1 BAJRANG/KUCHAMAN/[email protected]/MBA … · Financial Management is a related aspect of finance function. In the present business administration financial management is

1 BAJRANG/KUCHAMAN/[email protected]/MBA NOTES/FINANCIAL MANAGEMENT

COURSE NO 203-Financial Management Aims and Objectives of Financial Management; Financial Analysis and Control; Cost-Volume-Profit Analysis; Operating and Financial Leverage; Time Value of Money, Investment and Capital Structure Decisions; Instruments of Long Term Finance; Cost of Different Sources of Raising Capital; Weighted Average cost of capital; Optimum Capital Structure; Valuation and Rates of Return; Methods of Capital Budgeting; Short-term Financing Investment; Management of Working Capital-Cash Receivables and Inventory Management, Internal Financing and Dividend Policy An introduction to valuation of firm; and merger and acquisitions Financial Management: Definition, Aims, Scope and Functions Financial Management is a related aspect of finance function. In the present business administration financial management is an important branch. Nobody will think over about-business activity without finance implication.

Financial management includes adoption of general management principles for financial implementation. The following may be said as the related aspects of financial management rising of funds, using of these funds profitably, planning of future activities, controlling of present implementations and future developments with the help of financial accounting, cost accounting, budgeting and statistics. It acts as guidance where more opportunities for investment is available. Financial management is useful as a tool for allotment of resources to various projects depending on their importance and repayment capacity. Definition: James Van Morne defines Financial Management as follows: “Planning is an inextricable dimension of financial management. The term financial management connotes that funds flows are directed according to some plan”. Financial managements can be said a good guide for allotment of future resources of an organisation.

Preparing and implementation of some plans can be said as financial management. In other words, collection of funds and their effective utilisation for efficient running of and organization is called financial management. Financial management has influence on all activities of an organisation. Hence it can be said as an important one. Its main responsibility is to complete the finance function successfully. It also has relations with other business functions. All business decisions also have financial implications. According to Raymond Chambers, Management of finance function is the financial management’.

However, financial management shall not be considered as the profit extracting device. If finance is properly utilised through plans, they lead to profits. Besides, without profits there won’t be finance generation. All these are facts. But this is not complete.

The implication of financial management is not only attaining efficiency and getting profits but also maximising the value of the firm. It facilitates to protect the interests of various classes of people related to the firm. Hence, managing a firm for profit maximisation is not the meaning for financial management. Financial management is applicable to all kinds of organisations. According to Raymond Chambers, ‘the word financial management is applicable to all kinds of firms irrespective of their objectives’. Aims of Financial Management: The aims of financial management should be useful to the firm’s proprietors, managers, employees and consumers. For this purpose the only way is maximisation of firm’s value. The following aspects have place in maximising firm’s value: 1. Rice in profits: If the firm wants to maximise its value, it should’ increase its profits and revenues. For this purpose increase of sales volume or other activities can be taken up. It is the general feature of any firm to increase profits by proper utilisation of all opportunities and plans.

Theoretically, firm gets maximum profits if it is under equilibrium. At that stage the average cost is minimal and the marginal cost and the marginal revenues are equal. Here, we can’t say the sales because there must be suitable market for the increased sales. Further, the above costs must also be controlled. 2. Reduction in cost: Capital and equity funds are utilised for production. So all types of steps should be taken to reduce firm’s cost of capital. 3. Sources of funds: It should be decided by keeping in view the value of the firm to collect funds through issue of shares or debentures. 4. Reduce risks: There won’t be profits without risk. But for this reason if more risk is taken, it may become danger to the existence of the firm. Hence risk should be reduced to minimum level. 5. Long run value: It should be the feature of financial management to increase the long-run value of the firm. To earn more profits in short time, some firms may do the activities like releasing of low quality goods, neglecting the interests of consumers and employees. These trials may give good results in the short run. But for increasing the value of the firm in the long run, avoiding; such activities are more essential. Scope and functions of financial management: The scope of financial management includes three groups. First – relating to finance and cash, second – rising of fund and their administration, third – along with the activities of rising funds, these are part and parcel of total management, Isra Salomon felt that in view of funds utilisation third group has wider scope. It can be said that all activities done by a finance officer are under the purview of financial management. But the activities of these


officers change from firm to firm, it become difficult to say the scope of finance. Financial management plays two main roles, one – participating in funds utilisation and controlling productivity, two – Identifying the requirements of funds and selecting the sources for those funds. Liquidity, profitability and management are the functions of financial management. Let us know very briefly about them. 1. Liquidity: Liquidity can be ascertained through the three important considerations. i) Forecasting of cash flow: Cash inflows and outflows should be equalized for the purpose of liquidity. ii) Rising of funds: Finance manager should try to identify the requirements and increase of funds. iii) Managing the flow of internal funds: Liquidity at higher degree can be maintained by keeping accounts in many banks. Then there will be no need to depend on external loans. 2. Profitability: While ascertaining the profitability the following aspects should be taken into consideration: 1) Cost of control: For the purpose of controlling costs, various activities of the firm should be analysed through proper cost accounting system, ii) Pricing: Pricing policy has great importance in deciding sales level in company’s marketing. Pricing policy should be evolved in such a way that the image of the firm should not be affected. iii) Forecasting of future profits: Often estimated profits should be ascertained and assessed to strengthen the firm and to ascertain the profit levels. iv) Measuring the cost of capital: Each fund source has different cost of capital. As the profit of the firm is directly related to cost of capital, each cost of capital should be measured. 3. Management: It is the duty of the financial manager to keep the sources of the assets in maintaining the business. Asset management plays an important role in financial management. Besides, the financial manager should see that the required sources are available for smooth running of the firm without any interruptions. A business may fail without financial failures. Financial failures also lead to business failure. Because of this peculiar condition the responsibility of financial management increased. It can be divided into the management of long run funds and short run funds. Long run management of funds relates to the development and extensive plans. Short run management of funds relates to the total business cycle activities. It is also the responsibility of financial management to coordinate different activities in the business. Thus, for the success of any firm or organization financial management is said to be a must. Objectives of Financial Management: Financial management is one of the functional areas of business. Therefore, its objectives must be consistent with the overall objectives of business. The overall objective of financial management is to provide maximum return to the owners on their investment in the long- term. This is known as wealth maximisation. Maximisation of owners’ wealth is possible when the capital invested initially increases over a period of time. Wealth maximisation means maximising the market value of investment in shares of the company. Wealth of shareholders = Number of shares held ×Market price per share. In order to maximise wealth, financial management must achieve the following specific objectives: (a) To ensure availability of sufficient funds at reasonable cost (liquidity). (b) To ensure effective utilisation of funds (financial control). (c) To ensure safety of funds by creating reserves, re-investing profits, etc. (minimisation of risk). (d) To ensure adequate return on investment (profitability). (e) To generate and build-up surplus for expansion and growth (growth). (f) To minimise cost of capital by developing a sound and economical combination of corporate securities (economy). (g) To coordinate the activities of the finance department with the activities of other departments of the firm (cooperation). Profit Maximisation: Very often maximisation of profits is considered to be the main objective of financial management. Profitability is an operational concept that signifies economic efficiency. Some writers on finance believe that it leads to efficient allocation of resources and optimum use of capital.

It is said that profit maximisation is a simple and straightforward objective. It also ensures the survival and growth of a business firm. But modern authors on financial management have criticised the goal of profit maximisation. Wealth Maximisation: Prof. Ezra Solomon has advocated wealth maximisation as the goal of financial decision-making. Wealth maximisation or net present worth maximisation is defined as follows: “The gross present worth of a course of action is equal to the capitalised value of the flow of future expected benefits, discounted (or as capitalised) at a rate which reflects their certainty or uncertainty.

Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive (i.e., if only one can be undertaken), then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth. In short, the operating objective for financial management is to maximise wealth or net present worth.” Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets is also a part of investment decisions called as working capital decisions.


2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two:

a. Dividend for shareholders- Dividend and the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans

of the enterprise. Objectives of Financial Management The financial management is generally concerned with procurement, allocation and control of financial resources of a concern.

The objectives can be- 1. To ensure regular and adequate supply of funds to the concern. 2. To ensure adequate returns to the shareholders this will depend upon the earning capacity, market price of the share,

expectations of the shareholders. 3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least

cost. 4. To ensure safety on investment, i.e., funds should be invested in safe ventures so that adequate rate of return can be

achieved. 5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained

between debt and equity capital. Functions of Financial Management 1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the

company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise.

2. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties.

3. Choice of sources of funds: For additional funds to be procured, a company has many choices like- a. Issue of shares and debentures b. Loans to be taken from banks and financial institutions c. Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing. 4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on

investment and regular returns is possible. 5. Disposal of surplus: The net profits decision has to be made by the finance manager. This can be done in two ways: a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus. b. Retained profits - The volume has to be decided which will depend upon expansion, innovation, diversification plans of the

company. 6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many

purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc.

7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Financial Analysis and Control Introduction Management accounting reports are built around the information needs of managers, who must define specific objectives of the enterprise. Different institutions have different objectives, and management accounting focuses on the financial dimensions of how and why institutional objectives are achieved. Unlike audited financial reports, managerial financial reports are more subjective and less rigid in form. The form or content may vary and can include graphs or charts to supplement the statements. Moreover, these reports can encompass nonfinancial elements such as the size and quality of enrolment, faculty size, the condition of physical facilities, and the scope of administrative staff.

Nearly all facilities management problems involve alternatives, and resolution of these problems requires consideration and comparison of the costs of alternatives. What levels of electric power should be purchased and produced? Should a heating or power plant be converted to a different type of fuel? Should building cooling systems be converted to a central chillier plant with a chilled water distribution system? There are alternatives when replacing building components and equipment such as absorption chillies, compressors, components of a steam distribution system, roofs, and roof drainage systems. The choice among alternatives often is not simple; machines and structures generally are part of a complex plant, and this complexity creates difficulties when determining the effects of alternatives. Many alternatives embody subsidiary alternatives. Satisfaction of the engineer's sense of technical perfection is not normally the most economical alternative; imperfect alternatives are sometimes the most economical.

In most cases, the costs to be compared are not immediate costs but long-term costs. Initial cost, operating and maintenance costs, life expectancy, and replacement cost all must be considered. The time value of money is a factor and should


always be considered. A business manager who is not technically trained must rely on the facilities manager for advice as to the differences among technical alternatives. Facilities management must translate the differences among alternatives into money terms, both for internal decision making and to justify requests to higher authorities for funds. Control and Analysis Concepts Control is so closely interlinked with planning that the two are virtually inseparable. Planning is the process of deciding what needs to be done and anticipating the steps needed to produce the desired outcome. Control involves implementing the planning decision, comparing actual results with what was planned, and taking corrective action if there is an unacceptable deviation. This close relationship is illustrated by the planning and control cycle, which continues until goals are achieved:

Goals are set.

Steps to achieve the goals are chosen.

Actual performance occurs, either according to plan or with variation.

Performance is monitored through feedback mechanisms.

Adjustments are made to goals, plans, or actions.

Additional feedback is received.

Additional adjustment takes place.

Control To control, it is necessary to have a way of measuring performance and a standard to which that performance will be compared. The cost accounting system, when properly structured, provides a means of measuring cost performance. The standards for comparison can take many forms. The two most common comparisons are present versus past and actual versus budget. Present-Versus-Past Comparison Even the most rudimentary accounting systems permit a comparison of present to past costs for the same time period. If conditions are generally the same and the account breakdown is sufficiently detailed, this can be an effective control method. Even in the presence of other, more sophisticated techniques, a present-versus-past comparison is usually useful. Its usefulness is enhanced if trend lines are established that depict performance over a series of time periods. The chief difficulty with using past performance as a standard is that there is no indication of what performance should have been. Historical data could represent excellent or poor performance. Unless past conditions are known, a standard may be adopted that contains inefficiency and extraordinary costs. Although present-versus-past comparisons should not be dismissed entirely, they must be used with extreme caution and scepticism. They are most valuable when used in conjunction with other indicators. Actual-Versus-Budget Comparison Comparison of actual costs to budget is perhaps the most important technique available to the facilities manager. It is generally superior to comparisons against past performance because of the characteristics of budgets in general and the unique role they play in non-profit organizations. When properly prepared, budgets represent the plan, stated in monetary terms, that has been formulated to meet the objectives of the organization. As such, they force the manager to anticipate changes. In non-profit organizations, budgets play an even more important role in management control. In such organizations, control is generally viewed to be more difficult because of the absence of profit as an objective, as a criterion for appraising alternative courses of action, and as a measure of performance. This shifts the focus from profits to plans and budgets and makes the budget the principal means of overall control. When budgets are used, cost control will be much more effective if the cost accounting system is designed to be consistent with the budget, and vice versa. Unless the two are stated in the same terms and structured similarly, there is no way of determining whether spending occurred according to the budget plan. This does not mean that a budget should be set for each detail account, but it does mean that there should be accounts in the cost accounting system that match each line item in the budget so that a direct comparison can be made. Types of Analysis There are many different types of analysis that can be performed to get better insight into the effect of management on the institution's financial performance. The most common ones are comparative analysis, constant dollar analysis, performance analysis, ratio analysis, variance analysis, and exception analysis. Comparative Analysis Comparative analysis involves comparing specific internally stipulated objectives against those of other similar institutions. However, because of the inconsistency of inter institutional data, the validity of this technique is questionable. Most managers are interested in how their operations compare with those at other universities, or with the average of those at other universities, and seek performance measures common to all facilities. For example, the time required to run 100 ft. of electrical conduit can be measured on an absolute basis. The task should take the same amount of time anywhere, assuming that workers of equal ability do the job and similar conditions exist. However, few absolute measures exist against which actual performance can be compared. Most measurements are relative to past performance, are in index or ratio form, and are most meaningfully analysed using trend lines and charts. Every two years, APPA: The Association of Higher Education Facilities Officers surveys its members and publishes the results in its Comparative Costs and Staffing Report for College and University Facilities . The information reported by each participating institution includes the following:

Full-time equivalent (FTE) student enrolment

Total gross square footage of all buildings

Gross square footage maintained in facilities budget

Ground acreage

Administrative cost per gross square foot

FTE administrators

Engineering cost per gross square foot

FTE engineering personnel

Maintenance cost per gross square foot

FTE maintenance employees

Custodial cost per gross square foot

FTE custodial personnel


Landscape and grounds cost per gross square foot FTE landscape and grounds personnel The report presents this information in a format that permits comparisons. Managers can compare their institution's performance to that of institutions of similar size, type, and educational purpose. Other information, although not nearly as comprehensive as APPA's report, is published periodically in various trade journals. For example, American School & University magazine annually publishes a maintenance and operations cost survey, with costs analysed as follows:

Custodial salaries, stated in dollars per student and per square foot

Financial Analysis and Control Page 5 Copyright APPA 2009

Custodial salaries, stated in dollars per student and per square foot

Maintenance salaries, stated in dollars per student and per square foot

Heat, other utilities, and other costs, stated in dollars and per square foot

Average custodial and maintenance salaries

Square feet per custodian

The above data are presented for each of ten regions of the United States, including Alaska

and Hawaii At best, published indicators can serve only as a guide. Large differences are often noticeable, even among similar organizations. These wide variations reflect the differences not only in costs but also in methods of accounting for costs. For this reason, caution is required in using such comparative data. A better approach to comparative analysis is benchmarking, which is discussed later in this chapter. Constant-Dollar Analysis This analysis is a primary concern for institutions and indicates the impact of inflation on the institution's budget. These are several sources that can be used for comparison; an example is the Higher Education Price Index, from which an institution-specific cost index can be developed. Performance Analysis This analysis seeks to establish standards other than budgets against which to measure and compare actual performance. These standards are frequently nonmonetary and are intended to complement, not replace, budgets. In many cases these standards provide the detail on which budgets are built. Performance standards may be generated internally, or they may come from outside sources. Both are useful. Internal standards usually relate to the budget in some way or to an individual department's unique goals and objectives. Examples of internal standards are the following:

A 20-day backlog of work should be maintained at all times.

Actual job costs should be within 10 present of the estimates.

Actual labor performance should be from 95 to 105 present of standard labour.

Energy use should not exceed 100,000 Btus per square foot per year. Ratio Analysis This constitutes trending ratios of key financial indicators over time to determine their stability or instability over time. Following are some examples of these ratios:

Current asset/current liability

Long-term asset/long-term liability

Fund balances/debt

Fund balances/types of expenditures and mandatory transfer

Credit worthiness ratios

Return-on-investment ratios

Variance Analysis Deviation from a standard is known as variance. The standard can be historical data, comparable data from another university, or any other predetermined yardstick. For cost control, it is of little use to know only the dollar amount of the variance, especially if many factors are at work to influence cost. To take effective action, it is necessary to break down the total difference into its individual elements using variance analysis. There are basically two types of variance: price and quantity. Several other variances can be developed for specialized purposes, but each one is ultimately traceable to variations in price, variations in quantity used, or a combination of the two. Any cost can be stated in terms of price and quantity, as follows:

Cost = Price x Quantity If two costs are involved, one can be considered the standard and the other, the actual. The difference between them represents the variance. From this come the basic definitions of price and quantity variances: Price variance VP = the difference between actual price (PA) and standard price (P S) multiplied by the actual quantity (QA):

Quantity variance VQ = the difference between actual quantity (Q A) and standard quantity (QS) multiplied by the standard price

(PS): Exception Analysis A cost control system operated on the exception principle is one in which management's attention is focused on the relatively small number of items for which actual performance is significantly different from the standard. This principle acknowledges that management time is a scarce resource that should be applied to problems that have the greatest impact on the organization. The relatively large number of minor variances from standard are either ignored or left to become the priority concern of a lower level manager in the responsibility accounting hierarchy. Management by exception is implicitly based on "Pareto's Law". Vilfredo Pareto (1848-1923), an Italian economist and sociologist,first proposed the theory that in any type of activity, a small percentage of forces will influence a large percentage of results. This is also known as the 80-20 rule: 80 percent of any result is controlled by 20 percent of that which is producing the


result. Management by exception focuses on the 20 percent of the deviations from standard that account for 80 percent of the problems.

Operating and Financial Leverage By leverage we mean, making use of such asset or source of funds like debentures for which the company has to pay fixed cost or fixed financial charges, in order to generate more return. There are three kinds of Leverage i.e. operating leverage, financial leverage and combined leverage. The operating leverage measures the effect of fixed cost whereas the financial leverage evaluates the effect of interest expenses.

Leverage in its most general sense means the ability to magnify results at a relatively low cost. In business, you make decisions about leverage that affect your profitability. When you evaluate whether you can increase production profitably, you are addressing operating leverage. If you are contemplating taking on additional debt, you have entered the realm of financial leverage. Both types are crucial to business success and have different, though related, meanings. Definition of Operating Leverage When a firm utilizes fixed cost bearing assets, in its operational activities in order to earn more revenue to cover its total costs is known as Operating Leverage. Degree of Operating Leverage (DOL) is used to measure the effect on Earnings before interest and tax (EBIT) due to the change in Sales. The firm, which employs high fixed cost and low variable cost, is regarded as high operating leverage whereas the company which has low fixed cost and high variable cost is said to have less operating leverage. It is fully based on fixed cost. So, the higher the fixed cost of the company the higher will be the Break Even Point (BEP). In this way the Margin of Safety and Profits of the company will be low which reflects that the business risk is higher. Therefore, low DOL is preferred because it leads to low business risk. The following formula is used to calculate Degree of Operating Leverage (DOL):

Operating leverage compares sales to the costs of production. Fixed costs involve the

property, plant and equipment you use to create products. These costs are independent of the number of units you produce.

Variable costs are the additional costs required to produce a unit of marketable inventory, such as the costs of raw materials,

electricity, packaging and transportation. You can measure operating leverage as the ratio of fixed costs to variable costs or fixed

costs to total costs. Higher values of this ratio indicate high operating leverage. Definition of Financial Leverage The utilization of such sources of funds which carry fixed financial charges in company’s financial structure, in order to earn more return on investment is known as Financial Leverage. Degree of Financial Leverage (DFL) is used to measure the effect on Earning Per Share (EPS) due to the change in firms operating profit i.e. EBIT. When a company uses debt funds in its capital structure having fixed financial charges in the form of interest, it is said that the firm employed financial leverage. The DFL is based on interest and financial charges, if these costs are higher DFL will also be higher which will ultimately give rise to the financial risk of the company. If Return on Capital Employed > Return on debt, then the use of debt financing will be justified because in this case, the DFL will be considered favorable for the company. As the interest remains constant, a little increase in the EBIT of the company will lead to a higher increase in the earnings of the shareholders which is determined by the financial leverage. Hence, high DFL is suitable. The following formula is used to calculate Degree of Financial Leverage (DFL):

Financial leverage is a measure of debt, usually defined as total debt divided by the owners’ equity, which is assets minus liabilities. By increasing financial leverage instead of issuing stock, you can use the additional funds to increase production without diluting earnings among a greater number of shareholders. In this sense, it magnifies your profits per share. You can measure this effect with the formula for degree of financial leverage: EBIT divided by earnings before taxes. However, additional leverage increases your interest expense, which cuts into net income, even though interest is tax deductible. If you are overleveraged and sales fall, you might find yourself short of cash and face default on your debt. Combined Leverage The degree of combined, or total, leverage is defined as the percentage change in earnings per share divided by the percentage change in sales. It is the product of the degree of financial leverage and the degree of operating leverage. As such, it is a measure of the overall riskiness of your business. A high combined leverage indicates high fixed costs and heavy debt. In good times, these factors can increase profits as you increase sales. Should business falter, these same factors mean you cannot cut total costs substantially by decreasing production, putting a strain on cash flow and your ability to pay interest and repay debt Comparison Chart

BASIS FOR COMPARISON

OPERATING LEVERAGE FINANCIAL LEVERAGE

Meaning Use of such assets in the company's operations for which it has to pay fixed

costs is known as Operating Leverage.

