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Financial Management

This book is a part of the course by Jaipur National University, Jaipur.This book contains the course content for Financial Management.

JNU, JaipurFirst Edition 2013

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JNU makes reasonable endeavours to ensure content is current and accurate. JNU reserves the right to alter the content whenever the need arises, and to vary it at any time without prior notice.

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Index

ContentI. ...................................................................... II

List of FiguresII. ..........................................................VI

List of TablesIII. ......................................................... VII

AbbreviationsIV. ......................................................VIII

ApplicationV. ............................................................. 114

BibliographyVI. ......................................................... 117

Answers to Self AssessmentVII. .............................. 120

Book at a Glance

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Contents

Chapter I ......................................................................................................................................... 1Financial Management and Planning .......................................................................................... 1Aim .................................................................................................................................................. 1Objectives ........................................................................................................................................ 1Learning outcome .......................................................................................................................................... 11.1 Introduction to Financial Management .................................................................................................... 21.2 Goals of Financial Management .............................................................................................................. 21.3 Financial Decisions .................................................................................................................................. 21.4 Interface between Finance and Other Business Functions ...................................................................... 41.5 Financial Planning ................................................................................................................................... 41.6 Capitalisations .......................................................................................................................................... 5 1.6.1 Cost Theory .............................................................................................................................. 5 1.6.2 Earnings Theory ....................................................................................................................... 61.7 Over-capitalisation ................................................................................................................................... 61.8 Under-capitalisation ................................................................................................................................. 7Summary ....................................................................................................................................................... 8References ..................................................................................................................................................... 8Recommended Reading ............................................................................................................................... 8Self Assessment ............................................................................................................................................ 9

Chapter II ....................................................................................................................................................11Time Value of Money ..................................................................................................................................11Aim ...............................................................................................................................................................11Objectives .....................................................................................................................................................11Learning outcome .........................................................................................................................................112.1 Introduction to Time Value of Money .................................................................................................... 122.2 Simple Interest ....................................................................................................................................... 122.3 Compound Interest ................................................................................................................................. 13 2.3.1 Compounding Value of a Single Amount .............................................................................. 13 2.3.2 Variable Compounding Periods ............................................................................................. 132.4 Doubling Period ..................................................................................................................................... 152.5 Present Value .......................................................................................................................................... 162.6 Effective Vs Nominal Rate .................................................................................................................... 182.7 Sinking Fund Factor ............................................................................................................................... 182.8 Loan Amortisation ................................................................................................................................. 192.9 Shorter Discounting Periods .................................................................................................................. 20Summary ..................................................................................................................................................... 21References ................................................................................................................................................... 21Recommended Reading ............................................................................................................................. 21Self Assessment ........................................................................................................................................... 22

Chapter III .................................................................................................................................................. 24Valuation of Bonds and Shares ................................................................................................................. 24Aim .............................................................................................................................................................. 24Objectives .................................................................................................................................................... 24Learning outcome ........................................................................................................................................ 243.1 Introduction to Valuation ....................................................................................................................... 253.2 Nature of Value ...................................................................................................................................... 253.3 Bond Valuation ....................................................................................................................................... 25 3.3.1 Types of Bonds ...................................................................................................................... 263.4 Bond Yields ............................................................................................................................................ 273.5 Bond Value Behaviors ............................................................................................................................ 29

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3.5.1 Required Rate of Return and Bond Values ............................................................................ 29 3.5.2 Time to Maturity and Bond Values ........................................................................................ 30 3.5.3 Relationship between Bond Value and Time to Maturity Period ........................................... 313.6 Valuation of Shares ................................................................................................................................ 31 3.6.1 Valuation of Preference Shares .............................................................................................. 32 3.6.2 Valuation of Equity/Ordinary Shares ..................................................................................... 32Summary ..................................................................................................................................................... 35References ................................................................................................................................................... 35Recommended Reading ............................................................................................................................. 35Self Assessment ........................................................................................................................................... 36

Chapter IV .................................................................................................................................................. 38Cost of Capital ............................................................................................................................................ 38Aim .............................................................................................................................................................. 38Objectives .................................................................................................................................................... 38Learning outcome ........................................................................................................................................ 384.1 Introduction to Cost of Capital .............................................................................................................. 394.2 Cost of Different Sources of Finance ..................................................................................................... 40 4.2.1 Cost of Equity ........................................................................................................................ 40 4.2.2 Cost of Preference Shares ...................................................................................................... 41 4.2.3 Cost of Debentures ................................................................................................................. 414.3 Capital Asset Pricing Model Approach (CAPM) ................................................................................... 424.4 Weighted Average Cost of Capital (WACC) .......................................................................................... 43 4.4.1 Factors Affecting WACC ....................................................................................................... 44Summary ..................................................................................................................................................... 45References ................................................................................................................................................... 45Recommended Reading ............................................................................................................................. 45Self Assessment .......................................................................................................................................... 46

Chapter V .................................................................................................................................................... 48Capital Structure and Leverages .............................................................................................................. 48Aim ............................................................................................................................................................. 48Objective ...................................................................................................................................................... 48Learning outcome ........................................................................................................................................ 485.1 Meaning of Capital Structure ................................................................................................................. 495.2 Features of an Appropriate Capital Structure ......................................................................................... 505.3 Determination of Capital Structure ........................................................................................................ 515.4 Theories of Capital Structure ................................................................................................................. 51 5.4.1 Net Income Approach ............................................................................................................ 51 5.4.2 Net Operating Income (NOI) Approach ................................................................................ 52 5.4.3 Traditional Approach ............................................................................................................. 53 5.4.4 Miller and Modigliani Approach ........................................................................................... 545.5 Leverages ............................................................................................................................................. 55 5.5.1 Operating Leverage ................................................................................................................ 55 5.5.2 Financial Leverage ................................................................................................................. 57 5.5.3 Combined Leverage ............................................................................................................... 57Summary ..................................................................................................................................................... 59References ................................................................................................................................................... 59Recommended Reading ............................................................................................................................. 59Self Assessment .......................................................................................................................................... 60

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Chapter VI ............................................................................................................................................. 62Capital Budgeting ...................................................................................................................................... 62Aim .............................................................................................................................................................. 62Objectives .................................................................................................................................................... 62Learning outcome ........................................................................................................................................ 626.1 Introduction ............................................................................................................................................ 636.2 Definition of Capital Budgeting ............................................................................................................. 636.3 Importance of Capital Budgeting ........................................................................................................... 636.4 Objectives of Capital Budgeting ............................................................................................................ 636.5 Principles or Factors of Capital Budgeting Decisions ........................................................................... 646.6 Capital Budgeting Process ..................................................................................................................... 646.7 Types of Capital Expenditure ................................................................................................................. 646.8 Types of Capital Budgeting Proposals ................................................................................................... 646.9 Methods of Evaluating Capital Investment Proposals ........................................................................... 65 6.9.1 Traditional Methods ............................................................................................................... 65 6.9.2 Improvement of Traditional Approach to Pay-back Period ................................................... 67 6.9.3 Average Rate of Return Method (ARR) or Accounting Rate of Return Method ................... 68 6.9.4 Discounted Cash Flow Method (or) Time Adjusted Method ................................................. 69 6.9.5 Net Present Value Method (NPV) .......................................................................................... 69 6.9.6 Internal Rate of Return Method (IRR) ................................................................................... 70 6.9.7 Profitability Index Method ..................................................................................................... 71Summary ..................................................................................................................................................... 72Reference..................................................................................................................................................... 72Recommended Reading ............................................................................................................................. 73Self Assessment .......................................................................................................................................... 74

Chapter VII ................................................................................................................................................ 76Management of Working Capital ............................................................................................................. 76Aim .............................................................................................................................................................. 76Objectives .................................................................................................................................................... 76Learning outcome ........................................................................................................................................ 767.1 Introduction ............................................................................................................................................ 777.2 Meaning and Definition of Working Capital ......................................................................................... 777.3 Classification of Working Capital ......................................................................................................... 777.4 Components of Working Capital ............................................................................................................ 797.5 Aspects of Working Capital Management.............................................................................................. 797.6 Need for Working Capital ...................................................................................................................... 797.7 Estimation of Working Capital Requirements ....................................................................................... 847.8 Sources of Working Capital ................................................................................................................... 84Summary ..................................................................................................................................................... 86References ................................................................................................................................................... 86Recommended Reading ............................................................................................................................. 86Self Assessment ........................................................................................................................................... 87

Chapter VIII ............................................................................................................................................. 89Inventory Management ............................................................................................................................. 89Aim .............................................................................................................................................................. 89Objectives .................................................................................................................................................... 89Learning outcome ........................................................................................................................................ 898.1 Introduction ............................................................................................................................................ 908.2 Meaning and Definition of Inventory .................................................................................................... 908.3 Types of Inventory ................................................................................................................................. 908.4 Inventory Management Motives ............................................................................................................ 918.5 Objectives of Inventory Management .................................................................................................... 918.6 Costs of Holding Inventory .................................................................................................................... 91

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8.7 Risks of Holding Inventory .................................................................................................................... 928.8 Benefits of Holding Inventory ............................................................................................................... 938.9 Techniques of Inventory Control ........................................................................................................... 93 8.9.1 ABC Analysis ......................................................................................................................... 93 8.9.2 Economic Order Quantity (EOQ) .......................................................................................... 94 8.9.3 Order Point Problem .............................................................................................................. 95 8.9.4 Just in Time (JIT) ................................................................................................................... 96Summary ..................................................................................................................................................... 97Reference..................................................................................................................................................... 97Recommended Reading ............................................................................................................................ 97Self Assessment ........................................................................................................................................... 98

Chapter IX ................................................................................................................................................ 100Dividend Decision..................................................................................................................................... 100Aim ............................................................................................................................................................ 100Objectives .................................................................................................................................................. 100Learning outcome ...................................................................................................................................... 1009.1 Introduction .......................................................................................................................................... 101 9.1.1 Types of Dividend/ Form of Dividend ................................................................................. 1019.2 Dividend Decision ............................................................................................................................... 101 9.2.1 Irrelevance of Dividend ...................................................................................................... 102 9.2.2 Relevance of Dividend ......................................................................................................... 1049.3 Factors Determining Dividend Policy ................................................................................................. 1099.4 Types of Dividend Policy ......................................................................................................................110Summary ....................................................................................................................................................111References ..................................................................................................................................................111Recommended Reading ...........................................................................................................................111Self Assessment ..........................................................................................................................................112

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List of Figures

Fig. 1.1 Financial decisions ........................................................................................................................... 3Fig. 3.1 Bond value and time to maturity .................................................................................................... 31Fig. 5.1 Net income approach ...................................................................................................................... 52Fig. 5.2 Net operating income approach ...................................................................................................... 53Fig. 5.3 Traditional approach ....................................................................................................................... 54Fig. 7.1 Types of working capital ................................................................................................................ 78Fig. 7.2 Operating cycle ............................................................................................................................... 80Fig. 9.1 Classification of dividend theories ............................................................................................... 102

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List of Tables

Table 1.1 Cost dimension ............................................................................................................................... 3Table 1.2 Merits and demerits of cost approach ............................................................................................ 5Table 1.3 Merits and demerits of earnings theory .......................................................................................... 6Table 8.1 Categorisation of Inventory ......................................................................................................... 93

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Abbreviations

a - alphaAAI - Average Accounts PayableAAP - Average Accounts PayableAPP - Accounts Payable PeriodAPR - Accounts Receivables PeriodAR - Account ReceivablesARR - Accounting rate of returnBR - Bills ReceivablesCAPM - Capital asset pricing model CCC - Cash Conversion CycleCE - Certainty EquivalentCFAT - Cash Flow after TaxCV - Compound valueDCF - DiscountedcashflowDF - Discounting FactorECL - Economic Conversion LotEMV - Expected Monetary ValueEOQ - Economic Order QuantityERI - Effective rate of interestFM - Financial ManagementFMCG - Fast Moving Consumer GoodsFV - Future valueGDP - Gross Domestic ProductHR - Human ResourceIRR - Internal Rate of ReturnJIT - Just in TimeL/C - Letter of CreditLCL - Lower Control LimitMAN - Materials as NeededNI - Net incomeNOI - Net operating incomeNOT - Neck of TimeNPV - Net present valueOC - Operating CyclePI - ProfitabilityIndexPro - ProbabilityPV - Present ValuePVA - Proportional Value AnalysisPVIFA - Present Value Interest Factor of AnnuityRADR - Risk Adjusted Discount RateROI - Return on investmentRP - Return PointTD - Trade DebtorsUCL - Upper Control LimitWACC - weighted average cost of capitalWC - Working CapitalWCL - Working Capital LeverageYTC - Yield to callYTM - Yield to maturityZIN - Zero InventoriesZIPS - Zero Inventory Production System

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Chapter I

Financial Management and Planning

Aim

The aim of this chapter is to:

explaintheconceptoffinancialmanagement•

elucidateprofitmaximisation•

explicatefinancialplanning•

Objectives

The objectives of this chapter are to:

explain the concept of management planning•

enlistvariousfinancialdecisions•

explain the concept of capitalisations•

Learning outcome

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

identifythetypesoffinancialdecisions-investment,financinganddividend•

understandtheprocess,benefits,factorsoffinancialplanning•

describe the merits and demerits of cost and earnings theory•


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1.1 Introduction to Financial ManagementFinancial management "is the operational activity of a business that is responsible for obtaining and effectively utilisingthefundsnecessaryforefficientoperations".

Financial management is concerned with three key activities namely:Anticipatingfinancialneeds•Acquiringfinancialresources•Allocating funds in business•

Traditional approach to financial managementTraditionally,financialmanagementwasconsideredasabranchofknowledgewithfocusontheprocurementoffunds.Instrumentsoffinancing,formation,mergerandrestructuringoffirms,legalandinstitutionalframeworkinvolved therein occupied the prime place in this approach.

Modern approach to financial managementModern phase has shown the commendable development with combination of ideas from economic and statistics thatledthefinancialmanagementmoreanalyticalandquantitative.Thekeyworkareaofthisapproachisrationalmatching of funds to their uses, which leads to the maximisation of shareholders' wealth.

1.2 Goals of Financial ManagementGoaloffinancialmanagementofafirmismaximisationofeconomicwelfareofitsshareholders.Shareholders'wealthmaximisationisreflectedinthemarketvalueofthefirms'shares.Afirms'contributiontothesocietyismaximisedwhenitmaximisesitsvalue.Twowidelyacceptedgoalsoffinancialmanagementare:

Profit maximisation Profitisprimarymotivatingforceforanyeconomicactivity.Firmisessentiallybeinganeconomicorganisation,ithastomaximisetheinterestofitsstakeholders.Tothisendthefirmhastoearnprofitfromitsoperations.Theoverall objective of business enterprise is to earn at least satisfactory return on the funds invested, consistent with maintainingasoundfinancialposition.

Wealth maximisation: Wealth maximisation refers to maximising the net wealth of the company's share holders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company.

1.3 Financial DecisionsThefunctionsperformedbyafinancemanagerareknownasfinancefunctions.Inthecourseoffollowingthesefunctionsfinancemanagertakesthefollowingdecisions:

Limitations of Profit MaximisationThetermprofitisvagueanditdoesn'tclarifywhatexactlyitmeans.Ithasdifferentinterpretationsfor different people.Time value of money refers a rupee receivable today is more valuable than a rupee,whichisgoingtobereceivableinfutureperiod.Theprofitmaximisationgoaldoesnothelpindistinguishingbetweenthereturnsreceivableindifferentperiods.Theconceptofprofitmaximisationfailstoconsiderthefluctuationintheprofitsfromyeartoyear.

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Financial Decisions

Dividend Decisions

Financing Decisions

InvestmentDecisions

Fig. 1.1 Financial decisions

Investment decisions Itbeginswithadeterminationofthetotalamountofassetsneededtobeheldbythefirm.Itrelatestotheselectionofassets,onwhichafirmwillinvestfunds.Therequiredassetsfallintotwogroupsnamely:

Long-term assets: This involves huge investment and yield a return over a period of time in future. It is also •termedas'capitalbudgeting'andcanbedefinedasthefirm'sdecisiontoinvestitscurrentfundsmostefficientlyinfixedassetswithanexpectedflowofbenefitsoveraseriesofyears.Short-termassets:Thesearethecurrentassetsthatcanbeconvertedintocashwithinafinancialyearwithout•diminution in value. Investment in current assets is termed as 'working capital management'.

Financing decisions Financing decisions relate to the acquisition of funds at the least cost. The cost has two dimensions which have been illustrated in the below mentioned table.

Explicit cost Implicit cost

It refers to the cost in the form of couponrate,costoffloatingandissuing the securities and so on

It refers to the cost which is not visible but it may seriously affect the company's operations especially when it is exposed to businessandfinancialrisk

Table 1.1 Cost dimension

Thechallengebeforethefinancemanageristoarriveatacombinationofdebtandequityforfinancingdecisionswhich would attain an optimal structure of capital.

Dividend decisions Dividenddecisionisamajordecisionmadebythefinancemanagerontheformulationofdividendpolicy.Sincethegoaloffinancialmanagementismaximisationofwealthofshareholders,dividendpolicyformulationdemandsthe managerial attention on the impact of its policy on dividend on the market value of shares. Optimum dividend policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend.


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1.4 Interface between Finance and Other Business FunctionsFinancial management has relationship with almost all functional departments. But it has close relationship with economics and accounting.

Relationship to economicsThe relationship betweenfinance and economics is studied under two prime areas of economics.They aremacroeconomics and microeconomics:

Macroeconomics: It is the environment in which an industry operates, which is not controllable. It is important •forfinancialmanagers to understand changes inmacroeconomics and their impact on thefirm's operatingperformance. External environment analysis helps in identifying opportunities and threats. Microeconomics:Itisconcernedwiththedeterminationofoptimumoperationalstrategies.Allfinancialdecisions•ofafirmaremadeonthebasisofmarginalcost,andmarginalrevenue.Thereforeitisnecessarytounderstandtherelationshipbetweenfinanceandeconomics.

Relationship to accountingAccountingandfinancearecloselyrelated.Forcomputationofreturn-on-investment,earningspershareofvariousratiosforfinancialanalysis,thedatabasewillbeaccountinginformation.Withoutproperaccountingsystem,anorganisationcannotadministereffectivelyfunctionoffinancialmanagement.Thepurposeofaccountingistoreportthefinancialperformanceofthebusinessfortheperiodunderconsideration.

Relationship to HR (Human Resource)HRactivitiesincluderecruitment,training,development,fixingcompensationandsoonforwhichweneedfinance.HRmanagersneedtoconsultfinancemanagers.FinancemanagerstakedecisionafterstudyingtheimpactofHRactivity on organisation.

Relationship to productionProductiondepartmentisanotherfunctionalareathatinvolveshugeinvestmentonfixedassets.Theproductionmanagerandthefinancemanagerneedtoworkcloselyforeffectiveinvestmentonplantandmachinery.

Relationship to marketingMarketing functions involves selection of distribution channel and promotion policies. These two are the primary activitiesofmarketingdepartmentandinvolveshugecashoutflows.Thereforefinanceandmarketingmanagersneedtoworkwithcoordinationtomaximisevalueofthefirm.

1.5 Financial PlanningFinancialPlanningisaprocessbywhichfundsrequiredforeachcourseofactionisdecided.Afinancialplanhastoconsidercapitalstructure,capitalexpenditureandcashflow.Financialplanninggeneratesfinancialplanwhichindicates:

The quantum of funds required to execute business plans•Composition of debt and equity•Formulationofpolicesforgivingeffecttothefinancialplansunderconsideration•

Process of financial planningProjectionoffinancialstatements•Determination of funds needed•Forecast the availability of funds•Establish and maintain systems of controls•Develop procedures•Establish performance-based compensation system•

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Benefits of financial planningEffective utilisation of funds•Flexibility in capital structure is given adequate consideration•Formulation of policies and instituting procedures for elimination of all types of wastages in the process of •execution of strategic plans.Maintainingtheoperatingcapabilityofthefirmthroughtheevolutionofscientificreplacementschemesfor•plantandmachineryandotherfixedassets.

Factors affecting financial planNature of the industry•Size of the company•Status of the company in the industry•Sourcesoffinanceavailable•The capital structure of a company•Matching the sources with utilisation•Flexibility•Government policy•

1.6 CapitalisationsCapitalisationofafirmreferstothecompositionofitslong-termfunds.Itreferstothecapitalstructureofthefirm.It has two components, viz., debt and equity.

Afterestimatingthefinancialrequirementsofafirm,thenextdecisionthatthemanagementhastotakeistoarriveat the value at which the company has to be capitalised. The two theories of Capitalisation are:

1.6.1 Cost TheoryAccordingtothecosttheoryofcapitalisation,thevalueofacompanyisarrivedatbyaddingupthecostoffixedassets like plants, machinery patents, the capital that regularly required for the continuous operation of the company (working capital), the cost of establishing business and expenses of promotion. The original outlays on all these items become the basis for calculating the capitalisation of company.

Merits of cost approach Demerits of cost approachIt helps promoters to estimate the amount •of capital required for various activities like incorporation of company, conducting market surveys and so on.

Itthefirmestablishesitsproductionfacilitiesat•inflatedprices;productivityofthefirmwillbeless than that of the industry.

If done systematically it will lay foundation for •successfulinitiationoftheworkingofthefirm.

Net worth of a company is decided by the •investors by the earnings of a company. Earning capacitybasednetworthhelpsafirmtoarriveatthetotalcapitalintermsofindustryspecifiedyardstick cost theory fails in this respect.

Table 1.2 Merits and demerits of cost approach


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1.6.2 Earnings TheoryThe earnings theory of capitalisation recognises the fact that the true value (capitalisation) of an enterprise depends upon its earnings and earning capacity. According to it, the value or capitalisation of a company is equal to the capitalisedvalueofitsestimatedearnings.Forthispurposeanewcompanyhastoprepareanestimatedprofitandlossaccount.Forthefirstfewyearsofitslife,thesalesareforecastandthemanagerhastodependuponhis/herexperience for determining the probable cost. The earnings so estimated may be compared with the actual earnings of similar companies in the industry and the necessary adjustments should be made. Then the promoters will study the rate at which other companies in the same industry similarly situated are earning. The rate is then applied to the estimatedearningsofthecompanyforfindingoutthecapitalisation.

Merits of earnings theory Demerits of earnings theoryIt is superior to cost theory because there are •the least chances of neither under nor over capitalisation.

Themajor challenge that a newfirm faces is in•deciding on capitalisation and its division thereof into various procurement sources.

Comparison of earnings with that of cost •approach will make the management to be cautious in negotiating the technology and cost of procuring and establishing the new business.

Arriving at capitalisation rate is equally a formidable •task because the investors' perception of established companies cannot be really representative of what investors perceive of the earning power of new company.

Table 1.3 Merits and demerits of earnings theory

1.7 Over-capitalisationA company is said to be overcapitalised, when its total capital exceeds the true value of its assets. The correct indicatorofovercapitalisationistheearningscapacityofthefirm.Iftheearningsofthefirmarelessthenthatofthe market expectation, it will not be in position to pay dividends to its shareholders as per their expectations. It is a sign of overcapitalisation.

Effects of over-capitalisationDecline in the earnings of the company•Fall in dividend rates•Marketvalueofcompany'ssharefalls,andcompanylosesinvestorsconfidence•Companymaycollapseatanytimebecauseofanemicfinancialconditions•

Remedies for over-capitalisationRestructuring the firm is to be executed to avoid the situation of company becoming sick. It involves thefollowing:

Reduction of debt burden•Negotiation with term lending institutions for reduction in interest obligation•Redemption of preference shares through a scheme of capital reduction•Reducing the face value and paid-up value of equity shares•Initiatingmergerwithwellmanagedprofitmakingcompaniesinterestedintakingoverailingcompany•

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1.8 Under-capitalisationA company is considered to be under-capitalised when its actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity.

Causes of under-capitalisationUnder estimation of future earnings at the time of promotion of the company•Abnormal increase in earnings from new economic and business environment•Under estimation of total funds requirements•Maintainingveryhighefficiencythroughimprovedmeansofproductionofgoodsorrenderingofservices•Use of low capitalisation rate•Purchase of assets at exceptionally low prices during recession•

Effects of under-capitalisationEncouragement to competition•It encourages the management of the company to manipulate the company's share prices•Higherprofitswillattracthigheramountoftaxes•Higherprofitswillmaketheworkersdemandinghigherwages•Highmarginofprofitmaycreateamongconsumersanimpressionthatthecompanyischarginghighprices•for its product

RemediesSplitting up of the shares- This will reduce the dividend per share•Issue of bonus share – This will reduce both the dividend per share and earnings per share.•


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SummaryFinancial management "is the operational activity of a business that is responsible for obtaining and effectively •utilisingthefundsnecessaryforefficientoperations.Wealth maximisation refers to maximising the net wealth of the company's share holders.•Financial Planning is a process by which funds required for each course of action is decided. •Afinancialplanhastoconsidercapitalstructure,capitalexpenditureandcashflow.•Capitalisationofafirmreferstothecompositionofitslong-termfunds.Itreferstothecapitalstructureofthe•firm.Ithastwocomponents,viz.,debtandequity.The earnings theory of capitalisation recognises the fact that the true value (capitalisation) of an enterprise •depends upon its earnings and earning capacity.A company is said to be overcapitalised, when its total capital exceeds the true value of its assets.•

ReferencesReddy, G. S., 2008. • Financial Management. Himalaya publications, Mumbai.Correia, C., Flynn, D. K., Uliana, E. & Wormald, M., 2012. Financial Management, 6th ed., Juta and Company •Ltd.Financial Planning - Definition, Objectives and Importance,• [Online] Available at: <http://www.managementstudyguide.com/financial-planning.htm>[Accessed27May2013].Masters of Business Administration Notes• , [Online] Available at: <http://freemba.in/articlesread.php?artcode=299&substcode=19&stcode=10>[Accessed27May2013].2008.• Financial Management,[Videoonline]Availableat:<http://www.youtube.com/watch?v=iDlFPm3fqbs>[Accessed 27 May 2013].2011. • Financial Management - Lecture 01, [Video online] Available at: <http://www.youtube.com/watch?v=iDlFPm3fqbs>[Accessed27May2013].

