financial management

CAPITAL BUDGETING OR INVESTMENT DECISION

Meaning:-

It is the process of making investment decision in capital expenditure. The main

characteristics of capital expenditure is that the expenditure which is incurred at

one point of time where as the benefits of the expenditure are realized at all points

of time in future. The following are some of the elements of capital expenditure.

1) Cost of acquisition or purchase in permanent assets such as land and

building plant and machinery etc.

2) Cost of addition, expansion, improvement or alteration in the fixed asset.

3) Research and development product cost etc.

Definition:-

According to CHARLES-T-HORANGREEN “Capital budgeting is long term

planning for making and financing a proposed capital outlay.”

According to RICHARD & GREENLAW “Capital Budgeting” is acquiring

inputs with long run return.”

According to LYNCH “Capital Budgeting” consist in planning &

development of available capital for the purpose of maximizing the long term

profitability of the concern.

NEED & IMPORTANCE OF Capital Budgeting:-

1) It involves large investment of funds.

2) The large funds are invested more or less on permanent basis.

3) This decision is irreversible in nature.

4) It has long term effect on profitability.

PROCESS OF CAPITAL BUDGETING OR STEPS IN C.B.:-

1) Identification of investment proposal.

2) Screening the proposal.

3) Evaluation of various proposals.

4) Fixing priorities.

5) Preparation of budget.

6) Implementing proposals.

7) Performance review.

METHODS OR TECHNIQUES OF CAPITAL BUDGETING:-

Traditional Method:-

a) Pay Back period

b) Average rate of return method (ARR)

A. PAYBACK PERIOD (PBP)

The term payback period refers to the period in which the product will generate

the necessary cash to recover the initial investment.

Accept or Reject criteria:-

The selection of the project is based on the earning capacity of the project. A cut

off period for the project is fixed if the payback period is lower than the cut off

period such projects are accepted.

CALCULATIONS OF PAYBACK PERIOD:-

I. When cash inflows are uniform.

Cash inflows = Earnings after tax but before depreciation.

Payback period = Cash outflow (original investment) Cash inflow

MERITS OF PAYBACK PERIOD:-

1) It is traditional and old method

2) It involves simple calculations

3) Selection or Rejection of the project can be made easily

4) The results attain under this method are more reliable

5) It is the best method for evaluating high risky projects.

DEMERITS OF PAYBACK PERIOD:-

1) It is based on the principle of rule of thum method

2) It does not recognize the importance of time value of money

3) It does not consider the profitability and economic life of the project

4) It does not recognize the pattern of cash flows and its timings

5) Payback period concept does not reflects all the relevant dimensions of

profitability.

PROBLEMS:-

1) A project cost Rs. 1,00,000-00 and gives annual cash flow of Rs. 20,000-

00 for 8 years. Calculate payback period.

PBP= Cash outflow = 1,00,000-00 = 5 years Cash inflow 20,000-00

2) The project cost Rs. 5,00,000-00 gives annually a profit of Rs. 80,000-00

after depreciation at 12% p.a. But before tax of Rs. 50%, calculate the

PBP.

Calculation of cash inflow

Earnings Rs. 80,000-00

Before (-) tax at 50% 40,000-00

40,000-00

After (+) depreciation

5,00,000 x 12 = 60000 100 100000

PBP = CO = 500000 = 5 years CI 100000

II. When cash inflows are not uniform

PBP = 1st year + investment – cumulative C.I. of 1 st year Cumulative C.I. 2nd year – CCI 1st year

1) A project requires an initial cash outlay of Rs. 1,00,000-00 and generates cash

inflows as under.

Year Cash inflows1 100002 200003 250004 400005 100006 100007 100008 5000

Calculations of PBP when CI are not uniform

Cumulative cash inflows1 10000 100002 20000 300003 25000 550004 40000 95000 1st year5 10000 105000 2nd year6 10000 1150007 10000 1250008 5000 130000

PBP = 1st year + investment – CCI of 1 st year CCI of 2nd year – CCI of 1st year

= 4 + 100000 – 95000 105000 – 95000 = 4 + 5000 10000 = 4 + 0.5 = 4.5

That means 4 years 6 months.

2) MOHAN & Co, is considering the purchase of a machine. 2 machines ‘x’ and

‘y’ each costing Rs. 50,000-00 are available. Cash inflows are expected to be

as under. Calculate PBP.

Year Machine ‘X’ Rs. Machine ‘Y’ Rs.1 15000 50002 20000 150003 25000 200004 15000 300005 10000 20000

Calculation of PBP

Year Machine ‘X’ Machine ‘Y’CI CCI CI CCI

1 15000 15000 5000 50002 20000 35000 15000 200003 25000 60000 20000 40000 1st year4 15000 75000 30000 70000 2nd year5 10000 85000 20000 90000

PBP = 1yr + Invt - CCI 1yr CCI 2yr – CCI 1yr


= 2 + 50000 - 35000 60000 - 35000

= 3 + 50000 - 40000 70000 - 40000

= 2 + 15000 25000

= 3 + 10000 30000

= 2 + 0.6 = 2.6 = 3 + 0.33 = 3.332 years 7 months 3 years 4 months

Since machine ‘X’ PBP is less compare to machine ‘Y’ that means machine ‘X’

takes 2 years and seven months to payback 50,000-00 and machine ‘Y’ takes 3

years and 4 months to payback 50000-00. Therefore as finance the investment on

‘X’ to be accepted and machine ‘Y’ should be rejected.

3) From the following information suggest which project should be selected.

Particulars Project A Project BCost of project 180000 180000Net cash flows

1 80000 400002 64000 420003 40000 600004 - 800005 20000 320006 15000 5000

Calculation of PBP

Year Project A Year Project BCI CCI CI CCI

1 80000 80000 1 40000 400002 64000 144000 1st year 2 42000 820003 40000 184000 2nd year 3 60000 142000 1st year4 - 184000 4 80000 222000 2nd year5 2000 204000 5 32000 2540006 15000 219000 6 5000 259000



= 2 + 180000 - 144000 184000 - 144000

= 3 + 180000 – 142000 222000 - 142000

= 2 + 36000 40000

= 3 + 38000 80000


According to the PBP method project ‘A’ should be accepted for investment

because it takes less time (2.0) when compare to project ‘B’ which takes 3.475.

4) Determine PBP for the following project which requires cash outflow of Rs.

10000/-& generates the cash inflow of Rs. 2000/-, Rs.4000/-, Rs.3000/- & Rs.

2000/- in the 1st, 2nd, 3rd, & 4th, years respectively.

Year Cash inflow’s CCI

1 2,000 2,000

2 4,000 6,000

3 3,000 9,000- 1st year

4 2,000 11,000-II year

PBP = 1yr + Invt – CCI 1yr CCI 2yr – CCI 1yr

= 3 + 10000 - 9000 17000 - 9000

= 3 + 1000 2000

= 3 + 0.5 or 3.53 years 6 months

5) The following information relating to the machines are available for

consideration. Advice the management which of the 2 machines is preferable.

Particulars Machine A Machine B

Cost of investment 25000 40000

Estimated life 7 years 9 years

Net cash benefits or profits

I year 3,000 2,000

II year 4,000 5,000

III year 5,000 6,000

IV year 6,000 7,000

V year 7,000 8,000

VI year 7,200 12,000

VII year 7,500 13,000

VIII year 7,500 13,200

IX year 7,500 13,400

Calculate PBP

Year Machine A Year Machine BCI CCI CI CCI

1 3000 3000 1 2000 20002 4000 7000 2 5000 70003 5000 12000 3 6000 130004 6000 18000 4 7000 200005 7000 25000 III year 5 8000 28000 I year6 7200 32200 6 12000 40000 II year7 7500 39700 7 13000 530008 39700 8 13200 662009 39700 9 13400 79600



= 4 + 25000 – 16000 25000 - 18000

= 5 + 40000 – 28000 40000 - 28000

= 4+1 = 5+1= 5 years = 6 years

According to this method project ‘A’ should be selected because if takes

less time to PB the investment compare to machine ‘B’

II AVERAGE RATE OF RETURN or ACCOUNTING RATE OF RETURN:-

This method takes into A/c the earnings expected from the investment

over there whole life. If is known as a/c ing rate of return.

ACCEPT OR REJECT CRITERIA:-

The expected return is determined & the project which has a higher rate of

return than the minimum rate of return called the cut-off rate is accepted & the

project which gives a lower expected rate of return than the minimum rate is

rejected.

NOTE

Cash inflow or profit here means profit after fax & after dep

METHODS OF ARR:- or RETURN ON INVESTMENT

1) Average rate of return method :-

ARR= Average annual profit (after dep & after fax) x100Net investment

a) Where average annual profit= Total profit No. years

b) Net investment = original investment-scrap value

2) Return per unit of invt method:

RPU= Total profit (AT & D) x100Net investment

Return on average investment method:-

RAI = Total profits (AT & D)Average investment

Where a) Average investment =Total (original) investment2

3) Average return or average investment method:-

Average annual profits x100Average investment

a) Average investment = original investment-scrap value2

b) Average investment = original investment2

(DCF=Discounted Cash Flow)

c) Average investment = original investment – scrap value + additional WC + SC2

1) A project requires an investment of Rs. 5,00,000-00 and has a scrap value

of 20,000-00 after 5 years it is expected the yield profit after depreciation

and after tax during the 5 years amounting to Rs. 40,000-00, Rs. 60,000-

00, Rs. 70,000-00, Rs. 50,000-00 and Rs. 20,000-00 respectively.

Calculate ARR on investment.

I. ARR = Annual average profit x 100 Average investment

Average Annual profit = Total profit No. of year

= 40000+60000+70000+50000+20000 = 240000 = 48000 5 5

Net investment = original investment – SV

= 500000 – 20000 = 480000

ARR = 48000 x 100 = 0.1 x 100 480000

= 10

II. ARR = Total profit x 100 = 240000 x 100 = 50% Net investment 480000

III. ARR = Total profits x 100 Average investment

T.P. = 240000

Average investment = original investment – scrap value 2

= 240000 – 20000 = 480000 = 240000 2 2

= 240000 = 100% 240000

IV. ARR = Average profit x 100 = 480000 x 100 = 20% Average investment 240000

2) Calculate ARR from the data given below cost of the investment Rs.

630000/-, scrap value at the end of 5 years Rs. 30,000-00. It is expected to

yield profit after depreciation and taxes during the 5 years.