Use of debt in a company's capital structure for which it has to pay interest

expenses is known as Financial Leverage.

Measures Effect of Fixed operating costs. Effect of Interest expenses

Relates Sales and EBIT EBIT and EPS

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Ascertained by Company's Cost Structure Company's Capital Structure

Preferable Low High, only when ROCE is higher

Formula DOL = Contribution / EBIT DFL = EBIT / EBT

Risk It give rise to business risk. It give rise to financial risk.

Time Value of Money

Introduction Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you expect to receive in one year is only $1. A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the right-hand column below. The left column has references to more detailed explanations, formulas, and examples. Definition Time Value of Money is a concept that recognizes the relevant worth of future cash flows arising as a result of financial decisions by considering the opportunity cost of funds. Topic Contents:

Concept Money loses its value over time which makes it more desirable to have it now rather than later. There are several reasons why money loses value over time. Most obviously, there is inflation which reduces the buying power of money. But quite often, the cost of receiving money in the future rather than now will be greater than just the loss in its real value on account of inflation. The opportunity cost of not having the money right now also includes the loss of additional income that you could have earned simply by having received the cash earlier. Moreover, receiving money in the future rather than now may involve some risk and uncertainty regarding its recovery. For these reasons, future cash flows are worth less than the present cash flows. Time Value of Money concept attempts to incorporate the above considerations into financial decisions by facilitating an objective evaluation of cash flows from different time periods by converting them into present value or future value equivalents. This ensures the comparison of 'like with like'. The present or future value of cash flows are calculated using a discount rate (also known as cost of capital, WACC and required rate of return) that is determined on the basis of several factors such as:

Rate of inflation Higher the rate of inflation, higher the return that investors would require on their investment.

Interest Rates Higher the interest rates on deposits and debt securities, greater the loss of interest income on future cash inflows causing investors to demand a higher return on investment.

Risk Premium Greater the risk associated with future cash flows of an investment, higher the rate of return required by an investors to compensate for the additional risk.

Consider a simple example of a financial decision below that illustrates the use of time value of money.

Interest

Simple

Compound

Interest is a charge for borrowing money, usually stated as a percentage of the amount

borrowed over a specific period of time. Simple interest is computed only on the original

amount borrowed. It is the return on that principal for one time period. In

contrast, compound interest is calculated each period on the original amount

borrowed plus all unpaid interest accumulated to date. Compound interest is always

assumed in TVM problems.

Number of

Periods

Periods are evenly-spaced intervals of time. They are intentionally not stated in years

since each interval must correspond to a compounding period for a single amount or a

payment period for an annuity.

Payments

Payments are a series of equal, evenly-spaced cash flows. In TVM applications,

payments must represent all outflows (negative amount) or all inflows (positive amount).

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Present Value

Single Amount

Annuity

Present Value is an amount today that is equivalent to a future payment, or series of

payments, that has been discounted by an appropriate interest rate. The future amount

can be a single sum that will be received at the end of the last period, as a series of

equally-spaced payments (an annuity), or both. Since money has time value, the present

value of a promised future amount is worth less the longer you have to wait to receive it.

Future Value

Single Amount

Annuity

Future Value is the amount of money that an investment with a fixed, compounded interest

rate will grow to by some future date. The investment can be a single sum deposited at

the beginning of the first period, a series of equally-spaced payments (an annuity), or

both. Since money has time value, we naturally expect the future value to be greater than

the present value. The difference between the two depends on the number of

compounding periods involved and the going interest rate.

Loan Amortization A method for repaying a loan in equal installments. Part of each payment goes toward

interest and any remainder is used to reduce the principal. As the balance of the loan is

gradually reduced, a progressively larger portion of each payment goes toward reducing

principal.

Cash Flow

Diagram

A cash flow diagram is a picture of a financial problem that shows all cash inflows and

outflows along a time line. It can help you to visualize a problem and to determine if it

can be solved by TVM methods.

Capital Structure - Meaning and Factors Determining Capital Structure Meaning of Capital Structure Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. The capital structure involves two decisions-

a. Type of securities to be issued are equity shares, preference shares and long term borrowings (Debentures).

b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into two-

i. Highly geared companies - Those companies whose proportion of equity capitalization is small.

ii. Low geared companies - Those companies whose equity capital dominates total capitalization. For instance - There are two companies A and B. Total capitalization amounts to be USD 200,000 in each case. The ratio of equity capital to total capitalization in company A is USD 50,000, while in company B, ratio of equity capital is USD 150,000 to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company.

Factors Determining Capital Structure

1. Trading on Equity- The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity

share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of

debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on

borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should

go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when

expectations of shareholders are high.

2. Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders. These members

have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders

have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they

want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.

3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation

in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which

provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and

other loans.

4. Choice of investors- The company’s policy generally is to have different categories of investors for securities. Therefore, a capital

structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans

and debentures are generally raised keeping into mind conscious investors.

5. Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the

depression period, the company’s capital structure generally consists of debentures and loans. While in period of boons and inflation, the

company’s capital should consist of share capital generally equity shares.

6. Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while

for long period it goes for issue of shares and debentures.

7. Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that

debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity

shareholders demand an extra share in profits.

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8. Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet

fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high

and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If

company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such

cases.

9. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on

the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well

as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

Instruments of Long Term Finance. Financial instruments are tradable assets of any kind. They can be cash, evidence of an ownership interest in an entity, or a contractual right to receive or deliver cash or another financial instrument. International Accounting Standards IAS 32 and 39 define a financial instrument as "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity". Types

Financial instruments can be either cash instruments or derivative instruments: Cash instruments —instruments whose value is determined directly by the markets. They can be securities, which are readily

transferable, and instruments such as loans and deposits, where both borrower and lender have to agree on a transfer. Derivative instruments —instruments which derive their value from the value and characteristics of one or more underlying entities

such as an asset, index, or interest rate. They can be exchange-traded derivatives and over-the-counter (OTC) derivatives. Alternatively, financial instruments may be categorized by "asset class" depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorised into short term (less than one year) or long term. Foreign exchange instruments and transactions are neither debt nor equity based and belong in their own category.

Asset class

Instrument type

Securities Other cash Exchange-traded derivatives OTC derivatives

Debt (long term)

> 1 year Bonds Loans

Bond futures

Options on bond futures

Interest rate swaps

Interest rate caps and floors

Interest rate options

Exotic derivatives

Debt (short term)

≤ 1 year

Bills, e.g. T-bills

Commercial paper

Deposits

Certificates of deposit Short-term interest rate futures Forward rate agreements

Equity Stock N/A Stock options

Equity futures

Stock options

Exotic derivatives

Foreign exchange N/A Spot foreign exchange Currency futures

Foreign exchange options

Outright forwards

Foreign exchange swaps

Currency swaps

Some instruments defy categorization into the above matrix, for example repurchase agreements.

Measuring gain or loss The gain or loss on a financial instrument is as follows:

Instrument Types Categories Measurement Gains and losses

Assets Loans and receivables Amortized costs Net income when asset is derecognized or impaired (foreign exchange and impairment recognized in net income immediately)

Assets Available for sale financial assets

Deposit account ‟ fair value

Other comprehensive income (impairment recognized in net income immediately)

A. Financial Instruments 1. General issues 5.2 This section will briefly define financial instruments. The relationship between financial assets and other financial instruments will be explained, as per MFSM para. 117. Also instruments that are not financial assets will be identified (viz., contingencies, guarantees, nonfinancial contracts). It will be noted that the financial assets classification generally applies to both claims (described as

https://en.wikipedia.org/wiki/Asset

https://en.wikipedia.org/wiki/International_Accounting_Standards

https://en.wikipedia.org/wiki/IAS_39

https://en.wikipedia.org/wiki/Market_(economics)

https://en.wikipedia.org/wiki/Security_(finance)

https://en.wikipedia.org/wiki/Loans

https://en.wikipedia.org/wiki/Deposit_(finance)

https://en.wikipedia.org/wiki/Derivative_(finance)

https://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-traded

https://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_exchange-traded

https://en.wikipedia.org/wiki/Ownership

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https://en.wikipedia.org/wiki/Bond_(finance)

https://en.wikipedia.org/wiki/Loan

https://en.wikipedia.org/wiki/Futures_contract

https://en.wikipedia.org/wiki/Option_(finance)


https://en.wikipedia.org/wiki/Interest_rate_swap

https://en.wikipedia.org/wiki/Interest_rate_cap_and_floor

https://en.wikipedia.org/wiki/Interest_rate_option

https://en.wikipedia.org/wiki/Exotic_derivative

https://en.wikipedia.org/wiki/Treasury_security#Treasury_bill

https://en.wikipedia.org/wiki/Commercial_paper

https://en.wikipedia.org/wiki/Deposit_account

https://en.wikipedia.org/wiki/Certificate_of_deposit

https://en.wikipedia.org/wiki/Interest_rate_future

https://en.wikipedia.org/wiki/Forward_rate_agreement

https://en.wikipedia.org/wiki/Stock




https://en.wikipedia.org/wiki/Exotic_derivative

https://en.wikipedia.org/wiki/Currency

https://en.wikipedia.org/wiki/Foreign_exchange_spot

https://en.wikipedia.org/wiki/Currency_future


https://en.wikipedia.org/wiki/Forward_contract

https://en.wikipedia.org/wiki/Foreign_exchange_swap

https://en.wikipedia.org/wiki/Currency_swap

https://en.wikipedia.org/wiki/Repurchase_agreement

https://en.wiktionary.org/wiki/derecognized

https://en.wikipedia.org/wiki/Deposit_account

https://en.wikipedia.org/wiki/Fair_value

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assets) and obligations (described as liabilities). There are exceptions in that monetary gold and SDRs are international financial assets with no counterpart liabilities and that “accounts receivable” is an asset, while “accounts payable” is the corresponding liability.

The objectives of classification of financial instruments will be spelled out. The potential dimensions by which instruments can be classified are numerous, so the classification involves identifying the most economically crucial features. The implications of a high degree of financial innovation will be discussed†in particular, that the classification will need to define the instruments with reference to the characteristics, not just specific types of instrument, so that it is applicable to new instruments and helps deal with hybrid and other borderline cases. The importance of classification of financial assets for understanding financial markets and for consistency with other datasets, particularly monetary and financial statistics, will be highlighted. In addition, the financial asset classification will be presented as the foundation for the functional category classification, which in some cases takes into account the type of instrument. 2. Overview of classification of financial instruments It is proposed to adopt an instrument classification that is based largely on that of the MSFM (see Chapter IV) and the 1993 SNA (see p. 589). Also, see Table 5.1 ahead. The differences are (i) a rearrangement into broad category headings: equity, debt instruments, and other instruments, and (ii) some clarification of terminology. In addition, an explicit concordance is made between the assets and the corresponding income. The underlying components remain identical. 3. Discussion of the classification of particular instruments After introducing the main types of financial assets, this chapter will go on to discuss the application of the general classification to particular situations. This discussion will largely follow Chapter IV of MFSM (paras. 116‟181) because the content and level of description is considered appropriate for this manual. However, it should be elaborated and updated to account for any subsequent developments in particular cases: (a) Repurchase agreements, securities lending, and gold swaps will be defined and illustrated. The instrument classification will be highlighted by identification of security and loan aspects. (b) The borderline between monetary gold and other gold will be discussed, and the process of monetization and demonetization of gold will be explained. (In addition, if financial gold were to be recognized as a financial instrument, the borderline with nonfinancial gold would also be discussed.) (c) Gold loans, gold swaps, and gold deposits will be defined. Possible treatments are as the gold staying on the books of the gold provider, in conjunction with a loan or deposit (d) Employee stock options will be classified as a subcategory under a new instrument category “financial derivatives and employee stock options,” the other subcategory being financial derivatives. (e) Inclusion of financial leases as loans will be noted. (It is proposed that financial leases will be noted under Chapter 5 Classifications, Chapter 6 International Investment Position, Chapter 7 Financial Account, and Chapter 10 Primary Income, with a full exposition in an appendix to the manual.) (f) Loans that have been traded will be classified as securities under certain conditions, as stated in the Debt Guide para. 3.29. It will be noted that many loans are traded but not sufficiently to become securities. (g) Depository receipts are classified in the same way as the underlying security, as noted in Chapter 4 Economic Territory, Units, Institutional Sectors, and Residence. (h) Ownership of mutual funds, unit trusts, and other pooled investments will be regarded as equity, regardless of what kind of assets the fund holds. In contrast, because the assets of an asset-backed security remain owned by the issuer, the security is a debt instrument. (i) Convertible bonds will be classified as debt securities until the option to convert them is exercised, at which time they will be classified as the new instrument. (j) Islamic instruments will be discussed, with a reference to Appendix 2 of MFSM as a source for further information.


(k) Trade credit and advances that are sold to another party (e.g., discounting of an importer’s bill) will be treated as ceasing to be trade credit and advances and will be classified as a loan or some other instrument, depending on itsnature. (l) Financial reinsurance will be explained and will be treated as a loan. (m) Activation of guarantees. Chapter 3 Accounting Principles will state the recommended treatment in instances when a debt guarantee is invoked. It will state that, once the guarantee has been invoked, the debt of the primary debtor is assumed to have been repaid and then assumed by the guarantor, as its own debt. However, Chapter 3 Accounting Principles notes that guarantees are not recognized as liabilities until invoked. 4. Other issues associated with the instrument classification There will be an outline of the classification of specialized government-togovernment instruments, such as capital subscriptions to international nonmonetary organizations including development finance institutions, and payments agreement balances, as discussed in BPM5, para. 432. B. Functional Categories The five current functional categories will be highlighted as the major classification for each of financial transactions, positions, and income (with the exception that financial derivatives do not give rise to income). It will be noted that the classification combines functions and instruments to give a useful breakdown of investment flows and levels. The proposed category and instrument breakdown is shown in the following table. Table 5.3 shows a combined classification by functional category, major instruments, and maturity. 1. Direct investment This section will state the features that distinguish direct investment from other categories and why it requires a separate functional category, along the lines of BPM5 paras. 359‟361 and BPT paras. 509-513. The section on direct investment will give a more detailed definition of direct investment than BPM5. This section will present, primarily under direct investment, the issues of the borderline between direct investment and other categories. There will be a cross-reference to the appendix on foreign affiliate’s trade in services statistics in Chapter 9 Goods and Services. It will be noted that the definition of foreign affiliate used in foreign affiliates trade in services statistics differs from the direct investment definition.

Data for income, transactions, and positions between enterprises in direct investment relationships will be presented under “direct investment abroad” and “direct investment in the reporting economy.” This treatment will also apply in cases of reverse direct investment (described below, i.e., where the direct investment enterprise has less than 10 percent of the ordinary shares or voting power in the direct investor). That is, these claims/liabilities will be recorded, as appropriate, as “claims on direct investor” and “liabilities to direct investment enterprise” and be shown under “assets” or “liabilities.” In contrast, these were shown as offsets under “direct investment in the reporting economy” and “direct investment abroad” in BPM5. The direction of the direct investment relationship will still be apparent from the title of these items. 2. Portfolio investment Portfolio investment will be defined. Two alternative definitions for portfolio investment could be based on: (a) legal form of instrument, that is, any securities that are not included in direct investment or reserve assets (as in BPM5 para. 385); or (b) whether the securities are traded in organized financial markets. The two definitions overlap, to a large degree, but differ for untraded or nontradable securities (such as shares in open-end mutual funds, unlisted companies, and unincorporated enterprises). If such securities were excluded from portfolio investment, they would be included under other investment. Possible reasons for changing to the second definition would be as follows: · The concept behind portfolio investment would be more coherent. At present, it is largely a residual instrument classification. · The tradability element has clearer implications for economic analysis, for example for volatility. · Tradability might result in a more meaningful borderline, for example, nontraded debt instrument is similar to a loan. · The requirement that the instrument be readily traded on organized financial markets will provide a clear link to the valuation principles for portfolio investment based on market prices. · To treat these cases as being reclassified to other investment would have the benefit of keeping “portfolio investment” limited to traded instruments, with observable market prices. · To treat these cases as portfolio investment would have the benefit of avoiding moves back and forth between portfolio and other investment, and the associated anomaly of the valuation principle between market and nominal values. 3. Financial derivatives and employee stock options Consistent with the discussion under Section A.2 above (Financial Instruments/Overview of classification), the manual will recommend a new functional category “financial derivatives and employee stock options.” This section will cover what is included in Financial Derivatives Supplement to the Fifth Edition of the Balance of Payments Manual (2000), as well as including the later decisions (in 2002) that clarified classification of financial derivatives between affiliated entities, and employee stock options. It is proposed that all


financial derivatives be included in this functional category, including those related to the management of reserve assets. Depending on decisions made, a revision of the title of the functional category to “financial derivatives and employee stock options excluding reserves” could be considered. The section will note cases where transactions between two parties for a particular derivative occur in both directions. In such cases, it may not be feasible to apply the netting principle, which requires separate presentation of transactions in assets and transactions in liabilities. The section will note that presenting net changes of transactions in both assets and liabilities for such financial instruments may be acceptable. This issue will also be covered or cross-referenced in Chapter 6 International Investment Position and Chapter 7 Financial Account. When an entity has both asset and liability transactions for financial derivatives, the manual will recommend that transactions be recorded gross, that is, that transactions in assets are to be kept separate from transactions in liabilities. However, it will recognize that “net reporting,” that is, that transactions in assets will be netted against transactions in liabilities, may be accepted if gross data are impractical. For positions data, it will be stated that assets should be recorded separately from liabilities in all cases. The classification of employee stock options will be discussed. While employee stock options do not fully meet the definition of financial derivatives, they share some characteristics with financial derivatives. Employee stock options will be classified as a subcategory under “financial derivatives and employee stock options.” Payments made under a financial derivative contract before net settlement (in those cases where there is a lag between the payment by one party and that of the counterparty) will be classified as “loans.” For example, in an interest rate swap, a fixed-for-floating swap may involve a monthly interest payment (e.g., for the floating leg) and an annual coupon payment (e.g., for the fixed leg). In that case, the monthly payment is classified as a “loan” (under “other investment”) that is removed from the balance sheet when the reciprocal coupon payment is made. Only at that time will the financial derivative be regarded as having been settled†as the net difference. There are cases where an upfront payment is made when over-the-counter (OTC) swaps are entered into. The manual will propose that these upfront payments represent loans, unless they are otherwise identifiable as a fee, in which case they are a financial service. The manual will discuss the treatment of changes in value of swaps that occur merely through the passage of time. It will note that, as financial derivatives do not involve advancing funds, they do not earn interest, and, therefore, such changes in value are valuation hanges. Premium payments under credit default swap payments are classified as financial derivatives. Examples could be provided to illustrate some complex derivative arrangements. 4. Other investment Other investment will be defined in the same way as BPM5, both as a residual and in terms of specific instruments. (As noted under portfolio investment above, there is a proposal to move untraded equity and debt securities from portfolio investment to other investment.) It is a residual concept, that is, instruments other than those included in direct investment, portfolio investment, and reserve assets. Particular components are: (a) trade credit and advances; (b) loans; (c) currency and deposits; (d) other financial assets/liabilities other than those included under direct investment or reserves (would include untraded equity and debt securities under proposal under portfolio investment above); and (e) insurance and pension fund technical reserves. Instruments raising particular issues will be mentioned: (a) The conditions for a loan to become sufficiently traded to be reclassified as a security will be noted, following the Debt Guide para. 3.29. The implications for valuation of classifying a particular claim as a debt security will be stated. (b) In some instances, it is difficult to separate deposits from loans. However, in line with MSFM (footnote 8, para.139), this section will note that these instruments should, nevertheless, be kept separate and that they should be distinguishable on the basis of the representation in the documents that evidence them. (c) It will be noted that financial leases will usually be included as part of “other investment” under “loans” (unless between affiliated enterprises, in which case they will be included under direct investment). (d) Where an upfront payment is made when an over-the-counter swap is entered into, this section will propose that this upfront payment represents a loan, unless it is otherwise identifiable as a fee. (e) Financial claims imputed for other cases of imputed change in ownership (e.g., goods for processing) will be discussed. (f) The discussion of “loans” will elaborate on the use of Fund credit and loans from the Fund, along the lines of that presented in the BPT para. 592. This could be presented in an appendix (or a box), along with information on other Fund-related issues, such as remuneration, arrears to the Fund, etc. (g) It will be stated that benefits under life insurance or pension funds will be regarded as “other investment” transactions, that is, they are treated as withdrawals of equity, as in BPM5.2 The results of the ongoing work on this topic by an IMF electronic discussion group and the decision of the ISWGNA on this issue will be taken into account in the new manual. This issue will also be mentioned in Chapter 7 Financial Account and Chapter 11 Secondary Distribution of Income. (h) Payments made under a financial derivative contract before net settlement (in those cases where there is a lag between the payment by one party and that of the counterparty) will be classified as loans, as noted under financial derivatives above, (i) Long-term concessional loans to the International Development Association will continue to be treated as loans rather than current or capital transfers. (j) It will be noted that trade credit and advances have an independent meaning. (k) Certain financial transactions and positions between affiliated enterprises that have a limited connection to the direct investment relationship are included under other investment, as discussed under direct investment above. C. Classification by Maturity Debt items can be classified by maturity. This chapter will provide a definition of short and long term, that is, short-term debt is one year or less, longterm debt is more than one year. It will note the complexity of the distinction in practice (due to rollovers, early termination options, etc.). Maturity can be expressed in terms of original maturity (as adopted in BPM5) or residual maturity. This section will adopt original term as the basis for recording. The residual maturity is considered more relevant for analysing liquidity, which relates to balance sheet positions. To accommodate these needs, this section will adopt, as a supplementary Presentation for the IIP, the approach used in the Debt Guide (Table 7.1), namely: (i) Short-term debt on an original maturity basis; (ii) Long-term debt due for payment within one year or less; and (iii) Long-term debt due for payment in more than one year. With this presentation the short-term or long-term split can be presented on either a residual or original maturity basis In cases of obligations that consist of tranches with different maturities, it will be stated that the amount should be split into the separate components D. Classification by Currency Classification of data by currency was dealt with in the Debt Guide paras. 6.12‟6.14 and encouraged for the Coordinated Portfolio Investment Survey. In the case of debt, the classification is usually straightforward when all aspects relate to the same currency. In some cases, there are relationships to two or more currencies:


(a) When the debt is payable in one currency but linked to another in amounts, the debt will be classified with the currency that it is linked to, as this reflects the underlying economic reality. (b) Some aspects of the loan are payable according to different currencies (e.g., principal from one currency, accrual of interest in another); then the debt needs to be split according to present values of the components. In the case of equity, the classification is according to the currency of the market in which the share is traded or, if not traded, the jurisdiction where the entity is incorporated. This information may be collected on a supplementary basis. It will be recognized that a split by currency is of potential analytical interest to the extent that it shows exposure to exchange rate changes. It is useful in deriving changes in value owing to exchange rate changes on debt securities†how these changes are recorded is shown in Chapter 8 Other Changes in Financial Assets and Liabilities Account. However, the manual will point out the limitations in the interpretation of currency splits. In the case of equity, the currency of the market in which the share is traded does not necessarily reflect the currencies to which the equity is exposed. In the case of debt securities, foreign currency exposure may be hedged, so that data could be misleading if information on hedging is not collected (as shown in, for example BOPCOM-02/73). The standard components will identify a foreign currency/domestic currency split for external debt. The manual will also urge that the analysis should take into account relevant hedging, if applicable, so that a full view of exposure to exchange rate changes can be obtained. E. Classification by Type of Interest Rate This section will note the classification of debt instruments as being either variablerate or fixed-rate as a possible supplementary breakdown, not to be included in the standard components. The classification is adopted in the Debt Guide paras. 8 Sources of Funds to Raise Long Term Capital The sources of funds refer to the mediums by which an organization raises its longterm capital and working capital. The organization can select any of the sources of funds depending upon the need and gestation period of the project to be financed. Shows various sources of funds: (a) Issue of Shares: Involve the public issue of equity and preference shares in the stock exchange. Issuing shares is the most common method of raising longterm capital because there are various many investors who are ready to invest in the capital market. Therefore, shares are used to finance projects having long gestation period. (b) Issue of Debentures: Involve the collection of funds by issuing debentures in the stock exchange. When an organization issues debentures, it needs to pay a fixed rate of interest to debenture

holders. (c) Term Loans: Refers to the funds that are raised from financial institutions for financing longterm projects. The rate of interest on term loans is higher than the rate of interest on debentures. (d) Fund from Operations: Refers to the fund raised by the organization’s own operations. It is the accumulated profit of an organization; therefore, can be used to finance various shortterm and longterm projects. (e) Sale of Fixed Assets: Helps in generating funds by selling fixed assets, such as land, buildings, plants, and machineries to finance shortterm and longterm projects. However,

the usage of this method may hamper the goodwill and creditworthiness of the organization. (f) Sale of Current Assets: Involves selling assets, such as bills receivables and stocks. These assets are generally sold by an organization to meet shortterm fund requirements. (g) Decrease in Working Capital: Refers to the reduction in the working capital either by decreasing current liabilities or increasing current assets. The increase in current assets or decrease in current liabilities provides funds for financing shortterm projects. (h) Receipt of Interest, dividend, and refund of tax: Helps in financing shortterm projects or meeting the working capital needs. This type of funds does not create any liability, as these are income of the organizations. Capital budgeting is performed by using various techniques. These techniques help in measuring the actual cost and returns generated from a project and comparing multiple projects with respect to their profitability. However, the actual cost and returns of a project cannot be forecasted without understanding the concept of TVM.

Cost of Different Sources of Rising Type of cost (A)Actual Cost Actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring a good or service. The actual costs or expenditures are recorded in the books of accounts of a business unit. Actual costs are also called as "Outlay Costs" or "Absolute Costs" or "Acquisition Costs". Examples: Cost of raw materials, Wage Bill etc. (B) Opportunity Cost Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other words, it is the return from the second best use of the firms resources which the firms forgoes in order to avail of the return from the best use of the resources. It can also be said as the comparison between the policy that was chosen and the policy that was rejected. The concept of opportunity cost focuses on the net revenue that could be generated in the next best use of a scare input. Opportunity cost is also called as "Alternative Cost". If a firm owns a land, there is no cost of using the land (ie., the rent) in the firms account. But the firm has an opportunity cost of using the land, which is equal to the rent forgone by not letting the land out on rent. (C) Sunk Cost Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs are generally not taken into consideration in decision - making as they do not vary with the changes in the future. Sunk costs are a part of the outlay/actual costs. Sunk costs are also called as "Non-Avoidable costs" or "Inescapable costs". Examples: All the past costs are considered as sunk costs. The best example is amortization of past expenses, like depreciation. (D) Incremental Cost Incremental costs are addition to costs resulting from a change in the nature of level of business activity. As the costs can be avoided by not bringing any variation in the activity in the activity, they are also called as "Avoidable Costs" or "Escapable Costs". More ever incremental costs resulting from a contemplated change is the Future, they are also called as "Differential Costs" Example: Change in distribution channels adding or deleting a product in the product line. (E) Explicit Cost Explicit costs are those expenses/expenditures that are actually paid by the firm. These costs are recorded in the


books of accounts. Explicit costs are important for calculating the profit and loss accounts and guide in economic decision-making. Explicit costs are also called as "Paid out costs" Example: Interest payment on borrowed funds, rent payment, wages, utility expenses etc. (F) Implicit Cost Implicit costs are a part of opportunity cost. They are the theoretical costs ie., they are not recognised by the accounting system and are not recorded in the books of accounts but are very important in certain decisions. They are also called as the earnings of those employed resources which belong to the owner himself. Implicit costs are also called as "Imputed costs". Examples: Rent on idle land, depreciation on dully depreciated property still in use, interest on equity capital etc. (G) Book Cost Book costs are those business costs which don't involve any cash payments but a provision is made in the books of accounts in order to include them in the profit and loss account and take tax advantages, like provision for depreciation and for unpaid amount of the interest on the owners capital. (H) Out Of Pocket Costs Out of pocket costs are those costs are expenses which are current payments to the outsiders of the firm. All the explicit costs fall into the category of out of pocket costs. Examples: Rent Payed, wages, salaries, interest etc (I) Accounting Costs Accounting costs are the actual or outlay costs that point out the amount of expenditure that has already been incurred on a particular process or on production as such accounting costs facilitate for managing the taxation need and profitability of the firm. Examples: All Sunk costs are accounting costs (J) Economic Costs Economic costs are related to future. They play a vital role in business decisions as the costs considered in decision - making are usually future costs. They have the nature similar to that of incremental, imputed explicit and opportunity costs. (K) Direct Cost Direct costs are those which have direct relationship with a unit of operation like manufacturing a product, organizing a process or an activity etc. In other words, direct costs are those which are directly and definitely identifiable. The nature of the direct costs are related with a particular product/process, they vary with variations in them. Therefore all direct costs are variable in nature. It is also called as "Traceable Costs" Examples: In operating railway services, the costs of wagons, coaches and engines are direct costs. (L) Indirect Costs Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, a product, a process or a department. Like the direct costs indirect costs, do not vary ie., they may or may not be variable in nature. However, the nature of indirect costs depends upon the costing under consideration. Indirect costs are both the fixed and the variable type as they may or may not vary as a result of the proposed changes in the production process etc. Indirect costs are also called as Non-traceable costs. Example: The cost of factory building, the track of a railway system etc., are fixed indirect costs and the costs of machinery, labour etc. (M) Controllable Costs Controllable costs are those which can be controlled or regulated through observation by an executive and therefore they can be used for assessing the efficiency of the executive. Most of the costs are controllable. Example: Inventory costs can be controlled at the shop level etc. (N) Non Controllable Costs The costs which cannot be subjected to administrative control and supervision are called non controllable costs. Example: Costs due obsolesce and depreciation, capital costs etc. (O) Historical Costs and Replacement Costs. Historical cost or original costs of an asset refer to the original price paid by the management to purchase it in the past. Whereas replacement costs refers to the cost that a firm incurs to replace or acquire the same asset now. The distinction between the historical cost and the replacement cost result from the changes of prices over time. In conventional financial accounts, the value of an asset is shown at their historical costs but in decision-making the firm needs to adjust them to reflect price level changes. Example: If a firm acquires a machine for $20,000 in the year 1990 and the same machine costs $40,000 now. The amount $20,000 is the historical cost and the amount $40,000 is the replacement cost. (P) Shutdown Costs The costs which a firm incurs when it temporarily stops its operations are called shutdown costs. These costs can be saved when the firm again start its operations. Shutdown costs include fixed costs, maintenance cost, layoff expenses etc. (Q) Abandonment Costs Abandonment costs are those costs which are incurred for the complete removal of the fixed asset from use. These may occur due to obsolesce or due to improvisation of the firm. Abandonment costs thus involve problem of disposal of the asset. (R) Urget Costs and Postponable Costs Urgent costs are those costs which have to be incurred compulsorily by the management in order to continue its operations. If urgent costs are not incurred in time the operational efficiency of the firm falls. Example: Cost of material, labour, fuel etc Postponable costs are those which if not incurred in time do not affect the operational efficiency of the firm. Examples are maintenance costs. (S) Business Cost and Full Cost Business costs include all the expenses incurred by the firm to carry out business activities. Costs Include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment. Full costs include business costs, opportunity costs, and normal profits. Opportunity costs are the expected return/earnings from the next best use of the firm’s resources like capital, land and building, owner’s efforts and time. Normal profits are necessary minimum earning in addition to the opportunity costs, which a firm must receive to remain in its present occupation. (T) Fixed Costs Fixed costs are the costs that do not vary with the changes in output. In other words, fixed costs are those which are fixed in volume though there are variations in the output level.. If the time period in volume under consideration is long enough to make the adjustments in the capacity of the firm, the fixed costs also vary. Examples: Expenditures on depreciation costs of administrative, staff, rent, land and buildings, taxes etc.


(U) Variable Costs Variable Costs are those that are directly dependent on the output i.e., they vary with the variation in the volume/level of output. Variable costs increase in output level but not necessarily in the same proportion. The proportionality between the variable costs and output depends upon the utilization of fixed facilities and resources during the production process. Example: Cost of raw materials, expenditure on labour, running cost or maintenance costs of fixed assets such as fuel, repairs, routine maintenance expenditure. (V) Total Cost, Average Cost and Marginal Cost Total cost (TC) refers to the money value of the total resources/inputs required for the production of goods and services by the firm. In other words, it refers to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level output. Total cost includes both fixed and variable costs and is given by TC = VC + FC Average Cost (AC) , refers to the cost per unit of output assuming that production of each unit incurs the same cost. It is statistical in nature and is not an actual cost. It is obtained by dividing Total Cost(TC) by Total Output(Q) AC= TC/Q Marginal costs(MC), refers to the additional costs that are incurred when there is an addition to the existing output level of goods and services. In other words, it is the addition to the Total Cost (TC) on account of producing additional units. (W) Short Run Cost and Long Run Cost Both short run and long run costs are related to fix and variable costs and are often used in economic analysis. Short Run Cost: These costs are which vary with the variation in the output with size of the firm as same. Short run costs are same as variable costs. Broadly, short run costs are associated with variable inputs in the utilization of fixed plant or other requirements. Long Run Cost: These costs are which incurred on the fixed assets like land and building, plant and machinery etc., Long run costs are same as fixed costs. Usually, long run costs are associated with variations in size and kind of plant.

Sources of finance Sourcing money may be done for a variety of reasons. Traditional areas of need may be for capital asset acquirement - new machinery or the construction of a new building or depot. The development of new products can be enormously costly and here again capital may be required. Normally, such developments are financed internally, whereas capital for the acquisition of machinery may come from external sources. In this day and age of tight liquidity, many organisations have to look for short term capital in the way of overdraft or loans in order to provide a cash flow cushion. Interest rates can vary from organisation to organisation and also according to purpose.

Objectives „ An introduction to the different sources of finance available to management, both internal and external „ An overview of the advantages and disadvantages of the different sources of funds „ An understanding of the factors governing the choice between different sources of funds. Sources of funds 1. Bank lending 2. Capital markets 3. Debentures

4. Deferred ordinary shares

5. Franchising 6. Government assistance

7. Hire purchase 8. Loan stocks 9. New share issue 10. Ordinary shares

11. PARTS 12. Preference shares 13. Retained earnings 14. Rights issue

15. Sources of funds 16. Venture capital

Ordinary (equity) shares Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value, typically of $1 or 50 cents. The market value of a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares. Deferred ordinary shares are a form of ordinary shares, which are entitled to a dividend only after a certain date or if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary shares. Ordinary shareholders put funds into their company: a) By paying for a new issue of shares

b) through retained profits.

Simply retaining profits, instead of paying them out in the form of dividends, offers an important, simple low-cost source of finance, although this method may not provide enough funds, for example, if the firm is seeking to grow. A new issue of shares might be made in a variety of different circumstances: a) The company might want to raise more cash. If it issues ordinary shares for cash, should the shares be issued pro rata to

existing shareholders, so that control or ownership of the company is not affected? If, for example, a company with 200,000

ordinary shares in issue decides to issue 50,000 new shares to raise cash, should it offer the new shares to existing shareholders,

or should it sell them to new shareholders instead?

i) If a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company, we have

a rights issue. In the example above, the 50,000 shares would be issued as a one-in-four rights issue, by offering shareholders one

new share for every four shares they currently hold.

ii) If the number of new shares being issued is small compared to the number of shares already in issue, it might be decided instead to sell them to new shareholders, since ownership of the company would only be minimally affected. b) The company might want to issue shares partly to raise cash, but more importantly to float' its shares on a stick exchange. c) The company might issue new shares to the shareholders of another company, in order to take it over. New shares issues A company seeking to obtain additional equity funds may be: a) an unquoted company wishing to obtain a Stock Exchange quotation

b) an unquoted company wishing to issue new shares, but without obtaining a Stock Exchange quotation c) a company which is already listed on the Stock Exchange wishing to issue additional new shares. The methods by which an unquoted company can obtain a quotation on the stock market are:


a) an offer for sale

b) a prospectus issue

c) a placing

d) an introduction.

Offers for sale: An offer for sale is a means of selling the shares of a company to the public. a) An unquoted company may issue shares, and then sell them on the Stock Exchange, to raise cash for the company. All the

shares in the company, not just the new ones, would then become marketable.

b) Shareholders in an unquoted company may sell some of their existing shares to the general public. When this occurs, the company is not raising any new funds, but just providing a wider market for its existing shares (all of which would become marketable), and giving existing shareholders the chance to cash in some or all of their investment in their company. When companies 'go public' for the first time, a 'large' issue will probably take the form of an offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can be obtained more cheaply if the issuing house or other sponsoring firm approaches selected institutional investors privately. Rights issues A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings. For example, a rights issue on a one-for-four basis at 280c per share would mean that a company is inviting its existing shareholders to subscribe for one new share for every four shares they hold, at a price of 280c per new share. A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share. Preference shares Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available, although with 'cumulative' preference shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders. From the company's point of view, preference shares are advantageous in that:

Dividends do not have to be paid in a year in which profits are poor, while this is not the case with interest payments on long

term debt (loans or debentures).

Since they do not carry voting rights, preference shares avoid diluting the control of existing shareholders while an issue of equity shares would not.

Unless they are redeemable, issuing preference shares will lower the company's gearing. Redeemable preference shares are normally treated as debt when gearing is calculated.

The issue of preference shares does not restrict the company's borrowing power, at least in the sense that preference share capital is not secured against assets in the business.

The non-payment of dividend does not give the preference shareholders the right to appoint a receiver, a right which is normally given to debenture holders. However, dividend payments on preference shares are not tax deductible in the way that interest payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks. For the investor, preference shares are less attractive than loan stock because:

they cannot be secured on the company's assets

the dividend yield traditionally offered on preference dividends has been much too low to provide an attractive investment

compared with the interest yields on loan stock in view of the additional risk involved.

Loan stock Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed

rate. Holders of loan stock are therefore long-term creditors of the company.

Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10 interest each year. The rate quoted is the gross rate, before tax. Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital. Debentures with a floating rate of interest These are debentures for which the coupon rate of interest can be changed by the issuer, in accordance with changes in market rates of interest. They may be attractive to both lenders and borrowers when interest rates are volatile. Security Loan stock and debentures will often be secured. Security may take the form of either a fixed charge or a floating charge. a) Fixed charge; Security would be related to a specific asset or group of assets, typically land and buildings. The company would

be unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent.

b) Floating charge; With a floating charge on certain assets of the company (for example, stocks and debtors), the lender's security in the event of a default payment is whatever assets of the appropriate class the company then owns (provided that another lender does not have a prior charge on the assets). The company would be able, however, to dispose of its assets as it chose until a default took place. In the event of a default, the lender would probably appoint a receiver to run the company rather than lay claim to a particular asset.


The redemption of loan stock Loan stock and debentures are usually redeemable. They are issued for a term of ten years or more, and perhaps 25 to 30 years. At the end of this period, they will "mature" and become redeemable (at par or possibly at a value above par). Most redeemable stocks have an earliest and latest redemption date. For example, 18% Debenture Stock 2007/09 is redeemable, at any time between the earliest specified date (in 2007) and the latest date (in 2009). The issuing company can choose the date. The decision by a company when to redeem a debt will depend on: a) how much cash is available to the company to repay the debt

b) the nominal rate of interest on the debt. If the debentures pay 18% nominal interest and the current rate of interest is lower,

say 10%, the company may try to raise a new loan at 10% to redeem the debt which costs 18%. On the other hand, if current

interest rates are 20%, the company is unlikely to redeem the debt until the latest date possible, because the debentures would

be a cheap source of funds.

There is no guarantee that a company will be able to raise a new loan to pay off a maturing debt, and one item to look for in a company's balance sheet is the redemption date of current loans, to establish how much new finance is likely to be needed by the company, and when. Mortgages are a specific type of secured loan. Companies place the title deeds of freehold or long leasehold property as security with an insurance company or mortgage broker and receive cash on loan, usually repayable over a specified period. Most organisations owning property which is unencumbered by any charge should be able to obtain a mortgage up to two thirds of the value of the property. As far as companies are concerned, debt capital is a potentially attractive source of finance because interest charges reduce the profits chargeable to corporation tax. Retained earnings For any company, the amount of earnings retained within the business has a direct impact on the amount of

dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using

retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new

investments, are as follows:

a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not

true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders. c) The use of retained earnings as opposed to new shares or debentures avoids issue costs. d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares. Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods. A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors. Bank lending Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term,

although medium-term lending is quite common these days.

