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Managerial Finance
This book is a part of the course by Jaipur National University, Jaipur.This book contains the course content for Managerial Finance.
JNU, JaipurFirst Edition 2013
The content in the book is copyright of JNU. All rights reserved.No part of the content may in any form or by any electronic, mechanical, photocopying, recording, or any other means be reproduced, stored in a retrieval system or be broadcast or transmitted without the prior permission of the publisher.
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
I. Content .................................................................... II
II. List of Figures ..................................................... VII
III. List of Tables ................................................... VIII
IV. Abbreviations .......................................................IX
V. Case study ............................................................ 133
VI. Bibliography ...................................................... 140
VII. Self Assessment Answers ................................ 144
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 .................................................................................................................................. 31.4 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 ..................................................................................................................................... 162.5 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 Behaviours .......................................................................................................................... 29 3.5.1 Required Rate of Return and Bond Values ............................................................................ 29
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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 ................................................................................................................................ 32 3.6.1 Valuation of Preference Shares .............................................................................................. 32 3.6.2 Valuation of Equity/Ordinary Shares ..................................................................................... 33Summary ..................................................................................................................................................... 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 ..................................................................................................... 39 4.2.1 Cost of Equity ........................................................................................................................ 39 4.2.2 Cost of Preference Shares ...................................................................................................... 40 4.2.3 Cost of Debentures ................................................................................................................. 414.3 Capital Asset Pricing Model Approach (CAPM) ................................................................................... 424.4 Weighted Average Cost of Capital (WACC) .......................................................................................... 42 4.4.1 Factors Affecting WACC ....................................................................................................... 43Summary ..................................................................................................................................................... 44References ................................................................................................................................................... 44Recommended Reading ............................................................................................................................. 44Self Assessment .......................................................................................................................................... 45
Chapter V .................................................................................................................................................... 47Capital Structure and Leverages .............................................................................................................. 47Aim ............................................................................................................................................................. 47Objectives .................................................................................................................................................... 47Learning outcome ........................................................................................................................................ 475.1 Meaning of Capital Structure ................................................................................................................. 485.2 Features of an Appropriate Capital Structure ......................................................................................... 485.3 Determination of Capital Structure ........................................................................................................ 485.4 Theories of Capital Structure ................................................................................................................. 49 5.4.1 Net Income Approach ............................................................................................................ 49 5.4.2 Net Operating Income (NOI) Approach ................................................................................ 50 5.4.3 Traditional Approach ............................................................................................................. 51 5.4.4 Miller and Modigliani Approach ........................................................................................... 525.5 Leverages ............................................................................................................................................... 53 5.5.1 Operating Leverage ................................................................................................................ 53 5.5.2 Financial Leverage ................................................................................................................. 54 5.5.3 Combined Leverage ............................................................................................................... 55Summary ..................................................................................................................................................... 57References ................................................................................................................................................... 57Recommended Reading ............................................................................................................................. 57Self Assessment .......................................................................................................................................... 58
Chapter VI .................................................................................................................................................. 60Capital Budgeting ...................................................................................................................................... 60Aim .............................................................................................................................................................. 60Objectives .................................................................................................................................................... 60Learning outcome ........................................................................................................................................ 60
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6.1 Meaning of Capital Budgeting ............................................................................................................... 616.2 Process of Capital Budgeting ................................................................................................................. 616.3 Techniques of Investment Evaluation .................................................................................................... 62 6.3.1 Traditional Techniques ........................................................................................................... 62 6.3.2 Modern Techniques or Discounted Cash Flow (DCF) Techniques ....................................... 64Summary ..................................................................................................................................................... 66References ................................................................................................................................................... 66Recommended Reading ............................................................................................................................. 66Self Assessment ........................................................................................................................................... 67
Chapter VII ................................................................................................................................................ 69Risk Analysis in Capital Budgeting .......................................................................................................... 69Aim .............................................................................................................................................................. 69Objectives .................................................................................................................................................... 69Learning outcome ........................................................................................................................................ 697.1 Introduction ............................................................................................................................................ 707.2 Definition of Risk .................................................................................................................................. 70 7.2.1 Types of Decision Situations in Capital Budgeting ............................................................... 70 7.2.2 Sources of Risk ...................................................................................................................... 70 7.2.3 Perspectives of Risk ............................................................................................................... 717.3 Risk Adjusted Discount Rate ................................................................................................................. 717.4 Certainty Equivalent .............................................................................................................................. 73 7.4.1 Evaluation Certain Equivalent ............................................................................................... 737.5 Sensitivity Analysis ................................................................................................................................ 747.6 Probability Approach ............................................................................................................................. 757.7 Decision Tree Analysis .......................................................................................................................... 77Summary ..................................................................................................................................................... 79Reference..................................................................................................................................................... 79Recommended Reading ............................................................................................................................. 79Self Assessment ........................................................................................................................................... 80
Chapter VIII ............................................................................................................................................... 82Working Capital Management ................................................................................................................. 82Aim .............................................................................................................................................................. 82Objectives .................................................................................................................................................... 82Learning outcome ........................................................................................................................................ 828.1 Introduction ............................................................................................................................................ 838.2 Meaning and Definition of Working Capital ......................................................................................... 838.3 Types of Working Capital ...................................................................................................................... 83 8.3.1 Concept of Working Capital .................................................................................................. 84 8.3.2 Time Based Working Capital ................................................................................................. 848.4 Components of Working Capital ............................................................................................................ 848.5 Aspects of Working Capital Management.............................................................................................. 848.6 Need for Working Capital ...................................................................................................................... 858.7 Estimation of Working Capital Requirements ....................................................................................... 898.8 Sources of Working Capital ................................................................................................................... 89Summary ..................................................................................................................................................... 91References ................................................................................................................................................... 91Recommended Reading ............................................................................................................................. 91Self Assessment ........................................................................................................................................... 92
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Chapter IX .................................................................................................................................................. 94Cash Management ..................................................................................................................................... 94Aim .............................................................................................................................................................. 94Objectives .................................................................................................................................................... 94Learning outcome ........................................................................................................................................ 949.1 Introduction ............................................................................................................................................ 959.2 Meaning, Definition and Importance of Cash Management .................................................................. 959.3 Nature of Cash ....................................................................................................................................... 969.4 Objectives .............................................................................................................................................. 969.5 Motives for Holding Cash ...................................................................................................................... 969.6 Factors Determining Cash Need ........................................................................................................... 979.7 Models for Determining Optimal Cash .................................................................................................. 98Summary ................................................................................................................................................... 101Reference................................................................................................................................................... 101Recommended Reading ........................................................................................................................... 101Self Assessment ......................................................................................................................................... 102
Chapter X ................................................................................................................................................. 104Inventory Management ........................................................................................................................... 104Aim ............................................................................................................................................................ 104Objectives .................................................................................................................................................. 104Learning outcome ...................................................................................................................................... 10410.1 Introduction ........................................................................................................................................ 10510.2 Meaning and Definition of Inventory ................................................................................................ 10510.3 Types of Inventory ............................................................................................................................. 10510.4 Inventory Management Motives ........................................................................................................ 10610.5 Objectives of Inventory Management ................................................................................................ 10610.6 Costs of Holding Inventory ................................................................................................................ 10610.7 Risks of Holding Inventory ................................................................................................................ 10710.8 Benefits of Holding Inventory ........................................................................................................... 10810.9 Techniques of Inventory Control ....................................................................................................... 108Summary ....................................................................................................................................................112Reference....................................................................................................................................................112Recommended Reading ...........................................................................................................................112Self Assessment ..........................................................................................................................................113
Chapter XI .................................................................................................................................................115Receivables Management .........................................................................................................................115Aim .............................................................................................................................................................115Objectives ...................................................................................................................................................115Learning outcome .......................................................................................................................................11511.1 Introduction .........................................................................................................................................11611.2 Meaning of Accounts Receivables ......................................................................................................11611.3 Meaning of Accounts Receivables Management ................................................................................11611.4 Credit Policy .......................................................................................................................................11811.5 Evaluation of Credit Policy ................................................................................................................ 120Summary ................................................................................................................................................... 122Reference................................................................................................................................................... 122Recommended Reading ........................................................................................................................... 122Self Assessment ......................................................................................................................................... 123
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Chapter XII .............................................................................................................................................. 125Dividend Decision..................................................................................................................................... 125Aim ............................................................................................................................................................ 125Objectives .................................................................................................................................................. 125Learning outcome ...................................................................................................................................... 12512.1 Introduction ........................................................................................................................................ 12612.2 Meaning of Dividend ......................................................................................................................... 12612.3 Dividend Theories ............................................................................................................................. 12712.4 Bonus Shares ...................................................................................................................................... 12812.5 Stock Split .......................................................................................................................................... 129Summary ................................................................................................................................................... 130Reference................................................................................................................................................... 130Recommended Reading ........................................................................................................................... 130Self Assessment ......................................................................................................................................... 131
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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 ...................................................................................................................... 50Fig. 5.2 Net operating income approach ...................................................................................................... 51Fig. 5.3 Traditional approach ....................................................................................................................... 52Fig. 8.1 Operating cycle ............................................................................................................................... 85
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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 9.1 Difference between objective and subjective probability assignment ......................................... 76Table 10.1 Categorisation of inventory ...................................................................................................... 109
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Abbreviations
AAI - 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 - Discounted Cash FlowDF - 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 - Profitability IndexPro - 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:
introduce the concept of financial management•
define the traditional and modern approach of financial management•
explain the relationship of finance management with other management functions•
Objectives
The objectives of this chapter are to:
explain the concept of management planning•
elucidate various financial decisions•
explicate the concept of under and over-capitalisation•
Learning outcome
At the end of the chapter, you will be able to:
understand the the three types of financial decisions- investment, financing and dividend•
comprehend the process, benefits and factors of financial planning•
enlist 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 utilising the funds necessary for efficient operations".
Financial management is concerned with three key activities namely:Anticipating financial needs• Acquiring financial resources• Allocating funds in business•
Traditional approach to financial managementTraditionally, financial management was considered a branch of knowledge with focus on the procurement of funds. Instruments of financing, formation, merger and restructuring of firms, legal and institutional frame work involved 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 that led the financial management more analytical and quantitative. The key work area of this approach is rational matching of funds to their uses, which leads to the maximisation of shareholders' wealth.
1.2 Goals of Financial ManagementGoal of financial management of a firm is maximisation of economic welfare of its shareholders. Shareholders' wealth maximisation is reflected in the market value of the firms' shares. A firms' contribution to the society is maximised when it maximises its value. Two widely accepted goals of financial management are:
Profit maximisationProfit is primary motivating force for any economic activity. Firm is essentially being an economic organisation, it has to maximise the interest of its stakeholders. To this end the firm has to earn profit from its operations. The overall objective of business enterprise is to earn at least satisfactory return on the funds invested, consistent with maintaining a sound financial position.
Limitations of profit maximisationThe term profit is vague and it doesn't clarify what exactly it means. It has different interpretations for different people.Time value of money refers a rupee receivable today is more valuable than a rupee, which is going to be receivable in future period. The profit maximisation goal does not help in distinguishing between the returns receivable in different periods.The concept of profit maximisation fails to consider the fluctuation in the profits from year to year.
Wealth maximisationWealth 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.
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1.3 Financial DecisionsThe functions performed by a finance manager are known as finance functions. In the course of following these functions finance manager takes the following decisions:
Financial Decisions
Dividend Decisions
Financing Decisions
InvestmentDecisions
Fig. 1.1 Financial decisions
Investment decisionsIt begins with a determination of the total amount of assets needed to be held by the firm. It relates to the selection of assets, on which a firm will invest funds. The required assets fall into two groups namely-
Long-term Assets: This involves huge investment and yield a return over a period of time in future. It is also • termed as 'capital budgeting' and can be defined as the firm's decision to invest its current funds most efficiently in fixed assets with an expected flow of benefits over a series of years.Short-term Assets: These are the current assets that can be converted into cash within a financial year without • diminution in value. Investment in current assets is termed as 'working capital management'.
Financing decisionsFinancing 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 coupon rate, cost of floating and issuing 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 business and financial risk
Table 1.1 Cost dimension
The challenge before the finance manager is to arrive at a combination of debt and equity for financing decisions which would attain an optimal structure of capital.
Dividend decisionsDividend decision is a major decision made by the finance manager on the formulation of dividend policy. Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the 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 between finance and economics is studied under two prime areas of economics. They are macroeconomics and microeconomics.
Macroeconomics It is the environment in which an industry operates, which is not controllable. It is important for financial managers to understand changes in macroeconomics and their impact on the firm's operating performance. External environment analysis helps in identifying opportunities and threats.
MicroeconomicsIt is concerned with the determination of optimum operational strategies. All financial decisions of a firm are made on the basis of marginal cost, and marginal revenue. Therefore it is necessary to understand the relationship between finance and economics.
Relationship to accountingAccounting and finance are closely related. For computation of return-on-investment, earnings per share of various ratios for financial analysis, the data base will be accounting information. Without proper accounting system, an organisation cannot administer effectively function of financial management. The purpose of accounting is to report the financial performance of the business for the period under consideration.
Relationship to HR (Human Resource)HR activities include recruitment, training, development, fixing compensation and so on for which we need finance. HR managers need to consult finance managers. Finance managers take decision after studying the impact of HR activity on organisation.
Relationship to productionProduction department is another functional area that involves huge investment on fixed assets. The production manager and the finance manager need to work closely for effective investment on plant and machinery.
Relationship to marketingMarketing functions involves selection of distribution channel and promotion policies. These two are the primary activities of marketing department and involves huge cash outflows. Therefore finance and marketing managers need to work with coordination to maximise value of the firm.
1.5 Financial PlanningFinancial Planning is a process by which funds required for each course of action is decided. A financial plan has to consider Capital structure, Capital expenditure and Cash flow. Financial planning generates financial plan which indicates:
The quantum of funds required to execute business plans• Composition of debt and equity• Formulation of polices for giving effect to the financial plans under consideration•
Process of financial planningProjection of financial statements• Determination of funds needed• Forecast the availability of funds• Establish and maintain systems of controls•
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Develop procedures• Establish performance-based compensation system•
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.Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for • plant and machinery and other fixed assets.
Factors affecting financial planNature of the industry• Size of the company• Status of the company in the industry• Sources of finance available• The capital structure of a company• Matching the sources with utilisation• Flexibility• Government policy•
1.6 CapitalisationsCapitalisation of a firm refers to the composition of its long-term funds. It refers to the capital structure of the firm. It has two components viz. debt and equity.
After estimating the financial requirements of a firm, the next decision that the management has to take is to arrive at the value at which the company has to be capitalised. The two theories of Capitalisation are:
1.6.1 Cost TheoryAccording to the cost theory of capitalisation, the value of a company is arrived at by adding up the cost of fixed assets 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 Approach
It helps promoters to estimate the amount of capital required for various activities like incorporation of company, conducting market surveys and so on.
It the firm establishes its production facilities at inflated prices; productivity of the firm will be less than that of the industry.
If done systematically it will lay foundation for successful initiation of the working of the firm.
Net worth of a company is decided by the investors by the earnings of a company. Earning capacity based net worth helps a firm to arrive at the total capital in terms of industry specified yardstick 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, therefore, the value or Capitalisation of a company is equal to the capitalised value of its estimated earnings. For this purpose a new company has to prepare an estimated profit and loss account. For the first few years of its life, the sales are forecast and the manager has to depend upon his/her experience 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 estimated earnings of the company for finding out the capitalisation.
Merits of Earnings Theory Demerits of Earnings Theory
It is superior to cost theory because there are the least chances of neither under nor over capitalisation.
The major challenge that a new firm 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 indicator of overcapitalisation is the earnings capacity of the firm. If the earnings of the firm are less then that of the 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-capitalisationFollowing are the effects of over-capitalisation
Decline in the earnings of the company• Fall in dividend rates• Market value of company's share falls, and company loses investors confidence• Company may collapse at any time because of anemic financial conditions•
Remedies for over-capitalisationRestructuring the firm is to be executed to avoid the situation of company becoming sick.
It involves: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• Initiating merger with well managed profit making companies interested in taking over ailing company•
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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-capitalisationFollowing are the causes of under-capitalisation
Under 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• Maintaining very high efficiency through improved means of production of goods or rendering of services• Use of low capitalisation rate• Purchase of assets at exceptionally low prices during recession•
Effects of under-capitalisationFollowing are the effects of under-capitalisation
Encouragement to competition• It encourages the management of the company to manipulate the company's share prices• Higher profits will attract higher amount of taxes• Higher profits will make the workers demanding higher wages• High margin of profit may create among consumers an impression that the company is charging high prices • for its product
Remedies for under-capitalisationFollowing are the remedies of under-capitalisation
Splitting 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 • utilising the funds necessary for efficient operations.Traditionally, financial management was considered a branch of knowledge with focus on the procurement of • funds.Goal of financial management of a firm is maximisation of economic welfare of its shareholders.• Wealth maximisation refers to maximising the net wealth of the company's share holders. • Finance functions can be divided into three major decisions, which the firm must make, namely the investment • decision, the finance decision, and the dividend decision.Dividend decision is a major decision made by the finance manager on the formulation of dividend policy.• Financial Planning is a process by which funds required for each course of action is decided.• Capitalisation of a firm refers to the composition of its long-term funds. It refers to the capital structure of the • firm.The earnings theory of Capitalisation recognises the fact that the true value (capitalisation) of an enterprise • depends upon its earnings and earning capacity
ReferencesReddy, G.S., 2008. • Financial Management, Himalaya publications.Masters of Business Administration Notes,• [Online] Available at: <http://www.freemba.in/articlesread.php?artcode=299&stcode=10&substcode=19>[Accessed 10 November 2010].Financial Management: An Introduction• , [pdf] Available at: <http://www.egyankosh.ac.in/bitstream/123456789/38348/1/Unit-11.pdf> [Accessed 21 August 2012].Gitman, L. J., 2007. • Principles of Managerial Finance, 11th ed., Pearson Education India.2011. • Managerial Finance: Lecture 1a, [Video Online] Available at: <http://www.youtube.com/watch?v=bXo2M6BX2LA> [Accessed 21 August 2012].2008. • Managerial Finance in a Nutshell, Available at: <http://www.youtube.com/watch?v=llkL6DBoRZA> [Accessed 21 August 2012].
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 holders.1.
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. profit maximisationd.
Which of the following statements is false?3. Capitalisation of a firm refers the composition of its short-term funds.a. A financial plan has to consider Capital structure, Capital expenditure and cash flow.b. Wealth maximisation refers to maximising the net wealth of the company's share holders.c. Goal of financial management of a firm is maximisation of economic welfare of its shareholders.d.
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. it is exposed to business and financial risk.
Explicit costa. Implicit costb. Direct costc. Indirect costd.
Match the following6. Concept Description
1. Explicit cost A. A process by which funds required for each course of action is decided2. Financial Planning B. This involves huge investment and yield a return over a period of time in
future.3. Long-term assets C. The current assets that can be converted into cash within a financial year
without diminution in value4. Short-term assets D. The cost in the form of coupon rate, cost of floating and issuing the
securitiesA-2, B-1, C-4, D-3 a. A-4, B-3, C-1, D-2b. A-2, B-3, C-4, D-1c. 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. the funds necessary for efficient operations.
Financial planninga. Financial managementb. Asset managementc. Budget managementd.
______________is a major decision made by the finance manager on the formulation of dividend policy.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.
Which of the following is the primary goal of financial management of a firm?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
The aim of this chapter is to:
introduce the concept of time, value and money•
define simple and compound interest•
explain variable compounding periods•
Objectives
The objectives of this chapter are to:
explain the compound value of series of cash flows•
elucidate the concept of doubling period and sinking fund factor•
explicate the concept of present value•
Learning outcome
At the end of the chapter, you will be able to:
understand the sinking fund factor with its formula for calculation•
identify loan amortisation•
describe shorter disco• unting periods
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2.1 Introduction to Time Value of MoneyFirms can maximise wealth only when it is able to recognise the time value of money and risk. Shareholders wealth would be maximised when net wealth is created from sound financial decisions.
Hence, there is a need to understand the tools of compounding and discounting, which require in most financial decisions.
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.
UncertaintyFuture is uncertain and it involves risk. An individual is not certain about future cash inflows. Hence, the individual would prefer to receive cash toady instead of future.
Current consumptionMost of the people prefer to use the present money for satisfying existing present needs.
Possibility of investment opportunityThe 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 instanceMr. 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 InterestHere the future values of all cash inflows at the end of the time horizon at a particular rate of interest are found, interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the first compounding period.
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.
For instance: Suppose you have Rs. 10, 00,000 today and you deposit it with a financial institute, which pay 8 % 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. 72,240Note: * See compound value of one rupee Table for 20 years at 3 % rate of interest.For Instance (Quarterly compounding): Suppose that a firm deposits Rs. 50 lakhs at the end of each year for 4 years at 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 See compound one rupee Table for 5 years (total years – one year) till you find closest value to the compound factor, at closest value see upward to the table to get growth rate.
Compound value of series of cash flowsAnnuity means a series of cash flows (inflow or outflow) of a fixed amount for a specified number of years. Compound value of a series of cash flows can be calculated by the following formula (uneven cash flows)
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
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Compound Value of Annuity (Even Cash Flow)Annuity is a series of even cash flows for a specified duration. It involves a regular cash outflow or inflow. For instance like the payment of LIC premium, depositing in a recurring deposit account, and the like. Cash flows may happen either at the end of year or beginning of the year. If cash flows happen at the beginning of the year, it is called as an annuity due, where as when the cash flows happen at the end it is called as a regular or deferred annuity.
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. 3487.5
Short cut formula for the above is:
Where,P = Fixed periodic cash flow, I – Interest raten = 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 DueWhen the cash flows involves at the beginning of the year compound value of annuity is calculated with the following formula:
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
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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
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 periodEffective rate of interest can be defined with the use of following formula.
In case of rule of 72ERI = 72 ÷ Doubling period (DP)Where ERI = effective rate of interest, DP = Doubling period
In case of rule of 69
For instanceA financial institute has come with an offer to the public, where the institute pays double the amount invested in the 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 ValueThe present value of a future cash inflow (or outflow) is the amount of current cash that is of equivalent value to the present value. The processes of determining present value of future cash flows are called discounting. It is concerned with 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
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PV = Present value
= Future value receivable at the end of 'n' yearsI = Interest rate or discounting factor or cost of capitaln = Duration of the cash flow
= present value interest facts at 'I' interest and for 'n' years
For instanceAn investor wants to find the present value of Rs. 40,000 due 3 years. His interest rate is 10 %.
