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MB0045-Unit-01-Financial Management Unit-01-Financial Management

Structure:

1.1 Introduction

Learning objectives

1.2 Meanings and Definitions

1.3 Goals of Financial Management

Profit maximisation

Wealth maximisation

Wealth maximisation vs. Profit maximisation

1.4 Finance Functions

Financing decisions

Investment decisions

Dividend decisions

Liquidity decision

Organisation of Finance Function

1.5 Interface between Finance and Other Business Functions

Finance and accounting

Finance and marketing

Finance and production (operations)

Finance and HR

1.6 Summary

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1.7 Terminal Questions

1.8 Answers to SAQs and TQs

1.1 Introduction

Financial Management of a firm is concerned with procurement and effective utilisation of funds for the benefit of its stakeholders. It embraces all those managerial activities that are required to procure funds at the least cost and their effective deployment.

The most admired Indian companies are Reliance and Infosys. They have been rated well by the financial analysts on many crucial aspects that enabled them to create value for its share holders. They employ the best technology, produce good quality goods or render services at the least cost and continuously contribute to the shareholders’ wealth. The three core elements of financial management are:

a. Financial Planning

Financial Planning is to ensure the availability of capital investments to acquire the real assets. Real assets are land and buildings, plants and equipments. Capital investments are required for establishing and running the business smoothly.

b. Financial Control

Financial Control involves managing the costs and expenses of a business. For example, it includes taking decisions on the routine aspects of day to day management of collecting money due from the firms’ customers and making payments to the suppliers of various resources.

c. Financial Decisions

· Decision needs to be taken on the sources from which the funds required for the capital investments could be obtained.

· There are two sources of funds – debt and equity. In what proportion the funds are to be obtained from these sources is to be decided for formulating the financing plan.

In this unit, you will learn about these core elements of financial management.

1.1.1 Learning objectives

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

· The meaning of Business Finance

· The objectives of Financial Management

· The various interfaces between finance and other managerial functions of a firm

1.2 Meaning and Definitions

Financial Management is the art and science of managing money. Regulatory and economic environments have undergone drastic changes due to liberalisation and globalisation of Indian economy. This has changed the profile of Indian finance managers. Indian financial managers have transformed themselves from licensed raj managers to well-informed dynamic proactive managers capable of taking decisions of complex nature.

Traditionally, financial management was considered a branch of knowledge with focus on the procurement of funds. Instruments of financing, formation, merger and restructuring of firms and legal and institutional frame work occupied the prime place in this traditional approach.

The modern approach transformed the field of study from the traditional narrow approach to the most analytical nature. The core of modern approach evolved around the procurement of the least cost funds and its effective utilisation for maximisation of share holders’ wealth.

Self Assessment Questions

Fill in the blanks:

1. What has changed the profile of Indian finance managers?

2. Finance management is considered a branch of knowledge with focus on the __________.

1.3 Goals of Financial Management

Financial Management means maximisation of economic welfare of its shareholders. Maximisation of economic welfare means maximisation of wealth of its shareholders. Shareholders’ wealth maximisation is reflected in the market value of the firms’ shares. Experts believe that, the goal of the financial management is attained when it maximises its value. There are two versions of the goals of financial management of the firm – Profit Maximisation and Wealth Maximisation (see figure 1.1).

Figure 1.1: Goals of financial management

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1.3.1 Profit Maximisation

Profit maximisation is based on the cardinal rule of efficiency. Its goal is to maximise the returns, with the best output and price levels. A firm’s performance is evaluated in terms of profitability. Allocation of resources and investors perception of the company’s performance can be traced to the goal of profit maximisation. Profit maximisation has been criticised on many accounts:

1. The concept of profit lacks clarity. What does profit mean?

Is it profit after tax or before tax?

Is it operating profit or net profit available to share holders?

Differences in interpretation on the concept of profit expose the

weakness of profit maximisation.

2. Profit maximisation ignores time value of money. It does not differentiate between profits of current year with the profit to be earned in later years.

3. The concept of profit maximisation fails to consider the fluctuations in profits earned from year to year. Fluctuations may be attributed to the business risk of the firm.

4. The concept of profit maximisation apprehends to be either accounting profit or economic normal profit or economic supernormal profit.

Profit maximisation fails to meet the standards stipulated in an operational and a feasible criterion for maximising shareholders wealth, because of the deficiencies explained above.

1.3.2 Wealth Maximisation

Wealth maximisation means maximising the net wealth of a company’s shareholders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance managers as it overcomes the limitations of profit maximisation.

The following arguments are in support of the superiority of wealth maximisation over profit maximisation

· Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements.

· Wealth maximisation considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented.

Let us now look at some of the key definitions:

· Positive net present value can be defined as the excess of present value of cash inflows of any decision implemented over the present value of cash out flows

· Time value factor is known as the time preference rate, that is, the sum of risk free rate and risk premium.

· Risk free rate is the rate that an investor can earn on any government security for the duration under consideration

· Risk premium is the consideration for the risk perceived by the investor in investing in that asset or security.

· Required rate of return is the return that the investors want for making investment in that sector.

1.3.3 Wealth maximisation vs. Profit maximisation

Let us now see how wealth maximisation is superior to profit maximisation.

· Wealth maximisation is based on cash flow. It is not based on the accounting profit.

· Through the process of discounting, wealth maximisation takes care of the quality of cash flows. Distant cash flows are uncertain. Converting distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associated with cash flows. These risks are adequately considered when present values of cash flows are taken to arrive at the net present value of any project.


· Corporates play a key role in today’s competitive business scenario. In an organisation, shareholders typically own the company but the management of the company rests with the board of directors. Directors are elected by shareholders. Company management procures funds for expansion and diversification of capital markets.

In the liberalised set up, the society expects corporates to tap the capital markets effectively for their capital requirements. Therefore, to keep the investors happy throughout the performance of value of shares in the market, management of the company must meet the wealth maximisation criterion.

· When a firm follows wealth maximisation goal, it achieves maximisation of market value of share. A firm can practice wealth maximisation goal only when it produces quality goods at low cost. On this account, society gains because of the societal welfare. Maximisation of wealth demands on the part of corporates to develop new products or render new services in the most effective and efficient manner. This helps the consumers as it brings to the market the products and services that consumer needs.

· Another notable feature of the firms committed to the maximisation of wealth is that to achieve this goal, they are forced to render efficient service to their customers with courtesy. This enhances consumer welfare and benefit to the society.

· From the point of evaluation of performance of listed firms, the most remarkable measure is that of performance of the company in the share market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholders’ wealth maximisation could be considered a superior goal compared to profit maximisation.

· Since listing ensures liquidity to the shares held by the investors, shareholders can reap the benefits arising from the performance of company only when they sell their shares. Therefore, it is clear that maximisation of market value of shares will lead to maximisation of the net wealth of shareholders

Therefore, we can conclude that maximisation of wealth is the appropriate goal of financial management in today’s context.

1.4 Finance Functions

Finance functions deal with the functions performed by the finance manager. They are closely related to financial decisions. In the course of performing these functions, finance manager takes several decisions (see figure1.2):


· Finance decisions

· Investment decisions

· Liquidity decisions

· Dividend decisions

· Organisation of a finance function

Figure 1.2: Finance manager decisions

1.4.1 Finance decisions

Financing decisions relate to the acquisition of funds at the least cost. Cost has two dimensions:

· Explicit Cost

· Implicit cost

Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the security.

Implicit cost is not a visible cost but it may seriously affect the company’s operations especially when it is exposed to business and financial risk

In India, if a company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high degree of business risk.

In all financing decisions, a firm has to determine the proportion of equity and debt. The composition of debt and equity is called the capital structure of the firm.


Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India.

An investor in a company’s shares has two objectives for investing:

· Income from capital appreciation (capital gains on sale of shares at market price)

· Income from dividends

It is the ability of the company to give both these incomes to its shareholders that determines the market price of the company’s shares.

The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market.

Therefore, to declare a dividend of 12%, a company has to earn a pre-tax profit of 19%. On the other hand, to pay an interest of 12%, the company has to earn only 8.4%. This leads to the conclusion that for every Rs.100 procured through debt, it costs 8.4%, whereas the same amount procured in the form of equity (share capital) costs 19 %. This confirms the established theory that equity is costly but debt is a cheap and risky source of funds to the corporate.

Financing decision involves the consideration of managerial control, flexibility and legal aspects and regulatory and managerial elements.

1.4.2 Investment decisions



To survive and grow, all organisations have to be innovative. Innovation demands managerial proactive actions. Proactive organisations continuously search for innovative ways of performing the activities of the organisation. Innovation is wider in nature. It could be:

· expansion through entering into new markets

· adding new products to its product mix

· performing value added activities to enhance customer satisfaction

· adopting new technology that would drastically reduce the cost of production

· rendering services or mass production at low cost or restructuring the organisation to improve productivity

These innovations change the profile of an organisation. These decisions are strategic because they are risky. However, if executed successfully with a clear plan of action, investment decisions generate super normal growth to the organisation.

A firm may become bankrupt, if the management fails to execute the decisions taken. Therefore, such decisions have to be taken after taking into account all the facts affecting the decisions and their execution.

There are two critical issues to be considered in these decisions.

· Evaluation of expected profitability of the new investments.

· Rate of return required on the project.

The Rate of Return required by an investor is normally known as the hurdle rate or the cut-off rate or the opportunity cost of capital.

Investments in buildings and machineries are to be conceived and executed by a firm to enter into any business or to expand its business. The process involved is called Capital Budgeting. Capital Budgeting decisions demand considerable time, attention and energy of the management. They are strategic in nature as the success or failure of an organisation is directly attributable to the execution of Capital Budgeting decisions taken.

Investment decisions are also known as Capital Budgeting Decisions and hence lead to investments in real assets.

1.4.3 Dividend decisions

Dividends are pay-outs to shareholders. Dividends are paid to keep the shareholders happy. Dividend decision is a major decision made by a finance manager. It is based on 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 and on the market value of its 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. In the formulation of dividend policy, the management of a company will have to consider the relevance of its policy on bonus shares.

Dividend policy influences the dividend yield on shares. Dividend yield is an important determinant of an investor’s attitude towards the security (stock) in his portfolio management decisions.

The following issues need adequate consideration in deciding on dividend policy:

· Preferences of share holders – Do they want cash dividend or capital gains?

· Current financial requirements of the company

· Legal constraints on paying dividends

· Striking an optimum balance between desires of share holders and the company’s funds requirements

1.4.4 Liquidity decision

Liquidity decisions deals with Working Capital Management. It is concerned with the day-to-day financial operations that involve current assets and current liabilities.

The important elements of liquidity decisions are:

· Formulation of inventory policy

· Policies on receivable management

· Formulation of cash management strategies

· Policies on utilisation of spontaneous finance effectively

1.4.5 Organisation of finance function

Financial decisions are strategic in character and therefore, an efficient organisational structure is required to administer the same. Finance is like blood that flows throughout the organisation. In all organisations, CFOs play an important role in ensuring proper reporting based on substance of the stake holders of the company. Finance functions are organised directly under the control of board of directors, because of the crucial role these functions play. For the survival of the firm, there is a need to ensure both long term and short term financial solvency.

Weak functional performance by financial department will weaken production, marketing and HR activities of the company. The result would be the organisation becoming anaemic. Once anaemic, unless crucial and effective remedial measures are taken up, it will pave way for corporate bankruptcy. Under the CFO, normally two senior officers manage the treasurer and controller functions.

A Treasurer performs the following functions.

· Obtaining finance

· Liaison with term lending and other financial institutions

· Managing working capital

· Managing investment in real assets

A Controller performs the following functions.

· Accounting and auditing

· Management control systems

· Taxation and insurance

· Budgeting and performance evaluation

· Maintaining assets intact to ensure higher productivity of operating capital employed in the organisation

In India, CFOs have a legal obligation under various regulatory provisions to certify the correctness of various financial statements and information reported to the stake holders in the annual report. Listing norms, regulations on corporate governance and other notifications of Govt. of India have adequately recognised the role of finance function in the corporate set up in India.

1.5 Interface between Finance and other Business Functions

1.5.1 Finance and accounting


From the hierarchy of the finance function of an organisation, the controller reports to the CFO. Accounting is one of the functions that a controller discharges. Accounting and finance are closely related. For computation of Return on Investment, earnings per share and for various ratios of financial analysis, the data base will be accounting information. Without a proper accounting system, an organisation cannot administer the effective function of financial management.

The purpose of accounting is to report the financial performance of the business for the period under consideration. All the financial decisions are futuristic based on cash flow analysis. All the financial decisions consider quality of cash flows as an important element of decisions. Since financial decisions are futuristic, it is taken and put into effect, under conditions of uncertainty. Assuming the condition of uncertainty and incorporating the effect on decision making, results in use of various statistical models. In the

selection of the statistical models, element of subjectivity creeps in.

1.5.2 Finance and marketing

Marketing decisions generally have financial implications. Selections of channels of distribution, deciding on advertisement policy and remunerating the salesmen, have financial implications. In fact, the recent behaviour of rupee against US dollar (appreciation of rupee against US dollar), affected the cash flow positions of export oriented textile units and BPOs and other software companies.

It is generally believed that the currency in which marketing manager invoices the exports, decides the cash flow consequences of the organisation, if and only if the company is mainly dependent on exports. Marketing cost analysis, a function of finance managers, is the best example of application of principles of finance on the performance of marketing functions by a business unit. Formulation of policy on credit management cannot be done unless the integration of marketing with finance is achieved. Deciding on credit terms to achieve a particular level of sales has financial implications because sanctioning liberal credit may result in huge and bad debt. On the other hand, conservative credit terms may depress the sales.

Relation between Inventory and Sales:

Co-ordination of stores administration with that of marketing management is required to ensure customer satisfaction and good will. But investment in inventory requires the financial clearance because funds are locked in and the funds so blocked have opportunity cost of capital.

1.5.3 Finance and production (operations)

Finance and operations management are closely related. Decisions on plant layout, technology selection, productions or operations, process plant size, removing imbalance in the flow of input material in the production or operation process and batch size are all operation management decisions. Their formulation and execution cannot be done unless they are evaluated from the financial angle. The capital budgeting decisions are closely related to production and operation

management. These decisions make or mar a business unit. Failure to understand the implications of the latest technological trend on capacity expansions has cost even blue chip companies.

Many textile units in India became sick because they did not provide sufficient finance for modernisation of plant and machinery. Inventory management is crucial to successful operation management. But management of inventory involves quite a lot of financial variables.

1.5.4 Finance and HR

Attracting and retaining the best man power in the industry cannot be done unless they are paid salary at competitive rates. If an organisation formulates and implements a policy for attracting the competent man power, it has to pay the most competitive salary packages to them. However, by attracting competent man power, capital and productivity of an organisation improves.

1.6 Summary

Financial Management is concerned with the procurement of the least cost funds and its effective utilisation for maximisation of the net wealth of the firm. There exists a close relation between the maximisation of net wealth of shareholders and the maximisation of the net wealth of the company. The broad areas of decision are capital budgeting, financing, dividend and working capital. Dividend decision demands the managerial attention to strike a balance between the investor’s expectation and the organisations’ growth.


1. What are the objectives of financial management?

2. How does a finance manager arrive at an optimal capital structure?

3. Examine the relationship of financial management with other functional areas of a firm.

4. Examine the relationship between finance and accounting.

5. Examine the relationship between finance and marketing.


Answers to Self Assessment Questions


1. Effective utilisation

2. Liberalisation and globalisation of Indian economy

3. Procurement of funds.

4. Profit maximisation.

5. Wealth maximisation

6. Wealth maximisation

7. Investment decisions.

8. Financing decisions

9. Liquidity

10. Treasurers

11. The two critical issues are –

· evaluation of expected profitability of the new investment

· rate of return required on the project

12. Rate of return is normally defined as the hurdle rate or cut-off rate or opportunity cost of the capital

13. Dividend decision

Answers to Terminal Questions

1. Refer 1.3

2. Refer 1.4.1

3. Refer 1.5

4. Refer 1.5.1

5. Refer 1.5.2

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MB0045-Unit-02-Financial Planning Unit-02-Financial Planning

Structure:

2.1 Introduction

Learning Objectives

Objectives of financial planning

Benefits that accrue to a firm out of financial planning

Guidelines for financial planning

2.2 Steps in Financial Planning

Forecast of income statement

Forecast of balance sheet

Computerised financial planning system

2.3 Factors affecting Financial Plan

2.4 Estimation of Financial Requirements of a Firm

2.5 Capitalisation

Cost theory

Earnings theory

Over-capitalisation

Under-capitalisation

2.6 Summary




2.1 Introduction

Liberalisation and globalisation policies initiated by the government have changed the dimension of business environment. Therefore, for survival and growth, a firm has to execute planned strategies systematically. To execute any strategic plan, resources are required. Resources may be manpower, plant and machinery, building, technology or any intangible asset.

To acquire all these assets, financial resources are essentially required. Therefore the finance manager of a company must have both long-range and short-range financial plans. Integration of both these plans is required for the effective utilisation of all the resources of the firm.

The long-range plans must include:

· Funds required for executing the planned course of action

· Funds available at the disposal of the company

· Determination of funds to be procured from outside sources


After studying this unit you should be able to:

· Explain the steps involved in financial planning.

· Explain the factors effecting financial planning.

· List out the cases of over-capitation.

· Explain the effects of under-capitation.

2.1.2 Objectives of financial planning

Let us start with defining financial planning as an essential objective.

Financial 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. Decisions on the composition of debt and equity must be taken.

Financial planning or financial plan indicates:

· The quantum of funds required to execute business plans

· Composition of debt and equity, keeping in view the risk profile of the existing business, new business to be taken up and the dynamics of capital market conditions

· Formulation of policies, giving effect to the financial plans under consideration

2.1.3 Benefits of financial planning

Financial planning also helps firms in the following ways.

· A financial plan is at the core of value creation process. A successful value creation process can effectively meet the bench-marks of investor’s expectations.

· Financial planning ensures effective utilisation of the funds. To manage shortage of funds, planning helps the firms to obtain funds at the right time, in the right quantity and at the least cost as per the requirements of finance emerging opportunities. Surplus is deployed through well planned treasury management. Ultimately, the productivity of assets is enhanced.

· Effective financial planning provides firms the flexibility to change the composition of funds that constitute its capital structure in accordance with the changing conditions of the capital market.

· Financial planning helps in formulation of policies and instituting procedures for elimination of wastages in the process of execution of strategic plans.

· Financial planning helps in reducing the operating capital of a firm. Operating capital refers to the ratio of capital employed to the sales generated. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets will help the firm in reducing its operating capital.

A study of annual reports of Dell computers will throw light on how Dell strategically minimised the operating capital required to support sales. Such companies are admired by investing community.

2.1.4 Guidelines for financial planning

The following are the guidelines of a financial plan:

· Never ignore the coordinal principle that fixed asset requirements be met from the long term sources.

· Make maximum use of spontaneous source of finance to achieve highest productivity of resources.

· Maintain the operating capital intact by providing adequate out of the current periods earnings. Give due attention to the physical capital maintenance or operating capability.

· Never ignore the need for financial capital maintenance in units of constant purchasing power.


· Employ current cost principle wherever required.

· Give due weight age to cost and risk in using debt and equity.

· Keeping the need of finance for expansion of business, formulate plough back policy of earnings.

· Exercise thorough control over overheads.

Seasonal peak requirements to be met from short term borrowings from banks.

2.2 Steps in Financial Planning

There are six steps involved in financial planning which are as shown in figure 2.1

Figure 2.1: Steps in financial planning

· Establish corporate objectives

The first step in financial planning is to establish corporate objectives. Corporate objectives can be grouped into qualitative and quantitative.

For example, a company’s mission statement may specify “create economic – value added.” However this qualitative statement has to be stated in quantitative terms such as a 25 % ROE or a 12 % earnings growth rates. Since business enterprises operate in a dynamic environment, there is a need to formulate both short run and long run objectives.

· Formulate strategies

The next stage in financial planning is to formulate strategies for attaining the defined objectives. Operating plans helps achieve the purpose. Operating plans are framed with a time horizon. It can be a five year plan or a ten year plan.

· Delegate responsibilities

Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management bench-marks, profit targets is to be fixed on respective executives.

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· Forecast financial variables

The next step is to forecast the various financial variables such as sales, assets required, flow of funds and costs to be incurred. These variables are to be translated into financial statements.

Financial statements help the finance manager to monitor the deviations of actual from the forecasts and take effective remedial measures. This ensures that the defined targets are achieved without any overrun of time and cost.

· Develop plans

This step involves developing a detailed plan of funds required for the plan period under various heads of expenditure. From the plan, a forecast of funds that can be obtained from internal as well as external sources during the time horizon is developed. Legal constrains in obtaining funds on the basis of covenants of borrowings is given due weight-age. There is also a need to collaborate the firm’s business risk with risk implications of a particular source of funds. A control mechanism for allocation of funds and their effective use is also developed in this stage.

· Create flexible economic environment

While formulating the plans, certain assumptions are made about the economic environment. The environment, however, keeps changing with the implementation of plans. To manage such situations, there is a need to incorporate an inbuilt mechanism which would scale up or scale down the operations accordingly.

2.2.1 Income Statement

There are three methods of preparing income statement:

· Percent of sales method or constant ratio method

· Expense method

· Combination of both these two

Percent of sales method

This approach is based on the assumptions that each element of cost bears some constant relationship with the sales revenue.


Budgeted expense method

Expenses for the planning period are budgeted on the basis of anticipated behaviour of various items of cost and revenue. This demands effective database for reasonable budgeting of expenses.

Combination of both these methods

The combination of both these methods is used because some expenses can be budgeted by the management taking into account the expected business environment while some other expenses could be based on their relationship with the sales revenue expected to be earned.

2.2.2 Balance sheet

The following steps discuss the forecasting of the balance sheet.

· Compute the sales revenue, having a close relationship with the items of certain assets and liabilities, based on the forecast of sales and the historical database of their relationship

· Determine the equity and debt mix on the basis of funds requirements and the company’s policy on capital structure

2.2.3 Computerised financial planning system

All corporate forecasts use computerised forecasting models. Additional funds required to finance the increase in sales could be ascertained using a mathematical relationship based on the following:

Additional Funds Required = Required Increase in Assets – Spontaneous increase in Liabilities – Increase in Retained Earnings


(This formula has been recommended by Eugene F. Brigham and Michael C. Earnhardt in their book Financial Management – Theory and Practice, 10th edition, published on 31st July 1998)

Prof. Prasanna Chandra, in his book Financial Management,(6th edition- manohar publishers and distributors) has given a comprehensive formula for ascertaining the external financial requirements.

Here

· = Expected increase in assets, both fixed assets and current assets, required for the expected increase in sales in the next year.

· = Expected spontaneous finance available for the expected increase in sales.

· MS1 (1-d) = It is the product of profit margin, expected sales for the next year and the retention ratio.

· Retention ratio = 1 – payout ratio

· Payout ratio refers to the ratio of the dividend paid to the earnings per share.

· D1m = Expected change in the level of investments and miscellaneous expenditure.

· SR = It is the firm’s repayment liability on term loans and debenture for the next year.

The formula described above has certain features:

· Ratios of assets and spontaneous liabilities to sales remain constant over the planning period

· Dividend payout and profit margin for the next year can be reasonably planned in advance

· Since external funds requirements involve borrowings from financial institution, the formula rightly incorporates the management’s liability on repayments




2.3 Factors affecting Finanical Plan

The various other factors affecting financial plan are listed down in figure 2.2

Figure 2.2: Factors affecting financial plan

· Nature of the industry

The very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or labour intensive industry. This will have a major impact on the total assets that a firm owns.

· Size of the company

The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long term sources at competitive terms.




On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates

· Status of the company in the industry

A well established company enjoys a good market share, for its products normally commands investors’ confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment

· Sources of finance available

Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firm’s capability to manage the risk exposure.

· The capital structure of a company

The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders.

· Matching the sources with utilisation

The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed asset – investments are to be financed by long term sources, which is a cardinal principle of financial planning.

· Flexibility

The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalisation of capital market.

· Government policy

SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs (Govt. of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint.

2.4 Estimations of Financial requirements of a Firm

The estimation of capital requirements of a firm involves a complex process. Even with expertise, managements of successful firms could not arrive at the optimum capital composition in terms of the quantum and the sources.

Capital requirements of a firm could be grouped into fixed capital and working capital.

· The long term requirements such as investments in fixed assets will have to be met out of funds obtained on long term basis

· Variable working capital requirements which fluctuate from season to season will have to be financed only by short term sources

Any departure from this well accepted norm causes negative impact on firm’s finances.

2.5 Capitalisation

Capitalisation of a firm refers to the composition of its long term funds and its capital structure. It has two components – 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.

There are two theories of capitalisation for the new companies:

· Cost theory

· Earnings theory

Figure 2.3 displays the two theories.



Figure 2.3: Theories of capitalisation

2.5.1 Cost theory

Under this theory, the total amount of capitalisation for a new company is the sum of:

· Cost of fixed assets

· Cost of establishing the business

· Amount of working capital required

· It helps promoters to estimate the amount of capital required for incorporation of company, conducting market surveys, preparing detailed project report, procuring funds, procuring assets both fixed and current, running a trial production and successfully producing, positioning and marketing its products or rendering of services

· If done systematically, it will lay foundation for successful initiation of the working of the firm

If the firm establishes its production facilities at inflated prices, the productivity of the firm will become less than that of the industry.

Net worth of a company is decided by the investors and 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 (operating capital based on bench marks in that industry), cost theory fails in this respect.

2.5.2 Earnings theory

Earnings are forecasted and capitalised at a rate of return, which actually is the representative of the industry. Earnings theory involves two steps:




· Estimation of the average annual future earnings

· Estimation of the normal earning rate of the industry to which the company belongs

· Earnings theory is superior to cost theory because of its lesser chances of being either under or over capitalisation

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

· The major challenge that a new firm faces is deciding on capitalisation and its division thereof into various procurement sources

· Arriving at the capitalisation rate is equally a formidable task because the investors’ perception of established companies cannot be really unique of what the investors’ perceive from the earning power of the new company

Due to this problem, most of the new companies are forced to adopt the cost theory of capitalisation. Ideally every company should have normal capitalisation, which is a utopian way of thinking.

Changing business environment, role of international forces and dynamics of capital market conditions force us to think in terms of ‘what is optimal today need not to be so tomorrow’.

Even with these constraints, management of every firm should continuously monitor its capital structure to ensure and avoid the bad consequences of over and under capitalisation.

2.5.3 Over-capitalisation

A company is said to be over-capitalised, when its total capital (both equity and debt) exceeds the true value of its assets.

It is wrong to identify over-capitalisation with excess of capital because most of the over-capitalised firms suffer from the problems of liquidity. The correct indicator of over-capitalisation is the earnings capacity of the firm.



If the earnings of the firm are less than that of the market expectation, it will not be in a position to pay dividends to its shareholders as per their expectations. This is a sign of over-capitalisation. It is also possible that a company has more funds than its requirements based on current operation levels and yet have low earnings.