Short term lending may be in the form of: a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount

by which the company is overdrawn from day to day;

b) a short-term loan, for up to three years. Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate. Lending to smaller companies will be at a margin above the bank's base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility, he will consider several factors, known commonly by the mnemonic PARTS. - Purpose

- Amount

- Repayment

- Term

- Security

P The purpose of the loan A loan request will be refused if the purpose of the loan is not acceptable to the bank.

A The amount of the loan. The customer must state exactly how much he wants to borrow. The banker must verify, as far as he is able to do


so, that the amount required to make the proposed investment has been estimated correctly.

R How will the loan be repaid? Will the customer be able to obtain sufficient income to make the necessary repayments?

T What would be the duration of the loan? Traditionally, banks have offered short-term loans and overdrafts, although medium-term loans

are now quite common.

S Does the loan require security? If so, is the proposed security adequate?

Leasing A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows

the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases". Operating leases Operati0ng leases are rental agreements between the lessor and the lessee whereby: a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the leased equipment c) the period of the lease is fairly short, less than the economic life of the asset, so that at the end of the lease agreement, the lessor can either i) lease the equipment to someone else, and obtain a good rent for it, or

ii) sell the equipment secondhand.

Finance leases Finance leases are lease agreements between the user of the leased asset (the lessee) and a provider of finance (the lessor) for most, or all, of the asset's expected useful life. Suppose that a company decides to obtain a company car and finance the acquisition by means of a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in a finance leasing arrangement, and so will purchase the car from the dealer and lease it to the company. The company will take possession of the car from the car dealer, and make regular payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of the lease. Other important characteristics of a finance lease: a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is not involved in this at all.

b) The lease has a primary period, which covers all or most of the economic life of the asset. At the end of the lease, the lessor would not be able to lease the asset to someone else, as the asset would be worn out. The lessor must, therefore, ensure that the lease payments during the primary period pay for the full cost of the asset as well as providing the lessor with a suitable return on his investment. c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner) and to keep most of the sale proceeds, paying only a small percentage (perhaps 10%) to the lessor. Why might leasing be popular? The attractions of leases to the supplier of the equipment, the lessee and the lessor are as follows:

The supplier of the equipment is paid in full at the beginning. The equipment is sold to the lessor, and apart from obligations

under guarantees or warranties, the supplier has no further financial concern about the asset.

The lessor invests finance by purchasing assets from suppliers and makes a return out of the lease payments from the lessee. Provided that a lessor can find lessees willing to pay the amounts he wants to make his return, the lessor can make good profits. He will also get capital allowances on his purchase of the equipment.

Leasing might be attractive to the lessee: i) if the lessee does not have enough cash to pay for the asset, and would have difficulty obtaining a bank loan to buy it, and so

has to rent it in one way or another if he is to have the use of it at all; or

ii) if finance leasing is cheaper than a bank loan. The cost of payments under a loan might exceed the cost of a lease. Operating leases have further advantages:

The leased equipment does not need to be shown in the lessee's published balance sheet, and so the lessee's balance sheet

shows no increase in its gearing ratio.

The equipment is leased for a shorter period than its expected useful life. In the case of high-technology equipment, if the equipment becomes out-of-date before the end of its expected life, the lessee does not have to keep on using it, and it is the lessor who must bear the risk of having to sell obsolete equipment secondhand. The lessee will be able to deduct the lease payments in computing his taxable profits. Hire purchase Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the exception that ownership

of the goods passes to the hire purchase customer on payment of the final credit instalment, whereas a lessee never becomes the

owner of the goods.

Hire purchase agreements usually involve a finance house. i) The supplier sells the goods to the finance house.

ii) The supplier delivers the goods to the customer who will eventually purchase them.

iii) The hire purchase arrangement exists between the finance house and the customer.


The finance house will always insist that the hirer should pay a deposit towards the purchase price. The size of the deposit will depend on the finance company's policy and its assessment of the hirer. This is in contrast to a finance lease, where the lessee might not be required to make any large initial payment. An industrial or commercial business can use hire purchase as a source of finance. With industrial hire purchase, a business customer obtains hire purchase finance from a finance house in order to purchase the fixed asset. Goods bought by businesses on hire purchase include company vehicles, plant and machinery, office equipment and farming machinery. Government assistance The government provides finance to companies in cash grants and other forms of direct assistance, as

part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high

unemployment. For example, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the

government to assist small indigenous businesses in that country.

Venture capital Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman

starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than

his own pocket. However, the term 'venture capital' is more specifically associated with putting money, usually in return for an

equity stake, into a new business, a management buy-out or a major expansion scheme.

The institution that puts in the money recognises the gamble inherent in the funding. There is a serious risk of losing the entire investment, and it might take a long time before any profits and returns materialise. But there is also the prospect of very high profits and a substantial return on the investment. A venture capitalist will require a high expected rate of return on investments, to compensate for the high risk. A venture capital organisation will not want to retain its investment in a business indefinitely, and when it considers putting money into a business venture, it will also consider its "exit", that is, how it will be able to pull out of the business eventually (after five to seven years, say) and realise its profits. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and Anglo American Corporation Services Ltd. When a company's directors look for help from a venture capital institution, they must recognise that:

the institution will want an equity stake in the company

it will need convincing that the company can be successful

it may want to have a representative appointed to the company's board, to look after its interests.

The directors of the company must then contact venture capital organisations, to try and find one or more which would be willing to offer finance. A venture capital organisation will only give funds to a company that it believes can succeed, and before it will make any definite offer, it will want from the company management: a) a business plan

b) details of how much finance is needed and how it will be used c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a profit forecast d) details of the management team, with evidence of a wide range of management skills e) details of major shareholders f) details of the company's current banking arrangements and any other sources of finance g) any sales literature or publicity material that the company has issued. A high percentage of requests for venture capital are rejected on an initial screening, and only a small percentage of all requests survive both this screening and further investigation and result in actual investments. Franchising Franchising is a method of expanding business on less capital than would otherwise be needed. For suitable

businesses, it is an alternative to raising extra capital for growth. Franchisors include Budget Rent-a-Car, Wimpy, Nando's Chicken

and Chicken Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business, under the franchisor's trade name. The franchisor must bear certain costs (possibly for architect's work, establishment costs, legal costs, marketing costs and the cost of other support services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on the subsequent regular payments by the franchisee for an operating profit. These regular payments will usually be a percentage of the franchisee's turnover. Although the franchisor will probably pay a large part of the initial investment cost of a franchisee's outlet, the franchisee will be expected to contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost. The advantages of franchises to the franchisor are as follows:

The capital outlay needed to expand the business is reduced substantially.

The image of the business is improved because the franchisees will be motivated to achieve good results and will have the

authority to take whatever action they think fit to improve the results.

The advantage of a franchise to a franchisee is that he obtains ownership of a business for an agreed number of years (including stock and premises, although premises might be leased from the franchisor) together with the backing of a large organisation's marketing effort and experience. The franchisee is able to avoid some of the mistakes of many small businesses, because the franchisor has already learned from its own past mistakes and developed a scheme that works.


Weighted average cost of capital

Weighted average cost of capital (WACC) is the average of the minimum after-tax required rate of return which a company must

earn for all of its security holders (i.e. common stock-holders, preferred stock-holders and debt-holders). It is calculated by finding

out cost of each component of a company’s capital structure, multiplying it with the relevant proportion of the component to

total capital and then summing up the proportionate cost of components. WACC is a very useful tool because it tells whether a

particular project is increasing shareholders’ wealth or just compensating the cost. The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm’s cost of capital. Importantly, it is dictated by the external market and not by management. The WACC represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common stock, preferred stock, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities,executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC. Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.[2] Calculation (Formula)

In general, the WACC can be calculated with the following formula

where is the number of sources of capital (securities, types of liabilities); is the required rate of return for security ; and is the market value of all outstanding securities . In the case where the company is financed with only equity and debt, the average cost of capital is computed as follows:

where D is the total debt, E is the total shareholder’s equity, Ke is the cost of equity, and Kd is the cost of debt. The market values of debt and equity should be used when computing the weights in the WACC formula. Tax effects Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of and cost of equity and one type of bonds with the total market value of and cost of debt , in a country with corporate tax rate , is calculated as:

Actually carrying out this calculation has a problem. There are many plausible proxies for each element. As a result, a fairly wide range of values for the WACC for a given firm in a given year, may appear defensible.

For a company which has two sources of finance, namely equity and debt, WACC is calculated using the following formula:

WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)

Cost of equity In the formula for WACC, r(E) is the cost of equity i.e. the required rate of return on common stock of the company.

It is the minimum rate of return which a company must earn to keep its common stock price from falling. Cost of equity is

estimated using different models, such as dividend discount model (DDM) and capital asset pricing model (CAPM).

After-tax cost of debt In the WACC formula, r(D) × (1 – t) represents the after-tax cost of debt i.e. the after-tax rate of return

which the debt-holders need to earn till the maturity of the debt. Cost of debt of a company is based on the yield to maturity of

the relevant instruments. If no yield to maturity is available, the cost can be estimated using the instrument's current yield, etc.

After-tax cost of debt is included in the calculation of WACC because debt offers a tax shield i.e. interest expense on debt reduces

taxes. This reduction in taxes is reflected in reduction in cost of debt capital.

Weights w(E) is the weight of equity in the company’s total capital. It is calculated by dividing the market value of the company’s

equity by sum of the market values of equity and debt.

w(D) is the weight of debt component in the company’s capital structure. It is calculated by dividing the market value of the

company’s debt by sum of the market values of equity and debt.

Ideally, WACC should be estimated using target capital structure, which is the capital structure the company’s management

intends to maintain in the long-run. For practical purposes, market values are usually used and where the market values are not

available, book values may be used to find out the weight.

Example Sanstreet, Inc. went public by issuing 1 million shares of common stock @ $25 per share. The shares are currently

trading at $30 per share. Current risk free rate is 4%, market risk premium is 8% and the company has a beta coefficient of 1.2.

During last year, it issued 50,000 bonds of $1,000 par paying 10% coupon annually maturing in 20 years. The bonds are currently

trading at $950.

The tax rate is 30%. Calculate the weighted average cost of capital.

Solution: First we need to calculate the proportion of equity and debt in Sanstreet, Inc. capital structure.

https://en.wikipedia.org/wiki/Cost_of_capital

https://en.wikipedia.org/wiki/Common_stock

https://en.wikipedia.org/wiki/Preferred_stock

https://en.wikipedia.org/wiki/Debt

https://en.wikipedia.org/wiki/Convertible_bond

https://en.wikipedia.org/wiki/Exchangeable_bond

https://en.wikipedia.org/wiki/Exchangeable_bond

https://en.wikipedia.org/wiki/Warrant_(finance)


https://en.wikipedia.org/wiki/Pension

https://en.wikipedia.org/wiki/Executive_stock_option

https://en.wikipedia.org/wiki/Capital_structure

https://en.wikipedia.org/wiki/Weighted_average_cost_of_capital#cite_note-2

https://en.wikipedia.org/wiki/Rate_of_return

https://en.wikipedia.org/wiki/Cost_of_equity

https://en.wikipedia.org/wiki/Cost_of_capital#Cost_of_debt


Current Market Value of Equity = 1,000,000 × $30 = $30,000,000

Current Market Value of Debt = 50,000 × $950 = $47,500,000

Total Market Value of Debt and Equity = $77,500,000

Weight of Equity = $30,000,000 / $77,500,000 = 38.71%

Weight of Debt = $47,500,000 / $77,500,000 = 61.29%, or

Weight of Debt = 100% minus cost of equity = 100% − 38.71% = 61.29%

Now, we need estimates for cost of equity and after-tax cost of debt.

We can estimate cost of equity using either dividend discount model (DDM) or capital asset pricing model (CAPM).

Cost of equity (DDM) = expected dividend in 1 year /current stock price + growth rate

Cost of equity (CAPM) = risk free rate + beta coefficient × market risk premium

In the current example, the data available allow us to use only CAPM to calculate cost of equity.

Cost of Equity = Risk Free Rate + Beta × Market Risk Premium = 4% + 1.2 × 8% = 13.6%

Cost of debt is equal to the yield to maturity of the bonds. With the given data, we can find that yield to maturity is 10.61%. It is

calculated using hit and trial method. We can also estimate it using MS Excel RATE function.

For inclusion in WACC, we need after-tax cost of debt, which is 7.427% *= 10.61% × (1 − 30%)+.

Having all the necessary inputs, we can plug the values in the WACC formula to get an estimate of 9.82%.

WACC = 38.71% × 13.6% + 61.29% × 7.427% = 9.8166%

It is called weighted average cost of capital because as you see the cost of different components is weighted according to their

proportion in the capital structure and then summed up.

Importance of WACC Weighted average cost of capital is the discount rate used in calculation of net present value (NPV) and

other valuations models such as free cash flow valuation model. It is the hurdle rate in the capital budgeting decisions.

WACC represents the average risk faced by the organization. It would require an upward adjustment if it has to be used to

calculate NPV of projects which are riskier than the company's average projects and a downward adjustment in case of less risky

projects. Further, WACC is after all an estimation. Different models for calculation of cost of equity may yield different values. Limitations of Weighted Average Cost of Capital (WACC) The WACC formula seems easier to calculate than it really is. Because certain elements of the formula, like cost of equity, are not consistent values, various parties may report them differently for different reasons. As such, while WACC can often help lend valuable insight into a company, one should always use it along with other metrics when determining whether or not to invest in a company. Uses of Weighted Average Cost of Capital (WACC) Securities analysts frequently use WACC when assessing the value of investments and when determining which ones to pursue. For example, in discounted cash flow analysis, one may apply WACC as the discount rate for future cash flows in order to derive a business's net present value. WACC may also be used as a hurdle rate against which to gauge ROIC performance. WACC is also essential in order to perform economic value added (EVA) calculations.

Optimal Capital Structure The concept of optimal capital structure has drawn a great deal of attention in accounting and finance literature. Capital structure means the proportion of debt and equity in the total capital of a firm. The objective of a firm is to maximize the value of its business. This is done by maximizing market value of the shares and minimizing the cost of capital of a firm. An optimal capital structure is that proportion of debt and equity, which fulfils this objective of a firm. Thus an optimal capital structure tries to optimize two variables at the same time: cost of capital and market value of shares. Concept of Optimal Capital Structure: Every firm should aim at achieving the optimal capital structure and try to maintain it. Optimal capital structure refers to the combination of debt and equity in total capital that maximizes the value of the company. An optimal capital structure is designated as one at which the average cost of capital is the lowest which produces an income that leads to maximization of the market value of the securities at that income. Optimal capital structure may be defined as that relationship of debt and equity which maximizes the value of company’s share in the stock exchange. Kulkarni and Satyaprasad defined optimum capital structure as ‘the one in which the marginal real cost of each available method of financing is the same’. They included both the explicit and implicit cost under the term real cost. According to Prof Ezra Solomon, ‘Optimal capital structure is that mix of debt and equity which will maximize the market value of a company’. Hence there should be a judicious combination of the various sources of long-term funds which provides a lower overall cost of capital and so a higher total market value for the capital structure. Optimal capital structure may thus be defined as, the mixing of the permanent sources of funds used by the firm in a manner that will maximize the company’s common stock price by minimizing the firm’s composite cost of capital. Features of Optimal Capital Structure: The salient features of an optimal capital structure are described below: a) The relationship of debt and equity in an optimal capital structure is made in such a manner that the market value per equity share becomes maximum.

http://accountingexplained.com/misc/corporate-finance/dividend-discount-model

http://accountingexplained.com/misc/corporate-finance/capital-asset-pricing-model

http://accountingexplained.com/managerial/capital-budgeting/hurdle-rate

http://www.investopedia.com/terms/m/metrics.asp

http://www.investopedia.com/terms/s/securityanalyst.asp

http://www.investopedia.com/terms/d/dcf.asp

http://www.investopedia.com/terms/n/npv.asp

http://www.investopedia.com/terms/h/hurdlerate.asp

http://www.investopedia.com/terms/h/hurdlerate.asp

http://www.investopedia.com/terms/r/returnoninvestmentcapital.asp

http://www.investopedia.com/terms/e/eva.asp

http://www.investopedia.com/terms/e/eva.asp


b) Optimal capital structure maintains the financial stability of the firm. c) Under optimal capital structure the finance manager determines the proportion of debt and equity in such a manner that the financial risk remains low. d) The advantage of the leverage offered by corporate taxes is taken into account in achieving the optimal capital structure. e) Borrowings help in increasing the value of company leading towards optimal capital structure. f) The cost of capital reaches at its minimum and market price of share becomes maximum at optimal capital structure. Constraints in Designing Optimal Capital Structure: The capital structure of a firm is designed in such a manner that the cost of capital is kept at its lowest and the value of the firm reaches its maximum. The firm manoeuvers its debt-equity proportion to reach the optimum level. However in practice, reaching the level of optimum capital structure is a difficult task due to several constraints that appear on the way of implementing that structure. The main constraints in designing the optimum capital structure are: 1. The optimum debt-equity mix is difficult to ascertain in true sense. 2. The concept of appropriate capital structure is more realistic than the concept of optimum capital structure. 3. It is difficult to find an optimum capital structure as the extent to which the market value of an equity share will fall due to increase in risk of high debt content in capital structure, is very difficult to measure. 4. The market price of equity share rarely changes due to changes in debt-equity mix, so there cannot be any optimum capital structure. 5. It is impossible to predict exactly the amount of decrease in the market value of an equity share because market factors that influence market value of equity share are highly complex.

Valuation and Rates of Return In finance, return is a profit on an investment.[1] It comprises any change in value and interest or dividends or other such cash flows which the investor receives from the investment. It may be measured either in absolute terms (e.g., dollars) or as a percentage of the amount invested. The latter is also called the holding period return. A loss instead of a profit is described as a negative return. Rate of return is a profit on an investment over a period of time, expressed as a proportion of the original investment.[2] The time period is typically a year, in which case the rate of return is referred to as annual return. To compare returns over time periods of different lengths on an equal basis, it is useful to convert each return into an annual equivalent rate of return, or annualised return. This conversion process is called annualisation, described below. Return on investment (ROI) is return per dollar invested. It is a measure of investment performance, as opposed to size (c.f. return on equity, return on assets, return on capital employed). Calculation The return, or rate of return, can be calculated over a single period, or where there is more than one time period, the return and rate of return over the overall period can be calculated, based upon the return within each sub-period. Single-period Return - The return over a single period is:

where:

= final value, including dividends and interest

= initial value For example, if you hold 100 shares, with a starting price of 10, then the starting value is 100 x 10 = 1,000. If you then collect 0.50 per share in cash dividends, and the ending share price is 9.80, then at the end you have 100 x 0.50 = 50 in cash, plus 100 x 9.80 = 980 in shares, totalling a final value of 1,030. The change in value is 1,030 - 1,000 = 30, so the return is 30 / 1,000 = 3%.