Solution:
= Rs. 40,000 [1= Rs. 40,000 (0.751*) = Rs. 30,040Note: * Present value of one rupee Table at 3 years for the arte of 10 %
Present value of a series of cash flowsWe have calculated the present value of a single amount to be received after a specified period. In many cases, we may need to calculate present value of series cash flows. For example, in capital budgeting decisions, there is a need to convert the future cash inflows into present values to take decision and in case of raising funds through debt also needs to convert the future cash outflows into present values. Cash flows over a period may be even or uneven.
Present Value of Uneven Cash Flows
OR + …… +
PV = Present valueI = Interest rate or discounting factor or cost of capitaln = Duration of the cash inflows streamt = Year in which cash inflows are receivable
For instanceFrom the following information, calculate the present value at 10% interest rate.
Year 0 1 2 3 4 5Cash inflow (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 annuity
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I = Interest rate or discounting factorn = Duration of the annuityCIF = Cash inflows
For instance Mr. Ram wishes to determine the PV of the annuity consisting of cash flows of Rs. 40,000 per annum for 6 years. 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 %
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.
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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 Requests you to find out the annual payment required, if the savings earn an interest rate of 12% per annum.Solution:
= 1, 00,000 (0.12/2.1058)= Rs. 5.689
Present Value of PerpetuityPerpetuity is an annuity of infinite duration. It may be expressed as: Where: PV = Present value of a perpetuityCIF = Constant annual cash inflow
= 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
= 1000/0.08 = Rs. 12,500
2.8 Loan AmortisationLoan is an amount raised from outsiders at an interest and repayable at a specified period. Payment of loan is known as 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 = Loan installment, = Principal amount, I = Interest, n = Loan repayment period at specified interest rate.
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 AnnuityGrowing annuity means the cash flows that grow at a constant rate for a specified period of time.Steps involved in calculation of growing annuity:
Calculate the series of cash flows• Convert the series of cash flows into present values at a given discount factor• Add all the present values of series of cash flows to get total PV of a growing annuity•
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Formula:PVGA= PV of growing annuity CIF = Cash inflowsg= 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
2.9 Shorter Discounting PeriodsGenerally cash flows are discounted once a year, but some times cash flows have to be discounted less than one (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 = Present vale, = Cash inflow after 'n' year, m= No. of times per year discounting is doneI= Discount rateFor 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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SummarySimple 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 calculatedAnnuity means a series of cash flows (inflow or outflow) of a fixed amount for a specified number of years. • Annuity is a series of even cash flows for a specified duration. It involves a regular cash outflow or inflow.• Doubling period is the period required to double the amount invested at a given rate of interest.• The present value of a future cash inflow (or outflow) is the amount of current cash that is of equivalent value • to the present value. Loan is an amount raised from outsiders at an interest and repayable at a specified period. Payment of loan is • known as amortisation.
ReferencesReddy, G.S., 2008. • Financial Management, Himalaya publications. Porter, G. A. & Norton, C. L., 2007. • Financial Accounting: The Impact on Decision Makers, 5th ed., Cengage Learning.Basic Concept of Time Value of Money• , [pdf] Available at: <http://www.newagepublishers.com/samplechapter/001945.pdf> [Accessed 21 August 2012].Time Value of Money,• [pdf] Available at: <http://220.227.161.86/19748ipcc_fm_vol1_cp2.pdf>[Accessed 21 August 2012].Time Value of Money• , [Video Online] Available at: <ww.youtube.com/watch?v=As1QpFGlGbg> [Accessed 21 August 2012].Introduction to the Time Value of Money• ,[Video Online] Available at: <http://www.youtube.com/watch?v=cvxwisWK9vI> [Accessed 21 August 2012].
Recommended ReadingPeterson, P. & Drake, CFA., 2009. • Foundations and Applications of the Time Value of Money, Wiley.Benninga, S., 2006. • Principles of Finance with Excel, Oxford University Press.Stanley, B., 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
goodsa. moneyb. interestc. servicesd.
________ is an amount raised from outsiders at an interest and repayable at a specified period2. Moneya. Loanb. Principlec. Valued.
________ rate of interest or rate of interest per year is equal3. Sinkinga. Present valueb. Nominalc. Principled.
The present value of a future cash inflow (or outflow) is the amount of _________ cash that is of equivalent 4. value to the present value
currenta. futureb. pastc. lostd.
Which of the following statements is false?5. Annuity is a series of odd cash flows for a specified duration.a. Simple interest is the interest paid on only the original amountb. Growing annuity means the cash flows that grow at a constant rate for a specified period of timec. The processes of determining present value of future cash flows are called discountingd.
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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If cash flows happen at the beginning of the year, it is called as an __________.8. annuity duea. deferred annuityb. regular annuityc. mixed annuityd.
A rupee is received today is more valuable than a rupee receivable in ______.9. pasta. presentb. futurec. todayd.
The process of determining present value of future cash flows is called _____________.10. Sinkinga. Billingb. Discountingc. Amountingd.
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Chapter III
Valuation of Bonds and Shares
Aim
The aim of this chapter is to:
define the concept of valuation•
explain the five types of values•
introduce the basic bond valuation model•
Objectives
The objectives of this chapter are to:
explain nature of value•
enlist the types of bonds•
introduce them with the bond value behaviour•
Learning outcome
At the end of this chapter, you will be able to:
understand different ways of calculating bond yield•
recognise the formula for calculating preference share•
describe the different models for• the valuation of equity shares
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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 on the cash flow it is expected to provide over the holding period.
The fact is that, as on date there is no method by which 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 ValueFollowing are various values:
Book 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 • value per share is generally higher than the book value per share for profitable and growing firms.Going Concern Value: It is the value that a firm can be realised if it sells its business as a continuing operating • business. This value would be higher than the liquidation and book value. Valuation of securities is always considered as going concern, because if the firm is not running, investors would not invest in securitiesLiquidation Value: Liquidation value is the actual amount that can be realised when an asset is sold. Liquidation • value of a equity stock is the actual amount that would be received if all of the firm's assets were sold at their market value, liabilities were paid, and the remaining proceeds were by number of equity shares outstanding.
Intrinsic Value: Investors invest on equity stock with an expectation of intrinsic cash inflow stream. The • present value of the cash inflows expected from a security over its holding period. Present value is computed by discounting future cash inflows at an appropriate rate. It is also called economic value.
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 by different types of organisations like the government, financial institutions, public sector undertaking and private sector 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 BondsBonds are of three types:Redeemable bond: A 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 withsemi-annual interest
With the effect of compounding, the value of bonds with semi-annual interest is much more than the ones with annual interest payments. Hence the bond valuation equation can be modified as:
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 Bond: Irredeemable bond is the bond which is not repaid till closing of the firm. It is the bond without maturity period. 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.
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Solution: BVo = = Rs.120/.015 = Rs.800
Zero Coupon Bonds: In 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): It is the rate of return that an investor earns if they buy a bond at a specific price and • hold it until maturity.
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% +
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= 6% + 2.49
= 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 dateFor 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 yield: It is the yield relates to the annual interest to the annual interest to the current market price.
Current Yield = I / CMPWhere: 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
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Solution:
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 BehavioursFollowing concepts are explained here:
3.5.1 Required Rate of Return and Bond ValuesWhenever there is change in the required rate of return, bond value shows fluctuations from its par value. Required rate of return may change, due to shift in the basic cost of long-term sources of finance, and the change in the firm's risk 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 interest- rate– 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:Interest Rate > Required Rate: Bond Value > Par Value • 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.Value of Bond: When I (%) > Kd (%) and change in the time period to maturity – In this case value of bond • 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: Value Bond: I (%)>Kd (%) [10% > 6%]
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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
Value of bond increased when increase in time period for maturity
3.5.3 Relationship between Bond Value and Time to Maturity Period
Figure below shows the relationship between time to maturity period; required return and bond value.
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
Following points can be extracted from the figure above: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).• Market value of bond will always reach its face value by the end of its maturity period, provided the firm does • not go bankrupt.
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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 fixed rate of dividends. Some important features of preference and equity shares are.
DividendsRate is fixed for preference shareholders. They can be given cumulative rights, that is, the dividend can be paid off after accumulation. The dividend rate is not fixed for equity shareholders. The dividend rate is not fixed for equity shareholders.
ClaimsIn the event of the business closing down, the preference shareholders have a prior claim on the assets of the company. Their claims shall be settled first and the balance if any will be paid off to equity shareholders.
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.
ConversionA company can issue convertible preference shares. After a particular period as mentioned in the share certificate, the preference shares can be converted into ordinary shares.
3.6.1 Valuation of Preference SharesPreference share gives some preferential rights to preference stockholders. The preferential rights are payment of fixed rate of dividend and payment of principal amount at the time of liquidation, before paying to equity stockholders. Value of preference stock is the present value of fixed annual dividends expected and he principal amount.
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 instanceABC 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
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For instanceA 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.•
The value of a share which an investor is willing to pay is linked with the cash inflows expected and risks associated with these inflows. Intrinsic value of a share is associated with the earnings (past) and profitability (future) of the company, dividends paid and expected and future definite prospects of the company.
Basic share valuation modelStock value is present value of future cash inflows (dividends) that it is expected to provide over an infinite time horizon. An investor who buys a stock with the intention of holding in forever, on this case the value of equity stock is the present value of a stream of dividends expected over an infinite period.
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
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For instanceMr. 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.
Variable Growth Model: Growth of the firm should be different life cycle. That is in the early stages growth's much 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 and return to determine the worth of an asset.• Concept of value is used in different senses – Book value, Market value, Liquidation value, Going concern • value and intrinsic value.Bonds can be categorised into three – Par value bond, Premium bond and discount bond. This is based on the • relationship between coupon rate, required rate of return, and bond price.Bond yield can be calculated in three ways – YTM, YTC and CY.YTM is the rate of return earned on a security • if it is held till maturity. YTC is the return earned if it is held till call period. Current yield is derived interest dividend by current market price.Valuation of stocks and bonds are not only useful to finance manager but also useful for every common man • who is involved in buying or selling an asset, whether the asset may be fixed asset or financial asset.Whenever there is change in the required rate of return, bond value shows fluctuations from its par value.•
ReferencesBond Valuation.• [Online] Available at: <http://www.teachmefinance.com/bondvaluation.html> [Accessed 17 November 2010].Valuation of Bonds and Shares,• [Online] Available at: <http://www.scribd.com/doc/56996026/Valuation-on-BONDS-and-Shares> [Accessed 22 August 2012].2009. • Bond Valuation, [Video Online] Available at: <http://www.youtube.com/watch?v=MGEjuJS4iG4> [Accessed 22 August 2012].2010. The Basics of Bonds Valuation, [Video Online] Available at: <http://www.youtube.com/• watch?v=KMQIPHl15iw> [Accessed 22 August 2012].Banerjee. B., 1987. • Financial Policy and Management Accounting, 2nd ed., PHI Learning Pvt. Ltd.Khan, M. Y., 2004. • Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill Education.
Recommended ReadingStaff, I., 2005. • Stocks,Bonds,Bills,andInflation2005Yearbook:ValuationEdition, Ibbotson Associates.Appel, G., 2008. • Beat the Market: Win with Proven Stock Selection and Market Timing Tools, 1st ed., FT Press.Shim, J. K., 2008. • Financial Management, 3rd ed., Barron's Educational Series.
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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.
Interest Rate = Required Rate: Bond Value = ________ Value.2. maturitya. currentb. parc. netd.
Which of the following statements is false?3. Market value of an asset is the price at which the asset is bought or sold in the market.a. Liquidation value equals to value of assets minus value of liabilitiesb. Whenever there is change in the required rate of return, bond value shows fluctuations from its par value.c. Dividend rate is fixed for preference shareholders. .d.
Bond is also known as _____.4. debenturea. variableb. sharec. net valued.
Current yield relates to the annual interest to the current________.5. cost pricea. asset priceb. market pricec. specific priced.
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.
When I (%) = Kd (%) and change in the time period then value of bond is ____________ par value, whatever 7. may be the maturity period.
more thana. equal tob. not equal toc. less thand.
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Preference share gives some preferential rights to____________.8. equity stockholdersa. ordinary stockholdersb. preference stockholdersc. security stockholdersd.
_________ is present value of future cash inflows.9. Stock valuea. Bond valueb. Share valuec. Net valued.
In which of the following model the value of equity stock is valued assuming that dividends would growth at 10. a constant rate?
Constant Growth Modela. Zero Growth Modelb. Variable Growth Modelc. Changing Growth Modeld.
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Chapter IV
Cost of Capital
Aim
The aim of this chapter is to:
introduce the concept of cost of capital•
define cost of different sources of finance•
highlight the Capital Asset Pricing Model Approach (CAPM)•
Objectives
The objectives of this chapter are to:
explain the cost of equity – cost of retained earnings, cost of issue of equity shares •
elucidate the cost of preference shares – cost of irredeemable and redeemable share•
explicate the cost of debentures – cost of irredeemable and redeemable debt•
Learning outcome
At the end of this chapter, you will be able to:
understand the concept of Weighted Average Cost of Capital (WACC)•
discuss the steps involved in the computation of WACC•
comprehend the factors affec• ting WACC
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4.1 Introduction to Cost of CapitalCost of capital represents the rate of return that a firm must pay to the suppliers of capital for use of their funds. It is the weighted average cost of various sources of finance used by the firm in capital formation. The sources are equity shares, preference shares, long-term debt and short-term debt.
Cost of capital from three different viewpoints:Investors view point: The measurement of the sacrifice made by the individual for capital formation"• 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 • used to value cash flows.
Importance of cost of capitalDesigning optimal capital structure• Investment evaluation• Financial performance appraisal•
4.2 Cost of Different Sources of FinanceIt can be further classified into below mentioned categories:
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 providing funds to the firm to finance firm's investment proposals. Retention of earnings involves an opportunity cost. Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable risk to earn returns. So, irrespective of whether a firm raises equity finance by retaining earnings or issue of additional equity shares, the cost of equity is same. But issue of additional equity shares to the public involves a flotation cost where as there is no flotation cost for retained earnings.
Cost of Retained Earnings (Kre)Retained earnings are those parts of net earnings that are retained by the firm for investing in capital budgeting proposals 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 (%)
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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)The cost of equity capital (Ke) may be defined as the minimum rate of return that a firm must earn on the equity financed portions of an investment project in order to leave unchanged the market price of the shares. The cost of equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend at a fixed rate every year.
It is the most difficult and controversial cost to measure there is no common basis for computation.
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:
Preference in payment of dividend, from distributable profits• 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 proceeds
Cost 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, with an estimated flotation cost of 5%. What is cost of preference share with 10% dividend tax.
Solution:
= 16.21 %
Cost of Redeemable Preference ShareShares that are issued for a specific maturity period or redeemable after a specific period are known as redeemable preference shares. Cost of preference share when the principal amount is repaid in one lump sum amount.
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Where, Kp = Cost of preference shareNP = Net sales proceeds (after discount, flotation cost)D = Dividend on preference sharePn = Repayment of principal amount at the end of ‘n’ years
Short cut formula is :
4.2.3 Cost of DebenturesCompanies may raise debt capital through issue of debentures or raise loan from financial institutions or deposits from public. All these resources involve a specific rate of interest. Computation of cost of debenture or debt capital depends on their nature.
Cost of Irredeemable DebtPerpetual debt provides permanent funds to the firm, because the funds will remain in the firm till liquidation. Cost of 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
For instance: XYZ Company Ltd., decides to float perpetual 12%, debentures of Rs. 100 each. The tax rate is 50. 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’
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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 between the required rate of return, and the non-diversifiable or relevant risk, of the firm as reflected in its index of non-diversifiable risk that is beta (β). It shows the relationship between risk and return for efficient and inefficient portfolios. Symbolically,
Where, Ke = Cost of equity capital, Rf = Rate of return required on a risk free security (%)β= Beta coefficient, Rmf = Required rate of return on the market portfolio of assets, that can be viewed as the average 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•
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 the least and most expensive funds. This approach enables the maximisation of profits and the wealth of the equity shareholders 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 capitalisation of the • firmComputation of cost of specific source of funds• Assignment of weight to specific source of funds• Multiply the cost of each source by the appropriate assigned weights• Add individual source weight cost to get cost of capital•
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Assignment of Weights: The weights to specific funds may be assigned based on the following:
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 • on the targeted capital structure. Depending on target, capital structures have some difficulties in using it. They are
A company may not have a well defined target capital structure �It may be difficult to precisely estimate the components capital cost, if the target capital is different from �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 and capital employed by the firm.
For instance a firm has the following capital structure as the latest statement
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
Solution:Computation of cost of capital
Source of Finance Weights Specific Cost (%) Weighted CostDebt 0.30* 4.0 1.2
Preference share 0.10 8.5 8.5Equity share 0.20 11.5 2.3
Retained earnings 0.40 10.0 4.01.00 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): These are the factors that are within the firm control. They are:
Capital structure policy• Dividend policy• Investment policy•
Uncontrollable Factors (External Factors): The factors those are not possible to control by the firm that mostly affects the cost of capital. These types of factors are known as xxternal factors.
Tax rates• Level of interest rates• Market risk premium•
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SummaryCost of capital represents the rate of return that a firm must pay to the suppliers of capital for use of their • funds.Cost of capital from three different viewpoints: Investors view point: The measurement of the sacrifice made • by the individual for capital formation; Firm's view point: It is the minimum required rate of return needed to justify the use of capital; and Capital Expenditure View Point: The cost of capital is the minimum required rate of return or the cut off rate used to value cash flows.The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders • are providing funds to the firm to finance firm's investment proposals. Cost of Retained Earnings (Kre): Retained earnings are those parts of net earnings that are retained by the firm • for investing in capital budgeting proposals instead of paying them as dividends to shareholders.Cost of issue of Equity Shares (Ke): The cost of equity capital (Ke) may be defined as the minimum rate of • return that a firm must earn on the equity financed portions of an investment project in order to leave unchanged the market price of the shares.Preference share is one of the types of shares issued by companies to raise funds from public.• Cost of Debentures: Companies may raise debt capital through issue of debentures or raise loan from financial • institutions or deposits from public. All these resources involve a specific rate of interest. Computation of cost of debenture or debt capital depends on their nature.Capital Asset Pricing Model Approach (CAPM): CAPM was developed by William F.Sharpe. From cost of capital • point of view, CAPM explains the relationship between the required rate of return, and the non-diversifiable or relevant risk, of the firm as reflected in its index of non-diversifiable risk that is beta (β).Weighted average cost of capital is affected by a number of factors. They are divided into two categories such • as: controllable and uncontrollable factors.
ReferencesCost of Capital• , [pdf] Available at: <http://educ.jmu.edu/~drakepp/principles/module7/coc.pdf> [Accessed 22 August 2012].The Cost of Capital• , [pdf] Available at: <http://assets.cambridge.org/97805218/01959/frontmatter/9780521801959_frontmatter.pdf> [Accessed 22 August 2012].2009. • Introduction to Cost of Capital, [Video Online] Available at: <http://www.youtube.com/watch?v=AGaoDQgicVg> [Accessed 22 August 2012].2010. • CIMA F3 Lecture 6 Cost of Capital, [Video Online] Available at: <http://www.youtube.com/watch?v=D4Du8t3yKwk> [Accessed 22 August 2012].Shannon, P. P. & Grabowski, R. J., 2008. • Cost of Capital, 3rd ed., John Wiley & Sons.Khan, M. Y., 2004. • Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill Education.
Recommended Reading2005. • The Cost of Capital: Intermediate Theory, Cambridge University Press.Pratt, S. P., 2010. • Cost of Capital: Workbook and Technical Supplement, 4th ed., (Wiley Finance), Wiley.Ogier, T., 2004. • The Real Cost of Capital: A Business Field Guide to Better Financial Decisions, FT Press.
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Self Assessment Perfect capital market is one of the assumptions of ______.1.
WACCa. CAPMb. equityc. debenturesd.
Cost of capital is the ___________ required rate of return needed to justify the use of capital.2. minimuma. maximumb. higherc. reducedd.
Which of the following statements is false?3. Cost of capital comprises of three different viewpoints.a. Cost of capital is the minimum required rate of return needed to justify the use of capital.b. There is no cost for internally generated funds.c. Investors seek to maximise the expected utility of their portfolios over a single period planning horizon.d.
_______ value weights are based on the values found on the balance sheet.4. Booka. Capitalb. Marketc. Weightedd.
CAPM stands for what?5. Capital Asset Process 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. less expensiveb. 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 __________ cost.8. opportunitya. fixedb. capitalc. explicit d.
Retained earnings are those parts of ________ earnings that are retained by the firm for investing in capital 9. 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
The aim of this chapter is to :
define capital structure•
explain the features of appropriate capital structure•
enlist the factors that determine the capital structure•
Objectives
The objectives of the chapter are to:
explain the concept of Net Income (NI) and Net Operating Income (NOI) approach of capital structure•
elucidate the traditional and MM model of capital structure•
explicate the theories of capital structure•
Learning outcome
At the end of this chapter, you will be able to:
understand the concept of leverages •
enlist three types of leverages•
describe the formulas of calculating• the different types of leverages
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5.1 Meaning of Capital StructureCapital Structure is that part of financial structure, which represents long-term sources. The term capital structure is generally defined to include only long-term debt and total stockholders investment.
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 Structure:It is that capital structure at that level of debt – equity proportion where the market value per share is highest and the cost of capital is least. The optimum capital structure keeps balance between share capital and debt capital.
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)Financial manager need to raise fixed cost sources) loans, debenture, preference shares) of funds, only when ROI is higher that the fixed cost funds.
Tax benefitSince debt is the cheapest source, because the interest paid on the debt is allowed as a deductible expense in determining tax payment. Hence, a business firm should take the advantage of tax deduction.
Perceived financial riskUse of more debt in capital structure leads to increase perceived financial risk in the minds of equity shareholders which reduces the market price of equity share, thereby firm's wealth. Therefore financial management should not increase debt in capital structure when ordinary shareholders perceived an excessive risk.
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:
Tax benefit of debt• Flexibility• Control• Industry leverage ratios• Seasonal variations• Degree of competition•
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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 StructureEquity and debt are the two important sources of long-term sources of finance of a firm. The proportion of debt and equity in a firm's capital structure has to be independently decided case to case. Many theories have been propounded to understand the relationship between financial leverage and firm value.
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.• The total financing remains constant. The firm can change the degree of leverage either by selling the shares • and retiring debt or by issuing debt and redeeming equity.Operating profits (EBIT) are not expected to grow.• All the investors are assumed to have the same expectation about the future profits.• Business risk is constant over time and assumed to be independent of its capital structure and financial risk.• Corporate tax does not exit.• The company has infinite life.• Dividend payout ratio = 100%•
5.4.1 Net Income ApproachAccording to net income approach the firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure.