Year 1 2 3 4 5Profit 50000 70000 80000 60000 40000

I. ARR = Annual average profit x 100 Average investment

Where Average Annual profit = Total profit No. of year

= 50000+70000+80000+60000+40000 = 300000 = 60000 5 5

Where Net investment = original investment – SV

= 630000 – 30000 = 600000

ARR = 60000 x 100 = 10% 600000

II. ARR = Total profit x 100 = 300000 x 100 = 50% Net investment 600000

III. ARR = Total profits x 100 = 300000 x 100 = 100% Average investment 300000


= 630000 – 30000 = 300000 2


3) Calculate ARR from the following information cost of the project

10,00,000-00, scrap value 4,00,000-00, it is expected to generate the cash

inflows as under.

Year 1 2 3 4 5Profit 50000 70000 80000 60000 40000

I. ARR = Annual average profit x 100 = 70000 x 100 = 11.66% Average investment 600000

Average Annual profit = Total profit No. of year

= 350000 = 70000 5

Net investment = original investment – SV

= 1000000 – 400000 = 600000

II. ARR = Total profit x 100 = 350000 x 100 = 58.33% Net investment 600000

III. ARR = Total profits x 100 = 350000 x 100 = 116.66% Average investment 300000


= 1000000 – 400000 = 600000 = 300000 2 2


4) Calculate average rate of return for projects A and B from the following

information.

Project A Project BInvestment 30000 40000Expected life 5 years 6 years

Projected net income after depreciation and taxes

Years Project A Project B1 3000 60002 3000 60003 3000 5000

4 2000 30005 1000 20006 - 1000

12000 23000

If the required rate of return is 10% which project should be undertaken.

Project ‘A’ & Project ‘B’

AP= Total ProfitNo. years

1) ARR= Average of Profit x100 =1200Net Investment 6

A=2400 x100 =2400 30000 =8%

B= 3833 x100 =23000 40000 6 =9.58%

2) ARR= Total Profit x100 Net Investment

A= 12000x100 30000 = 40% = 23000x100 4000 = 57.5%3) ARR= Total Profit x100 Average = Original Investment-scarp value

Average Investment 2 A= 12000 x100 = 30000 15000 2 =80% = 15000 B= 23000 x100 = 40000 20000 2 =11.5%

3) ARR= Average annual Profit x100 Average investment A= 2400 x100 15000 =16%

B= 3833 x100 20000 =19.165%

4) Calculate ARR from the following information cost of the project 1000000/-, scrap value 4.00.000/- . It is expected to generate the cash inflows as under additional 1.00.000/-

year 1 2 3 4 5C. I 50000 60000 70000 80000 90000

ARR = Annual Average Profit x100 Average investment Where Average Profits = Total Profits No. years = 350000 = 70000 5Average Investment = Original Investment – Scrap value 2 = 1000000 – 400000 = 600000

2 2 = 300000ARR = 70000 x100 300000 = 23.33%ARR = Average Annual Profit x100 Average InvestmentAverage Investment = Original Investment – scarper value+ additional 2 = 1000000 – 400000 + 100000+ 400000 2 = 600000 + 500000 2 = 300000 + 500000 = 800000ARR = 70000 x 100 800000 8.75%

MODERN OR DISCOUNTED CASH FLOW

III NET PRESENT VALUE METHOD

[IRR] 2) Internal rate of return method3) Profitability index

Net present value method:-

Net present value value means the disblw the present value of cash outflows & the present value cash inflows occurring in the future period over the entire life of the project.

1) The following information is available pertaining to project ‘A’ u.r. require to calculate NPV

Cost of the investment Rs. 100000/-

The cash inflows 1 2 3 4 40000 30000 50000 20000

The discount factors at 10% are

Year 1 2 3 4Discount factor at 10% .909 .826 0.75 0.683

Calculation of NPV

Year C.I. Discount factor at 10% Pre. Value of CI (AxB)1 40000 0.909 363602 30000 0.826 247803 50000 0.751 375504 20000 0.683 13660

Total pre value of C.I. 1,12,350 Less: original investment 1,00,000 N.P.V. 12350

A firm where cost of capital is 10% is considering to mutually exclusive project X

and Y. The details of which are

Particulars Project X Project YCapital outlay 70000 70000Cash inflows -1 10000 50000

2 20000 400003 30000 200004 45000 100005 60000 10000

Compute NPV at 10%. The present value factors are given below.Year 1 2 3 4 5P.V. 10% 0.909 0.826 0.751 0.683 0.621

Calculation of Net Present Value of project X & YYear CI PV 10% PV of CI Year CI PV 10% PV of CI

1 10000 0.909 9090 1 50000 0.909 454502 20000 0.826 16520 2 40000 0.826 330403 30000 0.751 22530 3 20000 0.751 150204 45000 0.683 30735 4 10000 0.683 68305 60000 0.621 37260 5 10000 0.621 6210

116135 106550Less: Investment 70000 Less: Investment 70000

NPV 45135 NPV 36550

Since the NPV of project X is greater than (45135) project Y (36550) it is

advisable to accept project X and reject project Y.

3) From the following information suggest which project should be accepted

under project A PBP NPV project B

Particulars Project A Project B Dis FCost of project 180000 180000 10%

Net C.I.

Year Project A Project B PV1 8000 40000 0.5642 64000 42000 0.909

3 40000 60000 0.8264 - 80000 0.7515 20000 32000 0.6836 15000 5000 0.621

Compute NPV of Project A and Project B

Year CI PV 10% PV of CI Year CI PV 10% PV of CI1 80000 0.909 72720 1 40000 0.909 363602 64000 0.826 52864 2 42000 0.826 346923 40000 0.751 30040 3 60000 0.751 450604 - 0.683 4 80000 0.683 546405 20000 0.621 12420 5 32000 0.621 198726 15000 0.564 8460 6 5000 0.564 2820


NPV -3496 NPV 13444 Calculation of PBP

Year Project A Year Project BCI CCI CI CCI

1 80000 80000 1 40000 400002 64000 144000 I year 2 42000 820003 40000 184000 II year 3 60000 142000 I year4 - 184000 4 80000 222000 II year5 20000 204000 5 32000 2540006 15000 219000 6 5000 259000



= 2 + 180000 - 144000 184000 - 144000

= 3 + 180000 - 142000 222000 - 142000

= 2 + 36000 40000

= 3 + 38000 80000


4) From the following information calculate NPV.

Particulars Project X Project YInvestment 20000 30000

Life of the project 5 years 5 years

Cash inflows:

1 2 3 4 5Project X 5000 10000 10000 3000 2000Project Y 20000 10000 5000 3000 2000

Discount factor 10% should be takenPresent value at the rate of PV = (1/1+r)n

Here the discount factors are not provided therefore below calculation is advisable

to calculate discount factor.

I-year = (1/1+r)n = (1/1+10)1 = 0.909

II-year = (1/1+10)2 = 0.909 x 0.909 = 0.826

III-year = (1/1+10)3 = 0.826 x 0.909 = 0.751

IV-year = (1/1+10)4 = 0.751 x 0.909 = 0.683

V-year = (1/1+10)5 = 0.683 x 0.909 = 0.621

Calculation of NPV

Project X Project Y

1 5000 0.909 4545 1 20000 0.909 181802 10000 0.826 8260 2 10000 0.826 82603 10000 0.751 7510 3 5000 0.751 37554 3000 0.683 2049 4 3000 0.683 20495 2000 0.621 1242 5 2000 0.621 1242


NPV 3606 NPV 3486

5) Raja Ltd. wants to replace its existing plant. It has 3 proposals 1,2,3. The

plants under the 3 proposals are expected to cost Rs. 2,50,000-00 each and has

an estimated life of 5 years, 4 years and 3 years respectively. The companies

required rate of return is 10%. The anticipated net cash inflows after taxes for

the 3 plants are as follows.

Years Plant 1 Plant 2 Plant 31 80000 110000 1300002 60000 90000 1100003 60000 85000 200004 60000 35000 -5 180000 - -

Which of the above proposals would you recommend to the management for

acceptance? Use NPV technique for evaluation. The present value of Re.1 at 10%

for each of the 5 years is given below.

Year 1 2 3 4 5

PV at 10% 0.909 0.826 0.751 0.683 0.621

Plant 1 Plant 2 Plant 3Year CI PV

10%Year CI PV

10%Year CI PV

10%1 80000 0.909 72720 1 110000 0.909 99990 1 130000 0.909 1181702 60000 0.826 49560 2 90000 0.826 74340 2 110000 0.826 908603 60000 0.751 45060 3 85000 0.751 63835 3 20000 0.751 150204 60000 0.683 40980 4 35000 0.683 239055 180000 0.621 111780 5 - 0.621 -

320100 262070 224050

Less: Invest ment 250000 Less: Invest

ment 250000 Less: Invest ment 250000

NPV 70100 NPV 12070 NPV 25950

Since plant-1 has more net present value considering the CI for 5 years (70,100).

It should be accepted as for NPV. But the CI for plant-2 are only for 4 years and

when we take the average CI generated by plant-1 and plant-2 for the minimum

period of 3 years, plant-2 generates more profit than plant-1. Therefore when we

consider profits the management should select plant-2.

IV. PROFITABILITY INDEX:-

It is one of the modern techniques of capital budgeting like NPV and IRR

(internal rate of return) it is sound method of appraising investments. Under this

method projects can be ranked on the basis of profitability index. Highest rank

will be assigned to be project with highest profitability index, while the lowest

rank will be given to the project having lowest profitability index.

Profitability Index (PI) = Present value of CI x 100 Initial cash outlay

1) The initial cash outlay of a project is Rs. 1,00,000-00 and it generates CI of

Rs. 40,000-00, 30,000-00, 50,000-00 and Rs. 20,000-00, assume a 10% rate

of discount. Calculate profitability index.

Year 1 2 3 4

DF at 10% 0.909 0.826 0.751 0.683

Computation of PIYear Cash Inflow Dis. At 10% Present value of CI

1 40,000 0.909 363602 30,000 0.826 247803 50,000 0.751 375504 20,000 0.683 13660

Total PV of CI 112350

PI = Present value of CI x 100 Present value of CO

= 112350 x 100 100000

= 11235 x 100

= 112.35

V. INTERNAL RATE OF RETURN (IRR):-

It is a modern technique of capital budgeting that takes into account the time

value of money. It is also known as time adjusted rate of return, yield method,

trial and error, discounted cash flow etc. Under this method the cash flows of a

project are discounted at suitable rate by trial method which equates the NPV, so

calculated to the amount of investment. The IRR can be defined as that rate of

discount at which the present value of cash inflows is equal to be present value of

cash outflows.

PV Factor = Initial outlay Annual cash flows

IRR = % 1 yr + 1yr – investment x % 1yr – % 2 yr 1 yr – 2 yr

1) Calculate IRR from the following information initial investment Rs.