Annualisation Without any reinvestment, a return over a period of length is equivalent to a rate of return: For example, 20,000 USD returned on an initial investment of 100,000 USD is a return of 20%. If the 20,000 USD is paid in 5 annual installments of 4,000 USD per year, with no reinvestment, the rate of return is 4,000 / 100,000 = 20% / 5 = 4% per year. Assuming returns are reinvested however, due to the effect of compounding, the relationship between a rate of return , and a

return over a period of length is:

which can be used to convert the return to a rate of return :

For example, a 33.1% return over 3 months is equivalent to a rate of: per month with reinvestment. Annualisation is the process described above, of converting a return to an annual rate of return , where the length of the period is measured in years and the rate of return is per year. According to the CFA Institute's Global Investment Performance Standards (GIPS), "Returns for periods of less than one year must not be annualized." (Source: PROVISIONS OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS 5.A.4 ) This is because an annualised rate of return over a period of less than one year is statistically unlikely to be indicative of the annualised rate of return over the long run. Logarithmic or continuously compounded return

https://en.wikipedia.org/wiki/Compound_interest


The logarithmic return or continuously compounded return, also known as force of interest, is:

and the logarithmic rate of return is:

or equivalently it is the solution to the equation:

where:

= logarithmic rate of return = length of time period For example, if a stock is priced at 3.570 USD per share at the close on one day, and at 3.575 USD per share at the close the next day, then the logarithmic return is: ln(3.575/3.570) = 0.0014, or 0.14%. Annualisation of logarithmic return Under an assumption of reinvestment, the relationship between a logarithmic return and a logarithmic rate of return over a period of time of length is:

so trivially is the annualised logarithmic rate of return for a return , where is measured in years. For example, if the logarithmic return of a security per trading day is 0.14%, assuming 250 trading days in a year, then the annualised logarithmic rate of return is 0.14%/(1/250) = 0.14% x 250 = 35% Returns over multiple periods When returns are calculated over more than one time period, they are based on the investment value at the beginning of each period. If the returns over successive time sub-periods are , then the cumulative return or overall return over the overall time period is:

If the returns are logarithmic returns however, the logarithmic return over the overall time period is: Arithmetic average rate of return

The arithmetic average rate of return over time periods of equal length is defined as: If you have a sequence of logarithmic rates of return over equal successive periods, the appropriate method of finding their average is the arithmetic average rate of return. Geometric average rate of return Further information: True time-weighted rate of return For ordinary returns, if there is no reinvestment, and losses are made good by topping up the capital invested, so that the value is brought back to its starting-point at the beginning of each new sub-period, use the arithmetic average return. With reinvestment of all gains and losses however, the appropriate average rate of return is the geometric average rate of

return over n periods, which is: Note that the geometric average return is equivalent to the cumulative return over the whole n periods, converted into a rate of return per period. In the case where the periods are each a year long, and there is no reinvestment of returns, the annualized cumulative return is the arithmetic average return. Where the individual sub-periods are each a year, and there is reinvestment of returns, the annualized cumulative return is the geometric average rate of return. For example, assuming reinvestment, the cumulative return for annual returns: 50%, -20%, 30% and -40% is:

and the geometric average is: which is equal to the annualized cumulative return: Comparisons between various rates of return External flows In the presence of external flows, such as cash or securities moving into or out of the portfolio, the return should be calculated by

compensating for these movements. This is achieved using methods such as the time-weighted return. Time-weighted returns compensate for the impact of cash flows. This is useful to assess the performance of a

money manager on behalf of his/her clients, where typically the clients control these cash flows. Fees To measure returns net of fees, allow the value of the portfolio to be reduced by the amount of the fees. To calculate returns gross of fees, compensate for them by treating them as an external flow, and exclude accrued fees from valuations. Money-weighted rate of return Like the time-weighted return, the money-weighted rate of return (MWRR) or dollar-weighted rate of return also takes cash flows into consideration. They are useful evaluating and comparing cases where the money

Comparison of ordinary returns and logarithmic returns for an initial investment of $100

Initial investment, $100 $100 $100 $100 $100 $100 $100

Final investment, $0 $50 $99 $100 $101 $150 $200

Profit/loss, −$100 −$50 −$1 $0 $1 $50 $100

Ordinary return, −100% −50% −1% 0% 1% 50% 100%

Logarithmic return, −∞ −69.31% −1.005% 0% 0.995% 40.55% 69.31%

https://en.wikipedia.org/wiki/Continuous_compounding

https://en.wikipedia.org/wiki/Compound_interest#Force_of_interest

https://en.wikipedia.org/wiki/True_time-weighted_rate_of_return

https://en.wikipedia.org/wiki/Time-weighted_return

https://en.wikipedia.org/wiki/Time-weighted_return


manager controls cash flows, for example private equity. (Contrast with the true time-weighted rate of return, which is most applicable to measure the performance of a money manager who does not have control over external flows.) Internal rate of return The internal rate of return (IRR) (which is a variety of money-weighted rate of return) is the rate of return which makes the net present value of cash flows zero. It is a solution satisfying the following equation:

where: NPV = net present value and

= net cash flow at time , including the initial value and final value , net of any other flows at the beginning and at the end respectively. (The initial value is treated as an inflow, and the final value as an outflow.) When the internal rate of return is greater than the cost of capital, (which is also referred to as the required rate of return), the investment adds value, i.e. the net present value of cash flows, discounted at the cost of capital, is greater than zero. Otherwise, the investment does not add value. Note that there is not always an internal rate of return for a particular set of cash flows (i.e. the existence of a real solution to the equation depends on the pattern of cash flows). There may also be more than one real solution to the equation, requiring some interpretation to determine the most appropriate one. Comparing ordinary return with logarithmic return The value of an investment is doubled if the return = +100%, that is,

if = ln($200 / $100) = ln(2) = 69.3%. The value falls to zero when = -100%. The ordinary return can be calculated for any non-zero initial investment value, and any final value, positive or negative, but the logarithmic return can only be calculated when . Ordinary returns and logarithmic returns are only equal when they are zero, but they are approximately equal when they are small. The difference between them is large only when percent changes are high. For example, an arithmetic return of +50% is equivalent to a logarithmic return of 40.55%, while an arithmetic return of -50% is equivalent to a logarithmic return of -69.31%. Symmetry of logarithmic returns Logarithmic returns are useful for mathematical finance. One of the advantages is that the logarithmic returns are symmetric, while ordinary returns are not: positive and negative percent ordinary returns of equal magnitude do not cancel each other out and result in a net change, but logarithmic returns of equal magnitude but opposite signs will cancel each other out. This means that an investment of $100 that yields an arithmetic return of 50% followed by an arithmetic return of -50% will result in $75, while an investment of $100 that yields a logarithmic return of 50% followed by a logarithmic return of -50% will come back to $100. Comparing geometric with arithmetic average rates of return The geometric average rate of return is in general less than the arithmetic average return. The two averages are equal if (and only if) all the sub-period returns are equal. This is a consequence of the AM–GM inequality. The difference between the annualized return and average annual return increases with the variance of the returns – the more volatile the performance, the greater the difference. For example, a return of +10%, followed by −10%, gives an arithmetic average return of 0%, but the overall result over the 2 sub-periods is 110% x 90% = 99% for an overall return of −1%. The order in which the loss and gain occurs does not affect the result. For a return of +20%, followed by −20%, this again has an average return of 0%, but an overall return of −4%. A return of +100%, followed by −100%, has an average return of 0%, but an overall return of −100%, as the final value is 0. In cases of leveraged investments, even more extreme results are possible: a return of +200%, followed by −200%, has an average return of 0%, but an overall return of −300%. This pattern is not followed in the case of logarithmic returns, due to their symmetry, as noted above. A logarithmic return of +10%, followed by −10%, gives an overall return of 10% - 10% = 0%, and an average rate of return of zero also.

Average returns and overall returns[edit] Investment returns are often published as "average returns". In order to translate average returns into overall returns, compound the average returns over the number of periods.

Example #1 Level Rates of Return

Year 1 Year 2 Year 3 Year 4

Rate of Return 5% 5% 5% 5%

Geometric Average at End of Year

5% 5% 5% 5%

Capital at End of Year $105.00 $110.25 $115.76 $121.55

Dollar Profit/(Loss) $21.55

The geometric average rate of return was 5%. Over 4 years, this translates into an overall return of:

Example #2 Volatile Rates of Return, including losses


Rate of Return 50% -20% 30% -40%

Geometric Average at End of Year

50% 9.5% 16% -1.6%


Dollar Profit/(Loss) ($6.40)

The geometric average return over the 4-year period was -1.64%. Over 4 years, this translates into an overall return of:

Example #3 Highly Volatile Rates of Return, including losses


https://en.wikipedia.org/wiki/Net_present_value

https://en.wikipedia.org/wiki/Cash_flow


https://en.wikipedia.org/wiki/AM%E2%80%93GM_inequality

https://en.wikipedia.org/w/index.php?title=Rate_of_return&action=edit&section=18


Rate of Return -95% 0% 0% 115%

Geometric Average at End of Year -95% -77.6% -63.2% -42.7%


Dollar Profit/(Loss) ($89.25)

The geometric average return over the 4-year period was -42.74%. Over 4 years, this translates back into an overall return of:

Annual returns and annualized returns Care must be taken not to confuse annual with annualized returns. An annual rate of return is a return over a period of one year, such as January 1 through December 31, or June 3, 2006 through June 2, 2007, whereas an annualized rate of return is a rate of return per year, measured over a period either longer or shorter than one year, such as a month, or two years, annualised for comparison with a one-year return. The appropriate method of annualization depends on whether returns are reinvested or not. For example, a return over one month of 1% converts to an annualized rate of return of 12.7% = ((1+0.01)12 - 1). This means if reinvested, earning 1% return every month, the return over 12 months would compound to give a return of 12.7%. As another example, a two-year return of 10% converts to an annualized rate of return of 4.88% = ((1+0.1)(12/24) - 1), assuming reinvestment at the end of the first year. In other words, the geometric average return per year is 4.88%. In the cash flow example below, the dollar returns for the four years add up to $265. Assuming no reinvestment, the annualized rate of return for the four years is: $265 ÷ ($1,000 x 4 years) = 6.625% (per year).

Cash Flow Example on $1,000 Investment


Dollar Return $100 $55 $60 $50

ROI 10% 5.5% 6% 5%

Uses Rates of return are useful for making investment decisions. For nominal risk investments such as savings accounts or

Certificates of Deposit, the investor considers the effects of reinvesting/compounding on increasing savings balances over time to project expected gains into the future. For investments in which capital is at risk, such as stock shares, mutual fund shares and home purchases, the investor also takes into consideration the effects of price volatility and risk of loss.

Ratios typically used by financial analysts to compare a company’s performance over time or compare performance between companies include return on investment (ROI),return on equity, and return on assets.

In the capital budgeting process, companies would traditionally compare the internal rates of return of different projects to decide which projects to pursue in order to maximize returns for the company's stockholders. Other tools employed by companies in capital budgeting include payback period, net present value, and profitability index.

A return may be adjusted for taxes to give the after-tax rate of return. This is done in geographical areas or historical times in which taxes consumed or consume a significant portion of profits or income. The after-tax rate of return is calculated by multiplying the rate of return by the tax rate, then subtracting that percentage from the rate of return.

A return of 5% taxed at 15% gives an after-tax return of 4.25% 0.05 x 0.15 = 0.0075 0.05 - 0.0075 = 0.0425 = 4.25% A return of 10% taxed at 25% gives an after-tax return of 7.5% 0.10 x 0.25 = 0.025 0.10 - 0.025 = 0.075 = 7.5% Investors usually seek a higher rate of return on taxable investment returns than on non-taxable investment returns, and the

proper way to compare returns taxed at different rates of tax is after tax, from the end-investor's perspective. A return may be adjusted for inflation. When return is adjusted for inflation, the resulting return in real terms measures the

change in purchasing power between the start and the end of the period. Any investment with a nominal annual return (i.e. unadjusted annual return) less than the annual inflation rate represents a loss of value in real terms, even when the nominal annual return is greater than 0%, and the purchasing power at the end of the period is less than the purchasing power at the beginning.

Many online poker tools include ROI in a player's tracked statistics, assisting users in evaluating an opponent's performance. Time value of money Investments generate returns to the investor to compensate the investor for the time value of money. Factors that investors may use to determine the rate of return at which they are willing to invest money include: estimates of future inflation rates assessment of the risk of the investment, i.e. the uncertainty of returns (including how likely it is that investors will receive

interest/dividend payments they expect and the return of their full capital, with or without any possible additional capital gain)

whether or not the investors want the money available (“liquid”) for other uses. The time value of money is reflected in the interest rate that a bank offers for deposit accounts, and also in the interest rate that a bank charges for a loan such as a home mortgage. The “risk-free” rate on US dollar investments is the rate on U.S. Treasury bills, because this is the highest rate available without risking capital. The rate of return which an investor requires from a particular investment is called the discount rate, and is also referred to as the (opportunity) cost of capital. Each investment has a different discount rate, based on the cash flow expected in future from the investment. The higher the risk, the higher the discount rate (rate of return) the investor will demand from the investment.

https://en.wikipedia.org/wiki/Return_on_equity

https://en.wikipedia.org/wiki/Return_on_assets

https://en.wikipedia.org/wiki/Capital_budgeting

https://en.wikipedia.org/wiki/Internal_rate_of_return

https://en.wikipedia.org/wiki/Net_present_value

https://en.wikipedia.org/wiki/Profitability_index

https://en.wikipedia.org/wiki/Tax

https://en.wikipedia.org/wiki/Inflation

https://en.wikipedia.org/wiki/Purchasing_power

https://en.wikipedia.org/wiki/Inflation_rate

https://en.wikipedia.org/wiki/Poker_tools

https://en.wikipedia.org/wiki/Time_value_of_money

https://en.wikipedia.org/wiki/Inflation

https://en.wikipedia.org/wiki/Risk

https://en.wikipedia.org/wiki/Capital_gain

https://en.wikipedia.org/wiki/Capital_gain

https://en.wikipedia.org/wiki/Interest_rate

https://en.wikipedia.org/wiki/Bank

https://en.wikipedia.org/wiki/Deposit_accounts

https://en.wikipedia.org/wiki/Risk-free_interest_rate

https://en.wikipedia.org/wiki/United_States_Treasury_security#Treasury_bill

https://en.wikipedia.org/wiki/Discounted_cash_flow#Discount_rate


https://en.wikipedia.org/wiki/Risk


Compounding or reinvesting The annualized return of an investment depends on whether or not the return, including interest and dividends, from one period is reinvested in the next period. If the return is reinvested, it contributes to the starting value of capital invested for the next period (or reduces it, in the case of a negative return). Compounding reflects the effect of the return in the next period on the return from the previous period. For example, if an investor puts $1,000 in a 1-year certificate of deposit (CD) that pays an annual interest rate of 4%, paid quarterly, the CD would earn 1% interest per quarter on the account balance. The account uses compound interest, meaning the account balance is cumulative, including interest previously reinvested and credited to the account. Unless the interest is withdrawn at the end of each quarter, it will earn more interest in the next quarter.

Compound Interest Example

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Capital at the beginning of the period $1,000 $1,010 $1,020.10 $1,030.30

Dollar return for the period $10 $10.10 $10.20 $10.30

Account Balance at end of the period $1,010.00 $1,020.10 $1,030.30 $1,040.60

Quarterly return 1% 1% 1% 1%

At the beginning of the second quarter, the account balance is $1,010.00, which then earns $10.10 interest altogether during the second quarter. The extra dime was interest on the additional $10 investment from the previous interest accumulated in the account. The annualized return (annual percentage yield, compound interest) is higher than for simple interest, because the interest is reinvested as capital and then itself earns interest. The yield or annualized return on the above investment

is .

Capital Budgeting

Capital budgeting, which is also called "investment appraisal," is the planning process used to determine which of an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is to budget for major capital investments or expenditures (Capital budgeting is the planning process used to determine which of an organization's long term investments are worth pursuing.) 5 Techniques used in Capital Budgeting (with advantages and limitations)| Financial Management Some of the major techniques used in capital budgeting are as follows: 1. Payback period 2. Accounting Rate of Return method 3. Net present value method 4. Internal Rate of Return Method 5. Profitability index. 1. Payback period: The payback (or payout) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project, if the project generates constant annual cash inflows, the payback period can be computed dividing cash outlay by the annual cash inflow. Payback period = Cash outlay (investment) / Annual cash inflow = C / A Advantages: 1. A company can have more favourable short-run effects on earnings per share by setting up a shorter payback period. 2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss. 3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project. Limitations: 1. It fails to take account of the cash inflows earned after the payback period. 2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project. 3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows. 4. Administrative difficulties may be faced in determining the maximum acceptable payback period. 2. Accounting Rate of Return method: The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment. ARR= Average income/Average Investment Advantages: 1. It is very simple to understand and use. 2. It can be readily calculated using the accounting data. 3. It uses the entire stream of incomes in calculating the accounting rate. Limitations: 1. It uses accounting, profits, not cash flows in appraising the projects. 2. It ignores the time value of money; profits occurring in different periods are valued equally. 3. It does not consider the lengths of projects lives. 4. It does not allow for the fact that the profit can be reinvested. 3. Net present value method: The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows. The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:

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Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known. Advantages: 1. It recognizes the time value of money 2. It considers all cash flows over the entire life of the project in its calculations. 3. It is consistent with the objective of maximizing the welfare of the owners. Limitations: 1. It is difficult to use 2. It presupposes that the discount rate which is usually the firm’s cost of capital is known. But in practice, to understand cost of capital is quite a difficult concept. 3. It may not give satisfactory answer when the projects being compared involve different amounts of investment. 4. Internal Rate of Return Method: The internal rate of return (IRR) equates the present value cash inflows with the present value of cash outflows of an investment. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment, it can be determined by solving the following equation:

Advantages: 1. Like the NPV method, it considers the time value of money. 2. It considers cash flows over the entire life of the project. 3. It satisfies the users in terms of the rate of return on capital. 4. Unlike the NPV method, the calculation of the cost of capital is not a precondition. 5. It is compatible with the firm’s maximising owners’ welfare. Limitations: 1. It involves complicated computation problems. 2. It may not give unique answer in all situations. It may yield negative rate or multiple rates under certain circumstances. 3. It implies that the intermediate cash inflows generated by the project are reinvested at the internal rate unlike at the firm’s cost of capital under NPV method. The latter assumption seems to be more appropriate. 5. Profitability index: It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows. PI = PV cash inflows/Initial cash outlay A,

1. It gives due consideration to the time value of money. 2. It requires more computation than the traditional method but less than the IRR method. 3. It can also be used to choose between mutually exclusive projects by calculating the incremental benefit cost ratio. 6 Equivalent Annuity The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when comparing investment projects of unequal lifespans. For example, if project A has an expected lifetime of seven years, and project B has an expected lifetime of 11 years, it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. 7 Real Options Analysis The discounted cash flow methods essentially value projects as if they were riskybonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows or to decrease future cash outflows. In other words, managers get to manage the projects, not simply accept or reject them. Real options analysis try to value the choices–the option value–that the managers will have in the future and adds these values to the NPV. These methods use the incremental cash flows from each potential investment or project. Techniques based on accounting earnings and accounting rules are sometimes used. Simplified and hybrid methods are used as well, such as payback period anddiscounted payback period. IMPORTANCE OF CAPITAL BUDGETING 1) Long term investments involve risks: Capital expenditures are long term investments which involve more financial risks. That is why proper planning through capital budgeting is needed.

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2) Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses. 3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the profitability of the company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long run. SIGNIFICANCE OF CAPITAL BUDGETING

Capital budgeting is an essential tool in financial management Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken

up for investments It helps in exposing the risk and uncertainty of different projects It helps in keeping a check on over or under investments The management is provided with an effective control on cost of capital expenditure projects Ultimately the fate of a business is decided on how optimally the available resources are used

Example of Capital Budgeting: Capital budgeting for a small scale expansion involves three steps: recording the investment's cost, projecting the investment's cash flows and comparing the projected earnings with inflation rates and the time value of the investment. For example, equipment that costs $15,000 and generates a $5,000 annual return would appear to "pay back" on the investment in 3 years. However, if economists expect inflation to rise 30 percent annually, then the estimated return value at the end of the first year ($20,000) is actually worth $15,385 when you account for inflation ($20,000 divided by 1.3 equals $15,385). The investment generates only $385 in real value after the first year. Conclusion: According to the definition of Charles T. Hrongreen, “Capital Budgeting is a long-term planning for making and financing proposed capital outlays.” One can conclude that capital budgeting is the attempt to determine the future.