Assumptions of the Net Income (NI) ApproachThe use of debt does not change the risk perception of investors; as a result, the equity capitalisation rate, 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.•
Give below is the graphical representation of the net income approach:
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Cost
Ke, Ko Ke,
KoKd
Debt
Kd.
Fig. 5.1 Net income approach
According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.
For instance: Assume that a firm has an expected annual net operating income of Rs.200,000 an equity rate, Ke, of 10% and Rs. 10,00,000 of 6% debt.Solution: The value of the firm according to Net Income approach: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, 40,000Therefore: 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) ApproachIn Net operating income approach the market value of the firm is not affected by the change in capital structure, the weighed average cost of capital is said to be constant.
Assumptions of the Net Operating Income (NOI) approachThe market capitalises the value of the firm as a whole. 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
According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firm’s capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same.
For instance:Assume that a firm annual net operating income of Rs. 2,00,000 an average cost of capital Ko, of 10% and intial debt of Rs. 10,00,000 at 6%.Solution: Net operating Income = 2,00,000Therefore, Market value of firm, 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 this view the value of the firm can be increased or the cost of the capital can be reduced by a judicious mix of dent and equity capital.
This approach implies that the cost of capital decreases within the reasonable limit of debt and then increases with the leverage.
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This approach has the following propositions as shown in the Fig. below:
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 markets Securities can be freely traded, there are no hindrances on the borrowing, no presence of transaction costs, securities infinitely divisible, availability of all required information at all times.
Investors behave rationally They 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.
Taxes: There is no corporate or personal income tax
Dividend pay-out is 100%That is, the firms do not retain earnings for future activities.
Following three propositions can be derived based on the above assumptions:
Proposition I The market value of the firm is equal to the total market value of equity and total market value of debt and is independent of the degree of leverage.
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Proposition IIThe expected yield on equity is equal to discount rate (capitalisation rate) applicable plus a premium.
Proposition IIIThe average cost of capital is not affected by the financing decisions as investment and financing decisions are independent.
Criticism of MM PropositionsFollowing are the disadvantages of MM Propositions
Risk perception The assumption that risks are similar is wrong and the risk perceptions of investors are personal and corporate leverage is different.
ConvenienceInvestors find personal leverage inconvenient.
Transaction costsDue 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 to explain the financing decision and firm's value.
5.5 LeveragesLeverages has been defined as, the action of a lever and mathematical advantage gained by it. From the financial management point of view, the term leverage is commonly used to describe the firm's ability to use fixed cost assets or sources of funds to magnify the returns to its owners.
Types of LeveragesOperating leverage• Financial leverage•
5.5.1 Operating LeverageOperating leverage is present any time in a firm when it has operating (fixed) costs regardless of the level of production. It can be defined as "The firm's ability to use operating costs to magnify the effects of changes in sales on 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-variable Cost: which partly vary and partly fixed•
The degree of operating leverage may be defined as the change in the percentage of operating income (EBIT), for a 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:
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For instance: From the following particulars of ABC Ltd., calculate degree of operating leverage.
Particulars Previous Year 2009 Current Year 2010Sales revenue 10,00,000 12,50,000Variable 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 costContribution
Less: fixed costEBIT
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 LeverageIt is helpful to know how operating profit would change with a given change in units produced.• It will be helpful in measuring business risk.•
5.5.2 Financial LeverageFinancial manager job is to raise funds for long-term activities with different composition of sources. The required funds may be raised by two sources: equity and debt. The use of fixed charge sources of funds such as debt and preference share capital along with the equity share capital in capital structure is described as financial leverage. According to Lawrence, financial leverage is "the ability of the firm to use fixed interest bearing securities to magnify the rate of return as equity shares". It is also known as "trading as equity".
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Formula for calculating financial leverage is given below:
OR
For instance: A firm has sales of 1, 00,000 units at Rs. 10/ unit. Variable cost of the produced products is 60% of the total sales revenue. Fixed cost id Rs. 2, 00,000. The firm has used a debt of Rs. 5, 00,000 at 20% interest. Calculate the operating leverage and financial leverage.
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 LeverageIt is helpful to know how EPS would change with a change in operating profit.• It is helpful for measuring financial risk.•
5.5.3 Combined LeverageThe operating leverage has its effects on operating risk and is measured by the % change in EBIT due to the % change in sales. The financing leverage has its effects on financial risk and is measured by the % change in EPS due to the % change in EBIT. Since, both these leverages are closely related with the ascertainment of the firm's ability to cover fixed charges, the sum of them gives us the total leverage or combined leverage and the risk associated with combined leverage is known as total risk.
The degree of combined leverage may be defined as the % change in EPS due to the % change in sales. Thus combined leverage is:
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For instance: ABC corporation has sales of Rs. 40 lakhs, variable cost 70% of the sales and fixed cost is Rs. 8,00,000. The firm has raised Rs. 20 lakhs funds by issue of debentures at the rate of 10%. Compute operating, financial and combined leverages.
Solution: Calculation of EBT or PBT
Particulars Amount (Rs.)Sales revenue 40,00,000
28,00,000Less: Variable cost (40,00,000 X 0.70) Contribution 12,00,000
8,00,000Less: Fixed CostEBIT 4,00,000
2,00,000Less: 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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SummaryOrganisation requires funds to run and maintain the business. The required funds may be raised from short term • sources so as to equip itself with an appropriate combination of fixed assets and current assets.Capital structure refers to the mix of long-term sources of funds, such as equity shares capital, reserves and • surplus, debenture, long-term debt from outside sources and preference share capital.Capital structure indicated by the equation: Capital structure = long-term debt + preferred stock + net worth = • total assets – current liabilities.An appropriate capital structure should take into consideration. Profitability, solvency, flexibility of capital • structure, firm's debt capacity, and control.From the financial management point of view, the term leverage is commonly used to describe the firm's ability • to use fixed cost assets or sources of funds to magnify the returns to its owners. There are two types of leverages – operating and financial leverage.• Operating leverage refers as the firm's ability to use operating costs to magnify the effects of changes in sales • on its earnings before interest and taxes. The degree of operating leverage may be defined as the change in the percentage of operating income, for a given change in % of sales revenue .Financial leverage is the ability to use fixed financial charges to magnify the effects of changes in EBIT on the • firm's earnings per share. It is also known as 'trading as equity'.Both these leverages are closely related with the ascertainment of the firm's ability to cover fixed charges, the • sum of them gives us the total leverage or combined leverage and the risk associated with combined leverage is known as total risk. The degree of combined leverage may be defined as the % change in EPS due to the % change in sales.
ReferencesReddy, G. S., 2008. • Financial Management, Himalaya publications. Scribd.com. • Capital structure theory [Online] Available at: <http://www.scribd.com/doc/17348063/Capital-Structure-Theory>. [Accessed 18 November 2010].Capital structure theory• [Online] Available at: <http://www.slideshare.net/piyooshtripathi/capital-structure-theory> [Accessed 18 November 2010].2008. 16. • The Capital Structure of a Company, [Video Online] Available at: <http://www.youtube.com/watch?v=uPY5-gtkgL4> [Accessed 22 August 2012].2009. • Capital structure, [Video Online] Available at: <http://www.youtube.com/watch?v=6uB1eWJz9jI> [Accessed 22 August 2012].Shim, J. K. & Siegel, J.G., 2008. • Financial Management, 3rd ed., Barron's Educational Series.Brigham, E. F. & Houston, J. F., 2009. • Fundamentals of Financial Management, 12th ed., Cengage Learning.
Recommended ReadingBrigham, E. F., 2003. • Fundamentals of Financial Management, 10th ed., South-Western College Pub.Moyer, S. G., 2004. • Distressed Debt Analysis: Strategies for Speculative Investors, J. Ross Publishing.Belkaoui, A. B., 1999. • Capital Structure: Determination, Evaluation, and Accounting, Quorum Books.
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Self Assessment Capital structure is the proportion of debt and ______.1.
liabilitiesa. assetsb. equityc. costd.
___________ is one of the operating costs.2. Expenditurea. Variable costb. Capitalc. Tnagible costd.
Which of the following statements is false?3. Capital Structure is that part of financial structure, which represents long-term sources.a. The optimum capital structure does not keep a balance between share capital and debt capital.b. Profitability, flexibility, control, conservation and solvency are the features of capital structure. c. The capital structure should be determined keeping in mind the objective of wealth maximisation.d.
What is EBIT ÷ EBT equal to?4. Fixed leveragea. Financial leverageb. Combined leveragec. Operating leveraged.
What is defined as "the firm's ability to use operating costs to magnify the effects of changes in sales on its 5. earnings before interest and taxes"?
Operating leveragea. Financial leverageb. Trading as equityc. Combined leveraged.
Total assets – Current liabilities =?6. Optimal capital structurea. Financial leverageb. Operating leveragec. Capital structured.
Which approach is known as intermediate approach?7. Traditional approacha. Net Income approachb. Miller and Modigliani approachc. Net Operating Income approachd.
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Financial leverage is also known as __________.8. indifference pointa. trading as equityb. combined leveragec. capital structured.
Which of the following chooses the combination of risk and return that is most advantageous for them?9. Investors behave rationallya. Homogenityb. Perfect capital marketsc. Taxesd.
Contribution is divided by EBIT to get ________ leverage.10. financiala. operatingb. combinedc. fixedd.
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Chapter VI
Capital Budgeting
Aim
The aim of this chapter is to:
introduce capital budgeting•
explain the process of capital budgeting•
elucidate the importance of capital budgeting•
Objectives
The objectives of this chapter are to:
explain the cumulative cash flow method•
elucidate the accounting rate of return method•
explicate the concept of net present value•
Learning outcome
At the end of this chapter, you will be able to:
understand the pay back period•
comrpehend the difficulties in capital budgeting•
enlist the steps involvedin computation of net present value•
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6.1 Meaning of Capital BudgetingCapital budget may be defined as “the firm’s decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years”. Capital budgeting is the process of identifying, analysing and selecting investment projects whose returns are expected to extend beyond one year.
Importance of Capital BudgetingGrowth• More risk• Huge investments• Irreversibility• Effect on other projects• Difficult decision•
Difficulties in capital budgetingCapital budgeting decisions are very important, but they pose difficulties, which shoot from three principle sources:
Measurement problem Evaluation of project requires identifying and measuring its costs and benefits of hat project, which are difficult since they involve tedious calculations and lengthy process.
UncertaintySelection or rejection of a capital expenditure project depends upon expected costs and benefits that for in to the future, which is uncertain.
Temporal spreadThe cost and benefits, which are expected, to be associated with a particular capital expenditure project spread out over a long period of time, and the temporal spread creates some problems in estimating discount rates for conversation of future cash inflows in present values and establishing equivalences.
6.2 Process of Capital BudgetingThe process of capital budgeting can be divided into six broad phases that are:
Idea generation The planning phase of a firm’s capital budgeting process is concerned with articulation of its broad investment strategy and the generation and preliminary search of project proposals.
Evaluation or analysis In the preliminary screening when a project proposal suggests that the project is prima facie worthwhile, then it is required to go for evaluation. Analysis has to take from the aspects like, marketing, technical, financial, economic and ecological analysis.
SelectionSelection or rejection of project follows analysis phase. This depends upon the technique used to evaluate and its acceptance rule.
Financing the selected project After the selection of the project, the next step is financing. The amount required is known after selection of the project.
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Execution and implementation Implementation of an industrial project involves the stages like, engineering designs, negotiations and contracting, construction, training, and plant commissioning.
Review of the projectOnce the project is converted from paper work into concrete work, and then there is need to review the project. Performance review should be done periodically, in which phase actual performance is compared with the predetermined performance.
6.3 Techniques of Investment EvaluationThe investment evaluation techniques play a vital role in evaluating a project. Profitability of a firm will increase if the proposal is profitable and vice versa. Evaluation techniques are divided into two broad categories that is:
Traditional or non-discounted techniques• Modern or discounted cash flow techniques•
6.3.1 Traditional TechniquesThe traditional techniques are further divided into two namely:
Pay back period• Accounting Rate of Return or Average Rate of Return (ARR)•
Pay back periodPay back period may be defined as that period required recovering the original cash outflow invested in the project. The cash flow after taxes are used to compute pay back period.
Pay back period can be calculated in two ways:Using Formula •
It can be applied when the annual cash-flows-stream of each year is equal, that is uniform cash flows for all �the years. In this situation the following formula is used to calculate pay back period.
Pay back period = Original investment ÷ constant annual cash flows after taxes
Cumulative cash flow method It is applied when the annual cash flows after taxes are unequal or not uniform over the projects life period. In this situation, pay back period is calculated through the process of cumulative cash flows, cumulated process goes up to the period where cumulative cash flows equal to the actual cash outflows.
PBP = Year before full recovery + (Unrecovered Amount of Investment + Cash flows during the year)
Decision Rule: Acceptance or reject of the project decides based the comparison of calculated PBP with the (maximum) standard pay back period. Symbolically.
Accept: Cal PBP < Standard PBPReject: Cal PBP > Standard PBP
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For instance: A company is considering expanding its production. It can go in either for an automatic machine costing Rs. 2, 24,000 with an estimated life of 5 years or an ordinary machine costing Rs. 60,000 having an estimated life of 8 years. The annual sales and costs are estimated as follows.
SalesAutomatic machine (Rs.) Ordinary machine (Rs.)
1,50,000 1,50,000
Costs:
Materials 50,000 50,000
Labor 12,000 60,000
Variable overheads 24,000 20,000
Calculate the payback period
Solution:Calculation of PBP needs cash flows after tax. Hence, now calculate CFAT.
Particulars Automatic machine (Rs.) Ordinary machine (Rs.)Sales 1,50,000 1,50,000Less costs:Material + Labor +V.overheads 86,000 1,30,000EBDT 64,000 20,000Less: Depreciation (WN) 44,800 7,500EBT 19,200 12,500Less: Tax 50% (Assumed) 9,600 6,250EAT 9,600 6,250Add: Depreciation 44,800 7,500CFAT 54,400 13,750
Payback period = Initial Investment ÷ Constant Annual cash InflowsPBP of Automatic machine = 2, 24,000 ÷ 54,000 = 4.11 yearsPBP of ordinary machine = 60,000 ÷ 13,750 = 4.36 years
Depreciation = (Orginal Investment – Scrap Value) ÷ Life periodAutomatic Machine: (2, 24,000 – 0)/5 = Rs. 44,800Old machine: (60,000 – 0)/8 = Rs. 7,500
Accounting Rate of Return (ARR)Accounting rate of return method uses accounting information as revealed by financial statements, to measure the profitability of the investment proposals. It is also known as Return on Investment (ROI). Sometimes it is called as average rate of return (ARR). ARR can be calculated in two ways.
Whenever it is clearly mentioned as Accounting Rate of Return
OI* = Original investment + additional NWC + Installation charges + Transportation charges
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Whenever it is clearly mentioned as Average Rate of Return
AI* = (Original investment – Scrap Value )1/2+ Additional NWC + Scrap ValueIf ARR is given in the problem, any one of the above method can be used to calculate ARR
Decision rule Acceptance or reject of the project decides based the comparison of calculated ARR with the predetermined rate or cut of rate.
Accept: Cal ARR < Predetermined ARR or Cut-off rateReject: Cal ARR > Predetermined ARR or Cut-off rate
6.3.2 Modern Techniques or Discounted Cash Flow (DCF) TechniquesModern techniques take into consideration almost all the deficiencies of the traditional methods and they consider all benefits and cost occurring the projects’ entire life period. Modern techniques again subdivided into three categories:
Net present value• Internal rate of return or trial and error• Profitability index or discounted benefit cost ratio•
Net Present Value (NPV)NPV can be defined as preset value of benefits minus preset value of costs. It is process of calculating present values of cash inflows using cost of capital as an appropriate rate of discount and subtract present value of cash out flows from the present value of cash inflow and find the net present value, which may be positive or negative. It is also known as discounted benefit cost ratio method.
Steps involved in computation of NPVForecasting of cash inflows of the investment project based on realistic assumptions• Computation of cast of capital, which is used as discounting factor for conversion of future cash inflows into • present valuesCalculation of pv cash flows using cost of capital as discounting rate• Finding out NPV by subtracting PV of cash out flows from PV of cash inflows•
Decision ruleAcceptance or rejection rule of the project decision is based on the NPVAccept: NPV> Zero; Reject: NPV < Zero
Internal Rate of Return (IRR)Internal rate of return can be defined as that discounting factor at which the present value of cash inflows equals to the present value of cash outflows. It takes into account the magnitude and timing of cash flows. Computation of IRR is based on the cash flows after taxes. It is presented as ‘r’. This is calculated by the following formula is:
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Where, LDF = Lower discount factor; = Difference b/w low discounting factor and High discounting factor; PVLDF = PV of cash inflows at low discounting factor; PVHDF = PV of cash inflows at high discounting factor; COF = Cash inflows
Decision ruleAcceptance or rejection rule of the project decision is based on the calculated IRR and cost of capital (Ko).Accepted: IRR > cost of capital (Ko)Reject: IRR< cost of capital (Ko)
Profitability Index (PI)It is the ratio the present value of cash inflows, at the required rate of return, to the initial cash outflows of the investment proposal. PI is also known as discounted benefit cost ratio (DBCR).PI = Present Value of cash inflows ÷ Present value of cash outflows
Decision ruleAccept: PV>I; Reject: PI<ICharacteristics of Sound Investment TechniqueAny investment technique should be called sound, when it possess the following characteristics:
It should consider all cash flows to determine the true profitability• It should provide for an objective and unambiguous way of separating good projects from bad projects• It should help in ranking of projects according to their true profitability• It should recognise the fact that bigger cash inflows are preferable to smaller ones and early cash flows are • preferable to later ones
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SummaryCapital budget may be defined as “the firm’s decision to invest its current funds most efficiently in the long-term • assets in anticipation of an expected flow of benefits over a series of years”. Process of capital budgeting involves six phases namely – idea generation, evaluation or analysis, selection, • financing the selected project, execution or implementation and review of the project.The investment evaluation techniques play a vital role in evaluating a project. Profitability of a firm will increase • if the proposal is profitable and vice versa. Evaluation techniques are divided into two broad categories that is: Traditional or non-discounted techniques and Modern or discounted cash flow techniques.Pay back period may be defined as that period required recovering the original cash outflow invested in the • project. The cash flow after taxes are used to compute pay back period. It is calculated with two methods by using formula and Cumulative cash flow method.Accounting rate of return method uses accounting information as revealed by financial statements, to measure • the profitability of the investment proposals. It is also known as Return on Investment (ROI). Sometimes it is called as Average Rate of Return (ARR).Modern techniques take into consideration almost all the deficiencies of the traditional methods and they consider • all benefits and cost occurring the projects’ entire life period. Modern techniques again subdivided into three categories: Net present value, Internal rate of return or trial and error and Profitability index or discounted benefit cost ratio.NPV can be defined as preset value of benefits minus preset value of costs.• Internal rate of return can be defined as that discounting factor at which the present value of cash inflows equals • to the present value of cash outflows. It takes into account the magnitude and timing of cash flows.It is the ratio the present value of cash inflows, at the required rate of return, to the initial cash outflows of the • investment proposal. PI is also known as discounted benefit cost ratio (DBCR).
ReferencesCapital Budgeting• [Online] Available at: <http://www.netmba.com/finance/capital/budgeting/> [Accessed 19 November 2010].What is Capital Budgeting?,• [Online] Available at: <http://www.exinfm.com/training/capitalbudgeting.doc> [Accessed 22 August 2012].Dayananda, D., Irons, R., Harrison, S., Herbohn, J. & Rowland, P., 2002. • Capital Budgeting: Financial Appraisal of Investment Projects, Cambridge University Press.Seitz, N. & Ellison, M., 2004., • Capital Budgeting and Long-Term Financing Decisions, 4th ed., Thomson/South-Western.2008. • Capital Budgeting, [Video Online] Available at: <http://www.youtube.com/watch?v=qGgVGUcBqAg> [Accessed 22 August 2012].2012. • Capital Budgeting Part 1, [Video Online] Available at: <http://www.youtube.com/watch?v=-0g7CwRV76c> [Accessed 22 August 2012].
Recommended ReadingPeterson, P. P., 2002. • Capital Budgeting, 1st ed., Wiley. Bierman, H. Jr., 2007. • Advancedcapitalbudgeting:RefinementsintheEconomicanalysisofinvestmentprojects, Routledge.Seitz, N., 2004. • Capitalbudgetingandlong-termfinancingdecisions 4th ed., South-Western College Pub.
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Self AssessmentNet present value (NPV), __________, and profitability index are three discounted cash flow techniques.1.
internal rate of returna. average rate of returnb. earning after taxesc. low discount factord.
Original investment is divided by _________ to get pay back period.2. capital budgetinga. discount rateb. benefit cost ratioc. constant annual cash in flows after taxesd.
What are modern techniques also called?3. Trail and Error techniquesa. Discounted cash flow techniquesb. Payback period techniquesc. Non- Discounted cash flow techniquesd.
Acceptance or reject of the project decides based the comparison of calculated _____ with the predetermined 4. rate or cut of rate.
ARRa. CFATb. IRRc. PBPd.
NPV stands for which of the following?5. Net Present Valuea. Net Past Valueb. Non – Present Valuec. Net Past Valued.
Internal Rate of return is also called _________ method.6. net present valuea. trail and errorb. benefit cost ratioc. traditional d.
The process of capital budgeting can be divided into how many phases?7. threea. fourb. sixc. fived.
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NPV and IRR are both the categories of _______ techniques.8. DCFa. EATb. PATc. ARRd.
Which of the following statements is false?9. Capital budgeting is short-term decisiona. Additional, scrap value and cost of project are the components of average investmentb. Intermediate cash flows are reinvested at the rate of IRR is the assumption of IRRc. If there is size disparity the NPV and IRR will give different rankingsd.
Investment evaluation techniques can be divided into how many categories?10. onea. threeb. fourc. twod.
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Chapter VII
Risk Analysis in Capital Budgeting
Aim
The aim of this chapter is to:
elucidate capital budgeting•
define risk in capital budgeting•
explain capital budgeting by probability approach•
Objectives
The objectives of this chapter are to:
enlist the types of decision situations in capital budgeting•
explain the concept of probability and decision tree•
elucidate risk adjested discount rate•
Learning outcome
At the end of this chapter, you will be able to:
understand the characteristics, functions and importance of capital budgeting•
enlist the methods of incorporating the risk factor in capital budgeting•
describe the de• cision tree analysis
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7.1 IntroductionIn the previous chapter on capital budgeting the project appraisal techniques were applied on the assumption that the project will generate a given set of cash flows.
