Financial Management (2)

Financial Management Unit 1

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Unit 1 Financial Management Structure

1.1 Introduction

1.2 Meaning And Definitions

1.3 Goals Of Financial Management

1.3.1 Profit Maximization

1.3.2 Wealth Maximization

1.4 Finance Functions

1.4.1 Investment Decisions:

1.4.2 Financing Decisions:

1.4.3 Dividend Decisions

1.4.4 Liquidity Decision

1.5 Organization Of Finance Function

1.5.1 Interface Between Finance And Other Business Functions

1.5.2 Finance And Accounting

1.5.3 Finance And Marketing

1.5.4 Finance And Production (Operations)

1.5.5 Finance And HR

1.6 Summary

Terminal Questions

Answers to SAQs and TQs

1.1 Introduction To establish any business, a person must find answers to the following questions:

a) Capital investments are required to be made. Capital investments are made to acquire the

real assets, required for establishing and running the business smoothly. Real assets are land

and buildings, plant and equipments etc.

b) Decision to be taken on the sources from which the funds required for the capital investments

mentioned above could be obtained, to be taken.

c) Therefore, there are two sources of funds viz. debt and equity. In what proportion the funds

are to be obtained from these sources is to be decided for formulating the financing plan.


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d) Decision on the routine aspects of day to day management of collecting money due from the

firms’ customers and making payments to the suppliers of various resources to the firm.

These are the core elements of financial management of a firm.

Financial Management of a firm is concerned with procurement and effective utilization of funds

for the benefit of its stakeholders. The most admired Indian companies are Reliance, Infosys.

They have been rated well by the financial analyst on many crucial aspects that enabled them to

create value for its share holders. They employ the best technology, produce quality goods or

render services at the least cost and continuously contribute to the share holders’ wealth.

All corporate decisions have financial implications. Therefore, financial management embraces all

those managerial activities that are required to procure funds at the least cost and their effective

deployment. Finance is the life blood of all organizations. It occupies a pivotal role in corporate

management. Any business which ignores the role of finance in its functioning cannot grow

competitively in today’s complex business world. Value maximization is the cardinal rule of

efficient financial managers today.

Learning Objectives:

After studying this unit, you should be able to understand the following.

1. The meaning of Business Finance. 2. The objectives of Financial Management. 3. The various interfaces between finance and other managerial functions of a firm.

1.2Meaning And Definitions The branch of knowledge that deals with the art and science of managing money is called

financial management. With liberalization and globalization of Indian economy, regulatory and

economic environments have undergone drastic changes. This has changed the profile of Indian

finance managers today. Indian financial managers have transformed themselves from licensed

raj managers to well informed dynamic proactive managers capable of taking decisions of

complex nature in the present global scenario.

Traditionally, financial management was considered a branch of knowledge with focus on the

procurement of funds. Instruments of financing, formation, merger & restructuring of firms, legal

and institutional frame work involved therein occupied the prime place in this traditional approach.


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The modern approach transformed the field of study from the traditional narrow approach to the

most analytical nature. The core of modern approach evolved around, procurement of the least

cost funds and its effective utilization for maximization of share holders’ wealth. Globalization of

business and impact of information technology on financial management have added new

dimensions to the scope of financial management.

Self Assessment Question 1 1. Financial Management deals with procurement of funds at the least cost and ______ funds.

1.3Goals Of Financial Management Goals mean financial objective of a firm. Experts in financial management have endorsed the

view that the goal of Financial Management of a firm is maximization of economic welfare of its

shareholders. Maximization of economic welfare means maximization of wealth of its

shareholders. Shareholders’ wealth maximization is reflected in the market value of the firms’

shares. A firm’s contribution to the society is maximized when it maximizes its value. There are

two versions of the goals of financial management of the firm:

1.3.1 Profit Maximization: In a competitive economy, profit maximization has been considered as the legitimate objective of

a firm because profit maximization is based on the cardinal rule of efficiency. Under perfect

competition allocation of resources shall be based on the goal of profit maximization. A firm’s

performance is evaluated in terms of profitability. Investor’s perception of company’s

performance can be traced to the goal of profit maximization. But, the goal of profit maximization

has been criticized on many accounts:

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

a) Is it profit after tax or before tax?

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

Differences in interpretation on the concept of profit expose the weakness of the goal of profit

maximization

2. Profit maximization ignores time value of money because it does not differentiate between

profits of current year with the profit to be earned in later years.


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3. The concept of profit maximization fails to consider the fluctuation in the profits earned from

year to year. Fluctuations may be attributable to the business risk of the firm but the concept

fails to throw light on this aspect.

4. Profit maximization does not make clear the concept of profit as to whether it is accounting

profit or economic normal profit or economic supernormal profits.

5. Because of these deficiencies, profit maximization fails to meet the standards stipulated in an

operationally feasible criterion for maximizing shareholders wealth.