What Are Short-Term Investments Short-term investments are used to preserve capital. They offer a low return, but access to the capital is relatively easy. Short-term investments usually have a life of no more than three years. Definition and Types Short-term investments are any assets that are anticipated to expire or to be liquidated within the course of one to three years. The goal of this type of asset is to protect capital with low-risk investments. However, with low risk, the return on short-term investments is very low. There are thousands of different types of short-term investment opportunities. Listed below are some of the most common types that many people use: Savings Accounts These accounts are the least profitable type of short-term investments. Savings accounts are the most simple, liquid types of short-term investments, but in return for being easily accessible, they offer low yields. Most savings accounts do not even keep up with inflation, so they should not be used to store money over long periods of time. Certificates of Deposit (CD) CDs are one of the most common types of short-term investments. When you put your money into a CD, you agree not to withdraw it for a specific period of time, in return for a higher yield. CD lengths range from as little as three months to as long as five years. CDs are federally insured, so they are one of the safest types of short-term investments; yet, they still offer a reasonable yield. Money Market Funds These are typically liquid like savings accounts, but they offer a better yield. The downside of most money market funds is that they are not federally insured, unlike other types of short-term investments. This makes money market funds a higher-risk vehicle for short-term savings. Treasury Bills and Bonds These provide flexible short-term investment terms of four weeks to one year. Treasury bills are designed for short-term savings and offer an extremely low yield. Bonds offer slightly more flexibility, but they may be less secure for short-term savings than treasury bills. Long-Term vs. Short-Term Financing Long-Term Financing Businesses need long-term financing for acquiring new equipment, R&D, cash flow enhancement and company expansion. Major methods for long-term financing are as follows: Equity Financing This includes preferred stocks and common stocks and is less risky with respect to cash flow commitments. However, it does result in a dilution of share ownership, control and earnings. The cost of equity is also typically higher than the cost of debt - which is, additionally, a deductible expense - and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk. Corporate Bond A corporate bond is a bond issued by a corporation to raise money effectively so as to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allowinvestors to convert the bond into equity. Capital Notes Capital notes are a form of convertible security exercisable into shares. They are equity vehicles. Capital notes are similar to warrants, except that they often do not have an expiration date or an exercise price (hence, the entire consideration

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the company expects to receive, for its future issue of shares, is paid when the capital note is issued). Many times, capital notes are issued in connection with a debt-for-equity swaprestructuring: instead of issuing the shares (that replace debt) in the present, the company gives creditors convertible securities – capital notes – so the dilution will occur later. Short-Term Financing Short-term financing can be used over a period of up to a year to help corporations increase inventory orders, payrolls and daily supplies. Short-term financing includes the following financial instruments: Commercial Paper This is an unsecured promissory note with a fixed maturity of 1 to 364 days in the global money market. It is issued by large corporations to get financing to meet short-term debt obligations. It is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. ABCP is typically a short-term instrument that matures between 1 and 180 days from issuance and is typically issued by a bank or other financial institution. Promissory Note This is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms. Asset-based Loan This type of loan, often short term, is secured by a company's assets. Real estate, accounts (A/R), inventory and equipment are typical assets used to back the loan. The loan may be backed by a single category of assets or a combination of assets (for instance, a combination of A/R and equipment). Repurchase Agreements These are short-term loans (normally for less than two weeks and frequently for just one day) arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. Letter of Credit This is a document that a financial institution or similar party issues to a seller of goods or services which provides that the issuer will pay the seller for goods or services the seller delivers to a third-party buyer. The issuer then seeks reimbursement from the buyer or from the buyer's bank. The document serves essentially as a guarantee to the seller that it will be paid by the issuer of the letter of credit, regardless of whether the buyer ultimately fails to pay. WORKING CAPITAL MANAGEMENT-BASICS

WORKING CAPITAL MANAGEMENT Meaning and Types of Finance: Finance- Finance is the Art & Science of Managing Money . It is the Art of passing currency from hand to hand until it finally disappears Types & Sources of Finance Long Term Sources of Finance - Finance required to meet Capital Expenditure. Also, known as Fixed Capital Finance Short Term Sources of Finance - Finance required to meet day-to-day Business requirements. Also, known as Working Capital Meaning of Working capital - Working Capital is the amount of Capital that a Business has available to meet the day-to-day cash requirements of its operations - Working Capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities) .It refers to the amount of Current Assets that exceeds Current Liabilities (i.e. CA - CL) - Working Capital refers to that part of the firm’s Capital, which is required for Financing Short-Term or Current Assets such as Cash, Marketable Securities, Debtors and Inventories. -Working Capital is also known as Revolving or Circulating Capital or Short-Term Capital Concepts of Working Capital:- There are two concepts of working capital- (1) Gross Working Capital Concept (2) Net Working Capital Concept. (1) Gross working capital: Gross working capital; refers to firm's investment in currentassets. Current assets are the assets which can be converted into cash within an accounting year and include cash, short-term securities, debtors, bill receivables and stock. According to this concept, working capital means Gross working Capital which is the total of all current assets of a business. It can be represented by the following equation: Gross Working Capital = Total Current Assets Definitions favoring this concept are:- According to Mead, Mallot and Field : "Working Capital means total of Current Assets". (2) Net Working Capital Concept: Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors, bills payables, and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative Net working capital occurs when current liabilities are in excess of current assets.

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Net Working Capital = Current Assets - Current Liabilities Definitions Favoring Net Working Capital Concept:- According to C.W.Gestenbergh "It has ordinarily been defined as the excess of current assets over current liabilities". According to Lawrence. J. Gitmen " The most common definition of net working capital is the difference of firm's current assets and current liabilities". Classification of Working Capital (1) On the Basis of Concept: - (i) Gross Working Capital

(ii) Net Working Capital (2) On the Basis of time or Need:-

(i) Permanent Working Capital (ii) Temporary Working Capital

(3) On the basis of time or need (1) Permanent or Fixed Working Capital:- The need for working capital fluctuates from time to time. However, to carry on day-to-day operations of the business without any obstacles, a certain minimum level of raw materials, work-in-progress, finished goods and cash must be maintained on a continuous basis. The amount needed to maintain current assets on this minimum level is called permanent or regular working capital. The amount involved as permanent working capital has to be meet from long-term sources of finance, e.g. (i) Capital (ii) Debentures (iii) Long-term loans. (2) Temporary or Variable or Fluctuating Working Capital:- Depending upon the changes in production and sales, the need for working capital, over and above the permanent level of working capital is called temporary, fluctuating or variable working capital. It may be two types:- (a)Seasonal-Due to seasonal changes, level of business activities is higher than normal during some months of year and therefore additional working capital will be required along with the permanent working capital. It is so because during peak season, demand rises and more stock is to be maintained to meet the demand . (b) Special- Additional doses of working capital may be required to face cut throat competition in the market or other contingencies like strikes, lock outs, theft etc. ADEQUATE WORKING CAPITAL: The firm should maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from firm's point of view. Excessive working capital means holding costs and idle funds which earn no profit for the firm. Paucity of working capital not only impairs the firm's profitability but also results in production interruptions and inefficiencies and sales disruption Importance/Need/Advantage of Adequate Working Capital: (1) Availability of Raw Materials Regularly:- Adequacy of working capital makes it possible for a firm to pay the suppliers of raw materials on time. As a result it will continue to receive regular supplies of raw materials and thus there will be no disruption in production process. (2) Full Utilization of Fixed Assets:- Adequacy of working capital makes it possible for a firm to utilize its fixed assets fully and continuously. For example, if there is inadequate stock of raw material, the machines will not be utilized in full and their productivity will be reduced. (3) Cash Discount:- A firm having the adequate working capital can avail the cash discount by purchasing the goods for cash or by making the payment before the due date. (4) Increase in Credit Rating:- Paying its short-term obligations in time leads to a strong credit rating which enables the firm to purchase goods on credit on favourable terms and to maintain its line of credit with banks etc. it facilities the taking of loan in case of need. 5) Exploitation of Favourable Market conditions:- Whenever there arechances of increase in prices of raw materials, the firm can purchase sufficient quantity if it has adequate of working capital. Similarly, if a firm receives a bulk order for the supply of goods it can take advantage of such opportunity if it has sufficient working capital. (6) Facility in Obtaining Bank Loans:- Banks do not hesitate to advance even the unsecured loan to a firm which has the sufficient working capital. This is because the excess of current assets over current liabilities itself is a good security. (7) Increase in Efficiency of Management:- Adequacy of working capital has a favourable psychological effect on the managers. This is because no obstacle arises in the day-to-day business operations. Creditors, wages and all other expenses are paid on time and hence it keeps the morale of manager’s high (8) Ability to face crisis: - Adequate working capital enables a concern to face business crisis in emergencies such as depression. Because during such periods, generally, there is much pressure on working capital. (9) Solvency of the business:- Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. (10) Good will Sufficient working capital enables a business concern to male prompt payments and hence helps in creating and maintaining good will. EXCESSIVE AND INADEQUATE WORKING CAPITAL: A business enterprise should maintain adequate working capital according to the needs of its business operations. The amount of working capital should neither be excessive nor inadequate. If the working capital is in excess if its requirements it means idle funds adding to the cost of capital but which earn nom profits for the firm. On the contrary, if the working capital is short of its requirements, it will result in production interruptions and reduction of sales and, in turn, will affect the profitability of the business adversely.


Disadvantage of Excessive Working Capital:- (1) Excessive Inventory:- Excessive working capital results in unnecessary accumulation of large inventory. It increases the chances of misuse, waste, theft etc. (2) Excessive Debtors:- Excessive working capital will results in liberal credit policy which, in turn, will results in higher amount tied up in debtors and higher incidence of bad debts. (3) Adverse Effect on Profitability:- Excessive working capital means idle funds in the business which adds to the cost of capital but earns no profits for the firm. Hence it has a bad effect on profitability of the firm. (4) Inefficiency of Management:- Management becomes careless due to excessive resources at their command. It results in laxity of control on expenses and cash resources. Disadvantage of Inadequate Working Capital: (1) Difficulty in Availability of Raw-Material:-Adequacy of working capital results in non-payment of creditors on time. As a result the credit purchase of goods on favorable terms becomes increasingly difficult. Also, the firm cannot avail the cash discount. (2) Full Utilization of Fixed Assets not Possible:- Due to the frequent interruption in the supply of raw materials and paucity of stock, the firm cannot make full utilization of its machines etc. (3) Difficulty in the Maintenance of Machinery:- Due to the inadequacy of working capital, machines are not cared and maintained properly which results in the closure of production on many occasions. (4) Decrease in Credit Rating:- Because of inadequacy of working capital, firm is unable to pay its short-term obligations on time. It decays the firm's relations with its bankers and it becomes difficult for the firm to borrow in case of need. (5) Non Utilization of Favorable Opportunities: For example, a firm cannot purchase sufficient quantity of raw materials in case of sudden decrease in the prices. Similarly, if the firm receives a big order, it cannot execute it due to shortage of working capital. (6) Decrease in Sales: Due to the shortage of working capital, the firm cannot keep sufficient stock of finished goods. It results in the decrease in sales. Also, the firm will be forced to restrict its credit sales. This will further reduce the sales. (7) Difficulty in the Distribution of Dividends: Because of paucity of cash resources, firm will not be able to pay the dividend to its shareholders. (8) Decrease in the Efficiency of Management: It will become increasingly difficult for the management to pay its creditors on time and pay its day-to-day expenses. It will also be difficult to pay the wages regularly which will have an adverse effect on the morale of managers. DETERMINANTS OF WORKING CAPITAL: A firm should have neither too much nor too little working capital. A large number of factors, each has a different importance, influencing working capital needs of firms. The importance of factors also changes for a firm over time. Therefore, an analysis of relevant factors should be made in order to determine total investment in working capital. The following is the description of factors which generally influence the working capital requirements. The working capital requirement is determined by a large number of factors but, in general, the following factors influence the working capital needs of an enterprise: (1) Nature of Business :- Working capital requirements of an enterprise are largely influenced by the nature of its business. For instance, public utilities such as railways, transport, water, electricity etc. have a very limited need for working capital because they have invested fairly large amounts in fixed assets. Their working capital need is minimal because they get immediate payment for their services and do not have to maintain big inventories. On the other extreme are the trading and financial enterprises which have to invest fewer amounts in fixed assets and a large amount in working capital. This is so because the nature of their business is such that they have to maintain a sufficient amount of cash, inventories and debtors. Working capital needs of most of the manufacturing enterprises fall between these two extremes, that is, between public utilities and trading concerns. (2) Size of Business:- Larger the size of the business enterprise, greater would be the need for working capital. The size of a business may be measured in terms of scale of its business operations. (3) Growth and Expansion:- As a business enterprise grows, it is logical to expect that a larger amount of working capital will be required. Growing industries require more working capital than those that are static. (4) Production cycle:- Production cycle means the time-span between the purchase of raw materials and its conversion into finished goods. The longer the production cycle, the larger will be the need for working capital because the funds will be tied up for a longer period in work in process. If the production cycle is small, the need for working capital will also be small. (5) Business Fluctuations:- Business fluctuations may be in the direction of boom and depression. During boom period the firm will have to operate at full capacity to meet the increased demand which in turn, leads to increase in the level of inventories and book debts. Hence, the need for working capital in boom conditions is bound to increase. The depression phase of business fluctuations has exactly an opposite effect on the level of working capital requirement. (6) Production Policy:- The need for working capital is also determined by production policy. The demand for certain products (such as woolen garments) is seasonal. Two types of production policies may be adopted for such products. Firstly, the goods may be produced in the months of demand and secondly, the goods may be produces throughout the year. If the second alternative is adopted, the stock of finished goods will accumulate progressively upto the season of demand which requires an increasing amount of working capital that remains tied up in the stock of finished goods for some months.


(7) Credit Policy Relating to Sales:- If a firm adopts liberal credit policy in respect of sales, the amount tied up in debtors will also be higher. Obviously, higher book debts mean more working capital. On the other hand, if the firm follows tight credit policy, the magnitude of working capital will decrease (8) Credit Policy Relating to Purchase:- If a firm purchases more goods on credit, the requirement for working capital will be less. In other words, if liberal credit terms are available from the suppliers of goods (i.e., creditors), the requirement for working capital will be reduced and vice versa. (9) Availability of Raw Material:- If the raw material required by the firm is available easily on a continuous basis, there will be no need to keep a large inventory of such materials and hence the requirement of working capital will be less. On the other hand, if the supply of raw material is irregular, the firm will be compelled to keep an excessive inventory of such raw materials which will result in high level of working capital. Also, some raw materials are available only during a particular season such as oil seeds, cotton, etc. They would have to be necessarily purchased in that season and have to be kept in stock for a period when supplies are lean. This will require more working capital. (10) Availability of Credit from Banks:- If a firm can get easy bank facility in case of need, it will operate with less working capital. On the other hand, if such facility is not available, it will have to keep large amount of working capital. (11) Volume of Profit:- The net profit is a source of working capital to the extent it has been earned in cash. Higher net profit would generate more internal funds thereby contributing the working capital pool. (12) Level of Taxes:- Full amount of cash profit is not available for working capital purpose. Taxes have to be paid out of profits. Higher the amount of taxes less will be the profits for working capital. (13) Dividend Policy:- Dividend policy is a significant element in determining the level of working capital in an enterprise. The payment of dividend reduces the cash and thereby, affects the working capital to that extent. On the contrary, if the company does not pay dividend but retains the profits, more would be the contribution of profits towards capital pool. (14) Depreciation Policy:- Although depreciation does not result in outflow of cash, it affects the working capital indirectly. In the first place, since depreciation is allowable expenditure in calculating net profits, it affects the tax liability. In the second place, higher depreciation also means lower disposable profits and, in turn, a lower dividend payment. Thus, outgo of cash is restricted to that extent. (15) Price Level Changes:- Changes in price level also affect the working capital requirements. If the price level is rising, more funds will be required to maintain the existing level of production. Same level of current assets will need increased investment when prices are increasing. However, companies that can immediately their product prices with rising price levels will not face a severe working capital problem. Thus, it is possible that some companies may not be affected by rising prices while others may be badly hit. (16) Efficiency of Management:- Efficiency of management is also a significant factor to determine the level of working capital. Management can reduce the need for working capital by the efficient utilization of resources. It can accelerate the pace of cash cycle and thereby use the same amount working capital again and again very quickly. Working Capital Management In gross sense working capital means the total of current assets and in net sense it is the difference between current assets and current liabilities. Through working capital management, the finance manager tries to manage the current assets, current liabilities and to evaluate the interrelationship that exists between them, i.e. it involves the relationship between a firm’s short-term assets and short-term liabilities. The aim of working capital management is to deploy such amount of current assets and current liabilities so as to maximize short-term liquidity. The management of working capital involves managing inventories, accounts receivable and payable as also cash. The two steps involved in the working capital management are as follows: (i) Forecasting the amount of working capital; and (ii) Determining the sources of working capital. Apart from the two mentioned above the following two additional important aspects should be kept in mind while managing working capital: (a) Inclusion of Profit: There is a lot of controversy regarding inclusion of profit in working capital requirement forecast. There are two views. The first view suggests that profit should be included in the working capital. The second view suggests that it should not be included. Inclusion or exclusion of profit depends primarily on the managerial policy adopted by the firm. From the first view, if working capital is calculated on the basis of actual cash outflow then profit should not be included in calculating working capital because financing of profit is not required. From the second view, where balance sheet approach is adopted for calculating working capital, profit element is not ignored as this should be included in the amount of debtors. (b) Exclusion of Depreciation: Depreciation does not involve any actual cash outflow, so it should not be included in the estimation of working capital. Working Capital Management Introduction Businesses require adequate capital to succeed in business environment. There are two types of capital required by business; fixed capital and working capital. Businesses require investment in asset, which has to be utilized over a longer period of times. These long-term investments are considered as fixed capital, e.g. plant, machinery, etc.


Another type of finance required is short term in nature. This short term finance or capital is required to undertake day to day operation. Such short capital is called current capital or working capital. Working capital refers to company’s investment in short term asset such as cash, inventory, short term marketable securities and account receivable. Information technology is playing a big part in today’s working capital management. Several aspects of working capital management like the cash management, inventory management, account receivables/payable management, etc. are managed through enterprise resource planning modules. Cash Management System The cash management module within the working capital management system should be fully integrated with other modules like account receivable/payable, payroll and general ledger. The main features of cash management tools are as follows:

The module tracks complete audit trails of all transactions and adjustment for controls. It highlights current and future balances for all cash accounts. The module has the capability for complete drill down to the source of all transactions. The module provides full bank reconciliation. It allows export of information for analysis, forecasting, presentation, reports, etc.

Inventory Management System Inventory management and control module is utilized by companies to avoid product overstock and outages. There are several components of an inventory management tool such as order management, asset tracking, product identification, etc. The main purpose within the inventory management system is to reduce the overall costs of carrying. An inventory management tool helps in:

Sustain a balance between too less and too much inventory. Track inventory between locations. Track inventory been received at warehouse. Track product sales and finished goods inventory.

The main advantage of an inventory management tool is cost savings, increased efficiency, warehouse management, etc. Account Receivable Management An account receivable management tool helps solve critical question like when payment is due, how much payment is due, etc. The main features of account receivable tool are as follows:

Permits transfer of account receivable information for analysis, forecasting, presentation, reports, etc. Maintain complete customer information, including sales history, current balance, open deposit, last payment, etc. Minimize data entry errors and permit print invoice, credit memos, debit memos, etc.

Appropriate credit policy is essential to maintain the cash flow cycle and return on capital. Short Term Financing Another important aspect of working capital management is short term financing. The short term financing tool based on cash flow cycle, inventory position and requirement helps in deciding the quantity of capital required. It also helps identify the term of financing and track payment. Working capital management decision directly affects day to day business operations. One of such factors is the cash conversion cycle which immediately affects the liquidity of the organization.

Management of Cash, Receivables, Inventory and Current Liabilities In managing financial growth of company, Cash, receivables and inventory jointly form working capital of a firm. It is imperative for experts to keep good balance of these factors. Management of Cash Cash is considered as vital asset and its proper management support company development and financial strength. An effective cash management program designed by companies can help to realise this growth and strength. Cash is vital element of any company needed to acquire supply resources, equipment and other assets used in generating the products and services. Marketable securities also come under near cash, serve as back pool of liquidity which provides quick cash when needed. Cash management is the stewardship or proper use of an entity's cash resources. It assists to keep an organization functioning by making the best use of cash or liquid resources of the organization. Cash management is associated with management of cash in such a way as to realise the generally accepted objectives of the firm, maximum productivity with maximum liquidity. It is the management's capability to identify cash problems before they ascend, to solve them when they arise and having made solution available to delegate someone carry them out. The notion of cash management is not new and it has attained a greater significance in the modern world of business due to change that took place in business operations and ever increasing difficulties and the cost of borrowing" (Howard, 1953 ). It is the most liquid current assets, cash is the common denominator to which all current assets can be reduced because the other current assets i.e. receivables and inventory get eventually converted into cash (Khan, 1983 ). This emphasises the importance of cash management. The term cash management denotes to the management of cash resource in such a way that generally accepted


business objectives could be accomplished. In this perspective, the objectives of a firm can be combined as bringing about consistency between maximum possible effectiveness and liquidity of a firm. Cash management may be defined as the ability of a management to identify the problems related with cash which may come across in future course of action, finding appropriate solution to curb such problems if they arise, and lastly delegating these solutions to the competent authority for carrying them out. Cash management maintains sufficient quantity of cash in such a way that the quantity denotes the lowest adequate cash figure to meet business obligations. Cash management involves managing cash flows (into and out of the firm), within the firm and the cash balances held by a concern at a point of time. In financial literature, Cash management denotes to wide area of finance involving the collection, handling, and usage of cash. It involves assessing market liquidity, cash flow, and investments. The notion of cash management is not novel and it has gained more significance in contemporary business world due to change that took place in the conduct of business and ever increasing difficulties and the cost of borrowing. Objective of Cash Management 1. To make Payment According to Payment Schedule: Firm needs cash to meet its routine expenses including wages, salary, taxes

etc. 2. To minimise Cash Balance: The second objective of cash management is to reduce cash balance. Excessive amount of cash

balance helps in quicker payments, but excessive cash may remain unused & reduces profitability of business. Contrarily, when cash available with firm is less, firm is unable to pay its liabilities in time. Therefore optimum level of cash should be maintained (Excel Books India, 2008).

