Months 1 Year 2 Years

Amount Borrowed 100,000 100,000 100,000
Rate of Interest (r) 10% 10% 10%
Time Period (t) 0.5 1 2
Future Value: FV = P(1 + r)t 105,000 110,000 121,000

B] Finding the Growth Rate

It is the rate at which future cash flow grows. The growth rate may be increasing or
decreasing.

Illustration – Calculate the cash flow for 4 years if the cash flow at the end of the 1st
year is Rs. 200,000 and the growth rate is 5% per year in each of the following cases:

a) Increase by 10%
b) Decrease by 10%

Solution –

a) Increase by 10%

Statement of cash flow

Year P.Y. Cash Flow Growth Rate Total Amount at the

Year End
1 - - 200,000
2 200,000 5% 210,000
3 210,000 5.5% 221,550
4 221,550 6.05% 234,954
5 234,954 6.655% 250,590
b) Decrease by 10%

Statement of Cash flow

Year P.Y. Cash Flow Growth Rate Total Amount at the

Year End
1 - - 200,000
2 200,000 5% 210,000
3 210,000 4.5% 219,450
4 219,450 4.05% 229,325
5 229,325 3.64% 237,672

C] Doubling Period

Every investor asks a question about how many years required to double invested
amount at a given rate of interest.

15
For e.g. – National Savings Certificate

• Rule of 72 to calculate the doubling period

In this case 72 is divided by rate of interest to get the doubling period.

Supposing the rate of interest is 8% the doubling period will be:

72 / 8 = 9 Years

If the rate of interest is 4%

The doubling period will be 72 / 4 = 18 years

• Rule of 69 to calculate the doubling period

According to this rule, doubling period = 0.35 = 69 / Interest rate

Illustration – Calculate doubling period for two interest rates, 10% and 15% using rule
of 69.

Interest Rate Doubling Period

10% 0.35 + 69 / 10 = 7.25 years
15% 0.35 + 69 / 15 = 4.95 years

Arbitrage Process

The word 'arbitrage' is a technical term referring to a situation where two identical
commodities are selling in the same market for different prices, then the market will
reach equilibrium by the dealers starting to buy at the lower price and sell at the higher
price, thereby making profit.

The increase in demand will force up the price of the lower priced goods and increase in
supply will force down the price of the high priced commodities.

The arbitrage in (Modigliani-Miller) MM theory shows that the investors will move
quickly to take advantage and will make profit in an equilibrium capital market, and
then this would represent an arbitrage opportunity.

The cost of equity will rise by an amount just sufficient to offset any possible saving or
loss. The supply of debt is determined by the lenders. The optimal level is simply the
maximum amount of debt which lenders are prepared to subscribe in any given
circumstances e.g, level of inflation, rate of economic growth, level of profits etc. The
investors will exercise their own leverage by mixing their own portfolio with debt and
Equity. They call this the arbitrage process. Under these conditions of investment the
average cost of capital is constant.

If two different firms with the same level of business risk but different levels of gearing
sold for different values, then shareholders would move from over-valued firm to the
under-valued firm and adjust their level of borrowing through the market to maintain
financial risk at the same level. The shareholders would increase their income through
this method while maintaining their net investment and risk at the same level. This

16
process of arbitrage would drive the price of the two firms to a common equilibrium
total value.

Illustration -

The capital structures of ABC Ltd. and XYZ Ltd. are given below

Particulars ABC Ltd. XYZ Ltd.

Equity Capital 60,00,000 80,00,000
Debt 10% 60,00,000 ----
Total 1,20,00,000 80,00,000
Both the companies are in the same class of business risk with earnings before interest
of Rs. 18,00,000.

Mr. Tom is holding equity of 5% in ABC Ltd.

ABC Ltd.'s profits available for distribution

Particulars Amt.
Profit Before Interest 18,00,000
Less: Interest @ 10% 6,00,000
Total 12,00,000
Mr. TOM share in ABC Ltd’s profits

= Rs. 12,00,000 * 5/100

= Rs. 60,000

Mr. TOM noticed that POR Ltd. had the same level of business risk with equal earnings.

Mr. TOM Sold his ABC Ltd 5% shares for Rs. 300,000 (i.e. 5% of Rs. 60,00,000).

He borrowed another Rs. 100,000 on interest @15% p.a. and invested Rs. 400,000 in
PQR Ltd.'s shares and his holding shares in PQR Ltd. comes to 5%.

Particulars Amt.
Total Earnings in PQR Ltd. 18,00,000

Mr. TOM’s Share in XYZ Ltd. 90,000

(Rs. 18,00,000 * 5%)
LESS: Interest on Personal Loan 15,000
(Rs. 100,000 * 15%)
75,000

Mr. TOM could increase his income by Rs. 15,000 (i.e. Rs. 75,000 - Rs. 60,000) while
maintaining total risk at the same level.

17
Module 2

55
 Unit 5
Cost of Capital

Table of Contents

5.0 Objectives: .....................................................................................................................

5.1 Meaning of cost of capital: ................................................................................................

5.2 Components of cost of capital: ..........................................................................................

5.3 Relevance of cost of capital in decision making:...................................................................

5.4 Summary: ......................................................................................................................

5.5 Exercise: ........................................................................................................................

5.6 Additional Readings: ........................................................................................................

5.0 Objectives

At the end of this unit, you will be able to underatand:

 Meaning of cost of capital
 Components of cost of capital
 Relevance of cost of capital in decision making

5.1 Meaning of cost of capital

The cost of capital of a firm refers to the cost that a firm incurs in retaining the funds
obtained from various sources (i.e. Equity shares, Preference Shares, Debt, and Retained
Earnings)

5.2 Components of cost of capital

The overall cost of capital of a firm consists of the costs of various segments of the total
funds, which may be identified as follows:
 Cost of Debt Capital i.e. debentures & loans from various institutions;
 Cost of Preference Capital;
 Cost of Equity Capital;
 Cost of Retained Earnings.

56
5.3 Relevance of cost of capital in decision making

 Since the business should at least be capable of earning so much revenue as to be

able to meet its cost of capital and to finance its growth, cost of capital of a firm
constitutes a crucial factor in most financial decisions.
 It is relevant both to capital budgeting and capital structure planning, the main areas
in financial management.
 In capital budgeting decisions, cost of capital may be taken as the discounting rate.
Obviously, if a particular project gives an internal rate of return higher than its cost
of capital, it should be an attractive opportunity.
 In capital structuring decisions, the cost of capital is an important consideration
along with the risk factor. For example loan may be cheaper but it entails higher risk
of cash insolvency as also of variation in the earnings per share due to the financial
leverage effect. It is therefore essential that the cost of each source of funds is
carefully considered and compared with the risk involved in it.

Q. 1 Fill in the blanks:

1. of a firm constitutes a crucial factor in most financial decisions.
( cost of Capital, risk factor, profit)

2. Cost of capital may be taken as

(discounting rate, premium rate, growth rate).

1) Cost of Capital 2) Discounting rate

57
5.4 Summary

So friends let‟s sum up what we have discussed till now

 Overall cost of capital includes cost of equity, cost of debentures, cost of preference
shares and cost of retained earnings.

 Cost of Capital It is relevant both to capital budgeting and capital structure planning,
in financial management.

5.5 Exercise

Now let us check what we have learnt so far.

Q1.Explain the importance of cost of capital in decision making.

Q2.How cost of capital affects the decision making.

5.6 Additional Readings:

Bhattacharya, Hrishikas (2010), Working Capital Management; Strategies &

techniques, Prentice Hall, New Delhi.
Brealey Richard A & Steward C, Meyers (2008): Corporate Finance, Tata Mcgraw Hill,
New Delhi.
Hampton, John (2010): Financial decision making, Prentice Hall, New Delhi.
Pandey, I M( 2010), Financial Management, Vikas Publishing House, New Delhi.
Khan M Y, Jain P K(2009), Financial Management, Tata Mcgraw Hill, New Delhi.

58
 Unit 6
Calculation of Cost of Capital

Table of Contents

6.0 Objectives:......................................................................................................................

6.1 Determination of cost of capital .........................................................................................

6.2 Cost of Debt ....................................................................................................................

6.2.1 Factors affecting the Cost of Debt ................................................................................

6.2.2 Explicit and Implicit Cost of Debt .................................................................................

6.2.3 Classification of Debt on the basis of its Redeemability ...................................................

6.2.4 How to calculate the Cost of Irredeemable Debt (Perpetual Debt) ....................................

6.2.5 How to calculate the Cost of Debt Redeemable in lump sum ............................................

6.3 Cost of Preference Share...................................................................................................

6.3.1 Factors affecting the cost of Preference Shares ..............................................................

6.3.2 Classification of Preference shares on the basis of its Redeemability.................................

6.3.3 Cost of Irredeemable Preference Shares: ......................................................................

6.3.4 Cost of Redeemable Preference Shares:........................................................................

6.4 Cost of Equity Share.........................................................................................................

6.4.1 Meaning of Cost of Equity Share ..................................................................................

6.4.2 Factors affecting the Cost of Equity Share .....................................................................

6.4.3 Terms useful to study Different approaches as to cost of Equity capital.............................

6.4.4 Different Approaches as to the calculation of cost of Equity Share ....................................

6.5 Cost of Retained Earnings or Reserves ................................................................................

6.6 Summary ........................................................................................................................

6.7 Exercise:.........................................................................................................................

6.8 References :....................................................................................................................

59
6.0 Objectives:

After studying this chapter, you should be able to understand:

 Determination of cost of capital.
 Cost of debt
 Cost of preference share
 Terms useful to study different approaches as to cost of equity capital.
 Cost of Retained earnings.

6.1 Determination of cost of capital

To calculate the overall cost of capital of a firm, it is necessary to find the cost of each
source finance, which has been discussed in the following paragraphs.

6.2 Cost of Debt

6.2.1 Factors affecting the Cost of Debt

The considerable factors while calculating cost of debt are:

 Fixed Interest Rate
 Issue Expenses like Underwriting Commission, Brokerage
 Discount / Premium on issue/Redemption
 Income Tax Rate

6.2.2 Explicit and Implicit Cost of Debt

The debt may have explicit cost as well as implicit cost.

Explicit Cost of Debt = Interest rate as per contract + Cost of raising the debt

For example X ltd. Issues 1000, 9% Debentures of the face value of Rs. 100 at a discount of
5%. Underwriting, brokerage & other costs in connection with the issue Rs. 5,000.
Amount actually received by the company = Rs. 1,00,000 – Rs. 5,000 – Rs. 5000
= Rs. 90,000.
Annual cost in form of interest = Rs. 9,000
Before Tax cost = Rs. 9,000 / Rs. 90,000 x 100 = 10%
If income tax rate is 40%, Explicit cost after tax = 60% of 10% = 6% since interest will be
allowed as a charge against revenue and to that extent tax liability of the company will be
reduced.

60
Implicit cost of Debt = Cost of increase in expectations of equity shareholders.

Increase in Increase in Increase in expectations

debt capital firm‟s risk of equity shareholders.

When does implicit cost arise?

6.2.3 Classification of Debt on the basis of its Redeemability

On the basis of Redeemability the debt may be classified as follows:

Debt

Irredeemable Debt (Perpetual Redeemable Debt (i.e Debt

Debt) (i.e. Debt which is not which is redeemable during
redeemable during the life of the life of the company)
the company)

Redeemable in Lump Redeemable in

sum Installments

6.2.4 How to calculate the Cost of Irredeemable Debt (Perpetual Debt)

The cost of irredeemable debt is calculated as follows:

𝐼𝑛𝑡e𝑟e𝑠𝑡 (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡e) I (1 − t)
Cost of Debt = =
𝑁e𝑡 𝑆𝑎𝑙e 𝑃𝑟o𝑐ee𝑑𝑠 f𝑟o𝑚 𝐼𝑠𝑠𝑢e of 𝐷e𝑏𝑡 𝑆𝑃
Where,
𝑅𝑎𝑡e of i𝑛𝑡e𝑟e𝑠𝑡
Interest (I) = 𝐹𝑎𝑐e 𝑣𝑎𝑙𝑢e of 𝑎 𝐷e𝑏e𝑛𝑡𝑢𝑟e X
100
Net Sales Proceeds from Issue of Debt (SP) = Face value + Premium on Issue (or –
Discount on issue) – Floatation cost like underwriting commission or brokerage.

Tax Rate (t) = Income Tax Rate

61
Q. 1 Fill in the blanks:
1. Implicit cost arises when there is .
(Increase in debt capital, decrease in debt capital, No change in debt capital )

2. Perpetual debt is
(irredeemable ,redeemable )

1) Increase in debt capital 2) Irredeemable

Illustration 1 [Cost Of Perpetual/Irredeemable Debt]

Tulsian Ltd. Issued Rs. 100 Lakhs 12% Debentures of Rs. 100 each. Calculate the cost of
debt in each of the following cases. (Assume corporate tax rate being 40%).
 Case (a) If Debentures are issued at par with no floatation cost.
 Case (b) If Debentures are issued at par with 5% floatation cost.
 Case (c) If Debentures are issued at 10% premium with 5% floatation cost.
 Case (d) If Debentures are issued at 10% discount with 5% floatation cost.

Solution
Cost of Perpetual/Irredeemable Debt after tax
Interest (1−tax rate)
(𝑘𝑑) =
Net Sale Proceeds of Debt

Case (a) kd = 12(1−0.40) = 7.20 = 0.0720 = 7.20%

100 100

12(1−0.40)
Case (b) kd = = 7.20 = 0.0758 = 7.58%
100(1−0.05) 95

12(1−0.40) 7.20
Case (c) kd = =
= 0.0689 = 6.89%
104.50 104.50

Case (d) kd =
12 (1−0.40)
=
7.20 = 0.0842 = 8.42%

85.50 85.50

62
6.2.5 How to calculate the Cost of Debt Redeemable in lump sum

The cost of Debt redeemable in lump sum may be calculated using Approximation Method or
Present Value Method as follows:
(a) Under Approximation Method

Interest [(Redeemable Value − Net Sales Proceeds)/N](1 − tax rate)

𝑘𝑑 =
(𝑅e𝑑ee𝑚𝑎𝑏𝑙e 𝑉𝑎𝑙𝑢e + 𝑁e𝑡 𝑆𝑎𝑙e 𝑝𝑟o𝑐ee𝑑𝑠)/2
I + [(RV − SP)/N](1 − t)
=
(RV + SP)/2

Illustration 2
Surya Industries has raised the funds through issue of 10,000 debentures of Rs. 150 each
at discount of Rs. 10 per debenture with 10 years maturity. The coupon rate is 16%. The
flotation cost is Rs. 5 per debenture. The debentures are redeemable with a 10% premium.
The corporate taxation rate is 40% calculate the cost of debenture

24 + [(165 − 135)/10](1 − 0.40)

(165 + 135)/2

Kd = 16.2%

(b) Under Present Value Method

𝐼𝑛𝑡e𝑟e𝑠𝑡1 (1−𝑡) 𝐼𝑛𝑡e𝑟e𝑠𝑡2 (1−𝑡)

Net Proceeds of Debt = + +⋯
(1+k𝑑)1 (1+k𝑑)2

Interest n (1 − t) + Redeemable Value n

…+
(1 + kd)2
𝑛
𝐼𝑡(1 − 𝑡) 𝑅𝑉 𝑛
= ∑( + )
(1 + 𝑘𝑑)𝑡 (1 + 𝑘𝑑)𝑛
𝑡=1

To calculate kd the following steps may be followed:

Step 1: Calculate Total Present Value of cash Outflow during the maturity period at two
discount rates so as to have positive and negative Net present Values (NPV)
Step 2: Find kd by interpolation technique as follows:
Kd = RL+ 𝑁𝑃𝑉
x (RH -RL)
𝑁𝑃𝑉𝑙−𝑁𝑃𝑉 𝐻

63
Where, RL = Lower Discount Rate, RH = Higher Discount Rate
NPVL = Positive Net Present Value at Lower Discount Rate
NPVH = Negative Net Present Value at Higher Discount Rate
NPV = Present Value of Cash Outflow – Net Sale Proceeds from issue
of debt.

Note: Two Discount Rates within which kd (calculated under Approximation Method) lies
may be used so as to have positive and negative Net Present Values.

Business machines Ltd. has issued redeemable debentures of Rs. 100 each payable at the
end of 8 years period on a coupon rate of 14%. The Flotation expense is 10% of issue
amount. Calculate the cost of debt.

year Particulars Cash Discount PV Discount PV

Flow Factor Factor
Rs Rs
0 Net proceeds (90) 1.000 (90) 1.000 (90)
1-8 Interest Payments 14 4.639 64.95 4.078 57.09
8 Repayment on 100 0.351 35.10 0.266 26.60
maturity
NPV 10.05 -6.31

10.05
Kd = 14+ x (4) = 16.46%
10.05+6.31

6.3 Cost of Preference Share

6.3.1 Factors affecting the cost of Preference Shares

The considerable factors while calculating the cost of preference share are:
 Fixed Dividend Rate
 Issue expenses like underwriting commission, brokerage cost
 Discount / Premium on issue / Redemption
 Dividend Distribution Tax

For example X ltd. Issues 1000 10 % Preference Shares of the face value of Rs. 100 at a
premium of 5%. Underwriting, brokerage & other costs in connection with the issue Rs.
5,000. Income Tax Rate 40%, Dividend Distribution Tax 20%.
Amount actually received by the company = Rs. 1,00,000 + Rs. 5,000 – Rs.5,000
= Rs. 1,00,000.
Annual cost in form of fixed dividend = Rs. 10,000
Explicit Cost of Preference Share = Fixed Dividend + Dividend Distribution Tax

64
 = Rs. 10,000 + 20% of Rs.10,000 = Rs. 12,000

𝐸𝑥𝑝𝑙i𝑐i𝑡 𝐶o𝑠𝑡 of 𝑝𝑟efe𝑟e𝑛𝑐e 𝑆ℎ𝑎𝑟e = Rs.12,000

x 100 = 12%
Rs.1,00,000

Note: There is no tax advantage since the preference dividend is not allowed as a charge
against revenue. It is treated as an appropriation out of profits.

6.3.2 Classification of Preference shares on the basis of its Redeemability

On the basis of Redeemability the debt may be classified as follows:

 Irredeemable preference shares (Perpetual Preference shares) (i.e. shares which are
not redeemable during the life of the company).
 Redeemable preference shares i.e shares which are redeemable(repayable) during
the life of the company)

6.3.3 Cost of Irredeemable Preference Shares:

The cost of irredeemable preference shares is calculated as follows:

𝑝𝑟efe𝑟e𝑐e 𝐷i𝑣i𝑑e𝑛𝑑 (1+𝐷i𝑣i𝑑e𝑛𝑑 𝑡𝑎𝑥 ) Dp (1+Dt)
Cost of preference shares Kp = =
𝑁e𝑡 𝑆𝑎𝑙e 𝑃𝑟o𝑐ee𝑑𝑠 f𝑟o𝑚 𝐼𝑠𝑠𝑢e of 𝐷e𝑏𝑡 𝑆𝑃

Illustration 3
Tulsian Ltd. Issued Rs. 100 lakhs 12 % Preference shares of Rs. 100 each .Calculate the
cost of preference shares in the following cases of dividend tax rate is 20%.
 Case (a) if preference shares are issued at par with 5% flotation cost.
 Case (b) if preference shares are issued at 10% premium with 5% flotation
cost.
Solution:
Case (a) Kp = 12 (1+0.20) = 15.16%
95

Case (b) Kp = 12 (1+0.20)= 13.78%

104.50

Case (c) Kp = 12 (1+0.20)= 16.84%

85.50

65
6.3.4 Cost of Redeemable Preference Shares:

The cost of Redeemable Preference shares is calculated as follows:

D(1 + Dt) + [(Redeemable Value − Net Sales Proceeds)/N]
𝑘𝑝 =
(𝑅e𝑑ee𝑚𝑎𝑏𝑙e 𝑉𝑎𝑙𝑢e + 𝑁e𝑡 𝑆𝑎𝑙e 𝑝𝑟o𝑐ee𝑑𝑠)/2

= D(1 + Dt) + [(RV − SP)/N]

(RV + SP)/2
Where,
Kp = Cost of preference Shares
D = Constant Annual dividend payment
Dt = Divided Tax
N = No. of years to redemption
RV = Redeemable value of preference shares
SP = Sale value of preference shares less discount and floatation Expenses

Illustration 4
Dell ltd. has Rs. 100 preference share redeemable at a premium of 10% with 15 years
maturity. The Dividend rate is 12% Floatation cost is 5%. Sale price is 95. Calculate the
cost of preference shares.
Solution:
D+[(RV−SP)/N]
Kp=
(RV+SP)/2

D = Constant Annual dividend payment i.e Rs 12

N = No. of years to redemption i.e 15
RV = Redeemable value of preference shares with 10% premium i.e Rs. 110
SV = Sale value of preference shares less discount and floatation Expenses
Rs 95-5= Rs 90
12(110−90)/15]
Kp= = 12+1.33/100 = 13.33%
(110+90)/2

6.4 Cost of Equity Share

The funds required for the project are raised from the equity shareholders which are of
permanent nature. These funds need not be repayable during the life tome of the
organization. Hence, it is permanent source of funds. The equity shareholders are the
owners of the company. The main objective of the firm is to maximize the wealth of the
equity shareholders.

66
6.4.1 Meaning of Cost of Equity Share

It may be defined as minimum rate of return that the company must earn on that portion of
its total capital employed which is financed by equity capital, so that the market price of the
shares of the company remains unchanged.

6.4.2 Factors affecting the Cost of Equity Share

The computation of the Cost of an Equity Share requires an understanding of many factors
basically concerning the behavior of the investors and their expectations. The considerable
factors while calculating the Cost of Equity include:
 Price of an Equity Share in the beginning of year.
 Expected Equity Dividend at the end of a year.
 Growth Rate.