Over-capitalisation may be considered on the account of:

· Acquiring assets at inflated rates

· Acquiring unproductive assets

· High initial cost of establishing the firm

· Companies which establish their new business during boom condition are forced to pay more for acquiring assets, causing a situation of over-capitalisation once the boom conditions subside

· Total funds requirements have been over estimated

· Unpredictable circumstances (like change in import-export policy, change in market rates of interest and changes in international economic and political environment) reduce substantially the earning capacity of the firm. For example, rupee appreciation against US dollar has affected earning capacity of the firms engaged mainly in the export business because they invoice their sales in US dollar

· Inadequate provision of depreciation, adversely effects the earning capacity of the company, leading to over-capitalisation of the firm

· Existence of idle funds

Effects of over-capitalisation

· Decline in earnings of the company

· Fall in dividend rates

· Market value of the company’s share falls, and the company loses investors confidence

· Company may collapse at any time because of anaemic financial conditions which affect its employees, society, consumers and its shareholders. Employees will lose jobs. If the company is engaged in the production and marketing of certain essential goods and services to the society, the collapse of the company will cause social damage

Remedies of over capitalisation

Over-capitalisation often results in a company becoming sick Restructuring the firm helps avoid such a situation. Some of the other remedies of over-capitalisation are:

· 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

2.5.4 Under-capitalisation

Under-capitalisation is just the reverse of over-capitalisation. A company is considered to be under-capitalised when its actual capitalisation is lower than the proper capitalisation as warranted by the earning capacity.

Symptoms of under-capitalisation

The following bullets display the symptoms of under-capitalisation.

· Actual capitalisation is less than the warranted by its earning capacity

· Rate of earnings is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry

Causes of under-capitalisation

The following bullets display the causes of under-capitalisation.

· Under estimation of the future earnings at the time of the promotion of the company

· Abnormal increase in earnings from the new economic and business environments

· Under estimation of total funds requirement

· Maintaining very high efficiency through improved means of production of goods or rendering of services

· Companies which are set-up during the recession period will start making higher earning capacity as soon as the recession is over

· Purchase of assets at exceptionally low prices during recession

Effects of under-capitalisation

The following bullets display some of the effects of under-capitalisation.

· Under-capitalisation encourages competition by creating a feeling that the line of business is lucrative

· It encourages the management of the company to manipulate the company’s share prices

· High profits will attract higher amount of taxes

· High profits will make the workers demand higher wages. Such a feeling on the part of the employees leads to labour unrest

· High margin of profit may create an impression among the consumers that the company is charging high prices for its products

· High margin of profits and the consequent dissatisfaction among its employees and consumer, may invite governmental enquiry into the pricing mechanism of the company

Remedies

The following bullets display the remedies of under-capitalisation.

· Splitting up of the shares, which will reduce the dividend per share

· Issue of bonus shares, which will reduce both the dividend per share and the earnings per share

Both over-capitalisation and under-capitalisation are detrimental to the interests of the society.

2.6 Summary

Financial planning deals with the planning, execution and the monitoring of the procurement and utilisation of the funds. Financial planning process gives birth to financial plan. It could be thought of as a blue-print explaining the proposed strategy and its execution

There are many financial planning models. All these models forecast the future operations and then translate them to income statements and balance sheets. It will also help the finance managers to ascertain the funds to be procured from the outside sources The essence of all these is to achieve a least cost capital structure which would match with the risk exposure of the company


Failure to follow the principle of financial planning may lead a new firm of over or under capitalisation, when the economic environment undergoes a change

Ideally every firm should aim at optimum capitalisation or it might lead to a situation of over or under capitalisation. Both are detrimental to the interests of the society. There are two theories of capitalisation – cost theory and earnings theory.


1. Explain the steps involved in Financial Planning

2. Explain the factors affecting Financial Plan

3. List out the causes of over-capitalisation

4. Explain the effects of under-capitalisation



1. Qualitative, Quantitative

2. Allocation of funds

3. Short term borrowings

4. Nature of the industry

5. Debt, Equity

6. The product policy

7. Flexibility in capital structure, effect changes in the composites of capital structure

8. Fixed capital, working capital

9. Short term sources

10. Capitalisation

11. Cost theory

12. Over-capitalised

13. Under-capitalised


1. Refer to 2.2

2. Refer to 2.3

3. Refer to 2.5.3

4. Refer to 2.5.4



.

MB0045-Unit-03-Time Value of Money Unit-03-Time Value of Money

Structure:

3.1 Introduction

Learning objectives

Rationale

3.2 Future Value

Time preference rate or required rate of return

Compounding technique

Discounting technique

Future value of a single flow

Doubling period

Increased frequency of compounding

Effective vs. Nominal rate of interest

Future value of series of cash flows


Future value of annuity

Sinking fund

3.3 Present Value

Discounting or present value of a single flow

Present values of a series of cash flows

Present values of perpetuity

Present value of an uneven periodic sum

Capital recovery factor

3.4 Summary

3.5 Solved Problems



3.1 Introduction

In the previous unit, you have learnt that wealth maximisation is far more superior to profit maximisation. Wealth maximisation considers time value of money, which translates cash flows occurring at different periods into a comparable value at zero period.

For example, a firm investing in fixed assets will reap the benefits of such investments for a number of years. However, if such assets are procured through bank borrowings or term loans from financial institutions, there is an obligation to pay interest and return of principle.

Decisions, therefore, are made by comparing the cash inflows (benefits/returns) and cash outflows (outlays). Since these two components occur at different time periods, there should be a comparison between the two.

In order to have a logical and a meaningful comparison between cash flows occurring over different intervals of time, it is necessary to convert the amounts to a common point of time. This unit is devoted to a discussion of techniques of doing so.


After studying this unit, you should be able to:

· Explain the time value of money

· Understand the valuation concepts

· Calculate the present and the future values of lump sums and annuity flows

3.1.2 Rationale

“Time value of money” is the value of a unit of money at different time intervals. The value of the money received today is more than its value received at a later date. In other words, the value of money changes over a period of time. Since a rupee received today has more value, rational investors would prefer current receipts over future receipts. That is why, this phenomena is also referred to as “Time preference of money”. Some important factors contributing to this are:

· Investment opportunities

· Preference for consumption

· Risk

These factors remind us of the famous English saying, “A bird in hand is worth two in the bush”. The question now is: why should money have time value?

Some of the reasons are:

· Production

Money can be employed productively to generate real returns. For example, if we spend Rs. 500 on materials, Rs. 300 on labour and Rs. 200 on other expenses and the finished product is sold for Rs. 1100, we can say that the investment of Rs. 1000 has fetched us a return of 10%.

· Inflation

During periods of inflation, a rupee has higher purchasing power than a rupee in the future.

· Risk and uncertainty

We all live under conditions of risk and uncertainty. As the future is characterised by uncertainty, individuals prefer current consumption over future consumption. Most people have subjective preference for present consumption either because of their current preferences or because of inflationary pressures.

3.2 Future Value

3.2.1 Time preference rate or required rate of return

The time preference for money is generally expressed by an interest rate, which remains positive even in the absence of any risk. It is called the risk free rate.

For example, if an individual’s time preference is 8%, it implies that he is willing to forego Rs. 100 today to receive Rs. 108 after a period of one year. Thus he considers Rs. 100 and Rs. 108 as equivalent in value. In reality though this is not the only factor he considers. He requires another rate for compensating him for the amount of risk involved in such an investment. This risk is called the risk premium.

There are two methods by which the time value of money can be calculated:

· Compounding technique

· Discounting technique

3.2.1.1 Compounding technique

In the compounding technique, the future values of all cash inflows at the end of the time horizon at a particular rate of interest are calculated. The amount earned on an initial deposit becomes part of the principal at the end of the first compounding period.

The compounding of interest can be calculated by the following equation:

Where, A = Amount at the end of the period

P = Principle at the end of the year

i = Rate of interest

n = Number of years



3.2.1.2 Discounting technique

In the discounting technique, the present value of the future amount is determined. Time value of the money at time 0 on the time line is calculated. This technique is in contrast to the compounding approach where we convert the present amounts into future amounts.

3.2.2 Future value of a single flow (lump sum)

The process of calculating future value will become very cumbersome if they have to be calculated over long maturity periods of 10 or 20 years. A generalised procedure of calculating the future value of a single cash flow compounded annually is as follows:

Where, FVn = future value of the initial flow in n years hence

PV = initial cash flow




i = annual rate of interest

n = life of investment

The expression represents the future value of the initial investment of Re. 1 at the end of n number of years. The interest rate “i” is referred to as the Future Value Interest Factor (FVIF). To help ease the calculations, the various combinations of “i” and “n” can be referred to in the

table 3.1. To calculate the future value of any investment, the corresponding value of from the table 3.1 is multiplied with the initial investment.

3.2.2.1 Doubling period

A very common question arising in the minds of an investor is “how long will it take for the amount invested to double for a given rate of interest”. There are 2 ways of answering this question.

1. One is called ‘rule of 72’. This rule states that the period within which the amount doubles is obtained by dividing 72 by the rate of interest.

For instance, if the given rate of interest is 10%, the doubling period is 72/10, that is, 7.2 years.

2. A much accurate way of calculating doubling period is the ‘rule of 69’, which is expressed as 0.35+69/interest rate. Going by the same example given above, we get the number of years as 7.25 years {0.35 + 69/10 (0.35 +6.9)}.

3.2.2.2 Increased frequency of compounding

So far we have seen the calculation of the time value of money. It has been assumed that the compounding is done annually.

Let us now see the effect on interest earned when compounding is done more frequently – half-yearly or quarterly




Going by the calculations, we see that one gets more interest if compounding is done on a more frequent basis. The generalised formula for shorter compounding periods is:

Where, FVn = future value after n years

PV = cash flow today

i = nominal interest rate per annum

m = number of times compounding is done during a year

n = number of years for which compounding is done

3.2.2.3 Effective vs. Nominal rate of interest

We have just learnt that interest accumulation by frequent compounding is much more than the annual compounding. This means that the rate of interest given to us, that is 10% is the nominal rate of interest per annum.

If the compounding is done more frequently, say semi-annually, the principal amount grows at 10.25% per annum. 0.25% is known as the “Effective Rate of Interest”. The general relationship between the effective and nominal rates of interest is as follows:





Where,

r = Effective rate of interest

i = Nominal rate of interest

m = Frequency of compounding per year.

3.2.3 Future value of series of cash flows

An investor may be interested in investing money in instalments and wish to know the value of his savings after n years.

Let us understand the calculation of the same with the help of a solved problem.

f

3.2.4 Future value of an annuity

Annuity refers to the periodic flows of equal amounts. These flows can be either termed as receipts or payments.

The future value of a regular annuity for a period of n years at “i” rate of interest can be summed up as under:




Where, FVAn = Accumulation at the end of n years

i = Rate of interest

n = Time horizon or no. of years

A = Amount invested at the end of every year for n years

The expression is called the Future Value Interest Factor for Annuity (FVIFA). This represents the accumulation of Re.1 invested at the end of every year for n number of years at “i” rate of interest. From the tables 3.4 and 3.5, different combinations of “i” and “n” can be calculated. We just have to multiply the relevant value with A and get the accumulation in the formula given above.

We notice that we can get the accumulations at the end of n period using the tables. Calculations for a long time horizon are easily done with the help of reference tables. Annuity tables are widely used in the field of investment banking as ready beckoners.

3.2.5 Sinking fund

Sinking fund is a fund which is created out of fixed payments each period, to accumulate for a future sum after a specified period.





The sinking fund factor is useful in determining the annual amount to be put in a fund, to repay bonds or debentures or to purchase a fixed asset or a property at the end of a specified period.

is called the Sinking Fund Factor.

3.3 Present Value

Given the interest rate, compounding technique can be used to compare the cash flows separated by more than one time period. With this technique, the amount of present cash can be converted into an amount of cash of equivalent value in future.

Likewise, we may be interested in converting the future cash flows into their present values. The “Present Value” (PV) of a future cash flow is the amount of the current cash that is equivalent to the investor. The process of determining present value of a future payment or a series of future payments is known as discounting.

3.3.1 Discounting or present value of a single flow

We can determine the PV of a future cash flow or a stream of future cash flows using the formula:

Where, PV = Present Value

FVn = Amount

i = Interest rate

n = Number of years





3.3.2 Present value of a series of cash flows

In a business scenario, the businessman will receive periodic amounts (annuity) for a certain number of years. An investment done today will fetch him returns spread over a period of time. He would like to know if it is worthwhile to invest a certain sum now in anticipation of returns he expects after a certain number of years. He should therefore equate the anticipated future returns to the present sum he is willing to forego. The PV of a series of cash flows can be represented by the following formula:

The above formula or the equation reduces to:

The expression s known as Present Value Interest Factor Annuity (PVIFA). It represents the PVIFA of Re. 1 for the given values of i and n. The values of PVIFA (i, n) can be found out from the Table 3.6. It should be noted that these values are true only if the cash flows are equal and the flows occur at the end of every year.






3.3.3 Present value of perpetuity

An annuity for an infinite time period is perpetuity. It occurs indefinitely. A person may like to find out the present value of his investment assuming he will receive a constant return year after year. The PV of perpetuity is calculated as:

3.3.4 Present value of an uneven periodic sum

In some investment decisions of a firm, the returns may not be constant. In such cases, the PV is calculated as follows.

Or

PV= A1 PVIF (i, 1) + A2 PVIF (i, 2) + A3 PVIF (i, 3) + A4 PVIF (i, 4) +……………..…. + An PVIF (i, n)






3.3.5 Capital recovery factor

Capital recovery factor is the annuity of an investment for a specified time at a given rate of interest.

The reciprocal of the present value annuity factor is called capital recovery factor.

is known as the Capital Recovery Factor.

3.4 Summary

Money has time preference. A rupee in hand today is more valuable than a rupee a year later. Individuals prefer possession of cash now rather than at a future point of time. Therefore cash flows occurring at different points in time cannot be compared. Interest rate gives money its value and facilitates comparison of cash flows occurring at different periods of time. Compounding and discounting are two methods used to calculate the time value of money.






3.5 Solved Problems


1. If you deposit Rs.10000 today in a bank that offers 8% interest, how many years will the amount take to double?

2. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of each year for 20 years. What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest given by PF authorities is 9%?

3. A person can save _____________ annually to accumulate Rs. 400000 by the end of 10 years, if the saving earns 12%

4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the annuity assuming he can earn interest on his investment at 10% per annum

5. Aparna invests Rs. 5000 at the end of each year at 10% interest p.a. What is the amount she will receive after 4 years?



1. Investment opportunities, preference for consumption, risk

2. Higher purchasing power

3. Current and future

4. Compounding and discounting


5. Sinking fund

6. Present Value

7. Perpetuity

8. Capital Recovery Factor


1. (Hint: Use rule of 72 and 69)

2. 30000*FVIFA (9%, 20Y) = 30000*51.160 = Rs. 1534800

3. A*FVIFA (12%, 10y) = 400000 which is 400000/17.549 = Rs. 22795

4. 20000*PVIFA (105, 5y)=20000*3.791 = Rs. 75820

5000*FVIFA (10%, 4y) = 5000*6.105 = Rs. 23205



.

MB0045-Unit-04-Valuation of Bonds and Shares Unit-04-Valuation of Bonds and Shares

Structure:

4.1 Introduction

Learning objectives

Concept of intrinsic value

Concept of book value

4.2 Valuation of Bonds

Irredeemable or perpetual bonds



Redeemable bonds or bonds with maturity period

Bonds with annual interest payments

Bond values with semi-annual interest payments

Zero coupon bonds

Bond-yield measures

Current yield

Yield to maturity (YTM)

Bond value theorems

4.3 Valuation of Shares

Valuation of preference shares

Valuation of ordinary shares

Types of dividends

Valuation with constant dividends

Valuation with constant growth in dividends

Valuation with variable changing growth in dividends

Price earnings ratio

4.4 Summary

4.5 Solved Problems



4.1 Introduction

Valuation is the process of linking risk with returns to determine the worth of an asset. Assets can be real or financial; securities are called financial assets, physical assets are real assets.

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. This fact should be kept in mind by an investor before he decides to take an investment decision.

Ordinary shares are riskier than bonds or debentures and some shares are more risky than others. The investor would therefore commit funds on a share only if he is convinced about the rate of return being commensurate with risk.

The present unit will help us to know why some securities are priced higher than others. We can design our investment structure by exploiting the variables to maximise our returns.



· Define value in terms of Finance Theory

· Recall the procedure for calculating the value of bonds

· Recognise the mechanics of valuation of equity shares

4.1.2 Concept of intrinsic value

A security can be evaluated by the series of dividends or interest payments receivable over a period of time. In other words, a security can be defined as the present value of the future cash streams. The intrinsic value of an asset is equal to the present value of the benefits associated with intrinsic value. The expected returns (cash inflows) are discounted using the required return commensurate with the risk. Mathematically, intrinsic value can be represented by:

Where V0= value of the asset at time zero (t=0)

Cn= expected cash flow at the end of period n.

i = discount rate or the required rate of return on cash flows

n = expected life of an asset



4.1.3 Concept of Book value

Book value is an accounting concept. Value is what an asset is worth today in terms of their potential benefits. Assets are recorded at historical cost and these are depreciated over years. Book value may include intangible assets at acquisition cost minus amortised value. The book value of a debt is stated at an outstanding amount. Book value of a share is calculated by dividing the net worth by the number of outstanding shares.

Shareholders net worth = Assets – Liabilities

Net worth = Paid-up capital + Reserves + Surplus

The following factors explain the concept of book value more briefly

· Replacement value is the amount a company is required to spend, if it were to replace its existing assets in the present condition. It is difficult to find cost of assets presently used by the company.

· Liquidation value is the amount a company can realise if it sold the assets after winding up its business. It will not include the value of intangibles as the operations of the company will cease to exist. Liquidation value is generally the minimum value a company might accept if it sold its business.

· Going concern value is the amount a company can realise if it sells its business as an operating one. This value is higher than the liquidation value.



· Market value is the current price at which the asset or security is being sold or bought into the market. Market value per share is generally higher than the book value per share for profitable and growing firms

4.2 Valuation of Bonds

Bonds are long term debt instruments issued by government agencies or big corporate houses to raise large sums of money. Bonds issued by government agencies are secured and those issued by private sector companies may be secured or unsecured. The rate of interest on bonds is fixed and they are redeemable after a specific period.

Let us look at some important terms in bond valuation.

· Coupon rate is the specified rate of interest in the bond. 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. Generally, corporate bonds have a maturity period of 7-10 years and government bonds 20-25 years.

· Face value, also known as par value, is the value stated on the face of the bond. It represents the amount that the unit borrows which is to be repaid at the time of maturity, after a certain period of time. A bond is generally issued at values such as Rs. 100 or Rs. 1000.

· Market value 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 may be different from par value and redemption value.

· Redemption value 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.

Types of bonds

Bonds are of three types – Irredeemable bonds, Redeemable bonds and Zero Coupon Bonds. Figure 4.1 illustrates the three types of bonds.



Figure 4.1: Types of Bonds

4.2.1 Irredeemable bonds or perpetual bonds

Bonds which will never mature are known as irredeemable or perpetual bonds. Indian Companies Act restricts the issue of such bonds and therefore these are very rarely issued by corporates these days. In case of these bonds, the terminal value or maturity value does not exist because they are not redeemable. The face value is known; the interest received on such bonds is constant and received at regular intervals and hence, the interest receipt resembles perpetuity. The present value is calculated as:

If a company offers to pay Rs.70 as interest on a bond of Rs.1000 per value, and the current yield is 8%, the value of the bond is 70/0.08 which is equal to Rs. 875.

4.2.2 Redeemable bonds

Redeemable bonds are of two types, one with annual interest payments and the other one with semi-annual interest payments.

4.2.2.1 Bonds with annual interest payments

The holder of a bond receives a fixed annual interest for a specified number of years and a fixed principal repayment at the time of maturity. The intrinsic value or the present value of bond can be expressed as:

V0 or P0=∑nt=1 I/(I+ Kd)n +F/(I+ Kd)n

The above expression can also be stated as:

V0=I*PVIFA(Kd, n) + F*PVIF(Kd, n)

Where V0 = Intrinsic value of the bond

P0 = Present Value of the bond

I = Annual Interest payable on the bond

F = Principal amount (par value) repayable at the maturity time

N = Maturity period of the bond

Kd = required rate of return


This implies that the company is offering the bond at Rs.1000 but its worth is Rs.924.28 at the required rate of return of 10%. The investor should not pay more than Rs.924.28 for the bond today.

4.2.2.2 Bond values with semi-annual interest payments

In reality, it is quite common to pay interest on bonds semi-annually. 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:

V0 or P0=∑nt=1 I/2/(I+Kd/2)n +F/(I+Kd/2)2n

Where V0 = Intrinsic value of the bond

P0 = Present Value of the bond

I/2 = Semi-annual Interest payable on the bond

F = Principal amount (par value) repayable at the maturity time

2n = Maturity period of the bond expressed in half-yearly periods

kd/2 = Required rate of return semi-annually.



It is to be kept in mind that the required rate of return is halved (12%/2) and the period doubled (6y*2) as the interest is paid semi-annually.

4.2.3 Zero coupon bonds

In India Zero coupon bonds are alternatively known as Deep Discount bonds. These bonds became very popular in India, for over a decade, because of issuance of such bonds at regular intervals by IDBI and ICICI.

Zero coupon 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.

They are called Deep Discount bonds because these bonds are long term bonds whose maturity some time extends up to 25 to 30 years. Reading the compound value (FVIF) table, horizontally along the 25 year line, we find ‘r’ equals 8%. Therefore, the bond gives an effective return of 8% per annum.

4.2.4 Bond yield measures

The bond yield measures are categorised into two parts – current yield and the yield to maturity.

4.2.4.1 Current yield

Current yield measures the rate of return earned on a bond if it is purchased at its current market price and the coupon interest received.

4.2.4.2 Yield to maturity (YTM)





Yield to maturity is the rate earned by an investor who purchases a bond and holds it till its maturity.

The YTM is the discount rate equalling the present values of cash flows to the current market price.

An approximation

The trial and error method to obtain the rate of return (Kd) is a very tedious procedure and requires lots of time. The following formula can be used as a ready reference formula.

Where YTM = Yield to Maturity

i = Annual interest payment

f = Face value of the bond

p = Current market price of the bond

n = Number of years to maturity




4.2.5 Bond value theorems

The following factors affect the bond value theorems:

· Relationship between the required rate of interest (Kd) and the discount rate

· Number of years to maturity

· Yield to maturity (YTM)

The relation between the required rate of interest (Kd) and the discount rate are displayed below.

· When Kd is equal to the coupon rate, the intrinsic value of the bond is equal to its face value.

· When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face value.

· When Kd is lesser than the coupon rate, the intrinsic value of the bond is greater than its face value.

Number of years of maturity

· When Kd is greater than the coupon rate, the discount on the bond declines as maturity approaches.



· When Kd is less than the coupon rate, the premium on the bond declines as the maturity increases.

Yield to maturity

Yield to maturity (YTM) determines the market value of the bond. The bond price will fluctuate to the changes in market interest rates. A bond’s price moves inversely proportional to its YTM.

4.3 Valuation of shares

A company’s shares can be categorised into:

· Ordinary or equity shares

· Preference shares

The returns the shareholders get 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.

The following are some important features of preference and equity shares:

· Dividends

Rate 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. They change with an increase or decrease in profits. During years of big profits, the management may declare a high dividend. The dividends are not cumulative for equity shareholders, that is, they cannot be accumulated and distributed in later years. Dividends are not taxable.

· Claims


In 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. Equity shareholders are residual claimants to the company’s income and assets.

· Redemption

Preference shares have a maturity date, on which the company pays off the face value of the shares to the holders. Preference shares can be of two types – redeemable and irredeemable.

Irredeemable preference shares are perpetual. Equity shareholders have no maturity date.

· Conversion

A 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.

4.3.1 Valuation of preference shares

Preference shares like bonds carry a fixed rate of dividend or return. Symbolically, this can be expressed as:

P0= Dp/{1+Kp)n } + Pn/{(1+Kp)n}

or

P0 = Dp*PVIFA (Kp, n) + Pn *PVIF (Kp, n)

Where P0 = Price of the share

Dp = Dividend on preference share

Kp = Required rate of return on preference share

n = Number of years to maturity

4.3.2 Valuation of ordinary shares

People hold common stocks –

· to obtain dividends in a timely manner

· to get a higher amount when sold

Generally, shares are not held in perpetuity. An investor buys the shares, holds them for some time during which he gets dividends and finally sells it off to get capital gains. 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 pay and expect the future definite prospects of the company. Intrinsic value of the share is the economic value of a company considering its characteristics, nature of business and investment environment.

4.3.2.1 Dividend capitalisation model

When a shareholder buys a share, he is actually buying the stream of future dividends. Therefore the value of an ordinary share is determined by capitalising the future dividend stream at an appropriate rate of interest. So under the dividend capitalisation approach, the value of an equity share is the discounted present value of dividends received plus the present value of the resale price expected when the share is disposed. Two assumptions are made to apply this approach:

· Dividends are paid annually.

· First payment of dividend is made after one year from the day that the equity share is bought.

4.3.2.1.1 Single period valuation model

This model holds well when an investor holds an equity share for one year. The price of such a share will be:

Where P0 = current market price of the share

D1 = expected dividend after one year

P1 = expected price of the share after one year

Ke = required rate of return on the equity share

4.3.2.1.2 Multi period valuation model



An equity share can be held at an indefinite period as it has no maturity date, in which case the value of a price at time zero is:

P0 = D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +………..+ D∞/(1+Ke) ∞

Or

P0 = ∑∞t=1 Dn {(1+Ke)n}

Where P0 = Current market price of the share

D1 = expected dividend after one year

P1 = expected price of the share after one year

D∞ = expected dividend at infinite duration

Ke = required rate of return on the equity share.

The above equation can also be modified to find the value of an equity share for a finite period.

P0 = D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +……..+ D∞/(1+Ke) ∞ + Pn/(1+Ke)n

P0=∑∞t=1 Dn/ {(1+Ke)n} + Pn/(1+Ke)n

4.3.3 Types of Dividends

We can come across three types of dividends in companies:

· Constant dividends

· Constant growth of dividends

· Changing growth rates of dividends

4.3.3.1 Valuation with constant dividends

If constant dividends are paid year after year, then

P0=D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +………..+ D∞/(1+Ke)

Simplifying this we get, P=D/Ke

4.3.3.2 Valuation with constant growth in dividends

Here we assume that dividends tend to increase with time as and when businesses grow over time. If the increase in dividend is at a constant compound rate, then

Where, g stands for growth rate.

4.3.3.3 Valuation with changing growth in dividends

Some firms may not have a constant growth rate of dividends indefinitely. There are periods during which the dividends may grow super normally, that is, the growth rate is very high when the demand for the company’s products is very high. After a certain period of time, the growth rate may fall to normal levels when the returns fall due to fall in demand for products (with competition setting in or due to availability of substitutes).