60,000-00, life of the asset 4 years, estimated annual cash flows 15,000-

00, 20,000-00, 30,000-00, 20,000-00. The discount factor at the rate of

10%, 12%, 14% and 15% are as follows.

3.169 3.035 2.912 2.853

Year 10% 12% 14% 15%

1 0.909 0.892 0.877 0.869

2 0.826 0.797 0.769 0.756

3 0.751 0.711 0.674 0.657

4 0.683 0.635 0.592 0.571

PV factor = Initial outflow (investment) Average annual profit

= 60,000 85,000 = 21250 4

= 60000 = 2.82 21250

Year C.I. Dis 10%

P.V.CI Dis 12%

P.V.CI Dis 14%

P.V.CI Dis 15%

P.V.CI

1 15000 0.909 13635 0.892 13380 0.877 13155 0.869 130352 20000 0.826 16520 0.797 15940 0.769 15380 0.756 151203 30000 0.751 22530 0.711 21330 0.674 20220 0.657 197104 20000 0.683 13660 0.635 12700 0.592 11840 0.571 11420

66345 63350 60595 59285


= 14% + 60595 – 60000 x (14 – 15) 60595 - 59285

= 14 + 595 x 1 1310

= 14 + 0.45

IRR = 14.45

2) A project cost Rs. 16,000-00, life is 5 years, the cash flows will be Rs. 4000/-

for every year. The discount factors are as follows.

Year 1 2 3 4 5

7% 0.9346 0.8734 0.8163 0.7629 0.7130

8% 0.9259 0.8593 0.7938 0.7350 0.6809

9% 0.9174 0.8417 0.7722 0.7084 0.6499

Calculation of IRR

Year C.I. Dis 7% P.V.CI Dis 8% P.V.CI Dis 9% P.V.CI1 4000 0.9346 3738.4 0.8259 3703.6 0.9174 3669.62 4000 0.9734 3893.6 0.8593 3437.2 0.8417 3366.83 4000 0.7938 3265.2 0.7938 3175.2 0.7722 3088.84 4000 0.7629 3051.6 0.7350 2940.0 0.7084 2833.65 4000 0.7130 2852.0 0.6809 2723.6 0.6499 2599.6

16800.8 15979.6 15558.4


= 7% + 16800.8 – 16000 x 7 – 8 16800.8 – 15979.6

= 7 + 800.8 x 1 821.2

= 7 + 0.975

IRR = 7.975

3) A firm whose cost of capital is 10% is considering 10% is project X and Y

is details of which

Particulars Project X Project Y

Investment 100000 100000

Cash inflow 1 2 3 4 5

X 20000 30000 40000 50000 60000

Y 45000 40000 30000 10000 8000

Compute net present value at 10%, PI and IRR for two project separately, project

X by 20% and 29%, project Y by 9%, 15% use the following discount factors for

calculating IRR.

Project X NPV PI Project Y

20% 29% 10% 9% 15%

0.833 0.775 0.909 0.917 0.870

0.694 0.601 0.826 0.842 0.750

0.579 0.466 0.751 0.772 0.658

0.483 0.361 0.683 0.708 0.572

0.402 0.280 0.621 0.650 0.497

Calculation of NPV, PI & IRR of project X

Year Cash inflow Dis. Factor at 10% NPV1 20000 0.909 181802 30000 0.826 247803 40000 0.751 300404 50000 0.683 341505 60000 0.621 37260

144410Less investment 100000

NPV 44410PI = Prevalue of CI x 100 Prevalue of CO

= 144410 x 100 100000

= 144.41

Project Y

Year Cash inflow Dis. Factor at 10% NPV1 45000 0.909 409052 40000 0.826 330403 30000 0.751 225304 10000 0.683 68305 8000 0.621 4968

108273Less investment 100000

NPV 8273

PI = Prevalue of CI x 100 Prevalue of CO

= 108273 x 100 100000

= 108.273

Calculation of IRR - Project X

Year Cash inflow Dis at 20% PV Dis at 29% PV

1 20000 0.833 16660 0.775 15500

2 30000 0.694 20820 0.601 18030

3 40000 0.579 23160 0.466 18640

4 50000 0.483 24150 0.361 18050

5 60000 0.402 24120 0.280 16800

108910 87020


= 20% + 108910 – 100000 x 20 – 29 108910 – 87020

= 20 + 8910 x 9 21890

= 20 + 3.6633

IRR = 23.6633

Calculation of IRR - Project X

Year Cash inflow Dis at 9% PV Dis at 15% PV

1 45000 0.917 41265 0.870 39150

2 40000 0.842 33680 0.750 30000

3 30000 0.772 23160 0.658 19740

4 10000 0.708 7080 0.572 5720

5 8000 0.650 5200 0.497 3976

110385 98586


= 9% + 110385 – 100000 x 9 – 15 110385 – 98586

= 9 + 10385 x 6 11799

= 9 + 5.2809

IRR = 14.2809

4) Ragini enterprises can make either of two investments at the beginning of

2001 assuming the rate of written of 10% P.A. Evaluate the investment

proposal by using the following methods. PI, discounted cash flow

method.

Particulars Project X Project Y

Cash of investment 25000 30000

Life 5 yrs. 6 yrs.

Net income (after dep & tax)

Year 2001 2002 2003 2004 2005 2006

Project X 600 1000 2500 3000 3500 -

Project Y 3800 4500 5000 4500 5500 6000

It is estimated that each of the alternative project will require an additional WC

Rs. 2000-00 which will be received back in full after the expire of each project

life.

Dep is provided under straight line method. The PV of Rs. 1/- to be

received at the end of each year 10% PA given below.

Year 2001 2002 2003 2004 2005 2006

PV factor 0.909 0.826 0.751 0.683 0.621 0.564

Calculation of NPV/Discounted cash flow method

Year CI Dep. Factor PV Dep CI+dep PV CI2001 600 0.909 545.4 5000 5600 5090.42002 1000 0.826 826 5000 6000 4956

2003 2500 0.751 1877.5 5000 7500 5632.52004 3000 0.683 2049 5000 8000 54642005 3500 0.621 2173.5 5000 8500 5278.52006 - 0.564

7471.4 26421.4Less investment 25000Dis cash inflow 1421.4

Cash inflow = 25000 = 5000No. of years 5

Project X

PI = PV of cash inflow x 100 PV of cash outflow

= 26421.4 x 100 25000

= 105%

Project Y

= 42569.2 x 100 = 1.42 x 100 30000

= 142%

Year CI Add dep. TCI Dis Pre CI2001 3800 5000 8800 0.909 7999.22002 4500 5000 9500 0.826 78472003 5000 5000 10000 0.751 75102004 4500 5000 9500 0.683 6488.52005 5500 5000 10500 0.621 6520.52006 6000 5000 11000 0.564 6204

Total 42569.2Less Invt 30000NPV 12569.2

5) The following are particulars given for two firms.

Particulars A BInitial investment 500 900Cash inflows1 100 1269

2 2000 8643 200 -13054 250 -NPV at 25% (87.2) -NPV at 20% (41.6%) 1098

Evaluate the project by NPV and IRR method using 15% and 20% the discount

factors.

Year 15% 20%

1 0.870 0.833

2 0.856 0.694

3 0.658 0.579

4 0.572 0.482

Note :-

1) In the above problem the figures in brackets indicate values in negative

news.

2) NPV for project A at 20% already given.

3) You can reject the adequate data.

Calculation of NPV for “A”

Year Cash inflow Discount factor at 15% P.V. of CI Discount at

20% P.V. of CI

1 100 0.870 87 0.833 833

2 200 0.756 151.2 0.694 138.8

3 200 0.658 131.6 0.579 115.8

4 250 0.572 143.0 0.482 120.5

I-year 512.8 II-year 458.4

Less Invt 500.0 Less Invt 500.0

NPV 12.8 NPV 41.6

Calculation of NPV for “B”

Year Cash inflowDiscount factor at

15%P.V. of CI

Discount at

20%P.V. of CI

1 1269 0.870 1104.03 0.833 1057.07

2 364 0.756 653.18 0.694 599.61

3 1305 0.658 -858.69 0.579 -755.59

4 - 0.572 - 0.482 -

I-year 898.52 II-year 901.096

Less Invt 900.00 Less Invt 900.000

NPV 1.48 NPV 1.096

A) IRR = % 1 yr + 1yr – investment x % 1yr – % 2 yr 1 yr – 2 yr

= 15 + 512.8 – 500 x 20 – 15 512.8 – 458.4

= 15 + 12.8 x 5 54.4

= 15 + 1.17

IRR = 16.17

B) IRR = % 1 yr + 1yr – investment x % 1yr – % 2 yr 1 yr – 2 yr

= 20 + 901.096 – 900 x 15 – 20 901.096 – 898.52

= 20 + 1.096 x (-5) 2.57

= 20 + 0.08

IRR = 20.08

UNIT-III

WORKING CAPITAL MANAGEMENT

MEANING:-

Working Capital to that part of firm’s capital which is required for

financing short term or current assets such as cash, marketable securities, Dr. and

inventories. In other wards working capital means a capital which is required to

maintain and manage day to day affairs of business in alcing language working

capital means the difference between CA and CL i.e. (CA-CL=WC)

DEFENITION:-

According to SHUBIN “Working Capital is the amount of funds necessary to

cover the cost of operating the en.es.

According to GENESTENBERG “Circulating capital means CA of a Co. that are

changed in the ordinary course of business from one form to another as for

example from cash to inventories, inventories to receivables, receivables into

cash.”

IMPORTANCE OF ADEQUATE WC OR ADVANTAGES OF ADEQUATE

WC:-

1) Solvency of the business :-

It helps in maintaining solvency of business by providing un-interpreted flow of

production.

2) Goodwill :-

It enables a concern to make prompt payments and hence helps in creating and

maintaining goodwill.

3) Easy loans :-

A concern having adequate WC can arrange loans from banks.

4) Cash discounts :-

It enables a concern to avail discounts on the purchases.

5) Regular supply of Raw materials :-

It ensures regular supply of raw materials and continuous production.

6) It enables regular payment of salaries, wages etc.

7) It ensures the exploitation of favourable market conditions.

8) It strengthness of the ability of a concern to face crisis.

9) It helps in quick and regular return on investment.

10) It creates high morale.

EXCESS OR INADEQUATE WC:-

The WC should neither be excess nor shortage. Both excess as well as shortage

are bad for any business. Out of the two it is the inadequacy of the WC which is

more dangerous from the point of the view of the firm.

DISADVANTAGES OF EXCESSIVE WC:-

1) It means ideal funds which earn no profit.