An effective management is considered to be important for the following reasons: 1. Cash management guarantees that the firm has sufficient cash during peak times for purchase and for other purposes. 2. Cash management supports to meet obligatory cash out flows when they fall due. 3. Cash management helps in planning capital expenditure projects. 4. Cash management helps to organize for outside financing at favourable terms and conditions, if necessary. 5. Cash management helps to allow the firm to take advantage of discount, special purchases and business opportunities. 6. Cash management helps to invest surplus cash for short or long-term periods to keep the idle funds fully employed.

General Principles of Cash Management Harry Gross has recommended certain general principles of cash management. Determinable Variations of Cash Needs: A reasonable amount of funds, in the form of cash is required to be kept aside to overcome the period expected as the period of cash shortage. This period may either be short and temporary or last for a longer duration of time. Normal and regular payment of cash leads to small cutbacks in the cash balance at periodic intervals. Making this payment to different workers on different days of a week can balance these reductions. Another practice for balancing the level of cash is to schedule cash disbursements to creditors during the period when accounts receivables collected amounts to a large sum but without putting the helpfulness at stake. 1. Contingency Cash Requirement: There may arise certain cases, which fall beyond the forecast of the management. These

establish unexpected calamities, which are too difficult to be provided in the normal course of the business. Such contingencies always demand for special cash requirements that was not assessed and provided for in the cash budget. Denials of wholesale product, huge amount of bad debts, strikes, and lockouts are some of these contingencies. Only a prior experience and investigation of other similar companies prove supportive as a customary practice. A useful procedure is to shield the business from such calamities like bad-debt losses, fire by way of insurance coverage.

2. Availability of External Cash: This factor also has immense significance in the cash management which refer to the availability of funds from outside sources. There resources help in providing credit facility to the firm, which materialized the firm's objectives of holding minimum cash balance. As such if a firm succeeds in obtaining sufficient funds from external sources such as banks or private financers, shareholders, government agencies, the need to maintain cash reserves lessens.

3. Maximizing Cash Receipts: Nearly, all financial managers have objective to make the best possible use of cash receipts. Cash receipts if tackled carefully results in minimizing cash requirements of a concern. For this purpose, the comparative cost of granting cash discount to customer and the policy of charging interest expense for borrowing must be appraised continually to determine the ineffectiveness of either of the alternative or both of them during that particular period for maximizing cash receipts. Some techniques proved helpful in this context are mentioned below: i. Concentration Banking: In this system, a company launches banking centres for collection of cash in different areas. Thus,

the company instructs its customers of neighbouring areas to send their payments to those centres. The collection amount is then deposited with the local bank by these centres as early as possible. Whereby, the collected funds are transferred to the company's central bank accounts operated by the head office.

ii. Local Box System: Under this system, a company rents out the local post offices boxes of different cities and the customers are asked to forward their remittances to it. These remittances are picked by the approved lock bank from these boxes to be transferred to the company's central bank operated by the head office.

iii. Reviewing Credit Procedures: This type of technique assists to determine the impact of slow payers and bad debtors on cash. The accounts of slow paying customers should be revised to determine the volume of cash tied up. Besides this, evaluation of credit policy must also be conducted for introducing essential modifications. As a matter of fact, too strict a credit policy involves rejections of sales. Thus, restricting the cash inflow. On the other hand, too lenient, a credit policy would increase the number of slow payments and bad debts again reducing the cash inflows.


iv. Minimizing Credit Period: Shortening the terms allowed to the customers would definitely quicken the cash inflow side-by-side reviewing the discount offered would prevent the customers from using the credit for financing their own operations gainfully.

v. Others: There is a need to introduce various procedures for managing large to very large remittances or foreign remittances such as, persona pick up of large sum of cash using airmail, special delivery and similar techniques to accelerate such collections.

4. Minimizing Cash Disbursements: The intention to minimize cash payments is the ultimate benefit derived from maximizing cash receipts. Cash disbursement can be brought under control by stopping deceitful practices, serving time draft to creditors of large sum, making staggered payments to creditors and for payrolls.

5. Maximizing Cash Utilization: It is emphasized by financial experts that suitable and optimum utilization leads to maximizing cash receipts and minimizing cash payments. At times, a concern finds itself with funds in excess of its requirement, which lay idle without bringing any return to it. At the same time, the concern finds it imprudent to dispose it, as the concern shall soon need it. In such conditions, company must invest these funds in some interest bearing securities. Gitman suggested some fundamental procedures, which helps in managing cash if employed by the cash management. These include:

1. Pay accounts payables as late as possible without damaging the firm's credit rating, but take advantage of the favourable cash discount, if any. 2. Turnover, the inventories as quickly as possible, avoiding stock outs that might result in shutting down the productions line or loss of sales. 3. Collect accounts receivables as early as possible without losing future loss sales because of high-pressure collections techniques. Cash discounts, if they are economically justifiable, may be used to accomplish this objective (Gitman, 1979.). Function of Cash Management It is well acknowledged in financial reports and various studies that cash management is concerned with minimizing fruitless cash balances, investing temporarily excess cash usefully and to make the best possible arrangements for meeting planned and unexpected demands on the firm's cash (Hunt, 1966). Cash Management must have objective to reduce the required level of cash but minimize the risk of being unable to discharge claims against the company as they arise. There are five cash management functions: 1. Cash Planning: Experts emphases the wise planning of funds that can lead to huge success. For any management decision,

planning is the primary requirement. According to theorists, "Planning is basically an intellectual process, a mental pre-disposition to do things in an orderly way, to think before acting and to act in the light of facts rather than of a guess." Cash planning is a practise, which comprises of planning for and controlling of cash. It is a management process of predicting the future need of cash, its available resources and various uses for a specified period. Cash planning deals at length with formulation of necessary cash policies and procedures in order to perform business process constantly. A good cash planning aims at providing cash, not only for regular but also for irregular and abnormal requirements.

2. Managing Cash Flows: Second function of cash management is to properly manage cash flows. It means to manage efficiently the flow of cash coming inside the business i.e. cash inflow and cash moving out of the business i.e. cash outflow. These two can be effectively managed when a firm succeeds in increasing the rate of cash inflow together with minimizing the cash outflow. As observed accelerating collections, avoiding excessive inventories, improving control over payments contribute to better management of cash. Whereby, a business can protect cash and thereof would require lesser cash balance for its operations.

3. Controlling the Cash Flows: It has been observed that prediction is not an exact knowledge because it is based on certain conventions. Therefore, cash planning will unavoidably be at variance with the results actually obtained. Due to this, control becomes an unavoidable function of cash management. Moreover, cash controlling becomes indispensable as it increases the availability of usable cash from within the enterprise. It is understandable that greater the speed of cash flow cycle, greater would be the number of times a firm can convert its goods and services into cash and so lesser will be the cash requirement to finance the desired volume of business during that period. Additionally, every business is in possession of some concealed cash, which if traced out significantly decreases the cash requirement of the enterprise.

4. Optimizing the Cash Level: It is important that a financial manager must focus to maintain sound liquidity position i.e. cash level. All his efforts relating to planning, managing and controlling cash should be diverted towards maintaining an optimum level of cash. The prime need of maintaining optimum level of cash is to meet all requirements and to settle the obligations well in time. Optimization of cash level may be related to establishing equilibrium between risk and the related profit expected to be earned by the company.

5. Investing Idle Cash: Idle cash or surplus cash is described as the extra cash inflows over cash outflows, which do not have any specific operations or any other purpose to solve currently. Usually, a firm is required to hold cash for meeting working needs facing contingencies and to maintain as well as develop friendliness of bankers. In banking area, cash management is a marketing term for some services related to cash flow offered mainly to huge business customers. It may be used to describe all bank accounts (such as checking accounts) provided to businesses of a certain size, but it is more often used to describe specific services such as cash concentration, zero balance accounting, and automated clearing house facilities. Sometimes, private banking customers are given cash management services. Financial instruments involved in cash management include money market funds, treasury bills, and certificates of deposit.

Benefits of Cash Management System In the period of technology progression, the Cash Management System provides following Benefits to its customers: 1. Funds availability as per need on day zero, day one, day two, day three etc. i.e. Corporate can plan their cash flows.


2. Bank interest saved as instruments are collected faster. 3. Affordable and competitive rates.

4. Single point enquiry for all queries. 5. Pooling of funds at desired locations.

To summarize, Cash Management denotes to the concentration, collection and disbursement of cash. The major role for managers is to maintain the flow of cash. Cash Management include a series of activities aimed at competently handling the inflow and outflow of cash. This mainly involves diverting cash from where it is to where it is needed. It is established that cash management is the optimization of cash flows, balances and short-term investments. Management of Receivable Accounts receivable typically comprise more than 25 percent of a firm's assets. The term receivables is described as debt owed to the firm by the customers resulting from the sale of goods or services in the ordinary course of business. There are the funds blocked due to credit sales. Receivables management denotes to the decision a business makes regarding to the overall credit, collection policies and the evaluation of individual credit applicants. Receivables Management is also known as trade credit management. Robert N. Anthony, explained it as "Accounts receivables are amounts owed to the business enterprise, usually by its customers. Sometimes it is broken down into trade accounts receivables; the former refers to amounts owed by customers, and the latter refers to amounts owed by employees and others". Receivables are forms of investment in any enterprise manufacturing and selling goods on credit basis, large sums of funds are tied up in trade debtors. When company sells its products, services on credit, and it does not receive cash for it immediately, but would be collected in near future, it is termed as receivables. However, no receivables are created when a firm conducts cash sales as payments are received immediately. A firm conducts credit sales to shield its sales from the rivals and to entice the potential clienteles to buy its products at favourable terms. Generally, the credit sales are made on open account which means that no formal reactions of debt obligations are received from the buyers. This enables business transactions and reduces the paperwork essential in connection with credit sales. Accounts Receivables Management denotes to make decisions relating to the investment in the current assets as vital part of operating process, the objective being maximization of return on investment in receivables. It can be established that accounts receivables management involves maintenance of receivables of optimal level, the degree of credit sales to be made, and the debtors' collection. Receivables are useful for clients as it increases their resources. It is preferred particularly by those customers, who find it expensive and burdensome to borrow from other resources. Thus, not only the present customers but also the Potential creditors are attracted to buy the firm's product at terms and conditions favourable to them. Receivables have vial function in quickening distributions. As a middleman would act fast enough in mobilizing his quota of goods from the productions place for distribution without any disturbance of immediate cash payment. As, he can pay the full amount after affecting his sales. Likewise, the customers would panic for purchasing their needful even if they are not in a position to pay cash immediately. It is for these receivables are regarded as a connection for the movement of goods from production to distributions among the ultimate consumer. Maintenance of receivable Objectives of receivables management: The objective of Receivables Management is to promote sales and profits until that point is reached where the return on investment in further funding receivables is less than the cost of funds raised to finance that additional credit i.e. cost of capita. Management of Accounts Receivables is quite expensive. The following are the main costs related with accounts receivables management: Cost of Management of Accounts Receivables

Advantages of accounts receivable management: Accounts Receivables Management has numerous benefits. These include: 1. Increased Sales: Offering goods or services on credit enhances sales, by holding old customers and attraction potential

customers. 2. Increased Market Share: When the firm is able to maintain old customers and attract new customers automatically market

share will be bigger to the extent new sales. 3. Increase in profits: Increase sales, leads to increase in profits, because it need to produce more products with a given fixed

cost and sales of products with a given sales network in both cost per unit comes down and the profit will be better. Management of Inventory Inventory management is basically related to task of controlling the assets that are produced to be sold in the normal course of the firm's procedures. In supply chain management, major variable is to effectively manage inventory. The significance of inventory management to the company depends on the extent of its inventory investment. The objectives of inventory management are of twofold:


1. The operational objective is to uphold enough inventories, to meet demand for product by efficiently organizing the firm's production and sales operations.

2. Financial interpretation is to minimize unproductive inventory and reduce inventory, carrying costs.

Effective inventory management is to make good balance between stock availability and the cost of holding inventory. Components of inventory management: Inventories exist in different forms in a manufacturing company. These include: 1. Raw materials: Raw materials are those inputs that are transformed into completed goods throughout manufacturing process.

Those form a major input for manufacturing a product. In other words, they are very much needed for uninterrupted production.

2. Work-in-process: Work-in-process is a stage of stocks between raw materials and finished goods. Work-in-process inventories are semi-finished products. They signify products that need to undergo some other process to become finished goods.

3. Finished products: Finished products are those products which are totally manufactured and company can immediately sell to customers. The stock of finished goods provides a buffer between production and market.

4. Stores and spares: It comprises of office and plant cleaning materials like soap, brooms, oil, fuel, light, bulbs and are purchased and stored for the purpose of maintenance of machinery.

Component of inventory Inventory control encompasses managing the inventory that is previously in the warehouse, stockroom or store. This is to know the type of products are "out there", how many each item and where it is kept. It means having accurate, complete and timely inventory transactions record and avoiding differences between accounting and real inventory levels. Two tools commonly used to ensure inventory accuracy and control are ABC analysis and cycle counting. The process of Inventory management consists of determining, how to order products and how much to order as well as identifying the most effective source of supply for each item in each stocking location. Inventory management contains all activities of planning, forecasting and replenishment. The main purpose of inventory management is minimize differences between customers demand and availability of items. These differences have caused by three factors that include customers demand fluctuations, supplier's delivery time fluctuations and inventory control accuracy. Types of Inventory The aim of carrying inventories is to separate the operations of the firm. It means to make each function of the business independent of each other function so that delays or closures in one area do not affect the production and sale of the final product. Because production cessations result in increased costs, and because delays in delivery can lose customers, the management and control of inventory are important duties of the financial manager. There are many types of inventory. The common categories of inventory include raw materials inventory, work-in-process inventory, and finished-goods inventory. Raw-Materials Inventory: Raw materials inventory include basic materials purchased from other firms to be used in the firm's production operations. These goods may include steel, lumber, petroleum, or manufactured items such as wire, ball bearings, or tires that the firm does not produce itself. Regardless of the specific form of the raw-materials inventory, all manufacturing firms maintain a raw-materials inventory. The intention is to separate the production function from the purchasing function that is, to make these two functions independent of each other so delays in the delivery of raw materials do not cause production delays. If there is a delay, the firm can satisfy its need for raw materials by liquidating its inventory. Work-in-Process Inventory: Work-in-process inventory comprises of partly finished goods requiring additional work before they become finished goods. The more difficult and lengthy the production process, the larger the investment in work-in-process inventory. The main aim of work-in-process inventory is to disengage the various operations in the production process so that machine failures and work stoppages in one operation will not affect other operations. Finished-Goods Inventory: Finished-goods inventory includes goods on which production has been completed but that are not yet sold. The purpose of a finished-goods inventory is to separate the production and sales functions so that it is not required to produce the goods before a sale can occur and sales can be made directly out of inventory. Motives of inventory management: Managing inventories involve lack of funds and inventory holding costs. Maintenance of inventories is luxurious. Still there is motive to retain inventories. There are three general motives: 1. The transaction motive: Firm may hold the inventories in order to facilitate the smooth and continuous production and sales

operations. It may not be possible for the company to obtain raw material whenever necessary. There may be a time lag between the demand for the material and its supply. Therefore, it is needed to hold the raw material inventory. Similarly, it may not be possible to produce the goods instantly after they are demanded by the customers. Hence, it is needed to hold the finished goods inventory. The need to hold work-in-progress may arise due to production cycle.


2. The precautionary motive: Firms also prefer to hold them to protect against the risk of unpredictable changes in demand and supply forces. For example, the supply of raw material may get delayed due to the factors like strike, transport disruption, short supply, lengthy processes involved in import of the raw materials.

3. The speculative motive: Firms may like to buy and stock the inventory in the quantity which is more than needed for production and sales purposes. It is done to get the advantages in terms of quantity discounts connected with bulk purchasing or expected price rise.

Merits of Inventory Management There are several advantages of managing inventory in proper way. 1. Inventory management guarantees adequate supply of materials and stores to minimize stock outs and shortages and avoid

costly interruption in operations. 2. It keeps down investment in inventories, inventory carrying costs, and obsolescence losses to the minimum. 3. It eases purchasing economies throughout the measurement of requirements on the basis of recorded experience. 4. It removes duplication in ordering stock by centralizing the source from which purchase requisition emanate. 5. It allows better utilization of available stock by enabling inter-department transfers within a firm. 6. It offers a check against the loss of materials through carelessness or pilferage. 7. Perpetual inventory values provide a stable and reliable basis for preparing financial statements a better utilization.

Demerits of Holding Inventory Besides several benefits, there are some drawbacks of holding inventory. 1. Price decline: It is a major disadvantage of inventory holding. Price decline is the result of more supply and less demand. It can

be said that it may be due to introduction of competitive product. Generally, prices are not controllable in the short term by the individual firm. Controlling inventory is the only way that a firm can counter act with these risks. On the demand side, a decrease in the general market demand when supply remains the same may also cause price to increase. This is also long-lasting management problem, because reduction in demand may be due to change in customer buying habits, tastes and incomes.

2. Product deterioration: It is also serious demerits of inventory holding. Holding of finished completed goods for a long period or shortage under inappropriate conditions of light, heat, humidity and pressures lead to product worsening.

3. Product obsolescence: If items are hold for long time, it may become outdated. Product may become outmoded due to improved products, changes in customer choices, particularly in high style merchandise, changes in requirements. Then this is a major risk and it may affect in terms of huge revenue loss. It is costly for the firms whose resources are limited and tied up in slow moving inventories.

In final words, the notion of inventory management has been one of the many analytical characteristics of management. It involves optimization of resources available for holding stock of various materials. If there is shortage of inventory, it leads to stock-outs, causing stoppage of production and a very high inventory will result in increased cost due to cost of carrying inventory. Managing Current Liabilities A current liability is an obligation that is payable within one year. The collection of liabilities comprising current liabilities is closely watched, a business must have enough liquidity to guarantee that they can be paid off when due. In accounting area, current liabilities are often understood as all liabilities of the business that are to be settled in cash within the financial year or the operating cycle of a given firm, whichever period is longer. In exceptional cases where the operating cycle of a business is longer than one year, a current liability is described as being payable within the term of the operating cycle. The operating cycle is the time period required for a business to acquire inventory, sell it, and convert the sale into cash. In most cases, the one-year rule will apply. Since current liabilities are normally paid by liquidating current assets, the presence of a large amount of current liabilities calls attention to the size and prospective liquidity of the offsetting amount of current assets listed on a company's balance sheet. Current liabilities may also be settled through their replacement with other liabilities, such as with short-term debt. The combined amount of current liabilities is major component of several measures of the short-term liquidity of a business. That include: o Current ratio. This is current assets divided by current liabilities. o Quick ratio. This is current assets minus inventory, divided by current liabilities. o Cash ratio. This is cash and cash equivalents, divided by current liabilities.

Common examples of Current Liabilities Accounts payable: These are the trade payables due to suppliers, usually as evidenced by supplier invoices. Sales taxes payable: This is the obligation of a business to remit sales taxes to the government that it charged to customers on behalf of the government. Payroll taxes payable: This is taxes withheld from employee pay, or matching taxes, or additional taxes related to employee compensation. Income taxes payable: This is income taxes owed to the government but not yet paid. Interest payable: This is interest owed to lenders but not yet paid. Bank account overdrafts: These are short-term advances made by the bank to offset any account overdrafts caused by issuing checks in excess of available funding. Accrued expenses: These are expenses not yet payable to a third party, but already incurred, such as wages payable. Customer deposits: These are payments made by customers in advance of the completion of their orders for goods or services.


Dividends declared: These are dividends declared by the board of directors, but not yet paid to shareholders. Short-term loans: This is loans that are due on demand or within the next 12 months. Current maturities of long-term debt: This is that portion of long-term debt that is due within the next 12 months. To summarise, financial experts defined current liabilities as "obligations whose liquidation is reasonably expected to require the use of existing resources properly categorized as current assets or the certain of current liabilities."

Internal financing

In the theory of capital structure, internal financing is the name for a firm using its profits as a source of capital for

new investment, rather than a) distributing them to firm's owners or other investors and b) obtaining capital elsewhere. It is to

be contrasted with external financing which consists of new money from outside of the firm brought in for investment. Internal

financing is generally thought to be less expensive for the firm than external financing because the firm does not have to

incur transaction costs to obtain it, nor does it have to pay the taxes associated with paying dividends. Many economists

debate whether the availability of internal financing is an important determinant of firm investment or not. A

related controversy is whether the fact that internal financing is empirically correlated with investment implies firms are credit

constrained and therefore depend on internal financing for investment.