It is quite apparent that one of the set backs of DCF techniques is the difficulty in estimating cash flows with certain degree of certainty.
Certain projects when taken up by the firm will change the business risk complexion of the firm. This business risk complexion of the firm influences the required rate of return of the investors.
Suppliers of capital to the firm tend to be risk averse and the acceptance of a project that changes the profile of the firm may change their perception of required rates for investing in firm’s project.
Generally, the projects that generate high returns are risky which will naturally change the business risk of the firm. Because of this high risk perception associated with the new project a firm is forced to be employed in the process of evaluation.
7.2 Definition of RiskRisk may be defined as follows:
Risk may be defined as the variation of actual cash flows from the expected cash flows.• The term risk in capital budgeting decisions many be defined as the variability that is likely to occur in future • between the estimated and the actual returns.Risk exists on account of the inability of the firm to make perfect forecasts of cash flows. Risk arises in the • project evaluation because of the uncertainty about a project’s future profitability. The uncertain economic conditions are the sources of uncertainty in cash flows. Risk is associated with the variability of future returns of a project. The greater the variability of the expected • returns, the riskier the project is.The capital budgeting proposals based on perfect forecast of costs and revenues because the assumptions about • the future behavior of costs and revenue may change. Decisions have to be made in advance assuming certain future economic conditions.
7.2.1 Types of Decision Situations in Capital Budgeting
The decision situations with reference to risk in capital budgeting decisions can be broken down into three • types:Certainty means no risk. Here the estimated returns are equal to the actual returns like investing in Government • Securities where the investor can accurately estimate returns after a year. Therefore, it is risk free investment. Uncertainty is the decision situation in, which the probabilities are known. In the words of Osteryoung, risk • refers to a set of unique out comes for a given event which can be assigned probabilities.Risk exists only when a decision maker is in a position to assign probabilities to various out comes.•
It is possible only when the decision maker has some historical data, which helps to assign probabilities. Whereas uncertainty exists when the decision maker is not in a position to assign probabilities to various out-comes due to lack of historical data. A decision maker with completely new projects, may be able to assign subjective probabilities to various out comes, through research and consulting with others.
7.2.2 Sources of RiskThe following are the sources of risk:Project specific riskIt is the risk that arises due to estimation errors in earnings and cash flows or same factors that are specific to the project like quality of management, etc.
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Competitive or Competition riskThis type of risk arises due to actions of competitors that affect company’s estimated earnings and cash flows of the projects.
Industry specific riskHere the firms' earnings and cash flows are affected due to the industry specific factors like unexpected changes in government regulations, consumer behavior and technological development.
Market riskMarket risk affects the earnings and cash flows of all projects, due to unexpected changes in macroeconomic factors like the GDP growths rate; interest-rate and inflation.
International riskThis type of risks exists only in International (Foreign) projects, whose earnings and cash flows affects due to the unexpected exchange rate risk or political risk.
7.2.3 Perspectives of RiskThe following are the three different perspectives of risk:
Stand-alone riskIt refers the risk of a project when it is viewed in isolation. In other words, it is nothing but the risk of a firm investing in one and only project.
Firm riskIt is the project's risk to the corporation that affects firm’s future carvings. It is known as corporate risk.
Market riskIt refers to the risk of a project from the view point of a diversified investor. It is a part of a project’s risk that cannot be eliminated by diversification. It is also known as systematic risk.Stand-alone risk is the risk of a project when the project is considered in isolation Corporate risk is the projects risks of the firm. Market risk is systematic risk. The market risk is the most important risk because of the direct influence it has on stock prices.
7.3 Risk Adjusted Discount RateThe basis approach of this is that:
There should be adequate reward in the form of return to firms which decide to execute risky business • projects.Man by nature avoids risk and therefore, to motivate firms to take risky projects, returns expected from the • project shall have to be adequate. (keeping in view the expectation of the investors)Risk premium need to be incorporated in discount in the evaluation of risky project proposals.•
Therefore, the discount rate for appraisal of projects has two components. They areRisk-free rate, which is computed based on the return on Government Securities• Risk premium is the additional return that investors require as compensation for assuming the additional risk • associated with the project to be taken up for execution.
Risk Adjusted Discount rate = Risk free rate + Risk premium
The more uncertain the returns of the project, the higher the risk are. Higher the risk greater the premium are. Hence, Risk Adjusted Discount Rate (RADR) is a composite of the risk free interest rate and risk premium of the project.
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Decision Rule: RADR is the discount rate, since it can be used in two DCF techniques. They are NPV and IRR. If NVP Method is used: Accept: NPV > 0 Reject: NPV < 0 Consider: NVP = 0 If IRR Methods used: Accept: IRR> RADR; Reject: IRR> RADR Consider: IRR = RADR
Example: A project is required to invest Rs. 1, 00,000 and it is expected to generate cash flow after tax over its economic life 5 years, of Rs. 20, 000, Rs. 35,000, Rs. 55000 and Rs. 10,000. Risk free interest rate is 7 per cent, and decision makers are interested to add 3 per cent as risk premium for the project. You are required to calculate NPV using RADR and suggest whether the project is acceptable or not.Solution: Calculation NVP need discount rate
RADR = Risk free interest rate + Risk premium= 7% + 3% = 10%
Calculation of NPV
Years CFAT (Rs.) DF 10% (CFAT*DF10%) PVs (Rs.)12345
20,00030,00035,00055,00010,000
0.9090.8260.7510.6830.650
18,18024,78026,28537,5656,500
Total present valueLess: Cash outflow
1,13,3101,00,000
NPV 13,310
Project is acceptable since its NPV (Rs. 13,310) is greater than zero.
Advantages of RADRIt is simple to calculate• It is easy to understand• Risk premium takes care of the risk element in future cash flows• It gives psychological satisfaction to decision maker since it adds some premium for risk•
LimitationsIt is difficult to arrive a RADR – since there is no tailor made method to arrive it (based arbitrary method)• It assumes that risk increases with times at a constant rate, which is not valid• It does not make use of the information from probability distribution expected future cash•
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7.4 Certainty EquivalentUnder this method the risking uncertain, unexpected future cash flows are converted into cash flows with certainty.
Here we multiply uncertain future cash flows by the certainty – equivalent coefficient to convert uncertain cash • flows into certain cash flows.The certainty equivalent coefficient is also known as the risk – adjustment factor. • Risk adjustment factor is normally denoted by α (Alpha). • It is the ratio of certain net cash flow to risky net cash flow.•
The discount factor to be used is the risk rate of interest. Certainty equivalent coefficient is between 0 and 1. The risk – adjustment factor varies inversely with risk. If risk is high a lower value is used for risk adjustment. If risk is low a higher coefficient of certainty equivalent is used
Example: A project costs Rs. 50,000. It is expected to generate cash flows as under
Year Cash in flows Certainty Equivalent1 32,000 0.92 27,000 0.63 20,000 0.54 10,000 0.3
Risk – free discount rate is 10% compute NPV
Solution:
Year Uncertain cash in flows C E Certain cash
flowsPV Factor at
10%PV of certain cash inflows
1 32,000 0.9 28,800 0.909 26,1792 27,000 0.6 16,200 0.826 13,3813 20,000 0.5 10,000 0.751 7,5104 10,000 0.3 3,000 0.683 2,049
PV of certain cash in flows 49,119Initial cash out lay 50,000
NPV (881) negative
The project has a negative NPV.Therefore, it is rejected.
If IRR is used, the rate of discount at which NPV is equal to zero is computed and then compared with the • minimum (required) risk free rate.If IRR is greater than specified minimum risk free rate, the project is accepted, otherwise rejected.•
7.4.1 Evaluation Certain Equivalent
It recognises risk. • Recognition of risk by risk – adjustment factor facilitates the conversion of risky cash flows into certain cash • flows. But there are chances of being inconsistent in the procedure employed from one project to another.
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When forecasts pass through many layers of management, original forecasts may become highly • conservative.Because of high conservation in this process only, good projects are likely to be cleared when this method is • employed.Certainty – equivalent is considered to be theoretically superior to the risk- adjusted discount rate.•
7.5 Sensitivity AnalysisIt provides information as to how sensitive the estimated project parameters (input variables) viz. economic • life, discount rate, selling price; units sold, expected cash flow are to estimation of errors.Because of the uncertainty of the future, if an entrepreneur wants to know about the feasibility of a project in • variable quantities, sensitivity analysis can be a useful method. Sensitivity analysis is also known as a "what if analysis".Sensitivity analysis helps to build confidence in the project by studying the uncertainties that are often associated • with parameters in projects.It is a technique that shows the change in NPV given a change in one of the variables that determine cash flows • of a project.It measures the sensitivity of NPV of a project in respect to a change in one of the input variables of NPV.•
Example: Investments or sales change from the anticipated value, sensitivity analysis can be a useful method. This is calculated in terms of NPV, or net present value.
The reliability of the NPV depends on the reliability of cash flows.If forecasts go wrong on account of changes in assumed economic environments, reliability of NPV and IRR • is lost. Therefore, forecasts are made under different conditions:
The Pessimistic �The most likely �The optimistic �
NPV is arrived at for all the above three assumptions.•
Sensitivity analysis involves the following steps:Identification of variables that influence the NPV and IRR of the project• Examining and defining the mathematical relationship between the variables• Analysis of the effect of the change in each of the variables on the NPV of the project•
Example:A company has two mutually exclusive projects under consideration viz. project A and project B.• Each project requires an initial cash outlay of Rs. 3, 00,000 and has an effective life of 10 years. The company’s • cost of capital is 12%. The following forecasts of cash flows are made by the management.
Economic Project A Project BEnvironment Annual cash inflows Annual cash in flowsPessimistic 65,000 25,000Expected 75,000 75,000Optimistic 90,000 1,00,000
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What is the NPV of the project?Which project should the management consider?Given PVIFA = 5.650
Solution:NPV of project A
Economic Project PVIFA PV of cash in flows
NPV
Environment cash inflows At 12% 10 yearsPessimistic 65,000 5.650 3,67,250 67,250Expected 75,000 5.650 4,23,750 1,23,750Optimistic 90,000 5.650 5,08,500 2,08,500
NPV of project BPessimistic 25,000 5.650 1,41,250 (1,58,750)Expected 75,000 5.650 4,23,750 1,23,750
Optimistic 1,00,000 5.650 5,65,000 2,65,000
DecisionUnder pessimistic conditions project A gives a positive NPV of Rs. 67,250 and project B has a negative NPV • of Rs. 1, 58,750. Project A is acceptedUnder expected conditions, both gave some positive NPV of Rs. 1, 23,000. Any one of two may be accepted• Under optimistic conditions project B has a higher NPV of Rs. 2, 65,000 compared to that of A’s NPV of Rs. • 2, 08,500.Difference between optimistic and pessimistic NPV for project A is Rs. 1, 41,250 and for project B the difference • is Rs. 4, 23,750.Project B is risky compared to Project A, because the NPV range is of large difference•
Advantages of sensitivity analysisIt helps the decision maker in understanding the project in totally, by identifying variables that affect the cash • flow forecast (estimation)It helps to disclose inappropriate forecasts, and thus guides the decision maker to calculate as relevant • variables
LimitationsIt provides ambiguous results• It fails to focus on the inter-relationship between variables•
7.6 Probability ApproachAs already known, that sensitivity analysis provides different cash flow estimates (under three assumptions) of the future return of a project. However, it suffers from limitations in which it fails to focus on the interrelationship between variables and does not provide actual result. These limitations can be overcome by assigning appropriate probabilities to the three possible out comes.
Pessimistic• Most likely• Optimistic•
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Probability is the percentage chance of occurrence of each cash flows (event).Probability of chance of occurrence of any event lies between 0 and 1.
Determination of variability’s of returns includes two steps:• Probability Assignment can be divided in the following manner which is discussed in the below mentioned �table
Objective Probability Assignment Subjective Probability AssignmentBased on a larger number of observations, under independent identical situations, that has observed over a period of time.
Based on personal judgment, because it is not based on large number of observations under independent and identified situations.
Table 9.1 Difference between objective and subjective probability assignment
Capital-budget decisions assignment of probabilities is based on subjective probability, because they do not involve large number of independent observations repeated over time.
Estimation of Expected Returns Once assignment of probability to different possible cash flows is completed, the next step is estimation of expected value.
Possible cash flows are multiplied by the individual assigned probabilities to get expected monetary value• The total of all the possible cash flows expected value is the projects expected return•
The above explained are the two steps involved in determination of variability of returns.
However, students need not assign any probabilities because they are generally given in problem. They need to calculate the expected monetary returns.
Example: (Calculation of expected monetary value)The following possible cash in flow for a project A:
Year 1 2 3 4 5Cash inflow (Rs.) 5,000 6,000 7,000 8,000 9,000Probability 0.10 0.20 0.30 0.2 0.2
Calculate: Total expected monetary value.
Solution: Calculation of Expected Monetary value = Cash in flows * Probability
Year Cash in flows (Rs.) Probability Expected monetary value (Rs.)
1 5,000 0.10 5002 6,000 0.20 1,2003 7,000 0.30 2,1004 8,000 0.20 1,6005 9,000 0.20 1,800
Total expected monetary value: 7,200
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Example: (Calculation of expected present value)The following information is available with regard to a project, whose economic life is three years and cost is Rs. 1, 00,000
Possible Situation Year 1 Year 2 Year 3Cash in flow Probability Cash in flow Probability Cash in flow Probability
Pessimistic 2,000 0.20 2,000 0.40 2,000 0.25Most of likely 5,000 0.60 5,000 0.50 5,000 0.35Optimistic 7,000 0.20 7,000 0.10 7,000 0.40
Calculate:i. EMV (Expected Monetary Value)ii. Total Present value of project assuming 10% cost of capital.
Solution: i. Expected Monetary Value (Rs.)
Year 1 Year 2 Year 2CFs Pro MVS CFs Pro MVS CFs Pro MVS
2,000 0.20 400 2,000 0.4 800 2,000 0.25 5005,000 0.60 3,000 5,000 0.5 2,500 5,000 0.35 1,7507,000 0.20 1,400 7,000 0.1 700 7,000 0.40 2,800
4,800 4,000 4,050
Total expected monetary value = 1 year MV + 2nd year MV + 3rd year MV = Rs. 4,800 + 4,000 + 4,050 = Rs. 12,850
Solution: ii. Calculation of Present value of EMV
Year EMV(Rs.) DF 10% Total PV (Rs.)1 4,800 0.909 4,363.202 4,000 0826 3,304.003 4050 0.751 3,041.55
Total Present Value
10,708.74
7.7 Decision Tree AnalysisDecision tree analysis is useful to managers in choosing among various courses of action when the choice (or sequence of choices) will ultimately lead to some uncertain consequences.
Risk can be reduced by re-evaluating the decisions using new information and then either investing more funds • or terminating the project.Any project that can be made in different stages and a period of years can be evaluated by using ‘Decision • Tree’.
Features of decision tree It shows the relationship between a present decision and future events mapped out over time in a format • resembling branches of a tree.It is a tree form which indicates the magnitude, probability and inter-relationship of all possible out comes.•
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It is helpful to handle the sequential decisions, by showing sequential cash flows and NPV of the proposed • project under different circumstances.
Steps in decision tree analysisIdentifying the (problem) Investment:•
Investment is identified �Investment may be on a new project, new product, entering a new market replacement of machines, equation �programs etc
Identification of decision alternatives: The identified investment will have two or more alternatives.• Drawing the decision tree: The decision tree should be drawn indicating the decision points, chance points and • other data.Specification of data: Once drawing the decision is over, then the evaluator has to specify probabilities and • monitory values for each alternative.Evaluate the alternatives: Having drawn decision tree and specified the data, then the next step is to evaluate • alternatives.Selection of best alternative: This is the last step in decision tree analysis in which the evaluator selects a • profitable (more) alternative, there by rejecting other alternatives.
ExampleVenkat Inte’l Company provides the following estimates of the present values of the future expected cash flows after associated with investment proposal relating to the plant explanation.
CFAT (Rs.)Probability
With Expansion Without Expansion4,50,000 2,00,000 0.27,00,000 3,50,000 0.35,00,000 5,00,000 0.5
The plant expansion costs Rs. 4, 00,000. You are required to advice the Venkat Inte’l Company regarding the financial feasibility on the investment with the use of decision tree approach.
Solution:In the above example, PV of CFs is available.
Calculation of NPV (Rs.)
Decision:Proposed expansion is feasible, since, the NPV is positive i.e., Rs. 1,50,000
Advantages of decision tree analysisEasy to understand• Clearly brings out the implicit assumptions and calculations for all to see, question and revise•
LimitationsDecision tree became more complex when the alternatives increase• Involves cumbersome calculations• It is time consuming• It needs enormous information•
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SummaryRisk analysis, RADR and Certainty equivalent are very important in capital budgeting.• Risk refers to the variation in the expected results.• Risk may arise due to project nature, competition industry business environment, market factors and international • factors.Risk of a project can be assessed with the help of sensitivity analysis and probability approach.• RADR is equal to risk free rate plus premium for rate.• Certainty equivalent incorporates risk of a project adjusting the expected cash flows, instead of discounting • rate.Decision tree analysis indicated the magnitude probability and interrelationship of possible outcome.•
ReferenceBrigham, E. F. & Ehrhardt, M. C., 2008. • Financial Management: Theory and Practice, Thomson Learning Inc.Peterson, P. P. & Fabozzi, F. J., 2002.• Capital Budgeting: Theory and Practice, John Wiley and Sons, Inc. Capital budgeting & risk• , [pdf] Available at: <http://educ.jmu.edu/~drakepp/principles/module6/cbrisk.pdf> [Accessed 22 August 2012].Risk Analysis in Capital Budgeting• ,[pdf] Available at: <http://coursefacilitators.com/ddata/91.pdf> [Accessed 22 August 2012].2010. • Capital Budgeting Analysis, [Video Online] Available at: <http://www.youtube.com/watch?v=-MCg4xelGAU> [Accessed 22 August 2012].2012. • Chap 26 Lecture: Capital Budgeting, [Video Online] Available at: <http://www.youtube.com/watch?v=6YAJ1yN5r98> [Accessed 22 August 2012].
Recommended ReadingJones, C. V., 1991. • Financial Risk Analysis of Infrastructure Debt: The Case of Water and Power Investments, Quorum Books.Alexander, C., 1999. • Risk Management and Analysis, Measuring and Modelling Financial Risk (Volume 1), Wiley. Hackel, K. S., 2010 • Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making, McGraw-Hill.
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Self Assessment__________ may be defined as the variation of actual cash flows from the expected cash flows.1.
Certainty equivalenta. Sensitivity analysisb. Riskc. Uncertaintyd.
Which of the following statements is false?2. Sensitivity analysis is based on three cash flow estates.a. RADR is less than the risk free discount rate.b. Sensitivity analysis provides ambiguous results.c. Decision tree shows the relationship between a present decision and future events mapped out over time in d. a format resembling branches of a tree.
Match the following3. 1. Source of Risk A. ’what if analysis’
2.Sensitivity Analysis B. Most likely
3.Risk Adjusted Discount Rate C. Industry Specific Risk
4.Probability Approach D. Risk premium
1-C, 2-A, 3-D, 4-Ba. 1-D, 2-A, 3-B, 4-Cb. 1-C, 2-D, 3-B, 4-Ac. 1-B, 2-C, 3-D, 4-Ad.
_______________provides more alternatives to decision maker.4. Probability approacha. Sensitivity analysisb. Certainty equivalentc. Decision tree analysisd.
Which is the last step in decision tree analysis?5. Specification of dataa. Selection of best alternativeb. Evaluate the alternativesc. Drawing decision treed.
Which among the following is a limitation of RADR?6. Risk premium takes care of the risk element in future cash flowsa. It gives psychological satisfaction to decision maker since it adds some premium for riskb. It does not make use of the information from probability distribution expected future cashc. It is simple to calculated.
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Risk-free rate is computed based on the return on ___________.7. government premiumsa. government taxesb. government incomesc. government securitiesd.
Match the following8.
1. Subjective probability assignment a. Firm Risk
2.Risk premium b. fails to focus on the inter-relationship between variables
3. Sensitivity Analysis c. based on person judgment
4. Perspectives of Risk d. Additional return1-c, 2-a, 3-d, 4-ba. 1-d, 2-a, 3-b, 4-cb. 1-c, 2-d, 3-b, 4-ac. 1-b, 2-c, 3-d, 4-ad.
Which of the following statements is true?9. Risk is associated with the variability of future returns of a project.a. Risk is associated with the variability of present returns of a project.b. Risk is associated with the variability of past returns of a project.c. Risk is not associated with the variability of future returns of a project.d.
Certainty equivalent coefficient is between _________.10. 0 and 1a. 1 and 2b. 4 and 5c. 5 and 5d.
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Chapter VIII
Working Capital Management
Aim
The aim of this chapter is to:
introduce meaning, definition and types of working capital•
define determinants of working capital•
explain the components, aspects and needs for working capital•
Objectives
The objectives of this chapter are to:
explain the factors influencing the working capital•
elucidate the operating cycle and cash conversion cycle•
explicate the estimation of working capital•
Learning outcome
At the end of this chapter, you will be able to:
understand working capital•
enlist different types of working capital•
comprehend the sources and• analysis of working capital
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8.1 IntroductionCapital is divided into fixed capital and working capital. Fixed capital required for establishment of a business, where as working capital required to utilise fixed assets.
The efficiency of a business enterprise depends largely on its ability to manage its working capital.• Working capital management therefore, is one of the important facets of a firm’s overall financial • management.
8.2 Meaning and Definition of Working CapitalWorking capital refers to current assets that can be defined as
Those which are convertible into cash or equivalent within a period of one year and those which are required • to meet day-to-day operation.It is concerned with the management of the firm’s current assets and current liabilities.• It refers to the problems that arise in attempting to manage the current assets, current liabilities and their • interrelationship between themIf a firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and even forced • into bankruptcy.
To quote Ramamurthy, “It refers to the funds, which a company must possess to finance its day-to-day operations”.
J. S. Mill, "The sum of the current assets is the working capital of the business."
8.3 Types of Working CapitalWorking capital can be classified in two ways
Concept based• Time based•
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
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8.3.1 Concept of Working Capital
Gross Working Capital• It refers to the firm’s investment in total current or circulating assets. �It is also known as quantitative or circulating capital. �
Net Working Capital• It is the excess of current assets over current liabilities and provisions. �It is also known as qualitative capital. �It is positive when it exceeds current liabilities and negative when current liabilities exceed current �assets.It measures the firm’s liquidity. �
8.3.2 Time Based Working CapitalPermanent working capital
It refers to the minimum amount of investment required in all current assets at all times to carry on the day-to-• day operation of firm’s business.The minimum level of current assets has been given the name of “Core current assets’ by the Tandon • Committee.It is also known as fixed working capital.•
Temporary working capitalIt is known as variable working capital or fluctuating working capital.• The working capital keeps on fluctuating from time to time on the basis of business activities.• The additional working capital required as per the changing production and sales level of a firm is known as • temporary working capital.The firm’s working capital requirements vary depending upon the seasonal changes in demand for a firm’s • products.