2) It may lead to unnecessary purchasing and accumulation of inventories.

3) It implies excessive Dr. and defective Cr. Policy.

4) It may result into overall inefficiency of the organisation.

5) Due to low rate of return the value of shares may also fall.

6) It restricts relations with banks.

7) It gives raise to speculative transactions.

DETERMINANTS OF WC REQUIREMENT or factors determining WC

requirement of factors influencing WC management.

1) NATURE OR CHARACTER OF BUSINESS:-

Public utility undertakings like electricity, water supply and railways need very

limited WC on the other hand the trading and financial firm require less

investment in fixed assets. But have to invest large amounts in current asset.

2) SIZE OF BUSINESS OR SCALE OF OPERATION:-

Large industries require more amount of WC where as small industries require

less amount of WC.

3) PRODUCTION POLICY:-

If the production policy during the slack (dull) season is to curtail then it requires

less WC and if the policy is to have steady production during peak (busy) season

it require large amount of WC.

4) MANUFACTURING PROCESS:-

In manufacturing business the length of production is longer therefore it requires

high WC than the trading concern.

5) SEASONAL VARIATIONS:-

Seasonal industries require large WC in busy season to purchase and maintain

inventories for the entire year.

6) WC CAPITAL CYCLE:-

The speed with which the WC completes one cycle determines the requirements

of WC longer the period of cycle larger is requirement of WC.

WC cycle of Manufacturing Unit

DEBTORS

CASH FINISHED GOODS

WORK-IN-PROGRESS

RAW MATERIALS

WC cycle of Trading Unit

ACCOUNT RECEIVABLE

CASH

STOCK OF FINISHED GOODS

Service unit of WC cycle

CASH DEBTORS

7) RATE OF STOCK TURNOVER:-

If the turnover is high the WC requirement will be low. If the turnover is low the

WC requirement will be high.

8) RECEIVABLES TURNOVER:-

A prompt collection of receivables and god facilities for settling payables result

into low WC requirement.

9) PRODUCTION SCHEDULE:-

Availability of WC can solve the problem of stoppage of production.

10) TERMS OF PURCHASES AND SALES:-

If the Cr. terms with respect to purchases are more favourable and those of sales

less liberal, less cash will be invested in inventory. With more favourable Cr.

terms WC requirements can be reduced.

11) BUSINESS CYCLE:-

Business expands during period of prosperity and declaims during the period of

depression. Consequently more WC is required during period of prosperity and

less during the periods of depression.

12) VALUE OF CR.:-

A decrease in the real value of Cr. reduces the size of WC. If the real value of Cr.

increases there is an increase in the WC.

13) VARIATIONS IN SALES:-

A seasonal business requires the maximum amount of WC for a relatively short

period of time.

14) Credit control

15) Liquidity and profitability

16) Inflation

17) Seasonal fluctuations.

18) Profit planning and control

19) Repayment ability

20) Cash reserves

21) Operational and financial efficiency

22) Changes in technology

23) Firms policies

24) Activities of the firm

25) Attitude of risk

PROFORMA FOR CALCULATING WC

Requirements

Particulars Rs. Rs.

1) Current assets

* Opening inventories (Stock) Xxx

Raw materials Xxx

Finished goods Xxx

Work in progress Xxx Xxx

* Dr. based on Cr. sales

In land and foreign sales Xxx

* Advance paid or prepaid expenses Xxx

Cash Balance Xxx

2) Current liability

* Cr. based on Cr. purchases Xxx

* Advance received from Dr. Xxx

* Wages Xxx

* Manufacturing expenses Xxx Xxx

Xxx

Add contingencies Xxx

Required WC Xxx

1) Te board of directors of SHIVA Engineering Ltd. request you to advice

them the average amount of WC required in the first year’s working. You

are given the following estimates and instructed to add 10% to your

computed figure to allow for contingencies.

1) Amount blocked up for stocks

a) Stock of finished product Rs. 7000-00

b) Stock of stores materials Rs. 10000-00

2) Average Cr. given Dr.

a) Inland sales 6 week Cr. Rs. 208000-00

b) Export sales 1½ weeks Cr. Rs. 78000-00

3) Lag in payment of wages and other out going

a) Wages 2 weeks Rs. 260000-00

b) Stock of materials etc. 1½ month amount Rs. 48000-00

c) Rent, royalties etc 6 months 10000-00

d) Clerical staff ½ month (i.e.1.5months) Rs. 62400-00

e) Manager salary ½ month (i.e. 0.5month) 4800-00

f) Miscellaneous expenses 1½ month 48000-00

4) Payment in advance:

Sundry expenses paid quarterly in advance 8000-00

5) Undrawn profit on the average throughout the year 18000-00

Statement showing WC requirement for Shiva Engineering Ltd.

Particulars Rs. Rs.Current assets1) Stocka) Finished product 7000b) Stores materials 10000 170002) Credit sales or DVa) Inland sales(208000 x 6/52) 24000

b) Export sales(1½=3/2)=1.5 78000/52 x 3/2 2250 26250

3) Payment in advance (8000x1/4) 200045250

Less Current liability1) Lag in paymenta) Wages 2 weeks 260000x2/52 10000b) Stock of materials 1½ month (48000/52 x 3/2) 48000/12 x 3/2 6000

c) Rent and royalties10000x6/2 5000d) Clerical staff (1/2 month)(62400/12) 62400/12 x ½ 2600

e) Manager salary (1/2 month) (4800/12) 2400f) Miscellaneous expenses (1½ month) 48000/12 x 3/2 6000 29800Net WC 15450Add 10% for emergency 1545WC requirement 16995

NOTE:- The undrawn profit is not considered due to the following reasons.

1) Profit may be or may not be included in the WC.

2) If it is included in WC it should be balanced with income tax, dividends,

drawings.

2) X & Co. is interested in purchasing a business and it has consulted you and you

are asked to advice them in determining average amount of WC which will be

required in the first year.

You are given the following estimate and instructed to add 10% to your computed

figure to allow for emergencies.

1) Average amount of Stock:

a) Stock of finished products 5000-00

b) Stock of stores and materials 8000-00

2) Average debit given:

a) Inland sales 6 (weeks) credit 312000-00

b) Export sales 1½ (weeks) credit 78000-00

Lag in payments:

a) Wages 1½ (week) 260000-00

b) Stock & materials 1½ (month) 48000-00

c) Rent & Royalties 6 (month) 10,000-00

d) Clerical staff salary ½ (month) 62400-00

e) Manager salary ½ (month) 4800-00

f) Miscellaneous expenses 1½ (month) 48000-00

3) Payment in advance:

Sundry expenses paid quarterly in advance Rs. 8000-00

4) Undrawn profit on the average throughout the year Rs. 11000-00

Estimate the amount of WC.

Statement showing WC requirement for the X & Co. Ltd.

Particulars Rs. Rs.Current assets1) Average amount of Stocka) Stock of Finished product 5000b) Stock of Stores & materials 8000 130002) Debit sales or DVa) Inland sales 312000 x 6/52) 36000

b) Export sales 78000/52 x 3/2 2250 38250

3) Payment in advance (8000x1/4) Sundry expenses quarterly (8000 x ¼) 2000

53250Less Current liability1) Lag in paymenta) Wages (1½ weeks) 260000/52 x 3/2 7500b) Stock of materials 1½ month 48000/52 x 3/2 6000c) Rent and royalties (6 months) 10000x6/12 5000d) Clerical staff (1/2 month)(62400/12) 62400/12 x ½ 2600

e) Manager salary (½ month) 4800/12 x ½ 200

f) Miscellaneous expenses (1½ month) 48000/12 x 3/2 6000 27300Net WC 25950Add 10% for emergency 2595WC requirement 28545

From the following information estimate the WC requirements of a Co.

I. Amount blacked up for stocks

1) Stock of finished goods 6000-00

2) Stock of stores of materials 10000-00

II. Average credit given & to Drs.

1) Inland sales 8 weeks Cr. 300000

2) Export sales 2 weeks Cr. 80000

III. Lag in payment of wages & other outgoing

1) Wages (2 weeks) 250000

2) Stock of materials (8 weeks) 50000-00

3) Rent (26 weeks) 10000-00

4) Clerical staff (4 weeks) 5000-00

5) Miscellaneous expenses (8 weeks) 50000-00

IV. Payment in advance and general expenses (period quarterly) 10000-00

Statement showing WC requirement for the Co.

Particulars Rs. Rs.I. Current assetsa) Stock of Finished product 6000b) Stock of Stores of materials 10000 16000II. Average Credit given1) Inland sales (8 weeks) 800000 x 8/52 (46153.846) 46154b) Export sales (2 weeks) 80000 x 2/52 (3076.923) 3077III. Payment in advance and general expenses (quarterly) (10000x1/4) 2500 51731

67731Less Current liability1) Wages (2 weeks) 250000 x 2/52 (9615.3846) 9616b) Stock of materials (8 weeks) 50000 x 8/52 (7692.3076) 7693

3) Rent (26 weeks) 10000 x 26/52 50004) Clerical staff (4 weeks)(5000 x 4/52) (384.61538) 385

5) Miscellaneous expenses (8 weeks) 50000 x 8/52 (7692.3076) 7693 30387

WC requirement 37347

4) Following is the cost structure of product M, your are required to findout WC

required.

Elements of Cost Amount per unit

Raw materials 70

Direct labour 40

Overheads 60

Total cost 170

Add profit 30

Selling price 200

The following further particulars are available:-

Raw materials or in stoke are an average for (1 month), materials o in process on

an average for (½ a month), finished goods are in stoke on an average for (1

month)

Credit allowed by suppliers is (1 month)

Credit allowed to customers is (2 months)

Lag in payment of wages is (1½ weeks)

Lag in payment of overhead expenses is (1 month)

¼ of the output is sold against cash, cash in hand & at bank is expected to be Rs.

20000-00

Your are required to prepare a statement showing the WC needed to finance of

activity of 80000-00 units of production. You may assume that production is

carried on evenly throughout the year. Wages and overheads accrue similarly and

a time period of 4 weeks is equivalent to a month.