Internal financing

Advantages

Capital is immediately available

No interest payments

No control procedures regarding

creditworthiness

Spares credit line

No influence of third parties

More flexible

More freedom given to the owners Disadvantages

Expensive because internal financing is

not tax-deductible

No increase of capital

Losses (shrinking of capital) are not tax-

deductible

Limited in volume (volume of external

financing as well is limited but there is

more capital available outside - in the

markets - than inside of a company)

Concept And Meaning Of Dividend Policy Dividend refers to the portion of net income paid out to shareholders. It is paid in cash and/or stock for making investment and bearing risk. Dividend decision of the firm is yet another crucial area of financial management as it affects shareholders wealth and value of the firm. The percentage of earning paid out in the form of cash dividend is known as dividend payout ratio. A company may retain some portion of its earnings to finance new investment. The percentage of retained in the firm is called retention ratio. Dividend policy is an integral part of the firm's financing decision as it provides internal financing. Dividend policy is concerned with determining the proportion of firm’s earnings to be distributed in the form of cash dividend and the portion of earnings to be retained. A firm has three alternatives regarding the payment of cash dividends: 1. It can distribute all of its earnings in the firm of cash dividends, 2. It can retain all of its earnings for reinvestment, 3. It can distribute a part of earnings as dividend and retain the rest for reinvestment purpose. When dividends are paid to the stockholders the firm's cash is reduced. A firm may decrease its dividend payout and use the retained funds to expand its capacity, to pay off some of its debt or to increase investment. In this way, the firm's dividend policy is closely related with the firm'sinvestment and financing decisions. Determining the part of earnings to be distributed as dividends is a key decision that affects the value of firm's common stock in the market place. Similarly, the retained earnings are considered to be the most convenient internal source available for financing corporate growth. Thus, every corporate firm should establish and implement an effective dividend policy that leads the firm to stockholders wealth maximization. It should be recognized that a firm's dividend payout ratio depends on many factors. For example, it may be affected by the volatility in firm's cash flows and changing investment needs over time. If thefirm's cash flow is volatile, it may prefer to set a minimum level of regular cash dividends that can be maintained even at low profits. Similarly, if the firm has profitable investment opportunity it prefers to retain more amount by reducing dividend payout ratio. Dividends - Dividend Policy Dividend policy is the set of guidelines a company uses to decide how much of its earnings it will pay out to shareholders. Some evidence suggests that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash. This evidence is called the "dividend irrelevance theory," and it essentially indicates that an issuance of dividends should have little to no impact on stock price. That being said, many companies do pay dividends, so let's

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look at how they do it. There are three main approaches to dividends: residual, stability or a hybrid of the two. Residual Dividend Policy Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These companies usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, deciding on dividends only if there is enough money left over after all operating and expansion expenses are met. For example, let's suppose that a company named CBC has recently earned $1,000 and has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity). Now, suppose this company has a project with a capital requirement of $900. In order to maintain the debt/equity ratio of 0.5, CBC would have to pay for one-third of this project by using debt ($300) and two-thirds ($600) by using equity. In other words, the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000 - $600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000 - $1,000) for dividends. If any project required an equity portion that was greater than the company's available levels, the company would issue new stock. Typically, this method of dividend payment creates volatility in the dividend payments that some investors find undesirable. The residual-dividend model is based on three key pieces: an investment opportunity schedule (IOS), a target capital structure and a cost of external capital. 1. The first step in the residual dividend model to set a target dividend payout ratio to determine the optimal capital budget. 2. Then, management must determine the equity amount needed to finance the optimal capital budget. This should be done primarily through retained earnings. 3. The dividends are then paid out with the leftover, or residual, earnings. Given the use of residual earnings, the model is known as the "residual-dividend model." A primary advantage of the dividend-residual model is that with capital-projects budgeting, the residual-dividend model is useful in setting longer-term dividend policy. A significant disadvantage is that dividends may be unstable. Earnings from year to year can vary depending on business situations. As such, it is difficult to maintain stable earnings and thus a stable dividend. While the residual-dividend model is useful for longer-term planning, many firms do not use the model in calculating dividends each quarter. Dividend Stability Policy The fluctuation of dividends created by the residual policy significantly contrasts with the certainty of the dividend stability policy. With the stability policy, quarterly dividends are set at a fraction of yearly earnings. This policy reduces uncertainty for investors and provides them with income. Suppose our imaginary company, CBC, earned $1,000 for the year (with quarterly earnings of $300, $200, $100 and $400). If CBC decided on a stable policy of 10% of yearly earnings ($1,000 x 10%), it would pay $25 ($100/4) to shareholders every quarter. Alternatively, if CBC decided on a cyclical policy, the dividend payments would adjust every quarter to be $30, $20, $10 and $40, respectively. In either instance, companies following this policy are always attempting to share earnings with shareholders rather than searching for projects in which to invest excess cash. Hybrid Dividend Policy The final approach is a combination between the residual and stable dividend policy. Using this approach, companies tend to view the debt/equity ratio as a long-term rather than a short-term goal. In today's markets, this approach is commonly used by companies that pay dividends. As these companies will generally experience business cycle fluctuations, they will generally have one set dividend, which is set as a relatively small portion of yearly income and can be easily maintained. On top of this set dividend, these companies will offer another extra dividend paid only when income exceeds general levels.

Valuation for Mergers and Acquisitions Mergers and acquisitions are both aspects of strategic management, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture. M&A can be defined as a type of restructuring in that they result in some entity reorganization with the aim to provide growth or positive value. Consolidation of an industry or sector occurs when widespread M&A activity concentrates the resources of many small companies into a few larger ones, such as occurred with the automotive industry between 1910 and 1940.

The distinction between a "merger" and an "acquisition" has become increasingly blurred in various respects (particularly in terms of the ultimate economic outcome), although it has not completely disappeared in all situations. From a legal point of view, a merger is a legal consolidation of two companies into one entity, whereas an acquisition occurs when one company takes over another and completely establishes itself as the new owner (in which case the target company still exists as an independent legal entity controlled by the acquirer). Either structure can result in the economic and financial consolidation of the two entities. In practice, a deal that is a merger for legal purposes may be euphemistically called a "merger of equals" if both CEOs agree that joining together is in the best interest of both of their companies, while when the deal is unfriendly (that is, when the management of the target company opposes the deal) it is almost always regarded as an "acquisition". Several valuation methods are available, depending on a company’s industry, its characteristics (for example, whether it is a start-up or a mature company), and the analyst’s preference and expertise. In this chapter and the rest of the book, we focus on the

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mainstream valuation methods. These methods are classified into four categories, based on two dimensions. The first dimension distinguishes between direct (or absolute) valuation methods and indirect (or relative) valuation methods; the second dimension separates models that rely on cash flows from models that rely on another financial variable, such as sales (revenues), earnings, or book value. As their name indicates, direct valuation methods provide a direct estimate of a company’s fundamental value. In the case of public companies, the analyst can then compare the company’s fundamental value obtained from that valuation analysis to the company’s market value. The company appears fairly valued if its market value is equal to its fundamental value, undervalued if its market value is lower than its fundamental value, and overvalued if its market value is higher than its fundamental value. In contrast, relative valuation methods do not provide a direct estimate of a company’s fundamental value: They do not indicate whether a company is fairly priced; they indicate only whether it is fairly priced relative to some benchmark or peer group. Because valuing a company using an indirect valuation method requires identifying a group of comparable companies, this approach to valuation is also called the comparables approach. Exhibit 1.1 provides an overview of the mainstream valuation methods. Exhibit 1.1. Overview of Valuation Methods

Direct (or Absolute) Valuation Methods Relative (or Indirect) Valuation Methods

Valuation methods that rely on cash flows

Discounted cash flow models: Free cash flow to the firm model Free cash flow to equity model Adjusted present value model Option-pricing models: Real option analysis

Price multiples: Price-to-cash-flow ratio

Valuation methods that rely on a financial variable other than cash flows

Economic income models: Economic value analysis

Price multiples*: Price-to-earnings ratios (P/E ratio, P/EBIT ratio, and P/EBITDA ratio) Price-to-sales ratio Price-to-book ratio Enterprise value multiples: EV/EBITDA multiple EV/Sales multiple

* E stands for earnings; EBIT for earnings before interest and taxes; EBITDA to earnings before interest, taxes, depreciation, and amortization; and EV for enterprise value.

Academicians and practitioners are in relative agreement on what drives a company’s fundamental value: its future cash flows. However, no consensus has settled on what drives a company’s share price. In today’s global economic environment, it would be naïve to suggest that any single factor drives share prices. Indeed, the proliferation of valuation methods partly reflects the financial community’s inability to agree on exactly which factors are the primary drivers of share prices—cash flows, sales, accounting earnings, book value, or economic income. The dominant viewpoint is that changes in share prices are most closely related to changes in future cash flows, with all else being equal. This is the viewpoint this book endorses. We now turn to a closer examination of the valuation methods presented in Exhibit 1.1. 5.1. Relative Valuation Methods The notion that “time is money” or, stated alternatively, that “time is an expensive and limited commodity” is one of the principal reasons for relative valuation methods. Other reasons are that they are simple to apply and easy to understand. In essence, relative valuation methods give corporate executives and analysts a “quick and dirty” way to estimate the value of a company. Relative valuation methods rely on the use of multiples. A multiple is a ratio between two financial variables. In most cases, the numerator of the multiple is either the company’s market price (in the case of price multiples) or its enterprise value (in the case of enterprise value multiples). The enterprise value of a company is typically defined as the market value of its capital (debt and equity), net of cash. The denominator of the multiple is an accounting metric, such as the company’s earnings, sales, or book value. Multiples can be calculated from per-share amounts (market price per share, earnings per share, sales per share, or book value per share) or total amounts. Note that whether the analyst uses per-share amounts or total amounts does not affect the multiple, as long as the same basis is used in both the numerator and the denominator. 5.1.1. Price Multiples The most popular price multiples are earnings multiples. The price-to-earnings (P/E) ratio, which is equal to a company’s market price per share divided by its earnings per share (EPS), is the most widely used earnings multiple. It provides an indication of how much investors are willing to pay for a company’s earnings. For example, a company whose P/E ratio is 15 is said to be selling for 15 times earnings; put another way, investors are willing to pay $15 for each $1 of current or future earnings. Companies with high earnings growth prospects usually carry high P/E ratios because these companies are expected to be able to reward investors with a quicker and larger return on their investment in the form of dividends, increase in share price, or both. Because the earnings of a company are influenced to varying degrees by how the company is financed (with debt or with equity) and where it pays income taxes, some analysts have turned to a variant of the P/E ratio that removes the effect of a company’s capital structure and income taxes on its earnings. This variant is the price-to-earnings before interest and taxes (P/EBIT) ratio. Still other analysts, worried about the distortive effect on earnings of accounting policies with respect to the depreciation of tangible assets and the amortization of intangible assets, prefer to use the price-to-earnings before interest, taxes, depreciation,


and amortization (P/EBITDA) ratio. The P/EBITDA ratio is also popular because of the close relationship between a company’s EBITDA and its cash flow from operations. The P/E, P/EBIT, and P/EBITDA ratios all require positive accounting earnings. But not all companies are profitable—particularly young ones. For companies that are operating at a loss, analysts must find an alternative to accounting earnings. The most popular alternative is sales, which leads to the price-to-sales (P/Sales) ratio. The P/Sales ratio is useful in the early stages of a company’s life cycle, when marketplace acceptance and growth in market share are considered to be the two best indicators of the company’s likely future operating earnings and cash flows. Another price multiple is the price-to-book (P/Book) ratio. It indicates the relative premium that investors are willing to pay over the book value of their equity investment in a company. Unfortunately, a company’s book value is highly sensitive to accounting standards and management’s accounting decisions. For this reason, the P/B ratio is used selectively; realistically, it is neither a valid nor viable valuation method for most companies, except perhaps for financial institutions and insurance companies. These companies have highly liquid assets and liabilities on their balance sheets, which makes book values more realistic proxies for market values. In contrast to the previous five multiples, the last one is based on cash flows. Because cash flows are less sensitive than earnings to accounting choices and potential accounting manipulations, some analysts prefer to base their valuation on the price-to-cash-flow (P/CF) ratio than on the P/E, P/EBIT, or even P/EBITDA ratios.10 This approach is also consistent with the viewpoint that value is primarily driven by cash flows. 5.1.2. Enterprise Value Multiples Price multiples are popular with buy-side and sell-side analysts interested in valuing a company’s price per share—that is, the company’s equity value per share.11 In the context of M&As, however, corporate executives and analysts are often interested in assessing a target’s total value, reflecting both debt and equity. In this case, the enterprise value is a better basis for the valuation, hence the reason enterprise value multiples are widely used when valuing an acquisition target. The most popular enterprise value multiple is the EV/EBITDA multiple, although the EV/Sales multiple can be used for unprofitable companies. For example, an EV/EBITDA multiple of 8 indicates that the acquirer is willing to pay eight times the target’s current or future EBITDA. Many analysts often check that the EV/EBITDA multiple offered to acquire a target is in line with the EV/EBITDA multiples paid in previous acquisitions. Offering an EV/EBITDA multiple that is substantially higher than the average EV/EBITDA multiple for comparable transactions is usually an indication that the acquirer is overpaying for the target. 5.2. Direct Valuation Methods Unlike the relative valuation methods, direct valuation methods give investors an explicit equity value per share or share price objective. Preeminent among the group of direct valuation methods are the discounted cash flow (DCF) models. 5.2.1. Discounted Cash Flow Models DCF models are premised on one of the most fundamental tenets of corporate finance: The value of a company today is equal to the present value of the future (but uncertain) cash flows to be generated by the company’s operations, discounted at a rate that reflects the riskiness (or uncertainty) of those cash flows. The most widely used version of the DCF model is sometimes referred to as the free cash flow to the firm model, or weighted average cost of capital model. It provides an estimation of the company’s total value, based on its free cash flows (FCFs) to the firm discounted at the weighted average cost of capital (WACC). The FCFs of the firm are the cash flows from operations available to all capital providers, net of the required capital investments necessary to maintain the company as a going concern. The WACC reflects the hurdle rate that providers of capital require, based on the risk they face from investing in the company. The equity value per share—that is, the value accruing to the common (or voting) shareholders—is given by the operating value of the company minus the value of any claims on the company’s cash flows by debt holders, preferred shareholders, noncontrolling (minority) interest shareholders, and any contingent claimants. A variant is the free cash flow to equity model, which provides a direct estimate of a company’s equity value per share. Instead of relying on the FCFs available to all capital providers, it considers the FCFs available to equity holders: the FCFs to the firm minus all the cash flows owed to claimants other than common shareholders. Because the focus is on equity holders, the discount rate is the cost of equity, or the hurdle rate for common shareholders. The FCF to the firm and FCF to equity models are highly effective valuation methods, particularly when the capital structure of a target is expected to remain stable over time. Some acquisitions, however, are predicated on material changes in capital structure, as in the case of an LBO. In these situations, theadjusted present value (APV) model is easier to implement than the other DCF models. Under the APV model, the value of a target is decomposed into two components: the value of the company assuming that it is financed entirely with equity, and the value of the tax shield (benefits) provided by a company’s actual (or expected) debt financing. Because interest is tax deductible, using financial leverage increases a company’s value by reducing its cash outflow for income taxes. As a company’s capital structure changes over time, the first component (the unleveraged, or unlevered, value) is unaffected; the change in financial leverage affects only the second component (the interest tax shield), which is relatively straightforward to estimate. 5.2.2. Non Discounted Cash Flow Models Real option analysis is another valuation method that relies on cash flows, although it is grounded in option-pricing models instead of DCF models. Analysts rarely use real option analysis to value an entire company. However, this valuation method proves useful when a company has investment opportunities that have option-like features; these features are usually difficult, if not impossible, to capture using DCF models. For example, a company might have rights (but not obligations) to delay investments, expand into new markets, redeploy resources between projects, or exit investments. These rights are valuable


options, particularly in an uncertain environment. Real option analysis, which applies to real assets some of the techniques used for valuing financial options, enables analysts to value the wide range of rights a company has. Economic income models, also called residual income models, differ from DCF models and real option analysis, in that they rely not on cash flows, but on earnings to estimate a company’s fundamental value. However, in contrast with price and enterprise value multiples that are based on accounting earnings, economic income models rely on economic income. Economic income is usually defined as net income minus a charge for using equity—one of the issues with accounting earnings such as net income is that they include a charge for using debt (interest expense), but not for using equity. The principle behind economic income models is that a company that produces positive economic income creates shareholder value. Consequently, it should be rewarded with a higher share price. The most popular economic income model is economic value analysis, although other versions are also available. Academicians agree that, in theory, the FCF to the firm, FCF to equity, APV, and economic income models are equivalent, provided, of course, that the models use the same assumptions. In practice, however, differences arise, primarily because of implementation issues. Thus, as we review the different valuation methods in Chapters 3, “Traditional Valuation Methods,” and 4, “Alternative Valuation Methods,” we address the major issues an analyst faces when using relative and direct valuation methods. 5.3. The Use of Valuation Methods Imam, Barker, and Clubb (2008) conducted semi-structured interviews with sell-side and buy-side analysts in the United Kingdom to determine which valuation methods analysts used, why they used them, and how they used them. Their results showed that

The two most widely used valuation methods are the P/E ratio and the FCF to the firm model. In contrast, few analysts used economic value analysis, multiples based on book values (whether price or enterprise value multiples), or the P/Sales ratio.

Approximately 60 percent of the analysts expressed a strong preference for cash flow–based valuation methods, particularly buy-side analysts. However, most analysts admit that they often complement their cash flow–based analysis with a multiples-based analysis.

Some valuation methods are sector specific. For example, the P/B ratio and EV/Sales ratios are rarely used, except to value financial institutions and retailers, respectively.

The results of this survey are consistent with our own experience. This is the reason we have classified the FCF to the firm model and the P/E ratio as “traditional” valuation methods in this book, and we cover them both thoroughly in Chapter 3. Although other valuation methods are less often used, they are part of the analyst toolbox. Thus, we also discuss these “alternative” methods in Chapter 4, albeit less thoroughly Process of Merger and acquisition -Merger and acquisition process is the most challenging and most critical one when it comes to corporate restructuring. One wrong decision or one wrong move can actually reverse the effects in an unimaginable manner. It should certainly be followed in a way that a company can gain maximum benefits with the deal. Following are some of the important steps in the M&A process: Business Valuation Business valuation or assessment is the first process of merger and acquisition. This step includes examination and evaluation of both the present and future market value of the target company. A thorough research is done on the history of the company with regards to capital gains, organizational structure, market share, distribution channel, corporate culture, specific business strengths, and credibility in the market. There are many other aspects that should be considered to ensure if a proposed company is right or not for a successful merger. Proposal Phase Proposal phase is a phase in which the company sends a proposal for a merger or an acquisition with complete details of the deal including the strategies, amount, and the commitments. Most of the time, this proposal is send through a non-binding offer document. Planning Exit When any company decides to sell its operations, it has to undergo the stage of exit planning. The company has to take firm decision as to when and how to make the exit in an organized and profitable manner. In the process the management has to evaluate all financial and other business issues like taking a decision of full sale or partial sale along with evaluating on various options of reinvestments. Structuring Business Deal After finalizing the merger and the exit plans, the new entity or the take over company has to take initiatives for marketing and create innovative strategies to enhance business and its credibility. The entire phase emphasize on structuring of the business deal. Stage of Integration This stage includes both the company coming together with their own parameters. It includes the entire process of preparing the document, signing the agreement, and negotiating the deal. It also defines the parameters of the future relationship between the two. Operating the Venture After signing the agreement and entering into the venture, it is equally important to operate the venture. This operation is attributed to meet the said and pre-defined expectations of all the companies involved in the process. The M&A transaction after the deal include all the essential measures and activities that work to fulfill the requirements and desires of the companies involved. Types of merger & acquisitions There are many types of mergers and acquisitions that redefine the business world with new strategic alliances and improved corporate philosophies. From the business structure perspective, some of the most common and significant types of mergers and acquisitions are listed below: Horizontal Merger This kind of merger exists between two companies who compete in the same industry segment. The two companies combine their operations and gains strength in terms of improved performance, increased capital, and enhanced


profits. This kind substantially reduces the number of competitors in the segment and gives a higher edge over competition. Vertical Merger Vertical merger is a kind in which two or more companies in the same industry but in different fields combine together in business. In this form, the companies in merger decide to combine all the operations and productions under one shelter. It is like encompassing all the requirements and products of a single industry segment. Co-Generic Merger Co-generic merger is a kind in which two or more companies in association are some way or the other related to the production processes, business markets, or basic required technologies. It includes the extension of the product line or acquiring components that are all the way required in the daily operations. This kind offers great opportunities to businesses as it opens a hue gateway to diversify around a common set of resources and strategic requirements. Conglomerate Merger Conglomerate merger is a kind of venture in which two or more companies belonging to different industrial sectors combine their operations. All the merged companies are no way related to their kind of business and product line rather their operations overlap that of each other. This is just a unification of businesses from different verticals under one flagship enterprise or firm.

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1 BAJRANG/KUCHAMAN/[email protected]/MBA … · Financial Management is a related aspect of finance function. In the present business administration financial management is