The price of the equity share of such a firm is determined in the following manner:

· Expected dividend flows during periods of supernormal growth is to be considered and present value of this is to be computed with the following equation:

P0=∑∞t=1 Dn/(1+Ke)n

· Value of the share at the end of the initial growth period is calculated as:

Pn=(Dn+1)/ (Ke-gn) (constant growth model)

This is discounted to the present value and we get:

(Dn+1)/ (Ke-gn)*1 / (1+Ke)n

· Add both the present value composites to find the value P0 of the share, that is,

P0=∑∞t=1 Dn/(1+Ke)n + (Dn+1)/(Ke-gn)*1/(1+Ke)n



Other approaches to equity valuation

In addition to the dividend valuation approaches discussed in the previous section, there are other approaches to valuation of shares based on “Ratio Approach”.

Book value approach:

The book value per share (BVPS) is the net worth of the company divided by the number of outstanding equity shares.

Net worth is represented by the total sum of paid up equity shares, reserves and surplus. Alternatively, this can also be calculated as the amount per share on the sale of the assets of the company at their exact book value minus all liabilities including preference shares.

Liquidation value

The liquidation value per share is calculated as:

{(Value realised by liquidating all assets) – (Amount to be paid to all the credit and Preference shares)} divided by number of outstanding shares.

In the above example, if the assets can be liquidated at Rs.450 Cr., the liquidation value per share is (450Cr-350Cr) / 10 lakh shares which is equal to Rs.1000 per share.

4.3.4 Price Earnings Ratio



The price earnings ratio reflects the amount investors are willing to pay for each rupee of earnings.

Expected earnings per share = (Expected PAT) – (Preference dividend) / Number of outstanding shares.

Expected PAT is dependent on a number of factors like sales, gross profit margin, depreciation and interest and tax rate. The price earnings ratio has to consider factors like growth rate, stability of earnings, company size, company management team and dividend pay-out ratio.

Where, 1-b is dividend pay-out ratio

r is required rate of return

ROE*b is expected growth rate

4.4 Summary

Valuation is the process which links the risk and return to establish the asset worth. The value of a bond or a share is the discounted value of all their future cash inflows (interest/dividend) over a period of time. The discount rate is the rate of return which the investors expect from the securities. In case of bonds, the stream of cash flows consists of annual interest payment and repayment of principal (which may take place at par, at a premium or at a discount). The cash flows which occur in each year are a fixed amount.

Cash flows for preference share are also a fixed amount and these shares may be redeemed at par, at a premium or at a discount.

The equity shareholders do not have a fixed rate of return. Their dividend fluctuates with profits. Therefore the risk of holding an equity share is higher than holding a preference share or a bond.

4.5 Solved Problems




1. What should be the price of a bond which has a par value of Rs.1000 carrying a coupon rate of 8% and having a maturity period of 9 years? The required rate of return of the investor is 12%.

2. A bond of Rs. 1000 value carries a coupon rate of 10% and has a maturity period of 6 years. Interest is payable semi-annually. If the required rate of return is 12%, calculate the value of the bond.

3. A bond whose par value is Rs. 500 bearing a coupon rate of 10% and has a maturity of 3 years. The required rate of return is 8%. What should be the price of the bond?

4. If the current year’s dividend is Rs. 24, growth rate of a company is 10% and the required return on the stock is 16%, what is the intrinsic value of the stock?

5. If a stock is purchased for Rs. 120 and held for one year during which time Rs. 15 dividend per share is paid and the price decreases to Rs. 115, what is the nominal return on the share?



1. Liquidation value

2. Market value

3. Government agencies, secured or unsecured

4. Yield to Maturity

5. Greater


6. Intrinsic value

7. Book value per share (BVPS)


1. P = Int*PVIFA (12%, 9y) + Redemption Price*PVIF (12%, 10y)

80*PVIFA (12%, 9) + 1000*PVIF (12%, 9y)

80*5.328 + 1000*0.361

426.24 + 361 = Rs. 787.24

2. 50*PVIFA (6% + 12y) + 1000*PVIF (6% + 12y)

50*8.384 + 1000*0.497

= Rs. 916.2

3. P = Int*PVIFA (8%, 3y) + Redemption Price*PVIF (8%, 3y)

50*2.577 + 500*0.794

397 = Rs. 525.85

4. Intrinsic value = 24 {(1+0.1)} / 0.16-0.1 = Rs. 440

5. Holding period return = (D1 + Price gain/loss) / purchase price

{15 + (-5)} / 120 = 8.33%



.

MB0045-Unit-05-Cost of Capital Unit-05-Cost of Capital

Structure:

5.1 Introduction


Learning objectives

5.2 Design of an Ideal Capital Structure

5.3 Cost of Different Sources of Finance

Cost of debentures

Cost of term loans

Cost of preference capital

Cost of equity capital

Cost of retained earnings

Capital asset pricing model approach

Earnings price ratio approach

5.4 Weighted Average Cost of Capital

Assignment of weights

5.5 Summary

5.6 Solved Problems



5.1 Introduction

Capital structure is the mix of long-term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios.

It is always advisable for companies to plan their capital structure. Decisions taken by not assessing things in a correct manner may jeopardise the very existence of the company. Firms may prosper in the short-run by not indulging in proper planning but ultimately may face problems in future. With unplanned capital structure, they may also fail to economise the use of their funds and adapt to the changing conditions.


After studying this unit, you should be able to,

· Define cost of capital.

· Bring out the importance of cost of capital.

· Explain how to design an ideal capital structure.

· Compute Weighted Average Cost of Capital.

5.2 Design of an Ideal Capital Structure

The design of an ideal capital structure requires five factors to be considered (see in figure 5.1)

Figure 5.1: Design of an ideal capital structure

· Return

The capital structure of a company should be most advantageous. It should generate maximum returns to the shareholders for a considerable period of time and such returns should keep increasing.

· Risk

Debt does increase equity holders’ returns and this can be done till such time that no risk is involved. Use of excessive debt funds may threaten the company’s survival.

· Flexibility

The company should be able to adapt itself to situations warranting changed circumstances with minimum cost and delay.

· Capacity

The capital structure of the company should be within the debt capacity. Debt capacity depends on the ability for funds to be generated. Revenues earned should be sufficient enough to pay creditors’ interests, principal and also to shareholders to some extent.

· Control

An ideal capital structure should involve minimum risk of loss of control to the company. Dilution of control by indulging in excessive debt financing is undesirable.


With the above points on ideal capital structure, raising funds at the appropriate time to finance firm’s investment activities is an important activity of the Finance Manager. Golden opportunities may be lost for delaying decisions to this effect.

A combination of debt and equity is used to fund the activities. What should be the proportion of debt and equity? This depends on the costs associated with raising various sources of funds.

The cost of capital is the minimum rate of return of a company, which must earn to meet the expenses of the various categories of investors who have made investment in the form of loans, debentures and equity and preference shares.

A company now being able to meet these demands may face the risk of investors taking back their investments thus leading to bankruptcy.

Loans and debentures come with a pre-determined interest rate. Preference shares also have a fixed rate of dividend while equity holders expect a minimum return of dividend, based on their risk perception and the company’s past performance in terms of pay-out dividends.

The following graph on risk-return relationship of various securities summarises the above discussion.

Figure 5.2: Risk return relationship

5.3 Cost of Different Sources of Finance

The various sources of finance and their costs are explained in this section.

5.3.1 Cost of debentures

The cost of debenture is the discount rate which equates the net proceeds from issue of debentures to the expected cash outflows.

The expected cash outflows relate to the interest and principal repayments.

Kd =



Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,

T is the corporate tax rate,

F is the redemption price per debenture,

P is the net amount realised per debenture,

n is maturity period.

5.3.2 Cost of Term Loans

Term loans are loans taken from banks or financial institutions for a specified number of years at a pre-determined interest rate. The cost of term loans is equal to the interest rate multiplied by 1-tax rate. The interest is multiplied by 1-tax rate as interest on term loans is also taxed.

Kt = I (1—T)

Where I is interest,

T is tax rate

5.3.3 Cost of Preference Capital

The cost of preference share Kp is the discount rate which equates the proceeds from preference capital issue to the dividend and principal repayments. It is expressed as:

Kp = (D + {(F – P) / n} / ((F + P) / 2)



Where Kp is the cost of preference capital,

D is the preference dividend per share payable,

F is the redemption price,

P is the net proceeds per share,

n is the maturity period.

5.3.4 Cost of Equity Capital

Equity shareholders do not have a fixed rate of return on their investment. There is no legal requirement (unlike in the case of loans or debentures where the rates are governed by the deed) to pay regular dividends to them. Measuring the rate of return to equity holders is a difficult and complex exercise.

There are many approaches for estimating return – the dividend forecast approach, capital asset pricing approach, realised yield approach etc. According to dividend forecast approach, the intrinsic value of an equity share is the sum of present values of dividends associated with it.

Ke = (D1/Pe) + g

This equation is modified from the equation, Pe= {D1/Ke-g}.

Dividends cannot be accurately forecasted as they may sometimes be nil or have a constant growth or sometime have supernormal growth periods.

Is Equity Capital free of cost?

Some people are of the opinion that equity capital is free of cost as a company is not legally bound to pay dividends and also as the rate of equity dividend is not fixed like preference dividends. This is not a correct view as equity shareholders buy shares with the expectation of dividends and capital appreciation. Dividends enhance the market value of shares and therefore equity capital is not free of cost.


5.3.5 Cost of Retained Earnings

A company’s earnings can be reinvested in full to fuel the ever-increasing demand of company’s fund requirements or they may be paid off to equity holders in full or they may be partly held back and invested and partly paid off. These decisions are taken keeping in mind the company’s growth stages.

High growth companies may reinvest the entire earnings to grow more, companies with no growth opportunities return the funds earned to their owners and companies with constant growth invest a little and return the rest. Shareholders of companies with high growth prospects utilising funds for reinvestment activities have to be compensated for parting with their earnings.

Therefore the cost of retained earnings is the same as the cost of shareholders’ expected return from the firm’s ordinary shares. So,

Kr = Ke

5.3.6 Capital Asset Pricing Model Approach

This model establishes a relationship between the required rate of return of a security and its systematic risks expressed as “β”. According to this model,

Ke = Rf + β (Rm — Rf)

Where Ke is the rate of return on share,

Rf is the risk free rate of return,

β is the beta of security,

Rm is return on market portfolio

The CAPM model is based on some assumptions, some of which are:

· Investors are risk-averse.

· Investors make their investment decisions on a single-period horizon.


· Transaction costs are low and therefore can be ignored. This translates to assets being bought and sold in any quantity desired. The only considerations that matter are the price and amount of money at the investor’s disposal.

· All investors agree on the nature of return and risk associated with each investment.

5.3.7 Earnings Price Ratio Approach

Under the case of earnings price ratio approach, the cost of equity can be calculated as:

Ke = E1/P

Where E1 = expected EPS per one year

P = current market price per share

E1 is calculated by multiplying the present EPS with (1 + Growth rate).

Cost of Retained Earnings and Cost of External Equity

As we have just learnt that if retained earnings are reinvested in business for growth activities, the shareholders expect the same amount of returns and therefore

Ke=Kr

However, it should be borne in mind by the policy makers that floating of a new issue and people subscribing to the new issue will involve huge amounts of money towards floating costs which need not be incurred if retained earnings are utilised towards funding activities. From the dividend capitalisation model, the following model can be used for calculating cost of external equity.

Ke = {D1/P0(1—f)} + g

Where, Ke is the cost of external equity,

D1 is the dividend expected at the end of year 1,

P0 is the current market price per share,

g is the constant growth rate of dividends,


f is the floatation costs as a % of current market price

The following formula can be used as an approximation:

K’e = Ke/(1—f)

Where K’e is the cost of external equity,

Ke is the rate of return required by equity holders,

f is the floatation cost.

5.4 Weighted Average Cost of Capital

In the previous section, we have calculated the cost of each component in the overall capital of the company. The term cost of capital refers to the overall composite cost of capital or the weighted average cost of each specific type of fund. The purpose of using weighted average is to consider each component in proportion of their contribution to the total fund available. Use of weighted average is preferable to simple average method for the reason that firms do not procure funds equally from various sources and therefore simple average method is not used. The following steps are involved to calculate the WACC

Step I: Calculate the cost of each specific source of fund, that of debt, equity, preference capital and term loans.

Step II: Determine the weights associated with each source.

Step III: Multiply the cost of each source by the appropriate weights.

Step IV: WACC = We Ke + Wr Kr + Wp Kp + Wd Kd + Wt Kt

Assignment of weights


Weights can be assigned based on any of the following methods

· The book value of the sources of the funds in capital structure

· Present market value of funds in the capital structure and

· Adoption of finance planned for capital budget for the next period

As per the book value approach, weights assigned would be equal to each source’s proportion in the overall funds. The book value method is preferable. The market value approach uses the market values of each source and the disadvantage in this method is that these values change very frequently.




5.5 Summary

Any organisation requires funds to run its business. These funds may be acquired from short-term or long-term sources. Long-term funds are raised from two important sources – capital (owners’ funds) and debt. Each of these two has a cost factor, merits and demerits.

Having excess debt is not desirable as debt-holders attach many conditions which may not be possible for the companies to adhere to. It is therefore desirable to have a combination of both debt and equity which is called the ‘optimum capital structure’. Optimum capital structure refers to the mix of different sources of long term funds in the total capital of the company.

Cost of capital is the minimum required rate of return needed to justify the use of capital. A company obtains resources from various sources – issue of debentures, availing term loans from banks and financial institutions, issue of preference and equity shares or it may even withhold a portion or complete profits earned to be utilised for further activities.





Retained earnings are the only internal source to fund the company’s future plans. Weighted Average Cost of Capital is the overall cost of all sources of finance. The debentures carry a fixed rate of interest. Interest qualifies for tax deduction in determining tax liability. Therefore the effective cost of debt is less than the actual interest payment made by the firm.

The cost of term loan is computed keeping in mind the tax liability. The cost of preference share is similar to debenture interest. Unlike debenture interest, dividends do not qualify for tax deductions.

The calculation of cost of equity is slightly different as the returns to equity are not constant. The cost of retained earnings is the same as the cost of equity funds.

5.6 Solved Problems


1. The following data is available in respect of a company :

Equity Rs.10lakhs,cost of capital 18%

Debt Rs.5lakhs,cost of debt 13%

Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40%

2. Bharat chemicals has the following capital structure as shown in table 5.4

Table 5.4: Capital structure

Rs. 10 face value equity shares Rs. 400000


Term loan @ 13% Rs.1500009% Preference shares of Rs. 100, currently traded at Rs. 95 with 6 years maturity period

Rs. 100000

Total Rs. 650000

The company is expected to declare a dividend of Rs. 5 next year and the growth rate of dividends is expected to be 8%. Equity shares are currently traded at Rs. 27 in the market. Assume tax rate of 50%. What is WACC?

3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is Rs. 60 lakhs. The cost of equity and debt are 15% and 12%. What is the WACC?

4. A company has 3 divisions – X, Y and Z. Each division has a capital structure with debt, preference shares and equity shares in the ratio 3:4:3 respectively. The company is planning to raise debt, preference shares and equity for all the 3 divisions together. Further, it is planning to take a bank loan at the rate of 12% interest. The preference shares have a face value of Rs. 100, dividend at the rate of 12%, 6 years maturity and currently priced at Rs. 88. Calculate the cost of preference shares and debt if taxes applicable are 45%

5. Tanishk Industries issues partially convertible debentures of face value of Rs. 100 each and retains Rs. 96 per share. The debentures are redeemable after 9 years at a premium of 4%, taxes applicable are 40%. What is the cost of debt?



1. Capital structure

2. Maximum returns

3. Debt capacity

4. Minimum risk of loss of control

5. Equity shareholders

6. Present values of dividends


1. Hint: Use the equation

WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt





4. Hint: Apply the formula

5. Hint: Apply the formula



.

MB0045-Unit-06-Leverage Unit-06-Leverage

Structure:

6.1 Introduction

Learning objectives

6.2 Operating Leverage

Application of operating leverage

6.3 Financial Leverage

Uses of financial leverage

6.4 Combined Leverage

Uses of DTL

6.5 Summary




6.6 Solved Problems



6.1 Introduction

A company uses different sources of financing to fund its activities. These sources can be classified as those which carry a fixed rate of return and those whose returns vary. The fixed sources of finance have a bearing on the return on shareholders. Borrowing funds as loans have an impact on the return on shareholders and this is greatly affected by the magnitude of borrowing in the capital structure of a firm.

Leverage is the influence of power to achieve something. The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies how the dependent variable responds to a particular change in independent variable.

There are three types of leverage as shown in the following diagram 6.1 – operating, financial and combined.

Figure 6.1: Types of leverage

Operating leverage is associated with the asset purchase activities, while financial leverage is associated with the financial activities. However, combined leverage is the combination of operating leverage and the financial leverage.



· Explain the meaning of leverage

· Mention the different types of leverage

· Discuss the advantages of leverage

6.2 Operating Leverage


Operating leverage arises due to the presence of fixed operating expenses in the firm’s income flows. A company’s operating costs can be categorised into three main sections as shown in figure 6.2 – fixed costs, variable costs and semi-variable costs.

Figure 6.2: Classification of operating costs

· Fixed costs

Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced.

For example, consider that a firm named XYZ enterprises is planning to start a new business. The main aspects that the firm should concentrate at are salaries to the employees, rents, insurance of the firm and the accountancy costs. All these aspects relate to or are referred to as “fixed costs”.

· Variable costs

Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activities will have a direct effect on such types of costs incurred.

For example, we have discussed about fixed costs in the above context. Now, the firm has to concentrate on some other features like cost of labour, amount of raw material and the administrative expenses. All these features relate to or are referred to as “Variable costs”, as these costs are not fixed and keep changing depending upon the conditions.

· Semi-variable costs

Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firm’s activities.

For example, after considering both the fixed costs and the variable costs, the firm should concentrate on some-other features like production cost and the wages paid to the workers which act at some point of time as fixed costs and can also shift to variable costs. These features relate to or are referred to as “Semi-variable costs”.

The operating leverage is the firm’s ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume.


The illustration clearly tells us that when a firm has fixed operating expenses, an increase in sales results in a more proportionate increase in earnings before interest and taxes (EBIT) and vice versa. The former is a favourable operating leverage and the latter is unfavourable.

Another way of explaining this phenomenon is examining the effect of the degree of operating leverage (DOL). The DOL is a more precise measurement. It examines the effect of the change in the quantity produced on earnings before interest and taxes (EBIT).

DOL = % change in EBIT / % change in output

To put in a different way,

(ΔEBIT/EBIT) / (ΔQ/Q)

EBIT is Q(S—V)—F

Where Q is quantity

S is sales

V is variable cost

F is fixed cost

Substituting this we get,

{Q(S—V)} / {Q(S—V)—F}


As operating leverage can be favourable or unfavourable, high risks are attached to higher degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the operating risks of the company and hence a higher degree of operating leverage. Higher operating risks can be taken when income levels of companies are rising and should not be ventured into when revenues move southwards.

6.2.1 Application of Operating Leverage

The applications of operating leverage are as follows:

· Business risk measurement

· Production planning

Measurement of business risk

Risk refers to the uncertain conditions in which a company performs. A business risk is measured using the degree of operating leverage (DOL) and the formula of DOL is:

DOL = {Q(S–V)} / {Q(S–V)–F}

Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given change in unit sales. A high DOL is a measure of high business risk and vice versa.

Production planning

A change in production method increases or decreases DOL. A firm can change its cost structure by mechanising its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only if the company is confident of achieving a higher amount of sales thereby increasing its earnings.

6.3 Financial Leverage


Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company.

A company’s sources of funds fall under two categories –

· Those which carry a fixed financial charges like debentures, bonds and preference shares and

· Those which do not carry any fixed charges like equity shares

Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firm’s revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.

Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the company’s income stream. Such expenses have nothing to do with the firm’s performance and earnings and should be paid off regardless of the amount of earnings before income and tax (EBIT).

It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders.

A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as “Trading on Equity”.

This example shows that the presence of fixed interest source funds leads to a value more than that occurs due to proportional change in EPS. The presence of such fixed sources implies the presence of financial leverage. This can be expressed in a different way. The degree of financial


leverage (DFL) is a more precise measurement. It examines the effect of the fixed sources of funds on EPS.

DFL=%change in EPS

%change in EBIT

DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}

Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}

I is Interest, Dp is dividend on preference shares, T is tax rate.

6.3.1 Use of Financial Leverage

Studying the degree of financial leverage (DFL) at various levels makes financial decision-making, on the use of fixed sources of funds, for funding activities easy. One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS).



Like operating leverage, the risks are high at high degrees of financial leverage (DFL). High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments.

A firm which is not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances.

On one side the trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firm’s mix of sources of funds.

One main goal of financial planning is to devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up.

Impact of financial leverage

Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities.

Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used.

The company not using debt to finance its assets has a higher DFL compared to that of a company using it. Financial leverage does not exist when there is no fixed charge financing.

6.4 Total or combined leverage

The combination of operating and financial leverage is called combined leverage. Operating leverage affects the firm’s operating profit EBIT and financial leverage affects PAT or the EPS.


These cause wide fluctuations in EPS. A company having a high level of operating or financial leverage will find a drastic change in its EPS even for a small change in sales volume.

Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes in EPS due to leverages is more pronounced. The combined effect is quite significant for the earnings available to ordinary shareholders. Combined leverage is the product of degree of operating leverage (DOL) and degree of financial leverage (DFL).

DTL =



6.4.1 Uses of degree of total leverage (DTL)

· Degree of total leverage (DTL) measures the total risk of the company as DTL is a combined measure of both operating and financial risk

· Degree of total leverage (DTL) measures the variability of EPS




6.5 Summary

Leverage is the use of influence to attain something else. The advantage a company has, with the current status of the leverage can be used to gain other benefits. There are three measures of leverage – operating leverage, financial leverage and total or combined leverage. Operating leverage examines the effect of change in quantity produced upon EBIT and is useful to measure business risk and production planning. Financial leverage measures the effect of change in EBIT on the EPS of the company. It also refers to the debt-equity mix of a firm. Total leverage is the combination of operating and financial leverages.

6.6 Solved Problems


1. Mishra Ltd. provides the information as shown in the table 6.11. What is the degree of operating leverage?

Table 6.18: Details of Mishra Ltd.

Output 25,000 unitsFixed costs Rs.15,000Variable cost per unit Rs. 0.50Interests on borrowed funds Rs.15,000



Selling price per unit Rs. 1.50

2. X Ltd. provides the following information as shown in table 6.19. What is the degree of financial leverage?

Table 6.19: Details of X Ltd.

Output 25,000 unitsFixed costs Rs. 25,000Variable cost Rs. 2.50 per unitInterest on borrowed funds Rs.15,000Selling price Rs. 8 per unit

3. The information available in table 6.20 describes the sales, costs and interests of two firms. Comment on their relative performance through leverage?

Table 6.20: Sales and costs of two firms A and B

A Ltd. (Rs. In lakhs) B Ltd. (Rs. In lakhs)Sales 1000 1500Variable cost 300 600Fixed cost 250 400EBIT 450 500Interest 50 100

4. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL.

Table 6.21: Details of ABC Ltd.

Output 20,000 unitsFixed costs Rs.3,500Variable cost Rs.0.05 per unitInterest on borrowed funds NilSelling price per unit 0.20



1. Operating leverage

2. Q(S—V)—F

3. Income levels

4. Preference shares

5. Trading on Equity

6. Fixed costs, variable costs and semi-variable costs.

7. Operating leverage, financial leverage and combined leverage.


1. Hint DOL =

2. Hint DFL =

3. Hint calculate DFL

4. Hint calculate DFL =



.

MB0045-Unit-07-Capital Structure Unit-07-Capital Structure

Structure:

7.1 Introduction

Learning Objectives

7.2 Features of Ideal Capital Structure

7.3 Factors affecting Capital Structure





7.4 Theories of Capital Structure

Net income approach

Net operating income approach

Traditional approach

Miller and Modigliani approach

Basic proposition

Criticisms of MM proposition

7.5 Summary



7.1 Introduction

The capital structure of a company refers to the mix of long-term finances used by the firm. In short, it is the financing plan of the company. With the objective of maximising the value of the equity shares, the choice should be that pattern of using of debt and equity in a proportion which will lead towards achievement of the firm’s objective. The capital structure should add value to the firm. Financing mix decisions are investment decisions and have no impact on the operating earnings of the firm. Such decisions influence the firm’s value through the earnings available to the shareholders.

The value of a firm is dependent on its expected future earnings and the required rate of return. The objective of any company is to have an ideal mix of permanent sources of funds in a manner that it will maximise the company’s market price. The proper mix of funds is referred to as optimal capital structure. The capital structure decisions include debt-equity mix and dividend decisions. Both these have an effect on the EPS.

7.1.1 Learning Objectives


· Explain the features of ideal capital structure.

· Name the factors affecting the capital structure.

· Mention the various theories of capital structure.

7.2 Features of an Ideal Capital Structure

The features of an ideal capital structure are (see figure 7.1) – profitability, flexibility, control and solvency.

Figure 7.1: Features of an ideal capital structure

Profitability

The firm should make maximum use of leverage at a minimum cost.

Flexibility

An ideal capital structure should be flexible enough to adapt to changing conditions. It should be in a position to raise funds at the shortest possible time and also repay the money it borrowed, if they appear to be expensive.

This is possible only if the company’s lenders have not put forth any conditions like restricting the company from taking further loans, no restrictions placed on the assets usage or laying a restriction on early repayments. In other words, the finance authorities should have the power to take decisions on the basis of the circumstances warrant.

Control

The structure should have minimum dilution of control.

Solvency

Use of excessive debt threatens the very existence of the company. Additional debt involves huge repayments. Loans with high interest rates are to be avoided however attractive some investment proposals look. Some companies resort to issue of equity shares to repay their debt for equity holders do not have a fixed rate of dividend

7.3 Factors affecting Capital Structures

The major factor affecting the capital structure is leverage. There are a few different other factors effecting them also. All the factors are explained briefly here.

Leverage

The use of fixed charges sources of funds such as preference shares, loans from banks and financial institutions and debentures in the capital structure is known as “trading on equity” or


“financial leverage”. Creditors insist on a debt equity ratio of 2:1 for medium sized and large sized companies, while they insist on 3:1 ratio for SSI.

Debt equity ratio is an indicator of the relative contribution of creditors and owners. The debt component includes both long term and short term debt and this is represented as debt/equity. A debt equity ratio of 2:1 indicates that for every 1 unit of equity, the company can raise 2 units of debt. By normal standards, 2:1 is considered as a healthy ratio, but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 5:1 is considered good for a manufacturing company while a ratio of 3:1 is good for heavy engineering companies.

Debt equity ratio is generally perceived as that lower the ratio, higher is the element of uncertainty in the minds of lenders. Increased use of leverage increases commitments of the company, the outflows being in the nature of higher interest and principal repayments, thereby increasing the risk of the equity shareholders.

The other factors to be considered before deciding on an ideal capital structure are:

· Cost of capital – High cost funds should be avoided. However attractive an investment proposition may look like, the profits earned may be eaten away by interest repayments.

· Cash flow projections of the company – Decisions should be taken in the light of cash flows projected for the next 3-5 years. The company officials should not get carried away at the immediate results expected. Consistent lesser profits are any way preferable than high profits in the beginning and not being able to get any after 2 years.

· Dilution of control – The top management should have the flexibility to take appropriate decisions at the right time. The capital structure planned should be one in this direction.