6.4.3 Terms useful to study Different approaches as to cost of Equity capital

To study different approaches as to the Cost of Equity Share one must know:
 What is Retention Ratio?
 What is Price Earnings Ratio?
 What is Price earning of Return on Retained Earnings?
 What is Growth Rate?
 What is Expected Dividend?
 What is Current Market Price?
 Risk of Security

Following are the answer to the aforesaid questions:

6.4.3.1 Retention Ratio (b):

Retention Ratio means that proportion of earning per share (E) which is not distributed as
dividend (D). It is denoted by the symbol, „b‟. The remaining proportion of earning per share
which is distributed as dividend is known as „Dividend Payout Ratio‟. These are calculated as
follows:
Earning Per Share(E)− Dividend Per Share(D)
1. 𝑅e𝑡e𝑛𝑡io𝑛 𝑅𝑎𝑡io = x 100
Earning Per Share(E)

a. 𝐷i𝑣i𝑑e𝑛𝑑 𝑃𝑎𝑦o𝑢𝑡 𝑅𝑎𝑡io = 𝐷i𝑣i𝑑e𝑛𝑑 𝑝e𝑟 𝑠ℎ𝑎𝑟e(𝐷) = 𝐷 x 100

𝐸𝑎𝑟𝑛i𝑛g 𝑃e𝑟 𝑆ℎ𝑎𝑟e (𝐸) 𝐸

D/P Ratio = 1 – Retention ratio (b) = 1 – b

2.

Illustration 5 [Calculation of Retention Ratio (b)]

Calculate Retention ratio (b) in each of the following alternative cases:
 Case (a) Earnings per share Rs. 10, Dividend per share Rs.6
 Case (b) Dividend Payout Ratio 80%.

67
Solution
𝐸𝑎𝑟𝑛i𝑛g 𝑃e𝑟 𝑆ℎ𝑎𝑟e−𝐷i𝑣i𝑑e𝑛𝑑 𝑝e𝑟 𝑆ℎ𝑎𝑟e
Case (a) Retention Ratio (b) = x 100
𝐸𝑎𝑟𝑛i𝑛g 𝑃e𝑟 𝑆ℎ𝑎𝑟e
𝑅𝑠.10−𝑅𝑠.6
= x 100 = 40%
𝑅𝑠.10
Case (b) Retention ratio (b) = 100% - 80% = 20%

6.4.3.2 Price Earnings Ratio(P/E Ratio) :

Price Earnings Ratio means the number of times of EPs, the share is being quoted in the
market. The reciprocal of P/E Ratio Earning Yield (or performance of earning in relation to
market price) or expectations of the share holders. It is used to calculate Growth rate (g). It
is calculated as follows:
𝑀𝑎𝑟ke𝑡 𝑃𝑟i𝑐e of 𝑎𝑛 𝐸𝑞𝑢i𝑡𝑦 𝑠ℎ𝑎𝑟e (𝑃) 𝑃
1. Price-Earnings ratio = =
𝐸𝑎𝑟𝑛i𝑛g 𝑃e𝑟 𝑆ℎ𝑎𝑟e 𝐸

1
2. Price-Earnings Ratio = = 1

𝑅𝑎𝑡e of 𝑅e𝑡𝑢𝑟𝑛 o𝑛 𝑅e𝑡𝑎i𝑛e𝑑 𝐸𝑎𝑟𝑛i𝑛g𝑠(𝑟) 𝑟

Illustration 6 [Calculation of Price-Earnings ratio (P/E Ratio)]

Calculate Price – Earnings Ratio in each of the following alternatives cases:
 Case (a) Current Market Price of An Equity Share Rs. 50, Current Earning Per Share
Rs.10.
 Case (b) Rate of Return on Retained Earnings 25%.
 Case (c) Current Market price of an Equity Share Rs. 50, Current Dividend Per Share
Rs. 10, Dividend Payout Ratio 80%.

Solution
𝑀𝑎𝑟ke𝑡 𝑝𝑟i𝑐e 𝑝e𝑟 𝑆ℎ𝑎𝑟e
Case (a) Price-Earnings Ratio = =𝑃= 𝑅𝑠.50 =5
𝐸𝑎𝑟𝑛i𝑛g 𝑝e𝑟 𝑠ℎ𝑎𝑟e 𝐸 𝑅𝑠.10
1
Case (b) Price-Earnings ratio = = 1 =4
𝑅𝑎𝑡e of 𝑟e𝑡𝑢𝑟𝑛 o𝑛 𝑅e𝑡𝑎i𝑛e𝑑 𝐸𝑎𝑟𝑛i𝑛g𝑠 0.25
𝑀𝑎𝑟ke𝑡 𝑃𝑟i𝑐e 𝑃e𝑟 𝑆ℎ𝑎𝑟e
Case (c) Price Earnings ratio =
𝐷i𝑣i𝑑e𝑛𝑑 𝑝e𝑟 𝑠ℎ𝑎𝑟e /𝐷i𝑣i𝑑e𝑛𝑑 𝑝𝑎𝑦o𝑢𝑡 𝑅𝑎𝑡io
𝑅𝑠.50
= 10 =4
𝑅𝑠.80%

6.4.3.3 Price earning of Return on Retained Earnings(r):

Rate of Return on Retained Earnings (r) means the earning yield (or performance of earning
in relation to market price) or expectations of shareholders. it is the reciprocal of Price-
Earnings ratio (P/E Ratio). It is used to calculate Growth rate (g). It‟s usually denoted by
symbol. „r‟.
It is calculated as follows:
Rate of Return on Retained Earnings = Earning Yield
1. 𝐸𝑎𝑟𝑛i𝑛g 𝑃e𝑟 𝑆ℎ𝑎𝑟e
=
𝑀𝑎𝑟ke𝑡 𝑃𝑟i𝑐e 𝑃e𝑟 𝑆ℎ𝑎𝑟e

68
 Rate of Return on Retained Earnings(r) = 1
x 100
2. 𝑃𝑟i𝑐e 𝐸𝑎𝑟𝑛i𝑛g 𝑟𝑎𝑡io

Illustration 7 [Calculation of Rate of Return on Retained Earnings (r)]

Calculate the rate of Return on Retained Earnings (r) in each of the following alternative
cases:
 Case (a) Current Market Price of An Equity Share Rs. 50, current Earning Per share
Rs. 10.
 Case (b) Price Earnings Ratio 4
 Case (c) Current Market Price of earning Share Rs.50, Current Dividend Per Share
Rs.10.
 Dividend Payout Ratio 80%.
Solution
𝐸𝑎𝑟𝑛i𝑛g 𝑃e𝑟 𝑆ℎ𝑎𝑟e
Case (a) Rate of Return on Retained Earnings = x 100
𝑀𝑎𝑟ke𝑡 𝑃𝑟i𝑐e 𝑃e𝑟 𝑆ℎ𝑎𝑟e
𝑅𝑠.10
r= x 100 = 20%
𝑅𝑠.50
1
Case (b) Rate of Return on Retained Earnings = = 1 = 25%
𝑃𝑟i𝑐e 𝐸𝑎𝑟𝑛i𝑛g 𝑟𝑎𝑡io 4

Case (c) Rate of Return on Retained Earnings

𝑠ℎ𝑎re
𝐷i𝑣i𝑑e𝑛𝑑 𝑝e𝑟 𝐷i𝑣i𝑑e𝑛𝑑 𝑃𝑎𝑦o𝑢𝑡 𝑅𝑎𝑡io
= x 100
𝑀𝑎𝑟ke𝑡 𝑃𝑟i𝑐e 𝑝e𝑟 𝑠ℎ𝑎𝑟e
10
𝑅𝑠. %
= 80 x 100 = 25%
𝑅𝑠.50

6.4.3.4 Growth Rate (g):

Growth Rate (g) means the rate at which the earnings of a company are expected to grow
in future. It is denoted by the symbol, „g‟. It is calculated as follows:
Growth Rate (g) = Retention Ratio (b) x Rate of Return on Retained Earnings (r) =
1.
br.
Growth Rate (g) = (1 – Dividend Payout Ratio) x (1/ price – Earnings Ratio)
2.

Illustration 8 [Calculation of Growth rate (g)]

Calculate Growth Rate (g) in each of the following alternative cases:
 Case (a) Retention Ratio 40%. Rate of Return on Retained earnings 20%.
 Case (b) Dividend Payout Ratio 70%, rate of Return on retained earning 20%.
Solution
Case (a) Growth Rate = Retention Ratio (b) x Ratio of Return on Retained Earnings (r)
= 0.40 x 0.20 = 0.08 or 8%
Case (b) Retention Ratio (b) = 1 – Dividend Payout ratio = 1 – 0.80 = 0.20
Rate of Return on retained Earning = I/P/E Ratio = 1/8 = 0.125
Growth Rate = Retention Ratio (b) x ratio of Return on Retained Earnings (r)

69
 = 0.20 x 0.125 = 0.025 or 2.5%.

6.4.3.5 Expected Dividend (D1) :

Expected Dividend (D1) means dividend per share which is to be paid at the end of one
year. It is denoted by the symbol, „D1‟. D1 may be calculated as follows:
1. D1 = D0 (1+ g)
Where, D0 = Actual Dividend Per Share paid for the last year, g = Growth
Rate
2. D1 = E1 x Dividend Payout Ratio
Where, E1 = Expected Earning Per Share which means earning per share
which is expected to be earned at the end of one year.

Illustration 9 [Calculation of Expected Dividend per share (D1)]

Calculate Expected Dividend (D1) in each of the following alternative cases:
 Case (a) Present Earning per share Rs. 10, Growth Rate 8%.
 Case (b) Present Earning per share Rs. 10, Dividend payout Ratio 60%, Growth Rate
8%.
 Case (c) Expected Earning per share Rs. 10, Dividend Payout ratio 60%, Growth
rate 8%.
Solution
Case (a) D1 =D0 (1 + g) = Rs. 10 (1 + 0.08) = Rs. 10.80
Case (b) D0 = E0 x Dividend Payout ratio = Rs. 10x 60% = Rs. 6
D1 = d0 (1 + g) = Rs. 6 (1 + 0.08) = Rs. 6.48
Case (c) D1 = E1 x Dividend Payout Ratio = Rs. 10 x 60% = Rs. 6

6.4.3.6 Current Market Price (P0):

Current Market Price (P0) means the price at which the share is being currently quoted in
the market. It is usually denoted by the symbol, P0. It may be calculated as follows:
P = Current Earning Per Share x Current Price Earnings Ratio
1. 0
𝐶𝑢𝑟𝑟e𝑛𝑡 𝐷i𝑣i𝑑e𝑛𝑑 𝑝e𝑟 𝑠ℎ𝑎𝑟e
2. P0 = x Current Price-Earning Ratio
𝐶𝑢𝑟𝑟e𝑛𝑡 𝐷i𝑣i𝑑e𝑛𝑑 𝑃𝑎𝑦o𝑢𝑡 𝑅𝑎𝑡io

3. P0 = 𝐸𝑥𝑝e𝑐𝑡e𝑑 𝐸𝑎𝑟𝑛i𝑛g 𝑃e𝑟 𝑆ℎ𝑎𝑟e x 𝐶𝑢𝑟𝑟e𝑛𝑡 𝑝𝑟i𝑐e 𝐸𝑎𝑟𝑛i𝑛𝑔 𝑅𝑎𝑡io

(1+𝐺𝑟ow𝑡ℎ 𝑟𝑎𝑡e)

Illustrations 10 [Calculation of current Market Price (P0)]

Calculate the current Market Price (P0) of an equity share in each of the following alternative
cases:
 Case (a) Price Earnings Ratio 5, Present earning per share Rs. 10.
 Case (b) Price Earnings Ratio 5, Present Dividend per share Rs. 6, Dividend Payout
Ratio 60%.

70
  Case (c) Price Earnings Ratio 5, Expected Earnings per share Rs. 10.80, and Earning
Growth Rate 8%.
 Case (d) Price Earnings Ratio 5, Expected Dividend per share Rs.6.48, Dividend
Payout ratio 60%, Earning Growth Rate 8%.

Solution
Case (a) Current Market Price (P0) = EPS0 x P/E Ratio = Rs. 10 x 5 = Rs. 50
Case (b) EPS0 = D0/ dividend Payout Ratio = Rs. 6/60% = Rs. 10
Current Market Price (P0) = EPS0 x P/E Ratio = Rs. 10 x 5 = Rs. 50
Case (c) EPS0 = EPS1/ (1 + growth rate) = Rs. 10.80/ (1 = 0.08) = Rs. 10
Current Market Price (P0) = EPS1/ (1 = growth rate)
= Rs. 10.80/ (1 + 0.08) = Rs. 10 x 5 = Rs. 50
Case (d) EPS1 = D1/ Dividend Payout Ratio = Rs. 6048/60% = Rs. 10.80
EPS0 = EPS1/ (1 = growth rate) = Rs. 10.80/ (1 = 0.08) = Rs. 10
Current Market Price (P0) = EPS0 x P/E Ratio = Rs. 10 x 5 = Rs.50

6.4.3.7 Risk of Security

The total risk of security consists of the following two types of risks :
(a) Unsystematic Risk (or Diversifiable Risk) :

Meaning – I represents the fluctuations in return of a specific security due to factors

affecting a particular firm only. It can be eliminated through diversification (i.e by investing
in large number of well-diversified securities).
Examples: The Examples of unsystematic risk include :
 Strike by workers
 Resignation by R& D Expert.
 Entry of a formidable competitor.
 Losing a big contract in a bid.
 Inadequate Availability of Raw Material.
 Custom Duty imposed on a raw material used by the company.

(b) Systematic Risk (or Non – Diversifiable Risk or Market Risk)

Meaning - It represents the fluctuation in return of every security due to factors affecting
the market as a whole. It arises due to tendency of every security to move together with
changes in the market. It cannot be eliminated through diversification. Investors are
exposed to market risk even when they hold well diversified portfolios of securities.
Examples: The Examples of Systematic risk include:
 Change in Interest Rate Policy
 Change in Corporate Tax policy
 Increase in inflation Rate.
 Govt. resorting to massive deficit financing
 Change in Foreign Exchange Policy.

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6.4.4 Different Approaches as to the calculation of cost of Equity Share

Since there can be different interpretations of investor‟s behavior, there are many
approaches regarding calculation of cost of equity shares. The six main approaches have
been discussed below:

6.4.4.1 Dividend Price (D/P) Ratio Approach:

Under this approach, the cost of equity share capital is calculated on the basis of the
present value of the expected future streams of dividend. Here, the cost of equity Capital
will be the rate of expected dividend, which will maintain the market price of equity shares.
This approach assumes that dividends are paid at a constant rate to perpetuity.
Cost of Equity is calculated as follows:
𝐷1
Ke =
𝑃0

Where, D1 = Expected Dividend per share at the end of year 1.

P0 = Current Market Price per share in the beginning of year 1.
Example – Suppose an investor subscribes to the equity shares of X ltd. Having expected
dividend per share (D1) as Rs. 6 and the current market price of the share (P0) is Rs. 50.
Cost of equity will be:
𝐷1 𝑅𝑠.6 = 0.12 o𝑟 12%
Ke = =
𝑃0 𝑅𝑠.50

Drawbacks
 It ignores the factor of capital appreciation or depreciation in the market price of
shares.
 A company, which declares a higher amount of dividend out of a given amount of
earnings, will be placed at a premium as compared to a company, which earns the
same amount of profits but utilizes a major part of it in financing its expansion
programmes.
 This approach cannot be used to calculate the cost of equity of companies which are
not declaring dividend.

6.4.4.2 Dividend Price plus Growth approach:

Under this approach, the cost of equity share capital is calculated on the basis of the
present value of the expected future streams of dividends and the rate of growth in
dividend. This growth rate in dividend (g) is equal to the compound growth rate in earnings
per share. Here, the cost of capital is based upon the dividend rate and capital appreciation
expected by the shareholder. Cost of equity is calculated as follows:
𝐷1
Ke = +g
𝑃0
Where, D1 = Expected dividend per share at the end of year 1 = D0 (1 + g)
P0 = Current Market Price per Share at the beginning of year 1.
G = Growth rate= br
B = Retention Ratio = (1 – Dividend Payout Ratio)
𝐷𝑃𝑆 (1+𝐷𝑡)
=1–
𝐸𝑃𝑆

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 R = Internal Rate of Return on Retained Earnings

Example – Suppose an investor subscribes to the equity shares of X ltd. Having expected
dividend per share (D1) as Rs. 6 and the current market price of the share (P0) is Rs. 50
and the earnings and dividend per share are expected to grow at rate of 8% p.a.., Cost of
equity will be :
Ke = 𝐷1 +g= 𝑅𝑠.6 + 0.08 = 0.20 o𝑟 20%
𝑃1 𝑅𝑠.50

Drawback – It does not answer one problem – How to quantity the expectations of the
investor relating to dividend and growth in dividend?

6.4.4.3 Earning Price Ratio Approach:

Under this approach, the cost of equity share capital is calculated on the basis of the
present value of the expected future streams of earnings (whether distributed or not). Here,
the cost of equity capital is based upon that rate of expected earnings, which will maintain
the market price3 of equity shares. Cost of equity is calculated as follows:
Ke = 𝐸1
𝑃0

Where, E1 = Expected Earnings per share at the end of year 1 is Rs. 10 ,

Current Market Price in the beginning of year 1.
Example I – Expected Earnings per share at the end of year 1 is Rs. 10, Current Market
Price is Rs. 50. Here, Cost of Equity (ke) = 𝐸1 = 𝑅𝑠.10
𝑃0 𝑅𝑠.50

= 0.20 or 20%
Example II : If X ltd. Is expected to earn 30%; the investor who expects 20% rate of
earnings will be prepared to pay Rs. 150 per share of Rs. 100 each.
Merit – In comparison to D/P ratio approach seeks to nullify the effect of change in the
dividend policy.
Drawback – Like D/P ratio approach, it also ignores the factor of capital appreciation or
depreciation in the market price of shares.

6.4.4.4 Earning Price plus Growth approach :

Under this approach, the cost of equity share capital is calculated on the basis of the
present value of the expected future streams of earnings and the rate of growth in earnings.
Here, the cost of capital is based upon the earning rate and capital appreciation expected by
a shareholder. Cost of equity is calculated as follows :
𝐸1
Ke = +𝑔
𝑃0
Where, E1 = Expected earnings per share at the end of year 1 = E0 (1 + g)
P0 = Current Market Price per share the beginning of year 1.
G = Growth rate = br
b= Retention Ratio = (1 – Dividend Payout Ratio)
𝐷𝑃𝑆(1+𝐷𝑡)
=1–
𝐸𝑃𝑆

73
 r = Internal rate of Return on Retained Earnings
Example : Expected Earnings per share (E1) is Rs. 10 and the Current Market Price of the
share (P0) is Rs. 50 and the earning per share is expected to grow (g) at rate of 8% p.a.,
Cost of equity will be:
Ke = 𝐸1 +g= 𝑅𝑠.10 + 0.08 = 0.20 + 0.08 = 28%
𝑃0 𝑅𝑠.50

6.4.4.5 Realized Yield approach:

This approach assumes that past behavior will be repeated in future and uses past yields
instead of expected values of dividend and capital appreciation as the basis to formulate an
estimate of the cost of equity capital.

6.4.4.6 Capital Asset Pricing Model (CAPM):

The CAPM divides the cost of equity into two components, the near risk-free return available
on investing in government bonds and an additional risk premium in turn comprises the
average return on the overall market portfolio and the beta factor (or risk) of the particular
investment. Putting this all together the CAPM assesses the cost of equity for an investment
as the following:
Where KE = Rf + βi [Rm - Rf]
Rf = Risk –free rate of return
Rm = Average market return
βi = Beta of the investment

Illustration
Modern Ltd.‟s share factor is 1.40. The risk free rate of interest on government securities is
9%. The expected rate of return on company equity shares is 16%. Calculate cost of equity
capital based on capital asset pricing model.
KE = 9% + 1.40(16% -9%)
= 9% + 1.40(7%)
= 9% + 9.8%
Which Approach to use?
Type of Company Approach to be used
1. In case of companies with stable income Dividend Price Approach
and stable dividend policies
2. In case of growing companies Dividend Price plus Growth Approach
3. In case of companies whose earnings E/P ratio approach but representative
accrue in cycles figure should be taken into account to
include one complete cycle.
4. In case of companies enjoying stable Realized Yield Approach
growth rate & stable rate of divided.

