Unit-V

Capital management (CM) is a financial strategy aimed at ensuring maximum efficiency in a

company’s cash flow. Its aim is for the business to have adequate means to meet its day to day
expenses, as well as financial obligations in the short-term. The idea is to maintain a good ratio
between the company’s assets and liabilities. Effective CM guarantees that the business can
easily handle its expenses and debts without any risk to the core.

Capital: The initial investment to start a business is called a capital. The total amount required
for establishment of a business, that is, procuring materials, labour, fixed assets etc. is called as
capital.

Significance of Capital:

 It is essential to start a business

 It plays an important role in the functioning of a business
 It helps in acquiring materials, fixed assets, etc.
 It helps in the continuous existence of business
 It is required to pay dividends, interests & taxes
 It is necessary for all small, medium and large enterprises, and even for government
organizations
 It creates and enhances level of employment in the country

Fixed Capital

The assets which remain in the business for a period of more than one year are known as Fixed
Assets. For example, plant, machinery, building, land, furniture, equipment, etc. These assets
are not meant for sale. Fixed Capital is the money invested by a company in its fixed assets,
which are to be used over a long period of time. Hence, it can be said that fixed capital is used
for meeting the permanent or long-term needs of the business.

Factors Affecting Requirement of Fixed Capital

Fixed Capital refers to investment in fixed assets for a longer period. The fixed capital of an
organisation gets its funds through long-term sources of finance like preference shares, equity
shares, debentures, etc. The requirement of fixed capital in an organisation depends upon various
factors. These factors are as follows:

 Growth Prospects
Companies with higher growth plan still expanding require more fixed capital. This is because
they need more machinery and plants to increase their production capacity.
 Diversification
Businesses planning to diversify their activities (including more products) will require more
fixed capital than those who aren’t planning diversification.
 Joint Ventures
Companies that collaborate with other companies can share their plants and machinery and thus
have lower fixed capital needs. Companies that operate on their own will have higher fixed
capital needs.
 Production techniques
Companies that employ labour-intensive techniques will need less capital, but companies with
capital-intensive techniques will need more fixed capital for their plant and machinery needs.
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Working Capital

Excess of current assets of an organisation over its current liabilities is known as Working
Capital. It can also be defined as that part of total capital, which is required for holding current
assets.

Current Assets are the assets, which can be converted into cash and cash equivalents within a
period of one year. Investment in these assets helps an organisation in its day-to-day operations.
They also provide liquidity to the business but does not contribute much to its profits. Therefore,
an organisation has to maintain a balance between the liquidity and profitability. For
example, cash in hand, debtors, bills receivables, etc.

Current Liabilities are the liabilities of a firm which are payable within a period of one
year. For example, creditors, bills payable, advance received, outstanding expenses, etc.

WC = CA – CL

Factors determining the requirements of working capital

 Nature of business
Working capital needs vary from industry to industry. Companies in the manufacturing sectors
have higher working capital needs than companies in the service industries. Thus, according to
your business, your needs will vary.
 Raw material availability
Companies that use seasonal raw materials will need to store large quantities of the same,
resulting in higher working capital needs. Those that use readily available raw materials will
have lower needs.
 Operating efficiency
Operating efficiency is how long it takes to convert raw materials to finished goods, sell the
goods, and collect payments. Whereas high-efficiency businesses have lower needs, low-
efficiency businesses will have high needs.
 Competition level
When there’s high competition in the market, there is a greater need to supply goods on time.
Larger inventories are required and thus more working capital as well. Companies with a
monopoly or low competition can establish their terms and not need as much working capital.

Sources of Capital:

 Equity: The various sources of finance for entrepreneurs under equity are-
Inside Equity (founders, family, friends),
Public Offering.

 Debt: It is cheaper since long-term interest on loans is less than the investment return of
stock markets. It also offers a tax shield. However, debt requires regular repayment.
Lenders are mostly conservative and require collateral.

 Personal Investment or Personal Savings: Often, one of the first sources of project
financing is the entrepreneur himself or herself. Personal investment from the
entrepreneur builds his/her corporate reputation showing long-term dedication to the
project.
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  Venture Capital: Venture capitalists are major financial sources in the corporate world.
They invest in companies promising high potential in growth with efficient teams in the
management and less capacity of leverage. In this type of financing business, investors
participate in the business as a clause in sheer exchange for the cash and strategies they
provide. Some of the major venture capital financial sources in India are Helion Venture
Partners, Accel Partners, etc.

 Commercial Bank Loans and Overdrafts: One of the main sources of long-term
financing comes in the form of loans from banks. In the case of bank loans, the loan
tenure is specified by the financial institution along with the rate of interest, timing, and
the repayment amounts. Some collateral is kept as an exchange for the provided loan. For
the funding of fixed assets, loans serve as one of the most significant long-term sources
of working capital.

Introduction to Capital Budgeting

Raising fixed capital required by the firm at minimum cost and using it effectively sums up the
management of fixed capital. The decision taken by a firm to invest in fixed assets is known
as Capital Budgeting Decision. A firm must take capital budgeting decisions carefully as it
affects the profitability, growth, and risk of business in the long run. It consists of decisions
related to the purchase of land, plant and machinery, building, investing in advanced techniques
of production, or launching a new product line.

Time Value of Money

The Time Value of Money (TVM) is the concept that ‘money available today is more valuable
than the identical sum available in the future due to its potential earning capacity’.