Statement showing WC requirement

I Current asset:-a) stock Total unit 80000x70x4 52 (1 month __ 4 weeks)

4,30,769

b) work___ in progress( ½ a month = 2 week)Raw material 80000x70 = 5600000 ( 5600000x2/52

Direct labour 80000x40 = (3200000x2/52) Overheads 80000x60 = (4800000x2/52)

2,15,3851,23,0771,84,615 5,23,077

c) Finished goods(1 month = 4 weeks)Raw material 5600000x4/52Direct labour 3200000x4/52Overheads 4800000x 4/52

4,30,7692,46,1543,69,231 10,46,154

d) Debit or Credit salesIs ¾ because ¼ is on cash& ( 2 months = 8 weeks)R.M. 5600000x8/52x3/4 D.L 3200000x 8/52 x ¾ O.H. 4800000 x 8/52 x ¾

6,46,1543,69,2305,53,846 15,69,230

e) Cash in hand & at bankTotal Current Asset (A)

20,00035, 89,230

Less Current Liability:-a) Purchase of Raw Materials (

( 1 month = 4 weeks)5600000 x 4/52 4,30,769

b) Wages outstanding (Lag)3200000 /52 x 3/2 92,308

c) Lag in payment of overhead4800000 x 4/52 Total (B)Required account [A-B]

3,69,231 9,92,308

[ CA-CL] 25, 96,922

4) A proform cost sheet of a company provides the following particularsElements of Cost Amount per unitMaterials 50%Direct labour 10%Overheads 10%

The following further particulars are available:-

1) It is prepare to maintain a level of activity of 100000/- units.

2) Selling price is Rs. 10 per unit

3) Raw materials are expected to be in stores for an average of 2 months

4) Materials will be in process on an average of 1 month

5) Finished goods are required to be in stock for an average 2 months

6) Current allowed to debit is 3 months

7) Current allowed by suppliers is 2 months

Statement showing account requirement Rs. Rs.

I Current Assseta) Stock of R.M.

100000 x 50/100 x 2/12 x10 83,333 83,333b) Work-in-progress

R.M. 100000 x 50/100 x 1/12 x 10D.L. 100000 x 10/100 x 1/12 x 10O.H. 100000 x 10/100 x 1/12 x 10

41,667 8,333 8,333

41,667 8,333 8,333

c) Finished goods:-R.M. 100000 x 50/100 x 2/12 x 10D.L. 100000 x 10/100 x 2/12 x 10O.H. 100000 x 10/100 x 2/12 x 10

83,33316,66716,667

d) Current allowed to debit (3 month)R.M. 100000 x 50/100 x 3/12 x 10D.L. 100000 x 10/100 x 3/12 x 10O.H. 100000 x 10/100 x 3/12 x 10

1,25,000 25,000 25,000

Total A C.A. 4,33,333Less Current Liability R.M. 100000 x 50/100 x 2/12 x 10 8,33,333

WC requirement 3,50,000

5) Proform cost sheet of a company provides the following particulars

Elements of Cost Amount per unitMaterials 50%D.L. 15%O.H. 15%

The following further particulars are available

a) It is proposed to maintain a level of activity of 300000 units

b) Selling price is Rs. 20 per unit

c) R.M. are expected to be in the store for an average of 2 months

d) Materials will be in the process are an average of 1 month

e) Finished goods are required to be in stock for an average of 2 months

f) Current allowed to debit is 2 months

g) Current allowed by supplier is 2 months

Statement showing W/c requirements

Rs. Rs.I Current Asset:-

a) Stock of R.M. 300000 x 50/100 x 2/12 x 20 5,00,000b) Work- in- progress R.M. 300000 x 50/100 x 1/12 x 20 D.L. 300000 x 15/100 x 1/12 x 20 O.H. 300000 x 15/100 x 1/12 x 20

2,50,000 75,000 75,000 4,00,000

c) Finished goodsR.M. 300000 x 50/100 x 2/12 x 20D.L. 300000 x 15/100 x 2/12 x 20O.H. 300000 x 15/100 x 2/12 x 20

5,00,0001,50,0001,50,000 8,00,000

d) Debit or Credit saleR.M. 300000 x 50/100 x 2/12 x 20D.L. 300000 x 15/100 x 2/12 x 20O.H. 300000 x 15/100 x 2/12 x 20

5,00,0001,50,0001,50,000 8,00,000

Current Asset Total A 25,00,000

Less Current Liability R.M. 300000 x 50/100 x 2/12 x 20 Total B 5,00,000Net WC requirement 20,00,000

COST OF CAPITALINTRODUCTION:-

Cost means the amount spent on the form of money, material, & labour for

production of goods & services. Capital as a cost because interest is to be

paid an capital. Capital is an important invested on both fixed as well as

current asset of a firm.

Cost of capital is one of the basic Karnal Stone of the theory of financial

mgt. While deciding capital structure of a com. It is very essential to consider

the cost of each capital & compare then so as to decide which source of

capital is in the interest of the owners as well as the creditors.

Meaning of cost of capital:-

It is a rate of returns expected by the investors that is K = ro +b+f. That

means the cost of capital includes the rate of return at ‘O’ risk + premium for

business risk + premium for financial risk.

It is the minimum rate of return the firm earns as its investment on order to

satisfies the expectations of the investors who provide funds to the form.

Cost of capital is the measurement of the sacrifice made by the investor’s

on due to the capital formation with a view to get a fair return on investment

CALCULATION OF COST OF CAPITAL:-

The cost of capital can be calculated as follows

1) Computation of weighted average cost of capital

2) Computation of cost of capital for various sources of finance separately

like equity share capital, pre share capital, debenture share capital &

retained earnings

Computation of weighted average cost of capital [WACC] or Over all cost

of capital = KO

Weighted average cost of capital is the average cost of the costs of

various sources of financing. It is also known as composite cost of capital

or over all cost of capital or average cost of capital.

Weighted average cost is the average of the cost of specific sources

of capital employed in a business, properly weighted by the proportion

they hold in the firms capital structure.

DEFINITION:-

According ICMA (Institute of charted Mgt Accountant) in Landon “

weighted average cost of capital is the average cost of companies finance

weighted according to the proportion each element bears to the total pool

of capital, weighing is usually based on market valuations current yield &

costs after tax”

Computation of weighted average cost of capital

1) Calculation of the cost of each specific source of funds:-

The cost of each source of capital i.e equity capital, pre-capital, debt

capital, etc is ascertained either on the basis of before tax, after tax.

However it will be appropriate to measure the cost of capital after taxes.

2) Assigning weights to specific costs:-

This involves determination of the proportion of each source of

funds in the total capital structure of the company.

BOOK VALUE:-

Value shown in the books is called book value. Weightage to each

source of finance is given on the basis of book value as recorded in the books.

MARKET VALUE:-

It represents the prices of sources of finance prevailing in the stock

market. So current market price are applied in ascertaining the weightage.

I From the following inforn calculate weighted average cost of capital using

book value & market value

1) Equity shares: 10000/- of Rs. 10 each Market price Rs. 15 each

Cost of equity (Ke) 12%

2) Debentures 10000/- of Rs. 100 each.

Market value Rs. 120 each

Cost of debt (KD) (after tax) 11%

1) Calculation of cost of capital based on weights & book value

Source of capital

Amount Proportion Cost of capital A

Weighted AxB cost

Equity Capital10000 x 10 1,00,000

1,00,00011,00,000 =0.09

0.12 (12%)Converted Cost of capital

0.0108

Debentures10000 x 100 10,00,000

10,00,00011,00,000 =0.91

0.11 (11%) 0.1001

11,00,000 1.00

0.1109

0.1109 or 0.1109 x 100 = 11%

2) Using Market value:- (based on weights)

Source of capital

Amount Proportion Cost of capital B

Weighted AxB cost

Equity share Capital10000 x 15

1,50,0001,50,00013,50,000 =0.11

0.12 0.0132

Debentures10000 x 120 12,00,000

12,00,00013,50,000 =0.89

0.11 0.0979

13,50,000 1.00

0.1111

0.1111 or 0.1111 x 100 = 11%

3) Calculation of weighted average cost of capital based on (Total Cost)

Source of capital Amount Cost of capital Total CostEquity Capital10000 x 10 1,00,000

12% 100000 x 12% = 12,000

Debentures10000 x 100 10,00,000

11% 1000000 x 11% = 1100x100

=1,10.00011,00,000 1,22,000

Weighted average cost capital = Total Cost x 100 Total Amount = 1,22,000 11,00,000 = 11.0909

3) Calculation of weighted average cost using market value

Source of capital Amount Cost of capital Total CostEquity Capital10000 x 15 1,50,000

12% 150000 x 12/100 = 18,000

Debentures10000 x 120 12,00,000

1200000 x 11/100 =1,32,000

13,50,000 1,50,000 Weighted average cost ofCapital = Total Cost x 100 Total Amount = 1,50,000 x 100 13,50,000 = 11,1111

2) Anand Limited has the following capital structure equity expected dividend 12% Rs. 20,00,000/-

10% Pre shares Rs. 10,00,000 8% Debenture Rs. 30,00,000 Credit require to calculated weighted average cost of capital assuming 50% as the rate of tax before & after tax

Calculation of Weighted average cost of capital based on total cost before tax

Source of capital Amount Cost of capital Total CostEquity Capital 20,00,000 12% 2000000 x 12/100

= 2,40,000Pre Shares 10,00,000 10% 1000000 x 10/100

=1,00,000Debenture 30,00,000 8% 3000000 x 8/100

= 2,40,00060,00,000 5,80,000

Weighted Average cost of capital = Total Cost x 100 Total Amount = 5,80,000 x 100 60,00,000 = 9.6666 or 9.67

II Weighted Average cost of capital based on weights (before tax)

Source of capital Amount Cost of Capital Proportion Weighted costEquity Capital 20,00,000

12%33.3320,00,000 x10060,00,000

4

Pre Capital 10,00,000 10% 10,00,000 x10060,00,000 16.67

1.67

Debenture 30,00,000 30,00,000 x10060,00,00 50%

4.00

60,00,000 100.00 9.67

Calculation of proportion :-Equity share Capital = 20,00,000 x 100 60,00,000 = 33.33Pre capital = 10,00,000 x 100 60,00,000 = 16.67Debenture = 30,00,000 x100 60,00,000 = 50%

III Weighted average cost of capital based on weights ( after tax)

Source of capital Amount Cost of capital Total Cost AxBEquity Share 20,00,000 12% 2,40,000Pre Shares 10,00,000 10% 1,00,000Debenture at 50% tax it means 30,00,000 4% 1,20,000

of 8%60,00,000 4,60,000

Weighted Average cost of capital = Total Cost x 100 Total Amount = 4,60,000 x 100 60,00,000 = 7.6

Calculation of weighted average cost using market value

Source of capital Amount Proportion Cost of Capital Weighted costEquity Share 20,00,000 33.33 12% 4.00Pre Share 10,00,000 16.67 10% 1.67Debenture 30,00,000 50.00 4% 2.00