Recommended ReadingBrigham, E. F., 2010. • Financial Management: Theory & Practice. 13th ed., South-Western College Pub.Shim, J. K., 2008.• Financial Management (Barron’s Business Library). 3rd ed., Barron’s Educational Series.Brigham, E. F., 2009. • Fundamentals of Financial Management. 12th ed., South-Western College Pub.

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Self Assessment

Wealth maximisation refers to maximising the ___________ of the company's share holders1. profita. net wealthb. assetsc. liabilitiesd.

A company is said to be ____________, when its total capital exceeds the true value of its assets.2. under-capitaliseda. capitalisedb. overcapitalisedc. profitmaximisationd.

Which of the following statements is false?3. Capitalisationofafirmrefersthecompositionofitsshort-termfunds.a. AfinancialplanhastoconsiderCapitalstructure,Capitalexpenditureandcashflow.b. Wealth maximisation refers to maximising the net wealth of the company's share holdersc. Goaloffinancialmanagementofafirmismaximisationofeconomicwelfareofitsshareholdersd.

The earnings theory of Capitalisation recognises the fact that the _________ of an enterprise depends upon its 4. earnings and earning capacity.

false valuea. total valueb. true valuec. half valued.

Which of the following cost is not visible but it may seriously affect the company's operations especially when 5. itisexposedtobusinessandfinancialrisk.

Explicit costa. Implicit costb. Direct costc. Indirect costd.

Match the following6. Concept Description

A. Explicit cost 1. A process by which funds required for each course of action is decided

B. Financial Planning 2. This involves huge investment and yield a return over a period of time in future.

C. Long-term assets 3.Thecurrentassetsthatcanbeconvertedintocashwithinafinancialyearwithout diminution in value

D. Short-term assets 4.Thecostintheformofcouponrate,costoffloatingandissuingthesecuritiesA-2, B-1, C-4, D-3 a. A-4, B-3, C-1, D-2b. A-4, B-1, C-2, D-3c. A-1, B-2, C-3, D-4d.


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___________ is the operational activity of a business that is responsible for obtaining and effectively utilising 7. thefundsnecessaryforefficientoperations.

Financial planninga. Financial managementb. Asset managementc. Budget managementd.

______________isamajordecisionmadebythefinancemanagerontheformulationofdividendpolicy.8. Investment decisiona. Financing decisionb. Dividend decisionc. Accounting decisiond.

Financing decisions relate to the acquisition of funds at the _________ cost.9. maximuma. lessb. morec. leastd.

Whichamongthefollowingistheprimarygoaloffinancialmanagementofafirm?10. Maximisation of economic welfare of its shareholdersa. Encouragement to competitionb. Fall in dividend ratesc. Effective utilisation of fundsd.

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Chapter II

Time Value of Money

Aim


explain the concept of time, value and money•

explain simple and compound interest•

elucidate variable compounding periods•

Objectives


explainthecompoundvalueofseriesofcashflows•

elucidate the concept of doubling period and sinking fund factor•

explicate the concept of present value•

Learning outcome


describe the sinking fund factor with its formula for calculation•

understand the concept of loan amortisation•

identify shorter discounting periods•


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2.1 Introduction to Time Value of MoneyOneofthemostfundamentalconceptsinfinanceisthatmoneyhasa“timevalue.”Thatistosaythatmoneyinhand today is worth more than money that is expected to be received in the future. This leads us to summarise the conceptoftimevalue:“ARupeetodayisworthmorethanaRupeetomorrow."

Concept - Time value of moneyA rupee, which is received today, is more valuable than a rupee receivable in future. The amount that is received earlier period can be reinvested and it can earn an additional amount. Therefore, people prefer to receive the rupee that is receivable at the earliest.

Rationale of time preference for moneyIndividual prefers value opportunity to receive money now rather than waiting for one or more years to receive the same. It is referred to as an individual's time preference for money. There are three reasons that may be attributed to the individual's time preference for money:

Uncertainty:Futureisuncertainanditinvolvesrisk.Anindividualisnotcertainaboutfuturecashinflows.•Hence, the individual would prefer to receive cash toady instead of future.Current consumption: Most of the people prefer to use the present money for satisfying existing present •needs.Possibility of investment opportunity: The reason why individuals prefer present money is due to the possibility •of investment opportunity through which they can earn additional cash.

2.2 Simple InterestSimple interest is the interest paid on only the original amount, or principle borrowed. Simple amount is a function of three components such as principle amount borrowed or lent, interest per annum and the number of years for which the interest rate is calculated. Symbolically:SI = Po (I) (n)Where,SI= Simple interest, Po= Principle amount at year '0', I= Interest rate per annumn=Number of year for which interest is calculated

For instance Mr. Dorabjee has deposited Rs.1,00,000 in a Savings bank account at 7 per cent simple interest and interest and interested to keep the deposit for a period of 5 years. He requested you to give accumulated interest end of the years.

Solution: SI = Po (I) (n) = Rs.1, 00,000 X 0.07 X 5 years= Rs. 35,000If an investor wants to know his total future value at the end of 'n' years. Future value is the sum of accumulated interest and the principal amount. Symbolically:FVn = Po + Po (I) (n) OR SI + Po

For instanceManish annual savings are Rs. 1000, which is invested in a bank saving fund account that pays a 5 % simple interest. Krishna wants to know his total future value or terminal value at the end of 8 years period.

Solution: FVn = Po + Po (I) (n) OR SI + PoFVn = Rs. 1000 + Rs. 1000 (0.05) (8) = Rs. 1,400

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2.3 Compound InterestHerethefuturevaluesofallcashinflowsattheendofthetimehorizonataparticularrateofinterestarefound,interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the firstcompoundingperiod.

There is no difference between simple interest and compound interest when there is only one time investment yearly compounding, and for only one year maturity. But the difference can be seen only when the investment is made for more than two years. Compounding interest is also referred as future value (FV).

2.3.1 Compounding Value of a Single AmountCompound value or future value on an account can be calculated by the following formula.CV = Po (1 + I) nWhere, CV = Compound value, Po = Principal amount, I = Interest per annum, n = Number of years for which compound is done(1 + I) n = CVIF I…..n or future value inter factor for interest and 'n' years.Forinstance:SupposeyouhaveRs.10,00,000todayandyoudeposititwithafinancialinstitute,whichpay8%compound interest for a period of 5 years. Show how the deposit will grow.Solution: CV = Po (1 + I) nCV5 = 10, 00,000(1+0.08)5= 10, 00,000 (1.469*)CV5 = Rs. 14, 69,000Note: * See compound value of one rupee Table for 5 years at 8 % rate of interest.

2.3.2 Variable Compounding PeriodsGenerally compounding is done once in a year. In the above problem, we assumed that the compounding is done annually. If the investor promised to pay compound interest for variable periods, compound value with variable compound periods is determined with the following formula. Where,

CVn = Compound value at the end of year 'n', Po = Principal amount at the year '0', I = Interest per annum, m = Number of times per year compounding is donen = Maturity period

For instance (Semi compounding): How much does a deposit of Rs. 40,000 grow to at the end of 10 year at the rate of 6 % interest and compounding is done semi-annually. Determine the amount at the end of 10 years.

Solution:

= Rs. 40,000 [*1.86] = Rs. 72,240

Note: * See compound value of one rupee Table for 20 years at 3 % rate of interest.ForInstance(Quarterlycompounding):SupposethatafirmdepositsRs.50lakhsattheendofeachyearfor4yearsat the rate of 8 % interest and compounding is done on quarterly basis. What is the compound value at the end of 4 year?

Solution:

= Rs. 50, 00,000 [CVIF 2%..........16y] = Rs. 50, 00,000 x 1.373 = Rs. 68, 65,000


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Calculation of Compound Growth RateCompound growth rate can be calculated with the following formula:gr: Where gr= Growth rate in percentageV= Variable for which the growth rate is needed to found (i.e. sales, revenue, dividend at the end of year '0')Vo = Variable value at the end of year 1Vn = Variable value (amount) at the end of year 'n'

For instance: From the following dividend data of a company calculate compound rate of growth for period (1998-2003).

Year 1998 1999 2000 2001 2002 2003Dividend per share (Rs.) 21 22 25 26 28 31

Solution:

gr= 8%

Note SeecompoundonerupeeTablefor5years(totalyears–oneyear)tillyoufindclosestvaluetothecompoundfactor,at closest value see upward to the table to get growth rate.

Compound Value of Series of cash FlowsAnnuitymeansaseriesofcashflows(infloworoutflow)ofafixedamountforaspecifiednumberofyears.Compoundvalueofaseriesofcashflowscanbecalculatedbythefollowingformula(unevencashflows)

Where CVn= Compound value at the end of' 'n' yearP1 = Payment at the end of year 1, P2 = Payment at the end of year 2Pn = Payment at the end of year 'n', I = Interest rateCVn = P1 (CVIF I.1) + P2 (CVIF I.2) + …………… Pn (1+I I.n)

For instanceMr. Shyam deposits Rs. 5,000, Rs. 10,000, Rs. 15,000, Rs. 20,000 and Rs. 25,000 in his savings bank account in year 1,2,3,4 and 5 respectively. Interest rate of 6 %, he wants to know his future value of deposits at the end of 5 years.Solution: + +

= 6,610 + 11,910 + 16,860 + 21,200 + 25,000= Rs. 81,280

Compound Value of Annuity (Even Cash Flow)Annuityisaseriesofevencashflowsforaspecifiedduration.Itinvolvesaregularcashoutfloworinflow.ForinstancelikethepaymentofLICpremium,depositinginarecurringdepositaccount,andthelike.Cashflowsmayhappeneitherattheendofyearorbeginningoftheyear.Ifcashflowshappenatthebeginningoftheyear,itiscalledasanannuitydue,whereaswhenthecashflowshappenattheenditiscalledasaregularordeferredannuity.

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Compound Value of Deferred AnnuityFor instance: Mr. Ram deposits Rs. 500 at the end of every year for 6 years at 6 % interest. Determine Ram's money value at the end of 6 years.

Solution:

+

= 500(1.338) + 500(1.262) + 500(1.191) + 500(1.124) + 500(1.060) + 500(1.00)= 669 + 631 + 595.5 + 562 + 530 + 500 = Rs. 3487.5Short cut formula for the above is:

Where,P=Fixedperiodiccashflow,I–Interestraten = duration of the amount

= (CVIFA I.n)

(CVIFA I.n) = Future value for interest fact or annuity at 'I' interest and for 'n' years.For the example above this formula can be used as below. = 500(6.975)= Rs. 3,487.5Note: See compound value interest factor annuity Table of one rupee Table for 6 years at 6 % interest.

Compound Value of Annuity DueWhenthecashflowsinvolvesatthebeginningoftheyearcompoundvalueofannuityiscalculatedwiththefollowingformula: OR

For instance Suppose you deposit Rs. 2,500 at the beginning of every year for 6 years in a saving bank account at 6 % compound interest. What is your money value at the end of 6 years?

Solution:

= 2,500 (6.975) (1+0.06)= Rs. 18, 4863.75

2.4 Doubling PeriodDoubling period is the period required to double the amount invested at a given rate of interest.

Doubling period can be computed by adopting two rules:Rule of 72: To get doubling period, 72 is dividend by interest rate.•

Doubling period (DP) = 72 ÷ IWhere I = Interest rate, (%)DP = Doubling period in years


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For instance:If you deposit Rs. 500 today at 10 % of interest in how many years will this amount double?Solution: DP = 72÷ I = 72 ÷ 10 = 7.2 years (approx.)

Rule of 69Rule of 72 may not give exact doubling period, but rule of 69 gives a more accurate doubling period. The formula to calculate doubling period isDP =0.35 + 69/IFor instance: If you deposit Rs. 500 today at 10 % of interest in how many years will this amount double?Solution: 035 + 69/10 = 7.25 years

Effective rate of interest (ERI) in case of doubling periodEffectiverateofinterestcanbedefinedwiththeuseoffollowingformula.

In case of rule of 72•ERI = 72 ÷ Doubling period (DP)Where ERI = effective rate of interest, DP = Doubling period

In case of rule of 69•

For instanceAfinancialinstitutehascomewithanoffertothepublic,wheretheinstitutepaysdoubletheamountinvestedinthe institute at the end of 8 years. Mr. A who is interested to deposit with institute wants to know the effective rate of interest that will be given by institute.Solution as per rule of 72: 72 ÷ 8 years = 9 %

Solution as per rule of 69: = 9 % (approx.)

2.5 Present ValueThepresentvalueofafuturecashinflow(oroutflow)istheamountofcurrentcashthatisofequivalentvaluetothepresentvalue.Theprocessesofdeterminingpresentvalueoffuturecashflowsarecalleddiscounting.Itisconcernedwith determining the present value of a future amount, assuming that the decision maker has an opportunity to earn a certain return on individual's money. This return is referred as discount rate, cost of capital or an opportunity cost. Present value of a single amountPresent value can be calculated by the following formula:

OR

PV = Present value

= Future value receivable at the end of 'n' yearsI = Interest rate or discounting factor or cost of capitaln=Durationofthecashflow

= present value interest facts at 'I' interest and for 'n' years

For instanceAninvestorwantstofindthepresentvalueofRs.40,000due3years.Hisinterestrateis10%.

Solution: = Rs. 40,000 [1= Rs. 40,000 (0.751*)

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= Rs. 30,040Note: * Present value of one rupee Table at 3 years for the arte of 10 %

Present value of a series of cash flowsWehavecalculatedthepresentvalueofasingleamounttobereceivedafteraspecifiedperiod.Inmanycases,wemayneedtocalculatepresentvalueofseriescashflows.Forexample,incapitalbudgetingdecisions,thereisaneedtoconvertthefuturecashinflowsintopresentvaluestotakedecisionandincaseofraisingfundsthroughdebtalsoneedstoconvertthefuturecashoutflowsintopresentvalues.Cashflowsoveraperiodmaybeevenoruneven.

Present Value of Uneven Cash Flows

OR + …… +

PV = Present valueI = Interest rate or discounting factor or cost of capitaln=Durationofthecashinflowsstreamt=Yearinwhichcashinflowsarereceivable

For instanceFrom the following information, calculate the present value at 10% interest rate.

Year 0 1 2 3 4 5Cashinflow(Rs.) 2,000 3,000 4,000 5,000 4,500 5,500

Solution:

= 2,000+ 2,727 + 3,304 + 3,755 + 3,073.5 + 3,415.5 = Rs. 18,275

Present Value of even Cash Flows (annuity)

PVA = Present value of annuityI = Interest rate or discounting factorn = Duration of the annuityCIF=Cashinflows

For instance Mr.RamwishestodeterminethePVoftheannuityconsistingofcashflowsofRs.40,000perannumfor6years.The rate of interest he can earn from his investment is 10 %.

Solution:

= Rs. 40,000 X = Rs. 4000 X * 4.355 = Rs. 17,420*See present value of annuity for 6 years at 10 %


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Present Value of Annuity Due

(1+I)

For instance: Mr. Krishna has to receive Rs. 500 at the beginning of each year for 4 years. Calculate present value of annuity due assuming 10 % rate of interest.

Solution: = Rs. 1,743.5

2.6 Effective Vs Nominal RateNominal rate of interest or rate of interest per year is equal. Effective and nominal rate are equal only when the compounding is done yearly once, but there will be a difference, that is effective rate is greater than the nominal rate for shorter compounding periods. Effective rate of interest can be calculated with the following formula.

Where, I = Nominal rate of interestm = Frequency of compounding per year.

For instanceMr. Y deposited Rs. 1,000 in a bank at 10% of rate of interest with quarterly compounding. He wants to know the effective rate of interest.

Solution: = 1.1038-1= 0.1038 OR 10.38 %

2.7 Sinking Fund FactorFinancial manager may need to estimate the amount of annual payments so as to accumulate a predetermined amount after a future date to purchase assets or to pay a liability. The following formula is useful to calculate the annual payment.

Where, = Annual payment, , I = Interest rateFor instance: Finance manager of a company wants to buy an asset costing Rs. 1, 00,000 at the end of 10 years. He Requestsyoutofindouttheannualpaymentrequired,ifthesavingsearnaninterestrateof12%perannum.Solution:

= 1, 00,000 (0.12/2.1058)= Rs. 5.689

Present Value of PerpetuityPerpetuityisanannuityofinfiniteduration.Itmaybeexpressedas:Where: PV = Present value of a perpetuityCIF=Constantannualcashinflow

= PV interest factor for perpetuity = CIF/I

For instance: Mr. X an investor expects a perpetual amount of Rs. 1000 annually from his investment. What is his present value of perpetuity if the interest rate is 8 %?Solution: = CIF/I

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= 1000/0.08 = Rs. 12,500

2.8 Loan AmortisationLoanisanamountraisedfromoutsidersataninterestandrepayableataspecifiedperiod.Paymentofloanisknownas amortisation. Financial manager may take loan and may be interested to know the amount of equal installment to be paid every year to repay the complete loan amount including interest. Installment can be calculated with the following formula.

OR LI

Where:LI=Loaninstallment,=Principalamount,I=Interest,n=Loanrepaymentperiodatspecifiedinterestrate.

For instance: ABC company raised Rs. 10, 00,000 lakhs for an expansion program from IDBI at 7% interest per year. The amount has to be repaid in 6 equal annual installments. Calculate the installment amount.

Solution: = 10, 00,000 ÷ 7.767= Rs. 1, 28,750

Present Value of Growing AnnuityGrowingannuitymeansthecashflowsthatgrowataconstantrateforaspecifiedperiodoftime.Steps involved in calculation of growing annuity:

Calculatetheseriesofcashflows•Converttheseriesofcashflowsintopresentvaluesatagivendiscountfactor•AddallthepresentvaluesofseriesofcashflowstogettotalPVofagrowingannuity•

Formula:

PVGA= PV of growing annuityCIF=Cashinflowsg= Growth rateI = discount factorn= Duration of the annuity

For instance: A Real estate Agency has rented out one of their apartment for 5 years at an annual rent of Rs. 6,00,000 with the stipulation that rent will increase by 5% in every year. If the agency's required rate at return is 14%. What is the PV of expected (annuity) rent?

Solution: Calculate on series of annual rentYear Amount of Rent (Rs.)1 6,00,000 2 6,00,000 X (1+0.05) 6,30,0003 6,30,000 X (1+0.05) 6,61,5004 6,61,500 X (1+0.05) 6,94,5755 6,94,575 X (1+0.05) 7,29,303.75


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2.9 Shorter Discounting PeriodsGenerallycashflowsarediscountedonceayear,butsometimescashflowshavetobediscountedlessthanone(year) time, like, semi-annually, quarterly, monthly or daily. The general formula used for calculating the PV in the case of shorter discounting period is:

Where,PV=Presentvale,=Cashinflowafter'n'year,m=No.oftimesperyeardiscountingisdoneI= Discount rate

For instance: Mr. P expected to receive Rs. 1, 00,000 at the end of 4 years. His required rate of return is 12% and he wants to know PV of Rs. 1, 00,000 with quarterly discounting.Solution: = 1, 00,000 X = 1, 00,000 X 0.623= Rs. 62,300

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SummaryOneofthemostfundamentalconceptsinfinanceisthatmoneyhasa“timevalue.”Thatistosaythatmoney•in hand today is worth more than money that is expected to be received in the future.Simple interest is the interest paid on only the original amount, or principle borrowed. •Simple amount is a function of three components such as principle amount borrowed or lent, interest per annum •and the number of years for which the interest rate is calculated.Doubling period is the period required to double the amount invested at a given rate of interest.•Thepresentvalueofafuturecashinflow(oroutflow)istheamountofcurrentcashthatisofequivalentvalue•to the present value. Effective and nominal rate are equal only when the compounding is done yearly once, but there will be a •difference, that is effective rate is greater than the nominal rate for shorter compounding periods.Loanisanamountraisedfromoutsidersataninterestandrepayableataspecifiedperiod.Paymentofloanis•known as amortisation.

ReferencesIntroduction to the Time Value of Money,• [Online] Available at: <https://www.boundless.com/accounting/time-value-money/introduction-to-time-value-money/>[Accessed27May2013].Introduction to the Time Value of Money• ,[Pdf]Availableat:<http://www2.fiu.edu/~changch/Chapter2_4.pdf>[Accessed 27 May 2013].Paramasivan, C. & Subramanian, T., 2009. • Financial Management, New Age International.Ramagopal, C., 2008. • Financial Management, New Age International.2013. • Financial Management: Lecture 2, Chapter 5: Part 1 - Time Value of Money, [Video online] Available at:<http://www.youtube.com/watch?v=vpJszYCLH3o>[Accessed27May2013].Prof. Ahmed, M., 2010. • Time Value of Money, [Video online] Available at: <http://www.youtube.com/watch?v=CnRJ6Jypsj4>[Accessed27May2013].

Recommended ReadingDrake, P. P., 2009. • Foundations and Applications of the Time Value of Money. WileyBenninga, S., 2006. • Principles of Finance with Excel. Oxford University Press, USABlock, S., 2008. • Foundations of Financial Management w/S&P bind-in card + Time Value of Money bind-in card. 13th ed., McGraw-Hill/Irwin.


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Self Assessment

Individual prefers ________opportunity to receive money now rather than waiting for one or more years to 1. receive the same

valuea. moneyb. interestc. principled.

________isanamountraisedfromoutsidersataninterestandrepayableataspecifiedperiod2. Moneya. Loanb. Principlec. Valued.

________ rate of interest or rate of interest per year is equal3. Sinkinga. Present valueb. Nominalc. Principled.

Thepresentvalueofafuturecashinflow(oroutflow)istheamountof_________cashthatisofequivalent4. value to the present value

currenta. futureb. pastc. lostd.

Which of the following statements is false?5. Annuityisaseriesofoddcashflowsforaspecifieddurationa. Simple interest is the interest paid on only the original amountb. Growingannuitymeansthecashflowsthatgrowataconstantrateforaspecifiedperiodoftimec. Theprocessesofdeterminingpresentvalueoffuturecashflowsarecalleddiscountingd.

Compounding interest is also referred as __________.6. future value a. current valueb. asset valuec. amount valued.

________ period is the period required to double the amount invested at a given rate of interest.7. Compoundinga. Growthb. Discountingc. Doublingd.

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Ifcashflowshappenatthebeginningoftheyear,itiscalledasan?8. Annuity duea. Deferred annuityb. Regular annuityc. Mixed annuityd.

A rupee, which is received today, is more valuable than a rupee receivable in ______.9. pasta. presentb. futurec. todayd.

Theprocessofdeterminingpresentvalueoffuturecashflowsiscalled?10. Sinkinga. Billingb. Discountingc. Amountingd.


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Chapter III

Valuation of Bonds and Shares

Aim


explain the concept of valuation•

explicate types of values•

elucidate the basic bond valuation model•

Objectives


explain various types of bonds•

explicate bond valuation•

elucidate redeemable bond•

Learning outcome


understand relationship between bond value and time to maturity period•

identify zero coupon bonds•

describe current yield •

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3.1 Introduction to ValuationValuation is the process of linking risk with returns to determine the worth of an asset. The value of an asset depends onthecashflowitisexpectedtoprovideovertheholdingperiod.Thefactisthat,asondatethereisnomethodbywhich prices of shares and bonds can be accurately predicted. It should be kept in mind by an investor before one decides to take an investment decision.

3.2 Nature of ValueBook value: It is an accounting concept. Assets are recorded in balance sheet at their book values. Book value •of an asset is cost of acquisition less accumulated depreciation. It is determined by the formula below.

Market value: Market value of an asset is the price at which the asset is bought or sold in the market. Market •valuepershareisgenerallyhigherthanthebookvaluepershareforprofitableandgrowingfirms.Goingconcernvalue:Itisthevaluethatafirmcanberealisedifitsellsitsbusinessasacontinuingoperating•business. This value would be higher than the liquidation and book value. Valuation of securities is always consideredasgoingconcern,becauseifthefirmisnotrunning,investorswouldnotinvestinsecuritiesLiquidation value: Liquidation value is the actual amount that can be realised when an asset is sold. Liquidation •valueofaequitystockistheactualamountthatwouldbereceivedifallofthefirm'sassetsweresoldattheirmarket value, liabilities were paid, and the remaining proceeds were by number of equity shares outstanding.

Intrinsicvalue:Investorsinvestonequitystockwithanexpectationofintrinsiccashinflowstream.Thepresent•value of the cash inflows expected froma security over its holdingperiod.Present value is computedbydiscountingfuturecashinflowsatanappropriaterate.Itisalsocalledeconomicvalue.

3.3 Bond ValuationA bond is a legal document issued by the issuing company under is common seal acknowledging a debt and setting forth the terms under which they are issued and are to be paid. Bond is also known as 'debenture'. Bonds are issued bydifferenttypesoforganisationslikethegovernment,financialinstitutions,publicsectorundertakingandprivatesector organisations.

Few important terms in bond valuation are as follows:Par value: The par value (Face Value) is stated on the face of the bond. It is the amount at which a bond is issued •to public, and promises to pay either at the end of maturity period or in pre-decided installments.Coupon rate: Coupon rate is the interest rate with which a bond is issued. The interest payable at regular intervals •is the product of the par value and the coupon rate broken down to the relevant time horizon.Maturity period: Refers to the number of years after which the par value becomes payable to the bond-holder.•Redemption value: It is the amount the bond-holder gets on maturity. A bond may be redeemed at par, at a •premium (bond-holder gets more than the par value of the bond) or at a discount (bond-holder gets less than the par value of the bond)Market value: It is the price at which the bond is traded in the stock exchange. Market price is the price at which •the bonds can be bought and sold and this price maybe different from par value and redemption value.


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3.3.1 Types of BondsFollowing are the types of bonds:Redeemable BondA bond which the issuer has the right to redeem prior to its maturity date, under certain conditions. The appropriate discount rate is cost of debt (kd) required rate of return on bond (debenture).