74
6.5 Cost of Retained Earnings or Reserves

 Some people hold the view that retained earnings do not involve any cost on the
assumption that the company has a separate identity distinct from its shareholders
and it has not to pay anything for withholding the earnings in the company.
 However, the above view does not seem to be correct due to the presence of
opportunity cost of retained earnings. The cost of retained earnings may be taken as
equal to the rate of return which the shareholders would have earned after investing
the retained earnings passed to them in alternate investments.
 If earnings were distributed as dividend and simultaneously, an offer for right shares
were made, the shareholders would have subscribed to the right shares on the
expectations of a certain return. This return maybe taken as the indicator of the cost
of retained earnings. Thus, the opportunity cost of retained earnings is the rate of
return on dividend foregone by equity shareholders.
 Since the shareholders generally expect dividend and capital gain from their
investment, the cost of retained earnings will be equal to the shareholders required
rate of return, i.e., the Cost of Equity (ke).
 Since retained earnings do not involve any explicit cost (say floatation cost) the cost
of retained earnings shall be less than the cost of new equity capital.
Cost of Retained Earnings may be computed as follows:
kr = D1 +𝑔
P0

Where, kr = Cost of retained earnings

D1 = Dividend per share at the end of current year
P = Current Market price of share at the beginning of the current year
g = Growth Rate or

𝑘𝑟 = Ke(1 − T)
Kr = Cost of retained Earnings
Ke = Cost of equity Shares
T = Tax Rate

For example – suppose a company earns Rs. 10 per share and the current market price of
share is Rs. 200. The cost of retained earnings will be = 𝑅𝑠.10 = 5%
𝑅𝑠.200

6.6 Summary

So friends let‟s sum up what we have discussed till now

 Dividend Price (D/P) Ratio Approach : Under this approach, the cost of equity
share capital is calculated on the basis of the present value of the expected future
streams of dividend i.e Ke = 𝐷1
𝑃0

75
  Dividend Price plus Growth approach: Under this approach, the cost of equity
share capital is calculated on the basis of the present value of the expected future
streams of dividends and the rate of growth in dividend. Ke = 𝐷1 + g
𝑃0

 Earning Price Ratio Approach: Under this approach, the cost of equity share
capital is calculated on the basis of the present value of the expected future streams
of earnings (whether distributed or not). Ke = 𝐸1
𝑃0

 Earning Price plus Growth approach : Under this approach, the cost of equity
share capital is calculated on the basis of the present value of the expected future
streams of earnings and the rate of growth in earnings. Ke = 𝐸1 + 𝑔
𝑃0

 Realized Yield approach: this approach assumes that past behavior will be repeated
in future and uses past yields instead of expected values of dividend and capital
appreciation as the basis to formulate an estimate of the cost of equity capital.

 Weighted average cost is a cost of various sources of funds where the weights are
being the proportion of each source of funds in the capital structure. It is denoted as
k0.
 The weighted cost of capital can be computed by using book value weights or the
market value weights.

6.7 Exercise:

Now let us check what we have learnt so far.

Theory Questions
 How is the cost of Debt Computed?
 How is cost of preference shares computed?
 Explain different approaches as to the computation of the cost of equity shares.
 How can you determine of cost of equity in a growing company?

Practical Problems
A) Cost of Debt (Kd): Calculate the Cost of Debt in the following cases:
1. A Ltd. Issued 12 %, Debentures of Rs. 100 each at par. Brokerage 2% of issue
price. Corporate Tax Rate 30%.
2. B Ltd issued 12 % , Debentures of Rs. 100 each at 5% discount and
redeemable after 5 years at % premium. Corporate Tax Rate 30%.
3. D Ltd. Issued 12%, Debentures of Rs. 100 each at par. Flotation cost 10%.
Corporate Tax Rate 30%.
4. C Ltd. Issued 12%, redeemable Debentures of Rs. 100 each at par Flotation
cost 10%. Corporate Tax Rate 30%.

76
 Calculate the Cost of Preference Shares in the following cases:
1. P Ltd. Issued 12 % , preference shares of Rs. 100 each at par. Brokerage 2% of
issue price. Corporate Tax Rate 30%. Dividend Tax Rate 20%
2. Q Ltd issued 12 % , preference shares Rs. 100 each at 5% discount and
redeemable after 5 years at 5% premium. Corporate Tax Rate 30%. Dividend
Tax Rate 20%
3. R Ltd issued 12 % , preference Shares of Rs. 100 each at par and redeemable
after 5 years at par. Flotation cost 10%. Corporate Tax Rate 30%. Dividend Tax
Rate 20%
4. S Ltd issued 12 % , of Rs. 100 each at 5% discount and redeemable after 5
years at % premium. Corporate Tax Rate 30%. Flotation cost 10%. Dividend
Tax Rate 20%

B) Cost of Equity (ke): Calculate the Cost of Equity Shares in the following
cases:
1. The Current market price of V Ltd.‟s equity share of Rs. 10 each is Rs. 64. For
the last year, the company had paid equity dividend of Rs. 8 per share Which is
expected to grow @ 5% p. a. forever.
2. The current market price of W Ltd.‟s equity share of Rs. 10 each is Rs. 64. The
dividend expected on the equity share at the end of year is Rs. 8 which is
expected to grow @ 5% p. a. forever.
3. The current market price of X Ltd. „ s equity share of Rs . 10 ach is 90.
Earnings per share for the current year is Rs. 20 per share. Dividend payout
Ratio is 60% Anticipated Dividend Growth Rate is 5%. Floatation Cost is Rs.6
per share.
4. The current market price of Y Ltd. „ s equity share of Rs . 10 each is 90. The
Prevailing default risk free interest rate on 10 years GOI Treasury Bonds is
5.5%. The average market risk premium is 8% . The bête of the company is
1.5.
5. The prevailing default risk –free interest rate on 10 year GOI Treasury Bonds is
5.5% Rate of Return on Market Portfolio is 13.5%. Beta of the company is 1.5.

6.8 References :

Bhattacharya, Hrishikas (2010), Working Capital Management; Strategies &

techniques, Prentice Hall, New Delhi.
Brealey Richard A & Steward C, Meyers (2008): Corporate Finance, Tata Mcgraw Hill,
New Delhi.
Hampton, John (2010): Financial decision making, Prentice Hall, New Delhi.

Pandey, I M( 2010), Financial Management, Vikas Publishing House, New Delhi.

Khan M Y, Jain P K(2009), Fina cial Management, Tata Mcgraw Hill, New Delhi.

77
 Unit 7
Combined Cost of Capital

Table of Contents

7.0 Objectives: ..........................................................................................................................

7.1 Weighted Average Cost of Capital ...........................................................................................

7.1.1 What is Weighted Average Cost of Capital? ........................................................................

7.1.2 What is the Relevance of Weighted Average Cost of Capital?................................................

7.1.3 Book value Weights Vs. Market Value weights ....................................................................

7.1.4 How to determine weighted Average Cost of Capital? ..........................................................

7.2 Summary.............................................................................................................................

7.3 Exercise: .............................................................................................................................

7.4 Additional Readings...............................................................................................................

7.0 Objectives

At the end of this unit, you will be able to:

 Describe weighted average cost of capital
 Compute weighted Average cost of capital

7.1 Weighted Average Cost of Capital

7.1.1 What is Weighted Average Cost of Capital?

It is a weighted average of costs of various sources of funds where the weights are being
the proportion of each source of funds in the capital structure. It is denoted as k0.

7.1.2 What is the Relevance of Weighted Average Cost of Capital?

 Now the term cost of capital is used to refer weighted average cost of capital instead
of cost of specific source of capital such as cost of debt, cost of equity etc. since
there is relationship between methods of financing and their costs

For example :
o The firm‟s decision to use equity capital to finance its projects would enlarge its
potential for borrowings in future.

78
 o On the other hand, the firm‟s decision to use debt capital to finance its projects
not only adversely affects its potential for using low cost debt in future but also
increases the risk of shareholders and the increased risk to shareholders will
increase the cost of equity.

 The simple average cost of capital is not appropriate to use since firms need not
necessarily use various sources of funds in equal proportion in the capital structure.
 It facilitates the computation of equity Financial Break Even Point (i.e. that level of
EBIT at which the firm is just able to recover the fixed interest cost of Debt, fixed
Preference Dividend on Preference Shares and the cost of Equity) as follows :

Æf𝑡e𝑟−𝑡𝑎𝑥 𝖶eigℎ𝑡e𝑑 Æ𝑣e𝑟𝑎ge 𝐶o𝑠𝑡 of 𝐶𝑎𝑝i𝑡𝑎𝑙

Equity Financial B.E.P. = x Total
(1−𝑇𝑎𝑥 𝑟𝑎𝑡e)
Capital
7.1.3 Book value Weights Vs. Market Value weights

The weighted cost of capital can be computed by using book value weights or the market
value weights. Book Value Weights represents Values as per Balance Sheet are calculated as
follows:

(BVW for Equity Shares) = Face Value of an Equity Shares x No. of Equity Shares
(BVW for Preference Shares) = Face Value of a Preference Share x No. of Preference shares
(BVW for Debentures) = Face Value of a Debenture x No. of Debentures
(BVW for Retained Earnings) = Same amount as appear in the Balance sheet

 Market Value Weights represents Values as per Market Quotations and are calculated
as follows :

(MVW for Equity Shares) = Current Market Price of an Equity Share x No. of Equity Shares
(MVW for Preference Shares) = Current market Price a Preference Shares x No. of
Preference Share
(MVW for Debentures)= Current Market Price of a Debentures x No. of Debenture

Note : Retained Earnings are not shown separately since the market value of equity share
represents the combined market value of equity shares and retained earnings.

 The same after tax cost of each source of fund is used whether the weighted average
cost of capital is computed by using book value weights or the market value weights.

79
  The weighted cost of capital computed by using book value weights will be
understated if the market value of the share is higher than the book value and vice
versa.
 Theoretically, the market value weights should be preferred over the book value
weights because the market value weights reflect the actual expectation of the
investors.
 Why book value weights are preferred

In practice, book value weights are used because:

 Market value fluctuates very widely and frequently.
 Generally, the firms set their capital structure targets in terms of book value.
 Investors analyze Debt – Equity Ratio on book value basis to evaluate the risk of
the firms.

7.1.4 How to determine weighted Average Cost of Capital?

Practical Steps involved in the Determination of Weighted average Cost of Capital

Step 1: Calculate the cost of each of the specific sources of funds i.e. cost of debt,
cost of equity, cost of preference capital etc. on after tax basis.
Step 2: Calculate the weights being proportion of each source of funds in the capital
structure.
Step 3: Multiply the cost of each source by weights.
Step 4: Add the weighted cost of all sources of funds

Example: Format of the Statement showing the Computation of Weighted Average Cost of
Capital.
Statement showing the Weighted Average Cost of Capital (Using Book Value Weights)

Source of Capital Amount of Proportion of After tax Product

each source each source of cost of each
of capital capital source of
capital
B
A D E=CxD
C
Equity Share Capital …………… …………… …………… ……………
Retained Earnings …………… …………… …………… ……………
Preference Share capital …………… …………… …………… ……………
Debentures …………… …………… …………… ……………
Total …………… 1.00 ……………

80
 Source of Capital Amount of Proportion of After tax cost Product
each source each source of of each source
of capital capital of capital

B C D
A E=CxD
Equity Share Capital …………… …………… …………… ……………
Preference Share capital …………… …………… …………… ……………
Debentures …………… …………… …………… ……………
Total …………… 1.00 ……………

Statement showing the Weighted Average Cost of Captal (Using Book Value Weights)

Note : Retained Earnings are not shown separately since the market value of equity share
represents the combined market value of equity shares and retained earnings.

Illustration 1 :
Tulsian (1) Ltd. Has the following Capital Structure as per its Balance Sheet as at 31st
March, 2009:
Rs. In lakh
Equity Share Capital (fully paid shares of Rs. 10 each) 4
18% Preference Share Capital (fully paid shares of Rs. 100 each ) 3
Reatained Earnings 1
12.5% Debentures (fully paid of rs. 100 each) 8
12% Term loan 4
20
Additional Information :
(a) Currently Quoted Prices in the Stock Exchange :
Equity Shares @ Rs. 64.25; Preference Shares @ Rs. 90, Debentures @ Rs. 95.
(b) For the last year, the Company had paid equity dividend of Rs. 8 per share which is
expected to grow @5% p.a. forever.
(c) The corporate Tax rate is 30%
Required: Calculate Weighted Average Cost of Capital using (a) Book Value weights
(b) market Value Weights

81
Solution
(a) Statement showing the Weighted Average Cost of Capital (Using Book Value
Weights)

Source of Capital Amount of Proportion of After tax Product

each source each source of cost of each
of capital capital source of
capital
B
A D E=CxD
C

Equity Share Capital 4 0.20(i.e., 4/20) 0.1807 0.0361

Retained Earnings 1 0.05(i.e.,1/20) 0.1807 0.0090

18% Preference Share 3 0.15(i.e., 3/20) 0.2000 0.0300

capital

12.5% Debentures 8 0.40(i.e., 8/20) 0.0921 0.0368

12% Term loan 4 0.20(i.e., 4/20 0.0840 0.0168
Total 20 1.00

Weighted Average Cost of Capital = 0.1287 or 12.87%

(b) Statement showing the Weighted Average Cost of Capital (Using Market Value
weights

Source of Capital Amount of Proportion of each After tax Product

each source source of capital cost of
of capital each
source of
capital
B(in lakhs)
C D
A E=CxD

Equity Share Capital 25.70 0.6425 (i.e., 0.1807 0.1161

25.7/40)

18% Preference Shares 2.70 0.0675 (i.e., 0.2000 0.0135

Capital 2.7/40)

12.5% Debentures 7.60 0.1900(i.e. 0.0921 0.0175

7.6/40)

12% term loan 4.00 0.1000(i.e., 4/40) 0.0840 0.0084

Total 40.00 1.0000 0.1555

Weighted Average Cost of Capital = 0.1555 or 15.55%

82
Working Notes :
𝐼𝑛𝑡e𝑟e𝑠𝑡 (1−𝑡)
(i) Cost of 12.5% Debentures = = 12.5 (1− 0.3) = 0.0921 o𝑟 9.21%
𝑁𝑎𝑡 𝑠𝑎𝑙e𝑠 𝑃𝑟o𝑐ee𝑑𝑠 𝑅𝑠.95
𝐼𝑛𝑡e𝑟e𝑠𝑡 (1−𝑡) 𝑅𝑠.48000 (1−0.3)
(ii) Cost of 12% term loan = = = 0.084 o𝑟 8.4%
𝑁e𝑡 𝑆𝑎𝑙e𝑠 𝑃𝑟o𝑐ee𝑑𝑠 𝑅𝑠.4,00,000
𝑃𝑟efe𝑟e𝑛𝑐e 𝐷i𝑣i𝑑e𝑛𝑑
(iii) Cost of 18 % Preference Share Capital = = 𝑅𝑠.18 = 0.2 o𝑟 20%
𝑁e𝑡 𝑆𝑎𝑙e𝑠 𝑃𝑟o𝑐ee𝑑𝑠 𝑅𝑠.90
𝐷1
(iv) Cost of Equity Share Capital (kg) = +𝑔= 𝐷0(1+g) + 𝑔= 𝑅𝑠.8(1+0.05) + 0.05
𝑃0 𝑃0 𝑅𝑠.64.25
𝑅𝑠.8.4
=
𝑅𝑠.64.25
+ 0.05 = 0.1807 o𝑟 18.07%
(v) Cost of Retained Earnings = ke = 18.07%

Illustration 2
Calculate the cost of new debentures, new preference shares, new equity shares and
retained earnings from the point of view of company if anticipated external financing
opportunities are as follows :
(a) 13% Debentures Rs. 100 each issued at par and redeemable after 5 years at
5% premium. Floatation cost is 5% of issue price.
(b) 15% Preference Share of Rs. 100 each issued at par and redeemable after 5
years at 5% premium. Floatation cost is 5% of the issue price.
(c) Equity Shares of Rs. 10 each issued at Rs. 80. Floatation cost is Rs. 5 per
share. EPS for the current year is Rs. 25 per share. Dividend Payout Ratio is
60%. Anticipated growth rate is 5%. Corporate tax rate is 40%.

Solution
(a) Calculation of the Cost Of new Debebtures
[(𝑅e𝑑ee𝑚𝑎𝑏𝑙e 𝑣𝑎𝑙ue−𝑁et 𝑆𝑎𝑙e 𝑃r𝑜𝑐ee𝑑𝑠)]
𝐼𝑛𝑡e𝑟e𝑠𝑡 (1−𝑡𝑎𝑥 𝑟𝑎𝑡e)+
𝑁
Approxiamtion method = [(𝑅e𝑑ee𝑚𝑎𝑏𝑙e𝑉𝑎𝑙𝑢e +𝑁et 𝑆𝑎𝑙e 𝑃r𝑜𝑐ee𝑑𝑠)]
2

𝐼(1−𝑡)+ [(𝑅𝑉−𝑆𝑃)/𝑁]
Kd =
(𝑅𝑉+𝑆𝑃)/2
13(1−0.4) + [(105 − 95)/5]
Kd = = 0.098 = 9.80%
(105+95 )/2

(b) Calculation of new Preference Shares

𝑃𝑟efe𝑟e𝑛𝑐e 𝐷i𝑣i𝑑e𝑛𝑑 = [(𝑅e𝑑ee𝑚𝑎𝑏𝑙e 𝑉𝑎𝑙𝑢e – 𝑁e𝑡 𝑆𝑎𝑙e 𝑃𝑟o𝑐ee𝑑𝑠)]/ 𝑁
Kd = [(𝑅e𝑑ee𝑚𝑎𝑏𝑙e 7𝑎𝑙ue+𝑁𝑎t 𝑆𝑎𝑙e 𝑃r𝑜𝑐ee𝑑𝑠)]
2
𝐷𝑝 + [(𝑅𝑉 − 𝑆𝑃)/𝑁]
Kp =
(𝑅𝑉+𝑆𝑃)/2
15+(105−95)/5
Kp = = 0.17 or 17.00%
(105+95)/2

(c) Calculation of cost of New Equity Shares

83
 𝐷1 𝐷0(1 +g)
Cost of Equity Capital = +g= +g
𝑃0 𝑃0
15(1+0.05)
Ke = + 0.05
(80−5)

Ke = 0.210 + 0.05 = 0.26 or 26%.

(d) Calculation of New Cost of Retained Earnings
Cost of Retained Earnings = 𝐷1 +g= 𝐷0 (1+ g) +g
𝑃0 𝑃0
15(1 + 0.05)
Ke = + 0.05
80

Ke = 0.1969 + 0.05 = 0.2469 or 24.69%

7.2 Summary

So friends let‟s sum up what we have discussed till now.

 Weighted average cost is a cost of various sources of funds where the weights are
being the proportion of each source of funds in the capital structure. It is denoted as
k0.
 The weighted cost of capital can be computed by using book value weights or the
market value weights.

7.3 Exercise:

Now let us check what we have learnt so far

Theory Questions
Q1.What is the weighted average cost of capital?
Q2.What is the rationale behind the use of weighted average cost of capital?
Q3.How is weighted average cost of capital is determined?
Q4.Distinguish between the Book Value Weights and market value weights

Practical Problems
Tulsian (1) Ltd. Has the following Capita Structure as per its Balance Sheet as at 31st March
, 2009
Rs. In lakhs
Equity Share Capita (fully paid shares of Rs. 100 each) 8
18% Preference Share Capita (fully paid shares of Rs. 100 each) 6
Retained Earnings 2
12.5% Debentures (Fully paid of Rs. 100 each) 16
12% Term Loan 8

40

84
Additional Information
 Currently Quoted Prices in the Stock Exchange :
o Equity Shares @ Rs. 64.25, Preference Shares @ Rs. 90 , Debentures @ Rs.
95.
 For the last year , the Company had Paid equity dividend of Rs . 8 per share which is
expected to grow @ 5% p.a. forever .
 The Corporate Tax Rate is 30%.

7.4 Additional Readings

Bhattacharya, Hrishikas (201 0), Working Capital Management; Strategies & techniques,
Prentice Hall, New Delhi.

Brealey Richard A & Steward C , Meyers (2008): Corporate Finance, Tata Mcgraw Hill, New
Delhi.
Hampton, John (2010): Financial decision making, Prentice Hall, New Delhi.
Pandey, I M( 2010), Financial Management, Vikas Publishing House, New Delhi.
Khan M Y, Jain P K(2009), Financial Management, Tata Mcgraw Hill, New Delhi.

85
 Unit 2

Financing Decisions

Concepts of Operating and Financial Leverage

Operating Leverage:

The leverage related with operating activities of a business is known as operating

leverage. It is caused due to fixed operating expenses in the company.

Definition- Operating leverage may be defined as the company's ability to use fixed
operating costs to magnify the effects of changes in sales on its earnings before interest
and taxes ie. The firm’s ability to use its fixed costs to generate better returns.

Operating leverage comprises of two important costs viz., fixed cost and variable cost.

• Fixed costs- These costs are fixed, which will not change irrespective of the number
of units produced. E.g., Rent of the factory, which an organization pays on a monthly
basis, will remain fixed irrespective of the fact that they produce 500 or 5,000 units of
5,00,000 units of the product.

• Variable costs- Variable costs vary with the number of units produced. In other
words, there are directly proportionally with units produced. E.g., Raw materials
consumed in order to produce the finished product. If the company is in the business of
assembling a mobile phone, and the battery is a raw material for the company. In this
case, the cost of batteries consumed will be a variable cost for the company as the
volume is dependent directly on the volume of the total production of mobile phones in a
given period of time.

Effect of Operating Leverage-

Operating leverage measures the company’s fixed costs as a percentage of its total
costs. A company with a higher fixed cost will have higher Operating Leverage as
compared to a company having a higher variable cost

Lower Operating Leverage – This implies lower fixed costs and higher variable costs.
In this case, a company has to achieve minimum sales, which will cover its fixed costs.
Once it crosses the break-even point where all its fixed costs are covered, it can earn
incremental profit in terms of Selling Price minus the Variable Cost, which will not be
very substantial as the variable costs itself are high. When the operating leverage is low
and fixed costs are lower, we can conclude that the break-even units which a company
needs to sell in order to suffer a no loss & no profit equation will be comparatively lower.
Companies generally prefer lower operating leverage so that even in cases where there
is recession, it would not be difficult for them to cover the fixed costs.

Higher Operating Leverage – This implies lower variable costs and higher fixed costs.
Here, as the fixed costs are higher, the break-even point will be higher. The company

18
will have to sell higher number of units to ensure no loss and no profit situation. On the
other hand, the advantage here is that after the break-even is achieved, the company
will earn a higher profit on every product as the variable cost is very low. A company
with high operating leverage depends more on sales volume for profitability. The
company must generate high sales volume to cover the high fixed costs. In other words,
as sales increase, the company becomes more profitable.