8.4 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.
8.5 Aspects of Working Capital ManagementThe following four aspects are involved in the management of working capital. They are
Determining the total funds required to meet the current operation of the firm; determining the level of current • assets.Deciding the structure of current assets; the proportion of long-term and short-term capital to finance current • assets.Evolving suitable policies, procedures and reporting systems for controlling the individual components of current • assets; mainly cash, receivables and inventoryDetermining the various sources of working capital.•
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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.
8.6 Need for Working CapitalWorking capital is needed till a firm gets cash on sale of finished products as sales do not convert into cash immediately. There is an invisible time lag between the sale of goods and receipts of cash. Therefore, sufficient working capital is 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.
The following elements are the operating cycle of the firm:Conversion of cash into raw materials• Conversion of raw materials into work-in-process• Conversion of work-in-process into finished goods• Time for sale of finished goods-cash sales and credit sales.• 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. 8.1 Operating cycle
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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:Sales Rs. 3,000 lakhs;Inventory: Opening Rs. 610 lakhs; closing Rs. 475 lakhsReceivable: Opening Rs. 915 lakhs; closing Rs. 975 lakhsCost of goods sold Rs. 2,675 lakhsSolutionOC = 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 cycleThe amount of time a firm’s resources are tied up; calculated by subtracting the average payment period from the operating cycle. In other words, the time period between the dates a firm pays its suppliers and the date it receives cash from its customers.
Calculation of Cash Conversion Cycle (CCC) (see the fig. below)CCC = OC – APP
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
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Where: OC = Operating Cycle APP = Accounts Payable Period OC = AAI + ARP AAI = Average Age of Inventory ARP = Average Collection (receivables) Period
From the financial statements we can determine the constituents of Cash Conversion Cycle i. ., 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) ExampleFrom the following financial information calculate Cash Conversion Cycle.Average use of Inventories 80 days; accounts receivables collection period 50 days, and accounts payable period is 40 days.Solution: CCC = OC – APP OC = AAI + ARP = 80 + 50 = 130 days CCC = 130 days – 40 = 90 days
Determinants of working capitalA large number of factors influence the working-capital-needs of a firm.
The basic objective of a firm’s working capital management is to ensure that the firm has adequate working • capital for its operation, neither too much nor too little working capital.There is no set of rules or formulae to determine the working capital requirements of a firm.• The total working capital requirement is determined by a wide variety of factors.• The factors, however, affect different firm’s working capital• The relative importance of these factors should be made in order to determine the total investment in working • capital
The following will give description of the general factors influencing the working capital needs of a firm:Nature and Size of Business: The working capital requirements of a firm are basically influenced by the nature of the business.
The nature of the business - influence the working capital decisions.• The proportion of current assets needed in some lines of business activity varies from other lines.• Trading and financial firms have less investment in fixed assets but requires a large sum of money to be invested • in working capital.Size may be measured in terms of scale of operations.• A firm with large scale of operation normally requires more working capital than a firm with a low scale 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 • process leading to the production of finished goods.Longer the manufacturing cycle, the higher will be the working capital requirement and vice versa.•
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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.• There are two production policy that the company or the firm can follow• They can confine their production only to periods when goods are purchased or• 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.
If a company purchases all goods or raw materials in cash and sells its finished goods or product on credit, 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.
Terms and conditions of purchase and sale are generally governed by prevailing trade practices and by changing economic conditions
Operating efficiency: Operating efficiency relates to the optimum utilisation of a firm’s resources at minimum • costs.
The firm with high efficiency in operation can bring down the total investment in working capital to lower �level.Effective utilisation of resources helps the firm in bringing down the investment in working capital. �If a firm successfully controls operating cost, it will be able to improve net profit margin which, will, in �turn, release greater funds for working capital purposes.
Business cycle: The amount of working capital requirements of a firm varies with every movement of business • cycle.When there is an upward swing in the economy sales will increase, and also the firm’s investment in inventories • and book debts will increase, thus it will increase the working capital requirement of the firm and vice versa.Growth and expansion: As company grows, it is logical to expect that a larger amount of working capital • required.
A growing firm may need funds to invest in fixed assets in order to sustain its growing production and sales. �This will, in turn, increase investment in current assets to support increased scale of operations.Therefore, a growing firm needs additional funds continuously. �
Profit margin and dividend policy: The magnitude of working capital in a firm is dependent upon its profit • margin and dividend policy.A high net profit margin contributes towards the working capital pool.• To the extent the net profit has been earned in cash, it becomes a source of working capital. This depends upon • the dividends results in a drain on cash resources and thus reduces company’s working capital to that extend.
The working capital position of the firm is strengthened if the management follows conservation dividend �policy and vice versa.
Conditions of supply of raw material: If the supply of raw material is scarce the firm may need to stock it in • advance and hence need more WC and vice-versa.Availability of credit: The working capital requirement of a firm are also affected by credit terms granted by • its suppliers i.e., creditors.
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The need for working capital will be less in a firm, if liberal credit terms are available to it.Similarly, the availability of credit from banks also influences the firm’s working capital needs.• A firm, which can get bank credit easily on favorable conditions, will be operated with less working capital • than a firm without such a facility.Taxation policy: The tax policies of the Government will influence the working capital decisions.•
If the Government follows regressive policy, i.e., imposing heavy tax burdens on business firms, they are �left with very little profits for distribution and retention purpose.Consequently, the firm has to borrow additional funds to meet their increased working capital needs. �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, import policy, changes in the technology, co-ordination activities in firm, distribution policies and so on.
8.7 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 capitalEstimation of cash cost of the various current assets required by the firm.• Estimation of spontaneous current liabilities of the firm.• 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.
8.8 Sources of Working CapitalAfter the estimation of the working capital, the next step is financing the current assets. There are three financing policies vis-à-vis’, to finance current assets. Adoption the specific policy is left out to the firm. The following are the financing policies:
Short-term: Generally current assets should be financed by short-term financial sources.• Short-term financing refers to borrowing funds or raising credit for maximum of 1 year period i.e., at the �most the debt is payable within a year.The sources of short-term finance are loans from banks, short-term public deposits, commercial papers, �factoring of receivables, bills discounting, retention of profits etcA firm which required short-term finance can go for any one of the above sources. �
Long-term: Net current assets or working capital is supposed to be financed by long-term sources of finance.• Long-term finance refers to the borrowing of funds or raising credit for one year or more. �Long-term finance is raised for a period of above five years. �The sources of long-term include- ordinary share capital, preference share capital, debentures, long-term �loans from bankers and surplus (includes retained earnings).A firm that need to finance net current assets can go for any of 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.
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Spontaneous Financing: Refers to the automatic source of short term funds arising in the normal course of • business.
The source are trade credits and out standing expenses �The source of spontaneous finance is available at cost free �Firms that want to maximise owner’s wealth than it must and should utilise the sources to the fullest �extantSome extant of current assets can be financed with the use of spontaneous source �The requiring current assets should be financed with the combination of long-term and short-term sources �of finance
The policies for financing or working capital are divided into three categories:Conservative Financing Policy: in which manager depends more on long-term funds.• Aggressive Financing Policy: in which the manger depends more on short term funds.• Moderate Policy: suggests that the manager depends moderately on both long-term and short-term while • financing.
Analysis of working capitalDetermining the working capital is just not sufficient for a better performance. It should be analysed. It may be analysed 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 • liabilities and net working capital of the firm may be computed.
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 the net working capital indices also increase, it will further confirm that strength of working capital �position in a firm.
Working Capital Leverage: It measures the sensitivity of return on investment (ROI) to the changes in ROI of • current assets.Working capital leverage (WCL) may be defined as the percentage change in ROI with given percentage change • in current assets.
Symbolically:WCL = Percentage Change in ROI ÷ Percentage Change in Current Assets
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SummaryWorking capital management is concerned with the determination of optimum level of working capital and its • effective utilisation.The working capital is classified into two ways– Concept based and Time based.• Concept based: Gross and Net working capital and Time based: Permanent and Temporary Working Capital.• The operating cycle concept penetrates to the heart of the working capital management in a more dynamic • form.Cash conversion cycle is the time period between the date a firm pays its suppliers and the date it receives cash • from its customers.Determinants of Working Capital are determined by a large number of factors influencing the working capital • needs of a firm.Estimation of working capital requirements involve for steps procedure for estimation of working capital.• Sources of working capital involves three financing policies vis-à-vis’, to finance current assets – Short-term, • Long-term and spontaneous.Analysis of Working Capital is an important aspect which may be analysed with a view to gross and net • angles.
ReferencesMathur, S. B., 2002. • Working Capital Management and Control Principles and Practice. New Age International (P) Limited.Dr. Rustagi, R. P, • Principles of Financial Management, 4th ed., Taxmann Publications (P) Ltd. Doshi, P. N., 2009. • Management of Working Capital [pdf] Available at: <http://www.caalley.com/art/WorkingCapitalManagement.pdf, [Accessed 16 November 2010].Introduction to the Management of Working Capital• , [Online] Available at: <http://www.slideshare.net/rachitsingh12/working-capital-pdf-10005829> [Accessed 22 August 2012].2012. • Working Capital Management, [Video Online] Available at: <http://www.youtube.com/watch?v=C0UOvhnIqxE> [Accessed 22 August 2012].2010. • Working Capital Management Analysis, [Video Online] Available at: <http://www.youtube.com/watch?v=gx8PiJbjrmc> [Accessed 22 August 2012].
Recommended ReadingSagner, J., 2010. • Essentials of Working Capital Management (Essentials Series), Wiley.Preve, L. & Sarria-Allende, V. S., 2010. • Working Capital Management (Financial Management Association Survey and Synthesis Series), Oxford University Press. Fung, A., 2001. • Working Capital: The Power of Labor's Pensions, Cornell University Press.
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Self Assessment_____ is the time period between the dates a firm pays its suppliers and the date it receives cash from its 1. 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. fixed working capitalc. net working capitald.
What is the formula for computing operating cycle?3. OC = ICP − ARPa. OC = ICP ÷ ARPb. OC = ICP × ARPc. OC = ICP + ARPd.
Which of the following statement is false?4. Net working capital is also known as qualitative capital.a. Net working capital is also known as circulating capital.b. Gross working capital is also known as quantitative.c. Temporary working capital also known as variable working capital.d.
The amount of working capital requirements of a firm varies with every movement of ______________.5. business cyclea. production policyb. manufacturing cyclec. operating efficiencyd.
Match the following6.
1. Concept of working capital a. commercial papers, factoring of receivables, bills discounting, retention of profits etc
2. Short-term financing b. Current assets and Current liabilities3. 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-ca. 1-c, 2-a, 3-d, 4-bb. 1-d, 2-c, 3-a, 4-bc. 1-d, 2- a, 3-b, 4-cd.
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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. standard amountd.
Which of the following statements is true?8. In conservative financial policy manager depends more on long-term funds.a. Spontaneous Financing refers to the automatic source of long-term funds arising in the normal course of b. business.The requirement on working capital is determined on the basis of manufacturing policy of the firm.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 Credit2. Gross working capital b. Variable working capital3. Determinants of Working Capital c. Aspects of Working Capital Management4. Determining the various sources of working capital d. circulating capital
1-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 which of the following?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 IX
Cash Management
Aim
The aim of this chapter is to:
define the objectives of cash balance•
introduce the meaning and importance of cash management•
explain cash planning, cash forecasting and budgeting•
Objectives
The objectives of this chapter are to:
explain the factors and models of cash management•
elucidate the motives and objectives of cash management•
explicate the models for determining the optimal cash•
Learning outcome
At the end of this chapter, you will be able to:
understand the nature of cash management•
comprehend the objective and motives for holding cash in cash management•
describe the e• lements of cash forecasting and budgeting
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9.1 IntroductionCash is one of the important components of current assets.
Cash is the medium of exchange for purpose of goods and services and for discharging liabilities.• It is the most liquid asset and can be used to make immediate payments for the basic input required to keep the • business running on a continuous basis.Efficient management of the inflow and outflow of cash plays a crucial role in the overall performance of a • firm.Insufficiency of cash at any stage will disrupt the firm’s manufacturing process while excess will achieve the • end.Cash is not an end in itself but a means to achieve the end.• Cash management implies a proper balancing between the two conflicting objectives of the liquidity and • profitability.
9.2 Meaning, Definition and Importance of Cash ManagementCash means liquid assets that business owns. It includes cheques, money order and bank drafts.• Cash management refers to management of cash balance and the bank balance including the short term • deposits.Cash management means efficient collection and distribution of cash and any temporary investment of cash• To quote Gitman, "liquid assets provide a pool of funds to cover unexpected outlays, thereby reducing the risk • of a ‘liquidity crises"Brigham, "cash is a non-earning asset, so excessive cash balance simply lowers the total assets turnover, thereby • reducing both the rate of return on net worth and value of the stock."
Cash management is concerned with the following:Management of cash flows into and out of the firm• Cash management within the firm• Deficit financing or investing surplus cash•
Cash management tries to accomplish the following at a minimum cost:Cash collection• Payment of outstandings• Arranging for deficit funding or surplus investment•
There is always an element of uncertainty about the inflows which are correlated. The various strategies a firm should use to manage cash are Cash Planning: Cash budgets are used for cash planning to avoid excessive or shortage of cash. Managing Cash Flow: It is required that the cash collection and the inflow should be accelerated while cash outflows should be slowed down.
Optimum Cash Level: Balance should be struck between excess cash and cash deficient stage by the firm.Investing Surplus Cash: The surplus cash should be properly invested in number of investment avenues such as banks, Short-term deposits, T-Bills, Inter-corporate lending and so on.
An ideal cash management system will depend on:Firm’s product• Competition• Collection program• Delay in payments•
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Availability of cash at low rates of interests• Investment opportunities available•
9.3 Nature of CashIn cash management the term cash management may be used in two senses
Narrow Sense: It is pure cash or generally accepted cash equivalents which include currency, cheques, drafts, • demand deposits held by a firm.Broad Sense: Here, cash includes not only the above stated but also near cash assets. There are Bank’s time • deposits and marketable securities.
9.4 ObjectivesFinancial managers must know to manage cash to make balance between profitability and liquidity. In other words, the financial manager has to strike an acceptable balance to maintain optimum cash balance. Optimum cash means it should not be excess or inadequate. This is the focal point of cash risk-return trade-off. The risk-return trade-off of any firm can be reduced to two prime objectives for the firm’s cash management system. They are as follows
To Meet Cash Payments: The prime objective of the cash management is to ensure the cash outflow as and when • required to pay in business operation. The payments are like supplier of raw materials, payment of wages and salaries, payment of electricity bills and so on. Enough cash must be on hand to meet the disbursal needs that arise in the normal course of business; otherwise it will not be able to run the business. It means that the firm should have sufficient cash to meet the payment schedules and disbursement needs. It will help the firm in:Avoiding the chance of default in meeting financial obligation; otherwise the goodwill of the firm is affected• Availing the opportunities of getting cash discounts by making early or prompt payments• Meeting unexpected cash outflows without much problem• To Maintain Minimum Cash Balance (Reserve): This is second important objective of cash management. It • means that the firm should not maintain excess cash balance. Excess cash balance may ensure prompt payment but it will remain idle, as cash is a non-earning asset and the firm will have to forego profits. On the other hand, maintenance of low level of cash balance may not help to pay the obligations. Hence, the aim of cash management is to maintain optimum cash balance.Achievement of the objectives is possible with proper dealing of the aspects of cash management.•
9.5 Motives for Holding CashThe following are the four motives for holding cashTransaction motive
Business firms as well as the individual keep cash to meet demands for cash flow arising out of day to day • transactions. The necessity to hold cash will not arise if there is perfect co-ordination or synchronisation between the inflows • and outflows. Hence, the firm must have adequate cash balance particularly when payments are in excess of receipts to meet its obligations.The requirement of cash to meet routine cash needs is known as the transaction motive and such motive are • refers to the holding of cash to meet anticipated obligations whose timing is not perfectly synchronised with each receipts. It is thus, refers to the holding of cash to meet anticipated obligations whose timing is not perfectly synchronised with cash receipts.
Precautionary motive This refers to the need to hold cash to meet some exigencies which cannot be foreseen. Such unexpected • needs may arise due to sudden slow-down in collection of accounts receivable, sharp increase in the cost of raw materials, cancellation of order by a customer, strikes etc it provides a cushion or buffer to withstand some unexpected emergency. The money held to meet such unforeseen fluctuations in cash flows are called precautionary balances.
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The precautionary balance may be held in near-money assets like marketable securities.• The amount set aside for precautionary motive is not expected to earn anything. As a matter of abundant caution, • many companies had learnt the art of ‘cultivating the rich uncle’, by establishing and maintaining good lasting link with progressive banking institutions. Ready borrowing power is the best antidote to emergency cash drains and facilities release of available cash • resources for remunerative application.
Speculative motiveCash may be held for speculative purposes in order to take advantage of potential profit making situations. • A firm may come across an unexpected opportunity to make profit, which is not usually available in normal business routine. Some cash balance may be kept to take advantage of these windfalls example an opportunity to purchase raw • materials at a heavy discount, if paid in cash. The motive to keep cash balance for these purposes is obviously speculative in nature. The firm’s desire to • keep some cash balance to capitalise an opportunity of making an unexpected profit is known as speculative motive.The speculative motive provides a firm with sufficient liquidity to take advantage of unexpected profitable • opportunities that may suddenly appear (and just suddenly disappear if not capitalised immediately).
Compensating motive This is yet another motive to hold cash to compensate banks for providing certain services and loans. Banks • provides a variety of services like cheque collection, transfer of funds through demand draft, etc. To avail of all these purposes, the customers need to maintain a minimum balance in their account at all times. • The balance so maintained cannot be utilised for any other purpose. Such balances are called compensating balances.Compensating balances can take any of the following two forms - Maintaining an absolute minimum; say for • example, a minimum of Rs. 25000 in current account or maintaining an average minimum balance of Rs. 25000 over the month. A firm is more affected by the first restriction than the second restriction.
9.6 Factors Determining Cash Need The following factors are considered by a firm to balance cash based on their needs
Synchronisation of Cash Flow: Synchronisation of cash flows arises only when there is no balance between the • expected cash inflows and cash outflows. There is no need to maintain cash balance if there is match between cash inflows and cash outflows. Otherwise, there is a need to manage cash balance for managing synchronisation.Synchronisation is forecasted through the preparation of cash budget for a select period or the planning • period.A well-prepared cash budget will definitely point out the months or periods when the firm would have surplus • or deficit cash.Short Costs: Short costs are those that arise with the short fall of cash for the firm requirements. Shortage of • cash can be found through preparation of cash budgetCash shortage is not cost free it involves cost, whether it is expected or unexpected shortage.•
The expenses incurred as a result of shortfall are called short costs. They include the following:Cost of transaction• Cost of borrowing• Cost of deterioration of the credit rating• cost of loss of cash discount• cost of penalty rates•
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Surplus Cash Balance Costs: It means that the cost associated with excess or surplus cash balance. Cash is not • an earning asset. Surplus cash funds are idle; the impact of idle cash is that the firm losses opportunities to invest those funds and thereby lost interest, which would otherwise have earned. Put simple loss of interest is the surplus cash balance cost.Management Costs: Management costs are those which are involved with setting up and operating cash • management staff. These costs are generally fixed over a period, and mainly include staff, salary, storage, handling cost of security and so on.
9.7 Models for Determining Optimal CashOptimum cash balance can be determined by a number of mathematical models. But here the most important two models are discussed. They are:Baumol Model (Inventory Model)William J. Baumol developed a model (The transactions Demand for Cash: An Inventory Theoretic Approach) which is usually used in Inventory Management and Cash Management.
The model helps in determining the minimum cost amount of cash that a manager can obtain by converting • securities into cash.It is an approach to establish a firm’s optimum cash balance under certainty. • As such firm attempts to minimise the sum of the holding cash and the cost of converting marketable securities • to cash.
AssumptionFirm is able to forecast its cash requirements with certainty.• Firm’s cash payments occur uniformly over a period of time.• The opportunity cost of holding the cash is known and it remains stable over time.• Firm will incur the same transaction cost for all conversions of securities into cash.• Baumol's Model•
The total cost associated with cash management has two elementsConversion Cost (Transaction cost): are those costs that are associated with sale of marketable security and • raised whenever firm converts marketable security into cash.
Conversion Cost (C) = C (F/M)Where, C = Cost per conversion F = Expected cash need for future period M = Amount of marketable securities sold in each sale
Opportunity Cost: it is the benefit foregone by holding idle cash. Opportunity cost is the interest foregone on • average cash balance. Symbolically
Opportunity cost (O) = I (M 2)Where, I = Interest rate that could have been earned M 2 =- Average can balance [(Opening cash + Closing cash)/2] Total cost = Conversion cost = Opportunity cost = C (F/M) + I (M 2) Economical (optimal) Conversion lot size ECL = Where ECL = Economic Conversion Lot F = Expected cash need for future period (annually query; Hy) C = Cost per conversion O = Opportunity cost
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Example: VS International Coy Ltd., estimated cash needs of Rs. 20 lakhs for a year. Cost of transaction of marketable securities is Rs. 2000 per lot. The company has marketable securities in lot sizes of Rs. 1, 00,000, Rs. 2, 00,000, Rs. 500,000 and Rs. 10, 00,000. Determine economic conversion lot size if 20 per cent is the opportunity cost.Solution: =Rs. 2, 00,000
Miller and Orr modelMiller and Orr (1966) have expanded the Baumol’s model which is not applicable if the demand for cash is not steady. It is in fact an attempt to make Baumol model more realistic as regard to the pattern of periodic changes in cash balances.
Baumol’s model is based on the assumption of uniform and certain level of cash balances. But in practice, firms • do not use uniform cash balances nor are they able to predict daily cash inflows and outflows.The Miller and Orr Model overcame the limitations of Baumol model.• It is augmented on the Baumol model and came out a statistical model. This is useful for the firms with uncertain • cash flows.