OR

Where,

BVo = Value of bond (debenture) at time 'zero'I = Annual interest paid per yearM = Maturity of bondN = Number of years to maturitykd= Required rate of return, or cost of debtPVIF = Present value interest factorPVIFA = Present value interest factor annuity

For instance: AB company issues Rs. 1,000 par value bond at 12%. The bond is redeemable after 10 years. Determine value of bond assuming required rate of return is 14%.Solution:

BVo = (Rs.120 X 5.216) + (Rs. 1,000 X 0.270)BVo = Rs. 625.92 + Rs. 270BVo = Rs. 895.92

Bond values with semi-annual interestWith the effect of compounding, the value of bonds with semi-annual interest is much more than the ones with annualinterestpayments.Hencethebondvaluationequationcanbemodifiedas:

OR

For instance: MNC company issues bonds with face value of Rs. 1,000 each, at 12% per coupon rate with interest payable semi-annually. The bonds are redeemable after 5 years. Determine value of bond if required rate of return on this type of bond is 14%.

Solution: BVo = (Rs. 60 X 7.024) + (Rs. 1,000 X 0.508= Rs. 421.44 + Rs. 508= Rs. 929.44

Irredeemable BondIrredeemablebondisthebondwhichisnotrepaidtillclosingofthefirm.Itisthebondwithoutmaturityperiod.Value of perpetual bond is determined by the following formula.

OR

For instance: A company has issued 12 % perpetual bond of Rs. 1,000 each. Determine value of bond assuming 15 % cost of debt.

Solution: BVo = = Rs.120/.015 = Rs.800

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Zero Coupon BondsIn India Zero coupon bonds are also known as Deep discount bonds. These bonds have no coupon rate, that is, there is no interest to be paid out. Instead, these bonds are issued at a discount to their face value, and the face value is the amount payable to the holder of the instrument on maturity. The difference between the discounted issue price and face value is effective interest earned by the investor. These are called deep discount bonds because these bonds are long term bonds whose maturity some time extends up to 25 to 30 years.

3.4 Bond YieldsAlong with the bond value, investors are also interested in knowing the yield on bonds. Yields on bonds can be measured by applying various measures. They are:

Yield to Maturity (YTM)Itistherateofreturnthataninvestorearnsiftheybuyabondataspecificpriceandholdituntilmaturity.

If bond is sold at par and realised par value fully then yield to maturity equals to interest rate YTM is computed by using the following formulae.

Where,

SP = Sales proceeds a bond (price of bond)I = Annual Interest payment (Rs.)M = Maturity value of bondn= Maturity periodKd= Yield to maturity

Illustration: XYZ company bond, currently sells for Rs.1, 000 (Face value 900) it has a 10% interest rate, and with a maturity period of 10 years.

OR

Alternatively

Years CIFs (Rs.) DF PV (Rs.)10% 6% 10% 6%

1 to 10 90 6.145 7.360 553.05347.40

662.4502.2

10 900 0.386 0.558 900.451000.00

1164.61000.00

(-) Sales price (-)99.55 164.6

Yield to maturity:

=

= 6% +

= 6% + 2.49


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= 8.49 %

Yield to Call (YTC)Yield to call is exactly similar to YTM, but here yield is found till the call of the bond. Some corporate issues bonds with call feature that allows the company call back the bond before maturity period. In such cases bond holder would not have the option of holding the bond until the maturity period. Therefore, YTM would not ne earned. YTC is computed with the following formula:

Where, CP = Call price of bond, n*= Number of years until the assumed call date

For instance: ABC company issues 10 % callable bonds with a face value of Rs. 1000. The bond is currently selling of Rs. 1,100. Maturity period is 10 years. Determine YTC assuming company calls bonds after 5 years because interest rate has fallen by 2% at Rs. 1000.

Solution:

Years CIFs (Rs.) DF PV (Rs.)10% 5% 10% 5%

1 to 5 100 100 3.791 379.1621.0

432.9784

5 1000 1000 0.621 1000.11100

1216.91100.00

(-) Current price (-)99.55 116.9

Yield to Call =

= 5% +

= 5% + 2.69

= 7.69 %

Current yieldIt is the yield that relates to the annual interest to the annual interest to the current market price.

CurrentYield=ICMPWhere: I = Annual Interest (Rs.)CMP = Current market price

For instance: From the following determine current yield on a bond

Face value of bond – Rs.1200Interest Rate – 13 %Maturity – 10YearsCurrent market price – Rs. 1000

Solution:

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From the above calculation we can see that yield represents analyse interest rate, it excludes capital gain or loss. It ignores time value of money. Therefore, it is not a accurate measure of the bonds expected return.

3.5 Bond Value BehaviorsFollowing are the bond values discussed below.

3.5.1 Required Rate of Return and Bond ValuesWheneverthereischangeintherequiredrateofreturn,bondvalueshowsfluctuationsfromitsparvalue.Requiredrateofreturnmaychange,duetoshiftinthebasiccostoflong-termsourcesoffinance,andthechangeinthefirm'srisk level.

Let us determine value of bond considering the following three cases.

Value of bond when interest-rate equals to required rate of return – in this case value of bond is equals to par •value.

For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors required rate of return is 12%. Determine value of bond.

Solution:

B = (Rs.120 X4.111) + (Rs. 1,000 X 0.507)= Rs. 493.32 + 507= Rs. 1,000

Value of bond when required rate of return is higher than the interestrate– in this case value of bond would •be less than par value

For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors required rate of return is 15%. Determine value of bond

Solution:

B = (Rs.120 X3.784) + (Rs. 1,000 X 0.432)= Rs. 454.08 + 432= Rs. 886.08

Value of bond when required rate of return is less than interest rate – In this case, value of bond would be above •par value.

For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors required rate of return is 10%. Determine value of bond

Solution:

B = (Rs.120 X4.355) + (Rs. 1,000 X 0.564)= Rs. 522.60 + 564= Rs. 1086.6


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In nutshell the relationship between bond values and required rate of return is given below:InterestRate>RequiredRate:BondValue>ParValue•Interest Rate = Required Rate: Bond Value = Par Value •Interest Rate < Required Rate: Bond Value < Par Value •

3.5.2 Time to Maturity and Bond Values

Value of Bond: When I (%) = Kd (%) and change in the time period- In this case value of bond is equals to par •value, whatever may be the maturity period.For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period •is 10 year. Required rate of return is 10%. Determine value of bond when time period is (i) 5 years, and (ii) 15 years.

Solution: Value Bond: I(%) = Kd (%) [10%=10%]

Maturity Period Equation Value of Bond (Rs.)(i) 5 years10 years

(ii) 15 years

(100 X3.79)+(1000X0.621)(100 X6.145)+(1000X0.386)(100 X7.606)+(1000X0.239)

379 + 621= 1,000614 + 386 = 1,000761 + 239 = 1,000

Value of bond remains same (at par value) when interest rate equals to required rate of return, with the change •in time period to maturity.Value of Bond: When I (%) < Kd (%) and change in the time period - In this case, value of bond decreases •when the time period to maturity increases and vice versa.For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period •is 10 year. Required rate of return is 12%. Determine value of bond when time period is (i) 5 years, and (ii) 15 years.

Solution: Value Bond: I(%)< Kd (%) [10% < 12%]

Maturity Period Equation Value of Bond (Rs.)(i) 5 years 10 years(ii) 15 years

((100 X3.605)+(1000X0.567)(100 X5.650)+(1000X0.322)(100 X6.811)+(1000X0.183)

360.5 +567 = 927.5565 + 322 = 887

681.1 + 183 = 864.1

Value of bond decreases with the increase time period of maturity.

ValueofBond:WhenI(%)>Kd(%)andchangeinthetimeperiodtomaturity–Inthiscasevalueofbond•increases when time period to maturity increases.For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period •is 10 year. Required rate of return is 6%. Determine value of bond when time period is (i) 5 years, and (ii) 15 years.

Solution:ValueBond:I(%)>Kd(%)[10%>6%]

Maturity Period Equation Value of Bond (Rs.)(i) 5 years10 years

(ii) 15 years

(100 X4.212)+(1000X0.747)(100 X7.360)+(1000X0.558)(100 X9.712)+(1000X0.417)

421.2 + 747 = 1,168.20736 + 558 = 1,294

971.2 + 417 = 1,388.2

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Value of bond increased when increase in time period for maturity

3.5.3 Relationship between Bond Value and Time to Maturity PeriodFigurebelowshowstherelationshipbetweentimetomaturityperiod;requiredreturnandbondvalue.

1,600

1,400

12971,200

10001168

800

887

600

400

200

10 9 8 7 6 5 4 3 2 1 0

Premium BondRequired Rate 6%

Face value bond

Required Rate 10%

Discount BondRequired Rate 12%

Fig. 3.1 Bond value and time to maturity

Followingpointscanbeextractedfromthefigureabove:When required rate of return equals to coupon rate, a bond will sell at face value. At the time of issue of bond •interest rate is set at par with required rate of return, to sell bond of par initially.When required rate of return increases above coupon rate then, the bond value falls below par value. Such bond •is known as 'discount bond'.When required rate of return falls below the interest rate, then the band values goes above par value. This bond •is called as 'premium bond'Increase in required rate of return affects bond values (go up or fall below par value).•Marketvalueofbondwillalwaysreachitsfacevaluebytheendofitsmaturityperiod,providedthefirmdoes•not go bankrupt.

3.6 Valuation of SharesA company's shares may be categorised as

Ordinary / Equity shares•Preference shares•

The returns these shareholders receive are called dividends. Preference shareholders get a preferential treatment as to the payment of dividend and repayment of capital in the event of winding up. Such holders are eligible for a fixedrateofdividends.Someimportantfeaturesofpreferenceandequitysharesare.

Dividends Rateisfixedforpreferenceshareholders.Theycanbegivencumulativerights,thatis,thedividendcanbepaidoffafteraccumulation.Thedividendrateisnotfixedforequityshareholders.Thedividendrateisnotfixedforequityshareholders.


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ClaimsIn the event of the business closing down, the preference shareholders have a prior claim on the assets of the company. Theirclaimsshallbesettledfirstandthebalanceifanywillbepaidofftoequityshareholders.

RedemptionPreference shares have a maturity date on which day the company pays off the face value of the share to the holders. Preference shares are of two types – redeemable and irredeemable.

ConversionAcompanycanissueconvertiblepreferenceshares.Afteraparticularperiodasmentionedinthesharecertificate,the preference shares can be converted into ordinary shares.

3.6.1 Valuation of Preference SharesPreferencesharegivessomepreferentialrightstopreferencestockholders.Thepreferentialrightsarepaymentoffixedrate of dividend and payment of principal amount at the time of liquidation, before paying to equity stockholders. Valueofpreferencestockisthepresentvalueoffixedannualdividendsexpectedandheprincipalamount.

OR

Where, = Value of Preference stock = Preference dividend (Rs.)

= Required rate of return (%) or cash of preference share

PVIFA = Present value interest factor annuityPVIF = Present value interest factor

For instance ABC company issued 12% perpetual preference stock with a face value of Rs. 100. Compute value of preference stock assuring 14% require rate of return.

Solution: = = Rs. 85.71

For instance A company issued 12% preference stock with a face value of Rs. 100, redeemable after 5 years. Required rate of return is 10%. Determine value of preferred stock.

Solution: = (Rs.12 X 3.791) + (100x 0.621)= Rs. 45.492 + 62.1= Rs. 107.592

3.6.2 Valuation of Equity/Ordinary SharesPeople hold common stocks for two reasons:

To obtain dividends in a timely manner •To get a higher amount when sold.•

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Thevalueofasharewhichaninvestoriswillingtopayislinkedwiththecashinflowsexpectedandrisksassociatedwiththeseinflows.Intrinsicvalueofashareisassociatedwiththeearnings(past)andprofitability(future)ofthecompany,dividendspaidandexpectedandfuturedefiniteprospectsofthecompany.

Basic share valuation modelStockvalueispresentvalueoffuturecashinflows(dividends)thatitisexpectedtoprovideoveraninfinitetimehorizon. An investor who buys a stock with the intention of holding in forever, on this case the value of equity stock isthepresentvalueofastreamofdividendsexpectedoveraninfiniteperiod.

Where: ESo = Value of equity stock Dt = Expected dividend per share at the end of year 't' Ke = Required return on equity (cash of equity)

Under this we learn valuation of equity share using three models:Zero growth•Constant growth•Variable growth•

Single period valuationHere the value of the equity share is determined assuming an investors holds stock for one year period.

Where, = Value of stock = expected dividend at the end of one year = Price of the share at the end of one year = Required rate of return

For instance Mr. A purchased an equity stock of Gokul Company at Rs. 100 per share, it is expected to provide a dividend of Rs. 10 per share, and fetch a price of Rs. 110 after one year. Compute stock value assuming required date of return.

Solution:

= (Rs. 10x0.877) + (Rs. 110 X 0.877)= Rs.8.77 + Rs. 96.47= Rs. 105.24

Zero Growth Model: It is the model under which value of stock is determined assuming dividends are not •expected to grow, (non-growing). Here value of equity stock is the present value of perpetuity of dividends:

Constant Growth (Gorden) Model: In this model value of equity stock is valued assuming that dividends would •growth at a constant rate.


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VariableGrowthModel:Growthofthefirmshouldbedifferentlifecycle.Thatisintheearlystagesgrowth'smuch•be faster than that of economy as a whole. Economic growth in the later stages the growth comes down.

It is calculated in four step process.Compute the value of the dividends at the end of each year during the super normal growth period. •

Compute the present value of the dividends expected during the initial growth period •

Determine PV value of stock at the end of the initial growth period. •

PV of stock is

Add the PV found in step 2 and step 3 to get intrinsic value of stock. (ESo)•

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SummaryValuation is the process of linking risk with returns to determine the worth of an asset. The value of an asset •dependsonthecashflowitisexpectedtoprovideovertheholdingperiod.Book value is an accounting concept. Assets are recorded in balance sheet at their book values. Book value of •an asset is cost of acquisition less accumulated depreciation.Market value of an asset is the price at which the asset is bought or sold in the market. Market value per share •isgenerallyhigherthanthebookvaluepershareforprofitableandgrowingfirms.Liquidationvalueofaequitystockistheactualamountthatwouldbereceivedifallofthefirm'sassetswere•sold at their market value, liabilities were paid, and the remaining proceeds were by number of equity shares outstanding.A bond is a legal document issued by the issuing company under is common seal acknowledging a debt and •setting forth the terms under which they are issued and are to be paid.Irredeemablebond is thebondwhich isnot repaid till closingof thefirm. It is thebondwithoutmaturity•period.

ReferencesIntroduction to Bond Valuation• , [Pdf]Available at:<http://www.arts.uwaterloo.ca/~kvetzal/AFM271/bond.pdf>[Accessed28May2013].Bond Valuation,• [Online]Availableat:<http://www.prenhall.com/divisions/bp/app/cfl/BV/BondValuation.html>[Accessed 28 May 2013].Jonathan, B., 2010. • Financial Management, Pearson Education India.Shim, J. K. & Siege, J. G., 2008. Financial Management, 3rd ed., Barron's Educational Series.•Prof. Ahmed, M., 2012. • Bond Valuation, [Video online] Available at: <http://www.youtube.com/watch?v=tid0RVUmY3M>[Accessed28May2013].2012. • Value a Bond and Calculate Yield to Maturity (YTM), [Video online] Available at: <http://www.youtube.com/watch?v=pfhjJ00IuW4>[Accessed28May2013].

Recommended ReadingStaff, I., 2005. • Stocks,Bonds,Bills,andInflation2005Yearbook. Ibbotson AssociatesAgarwal, O.P., 2009. • International Financial Management. Global Media.Satyaprasad, B.G. & Raghu, G.A. 2010. • Advanced Financial Management.Global Media.


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Self Assessment

_________ is divided by the number of equity shows outstanding to get book value per share.1. Net wortha. Yieldb. Equity stockc. Premium bondd.

Value of bond equals to __________ value when required rate equals to interest rate.2. presenta. currentb. parc. netd.

Which of the following statements is false?3. Preference stock is also known as hybrid security.a. Liquidation value equals to value of assets minus value of liabilitiesb. Value of bond is less than par value when required rate of return than interest rate.c. Cashinflows,timingandrequiredreturnarethethreeinputsrequiredtovalueanyasset.d.

Bond value equals to par value when it reaches to __________ period.4. maturitya. premiumb. valuec. completiond.

Current yield relates to the annual interest to the current________.5. cost pricea. asset priceb. market pricec. specificpriced.

A bond is said to be premium bond when its value is:6. Higher than the par valuea. Less than the par valueb. Equal to than the par valuec. Higher than the present valued.

Intrinsicvalueisthe__________valueofcashflowsexpectedoveraseriesyearsofholdinganasset.7. cominga. goingb. presentc. netd.

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Preference stock is also known as:8. Equity stocka. Ordinary stockb. Hybrid securityc. Security stockd.

When required rate of return is different from the interest rate the length of time to maturity effects _______ 9. values.

bonda. equityb. sharec. netd.

Value of bond is less than par value when required rate of return higher than ________ rate.10. interesta. returnb. requiredc. presentd.


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Chapter IV

Cost of Capital

Aim


explain the concept of cost of capital•

elucidatethecostofdifferentsourcesoffinance•

explicate the capital asset pricing model approach•

Objectives


definethecostofequity•

determine the cost of preference shares – cost of irredeemable and redeemable share•

enlist the factors affecti• ng WACC

Learning outcome


understand the concept of Weighted Average Cost of Capital (WACC)•

identify the steps involved in the computation of WACC•

describe the importance of cost of capital•

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4.1 Introduction to Cost of CapitalCost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal providedbythebusinessconcern.Itisusedasadiscountrateindeterminingthepresentvalueoffuturecashflowsassociated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rateofreturn.Whenthefirmsareusingdifferentsourcesoffinance,thefinancemanagermusttakecarefuldecisionwithregardtothecostofcapital;becauseitiscloselyassociatedwiththevalueofthefirmandtheearningcapacityofthefirm.

Meaning of Cost of Capital Costofcapitalistherateofreturnthatafirmmustearnonitsprojectinvestmentstomaintainitsmarketvalueand attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retainedearnings.Ifafirmfailstoearnreturnattheexpectedrate,themarketvalueoftheshareswillfallanditwill result in the reduction of overall wealth of the shareholders.

DefinitionsThe following importantdefinitionsarecommonlyused tounderstand themeaningandconceptof thecostofcapital. AccordingtothedefinitionofJohnJ.Hampton“Costofcapitalistherateofreturnthefirmrequiredfrominvestmentinordertoincreasethevalueofthefirminthemarketplace”.

AccordingtothedefinitionofSolomonEzra,“Costofcapitalistheminimumrequiredrateofearningsorthecut-offrateofcapitalexpenditure”.

AccordingtothedefinitionofJamesC.VanHorne,Costofcapitalis“Acut-offratefortheallocationofcapitalto investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock”.

AccordingtothedefinitionofWilliamandDonaldson,“Costofcapitalmaybedefinedastheratethatmustbeearnedonthenetproceedstoprovidethecostelementsoftheburdenatthetimetheyaredue”.

Cost of capital from three different viewpointsInvestorsviewpoint:Themeasurementofthesacrificemadebytheindividualforcapitalformation"•Firm's view point: It is the minimum required rate of return needed to justify the use of capital. It is supported •by Hompton, John.Capital Expenditure view point: The cost of capital is the minimum required rate of return or the cut off rate •usedtovaluecashflows.

Importance of cost of capitalComputationofcostofcapitalisaveryimportantpartofthefinancialmanagementtodecidethecapitalstructureof the business concern. Following points illustrates the importance of cost of capital.

Importance to capital budgeting decision: Capital budget decision largely depends on the cost of capital of each •source.Accordingtonetpresentvaluemethod,presentvalueofcashinflowmustbemorethanthepresentvalueofcashoutflow.Hence,costofcapitalisusedtocapitalbudgetingdecision.Importance to structure decision: Capital structure is the mix or proportion of the different kinds of long term •securities.Afirmusesparticulartypeofsourcesifthecostofcapitalissuitable.Hence,costofcapitalhelpstotake decision regarding structure.Importance toevolutionoffinancialperformance:Costofcapital isoneof the importantdeterminewhich•affectsthecapitalbudgeting,capitalstructureandvalueofthefirm.Hence,ithelpstoevaluatethefinancialperformanceofthefirm.


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Importancetootherfinancialdecisions:Apartfromtheabovepoints,costofcapitalisalsousedinsomeother•areassuchas,marketvalueofshare,earningcapacityofsecuritiesetc.hence,itplaysamajorpartinthefinancialmanagement.

4.2 Cost of Different Sources of FinanceItcanbefurtherclassifiedintobelowmentionedcategories:

4.2.1 Cost of EquityFirms may obtain equity capital in two ways:

Retention of earnings•Issue of equity shares to the public•

The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders are providingfundstothefirmtofinancefirm'sinvestmentproposals.Retentionofearningsinvolvesanopportunitycost.Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable risktoearnreturns.So,irrespectiveofwhetherafirmraisesequityfinancebyretainingearningsorissueofadditionalequityshares,thecostofequityissame.Butissueofadditionalequitysharestothepublicinvolvesaflotationcostwhereasthereisnoflotationcostforretainedearnings.

Cost of Retained Earnings (Kre)Retainedearningsarethosepartsofnetearningsthatareretainedbythefirmforinvestingincapitalbudgetingproposals instead of paying them as dividends to shareholders. The opportunity cost of retained earnings is the rate of return the shareholders forgoes by not putting their funds elsewhere, because the management has retained the funds. The opportunity cost can be well computed with the following formulae.

Where, Ke = Cost of equity capital [D ÷P or (E/P) + g]Ti = Marginal tax rate applicable to the individuals concernedTb = Cost of purchase of new securitiesD = Expected dividend per shareNP = Net proceeds of equity shareg= Growth rate (%)

For instance A company paid a dividend of Rs. Per share, market price per share is Rs. 20, income tax rate is 60% and brokerage is expected to be 2%. Compute cost of retained earnings.

Solution:

=

= 0.10 X 0.408 X 100 = 4.1 %

Cost of Issue of Equity Shares (Ke)Thecostofequitycapital(Ke)maybedefinedastheminimumrateofreturnthatafirmmustearnontheequityfinancedportionsofaninvestmentprojectinordertoleaveunchangedthemarketpriceoftheshares.Thecostofequityisnottheout-of-pocketcostofusingequitycapitalastheequityshareholdersarenotpaiddividendatafixedrate every year.

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Itisthemostdifficultandcontroversialcosttomeasurethereisnocommonbasisforcomputation.

4.2.2 Cost of Preference SharesPreference share is one of the types of shares issued by companies to raise funds from public. Preference share is the share that has two preferential rights over equity shares:

Preferenceinpaymentofdividend,fromdistributableprofits•Preference in the payment of capital at the time of liquidation of the company•

Cost of Irredeemable (Perpetual) Preference ShareShare that cannot be paid till liquidation of the company are called as irredeemable preference shares. The cost is measured by the following formulas:

Where, Kp = Cost of preference shareD= Dividend per shareCMP = Current market price per shareNP = Net proceedsCost of irredeemable preference stock (with dividend tax)

Where Dt = Tax on preference dividend

For instance(Kp with dividend tax) : A coy planning to issue 14% irredeemable preference share at the face value of Rs. 250 per share,withanestimatedflotationcostof5%.Whatiscostofpreferencesharewith10%dividendtax.

Solution:

= 16.21 %

Cost of Redeemable Preference ShareSharesthatareissuedforaspecificmaturityperiodorredeemableafteraspecificperiodareknownasredeemablepreference shares. Cost of preference share when the principal amount is repaid in one lump sum amount.

Where, Kp = Cost of preference shareNP=Netsalesproceeds(afterdiscount,flotationcost)D = Dividend on preference sharePn = Repayment of principal amount at the end of ‘n’ years

Short cut formula is :

4.2.3 Cost of DebenturesCompaniesmayraisedebtcapitalthroughissueofdebenturesorraiseloanfromfinancialinstitutionsordepositsfrompublic.Alltheseresourcesinvolveaspecificrateofinterest.Computationofcostofdebentureordebtcapitaldepends on their nature.


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Cost of Irredeemable DebtPerpetualdebtprovidespermanentfundstothefirm,becausethefundswillremaininthefirmtillliquidation.Costof perpetual debt is the rate of return that lender expect. The following formulae used to compute cost of debentures or debt of bond.

Pre-tax cost = •

Post-tax cost = •

Where, Kdi = Pre-tax cost of debentures, I – Interest , P = Principle amount or face vlueP = Net sales proceeds , t = Tax rate

Forinstance:XYZCompanyLtd.,decidestofloatperpetual12%,debenturesofRs.100each.Thetaxrateis50.Calculate cost of debenture (pre and post tax cost)

Solution: Pre-tax cost =

Post-tax cost =

Cost of Redeemable DebtRedeemable debentures are those having a maturity period or repayable after a certain given period of time. These type of debentures are issued by many companies when they require capital for temporary needs. It is calculated by the following formula:

Where, Kd = Cost of debentures, n = Maturity period, NI= Net interest (after tax adjustment)Pn = Principal repayment in the year ‘n’

4.3 Capital Asset Pricing Model Approach (CAPM)CAPM was developed by William F.Sharpe. From cost of capital point of view, CAPM explains the relationship betweentherequiredrateofreturn,andthenon-diversifiableorrelevantrisk,ofthefirmasreflectedinitsindexofnon-diversifiableriskthatisbeta(β).Itshowstherelationshipbetweenriskandreturnforefficientandinefficientportfolios. Symbolically,

Where, Ke = Cost of equity capital, Rf = Rate of return required on a risk free security (%)β=Betacoefficient,Rmf=Requiredrateofreturnonthemarketportfolioofassets, thatcanbeviewedastheaverage rate of return on all assets.

Assumptions of CAPMCAPM approach is based on the following assumptions

Perfect Capital Market: all investors have same information about securitiesThere are no restrictions on investments•Securities of completely divisible•There are no transaction costs•There are no taxes•

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Investors Preference: Investors are risk averseInvestors have homogenous expectations regarding the expected returns, variances and correlation of returns •among all securities.Investors seek to maximise the expected utility of their portfolios over a single period planning horizon•

For instance The capital Ltd. Wishes to calculate its cost of equity capital using the Capital Asset Pricing Model (CAPM) approach. Company’s analyst found that its risk free rate if return equals 12%, beta equals 1.7 and the return on market portfolio equals 14.5 %.Solution:

= 12 + [14.5 – 12]1.7= 12+4.25= 16.25 %

4.4 Weighted Average Cost of Capital (WACC)A company has to employ a combination of creditors and owners funds. The composite cost of capital lies between theleastandmostexpensivefunds.Thisapproachenablesthemaximisationofprofitsandthewealthoftheequityshareholders by investing the funds in projects earning in excess of the overall cost of capital.