Operating Leverage Vis-À-Vis Breakeven Point & Contribution Margin:

Company’s operating leverage will directly affect its contribution margin and breakeven
point. Contribution margin is essentially a product’s selling price minus its unit-level
variable cost (Selling Price per unit – Variable Cost Per unit). A company with
proportionately less variable cost has a higher contribution margin. Hence, a product
with a higher contribution margin corresponds with a production process that has high
operating leverage – or higher fixed costs in relation to variable costs. Similarly, a
company with a high breakeven point has high operating leverage. The breakeven point
refers to the level of sales volume at which per-unit profits fully cover fixed costs of
production. In other words, it is the point at which revenues equal costs. As fixed costs
leads to a higher breakeven point, more sales volume is required to cover the fixed costs
ie. a production process with a high breakeven point utilizes high operating leverage.
Thus, when a company with high operating leverage and a high breakeven point reach
sales volumes that exceed the breakeven point, a greater proportion of revenues
generating are profit.

Importance & Application of Operating Leverage:

Operating leverage augments changes in earnings before interest and taxes (EBIT) as a
response to changes in sales when a company's operational costs are comparatively
fixed. Operational leverage is the use of fixed operating costs by the firm. Operating
leverage reproduces the impact on operating income of a change in the level of
productivity. Operating leverage measures the extent to which a firm or specific project
needs some cumulative of both fixed and variable costs. Fixed costs are amount not
changed by an increase or decrease in the total number of goods or services a company
produces. Variable costs can be defined as the costs that differ in direct relationship to a
company's production. Variable costs rise when production rises and fall when production
drops. Businesses with higher ratios of fixed costs to variable costs are considered as
using more operating leverage, while businesses with lower ratios of fixed costs to
variable costs use less operating leverage.

Thus, the operating leverage indicates the impact of change in sales on operating
income. If a firm has a high degree of operating leverage, small change in sales will have
large effect on operating income. A few areas of application are as follows :

(1) Operating leverage has an important role in capital budgeting decisions. Infact, this
concept was originally developed for use in capital budgeting.

19
(2) Long term profit planning is also possible by looking at quantam of fixed cost
investment and its possible effects.

(3) Generally, a high degree of operating leverage increases the risk of a firm. For
deciding capital structure in favour of debt, the impact of further increase in risk will
influence capital structure decision.

Calculation of Operating Leverage

Degree of Operating Leverage (Dol):

The degree of operating leverage measures how much operating income of a company
will change in response to a change in sales.

The formula for calculating degree of operating leverage is :

1) DOL= % CHANGE IN EBIT/ % CHANGE IN SALES

When DOL = 1 , it is a breakeven situation

And DOL > 1, there is operating leverage present.

2) DOL= CONTRIBUTION/ EBIT,

Where Contribution= Sales Revenue – Variable cost

SOLVED PROBLEM:

STAR CO. provides you the brief income and expenditure details of the given three
years.

Compute the operating leverage.

PARTICULARS AMOUNT (2017) AMOUNT (2018) AMOUNT (2019)

Sales (in units) 2000 2200 1900
Sales Price (per unit) 300 300 300
Variable cost (per unit) 150 150 150
Fixed Operating Cost 200000 200000 200000
(Rs.)
Solution:

PARTICULARS AMOUNT (2017) AMOUNT (2018) AMOUNT (2019)

Sales (in units) A 2000 2200 1900
Sales Price (per unit) B 300 300 300
Total Revenue (A*B) C 600000 660000 570000
Variable cost (per D 150 150 150
unit)
Total Variable Cost E 300000 330000 285000
(A*D)
Contribution (C-E) F 300000 330000 285000
Fixed Operating Cost G 200000 200000 200000
Earnings Before H 100000 130000 85000
Interest & Taxes
(EBIT) (F-G)

20
% Change in EBIT=

Year 2018= 30000/ 100000 = 30%

Year 2019= 45000/ 130000= 34.6%

% Change in Sales=

Year 2018= 60000/ 600000 = 10%

Year 2019= 90000/ 660000 = 13.6%

DOL= % CHANGE IN EBIT/ % CHANGE IN SALES

DOL 2018= 30%/ 10% = 3.0 times

DOL 2019= 34.6%/ 13.6% = 2.54 times

PRACTICE PROBLEMS:

1) Compute the operating leverage from the following information given about a
company

Particulars Amount (2017) Amount (2018) Amount (2019)

Sales (in units) 450 420 460
Sales Price (per unit) 500 500 500
Variable cost (per unit) 200 200 200
Fixed Operating Cost 135000 135000 135000
(Rs.)

2) Calculate operating leverage from the following information of Reliable Industries in

the given two situations:

Installed Capacity- 2000 Units

Actual production and sales- 50% of the capacity

Selling price per unit- Rs. 20

Variable cost per unit- Rs. 10

Fixed cost:

Under situation I- Rs. 4000

Under situation II- Rs. 5000

Financial Leverage:

Financial leverage is expressed as the firm’s ability to use fixed financial cost in such a
manner so as to have magnifying impact on the EPS due to any change in EBIT (Earning
Before Interest and Taxes). In other words, financial leverage is a process of using debt
capital to increase the return on equity.

21
The following are the essentials of financial leverage :

(1) It relates to liabilities side of balance sheet

(2) It is related to capital structure

(3) It is related to financial risk

(4) It affects earning after tax and earnings per share

(5) It may be favourable or unfavourable. Unfavourable leverage occurs when the firm
does not earn as much as the funds cost.

Definition-

1. “Financial leverage exists whenever a firm has debts or other sources of funds that

carry fixed charges.” -Hampton

2. “Financial leverage is defined as the tendency of the residual net income to vary

disproportionately with operating profit.”-Soloman Ezra

Effect of Financial Leverage:

Financial leverage is concerned with the effects of changes in Earnings before Interest &
Tax (EBIT) on the earnings available to equity shareholders. It can also be said that the
Earnings Per Share (EPS) is a function of availability of profit percentage to equity
shareholders ie. EBIT to the number of equity shares.

This can be explained using an income statement as given below

Particulars Amount (Rs.)

Sales Revenue XXXX
Less: Cost of goods sold XXXX
GROSS PROFIT XXXX
Less: Operating expenses XXXX
OPERATING PROFIT / EBIT XXXX
Less: Interest on debt securities XXXX
EARNINGS BEFORE TAX (EAT) XXXX
Less: Dividend on preference share capital XXXX
EARNING AVAILABLE FOR EQUITY SHAREHOLDERS XXXX
It can be understood from the above table that interest on debt securities is a fixed
charge payment irrespective of amount of profits. Also it has an advantage of tax
adjustments which is not available in case of Equity. So, if a firm increases it equity
capital and reduces it debt capital, the resultant Earnings After Tax will not rise in same
proportion as there is decline in debt and the advantage tax adjustments. It can be said
that Financial Leverage is thus a function of Earnings Before Interest & Tax and Earnings
Before Tax.

Importance & Application of Financial Leverage

Financial leverage is useful in

22
 (i) Capital structure planning

(ii) Profit Planning

Financial leverage helps the finance managers while devising the capital structure of the
company. A high financial leverage means high fixed financial costs and high financial
risk. Increase in fixed financial costs may force the company into liquidation.

Calculation Of Financial Leverage:

The Computation Of Financial Leverage Can Be Done According To The Following Methods:

1) Degree Of Financial Leverage (Dfl) = % Change In Eps / % Change In Ebit

Where; Eps= Earning Per Share

Ebit= Earnings Before Interest & Tax

2) Degree Financial Leverage (Dfl) = Op Or Ebit / Ebt

Where, Op Operating Profit Or Ebit= Earnings Before Interest And Tax

Ebt= Earnings Before Tax.

Solved Problems:

1. Sales = Rs. 1,000, Variable Cost = Rs 300, Contribution = Rs 700, Fixed Cost = 400,

Interest= Rs 100. Find Financial Leverage.

SOLUTION:

EBIT = Sales – Variable Cost – Fixed Cost = 1,000 – 300 – 400 = Rs 300

DFL = [EBIT / EBIT – INT] = [300 / 300 – 100] = [300 / 200] = 1.5

2. A company has a choice of following three financial plans. You are required to calculate

the financial leverage in each case and interpret it.

PARTICULARS PLAN A PLAN B PLAN C

Equity 20000 10000 30000
Debt @ 10% 40000 60000 20000
Operating Profit 10000 10000 10000
SOLUTION:

Calculation of DFL

PARTICULARS PLAN A PLAN B PLAN C

Operating Profit (OP)/ 10000 10000 10000
EBIT 4000 6000 2000
Less: Interest @ 10%
Earnings Before Tax 6000 4000 8000
(EBT)
DFL= OP / EBT 10000/ 6000 10000/ 4000 10000/ 8000
= 1.67 = 2.5 = 1.25
It becomes clear from the above calculation of financial leverage that an increase or

23
decrease in the EBIT will cause an increase or decrease of 1.67 times, 2.5 times and
1.25 times respectively in earnings before tax (EBT) under the execution of A, B and C
financial plans.

Practice Problems:

1) A Ltd. has the following capital structure :

Equity share capital (of Rs. 100 each)= Rs. 1,00,000

10% Preference share capital (of Rs. 100 each)= Rs. 2,00,000

10% debentures (of Rs. 100 each) = Rs. 2,00,000

If EBIT is (i) Rs. 1,00,000 (ii) Rs. 80,000 and (iii) Rs. 1,20,000

Calculate financial leverage under three situations. Assume 50% tax rate.

Combined Leverage:

When the company utilizes both financial and operating leverage to use any change in
sales into a larger relative change in earning per share, it is called combined leverage.
It means it uses the fixed components of both operating and financial leverages to
enhance or increase the earnings per share to the shareholders. Combined leverage is
also known as composite leverage or total leverage. Combined leverage shows the
relationship between the revenue in the account of sales and the taxable income.

Calculation Of Combined Leverage:

Degree of Combined Leverage (DCL)=

Degree of Operating leverage (DOL) X Degree of Financial Leverage (DFL )

In other words, DCL = CONTRIBUTION/ EBT

Solved Problems:

The following particulars are available:

Sales- Rs. 100000, Variable cost- Rs. 70000, Fixed Cost- Rs. 20000, Long term loans
(10%)- Rs. 50000.

Compute combined leverage. Solution:

DCL= DOL X DFL

DOL= CONTRIBUTION/ EBIT

Contribution= Sales Revenue – Variable cost

= 100000- 70000= 30000

EBIT= Sales – Variable cost – Fixed Cost

EBIT= 100000- 70000- 20000= 10000

24
DOL= CONTRIBUTION/ EBIT = 30000/ 10000 = 3 times

DFL= EBIT / EBT

EBT= EBIT – Interest

EBT= 50000- 5000= 45000

DFL= 10000/ 5000= 2 times

DCL= DOL x DFL = 2 x 3 = 6 times

Practice Problems:

1) Calculate operating leverage, financial leverage and combined leverage under situation 1 and 2

in financial plans A & B from the following information relating to the operation and

capital structure of a company.

Installed capacity – 2,000 units

Actual production and sales – 50% of the capacity

Selling price 20 per unit

Variable Cost 10 per unit

Fixed Cost: Under Situation I 4,000 , Under Situation II 5,000

Capital Structure:

PLAN A- Equity= Rs. 5000

Debt @ Rate of Interest 10%= Rs. 15000

Total= Rs. 20000

PLAN A- Equity= Rs. 15000

Debt @ Rate of Interest 10%= Rs. 5000

Total= Rs. 20000

2) Calculate combined leverage for the following three companies and

also prepare an income statement for them.

Company A
2/3
Variable cost as a percentage of sales = 66

Interest expenses in Rupees= 200

Degree of Operating leverage= 5

Degree of Financial leverage= 3

Income tax rate= 35%

25
Company B

Variable cost as a percentage of sales = 75

Interest expenses in Rupees= 300

Degree of Operating leverage= 6

Degree of Financial leverage= 4

Income tax rate= 35%

Company C

Variable cost as a percentage of sales = 50

Interest expenses in Rupees= 1000

Degree of Operating leverage= 6

Degree of Financial leverage= 2

Income tax rate= 35%

3) The following particulars are available:

Sales Rs. 1,00,000, Variable Cost Rs. 70,000, Fixed Cost Rs. 20,000,

Long term loans Rs. 50,000 @ 10 percent

Compute the combined leverage.

26
Module 3

86
 Unit 8
Dividend Policy

Table of Contents
8.0 Objectives:......................................................................................................................

8.1 Definition of Dividend Policy: .............................................................................................

8.2 Nature of Dividend Policy: .................................................................................................

8.3 Objectives of Dividend Policy: ............................................................................................

8.4 Basic Issues Involved in dividend Policy: .............................................................................

8.5 Factors Which Influence the dividend Policy:........................................................................

8.6 Walter‟s Dividend Model:...................................................................................................

8.7 Formula for Determining the Market Price per Share:............................................................

8.8 Gordon‟s Model of Dividend Effect: .....................................................................................

8.9 Gordon‟s Model versus Walters Model: ................................................................................

8.0 Objectives

At the end of this unit, you will be able to:

 Define dividend policy.

 Explain the issues related to dividend policy

8.1 Definition of Dividend Policy

 Weston and Brigham “Dividend policy determines the division of earnings between
payments to shareholders and retained earnings”.
 Gitman. “The firm‟s dividend policy represents a plan of action to be followed
whenever dividend decision must be made.”

8.2 Nature of Dividend Policy

 Tied up with Retained Earnings:

A dividend Policy is tied up with the retained earnings policy. It has the effect of dividing
net earnings into two parts: Retained earnings and Dividends.

87
  Constitutes Imported Areas of Decision making and Problem-Solving for
the Financial Manager:

Dividend policy has an influence on the financing decision of the business. Distribution of
dividends reduces the cash funds of the business and to that extent it has to depend
upon external sources of finance. The cost of funds raised from external sources is
relatively higher than the cost of retained earnings. The management will decide to pay
dividend when the firm does not have profitable investment opportunities.

 Impact on Share:

Dividend policy of the firm has far-reaching consequences on the share prices, financing
decision, growth rate of the business and the wealth of shareholders. Due to market
imperfections and uncertainty, share holders give a higher weightage to the current
dividends rather than future dividends and capital gains. Thus, the payment of dividends
influences the market price of shares. Higher the rate of dividend, greater the price of
shares and vice-versa. Higher market price of shares and bigger current dividends
enhance the wealth of shareholders.

 Optimal dividend Policy:

Hence dividend is an active decision variable. It has to be intelligently managed by the

financial manager who should Endeavour to formulate an optimal dividend policy, i.e., a
policy marked with few or no dividends payment fluctuations, over a long period of time,
having a favorable impact on the wealth of shareholders.

8.3 Objectives of Dividend Policy

 Wealth Maximization:

The dividend policy of a firm aims at maximizing of the owner‟s wealth. It is formulated
not merely to increase the share price in the short run, but to maximize the owner‟s
wealth in the long run. The shareholders may not fully appreciate such a dividend policy
and may prefer immediate dividends to dividends later, otherwise capital grains and the
share prices will drop in the market and this is not in the genuine interest of
shareholders. It is the responsibility of the management to make the owners aware of
the objectives and implications of dividend policy so that the market reaction is
favorable.

88
  Providing Adequate Finances:

Wealth maximization objective would remain a sheer dream in the absence of adequate
finances. One of the important sources of long-term financing is retained earnings. The
management has to decide what shall be the proper ratio between dividends and
retained earnings so that the twin objectives of short-term interest of shareholders and
long term gain of capital appreciation are realized.

8.4 Basic Issues Involved in dividend Policy

 Cost of Capital:

One of the considerations for taking a decision whether to distribute dividend or not is
cost of capital. The board calculates the ratio of rupee profits, the business expects to
earn (Ra) to the rupee profits that the shareholders can expect to earn outside (Rc) i.e
Ra/Rc. If the ratio is less than one, it is a signal to distribute and it is more than one, the
distribution of dividend will be discontinued.

 Realization of Objectives:

In formalizing the dividend policy the main objectives the firm i.e. maximization of wealth
for shareholders including the current rate of dividend should be aimed at.

 Shareholders Group:

Dividend Policy affects the shareholders group. A company with low pay-out but heavy
reinvestment attracts shareholders interested in capital gains rather than in current
income. On the contrary, a company with high dividend pay-out attracts those who are
interested in current income.

 Release of Corporate Earnings:

Dividend distributions is a means of distributing unused funds. By varying its dividend

pay-out ratio dividend policy which affects the shareholder‟s wealth. The financial
manager decides in dividend policy, whether to release corporate earnings or not.

The above basic issues are involved in formulating a dividend policy which affects the
financial structure, the flow of funds liquidity, stock prices and the shareholder‟s
satisfaction. Therefore, the management needs to exercise a high degree discriminative
decision in establishing a sound dividend pattern.

89
8.5 Factors Which Influence the dividend Policy

 Legal Restrictions:

Legal restrictions provide a framework within which the dividend policy is formulated.

 Legal restrictions in the companies Act 1956. Income, Sections 93 and 205 to 207
of the Companies Act embody following regarding dividend.
o Dividends can be paid only out of profits and not out of capital.
o Profits must be retained to the current year. In the event of inadequacy or
absence of profits of any year the company may declare dividends out of the
accumulated profits.
o The Companies Amendment Act, 1974 prohibits the declaration of dividends
unless a percentage of profits not exceeding 10 percent is transferred to the
reserves of the company. The Company may, voluntarily transfer a higher
percentage of its profits to the reserves in accordance with its over-all
business philosophy.
o The dividend is payable only in cash. However, the capitalization of profits or
reserves of the company for the purpose of issuing fully-paid bonus share is
not prohibited.
 Legal Restrictions in Income-tax Act Sections 104-109 of the Income-tax Act
impose certain restrictions on payment of dividends. A closely-held company is
required to pay a minimum percentage of its net-profits as dividends to its
members.
 The Restriction Act, 1978. It has exempted manufacturing private limited
companies from the compulsory distribution of profits. The firm‟s dividend Policy
must take care of these legal restrictions, otherwise the decision may be ultra-
virus.

 Size of the Earnings:

Practically and truly Speaking, the upper ceiling on dividend is dedicated by the earnings
of the business. If the amount and the nature of earnings are relatively stable a firm is
better able to predict what its future earnings will be and is, therefore, more likely to
pay-out a higher percentage of profits. A rational dividend policy should take into account
both the amount and nature of earnings from year to year.

90
 Investment Opportunities and Shareholder’s Preferences:

Management should adopt a dividend policy which strikes a balance between the
shareholder‟s preference for dividend and financing investment opportunities with
retained profits. Having a large number of profitable projects in hand, a company should
give preference to the retention of earnings over the payment of dividends. The
preference of shareholders for dividends and capital gains needs to be paid full heed. To
a great extent the preference for dividends or capital gain is determined by the economic
status of the shareholders and the tax bracket to which he belongs. The capital gains tax
rate is generally lower than the dividend tax rate. As against current dividends a
financially better off shareholder in a high income tax bracket may be interested in
capital gains. A prudent dividend policy should take full care of these aspects.

 Liquidity Position:

Because the payment of dividend involves outflow of cash from the business, the
dividend policy must take into account the liquidity position of the firm. Even if a firm has
a good record of earnings, it may not be able to pay cash dividends due to its liquidity
position. Even a very profitable business has a pressing need for funds. Hence, a firm
may elect not to pay cash dividends.

 Management’s Attitude towards Control:

As a matter of policy, some companies expand only to the extent of their internal
earnings. This is justified on the ground that raising funds by selling additional shares
would dilute the control of the company. Selling debentures will increase the risks of
fluctuating earnings to the detriment of the present members of the company. The
management‟s attitude towards control would reduce the dividend pay-out and increase
reliance on internal financing.

 State of Capital Market and Access to it:

The Corporate management may be tempted to follow a liberal policy if the fund position
in the capital market of the country is comfortable and the firm can take recourse to it
due to its good earning positions. If the capital market funds position is comfortable but
the firm has no access to it due to high capital it would compel the company to rely on
retained earnings and follow a conservative dividend policy.

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 Contractual Restrictions:

Sometimes a firm‟s ability to pay cash dividends is restricted by certain specific

conditions in loan agreements. When the finances are raised from external sources,
creditors may impose various restrictions to immunize themselves from possible
insolvency of the firm. While formulating the dividends policy, the financial manager
must keep in mind various contractual requirements. The creditors may withdraw their
money from the firm if this requirement is violated.

 Profit Rate and Stability of Earnings:

A firm with a large rate of return on its investment will have larger profits. It can pay
more dividends to its shareholders are compared to a firm with lesser return. Again, if
the earnings are relatively stable and do not fluctuate from time to time, a firm can
predict its future earnings and pay a higher rate of dividend than a firm with fluctuating
earnings. An unstable firm cannot determine what will be its actual future earnings.
Therefore, to meet adverse conditions, it is likely to plough back more profits.

 Control:

If the management wants that the existing shareholders should continue to retain control
over the company it would not be wise to raise finances through issue of fresh shares lest
the control is diluted into the hands of new shareholders. Besides, raising additional
finances through the issue of debenture can increase the financial risk of the firm.
Therefore, firm may rely more on retained earnings. It is likely to have a lesser dividend
pay-out ratio.

 Inflation:

Inflation increase the replacement cost of asset which are being depreciated every year
at the book value. Funds generated from providing depreciation may be insufficient to
meet the rising cost of asset which might become obsolete and have to be replaced in
future. Therefore the management should reduce the rate of dividends during a period of
inflation to maintain the earning power of the firm. To conclude, every firm should
establish a general policy about the payment of dividends. An appropriate dividend policy
can be shaped by a multiplicity of considerations. The financial manager should bring
about a balance among various factors.

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8.6 Walter’s Dividend Model

Walter‟s Model supports the theory that dividends are relevant. The choice of dividend
policies always affects the value of enterprise because dividend policy maximizes the
wealth of shareholders. The investment policy of a firm cannot be separated from its
dividend policy and both are, interlinked. The choice of an appropriate dividend policy
affects the value of an enterprise.