· Floatation costs – A company desiring to increase its capital by way of debt or equity will definitely incur floatation costs. Effectively, the amount of money raised by any issue will be lower than the amount expected because of the presence of floatation costs. Such costs should be compared with the profits and right decisions taken.

7.4 Theories of Capital Structure

As we are aware, equity 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.

A proposal, though not being favourable to lenders, may be taken up if they are convinced with the earning potential and long-term benefits. Many theories have been propounded to understand the relationship between financial leverage and firm value.

Assumptions

The following are some common assumptions made:

· The firm has only two sources of funds – debt and ordinary shares.

· There are no taxes – both corporate and personal

· The firm’s dividend pay-out ratio is 100%, that is, the firm pays off the entire earnings to its equity holders and retained earnings are zero

· The investment decisions of a company are constant, that is, the firm does not invest any further in its assets

· The operating profits EBIT are not expected to increase or decrease

· All investors shall have identical subjective probability distribution of the future expected EBIT

· A firm can change its capital structure at a short notice without the occurrence of transaction costs

· The life of the firm is indefinite

Based on the assumptions regarding the capital structure, we derive the following formulae.

· Debt capital being constant, Kd is the cost of debt which is the discount rate at which the discounted future constant interest payments are equal to the market value of debt, that is, Kd = I/B where, I refers to total interest payments and B is the total market value of debt.

· Therefore value of the debt B = I/Kd

· Cost of equity capital Ke = (D1/P0) + g

where D1 is dividend after one year, P0 is the current market price and g is the expected growth rate.

· Retained earnings being zero, g = br where r is the rate of return on equity shares and b is the retention rate, therefore g is zero. Now we know Ke = E1/P0 + g and g being zero, so Ke = NI/S where NI is the net income to equity holders and S is market value of equity shares.

· The net operating income being constant, overall cost of capital is represented as K0 = W1 K1 + W2 K2.

· That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S is the market value of equity and V is the total market value of the firm and can be given as (B+S). The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1 being the debt component and Ke being the equity component) which can be expressed as

K0 = I + NI/V or EBIT/V

or in other words, net operating income/market value of firm.

7.4.1 Net income approach

Net income approach is suggested by Durand and he is of the view that capital structure decision is relevant to the valuation of the firm. Any change in the financial leverage will have a corresponding change in the overall cost of capital and also the total value of the firm. As the ratio of debt to equity increases, the WACC declines and market value of firm increases. The NI approach is based on 3 assumptions – no taxes, cost of debt less than cost of equity and use of debt does not change the risk perception of investors.

We know that,

K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

The following graphical representation of net income approach may help us understand this better (see figure 7.2).

Figure 7.2: Net income approach



7.4.2 Net operating income approach (NOI)

Net operating income approach is propounded by Durand and is totally opposite of the Net Income Approach. Durand says that any change in leverage will not lead to any change in the total value of the firm, market price of shares and overall cost of capital. The overall capitalisation rate is the same for all degrees of leverage. We know that:

K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

As per the NOI approach the overall capitalisation rate remains constant for all degrees of leverage. The market values the firm as a whole and the split in the capitalisation rates between debt and equity is not very significant.

The increase in the ratio of debt in the capital structure increases the financial risk of equity shareholders and to compensate this, they expect a higher return on their investments. Thus the cost of equity is

Ke = K0 +[ (K0 – Kd)(B/S)]

Cost of debt

The cost of debt has two parts as shown in the figure 7.3

Figure 7.3: Cost of debt



Explicit cost can be considered as the given rate of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can result to a conclusion that the increasing proportion of debt does not affect the financial risk of lenders and they do not charge higher interest.

Implicit cost is nothing but increase in Ke attributable to Kd. Thus the advantage of use of debt is completely neutralised by the implicit cost resulting in Ke and Kd being the same.

Graphical representation of the debts is shown in figure 7.4:

Figure 7.4: Graphical representation of debts



7.4.3 Traditional Approach

The traditional approach has the following propositions:

· Kd remains constant until a certain degree of leverage and there-after 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, K0 decreases till a certain level, remains constant for moderate increases in leverage and rises beyond a certain point

Graphical representation based on the propositions made on the traditional approach is as shown in figure 7.5

Figure 7.5: Propositions of traditional approach

7.4.4 Miller and Modigliani Approach

Miller and Modigliani criticise that the cost of equity remains unaffected by leverage up to a reasonable limit and K0 remains constant at all degrees of leverage. They state that the relationship between leverage and cost of capital is elucidated as in net operating income(NOI) approach.



The assumptions regarding Miller and Modigliani (“MM”) approach are (see figure 7.6): Perfect capital markets, Rational behaviour, Homogeneity, Taxes and Dividend Pay-out.

Figure 7.6: Analysis of Miller and Modigliani approach

· Perfect capital markets: Securities can be freely traded, that is, investors are free to buy and sell securities (both shares and debt instruments), there are no hindrances on the borrowings, no presence of transaction costs, securities are infinitely divisible, availability of all required information at all times.

· Investors behave rationally: They choose the combination of risk and return which is most advantageous to them.

· Homogeneity of investors’ risk perception: 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%: The firms do not retain earnings for future activities.

7.4.4.1 Basic propositions

Three propositions can be derived based on the assumptions made on Miller and Modigliani approach:

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. Therefore, the market value of the firm can be expressed as:

Expected overall capitalisation rate



which is equal to O/K0

which is equal to NOI/K0

Where V is the market value of the firm,

S is the market value of the firm’s equity,

D is the market value of the debt,

O is the net operating income,

K0 is the capitalisation rate of the risk class of the firm

The graphical representation of proposition 1 is as shown in figure 7.7

Figure 7.7: Representation of Proposition 1

The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage mechanism.

Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about equilibrium. This is a balancing act.

Miller and Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in return buy shares of the firm whose value is lower. They will earn the same return at lower outlay and lower perceived risk.

Such behaviours are expected to increase the share prices whose shares are being purchased and lowering the share prices of those share which are being sold. This switching operation will continue till the market prices of identical firms become identical.

Proposition II: The expected yield on equity is equal to discount rate (capitalisation rate) applicable plus a premium.




Proposition III: The average cost of capital is not affected by the financing decisions as investment and financing decisions are independent.

7.4.4.2 Criticisms of MM Proposition

There were kind of many criticisms over MM propositions which are described briefly and shown below in the form of a diagram as figure 7.8

Figure 7.8: Criticisms of MM proposition

Risk perception

The assumptions that risks are similar is wrong. The risk perceptions of investors are personal and corporate leverage is different. The presence of limited liability of firms in contrast to unlimited liability of individuals puts firms and investors on a different footing.

All investors lose if a levered firm becomes bankrupt but an investor loses not only his shares in a company but would also be liable to repay the money he borrowed.

Arbitrage process is one way of reducing risks. It is more risky to create personal leverage and invest in unlevered firm than investing in levered firms.

Convenience

Investors find personal leverage inconvenient. This is so because it is the firm’s responsibility to observe corporate formalities and procedures whereas it is the investor’s responsibility to take care of personal leverage. Investors prefer the former rather than taking on the responsibility and thus the perfect substitutability is subjected to question.

Transaction costs

Another cost that interferes in the system of balancing with arbitrage process is the presence of transaction costs. Due to the 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 to explain the financing decision and firm’s value.



Agency costs

A firm requiring loan approaches creditors and creditors may sometimes impose protective covenants to protect their positions. Such restriction may be in the nature of obtaining prior approval of creditors for further loans, appointment of key persons, restriction on dividend pay-outs, limiting further issue of capital, limiting new investments or expansion schemes etc.

7.5 Summary

According to the NOI approach, overall cost of capital continuously decreases as and when debt goes up in the capital structure. Optimal capital structure exists when the firm borrows maximum.

NOI approach believes that capital structure is not relevant. K0 is dependent business risk which is assumed to be constant.

Traditional approach tells us that K0 decreases with leverage in the beginning, reaches its maximum point and further increases.

Miller and Modigliani Approach also believes that capital structure is not relevant.


1. What are the assumptions of MM approach?

2. The following data, shown under in table 7.5, are available in respect of 2 firms. What is the average cost of capital?

Table 7.5: Data of a company

Firm A Firm BNet operating income Rs.5,00,000 Rs.5,00,000Interest on debt Nil Rs.50,000Equity earnings Rs.5,00,000 Rs.4,50,000


Cost of equity capital 15% 15%Cost of debt Nil 10%Market value of equity shares Rs.20,00,000 Rs.14,00,000Market value of debt Nil Rs.4,00,000Total value of firm Rs.20,00,000 Rs.18,00,000

3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach?

4. The market values of debt and equity of a firm are Rs. 10 Cr. and Rs. 20 Cr. respectively and their respective costs are 12% and 14%. The overall capital is 13.33%. Assuming that the company has a 100% dividend pay-out ratio and there are no taxes, calculate the net operating income of the firm.

5. If a company has equity worth Rs. 300 lakhs, debentures worth Rs. 400 lakhs and term loan worth Rs. 50 lakhs, calculate the WACC.



1. Investment decisions, operating earnings

2. Expected future earnings, required rate of return

3. Equity debt

4. WACC, market value

5. Overall capitalisation rate

6. Arbitrage, equilibrium

7. Risk perception, convenience, transaction costs, taxes and Agency costs.

8. Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about equilibrium. Thus arbitrage process is a balancing act.

9. Profitability, flexibility, control and solvency.

10. Financing, firms’


1. Refer to 6.44

2. Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke



5. WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt

Hint : we =0.4; Wd = 0.533; wt = 0.067



.

MB0045-Unit-08-Capital Budgeting Unit-08-Capital Budgeting

Structure:

8.1 Introduction

Learning objectives

8.2 Importance of Capital Budgeting

8.3 Complexities involved in Capital Budgeting Decisions

8.4 Phases of Capital Expenditure Decisions

8.5 Identification of Investment Opportunities

8.6 Rationale of Capital Budgeting Proposals

8.7 Capital Budgeting Process

Technical appraisal

Economic appraisal


Financial appraisal

8.8 Investment Evaluation

Estimation of cash flows

8.9 Appraisal Criteria

Traditional techniques

Pay back method

Accounting rate of return

Discounted pay-back period

Discounted cash flow period

8.10 Summary



8.1 Introduction

Indian economy is growing at 9% per annum. New lines of business such as retailing investment, investment advisory services and private banking are emerging. All such businesses involve investment decisions. These investment decisions that corporates take are known as capital budgeting decisions. Such decisions help corporates reap the benefits arising out of the emerging business opportunities.

Capital budgeting decisions involve evaluation of specific investment proposals. Here the word “capital” refers to the operating assets used in production of goods or rendering of services. Budgeting involves formulating a plan of the expected cash flows during the future period.

Capital budgeting is a blue-print of planned investments in operating assets. Therefore, capital budgeting is the process of evaluating the profitability of the projects under consideration and deciding on the proposal to be included in the capital budget for implementation.

Capital budgeting decisions involve investment of current funds in anticipation of cash flows occurring over a series of years in future. All these decisions are strategic because they change the profile of the organisations.

Successful organisations have created wealth for their shareholders through capital budgeting decisions. Investment of current funds in long term assets for generation of cash flows in future over a series of years characterises the nature of capital budgeting decisions.

HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over Bank of Madurai. The motive behind all these mergers is to grow because in this era of globalisation the need of the hour is to grow as big as possible. In all these, one could observe the desire of the management to create value for shareholders as a motivating force.

Another way of growing is through branch expansion, expanding the product mix and reducing cost through improved technology for deeper penetration into the market for the company’s products.

Investment of current funds in long-term assets for generation of cash flows in future over a series of years characterises the nature of capital budgeting decisions.



· Explain the concept of capital budgeting.

· Recoil the importance of capital budgeting.

· Examine the complexity of capital budgeting procedures.

· Discuss the various techniques of appraisal methods

· Evaluate capital budgeting decision.

8.2 Importance of Capital Budgeting

Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organisation. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into:

· Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions


· Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution

· Decisions for production of new goods or rendering of new services

· Decisions on penetrating into new geographical area

· Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act

· Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant

The reasons that make the capital budgeting decisions most crucial for finance managers are:

· These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.

- For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes has declined drastically.

The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions.

- Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for share-holders. The best example is the Reliance Group.

- Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness.

- Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors.

· Long time investments of the funds sometimes may change the risk profile of the firm.

· Most of the capital budgeting decisions involve huge outlay. The funds required during the phase of execution must be synchronised with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run.

These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a company’s operation unproductive.

· Capital budgeting decisions involve assessment of market for company’s product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment.

If a firm were to realise after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialised costly equipments. Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are:

- Cost

- quality

- timing

Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken, will strategically affect the firms profitability.

· Liberalisation and globalisation gave birth to economic institutions like world trade organisations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric company. Ability of GE to sell its products in India at a rate less than the rate at which Indian companies sell cannot be ignored.


Therefore, the growth and survival of any firm in today’s business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth.

· The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex.

· Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project.

Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today.

8.3 Complexities involved in Capital Budgeting Decisions

Capital expenditure decision involves forecasting of future operating cash flows. Forecasting the future cash flows demands certain assumptions about the behaviour of costs and revenues in future.

However, there are complexities involved in capital budgeting decisions They are:

· Estimation of future cash flows

· Commitment of funds on long-term basis

· Problem of irreversibility of decisions




8.4 Phases of Capital Expenditure Decisions

There are various phases involved in capital budgeting decisions.

· Identification of investment opportunities.

· Evaluation of each investment proposal

· Examination of the investments required for each investment proposal

· Preparation of the statements of costs and benefits of investment proposals

· Estimation and comparison of the net present values of the investment proposals that have been cleared by the management on the basis of screening criteria

· Examination of the government policies and regulatory guidelines, for execution of each investment proposal screened and cleared based on the criteria stipulated by the management

· Budgeting for capital expenditure for approval by the management

· Implementation

· Post-completion audit

8.5 Identification of Investment Opportunities

A firm is in a position to identify investment proposal only when it is responsive to the ideas of capital projects emerging from various levels of the organisation. The proposal may be to:

· Add new products to the company’s product line,

· Expand capacity to meet the emerging market at demand for company’s products

· Add new technology based process of manufacture that will reduce the cost of production.


Therefore, generation of ideas with the feasibility to convert the same into investment proposals occupies a crucial place in the capital budgeting decisions. Proactive organisations encourage a continuous flow of investment proposals from all levels in the organisation.

In this connection following points deserve to be considered:

· Analysing the demand and supply conditions of the market for the company’s product could be a fertile source of potential investment proposals.

· Market surveys on customer’s perception of company’s product could be a potential investment proposal to redefine the company’s products in terms of customer’s expectations.

· Companies which invest in Research and Development constantly get exposure to the benefit of adapting the new technology quite relevant to keep the firm competitive in the most dynamic business environment. Reports emerging from R & D section could be a potential source of investment proposal.

· Economic growth of the country and the emerging middle class endowed with purchasing power could generate new business opportunities in existing firms. These new business opportunities could be potential investment ideas.

· Public awareness of their rights compels many firms to initiate projects from environmental protection angle. If ignored, the firm may have to face the public wrath through PILs entertained at the Supreme Court and High courts.

Therefore project ideas that would improve the competitiveness of the firm by constantly improving the production process with the sole objective of cost reduction and customer welfare, are accepted by well managed firms.

8.6 Rationale of Capital Budgeting Proposals



The investors and the stake-holders expect a firm to function efficiently to satisfy their expectations. The stake-holders’ expectation and the performance of the company may clash among themselves, the one that touches all these stake-holders’ expectation could be visualised in terms of firm’s obligation to reduce the operating costs on a continuous basis and increasing its revenues.

Therefore, capital budgeting decisions could be grouped into two categories:

· Decisions on cost reduction programmes

· Decisions on revenue generation through expansion of installed capacity

8.7 Capital Budgeting Process

Once the screening of proposals for potential involvement is over, the company should take up the following aspects of capital budgeting process:

· A proposal should be commercially viable. The following aspects are examined to ascertain the commercial viability of any investment proposal

- Market for the product

- Availability of raw materials

- Sources of raw materials

- The elements that influence the location of a plant i.e. the factors to be considered in the site selection

· Infrastructural facilities such as roads, communication facilities, financial services such as banking and public transport services

Ascertaining the demand for the product or services is crucial. It is done by market appraisal. In appraisal of market for the new product, the following details are compiled and analysed.

· Consumption trends

· Competition and players in the market

· Availability of substitutes

· Purchasing power of consumers


· Regulations stipulated by Government on pricing the proposed products or services

· Production constraints

Relevant forecasting technologies are employed to get a realistic picture of the potential demand for the proposed product or service. Many projects fail to achieve the planned targets on profitability and cash flows if the firm could not succeed in forecasting the demand for the product on a realistic basis. Capital budgeting process involves three steps (see figure 8.1) – Financial appraisal, Technical appraisal and Economic appraisal.

Figure 8.1: Capital budgeting process

8.7.1 Technical appraisal

Technical appraisal ensures implementation of all the technical aspects of the project. The technical aspects of the project are:

· Selection of process know-how

· Decision on determination of plant capacity

· Selection of plant, equipment and scale of operation

· Plant design and layout

· General layout and material flow

· Construction schedule

8.7.2 Economic appraisal

Economic appraisal examines the project from the social point of view. Hence, is referred to as social cost benefit analysis. It examines:

· The impact of the project on the environment

· The impact of the project on the income distribution in the society

· The impact of the project on fulfilment of certain social objective like generation of employment and attainment of self sufficiency


· Will the project materially alter the level of savings and investment in the society?

8.7.3 Financial appraisal

Financial appraisal is to examine the financial viability of the project. Under this appraisal, the risk and returns at various stages of project execution are assessed. Besides, it examines whether the risk adjusted return from the project exceeds the cost of financing the project. Financial appraisal technique examines:

· Cost of the project

· Investment outlay

· Means of financing and the cost of capital

· Expected profitability

· Expected incremental cash flows from the project

· Break-even point

· Cash break-even point

· Risk dimensions of the project

· Will the project materially alter the risk profile of the company ?

· If the project is financed by debt, expected “Debt Service Coverage Ratio”

· Tax holiday benefits, if any.

8.8 Investment Evaluation

Steps involved in the evaluation of any investment proposal are:

· Estimation of cash flows both inflows and outflows occurring at different stages of project life cycle

· Examination of the risk profile of the project to be taken up and arriving at the required rate of return

· Formulation of the decision criteria

8.8.1 Estimation of cash flows

Estimating the cash flows associated with the project under consideration is the most difficult and crucial step in the evaluation of an investment proposal. Estimation is the result of the team work of many professionals in an organisation.

· Capital outlays are estimated by engineering departments after examining all aspects of production process

· Marketing department on the basis of market survey forecasts the expected sales revenue during the period of accrual of benefits from project executions

· Operating costs are estimated by cost accountants and production engineers

· Incremental cash flows and cash out flow statement is prepared by the cost accountant on the basis of the details generated in the above steps

The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the success of the implementation of any capital expenditure decision.

8.8.2 Estimation of incremental cash flows

Investment (capital budgeting) decision requires the estimation of incremental cash flow stream over the life of the investment. Incremental cash flows are estimated on tax basis.

Incremental cash flows stream of a capital expenditure decision has three components.

· Initial cash outlay (Initial investment)

Initial cash outlay to be incurred is determined after considering any post tax cash inflows. In replacement decisions existing old machinery is disposed of and a new machinery incorporating the latest technology is installed in its place.

On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis. The net cash out flow (total cash required for investment in capital assets minus post tax cash inflow on disposal of the old machinery being replaced by a new one) therefore is the incremental cash outflow. Additional net working capital required on implementation of new project is to be added to initial investment.

· Operating cash inflows

Operating cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here also incremental inflows and outflows attributable to operating activities are considered. Any savings in cost on installation of a new machinery in the place of the old machinery will have to be accounted on post tax basis. In this connection incremental cash flows refer to the change in cash flows on implementation of a new proposal over the existing positions.

· Terminal cash inflows

At the end of the economic life of the project, the operating assets installed will be disposed off. It is normally known as salvage value of equipments. This terminal cash inflows are computed on post tax basis.

Prof. Prasanna Chandra in his book Financial Management (Tata McGraw Hill, published in 2007) has identified certain basic principles of cash flow estimation. The knowledge of these principles will help a student in understanding the basics of computing incremental cash flows.

The basic principles of cash flow estimation, by Prof. Prasanna Chandra, are (see figure 8.2) – Separation principle, Increment principle, Post-tax principle and Consistency principle.

Figure 8.2: Principles of Prof. Prasanna Chandra

Separation principle

The essence of this principle is the necessity to treat investment element of the project separately (i.e. independently) from that of financing element. The financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of return expected on implementation of the project. Therefore, we compute separately cost of funds for execution of project through the financing mode. The rate of return expected on implementation if the project is arrived at by the investment profile of the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows.

The following formula is used to calculate profit after tax

EBIT = earnings (profit) before interest and taxes

t = tax rate

Incremental principle

Incremental principle says that the cash flows of a project are to be considered in incremental terms. Incremental cash flows are the changes in the firms total cash flows arising directly from the implementation of the project. Keep the following in mind while determining incremental cash flows.

· Ignore sunk costs



Sunk costs are costs that cannot be recovered once they have been incurred. Therefore, sunk costs are ignored when the decisions on project under consideration is to be taken.

· Opportunity costs

If the firm already owns an asset or a resource which could be used in the execution of the project under consideration, the asset or resource has an opportunity cost. The opportunity cost of such resources will have to be taken into account in the evaluation of the project for acceptance or rejection.

· Need to take into account all incident effect

Effects of a project on the working of other parts of a firm also known as externalities must be taken into account.

· Cannibalisation

Another problem that a firm faces on introduction of a new product is the reduction in the sale of an existing product. This is called cannibalisation. The most challenging task is the handling the problems of cannibalisation. Depending on the company’s position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored.

Depending on the company’s position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored. Product cannibalisation will affect the company’s sales if the firm is marketing its products in a market characterised by severe competition, without any entry barriers. In this case costs are not relevant for decision.

However, if the firm’s sales are not affected by competitor’s activities due to certain unique protection that it enjoys on account of brand positioning or patent protection, the costs of cannibalisation cannot be ignored in taking decisions.

Post tax principle



All cash flows should be computed on post tax basis

Consistency principle

Cash flows and discount rates used in project evaluation need to be consistent with the investor group and inflation.




8.9 Appraisal Criteria

The methods of appraising an investment proposal can be grouped into

1. Traditional methods.

2. Modern methods.

· Traditional methods are:

- Payback method

- Accounting rate of return

· Modern techniques are:

- Net present value

- Internal rate of return

- Modified internal rate of return

- Profitability index

8.9.1 Traditional techniques

Traditional methods are of two types – payback method and accounting rate of return.

8.9.1.1 Payback method

Payback period is defined as the length of time required to recover the initial cash out lay.


8.9.1.1.1 Evaluation of payback period:

Simple in concept and application Emphasis is on recovery of initial cash outlay. Pay-back period is the best method for

evaluation of projects with very high uncertainty

With respect to accept or reject criterion, pay back method favours a project which is less than or equal to the standard pay back set by the management. In this process early cash flows get due recognition than later cash flows. Therefore, pay-back period could be used as a tool to deal with the ranking of projects on the basis of risk criterion

For firms with short-age funds this is preferred because it measures liquidity of the project

Pay-back period ignores time value of money. It does not consider the cash flows that occur after the pay-back period.





It does not measure the profitability of the project.

It does not throw any light on the firm’s liquidity position but just tells about the ability of the project to return the cash out lay originally made.

Project selected on the basis of pay back criterion may be in conflict with the wealth maximisation goal of the firm.

Accept or reject criteria

· If projects are mutually exclusive, select the project which has the least pay-back period

· In respect of other projects, select the project which have pay-back period less than or equal to the standard pay back stipulated by the management

Illustration

· Pay-back period:

Project A = 3 years

Project B = 2.5 years

· Standard set up by management = 3 years

· If projects are mutually exclusive, accept project B which has the least pay-back period.

· If projects are not mutually exclusive, accept both the projects because both have pay-back period less than or equal to the standard pay-back period set by the management

Pay-back formula

8.9.1.2 Accounting rate of return

Accounting rate of return (ARR) measures the profitability of investment (project) using information taken from financial statements:

ARR = Average income / Average investment

ARR = Average of post tax operating profit / Average investment


Solved Problem

The following particulars shown in table 8.7 refers to two projects:

Table 8.7: Particulars of two projects

X YCost 40,000- 60,000Estimated life 5 years 5 yearsSalvage value Rs. 3,000 Rs. 3,000

Estimate income

Table 8.8: After tax

Rs. Rs.1 3,000 10,0002 4,000 8,0003 7,000 2,0004 6,000 6,0005 8,000 5,000Total 28,000 31,000

· It is based on accounting information

Simple to understand It considers the profits of entire economic life of the project

Since it is based on accounting information, the business executives familiar with the accounting information understand it




ARR is based on accounting income not on cash flows, as the cash flow approach is considered superior to accounting information based approach

ARR does not consider the time value of money

Different investment proposals which require different amounts of investment may have the same accounting rate of return. The ARR fails to differentiate projects on the basis of the amount required for investment

ARR is based on the investment required for the project. There are many approaches for the calculation of denominator of average investment. Existence of more than one basis for arriving at the denominator of average investment may result in adoption of many arbitrary bases

Due to this the reliability of ARR as a technique of appraisal is reduced when two projects with the same ARR but with differing investment amounts are to be evaluated.


· In any project which has an excess ARR, the minimum rate fixed by the management is accepted.

· If actual ARR is less than the cut-off rate (minimum rate specified by the management ) then that project is rejected.

· When projects are to be ranked for deciding on the allocation of capital on account of the need for capital rationing, project with higher ARR are preferred to the ones with lower ARR.

8.9.2 Discounted pay-back period

The length in years required to recover the initial cash out lay on the present value basis is called the discounted pay-back period. The opportunity cost of capital is used for calculating present values of the cash inflows. Discounted pay-back period for a project will be always higher than simple pay-back period because the calculation of discounted pay-back period is based on discounted cash flows.


8.9.3 Discounted cash flow method

Discounted cash flow method or time adjusted technique is an improvement over the traditional techniques. In evaluation of the projects the need to give weight-age to the timing of return is effectively considered in all DCF methods. DCF methods are cash flow based and take the cognisance of both the interest factors and cash flow after the pay-back period.

DCF technique involves:

· Estimation of cash flows, both inflows and outflows of a project over the entire life of the project

· Discounting the cash flows by an appropriate interest factor (discount factor)

· Deducting the sum of the present value of cash outflows from the sum of present value of cash inflows to arrive at net present value of cash flows

The most popular techniques of DCF methods are:

· The net present value

· The internal rate of return

· Profitability index

Net present value

Net present value (NPV) method recognises the time value of money. It correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is the need to find out the present values of all cash flows. NPV method is the most widely used technique among the DCF methods.

Steps involved in NPV method involve:

· Forecasting the cash flows, both inflows and outflows of the projects to be taken up for execution


· Decisions on discount factor or interest factor. The appropriate discount rate is the firm’s cost of capital or required rate of return expected by the investors

· Computation of the present value of cash inflows and outflows using the discount factor selected

· Calculation of NPV by subtracting the PV of cash outflows from the present value of cash inflows.