Miller and Orr model provide two control limits:The upper limit• The lower limit•
According this modelCash balance fluctuates between LCL and ULC.• Whenever cash balance touches ULC then the firm purchases sufficient (ULC-RP) marketable securities to take • back cash balance to return point.When the firm touches to lower control limit, it will sell the marketable securities to the extent of (RP – LCL), • take back cash balance to return point.The cash balance at the lower limit (LCL) is set by the firm as per requirement of maintaining minimum cash • balanceThe cash balances at upper control limit (UCL) and record points will be determined on the basis of the transaction • cost ©, the interest rate (O) and standard deviation (S) of net cash flows.
The following formula is used to determine the spread between ULC and LCL (called Z). Where Z = Control limit of cash balance (or) return point = Variance of net cash flow O = Opportunity cost or interest rate earned on marketable security C = Transaction cost LCL = Lower control limit ULC = 3RP – 2LCL
Example: VSL International Company Ltd., provided the following information and requested to compute the upper control limit (UCL) and return point (RP) with the adoption of MO model
Standard deviation of company’s daily cash flow’s Rs. 1,00,000• The annual yield on marketable securities is 12 per cent• It maintains a minimum cash balance of Rs. 3,00,000• Cost of buying or selling marketable security is Rs. 1500 per transaction•
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Solution:
UCL = 3 RP 2LCL
Cash planningCash planning is a technique to plan and control the use of cash.• It helps in developing a projected cash statement from the expected inflows and outflows of cash.• Cash planning can be done daily, weekly or on a monthly basis• Generally, firms prepare monthly forecasts.• Cash Forecasting and Budgeting• Cash budget is a device to plan and control cash receipts and payments• It gives a summary of cash flows over a period of time.• The finance manager can plan the future cash requirements of a firm based on the cash budgets• The first element of a cash budget is the selection of the time period which is referred to as the planning • horizon.
Firms should keep in mind that the period selected should be neither too long nor too short �Too long a period, estimates will not be accurate and too short a period requires periodic changes. �Yearly budgets can be prepared by such companies whose business is very stable and they do not expect �major changes affecting the company’s flow of cash
The second element that has a bearing on cash budget preparation is the selection of factors that have a bearing • on cash flows.Only items of cash nature are to be selected while non-cash items such as depreciation and amortisation are • excluded.Cash budget are prepared under three methods:•
Receipts and Payments method �Income and Expenditure method �Balance Sheet method �
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SummaryCash is one of the important components of current assets and is the medium of exchange for purpose of goods • and services and for discharging liabilities.Firms are required to maintain a minimum level of current assets at all point of time.• Cash management is concerned with determination of relevant levels of cash assets and their efficient use.• The strategies of firm are – cash planning, managing cash flow, optimum cash level and investing surplus • cash.The objectives of cash management are: to meet cash payments needs and to maintain minimum cash balance • (reserve).The need for holding cash arises due to a variety of motives – transaction, speculation, precautionary and • compensating motives.The required cash balance is estimated after taking into consideration of the factors – synchronisation of cash • flows; short costs; surplus cash balance costs; and management costs.Optimum cash balance can be determined by a number of mathematical models. But two models are the most • important i.e., Baumol Model (Inventory Moidel) and Miller and Orr Models. Baumol Model is one method available to determine optimum cash balance and is based on EOQ technique. Miller and Orr Model is another model that helps in determining LCL and UCL.
ReferenceBaker, H. K. & Powell, G. E., • Understanding Financial Management: A Practical Guide, Wiley-Blackwell. Dr. Rustagi, R. P. • Principles of Financial Management, 4th ed., Taxmann Publications (P) Ltd. Doshi, P. N., 2009. • Management of Working Capital [pdf] Available at: <http://www.caalley.com/art/WorkingCapitalManagement.pdf>. [Accessed 17 November 2010].TheIntroductiontofinancialmanagement,• [Online] Available at: <http://jpkc.szpt.edu.cn/english/supplement/cash%20managment3.htm> [Accessed 22 August 2012].Stone, C., 2012. • Cash Management, [Video Online] Available at: <http://www.youtube.com/watch?v=BbHigg5fvr8> [Accessed 22 August 2012].2011. • Importance of Cash Flow and Liquidity, [Video Online] Available at: <http://www.youtube.com/watch?v=_wZU8eraGOc> [Accessed 22 August 2012].
Recommended ReadingWielen, L., Alphen, W., Bergen, J. & Lindow, P., 2006. • International Cash Management (Treasury Management and Finance Series), 2nd ed., Riskmatrix. Schaeffer, H. A . Jr., 2002. • Essentials of Cash Flow, 1st ed., Wiley.Jones, E. B., 2001. • Cash Management, ScarecrowEducation.
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Self AssessmentAccording to Baumol Model, which are the two elements of the total cost associated with cash management 1. has two elements?
Conversion cost and opportunity costa. Transaction and precautionary motiveb. Narrow and broad sensesc. Upper and lower limitsd.
_______________ means liquid assets that business owns.2. Liabilitya. Budgetb. Cashc. Bankd.
Which of the following statements is false?3. There are four motives for cash holding.a. Synchronisation of cash flows arises only when there is no balance between the expected cash inflows and b. cash outflows.Cash management is concerned with cash management within the firm.c. There is no time gap between cash inflows and outflows.d.
The transaction motive for holding cash is for _________.4. current assetsa. daily operationsb. safety cushionc. payment of dividendsd.
Which of the following is not the objective of cash management?5. maximisation of cash balancea. minimum of cash balanceb. maintain minimum cash balance (reserve)c. zero cash balanced.
The firm’s desire to keep some cash balance to capitalise an opportunity of making an unexpected profit is 6. known as _____________.
transaction motivea. precautionary motiveb. speculative motivec. compensation motived.
Which of the following statement is true?7. Cash management implies a proper balancing between the two conflicting objectives of the liquidity and a. profitability.Management of cash means management of cash inflows.b. Synchronisation of cash flows arises only when there is a balance between the expected cash inflows and c. cash outflows.Cash management tries to accomplish the payment of cash collection at a minimum cost.d.
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Match the following8. 1.Cash planning a. minimisation of total cost
2.Baumol Motive b. upper and lower limits
3.Short costs c. avoid excessive or shortage of cash
4.Miller and Orr Model d. cost of loss of cash discount
1-b,2-c,3-d, 4-a.a. 1-d,2-a,3-b, 4-c.b. 1-c,2-d,3-a, 4-b.c. 1-c,2-a,3-d, 4-b.d.
Cash is the most ______________asset.9. costa. liquidb. motivec. modeld.
The cash balance at the lower control limit is set by the firm as per requirement of maintaining which of the 10. following?
minimum cash balancea. maximum cash balanceb. optimum cash balancec. average cash balanced.
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Chapter X
Inventory Management
Aim
The aim of this chapter is to:
define cash management•
introduce the motives of inventory management•
explain the techniques of inventory control•
Objectives
The objectives of this chapter are to:
explain the objectives and motives of inventory management•
elucidate inventory costs•
explain benefits of holding inventory•
Learning outcome
At the end of this chapter, you will be able to:
understand the costs of holding inventory•
enlist different types of inventory•
describe the risks of holding inventory•
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10.1 IntroductionInventory management occupies the most significant position in the structure of working capital.• Inventories are the most significant part of current assets.• Inventory management is an important area of working capital management, which plays a crucial role in • economic operation of the firm.Maintenance of large size of inventories requires a considerable amount of funds to be invested on them.• Efficient and effective inventory management is necessary in order to avoid unnecessary investment and • inadequate investment.A considerable amount of funds is required to be committed in inventories.• It is absolutely imperative to manage inventories efficiently and effectively in order to optimise investment in • them cannot be ignored. Any lapse on the part of management of a firm in managing inventories may cause the failure of the firm.•
10.2 Meaning and Definition of InventoryThe term “Inventory” is originated from the French word “Inventaire” and the Latin “Inventariom” which implies a list of things found.
The term has been defined by the American Institute of Accountants as the aggregate of those items of tangible • personal property which
are held for sale in the ordinary course of business �are in the process of production for such sales, or �are to be currently consumed in the production of goods or services to be available for sale �
The term inventory refers to the stockpile of the products a firm is offering for sales and the components that • make up the product.
Inventories are the stocks of the product of a company, manufacturing for sale and the components that make up the product. The various forms in which inventories exist in a manufacturing company are
raw materials• work-in process• finished goods• stores and spares•
However, in commercial parlance, inventory usually includes stores, raw materials, work-in-process and finished goods.
The term inventory includes – raw material, work in process, finished goods packaging, spares and others stocked in order to meet an unexpected demand or distribution in the future.
10.3 Types of InventoryThe following are the types of inventory:
Raw Materials: Raw materials are those inputs that are converted into finished goods through manufacturing • 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-process is that stage of stocks that are between raw materials and finished goods. • Work-in-process inventories are semi-finished products. They represent products that need to under go some process to become finished goods.Finished Products: Finished products are those products, which are ready for sale. The stock of finished goods • provides a buffer between production and market.
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Stores and Spares: Stores and spares inventory (include office and plant cleaning materials like soap, brooms, • oil, fuel, light, etc.) are those purchased and stored for the purpose of maintenance of machinery.
10.4 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.
10.5 Objectives of Inventory ManagementThe objectives of inventory management may be viewed in two. They are
Operational: the operational objective is to maintain sufficient inventory, to meet demand for product by efficiently • organising the firm’s production and sales operationsFinancial: financial view is to minimise inefficient inventory and reduce inventory carrying costs.•
These two conflicting objectives of inventory management can also be expressed in terms of costs and benefits associated with inventory.
The firm should maintain investment in inventory implies that maintaining an inventory involves costs, such • that smaller the inventory the lower the carrying cost and vice versa. But inventory facilitates (benefits) the smooth functioning of the production. An effective inventory management should:Ensure a continuous supply of raw materials and supplies to facilities uninterrupted production• Maintain sufficient stocks or raw materials in periods of short supply and anticipate price changes• Maintain sufficient finished goods inventory for smooth sales operation and efficient customers services• Minimise the carrying costs and time and• Control investment in inventories and keep it at an optimum level•
Apart from the above, the following are also objects of inventory management. Control of materials costs; elimination of duplication in ordering by centralisation of purchasers; supply of right quality of goods of reasonable prices, 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 inventory in relation to the operational requirement of a firm. To achieve higher operational efficiency and profitability of a firm, it is essential to reduce the amount of capital locked up in inventories. This will not only help in achieving higher return on investment by minimising tied-up working capital, but will also improve the liquidity position of the enterprise.
10.6 Costs of Holding InventoryMinimising 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.
Ordering Costs: Ordering 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:
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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)• 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.,•
Ordering costs are fixed per order placed, irrespective of the amount of the order but ordering costs increases in proportion to the number of order placed. If the firm maintains small inventory levels then the number of orders will increase, there by ordering cost will increase and vice versa.
Carrying costs: Inventory 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 (on inventory – against fire and theft insurance)• 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): Shortage costs are those costs that arise due to stock out or either shortage of raw materials or finished goods.
Shortage of inventories of raw materials over affect the firm in one or more of the following ways:• The firm may have to pay some what higher price, connected with immediate (cash) procurements �The firm may have to compulsorily resort the some different production schedules, which may not be as �efficient and economical
Stock of finished goods – may result in the dissatisfaction of the customers and the resultant loss of rules•
Thus, 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.
10.7 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). • Generally prices are not controllable in the short-run by the individual firm. Controlling inventory is the only way that a firm can counter act with these risks.
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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 firms whose resources are limited and tied up in slow moving inventories. Product obsolescence cost risk least controllable except by reduction in inventory investment.
Thus, inventories are risky assets to manage and the effective way to minimising risks is setting up of efficient inventory control system.
10.8 Benefits of Holding InventoryProper management of inventory will result in the following benefits to a firm:
Ensures an adequate supply of materials and stores, minimises stock outs and shortages and avoids costly • interruptions in operationsKeep down investment in inventories; inventory carrying costs and obsolescence losses to the minimum• 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 • emanatePermits better utilisation of available stocks by facilitating inter-department transfers within a firm• Provides a check against the loss of materials through careless or pilferage• Perpetual inventory values provide a consistent and reliable basis for preparing financial statements a better • utilisation
10.9 Techniques of Inventory ControlThere are many techniques of management of inventory. Some of them are
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.
The firm should not keep same degree of control on all the items of inventory. The firm should put maximum • 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 a firm has to maintain several types of inventories, for proper control of them, firm should have • to classify inventories in the instance of their relative value. Hence, it is also known as Proportional Value Analysis(PVA)
According to this technique the task of inventory management is proper classification of all inventory items in to three categories namely A, B and C category. The ideal categorisation of inventory items is shown in the Table 12.1. The higher value items are classified ' A items' and would be under tight control. At the other end of the classification we find category 'C items', on these types of inventory firm cannot afford expenses of rigid controls, frequent ordering and 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.
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Category No. of Items (%) Items Value (%)A 15 70B 30 20C 55 10Total 100 100
Table 10.1 Categorisation of inventory
The above table indicate 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 figure numbers of items (%) are shown on 'X' axis and value of items (%) are represented on 'Y' axis. Greater attention will be paid on category 'A' item, because greater benefit. The control of 'C' items may be released due to less benefit (some times control cost may exceed benefit of control) and reasonable attention should be paid on category 'B' items.
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 inventory due to the difficulty in computation of shortage cost. EOQ are also known as Economic Lot Size (ELS).
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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• All demand for the product will be satisfied (no back orders are allowed)•
EOQ FormulaEOQ can be obtained by adopting two methods• Trail and Error approach• Short cut or Simple mathematical formula•
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 formula will not be sufficient to determine EOQ when more complex cost equations are involved.
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.
Order point problem If the inventory level is too high it will unnecessary blocks the capital and if the level is too low, it will disturb production by frequent stock out and also involves high ordering cost. Hence, an efficient management of inventory needs to maintain optimum inventory level, where there is no stock out and the costs are minimal. The different stock levels are
Minimum levelMinimum stock is that level that must be maintained always for smooth flow of production. While determination • of minimum stock level, lead time, and consumption rate, material nature must be considered.
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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 Level: Reorder 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.
Safety stock: Prediction of average daily usage and lead-time is difficult. Raw materials may vary from day to day or from week to week, it is the case for lead-time also. Lead-time may be delayed if the usage increases, than the company faces problem of stock out. To avoid stock out firm may require maintaining safety stock.Formula (under uncertainty of usage and lead time)
RE-order point = (Lead time (in days) × Average usage) + Safety stock
Maximum level: Maximum level of stock is that level of stock beyond which a firm should not maintain the stock. If firm stocks inventory beyond the maximum stock level is called as overstocking. Excess inventory (overstock) involves heavy cost of inventory, because it blocks firms’ funds in inventory, excess carrying cost, wastage, obsolescence and theft cost. Hence, firm should not stock above the maximum stock level. Safety stock is that minimum additional inventory to serve as a safety margin or better or buffer or cushion 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)
Average Stock Level
Average Stock Level = Minimum level + (Reorder Quantity ÷ 2)
Danger Stock Level: Danger level is that level of materials beyond that materials should not fall in any situation. • When it falls in danger level it will disturb production. Hence, the firm should not allow the stock level to go to danger level if at all falls in that level then immediately stock should be arranged even if it costly.Danger Level = Average Usage × minimum Deliver Time (for emergency purchase)• Just in Time (JIT): Popularly known in its acronym JIT. It may be applied for either raw materials purchase or • producing finished goods. 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 when the order are received, there by no • storage of finished goods, and can avoid costs of carrying finished goods.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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SummaryInventory management occupies the most significant position in the structure of Working capital.• The types of inventory are: raw materials; work-in process; finished goods; and stores and spares.• There are three motives for holding inventories. They are: transaction motive; precautionary motive and • speculative motive.The two conflicting objectives of inventory management are: maintaining investment in inventory and to facilitate • (benefits) the smooth functioning of the production, which in turn meet the demand.Efficient management of inventory reduces the cost of production and consequently increases the profitability • 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 • facilitates uninterrupted production; maintain sufficient finished goods inventory for smooth sales operations; and efficient customer service; minimise the carrying costs and time; and Control investment in investment and keep 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.Risk associated with inventory management is Price Decline, Product Deterioration and product • Obsolescence.Proper management of inventory will result in the benefits to a firm.• 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.
ReferenceWild, A. & Wild, T., 2002.• Best practice in inventory management, Elsevier Science Ltd.Dr. Rustagi, R.P., • Principles of Financial Management, 4th ed.,Taxmann Publications (P) Ltd. Doshi, P. N., 2009.• Management Of Working Capital, [pdf] Available at: <http://www.caalley.com/art/WorkingCapitalManagement.pdf> . [Accessed 17 November 2010].Viale, J. D., • Basics of Inventory management, [Online] Available at: <http://www.axzopress.com/downloads/pdf/1560523611pv.pdf> [Accessed 22 August 2012]Walker, M., 2008. • Inventory Management - An Introduction, [Video Online] Available at: <http://www.youtube.com/watch?v=qkZQxXJuqKo> [Accessed 22 August 2012].Uchil, Y., 2012. I• nventory management-Basics, [Video Online] Available at: <http://www.youtube.com/watch?v=_wZU8eraGOc> [Accessed 22 August 2012].
Recommended Reading Max Muller, 2003. • Essentials of Inventory Management, AMACOM. Piasecki, D. J., 2009. • Inventory Management Explained: A focus on Forecasting, Lot Sizing, Safety Stock, and Ordering Systems, 1st ed., Ops Publishing.Toomey, J. W., 2000. • Inventory Management: Principles, Concepts and Techniques, Kluwer Academic Publishers.
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Self AssessmentWhich 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 significant part of _________ assets.2. liabilitiesa. cash budgetb. balancec. currentd.
Which of the following statements 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 preparing financial statements a better 5. utilisation.
Increase inventorya. Perpetual inventoryb. Costs of Holding Inventoryc. Risks of Holding Inventoryd.
Which of the following is one of the carry cost of inventory?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. operational and financial
3.Techniques of inventory control c. Zero Inventory Production System (ZIPS)
4.JIT is known as d. product obsolescence1-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
In EOQ formula √2AO÷CC, 'A' stands for __________.9. Biennial Usagea. Perennial Usageb. Annual usagec. Monthly Usaged.
Which of the following is one of the sisks of holding inventory?10. Shortage Costsa. Product Obsolescenceb. ABC analysisc. Work-in Processd.
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Chapter XI
Receivables Management
Aim
The aim of this chapter is to:
deinfe accounts receivables•
introduce the concept of receivables management•
explain the credit policy and credit policy variables•
Objectives
The objectivae of this chapter are to:
explain benefits and costs of receivables management•
eludicdate the credit policy variables and evaluation of credit policy•
explicate the nature and characteristics of account receivables•
Learning outcome
At the end of this chapter, you will be able to:
describe the factors influencing investment in receivables management•
understand the advantages and disadvantages of credit policy•
enlist the steps involved in• credit evaluation
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11.1 IntroductionAccounts Receivables occupy an important position in the structure of current assets of a firm. They are the outcome of rapid growth of credit sales granted by the firm to their customers. Credit sales are reflected in the value of Sundry Debtors. It is also known as Trade Debtors (TD), Accounts Receivables (AR), and Bills Receivables (BR) on the asset side of balance sheet.
Trade credit is most prominent force of modern business. It is considered as a marketing tool acting as a bridge between production places to customers.
Firm grants credit to protect its sales from the competitors and attract the potential customers. It is not possible to increase sales without credit facility, increase in sales also increase profit. But investments on accounts receivables involve certain costs and risk. Therefore a great deal of attention is normally paid to the effective and efficient management of accounts receivables.
11.2 Meaning of Accounts ReceivablesReceivables are defined as Debt owed to the firm by customers arising from sales of goods or services in the ordinary course of business. When a firm makes a sale of goods or services and does not receive payment or cash, the firm grants trade credits and creates accounts receivable which could be collected in future. Till collection they form as current assets. Receivable management is also called Trade Credit Management.
Characteristics of receivablesThe accounts receivables arising out of credit sales have the following characteristics
Risk Involvement: Receivables involve risk. Since payment takes place in future and future is uncertain so they • should be carefully analysed.Based on Economic Value: Accounts receivable are based on economic value. The economic value in goods or • services passes to the buyer currently in return the seller expects an equivalent value from the buyer later.Implies Futurity: The buyer makes payment of the goods or services received by them in a future period.•
11.3 Meaning of Accounts Receivables ManagementAccounts receivables management means making decisions relating to the investments in the current assets which are an integral part of operating process, and the objective being highest of return on investment in receivables.
Accounts receivables management involves maintenance of receivables at optimum level, the degree of credit sales to be made and the debtors' collection. In simple words, the key function of credit management is to optimise the sales at the minimum possible cost of credit.
According to Joseph, "The purpose of any commercial enterprise is the earning of profit. Credit in itself is utilised to increase sales, but sales must return a profit".
The offer of goods on credit should not only optimise sales but also lead to maximisation of overall return on investment. Management of receivable, therefore, should be based on sound credit policies and practices.
Objectives of Accounts Receivables ManagementThe following are the main objectives of accounts receivables management:Maximising the Value of the Firm
The basic objective of debtors' management is to maximise the value of the firm by achieving a trade off between liquidity (risk) and return.
The main purpose of receivables management is to minimise the risk of bad debts and not maximisation of • order.Efficient management of receivables expands sales by retaining old customers and attracting new customers.•
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Optimum Investment in Sundry DebtorsAllowing credit, expands sales, but they involve block of funds, that have an opportunity cost, which cab be • reduced by optimum investment in receivables.Providing liberal credit increases sales consequently profits will increase, but increasing investment in receivables • results in increased costs.Control and Managing the Cost of Trade Credit• When there are no credit sales, there will not be any trade credit cost. But credit sale increases profits and it is • possible only when the firm is able to keep the costs at minimum.
Costs of accounts receivables managementCapital Costs: It is the cost on the use of additional capital support credit sales which alternatively could have • been employed elsewhere.Collection Costs: Administrative costs incurred in collecting the accounts receivable. Costs of additional steps • to increase the chances for eventful payment.Delinquency Costs: Costs of financing the debtors for extended period and cost of additional steps to collect • over-due debtors.Default Costs: Amounts which are to be written off as Bad debts, which cannot be collected in spite of serious • efforts. Sometimes customers may not be able to honor the dues to the firm because of the inability to pay. Such costs are referred as bad debts.
Benefits of accounts receivables managementThe following are the benefits of accounts receivables management
Increased Sales: providing goods or services on credit expands sales, by retaining old customers and attracting • of prospective customers.Market Share Increase: When the firm is able to retain old customer and attract new customers. Automatically • market share will be increased to the extent of new sales.Increase in Profits: Increased sales, leads to increase in profits because it need to produce more products with • a given fixed cost and sales of product with a given sales network, in both cases cost per unit comes down and the profit will be increased.