Assumptions:

 All financing is done through retained earnings and external sources of funds like
debt or new equity capital are not used.
 With additional investments undertaken, the firm‟s business risk does not change.
It implies that firm‟s internal rate of return “r” and its cost of capital “k” are
constant.
 The firm has a very long or perpetual life.
 All earnings are either distributed as dividends or invested internally immediately.
 There is no change in the key variables, namely beginning earnings per share (E)
and dividends per share (D).

The Key Argument:

The key argument in support of this model is the relationship between the return on a
firms‟ investment or its internal rate of return (K) and its cost of capital or the required
rate of return (k). The firm would have an optimum dividend policy which will be
determined by the relationship of r and k. In other words, if the return on investments
exceeds the cost of capital, the firm should retain the earnings. On the contrary, it should
distribute the earnings to the shareholders if the required rate of return exceeds the
expected return on the firm‟s investments. If a firm has adequate profitable investment
opportunities, it will be able to earn more than investors expect so that r>k. Such firms
are called “growth firms” which should plough back the entire earnings within the firm. If
a firm does not have profitable investment opportunities (when r < K) the entire earnings
should be distributed as dividend. Finally, when r = k (normal firms), it is a matter of
indifference whether earnings are retained or distributed.

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8.7 Formula for Determining the Market Price per Share

𝑃= 𝐷
………………………………………… (1)
𝐾 𝑎= g

Where, 𝑃 = Price of equity shares

D = Initial dividend

E = Cost of equity capital

R = Expected growth rate of earnings

To reflect earnings retentions, we have

𝑃= 𝐷
………………………………………… (2)
𝐾𝑎 = g

Where, r = Expected rate of return on firm‟s investments

b = Retention rate (E – D) / E.

Thus rb measures growth rate in dividends, which is the product of the rate of
profitability of retained earnings (r) and the earnings retention percentage (b).

From eq. 13.7, we derive an equation for determining 𝐾𝑐

𝐷
𝐾𝑐 = +𝑔
𝑃

∆𝑃
Since 𝑔 = we have
𝑃

𝐾𝑎 =
𝐷
+
∆𝑃 ………………………………………… (3)
𝑃 𝑃

𝑟
And since, ∆P = (𝐸 − 𝐷)
𝐾𝑎

Substituting the value of DP, We have

r
𝐷+ (𝐸−𝐷)
𝐾𝑎
𝐾𝑐 = ………………………………………… (4)
𝑃

Where, P = The prevailing market price of a share

D = Dividend per share

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 E = Earnings per share

R = The rate of return on the firm‟s investment

Equation 4 shows that the value of a share is the present value of all dividends plus the
present value of all capital gains. We shall use this equation to illustrate the Walter‟s
model.

Limitations:

Through Walter‟s model of share valuation is quite useful in explaining the effects of
dividend policy on value of shares under different circumstances and assumptions, it has
the following weakness:

 It assumes that the firm‟s investments are financed exclusively by retained

earnings and no external financing is used. It is an unrealistic assumption.
 It assumes that “r” is constant. This is not a realistic assumption because when
increased investments are made by the firm, r also changes. Thus, this model
becomes in-cooperative.
 It assumes that “K” is constant. By assuming k to be constant, it ignores the
effect of risk on the value of the firm.

8.8 Gordon’s Model of Dividend Effect

Gordon‟s model is based on relevance of dividend concept. According to it dividends are
relevant and dividend policy affects the value of the firm. Gordon‟s model is based on the
relationship of dividend policy and the market value of the firm. The financial manager
can use it to determine how much should be retained or paid out and can also ascertain
its subsequent effect on market price.

Assumptions:

 The firm is an all equity firm. No external financing is used and investment
programmes are financed exclusively by retained earnings.
 The internal rate of return (r) and appropriate discount rate (k) for the firm are
constant.
 The firm has perpetual life and its stream of earnings is perpetual.
 The corporate taxes do not exist.
 The retention ratio, once decided upon, is constant. Thus the growth rate (g - br)
is also constant.

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  K > br. If this condition is not fulfilled we cannot get a meaningful value for the
share.

8.9 Gordon’s Model versus Walters Model:

Gordon‟s model contends that dividend policy of the firm is relevant and that investors
put a positive premium on current incomes/ dividends. He argues that dividend policy
affects the value of shares even in a situation in which the return on investment of a firm
is equal to the required / capitalization rate (i.e., r = 𝐾𝑐). Walter‟s model is of the view
that the investors are indifferent between dividends and retention.

 Cruz of Arguments:

The crux of Gordon‟s arguments is that investors are risk averse and they put a premium
on a certain return and discount/ penalize uncertain returns. The investors are rational
and they want to avoid risk which means the possibility of not getting a return on
investment. The payment of current dividends ipso facto removes any chance of risk. If
the firm retains the earnings (i.e. current dividends are withheld) the investors can
expect to get a dividend in future. Both with respect to the amount as well as the timing
the future dividend is uncertain. The rational investors can be expected to prefer
current dividend and discount future dividends. As compared to current dividend they
would place less importance on future dividends. The retained earnings are evaluated by
the investors as a risky promise. If the earnings are retained, the market price of the
shares would be adversely affected.

 Bird-in-the House Argument:

The above argument underlying Gordon‟s model of dividend relevance is also described
as bird-in-the –hand argument. It is based on the logic that what is available at present
is preferable to what may be available in the future. Basing this model on this argument,
Gordon argues that the future is uncertain and the more distant future, the more
uncertain it is likely to be. If current dividends are withheld to retain profits it is uncertain
whether the investor would at all receive them later. Investors would naturally like to
avoid uncertainty. They would be inclined to pay higher price for shares on which current
dividends are paid. Conversely, they would discount the value of shares of a firm which
postpones dividends. As shown in the figure given below the discount rate changes with
retention rate or the level of retained earnings. According to Gordon, the market value of
a share is equal to the present value of future streams of dividends.

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Symbolized Version:

A simplified version of Gordon‟s model can be symbolically expressed as follows:

E (1−b)
𝑃=
𝐾𝑐= −br

Where, 𝑃 = Price of shares

E = Earnings per share

b = Retention ration of earnings retained

1 – b = D/P ration, i.e. percentage of earnings distributed as dividends

𝐾𝑐= Capitalization rate/ cost of capital

br = 𝑔 = Growth rate in r, i.e. rate of return on investment of all equity firm.

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 Unit 3
Investment Decision

Unit Structure
3.0 Objectives
3.1 Concept, Nature & Importance of Investment Decision/ Capital Budgeting
Techniques
3.2 Purpose/ Objectives of Investment Decisions
3.3 Process of investment decision making
3.4 Types of Investments
3.5 Ideal Investment Decision Criteria
3.6 Investment decision making/ Capital Budgeting Techniques
3.7 Comparison of NPV and IRR
3.8 Capital Rationing

3.0 Objectives
At the end of the unit, you will be able to:

1. Understand the concept of Capital Budgeting and Investment decisions

2. Identify capital budgeting techniques and various aspects related to it
3. Understand the application of various capital budgeting techniques

3.1 Concept, Nature & Importance of Investment Decision Techniques

3.1.1 Concept of Investment Decision/ Capital Budegting

Any investment decision depends upon the decision rule that is applied under
circumstances. However, the decision rule itself considers following inputs:

• Cash Flows
• Discounting Factor
• Project Life

The effectiveness of the decision rule depends on how these three factors have been
properly assessed. Estimation of cash flows requires immense understanding of the
project before it is implemented; particularly macro and micro view of the economy,
polity and the company. Project life is very important; otherwise it will change the entire
perspective of the project. So great care is required to be observed for estimating the
project life. Cost of capital is being considered as discounting factor which has
undergone a change over the years. Cost of capital has different connotations in different
economic philosophies. Particularly, India has undergone a change in its economic
ideology from a closed- economy to open-economy. Hence determination of cost of
capital would carry greatest impact on the investment evaluation.

27
Capital budgeting techniques or investment decisions focus on various techniques
available for evaluating capital budgeting projects. There are certain investment
evaluation criteria that have to be considered from its economic viability point of view
and how it can help in maximizing shareholders’ wealth.

3.1.2 Nature & Importance of Investment decisions/ Capital Budgeting

Techniques
The following is the nature of any investment decision or capital budgeting techniques
1. They consider all cash flows to determine the true profitability of the project.
2. They provide for an objective and unambiguous way of separating good projects from
bad projects.
3. They help ranking of projects according to its true profitability.
4. They recognize the fact that bigger cash flows are preferable to smaller ones and
early cash flows are preferable to later ones.
5. They help to choose among mutually exclusive projects that project which maximizes
the shareholders’ wealth.
6. They are a criterion which is applicable to any conceivable investment project
independent of others.

3.2 Purpose/ Objectives of Investment Decisions

1. Selecting Profitable projects

2. Capital Expenditure control
3. Raising funds
4. Seeking appropriate sources of funds
5. Understanding overall long run Profitability

3.3 Process Of Investment Decision Making

An organisation usually undergoes the following process to evaluate projects for the
purpose of investment decision making:
1. Identifying Investment Opportunities
An organization needs to first identify an investment opportunity. An investment
opportunity can be anything from a new business line to product expansion to
purchasing a new asset. For example, a company finds two new products that they can
add to their product line.
2. Evaluating Investment Proposals
Once an investment opportunity has been recognized an organization needs to evaluate
its options for investment. For example; once it is decided that new product/products
should be added to the product line, the next step would be deciding on how to acquire
these products. There might be multiple ways of acquiring them. Each option has to be
carefully evaluated.

28
3. Selection of Profitable Investment
Once the investment opportunities are identified and all proposals are evaluated an
organization needs to decide the most profitable investment and select it. While selecting
a particular project an organization may have to use the capital budgeting techniques
and capital rationing to rank the projects as per returns and select the best option
available.
4. Capital Budgeting and Apportionment
After the project is selected an organization has to fund this project. To fund the project,
it needs to identify the sources of funds and allocate it accordingly. The sources of
these funds could be reserves, investments, loans or any other available channel.
5. Performance Review
The last step in the process of capital budgeting is reviewing the investment. Initially,
the organization had selected a particular investment for a predicted return. Later, they
will compare the investments expected performance to the actual performance and
review the project performance

3.4 Types of Investments

A firm in the course of its operations will have to undertake the following types of
investments or projects for which capital budgeting techniques will be used:
1. Expansion- These type of projects or investments involve adding capacity to existing
product lines.
2. Diversification- These refer to expanding operations in new areas/ businesses
3. Acquisition- Acquiring or taking over other companies to expand business refers to
Acquisition
4. Modernisation- This implies modernising existing production techniques to increase
efficiency and reduce costs.
5. Replacement- Replacing old and outdated equipment with new ones isoehr also an
important investment decision.
6. Mutually Exclusive Investments- When two or more projects serve the same
purpose and compete with each other are known as mutually exclusive investments ie. If
one is undertaken, other is excluded
7. Independent Investments- When two or more projects do not compete with each
other are known as independent investments. Availability of funds and profitability can
decided if either or all can be undertaken.
8. Contingent Investments- These are dependent projects. Ie. Choice of one project
necessitates undertaking of the other project.

3.5 Ideal Investment Decision Criteria

Several capital budgeting techniques are used to evaluate investments. The techniques
should fulfil the following criteria while making investment decisions:
1. Maximisation of shareholder wealth

29
2. Provision of an objective and unambiguous way of separating good projects from the
bad
3. Help ranking of projects as per profitability
4. Ability to recognise that larger cash flows are better than smaller ones
5. Help chose amongst mutually exclusive projects in order to maximise shareholder
wealth

3.6 Investment Decision Making/ Capital Budgeting Techniques

A number of capital budgeting techniques are used in practice. They may be grouped in
the following two categories: -
I. Capital budgeting techniques under certainty
II. Capital budgeting techniques under uncertainty

3.6.1 Capital Budgeting Techniques under Certainty

Capital budgeting techniques (Investment appraisal criteria) under certainty can be
divided into following two groups:
Non-Discounted Cash Flow Criteria: -
(a) Pay Back Period (PBP)
(b) Accounting Rate of Return (ARR)

Discounted Cash Flow Criteria: -

(a) Net Present Value (NPV)
(b) Internal Rate of Return (IRR)
(c) Profitability Index (PI)

3.6.2 Non Discounted Cash Flow Criteria Capital Budgeting Techniques

(a) Payback period:
The payback period (PBP) is the traditional method of capital budgeting. It is the
simplest and perhaps, the most widely used quantitative method for appraising capital
expenditure decision.
Meaning: It is the number of years required to recover the original cash outlay invested
in a project.

Methods to compute the Payback period

There are two methods of calculating the PBP.

(a) The first method can be applied when the Cash Flow After Taxes (CFAT) is uniform.
In such a situation the initial cost of the investment is divided by the constant annual
cash flow:
For example, if an investment of Rs. 100000 in a machine is expected to generate cash
inflow of Rs. 20,000 p.a. for 10 years. It’s Payback period will be calculated using
following formula:

30
Payback Period= Initial Investment / Constant Annual Cash Inflow
= 100000/ 20000= 5 years

(b) The second method is used when a project’s CFAT are not equal. In such a situation
Payback Period is calculated by the process of cumulating CFAT till the time when
cumulative cash flow becomes equal to the original investment outlays.
For example, A firm requires an initial cash outflow of Rs. 20,000 and the annual cash
inflows for 5 years are Rs. 6000, Rs. 8000, Rs. 5000, Rs. 4000 and Rs. 4000
respectively. Calculate Payback period.
Here, When we cumulate the cash flows for the first three years, Rs. 19,000 is
recovered. In the fourth year Rs. 4000 cash flow is generated by the project but we need
to recover only Rs. 1000 so the time required recovering Rs. 1000 will be
(Rs.1000/Rs.4000) × 12 months = 3 months.
Thus, the PBP is 3 years and 3 months (3.25 years).

Decision Rule under Payback Period:

The Payback period technique can be used as a decision criterion to select investment
proposal.

If the Payback period is less than the maximum acceptable payback period, accept
the project.

If the Payback period is greater than the maximum acceptable payback period,
reject the project.

This technique can be used to compare actual pay back with a standard pay back set up
by the management in terms of the maximum period during which the initial investment
must be recovered.
The standard Payback period is determined by management subjectively on the basis of
a number of factors such as the type of project, the perceived risk of the project etc.
Payback period can be even used for ranking mutually exclusive projects. The projects
may be ranked according to the length of Payback period and the project with the
shortest Payback period will be selected.

Merits of Payback Period Technique

1. It is simple both in concept and application and easy to calculate.
2. It is a cost effective method which does not require much of the time of finance
executives as well as the use of computers.
3. It is a method for dealing with risk. It favours projects which generates substantial
cash inflows in earlier years and discriminates against projects which brings substantial
inflows in later years . Thus PBP method is useful in weeding out risky projects.
4. This is a method of liquidity. It emphasizes selecting a project with the early recovery
of the investment.

31
Demerits of Payback Period Technique
1. It fails to consider the time value of money. Cash inflows, in pay back calculations,
are simply added without discounting. This violates the most basic principles of financial
analysis that stipulates the cash flows occurring at different points of time can be added
or subtracted only after suitable compounding/ discounting.
2. It ignores cash flows beyond Payback period. This leads to reject projects that
generate substantial inflows in later years.
3. It is a measure of projects capital recovery, not profitability so this cannot be used as
the only method of accepting or rejecting a project. The organization needs to use some
other method also which takes into account profitability of the project.
4. The projects are not getting preference as per their cash flow pattern. It gives equal
weightage to the projects if their Payback period is same but their pattern is different.
For example, each of the following projects requires a cash outlay of Rs. 20,000. If we
calculate its Payback period it is same for all projects i.e. 4 years so all will be treated
equally. But the cash flow pattern may be different. In fact, projects with higher cash
inflows in the initial years should be preferred over those with lower cash inflows in the
initial years

Application of Payback Period

The Payback period can be gainfully employed under the following circumstances.
1. The Payback method may be useful for the firms suffering from a liquidity crisis.
2. It is very useful for those firms which emphasizes on short run earning performance
rather than its long term growth.
3. The reciprocal of Payback period is a good approximation of Internal rate of Return
(IRR) which otherwise requires trial & error approach.

(b) Accounting/Average Rate of Return (ARR)

This method is also known as the return on investment (ROI), return on capital
employed (ROCE) and uses accounting information rather than cash flow.

Meaning: The ARR is the ratio of the average after tax profit divided by the average
investment.
Methods to compute ARR:
There are a number of alternative methods for calculating ARR. The most common
method of computing ARR is using the following formula:

ARR=Average Annual Profit after Tax X 100

Average Investment

Where;
The average profits after tax are determined by adding up the Profit After Tax (PAT) for
each year and dividing the result by the number of years.

32
The average investment is calculated by dividing the net investment by two.

For example, A project requires an investment of Rs. 10, 00,000. The plant & machinery
required under the project will have a scrap value of Rs. 80,000 at the end of its useful
life of 5 years. The profits after tax and depreciation are estimated to be as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
PAT 50000 75000 125000 130000 80000

In this case, ARR= (50000+ 75000+ 125000+ 130000+ 80000) ÷ 5

(1000000+ 80000) ÷ 2
ARR= 17.04%

Decision Rule
The ARR can be used as a decision criterion to select investment proposal.

If the ARR is higher than the minimum rate established by the management, accept
the project.

If the ARR is less than the minimum rate established by the management, reject the
project.

The ranking method can also be used to select or reject the proposal using ARR. It will
rank a project number one if it has highest ARR and lowest rank would be given to the
project with lowest ARR.

Merits:
1. It is simple to calculate.
2. It is based on accounting information which is readily available and familiar to
businessman.
3. It considers benefit over entire life of the project.

Demerits:
1. It is based upon accounting profit, not cash flow in evaluating projects.
2. It does not take into consideration time value of money so benefits in the earlier years
or later years cannot be valued at par.
3. This method does not take into consideration any benefits which can accrue to the
firm from the sale or abandonment of equipment which is replaced by a new investment.
ARR does not make any adjustment in this regard to determine the level of average
investments.
4. Though it takes into account all the years income but it is averaging out the profit
5. The firm compares any project’s ARR with the one which is arbitrarily decided by
management generally based on the firm’s current return on assets. Due to this
yardstick sometimes super normal growth firm’s reject profitable projects if it’s ARR is
less than the firm’s current earnings.

33
 Application of ARR
The ARR can better be used as performance evaluation measure and control devise but it
is not advisable to use as a decision making criterion for capital expenditures of the firm
as it is not using cash flow information.

3.6.3 Discounted Cash Flow Criteria Capital Budgeting Techniques:

The traditional method does not take into consideration the time value of money. They
give equal weight age to the present and future flow of incomes. The discounted cash
flow methods are based on the concept that a rupee earned today is more worth than a
rupee earned tomorrow. These methods take into consideration the profitability and also
time value of money.

(a) Net Present Value (NPV)

The NPV takes into consideration the time value of money. The cash flows of different
years and valued differently and made comparable in terms of present values for this the
net cash inflows of various period are discounted using required rate of return which is
predetermined. According to Ezra Solomon, “It is a present value of future returns,
discounted at the required rate of return minus the present value of the cost of the
investment.” NPV is the difference between the present value of cash inflows of a project
and the initial cost of the project. According the NPV technique, only one project will be
selected whose NPV is positive or above zero. If a project(s) NPV is less than ‘Zero’. It
gives negative NPV hence. It must be rejected. If there are more than one project with
positive NPV’s the project is selected whose NPV is the highest. The formula for NPV is

NPV= Present value of cash inflows – Investment

NPV= C1 + C2 + C3 + Cn - C0
2 3 n
1+k (1+k) (1+k) (1+k)

Where, C1, C2, C3 = Cash Flows

k= Discounting rate/ Cost of capital
C0 = Initial Investment
n = Number of Years

Decision Rule:
The decision rule of NPV is that:

Accept the project of the NPV is positive

Reject the project of the NPV is negative

Accept or reject the project if the NPV is zero

Merits:
1. It recognizes the time value of money

34
2. It is based on the entire cash flows generated during the useful life of the asset
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining the
present value.

Demerits:
1. It is different to understand and use.
2. The NPV is calculated by using the cost of capital as a discount rate. But the concept
of cost of capital is difficult to determine
3. It does not give solutions when the comparable projects are involved with different
amounts of investment.
4. It does not identify suitable investment opportunities amongst alternative projects or
limited funds are available with unequal lines.

(b) Internal Rate of Return (IRR)

The IRR for an investment proposal is that discount rate which equates the present value
of cash inflows with the present value of cash out flows of an investment. The IRR is also
known as cut- off or handle rate. It is usually the project/ investment’s cost of capital.
According to Weston and Brigham “The internal rate is the interest rate that equates the
present value of the expected future receipts to the cost of the investment outlay.” The
IRR is not a predetermine rate, rather it is to be trial and error method. It implies that
one has to start with a discounting rate to calculate the present value of cash inflows. If
the obtained present value is higher than the initial cost of the project one has to try
with a higher rate. Likewise, if the present value of expected cash inflows obtained is
lower than the present value of cash flow, a lower rate is to be taken up. The process is
continued till the net present value becomes Zero. This is also known as Yield on
investment, Marginal Efficiency of Capital, Rate of Return on Capital, Time adjusted rate
of Internal Return. As this discount rate is determined internally, this method is called
internal rate of return method.

Formula for IRR

- C0 = 0

Where, Cn = Cash Flow

r= Internal Rate of Return
n= Number of years

The above formula has to be used with IRR rates till the NPV becomes 0. In other words,
IRR is that rate of return at which the discounted value of cash flows equals to the initial
investment.