60,00,000 100.00 7.67

3) Mallikarjun Company Limited desires to finance to the following process

Sources Amount CostEquity Capital 1,00,000 18%Reserves 1,00,000 15%Debentures 50,000 14%Pre share capital 1,00,000 12%

Calculate the weighted average cost of capitalSOLUTION:- Calculation of weighted average cost of capital based on Total Cost

Source of capital Amount Cost Total Cost Equity Capital 1,00,000 18% 18,000Reserves 1,00,000 15% 15,000

1,00,000x 15/100Debentures 50,000 14% 50,000 x 14/100

= 7000Pre Share Capital 1,00,000 12% 12,000

3,50,000 52,000Weighted Average cost of Capital = Total Cost x100 Total Amount = 52,000 x100

3,50,000 = 14.86%

Based on weighted Cost A X B 100

A BSource of capital Amount Proportion Cost Weighted costEquity Capital 1,00,000 1,00,000 x 100

3,50,000= 28.57%

18% 5.142628.57 x18 100

Reserves 1,00,000 1,00,000 x1003,50,000= 28.57%

15% 4.2855

Debentures 50,000 50,000 x 1003,50,000=14.29%=1,00,000 x100 3,50,000

14% 2.0006

Pre share capital 1,00,000 =28.57% 12% 3.42843,50,000 100% 14.86%

4) weighted average cost of capital of Hubli Company Limited from the

following

Sources Amount CostEquity Shares 15,00,000 20%Pre Shares 6,00,000 15%Retained Earnings 3,00,000 10%Long term debt 6,00,000 10%

Calculation of weighted average cost of capital based on Total Cost

Sources Amount Cost Total Cost Equity Shares 15,00,000 20% 3,00,000

15,00,000 x 20/100Pre Share 6,00,000 15% 90,000

Retained earnings 3,00,000 10% 30,000

Long term debt 6,00,000 10% 60,00030,00,000 4,80,000

Weighted Average cost of Capital = Total Cost x 100 Total Amount = 4,80,000 x100 30,00,000 = 16%

Based on weighted cost

Equity Capital 15,00,000 15,00,000 x100

30,00,000

= 50%

20% 5%

10%

Pre shares 6,00,000 6,00,000 x 100

30,00,000

= 20%

15% 3%

Retained earning 3,00,000 8,00,000 x100

30,00,000

= 10%

10% 1%

Long term debt 6,00,000 6,00,000 x 100

30,00,000

= 20% 10% 2%

30,00,000 100% 16%

5) Compute weighted average cost of capital of Babu company from the

following

Inforn sources Amount Specific Cost, After tax

Equity share capital 15,00,000 15%

Retained earnings 2,00,000 12%

Pre share capital 1,00,000 12%

Debentures 2,00,000 6%

Calculation of weighted average cost of capital based on

Sources Amount Cost Total Cost

Equity share capital 5,00,000 15% 75,000

Retained earnings 2,00,000 12% 24,000

Pre share capital 1,00,000 12% 12,000

Debentures 2,00,000 6% 12,000

10,00,000 1,23,000

Weighted average cost of capital = TC x 100 = 123000 x 100 TA 1000000

= 12.3%

Based on weighted average cost

Sources Amount Proportion Cost Weighted cost AxB/100

Equity Share Capital

5,00,000 5,00,000 x 10010,00,000= 50%

15% 15x501007.5%

Retained earnings

2,00,000 2,00,000 x10010,00,000= 20%

12% 12x201002.4%

Pre Share Capital 1,00,000 1,00,000 x10010,00,000

12% 12x10100

=10%Debentures 2,00,000 2,00,000 x100

10,00,000=20%

6% 6x20100=1.2%

10,00,000 100% 12.3%

6) Following are the details regarding the capital structure of a company.

Source of capital Book Value Market value Specific costDebentures 80,000 76,000 10%Pre Shares 20,000 22,000 15%

Equity Shares 1,20,000 1,80,000 30%

Retained earnings 40,000 60,000 15%

You are require to determine the weighted average cost of capital using

1) Book value as weights

2) Market value as weights

Based on Book value calculation of weighted average cost of capital

Based on Total CostSources Book Value

Total Rs.Cost of Capital

Total cost

Debentures 80,000 10% 8,000Pre Shares 20,000 15% 3,000

Equity Shares 1,20,000 30% 36,000

Retained earnings 40,000 15% 6,0002,60,000 53,000

Weighted Average cost of capital = Total Cost x100 Total Amount = 53,000 x 100 2,60,000 = 20.38% Based on weighted average cost, based on market value

Sources Market Value Amount

Cost of capital

Total Cost

Debentures 76,000 10% 76,000Pre Shares 22,000 15% 3300Equity Shares 1,80,000 30% 54,000Retained earning 60,000 15% 9,000

3,38,000 73,900

Weighted Average cost of capital = Total Cost x 100 Total Amount = 73,900 x 100 3,38,000 = 21.87%Calculation of Weighted Average cost of capital based on weighted cost

Sources Amount Proportion Cost Weighted cost AxB/100

Debentures 80,000 30.76 10% 3.076 or 154Pre shares 20,000 7.69 15% 1.1535.16Equity Shares 1,20,000 46.16 30% 13.848

Retained Earnings 40,000 15.39 15% 2.30852,60,000 100.00 20.386

Calculation of weighted average cost of capital based on market value

Sources Market value

Proportion Cost Weighted cost AxB/100

Debentures 76,000 76,000x1003,38,00 =22.49

10% 224.9= 2.249

Pre shares 22,000 22,000 x 1003,38,000 = 6.51

15% 97.65=0.9765

Equity Shares 1,80,000 1,80,000x 1003,38,000 =53.25

30% 1.597.5=15.97

Retained Earnings 60,000 60,000 x1003,38,000 = 17.75

15% 266.25=2.6625

3,38,000 100.00 21.858

The Vinayaka Company Limited cost of capital along with the indicated

book value & market value weighted

Types of capital Cost Book value weight

Market Value weight

Equity Capital 0.20 0.50 0.60Pre Shares 0.15 0.25 0.15Long term debt 0.10 0.25 0.25

1.00 1.00

Calculate weighted average cost of capital using book value & market

value weights

Calculation of weighted average cost of capitalType of capital

Cost of capital

Book value weight

Market value weight

Book value W.A Cost

Market value W.A. Cost

Equity capital

0.20 0.50 0.60 0.10 0.12

Pre shares 0.15 0.25 0.15 0.0375 0.0225Long term debt

0.10 0.25 0.25 0.0250 0.025

1.00 1.00 0.1625 0.1675 Or 16.25% or 16.75%

Computation of cost of capital for different sources of capital:-

Computation varies from one source of capital to the another source. The

company may raise the capital with the help of long term liabilities to purchase

the fixed asset in different forms. They are:-

1) Debentures

2) Equity shares

3) Preference shares

4) Long term loans

5) Retained earnings

1) Debentures:-

Debenture is a piece of paper acknowledging the ownership to the holder. The

return to the debenture holder is a cost to the company. They return may be in

the form of interest or tax.

The computation of cost of debenture is as follows:-

1) Before Tax:-

Cost of debenture [kd] = I/P

Kd = Cost of debenture

I = Interest P= principle

2) After Tax:-

Kd = (1– T) R

Kd = cost of debenture

1 = Re 1

T = Tax rate

R= Rate of interest

2) Cost of debenture on paper

When the debentures are issued on the basis of face value it is called

debentures on issued on paper

Kd= (1- T) R or Interest x (1-T)

Principle

Where Kd = cost of debenture

I = Interest

T = Tax ratem

P = Net Proceeds [issue price]

4) Cost of debenture issued on discount:-

When the cost of debentures are issued less than the face value it is

called debentures issued on

Kd = I/P ( 1-T) Kd= cost of debentures

I = Interest

T= Tax

P = Face value – discount

5) Cost of debenture issued on premium:-

When the cost of debentures are issued more than the face value it is

called debentures issued on premium.

Kd = I/P (1-T) Kd = cost of debenture

I = Interest

T = Tax

P = face value + Premium

PROBLEMS

1) A company issues 12% debentures it’s marginal tax rate is 50% calculate cost of debenture.

AfterKd= (1-T)R (50%)= (1-0.50) 12%= 0.50 x 12/100 = 0.06(convert into percentage. Because = 0.06x 100 = 6% the answer shows x 100

2) A company issues Rs. 50,000/- 8% debentures at paper, what is the cost of debtBefore tax * (there is not given tax. So it is before tax)Kd = I/P x 100= 50,000 x 8/100 x 100 50,000= 4,000 x 100 50,000= 8%

3) A company issues Rs. 50,000 8% debentures at paper. The tax rate is 50% what is the cost of debentures.Kd= (1-T) R = (1-50/100) 8% = (1-0.50) 8/100 = (1-0.50) 0.08

= 0.50 x 0.08 = 0.40 x 100 = 40%

4) Calculate the cost of debenture when they are issued at paper from the following inforn

1) Face value of debenture Rs. 1000/-2) Floatation Cost 2%3) Net proceeds?4) Kd = face value – discount = 1000 -1000 x 2/100 = 1000-20 Net proceeds 980

5) Calculate the cost of debentures when they are issued at discount from the following inforn

1) Issue price of debentures Rs. 10002) Floatation cost 2%3) Discount 5%4) Net proceeds

Kd or Net proceeds = Face value – discount – floatation cost = 1000 – (1000x 5/100) – 2% = 1000 – 50 = 2/100 = 950 – 950 x 2/100 NP = 931

5) Face value of debentures Rs. 1000 premium 10%Floatation cost 2%Net proceeds ?Net proceeds or kd= face value + premium – floatationcost = 1000 + 1000 x 10/100 – 2/100 = 1000 + 100 – 2/100 = 1100 – 1100 x 2/100 = 1100 – 22 Rs. = 1078

6) Company issues Rs. 80,000, 9% debentures at paper. The tax rate applicable to the company is 50% , compute the cost of debenture.