Steps involved in computation in WACCDetermination of the source of funds to be raised and their individual share in the total capitalization of the •firmComputationofcostofspecificsourceoffunds•Assignmentofweighttospecificsourceoffunds•Multiply the cost of each source by the appropriate assigned weights•Add individual source weight cost to get cost of capital•

Assignment of Weights Theweightstospecificfundsmaybeassignedbasedonthefollowing:

Book values: Book value weights are based on the values found on the balance sheet. The weight applicable to a •given source of fund is simply the book value of the source of fund divided by the book value of total funds.Capital structure weights: Under this method weights are assigned to the components of capital structure based •onthetargetedcapitalstructure.Dependingontarget,capitalstructureshavesomedifficultiesinusingit.Theyare

Acompanymaynothaveawelldefinedtargetcapitalstructure �Itmaybedifficulttopreciselyestimatethecomponentscapitalcost,ifthetargetcapitalisdifferentfrom �present capital structure.

Market value weights: Under this method, assigned weights to a particular component of capital structure is •equal to the market value of the component of capital dividend by the market value of all components of capital andcapitalemployedbythefirm.

Forinstanceafirmhasthefollowingcapitalstructureasthelateststatement

Source of finance Amount (Rs.) After Tax Cost %Debt Capital 30,00,000 4.0Preference Share Capital 10,00,000 8.5Equity Share Capital 20,00,000 11.5Retained earnings 40,00,000 10.0Total 100,00,000


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Solution:Computation of cost of capital

Source of Finance Weights Specific Cost (%) Weighted CostDebt 0.30* 4.0 1.2Preference share 0.10 8.5 8.5Equity share 0.20 11.5 2.3Retained earnings 0.40 10.0 4.0

1.00 8.35

Note * Debt weight =

4.4.1 Factors Affecting WACCWeighted average cost of capital is affected by a number of factors. They are divided into two categories such as:

Controllable factors (Internal factor)•Uncontrollable factors (External factors)•

Controllable factors (Internal factor): ControllablefactorsarethosefactorsthataffectWACC,butthefirmcancontrol them. They are:

Capital structure policy•Dividend policy•Investment policy•

Uncontrollable factors (External factors): Thefactorsthosearenotpossibletobecontrolledbythefirmandmostly affects the cost of capital. These types of factors are known as external factors.

Tax rates•Level of interest rates•Market risk premium•

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SummaryCost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal •provided by the business concern.Costofcapitalistherateofreturnthatafirmmustearnonitsprojectinvestmentstomaintainitsmarketvalue•and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained •earnings.Computationofcostofcapitalisaveryimportantpartofthefinancialmanagementtodecidethecapitalstructure•of the business concern. Following points illustrates the importance of cost of capital.The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders •areprovidingfundstothefirmtofinancefirm'sinvestmentproposals.Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable •risk to earn returns.Retainedearningsarethosepartsofnetearningsthatareretainedbythefirmforinvestingincapitalbudgeting•proposals instead of paying them as dividends to shareholders

ReferencesReddy, G. S., 2008. • Financial Management. Mumbai: Himalaya publications. Paramasivan, C. & Subramanian, T., 2009. • Financial Management. New Age International.Definingthecostofcapital,• [Pdf]Availableat:<http://www.iassa.co.za/articles/002_may1973_02.pdf>[Accessed28 May 2013].The cost of capital• , [Pdf] Available at: <http://www.goldsmithibs.com/resources/free/Cost-of-Capital/notes/Summary%20-%20Cost%20of%20Capital.pdf>[Accessed28May2013].2009. • Introduction to Cost of Capital, [Video online] Available at: <http://www.youtube.com/watch?v=AGaoDQgicVg>[Accessed28May2013].2013. • Cost of Capital Part 1 , [Video online] Available at : <http:/ /www.youtube.com/watch?v=suqQ3huNtrk>[Accessed28May2013].

Recommended ReadingPratt , S. P., 2010. • Cost of Capital: Workbook and Technical Supplement, 4th ed., Wiley.Tennent, J., 2008. • Guide to Financial Management,ProfileBooks/TheEconomist.Avadhani, V.A., 2010.• International Financial Management. Global Media.


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Self Assessment

Existence of perfect capital market is one of the assumptions of ______.1. WACCa. CAPMb. equityc. debenturesd.

Cost of the capital is the ___________ required rate of return expected by investors.2. minimuma. maximumb. higherc. reducedd.

Which of the following statements is false?3. Cost of capital comprises of three componentsa. Cost of capital is the minimum required rate of needed to justifyb. There is no cost for internally generated fundsc. CAPM approach is one of the approaches used in computation of equity capitald.

_______ value weights are based on the values found on the balance sheet4. Booka. Capitalb. Marketc. Weightedd.

CAPM stands for?5. Capital asset price model a. Capital asset pricing model b. Capital asset pricing maturityc. Capital assignment pricing modeld.

The composite cost of capital lies between the least and most _________ funds.6. expensivea. costlyb. low costc. cheapd.

____________debentures are those having a maturity period or repayable after a certain given period of time.7. Redeemablea. Irredeemableb. Capitalc. Assetd.

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Retention of earnings involves an __________ cost8. opportunitya. fixedb. capitalc. explicit d.

Retainedearningsarethosepartsof________earningsthatareretainedbythefirmforinvestingincapital9. budgeting proposals instead of paying them as dividends to shareholders

reduceda. netb. completec. entired.

Cost of preference share when the _______ amount is repaid in one lump sum amount.10. interesta. totalb. principalc. halfd.


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Chapter V

Capital Structure and Leverages

Aim


explain the concept of capital structure•

explicate the features of appropriate capital structure•

elucidatethefactorsthatdetermineafirm'scapitalstructure•

Objective

The objective of the chapter is to:

definecapitalstructure•

enlist the forms of capital structure•

defineleverage•

Learning outcome


undertsand the concept of leverages •

decribe the types of leverages•

identify the objectives of capital structure•

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5.1 Meaning of Capital StructureCapital is the major part of all kinds of business activities, which are decided by the size, and nature of the business concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level ofcapital,itwillearnhighprofitandtheycanprovidemoredividendstoitsshareholders.

Meaning of capital structureCapital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings. The term capital structure refers to the relationship between the various long-term source financingsuchasequitycapital,preferencesharecapitalanddebtcapital.Decidingthesuitablecapitalstructureistheimportantdecisionofthefinancialmanagementbecauseitiscloselyrelatedtothevalueofthefirm.Capitalstructureisthepermanentfinancingofthecompanyrepresentedprimarilybylong-termdebtandequity.

Definition of capital structureThefollowingdefinitionsclearlyinitiate,themeaningandobjectiveofthecapitalstructures.

AccordingtothedefinitionofGerestenbeg,“CapitalStructureofacompanyreferstothecompositionormakeupofitscapitalizationanditincludesalllong-termcapitalresources”.

AccordingtothedefinitionofJamesC.VanHorne,“Themixofafirm’spermanentlong-termfinancingrepresentedbydebt,preferredstock,andcommonstockequity”.

AccordingtothedefinitionofPresanaChandra,“Thecompositionofafirm’sfinancingconsistsofequity,preference,anddebt”.

AccordingtothedefinitionofR.H.Wessel,“Thelongtermsourcesoffundemployedinabusinessenterprise”.

CapitalStructureisthatpartoffinancialstructure,whichrepresentslong-termsources.Thetermcapitalstructureisgenerallydefinedtoincludeonlylong-termdebtandtotalstockholdersinvestment.

To quote Bogan "Capital structure may consists of a single class of stock, or it may be comprised by several issues of bonds and preferred stock, the characteristics of which may vary considerably". Capital structure is indicated by the following equations:

Capital Structure = Long-term Debt + Preferred Stock + Net worth OR Capital Structure = Total assets – Current Liabilities

Optimum capital structureOptimum capital structure is the capital structure at which the weighted average cost of capital is minimum and therebythevalueofthefirmismaximum.Optimumcapitalstructuremaybedefinedasthecapitalstructureorcombinationofdebtandequity,thatleadstothemaximumvalueofthefirm.

Objectives of capital structureDecision of capital structure aims at the following two important objectives:

Maximizethevalueofthefirm.•Minimize the overall cost of capital•

Forms of capital structureCapitalstructurepatternvariesfromcompanytocompanyandtheavailabilityoffinance.Normallythefollowingforms of capital structure are popular in practice.


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Equity shares only •Equity and preference shares only•Equity and Debentures only.•Equity shares, preference shares and debentures•

Factors determining capital structure Thefollowingfactorsareconsideredwhiledecidingthecapitalstructureofthefirm.

Leverage:Itisthebasicandimportantfactor,whichaffectthecapitalstructure.Itusesthefixedcostfinancing•such as debt, equity and preference share capital. It is closely related to the overall cost of capital. CostofCapital:Costofcapitalconstitutesthemajorpartfordecidingthecapitalstructureofafirm.Normally•longtermfinancesuchasequityanddebtconsistoffixedcostwhilemobilization.Whenthecostofcapitalincreases,valueofthefirmwillalsodecrease.Hencethefirmmusttakecarefulstepstoreducethecostofcapital.

Nature of the business:Useoffixed interest/dividendbearingfinancedependsupon the nature of the �business. If the business consists of long period of operation, it will apply for equity than debt, and it will reduce the cost of capital. Sizeofthecompany:Italsoaffectsthecapitalstructureofafirm.Ifthefirmbelongstolargescale,itcan �managethefinancialrequirementswiththehelpofinternalsources.Butifitissmallsize,theywillgoforexternalfinance.Itconsistsofhighcostofcapital.Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure �ofafirm.Forexample,bankingcompaniesarerestrictedtoraisefundsfromsomesources.Requirement of investors: In order to collect funds from different type of investors, it will be appropriate �for the companies to issue different sources of securities.

Governmentpolicy:PromotercontributionisfixedbythecompanyAct.Itrestrictstomobilizelarge,longterm•funds from external sources. Hence the company must consider government policy regarding the capital structure

5.2 Features of an Appropriate Capital StructureAn appropriate capital structure should have the following features:

Profitability•Solvency•Flexibility•Conservation•Control•

ConsiderationsFinancial manager has to consider the following while developing optimum capital structure

Return on Investment (ROI) Financialmanagerneedtoraisefixedcostsources)loans,debenture,preferenceshares)offunds,onlywhenROIishigherthatthefixedcostfunds.

Tax benefit Since debt is the cheapest source, because the interest paid on the debt is allowed as a deductible expense in determiningtaxpayment.Hence,abusinessfirmshouldtaketheadvantageoftaxdeduction.

Perceived financial risk Useofmoredebtincapitalstructureleadstoincreaseperceivedfinancialriskinthemindsofequityshareholderswhichreducesthemarketpriceofequityshare,therebyfirm'swealth.Thereforefinancialmanagementshouldnotincrease debt in capital structure when ordinary shareholders perceived an excessive risk.

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5.3 Determination of Capital StructureThe capital structure should be determined keeping in mind the objective of wealth maximisation. Following are the factors affecting the capital structure:

Taxbenefitofdebt•Flexibility•Control•Industry leverage ratios•Seasonal variations•Degree of competition•Industry life-cycle•Timing of public issue•Requirements of investors•

Patterns of capital structureConstruction of optimum capital structure is possible only when there is a appropriate mix of the above sources (debt and equity). The following are the forms of capital structure

Complete equity share capital•Different proportions of equity and preference share capital•Different proportions of equity and debenture (debt) capital and•Different proportions of equity, preference, and debenture (debt) capital•

5.4 Theories of Capital StructureEquityanddebtarethetwoimportantsourcesoflong-termsourcesoffinanceofafirm.Theproportionofdebtandequityinafirm'scapitalstructurehastobeindependentlydecidedcasetocase.Manytheorieshavebeenpropoundedtounderstandtherelationshipbetweenfinancialleverageandfirmvalue.

Assumption of capital structure theoriesThere are only two sources of funds i.e.: debt and equity.•The total assets of the company are given and do no change.•Thetotalfinancingremainsconstant.Thefirmcanchangethedegreeofleverageeitherbysellingtheshares•and retiring debt or by issuing debt and redeeming equity.Operatingprofits(EBIT)arenotexpectedtogrow.•Alltheinvestorsareassumedtohavethesameexpectationaboutthefutureprofits.•Businessriskisconstantovertimeandassumedtobeindependentofitscapitalstructureandfinancialrisk.•Corporate tax does not exit.•Thecompanyhasinfinitelife.•Dividend payout ratio = 100%•

5.4.1 Net Income ApproachAccordingtonetincomeapproachthefirmcanincreaseitsvalueorlowertheoverallcostofcapitalbyincreasingthe proportion of debt in the capital structure.

Assumptions of the Net Income (NI) ApproachTheuseofdebtdoesnotchangetheriskperceptionofinvestors;asaresult,theequitycapitalisationrate,Ke,•and the debt capitalisation rate Kd, remain constant with changes in leverage.The debt capitalisation rate is less than the equity capitalisation rate•The corporate income taxes do not exist.•


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Give below is the graphical representation of the net income approach:

Cost

Ke, Ko Ke,

KoKd

Debt

Kd.

Fig. 5.1 Net income approach

AccordingtoNIapproachboththecostofdebtandthecostofequityareindependentofthecapitalstructure;theyremainconstantregardlessofhowmuchdebtthefirmuses.Asaresult,theoverallcostofcapitaldeclinesandthefirmvalueincreaseswithdebt.Thisapproachhasnobasisinreality;theoptimumcapitalstructurewouldbe100percentdebtfinancingunderNIapproach.

For instance:AssumethatafirmhasanexpectedannualnetoperatingincomeofRs.200,000anequityrate,Ke,of10%andRs.10,00,000 of 6% debt.Solution:ThevalueofthefirmaccordingtoNetIncomeapproach:Net Operating Income NI = 2, 00,000Total cost of debt Interest = KdD (10, 00,000 X 0.6) = 60,000Net Income available to shareholders, NOI-I = Rs.1, 40,000

Therefore: Market Value of Equity (Rs. 140,000/.10) = 14, 00,000Market Value of debt D (Rs. 60,000/.06) = 10, 00,000Total = 24, 00,000The cost of equity and debt are respectively 10% and 6% and are assumed to constant under the Net income approach.Ko = NOI/V = 200,000/24, 00,000 = 0.0833 = 8.33%

5.4.2 Net Operating Income (NOI) ApproachInNetoperatingincomeapproachthemarketvalueofthefirmisnotaffectedbythechangeincapitalstructure,theweighed average cost of capital is said to be constant.

Assumptions of the Net Operating Income (NOI) ApproachThemarket capitalises the value of the firm as awhole.Thus, the split between debt and equity is not•importantThe market uses an overall capitalisation rate Ko to capitalise the net operating income. Ko depends on the •business risk. If the business risk is assumed to remain unchanged, Ko is a constant.The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalisation rate •to increase.

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Give below is the graphical representation of the net operating income approach:

Cost

Ke, Ko Ke,

KoKd

Debt

Kd.

Fig. 5.2 Net operating income approach

AccordingtoNOIapproachthevalueofthefirmandtheweightedaveragecostofcapitalareindependentofthefirm’scapitalstructure.Intheabsenceoftaxes,anindividualholdingallthedebtandequitysecuritieswillreceivethesamecashflowsregardlessofthecapitalstructureandtherefore,valueofthecompanyisthesame.

For instance:AssumethatafirmannualnetoperatingincomeofRs.2,00,000anaveragecostofcapitalKo,of10%andintialdebt of Rs. 10,00,000 at 6%.Solution: Net operating Income = 2,00,000Therefore,Marketvalueoffirm,V=S+D=2,00,000/0.10=20,00,000Market value of the debt, D = 10,00,000Market value of the equity S= V-D = 10,00,000Ko = NOI/V = 200,000/0.10 = 20,00,000Here, Ke is not constant as that in NI approach. It is computed using the formula:Ke = Ko + (Ko-Kd)D/S= 0.10 + (0.10+0.06)10,00,000/10,00,000= 0.10 + 0.04(1) = 0.14To verify that the weighted average cost of capital is a constant:Ko = Kd(D/V) + Ke(S/V)= 0.06(10, 00,000/20, 00,000) + 0.14(10, 00,000/20, 00,000)= 0.06(0.50) + 0.14(0.5)= 0.03 + 0.07 = 0.10

5.4.3 Traditional ApproachThis is also known as intermediate approach. It is a compromise between the NI and NOI approach. According to thisviewthevalueofthefirmcanbeincreasedorthecostofthecapitalcanbereducedbyajudiciousmixofdentand equity capital.

This approach implies that the cost of capital decreases within the reasonable limit of debt and then increases with the leverage.

This approach has the following propositions as shown in the Fig. below:


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Ke,

KoKdCost

Debt

Fig. 5.3 Traditional approach

kd remains constant until a certain degree of leverage and thereafter rises at an increasing rate•ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very sharply•as a sequence to the above 2 propositions, ko decreases till a certain level, remains constant for moderate •increases in leverage and rises beyond a certain point

5.4.4 Miller and Modigliani ApproachMiller and Modigliani criticise that the cost of equity remains unaffected by leverage up to a reasonable limit and Ko being constant at all degrees of leverage. The assumptions for their analysis are:Perfect Capital MarketsSecurities can be freely traded, there are no hindrances on the borrowing, no presence of transaction costs, securities infinitelydivisible,availabilityofallrequiredinformationatalltimes.

Investors Behave RationallyThey choose that combination of risk and return that is most advantageous to them

Homogeneityof investors risk perception, that is, all investors have the same perception of business risk and returns.

TaxesThere is no corporate or personal income tax

Dividend pay-out is 100%thatis,thefirmsdonotretainearningsforfutureactivities.

Following three propositions can be derived based on the above assumptions:Proposition I: Themarketvalueof thefirmisequal to the totalmarketvalueofequityandtotalmarketvalueofdebtandisindependent of the degree of leverage. Proposition IIThe expected yield on equity is equal to discount rate (capitalisation rate) applicable plus a premium.

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Proposition IIITheaveragecostofcapitalisnotaffectedbythefinancingdecisionsasinvestmentandfinancingdecisionsareindependent.

Criticism of MM PropositionsRisk perceptionThe assumption that risks are similar is wrong and the risk perceptions of investors are personal and corporate leverage is different.

Convenience: Investorsfindpersonalleverageinconvenient.

Transaction Costs: Due to presence of such costs in buying and selling securities, it is necessary to invest a higher amount to earn the same amount of return.

Taxes: When personal taxes are considered along with corporate taxes, the Miller and Modigliani approach fails the fails toexplainthefinancingdecisionandfirm'svalue.

5.5 LeveragesFinancial decision is oneof the integral and important parts offinancialmanagement in anykindof businessconcern.Asoundfinancialdecisionmustconsidertheboardcoverageofthefinancialmix(CapitalStructure),totalamountofcapital(capitalisation)andcostofcapital(Ko).Capitalstructureisoneofthesignificantthingsforthemanagement,sinceitinfluencesthedebtequitymixofthebusinessconcern,whichaffectstheshareholder’sreturnand risk. Hence, deciding the debt-equity mix plays a major role in the part of the value of the company and market value of the shares. The debt equity mix of the company can be examined with the help of leverage. The concept of leverage is discussed in this part. Types and effects of leverage is discussed in the part of EBIT and EPS.

Meaning of leverageThe term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects,whichmaynotbeotherwisepossible.Inthefinancialpointofview,leveragereferstofurnishtheabilitytousefixedcostassetsorfundstoincreasethereturntoitsshareholders.

Definition of leverageJamesHornehasdefinedleverageas,“theemploymentofanassetorfundforwhichthefirmpaysafixedcostorfixedreturn.TypesofLeverageLeveragecanbeclassifiedintothreemajorheadingsaccordingtothenatureofthefinancemixofthecompany.

Types of LeveragesOperating leverage•Financial leverage•

5.5.1 Operating LeverageOperating leverage is present any time in afirmwhen it hasoperating (fixed) costs regardlessof the level ofproduction.Itcanbedefinedas"Thefirm'sabilitytouseoperatingcoststomagnifytheeffectsofchangesinsaleson its earnings before interest and taxes. The operating costs are categorised into three:

Fixed Costs: which do not vary with the level of production they must be paid regardless of the amount of •revenue availableVariable Costs: raw materials, direct labor, costs and so on that varies directly with the level of production•Semi-variableCost:whichpartlyvaryandpartlyfixed•


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Thedegreeofoperatingleveragemaybedefinedasthechangeinthepercentageofoperatingincome(EBIT),fora given change in % of sales revenue.

When the data is given for one year, then we have to compute operating leverage, by the following formula:

For instance: From the following particulars of ABC Ltd., calculate degree of operating leverage.

Particulars Previous Year 2009 Current Year 2010

Sales revenue 10,00,000 12,50,000

Variable cost 6,00,000 7,50,000

Fixed cost 2,50,000 2,50,000

Solution: Calculation of EBIT on a percentage change

Particulars 2009 2010 % changeSales Revenue

Less: Variable costContributionLess:fixedcost

EBIT

10,00,0006,00,000

12,50,0007,50,000

252525

66.674,00,0002,50,000

5,00,0002,50,000

1,50,000 2,50,000

Operating leverage 2.667 indicates that when there is 25% change in sales, the change in EBIT is 2.66 times.

Application of operating leverageItishelpfultoknowhowoperatingprofitwouldchangewithagivenchangeinunitsproduced.•It will be helpful in measuring business risk.•

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5.5.2 Financial LeverageFinancial manager job is to raise funds for long-term activities with different composition of sources. The required fundsmayberaisedbytwosources:equityanddebt.Theuseoffixedchargesourcesoffundssuchasdebtandpreferencesharecapitalalongwiththeequitysharecapitalincapitalstructureisdescribedasfinancialleverage.AccordingtoLawrence,financialleverageis"theabilityofthefirmtousefixedinterestbearingsecuritiestomagnifythe rate of return as equity shares". It is also known as "trading as equity".

Formulaforcalculatingfinancialleverageisgivenbelow:

OR

For instance Afirmhassalesof1,00,000unitsatRs.10/unit.Variablecostoftheproducedproductsis60%ofthetotalsalesrevenue.FixedcostidRs.2,00,000.ThefirmhasusedadebtofRs.5,00,000at20%interest.Calculatetheoperatingleverageandfinancialleverage.

Solution: Calculation of EBT

Particulars Amount (Rs.)Sales Revenue (1,00,000 units X Rs.10/unit) 10,00,000

6,00,000

Less: Variable cost (10,00,000 X 0.60) 4,00,0002,00,000

Contribution 2,00,0001,00,000

Less: Fixed cost 1,00,000EBITLess: Interest (5,00,000 X 20/100)Earning Before Tax (EBT)

Operating Leverage = Contribution ÷ EBIT = 4, 00,000 ÷ 2, 00,000 = 2timesFinancial Leverage = EBIT÷EBT = 2, 00,000 ÷ 1, 00,000 = 2 times

Application of financial leverageItishelpfultoknowhowEPSwouldchangewithachangeinoperatingprofit.•Itishelpfulformeasuringfinancialrisk.•

5.5.3 Combined LeverageThe operating leverage has its effects on operating risk and is measured by the % change in EBIT due to the % changeinsales.Thefinancingleveragehasitseffectsonfinancialriskandismeasuredbythe%changeinEPSduetothe%changeinEBIT.Since,boththeseleveragesarecloselyrelatedwiththeascertainmentofthefirm'sabilitytocoverfixedcharges,thesumofthemgivesusthetotalleverageorcombinedleverageandtheriskassociatedwith combined leverage is known as total risk.


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Thedegreeofcombinedleveragemaybedefinedas the%changeinEPSdue to the%changeinsales.Thuscombined leverage is:

For instance: ABCcorporationhassalesofRs.40lakhs,variablecost70%ofthesalesandfixedcostisRs.8,00,000.ThefirmhasraisedRs.20lakhsfundsbyissueofdebenturesattherateof10%.Computeoperating,financialandcombinedleverages.

Solution: Calculation of EBT or PBT

Particulars Amount (Rs.)

Sales revenue 40,00,00028,00,000Less: Variable cost (40,00,000 X 0.70)

Contribution 12,00,0008,00,000Less: Fixed Cost

EBIT 4,00,0002,00,000

Less: interest (20,00,000 X 0.10)

EBT 2,00,000

Operating leverage = Contribution ÷ EBIT = 12, 00,000 ÷ 4, 00,000 = 3 timesFinancial leverage = EBIT ÷ EBT = 4, 00,000 ÷ 2, 00,000 = 2 timesCombined leverage = OL x FL = 3x2 = 6 times

The combined leverage can work in both directions. It is favorable if sales increase and unfavorable when sales decrease.

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SummaryCapital is the major part of all kinds of business activities, which are decided by the size, and nature of the •business concern.Thetermcapitalstructurereferstotherelationshipbetweenthevariouslong-termsourcefinancingsuchas•equity capital, preference share capital and debt capital.Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and •therebythevalueofthefirmismaximum.Optimumcapitalstructuremaybedefinedasthecapitalstructureorcombinationofdebtandequity,thatleads•tothemaximumvalueofthefirmThe capital structure should be determined keeping in mind the objective of wealth maximisation.•Construction of optimum capital structure is possible only when there is a appropriate mix of debt and equity.•Equityanddebtarethetwoimportantsourcesoflong-termsourcesoffinanceofafirm.•Inthefinancialpointofview,leveragereferstofurnishtheabilitytousefixedcostassetsorfundstoincrease•the return to its shareholders.