35
 Decision Rule:

Accept the project if the IRR exceeds the cost of capital

Reject the project of the IRR is less than the cost of capital

Merits:
1. It considers the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It uses logic to identify the best investment areas because when the projects with
high rates are selected, it satisfies the investors in terms of the rate of return and capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is in conformity with the firm’s objective of maximum owner’s welfare.

Demerits:
1. It is very difficult to understand and use.
2. It involves a very complicated computational work.
3. It may not give a single decision regarding suitability of projects in all situations.

(c) Profitability Index (PI)

The method is also called benefit cost ration. This method is obtained cloth a slight
modification of the NPV method. In case of NPV the present value of cash out flows are
profitability index (PI), the present value of cash inflows are divide by the present value
of cash out flows, while NPV is a absolute measure, the PI is a relative measure. It the PI
is more than one (>1), the proposal is accepted else rejected. If there are more than
one investment proposal with the more than one PI the one with the highest PI will be
selected. This method is more useful incase of projects with different cash outlays cash
outlays and hence is superior to the NPV method.

The formula for PI is

PI= Present value of future cash flows

Initial Investment

Where, Present value of future cash flows= Initial Investment + Net present value

Decision Rule:

If the PI is more than 1, accept the project

If the PI is less than 1, reject the project

If PI= 1, the project will breakeven and the company may accept/ reject the project

Merits:
1. It requires less computational work then IRR method

36
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the index.
5. It takes into consideration the entire stream of cash flows generated during the
useful life of the asset.

Demerits:
1. It is a difficult concept to understand
2. Decision making is too analytical and involves ranking on the basis of probability index
which may be a complicated process.

3.7 Comparison of NPV and IRR

The two capital budgeting methods have the following differences:

Outcome- The NPV method results in a monetary/ rupee value that a project
will produce, while IRR generates the percentage return that the project is
expected to create.

Purpose- The NPV method focuses on project surpluses, while IRR is focused on
the breakeven cash flow level of a project.

Decision Support- The NPV method presents an outcome that forms the
foundation for an investment decision, since it presents a rupee return. The IRR
method does not help in making this decision, since its percentage return does
not tell the investor how much monetary returns the project will give.

Reinvestment Rate- The presumed rate of return for the reinvestment of
intermediate cash flows is the firm's cost of capital when NPV is used, while it is
the internal rate of return under the IRR method.

Discount Rate Issues- The NPV method requires the use of a discount rate,
which can be difficult to derive, since management might want to adjust it based
on perceived risk levels. The IRR method does not have this difficulty, since the
rate of return is simply derived from the underlying cash flows.
Conclusion- Generally, NPV is the more heavily-used method. IRR tends to be
calculated as part of the capital budgeting process and supplied as additional
information.

3.8 Capital Rationing

Capital rationing is a strategy used by companies or investors to limit the number of
projects they take on at a time. If there is a pool of available investments that are all
expected to be profitable, capital rationing helps the investor or firm choose the most
profitable ones to pursue.

Companies that employ a capital rationing strategy typically produce a relatively higher
return on investment. This is simply because the company invests its resources where it
identifies the highest profit potential.

37
Example of Capital Rationing:

Example 1:

Consider the following projects

PROJECT CASH FLOWS (IN ‘000 RS.) NPV @9% IRR

C0 C1 C2 C3
M -1680 1400 700 140 301 23%
O 0 -1400 700 948 37 11%

Comparing the above two projects where Project M has to be undertaken in Year 0 and
Project O in Year 1, it is argued that Project M would be a better choice. This is due to
the fact that Project O can be financed out of the cash flows generated by Project M in
the Year 1.

This reasoning implies that capital shortage will occur next year to undertake Project O
of Project M is rejected. This situation is known as Capital Rationing.

Example 2:

Consider the following projects

PROJECT INITIAL INVESTMENT (IN EXPECTED REVENUE

BILLION $) ( IN BILLION $)
A 5 7
B 6 8
C 5 6
Total cash Available for 10
Investment

In the above case, those project/ projects will have to be accepted which give the
company highest amount of profits within the limited budget of $ 10 Billion. The
expected rate of return for all projects will have to be computed and then ranking will
have to be given to them on the basis of profitability index (as shown below)

PROJECT INITIAL EXPECTED EXPECTED EXPECTED RANK

INVESTMENT REVENUE RETURN RATE OF
(IN BILLION ( IN BILLION (IN BILLION RETURN (%)
$) $) $)
A 5 7 2 0.40 1
B 6 8 2 0.33 2
C 5 6 1 0.20 3
Total cash 10
Available for
Investment
Looking at the above table Project A and B would be selected as they have the highest
profitability. However, the total available is 10 Billion $, which will not suffice if Project A
and B are undertaken. For Project A and B, total funding of 11$ Billion would be
required. In this case, the firm will have to reject one project and move to the next

38
ranked project which suits the investment availability. Thus, Project B would be
foregone.

3.8.1 Types of Capital Rationing

1. Hard Capital Rationing

This is imposed on a firm by circumstances beyond its control. For example: A firm may
be restricted from borrowing for new projects due to downgrading of its credit rating.

2. Soft Capital Rationing

In this case the company imposes restrictions on capital investments on its own will. The
company may use its own criteria to accept/ reject projects and rank them.

39
Module 4

98
 Unit 9
Cash Management
Table of Contents

9.0 Objectives ......................................................................................................................

9.1 Meaning of Cash Management: .........................................................................................

9.2 Motives of Holding Cash: ..................................................................................................

9.3 Objectives of Cash Management: ......................................................................................

9.4 Factors Determining Cash Needs:......................................................................................

9.5 Problems of Cash Management: ........................................................................................

9.5.1 Controlling level of cash:............................................................................................

9.5.2 Controlling inflows of cash: ........................................................................................

9.5.3 Control over cash outflows: ........................................................................................

9.5.4 Investing surplus cash: ..............................................................................................

9.6 Exercise: ........................................................................................................................

9.0 Objectives
At the end of the unit, you will be able to:

 Explain the term Cash Management

 Determine the factors of costs based on the needs of the company
 Describe the techniques of cash collection in your own words

9.1 Meaning of Cash Management:

Cash is one of the components of current assets. It is a medium of exchange for purpose
of goods and services and for discharging liabilities. Management of cash is one of the
most important areas of overall working capital management due to the fact that cash is
the most liquid type of current assets and it is both beginning and the end of the working
capital cycle to quote Gitman, “liquid assets provide a pool of funds to cover unexpected
outlays, thereby reducing the risk of a liquidity crisis”. It is like blood stream in the
human body, gives vitality and strength to the firm. Adequate availability of cash is
essential to meet the business needs. Since, it is necessary in daily business operations
and is productive, the cash owned by an enterprise at any time should be carefully
regulated.

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As such, it is the responsibility of the finance manager to see that the various functional
areas of the business have sufficient cash whenever they require the same. At the same
time, it has also to be ensured that the funds are not blocked in the form of idle cash, as
the cash remaining idle also involves cost in the form of interest cost and opportunity
cost. As such, the management of cash has to find a mean between these two extremes
of shortage of cash as well as idle cash.

Therefore, effective management of cash involves an effort to minimize investment in

cash without impairing to liquidity of the firm. It implies a proper balancing between the
two conflicting objectives of the liquidity and profitability.

9.2 Motives of Holding Cash:

A company may hold the cash with the various motives as stated below:

Transaction

Speculative

Precautionary

Motives of Holding Cash

Chart 1.1 Motives of Holding Cash

 Transaction motive:

The company may be required to make various regular payments like purchases,
wages/salaries, various expenses, interest, taxes, dividends etc. for which the company
may hold the cash similarly, the company may receive the cash basically from its sales
operations. However, receipts of the cash and the payment by cash may not always
match with each other. In such situations, the company will like to hold the cash to honor
the commitments whenever they become due. The requirement of cash balances to meet
routine needs is known as transaction motive.

 Precautionary motive:

In addition to the requirement of cash for routine transactions, the company may also
require the cash for such purposes which cannot be estimated or foreseen. E.g.: there
may be a sudden decline in the collection from the customers; there may be a sharp
increase in the prices of the raw materials etc. The company may like to hold the cash

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balance to take care of such contingencies and unforeseen circumstances. This need of
cash is known precautionary motive.

 Speculative motive:

The company may like to hold some reserve kind of cash balance to take the benefit of
favorable market conditions of some specific nature. E.g. purchases of raw material
available at low prices on the immediate payment of cash, purchase of securities if
interest rates are expected to increase etc. This need to hold the cash for such purposes
is known as speculative motive.

9.3 Objectives of Cash Management:

One of the prime responsibilities of the financial manager is that managing cash to
make balance between profitability and liquidity. In other words, there should not be
excess cash or inadequate cash.

From the above, we can trace the following as the objectives of cash management:

 To meet cash payments:

The prime objective of cash management is to meet various cash payments needed to
pay in business operations. The payments are like payment to supplier of row materials,
payment of wages and salaries, payment of electricity bills, telephone bills and so on
.firm should maintain cash balances to meet the payments; otherwise it will not be able
to run business. To quote Bollen, “cash is an oil to lubricate the ever turning wheels of
business: without it, the process grinds to a stop”. Hence, one of the cash management
objectives is to meet the payments with the maintenance of sufficient cash.

 To maintain minimum cash balance:

This is the second important objective of cash management. It means the firm should not
maintain excess cash balances. Excess cash balance may ensure prompt payment, but it
the excess balance will remain idle, as cash is a non-earning asset and firm will have to
forego profit on the other hand, Maintenance of low level of cash balance, may not help
to pay the obligations. Hence, the aim of the cash management is to maintain optimum
cash balance.

One of the tools available to the company to ensure the maintenance of optimum cash
balance is to prepare the cash budget. By preparing the cash budget in a proper manner,
the company can have an idea in advance of the timing and quantum of excess
availability of cash or shortage of cash. Accordingly, the company can take the decision
of investment of excess cash on short term basis (in case of excess cash available) or to
meet the short fall (in case of shortage of cash).

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9.4 Factors Determining Cash Needs:
A firm has to decide the cash balance based on their needs, which is determined after
taking into consideration the following factors:

 Synchronization of Cash Flows:

Synchronization of cash flows arises only when there is no balance between the expected
cash inflows and cash outflows. There is no need to manage cash balance, if there is
perfect match between cash inflows and cash outflows. Otherwise, there is a need to
manage cash balance for managing.

 Short Costs:

This is another factor to be considered while determining the cash needs. Short costs are
those costs that arise with a short fall of cash for the firm‟s requirements. Shortage of
cash can be found through preparation of cash budget. Cash shortage is not cost free; it
involves cost whether it is expected or unexpected shortage. The expenses incurred as a
result of shortfall are called short costs. They include the following:

 Cost of transaction:

Whenever there is a shortage of cash it should be financed. Financing may be done

through the borrowings from banks or sale marketable securities. If the firm is planning
to finance the deficit cash by sale of marketable securities, then the firm is expected to
spend some expenses from brokerage.

 Cost of borrowings:

If the firm does not have marketable securities with it, then it prefers borrowing as a
source of financing, shortage of cash. It involves costs like interest on loan, commitment
charges and other expenses relating to the loan.

 Cost of deterioration of the credit rating:

Generally, credit rating is given by credit rating agencies. Low credit rating firms may
have to go for bank loans with high interest charges, since they cannot raise the required
amount from the public. Low credit rating may also leads to stoppage of supplies,
demands from cash payment, refusal to sell, loss of image and attendant decline in sales
and profits.

 Cost of loss of cash discount:

Sufficient cash helps to get cash discount benefits, but shortage of cash cannot help to
obtain cash discounts.

 Cost of penalty rates:

Whenever there is shortage of cash firm may not be able to honor current returned
obligations, which in turn demand penalty.

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  Surplus Cash Balance Costs:

It is self-explanatory. It means that the cost associated with excess or surplus cash
balance, cash is not an earning asset surplus cash funds are idle, an impact of idle cash
is that the firm losses opportunities to invest those funds and thereby lose interest, which
would otherwise have been earned.

 Management Costs:

Management Costs are those costs involved with setting up and operating cash
Management staff. These casts are generally fixed over a period, and are mainly include
staff salary, storage handling cost of security and so on.

9.5 Problems of Cash Management:

The problem of cash management can be examined under four heads. They are:

9.5.1 Controlling level of cash:

One of the fundamental objectives of cash management is the minimization of the level
of cash balance with the firm. This goal can be accomplished in the following ways:

 Preparing cash budget:

Cash budget is an important device to forecast the predictable discrepancies between

cash inflows and cash outflows. It reveals the timing and size of net cash flows and the
periods during which excess cash may be available for temporary investment. In large
firms, the preparation of cash budget is almost a full-time exercise and it is a common
practice to delegate this responsibility to the controller or the treasurer. But in the case
of small firms its preparation is relatively a minor job as it does not involve much of
complications.

 Providing for unpredictable discrepancies:

Although cash budget predicts discrepancies between cash inflows and outflows on the
basis of normal business activities, it does not consider discrepancies between cash
inflows and outflows through unforeseen situations such as strikes, short-term recession,
floods, etc. These unforeseen events can either interrupt cash or cause sudden outflow.
Thus a certain portions of cash balance is to be kept for meeting such contingencies and
this amount is fixed on the basis of past experience and some intuition regarding the
future.

 Availability of other sources of funds:

A firm may have external sources to obtain funds on short notice. If a firm has to pay a
slightly higher rate of interest than that on a long-term debt, it can avoid holding
unnecessary large balance of cash.

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  Consideration of short costs:

The cost which incurs as a result of shortage of cash is called the short cost. Such costs
may arise in any of the following forms:

If a firm fails to meet its obligation in time, the creditors may file suit against it. In such
a situation, the cost is incurred in terms of fall in the firm‟s reputation apart from
financial costs to be incurred in defending the suit.

Sometimes, a firm may resort to borrowings at high rates of interest. In such a situation,
if the firm fails to meet its obligation to bank in time, it is required to pay penalties.

9.5.2 Controlling inflows of cash:

In order to manage cash efficiently, the process of cash inflow can be accelerated by way
of systematic planning and redefined techniques. Thus an important problem for the
financial manager is to control cash inflows. He has to devise action not only to prevent
fraudulent diversion of cash receipts but also to speed up collection of cash. However, the
proper installation of internal can minimize the possibility of misuse of cash. Moreover,
collection of cash can be expedited through the adoption of various techniques such as:

 Concentration banking:

It is a system of decentralizing collection of accounts receivables in the case of big firms

having business spread over a large area. Under this system, the firm establishes a large
number of collection centers in different areas selected on geographical basis and opens
its bank accounts in local banks of different areas. These collection centers are required
to collect and deposit remittances in local banks and from the local banks; they are
transferred to the firm‟s head office bank. However, fast movement of funds is effected
by means of wire transfer or telex.

The system of concentration has the following advantages:

o Reduction of mailing time

o Reduction of time required to collect cheques
o Expediting collection of cash
 Lock-box system:

Lock-box is a post office maintained by a firm‟s bank that is used as a receiving point for
customer remittance. Lock-box system is another step in expediting collection of cash.
This system is developed to eliminate the time gap between the actual receipt of cheques
by a collection center and its actual depositing in the local bank account under
concentration banking. Under lock-box system, the firm hires a post office and instructs
its customers to mail their remittances to the box. The firm‟s local bank is given the
authority to pick up the remittances directly from the local box. The bank collects from
the box several times a day. It deposits the cheques, clears them locally and credits the
cash in the firm‟s account. Local banks are given standing instructions to transfer funds
to the head office when they exceed a particular limit.

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The following are the advantages of lock-box system:

 It helps to eliminate time lag between the receipt of cheques by a firm and their
deposit into the bank.
 This system helps to reduce the overhead expenses.
 It facilitates control by separating remittance from the accounts section.
 It also helps to reduce the credit losses by speeding up the time at which data are
posted to the ledger.

9.5.3 Control over cash outflows:

In order to conserve cash and reduce financial requirements, the firm should have strong
control over its cash outflows or disbursements. It aims at slowing down disbursements
as much as possible as against the maximum acceleration of collection in the case of
control over inflows. However, the combination of fast collections and slow
disbursements will result in the maximum availability of funds.

A firm can beneficially control outflows if the following points are considered:

 The firm should follow the centralized system for disbursements as against
decentralized system for collections. Under centralized system, as all payments
are made from a single control account, there will be delay in presentation of
cheques for payment by parties who are away from the place of account control.

 The financial manager should generally stress on the value of maintaining careful
controls over the timing of payments so as to ensure that bills are paid only as
they become due. When a firm makes payment on due dates, it should neither
lose cash discount nor its prestige on account of delay in payments. Thus, all
payments should be made on the due dates, neither before nor after.

 The firm should adopt the technique of „playing float‟ for maximizing the
availability of funds. The term „float‟ refers to the amount tied up in cheques that
have been drawn but have not been presented for payment. Usually, there is a
time gap between the issue of cheque by the firm and its actual presentation for
payment. Consequently, the firm‟s actual balance at bank is greater than the
balance shown by its books. The longer the „float period‟, the higher the benefit to
the firm.

9.5.4 Investing surplus cash:

Cash in excess of the firm‟s normal cash requirement is surplus cash. It may be
temporary or it may exist more or less on permanent basis. Temporary cash surplus is
composed of funds that are available for investment on a short-term basis as they are
required to meet regular obligations such as dividend and tax liabilities. Cash surplus
may also be maintained more or less permanently as a hedge against unforeseen heavy
expenses. Cash may also be accumulated over several years as a measure of a long-term
plan.

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9.6 Exercise:

Now let us check what we have learnt so far.

Q1.Prepare a flowchart depicting controlling level of cash.

Q2.Explain motives of holding cash with suitable examples.
Q3.Write the disadvantages of lock-box system

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 Unit 10
Inventory Management

Table of Contents
10.0 Objectives ....................................................................................................................

10.1 Meaning and Definition of Inventory: ...............................................................................

10.2 Components of Inventory: ..............................................................................................

10.2.1 Raw materials:........................................................................................................

10.2.2 Work-in-process:.....................................................................................................

10.2.3 Finished products: ...................................................................................................

10.2.4 Stores and spares: ..................................................................................................

10.3 Inventory Management Motives: .....................................................................................

10.3.1 The transaction motive: ...........................................................................................

10.3.2 The precautionary motive:........................................................................................

10.3.3 The speculative motive: ...........................................................................................

10.4 Objectives of Inventory Management: ..............................................................................

10.5 Benefits or Advantages of Holding Inventory:....................................................................

10.6 Disadvantages or Risks of Holding Inventory: ...................................................................

10.7 Need for Balanced Investment Inventory:.........................................................................

10.7.1 Dangers of Excessive Investment in Inventory: ...........................................................

10.7.2 Dangers of Inadequate Investment in Inventory: ........................................................

10.8 Tools and Techniques of Inventory Management: ..............................................................

10.8.1 ABC Analysis: .........................................................................................................

10.8.2 Economic Order Quantity (EOQ) ................................................................................

10.8.3 Order Point Problem: ...............................................................................................

10.8.4 Two-Bin Technique: .................................................................................................

10.8.5 VED Classification: ..................................................................................................

10.8.6 HML Classification: ..................................................................................................

10.8.7 SDE Classification: ..................................................................................................

10.8.8 FSN Classification:...................................................................................................

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 10.8.9 Just- In-Time Classification: .....................................................................................

10.8.10 Bill of Materials: ....................................................................................................

10.8.11 Perpetual Inventory System: ..................................................................................

10.9 Exercise: ......................................................................................................................

10.0 Objectives
At the end of the unit, you will be able to:

 Explain the components of inventory

 Compare the merits and demerits of holding inventory
 Calculate EOQ of an item

10.1 Meaning and Definition of Inventory:

The term “Inventory” is originated from the French word “Inventaire” and the Latin
“Inventoriom” which implies a list of things found. The term inventory has been defined
by the American Institute of Accountants, “as the aggregate of those items of tangible
personal property which:

 are held for sale in the ordinary course of business;

 are in the process of production for such sales, or
 are to be currently consumed in the production of goods or services to be
available for sale.

The term inventory refers to the stockpile of the products a firm is offering for the sales
and the components that make up the product. Inventories are the stocks of the product
of a company manufacturing for sale and the components that make up the product. The
various forms in which inventories exist in a manufacturing company are:

 Raw materials,
 Work-in process,
 Finished goods, and
 Stores and spares.

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10.2 Components of Inventory:

Raw
Materials

Componet Stores
Work-in-
Process
s of and
Invnetory Spares

Finished
Goods

Chart 3.2 Components of Inventory

10.2.1 Raw materials:

Raw materials are those inputs that are converted into finished goods throughout
manufacturing or conversion process. Those form a major input for manufacturing a
product. In other words, they are very much needed for uninterrupted production.

10.2.2 Work-in-process:

Work –in- process is a stage of stocks between raw materials and finished goods. Work-
in-process inventories are semi-finished products. They represent products that need to
undergo some other process to become finished goods.

10.2.3 Finished products:

Finished products are those products which are completely manufactured and ready for
sale. The stock of finished goods provides a buffer between production and market.

10.2.4 Stores and spares:

It includes office and plant cleaning materials like soap, brooms, oil, fuel, light, bulbs etc.
and are purchased and stored for the purpose of maintenance of machinery.

10.3 Inventory Management Motives:

Managing inventories involves lack of funds and inventory holding costs. Maintenance of
inventories is expensive, then why should firms hold inventories. There are three general
motives:

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10.3.1 The transaction motive:
The company may be required to hold the inventories in order to facilitate the smooth
and uninterrupted production and sales operations. It may not be possible for the
company to procure raw material whenever necessary. There may be a time lag between
the demand for the material and its supply. Hence it is needed to hold the raw material
inventory. Similarly, it may not be possible to produce the goods immediately after they
are demanded by the customers. Hence, it is needed to hold the finished goods
inventory. The need to hold work-in-progress may arise due to production cycle.