There are some reasons why a rupee tomorrow is worth less than a rupee today:

 Individuals prefer ‘present consumption’ to ‘future consumption’.

 When there is monetary inflation, the value of currency decreases over a period of time.
The greater the inflation, the greater will be the difference in the value between a rupee
today a rupee tomorrow.
 If there is any uncertainty (risk) associated with the cash flow in the future, the less that
cash flow will be valued.

Importance of Time Value of Money:

In Investment decisions: Small businesses often have limited resources to invest in business
operations, activities and expansion. One of the factors we have to look at is ‘how to invest’, is
the time value of money.

In Capital Budgeting decisions: When a business chooses to invest money in a project such as
expansion, a strategic acquisition or the purchase of an asset – it may be years before that project
begins producing a positive cash flow. The business needs to know whether those future cash
flows are worth the upfront investment today (cash outflow).

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Methods of Capital Budgeting (Capital Budgeting Techniques)

Traditional Methods

 Payback Period (PBP) Method

 Average Rate of Return (ARR) Method

Modern Methods

 Net Present Value (NPV) Method

 Profitability Index (PI) Method (or) Benefit-Cost Ratio (BCR) Method

 Internal Rate of Return (IRR) Method

1) Payback Period Method (PBP Method)

The Payback Period is the number of years required to recover the original cash outlay (cash
outflow, investment, cost) involved in a project.

a) When cash inflows (returns) are uniform (even)

If a project generates ‘uniform’ annual cash inflows, then the following formula is used to
calculate PBP:

PBP = (Initial Investment – Scrap Value)/ Annual Cash Inflows

b) When the cash inflows are ‘not uniform (not even)’, then the following formula is used to
calculate the PBP:

PBP = Years before full recovery + (unrecovered cost in the year before full recovery/ cash
Inflow of succeeding year)
Decision Rule:

 If the PBP is less than the life of the project, the project will be accepted

 If the PBP is greater than the life of the project, then the project will be rejected

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2) Accounting/ Average Rate of Return (ARR) Method

 The ARR is a method that represents the ratio of the average annual profits after tax to
average investment of the project.

 It is the rate at which a project returns the investment to the investor

 This method takes into account the earnings from the investment over its ‘whole life’

 Earnings expected from the ‘investment’ over the ‘entire life of project’ is considered

 Income (cash inflows) is not Profit – Profit is the amount after Depreciation & Tax

 For example, in PBP, time period is considered – till investment is recovered, but in ARR
– all Profit even after recovered amount/ time period, during the whole life of the project
is considered.

 ARR takes into account, the accounting concept of Profit i.e., Net Profit After
Depreciation & Tax, instead of cash inflow.

Formula to calculate ARR:

ARR = (Average Profit/ Average Investment) x 100

To calculate Average Profit, first we need to find out Profit

Profit = Total Cash inflows – Depreciation – Tax

Average Profit = Profit/ No. of years (life of the project

Average Investment = (Initial Investment + Scrap Value)/ 2

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.

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3) Net Present Value (NPV) Method

 NPV refers to the difference between the present value of cash inflows and present value
of cash outflows

 The NPV technique is a discounted cash flow method that considers ‘time value of
money’ in evaluating capital investments

 It is a method of calculating ‘present value’ of cash flows of an investment proposal

using the cost of capital as an appropriate discounting rate

TVM example:

Rs.500/- today is less than Rs.500/- after a year

Because the purchasing power of money falls!!

FV (Future Value) discounted with PV (Present Value)

PV Discounting FV

Rs.455/- 10% Rs.500/-

PV = FV x 1/ (1+r)n = 500 x 1/ 1.10 = 455/-

Format
PVCF
PV
Year Cash Inflow (Cash inflow x PV @
Discounting rate
Discounting rate)

Total PVCF xxxxx

Formula = NPV = ∑PVCF – Cash Outflow (Investment, Cost)

Decision Rule:

If the NPV is ‘positive’, accept the project.

If the NPV is ‘negative’, reject the project.

Calculation of Present Value Discounted Factor

PV = 1/ (1+r)n

Where r = discount rate

n = no. of year

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4) Profitability Index (PI) or Benefit-Cost Ratio (BCR) Method

 The profitability index (PI), describes an index that represents the relationship between
the costs and benefits of a proposed project.

 Profitability Index is a capital budgeting tool used to rank projects based on their
profitability. It is calculated by dividing the present value of all cash inflows by the initial
investment. Projects with higher profitability index are better.

 The profitability index (PI) is a measure of a project's or investment's attractiveness.

Formula

PI = PV of Cash Inflows (PVCF)/ PV of Cash Outflows (Investment)

Decision Rule:

If PI is greater than 1, proposal is accepted, otherwise it is rejected.

5) Internal Rate of Return (IRR) Method

 IRR is the rate at which the sum of discounted ‘cash inflows’ will become equal to the
sum of discounted ‘cash outflows’

 It is the rate at which the NPV of the investment is ‘0’

 PV of expected cash inflows = Initial cash outflow (investment)

 Discounting is NOT given

 We have to assume 2 rates – 1 Higher, 1 Lower

 We have to calculate 2 NPVs for the project at 2 different rates

 We have to find out ‘what is the discount rate that makes the NPV equal to zero’?

 This is called as Trial & Error Method

Formula

IRR = L + [(NL/ NL – NH) x (H – L)]

L – Lower Rate
H – Higher Rate
NL – NPV at Lower Rate
NH – NPV at Higher Rate