If NPV is positive, the project should be accepted. If NPV is negative the project should be rejected.

Accept or reject criterion can be summarised as given below:

· NPV > Zero = accept

· NPV < Zero = reject

NPV method can be used to select between mutually exclusive projects by examining whether incremental investment generates a positive net present value.

It takes into account the time value of money. It considers cash flows occurring over the entire life of the project.

NPV method is consistent with the goal of maximising the net wealth of the company.

It analyses the merits of relative capital investments.

Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project generates profits from the investment made for it.

· Forecasting of cash flows is difficult as it involves dealing with the effect of elements of uncertainties on operating activities of the firm.

· To decide on the discounting factor, there is the need to assess the investor’s required rate of return. But it is not possible to compute the discount rate precisely.



· There are practical problems associated with the evaluation of projects with unequal lives or under funds’ constraints

For ranking of projects under NPV approach, the project with the highest positive NPV is preferred to that with a lower NPV.




Properties of the NPV

· NPVs are additive. If two projects A and B have NPV (A) and NPV (B) then by additive rule the net present value of the combined investment is NPV (A + B)

· Intermediate cash inflows are reinvested at a rate of return equal to the cost of capital.

Internal rate of return (IRR)

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the NPV of any project equal to zero. IRR is the rate of interest which equates the PV of cash inflows with the PV of cash outflows.

IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns.

IRR takes into account the time value of money IRR calculates the rate of return of the project, taking into account the cash flows over

the entire life of the project.

It gives a rate of return that reflects the profitability of the project.

It is consistent with the goal of financial management i.e. maximisation of net wealth of share holders

IRR can be compared with the firm’s cost of capital.

To calculate the NPV the discount rate normally used is cost of capital. But to calculate IRR, there is no need to calculate and employ the cost of capital for discounting because the project is evaluated at the rate of return generated by the project. The rate of return is internal to the project.

IRR does not satisfy the additive principle. Multiple rate of returns or absence of a unique rate of return in certain projects will affect

the utility of this technique as a tool of decision making in project evaluation.

In project evaluation, the projects with the highest IRR are given preference to the ones with low internal rates.



· Application of this criterion to mutually exclusive projects may lead under certain situations to acceptance of projects of low profitability at the cost of high profitability projects.

IRR computation is quite tedious.


If the project’s internal rate of return is greater than the firm’s cost of capital, accept the proposal, otherwise reject the proposal.

IRR can be determined by solving the following equation for

Sum of the present values of cash inflows at the rate of interest of r :-

where t = 1 to n

Modified Internal Rate of Return (MIRR)

Modified internal rate of return (MIRR) is a distinct improvement over the IRR. Managers find IRR intuitively more appealing than the rupees of NPV because IRR is expressed on a percentage rate of return. MIRR modifies IRR. MIRR is a better indicator of relative profitability of the projects. MIRR is defined as

PV of Costs = PV of terminal value




PVC = PV of costs

To calculate PVC, the discount rate used is the cost of capital. To calculate the terminal value, the future value factor is based on the cost of capital

MIRR is obtained on solving the following equation.

Superiority of MIRR over IRR

· MIRR assumes that cash flows from the project are reinvested at the cost of capital. The IRR assumes that the cash flows from the project are reinvested at the projects own IRR. Since reinvestment at the cost of capital is considered realistic and correct, the MIRR measures the project’s true profitability

· MIRR does not have the problem of multiple rates which we come across in IRR

Profitability Index

Profitability index is also known as benefit cost ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows.






· Accept the project if PI is greater than 1

· Reject the project if PI is less than 1

If profitability index is 1 then the management may accept the project because the sum of the present value of cash inflows is equal to the sum of present value of cash outflows. It neither adds nor reduces the existing wealth of the company.

It takes into account the time value of money It is consistent with the principle of maximisation of share holders wealth

It measures the relative profitability

· Estimation of cash flows and discount rate cannot be done accurately with certainty

· A conflict may arise between NPV and profitability index if a choice between mutually exclusive projects has to be made.





8.10 Summary

Capital investment proposals involve current outlay of funds in the expectation of a stream of cash inflow in future. Various techniques are available for evaluating investment projects. They are grouped into traditional and modern techniques. The major traditional techniques are payback period and accounting rate of return.

The important discounting criteria are net present value, internal rate of return and profitability index. A major deficiency of payback period is that it does not take into account the time value of money. DCF techniques overcome this limitation. Each method has both positive and negative aspects. The most popular method for large project is the internal rate of return. Payback period and accounting rate of return are popular for evaluating small projects.


1. Examine the importance of capital budgeting.

2. Briefly examine the significance of identification of investment opportunities in capital budgeting process.

3. Critically examine the pay-back period as a technique of approval of projects.

4. Summarise the features of DCF techniques.



1. Capital budgeting


3. Highly complex

4. Capital budgeting decisions

5. Irreversible

6. Uncertainty, highly uncertain.

7. Final step

8. First step

9. A fertile source

10. The most crucial phase


12. Cost reduction

13. Economic appraisal

14. Technical appraisal

15. Financial viability

16. Demand for the product or service.

17. Decision criteria

18. Sunk cost

19. Externalities

20. Investment element; Financing element

21. Ignores

22. Profitability of


1. Refer to 8.2

2. Refer to 8.5

3. Refer to 8.8.1

4. Refer to 8.8.2



.

MB0045-Unit-09-Risk Analysis in Capital Budgeting



Unit-09-Risk Analysis in Capital Budgeting

Structure:

9.1 Introduction

Learning objectives

9.2 Types and Sources of Risk in Capital Budgeting

Sources of risk

Conventional techniques

9.3 Risk Adjusted Discount Rate

Evaluation of risk adjusted discount rate

9.4 Certainty Equivalent

Evaluation of certainty equivalent

9.5 Sensitivity Analysis

9.6 Probability Distribution Approach

Variance

9.7 Decision Tree Approach

Evaluation of decision tree approach

9.8 Summary



9.1 Introduction

Capital budgeting decisions typically involve forecasting the future operating cash flows. Forecasting involves making certain assumptions about the future behaviour of costs and revenues.

Such forecasting, however, suffers from uncertainty because the future is highly uncertain. Assumptions made about the future behaviour of costs and revenues may change and can significantly alter the fortunes of a company. The process is thereby inherently risky.

Analysing the risks to reduce the element of uncertainty has therefore become an essential aspect of today’s corporate project management. This unit will help you understand the various types of risks involved in capital budgeting decisions. In this unit, you will study how sensitivity analysis is used to determine the most critical uncertainties in the estimation. You will also study the pitfalls of using uncertain single-point estimates for the cash flows associated with the project.

This unit will help the capital budget decision-makers to avoid costly mistakes.



· Define risk in capital budgeting

· Examine the importance of risk analysis in capital budgeting

· Determine the methods of incorporating the risk factor in capital budgeting decision

· Understand the types and sources of risk in capital budgeting decision

9.1.2 Definition of Risk

Before we start to discuss about risk analysis in capital budgeting, let us first understand what risk in capital budgeting means.

Risk in capital budgeting may be defined as the variation of actual cash flows from the expected cash flows.

Every business decision involves risk. Risk exists on account of the inability of a firm to make perfect forecasts of cash flows. The inability can be attributed to factors that affect forecasts of investment, cost and revenue. Some of these are as follows:

· The business is affected by changes in political situations, monetary policies, taxation, interest rates and policies of the central bank of the country on lending by banks

· Industry specific factors influence the demand for the products of the industry to which the firm belongs

· Company specific factors like change in management, wage negotiations with the workers, strikes or lockouts affect company’s cost and revenue positions

Let us see a case explaining why making a perfect forecast of cash flows is difficult.

9.2 Types and Sources of Risk in Capital Budgeting

Having understood what risk in capital budgeting means, let us now understand the types of risk and their sources.

Capital budgeting involves four types of risks in a project – stand-alone risk, portfolio risk, market risk and corporate risk (see figure 9.1)

Figure 9.1: Types of risks

Stand-alone risk

Stand alone risk of a project is considered when the project is in isolation. Stand-alone risk is measured by the variability of expected returns of the project.

Portfolio risk

A firm can be viewed as portfolio of projects having a certain degree of risk. When new project is added to the existing portfolio of project, the risk profile of the firm will alter. The degree of the change in the risk depends on:

· The co-variance of return from the new project

· The return from the existing portfolio of the projects

If the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be further diversified.



Market risk

Market risk is defined as the measure of the unpredictability of a given stock value. However, market risk is also referred to as systematic risk. The market risk has a direct influence on stock prices. Market risk is measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to estimate.

Corporate risk

Corporate risk focuses on the analysis of the risk that might influence the project in terms of entire cash flow of the firms. Corporate risk is the projects risks of the firm.

9.2.1 Sources of risk

The five different sources of risk are:

· Project – specific risk

· Competitive or Competition risk

· Industry – specific risk

· International risk

· Market risk

Project-specific risk

Project-specific risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash flows realised being less than the projected.

Competitive or Competition risk

Unanticipated actions of a firm’s competitors will materially affect the cash flows expected from a project. As a result of this, the actual cash flows from a project will be less than that of the forecast.

Industry-specific risk

Industry-specific risks are those that affect all the industrial firms. Industry-specific risk could be again grouped into technological risk, commodity risk and legal risk. All these risks will affect the earnings and cash flows of the project.

· Technological risk

The changes in technology affect all the firms not capable of adapting themselves in emerging into a new technology.

· Commodity risk

Commodity risk is the risk arising from the effect of price-changes on goods produced and marketed.

· Legal risk

Legal risk arises from changes in laws and regulations applicable to the industry to which the firm belongs.

International risk

These types of risks are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets.

Let us now look at the firms facing such kind of risk:

· The rupee-dollar crisis affected the software and BPOs because it drastically reduced their profitability.

· Another example is that of the textile units in Tirupur in Tamil Nadu, which exports the major part of the garments produced. Rupee gaining and dollar weakening reduced their competitiveness in the global markets.

· The surging Crude oil prices coupled with the governments delay in taking decision on pricing of petro products, eroded the profitability of oil marketing companies in public sector like Hindustan Petroleum Corporation Limited.

· Another example is the impact of US sub-prime crisis on certain segments of Indian economy.

The changes in international political scenario also affected the operations of certain firms.



Market risk

Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and all industries. Firms cannot diversify this risk in the normal course of business.

There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology as far as incorporation of risk in the evaluation process is concerned.

9.2.2 Techniques for incorporation of risk factor in capital budgeting

The techniques for incorporation of risk factor in capital budgeting decisions could be grouped into conventional and statistical techniques.

In this chapter, we are going to discuss mainly the conventional techniques – pay-back period.

Pay-back period

The oldest and the most commonly used method of recognising risk associated with a capital budgeting proposal is pay-back period. Pay-back period is defined as the length of time required to recover the initial cash out-lay. Pay-back period ignores time value of money (cash flows).

Pay-back period prefers projects of short – term pay backs to that of long-term pay backs. The emphasis is on the liquidity of the firm through recovery of capital. Traditionally, Indian business community employs this technique in evaluating projects with very high level of uncertainty.

The changing trends in fashion, makes the fashion business risky and therefore, pay-back period has been endorsed as a tradition in India to take decisions on acceptance or rejection of such projects.

The usual risk in business is more concerned with the forecast of cash flows. It is the down side risk of lower cash flows arising from lower sales and higher costs of operation that matters in formulating standards of pay back.


This method considers only time related risks and ignores all other risks of the project under consideration.

9.3 Adjusted Discount Rate

The basic principle of risk adjusted discount rate is that there should be adequate reward in the form of return to the firms which decide to execute risky business projects. Man by nature is risk-averse and tries to avoid risk.

To motivate firms to take up risky projects, returns expected from the project shall have to be adequate, keeping in view the expectations of the investors. Therefore risk premium need to be incorporated in discount rate during the evaluation of risky project proposals.

Risk adjusted discount rate is more briefly described as:

· Risk free rate is computed based on the returns on government securities.

· Risk premium is the additional returns that the investors require for assuming the additional risk associated with the project to be taken up for execution.

The more the uncertainty in the returns of the project, higher is the risk.

Higher the risk, greater is the premium




9.3.1 Evaluation of risk-adjusted discount rate

The advantages and limitations occurring during the evaluation of risk-adjusted discount rate are listed as follows:

· Risk adjusted discount rate is simple and easy to understand

· Risk premium takes care of the risk element in future cash flows

· Risk adjusted discount rate satisfies the businessmen who are risk – averse

· There are no objective bases of arriving at the risk premium. In this process the premium rates computed become arbitrary.

· The assumption that investors are risk-averse may not be true in respect of certain investors who are willing to take risks. To such investors, as the level of risk increases, the discount rate would be reduced

· Cash flows are not adapted to incorporate the risk adjustment for net cash inflows

9.4 Certainty Equivalent





Under the method of certainty equivalent, risking is found to be uncertain and 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). Risk adjustment factor is the ratio of certain net cash flow to risky net cash flow.

The discount factor to be used is the risk free rate of interest. Certainty equivalent coefficient is between 0 and 1. This 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.

If internal rate of return (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.

9.4.1 Evaluation of certainty equivalent

Evaluation of certainty equivalent 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 inconsistency in the procedure employed from one project to another.

When forecasts pass through many layers of management, original forecasts may become highly conservative. Due to high conservation in this process, good projects are likely to be cleared when this method is employed.



Certainty-equivalent approach is considered to be theoretically superior to the risk-adjusted discount rate.


Fill in the blanks:

8. CE coefficient is the _______ .

9. Discount factor to be used under CE approach is _________.

10. Because of high ______________ CE clears only good projects.

11. ___________ is considered to be superior to RADR.

9.5 Sensitivity Analysis

There are many variables like sales, cost of sales, investments and tax rates which affect the NPV and IRR of a project. Analysing the change in the project’s NPV or IRR on account of a given change in one of the variables is called Sensitivity Analysis.

Sensitivity analysis measures the sensitivity of NPV of a project in respect to a change in one of the input variables of NPV.

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 & IRR is lost. Therefore, forecasts are made under different economic conditions like pessimistic, expected and optimistic. NPV is arrived at for all the three assumptions.

Following steps are involved in sensitivity analysis:

· Identification of variables that influence the NPV & 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.


9.6 Probability distribution approach

Net present value becomes more reliable when we incorporate the chances of occurrences of various economic environments. The chances of occurrences are expressed in the form of probability.

Probability is the likelihood of occurrence of a particular economic environment. After assigning probabilities to future cash flows, expected net present value is computed.




9.6.1 Variance

A study of dispersion of cash flows of projects will help the management in assessing the risk associated with the investment proposal.

Dispersion is computed by variance or standard deviation.

Variance measures the deviation of each possible cash flow from the expected.

Square root of variance is standard deviation.



Here the assumption is that there is no relationship between cash flows from one period to another. Under this assumption the standard deviation of NPV is Rs 96,314.

On the other hand, if cash flows are perfectly correlated, cash flows of all years have linear correlation to one another, then

= 40083 + 7157 + 87284 = 134524

The standard deviation of NPV when cash flows are perfectly correlated will be higher than under the situation of independent cash flows.

9.7 Decision tree approach

Many project decisions are complex investment decisions. Such complex investment decisions involve a sequence of decisions over time.

Decisions tree can handle the sequential decisions of complex investment proposals. The decision of taking up an investment project is broken into different stages. At each stage the proposal is examined to decide whether to go ahead or not. The multi – stages approach can be handled effectively with the help of decision trees. A decision tree presents graphically the relationship between

· Present decision and future events

· Future decisions and the consequences of such decisions




Suggest the optimal course of action using decision tree analysis (Bangalore University MBA, adapted).





9.7.1 Evaluation of Decision tree approach

The evaluation of decision tree approach leads to the following assumptions

· Decision tree approach portrays inter – related, sequential and critical multi dimensional elements of major project decisions

· Adequate attention is given to the critical aspects in an investment decision which spread over a time sequence

· Complex projects involve huge out lay and hence are risky. There is the need to define and evaluate scientifically the complex managerial problems arising out of the sequence of interrelated decisions with consequential outcomes of high risk. It is effectively answered by decision tree approach

· Structuring a complex project decision with many sequential investment decisions demands effective project risk management. This is possible only with the help of an analytical tool like decision tree approach

· Ability to eliminate unprofitable outcomes helps in arriving at optimum decision stages in time sequence

9.8 Summary

Risk in project evaluation arises on account of the inability of the firm to predict the performance of the firm with certainty. Risk in capital budgeting decision may be defined as the variability of actual returns from the expected. There are many factors that affect forecasts of investment, costs and revenues of a project. It is possible to identify three types of risk in any project-stand-alone risk, corporate risk and market risk. The sources of risks are:

Project Competition

Industry



International factors and

Market

The techniques for incorporation of risk factor in capital budgeting decision could be grouped into conventional techniques and statistical techniques.


1. Define risk. Examine the need for assessing the risks in a project.2. Examine the type and sources of risk in capital budgeting .

3. Examine risk adjusted discount rate as a technique of incorporating risk factor in capital budgeting.

4. Examine the steps involved in sensitivity analysis.

5. Examine the features of Decision-tree approaches.



1. Stand-alone risk.

2. Beta

3. Diversify

4. International risk

5. Additional return

6. Risk free rate, risk premium

7. Greater

8. Risk – adjustment factor

9. Risk free rate of interest

10. Conservation

11. CE

12. Sensitivity analysis

13. One of the steps of sensitivity analysis

14. Different economic conditions

15. More reliable

16. Probability

17. Sequential decisions

18. Decision tree

19. Critical aspects

20. Complex projects


1. Refer to 9.1

2. Refer to 9. 2

3. Refer to 9.3

4. Refer to 9.5

5. Refer to 9.7



.

MB0045-Unit-10-Capital Rationing Unit-10-Capital Rationing

Structure:

10.1 Introduction

Learning Objectives

10.2 Meaning of Capital Rationing


10.3 Types of Capital Rationing

10.4 Steps Involved in Capital Rationing

10.5 Various Approaches to Capital Rationing

10.6 Summary

10.7 Example of Capital Rationing



10.1 Introduction

Capital budgeting decisions involve huge outlay of funds. Funds available for projects may be limited. Therefore, a firm has to prioritise the projects on the basis of availability of funds and economic compulsion of the firm.

It is not possible for a company to take up all the projects at a time. There is the need to rank them on the basis of strategic compulsion and funds availability. Since companies will have to choose one from among many competing investment proposals, the need to develop criteria for capital rationing cannot be ignored.

The companies may have many profitable and viable proposals but cannot execute them because of shortage of funds. Another constraint is that the firms may not be able to generate additional funds for the execution of all the projects.

When a firm imposes constraints on the total size of the firm’s capital budget, it requires capital rationing. When capital is rationed, there is a need to develop a method of selecting the projects that could be executed with the company’s resources yet giving the highest possible net present value.



· Describe the meaning of capital rationing

· Recognise the need for capital rationing

· Explain the process of capital rationing

· Describe the various approaches to capital rationing

10.2 Meaning of Capital Rationing

Firms may have to make a choice from among profitable investment opportunities, because of the limited financial resources. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control.

Capital rationing may be needed due to:

· External factors

· Internal constraints imposed by management

Figure 10.1: Reasons for capital rationing

External capital rationing

External capital rationing is due to the imperfections of capital market. Imperfections are caused mainly due to:

· Deficiencies in market information

· Rigidities that hamper the force flow of capital between firms

When capital markets are not favourable to the company, the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing:-

· The inability of the firm to procure required funds from capital market because the firm does not command the required investor’s confidence

· National and international economic factors may make the market highly volatile and unstable

· Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds


· High cost of issue of securities i.e. high floatation costs. Smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital market for funds

Internal capital rationing

Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing.

This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects.

Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the management’s expectation on the rate of return will be cleared.

Generally internal capital rationing is used by a firm as a means of financial control.

The various factors relating to the internal constraints imposed by the management are (see figure 10.2) – Private owned company, Divisional constraints, Human resource limitations, Dilution and Debt constraints.

Figure 10.2: Internal constraints

· Private owned company

Under internal constraint, the management of the firms might decide that expansion of the company might be a problem and not worth taking. This kind of condition arises only when the management of a firm fears losing the control in the company.

· Divisional constraints

Another constraint might lead to the allocation of fixed amount for each division in a firm by the upper management. This procedure can also be considered as an overall corporate strategy. These situations arise mainly from the point of view of a department. The cost of capital or the cost structure of the management, the budget constraints imposed by the senior officials or decisions coming from the head-office and wholly owned subsidiary decisions relate to the internal constraints.


· Human Resource limitations

The management of the firm or the company should see that excessive labour is being used for the project. Lack of proper man-power can become an internal constraint.

· Dilution

Dilution refers to the dilution of the company. This constraint occurs mainly when a reluctance in the issuing of further equity takes place, due to the fear of management losing the control over the company.

· Debt constraints

Debt constraints also constitute to the internal constraints in capital rationing. This constraint occurs mainly due to the issue of earlier debt which prohibits the issue of debts in the firm up-to a certain level.

These are the methods by which various factors are effecting the capital rationing of a particular firm or a management. Let us now look at the different types of capital rationing in the following topic.


Fill in the blanks:

1. When a firm imposes constraints on the total size of its capital budget, it is known as _____________.

2. Internal capital rationing is used by a firm as a ____________________.

3. Rigidities that affect the free flow of capital between firms cause _________________.

4. Inability of a firm to satisfy the regularity norms for issue of equity shares for tapping the market for funds causes __________________.

5. The various internal constraints for capital rationing are _____, ________, ____, _____ and ________.

6. Lack of ____ will become a huge failure and also an essential effect of internal constraint.

7. The reasons for capital rationing are _______ and ________.

10.3 Types of Capital Rationing

Now let us discuss the various types of capital rationing effecting the management of a firm. There are basically two types of capital rationing (see figure 10.3):

· Hard capital rationing

· Soft capital rationing

Figure 10.3: Types of capital rationing

Hard capital rationing

Hard capital rationing is defined as the capital rationing that under no circumstances can be violated. Hard capital rationing also refers to the companies acting external to the firms, which will not supply enough amount of investment capital, though having positive NPV projects. Hard capital rationing does not occur under perfect market.

Soft capital rationing

Soft capital rationing is defined as the circumstances under which the constraints on spending can be violated. Soft capital rationing refers to or arises with the internal, management-imposed limits on investment expenditure.

10.4 Steps involved in Capital Rationing

In the above topic we have discussed about the different types of capital rationing. Now let us look at the different steps involved in capital rationing. The following are the steps involved in capital rationing (see figure 10 .4).

· Ranking of different investment proposals

· Selection of the most profitable investment proposal

Figure 10.4: Steps involved in capital rationing



Ranking of different investment proposals means the various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the descending order.

Net present value method recognises the time value of money. Net present value correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is a need to find out the present values of all the cash flows. NPV can be represented with the following formula.

Profitability index is also known as benefit cash ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows.

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the net present value of any project equal to zero. Internal rate of return is the rate of interest which equates the present value (PV) of cash inflows with the present value of cash outflows.

IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns. IRR can be determined by solving the following equation for

Profitability Index as the Basis of Capital Rationing

Let us now discuss a Caselet regarding the concept of profitability index as the basis of capital rationing. The profitability index is calculated in the following Caselet based on the capital rationing factors per annum and the ranking is given according to the most preferable investment proposal.





The objective is to maximise NPV per rupee of capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis of ranks assigned by profitability index.




Let us consider another caselet discussing about the profitability index as the basis of capital rationing.

The objective in the above explained caselet is to maximise NPV per rupee of capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis of ranks assigned by profitability index.

Selection of the most profitable investment proposal

After ranking the different investment proposals based on their net present value, profitability index and the internal rate of return, the selection of the most profitable investment proposal is to




be done. The selection is done mainly in a view to select the investment proposal which earns more profits than compared to the other proposals.

The basic features to be taken under consideration during the selection of the most profitable investment proposal are:

· The proposal should have the potentiality of making large anticipated profits

· The proposal should involve high degree of risk

· The proposal should involve a relatively long time-period between the initial outlay and the anticipated return

Evaluation of the selection procedure

· PI rule of selecting projects under capital rationing may not yield satisfactory result because of project indivisibility. When projects involving high investment is accepted many small projects will have to be excluded. But the sum of the NPVs of small projects to be accepted may be higher than the NPV of a single large project

· Capital rationing also suffers from the multi-period capital constraints

10.5 Various Approaches to Capital Rationing

There are various approaches to analyse capital rationing, but here we will mainly deal with the programming approach.

Programming approach

There are many programming techniques of capital rationing. Among them are – Linear programming and Integer programming (see figure 10.5)

Figure 10.5: Programming approach

· Linear programming


Linear programming (LP) approach to capital rationing tries to achieve maximum NPV subject to many constraints. Here the objective function is maximisation of sum of the NPVs of the projects.

Here the constraints matrix incorporates all the restrictions associated with capital rationing imposed by the firm.

· Integer programming

LP may give an optimal mix of projects in which there may be need to accept fraction of a project. Accepting fraction of a project is not feasible. Therefore, optimum may not be attainable. The actual implementation of projects may be suboptimal. When projects are not divisible, integer programming can be employed to avoid the chances of accepting fraction of projects.

· Programming approach provides information on dual variables

· Programming approach also gives information on shadow prices of budget constraints

· Dual variables provide information for decision on transfer of funds from one year to another year

· They are costly to use when large, indivisible projects are being examined

· They are deterministic models

· The variables of capital budgeting are subjected to change, making the assumption of deterministic highly invalid


Fill in the blanks:

8. The two steps involved in capital rationing are __________ and __________________.




9. Project indivisibility can lead to sub optimal result when ____________ is used for capital rationing.

10. Objective function under linear programming approach is ___________.

11. When project are not divisible ______________ can be employed to avoid the changes of accepting fraction of a project.

12. The programming techniques of capital rationing are ______ and ____________.

13. The selection is done mainly in the view that which investment proposal earns __________than compared to the other proposals.

14. The proposal should have the potentiality of making large ____________.

10.6 Summary

Often, firms are forced to ration the funds among the eligible projects that the firm wants to take up. The inability of the firm in finding adequate funds for execution of the projects could be due to many factors. It may be due to external factors or internal constraints imposed by the management. External capital rationing occurs mainly because of imperfections in capital markets. Internal capital rationing is caused by restrictions imposed by the managements.

10.7 Example of Capital Rationing

Criteria of a Finance Manager



We generally know from various units discussed under finance management that rate of return on the intermediate cash flows is equal to the risk-adjusted discount rate. However in many situations the two rates are different. In this unit we have discussed that Net present value and the Profitability index are used in ranking of the proposed projects, but this technique is found incorrect in many situations. Another problem is that in the present business scenario, finance managers would prefer to use internal rate of return for ranking the proposed projects, although ranking by Net present value is theoretically superior.

The reason behind the finance manager considering Internal rate of return rather than the Net present value, may be that the rate of return gives the finance manager a clear idea about the proposal than compared to the net present value. For example, we consider NPV in dollars whereas rate of return in percentages. The value in percentages gives more clear idea to the finance manager rather than the value in dollars. Theoretically, a company should be able to obtain the financing for all the acceptable projects (NPV>0). However, in reality all companies practice capital rationing.