ReferencesParamasivan, C. & Subramanian, T., 2009. • Financial Management. New Age International.Khan, M. Y.., 2004. • Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill Education.Capital Structure and Leverage,• [Pdf] Available at: <http://faculty.unlv.edu/msullivan/FIN301%20-%20Chpts%2013%20and%2014%20-%20Capital%20Structure%20and%20Dividends-%20classnotes.pdf>[Accessed 29 May 2013].Capital Structure and Leverage• ,[Pdf]Availableat:<http://www.csun.edu/~dm59084/FIN303/Ch%2013.pdf>[Accessed 29 May 2013].2011. • Capital Structure class I,[Videoonline]Availableat:<http://www.youtube.com/watch?v=lqHuYKGByIQ>[Accessed 29 May 2013].2011. • Capital Structure class II,[Videoonline]Availableat:<http://www.youtube.com/watch?v=6vtuNgGxbso>[Accessed 29 May 2013].

Recommended ReadingBrigham,E. F., 2003.• Fundamentals of Financial Management. 10th ed., South-Western College Pub.Brigham, E. F. & Ehrhardt, M. C., 2008. • Financial management: theory and practice, 12th ed., Cengage Learning.Gitman, 2007. • Principles Of Managerial Finance, 11th ed., Pearson Education India.


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Self Assessment

Optimumcapitalstructuremaybedefinedasthecapitalstructureorcombinationofdebtand__________,that1. leadstothemaximumvalueofthefirm.

liabilitiesa. assetsb. equityc. costd.

Contribution is equal to sales minus _________ cost.2. fixeda. variableb. operatingc. semi-variabled.

Which of the following statements is false?3. Optimumcapitalstructuremaybedefinedasthecapitalstructureorcombinationofdebtandequity,thata. leadstothemaximumvalueofthefirm.Use debt to any extent to maximise EPS.b. Financialleverageismultipliedbyfinancialleveragetogetcombinedleverage.c. Financial leverage is also known as trading on equity.d.

S-V-EBIT =?4. Variable costa. Fixed costb. Operating costc. Profitd.

The use of leverage is essential to maximise ____________.5. profita. lossb. earningsc. contributiond.

Total assets – Current liabilities =?6. Optimal capital structurea. Financial leverageb. Operating leveragec. Capital structured.

_________ofoperatingleverageandhighdegreeoffinancialleverageisidealsituation7. Low degreea. High degreeb. Medium degreec. Optimum degreed.

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Financial leverage is also known as __________.8. indifference pointa. trading on equityb. combined leveragec. capital structured.

Increaseduseofdebt______thefinancialriskofequityshareholders.9. increasesa. decreasesb. constantc. reducesd.

Contribution is divided by EBIT to get ________ leverage10. financiala. operatingb. combinedc. fixedd.


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Chapter VI

Capital Budgeting

Aim


introduce the term capital budgeting•

explicate the methods for evaluating the capital investment proposals•

elucidateprofitabilityindexmethodanditsruleofacceptance•

Objectives


explain the formula for reciprocal pay-back period•

explicate principles or factors of capital budgeting decisions•

definecapitalbudgeting•

Learning outcome


distinguishbetweentraditionalmethodsanddiscountedcashflowmethod•

understand importance of capital budgeting •

identify capital budgeting process•

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6.1 IntroductionThe term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the purpose of maximising return on investments. The capital expenditure may be:

Cost of mechanization, automation and replacement.•Costofacquisitionoffixedassets,e.g.,land,buildingandmachineryetc.•Investment on research and development.•Cost of development and expansion of existing and new projects.•

6.2 Definition of Capital BudgetingCapitalBudgetisalsoknownas“InvestmentDecisionMakingorCapitalExpenditureDecisions”or“PlanningCapitalExpenditure”etc.Normallysuchdecisionswhereinvestmentofmoneyandexpectedbenefitsarisingtherefrom are spread over more than one year, it includes both rising of long-term funds as well as their utilisation. CharlesT.Horngnenhasdefinedcapitalbudgetingas“CapitalBudgetingislongtermplanningformakingandfinancingproposedcapitaloutlays.”

Inotherwords,capitalbudgetingisthedecisionmakingprocessbywhichafirmevaluatesthepurchaseofmajorfixedassetsincludingbuilding,machineryandequipment.AccordingtoHamption,John.J.,“Capitalbudgetingisconcernedwiththefirm’sformalprocessfortheacquisitionandinvestmentofcapital.”Fromtheabovedefinitions,it may be concluded that capital budgeting relates to the evaluation of several alternative capital projects for the purpose of assessing those which have the highest rate of return on investment.

6.3 Importance of Capital BudgetingCapital budgeting is important because of the following reasons:

Capitalbudgetingdecisionsinvolvelong-termimplicationforthefirm,andinfluenceitsriskcomplexion.•Capital budgeting involves commitment of large amount of funds.•Capital decisions are required to assessment of future events which are uncertain.•Wrongsaleforecast;mayleadtooverorunderinvestmentofresources.•Inmostcases,capitalbudgetingdecisionsareirreversible.Thisisbecauseitisverydifficulttofindamarket•for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.Capitalbudgetingensurestheselectionofrightsourceoffinanceattherighttime.•Manyfirmsfail,becausetheyhavetoomuchortoolittlecapitalequipment.•Investment decision taken by individual concern is of national importance because it determines employment, •economic activities and economic growth.

6.4 Objectives of Capital BudgetingThe following are the important objectives of capital budgeting:

Toensuretheselectionofthepossibleprofitablecapitalprojects.•Toensuretheeffectivecontrolofcapitalexpenditureinordertoachievebyforecastingthelong-termfinancial•requirements.Tomakeestimationofcapitalexpenditureduringthebudgetperiodandtoseethatthebenefitsandcostsmay•bemeasuredintermsofcashflow.Determining the required quantum takes place as per authorisation and sanctions.•To facilitate co-ordination of inter-departmental project funds among the competing capital projects.•Toensuremaximisationofprofitbyallocatingtheavailableinvestible.•


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6.5 Principles or Factors of Capital Budgeting DecisionsA decision regarding investment or a capital budgeting decision involves the following principles or factors:

A careful estimate of the amount to be invested.•Creativesearchforprofitableopportunities.•Careful estimates of revenues to be earned and costs to be incurred in future in respect of the project under •consideration.Alistingandconsiderationofnon-monetaryfactorsinfluencingthedecisions.•Evaluation of various proposals in order of priority having regard to the amount available for investment.•Proposals should be controlled in order to avoid costly delays and cost over-runs.•Evaluation of actual results achieved against those budget.•Care should be taken to think all the implication of long range capital investment and working capital •requirements.Itshouldrecognisethefactthatbiggerbenefitsarepreferabletosmalleronesandearlybenefitsarepreferable•tolatterbenefits

6.6 Capital Budgeting ProcessThe following procedure may be considered in the process of capital budgeting decisions:

Identificationofprofitableinvestmentproposals•Screening and selection of right proposals•Evaluationofmeasuresofinvestmentworthonthebasisofprofitabilityanduncertaintyorrisk•Establishingpriorities,i.e.,uneconomicalorunprofitableproposalsmayberejected.•Final approval and preparation of capital expenditure budget•Implementing proposal, i.e., project execution•Review the performance of projects•

6.7 Types of Capital ExpenditureCapital Expenditure can be of two types:

Capital expenditure increases revenue•Capital expenditure reduces costs•

CapitalExpenditure IncreasesRevenue: It is the expenditurewhichbringsmore revenue to thefirmeitherbyexpanding the existing production facilities or development of new production line.

Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of present product and thereby increasestheprofitabilityofexistingoperations.Itcanbedonebyreplacementofoldmachinebyanewone.

6.8 Types of Capital Budgeting ProposalsAfirmmayhaveseveralinvestmentproposalsforitsconsideration.Itmayadoptafterconsideringthemeritsanddemeritsofeachoneofthem.Forthispurposecapitalexpenditureproposalsmaybeclassifiedinto:

Independent Proposals•Dependent Proposals or Contingent Proposals•Mutually Exclusive Proposals•

Independent Proposals: These proposals are said be to economically independent which are accepted or rejected on the basis of minimum return on investment required. Independent proposals do not depend upon each other.

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Dependent Proposals or Contingent Proposals: In this case, when the acceptance of one proposal is contingent upon theacceptanceofotherproposals,itiscalledas“DependentorContingentProposals.”Forexample;constructionof new building on account of installation of new plant and machinery describes it.

Mutually Exclusive Proposals: Mutually Exclusive Proposals refer to the acceptance of one proposal results in the automatic rejection of the other proposal. Then the two investments are mutually exclusive. In other words, one can be rejectedandtheothercanbeaccepted.Itiseasierforafirmtotakecapitalbudgetingdecisionsonsuchprojects.

6.9 Methods of Evaluating Capital Investment ProposalsThere are number of appraisal methods which may be recommended for evaluating the capital investment proposals. We shall discuss the most widely accepted methods. These methods can be grouped into the following categories:

Traditional MethodsTraditional methods are grouped in to the following:

Pay-back period method or Payout method•Improvement of Traditional Approach to Pay-back Period Method•

PostPay-backprofitabilityMethod �Discounted Pay-back Period Method �Reciprocal Pay-back Period Method �

Rate of Return Method or Accounting Rate of Return Method•

Time Adjusted Method or Discounted Cash Flow MethodTimeAdjustedMethodfurtherclassifiedinto:

Net Present Value Method•Internal Rate of Return Method•ProfitabilityIndexMethod•

6.9.1 Traditional MethodsPay-backPeriodMethod:Pay-backperiodisalsotermedas“Pay-outperiod”orPay-offperiod.PayoutPeriodMethod is one of the most popular and widely recognised traditional methods of evaluating investment proposals. Itisdefinedasthenumberofyearsrequiredtorecovertheinitialinvestmentinfullwiththehelpofthestreamofannualcashflowsgeneratedbytheproject.CalculationofPay-backPeriod:Pay-backperiodcanbecalculatedintothe following two different situations:

Inthecaseofconstantannualcashinflows.•Inthecaseofunevenorunequalcashinflows.•

Inthecaseofconstantannualcashinflows:IftheprojectgeneratesconstantcashflowthePay-backperiodcanbecomputedbydividingcashoutlays(originalinvestment)byannualcashinflows.Thefollowingformulacanbeused to ascertain pay-back period:

Pay-back Period =

Example 1:AprojectrequiresinitialinvestmentofRs.40,000anditwillgenerateanannualcashinflowofRs.10,000for6years.Youarerequiredtofindoutpay-backperiod.


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Solution:Calculation of Pay-back period:

Pay-back Period =

=

= 4 years

Pay-back period is 4 years, i.e., the investment is fully recovered in 4 years.

Example 2: In the case of Uneven or Unequal Cash InflowsInthecaseofunevenorunequalcashinflows,thePay-backperiodisdeterminedwiththehelpofcumulativecashinflow.Itcanbecalculatedbyaddingupthecashinflowsuntilthetotalisequaltotheinitialinvestment.

From the following information you are required to calculate pay-back period:AprojectrequiresinitialinvestmentofRs.40,000andgeneratescashinflowsofRs.16,000,Rs.14,000,Rs.8,000andRs.6,000inthefirst,second,third,andfourthyearrespectively.

Solution:CalculationPay-backPeriodwiththehelpof“CumulativeCashInflows”

Year Annual Cash InflowsRs.

Cumulative Cash InflowsRs.

1 16,000 16,0002 14,000 30.0003 8,000 38,0004 6,000 44,000

Theabovetableshowsthatattheendof4thyearsthecumulativecashinflowsexceedstheinvestmentofRs.40.000.Thus the pay-back period is as follows:

Pay-back Period = 3 Years+

= 3 Years+

= 3.33 Years

Accept or Reject CriterionInvestmentdecisionsbasedonpay-backperiodareusedbymanyfirmstoacceptorrejectaninvestmentproposal.Among the mutually exclusive or alternative projects whose pay-back periods are lower than the cut off period, the project would be accepted, if not it would be rejected.

Advantages of Pay-back Period MethodIt is an important guide to investment policy.•It is simple to understand and easy to calculate.•Itfacilitatestodeterm.inetheliquidityandsolvencyofafirm.•Ithelpstomeasuretheprofitableinternalinvestmentopportunities.•Itenablesthefirmtoselectaninvestmentwhichyieldsaquickreturnoncashfunds.•

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It used as a method of ranking competitive projects.•It ensures reduction of cost of capital expenditure.•

Disadvantages or Pay-back Period MethodItdoesnotmeasuretheprofitabilityofaproject•It does not value projects of different economic lives•This method does not consider income beyond the pay-back period•Itdoesnotgiveproperweighttotimingofcashflows•Itdoesnotindicatehowtomaximisevalueandignorestherelativeprofitabilityoftheproject•It does not consider cost of capital and interest factor which are very important factors in taking sound investment •decisions.

6.9.2 Improvement of Traditional Approach to Pay-back PeriodThe demerits of the pay-back period method may be eliminated in the following ways:(a) Post Pay-back Profitability MethodOne of the limitations of the pay-back period method is that it ignores the post pay-back returns of project. To rectify thedefect,postpay-backperiodmethodconsiderstheamountofprofitsearnedafterthepay-backperiod.ThismethodisalsoknownasSurplusLifeoverPaybackMethod.Accordingtothismethod,pay-backprofitabilityiscalculatedbyannualcashinflowsineachoftheyear,afterthepay-backperiod.Thiscanbeexpressedinpercentageof investment.

PostPay-backProfitability=AnnualCashInflowx(EstimatedLife-Pay-backPeriod)

Thepostpay-backprofitabilityindexcanbedeterminedbythefollowingequation:

PostPay-backProfitabilityIndex=

(b) Discounted Pay-back MethodThis method is designed to overcome the limitation of the payback period method. When savings are not leveled, it isbettertocalculatethepay-backperiodbytakingintoconsiderationthepresentvalueofcashinflows.Discountedpay-backmethodhelpstomeasurethepresentvalueofallcashinflowsandoutflowsatanappropriatediscountrate.Thetimeperiodatwhichthecumulatedpresentvalueofcashinflowsequalsthepresentvalueofcashoutflowsisknown as discounted pay-back period.

(c) Reciprocal Pay-back Period MethodThis methods helps to measure the expected rate of return of income generated by a project Reciprocal pay-back period method is a close approximation of the Time Adjusted Rate of Return, if the earnings are leveled and the estimated life of the project is somewhat more than twice the pay-back period. This can be calculated by the following formula:

Reciprocal Pay-back Period =

Example 3:The company is considering investment of Rs. 1, 00,000 in a project. The following are the income forecasts, after depreciation and tax, 1st year Rs. l 0,000, 2nd year Rs. 40.000, 3rd year Rs. 60,000, 4th year Rs. 20,000 and 5th year Rs. Nil. From the above information you are required to calculate: (1) Pay-back Period (2) Discounted Pay-back Period at 10% interest factor.

Solution:(1) Calculation of Pay-back Period


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Year Annual Cash InflowsRs.

Cumulative Cash InflowsRs.

1 10,000 10,0002 40,000 50,0003 60.000 1,10,0004 20,000 1,30.0005 -- 1,30,000

Theabovetableshowsthatattheendof3rdyeartheCumulativeCashInflowsexceedstheinvestmentofRs.1,00,000. Thus the Pay-back Period is as follows:

Pay-back Period = 2 Years +

= 2 Years +

= 2 Years + 0.833 = 2.833 Years

(2) Calculation of Discounted Pay-back Period 10% Interest Rate

Year

1

CashInflows

2

Discontinuing Pres-ent Value

Factor at 10%3

Present Value of CashInflows

(Z x3)4

Rs.

Cumulative Value ofCashInflows

Rs.

1 10,000 0.9091 9,091 9.0912 40,000 0.8265 33,060 42,1513 60,000 0.7513 45,078 87,2294 20,000 0.6830 13,660 1,00,8895 -- 0.6209 -- 1,00,889

From the above table, it is observed that up to the 4th year Rs. 1, 00,000 is recovered. Because the Discounting CumulativeCashInflowsexceedstheoriginalcashoutlaysofRs.1,00,000.ThustheDiscountedPay-backPeriodis calculated as follows:

Pay-back Period = 3 Years +

= 3 Years+

= 3 Years + 0.935 == 3.935 Years

6.9.3 Average Rate of Return Method (ARR) or Accounting Rate of Return MethodAverage Rate of Return Method is also termed as Accounting Rate of Return Method. This method focuses on the average net income generated in a project in relation to the project’s average investment outlay. This method involves accountingprofitsnotcashflowsandissimilartothepe1formancemeasureofreturnoncapitalemployed.

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The average rate of return can be determined by the following equation:

Average Rate of Return (ARR) =

=

=

Where,Average investment would be equal to the Original investment plus salvage value divided by 2.

Average Investment = (or)

=

AdvantagesIt considers all the years involved in the life of a project rather than only pay-back years•Itappliesaccountingprofitasacriterionofmeasurementandnotcashflow•

DisadvantagesItappliesprofitasameasureofyardsticknotcashflow•The time value of money is ignored in this method•Yearlyprofitdeterminationmaybeadifficulttask•

6.9.4 Discounted Cash Flow Method (or) Time Adjusted MethodDiscountcashflowisamethodofcapitalinvestmentappraisalwhichtakesintoaccountboththeoverallprofitabilityofprojectsandalsothetimingofreturn.Discountedcashflowmethodhelpstomeasurethecashinflowandoutflowof a project as if they occurred at a single point in time so that they can be compared in an appropriate way. This method recognises that the use of money has a cost, i.e., interest foregone. In this method risk can be incorporated into Discounted Cash Flow computations by adjusting the discount rate or cut off rate.

DisadvantagesThe following are some of the limitations of Discounted Pay-back Period Method:

Theremaybedifficultyinaccuratelyestablishingratesofinterestoverthecashflowperiod.•Lack of adequate expertise in order to properly apply the techniques and interpret results.•Thesetechniquesarebasedoncashflows,whereasreportedearningsarebasedonprofits.•

TheinclusionofDiscountedCashFlowAnalysismaycauseprojectedearningstofluctuateconsiderablyandthushave an adverse on share prices.

6.9.5 Net Present Value Method (NPV)This is one of the Discounted Cash Flow techniques which explicitly recognise the time value of money. In this methodallcashinflowsandoutflowsareconvertedintopresentvalue(i.e.,valueatthepresenttime)applyinganappropriate rate of interest (usually cost of capital).

Inotherwords,NetPresentValueMethoddiscountinflowsandoutflowstotheirpresentvalueattheappropriatecostofcapitalandsetthepresentvalueofcashinflowagainstthepresentvalueofoutflowtocalculateNetPresentValue.Thus,theNetPresentValueisobtainedbysubtractingthepresentvalueofcashoutflowsfromthepresentvalueofcashinflows.


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Advantages of Net Present Value MethodItrecognisesthetimevalueofmoneyandisthusscientificinitsapproach.•Allthecashflowsspreadovertheentirelifeoftheprojectareusedforcalculations.•It is consistent with the objectives of maximising the welfare of the owners as it depicts the positive or otherwise •present value of the proposals.

DisadvantagesThismethodiscomparativelydifficulttounderstandoruse.•When the projects in consideration involve different amounts of investment, the Net Present Value Method •may not give satisfactory results.

6.9.6 Internal Rate of Return Method (IRR)InternalRateofReturnMethodisalsocalledas“TimeAdjustedRateofReturnMethod.”Itisdefinedastheratewhichequatesthepresentvalueofeachcashinflowswiththepresentvalueofcashoutflowsofaninvestment.Inother words, it is the rate at which the net present value of the investment is zero.

HorngrenandFosterdefineInternalRateofReturnastherateofinterestatwhichthepresentvalueofexpectedcashinflowsfromaprojectequalsthepresentvalueofexpectedcashoutflowsoftheproject.TheInternalRateofReturncanbefoundoutbyTrialandErrorMethod.First,computethepresentvalueofthecashflowfromaninvestment, using an arbitrarily selected interest rate, for example 10%. Then compare the present value so obtained with the investment cost.

If the present value is higher than the cost of capital, try a higher interest rate and go through the procedure again. Ontheotherhandifthecalculatedpresentvalueoftheexpectedcashinflowsislowerthanthepresentvalueofcashoutflowsalowerrateshouldbetried.ThisprocesswillberepeateduntilandunlesstheNetPresentValuebecomeszero.TheinterestratethatbringsaboutthisequalityisdefinedastheInternalRateofReturn.

Alternatively,theinternalratecanbeobtainedbyInterpolationMethodwhenwecomeacrosstworates;onewithpositive net present value and other with negative net present value. The IRR is considered as the highest rate of interestwhichabusinessisabletopayonthefundsborrowedtofinancetheprojectoutofcashinflowsgeneratedby the project. The Interpolation formula can be used to measure the Internal Rate of Return as follows:

Lower Interest Rate + × (higher rate – lower rate)

EvaluationApopulardiscountedcashflowmethod,theinternalrateofreturncriterionhasseveralvirtues:

It takes into account the time value of money.•Itconsidersthecashflowsovertheentirelifeoftheproject.•Itmakesmoremeaningfulandacceptabletousersbecauseitsatisfiesthemintermsoftherateofreturnon•capital.

LimitationsTheinternalrateofreturnmaynotbeuniquelydefined.•TheIRRisdifficulttounderstandandinvolvescomplicatedcomputationalproblems.•Theinternalrateofreturnfigurecannotdistinguishbetweenlendingandborrowingsandhencehighinternal•rate of return need not necessarily be a desirable feature.

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6.9.7 Profitability Index MethodProfitabilityIndexisalsoknownasBenefitCostRatio.Itgivesthepresentvalueoffuturebenefits,computedattherequiredrateofreturnontheinitialinvestment.ProfitabilityIndexmayeitherbeGrossProfitabilityIndexorNetProfitabilityIndex.NetProfitabilityIndexistheGrossProfitabilityIndexminusone.TheProfitabilityIndexcanbe calculated by the following equation:

ProfitabilityIndex=

Rule of AcceptanceAspertheBenefitCostRatioorProfitabilityIndexaprojectwithProfitabilityIndexgreaterthanoneshouldbeacceptedasitwillhavePositiveNetPresentValue.LikewiseifProfitabilityIndexislessthanonetheprojectisnotbeneficialandshouldnotbeaccepted.

AdvantagesofProfitabilityIndex:It duly recognises the time value of money.•For calculations when compared with internal rate of return method it requires less time.•It helps in ranking the project for investment decisions.•Asthismethodiscapableofcalculatingincrementalbenefitcostratio,itcanbeusedtochoosebetweenmutually•exclusive projects.


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SummaryThe term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the •purpose of maximising return on investments.CapitalBudgetisalsoknownas“InvestmentDecisionMakingorCapitalExpenditureDecisions”or“Planning•CapitalExpenditure”etc.According toHamption, John. J., “Capital budgeting is concernedwith thefirm’s formal process for the•acquisitionandinvestmentofcapital.”Capitalbudgetingdecisionsinvolvelong-termimplicationforthefirm,andinfluenceitsriskcomplexion.•Investment decision taken by individual concern is of national importance because it determines employment, •economic activities and economic growth.CapitalExpenditureIncreasesRevenueis theexpenditurewhichbringsmorerevenueto thefirmeitherby•expanding the existing production facilities or development of new production line.Afirmmayhaveseveralinvestmentproposalsforitsconsideration.•There are number of appraisal methods which may be recommended for evaluating the capital investment •proposals.Pay-backperiodisalsotermedas“Pay-outperiod”orPay-offperiod.•One of the limitations of the pay-back period method is that it ignores the post pay-back returns of project.•Discountedpay-backmethodhelpstomeasurethepresentvalueofallcashinflowsandoutflowsatanappropriate•discount rate.Average Rate of Return Method is also termed as Accounting Rate of Return Method.•Discount cashflow is amethodof capital investment appraisalwhich takes into account both the overall•profitabilityofprojectsandalsothetimingofreturn.NetPresentValueisobtainedbysubtractingthepresentvalueofcashoutflowsfromthepresentvalueofcash•inflows.InternalRateofReturnMethodisalsocalledas“TimeAdjustedRateofReturnMethod.•HorngrenandFosterdefineInternalRateofReturnastherateofinterestatwhichthepresentvalueofexpected•cashinflowsfromaprojectequalsthepresentvalueofexpectedcashoutflowsoftheproject.ProfitabilityIndexisalsoknownasBenefitCostRatio.•AspertheBenefitCostRatioorProfitabilityIndexaprojectwithProfitabilityIndexgreaterthanoneshould•be accepted as it will have Positive Net Present Value.

ReferencePeterson, P. P. & Fabozzi, J. F., 2004. • Capital Budgeting: Theory and Practice, John Wiley & Sons.Periasamy, P., 2010. • A TEXTBOOK OF FINANCIAL COST AND MANAGEMENT ACCOUNTING, Global Media.WHAT IS CAPITAL BUDGETING?• [Pdf] Available at: <http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/CapitalBudget/CapitalBudgetingTraining.pdf>[Accessed16May2013].CHAPTER 29 Capital Budgeting• [Pdf] Available at: <http://mfile.narotama.ac.id/files/Accounting%20&%20Financial/A%20Textbook%20of%20Financial%20Cost%20&%20Management%20Accounting%20(Revised%20Edition)/Chapter%2029%20%20Capital%20Budgeting.pdf>[Accessed16May2013].Irfanullah, A., 2011. • CFA Level I Capital Budgeting Video Lecture by Mr. Arif Irfanullah part 2 [Video online] Availableat:<http://www.youtube.com/watch?v=qfzQwqLdXH0>[Accessed16May2013].Capital Budgeting• [Videoonline]Availableat:<http://www.youtube.com/watch?v=qGgVGUcBqAg>[Accessed16 May 2013].

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Recommended ReadingJacobs & Davina, F., 2006. • A Reviews of Capital Budgeting Practices, International Monetary Fund.Dayananda, D., 2002. • Capital Budgeting: Financial Appraisal of Investment Projects, 2nd ed. Cambridge University Press.Baker, K. H. & English, P., 2011. • Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects, John Wiley & Sons.


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Self Assessment

___________isconcernedwiththefirm’sformalprocessfortheacquisitionandinvestmentofcapital.1. Investmenta. Capital budgetingb. Capital expenditurec. Planningd.

Which of the following statements is false?2. Capital budgeting involves commitment of small amount of funds.a. Wrongsaleforecast;mayleadtooverorunderinvestmentofresources.b. Manyfirmsfail,becausetheyhavetoomuchortoolittlecapitalequipment.c. Capital decisions are required to assessment of future events which are uncertain.d.