Modes of paymentThe various modes of payments are the following:
Cash Mode: Whenever a firm, sells goods or services on cash term, the value of goods or services will be received • either cash in advance (before the goods are shifted) or on delivery (after the goods are delivered).Open Account: Open account means, after the sale and purchase agreement between seller and buyers. •
Credit period �Cash discount �
Bill of Exchange: A bill of exchange represents an unconditional order issued by the seller asking the buyer to pay the amount mentioned on it on demand at a certain future date. This type of demand is made only when the seller does not have strong evidence of the buyer's obligation. Hence there is a need of secured arrangement in the form of bills of exchange. Generally, the bill accompanied by documents (shipping or other transport documents) that are delivered to the drawee when he/she pays accepts the bill than it will becomes a trade acceptance, which may be hold till the maturity or get it discounted.
The advantages of bills of exchange areIt represents negotiable instrument• It serves as a written evidence of a definite obligation• It helps in reducing cost of finance to some extent, since it can be discounted.•
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Letter of Credit (L/C): Letter of credit is a formal document issued by a bank on behalf of customer, stating the conditions under which the bank will honor the commitments of its customer (buyer). Payment through the letter of credit arises whenever trade takes place at international as well as domestic level. In simple words, whenever trade takes place in the absence of face-to face unknown people, issue of letter of credit (L/C) arises.
Consignment: In consignment business consignor (seller) sends goods to consignee (agent of the seller). In this case goods are just shipped but not sold to the consignee. Since the consignor retains the title of the goods till they sold by the consignee to a third party. In this consignment only sales proceeds are remitted to the consignor by the consignee.
Factors influencing the size of investment in receivablesThe level of investment in receivables is affected by the following factors:
Volume of credit sales: Size of credit sale is the prime factor that affects the level of investment in receivables. • Investment in receivables increases when the firm sells major portion of goods on credit base and vice versa.Credit policy of the firm: There are two types of credit policies•
Lenient credit policy: Firm following lenient credit policy tends to sell on credit to customers very liberally, �which will increase the size of receivables.Stringent credit policy: Firm that following stringent credit policy will have low size of receivables, because �the firm is very selective in providing of stringent credit. A firm that providing stringent credit may be able to collect debts promptly this will keep the level of receivable under control.
Trade terms: It is the most important factor in determining the level of investment in receivables. The important • credit terms are 'credit period and 'cash discount'. If credit period is more when compared to other companies, then the investment in receivables will be more. Cash discount reduces the investment in receivables because it encourages early payments.Seasonality of business: Firm doing seasonal business has to provide credit dales in unseasonal. When the firm • provides credit automatically the level of investment in receivables will increase with the comparison of the level of receivables in the season; because in season firm will sell goods on cash basis only.Collection policy: Collection policy is needed because all customers do not pay the firm's bill in time. A firm's • liberal collection policy will not be able to reduce investment in receivables but in future sales may be increased. On the other hand, firms that follow stringent collection policy will definitely reduce receivables but it may reduce future sales. Therefore, the collection policy should aim at accelerating collections from slow payers and reducing bad debt base.Bill discounting and endorsement: Bill discounting and endorsing to the third party to the firm has to pay will • reduce the size of investment in receivables. If the bills are dishonored on the due date, again the investment in receivables will increase because discounted bills or endorsed bills have to be paid by the firm.
11.4 Credit PolicyA firm credit policy regarding its credit standards, credit period, cash discounts, and collection procedures. The credit policy may be lenient or stringent (tight).
Lenient credit policyIt is the policy where the seller sells goods on very liberal credit terms and standards. In other words, goods are sold to the customers whose credit worthiness is not up to the standards or whose financial position is doubtful.
Advantages of Liberal credit policyIncrease in sales- Lenient credit policy increases sales because of the liberal credit terms and favorable incentives • granted to customers.Higher profits- Increase in sales leads to increase in profits, because higher level of production and sales reduces • fixed cost.
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Disadvantages of Lenient credit policyApart from the advantages it has some disadvantages.
Bad debt loss: A firm that follows lenient credit policy may suffer from bad debt losses that arise due to the • non-payment credit sales.Liquidity problem: Lenient credit policy not only increase bad debt losses but also creates liquidity problem, • because when the firm is not able to receive the payment at a due date, it may become difficult to pay currently maturing obligations.
Stringent credit policyStringent credit policy is the policy of credit when seller sells goods on credit on a highly selective basis i.e., the customers who have proven creditworthiness and financially sound will be granted credit facility.
Advantages of stringent credit policyLess bad losses: A firm that adopts stringent credit policy will have minimum bad debt losses, because it had • granted credit to only the customers who are creditworthy.Sound liquidity position: Firm that follows stringent credit policy will have sound liquidity position, due • to the receipt of all payments from customers on due date, the firm easily can pay the currently maturing obligations.
Disadvantages of stringent credit policyLess sales: Stringent credit policy restricts sales, because it is not extending credit to average creditworthiness • customers.Less profits: Less sales automatically reduces profits, because firm may not be able to products goods economically, • and it may not be able to use resources efficiently that leads increase in production cost per unit.
In fact, firm’s follows credit policy that lies between lenient and stringent credit policy. In other words, they follow optimum credit policy. Optimum credit policy involves a balance between costs and benefits. The major consideration in costs is liquidity and opportunity costs. The optimum credit policy occurs at point where there is a tradeoff between liquidity and profitability. Therefore, the management has to strike a balance between easy credit to promote sales and profit and tight credit to improve liquidity. The important variables of credit policy should be identified before establishing an optimum credit policy.
Credit policy variablesCredit Standards: The term credit standards refer to the criteria for extending credit to customers. The bases for
setting credit standards are • redit rating• References• Average payment period• Ratio analysis•
There is always a benefit to the company with the extension of credit to its customers but with the associated risks of delayed payments or non-payment, funds blocked in receivables etc. The firm may have light credit standards. It may sell on cash basis and extend credit only to financially strong customers. Such strict credit standards will bring down bad – debt losses and reduce the cost of credit administration. But the firm may not be able to increase its sales. The profit on lost sales may be more than the costs saved by the firm. The firm should evaluate the trade-off between cost and benefit of any credit standards.
Credit Period: Credit period refers to the length of time allowed to its customers by a firm to make payment for the purchases made by the customers of the firm. It is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if payments are made within the specified period.
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If a firm follows a credit period of ‘net 20’ it means that it allows to its customers 20 days of credit with no inducement for early payments. Increasing the credit period will bring in additional sales from existing customers and new sales from new customers. Reducing the credit period will lower sales, decrease investments in receivables and reduce the bad debt loss. Increasing the credit period increases sales, increases investment in receivables and increases the incidence of bad debt loss.
The effects of increasing the credit period on profits of the firm are similar to that of relaxing the credit standards.
Cash discountFirms offer cash discounts to induce their customers to make prompt payments. Cash discounts have implications on sales volume, average collection period, investment in receivables, incidence of bad debts and profits. A cash discount of 2/10 net 20 means that a cash discount of 2 % is offered if the payment is made by the tenth day, otherwise full payment will have to be made by 20th day.
Collection programme The success of a collection programme depends on the collection policy pursued by the firm. The objective of a collection policy is to achieve timely collection of receivables, there by releasing funds locked in receivables and minimises the incidence of bad debts. The collection programmes consists of the following.
Monitoring the receivables• Reminding customers about due date if payment• On line interaction through electronic media to customers about the payments due around the due date • Initiating legal action to recover the amount from overdue customers as the last resort to recover the dues from • defaulted customers
Collection Policy formulated shall not lead to bad relationship with customers.
11.5 Evaluation of Credit PolicyOptimum credit policy is one which would maximise the value of the firm. Value of a firm is maximised when the incremental rate of return on an investment is equal to the incremental cost of funds used to finance the investment. Therefore, credit policy of a firm can be regarded as a trade-off between higher profits from increased sales and the incremental cost of having large investment in receivables. The credit policy to be adopted by a firm is influenced by the strategies pursued by its competitors. If competitors are granting 15 days credit and if the firm decides to extend the credit period to 30 days, the firm will be flooded with customers demand for company’s products.
Credit policy variables of a firm areCredit StandardsThe effect of relaxing the credit standards on profit can be estimated as underChange in profit = PIncrease in sales = SContribution = c= 1 - VWhere V = Variable cost to salesBad- Debts on new sales = S × bnPost tax cost of capital = KIncrease in receivables investment = ITherefore,Change in profit = (Additional contribution on increase in sales – Bad debts on new sales) (1-tax rate) – Cost of incremental investment. (1 – Tax rate) – cost of capital × incremental investment in receivables.Increase in profit i.e. change in profit = (Incremental contribution – bad debts on new sales)
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Credit periodThe effect of changing the credit period on profits of the firm can be computed as under:Change in profit = (Incremental Contribution – bad debts on new sales) ( 1- tax rate) – Cost of incremental investment in receivables.
Cash discountFor assessing the effect of cash discount the following formula can be used:Change in profit = (Incremental contribution – increase in discount cost) (1-t) + opportunity cost of savings in receivables investment.
Collection policy Computation of the effect of new collection programme can be evaluated with the help of following formula:Change in profit = (Incremental contribution – Increase in bad debts) (1 – tax rate)- cost of increase in investment in receivables.
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SummaryAccounts receivables occupy an important position in the structure of current assets of a firm. They are the • outcome of rapid growth of credit sales granted by the firms to their customers. Credit sales are reflected in the value of Sundry Debtors.The characteristics of accounts receivables are risk involvement, based on economic value, the degree of credit • sales to be made, and the debtors' collection.The objectives of accounts receivables management are: maximising the value of the firm, by optimum investment • in sundry debtors, control and managing the cost of trade credit.The management of accounts receivables is not cost free. It involves cost, the costs main costs associate with • accounts receivables are capital cost, collection cost, default costs and delinquency costs/ bad debs.The economic value of goods or services sold on credit will be paid by adoption of different modes. Cash mode, • open account, bill of exchange, letter of credit and consignment.The level of investment in receivables is affected by the factors: Volume of credit sales, credit policy of the firm, • trade terms seasonality of business, collection policy, bill discounting and endorsement.Receivables management involves the decisions areas: credit standards, credit period, cash discount and collection • policy and procedures.Liberal credit policy is that policy where the seller sells goods on very liberal credit terms and standards, which • increase in Sales, higher profits. But it involves bad debt loss and liquidity problem.Stringent credit policy seller sells goods on credit on a higher selective basis only, which reduces bad losses, • sound liquidity position. These benefits are accompanied by less sales less profits.Firms should follow optimum credit policy that lies between lenient and stringent credit policy. Optimum credit • policy involves a balance between costs and benefits. The optimum credit policy occurs at point where there is a trade off between liquidity and profitability.The major controllable variables of credit policy are: credit standards, credit period cash discount and collection • policy.Optimum credit policy is one which would maximise the value of the firm.•
ReferenceChandra, D. & Bose., C., 2006. • Fundamentals of Financial Management, Prentice-Hall of India Private Limited.Dr. Rustagi, R.P., • Principles of Financial Management. 4th ed., Taxmann Publications (P) Ltd. 2010. • Accounts Receivable Management & Debt Collection Solutions, [Video Online] Available at: <http://www.youtube.com/watch?v=UuG7fcrXhB8> [Accessed 22 August 2012]. 2011. • Accounts Receivable Management & Debt Collection Solutions, [Video Online] Available at: <http://www.youtube.com/watch?v=OMtpVJj_gPA> [Accessed 22 August 2012].TheIntroductiontofinancialmanagement,• [Online] Available at: <http://jpkc.szpt.edu.cn/english/supplement/cash%20managment3.htm> [Accessed 22 August 2012]Financial Management: An Introduction• , [pdf] Available at: <http://www.egyankosh.ac.in/bitstream/123456789/38348/1/Unit-11.pdf> [Accessed 21 August 2012].
Recommended ReadingFabozzi, F. J. and Peterson, P. P., 2003. • Financial Management and Analysis, 2nd ed., Wiley.Salek, J. G., 2005. • Accounts Receivable Management Best Practices, Wiley. Shim, J. K., 2008. Financial Management, 3rd ed., Barron's Educational Series.•
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Self Assessment
___________ refers to bad debt losses to the firm.1. Delinquency Costsa. Default Costsb. Capital Costsc. Collection Costsd.
Receivables are defined as ________ owed to the firm by customers arising from sales of goods or services in 2. the ordinary course of business.
debta. cashb. creditc. costd.
__________ involvement is one of the characteristic features of receivables.3. Default costsa. Debtb. Riskc. Costd.
Firms offer which of the following to induce their customers to make prompt payments?4. Credit standardsa. Collection programmeb. Credit periodc. Cash discountsd.
Match the following:5. 1. Credit Standards a. Lenient and Stringent2. Credit policy b. Bill of exchange3. Trade terms c. Ratio analysis4. Modes of Payment d. Credit period
1-d, 2-c, 3-a, 4-ba. 1-c, 2-a, 3-d, 4-bb. 1-b, 2-d, 3-a, 4-cc. 1-d, 2-a, 3-b, 4-cd.
Which of the following statements is true?6. Cash mode, open account and bill of exchange are the modes of payment.a. Accounts receivables do not occupy any position in the structure of current assets of a firm.b. Whenever trade takes place in the presence of known people, issue of letter of credit (L/C) arises.c. Increased Sales is not the benefits of accounts receivables management.d.
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Which of the following is false?7. Letter of credit is one of the modes of payment.a. Credit period is one of the terms of credit.b. The success of a collection programme depends on the collection policy pursued by the firm.c. Optimum credit policy involves a balance between costs and loses.d.
Match the following:8. 1. Bills of exchange a. non-payment credit sales
2. Bad debt loss b. Length of time allowed to the customers by a firm to make payment for the purchases
3. Credit period c. Implies futurity4. Characteristics of receivables d. represents negotiable instrument
1-c, 2-d, 3-a, 4-ba. 1-b, 2-c, 3-d, 4-ab. 1-d, 2-a, 3-b, 4-cc. 1-c, 2-a, 3-b, 4-ad.
When there are no credit sales, there will not be any ___________.9. value of the firma. trade credit costb. optimum investmentc. collectiond.
____________ increases sales because of the liberal credit terms and favorable incentives granted to 10. customers.
Lenient credit policya. Stringent credit policyb. Volume of Credit Salesc. Credit Policy of the Firmd.
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Chapter XII
Dividend Decision
Aim
The aim of this chapter is to:
define the concept of dividend•
introduce dividend decision •
highlight different dividend theories•
Objectives
The objectives of this chapter are to:
explain bonus shares•
elucidate the concept of stock split•
explicate stability of dividends•
Learning outcome
At the end of this chapter, you will be able to:
discuss different forms of dividend•
enlist the types of dividend policy•
understand the conditions and reasons for issuing bonus shares•
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12.1 IntroductionDividend decision is one of the decisions of financial management.
It decides the proportion of equity earnings to be paid to equity shareholders by way of dividends and the • remaining proportion of net warnings are retained in the firm.While discussing the proportion of net earnings that are distributed as dividends to equity shareholders, financial • manager must keep in mind that the firm’s objective is to maximise shareholders wealth. Target of dividend payout ratio should be based on the majority of investors preferences for dividends or capital • gainsPayment of divided has two opposing effects•
it increases dividend there by stock price rise and �it reduces the funds available for investment which will reduce the expected growth rate, thereby stock �price declines
Therefore the firm’s optimal dividend policy must strike a balance between current dividends and future growth (retained earnings).
12.2 Meaning of DividendThe term dividend refers to that portion of company’s net earnings that are paid out to the equity • shareholders.Preference shareholders are entitled to a fixed rate of dividend irrespective of the firms earnings.• Dividend policy of a firm decides the portion of earnings which are paid as dividends to ordinary shareholders • and the portion that is ploughed back in the firm for investment purpose.Equity holders’ dividends fluctuate year after year. It depends on what portion of earnings is to be retained by • the firm and what portion is to be paid off.As dividends are distributed out of net profits, the firm’s decisions on retained earnings have a bearing on the • amount to be distributed. Retained earnings constitute an important source of financing investment requirements of a firm. However, such • opportunities should have enough growth potential and sufficient profitability.There is an inverse relationship between these two-larger retentions, lesser dividends and vice versa• Thus two constituents of net profits are always competitive and conflicting.•
Types of dividend policies
Dividend policies may be of following types:Stable dividend policy: Under this policy dividend is paid at stable or almost stable rate year after year. A • company favors the stable dividend policy due to the following reasons:
Confidence among shareholders: Stable dividend policy creates confidence among shareholders because �they get a fixed dividend every year irrespective of the earnings.Income conscious investor: Where investors are income conscious they prefer stable dividend policy. �Stability in market price of shares: Stables dividend policy raises the price of shares in the market. �Encouragement to institutional investors: Stable dividend policy attracts the institutional investors to invest �their funds in such securities.
The stable dividend policy may take any of the following three forms:Constant dividend per share• Constant percentage of net earnings: Under this policy, fixed percentage of net earnings is made available for • dividend payment and the excess is transferred to reserves.Constant dividend per share plus extra.•
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Under this policy the rate of dividend is fixed per share. Any extra dividend is paid in the year of prosperity. Policy of no Immediate Dividend: Under this policy, company accumulates profits and pays no dividend for long.
Policy of Regular Stock Dividend: Under this policy, company pays no cash dividend and offer bonus shares every year in place of cash dividend.
Policy to pay Irregular Dividend: Under this policy, the rate of dividend directly fluctuates with the fluctuations in earning level of the company.
12.3 Dividend Theories Walter’s Model: Proposition of Walter’s model supports the doctrine that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both interlinked according to Walter. The choice of an appropriate dividends policy affects the value of an enterprise.
The key argument in support of the relevance proposition of Walter’s model is the relationship between theReturn on a firm’s investment or its internal rate of return (r)• Its cost of capital or the required rate of return (k)•
The firm would have an optimum dividend policy which will be determined by the relationship of r and k. in other words, if the return on investment exceeds the cost of capital, the firm should retain the earnings, whereas it should distribute the earnings to the shareholders in case the required rate of return exceeds the expected return on the firm’s investments.
Gordon’s Model: Another theory which contends that dividends are relevant is Gordon’s model. This model, • which opines that dividend policy of a firm affects its value is based on the following assumptions:The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively • by retained earnings.r and ke are constants.• The firm has perpetual life.• The retention ratio, once decided upon, is constant. Thus the growth rate (g=br) is also constant.• K3>b.r (b = retention ratio)• The Modigliani – Miller hypothesis of dividend irrelevance: Modigliani and Miller maintain that dividend-policy • has no effect on the share price of the firm and is therefore, of no consequences. What matters according to them, is the investment policy through which the firm can increase its earnings and thereby the value of the firm.
The above hypothesis is based on the following Critical Assumptions:Perfect capital markets in which all investors are rational. Information is available to all free of cost, there are • no transaction costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities, and there are no floatation costs.There are no taxes. There are no differences in tax rates and applicable to capital gains and dividends.• A firm has its investment policy which does not change. The operational implication of this assumption is that • financing of new investments out of retained earnings will not change the business risk complexion of the firm and therefore, there would be no change in the required rate of return.
Stability of dividendStability of dividends is the consistency in the stream of dividend payments.• It is the payments of certain amount of minimum dividend to the shareholders.•
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The steadiness is a sign of good health of the firm and may take any of the following forms:• Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount of dividend �per share year after year. Generally, a firm following such a policy will continue payments even if it incurs losses. In such years when there is a loss, the amount accumulated in the dividend equalisation reserve is utilises. As and when the firm starts earning a higher amount of revenue it will consider payment of higher dividends and in future it is expected to maintain the higher level. Constant DP ratio: With this type of DP policy, the firm pays a constant percentage of net earnings to the �shareholders.Constant dividend per share plus extra dividend: Under this policy, a firm usually pays a fixed dividend �ordinarily and in years of good profits, additional or extra dividend is paid over and above the regular dividend.
Forms of dividendDividends are that potion of earnings to available to shareholders. Generally, dividends are distributed in cash, but sometimes they may also declare dividends in other forms which are discussed below:
Cash dividends: many companies pay dividends in the form of cash. The investors also, especially the old and • retired investors depend on this form of payment for want of current income.Scrip dividends: in this form, equity shareholders are issued transferable promissory notes with shorter maturity • periods which may or may not have interest bearing. In simple payment of dividends in the form of promissory notes. Payments of dividends in the form take place only when the firm is suffering from shortage of cash or weak liquidity position of cash. Payment of dividends in the form of cash is justifiable only when the company has earned profits and it will take some time to convert current assets into cash.Bond dividend: Both scrip and bond dividend are the same but they differ in terms of maturity. Bond dividend • carries longer maturity period and bear interest, where as scrip dividend carries shorter maturity and may or may not carry interest.Property dividend: The name itself suggests that payment of dividend takes place in the form of property. • This form of dividends takes place only when a firm has assets that are no longer necessary in the operation of business and shareholders are ready to accept dividend in the form of assets. This form of dividend payment is not popular in India.Stock dvidend (Bonus Shares): Stock dividend is the payment of additional shares of common stocks to the • ordinary shareholders. It is known as stock dividend in USA or bonus shares in India, is the distribution of additional shares to the shareholders at no additional cost. This has the effect of increasing the number of outstanding shares of the firm. The reserves and surplus (retained earnings) are capitalised to give effect to bonus issue. This decision has the effect of recapitalisation, that is, transfer from reserves to share capital not changing the total net worth. The investors are allotted shares in proportion to their present shareholding. Declaration of bonus shares has a favorable psychological effect on investors. They associate it with prosperity.
12.4 Bonus SharesBonus shares are those shares which are issued to existing shareholders as a result of capitalisation of reserves. Bonus shares can be defined as ‘Shares issued by a company to its members, either fully paid up or partly paid-up, out of accumulated profits, in lieu of a dividend or bonus in cash or in other words instead of profits being paid in cash, they are capitalised, retained in the business the members benefiting by an allotment of shares instead of a payment of cash Companies which have large accumulated reserves may issue bonus shares to their equity shareholders. Bonus shares are given free of charge to the existing members. No consideration has to be paid by the member.
The amount equal to the value of the bonus share is capitalised out the accumulated reserves. The company may distribute dividend or issue bonus shares out of undistributed profit. All rights attached to equity shares are also applicable to bonus shares. The company may give bonus shares in a proportion to shareholder’s existing holdings. The policy regarding issue of bonus shares is decided by the directors. In the general meeting, it is formal approved by a resolution. Issue of bonus shares may be called capitalisation of undistributed profits.