The objective of capital rationing is to maximise NPV per rupee of capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis of ranks assigned by profitability index. Obviously when one project is allowed by the budget, the NPV criterion is appropriate. However, when two or more projects are allowed, the NPV criterion might fail to serve that purpose because it does-not consider the investment size at the same time.

For example, when the company is in the business of a single line of products (e.g., computer hardware) and the project is to expand the production and sales (in the same market) of the line of products, then risk adjusted discount rate (RADR) will be equal to normal rate of return (k), as the risks are the same. Thus the financing of the project and future projects is consistent with the target capital structure of the company. The actual rate of return on the project may be different from the Risk adjusted discount rate (RADR), as the expansion of business may be more efficient or less efficient than the current business. Concerning r and RADR, r is the actual rate (not required rate) of return on the cash flows.

Even if the reinvestment has the same risk as the project, r is not necessarily equal to RADR.

Thus a finance manager considers all the situations and scenario and depends only on the Internal rate of return in ranking the projects rather than going for Net present value and Profitability index.


1. Examine the need for capital rationing

2. Examine the reasons for external capital rationing

3. Internal capital rationing is used by firms for exercising financial control How does a firm achieve this?

4. Brief explain the process of capital rationing



1. Capital rationing

2. Means of financial control

3. External capital rationing

4. External capital rationing

5. Private owned company, Divisional constraints, Human resource limitations, Dilution and Debt constraints

6. Lack of man-power

7. External constraints and internal constraints imposed by the management

8. Ranking the project, selection of the most profitable investment proposal

9. Profitability index

10. Maximisation of sum of NPVs of the projects

11. Integer programming

12. Linear programming and integer programming

13. More profits

14. Anticipated profits


1. Refer to 10.1

2. Refer to 10.1

3. Refer to 10.1

4. Refer to 10.3



.

MB0045-Unit-11-Working Capital Management Unit-11-Working Capital Management

Structure:

11.1 Introduction

Learning Objectives

11.2 Components of Current Assets and Current Liabilities

11.3 Concepts of Working Capital

Gross working capital

Net working capital

11.4 Objective of Working Capital Management

11.5 Need for Working Capital

11.6 Operating Cycle

11.7 Determinants of Working Capital

11.8 Estimation of Working Capital

Estimation of current assets

Estimation of current liabilities

11.9 Summary



11.1 Introduction



Working capital is defined as the excess of current assets over current liabilities and provisions. It is that portion of asset of a business which is used frequently in current operations and in the operating cycle of the firm.

Inadequacy or mismanagement of working capital is the leading cause of many business failures. A financial manger, therefore, spends a larger part of his time in managing working capital. There are two important elements to be considered under the working capital management:

· Decisions on the amount of current assets to be held by a firm for efficient operations of its business

· Decisions on financing working capital requirement

The need for proper management of working capital management is even more important in the modern era of information technology. In support of the above argument, let us consider the performance of Dell computers as reported in one of the recent Fortune articles. A perusal of the article will give you an insight into how Dell could use the technology for improving the performance of components of working capital.

· Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and dealers

· Outsourcing on operations, if the firms’ competence does not permit the performance of the operation effectively

· Training the employees to accept change

· Introducing to internet business

· Releasing capital by reduction in investment in inventory for improving the profitability of operating capital



· Explain the meaning, definition and various concepts of working capital

· State the objectives of working capital management

· Recognise the importance of working capital management

· Estimate the process of working capital

11.2 Components of Current Assets and Current Liabilities

Working capital management is concerned with managing the different components of current assets and current liabilities.

The following are the components of current assets:

· Inventories

· Sundry debtors

· Bills receivables

· Cash and bank balances

· Short-term investments

· Advances such as advances for purchase of raw materials, components and consumable stores and pre-paid expenses

The components of current liabilities are:

· Sundry creditors

· Bills payable

· Creditors for out-standing expenses

· Provision for tax

· Other provisions against the liabilities payable within a period of 12 months

A firm must have adequate working capital, neither excess nor inadequate. Maintaining adequate working capital is crucial for maintaining the competitiveness of a firm.

Any lapse of a firm on this account may lead a firm to the state of insolvency.


Fill in the blanks:

1. Maintaining adequate working capital at the satisfactory level is very crucial for ___________ and _______ of a firm.

2. Pre-paid expenses are __________.

3. Provision for tax is____________.

4. A firm must have _________ neither excess nor shortage.

5. List any two components of current assets.

6. List any two components of current liabilities.

11.3 Concepts of Working Capital

The four most important concepts of working capital are (see figure 11.1) – Gross working capital, Net working capital, Temporary working capital and Permanent working capital.

Figure 11.1: Concepts of working capital

Gross working capital

Gross Working Capital refers to the amounts invested in various components of current assets. This concept has the following practical relevance.

· Management of current assets is the crucial aspect of working capital management

· Gross working capital helps in the fixation of various areas of financial responsibility

· Gross working capital is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets

· The need to plan and monitor the utilisation of funds of a firm demands working capital management, as applied to current assets

Net working capital

Net working capital is the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance.

· Net working capital indicates the ability of the firm to effectively use the spontaneous finance in managing the firm’s working capital requirements

· A firm’s short term solvency is measured through the net working capital position it commands

Permanent Working Capital


Permanent working capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firm’s business. This minimum level of current assets has been given the name of core current assets by the Tandon Committee.

Permanent working capital is also known as fixed working capital.

Temporary Working Capital

Temporary working capital is also known as variable working capital or fluctuating working capital. The firm’s working capital requirements vary depending upon the seasonal and cyclical changes in demand for a firm’s products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital.


Fill in the blanks:

7. _______________ refers to the amounts invested in current assets.

8. To _______ and monitor the utilisation of funds of a firm ________________________ is to be given top priority.

9. When current assets exceed current liabilities the net working capital is _____.

10. Permanent working is called ____ working capital.

11.4 Objective of Working Capital Management

The objective of financial management is maximising the net wealth of the shareholders. A firm must earn sufficient returns from its operations to ensure the realisation of this objective. There exists a positive co-relation between sales and firm’s return on its investment. The amount of earnings that a firm earns depends upon the volume of sales achieved. There is the need to ensure adequate investment in current assets, keeping pace with accelerating sales volume.

Firms make sales on credit. There is always a time gap between sale of goods on credit and the realisation of earnings of sales from the firm’s customers. Finance manger of a firm is required to finance the operation during this time gap.

Therefore, objective of working capital management is to ensure smooth functioning of the normal business operations of a firm. The firm has to decide on the amount of working capital to be employed.

The firm may have a conservative policy of holding large quantum of current assets to ensure larger market share and to prevent the competitors from snatching any market for their products. However such a policy will affect the firm’s returns on its investment. The firm will have returns

higher than the required amount of investment in current assets. This excess funds locked in current assets will reduce the firm’s profitability on operating capital.

On the other hand a firm may have an aggressive policy of depending on spontaneous finance to the maximum extent. Credit obtained by a firm from its suppliers is known as spontaneous finance. Here a firm will try to reduce its investments in current assets as much as possible but checks that they are not affecting the firm’s ability to meet working capital needs for sales growth targets. Such a policy will ensure higher return on its investment as the firm will not be locking in any excess funds in current assets. However, any error in forecasting can affect the operations of the firm unfavourably if the error is fraught with the down side risk. There is also another risk of firm losing on maintaining its liquidity position.

Objective of working capital management is achieving a trade–off between liquidity and profitability of operations for the smooth conduct of normal business operations of the firm.


Fill in the blanks:

11. Objective of working capital management is achieving a trade-off between _________ and _____________.

12. Credit obtained by a firm from its suppliers is known as _______.

13. An aggressive policy of working capital management means depending on _________ to the maximum extent.

14. To prevent the competitors from snatching any market for their products the firm may have ___________ a policy of holding _______ of current assets.

11.5 Need for Working Capital

The need for working capital arises on account of two reasons:

· To finance operations during the time gap between sale of goods on credit and realisation of money from customers of the firm

· To finance investments in current assets for achieving the growth target in sales

Therefore to finance the operations in operating cycle of a firm, working capital is required. In the next section, we will know more about the operating cycle of the firm.


Fill in the blanks:

15. To finance the operations in _______ of a firm working capital is required.

16. To finance operations during the time gap between _______ and ________ time gap is required.

11.6 Operating Cycle

The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle

Operating cycle of a firm involves the following elements.

· Acquisition of resources from suppliers

· Making payments to suppliers

· Conversion of raw materials into finished products

· Sale of finished products to customers

· Collection of cash from customers for the goods sold

The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle.

Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods.

Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements.

Inventory conversion period is the average length of time required to produce and sell the product.

Receivables conversion period is the average length of time required to convert the firm’s receivables into cash.



Accounts payables period is also known as payables deferral period.

Accounts payables period =

(Payables deferral period)

Purchases per day =

Cash conversion cycle is the length of time between the firms actual cash expenditure and its own cash receipt. The cash conversion cycle is the average length of time a rupee is tied up in current assets.

Cash Conversion Cycle is

CCC = ICP + RCP – PDP

CCC = Cash Conversion Cycle

ICP = Inventory Conversion Period

RCP = Receivables Conversion Period

PDP = Payables deferral period





The Cash conversion cycle shows the time interval over which additional non-spontaneous sources of working capital financing must be obtained to carry out firm’s activities. An increase in the length of operating cycle, without a corresponding increase in payables deferral period, increases the cash conversion cycle. Any increase in cash conversion cycle leads to additional working capital needs of the firm.


Fill in the blanks:

17. The time gap between acquisition of resources from suppliers and collection of cash from customers is known as ______.

18. ___________ is the average length of time required to produce and sell the product.

19. __________ is the average length of time required to convert the firms receivables into cash.

20. _________ conversion cycle is the length of time between firms’ actual cash expenditure and its own receipt.

11.7 Determinants of Working Capital

A large number of factors influence 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 operations, neither too much nor too little. Investing heavily in current assets will drain the firm’s earnings and inadequate investment in current assets will reduce the firm’s credibility as it affects the firm’s liquidity. Therefore, the need to strike a balance between liquidity and profitability cannot be ignored. The following factors determine a firm’s working capital requirements (see figure 11.2)

· Nature of business: Working Capital requirements are basically influenced by the nature of business of the firm. Trading organisations are forced to carry large stocks of finished goods, accounts receivables and accounts payables. Public utilities require lesser investment in working capital.

· Size of business operation: Size is measured in terms of a scales 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: Capital intensive industries with longer manufacturing process will have higher requirements of working capital because of the need to run their sophisticated and long production process.

Figure 11.2: Factors determining working capital

· Products policy: Production schedule of a firm influences the investments in inventories. A firm, exposed to seasonal changes in demand when following a steady production policy will have to face the costs and risks associated with inventory accumulation during the off-season periods. On the other hand a firm with a variable production policy will be facing different dimensions of management of working capital. Such a firm has to effectively handle the problem of production planning and control associated with utilisation of installed plant capacity under conditions of varying volumes of production of products of seasonal demand.

· Volume of sales: There is a positive direct correlation between the volume of sales and the size of working capital of a firm.

· Term of purchase and sales: A firm which allows liberal credit to its customers will need more working capital than that of a firm with strict credit policy. A firm which enjoys liberal credit facilities from its suppliers requires lower amount of working capital when compared to a firm which does not have such a facility.

· Operating efficiency: The firm with high efficiency in operation can bring down the total investment in working capital to lower levels. Here effective utilisation of resources helps the firm in bringing down the investment in working capital.

· Price level changes: Inflation affects the working capital levels in a firm. To maintain the operating efficiency under an inflationary set up, a firm should examine the maintenance of working capital position under constant price level. The financial capital maintenance demands a firm to maintain higher amount of working capital keeping pace with rising price levels. Under inflationary conditions same levels of inventory will require increased investment. The ability of a firm to revise its products prices with rising price levels will decide the additional investment to be made to maintain the working capital intact.

· Business Cycle: During boom, sales rise as business expands. Depression is marked by a decline in sale. During boom, expansion of business can be achieved only by augmenting investment in various assets that constitute working capital of a firm. When there is a decline in business on account of depression in economy, inventory glut forces a firm to maintain working capital at a level far in excess of the requirements under normal conditions.


· Processing technology: Longer the manufacturing cycle, the larger is the investment in working capital. When raw material passes through several stages in the production, process work in process inventory will increase correspondingly.

· Fluctuations in the supply of raw materials: Companies which use raw materials available only from one or two sources are forced to maintain buffer stock of raw materials to meet the requirements of uncertainty in lead time Such firms normally carry more inventory than it would have had the materials been available in normal market conditions.


Fill in the blanks:

21. Capital intensive industries require _________ amount of working capital.

22. There is a __________ between volume of sales and the size of a working capital of a firm.

23. Under inflationary conditions same level of inventory will require __________ investment in working capital.

24. Longer the manufacturing cycle, ________ the investment in working capital.

11.8 Estimation of Working Capital

The approach to estimate a working capital is based on an operation cycle. Operation cycle comprises of two important components of working capital (see figure 11.3) – Current assets and Current liabilities

Figure 11.3: Components of working capital

Estimation of working capital is based on the assumption that production and sales occur on a continuous basis and all costs occur accordingly.

Estimation of Current Assets

Current assets are estimated based on the following assumptions:

· Average investment in raw material is estimated


· Average investment in work-in-progress inventory is estimated

· Average investment in finished goods inventory is estimated

· Average investment in receivables (both in debtors and bills receivables) is estimated based on credit policy that the firm wishes to pursue

· Based on the firm’s attitude towards risk, access to borrowing sources, past experience and nature of business, firms decide on the policy of maintaining the minimum cash balances

Estimation of Current Liabilities

Current liabilities are estimated based on the following factors – Trade creditors, Direct wages and Overheads (see figure 11.4).

Figure 11.4: Estimation of current liabilities

Trade creditors

The average amount of financing available to the firm is estimated based on the production budget, raw material consumption and the credit period enjoyed from suppliers.

Direct wages

Estimation is made on total wages, to be paid on average basis, based on production budget, direct labour cost per unit and average time-lag in payment of wages.

Overheads

Estimation on an average basis of the outstanding amount to be paid to the creditors for overhead is estimated based on production budget, overhead cost per unit and average time-lag in payment of overhead.



Fill in the blanks:

25. ______ is used to estimate working capital requirements of a firm.

26. Operating cycle approach is based on the assumption that production and sales occur on a ___________.

27. The factors involved in the estimation of the current liabilities are _____, _________ and _________.

11.9 Summary

All companies are required to maintain a minimum level of current assets at all point of time. This level is called core or permanent working capital of the company. Working capital management is concerned with the determination of optimum level of working capital and its



effective utilisation. To assess the working capital required for a form to conduct its operations smoothly, firms use operating cycle concept and compute each component of working capital.


1. Examine the components of working capital.

2. Explain the concepts of working capital

3. What are the objectives of working capital management ?

4. Briefly explain the various elements of operating cycle



1. Maintaining, Competitiveness.

2. Current assets.

3. Current Liabilities

4. Adequate working capital

5. Inventories

6. Sundry debtors

7. Gross working capital

8. Plan, working capital management as applied.

9. Positive

10. Fixed

11. Liquidity, Profitability.

12. Spontaneous finance.

13. Spontaneous finance.

14. Conservative, Large quantum.

15. Operating cycle

16. Sale of goods on credit, realisation of money from customers.

17. Operating cycle

18. Inventory conversion period

19. Receivables conversion period

20. Cash Conversion cycle

21. Higher

22. Positive direct correlation.

23. Increased

24. Larger

25. Operating cycle

26. Continuous bases

27. Trade creditors, Direct wages and Overheads


1. Refer to 11.2

2. Refer to 11.3

3. Refer to 11.4

4. Refer to 11.6



.

MB0045-Unit-12 -Cash Management Unit-12 -Cash Management

Structure:


12.1 Introduction

Learning objectives

Meaning of cash

12.2 Meaning and Importance of Cash Management

12.3 Motives for Holding Cash

12.4 Objectives of Cash Management

12.5 Models for Determining Optimal Cash Needs

Baumol model

Miller-Orr model

Cash planning

Cash forecasting and budgeting

12.6 Summary



12.1 Introduction

Cash is the most important current asset for a business operation. It is the energy that drives business activities and also gives the ultimate output expected by the owners. The firm should keep sufficient cash at all times. Excessive cash will not contribute to the firm’s profits and shortage of cash will disrupt its manufacturing operations.


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

· Meaning of cash and near cash assets

· The importance of cash management in a firm

· The different models of determining the optimal cash balances

· Techniques for forecasting the cash inflows and outflows

12.1.2 Meaning of cash

Now, before getting into various other concepts of cash management, let us first discuss about the meaning of the cash and the near cash assets. “Cash” can be classified into or can be used in two senses (see figure 12.1) – Narrow sense and Broader sense.

Figure 12.1: Classification of cash

· In a narrow sense, it means the currency and other cash equivalents such as cheques, drafts and demand deposits in banks.

· In a broader sense, it includes near-cash assets like marketable securities and time deposits in banks.

The distinguishing nature of this kind of asset is that they can be converted into cash very quickly. Cash in its own form is an idle asset. Unless employed in some form or another, it does not earn any revenue.

12.2 Meaning and Importance of Cash Management

Cash management is concerned with the following requirements:

· Management of cash flows in and out of the firm

· Cash management within the firm

· Management of cash balances held by the firm – deficit financing or investing surplus cash.

Cash management tries to accomplish at a minimum cost the various tasks of cash collection, payment of out-standings and arranging for deficit funding or surplus investment. It is very difficult to predict cash flows accurately.

Generally, there is no co-relation between inflows and outflows. At some point of time, cash inflows may be lower than outflows because of the seasonal nature of product sale thus prompting the firm to resort to borrowings and sometimes outflows may be lesser than inflows resulting in surplus cash.


There is always an element of uncertainty about the inflows and outflows. The firm should therefore evolve strategies to manage cash in the best possible way. The management of cash can be categorised into:

· Cash planning: Cash flows should be appropriately planned to avoid excessive or shortage of cash. Cash budgets can be prepared to aid this activity

· Managing cash flows: The flow of cash should be properly managed. Steps to speed up cash collection and inflows should be implemented while cash outflows should be slowed down

· Optimum cash level: The firm should decide on the appropriate level of cash balance. Balance should be struck between excess cash and cash deficient stage

· Investing surplus cash: The surplus cash should be properly invested to earn profits. Many investment avenues to invest surplus cash are available in the market such as, bank short term deposits, T-Bills and inter corporate lending.

The ideal cash management system will depend on a number of issues like, firm’s product, competition, collection program, delay in payments, availability of cash at low rates of interests and investment opportunities available.

12.3 Motives of Holding Cash

The main motives behind holding cash are

· Transaction motive

· Precautionary motive

· Speculative motive

· Compensating motive

Figure 12.2 displays the various motives.

Figure 12.2: Motives of holding cash

Transaction motive

Transaction motive refers to a firm holding some cash to meet its routine expenses which are incurred in the ordinary course of business. A firm will need finances to meet an excess of payments like wages, salaries, rent, selling expenses, taxes and interests.


The necessity to hold cash will not arise if there were a perfect co-ordination between the inflows and outflows. These two never coincide. At times, receipts may exceed outflows and at other times, payments outrun inflows. For such periods when payments exceed inflows, the firm should maintain sufficient balances to be able to make the required payments. For transactions motive, a firm may invest its cash in marketable securities. Generally, they purchase such securities whose maturity will coincide with payment obligations.

Precautionary motive

Precautionary motive 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, cancellation of an order by a customer, sharp increase in prices of raw materials and skilled labour. The money held to meet such unforeseen fluctuations in cash flows are called precautionary balances.

The amount of precautionary balance also depends on the firm’s ability to raise additional money at a short notice. The greater the creditworthiness of the firm in the market, the lesser is the need for such balances. Generally, such cash balances are invested in highly liquid and low risk marketable securities.

Speculative motive

Speculative motive relates to holding cash to take advantage of unexpected changes in business scenario which are not normal in the usual course of firm’s dealings. Speculative motive may also result in investing in profit-backed opportunities as the firm comes across.

The firm may hold cash to benefit from a falling price scenario or getting a quantity discount when paid in cash or delay purchases of raw materials in anticipation of decline in prices. By and large, business firms do not hold cash for speculative purposes and even if it is done, it is done only with small amounts of cash. Speculation may sometimes also boomerang, in which case the firms lose a lot.

Compensating motive

Compensating motive is yet another motive to hold cash to compensate banks for providing certain services and loans. Banks provide a variety of services like cheque collection, transfer of funds through DD and MT.

To avail all these purposes, the customers need to maintain a minimum balance in their accounts at all times. The balance so maintained cannot be utilised for any other purpose. Such balances are called compensating balance.

Compensating balances can restrict to any of the following 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.

12.4 Objectives of Cash Management

The major objectives of cash management in a firm are:

· Meeting payments schedule

· Minimising funds held in the form of cash balances

Meeting payments schedule

In the normal course of functioning, a firm will have to make many payments by cash to its employees, suppliers and infrastructure bills. Firms will also receive cash through sales of its products and collection of receivables. Both these do not happen simultaneously.

A basic objective of cash management is therefore to meet the payment schedule in time. Timely payments will help the firm to maintain its creditworthiness in the market and to foster good and cordial relationships with creditors and suppliers. Creditors give a cash discount if payments are made in time and the firm can avail this discount as well.

Trade credit refers to the credit extended by the supplier of goods and services in the normal course of business transactions.

Generally, cash is not paid immediately for purchases but after an agreed period of time. There is deferral of payment and is a source of finance. Trade credit does not involve explicit interest charges, but there is an implicit cost involved. If the credit terms are, say, 2/10, net 30, it means the company will get a cash discount of 2% for prompt payment made within 10 days or else the entire payment is to be made within 30 days. Since the net amount is due within 30 days, not availing discount means paying an extra 2% for 20-day period.

The other advantage of meeting the payments in time is that it prevents bankruptcy that arises out of the firm’s inability to honour its commitments. At the same time, care should be taken not to keep large cash reserves as it involves high cost.

Minimise funds committed to cash balances

Trying to achieve the second objective is very difficult. A high level of cash balances will help the firm to meet its first objective discussed above, but keeping excess reserves is also not desirable as funds in its original form is idle cash and a non-earning asset. It is not profitable for firms to keep huge balances.

A low level of cash balances may mean failure to meet the payment schedule. The aim of cash management is therefore to have an optimal level of cash by bringing about a proper

synchronisation of inflows and outflows and to check the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of mismatches between inflows and outflows. The efficiency of cash management can be augmented by controlling a few important factors:

· Prompt billing and mailing

There is a time lag between the dispatch of goods and preparation of invoice. Reduction of this gap will bring in early remittances.

· Collection of cheques and remittances of cash

Generally, we find a delay in the receipt of cheques and their deposits into banks. The delay can be reduced by speeding up the process of collection and depositing cash or other instruments from customers.

· Floatation cost

The concept of ‘float’ helps firms to a certain extent in cash management. Float arises because of the practice of banks not crediting firm’s account in its books when a cheque is deposited by it and not debit firm’s account in its books when a cheque is issued by it until the cheque is cleared and cash is realised or paid respectively.

A firm issues and receives cheques on a regular basis. It can take advantage of the concept of float. Whenever cheques are deposited in the bank, credit balance increases in the firm’s books but not in bank’s books until the cheque is cleared and money is realised. This refers to ‘collection float’, that is, the amount of cheques deposited into a bank and clearance awaited.

Likewise the firm may take benefit of ‘payment float’.

Net float = Payment float – Collection float

When net float is positive, the balance in the firm’s books is less than the bank’s books; when net float is negative; the firm’s book balance is higher than in the bank’s books.

12.5 Models for Determining Optimal Cash Needs

One of the prime responsibilities of a finance manager is to maintain an appropriate balance between cash and marketable securities. The amount of cash balance will depend on risk-return trade-off. A firm with less cash balances has a weak liquidity position but earns profits by investing its surplus cash, while on the other hand it loses profits by holding too much cash.

A balance has to be maintained between these aspects at all times. So how much is optimum cash? This section explains the models for determining the appropriate balance. Two important models which determine the optimal cash needs are studied here:

· Baumol model

· Miller-Orr model.

12.5.1 Baumol Model

The Baumol model helps in determining the minimum amount of cash that a manager can obtain by converting securities into cash. Baumol model is an approach to establish a firm’s optimum cash balance under certainty. As such, firms attempt to minimise the sum of the cost of holding cash and the cost of converting marketable securities to cash.

The Baumol model is based on the following assumptions.

· The firm is able to forecast its cash requirements in an accurate way

· The firm’s pay-outs are uniform over a period of time

· The opportunity cost of holding cash is known and does not change with time

· The firm will incur the same transaction cost for all conversions of securities into cash

A company sells securities and realises cash and this cash is used to make payments. As the cash balance comes down and reaches a point, the finance manager replenishes its cash balance by selling marketable securities available with it and this pattern continues.

Cash balances are refilled and brought back to normal levels by the acts of sale of securities. The average cash balance is C/2. The firm buys securities as and when they have above-normal cash balances. This pattern is explained in figure 12.3.

Figure 12.3: Baumol model

Baumol cut-off model

The total cost associated with cash management has two elements:

· Cost of conversion of marketable securities into cash and

· Opportunity cost


The firm incurs a holding cost for keeping cash balance which is the opportunity cost. Opportunity cost is the benefit foregone on the next best alternative for the current action. Holding cost is k(C/2).

The firm also incurs a transaction cost whenever it converts its marketable securities into cash. Total number of transactions during the year will be the total funds requirement, T, divided by the cash balance, C, i.e. T/C. If per transaction cost is c, then the total transaction cost is c(T/C).

The total annual cost of the demand for cash is k(C/2) + c(T/C).

Figure 12.4: Baumol cut-off model

The optimum cash balance C* is obtained when the total cost is minimum which is expressed as

C* = √2cT/k

where C* is the optimum cash balance,

c is the cost per transaction,

T is the total cash needed during the year and

k is the opportunity cost of holding cash balance.

The optimum cash balance will increase with increase in the per transaction cost and total funds required and decrease with the opportunity cost.


12.5.2 Miller-Orr model

Miller-Orr came out with another model due to the limitation of the Baumol model. Baumol model assumes that cash flow does not fluctuate. In the real world, rarely do we come across firms which have their constant cash needs. Keeping other factors such as expansion, modernisation and diversification constant, firms face situations wherein they need additional cash to maintain their present position because of the effect of inflationary pressures. The firms therefore cannot forecast their fund requirements accurately.

The Miller-Orr (“MO”) model overcomes these shortcomings and considers daily cash fluctuations. The MO model assumes that cash balances randomly fluctuate between an upper bound (upper control limit) and a lower bound (lower control limit). When cash balances hit the upper limit, the firm has too much cash and it is time to buy enough marketable securities to bring back to the optimal bound. When cash balances touch zero level, the level is brought up by selling securities into cash. Return point lies between the upper and lower limits.

Symbolically, this can be expressed as

Z = 3√3/4*(cσ2/i)

where Z is the optimal cash balance,

c is the transaction cost,

σ2 is the standard deviation of the net cash flows and

i is the interest rate.