____________ is the expenditurewhichbringsmore revenue to thefirmeither by expanding the existing3. production facilities or development of new production line.

Mutually Exclusive Proposalsa. Independent Proposalsb. Capital Expenditure Increases Revenuec. Capital Expenditure Reduces Costsd.

Whatreducesthecostofpresentproductandtherebyincreasestheprofitabilityofexistingoperations?4. Mutually Exclusive Proposalsa. Independent Proposalsb. Capital Expenditure Increases Revenuec. Capital Expenditure Reduces Costsd.

____________ refer to the acceptance of one proposal results in the automatic rejection of the other proposal.5. Mutually Exclusive Proposalsa. Dependent Proposalsb. Contingent Proposalsc. Independent Proposalsd.

Which proposals are said be to economically independent?6. Mutually Exclusive Proposalsa. Independent Proposalsb. Dependent Proposalsc. Contingent Proposalsd.

WhichofthefollowingformulacalculatesProfitabilityIndex?7.

Average Rate of Return (ARR) = a.

Lower Interest Rate + b. × (higher rate – lower rate)

Reciprocal Pay-back Period = c.

ProfitabilityIndex=d.

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____________isdefinedasthenumberofyearsrequiredtorecovertheinitialinvestmentinfullwiththehelp8. ofthestreamofannualcashflowsgeneratedbytheproject.

ProfitabilityIndexMethoda. Internal Rate of Return Methodb. Pay out Period Methodc. Net Present Value Methodd.

Iftheprojectgeneratesconstantcashflowthepay-backperiodcanbecomputedbydividing__________by9. annualcashinflows.

constantannualcashinflowsa. investment proposalsb. cashinflowsc. cash outlaysd.

____________isamethodofcapitalinvestmentappraisalwhichtakesintoaccountboththeoverallprofitability10. of projects and also the timing of return.

Discountcashflowa. Cashflowb. Net present value methodc. Internal rate of return methodd.


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Chapter VII

Management of Working Capital

Aim

The aim of this chapter is to enable the students to:

explain working management•

elucidate components, aspects and need for working capital•

explicate the determinants of working capital•

Objectives


enlist the types of working capital •

explain gross working capital •

elucidate the components of working capital•

Learning outcome

At the end of the chapter, you will be able to:

defineworkingcapital•

understandthefactorsinfluencingtheworkingcapital•

identify net working capital•

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7.1 IntroductionWorking capital may be regarded as the lifeblood of a business enterprise. It is, closely, related to the day-to-day operations of the business. Every business needs funds for two purposes. Longterm funds are required for creation of production facilities such as plant and machinery, land, building and furniture, etc. Investment in these assets representsthatpartoffirm’scapital,whichispermanentlyblockedonapermanentorfixedbasisandiscalledfixedcapital. The form of these assets does not change, in the normal course.

Funds are, also, needed for purchase of raw materials, payment of wages and other day-today expenses etc. These funds are known as working capital. Funds invested in these assets keep revolving, fast. These assets are converted into cash and, again, cash is converted into current assets. So, working capital is also called revolving or circulating capital. The assets change the form, on a continuous basis. In other words, working capital refers to that part of the firm’scapital,whichisrequiredforfinancingshort-termorcurrentassetssuchascash,debtors,inventoriesandmarketable securities, etc.

Capitalisdividedintofixedcapitalandworkingcapital.Fixedcapitalrequiredforestablishmentofabusiness,whereasworkingcapitalrequiredtoutilisefixedassets.

Theefficiencyofabusinessenterprisedependslargelyonitsabilitytomanageitsworkingcapital.•Working capital management therefore, is one of the important facets of a firm’s overall financial •management.

7.2 Meaning and Definition of Working CapitalWorkingcapitalreferstocurrentassetsthatcanbedefinedas:

Those which are convertible into cash or equivalent within a period of one year and those which are required •to meet day-to-day operationItisconcernedwiththemanagementofthefirm’scurrentassetsandcurrentliabilities.•It refers to the problems that arise in attempting to manage the current assets, current liabilities and their •interrelationship between themIfafirmcannotmaintainasatisfactorylevelofworkingcapital,itislikelytobecomeinsolventandevenforced•into bankruptcy.

To quote Ramamurthy, “It refers to the funds,which a companymust possess to finance its day-to-dayoperations”.J. S. Mill, "The sum of the current assets is the working capital of the business."

7.3 Classification of Working Capital Workingcapitalcanbeclassifiedintwoways

On the basis of concept •On the basis of time•


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Kinds of Working Capital

Concept Base

Gross Working Capital or Quantitative

Net Working Capital or Qualitative

Permanent or Regular Working Capital

Temporary or Variable Working Capital

Time Base

Fig. 7.1 Types of working capital

Onthebasisofconcept,workingcapitalisclassifiedasgrossandnetasdiscussedearlier.

Gross working capitalGrossworkingcapitalreferstothefirm’sinvestmentintotalcurrentassetsoftheenterprise.Currentassetsarethose,which can be converted into cash, within an accounting year (or operating cycle). They include cash, debtors, bills receivable, stock and marketable securities etc. In a broader sense, working capital refers to gross working capital. liabilities are accounting outstanding

Net working capitalIn the narrow sense, working capital refers to net working capital. Net working capital is the difference between current assets and current liabilities. Current of outsiders, which are expected to mature for payment, within an include creditors, bills payable, bank overdraft/cash credit account and those claims year. They expenses.

Ifthepaymentofcurrentliabilitiesisdelayed,thefirmgetstheavailabilityoffundstothatextent.So,apartofthefundsrequiredtomaintaincurrentassetsisfinancedbythecurrentliabilities.Thefirmisrequiredtoinvestinthecurrentassets,tothatextent,notfinancedbythecurrentliabilities.

If current assets are in excess of current liabilities, net working capital is positive. A negative working capital occurs when the current liabilities exceed current assets.

Treatment of Bank overdraft/cash credit account: Bank overdraft/cash credit account is treated as current liability as the sanction of bank is for one year. It is a different matter bank renews these facilities on a continuous basis, at the request of the borrower, on submission

While, on the basis of time, working capital is divided in two types:Permanent working capital•Variable working capital•

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Permanent working capitalIt refers to the minimum amount of investment required in all current assets at all times to carry on the day-to-•dayoperationoffirm’sbusiness.Theminimum level of current assets has been given the name of “Core current assets’ by theTandon•Committee.Itisalsoknownasfixedworkingcapital.•

Variable/Temporary working capitalItisknownasvariableworkingcapitalorfluctuatingworkingcapital.•Theworkingcapitalkeepsonfluctuatingfromtimetotimeonthebasisofbusinessactivities.•Theadditionalworkingcapitalrequiredasperthechangingproductionandsaleslevelofafirmisknownas•temporary working capital.Thefirm’sworkingcapitalrequirementsvarydependingupontheseasonalchangesindemandforafirm’s•products.

7.4 Components of Working CapitalThe main components of working capital are:

Current assets: Current assets consist of cash, marketable securities, inventories, sundry debtors, bills receivables, •short term investments, prepaid expenses etc. Current assets are those assets that, in the ordinary course of business, can be turned into cash within an accounting period (not exceeding one over) within undergoing diminution in value and without disrupting the operations.Current liabilities: They consist of loans and advances, sundry creditors, short-term borrowing, bank over-•draft, taxes and proposed dividend. Current liabilities are those liabilities intended to be paid in the ordinary course of business within a reasonable period (normally within a year) out of the current assets or revenue of the business.

7.5 Aspects of Working Capital ManagementThe following four aspects are involved in the management of working capital.

Determiningthetotalfundsrequiredtomeetthecurrentoperationofthefirm;determiningthelevelofcurrent•assets.Decidingthestructureofcurrentassets;theproportionoflong-termandshort-termcapitaltofinancecurrent•assets.Evolving suitable policies, procedures and reporting systems for controlling the individual components of current •assets;mainlycash,receivablesandinventoryDetermining the various sources of working capital.•

For determining the sources of working capital (short term and long term) capital the net concept becomes �usefulFor determining the level and composition of working capital it is the gross concept, which becomes more �meaningful.

7.6 Need for Working CapitalWorkingcapitalisneededtillafirmgetscashonsaleoffinishedproductsassalesdonotconvertintocashimmediately.Thereisaninvisibletimelagbetweenthesaleofgoodsandreceiptsofcash.Therefore,sufficientworkingcapitalis necessary to sustain sales activity.

The operating cycle concept penetrates to the heart of working capital management in a more dynamic form. The time that elapses to convert raw materials into cash (elapses between the purchase of raw materials and the collection of cash from sale) is known as operating cycle.


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Thefollowingelementsaretheoperatingcycleofthefirm:Conversion of cash into raw materials•Conversion of raw materials into work-in-process•Conversionofwork-in-processintofinishedgoods•Timeforsaleoffinishedgoods-cashsalesandcreditsales.•Time for realisation from debtors and Bills receivables into cash•Credit period allowed by creditors for credit purchase of raw materials, inventory and creditors for wages and •overheads.

Finished goods

Sales

Work-in Process

Raw Materials

Cash

Debtor

Fig 7.2 Operating cycle

Operating Cycle can be computed with the following formula:OC = ICP + ARPWhere OC = Operating Cycle ICP = Inventory Conversion Period ARP = Accounts Receivable Period

Example ABC company provided the following information and requested you to compute operating cycle:SalesRs.3,000lakhs;Inventory:OpeningRs.610lakhs;closingRs.475lakhsReceivable:OpeningRs.915lakhs;closingRs.975lakhsCost of goods sold Rs. 2,675 lakhs

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SolutionOC = ICP + ARP

= = 74 days

=

= 114.97 daysOC = 74 days + 115 days = 189 daysOC 189 days indicates that ABC company takes (requires) 189 days to convert raw materials into cash. In other words, some amount of cash blocked for 189 days, therefore there is a need to have working capital.

Cash conversion cycleTheamountoftimeafirm’sresourcesaretiedup;calculatedbysubtractingtheaveragepaymentperiodfromtheoperatingcycle.Inotherwords,thetimeperiodbetweenthedatesafirmpaysitssuppliersandthedateitreceivescash from its customers. CalculationofCashConversionCycle(CCC)(seethefig.below) CCC = OC – APPWhere: OC = Operating Cycle APP = Accounts Payable Period OC = AAI + ARP AAI = Average Age of Inventory ARP = Average Collection (receivables) Period FromthefinancialstatementswecandeterminetheconstituentsofCashConversionCyclei..,AAI,ARP,APP

AAI = Average Inventory (Cost of Goods sold / 365)

ARP = Average Accounts Receivables (Annual Sales / 365)

APP = Average Accounts Payables (Cost of Goods Sold / 365)

Purchase of Raw Materials on Credit

Sales of Goods on Credit

Payment to Suppliers

Operating Cycle (OC)Cash Conversion Cycle (CCC)

Collection of Accounts Receivables

Accounts Receivables Period (ARP)

Average Age of Inventory (AAI)

Accounts Payable Period (APP)

Receipt ofInvoice

ExampleFromthefollowingfinancialinformationcalculateCashConversionCycle.

AverageuseofInventories80days;accountsreceivablescollectionperiod50days,andaccountspayableperiodis 40 days.


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Solution: CCC = OC – APPOC = AAI + ARP = 80 + 50 = 130 daysCCC = 130 days – 40 = 90 days

Determinants of working capitalAlargenumberoffactorsinfluencetheworking-capital-needsofafirm.

Thebasicobjectiveofafirm’sworkingcapitalmanagementistoensurethatthefirmhasadequateworking•capital for its operation, neither too much nor too little working capital.Thereisnosetofrulesorformulaetodeterminetheworkingcapitalrequirementsofafirm.•The total working capital requirement is determined by a wide variety of factors.•Thefactors,however,affectdifferentfirm’sworkingcapital•The relative importance of these factors should be made in order to determine the total investment in working •capital

Thefollowingwillgivedescriptionofthegeneralfactorsinfluencingtheworkingcapitalneedsofafirm:Natureandsizeofbusiness:Theworkingcapitalrequirementsofafirmarebasicallyinfluencedbythenature•of the business.

Thenatureofthebusiness-influencetheworkingcapitaldecisions. �The proportion of current assets needed in some lines of business activity varies from other lines. �Tradingandfinancialfirmshavelessinvestmentinfixedassetsbutrequiresalargesumofmoneytobe �invested in working capital.Size may be measured in terms of scale of operations. �Afirmwithlargescaleofoperationnormallyrequiresmoreworkingcapitalthanafirmwithalowscale �of operation.

Manufacturing cycle: It is a factor, which has bearing on the quantum of working capital.•The term is refer to the time involves in manufacturing of goods. �It covers the time span between the procurement of raw materials and the completion of the manufacturing �processleadingtotheproductionoffinishedgoods.Longer the manufacturing cycle, the higher will be the working capital requirement and vice versa. �

Production policy: The requirement on working capital is determined on the basis of production policy of the •firm.

Production policy means whether it is continuous or seasonal production. �Therearetwoproductionpolicythatthecompanyorthefirmcanfollow �Theycanconfinetheirproductiononlytoperiodswhengoodsarepurchasedor �They can follow a steady production policy throughout the year and produce goods at a level to meet peak �demand.FMCG goods business of production and sales goes simultaneously and the amount of working capital �required is less.Umbrella business sales will be only in seasonal and production will take place throughout the year �continuously the amount of working capital required is very high.

Terms of purchase and sales: Terms (cash or credit) of purchase and sales also affect the amount of working •capital.

Ifacompanypurchasesallgoodsorrawmaterialsincashandsellsitsfinishedgoodsorproductoncredit, �it will require larger amount of working capitalOn the contrary, a concern having credit facilities and allowing no credit to its customers will require lesser �amount of working capital.

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Terms and conditions of purchase and sale are generally governed by prevailing trade practices and by �changing economic conditions

Operatingefficiency:Operatingefficiencyrelatestotheoptimumutilisationofafirm’sresourcesatminimum•costs.

Thefirmwithhighefficiencyinoperationcanbringdownthetotalinvestmentinworkingcapitaltolower �level.Effectiveutilisationofresourceshelpsthefirminbringingdowntheinvestmentinworkingcapital. �Ifafirmsuccessfullycontrolsoperatingcost,itwillbeabletoimprovenetprofitmarginwhich,will,in �turn, release greater funds for working capital purposes.

Businesscycle:Theamountofworkingcapitalrequirementsofafirmvarieswitheverymovementofbusiness•cycle.Whenthereisanupwardswingintheeconomysaleswillincrease,andalsothefirm’sinvestmentininventories•andbookdebtswillincrease,thusitwillincreasetheworkingcapitalrequirementofthefirmandviceversa.Growth and expansion: As company grows, it is logical to expect that a larger amount of working capital •required.

Agrowingfirmmayneedfundstoinvestinfixedassetsinordertosustainitsgrowingproductionandsales. �This will, in turn, increase investment in current assets to support increased scale of operations.Therefore,agrowingfirmneedsadditionalfundscontinuously. �

Profitmarginanddividendpolicy:Themagnitudeofworkingcapital inafirmisdependentuponitsprofit•margin and dividend policy.Ahighnetprofitmargincontributestowardstheworkingcapitalpool.•Totheextentthenetprofithasbeenearnedincash,itbecomesasourceofworkingcapital.Thisdependsupon•the dividends results in a drain on cash resources and thus reduces company’s working capital to that extend.

Theworkingcapitalpositionofthefirmisstrengthenedifthemanagementfollowsconservationdividend �policy and vice versa.

Conditionsofsupplyofrawmaterial:Ifthesupplyofrawmaterialisscarcethefirmmayneedtostockitin•advance and hence need more WC and vice-versa.Availabilityofcredit:Theworkingcapitalrequirementofafirmarealsoaffectedbycredittermsgrantedby•its suppliers, i.e., creditors.

Theneedforworkingcapitalwillbelessinafirm,ifliberalcredittermsareavailabletoit.Similarly,theavailabilityofcreditfrombanksalsoinfluencesthefirm’sworkingcapitalneeds.•Afirm,whichcangetbankcrediteasilyonfavorableconditions,willbeoperatedwithlessworkingcapital•thanafirmwithoutsuchafacility.Taxationpolicy:ThetaxpoliciesoftheGovernmentwillinfluencetheworkingcapitaldecisions.•

IftheGovernmentfollowsregressivepolicy,i.e.,imposingheavytaxburdensonbusinessfirms,theyare �leftwithverylittleprofitsfordistributionandretentionpurpose.Consequently,thefirmhastoborrowadditionalfundstomeettheirincreasedworkingcapitalneeds. �When there is a liberalised tax policy, the pressure on working capital requirement is minimised. �

Other factors: There are many other factors which affect the requirement of working capital like infrastructural •facilities,importpolicy,changesinthetechnology,co-ordinationactivitiesinfirm,distributionpoliciesandso on.


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7.7 Estimation of Working Capital RequirementsThe best approach to estimate is based on operating cycle. Working capital consists of two components – current assets and current liabilities. There is a need to follow the following four – steps procedure for estimation of working capital

Estimationofcashcostofthevariouscurrentassetsrequiredbythefirm.•Estimationofspontaneouscurrentliabilitiesofthefirm.•Compute net working capital by subtracting the estimated current liabilities (step (2)) from current assets (step •(1))Add some percentage (given in the problem) of net working capital if there is any contingency or safety working •capital required, to get the required working capital.

7.8 Sources of Working CapitalAftertheestimationoftheworkingcapital,thenextstepisfinancingthecurrentassets.Therearethreefinancingpoliciesvis-à-vis’,tofinancecurrentassets.Adoptionthespecificpolicyisleftouttothefirm.Thefollowingarethefinancingpolicies:

Short-term:Generallycurrentassetsshouldbefinancedbyshort-termfinancialsources.•Short-termfinancingreferstoborrowingfundsorraisingcreditformaximumof1yearperiodi.e.,atthe �most the debt is payable within a year.Thesourcesofshort-termfinanceareloansfrombanks,short-termpublicdeposits,commercialpapers, �factoringofreceivables,billsdiscounting,retentionofprofitsetcAfirmwhichrequiredshort-termfinancecangoforanyoneoftheabovesources. �Long-term:Net current assets orworking capital is supposed to befinancedby long-term sources of �finance.Long-termfinancereferstotheborrowingoffundsorraisingcreditforoneyearormore. �Long-termfinanceisraisedforaperiodofabovefiveyears. �The sources of long-term include- ordinary share capital, preference share capital, debentures, long-term �loans from bankers and surplus (includes retained earnings).Afirm that need tofinancenet current assets cango for anyof the above sources, but it depends on �company’s attitude towards risk or control over the company, companies earnings, capacity and period of loan reserved.

Spontaneousfinancing:Refers to theautomatic sourceof short termfundsarising in thenormalcourseof•business.

The source are trade credits and out standing expenses �Thesourceofspontaneousfinanceisavailableatcostfree �Firms that want to maximise owner’s wealth than it must and should utilise the sources to the fullest �extantSomeextantofcurrentassetscanbefinancedwiththeuseofspontaneoussource �Therequiringcurrentassetsshouldbefinancedwiththecombinationoflong-termandshort-termsources �offinance

Thepoliciesforfinancingorworkingcapitalaredividedintothreecategories:•Conservativefinancingpolicy:inwhichmanagerdependsmoreonlong-termfunds. �Aggressivefinancingpolicy:inwhichthemangerdependsmoreonshorttermfunds. �Moderate policy: suggests that the manager depends moderately on both long-term and short-term while �financing.

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Analysis of working capitalDeterminingtheworkingcapitalisjustnotsufficientforabetterperformance.Itshouldbeanalysed.Itmaybeanalysed with a view to gross and net angles i.e., quantitative and qualitative.The quantitative aspect of working capital refers to the quality of current assets while the qualitative aspect of working capital refers to the liquidity and its adequacy.The following are the aspects of working capital:

Structure of working capital: It helps to have a better perspective of the working capital position of any •company.Working capital status: In order to ascertain the trends in working capital, indices of current assets, current •liabilitiesandnetworkingcapitalofthefirmmaybecomputed.

First year of the selected period may be taken as base, for computing trends in current assets, current �liabilities and net working capital.Working capital position in a concern would be satisfactory, provides the pace of increase in current assets �is more than that of the current liabilities and vice-versa.If thenetworkingcapital indicesalso increase, itwill furtherconfirmthat strengthofworkingcapital �positioninafirm.

Working Capital Leverage: It measures the sensitivity of return on investment (ROI) to the changes in ROI of •current assets.Workingcapitalleverage(WCL)maybedefinedasthepercentagechangeinROIwithgivenpercentagechange•in current assets.

Symbolically:

WCL = Percentage Change in ROI ÷ Percentage Change in Current Assets


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SummaryWorking capital may be regarded as the lifeblood of a business enterprise.•Longterm funds are required for creation of production facilities such as plant and machinery, land, building •and furniture, etc.Investmentintheseassetsrepresentsthatpartoffirm’scapital,whichispermanentlyblockedonapermanent•orfixedbasisandiscalledfixedcapital.Grossworkingcapitalreferstothefirm’sinvestmentintotalcurrentassetsoftheenterprise.Currentassetsare•those, which can be converted into cash, within an accounting year (or operating cycle). If current assets are in excess of current liabilities, net working capital is positive. A negative working capital •occurs when the current liabilities exceed current assets.Current assets are those assets that, in the ordinary course of business, can be turned into cash within an accounting •period (not exceeding one over) within undergoing diminution in value and without disrupting the operations

ReferencesMathur, S. B., 2002. • Working Capital Management and Control Principles & Practice. New Delhi. New Age International (P) Limited. Dr. Rustagi, R. P., • Principles of Financial Management. 4th ed., New Delhi. Taxmann Publications (P) Ltd. Working Capital Management• ,[Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/703/7/07_chapter1.pdf>[Accessed29May2013].Working Capital Management,• [Pdf]Available at: <http://www.ediindia.org/doc/SpecialPDF/chp-14.pdf>[Accessed 29 May 2013].2012. • Working Capital Management, [Video online] Available at: <http://www.youtube.com/watch?v=C0UOvhnIqxE>[Accessed29May2013].2010. • Whats working capital?[Videoonline]Availableat:<http://www.youtube.com/watch?v=AnwK1BQxJVw>[Accessed 29 May 2013].

Recommended ReadingPreve, L. & Sarria-Allende, V., 2010. • Working Capital Management. Oxford University Press.Kumar, A. V., 2001. • Working Capital Management. Northern Book Centre.Sagner, J., 2010. • Essentials of Working Capital Management. John Wiley & Sons.

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Self Assessment

Whichofthefollowingcycleisthetimeperiodbetweenthedatesafirmpaysitssuppliersandthedateitreceives1. cash from its customers?

Operating Cyclea. Cash Conversion Cycleb. Cash Conversion Periodc. Net Working Capitald.

Permanent Working Capital is also known as _________2. total current assetsa. gross working capital b. fixedworkingcapitalc. net working capitald.

Operatingcycleofafirmcanbeshortenedbywhichofthefollowing?3. Increasing stock of raw materiala. Increasing credit period to customersb. Increasing working-in-processc. Increasing credit period from suppliersd.

Which of the following statements is false?4. Inconservativeapproach,thereislongtermfinancingofworkingcapital.a. Inaggressiveapproach,thereisnoshorttermfinancingofworkcapital.b. Working Capital Leverage measures the sensitivity of return on investment (ROI) to the changes in ROI of c. current assets.Therequirementonworkingcapitalisdeterminedonthebasisofproductionpolicyofthefirm.d.

Theamountofworkingcapitalrequirementsofafirmvarieswitheverymovementof______________.5. business cyclea. production policyb. manufacturing cyclec. operatingefficiencyd.

Match the following6.

1. Concept of working capital a. commercial papers, factoring of receivables, bills discounting, retentionofprofitsetc

2.Short-termfinancing b. Current assets and Current liabilities

3. Structure of Working Capital c. Net working capital

4. Components of working capital d. helps to have a better perspective of the working capital position of any company

1-b, 2-d, 3-a, 4-c.a. 1-c, 2-a, 3-d, 4-b.b. 1-d, 2-c, 3-a, 4-b.c. 1-d, 2- a, 3-b, 4-c.d.


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Permanent working capital is the _______________ of current assets needed to conduct a business during the 7. normal season of the business.

maximum amounta. moderate amountb. minimum amountc. increasing amountd.

Which of the following statements is true?8. Conservativefirmdependsonmorelong-termfundsforfinancingneed.a. Spontaneous Financing refers to the automatic source of long-term funds arising in the normal course of b. business.Therequirementonworkingcapitalisdeterminedonthebasisofmanufacturingpolicyofthefirm.c. Net working capital is the surplus of current liabilities over current assets and provisionsd.

Match the following9.

1. Temporary working capital a. Availability of Credit

2. Gross working capital b. Variable working capital

3. Determinants of Working Capital c. Aspects of Working Capital Management

4. Determining the various sources of working capital d. circulating capital1-c, 2-a, 3-d, 4-b.a. 1-d, 2-c, 3-a, 4-b.b. 1-c, 2-d, 3-b, 4-b.c. 1-b, 2-d, 3-a, 4-c.d.

Working capital consists of _______________.10. current assets and current liabilitiesa. permanent and temporary working capitalb. gross and net working capitalc. concept based and time based working capitald.

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Chapter VIII

Inventory Management

Aim


explain the types of inventory •

elucidate the objectives of inventory management•

defineinventory•

Objectives


explain motives of inventory management•

enlist the risks of holding inventory•

elucidate the techniques of inventory control•

Learning outcome

At the end of the chpater, you will be able to:

understandthemeaning,definitionandobjectivesofinventorymanagement•

identify the types of inventory•

understand the motives of inventory management•


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8.1 IntroductionInventories constitute a major component in current assets. It constitutes around 60% in the public limited companies, in India. For the smooth running, every enterprise needs inventory. Inventories serve as a link between production and distribution processes. Due to its major composition in current assets, the management of inventories occupies a key role in working capital management. Excessive investment affects the liquidity. Inadequate investment makes thefirmtoloosethebusinessopportunities,otherwiseavailable.Profitabilitywouldbeaffectedwithexcessiveorinadequateinvestment.So,inventorymanagementisessentialtoallowthefirmtoavailtheopportunitiestoimproveprofitabilityandatthesametimedoesnotimpairitsliquidity,withexcessiveorunproductiveinvestment.Afirm,whichneglectstheinventorymanagement,jeopardizesitslongtermprofitability.So,itisabsolutelyimperativetocontrolandmanageinventoryholding,bothefficientlyandeffectively,toavoidunnecessaryinvestment.