10.3.2 The precautionary motive:

In addition to the requirement to hold the inventories for routine transactions, the
company may like to hold them to guard against the risk of unpredictable changes in
demand and supply forces. E.g. the supply of raw material may get delayed due to the
factors like strike, transport disruption, short supply, lengthy processes involved in
import of the raw materials etc.

10.3.3 The speculative motive:

The company may like to purchase and stock the inventory in the quantity which is more
than needed for production and sales purposes. This may be with intention to get the
advantages in terms of quantity discounts connected with bulk purchasing or anticipated
price rise.

10.4 Objectives of Inventory Management:

The objectives of inventory management may be viewed in two ways and they are
operational and financial:

10.4.1 The operational objective is to maintain sufficient inventory, to meet demand

forproduct by efficiently organizing the firm‟s production and sales operations, and

10.4.2 Financial view is to minimize inefficient inventory and reduce inventory-carrying

costs.

These two conflicting objectives of inventory management can also be expressed in

terms of cost and benefit associated with inventory. The firm should maintain
investments in inventory which implies that maintaining an inventory involves cost such
that smaller the inventory the lower the carrying cost and vice-versa. But inventory
facilitates the smooth functioning of the production.

Effective inventory management should ensure:

o A continuous supply of raw materials and supplies to facilitate uninterrupted

manufacturing.

o Maintaining sufficient stock of raw materials in periods of short supply and

anticipate price changes.

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 o Maintaining sufficient finished goods inventory for smooth sales operation, and
efficient customer service.

o Minimize the carrying cost and time, and

o Control investment in inventories and keep it at an optimum level.

o Others: apart from the above, the following are also objectives of inventory
management; control of cost, control of materials cost, elimination of duplication
in ordering by decentralization of purchasers, supply of right quality of goods of
reasonable price provide data for short term and long term for planning control of
inventories.

Therefore, management of inventory needs careful and accurate planning so as to avoid

both excess and inadequate inventory in relation to the operational requirement of a
firm. To achieve higher operational efficiency and profitability of a firm, it is very
essential to reduce the amount of capital locked up in inventories. This will not only help
in achieving higher return on investment by minimizing tied up working capital, but will
also improve the quality position of the enterprise.

10.5 Benefits or Advantages of Holding Inventory:

Optimum level of inventory is that level where the total cost of inventory is less. The
major benefits of inventory are the basic functions of inventory. Proper management of
inventory will result in the following benefits to a firm:

10.5.1 Inventory management ensures an adequate supply of materials and stores

minimize stock outs and shortages and avoid costly interruption in
operations.

10.5.2 It keeps down investment in inventories; inventory carrying costs, and

obsolescence losses to the minimum.

10.5.3 It facilitates purchasing economies throughout the measurement of

requirementson the basis of recorded experience.
10.5.4 It eliminates duplication in ordering stock by centralizing the source from
whichpurchase requisition emanate.

10.5.5 It permits better utilization of available stock by facilitating inter-

departmenttransfers within a firm.

10.5.6 It provides a check against the loss of materials through carelessness or pilferage.

10.5.7 Perpetual inventory values provide a consistent and reliable basis for
preparingfinancial statements a better utilization.

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10.6 Disadvantages or Risks of Holding Inventory:
Holding of inventories involves the different costs, they also exposes the firm to take
some risks. Risk in inventory management refers to the chance that inventories cannot
be turned over into cash through normal sales without loss. Risks associated with
inventory management are as follows:

10.6.1 Price decline:

Price decline is the result of more supply and less demand. In other words, it may be the
result due to introduction of competitive product. Generally, prices are not controllable in
the short run by the individual firm. Controlling inventory is the only way that a firm can
counter act with these risks. On the demand side, a decrease in the general market
demand when supply remains the same may also cause price to increase. This is also a
long run management problem, because decrease demand may be due to change in
customer buying habits, tastes and incomes.

10.6.2 Product deterioration:

Holding of finished goods for a long period or shortage under improper conditions for
light, heat, humidity and pressures lead to product deterioration. For example: Cadbury‟s
chocolate. Recently, there were some live worms in chocolate; it was due to improper
storage. Deterioration usually prevents selling the product through normal channels.

10.6.3 Product obsolescence:

Product may become obsolete due to improved products, changes in customer tastes,
particularly in high style merchandise, changes in requirements etc. This risk may prove
very costly for the firms whose resources are limited and tied up in slow moving
inventories. Obsolescence cost risk is least controllable except by reduction in inventory
management.

10.7 Need for Balanced Investment गn Inventory:

Management of optimum level of inventory investment is the prime objective of inventory

management. Inadequate or excess investment in inventories is not healthy by for any
firm. In other words, a firm should avoid inadequate investments or excess investment in
inventory. The investment in inventories should be sufficient. The optimum level of
investment in inventories lies between excess investment and inadequate investment.

10.7.1 Dangers of Excessive Investment in Inventory:

The following are the dangers of excessive investment in inventory:

 The excessive level of inventories consumes funds of the company, they cannot
be used for any purpose since they have locked in inventory, and they involve an
opportunity cost.

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  The excessive investment in inventory increases carrying costs that include cost of
storage, capital cost (interest on capital in inventories, insurance, handling,
recording, inspection, obsolescence cost, and taxes). These costs will reduce the
firm‟s profits.

 Carrying excessive inventory over a long period leads to the loss of liquidity. It
may not be possible to sell the inventories in time without loss.

 Another danger of carrying excessive inventory is the physical deterioration of

inventories while in storage. In case of certain goods or raw materials,
deterioration occurs with the passage of time or it may be due to mishandling and
improper storage facilities.

 Excess purchases or storage leads to theft, waste and mishandling of inventories.

10.7.2 Dangers of Inadequate investment in Inventory:

Under investment in inventory is also not healthy one. It has more negative points, they
are:

10.7.2.1 Inadequate raw materials and work-in-progress inventories will disturb

production.

10.7.2.2 When the firm is not able to produce goods without interruption that leads the
inadequate storage of finished goods. If finished goods are not sufficient to
meet customer demand, the customers may shift to the competitors, which
will lead to loss of customers permanently.

10.8 Tools and Techniques of Inventory Management:

Financial manager should aim at determination of optimum inventory level based on
costs and benefits to maximize shareholders wealth. Inventory management problem can
be handled by sophisticated/ refined mathematical techniques. The major areas are:

10.8.1 Classification problem to determine the type of control required.

10.8.2 The order quantity problem.

10.8.3 The order point problem.

The following are some of the inventory control techniques:

10.8.1.1 ABC Analysis:

This is one of the widely used techniques to identify various items of inventory for the
purpose of inventory control. In other words, it is very effective and useful tool for
classifying, monitoring and control of inventories. The firm should not keep same degree
of control on all the items of inventory. It is based on Pareto‟s Law. It is also known as
selective inventory control.

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The firm should put maximum control on those items whose value is the highest with the
comparison of the other two items. The technique concentrates on important items and is
also known as Control by Importance and Exception. Usually a firm has to maintain
several types of inventories for proper control of them firm should have to classify
inventories in the instance of their relative value. Hence, it is also known as Professional
Value Analysis (PVA). The higher value items are classified as „A Items‟ and would be
under tight control. At the other end of the classification, we find category „C Item‟, on
this type of inventory, we cannot offer expenses on rigid controls, frequent ordering and
expending because of the low value or low amount in this area. Thus with “C Items”, we
may maintain somewhat higher safety stocks, order more months of supply, expect lower
levels of customer service, or all the three. “B Items” fall in between “A Item” and “C
Item” and require reasonable attention of management.

According to this technique the task of inventory management is proper classification of

all inventory items into three categories namely A, B and C. it is as follows:

Category Number of items (in %) Item Value (in %)

A 15 70

B 30 20

C 55 10

Total 100 100

The above table indicates that only 15 percent of the items may account for 70 percent
of the value of “A items” on which greater attention is required, whereas 55 percent of
items may account for 10 percent of the table value of inventory of “C item” which will be
given a reasonable attention. The remaining 30 percent of inventory account for 20
percent of total value of inventory of “B item” which will again be given reasonable
attention as this category value lies between the two other categories.

10.8.2.1 Economic Order Quantity (EOQ)

Once categorization of inventory items is completed, then the next question is how much
inventory should be bought in one order on each replenishment?, should quantity to be
purchased be large or small?, buying inventory items in large quantities has its own
virtues, but it increases carrying costs. Then what is the solution for the determination of
an order, where the total inventory costs are minimum? To this problem the answer
Economic Order Quantity.

10.8.2.2 Meaning of EOQ:

EOQ refers to that level of inventory at which the total cost of inventory is minimum. The
total inventory cost comprising ordering and carting costs. Storage costs are excluded in
adding total cost of inventory due to the difficulty in computation of storage cost. EOQ is
also known as Economic Lot Size (ELS).

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 10.8.2.3 Assumptions of EOQ Model:

10.8.2.3.1 Demand for the product is constant and uniform throughout the period.
10.8.2.3.2 Lead time (time from ordering to receipt) is constant.
10.8.2.3.3 Price per unit of product is constant.
10.8.2.3.4 Inventory holding cost is based on average inventory.
10.8.2.3.5 Ordering costs are constant.
10.8.2.3.6 All demand for the product will be satisfied (no back orders are allowed).

10.8.2.4 E

OQ Formula:

EOQ = √2×A×O

(2AO)
C

Where,

A = Annual usage

O = Ordering cost per order

C = Carrying cost per unit

EOQ is applicable both to single items and to any group of stock items with similar
holding and ordering costs. Its use causes the sum of the two costs to be lower than
under any other system of replenishment.

10.8.2.5 Limitation of EOQ:

10.8.2.5.1 Constant usage:

This may not be possible to predict, it usage varies unpredictably, as it often does, no
formula will work well.

10.8.2.5.2 Faulty basic information:

Ordering and carrying cost is the base for EQA calculation. It assumes that ordering cost
is constant per order is fixed, but actually varies from commodity to commodity. Carrying
cost also can vary with the company‟s opportunity cost of capital.

10.8.2.5.3 Costly calculations:

In many cases, the cost of estimation, cost of possession and acquisition and calculating
EQA exceeds the savings made by buying that quantity.

10.8.3 Order Point Problem:

After determination of EQA, then at what level should the order be placed? If the
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 inventory level is too high, it will be unnecessary blocks the capital and it the level is too
low, it will disturb the production by frequent stock out and also involves high ordering
cost. Hence, an efficient management of inventory need to maintain optimum inventory
level, where there is no stock out and the costs are minimum. The different stock levels
are:

10.8.3.1 Minimum level:

10.8.3.1.1 Minimum stock is that level that must be maintained always, production will be
disturbed if it is that the minimum level. While determination of minimum
stock level lead time, consumption rate, the material nature must be
considered.

10.8.3.1.2 Lead time the time taken to receive the delivery after placing orders with the
supplier. In other order, the number of days required to receive the inventory
from the data of placing order lead time also called as procurement time of
inventory.

10.8.3.1.3 The average quantity of raw materials consumed daily. The consumption rate
is calculated based on the past experience and production plan.

10.8.3.1.4 Requirement of material for normal or regular production or special order

production. If the material is required for special order production then the
minimum stock level need not maintain.

10.8.3.1.5 Minimum stock level = Re-order level - (Normal usage × average delivery
time).

10.8.3.2 Re-ordering level:

Re-order level is that level of inventory at in weeks, which an order should be placed for
replenishing the current stock of inventory. Generally, the re-order level lies between
minimum stock level and maximum stock level.

Re-order point = Lead Time (in days) × Average Daily Usage

The above formula is based on the assumption that:

10.8.3.2.1 Consistent daily usage

10.8.3.2.2 Fixed lead time

10.8.3.3 Maximum level:

Maximum level of stock is that level of stock beyond which a firm should not maintain the
stock. If the firm stock inventory beyond the maximum stock level it is called as
overstocking. Excess inventory involves heavy cost of inventory because it blocks firm‟s
funds in investment inventory, excess carrying cost, wastage obsolescence, and theft
cost. Hence firm should not stock above the maximum stock level safety stock is that
minimum additional inventory to serve as a safety margin or better or buffer or cushion

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 to meet an unanticipated and increase in usage resulting from an unusually high demand
and or an uncontrollable late receipt of incoming inventory.
Maximum stock level = Reorder level +Reorder Quantity (minimum usage +minimum
delivery time)

10.8.3.4 Average Stock level:

Average stock level = Minimum level + (Reorder quantity ÷2)

Or

Maximum level+minimum level

2

10.8.3.5 Danger Stock Level:

Danger level is that level of materials beyond which materials should not fall in any
situation. When it falls in danger level it will disturb production. Hence, the firm should
not allow the stock level to go to danger level; if at all falls in that level then immediately
stock should be arranged even if it is costly.

Danger level = average usage × minimum deliver time (for emergency purchase)

10.8.4 Two-Bin Technique:

It is the oldest techniques of inventory control. Generally, it is used to control „c‟ category
inventories. According to this technique, stock of each item is separated into two piles,
bins or group. First bin contains stock, just enough to last from the date a new order is
placed until it is received for inventory. The second bin contains stock, which is enough
to meet current demand over the period of replenishment. First stock is issued from first
bin whenever the first bin is completed, then an order for replenishment is placed, and
the stock in the second is utilized until the ordered material is received.

10.8.5 VED Classification:

According to this classification, inventories are grouped based on the effect of production
and are grouped into three broad areas: they are Vital, Essential and Desirable
inventories. It is specially used for classification of spare parts. If a part is Vital in
production, then it is classified a „V‟, if it is Essential, then it is assigned as ‟E‟ and if it is
not so essential i.e. Desirable, then it is given „D‟. „V‟ category items are stocked high
and category „D‟ items are maintained at minimum level.

10.8.6 HML Classification:

Here the materials are classified based on the unit value and not on the annual usage
value. The inventory is classified into three categories such as High, Medium and Low, as
it is adopted in selective inventory control technique. The inventory items should be
listed in the descending order of unit value and it is upto the management to fix limits for
three categories. This classification is useful for keeping control over consumption at
departmental levels, for deciding the frequency of physical verification and for controlling
purchases.

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10.8.7 SDE Classification:

This SDE classification is made based on the availability of materials. It is very much
useful in the case of scarcity of supply of inventories. Here „S‟ refers to „Scarce‟ inventory
item, generally imported and those, which are in short supply category referred to as „D‟-
Difficult‟ inventory item that are available indigenously but are difficult to procure. „E‟
refers to items, which are easy to acquire and are available in the local markets.

10.8.8 FSN Classification:

Under this technique inventory is classified based on movement of inventories from

stores. FSN stands for Fast moving, Slow moving and Non-moving. This technique
particularly involved in inventory useful for avoiding obsolescence. For determination
whether a particular inventory is fast moving or not the date of receipt or the last date of
issue, whichever is later, is taken, which have lapsed since the last transaction. The
items are usually grouped in periods of 12 months. Active moving items need to be
reviewed regularly and surplus items which have to be examined further. Non-moving
items may be examined further and their disposal can be considered.

10.8.9 Just- In-Time Classification:

Popularly known in its acronym as JIT. JIT may be applied for either raw material
purchased or producing finished goods. From raw material purchases it means that no
inventories are held at any stage of production and that exact requirement is bought in
each and every successive stage of production of the right item. In other words,
maintenance of a minimum level of raw materials, whereby the inventory carrying cost
could be minimized and the risk of loss due to stock-out position could be well avoided.
From production of goods view, JIT means goods are produced not only when the orders
are received, thereby no storage of finished goods can avoid costs of carrying finished
goods. JIT also known as, Zero Inventory Production System (ZIPS), Zero Inventories
(ZIN), Materials as Needed (MAN), or Neck of Time (NOT).

10.8.10 Bill of Materials:

In order to ensure proper inventory control, the basic principle to be kept in mind is that
proper material is available for production purposes whenever it is required. This aim can
be achieved by preparing what is normally called as “Bill of Materials”.

A bill of material is the list of all the materials required for a job, process or production
order. It gives the details of the necessary materials as well as the quantity of each item.
As soon as the order for the job is received, bill of materials is prepared by Production
Department or Production Planning Department.

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 The form in which the bill of materials is usually prepared is as follows:

BILL OF MATERIALS

No: Date of Issue: Production/Job Order No:

Department Authorised

Sr. Description Code Qty For Department Use Only Remarks

No. of Material No.
Material Date Qty
Requisition Demanded
No.

The functions of bill of materials are as follows:

10.8.10.1 Bill of materials gives an indication about the orders to be executed to all the
persons concerned.

10.8.10.2 Bill of materials gives an indication about the materials to be purchased by the
Purchase Department if the same is not available with the stores.

10.8.10.3 Bill of materials may serve as a base for the Production Department for placing
the materials requisition slips.

10.8.10.4 Costing/Accounts department may be able to compute the material cost in respect
of a job or production order.

10.8.11 Perpetual Inventory System:

As discussed earlier, in order to exercise proper inventory control, perpetual inventory

system may be implemented. It aims basically at two facts:

10.8.11.1 Maintenance of Bin Cards and Stores Ledger in order to know about the stock in
quantity and value at any point of time.

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10.8.11.2 Continuous verification of physical stock to ensure that the physical balance and
the book balance tallies

The continuous stock taking may be advantageous from the following angles:

10.8.11.3 Physical balances and book balances can be compared and adjusted without
waiting for the entire stock taking to be done at the year end. Further, it is not
necessary to close down the factory for annual stock taking.

10.8.11.4 The figures of stock can be readily available for the purpose of periodic profit an
loss account.

10.8.11.5 Discrepancies can be located and adjusted in time.

10.8.11.6 Fixation of various levels and bin cards enables the action to be taken for the
placing of order for acquisition of material.

10.8.11.7 A systematic maintenance of perpetual inventory system enables to locate slow

and non-moving items and to take the remedial actions for the same.

10.8.11.8 Stock details are available correctly for getting the insurance of stock.

11.9 Exercise:

Now let us check what we have learnt so far.

Q1.Explain Economic Order Quantity

Q2.Explain the tools for inventory management
Q3.Describe various stock levels with suitable examples.

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 SUMMARY

Management of Cash, Receivables and Inventory are the major constituents of

working capital management.

A control of the cash position is a vital aspect of the financial management of a

concern. There should be a balance between cash and cash demanding activities –
operations, capital additions, etc. The objectives of cash management are to make the
most effective use of funds, on the one hand, and accelerate the inflow and decelerate
the outflow of cash on the other.

Accounts receivable is a permanent investment in the business. As old accounts

are collected, new accounts are created. Accounts receivable is a major component of the
current assets. This account emerges because of the existence of credit sales. As this
account constitutes a major share it has got a greater significance in working capital
management. Credit sales no doubt increases turnover and profit of the business. But
carrying permanently the accounts receivable in the firm involves greater risk. Hence
there is a need for management to establish the level of accounts receivable.

The concept of inventory management has been one of the many analytical
aspects of management. It involves optimization of resources available for holding stock
of various materials. Lack of inventory can lead to stock-outs, causing stoppage of
production and a very high inventory will result in increased cost due to cost of carrying
inventory. Thus, optimization of inventory should ensure that inventories are neither too
low nor too high.

A clever finance manager is one who strikes a golden mean between these two
conflicting goals of the firm. (Profitability and liquidity)

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 Bibliography

D, B. C. (2006). Financial Management. New Delhi: Prentice Hall of India Private Ltd.

Inamdar, S. (2006). Principles of Financial Management. Pune: Everest Publishing House.

Kulkarni, M. (2003). Financial Management. Nashik: Replica Printers.

M. Y. Khan, P. J. (2002 ). Theory and Problems in Financial Management (2nd ed.). New
Delhi: Tata McGraw Hill Publishing Company Ltd.

Rustagi. (2002). Fundamentals of Financial Management (3rd ed.). New Delhi: Galgotia
Publishing Company.

Sudhindra, B. (2007). Financial Management: Principles and Practice. New Delh: Excel
Books.

Van Horne, J. C. (2003). Financial Management. New Delhi: Prentice Hall of India Pvt.
Ltd.

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 Unit 4

Working capital and Dividend Decision

Meaning:

Working capital also called net current assets, is the excess of current assets over
current liabilities. All organizations have to carry working capital in one form or the
other. The efficient management of working capital is important from the point of view of
both liquidity and profitability. Poor management of working capital means that funds
are unnecessarily tied up in idle assets hence reducing liquidity and also reducing the
ability to invest in productive assets such as plant and machinery, so affecting the
profitability.

Working Capital Managements

Working capital management refers to management of the working capital. A firm’s

working capital includes investment in current assets. Current assets can be defined as
those which can be converted in to cash or equivalents within a year and those which are
necessary for meeting the day to day requirements. They consist of assets like cash and
bank balances, inventories, marketable securities and receivables.

The need for working capital management rises on two counts. (i) Existence of working
capital is necessary for every firm; and (ii) The working capital involves the investment
of funds of the firm. If working capital is not sufficient, it will create hindrances in the
smooth working of the firm.

Nature of Working Capital

Too much investment in current assets may lead to tying up funds which can be
productively used somewhere else. Excess investment may also expose the firm to
unnecessary risks. Too little investment also poses some risks for the firm. For example,
if the firm has insufficient inventories, it may lose customers. Therefore, a financial
manager has to keep the following in consideration while making decisions regarding
working capital requirements.

1. What should be the total investment in working capital of the firm?

2. What should be the level of individual current assets?
3. What should be the relative importance of different sources of finance for the
working capital requirements?

Keeping the above in mind, working capital can be defined as the management of a
firm’s sources and uses of working capital to maximize the wealth of the shareholders.
Careful management of the working capital needs medium term planning as well as
careful adaptation to the changes coming due to fluctuations in operational levels of the
firms.