MO model also suggests that the optimum upper boundary “b” is three times the optimal cash balance plus the lower limit, i.e.

upper limit b = lower limit + 3Z and


return point = lower limit + Z.

The above explanations are more briefly explained or described using a graphical representation in figure 12.5.

Figure 12.5: Miller-Orr model

12.5.3 Cash Planning

Cash planning is a technique to plan and control the use of cash. Cash planning helps in developing a projected cash statement from the expected inflows and outflows of cash.

Forecasts are based on the past performance and future anticipation of events. Cash planning can be done based on a daily, weekly or on a monthly basis. Generally, monthly forecasts are commonly prepared by firms.

Cash budget is a device which is used 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.

Selecting the appropriate time period is based on the factors exclusive to the firms. Some firms may prefer to prepare weekly budget while others may work out on monthly estimates while some others may be preparing quarterly or yearly budgets. Firms should keep in mind that the period selected should be neither too long nor too short.



Over 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 who 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 budgets are prepared based on the following three methods:

· Receipts and Payments method

· Income and Expenditure method

· Balance Sheet method

We shall be discussing only the receipts and payments method of preparing cash budgets.




Fill in the blanks:

1. Management of cash balances can be done by ____________ and _________.

2. The four motives for holding cash are ______________________, ____________ , ____________ and ____________.

3. The greater the creditworthiness of the firm in the market lesser is the need for ___________ balances.

4. __________refers to the credit extended by the supplier of goods and services in the normal course of business transactions.

5. When cheques are deposited in a bank, credit balance increases in the firm’s books but not in bank’s books until the cheque is cleared and money realised. This is called as ________________.

6. According to Baumol model, the total cost associated with cash management has two elements __________ and __________.

7. The MO model assumes that cash balances randomly fluctuate between a ____________and a __________________.

12.6 Summary

All companies are required to maintain a minimum level of current assets at all points of time. Cash management is concerned with determination of relevant levels of cash balances, near cash assets and their efficient use.

The need for holding cash arises due to a variety of motives – transaction motive, speculation motive, precautionary motive and compensating motive. The objective of cash management is to make short-term forecasts of cash inflows and outflows, investing surplus cash and finding means to arrange for cash deficits. Cash budgets help Finance Manager to forecast the cash requirements.


1. Miraj Engineering Co. has forecasted its sales for 3 months ending on Dec. as follows:


Oct. Rs. 500000

Nov. Rs. 600000

Dec. Rs. 650000

The goods are sold on cash and credit basis at a rate of 50% each. Credit sales are realised in the month following the sale. Purchases amount to 50% of the month’s sales and are paid in the following month. Wages and administrative expenses per month amount to Rs. 1,50,000 and Rs. 80,000 respectively and are paid in the following month. On 1st Dec. the company has purchased a testing equipment worth Rs. 20,000 payable on 15th Nov. On 31st Dec. a cash deposit with a bank will mature for Rs. 1,50,000. The opening cash balance on 1st Nov. is Rs. 1,00,000.

What is the closing balance in Nov. and Dec.?

2. Michael Industries Ltd. requests you to help them in preparing a cash budget for the period ending on Dec. 2007 based on the information given in table 12.4.

Table 12.4: Cash budget

Particulars May June July Aug Sep Oct Nov Dec JanSales 15 20 22 3 34 25 25 15 15Materials 7 20 22 29 15 15 8 8 NilRent – – 0.50 0.5 0.5 0.50 0.5 0.5 –Salaries – – 1.5 2 2.5 1.5 1 1 –Misc charges

– – 0.15 0.2. 0.2 0.4. 0.3. 0.2 –

Taxes – – – – – 4 – – –Purchase of asset

– – – – – – 10 – –

Credit terms: Customers are allowed 1 month time.

Suppliers of materials are paid after 2 months.

The company pays salaries after a gap of 15 days.

Rent is paid after a gap of 1 month.

The company has an opening balance of Rs. 2,00,000 on 1st June.

Prepare a cash budget and find out what is the closing cash balance on 31st Dec.

12.8 Answers to SAQs an TQs


1. Deficit financing or investing surplus cash

2. Transaction, speculative, precautionary and compensating

3. Precautionary

4. Trade credit

5. Collection float

6. Cost of conversion of marketable securities into cash and opportunity cost.

7. Upper bound (upper control limit) and lower bound (lower control limit).


1. Prepare a cash budget for November and December. Refer to the Example 12.5.4.

2. Prepare a cash budget as shown in Example 12.5.4.



.

MB0045-Unit-13 Inventory Management Unit-13 Inventory Management

Structure:

13.1 Introduction

Learning objectives

Role of inventory in working capital

13.2 Costs Associated with inventories

13.3 Inventory Management Techniques

Economic order quantity


ABC system

Determination of stock levels

Pricing of inventories

13.4 Summary



13.1 Introduction

Inventories are the most significant part of current assets of most of the firms in India. Since they constitute an important element of the total current assets held by a firm, the need to manage inventories efficiently and effectively for ensuring optimal investment in inventory cannot be ignored. Any lapse on the part of a management of a firm in managing inventories may cause the failure of the firm. The major objectives of inventory management are:

· Maximum satisfaction to customer

· Minimum investment in inventory

· Achieving low cost plant operation

These objectives conflict each other. Therefore, a scientific approach is required to arrive at an optimal solution for earning maximum profit on investment in inventories. Decisions on inventories involve many departments:

· Raw material policies are decided by purchasing and production departments

· Production department plays an important role in work – in – process inventory, policy

· Finished goods inventory policy is shaped by production and marketing departments.

But the decisions of these departments have financial implications. Therefore, as an executive entrusted with the responsibility of managing finance of the company, the financial manager of the firm has to ensure that monitoring and controlling inventories of the firm are executed in a scientific manner for attaining the goal of wealth maximisation of the firm.

13.1.1 Learning objectives:


· Explain the meaning of inventory management

· State the objectives of inventory management

· Recall the importance of inventory management

· State the purpose of inventory

· Discuss the techniques of inventory control

13.1.2 Role of inventory in working capital

Inventories constitute an important component of a firm’s working capital. The various features of inventory (see figure 13.1) – Inventory as current assets, Level of liquidity and Liquidity lags, highlight the significance of inventory in working capital management.

Figure 13.1: Features of inventory

Characteristics of inventory as current assets

Current assets are those assets which are expected to be realised in cash or sold or consumed during the normal operating cycle of the business. Various forms of inventory in any manufacturing unit are:

· Process of production, where the raw materials are to be converted into finished goods

· Work – in – process inventories are semi finished products in the process of being converted into finished good

· Finished goods inventories are completely manufactured products that can be sold immediately.

The first two are inventories concerned with production and the third is meant for smooth performance of marketing function of the firm.

Nature of business influences the levels of inventory that a firm has to maintain in these three kinds. A manufacturing unit will have to maintain high levels of inventory in all the three forms. A retail firm will be maintaining very high level of finished goods inventory only.

The three kinds of inventories listed above are direct inventories. There is another form of inventories called indirect inventories. These indirect inventories are those items which are necessary for manufacturing but do not become part of the finished goods.

The indirect inventories are:


· Lubricants

· Grease

· Oil

· Petrol

· Office maintenance material

The inventories are held for the following four reasons:

i. Smooth production

To ensure smooth production as per the requirements of marketing department, inventories are procured and sold.

ii. Competitive edge

To achieve competitive edge most of the retail and industrial organisations carry inventory to ensure prompt delivery to customers. No firm wants to lose their customers on account of their item being out of stock.

iii. Benefits of buying in large volume

Sometimes buying in large volumes may give the firm quantity discounts. This quantity discounts may be substantial that the firm will take the benefit of it.

iv. Hedge against uncertain lead times

Lead time is the time required to procure fresh supplies of inventory. Uncertainty due to supplier taking more than the normal lead time will affect the production schedule and the execution of the orders of customers as per the orders received from customers. To avoid all these problems arising from uncertainty in procurement of fresh supplies of inventories, the firms maintain higher levels of inventories for certain items of inventory.

Levels of liquidity

Inventories are meant for consumption or sale. Both excess and shortage of inventory affect the firm’s profitability.

Though inventories are called current assets, in calculating absolute liquidity of a firm inventories are excluded because it may have slow moving or dormant items of inventory which cannot be easily disposed of. Therefore level and composition of inventory significantly influence the quantum of working capital and hence profitability of the firm.

Liquidity lags

Inventories have three types of liquidity lags (see figure 13.2) – Creation lag, Storage lag and Sale lag.

Figure 13.2: Liquidity lags

Creation lag

Raw materials are purchased on credit and consumed to produce finished goods. There is always a lag in payment to suppliers from whom raw materials are procured. This is called spontaneous finance. Spontaneous finance is that amount of a firm which is capable of enjoying the influences of the quantum of working capital of the firm.

Storage lag

The goods manufactured or held for sale cannot be converted into cash immediately. Before dispatching the goods to the customers on sale, there is always a time lag. During this time lag goods are stored in warehouse. Many expenses of storage will be recurring in nature and cannot be avoided. The level of expenditure that a firm incurs on this account is influenced by the inventory levels of the firm. This influences the working capital management of a firm.

Sale lag

Firms sell their products on credit. There is some time lag between sale of finished goods and collection of dues from customers. Firms which are aggressive in capturing markets for their products maintain high levels of inventory and allow its customers liberal credit period. This will increase its investment in receivables. This increase in investment in receivables will have its effect on working capital of the firm.

Purpose of inventory

The purpose of holding inventory is to achieve efficiency through cost reduction and increased sales volume. Figure 13.3 displays various purposes involved in holding inventories:

Figure 13.3: Purpose for holding inventory



· Sales

Customers place orders for goods only when they need it. But when customers approach the firm with orders the firms must have adequate inventory of finished goods to execute it. This is possible only when firms maintain ready stock of finished goods in anticipation of orders from the customers.

If a firm suffers from constant customer complaints about the product being out of stock, customers may migrate to other producers. This will affect the firm’s customer’s base, customer loyalty and market share.

· To avail quantity discounts

Suppliers give discounts for bulk purchases. Such discounts decrease the cost per unit of inventory purchased. Such cost reduction increase firm’s profits. Firms may go in for orders of large quantity to avail themselves of the benefit of quantity discounts.

· Reduce risk of production stoppages

Manufacturing firms require a lot of raw materials and spares and tools for production and maintenance of machines. Non availability of any vital item can stop the production process. Production stoppage has serious consequences. Loss of customers on account of the failure to execute their orders will affect the firm’s profitability. To avoid such situations, firms maintain inventories as hedge against production stoppages

· Reducing ordering costs and time

Every time a firm places an order it incurs cost of procuring it. It also involves a lead time in procurement. In some cases the uncertainty in supply due to certain administrative problems of the supplier of the product will affect the production schedules of the organisation. Therefore, firms maintain higher levels of inventory to avoid the risks of lengthening the lead time in procurement.

Therefore, to save on time and costs, firms may place orders for large quantities.

Therefore, it can be concluded that the motives for holding inventories are

· Transaction motive: For making available inventories to facilitate smooth production and sales

· Precautionary motive: For guarding against the risk of unexpected changes in demand and supply

· Speculative motive: To take benefit out of the changes in prices, firms increase or decrease in the inventory levels

13.2 Costs Associated with Inventories

Figure 13.4 shows the various types of costs associated with the inventories:

Figure 13.4: Costs associated with inventories

Material cost

Material costs are the costs of purchasing the goods and related costs such as transportation and handling costs are associated with it.

Ordering cost

The expenses incurred to place orders with suppliers and replenish the inventory of raw materials are called ordering costs. They include the costs of the following:

a. Requisitioning

b. Purchase ordering or set-up

c. Transportation

d. Receiving, inspecting and receiving at the ware house.

These costs increase in proportion to the number of orders placed. Firms maintaining large inventory levels, place a few orders and incur less ordering costs

Carrying costs

Costs incurred for maintaining the inventory in warehouses are called carrying costs. They include interest on capital locked up in inventory, storage, insurance, taxes, obsolescence, deterioration spoilage, salaries of warehouse staff and expenses on maintenance of warehouse building. The greater the inventory held, the higher the carrying costs.


Shortage costs or stock-out costs

These are the costs associated with either a delay in meeting the demand or inability to meet the demand at all due to shortage of stock. These costs include:

· Loss of profit on account of sales and loss caused by the stock out

· Loss of future sales as customers migrate to other dealers

· Loss of customer goodwill

· Extra costs associated with urgent replenishment purchases

Measurement of shortage cost attributable to the firm’s failure to meet the customers demand is difficult because it is intangible in nature and it affects the operation of the firm now and then in future.


Fill in the blanks:

1. Lead time is the time required to ____________

2. Both excess and shortage of inventory affect the firms’ _____

3. Precautionary motive of holding inventory is for guarding against the risk of _______ and supply

4. Costs incurred for maintaining the inventory in warehouse are called __________.

5. The purposes involved in holding inventory are ___, ____, ___ and ___.

13.3 Inventory Management Techniques

There are many techniques of management of inventory. Some of them are as shown in the figure 13.5

Figure 13.5: Inventory management techniques

Economic order quantity (EOQ)


Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage.

EOQ model answers the following key quantum of inventory management.

· What should be the quantity ordered for each replenishment of stock?

· How many orders are to be placed in a year to ensure effective inventory management?

EOQ is defined as the order quantity that minimises the total cost associated with inventory management.

EOQ is based on the following assumptions, as shown in figure 13.6:

Figure 13.6: Assumptions

· Constant or uniform demand: The demand or usage is even through-out the period

· Known demand or usage: Demand or usage for a given period is known i.e. deterministic

· Constant unit price: Per unit price of material does not change and is constant irrespective of the order size

· Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory

· Constant ordering cost: Cost per order is constant whatever be the size of the order

Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory.

Economic order quantity is represented using the following formula:


Figure 13.7: Economic order quantity

Where D = Annual usage or demand

Qx = Economic order quantity

K = ordering cost per order

kc = pc = price per unit x percent carrying cost = carrying cost of inventory per unit per annum.

ABC system

The inventory of an industrial firm generally comprises of thousands of items with diverse prices, large lead time and procurement problems. It is not possible to exercise the same degree of control over all these items. Items of high value require maximum attention while items of





low value do not require same degree of control. The firm has to be selective in its approach to control its investment in various items of inventory. Such an approach is known as selective inventory control. ABC system belongs to selective inventory control.

ABC analysis classifies all the inventory items in an organisation into three categories.

· Items are of high value but small in number. All items require strict control

· Items of moderate value and size which require reasonable attention of the management

· Items represent relatively small value items and require simple control

Since this method concentrates attention on the basis of the relative importance of various items of inventory, it is also known as control by importance and exception. As the items are classified in order of their relative importance in terms of value, it is also known as proportional value analysis.

Advantages of ABC analysis

· ABC analysis ensures closer controls on costly elements in which firm’s greater part of resources are invested

· By maintaining stocks at optimum level it reduces the clerical costs of inventory control

· Facilitates inventory control over usage of materials, leading to effective cost control

Limitations

· A never ending problem in inventory management is adequately handling thousands of low value of C items. ABC analysis fails to answer this problem

· If ABC analysis is not periodically reviewed and updated, it defeats the basic purpose of ABC approach

13.3.1 Determination of stock levels

Most of the industries which are subjected to seasonal fluctuations and sales during different months of the year are usually different. If, however, production during every month is geared to sales demand of the month, facilities have to be installed to cater for the production required to meet the maximum demand.

During the slack season, a large portion of the installed facilities will remain idle with consequent uneconomic production cost. To remove this disadvantage, attempt has to be made to obtain a stabilised production programme throughout the year.

During the slack season, there will be accumulation of finished products which will be gradually cleared as sales progressively increase. Depending upon various factors of production, storing and cost, a normal capacity will be determined. To meet the pressure of sales during the peak season, however, higher capacity may have to be used for temporary periods.

Similarly, during the slack season, to avoid loss due to excessive accumulation, capacity usage may have to be scaled down. Accordingly, there will be a maximum capacity and minimum capacity, consumption of raw material will accordingly vary depending upon the capacity usage.

Again, the delivery period or lead time for procuring the materials may fluctuate. Accordingly, there will be maximum and minimum delivery period and the average of these two is taken as the normal delivery period.

Maximum level

Maximum level is that level above which stock of inventory should never rise.

Maximum level is fixed after taking in to account the following factors.

· Requirement and availability of capital

· Availability of storage space and cost of storing

· Keeping the quality of inventory intact

· Price fluctuations

· Risk of obsolescence

· Restrictions, if any, imposed by the government

Maximum Level = Ordering level – (MRC x MDP) + standard ordering quantity

Where, MRC = minimum rate of consumption

MDP = minimum lead time

Minimum Level

Minimum level is that level below which stock of inventory should not normally fall.

Minimum level = OL – (NRC x NLT)

Where, OL = ordering level

NRC = Normal rate of consumption

NLT = Normal lead time

Ordering Level

Ordering level is that level at which action for replenishment of inventory is initiated.

OL = MRC X MLT

Where, MRC = Maximum rate of consumption

MLT = Maximum lead time

Average stock level

Average stock level can be computed in two ways

1.

2. Minimum level + 1 /2 of re-order quantity

Average stock level indicates the average investment in that item of inventory. It is quite relevant from the point of view of working capital management.

Managerial significance of fixation of Inventory level

· Inventory level ensures the smooth productions of the finished goods by making available the raw material of right quality in right quantity at the right time.

· Inventory level optimises the investment in inventories. In this process, management can avoid both overstocking and shortage of each and every essential and vital item of inventory.

· Inventory level can help the management in identifying the dormant and slow moving items of inventory. This brings about better co-ordination between materials management and production management on one hand and between stores manager and marketing manager on the other.

Re-order Point

“When to order” is another aspect of inventory management. This is answered by re-order point.

The re-order point is that inventory level at which an order should be placed to replenish the inventory.

To arrive at the re-order point under certainty, the two key required details are:

· Lead time


· Average usage

Lead time refers to the average time required to replenish the inventory after placing orders for inventory.

Under certainty, re-order point refers to that inventory level which will meet the consumption needs during the lead time.

Safety Stock

Since it is difficult to predict in advance usage and lead time accurately, provision is made for handling the uncertainty in consumption due to changes in usage rate and lead time. The firm maintains a safety stock to manage the stock – out arising out of this uncertainty. When safety stock is maintained, (When variation is only in usage rate)

13.3.2 Pricing of inventories

There are different ways of pricing inventories used in production. If the items in inventory are homogenous (identical except for insignificant differences) it is not necessary to use specific identification method. The convenient price is using a cost flow assumption referred to as a flow assumption.

When flow assumption is used, it means that the firm makes an assumption as to the sequence in which units are released from the stores to the production department.

The flow assumptions selected by a company need not correspond to the actual physical movement of raw materials. When units of raw material are identical, it does not matter which units are issued from the stores to the production department.



The method selected should match the costs with the revenue to ensure that the profits are uncertain in a manner that reflects the conditions actually prevalent.

· First in, first out (FIFO): FIFO assumes that the raw materials (goods) received first are used first. The same sequence is followed in pricing the material requisitions.

· Last in, first out (LIFO): The consignment last received is first used and if this is not sufficient for the requisitions received from production department then the use is made from the immediate previous consignment and so on. The requisitions are priced accordingly. This method is considered to be suitable under inflationary conditions. Under this method, the cost of production reflects the current market trend. The closing inventory of raw material will be valued on a conservative basis under the inflationary conditions.

· Weighted average: Material issues are priced at the weighted average of cost of materials in stock. This method considers various consignments in stock along with their unit’s prices for pricing the material issues from stores.

Other methods are

a. Replacement price method

Replacement price method prices the issues at the value at which it can be procured from the market.

b. Standard price method

Under the standard price method the materials are priced at standard price. Standard price is decided based on market conditions and efficiency parameters. The difference between the purchase price and the standard price is analysed through variance analysis.


Fill in the blanks:

6. ABC system belongs to ______.

7. ______________ are of high value but small in number.

8. ABC system is known as _____________ because the items are classified in order of their relative importance in terms of value.

9. _________ is defined as the order quantity that minimises the total cost of inventory management.

10. Define Re-order point.

11. Define Lead time.

13.4 Summary

Inventories form part of current assets of firm. Objectives of inventory management are.

· Maximum customer satisfaction

· Optimum investment in inventory

· Operation of the plant at the least cost structure

Inventories could be grouped into direct inventories as raw materials, work-in-process inventories and finished goods inventory. Indirect inventories are those items which are necessary for production process but do not become part of the finished goods. There are many reasons attributable to holding of inventory by the managements.


Examine the reasons for holding inventories by a firm.

1. Discuss the techniques of inventory control.

2. Discuss the relevance and factors that influence the determination of stock level.

3. Explain the various cost of inventory decision.



1. Obtain fresh supplies of inventory

2. Profitability

3. Unexpected changes in demand

4. Carrying costs

5. Sales, To avail quantity discounts, Reduce risk of production stoppages and Reducing ordering costs and time

6. Selective inventory control.

7. ABC items

8. Proportional value analysis

9. Economic order quantity (EOQ)

10. The re-order point is that inventory level at which an order should be placed to replenish the inventory.

11. Lead time refers to the average time required to replenish the inventory after placing orders for inventory.


1. Refer to 13.1

2. Refer to 13.3

3. Refer to 13.3.3

4. Refer to 13.2



.

MB0045-Unit-14-Receivable Management Unit-14-Receivable Management Structure:

14.1 Introduction

Learning Objectives

Meaning of receivable management

14.2 Costs Associated with Maintaining Receivables

14.3 Credit Policy Variables

14.4 Evaluation of Credit Policy

14.5 Summary




14.1 Introduction

Firms sell goods on credit to increase the volume of sales. In the present era of intense competition, business firms, to improve their sales, offer relaxed conditions of payment to their customers. When goods are sold on credit, finished goods get converted into receivables.

Trade credit is a marketing tool that functions as a bridge for the movement of goods from the firm’s warehouse to its customers. When a firm sells goods on credit, receivables are created. The receivables arising out of trade credit have three features:

· Receivables out of trade credit involves an element of risk. Therefore, before sanctioning credit, careful analysis of the risk involved needs to be done

· Receivables out of trade credit are based on economic value. Buyer gets economic value in goods immediately on sale, while the seller will receive an equivalent value later on

· Receivables out of trade credit have an element of futurity. The buyer makes payment in a future period

Amounts due from customers, when goods are sold on credit, are called trade debits or receivables. Receivables form part of current assets. They constitute a significant portion of the total current assets of the buyers next to inventories.

Receivables are asset – accounts representing amounts owing to the firm as a result of sale of goods/services in the ordinary course of business.

The main objective of selling goods on credit is to promote sales for increasing the profits of the firms. Customers will always prefer to buy on credit rather than buying on cash basis. They always go to a supplier who

gives credit. All firms therefore grant credit to their customers to increase sales, profit and to beat competition.



· Understand the meaning of receivables management

· Recognise the costs associated with maintaining receivable

· Understand the credit policy variables

· Understand the process of evaluation of credit policy

14.1.2 Meaning of receivables management

Receivables are a direct result of credit. Sales are resorted by a firm, to push up its sales which ultimately result in pushing up the profits earned by the firm. At the same time, selling goods on credit results in blocking of funds in accounts receivables.

Additional funds are, therefore, required for the operating needs of the business which involve extra costs in terms of interest. Moreover, increase in receivables also increases the chances of bad debts. Thus, creation of accounts receivables is beneficial as well as dangerous to the firm.

The financial manager needs to follow a policy of using cash funds economically to the extent possible, in extending receivables without adversely affecting the chances of increasing sales and making more profits.

Management of accounts receivables may, therefore, be defined as, the process of making decision relating to the investment of funds in receivables which will result in maximising the overall return on the investment of the firm.

Thus, the objective of receivables management is to promote sales and projects until the level where the return on investment in further finding of receivables is less than the cost of funds raised to finance that additional credit.

14.2 Costs Associated with Maintaining Receivables

There are four different varieties of costs associated with maintaining receivables (see figure 14.1): capital cost, administration cost, delinquency cost and bad-debts or default cost.

Figure 14.1: Costs associated with maintaining receivables

Capital cost


When firm sells goods, credit on that good achieves higher sales. Selling goods on credit has consequences of blocking the firm’s resources in receivables as there is a time lag between a credit sale and cash receipt from customers.

To the extent the funds are held up in receivables, the firm has to arrange for additional funds to meet its own obligation of monthly as well as daily recurring expenditure. Additional funds may have to be raised either out of profits or from outside.

In both the cases, the firm incurs a cost. In the former case there is the opportunity cost of the income the firm could have earned had the same been invested in some other profitable avenue. In the latter case of obtaining funds from outside, the firm has to pay interest on the loan taken.

Therefore, sanctioning credit to customers on sale of goods on credit has a capital cost.

Administration cost

When a firm sells goods on credit it has to incur two types of administration costs:

· Credit investigation and supervision costs

· Collection Costs.

Before sanctioning credit to any customer, the firm has to investigate the credit rating of the customer to ensure that credit given will be recovered on time. Therefore, administration costs have to be incurred in this process.

Costs incurred in collecting receivables are administrative in nature. These include additional expenses on staff for administering the process of collection of receivables from customers.

Delinquency cost

The firm incurs this cost when the customer fails to pay the amount to it on the expiry of credit period. These costs take the form of sending remainders and legal charges.

Bad-debts or Default costs

When the firm is unable to recover the amount due from its customers, it results in bad debts. When a firm relaxes its credit policy, selling to customers with relatively low credit rating occurs. In this process a firm may make credit sales to its customers who do not pay at all.

Therefore, assessing the effect of a change in credit policy of a firm involves examination of

· Opportunity Cost of lost contribution

· Credit administration Cost

· Collection Costs

· Delinquency Cost

· Bad – debt loses


Fill in the blanks:

1. Costs of maintaining receivables are _____________, _________ cost and _______.

2. A period of “Net 30” means that it allows to its customers 30 days of credit with ____ for ___________.

3. Selling goods on credit has consequences of blocking the firm’s resources in receivables as there is a time lag between _____________ and ____________.

4. When a firm sells goods on credit it has to incur two types of administration cost _____ and _________________.

5. The four different varieties of costs associated with maintaining receivables are _________, ________, _____ and ____.

6. Define receivable management

7. Define receivables.

14.3 Credit Policy Variables

The following are the four varieties of credit policy variables (see figure 14.2):

· Credit standards

· Credit period

· Cash discounts and

· Collection programme

Figure 14.2: Credit policy variables


· Credit standards

The term credit standards refer to the criteria for extending credit to customers. The bases for setting credit standards are:

- Credit ratings

- 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, the funds get blocked in receivables.

The firm may have light credit standards. The firm 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.

However, the firm will 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 customers of the firm. Credit period is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if payments are made within the specified period.

If a firm follows a credit period of ‘net 20’ it means that it allows 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 the profits of the firms are similar to that of relaxing the credit standards.

· Cash discount

Firms 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 a timely collection of receivables. Releasing funds locked in receivables and minimising the incidence of bad debts are the other objectives of the collection policy. The collection programmes consists of the following.

- Monitoring the receivables

- Reminding customers about due date of payment

- On line interaction through electronic media to customers about the payments due around the due date

- nInitiating 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 the customers

Self Assessment Question

Fill in the blanks:

8. Credit period is a ______________.

9. _______ refer to the criteria for extending credit to customers.