Inventorymanagementoccupiesthemostsignificantpositioninthestructureofworkingcapital.Inventoriesarethemostsignificantpartofcurrentassets.Inventorymanagementisanimportantareaofworkingcapitalmanagement,whichplaysacrucialroleineconomicoperationofthefirm.Maintenanceoflargesizeofinventoriesrequiresaconsiderableamountoffundstobeinvestedonthem.Efficientandeffectiveinventorymanagementisnecessaryinorder to avoid unnecessary investment and inadequate investment. A considerable amount of funds is required to becommittedininventories.Itisabsolutelyimperativetomanageinventoriesefficientlyandeffectivelyinordertooptimiseinvestmentinthemcannotbeignored.Anylapseonthepartofmanagementofafirminmanaginginventoriesmaycausethefailureofthefirm.

8.2 Meaning and Definition of InventoryTheterm“Inventory”isoriginatedfromtheFrenchword“Inventaire”andtheLatin“Inventariom”whichimpliesalistofthingsfound.ThetermhasbeendefinedbytheAmericanInstituteofAccountantsastheaggregateofthoseitems 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•

Theterminventoryreferstothestockpileoftheproductsafirmisofferingforsalesandthecomponentsthatmakeupthe 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 as follows:

Raw materials•Work-in process•Finished goods•Stores and spares•

However,incommercialparlance,inventoryusuallyincludesstores,rawmaterials,work-in-processandfinishedgoods.Theterminventoryincludes–rawmaterial,workinprocess,finishedgoodspackaging,sparesandothersstocked in order to meet an unexpected demand or distribution in the future.

8.3 Types of InventoryThe following are the types of inventory:

Rawmaterials:Rawmaterialsarethoseinputsthatareconvertedintofinishedgoodsthroughmanufacturing•process. These form major inputs for manufacturing a product. In other words, they are very much needed for uninterrupted production.Work-in-process:Work-in-processisthatstageofstocksthatarebetweenrawmaterialsandfinishedgoods.•Work-in-processinventoriesaresemi-finishedproducts.Theyrepresentproductsthatneedtoundergosomeprocesstobecomefinishedgoods.Finishedproducts:Finishedproductsarethoseproducts,whicharereadyforsale.Thestockoffinishedgoods•provides a buffer between production and market.

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Storesandspares:Storesandsparesinventory(includeofficeandplantcleaningmaterialslikesoap,brooms,•oil, fuel, light, etc.) are those purchased and stored for the purpose of maintenance of machinery.

8.4 Inventory Management MotivesManaging inventories involves block of funds and inventory holding costs. There are three general motives for holding inventories

Transaction motives: It includes production of goods and sale of goods. It facilities uninterrupted production •and delivery of order at a given time (right time)Precautionary motive: This motive necessitates the holding of inventories for unexpected changes in demand •and supply factors.Speculative motive: This compels to hold some inventories to take the advantage of changes in prices and •getting quantity discounts.

8.5 Objectives of Inventory ManagementThe objectives of inventory management may be viewed in two. They are

Operational:theoperationalobjectiveistomaintainsufficientinventory,tomeetdemandforproductbyefficiently•organisingthefirm’sproductionandsalesoperationsFinancial:financialviewistominimiseinefficientinventoryandreduceinventorycarryingcosts.•

Thesetwoconflictingobjectivesofinventorymanagementcanalsobeexpressedintermsofcostsandbenefitsassociatedwithinventory.Thefirmshouldmaintaininvestmentininventoryimpliesthatmaintaininganinventoryinvolves costs, such that smaller the inventory the lower the carrying cost and vice versa. But inventory facilitates (benefits)thesmoothfunctioningoftheproduction.Aneffectiveinventorymanagementshould:

ensure a continuous supply of raw materials and supplies to facilities uninterrupted production•maintainsufficientstocksorrawmaterialsinperiodsofshortsupplyandanticipatepricechanges•maintainsufficientfinishedgoodsinventoryforsmoothsalesoperationandefficientcustomersservices•minimise the carrying costs and time and•control investment in inventories and keep it at an optimum level•

Apartfromtheabove,thefollowingarealsoobjectsofinventorymanagement.Controlofmaterialscosts;eliminationofduplicationinorderingbycentralisationofpurchasers;supplyofrightqualityofgoodsofreasonableprices,provide data for short-term and long-term for planning and control of inventories.Therefore, management of inventory needs careful and accurate planning so as to avoid both excess and inadequate inventoryinrelationtotheoperationalrequirementofafirm.Toachievehigheroperationalefficiencyandprofitabilityofafirm,itisessentialtoreducetheamountofcapitallockedupininventories.Thiswillnotonlyhelpinachievinghigher return on investment by minimising tied-up working capital, but will also improve the liquidity position of the enterprise.

8.6 Costs of Holding InventoryMinimising cost is one of the operating objectives of inventory management. There are three costs involved in the management of inventories.

Ordering costsOrdering costs are those costs that are associates with the acquisition of raw materials. In other words, the costs that are spend from placing an order till the receipt of raw materials. They include the following:

Cost of requisitioning the items (raw materials)•Cost of preparation of purchase order (i.e., drafting typing, dispatch, postal etc)•Cost of sending reminders to get the dispatch of the items expedited•Cost of transportation of goods (items)•


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Cost of receiving and verifying the goods•Cost of in unloading of the (items) of goods•Shortage and stocking charges•

However, incase of items manufactured in house the ordering costs would comprise the following costs:Requisitioning cost•Set-up cost•Cost of receiving and verifying the items•Cost of placing and arranging/stacking of the items in the store etc.,•

Orderingcostsarefixedperorderplaced,irrespectiveoftheamountoftheorderbutorderingcostsincreasesinproportiontothenumberoforderplaced.Ifthefirmmaintainssmallinventorylevelsthenthenumberoforderswill increase, there by ordering cost will increase and vice versa.

Carrying costsInventory carrying costs are those costs, which are associated with carrying or maintaining inventory. The following are the carry costs of inventory:

Capital cost (interest on capital locked in the inventories)•Storage cost (insurance, maintenance on building, utilities serving costs)•Insurance(oninventory–againstfireandtheftinsurance)•Obsolescence cost and deterioration•Taxes•Carrying costs usually constitute around 252 per cent of the value of inventories held•

Shortage costs (Costs of stock out)Shortagecostsarethosecoststhatariseduetostockoutoreithershortageofrawmaterialsorfinishedgoods.Shortageofinventoriesofrawmaterialsoveraffectthefirminoneormoreofthefollowingways:

Thefirmmayhavetopaysomewhathigherprice,connectedwithimmediate(cash)procurements•Thefirmmayhavetocompulsorilyresortthesomedifferentproductionschedules,whichmaynotbeasefficient•and economical

Stockoffinishedgoods–mayresultinthedissatisfactionofthecustomersandtheresultantlossofrulesThus, with a view to keep inventory costs of minimum level, we may have to arrive at the optional level of inventory cost, it is the total orders costs plus carrying costs are minimal. In other words, we have to determine Economic Order Quantity (EOQ), is that level at which the total inventory (ordering plus carrying less) cost is minimum.

8.7 Risks of Holding InventoryRisk in inventory management refers to the chance that inventory management cannot be turned over into cash through normal sales without loss. The following are the risk associated with inventory management

Price decline: Price decline is the result of more supply and less demand (introduction of competitive product). •Generallypricesarenotcontrollableintheshort-runbytheindividualfirm.Controllinginventoryistheonlywaythatafirmcancounteractwiththeserisks.Product deterioration: Holding inventory for a long period or shortage under improper conditions of light, heat, •humidity and pressure lead to product deterioration. Deterioration usually prevents selling in product through normal channels.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 firmswhoseresourcesarelimitedandtiedupinslowmovinginventories.Productobsolescencecostriskleastcontrollable except by reduction in inventory investment.

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Thus,inventoriesareriskyassetstomanageandtheeffectivewaytominimisingrisksissettingupofefficientinventory control system.

8.8 Benefits of Holding InventoryPropermanagementofinventorywillresultinthefollowingbenefitstoafirm:

Ensures an adequate supply of materials and stores, minimises stock outs and shortages and avoids costly •interruptions in operationsKeepdowninvestmentininventories;inventorycarryingcostsandobsolescencelossestotheminimum•Facilitates purchasing economics through the measurement of requirements on the basis of recorded •experienceEliminates duplication in ordering stocks by centralising the source from which purchase requisitions •emanatePermitsbetterutilisationofavailablestocksbyfacilitatinginter-departmenttransferswithinafirm•Provides a check against the loss of materials through careless or pilferage•Perpetualinventoryvaluesprovideaconsistentandreliablebasisforpreparingfinancialstatementsabetter•utilisation

8.9 Techniques of Inventory ControlThere are many techniques used to management inventory. Some of them are listed below:

8.9.1 ABC AnalysisIt 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 inventories.

Thefirmshouldnotkeepsamedegreeofcontrolonalltheitemsofinventory.Thefirmshouldputmaximum•control on those items whose value is the highest, with the comparison of the other two items.It is based on Pareto's Law and is known as Selective Inventory Control.•Usually afirmhas tomaintain 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 Proportional Value Analysis(PVA)

Accordingtothistechniquethetaskofinventorymanagementisproperclassificationofallinventoryitemsintothreecategories namely A, B and C category. The ideal categorisation of inventory items is shown in the Table 12.1. The highervalueitemsareclassified'Aitems'andwouldbeundertightcontrol.Attheotherendoftheclassificationwefindcategory'Citems',onthesetypesofinventoryfirmcannotaffordexpensesofrigidcontrols,frequentorderingand expending, because of the low value or low amounts. Thus with the '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 items' and 'C items' and require reasonable attention of management.

Category No. of Items (%) Items Value (%)

A 15 70

B 30 20

C 55 10

Total 100 100

Table 8.1 Categorisation of Inventory


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The above table indicates that only 15 per cent of the items may account for 70 per cent of the total value (A category items), on which greater attention is required, when as 55 per cent of items may account for 10 per cent of the total value of inventory (C category items), will be paid a reasonable attention. The remaining 30 per cent of inventory account for 20 per cent of total value of inventory (B category items) will be paid a reasonable attention as this, category value lies between the two other categories. The above data can be shown by the following graph.

Item

A

Item

B

Item

C

Valu

e of

item

s (%

)

100

80

60

40

20

010 20 30 40 50 60 70 80 90 100

No. of Items (%)

In the above Fig. numbers of items (%) are shown on 'X' axis and value of items (%) are represented on 'Y' axis. Greaterattentionwillbepaidoncategory'A'item,becausegreaterbenefit.Thecontrolof'C'itemsmaybereleasedduetolessbenefit(sometimescontrolcostmayexceedbenefitofcontrol)andreasonableattentionshouldbepaidon category 'B' items.

8.9.2 Economic Order Quantity (EOQ)Economic order quantity (EOQ) refers to that level of inventory at which the total cost of inventory is minimal. The total inventory cost comprising of ordering and carrying costs. Shortage costs are excluded in adding total cost of inventoryduetothedifficultyincomputationofshortagecost.EOQarealsoknownasEconomicLotSe (ELS).

Assumptions of EOQ ModelThe following assumptions are implied in the calculation of EOQ:

Demand for the product is constant and uniform throughout the period•Lead time (time from ordering to receipt) is constant•Price per unit of product is constant•Inventory holding cost is based on average inventory•Ordering costs are constant, and•Alldemandfortheproductwillbesatisfied(nobackordersareallowed)•

EOQ FormulaEOQ can be obtained by adopting two methods•Trail and Error approach•Short cut or Simple mathematical formula•

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Here for calculation of EOQ we have adopted simple short cut method. The formula is

Where:A = Annual usageO = Ordering cost per orderCC = Annual carrying per unitCC = Price per unit × Carrying cost per unit in percentage

The above simple formulawill not be sufficient to determineEOQwhenmore complex cost equations areinvolved.

EOQ is applicable both to single 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.

LimitationsApart from the above application it has its own limitations, which are mainly due to the restrictive nature of the assumptions on which it is based

Constant usage: It may not be possible to predict, if usage varies unpredictably, as it often does, no formula •will work well.Faulty basic information: Ordering and carrying costs is the base for calculation EOQ. It assumes that ordering •cost is constant per order, but actually varies from commodity to commodity. Carrying cost also can vary with the company's opportunity cost of capital.Costly calculation: In many cases the cost estimating, cost of possession and acquisition and calculating EOQ •exceeds the savings made by buying that quantity.

8.9.3 Order Point ProblemIf the inventory level is too high it will unnecessary block the capital and if the level is too low, it will disturb productionbyfrequentstockoutandalsoinvolveshighorderingcost.Hence,anefficientmanagementofinventoryneeds to maintain optimum inventory level, where there is no stock out and the costs are minimal. The different stock levels are

Minimum levelMinimumstockisthatlevelthatmustbemaintainedalwaysforsmoothflowofproduction.Whiledetermination•of minimum stock level, lead time, and consumption rate, material nature must be considered.Lead-time is the number of days required to receive the inventory from the date of placing order. It is also called •as procurement time of inventoryThe average quantity of raw materials consumed daily. The consumption rate is calculated based on the past •experience and production plan.Requirement of materials for normal or regular production or special order production. If the material is required •for special order production, then the minimum stock levels need not to maintain.

Minimum stock level = Re-order level – (Average Usage × Average delivery time)

Reorder levelReorder level is that level of inventory at which an order should be placed for replenishing the current stock of inventory. Generally the reorder 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 Consistent usage and Fixed lead-time.


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SafetyStock:Predictionofaveragedailyusageandlead-timeisdifficult.Rawmaterialsmayvaryfromdaytodayor from week to week, it is the case for lead-time also. Lead-time may be delayed if the usage increases, than the companyfacesproblemofstockout.Toavoidstockoutfirmmayrequiremaintainingsafetystock.Formula (under uncertainty of usage and lead time)

RE-order point = (Lead time (in days) × Average usage) + Safety stock

Maximum levelMaximumlevelofstockisthatlevelofstockbeyondwhichafirmshouldnotmaintainthestock.Iffirmstocksinventory beyond the maximum stock level is called as overstocking. Excess inventory (overstock) involves heavy costofinventory,becauseitblocksfirms’fundsininventory,excesscarryingcost,wastage,obsolescenceandtheftcost.Hence,firmshouldnotstockabovethemaximumstocklevel.Safetystockisthatminimumadditionalinventoryto serve as a safety margin or better or buffer or cushion 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 Delivery Time)

Danger stock levelDanger level is that level of materials beyond that materials should not fall in any situation. When it falls in danger levelitwilldisturbproduction.Hence,thefirmshouldnotallowthestockleveltogotodangerlevelifatallfallsin that level then immediately stock should be arranged even if it costly.

Danger Level = Average Usage × minimum Deliver Time (for emergency purchase)

8.9.4 Just in Time (JIT)PopularlyknowninitsacronymJIT.Itmaybeappliedforeitherrawmaterialspurchaseorproducingfinishedgoods. From raw materials purchase it means, that no inventories are held at any stage of production and the exact requirement is bought in each and every successive stage of production of the right time. In other words, maintenance of a minimum level of raw materials where by the inventory carrying cost could be minimised, and the risk of loss due to stock-out position could be well avoided. From production of goods view JIT means goods are produced only whentheorderarereceived,therebynostorageoffinishedgoods,andcanavoidcostsofcarryingfinishedgoods.JIT is also known as "Zero Inventory Production System" (ZIPS), Zero Inventories (ZIN), Materials as Needed (MAN) or Neck of Time (NOT).

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SummaryInventorymanagementoccupiesthemostsignificantpositioninthestructureofWorkingcapital.•Thetypesofinventoryare:rawmaterials;work-inprocess;finishedgoods;andstoresandspares.•Thetwoconflictingobjectivesofinventorymanagementare:maintaininginvestmentininventoryandtofacilitate•(benefits)thesmoothfunctioningoftheproduction,whichinturnmeetthedemand.Efficientmanagementofinventoryreducesthecostofproductionandconsequentlyincreasestheprofitability•of the enterprise by minimising costs associated with holding inventory.An effective inventory management should: Ensure a continuous supply of raw materials and supplies to •facilitatesuninterruptedproduction;maintainsufficientfinishedgoodsinventoryforsmoothsalesoperations;andefficientcustomerservice;minimisethecarryingcostsandtime;andControlinvestmentininvestmentandkeep it at an optimum level.Minimising cost is one of the operating objectives of inventory management. The costs (excluding merchandise •cost), there are three costs involved in the management of inventories. They are Ordering Costs, Inventory Carrying Costs and Shortage Costs.There are many techniques of management of inventory. Some of them are ABC analysis, Economic Order •Quantity (EOQ), Order Point Problem, Just in Time etc.

Reference2008. I• nventory Management,[Videoonline]Availableat:<http://www.youtube.com/watch?v=HZPMaTifdBg>[Accessed 29 May 2013].2008. • Lecture - 38 Basic Inventory Principles, [Video online] Available at: <http://www.youtube.com/watch?v=HZPMaTifdBg>[Accessed29May2013].Viale, J. D., • Basics of Inventory Management, [Pdf] Available at: <http://www.axzopress.com/downloads/pdf/1560523611pv.pdf>[Accessed29May2013].Inventory Management,• [Pdf] Available at: <http://highered.mcgraw-hill.com/sites/dl/free/0073525235/940447/jacobs3e_sample_ch11.pdf>[Accessed29May2013].Bose, C. D., 2006. INVENTORY MANAGEMENT, PHI Learning Pvt. Ltd.•Axst• er, S.,2006. Inventory control, 2nd ed., Springer.

Recommended Reading Muller, M., 2003. • Essentials of Inventory Management. AMACOM. Mullar, M., 2011. • Essentials of Inventory Management, 2nd ed., AMACOM Books.Viale, J. D. & Christopher, C., 1996. • Inventory Management: From Warehouse to Distribution Center, Course Technology / Cengage Learning .


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Self Assessment

Which of the following statements is true?1. Transaction motive includes production of goods and sale of goods. It facilities interrupted production and a. delivery out of order at a given time (right time)Precautionary motive necessitates the holding of inventories for expected changes in demand and supply b. factors.Speculative motive compels to hold some inventories to take the advantage of changes in prices and getting c. quantity discounts.Lead-time is the number of days required to receive the inventory from the date of placing order and is also d. called as procurement time of inventory.

Inventory is one of the components of _________ assets.2. liabilitiesa. cash budgetb. balancec. currentd.

Which of the following is true?3. Price decline, product deterioration and product obsolescence are the risks of holding inventory.a. Costs of holding inventory are ordering costs, capital costs and shortage costs.b. Carrying costs are those costs that are associates with the acquisition of raw materials.c. Price decline is the result of less supply and more demandd.

EOQ is the quantity that minimises:4. Total Inventory Costa. Total Ordering Costb. Total Interest Costc. Safety Stock Leveld.

_____________values provide a consistent and reliable basis for preparingfinancial statements a better5. utilisation.

Increase inventorya. Perpetual inventoryb. Costs of Holding Inventoryc. Risks of Holding Inventoryd.

Which of the following is one of the components of inventory carrying cost?6. Price declinea. Speculative motiveb. Capital costc. Work-in processd.

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Match the following7. 1. Objectives of Inventory Management a. Economic Order Quantity (EOQ)

2. Risks of holding inventory b.operationalandfinancial

3. Techniques of inventory control c. Zero Inventory Production System (ZIPS)

4. JIT is known as d. product obsolescence

1-c, 2-d, 3-b, 4-aa. 1-d, 2-a, 3-b, 4-cb. 1-b, 2-c, 3-d, 4-ac. 1-b, 2-d, 3-a, 4-cd.

Which of the following statements is false?8. ABC is also known as PAV.a. The EOQ model attempts to minimising the total cost of holding inventoryb. EOQ model assumes a constant usage rate for a particular item.c. Risk in inventory management refers to the chance that inventory management cannot be turned over into d. cash through normal sales without loss

InEOQformula√2AO÷CC,'A'standsforAnnualusage.9. Biennial Usagea. Perennial Usageb. Annual usagec. Monthly Usaged.

Which of the following is one of the risks of holding inventory?10. Shortage Costsa. Product Obsolescenceb. ABC analysisc. Work-in Processd.


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Chapter IX

Dividend Decision

Aim


explain the concept of dividend •

elucidate various dividend theories•

explicate Modigliani and Miller’s Approach•

Objectives


enlist the types of dividend•

explain Walter's model•

eluicdate dividend decision•

Learning outcome

At the end of the chapter, you will be able to:

understand Gordon's model•

describe dividend theories •

idenfitycashdividend•

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9.1 IntroductionThefinancialmanagermusttakecarefuldecisionsonhowtheprofitshouldbedistributedamongshareholders.It is very important and crucial part of the business concern, because these decisions are directly related with the valueofthebusinessconcernandshareholder’swealth.Likefinancingdecisionandinvestmentdecision,dividenddecisionisalsoamajorpartofthefinancialmanager.Whenthebusinessconcernsdecidedividendpolicy,theyhaveto consider certain factors such as retained earnings and the nature of shareholder of the business concern.

Meaning of DividendDividendreferstothebusinessconcernsnetprofitsdistributedamongtheshareholders.Itmayalsobetermedasthepartoftheprofitofabusinessconcern,whichisdistributedamongitsshareholders.AccordingtotheInstituteofCharteredAccountantofIndia,dividendisdefinedas“adistributiontoshareholdersoutofprofitsorreservesavailableforthispurpose”.

9.1.1 Types of Dividend/ Form of DividendDividendmaybedistributedamongtheshareholdersintheformofcashorstock.Hence,Dividendsareclassifiedinto:

Cash dividend•Stock dividend•Bond dividend•Property dividend•

Cash DividendIf the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are common and popular types followed by majority of the business concerns.

Stock DividendStockdividendispaid in theformof thecompanystockdue toraisingofmorefinance.Under this type,cashis retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the existing shareholders of the business concern.

Bond DividendBonddividendisalsoknownasscriptdividend.Ifthecompanydoesnothavesufficientfundstopaycashdividend,thecompanypromisestopaytheshareholderatafuturespecificdatewiththehelpofissueofbondornotes.

Property DividendProperty dividends are paid in the form of some assets other than cash. It will distributed under the exceptional circumstance. This type of dividend is not published in India.

9.2 Dividend DecisionDividenddecisionofthebusinessconcernisoneofthecrucialpartsofthefinancialmanager,becauseitdeterminestheamountofprofittobedistributedamongshareholdersandamountofprofittobetreatedasretainedearningsforfinancingitslongtermgrowth.Hence,dividenddecisionplaysveryimportantpartinthefinancialmanagement.Dividend decision consists of two important concepts which are based on the relationship between dividend decision andvalueofthefirm.


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Dividend Theories

Irrelevance of Dividend

Soloman Approach

MM Approach

Walter's Model

Gordon's Model

Relevance of Dividend

Fig. 9.1 Classification of dividend theories

9.2.1 Irrelevance of Dividend According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of the company.Thereisnorelationbetweenthedividendrateandvalueofthefirm.Dividenddecisionisirrelevantofthevalueofthefirm.ModiglianiandMillercontributedamajorapproachtoprovetheirrelevancedividendconcept.

Modigliani and Miller’s ApproachAccording to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not affectthevalueofthefirm.“Underconditionsofperfectmarket,rationalinvestors,absenceoftaxdiscriminationbetweendividendincomeandcapitalappreciation,giventhefirm’sinvestmentpolicy,itsdividendpolicymayhavenoinfluenceonthemarketpriceofshares”.

AssumptionsMM approach is based on the following important assumptions:

Perfect capital market•Investors are rational•There are no tax •Thefirmhasfixedinvestmentpolicy• No risk or uncertainty•

Proof for MM approach MM approach can be proved with the help of the following formula:

Where, Po = Prevailing market price of a share. Ke = Cost of e equity capital. D1 = Dividend to be received at the end of period one. P1 = Market price of the share at the end of period one.

P 1 can be calculated with the help of the following formula.

P1= Po (1+Ke) – D 1

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The number of new shares to be issued can be determined by the following formula:

M × P1 = I – (X – nD1)

Where, M = Number of new share to be issued. P1 = Price at which new issue is to be made. I = Amount of investment required.X=Totalnetprofitofthefirmduringtheperiod.nD1 = Total dividend paid during the period.

Example 1: X Company Ltd., has 100000 shares outstanding the current market price of the shares Rs. 15 each. ThecompanyexpectsthenetprofitofRs.2,00,000duringtheyearanditbelongstoarichclassforwhichtheappropriate capitalisation rate has been estimated to be 20%. The company is considering dividend of Rs. 2.50 per share for the current year. What will be the price of the share at the end of the year (i) if the dividend is paid and (ii) if the dividend is not paid?

Solution:

(i) If the dividend is paidPo= Rs. 15Ke = 20%D1= 2.50P1=?

2.50 +P1= 15x1.2

P1= 18-2.50

P1=Rs. 15.50

(ii) If the dividend is not paidPo= Rs. 15Ke = 20%D1= 0P1=?


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0 +P1= 15x1.20

P1= Rs.18

Criticism of MM approachMM approach consists of certain criticisms also. The following are the major criticisms of MM approach.

MMapproachassumesthattaxdoesnotexist.Itisnotapplicableinthepracticallifeofthefirm.•MM approach assumes that, there is no risk and uncertain of the investment. It is also not applicable in present •day business life. MMapproachdoesnotconsiderfloatationcostandtransactioncost.Itleadstoaffectthevalueofthefirm.•MM approach considers only single decrement rate, it does not exist in real practice.• MM approach assumes that, investor behaves rationally. But we cannot give assurance that all the investors •will behave rationally.

9.2.2 Relevance of DividendAccordingtothisconcept,dividendpolicyisconsideredtoaffectthevalueofthefirm.Dividendrelevanceimpliesthat shareholders prefer current dividend and there is no direct relationship between dividend policy and value of thefirm.RelevanceofdividendconceptissupportedbytwoeminentpersonslikeWalterandGordon.