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Condition for Issue of Bonus SharesThere should be sufficient amount of accumulated general reserves.• Issue should be permitted by the Article of Association of company.• The Board should pass a Resolution proposing the issue of bonus shares.• Shareholders should give their formal approval to the directors’ proposal for the issue of bonus shares.• The company should obtain the approval of the controller of Capital Issues, under the capital Issues Control • Act, 1947.
Reasons for the Issue of Bonus SharesThe bonus issue tends to bring the market price per share within a more popular range.• It increases the number of outstanding shares. This promotes more active trading.• The nominal rate of dividend tends to decline. This may dispel the impression of profiteering.• The share capital base increases and the company may achieve a more respectable size in the eyes of the • investing community.
12.5 Stock SplitA stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share. A stock spilt affects only the par value and does not have any effect on the total amount outstanding in share capital. The reasons for splitting shares are:
To make shares attractive: The prime reason for affecting a stock split is to reduce the market price of a share • to make it more attractive to investors. Shares of some companies enter into higher trading zone making it out of reach to small investors. Splitting the shares will place them in more popular trading range thus providing marketability and motivating small investors to buy them.Indication of higher future profits: Share split is generally considered a method of management communication • to investors that the company is excepting high profits in future.Higher dividend to shareholders: When shares are splits, the company does not resort to reducing the cash • dividends. If the company follows a system of stable dividend per share, the investors would surely get higher dividends with stock split.
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SummaryDividend policy of a firm decides the portion of earnings which are paid as dividends to ordinary shareholders • and the portion that is ploughed back in the firm for investment purpose.There are different types of dividend policies: Stable Dividend Policy, Policy of no Immediate Dividend, Policy • of Regular Stock Dividend, Policy to pay Irregular Dividend.The Modigliani – Miller proposed dividend irrelevance theory. Modigliani and Miller maintain that dividend • policy has no effect on the share price of the firm and is therefore, of no consequences. But the theory was criticised by many people on the base of their assumptions.Stability of dividends is the consistency in the stream of dividend payments. It is the payments of certain amount • of minimum dividend to the shareholders. The steadiness is a sign of good health of the firm and may take any of the following forms: Constant dividend per share, Constant DP ratio and Constant dividend per share plus extra dividend.Sometimes firms may be declare dividends in the form of: Cash Dividends, Scrip Dividends, Bond Dividend, • Property Dividend and Stock Dividend (Bonus Shares).Bonus shares are those shares which are issued to existing shareholders as a result of capitalisation of • reserves.A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value • of a share. The reasons for splitting shares are: To make shares attractive, Indication of higher future profits and Higher dividend to shareholders.
ReferenceBaker, H. K., 2009. • Dividends Dividend Policy, John Wiley and Sons, Inc. Wiley. Chandra. P., 2005. • Fundamentalsoffinancialmanagement, New Delhi. Tata McGraw-Hill. Dividend Decisions,• [ppt] Available at: <http://www.slideshare.net/sagar_sjpuc/dividend-decisions-presentation> [Accessed 22 August 2012].2011. • FINANCIAL MANAGEMENT (Module 1, pt 6), [Video Online] Available at: <http://www.youtube.com/watch?v=msG-mcSeDt0> [Accessed 22 August 2012].2011. • FINANCIAL MANAGEMENT (Module 1, pt 1), [Video Online] Available at: <http://www.youtube.com/watch?v=LgRt1gb22cA> [Accessed 22 August 2012].Dividend Decision• , [Online] Available at: <http://finance.mapsofworld.com/corporate-finance/investment-decision/dividend.html> [Accessed 22 August 2012].
Recommended ReadingKeown, A. J., 2004. • Foundationsoffinance:thelogicandpracticeoffinancialmanagement, Pearson Education Asia Limited and Tsinghua University Press.Bierman, H. & Smidt, S., 2003. • Financial Management for Decision Making, Macmillan Publishing Company. Dr. Mittal, R. K., 2007. • Management Accounting and Financial Management. New Delhi. V.K. (India) Enterprises.
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Self AssessmentDividend refers to that portion of company’s _________________ that are paid out to the equity 1. shareholders.
gross earningsa. net earningsb. firm earningsc. retention of earningsd.
Proposition of Walter’s model supports the doctrine that dividends are _________.2. irrelevanta. unrelatedb. retainingc. relevantd.
The term _________ refers to that portion of company’s net earnings that are paid out to the equity 3. shareholders.
inventorya. receivablesb. dividendc. working capitald.
Which of the following is the payment of additional shares of common stocks to the ordinary shareholders?4. Stock dividenda. Scrip Dividendsb. Cash Dividendsc. Property Dividendd.
The Modigliani – Miller proposed dividend _____________ theory5. irregulara. regularb. irrelevancec. relevanced.
In Gordon’s model what are r and ke? 6. inconstantsa. constantsb. flexiblec. rigidd.
Which of the following statements is true?7. Stables dividend policy raises the price of shares in the market.a. Stability of dividends is the inconsistency in the stream of dividend paymentsb. When shares are splits, the company does resort to reducing the cash dividends.c. Stable dividend policy creates no-confidence among shareholders because they get a fixed dividend every d. month irrespective of the earnings.
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Which of the following statements is false?8. Payment of divided has two opposing effectsa. Share split is generally considered a method of management communication to investors that the company b. is excepting high profits in future.Perfect capital markets in which all investors are rationalc. Stability of Dividend is the payments of certain amount of maximum dividend to the shareholdersd.
Match the following9. 1. Cash dividend a. constant dividend per share plus extra dividend
2. Stability of dividend b. higher dividend to shareholders
3. Forms of dividend c. may companies pay dividends in the form of cash
4. Stock split d. Scrip dividend
1-b, 2-d, 3-a, 4-ca. 1-d, 2-c, 3-b, 4-ab. 1-c, 2-a, 3-d, 4-bc. 1-b, 2-c, 3-d, 4-cd.
Stable dividend policy attracts the institutional investors to invest their funds in which securities?10. Bonus Sharesa. Cash dividendb. Gordon’s model theoryc. Stable dividend policyd.
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Case Study I
Financial management at Bajaj Auto
IntroductionIn 2003, Bajaj Auto Limited (Bajaj) was one of India’s largest manufacturers of both two and three-wheelers. The three-wheelers, also known as autorickshaws, were unique to the South Asian region. The company recorded revenue of Rs.5125.73 crores representing a 13% increase over the previous year. Once the unchallenged market leader, Bajaj trailed Hero Honda in the late 1990s. Bajaj’s market share declined from 49.3% in 1994, to 38.9% in 1999.3 Thereafter, Bajaj had initiated several measures to regain its market share and strengthened its competitive position. In 2003, Bajaj had a workforce of 12,000 employees and a network of 422 dealers and over 1,300 authorised service centres.
The Indian Two-wheeler IndustryTwo-wheelers had become the standard mode of transportation in many of India’s large urban centres. Use of two-wheelers in the rural areas had also increased significantly in the 1990s.
The birth of the Indian two-wheeler industry could be traced to the early 1950s, when Automobile Products of India (API) started manufacturing scooters in the country. While API initially dominated the scooter market with its Lambrettas, it was Bajaj which rapidly emerged as the unchallenged leader in the scooter industry. A number of government and private enterprises who entered the scooter segment, had disappeared from the market by the turn of the century. The License Raj that existed prior to economic liberalisation (1940s-1980s) in India did not allow foreign players to enter the market, making it an ideal breeding ground for local players.
Background NoteThe Bajaj group was founded by Jamnalal Bajaj in the 1930s. His eldest son Kamalnayan established Bajaj Auto, the flagship of the Bajaj group, in 1945, as a private limited company. From 1948 to 1959, Bajaj imported scooters and three wheelers from Italy and sold them in India.
Financial ManagementBajaj earned bulk of its revenue from the automotive business. In 2003, motorcycles dominated the automotive segment, accounting for 55 % of its revenues.
Looking AheadIn the motorcycles segment, ‘Boxer’ had performed well and had increased its market share to 45% in the entry-level market, which was estimated at 102,000 units (35% of total motorcycle sales). But growth was primarily led by ‘Pulsar’, the premium-end motorcycle.
(Source: icmrindia.com. Financial management at Bajaj Auto [Online] Available at: <http://www.icmrindia.org/casestudies/catalogue/Finance/Financial%20management%20at%20Bajaj%20Auto.htm>. [Accessed 1 November 2011]).
QuestionsWhat boosted Bajaj to increase its revenue in 1950’s and 2003?1. Answers:While API initially dominated the scooter market with its Lambrettas, it was Bajaj which rapidly emerged as the unchallenged leader in the scooter industry. Bajaj earned bulk of its revenue from the automotive business. In 2003, motorcycles dominated the automotive segment, accounting for 55 % of its revenues. In the motorcycles segment, ‘Boxer’ had performed well and had increased its market share to 45% in the entry-level market, which was estimated at 102,000 units (35% of total motorcycle sales). But growth was primarily led by ‘Pulsar’, the premium-end motorcycle.
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Write a note on the Indian two-wheeler industry.2. Answers:Two-wheelers had become the standard mode of transportation in many of India’s large urban centres. Use of two-wheelers in the rural areas had also increased significantly in the 1990s. The birth of the Indian two-wheeler industry could be traced to the early 1950s, when Automobile Products of India (API) started manufacturing scooters in the country. While API initially dominated the scooter market with its Lambrettas, it was Bajaj which rapidly emerged as the unchallenged leader in the scooter industry. A number of government and private enterprises who entered the scooter segment, had disappeared from the market by the turn of the century. The License Raj that existed prior to economic liberalisation (1940s-1980s) in India did not allow foreign players to enter the market, making it an ideal breeding ground for local players.
According to you what strategy Bajaj group should use to be a leader in the automobile industry?3. Answers:Bajaj should implement financial strategies and marketing strategies so as to control the flow of revenue and to develop huge market for two and three wheelers.
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Case Study II
Best Practices in Inventory Management
IntroductionA leading consumer products company dealing in cosmetics and other personal care products was seeking ways to:
Reduce inventory levels across their forward supply chain • Improve Inventory Record Accuracy at their storage points • Accurately track damaged goods at various points in the supply chain •
The above problems together were a significant burden to the company.
Implementation of best practices after a detailed business analysis resulted in the following benefits: Inventory Record Accuracy improved to 95% within 2 months • Stock levels reduced by about 30% across stocking points in the supply chain • Complete visibility was achieved in the supply chain with respect to damaged goods inventory•
Organisation Background The firm was a leading consumer products company dealing in cosmetics and personal care products with its head office located overseas. The company had a supply chain network of 3 factories with bonded stock rooms (BSR) attached for despatch to the depots and 35 depots for servicing distributors. Goods move from the factory to the BSR. BSR despatches stocks to Mother CFAs (depot). Other depots receive stocks from the Mother depot and sell them to distributors.
Key Concerns for the Company To reduce inventory level at the BSR and depots. • To improve inventory accuracy at stocking points including both BSRs and depots • To identify the damaged stocks across the chain and initiate action in a timely manner•
Focus of Study A study was completed focusing on the
Inventory-related issues at BSRs and depots. These included: • Inventory holding as a proportion of sales �Practices employed for track goods in the warehouse �Proportion of fast and slow moving stocks to the total inventory �Linkages of factory dispatches to BSR with patterns of BSR dispatches to depots �Accuracy of inventory records especially of fast selling lines �
Demand Planning process. The study looked at: • Forecast Accuracy and process of reviewing and revising forecasts �Level of safety stock at each location combined with process to review and reset the same �Linkages of forecasts and consequent despatches with relevant available closing stocks at depots �
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Findings Key Business Indicators
Total average inventory holding at BSRs was 8.2 weeks of sales • Average inventory holding at the depots was 6.5 weeks of sales • Depots were holding •
High inventory of old/withdrawn stocks �Damaged stocks for a long time (over 3 months) �
Book and physical stocks had discrepancy of over 30% •
ConclusionsHigh Inventory Levels: Inventory levels were very high across the distribution chain on account of: •
Sales and despatch forecasts that were not in line with actual primary / secondary sales �There was no process to periodically review and refine the Annual Forecasts, in line with market �feedback Stocking across all points in the distribution chain was driven by a push-oriented system that did not have �provisions to be tuned to market requirements Actual safety stocks maintained at depots were significantly higher that target safety stocks agreed at the �beginning of the year. No system was in place to monitor and correct the same during the year Stock allocation from depots was manual. Orders received from distributors were manually processes and �no process was in place to automatically collate orders and allocate stocks
High Levels of Old / Withdrawn / Damaged / Slow-moving stocks: Dead stocks were allowed to accumulate in the system mainly because: •
There was an absence of visibility into inventory details across stocking points �The process to monitor and act on dead stocks was not adhered to �Records of slow-moving / old / withdrawn / damaged stocks were not maintained methodically at the �stocking points. Records were inaccurate. Communication of details of dead stocks to the relevant teams was based on manually filed reports which �was time-taking and open to error
Inaccuracy in inventory records: • The organisation did not have a clear policy on periodic reconciliation of physical stock with book �records Inaccuracies grew over time, compounded with process failure on accounting for dead stocks �
Action Steps Advised and Undertaken Process Improvements
Bin card system was implemented for each rack at the CFAs and the delivery staff was trained in relevant bind • card maintenance practices.A process to regularly reconcile physical and book stocks using the cycle-count process was mandated • An IT solution was identified and implemented for•
Accounting the Cycle count process, providing MIS on deviations and accounting the adjustment notes �Computing the forecast using consolidated orders, with factoring for promotions and seasonality �Calculating safety stock level based on number of weeks of sales target �Facilitating communication of closing stock data from BSR and depots to logistics department �Facilitating communication of damaged and un-saleable stock quantity to commercial department �Automatically allocating stocks using FIFO principle at the depots �
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Demand planning and forecasting were made a periodic activity using the above IT solution to align forecasting • with market orders and actual sales. The process of setting safety stocks at depots was made periodic and dynamic, based on updated sales data. Norms were set to act on damaged / old and other dead stocks. Clear action steps were laid down to liquidate or • destroy these stocks. Responsibility and accountability were set to in the organisation to monitor and authorise activities in this regard based on visibility provided by the IT solution.
Benefits The organisation achieved an inventory record accuracy (book stocks correctly reflecting physical stocks) of • 95% within 2 months. The company achieved (Within 2 Planning cycles i.e. 2 Months) •
Stock level reduction �From 8.2 weeks to 5.5 weeks at the BSR –From 6.5 weeks to 4 weeks at the depots which included Damaged Inventory –Reduction in stock Value holding across the supply chain –
Transparency of saleable and damaged stocks quantities across the supply chain resulting in more accurate �demand planning, stock allocation and production. Better management of damaged and un-saleable stocks: �
Sales realisation on salvaging and selling damaged stocks at a discounted price –Timely destruction of unusable and potentially harmful products –Timely action on transport, handling, stock management and product development fronts to reduce –damages
Reduction in proportion of old and damaged stocks; Facilitation of ensuring fresher stocks in the market. �This was achieved mainly by reducing inventory levels across the chain and also by better stock management at the depots
(Source: Ravichandra, K. and Paul, D. Best Practices in Inventory Management [PDF] Available at: <http://forumcentral.sify.com/athena/login/casestudyinventory.pdf>. [Accessed1 November 2011]).
QuestionsWhat are the key concerns for the company mentioned in the above case study?1. Which are the Inventory-related issues at BSRs and depots for the company?2. State the action steps advised and undertaken by the company to improve the process. 3.
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Case Study III
Inventory Management
Preface:Just like any investment in business, inventory needs to serve the purpose of maximising profit. However, in many cases inventory has turned into a major cash flow constraint thus making it necessary to optimise inventory using analytical and statistical methods in an integrated approach.
One of the biggest challenges in optimising inventory is the fact that it is merely an output of many inter-organisational processes. All too often organisations attempt to lower inventory using non-analytical approaches which lower service levels.
Although counterintuitive, it in fact is possible to reduce inventory while improving service levels simultaneously using our proven inventory management methodology.
Our inventory management methodology attacks inventory from two directions:Optimising inventory levels while viewing the existing order fulfilment process as a given constraint• Changing the fundamental order fulfilment process across the entire system•
Most clients find this two-step approach of significant value. During the first step cash can be made available quickly and success is immediately generated. Step two is used to generate breakthrough business results and provide a robust order fulfilment process that will be able to perform at lower inventory levels while providing extraordinary service levels.
Case:A major US corporation identifies a cash flow problem. Further analysis reveals that inventory levels are high and turns are below most major competitors. In addition a technology change and a proliferation of models amplify the issue.
The corporate goal is a reduction of inventory across the order fulfilment process in excess of 50% with no negative impact on service levels. Customer feedback reveals that a key to customer satisfaction is on time delivery and any deviation from promised dates has a negative impact on customer satisfaction.
Course of action:A baseline of the existing order fulfilment process is conducted. It quickly highlights some key leverage points in the order fulfilment process. Furthermore it becomes apparent that much of the current inventory is present due to internally generated variation versus customer driven order variation.
Following the baseline activity various process changes are modelled to verify their impact on inventory levels and service levels. Real world constraints are taken into account prior to deciding on the appropriate changes. Simulations are conducted to verify the appropriateness of the analytical models using actual process data.
As a result the following changes are made to accomplish the goals.Implementation of a Pull System for the order fulfilment process. This pull system spans from supplier through • manufacturing, logistics to the customer. The previous order fulfilment process was managed via an MRPII system.Determination of inventory levels using economic and statistical methods in an integrated approach.• Implementation of appropriate inventory management models to minimise cost given various real world • conditions in the supply chain (flow production, batch production, re-manufactured parts inflow etc.).Revision of the planning process to support the order fulfilment process.•
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Training of analysts to determine the appropriateness of forecast models.• Reduction of internally generated variation through•
Organisational changes to reduce tampering. �Application of statistical methods. �
Management of the new process is significantly less resource intensive than the original process. Changes in volume are easily accomplished due to the simplicity of the new order fulfilment process. Inventory is reduced and service levels to customers are improved.
Results:Inventory reduction post full implementation: > $20,000,000
(Source: sixsigmasystems.com, Inventory management case study [Online] Available at: http://www.sixsigmasystems.com/case_studies.htm>. [Accessed 1 November 2011]).
QuestionWhich two factors were used for reducing internally generated variations?1. What is the course of action taken by the company to overcome the cash flow problem?2. Which are the two directions where inventory management methodology attacks inventory?3.
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Recommended Reading2005. • The Cost of Capital: Intermediate Theory, Cambridge University Press.Alexander, C., 1999. • Risk Management and Analysis, Measuring and Modelling Financial Risk (Volume 1), Wiley. Appel, G., 2008. • Beat the Market: Win with Proven Stock Selection and Market Timing Tools, 1st ed., FT Press.Belkaoui, A. B., 1999. • Capital Structure: Determination, Evaluation, and Accounting, Quorum Books.Benninga, S., 2006. • Principles of Finance with Excel, Oxford University Press.Bierman, H & Smidt, S., 2003. • Financial Management for Decision Making, Macmillan Publishing Company. Bierman, H. Jr., 2007. • Advancedcapitalbudgeting:RefinementsintheEconomicanalysisofinvestmentprojects, Routledge.Brigham, E. F., 2003• . Fundamentals of Financial Management, 10th ed., South-Western College Pub.Dr. Mittal, R. K., 2007. • Management Accounting and Financial Management. New Delhi. V.K. (India) Enterprises.Fabozzi, F. J. and Peterson, P. P., 2003. • Financial Management and Analysis, 2nd ed., Wiley.Fung, A., 2001. • Working Capital: The Power of Labor’s Pensions, Cornell University Press.Hackel, K. S., 2010 • Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making, McGraw-Hill.Jones, C. V., 1991. • Financial Risk Analysis of Infrastructure Debt: The Case of Water and Power Investments, Quorum Books.Jones, E. B., 2001. • Cash Management, ScarecrowEducation.Keown, A. J., 2004. • Foundationsoffinance:thelogicandpracticeoffinancialmanagement, Pearson Education Asia Limited and Tsinghua University Press.Max Muller, 2003. • Essentials of Inventory Management, AMACOM. Moyer, S. G., 2004. • Distressed Debt Analysis: Strategies for Speculative Investors, J. Ross Publishing.Ogier, T., 2004. • The Real Cost of Capital: A Business Field Guide to Better Financial Decisions, FT Press.Peterson, P. & Drake. 2009. • Foundations and Applications of the Time Value of Money, Wiley.
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Peterson, P. P., 2002. • Capital Budgeting, 1st ed., Wiley. Piasecki, D. J., 2009. • Inventory Management Explained: A focus on Forecasting, Lot Sizing, Safety Stock, and Ordering Systems, 1st ed., Ops Publishing.Pratt, S. P., 2010. • Cost of Capital: Workbook and Technical Supplement, 4th ed., (Wiley Finance), Wiley.Preve, L. & Sarria-Allende, V. S., 2010. • Working Capital Management (Financial Management Association Survey and Synthesis Series), Oxford University Press. Sagner, J., 2010. • Essentials of Working Capital Management (Essentials Series), Wiley.Salek, J. G., 2005. • Accounts Receivable Management Best Practices, Wiley. Schaeffer, H. A . Jr., 2002. • Essentials of Cash Flow, 1st ed., Wiley.Seitz, N., 2004. • Capitalbudgetingandlong-termfinancingdecisions 4th ed., South-Western College Pub.Shim, J. K., 2008, • Financial Management (Barron’s Business Library), 3rd ed., Barron’s Educational Series.Staff, I., 2005. • Stocks,Bonds,Bills,andInflation2005Yearbook:ValuationEdition, Ibbotson Associates.Stanley, B., 2008. • Foundations of Financial Management w/S&P bind-in card + Time Value of Money bind-in card, 13th ed., McGraw-Hill/Irwin.Toomey, J. W., 2000. • Inventory Management: Principles, Concepts and Techniques, Kluwer Academic Publishers.Wielen, L., Alphen, W., Bergen, J. & Lindow, P., 2006. • International Cash Management (Treasury Management and Finance Series), 2nd ed., Riskmatrix.
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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.
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Chapter Vc1. b2. b3. b4. a5. d6. a7. b8. a9. b10.
Chapter VIa1. d2. b3. a4. a5. b6. c7. a8. a9. d10.
Chapter VIIc1. b2. a3. d4. b5. c6. d7. c8. a9. a10.
Chapter VIIIb1. c2. d3. b4. a5. b6. c7. a8. d9. a10.
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Chapter IXa1. c2. d3. b4. c5. c6. a7. d8. b9. a10.
Chapter Xc1. d2. a3. a4. b5. c6. d7. a8. c9. b10.
Chapter XIb1. a2. c3. d4. b5. a6. d7. c8. b9. a10.
Chapter XIIb1. d2. c3. a4. c5. b6. a7. d8. c9. d10.