40
Types of Working Capital

Working capital can be classified into two categories.

1. Gross Working or Total Working Capital: It refers to the firm’s investment in all
the current assets taken together.
The total current assets are termed as the gross working capital. It is known as
quantitative or circulating capital. Total currents assets includes cash, marketable
securities, accounts receivables, inventory, prepaid expenses etc.
According to Weston and Brigham, “Gross working capital refers to firm’s investment
in short – term assets such as cash, shorts term securities, accounts receivables and
inventories.”
According to Walker, “Use of this concept is helpful in providing for the current
amount of working capital at the right time so that the firm is able to realise the
greatest return on investment.”
2. Net Working Capital: It is the excess of the total current assets over total current
liabilities. Those liabilities which are to be paid within one year are called current
liabilities. When the payment of current liabilities is delayed, the funds become
available to the firm for its use. As such a part of the funds needed for maintaining
current assets, is provided by the current liabilities. Further the firm can invest these
funds in those current assets only which are not financed by the current liabilities.
According to Roy Chowdary, “Net working capital indicates the liquidity of the
business whilst gross working capital denotes the quantum of working capital with
which business has to operate.”

The net working capital may be positive or negative. If the total current assets are more
than the total current liabilities then the difference is positive net working capital. The
greater this difference the better it would be for the firm. In the reverse case, it would
be negative.

A financial manager needs to consider both gross working capital as well as net working
capital because they provide different interpretations. Gross working capital refers to
total investment of the firm in the current assets. A firm must maintain optimum level
of gross working capital. Further gross working capital provides an idea of total funds
required for maintaining current assets.

Conversely the net working capital denotes the amount of funds which must be invested
by the firm on a regular basis in current assets. Net working capital also refers to the
amount of net liquidity being maintained by the firm. Thus both concepts of working
capital have their own relevance.

Need for Working Capital

The working capital requirement of a firm to a large extent depends on the operating
cycle of that firm. This we shall briefly examine below.

41
The Operating Cycle

“The operating cycle may be defined as the time duration starting from the procurement
of goods or raw materials and ending with the sales realization. The length and the
nature of the operating cycle may differ from one firm to another depending upon the
size and nature of the firm.” (Rustagi R.P., 2011, Fundamentals of Financial
Management, Taxman Publications Pvt. Ltd., New Delhi, p.243)

In a trading firm, there are a series of activities which start with procurement of goods
i.e. saleable goods and end with the realization of sales revenue. In case of a
manufacturing firm, these series start with procurement of raw materials and end with
the sales realization of finished goods. However in both cases, what is common is that
there is a time gap between the happenings of the first and last event. This time gap is
known as the Operating cycle.

The operating cycle has the following sequences:

(i) Procurement of raw materials and services.

(ii) Conversion of raw materials into wok-in-progress.
(iii) Conversion of wok-in-progress into finished goods.
(iv) Sale of finished goods (cash or credit).
(v) Conversion of receivables into cash.

The above activities create and necessitate cash flows. These flows are neither certain
nor synchronized. Cash flows are uncertain because the future costs and sales determine
these. Payment for purchases, wages and other expenses are less uncertain in terms of
both time and quantity. The firms try to reduce the uncertainty and unsynchronization of
cash flows.

Further the firms need to provide credit facilities to the customers. They need to keep
finished goods in store to fulfil the orders. Also a minimum cash balance must be
maintained. Smooth producing requires a minimum stock of raw materials. All these
require investment in the current assets. This requirement of funds depends upon the
operating cycle of the firm. It can also be denoted as the working capital needs of the
firm.

Operating Cycle Period

“The length of time duration of the operating cycle of any firm can be defined as the sum
of its inventory conversion period and the receivables conversion period.”

(a) Inventory Conversion Period (ICP): It refers to the time period required to
convert raw materials into finished product sales. ICP consists of various periods i.e.
RMCP, WPCP, FGCP. RMCP (the raw material conversion period is the period during
which raw materials are kept in the store before they are issued to the production
department. WPCP is the period in which the raw materials remain in the production
process before they are taken out as finished units. FGCP is the period during which the
finished units remain in the stores before they are sold to the customers.

42
(b) Receivable Conversion Period (RCP): It is the time period required to change the
credit sales into cash realization. It denotes the period between the occurrence of credit
sales and collection of debtors. The ICP and RCP together are called Total Operating
Cycle Period (TOCP). The firms may be given some credit facilities by the suppliers of
raw materials etc. The period for which the paymets are deferred is called Deferral
Period (DP). The Net Operating Cycle (NOC) of a firm is arrived by deducting the DP
from the TOCP.

Thus,

NOC = TOCP - DP

= ICP + RCP - DP

Example:

From the following information taken from the books of a manufacturing concern,
compute the operating cycle in days.

Period covered 365days

Average period of credit allowed by suppliers 16days

(Rs. In ‘000)

Average debtors outstanding 480

Raw materials consumption 4,400

Total Production cost 10,000

Total cost of goods sold 10,500

Sales for the year 16,000

Value of average stock maintained:

Raw materials 320

Work-in-progress 350

Finished goods 260

Solution:

Operating Cycle of XYZ Ltd.

Average raw material 320

1. Raw material : ------------------------------ X 365 = --------X 365 = 27days

Raw material consumed 4,400

Average Work-in-progress 350

2. Work-in-progress : --------------------------------X 365 = ------X365=13days

Total cost of Production 10,000

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 Average Stock 260

3. Finished goods : -----------------------------------X 365 = ------X365 =9days

Total cost of goods sold 10,500

Average Debtors 480

4. Debtors: -------------------------------------X 365 = --------X 365 = 11days
Credit sales 16,000
The credit allowed by Creditors = 16 days

TOCP = RMCP + WPCP + FGCP + RCP

27 + 13 +9 + 11 = 60 days

NOC = TOCP - DP
60 - 16 = 44 days

Therefore, the firm has a NOC of 44 days.

(Rustagi R.P., 2011, Fundamentals of Financial Management, Taxman Publications Pvt.

Ltd., New Delhi, p.244 and 245)

The TOCP and NOC do not measure the absolute amount of funds invested in working
capital. However a longer NOC will require more working capital. It is very difficult to
decide an optimum operating cycle for a particular firm. The comparison of firm’s
operating cycle with those of other firms may help in maintaining and controlling the
length of the operating cycle of this particular firm.

Need for Adequate Working Capital

Every firm must maintain sufficient working capital. Accordingly it should frame a proper
policy to manage this need. It should ensure that the firm always has enough working
capital. Its availability should be flexible so as to ensure that the fixed assets are
utilised to the optimum. Operations of a firm need to be optimized so that the wealth of
the shareholders is maximized. Therefore every firm should have enough working
capital.

If the availability of working capital is more than required, it will have the following
consequences:

(i)There will be unnecessary accumulation of inventories which would result in wastage,

theft, damage etc.

(ii)Delay in collecting receivables may give rise to more liberal credit terms than
required by the conditions of the market.

(iii)It may lead to adverse influence on the performance of the management.

44
On the contrary, inadequate working capital availability will have adverse impact on the
firm as follows:

(i)Optimum utilization of fixed assets is not possible.

(ii)Growth of the firm will stagnate.

(iii)The production schedule may be disturbed. This may reduce the profit margin of the
firm.

(iv)The firm may lose the opportunities.

(v)If a firm is unable to meet its liabilities on time, it may lose goodwill in the market.

Therefore, a firm must always maintain adequate level of working capital. For this the
financial manager must develop –

(a)A self-sufficient working capital management system and

(b) A well-articulated policy of working capital.

This requires consideration of the following aspects:

(i)What is the expected sales level?

(ii)Accordingly what has to be the level of individual and total current assets?

Types of Working Capital Needs

The working capital need is of two types – (i) permanent and (ii) temporary. They are
explained below.

(i)Permanent Working Capital: Firms always need a minimum level of working capital
to maintain their activities. They should always have a minimum of stocks, cash and
other current assets to maintain their business whatever may be their level of
operations. During the lean season too they need to maintain some current assets. This
minimum level of current assets which needs to be maintained by every firm at all the
times is known as permanent working capital of that firm. This is also called fixed
working capital because like fixed assets, this requirement is fixed in nature.

(ii) Temporary Working Capital: Besides the permanent working capital, the firms
also need more working capital to cater to the need coming due to fluctuations in the
volume of sales. This extra working capital required is called temporary or fluctuating
working capital. To illustrate, when there is sudden increase in sales, the firm needs to
provide more stocks to meet the demand. After sometime when normalcy is restored,
these inventories become excess.

Each firm requires both permanent and temporary working capital. Financial manager of
the company has to distinguish between these two types of working capital. The
permanent working capital does not need regular attention once it is decided. Firm needs
to be careful about the temporary working capital. It must be able to arrange additional

45
funds whenever the need for additional working capital arises. The temporary working
capital is required to meet the temporary liquidity needs of the firm.

Determinants of Working Capital:

Working capital needs of a firm are determined by a number of factors. A number of

considerations are involved in this process and these considerations may change from
time to time. It is a continuous process which needs to be undertaken on a regular basis.
The determinants are briefly explained below:

1. Basic Nature of Business: Nature of the business involved is closely related to the
requirement of the working capital. For example, the trading firms mostly have
smaller working capital requirements. In some cases, if they require large
inventories, the need for more working capital would arise. In case of finance firms,
they have to maintain sufficient liquidity all the time. In case of manufacturing firms,
there is a requirement of substantial working capital because funds in raw materials,
labour expenses and overheads at each and every stage of production, are blocked.
This happens as the production process is long drawn.
2. Production Cycle: The term Production or manufacturing cycle refers to the time
involved in the manufacture of goods. It covers the time- span between the
procurement of raw materials and the completion of the manufacturing process
leading to the production of finished goods.
3. Business Cycle Fluctuations: Different phases of business cycles have different
effect on the working capital requirements. During inflation, business activity
expands. As a result need for cash, inventories etc. increases. This results into more
and more funds being blocked in the current assets. On the contrary during
depression the opposite effect takes place and the need for working capital reduces.
4. Seasonal Operations: If a firm produces commodities which have seasonal
variations, production will be fluctuating according to season. Accordingly the
demand for working capital will also fluctuate. For example, in case of a cold drinks
manufacturing firm, during cold season there will be hardly any demand for cold
drinks. Therefore the working capital required during winter would be less. During
summer it would be reverse. If the operations are smooth and no seasonal variation
is experienced then the demand for working capital will be constant.
5. Market Competitiveness: This factor has an important influence on the working
capital requirement of a firm. If too much competition exists, the firm may be
required to give liberal credit terms to attract the consumers which will increase the
number of high debtors. Therefore the working capital requirement will be higher so
as to invest in receivables and inventories. This will not be true in case of a
monopolistic firm.
6. Credit Policy: Credit policy refers to all he terms and conditions for selling and
purchasing goods. At a time a firm needs to have two types of credit policy. The
first one refers to the credit it needs to extend to its customers. The second one

46
 refers to the credit policy extended to the supplier of raw materials, goods etc. In
both cases it has to consider the credit policy prevailing in the market. To illustrate,
a firm may be buying goods on credit but will sell goods on cash basis only. In this
case, the working capital requirement will be less.
7. Supply Conditions: Time gap between placing an order for raw materials etc. and
the supply of the same also determines the need for working capital. If the goods
are supplied immediately or within a short period of time then the firm does not
have to maintain a high level of inventory. In such cases, the working capital
requirement will be less. In some cases large stock of inventories is required. For
example, some firms need to keep large quantities of inventories like in case of
imported goods. In this case working capital requirement will be higher.

As we have examined above, a number of factors determine the demand for working
capital. Every factor has its own influence. Further it is not one time phenomenon. We
need to review the requirement from time to time

Estimation of Working Capital Need:

In a proforma projection of working capital requirements, management must forecast

the maximum level of current assets required to support an expected volume of sales
and maximum level of short term credit it can anticipate to finance these assets.

Need for Working Capital Estimation

Correct estimation of working capital requirement is a basic necessity of a good and

efficient working capital management. In this section we will briefly understand the
different methods of estimating the working capital requirement.

Estimation Process

For smooth conduct of business, a firm must estimate beforehand the need for net
working capital. The following are the different ways of measuring the need for working
capital.

1. Working capital as a percentage of net sales:

Working capital of a firm is directly related to the sales volume of that firm. Therefore,
need for working capital can be found as percentage of expected sales for a particular
period. Here we assume that higher the sales level, the greater would be the
requirement for working capital.

There are three stages involved in calculating the working capital:

(i) Estimating total current assets as a percentage of estimated net sales;

(ii) Estimating the current liabilities as a percentage of estimated net sales; and
(iii) When we calculate the difference between the above two variables, we get the
working capital as a percentage of net sales;

47
On the basis of past experience or other firm’s experience in similar business
environment, a firm can find how much of total current assets and total current liabilities
it should maintain for a given level of expected sales.

The first stage will give gross working capital requirement. The second stage will inform
us about the funds available from the current liabilities. The difference between the two
will gives us the net working capital required by the firm.

2. Working Capital as a Percentage of Total Assets or Fixed Assets:

We know that assets of a firm are an addition of fixed assets and current assets. Based
on the past experience, a relationship can be found between (a) the gross working
capital i.e. total current assets or net working capital which is the difference between the
current assets and current liabilities, and (b) total fixed assets or total assets of the firm.

Here working capital can also be calculated as a percentage of fixed assets. To use its
fixed assets efficiently and at optimum level, a firm needs to acquire sufficient working
capital. Therefore estimation of working capital depends upon the estimation of fixed
capital which ultimately depends on the capital budgeting decisions.

Both the above methods are a relatively simple but difficult to calculate. The main
weakness of these two methods is that they require establishing a relationship of current
assets with net sales or fixed assets which are not easy.

3. Working capital based on Operating Cycle:

In this method, estimating the working capital need depends on the operating cycle of
the firm. A detailed analysis is undertaken for each component of working capital and
estimate is made for each component.

Depending upon the respective operating cycle and the cost involved, the requirement of
funds for each of the components of the working capital differs. On the contrary the
current liabilities can provide the finances depending on the respective operating cycle or
the lag period in payment.

The need for working capital can be calculated as follows:

(i)Need for Cash and Bank Balance: The minimum cash requirement for petty and
general expenses and cash purchases can be estimated on the basis of the past
experience. This estimation should be done correct for two reasons- (a) Cash and bank
balances are the least productive and so the firm must maintain a minimum balance ;
(b) These balances provide liquidity to the firm which is very important for every firm.

(ii)Need for Raw Materials: The number of units to be maintained in store for
different types of raw materials depends on various factors such as raw material
consumption rate, time lag in procuring fresh stock, contingencies and other factors.

(iii)Need for Work in Progress: In any firm at a particular point of time, there will be a
different number of units in different stages of production. These units are neither raw
materials nor finished goods. So we call them work-in-progress or semi-finished goods.

48
The value of raw material, wages and other expenses locked in these semi- finished
goods is the working capital requirement for work-in- progress.

(iv)Need for Finished Goods: For many firms heir finished goods are not immediately
sold after production. They would be lying in the store for some time before they are
sold. Since they are lying in the go down locked up, working capital is required for them.
They are valued on the basis of cost of these units.

(v)Need for Receivables: Receivables include the debtors and bills. In case of credit
sales, there is a time lag between sales and collection of sales revenue. This gap
necessitates working capital. We can calculate the working capital locked up in
receivables on the basis of their cost.

The working capital requirement for all the above five elements together is called gross
working capital of the firm.

(vi)Creditors for the Purchases: A firm sells goods and services on credit. It will also
buy raw materials etc, on credit. Therefore, the suppliers will be providing working
capital to the firm for the credit period.

(Vii)Creditors for Expenses and Wages : The time lag in the payment of wages and
other expenses provides some working capital to the firm.

This method of estimating working capital based on the operating cycle is the most
systematic and legal method.

Different steps are involved in calculating working capital need in this method:

a) Estimation of each element of current assets and current liabilities is needed.

b) Decide the average operating cycle for each of the components.

c) Firm has to find he rate per unit for each of the components.

d) Find the amount of funds expected to be kept aside for each of these components.

e) Firm has to prepare the working capital estimation sheet and find the working capital
requirement.

The following points need to be noted while preparing the working capital need.

i) Depreciation: Usually depreciation on the fixed assets is ignored in the working

capital estimation. Such calculation is called cash basis working capital. In case
depreciation is included, such estimate is called total basis working capital.
ii) Safety Margin: It is a percentage of total current assets or liabilities or net
working capital. Quantum of safety margin depends upon the nature and
characteristics of the firm, its current assets and current liabilities.

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Estimation of Required Working Capital:

Statement of Working Capital Estimation

Particulars Amount(Rs.) Amount (Rs.)

A. Estimation of Current Assets :

(i) Raw Materials XXX
(ii) Work-in-progress
Raw materials (full cost) XX
Direct labour (to the extent
of completed stage) XX
Overheads( to the extent
of completed stage) XX
---------- XXX
(iii) Finished goods inventory XX
(iv) Debtors XXX
(v) Cash balance XXX
------------

Total Current Assets XXX

B. Estimated of Current Liabilities :

(i) Creditors XX
(ii) Expenses XX
(iii) Overheads XX
(iv) Labour XX
-------------

Total Current Liabilities XXX

C. Working Capital (A- B) XXX

Add: Contingency (Percentage on working capital,i.e. C) XXX
-----------
D. Working Capital Required XXXX

(G. Sudarsana Reddy (2019), Financial Management, Himalaya Publishing House Pvt.
Ltd., Mumbai, p.533)

Summary

1. The term working capital may be used to denote either the gross working capital
which refers to total current assets or net working capital which refers to excess of
current assets over current liabilities.

2. Operating cycle is defined as the time duration which the firm requires to manufacture
and sell the product and collect cash. Thus operating cycle refers to the acquisition of the

50
resources, conversion of raw materials into work-in-progress into finished goods,
conversion of finished goods into sales and collection of sales. Larger is the operating
cycle, larger will be the investment in current assets.

3. The working capital requirement for a firm depends upon several factors such as
operating cycle, nature of business, business cycle fluctuations, seasonally of operations,
market competitiveness, credit policy, supply conditions etc.

4. The working capital need of the firm may be bifurcated into Permanent and
Temporary working capital.

5. Every firm must estimate in advance as to how much net working capital will be
required for the smooth operations of the business.

6. Working capital estimates may be made on the basis of (i) As a percentage of net
sales, (ii) As a percentage of total assets or fixed assets and (iii) operating cycle of the
firm.

7. While finding out the working capital requirement, the firm should also include a
safety margin to take care of the contingencies.

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Questions for Self-study
SECTION I

Answer the following Questions: (Any One) 15 Marks

1. “Financial management has undergone significant changes over years, as

regards itsscope”. Explain.
2. Describe the Traditional View on Optimal Capital Structure. Compare and
Contrastthis view with the NOI Approach and NI Approach.
3. Explain MM Hypothesis of Capital Structure with following premises
• Without corporate taxes
• With corporate taxes.
4. Cost of Debt (Kd): Calculate the Cost of Debt in the following cases:
1. A Ltd. Issued 12 %, Debentures of Rs. 100 each at par. Brokerage 2% of issue
price. Corporate Tax Rate 30%.
2. B Ltd issued 12 %, Debentures of Rs. 100 each at 5% discount and
redeemable after 5 years at % premium. Corporate Tax Rate 30%.
3. D Ltd. Issued 12%, Debentures of Rs. 100 each at par. Flotation cost 10%.
Corporate Tax Rate 30%.
5. Calculate the Cost of Preference Shares in the following cases:

1. P Ltd. Issued 12 %, preference shares of Rs. 100 each at par. Brokerage 2% of

issueprice. Corporate Tax Rate 30%. Dividend Tax Rate 20%
2. Q Ltd issued 12 %, preference shares Rs. 100 each at 5% discount and
redeemable after 5 years at 5% premium. Corporate Tax Rate is 30%. Dividend
Tax Rate 20%
3. R Ltd issued 12 %, preference Shares of Rs. 100 each at par and redeemable
after 5 years at par. Flotation cost 10%. Corporate Tax Rate 30%. Dividend Tax
Rate 20%

6. Cost of Equity (ke): Calculate the Cost of Equity Shares in the following
cases:

1. The Current market price of V Ltd.‟s equity share of Rs. 10 each is Rs. 64. For
the last year, the company had paid an equity dividend of Rs. 8 per share Which
is expected to grow @ 5% p. a. forever.
2. The current market price of X Ltd‟s equity share of Rs . 108 which is each Rs 90.
Earnings per share for the current year is Rs. 20 per share. Dividend payout
Ratio is 60%, Anticipated Dividend Growth Rate is 5%. Floatation Cost is Rs.6 per
share.
3. The current market price of Y Ltd„s equity share of Rs . 10 each is 90. The
prevailing
 default risk –free interest rate on 10 year GOI Treasury Bonds is 5.5%
Rate ofReturn on Market Portfolio is 13.5%. Beta of the company is 1.5.

7. Define working capital. What are its types and determinants?

SECTION II

Answer the following Questions: (Any One) 10 Marks

1. Explain the meaning of financial management. What are its objectives?

2. What is the need for working capital management?

3. State the determinants of working capital of an organisation.

4. Concept of operating cycle of working capital.

5. What factors have an important bearing on working capital needs?

6. Discuss the steps involved in estimation of working capital needed by a firm.

7. Explain the concept of value of the firm.

8. Compare Net Income Approach with Net Operating Income Approach.

9. How does cost of equity behave with leverage under Traditional Approach?

10. MM Model is an extension of the NOI Approach‟ Explain

11. Explain the importance of cost of capital in decision making.

12. How cost of capital affects the decision making.

13. Explain “The assumptions underlying the MM Model are unrealistic and
untenable”

14. Define Capital Structure. What are its features and determinants?

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