10. _________ refers to the length of time allowed to its customers by a firm to make payment for purchase made by customers of the firm.

11. A cash discount of 2 / 10 net 20 means that a ____________ is offered if the payment is made __________________

12. The four varieties of credit policy variables are ____, ______, _____ and _____.

14.4 Evaluation of Credit Policy

Optimum 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

· 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.

Individual evaluation of all the four credit policy variables of a firm are as shown:

Credit Standard

The effect of relaxing the credit standards on profit can be estimated as under:

Therefore




Credit period

The effect of changing the credit period on profits of the firm can be computed as shown:

Solved Problem

A company is currently allowing its customers, 30 days of credit. Its present sales are Rs 100 million. The firm’s cost of capital is 10% and the ratio of variables cost to sales is 0.80. The company is considering extending its credit period to 60 days. Such an extension will increase the sales of the firm by Rs 100 million. Bad debts on additional sales would be 8%. Tax rate is 30%. Assume 360 days in a year. Examine the effect of relaxing the credit policy on the profitability of the organisation (MBA) adopted.




Solved Problem

A company is currently allowing its customers, 30 days of credit. Its present sales are Rs 150 million. The firm’s cost of capital is 10% and the ratio of variables cost to sales is 0.60. The company is considering extending its credit period to 60 days. Such an extension will increase the sales of the firm by Rs 200 million. Bad debts on additional sales would be 10%. Tax rate is 50%. Assume 360 days in a year. Examine the effect of relaxing the credit policy.

Solution

Incremental contribution = 150,000,000 x 0.4 = Rs 60,000,000

Bad debts on new sales = 150,000,000 x 0.1 = Rs 150,000,000

Existing investment in receivables =

Expected investment in receivables after increasing the credit period to 60 days:

Expected investment in receivables on current sales =

Additional investment in receivable on new sales




Additional investment in receivable on new sales = Rs. 3,333,333

Expected total investment in receivables on increasing the period of credit = 403,333,333

Incremental investment in receivables = 403,333,333 – 12,500,000 = Rs. 390,833,333

Opportunity cost of Incremental investment in receivables =

0.10 x 390,833,333 = Rs.39,083,333

Cash discount

For 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

Solved Problem

Present credit terms of a company are 1/10 net 30. Its sales are Rs 100 million, average collection period is 20 days, variable cost to sales ratio is 0.8, and cost of capital is 10%. The proportion of sales on which customers currently take discount is 0.5.

The company is considering relaxing its discount terms to 2/10, net 30. Such a relaxation is expected to increase sales by Rs 10 million, reduce Average collection period to 14 days, increase discount sales to 0.8. Tax rate is 0.30.

Examine the effect of relaxing the discount policy on profits of the



organisation

Assume 360 days in a year (MBA adopted).

Collection policy

Computation of the effect of new collection programme can be evaluated with the help of the following formula.





Fill in the blanks:

13. Credit policy of a firm can be regarded as a trade-off between ___________ and _______.

14. Optimum credit policy maximises the __________.

15. Value of a firm is maximised when the incremental rate of return on investment in receivable is ________________ to the incremental cost of funds used to finance that investment.

16. Credit policy to be adopted by a firm is influenced by strategies pursued by its competitors. (True/False).

14.5 Summary

Receivables are a direct result of credit sales. Management of accounts receivables is the process of making decision relating to investment of funds in receivable which will result in maximising the overall return on the investment of the firm. Cost of maintaining receivables are of three types – capital costs, administration costs and delinquency costs. Credit policy variables are credit standards, credit period, cash discounts and

collection programme. Optimum credit policy is that which maximises the value of the firm.


1. Examine the meaning of receivable management.

2. Examine the costs of maintaining receivables.

3. Examine the variables of credit policy.

4. What are the features of optimum credit policy?




1. Capital costs, administration, Delinquency costs

2. No inducement for early payments

3. Credit sale, Cash receipt from customers

4. Credit investigation and supervision cost, collection costs

5. Capital cost, administration cost, delinquency cost and bad-debts or default cost

6. Management of accounts receivables may be defined as the process of making decision relating to the investment of funds in receivables that will result in maximising the overall return on the firm’s investment

7. Receivables are asset-accounts representing amounts owing to the firm as a result of sale of goods/services

8. Credit policy variable

9. Credit standards

10. Credit period

11. Cash discount of 2% , on the tenth day

12. Credit standards, credit periods, cash discounts and collection programme

13. Higher profits from increased sales, incremental cost of having large investment in receivable.

14. Value of the firm.

15. Equal

16. True


1. Refer to 14.1

2. Refer to 14.2

3. Refer to 14.3

4. Refer to 14.4



.

MB0045-Unit-15-Dividend Decisions Unit-15-Dividend Decisions

Structure:

15.1 Introduction

Learning objectives

15.2 Traditional Approach

15.3 Dividend Relevance Model

Walter Model

Gordon’s Dividend Capitalisation Model

15.4 Miller and Modigliani Model

15.5 Stability of Dividends

15.6 Forms of Dividends

15.7 Stock Split

15.8 Summary



15.11 References

15.1 Introduction


Dividends are that portion of a firm’s net earnings which are paid to the shareholders. Preference shareholders are entitled to a fixed rate of dividend irrespective of the firm’s earnings. Equity holders’ dividends fluctuate year after year. Dividend decisions depend 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 the retentions, lesser the dividends and vice versa. The constituents of net profits – dividends and retentions, are always competitive and conflicting.

Dividend policy has a direct influence on the two components of shareholders’ return – dividends and capital gains. A low payout and high retention may have the effect of accelerating earnings growth.

Investors of growth companies realise their money in the form of capital gains. Dividend yield will be low for such companies. The influence of dividend policy on future capital gains is to happen in distant future and therefore by all means uncertain.

Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient investment opportunities will retain the entire earnings to fund its growth avenues. Conversely, if no such avenues are forthcoming, the firm will pay-out its entire earnings. So there exists a relationship between return on investments “r” and the cost of capital “k”. So as long as r exceeds k, a firm shall have good investment opportunities.

That is, if the firm can earn a return “r” higher than its cost of capital “k”, it will retain its entire earnings and if this source is not sufficient, it will go in for additional sources in the form of additional financing like equity issue, debenture issue or term loans. Thus, the dividend decision is a trade-off between retained earnings and financing decisions.

Different theories have been given by various people on dividend policy. We have the traditional theory and new sets of theories based on the relationship between dividend policy and firm value.

The modern theories can be grouped as:

· Theories that consider dividend decision as an active variable in determining the value of the firm and

· Theories that do not consider dividend decision as an active variable in determining the value of the firm



· Explain the importance of dividends to investors

· Discuss the effect of declaring dividends on share prices

· Mention the advantages of a stable dividend policy

· List out the various forms of dividend

· Give reasons for stock split

15.2 Traditional approach

Traditional approach is given by B. Graham and D. L. Dodd (3rd edition, McGraw Hill, Newyork, 1951). They clearly emphasise the relationship between the dividends and the stock market. According to them, the stock value responds positively to high dividends and negatively to low dividends, that is, the share values of those companies rises considerably which pay high dividends and the prices fall in the event of low dividends paid.

Symbolically, P = [m (D+E/3)]

Where P is the market price,

m is the multiplier,

D is dividend per share,

E is Earnings per share.

Drawbacks of traditional approach

As per this approach, there is a direct relationship between P/E ratios and dividend pay-out ratio. High dividend pay-out ratio will increase the P/E ratio and low dividend pay-out ratio will decrease the P/E ratio. This may not always be true. A company’s share prices may rise in spite of low dividends due to other factors.

15.3 Dividend Relevance Model

Under this section we examine two theories:

· Walter Model

· Gordon Model

15.3.1 Walter model

Prof. James E. Walter considers dividend pay-outs are relevant and have a bearing on the share prices of the firm. He further states that investment policies of a firm cannot be separated from its dividend policy and both are inter-linked. The choice of an appropriate dividend policy affects the value of the firm.

Walter model clearly establishes a relationship between the firm’s rate of return “r” and its cost of capital “k” to give a dividend policy that maximises shareholders’ wealth. The firm would have the optimum dividend policy that will enhance the value of the firm.

Walter model can be studied with the relationship between r and k.

· If r>k, the firm’s earnings can be retained as the firm has better and profitable investment opportunities and the firm can earn more than what the shareholders could by re-investing, if earnings are distributed. Firms which have r>k are called ‘growth firms’ and such firms should have a zero pay-out ratio.

· If r<k, the firm should have a 100% pay-out ratio as the investors have better investment opportunities than the firm. Such a policy will maximise the firm value.

· If r = k, the firm’s dividend policy will have no impact on the firm’s value. The dividend pay-outs can range between zero and 100% and the firm value will remain constant in all cases. Such firms are called ‘normal firms’.

Walter’s model is based on the following assumptions (see figure 15.1)

Figure 15.1: Assumptions regarding Walter’s Model

· Financing

All financing is done through retained earnings. Retained earnings is the only source of finance available and the firm does not use any external source of funds like debt or equity

· Constant rate of return and cost of capital

The firms’ “r” and “k” remain constant and it follows that any additional investment made by the firm will not change the risk and return profile

· 100% pay-out or retention

All earnings are either completely distributed or re-invested immediately


· Constant EPS and DPS

The earnings and dividends do not change and are assumed to be constant forever

· Life

The firm has a perpetual life

Walter’s formula to determine the market price is as follows:

P =

Where P is the market price per share

D is the dividend per share

Ke is the cost of capital

g is the growth rate of earnings

E is Earnings per share

r is IRR

Case Study

The following information relates to Alpha Ltd. Show the effect of the dividend policy on the market price of its shares using the Walter’s Model

Equity capitalisation rate Ke is 11%

Earnings per share is given as Rs. 10

ROI (r) may be assumed as follows: 15%, 11% and 8%

Show the effect of the dividend policies on the share value of the firm for three different levels of r, taking the DP ratios as zero, 25%, 50%, 75% and 100%

Solution

Ke 11%, EPS 10, r 15%, DPS=0


P =

Case I r >k (r = 15%, Ke = 11%)

a. DP = 0 = 13.64/0.11 = Rs. 123.97

b. DP = 25% = 12.73/0.11 = Rs. 115.73

c. DP = 50% = 11.82/0.11 = Rs. 107.44

d. DP = 75% = 10.91/0.11 = Rs. 99.17

e. DP = 100% = 10/0.11 = Rs. 90.91

Case II r = k (r = 11%, Ke = 11%)

a. DP = 0 = 10/0.11 = Rs. 90.91

b. DP = 25% = 10/0.11 = Rs. 90.91

c. DP = 50% = 10/0.11 = Rs. 90.91

d. DP = 75% = 10/0.11 = Rs. 90.91

e. DP = 100% = 10/0.11 = Rs. 90.91

Case III r<k (r = 8%, K = 11%)












a. DP = 0 = 13.75/0.08 = Rs. 171.88

b. DP = 25% = 12.81/0.08 = Rs. 160.13

c. DP = 50% = 11.88/0.08 = Rs. 107.95

d. DP = 75% = 10.94/0.08 = Rs. 99.43

e. DP= 100% = 10/0.08 = Rs. 90.91

Interpretation

The above workings can be summarised as follows:

· When r>k, that is, in growth firms, the value of shares is inversely related to dividend policy (DP) ratio, as the DP increases, market value of shares decline. Market value of share is highest when DP is zero and least when DP is 100%.

· When r=k, the market value of share is constant irrespective of the DP ratio. The market value of the share is not affected, though the firm retains the profits or distributes them.

· In the third situation, when r<k, in declining firms, the market price of a share increases as the DP increases. There is a positive correlation between the two.

Limitations of Walter’s Model

· Walter has assumed that investments are exclusively financed by retained earnings and no external financing is used

· Walter’s model is applicable only to all-equity firms. Also, “r” is assumed to be constant which again is not a realistic assumption

· Finally, Ke is also assumed to be constant and this ignores the business risk of the firm which has a direct impact on the firm value






15.3.2 Gordon’s Dividend Capitalisation Model

Myron Gordon also contends that dividends are relevant to the share prices of a firm. Gordon uses the dividend capitalisation model to study the effect of the firm’s dividend policy on the stock price.

The following are some assumptions regarding Gordon’s dividend capitalisation model:

· The firm is an all equity firm with no debt

· No external financing is used and only retained earnings are used to finance any expansion schemes

· Constant return “r”

· Constant cost of capital “Ke”

· The life of the firm is indefinite

· The retention ratio g = br is constant forever

· Cost of capital is greater than br, that is Ke > br

Gordon’s model assumes investors are rational and risk-averse. Investors prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount to uncertain returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they discount future dividends. Retained earnings are evaluated by the shareholders as risky and therefore the market price of the shares would be adversely affected.

Gordon explains his theory with preference to the current income. Investors prefer to pay higher price for stocks which fetch them current dividend income. Gordon’s model can be symbolically expressed as:

Where P is the price of the share,

E is Earnings per share,

b is Retention ratio,

(1 – b) is dividend payout ratio,

Ke is cost of equity capital,


br is growth rate in the rate of return on investment

Case Study

Given Ke as 11%, E as Rs. 10, calculate the stock value of Mahindra Tech. for (a) r=12%, (b) r=11% and (c) r=10% for various levels of DP ratios given under:

Table 15.1: Various levels of DP ratio

DP ratio (1 – b) Retention ratioA 10% 90%B 20% 80%C 30% 70%D 40% 60%E 50% 50%

Solution

Case I r >k (r = 12%, K = 11%)

P =

a. DP 10%, b 90%

equals 1/.002 = Rs. 500

b. DP 20%, b 80%

equals 2/.014 = Rs. 142.86

c. DP 30%, b 70%

equals 3/.026 = Rs. 115.38

d. DP 40%, b 60%





equals 4/.038 = Rs. 105.26

e. DP 50%, b 50%

equals 5/.05 = Rs. 100

Case II r = k ( r = 11%, K = 11%)

P =

a. DP 10%, b 90%

equals 1/.011 = Rs. 90.91

b. DP 20%, b 80%

equals 2/.022 = Rs. 90.91

c. DP 30%, b 70%

equals 3/.033 = Rs. 90.91

d. DP 40%, b 60%

equals 4/.044 = Rs. 90.91

e. DP 50%, b 50%

equals 5/.55 = Rs. 90.91

Case III r<k ( r=10%, K=11%)










P =

a. DP 10%, b 90%

equals 1/.02 = Rs. 50

b. DP 20%, b 80%

equals 2/.03 = Rs. 66.67

c. DP 30%, b 70%

equals 3/.04 = Rs. 75

d. DP 40%, b 60%

equals 4/.05 = Rs. 80

e. DP 50%, b 50%

equals 5/.06 = Rs. 83.33

Interpretation

Gordon is of the opinion that dividend decision does have a bearing on the market price of the share.

· When r > k, the firm’s value decreases with an increase in pay-out ratio. Market value of share is highest when dividend policy (DP) is least and retention highest

· When r = k, the market value of share is constant irrespective of the DP ratio. It is not affected whether the firm retains the profits or distributes them

When r < k, market value of share increases with an increase in DP ratio







15.4 Miller and Modigliani Model

The Miller and Modigliani (MM) hypothesis seeks to explain that a firm’s dividend policy is irrelevant and has no effect on the share prices of the firm. This model advocates that it is the investment policy through which the firm can increase its share value and hence this should be given more importance.

The following are certain assumptions regarding Miller and Modigliani model:

· Existence of perfect capital markets: All investors are rational and have access to all information, free of cost. There are no floatation or transaction costs, securities are infinitely divisible and no single investor is large enough to influence the share value

· No taxes: There are no taxes, implying there is no difference between capital gains and dividends

· Constant investment policy: The investment policy of the company does not change. The implication is that there is no change in the business risk position and the rate of return

· Certainty about future investments, dividends and profits of the firm had no risk. This assumption was, however, dropped at a later stage

Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as the crux of the arbitrage argument.

The arbitrage process refers to setting off or balancing two transactions which are entered into investment programmes simultaneously.

The two transactions which the arbitrate process refers to are:

· paying out dividends and

· raising external funds to finance additional investment programs

If the firm pays out dividend, it will have to raise capital by selling new shares for financing activities.

The arbitrage process will neutralise the increase in share value (due to dividends) with the issue of new shares. This makes the investor indifferent to dividend earnings and capital gains as the share value is more dependent on the future earnings of the firm than on its current dividend policy.

Symbolically, the model is given as

Step I: The market price of a share in the beginning is equal to the PV of dividends paid and market price at the end of the period.

Where P0 is the current market price

P1 is market price at the end of period 1

D1 is dividends to be paid at the end of period 1

Ke is the cost of equity capital

Step II: Assuming there is no external financing, the value of the firm is:

Where n is number of out-standing shares

Step III: If the firm’s internal sources of financing its investment opportunities fall short of funds required, new shares are issued at the end of year 1 at price P1. The capitalised value of the dividends to be received during the period plus the value of the number of shares outstanding is less than the value of new shares.

Firms will have to raise additional capital to fund their investment requirements after utilising their retained earnings, that is,

n1 P1 = I – (E – nD1) which can be written as n1 P1 = I – E + nD1

Where I is total investment required,

nD1 is total dividends paid,

E is earnings during the period,

(E – nD1) is retained earnings.

Step IV: The value of share is thus:

Case Study

A company has a capitalisation rate of 10%. It currently has outstanding





shares worth 25,000 selling currently at Rs. 100 each. The firm expects to have a net income of Rs. 400000 for the current financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also requires Rs. 600000 to fund its investment requirement. Show that under MM model, the dividend payment does not affect the value of the firm.

Solution:

Case I: When dividends are paid:

Step I:

P0 = * (D1 + P1)

100 = 1/(1+0.1) * (4 + P1)

P1 = Rs. 106

Step II:

n1 P1 = I – (E – nD1), nD1 is 25000*4

n1 P1 = 600000 – (400000 – 100000) = Rs. 300000

Step III: Number of additional shares to be issued

300000/106 = 2831 shares

Step IV: The firm value

nP0 = =

equals Rs. 2500000

Case II: When dividends are not paid:

Step I:




P0 = * (D1 + P1)

100 = 1/(1+0.1) * (0 + P1)

P1 = Rs. 110

Step II:

n1P1 = I – (E – nD1), nD1 is 25000*4

n1P1 = 600000 – (400000 – 0) = Rs. 200000

Step III: Number of additional shares to be issued

200000/110 = 1819 shares

Step IV: The firm value

nP0 = =

equals Rs. 2500000

Thus, the value of the firm remains the same in both the cases whether dividends are declared or not.

Critical Analysis of MM Hypothesis

The analysis of MM hypothesis considers the following costs (see figure 15.2) – transaction cost, floatation cost, under-pricing of shares,

Figure 15.2: Analysis of MM hypothesis





· Floatation cost

Miller and Modigliani have assumed the absence of floatation costs. Floatation costs refer to the cost involved in raising capital from the market, that is, the costs incurred towards underwriting commission, brokerage and other costs.

Floatation costs ordinarily account for around 10%-15% of the total issue and they cannot be ignored given the enormity of these costs. The presence of these costs affects the balancing nature of retained earnings and external financing.

External financing is definitely costlier than retained earnings. For instance, if a share is issued worth Rs. 100 and floatation costs are 12%, then the net proceeds are only Rs. 88.

· Transaction cost

This is another assumption made by MM which implies that there are no transaction costs like brokerage involved in capital market. These are the costs associated with sale of securities by investors.

This theory implies that if the company does not pay dividends, the investors desirous of current income sell part of their holdings without any cost incurred. This is very unrealistic as the sale of securities involves cost; investors wishing to get current income should sell higher number of shares to get the income they are to receive.

· Under-pricing of shares

If the company has to raise funds from the market, it should sell shares at a price lesser than the prevailing market price to attract new shareholders. This follows that at lower prices, the firm should sell more shares to replace the dividend amount.

· Market conditions

If the market conditions are bad and the firm has some lucrative opportunities, it is not worth-approaching new investors at this juncture, given the presence of floatation costs. In such cases, the firms should depend on retained earnings and low pay-out ratio to fuel such opportunities.

15.5 Stability of Dividends

Stability of dividends is the consistency in the stream of dividend payments. This method relates to the payment 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

· constant dividend per share plus extra dividend

Constant dividend per share

As per this form of dividend policy, a firm pays a fixed amount of dividend per share year after year.

Constant DP ratio

With this type of DP policy, the firm pays a constant percentage of net earnings to the shareholders.

For example, if the firm fixes its DP ratio as 25% of its earnings, it implies that shareholders get 25% of earnings as dividend year after year. In such years where profits are high, they get higher amount.

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.

The stability of dividends is desirable due to the following advantages:

· Building confidence amongst investors

A stable dividend policy helps to build confidence and remove uncertainty in investors. A constant dividend policy will not have any fluctuations thereby suggesting to the investors that the firm’s future is bright. In contrast, shareholders of a firm having an unstable DP will not be certain about their future in such a firm.

· Investors desire for current income

A firm has different categories of investors –

- old and retired persons

- pensioners

- youngsters


- salaried class

- housewives

Of these, people like retired persons prefer current income. Their living expenses are fairly stable from one period to another. Sharp changes in current income, that is, dividends, may necessitate sale of shares. Stable dividend policy avoids sale of securities and inconvenience to investors.

· Information about firms profitability

Investors use dividend policy as a measure of evaluating the firm’s profitability. Dividend decision is a sign of firm’s prosperity and hence a firm should have a stable DP.

· Institutional investors’ requirements

Institutional investors like LIC, GIC and MF prefer to invest in companies with a record of stable DP. A company having erratic DP is not preferred by these institutions. Thus to attract these organisations which have large quantities of investible funds, firms follow a stable DP.

· Raise additional finance

Shares of a company with stable and regular dividend payments appear as quality investment rather than a speculation. Investors of such companies are known for their loyalty and whenever the firm comes with new issues, they are more responsive and receptive. Thus raising additional funds becomes easy.

· Stability in market

The market price of shares varies with the stability in dividend rates. Such shares will not have wide fluctuations in the market prices which is good for investors.


Fill in the blanks:

1. ____________ constitute an important source of financing investment requirements of a firm

2. Dividend policy has a direct influence on the two components of shareholders’ return __________ and ____________

3. ______________ considers dividend pay-outs are relevant and have a bearing on the share prices of the firm.

4. ____________ constitute an important source of financing investment requirements of a firm

5. Dividend policy has a direct influence on the two components of shareholders’ return __________ and ____________

6. ______________ considers dividend pay-outs are relevant and have a bearing on the share prices of the firm to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns

7. The __________ process refers to setting off or balancing two transactions which are entered into simultaneously

8. ______ costs refer to the cost involved in raising capital from the market

9. ______ are the costs associated with sale of securities by investors.

15.6 Forms of Dividends

Dividends are portions of earnings available to the shareholders. Generally, dividends are distributed in cash, but sometimes they may also declare dividends in other forms which are discussed below (see figure 15.3):

Figure 15.3: Forms of dividend

· Cash dividends

Most companies pay dividends in cash. The investors also, especially the old and retired investors depend on this form of payment for want of current income.

· Scrip dividend

In this form of dividends, equity shareholders are issued transferable promissory notes with shorter maturity periods which may or may not have interest bearing. This form is adopted if the firm has earned profits and it will take some time to convert its assets into cash (having more of current sales than cash sales). Payment of dividend in this form is done only if the firm is suffering from weak liquidity position.


· Bond dividend

Scrip and bond dividend are the same except that they differ in terms of maturity. Bond dividends carry longer maturity periods and bear interest, whereas scrip dividends carry shorter maturity periods and may or may not carry interest.

· Stock dividend (bonus shares)

Stock dividend, as known is 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 and not changing the total net worth. The investors are allotted shares in proportion to their present shareholding. Declaration of bonus shares has a favourable psychological effect on investors. They associate it with prosperity

15.7 Stock Split

Before going into the concept of stock split, let us start with its definition.

A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share.

A stock split affects only the par value and does not have any effect on the total outstanding amount in share capital. The reasons for splitting shares are:

· To make shares attractive

The prime reason for effecting 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 expecting high profits in future.

· Higher dividend to shareholders

When shares are split, 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.

15.8 Summary

Dividends are the earnings of the company distributed to shareholders. Payment of dividend is not mandatory, but most companies see to it that dividends are paid on a regular basis to maintain the image of the company.

As payment of dividend is not compulsory, the question which arises in the minds of policy makers is- “Should dividends be paid, if yes, what should be the quantum of payment?”

Various theories have come out with various suggestions on the payment of dividend. B. Graham and D. L. Dodd are of the view that there is a close relationship between the dividends and the stock market. The stock value responds positively to high dividends and vice versa.

Prof. James E. Walter considers dividend pay-outs are necessary but if the firm’s ROI (rate of interest)is high, earnings can be retained as the firm has better and profitable investment opportunities.

Gordon also contends that dividends are significant to determine the share prices of a firm. Shareholders prefer certain returns (current) to uncertain returns (future) and therefore give a premium to the constant returns and discount to uncertain returns.

Miller and Modigliani explain that a firm’s dividend policy is irrelevant and has no effect on the share prices of the firm. They are of the view that it is the investment policy through which the firm can increase its share value and hence this should be given more importance.

Dividends can be paid out in various forms such as cash dividend, scrip dividend, bond dividend and bonus shares.


1. Write a short note on the different types of dividend.

2. What is stock split? What are its advantages?

3. The following information (shown in table 15.1) is available in respect of a company. Calculate the price of the share as per Walter model.

Table 15.1: Information of a company

Equity capitalisation 15%Earnings per share Rs.25Dividend pay-out ratio 25%Rate of interest (ROI) 12%

4. Considering the following information, what is the price of the share as per Gordon’s Model?

Table 15.2: Details of the company

Net sales Rs.120 lakhsNet profit margin 12.5%Outstanding preference shares Rs.50 lakhs@ 12% dividendNo. of equity shares 25, 000Cost of equity shares 12%Retention ratio 40%Rate of interest (ROI) 16%

5. If the EPS is Rs.5, dividend pay-out ratio is 50%, cost of equity is 20%, growth rate in the ROI is 15%, what is the value of the stock as per Gordon’s Dividend Equalisation Model?

6. Nile Ltd. makes the following information available. What is the value of the stock as per Gordon Model?

Ke 14%, EPS Rs. 20, D/P ratio 35% Retention ratio 65%, ROI 16%

7. What is the stock price as per Gordon Model if DP ratio is 60% in the above case?



1. Retained earnings

2. Dividends and capital gains

3. Prof. James E. Walter

4. Normal firm

5. Gordon

6. Arbitrage

7. Floatation costs

8. Transaction costs


1. Refer to 15.6

2. Refer to 15.7

3. Hint: Apply the formula – Walter’s formula to determine the market price

P = +

4. Hint: Apply the Gordon formula of P = .




15.11 References

1. Financial Management by Khan Jain, 4th edition, 2005

2. Financial Management by I. M. Pandey, 9th edition, 2005

3. Financial Management by Prasanna Chandra, 6th edition, 2005

4. Financial Management by Shashi Gupta and Neeti Gupta, 2nd edition, 2008

5. Financial Management by Rustogi, first edition, 2010.



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