Walter’s Model Prof.JamesE.Walterarguesthatthedividendpolicyalmostalwaysaffectsthevalueofthefirm.Waltermodelisbased in the relationship between the following important factors:

Rate of return I•Cost of capital (k) •

AccordingtotheWalter’smodel,ifr>k,thefirmisabletoearnmorethanwhattheshareholderscouldbyreinvesting,iftheearningsarepaidtothem.Theimplicationofr>kisthattheshareholderscanearnahigherreturnbyinvestingelsewhere.

Ifthefirmhasr=k,itisamatterofindifferentwhetherearningsareretainedordistributed.

AssumptionsWalters model is based on the following important assumptions:

Thefirmusesonlyinternalfinance•Thefirmdoesnotusedebtorequityfinance•Thefirmhasconstantreturnandcostofcapital•Thefirmhas100recentpayout•ThefirmhasconstantEPSanddividend•Thefirmhasaverylonglife.•

Walter has evolved a mathematical formula for determining the value of market share.

Where,P = Market price of an equity shareD = Dividend per share

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r = Internal rate of return E = Earning per share Ke = Cost of equity capital

Example2:Fromthefollowinginformationsuppliedtoyou,ascertainwhetherthefirmisfollowinganoptionaldividend policy as per Walter’s Model? Total Earnings Rs. 2, 00,000 No. of equity shares (of Rs. 100 each 20,000) Dividend paid Rs. 1, 00,000P/E Ratio 10Return Investment 15%

Thefirmisexpectedtomaintainitsrateonreturnonfreshinvestments.AlsofindoutwhatshouldbetheE/Pratioat which the dividend policy will have no effect on the value of the share? Will your decision change if the P/E ratio is 7.25 and interest of 10 %?

Solution

= = Rs. 10

P/E Ratio = 10

Ke = = = 0.10

DPS = = = Rs. 5

The value of the share as per Walter’s Model is

Rs. 12.5

Dividend Payout =

=

= 60%

r>Kethereforebydistributing60%ofearnings,thefirmisnotfollowinganoptionaldividendpolicy.Inthiscase,theoptionaldividendpolicyforthefirmwouldbetopayzerodividendandtheMarketPricewouldbe:


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Dividend Payout =

P= Rs. 200

So, the MP of the share can be increased by following a zero payout, of the P/E is 7.25 instead of 10 then the Ke =1=0.138andinthiscaseKe>randtheMPoftheshareis7.25.

P = 5+5.435

P= Rs. 75.62

Criticism of Walter’s ModelThe following are some of the important criticisms against Walter model:

Waltermodelassumesthatthereisnoextractedfinanceusedbythefirm.Itisnotpracticallyapplicable.•There is no possibility of constant return. Return may increase or decrease, depending upon the business situation. •Hence, it is applicable. According to Walter model, it is based on constant cost of capital. But it is not applicable in the real life of the •business.

Gordon’s ModelMyronGordensuggestsoneofthepopularmodelswhichassumethatdividendpolicyofafirmaffectsitsvalue,and it is based on the following important assumptions:

Thefirmisanallequityfirm•Thefirmhasnoexternalfinance•Cost of capital and return are constant•Thefirmhasperpectuallife•There are no taxes.•Constant relation ratio (g=br)•Cost of capital is greater than growth rate (K• e>br)

Gordon’s model can be proved with the help of the following formula:

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Where, P = Price of a shareE = Earnings per share 1–b = D/p ratio (i.e., percentage of earnings distributed as dividends) Ke= Capitalization ratbrGrowthrate=rateofreturnoninvestmentofanallequityfirm.

Example 3: Raja company earns a rate of 12% on its total investment of Rs. 6, 00,000 in assets. It has 6, 00,000 outstandingcommonsharesatRs.10pershare.Discountrateofthefirmis10%andithasapolicyofretaining40% of the earnings. Determine the price of its share using Gordon’s Model. What shall happen to the price of the share if the company has payout of 60% (or) 20%?

SolutionAccording to Gordon’s Model, the price of a share is

Given: E = 12% of Rs. 10=Rs. 1.20 r = 12%=0.12 Ke = 10%=0.10 t = 10%=0.10 b = 40%=0.40 Put the values in formula

P = Rs. 13.85

Ifthefirmfollowsapolicyof60%payoutthenb=20%=0.20

The price is

= 0.05

r= 4%= 0.04, D= 25% of 10 = 2.50


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= Rs. 41.67

If payout ratio is 50%, D= 50% of 10= Rs. 5r= 12%= 0.12, D= 50% of 10 = Rs. 5

= Rs. 83.33

r= 8%= 0.08, D= 50% of 10 = Rs. 5

= Rs. 69.42r= 4%= 0.04, D= 50% of 10 = Rs. 5

= Rs. 55.58

If payout ratio is 20%, the value of b= 0.60 and the price of the share is

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= Rs 120

Criticism of Gordon’sModel Gordon’s model consists of the following important criticisms:

Gordonmodelassumesthatthereisnodebtandequityfinanceusedbythefirm.Itisnotapplicabletopresent•day business. Keandrcannotbeconstantintherealpractice.AccordingtoGordon’smodel,thereisnotaxpaidbythefirm.•It is not practically applicable.

9.3 Factors Determining Dividend PolicyFollowing are the factors that determine dividend policy:Profitable position of the firm Dividenddecisiondependsontheprofitablepositionofthebusinessconcern.Whenthefirmearnsmoreprofit,theycan distribute more dividends to the shareholders.

Uncertainty of future income Future income is a very important factor, which affects the dividend policy. When the shareholder needs regular income,thefirmshouldmaintainregulardividendpolicy.

Legal constrainsThe Companies Act 1956 has put several restrictions regarding payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.

Liquidity positionLiquiditypositionofthefirmsleadstoeasypaymentsofdividend.Ifthefirmshavehighliquidity,thefirmscanprovide cash dividend otherwise, they have to pay stock dividend.

Sources of finance If the firmhas finance sources, itwill be easy tomobilise large finance.Thefirm shall not go for retainedearnings.

Growth rate of the firmHighgrowthrateimpliesthatthefirmcandistributemoredividendtoitsshareholders.

Tax policyTaxpolicyofthegovernmentalsoaffectsthedividendpolicyofthefirm.Whenthegovernmentgivestaxincentives,the company pays more dividend.

Capital market conditions Due to the capital market conditions, dividend policy may be affected. If the capital is prefect, it leads to improve the higher dividend.


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9.4 Types of Dividend PolicyDividendpolicydependsuponthenatureofthefirm,typeofshareholderandprofitableposition.Onthebasisofthedividenddeclarationbythefirm,thedividendpolicymaybeclassifiedunderthefollowingtypes:

Regular dividend policy •Stable dividend policy •Irregular dividend policy •No dividend policy.•

Regular dividend policyDividend payable at the usual rate is called as regular dividend policy. This type of policy is suitable to the small investors, retired persons and others.

Stable dividend policy Stable dividend policy means payment of certain minimum amount of dividend regularly. This dividend policy consists of the following three important forms:

Constant dividend per share •Constant payout ratio •Stable rupee dividend plus extra dividend. •

Irregular dividend policyWhen the companies are facing constraints of earnings and unsuccessful business operation, they may follow irregulardividendpolicy.Itisoneofthetemporaryarrangementstomeetthefinancialproblems.Thesetypesarehavingadequateprofit.Forothersnodividendisdistributed.

No Dividend policy Sometimes the company may follow no dividend policy because of its unfavourable working capital position of the amount required for future growth of the concerns.

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Summary The financial manager must take careful decisions on how the profit should be distributed among •shareholders.Dividendreferstothebusinessconcernsnetprofitsdistributedamongtheshareholders.•If the dividend is paid in the form of cash to the shareholders, it is called cash dividend..•Stockdividendispaidintheformofthecompanystockduetoraisingofmorefinance..•Bonddividendisalsoknownasscriptdividend.Ifthecompanydoesnothavesufficientfundstopaycash•dividend,thecompanypromisestopaytheshareholderatafuturespecificdatewiththehelpofissueofbondor notes.Property dividends are paid in the form of some assets other than cash. It will distributed under the exceptional •circumstance. This type of dividend is not published in India.Dividenddecisionofthebusinessconcernisoneofthecrucialpartsofthefinancialmanager,becauseitdetermines•theamountofprofittobedistributedamongshareholdersandamountofprofittobetreatedasretainedearningsforfinancingitslongtermgrowth.According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it •doesnotaffectthevalueofthefirm.Dividend relevance implies that shareholders prefer current dividend and there is no direct relationship between •dividendpolicyandvalueofthefirm.

ReferencesDividend Decisions,• [Pdf]Availableat:<http://220.227.161.86/19347sm_sfm_finalnew_cp4.pdf>[Accessed30 May 2013].DIVIDEND POLICY• ,[Pdf]Availableat:<http://www.morevalue.com/i-reader/ftp/Ch17.PDF>[Accessed30May 2013].2012. • Dividend Policy, [Videoonline]Available at: <http://www.youtube.com/watch?v=o972MF8rOKM>[Accessed 30 May 2013].2009. CF1. • Dividend Policy,[Videoonline]Availableat:<http://www.youtube.com/watch?v=3WURHeTxoRE>[Accessed 30 May 2013].Paramasivan, C. & Subramanian, T., 2009. • Financial Management. New Age International.Khan, M. Y., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill Education•

Recommended Reading Gallagher and Andrew, • Financial Management; Principles and Practice. Freeload Press, Inc.Brigham, E. F. & Ehrhardt, M. C., 2011. • Financial Management: Theory and Practice, 13th ed., Cengage Learning.Apte, 2006. • International Financial Management, 4th ed., Tata McGraw-Hill Education.


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Self Assessment

According to professors Soloman, Modigliani and Miller, ___________ has no effect on the share price of the 1. company.

dividend policya. financialpolicyb. economic policyc. market policyd.

Prof.JamesE.Walterarguesthatthedividendpolicyalmostalwaysaffectsthe________ofthefirm2. profita. valueb. incomec. revenued.

Gordonmodelassumesthatthereisnodebtand_______financeusedbythefirm.3. liabilitya. arrearsb. equityc. stockd.

Dividendpolicydependsuponthenatureofthefirm,typeof____________andprofitableposition4. shareholdera. businessb. marketc. organisationd.

Which of the following statements is true?5. Dividend payable at the usual rate is called as regular dividend policy.a. Dividend payable at the usual rate is called as stable dividend policy.b. Dividend payable at the usual rate is called as irregular dividend policy.c. Dividend payable at the usual rate is called as no dividend policy.d.

When the companies are facing constraints of earnings and unsuccessful business operation, they may follow 6. _______________ dividend policy.

regulara. irregularb. stablec. unstabled.

Sometimes the company may follow ___________ policy because of its unfavourable working capital position 7. of the amount required for future growth of the concerns

regulara. irrgualrb. no dividendc. stabled.

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Which of the dividend policy means payment of certain minimum amount of dividend regularly?8. irregulara. unstableb. no dividendc. Stabled.

___________growthrateimpliesthatthefirmcandistributemoredividendtoitsshareholders9. Higha. Lowb. Stablec. Balance d.

_____________positionofthefirmsleadstoeasypaymentsofdividend.10. Liquiditya. Equityb. Stablec. Debtd.


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Application I

Trial Balance TheaccountantMr.P.R.VaidyaofXYZLtd.isnotanefficientone,andhehaspreparedthetrial balance as under-

ABC Ltd. appoints you as a senior accountant and it is your responsibility to correct the trial balance.

Particulars DebitRs.

CreditRs.

Capital 1,556Drawings 564Land 741Sales 2,756Due from customers 530Purchases 1,268Purchase Returns 264Loan from Bank 250Creditors 528OfficeExpenses 784Bank 142Bill Payable 100Salaries 598Opening Stock 264Rent and Tax 465Sales Returns 98

5,454 5,454

Solution:Corrected Trial Balance

Sr. No Particulars L.F.NO. (Rs.) Amount (Rs.) Amount

1. Capital 1,5562. Drawings 5643. Land 7414. Sales 2,7565. Due from Customers 5306. Purchases 1,2687. Purchase Returns 2648. Loan from Bank 2509. Creditors 52810. OfficeExpenses 78411. Bank 14212. Bills Payable 10013. Salaries 59814. Opening Stock 26415. Rent and Tax 46516. Sales Returns 98

Total of Trial balance 5,454 5,454

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Application II

Ratio Analysis

ThefollowingaretheprofitandlossaccountofABCEnterprisesfortheyearendedon31st March 2008.

Profit and loss Account

Particulars Rs. Particulars Rs.

To Opening StockTo PurchasesTo WagesToGrossProfit

4,40,00012,00,000 3,20,000 4,40,000

By SalesBy Closing Stock

18,00,000 6,00,000

24,00,000 24,00,000To Administrative ExpensesTo Selling & Distributive Exp.To Non-operating Exp.ToNetProfit

80,000 90,000 80,000 3,50,000

ByGrossprofitInterestByProfitonsaleofinvestment

4,40,000 80,000 80,000

6,00,000 6,00,000

Rate of tax is 40%.You need to calculate:

GrossProfitRatio•NetprofitRatio•


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Application III

The following figures have been extracted from the records of Neha Fancy Stores, a proprietorship concern, as on 31st December 2008

Particulars Rs.Furniture 15,000Proprietor’s Capital Account 54,000Cash in Hand 3,000Opening Stock 50,000Fixed Deposit 1,34,000Drawings 5,000Provision For Bad Debts 3,000Cash at Bank 10,000Purchases 3,00,000Salaries 19,000Carriage Inwards 41,000Insurance 6,000Rent 22,000Sundry Debtors 60,000Sales 6,00,000Advertisements 10,000Postage & Telephones 3,400Bad Debts 2,000Printing &Stationery 9,000General Charges 15,000Sundry Creditors 30,000Deposits From Customers 6,000

Prepare Trading, Profit and Loss Account and Balance Sheet after taking into consideration the following additional information:

The closing stock as on 311. st December 2008 was Rs. 10,000A sale of Rs. 25,000made for cash had been entered to the purchases account2. Salary of Rs. 3,000 paid to an employee had been entered in the Cash bank as Rs. 1,5003. Charge depreciation of furniture at 10%4. Furniture had been sold during the year for Rs. 10,000 and the proceeds had been credited to furniture Account. 5. The written down value of furniture sold was Rs. 5,000A sum of Rs. 10,000 received from a party which had purchased some stocks belonging to a separate business 6. of the proprietor was credited to sundry debtors AccountTheproceedsofamaturedfixeddepositamountingtoRs.25,500hadbeencreditedtotheFixedDepositAccount.7. The original amount of the deposit was Rs. 20,000There was an outstanding liability for Rent of Rs. 2,0008. An advance of Rs. 1,000 paid to AN EMPLOYEE AGAINST HIS SALARY OF January 2007 had been debited 9. to salary accountTheofficepremisesweresub-letfromDecember2008foramonthlyrentalofRs.1000buttherentforDecember10. has not yet been received

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Bibliography

ReferencesReddy, G. S., 2008. Financial Management. Himalaya publications, Mumbai.•Correia, C., Flynn, D. K., Uliana, E. & Wormald, M., 2012. Financial Management, 6th ed., Juta and Company •Ltd.Financial Planning - Definition, Objectives and Importance, [Online] Available at: <http://www.•managementstudyguide.com/financial-planning.htm>[Accessed27May2013].Masters of Business Administration Notes, [Online] Available at: <http://freemba.in/articlesread.php?artcode=•299&substcode=19&stcode=10>[Accessed27May2013].2008.FinancialManagement,[Videoonline]Availableat:<http://www.youtube.com/watch?v=iDlFPm3fqbs>•[Accessed 27 May 2013].2011. Financial Management - Lecture 01, [Video online] Available at: <http://www.youtube.com/•watch?v=iDlFPm3fqbs>[Accessed27May2013].Introduction to the Time Value of Money, [Online] Available at: <https://www.boundless.com/accounting/time-•value-money/introduction-to-time-value-money/>[Accessed27May2013].IntroductiontotheTimeValueofMoney,[Pdf]Availableat:<http://www2.fiu.edu/~changch/Chapter2_4.pdf>•[Accessed 27 May 2013].Paramasivan, C. & Subramanian, T., 2009. Financial Management, New Age International.•Ramagopal, C., 2008. Financial Management, New Age International.•2013. Financial Management: Lecture 2, Chapter 5: Part 1 - Time Value of Money, [Video online] Available at: •<http://www.youtube.com/watch?v=vpJszYCLH3o>[Accessed27May2013].Prof. Ahmed, M., 2010. Time Value of Money, [Video online] Available at: <http://www.youtube.com/•watch?v=CnRJ6Jypsj4>[Accessed27May2013].Introduction toBondValuation, [Pdf]Available at:<http://www.arts.uwaterloo.ca/~kvetzal/AFM271/bond.•pdf>[Accessed28May2013].BondValuation,[Online]Availableat:<http://www.prenhall.com/divisions/bp/app/cfl/BV/BondValuation.html>•[Accessed 28 May 2013].Jonathan, B., 2010. Financial Management, Pearson Education India.•Shim, J. K. & Siege, J. G., 2008. Financial Management, 3rd ed., Barron’s Educational Series.•Prof. Ahmed, M., 2012. Bond Valuation, [Video online] Available at: <http://www.youtube.com/•watch?v=tid0RVUmY3M>[Accessed28May2013].2012. Value a Bond and Calculate Yield to Maturity (YTM), [Video online] Available at: <http://www.youtube.•com/watch?v=pfhjJ00IuW4>[Accessed28May2013].Reddy, G. S., 2008. Financial Management. Mumbai: Himalaya publications. •Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.•Definingthecostofcapital,[Pdf]Availableat:<http://www.iassa.co.za/articles/002_may1973_02.pdf>[Accessed•28 May 2013].The cost of capital, [Pdf] Available at: <http://www.goldsmithibs.com/resources/free/Cost-of-Capital/notes/•Summary%20-%20Cost%20of%20Capital.pdf>[Accessed28May2013].2009. Introduction to Cost of Capital, [Video online] Available at: <http://www.youtube.com/•watch?v=AGaoDQgicVg>[Accessed28May2013].2013. Cost of Capital Part 1, [Video online] Available at : <http: / /www.youtube.com/•watch?v=suqQ3huNtrk>[Accessed28May2013].Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.•Khan, M. Y.., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill •Education.


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Capital Structure and Leverage, [Pdf] Available at: <http://faculty.unlv.edu/msullivan/FIN301%20-%20Chpts%20•13%20and%2014%20-%20Capital%20Structure%20and%20Dividends-%20classnotes.pdf> [Accessed 29May 2013].CapitalStructureandLeverage,[Pdf]Availableat:<http://www.csun.edu/~dm59084/FIN303/Ch%2013.pdf>•[Accessed 29 May 2013].2011.CapitalStructureclassI,[Videoonline]Availableat:<http://www.youtube.com/watch?v=lqHuYKGByIQ>•[Accessed 29 May 2013].2011.CapitalStructureclassII,[Videoonline]Availableat:<http://www.youtube.com/watch?v=6vtuNgGxbso>•[Accessed 29 May 2013].Peterson, P. P. & Fabozzi, J. F., 2004. Capital Budgeting: Theory and Practice, John Wiley & Sons.•Periasamy, P., 2010. A TEXTBOOK OF FINANCIAL COST AND MANAGEMENT ACCOUNTING, Global •Media.WHAT IS CAPITAL BUDGETING? [Pdf] available at: <http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/•CapitalBudget/CapitalBudgetingTraining.pdf>[Accessed16May2013].CHAPTER 29 Capital Budgeting [Pdf] available at: <http://mfile.narotama.ac.id/files/Accounting%20•&%20Financial/A%20Textbook%20of%20Financial%20Cost%20&%20Management%20Accounting%20(Revised%20Edition)/Chapter%2029%20%20Capital%20Budgeting.pdf>[Accessed16May2013].Irfanullah, A., 2011. CFA Level I Capital Budgeting Video Lecture by Mr. Arif Irfanullah part 2 [Video online] •Availableat:<http://www.youtube.com/watch?v=qfzQwqLdXH0>[Accessed16May2013].CapitalBudgeting[Videoonline]Availableat:<http://www.youtube.com/watch?v=qGgVGUcBqAg>[Accessed•16 May 2013].Mathur, S. B., 2002. Working Capital Management and Control Principles & Practice. New Delhi. New Age •International (P) Limited. Dr. Rustagi, R. P., Principles of Financial Management. 4th ed., New Delhi. Taxmann Publications (P) Ltd. •WorkingCapitalManagement,[Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/703/7/07_•chapter1.pdf>[Accessed29May2013].WorkingCapitalManagement, [Pdf]Available at: <http://www.ediindia.org/doc/SpecialPDF/chp-14.pdf>•[Accessed 29 May 2013].2012. Working Capital Management, [Video online] Available at: <http://www.youtube.com/•watch?v=C0UOvhnIqxE>[Accessed29May2013].2010.Whatsworkingcapital?[Videoonline]Availableat:<http://www.youtube.com/watch?v=AnwK1BQxJVw>•[Accessed 29 May 2013].2008.InventoryManagement,[Videoonline]Availableat:<http://www.youtube.com/watch?v=HZPMaTifdBg>•[Accessed 29 May 2013].2008. Lecture - 38 Basic Inventory Principles, [Video online] Available at: <http://www.youtube.com/•watch?v=HZPMaTifdBg>[Accessed29May2013].Viale, J. D., Basics of Inventory Management, [Pdf] Available at: <http://www.axzopress.com/downloads/•pdf/1560523611pv.pdf>[Accessed29May2013].Inventory Management,[Pdf] Available at: <http://highered.mcgraw-hill.com/sites/dl/free/0073525235/940447/•jacobs3e_sample_ch11.pdf>[Accessed29May2013].Bose, C. D., 2006. INVENTORY MANAGEMENT, PHI Learning Pvt. Ltd.•Axst• er, S.,2006. Inventory control, 2nd ed., Springer.DividendDecisions,[Pdf]Availableat:<http://220.227.161.86/19347sm_sfm_finalnew_cp4.pdf>[Accessed•30 May 2013].DIVIDENDPOLICY,[Pdf]Availableat:<http://www.morevalue.com/i-reader/ftp/Ch17.PDF>[Accessed30•May 2013].

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2012.DividendPolicy, [Videoonline]Available at: <http://www.youtube.com/watch?v=o972MF8rOKM>•[Accessed 30 May 2013].2009.CF1.DividendPolicy,[Videoonline]Availableat:<http://www.youtube.com/watch?v=3WURHeTxoRE>•[Accessed 30 May 2013].Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.•Khan, M. Y.., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill •Education

Recommended ReadingBrigham, E. F., 2010. • Financial Management: Theory & Practice. 13th ed., South-Western College Pub.Shim, J. K., 2008.• Financial Management (Barron’s Business Library). 3rd ed., Barron’s Educational Series.Brigham, E. F., 2009. • Fundamentals of Financial Management. 12th ed., South-Western College Pub.Drake, P. P., 2009. • Foundations and Applications of the Time Value of Money. WileyBenninga, S., 2006. • Principles of Finance with Excel. Oxford University Press, USABlock, S., 2008. • Foundations of Financial Management w/S&P bind-in card + Time Value of Money bind-in card. 13th ed., McGraw-Hill/Irwin.Staff, I., 2005. • Stocks,Bonds,Bills,andInflation2005Yearbook. Ibbotson AssociatesAgarwal, O.P., 2009. • International Financial Management. Global Media.Satyaprasad, B.G. & Raghu, G.A. 2010. • Advanced Financial Management.Global Media.Pratt , S. P., 2010. • Cost of Capital: Workbook and Technical Supplement, 4th ed., Wiley.Tennent, J., 2008. • Guide to Financial Management,ProfileBooks/TheEconomist.Avadhani, V.A., 2010.• International Financial Management. Global Media.Brigham,E. F., 2003.• Fundamentals of Financial Management. 10th ed., South-Western College Pub.Brigham, E. F. & Ehrhardt, M. C., 2008. • Financial management: theory and practice, 12th ed., Cengage Learning.Gitman, 2007. • Principles Of Managerial Finance, 11th ed., Pearson Education India.Jacobs & Davina, F., 2006. • A Reviews of Capital Budgeting Practices, International Monetary Fund.Dayananda, D., 2002. • Capital Budgeting: Financial Appraisal of Investment Projects, 2nd ed. Cambridge University Press.Baker, K. H. & English, P., 2011. • Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects, John Wiley & SonsPreve, L. & Sarria-Allende, V., 2010. • Working Capital Management. Oxford University Press.Kumar, A. V., 2001. • Working Capital Management. Northern Book Centre.Sagner, J., 2010. • Essentials of Working Capital Management. John Wiley & Sons.Muller, M., 2003. • Essentials of Inventory Management. AMACOM. Mullar, M., 2011. • Essentials of Inventory Management, 2nd ed., AMACOM Books.Viale, J. D. & Christopher, C., 1996. • Inventory Management: From Warehouse to Distribution Center, Course Technology / Cengage Learning.Gallagher and Andrew, • Financial Management; Principles and Practice. Freeload Press, Inc.Brigham, E. F. & Ehrhardt, M. C., 2011. • Financial Management: Theory and Practice, 13th ed., Cengage Learning.Apte, 2006. • International Financial Management, 4th ed., Tata McGraw-Hill Education.


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Self Assessment Answers

Chapter Ib1. c2. a3. c4. b5. c6. b7. c8. d9. a10.

Chapter IIa1. b2. c3. a4. a5. a6. d7. a8. c9. c10.

Chapter IIIa1. c2. b3. a4. c5. a6. b7. c8. a9. a10.

Chapter IVb1. a2. c3. a4. b5. a6. a7. a8. b9. c10.

121/JNU OLE

Chapter Vc1. b2. b3. b4. a5. d6. a7. b8. a9. b10.

Chapter VIb1. a2. c3. d4. a5. b6. d7. c8. d9. a10.

Chapter VIIb1. c2. d3. b4. a5. b6. c7. a8. d9. a10.

Chapter VIIIc1. d2. a3. a4. b5. c6. d7. a8. c9. b10.


122/JNU OLE

Chapter IXa1. b2. c3. d4. a5. b6. c7. d8. d9. a10.

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