Kd= I/P (1 – T)

Kd = cost of capital = 80,000 x 9/100 x (1 - 50/100)I = Interest = 7200 80,000 T= Tax = 0.50 = 7,200 x (1 – 0.50) 80,000P = Issue price = 80,000 = 0.09 x 0.50 = 0.045 x 100 = 4.5%

8) Nagu company issues Rs. 80,000/-, 9% debentures at a premium of 10% the tax rate applicable to the company is compute the cost of debenture capital. Kd = I/P (1 – T) = 80,000x 9/100 x (1 – 60/100) 80,000 + 80,000x 10/100 = 8,000 = 7,200 (1 – 0.60) 88,000 = 0.081 (0.40) = 0.0324 x 100 = 3.24%

9) Ashok company issues 80,000, 9% debentures at discount of 5%. The tax rate is 50% compute the cost of debenture capital

Kd = I/P (1 – T) Face value= face value – discount = 80,000 x 9/100 x ( 1 – 50/100) 80,000 – 80,000 x 5/100 = 7,200 x (1 – 0.50) 80,000 – 4,000 = 7,200 (0.50) 76,000 = 0.095 x 0.50 = 0.0475 x 100 = 4.75

10) Ashok company issues 12% debentures of Rs. 6,00,000. The company is in 50% tax bracket. The cost of debenture if the debenture at 1) paper 2) 10% discount 3) 10% premium 1) Paper Kd = I/P (1 – T ) = 6,00,000 x 12/100 x (1 – 50/100) 6,00,000 = 72,000 x (1 – 0.50) 6,00,000

= 0.12 x 0.50 = 0.06 x 100 = 6%2} If issued at 10% discount:-

Kd = I/P (1 – T) = 6,00,000 x 12/100 x (1 – 0.50) 6,00,000 – 6,00,000 x 10/100 = 72,000 x 0.50 6,00,000 – 60,000 = 72,000 x 0.50 5,40,000 = 0.133 x 0.50 = 0.0665 x 100 = 6.65%

3} If issued at 10% premium:- Kd = I/P (1 – T) = 6,00,000 x 12/100 x( 1 – 0.50) 6,00,000 + 6,00,000x 10/100 = 72,000 x0.50 6,00,000+60,000 = 72,000 x0.50 6,60,000 = 0.109 x 0.50 = 0.0545 x 100 = 5.45%

11) Arun Limited issues Rs. 1,00,00/-, 8% debentures at paper compute the cost of debenture capital if tax rate is 50% On paper kd = I/P (1 – T ) = 1,00,000 x 8/100 x (1 – 50/100) 1,00,000 = 8,000 x(1 – 0.50) 1,00,000 = 0.08 x 1.50 = 0.04 x 100 = 4%

12) Vikas company Limited issues Rs. 1,00,000, 8% debentures at a premium of 10% the tax rate applicable to the company is 50% compute the cost of debenture capital

= I/P (1 – T)

= 1,00,000 x 8/100 x(1 – 50/100) 1,00,000+1,00,000x 10/100 = 8,000 x(1 – 0.50) 1,00,000+10,000 = 8,000 x 0.50 11,000 = 0.0727 x 0.50 = 0.03635 x 100 = 3.635%

13) Leela Ltd issues Rs. 1,00,000/-, 8% debentures at a discount of 5% . The tax rate is 50% compute the cost of debenture capital

Kd = I/P (1 – T) = 1,00,000 x 8/100 x (1 – T) 1,00,000 – 1,00,000x 5/100 = 8,000 (1 – 50/100) 1,00,000 – 5000 = 0.0842 x 0.50 = 0.0421 x 100 = 4.21%

14) Basu Ltd issues Rs. 1,00,000/-, 10% debentures at a premium of 10% the brokerage charges 2% the tax rate applicable is 60% compute the cost of debenture capital

Kd at premium Kd = I/P (1 – T) = 1,00,000x 10/100 x(1 – 60/100) 1,00,000 + 1,00,000x 10/100 – 1,00,000x 2/100 = 10,000 x (1 – 60/100) 1,00,000 + 10,000 – 2000 = 10,000 x(1 – 0.60) 1,10,000 – 2000

= 10,000 x 0.40 1,08,000 = 0.0925 x 0.40 = 0.037 x 100 = 3.7%

COST OF PREFERENCE CAPITAL:-

A fixed rate of dividends is payable on pre shares, but payment of

dividend is not a legal binding it is generally paid whenever the company

makes sufficient profit.

If the dividend is not paid to preference share holders. It will affect

the fund raising capacity of the company. Hence dividends are regularly paid

on pre shares except when there is no profits to pay dividends. The cost of pre

share capital can be calculated as

KP = R/P where Kp = cost of pre capital

R = Rate of dividend

P = Proceeds of Net

1) If shares are issued at Par:-

Kp = R/P

2) If shares are issued at discount:-

Kp = R/P = (P = Face value – discount)

3) If the share are issued at premium:-

Kp = R/P = ( P= Face value + Premium)

NOTE:-

1) If any expenses incurred in the form of brokerage or cost of floatation. Such

expenses is deducted from the Face value in order to find out ‘P’ (Net

Proceeds) of shares.

2) Dividends are deducted in computation of tax

3) Pre shares may be issued at par, at a premium & discount

1) A Co. issue 20,000-00 10% Pre. Share of Rs. 100-00 each. Cost of issue is Rs.

2% per share. Calculate cost of Pre. Cap if there shares are issued (a) at par (b) at

a premium of 10% (c) at a discount of 5%

1) When pre. Shares are issued at par KP = R/P

Where R= Rate of dividend

20000x100=2000000

2000000x10/100 = 200000

P= Net proceeds = FV-cost of floation

= 2000000-2000000x2/100

= 2000000-40000

= 1960000

So KP = 200000 x 100 1960000

= 10.20%

2) Shares issued at premium

KP = R/p

= 200000 FV+premium-floatation cost

= 200000 2000000+2000000x10/100 – 40000

= 200000 2000000+200000 – 40000

= 200000 2200000 – 40000

= 200000 2160000x100 = 9.26%

3) Shares are issued at discount

KP = R/P

= 200000 2000000-2000000x5/100 – 2000000x2/100

= 200000 2000000 - 100000 – 40000

= 200000 1900000-40000

= 200000 x 100 1860000

= 10.75%

2) A Company raise pre. Share capital of Rs. 500000-00 by issue of 10% pre

shares of Rs. 10 each, calculate the cost of pre. Capital when they are issued (a)

par (b) at dis. 10% (c) at 10%

1) Shares issued at par:-

KP = R/P

= 500000 x 10/100 = 50000 x 100 500000 500000

= 0.1x100 = 10%

2) Shares issued at discount:-

KP = R/P

= 500000 x 10/100 500000 - 500000 x 10/100

= 50000 5000000 – 50000

= 50000 x 100 450000

= 11.11%

KP = R+MV-P/N ½ (MV+P)

3) Shares issued at premium:-

KP = R/P

= 500000 x 10/100 500000 - 500000 x 10/100

= 50000 500000 + 50000

= 50000 x 100 550000

= 9.09%

Calculation of cost of redeemable premium shares.

Redeemable premium shares are issued which can be redeemed or cancelled on

maturity date. The cost of redeemable preference share capital can be calculated

as


Where KP = cost of redeemable premium, R = Rate of dividend, MV = Maturity

Value (FV+Premium)

P = Net Proceeds

N = No. of years to maturity

(1) Redeemable premium shares at premium:-

1) A company issues 20000, 10% premium shares of Rs. 100 each redeemable

after 10 years at a premium of 5%. The cost of issue is Rs. 2 per share. Calculate

the cost of premium cap.


R = 2000000 x 10/100 = 200000

MV = 2000000+2000000 x 5/100

= 2000000+100000 = 2100000

P = FV – cost

= 2000000 – 40000 (20000 x 2/100)

= 1960000

KP = 200000+2100000 – 1960000/10 ½ (2100000+1960000)

= 200000 + 140000/10 ½ (4060000)

= 200000 + 14000 2030000

= 214000 x 100 2030000

= 10.54%

Issued at premium repayable at par:-

A Company issues 20000, 7% premium share of Rs. 10 each at a premium of 10%

redeemable after 5 years at par. Compute the cost of premium capital.


Cost = 20000 x 10 = 200000

R = 200000 x 7/100 = 14000

MV = 200000

P = FV + cost

= 200000 + 200000 x 10/100

= 200000 + 20000

= 220000

N = 5 years

KP = 14000+200000 – 220000/5 ½ (200000+220000)

= 14000 - 20000/5 ½ (420000)

= 14000 - 4000 210000

= 10000 210000

= 4.8% or 4.77%

Cost of equity share capital:-

The cost of equity share is the minimum rate of return co. has to earn.

Equity share holders are not paid dividend at a fixed rate every year. The

distribution of dividend depends upon the profitability of the co.

More over the payment of dividend depends upon the retained earnings as well as

the present profits but it is not a legal binding. It may or may not be paid.

The cost of equity capital is calculated based on the following approaches.

a) Dividend price ratio

b) Earning price ratio

c) Dividend price + growth of earnings (P+G)

d) Realised yield approach

Dividend Price + Growth of Earnings:-

This approach emphasises what the investors actually received as dividend + the

rate of growth in dividend

Ke = D + G P

D = expected dividend per share

Ke = cost of equity share capital

P = Net proceed per share

G = Growth rate in dividend

Ke = D + G MP

Ke = cost of equity

D = Dividend rate per share

MP = Market price of shares

G = Growth rate in earnings per share

1) The current market price of equity share of the Co. is Rs. 80-00, but its face

value is Rs. 10-00. The current dividend per share is Rs. 5-00, in case of

dividends are expected to grow at the rate of 9%, calculate the cost of equity

capital.

Ke = D + G MP

= 5 + 9% 80

= 5 + 0.09 80

= 0.0625 + 0.09

= 0.1525 x 100

= 15.25%

2) A Co. plans to issue 2000 new equity shares of Rs. 100-00 each at par. The

floatation cost are expected to be 5% of the share price. The Co. pays a dividend

of Rs. 10-00 per share initially and the growth in dividend is expected to be 5%.

Compute the cost of new issues equity shares.

If the current market price of equity share is Rs. 160-00 calculate the cost of

existing equity share capital.

1) Cost of equity at par

Ke = D + G P

= 10 + 5% FV – flotation cost

= 10 + 0.05 100 – 5

= 10 + 0.05 95

= 0.1552 x 100

= 15.52%

2) Cost of equity at Market Price

Ke = D + G MP

= 10 + 5% 160

= 10 + 0.05 160

= 0.1125 x 100

= 11.25%

SOURCES OF FINANCE:-

INTRODUCTION:-

Finance is essential for all organs in order to carry out his day activity &

to achieve the target of the enes. The business cannot run without adequate

finance, that is why finance is called “ life blood of business”

MEANING:-

It means the agencies or services from which the funds are obtained or

collected, method of raising finance & period for which funds are required.

The financial requirements can be classified into 2 groups

1) Fixed capital / long term financial requirements:-

The capital is required to meet the capital expenditure as purchase of L/B,

P/M, F/F….etc

2) working capital / short term financial requirements:-

This capital is required to meet day to day expenses such as purchase of

materials, payment of salaries & wages………etc

CLASSIFICATION OF SOURCES OF FINANCE:-

I On the basis of period:-

1) Long term sources:-

Ex:- equity & preference shaves, debentures, retained earnings, long term

loans…etc

2) Short term sources:-

Ex:- Public deposits, trade credit, short term loans……etc

II On the basis of ownership:-

1) Own capital:-

Ex:- Share capital, reserves & scirples, retained earnings

2) Barrowed capital:-

Ex:- Debentures, public deposits, loans…..etc

III On the basis of source of generation:-

1) Internal sources:-

Ex:-Retained earnings, depreciation…….etc

2) External sources:-

Ex:- Shaves, debentures, loans………etc

However the most popular form to classify sources of finance is

1) Long term & medium term sources of finance

2) Short term sources of finance

SOURCES OF FINANCE:-

SHORT TERM MEDIUM TERM LONG TERM

1 yr or less than 1 yr 1 yr to 5 yr 5 years above

1 Indigeneous bankers 1 Issue of debentures 1 Issue of shares

2 Customers advance

debentures

2 Issue of preference

shaves

2 Ploughing bank of profits

3 Trade Credit 3 Bank loans 3 Loans from specialised

financial institutions

4 Bank Credit 4 Public deposits

5 Factoring 5 Fixed deposits

6 Accruals 6 Loans from the

financial institutions

7 Deferred incomes

8 Commercial papers 8 Instalment Credit

SHORT TERM FINANCE:-

It is a fund required to meet the working capital for a period of 12 months

or less than 12 months. It is used for office equipment, furniture, loose tools,

payment of salaries & wages, purchase of raw materials….etc

Advantages of short term Finance:-

1) Easy to obtain:-

It is easy to secure short term funds because creditors advance the funds

for a few weeks or months generally assume less risk as compared to

longer period

2) Low cost:-

Cost means interest charged an annual basis for the funds raised

3) Flexibility:-

As & when they are required

Disadvantages of short term financing:-

1) Frequent maturities:-

Liability on the maturity should be otherwise more cost incurred

2) High cost:-

In rate of interest is very high because it is for short term & there by

increases the cost of capital

SOURCES OF SHORT TERM FINANCE:

1) Indigeneous Bankers:-

Private money lenders are called indigeneous bankers. They charges high

rate of interest.

2) Customers advance:-

Companies may take advance from their customers for meeting out their

short term financial requirement, some times ene may take some advance

money from customers @ the time of receiving orders for supply of goods

to them.

Advantages of customer’s advance:-

1) It is an easy source of finance

2) It is free from the interest

3) It is an un-secured loan i.e. no security is required

4) It is refunded without interest

Dis-advantages:-

1) It’s duration is short

2) It is a loss to customer

3) TRADE CREDIT:-

It is a credit granted by a seller to the buyer for a short period. It is made

available to companies who have sufficient financial reputation &

goodwill. Trade is granted on an open account basis.

ADVANTAGES:

1) It is simple & easy method of finance

2) It is flexible

3) It doesn’t require any agreement

4) It is unsecured loan i.e. no security is required

Disadvantages:-

1) It is a short period

2) High price is charged by the seller

3) It is loss of cash discount

4) Too much depend upon reputation & credit wothiness

5) BANK CREDIT:-

Bank provides financial accommodation to the business firms in the

following ways

1) Over draft:

It is a temporary financial accommodation provided by a bank to its

customer, where a customer is allowed to draw money over & above

their credit balance.

2) Cash credit:-

It is also a temporary financial accommodation granted by a bank

against tangible security or promissory note signed by at-least two

parties

3) Advancing loans:-\

Secured and un-secured loans.

4) Discounting & purchase of bills of exchange, promissory notes,

5) Factoring:-

It is a method by which a businessmen obtains cash for invoice that he

sends to his customers in respect of foods & services to them. It is

also called as invoice discounting. It is a method of financing under

which a business ene obtains cash by selling accounts receivables.

The financial institution which undertake factoring is called ‘factor’

the business is called ‘client’

ADVANTAGES:-

1) It provides specified services in credit mgt

2) It helps in reduction in the cost of maintainance & collection of book

debts

3) It helps in increasing the sales by purchasing the customers

receivables

4) It saves in time man power……..etc received for collection

DISADVANTAGES:-

1) High cost of factoring as compared to other short-term sources

2) Shows the financial weakness of the ene

3) It is a short period

LONG TERM & MEDIUM TERM SOURCES OF FINANCE:-

1) Equity Share:-

These are the shares which do not carry preferential rights in respect

of payment of dividend or repayment of capital. They are also called as ordinary

or common shares. Equity shareholders are called the owners of the joint stock

company. Equity shares has the following characteristics

a) voting right

b) Right to income

c) Limited liability

ADVANTAGES

1) No charge on assets:-

The company is liable to collect the required funds without any charge on

its assets

2) It is a permanent & long term source of finance

3) Dividends are payable only when profits are earned.

4) WIDE MARKET:-

These shares are of nominal value & hence attract large number of

investors

5) Owners of the company:-

The share holders of equity shares has the voting right

DISADVANTAGES:-

1) No trading on equity:-

Company will not get the benefit of trading on equity if is has only equity

shares

2) Over capitalization:-

As they cannot be redeemed during the life time of the company, a slight

miscalculation in estimating the financial needs may lead to over

capitalization

3) Speculation in prices:-

Increase in the value of shares causes for a lot of speculation

4) Manipulation of control:-

Shareholders can put obstacles in mgt by organizing themselves

II Preference shares:-

These shares are those who enjoy two preferential right over equity shares

a) preference as to payment of dividend @ a fixed rate

b) preference as to the return of capital when the company winds-up

There are different types of pre shares:-

1) Cumulative & non- cumulative

2) Participating & non-participating

3) Convertible & non- convertible

4) Redeemable & non-redeemable

ADVANTAGES:-

1) Facilitates trading on equity in the capital structure of company

2) No control over companies mgt as the shareholders do not carry voting

rights

3) Since they can be redeemed whenever company does not service them

they eliminate over capitalization

4) Lesser financial burden because dividends are payable only when

company makes sufficient profits

5) It is an unsecured source of finance no charge on asset

DISADVANTAGES:-

1) It is costly source of finance because high rate of dividend will be paid

than interest on debentures

2) No voting right

3) Permanent burden on company

4) No scope for participation in prosperity

III DEBENTURES:- (Medium term of finance)

It is a long term borrowed capital. A debenture is an acknowledgement in

writing of debt taken by a company. The debenture holders are entitled to get the

fixed rate of interest. These are different types of debentures. They are

1) Simple & mortgage debentures

2) Bearer debentures & registered debentures

3) Redeemable debentures & non redeemable debentures

4) Convertible debentures & non-convertible debentures

5) First debentures & Second debentures

6) Guaranteed debentures

7) Collateral debentures

8) Zero interest debentures

9) Zero coupon bonds (ZCB)

10) Deep discount bonds

ADANTAGES:-

1) Lower rate of interest when compared to the dividends of pre

shares

2) Trading on equity is allowed with fixed interest security

3) Freedom in mgt as the holders do not have voting rights

4) Reduction in tax liability hence exemption of tax is availed

5) Surety of finance

6) Capital from ordinary investors can be attracted

7) Finance during boom is possible with debentures

8) Control on over capitalization

9) Finance during depression is also possible

10) Consolidation of debt

11) Fixed & stable income ( investors)

12) Safe investment ( investors)

13) Liquid investment

14) Convention of loan

DIS-ADAVANTAGES

1) Fixed charge on assets:- (interest)

As debenture carry fixed interest charge on all assets further

money can not be raised if needed

2) Fixed burden:- (liable)

Interest is payable even if company does not earn profit

3) Risk of winding up:-

If the interest on debentures is not paid by the company, the

debenture holders can demand the winding up company

particularly when there are no profit

4) Debenture holder do not have voting right

5) Share in profits is fixed even of company earns more profit

6) There is always uncertainty of redemption of debentures

IV PUBLIC DEPOSITS:-

Company may invite general public to deposit their savings with the

company @ specified rate of interest for a specified period which may range from

1 year to 6 years. The total amount of such deposits should not exceed 25% of

paid-up capital & free reserves of the company

ADAVANTAGES:-

1) It is simple

2) It is a cheap source of finance

3) It is reduces the cost of finance

4) It helps companies to pay higher rate of dividend

5) There is no interference

DISADVANTAGES:-

1) It is un-reliable source of finance

2) Loss of money may be due to miss-mgt

3) Maturity period is very short

V PLOUGHING BACK & PROFIT (Self financing/ Internal financing/ Retained

earnings/ Re-investment of earnings):

Under this method, companies re-invest a part of the profits in the business

& only a part of the earnings is distributed in the form of dividends. In other

words a part of profit is retained or re-invested in the company

ADVANTAGES TO THE COMPANY:-

1) It is a cushion to absorb the shocks of the company.

2) It is a economical method of financing

3) It helps to maintain stable dividend policy

4) It helps in making good the defeliencies of depreciation

5) It helps to redeem long term debt

ADVANTAGES TO THE SHAREHOLDERS:-

1) It increase in the value of shares

2) It is a safe investment

3) It increase the earning capacity.

4) It provides an opportunity for evasion of super tax

ADVANTAGES TO THE SOCIETY:-

1) It increases productivity

2) It leads to higher standard of living

3) It leads to rapid industrialization

DISADVANTAGES:-

1) Danger of over capitalization due to excessive earnings

2) It may lead to the creation of monopoly power to few

3) It is subject to minimize of retained earnings

4) Evasion of taxes reduces the revenue of the government

VI LOANS FROM FINANCIAL INSTITUTIONS:-

The institutions set up by the government to facilitate finance for industrial

purpose. There are 2 entities with respect to this work

1) Financial institutions like ICICI, IDBI, ICFC, SFC

2) Financial intermediaries like venture capital, credit rating

SHORT TERM SOURCES

1) ACCRUALS- Accrued expenses:-

Companies postpone the accrued expenses in respect of which payments

are due. This delay in payments of accrued expenses helps the company to

use such amount for meeting their short term financial requirements of

expenses like accrued expenses, wages, salaries, interest & tax…….etc

2) DEFERED INCOMES:-

These are the incomes received in advances before supplying

goods or services. These funds increases the liquidity of a firm

3) COMMERCIAL PAPER:-

It represents unsecured promissory notes issued by firms to raise

the short term funds. It may be issued even @ discount. The maturity period

of commercial paper in India ranges from 91 to 180 days.

4) INSTALMENT CREDIT:-

Purchase of any durable goods or capital goods like plant &

machineries, furniture etc paying the cash price by way of instalment

including interest over a pre-determined period of time.

financial management

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