1.3.2 Wealth Maximization Wealth Maximization has, been accepted by the finance managers, because it overcomes the

limitations of profit maximisation. Wealth maximisation means maximizing the net wealth of the

Company’s share holders. Wealth maximisation is possible only when the company pursues

policies that would increase the market value of shares of the company.

Following arguments are in support of the superiority of wealth maximisation over profit

maximisation:

1. Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not

based on any subjective interpretation. On the other hand there are many subjective

elements in the concept of profit maximisation.

2. It considers time value of money. Time value of money translates cash flows occurring at

different periods into a comparable value at zero period. In this process, the quality of cash

flows is considered critically in all decisions as it incorporates the risk associated with the cash

flow stream. It finally crystallizes into the rate of return that will motivate investors to part with

their hard earned savings. It is called required rate of return or hurdle rate which is employed

in evaluating all capital projects undertaken by the firm. Maximizing the wealth of

shareholders means positive net present value of the decisions implemented. Positive net

present value can be defined as the excess of present value of cash inflows of any decision

implemented over the present value of cash out flows associated with the process of

implementation of the decisions taken. To compute net present value we employ time value

factor. Time value factor is known as time preference rate i.e. the sum of risk free rate and

risk premium. Risk free rate is the rate that an investor can earn on any government security

for the duration under consideration. Risk premium is the consideration for the risk perceived

by the investor in investing in that asset or security.

X Ltd is a listed company engaged in the business of FMCG (Fast Moving Consumer goods).

Listed means the company’s shares are allowed to be traded officially on the portals of the stock


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exchange. The Board of Directors of X Ltd took a decision in one of its Board meeting, to enter

into the business of power generation. When the company informs the stock exchange at the

conclusion of the meeting of the decision taken, the stock market reacts unfavourably with the

result that the next days’ closing of quotation was 30 % less than that of the previous day.

The question now is, why the market reacted in this manner. Investors in this FMCG Company

might have thought that the risk profile of the new business (power) that the company wants to

take up is higher compared to the risk profile of the existing FMCG business of the X Ltd. When

they want a higher return, market value of company’s share declines. Therefore the risk profile of

the company gets translated into a time value factor. The time value factor so translated

becomes the required rate of return. Required rate of return is the return that the investors want

for making investment in that sector.

Any project which generates positive net present value creates wealth to the company. When a

company creates wealth from a course of action it has initiated the share holders benefit because

such a course of action will increase the market value of the company’s shares.

Superiority of Wealth Maximisation over Profit Maximisation

1. It is based on cash flow, not based on accounting profit.

2. Through the process of discounting it takes care of the quality of cash flows. Distant cash

flows are uncertain. Converting distant uncertain cash flows into comparable values at base

period facilitates better comparison of projects. There are various ways of dealing with risk

associated with cash flows. These risks are adequately considered when present values of

cash flows are taken to arrive at the net present value of any project.

3. In today’s competitive business scenario corporates play a key role. In company form of

organization, shareholders own the company but the management of the company rests with

the board of directors. Directors are elected by shareholders and hence agents of the

shareholders. Company management procures funds for expansion and diversification from

Capital Markets. In the liberalized set up, the society expects corporates to tap the capital

markets effectively for their capital requirements. Therefore to keep the investors happy

through the performance of value of shares in the market, management of the company must

meet the wealth maximisation criterion.

4. When a firm follows wealth maximisation goal, it achieves maximization of market value of

share. When a firm practices wealth maximisation goal, it is possible only when it produces

quality goods at low cost. On this account society gains because of the societal welfare.


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5. Maximization of wealth demands on the part of corporates to develop new products or render

new services in the most effective and efficient manner. This helps the consumers as it will

bring to the market the products and services that consumers need.

6. Another notable features of the firms committed to the maximisation of wealth is that to

achieve this goal they are forced to render efficient service to their customers with courtesy.

This enhances consumer welfare and hence the benefit to the society.

7. From the point of evaluation of performance of listed firms, the most remarkable measure is

that of performance of the company in the share market. Every corporate action finds its

reflection on the market value of shares of the company. Therefore, shareholders wealth

maximization could be considered a superior goal compared to profit maximisation.

8. Since listing ensures liquidity to the shares held by the investors, shareholders can reap the

benefits arising from the performance of company only when they sell their shares.

Therefore, it is clear that maximization of market value of shares will lead to maximisation of

the net wealth of shareholders.

Therefore, we can conclude that maximization of wealth is the appropriate of goal of financial

management in today’s context.

Self Assessment Questions 2 1. Under perfect competition, allocation of resources shall be based on the goal of _______.

2. _____________ is based on cash flows.

3. __________________ consider time value of money.

1.4 Finance Functions Finance functions are closely related to financial decisions. The functions performed by a finance

manager are known as finance functions. In the course of performing these functions finance

manager takes the following decisions:

1. Financing decision 2. Investment Decision 3. Dividend decision 4. Liquidity decision.


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1.4.1 Investment Decisions: To survive and grow, all organizations must be innovative. Innovation demands managerial

proactive actions. Proactive organization continuously search for innovative ways of performing

the activities of the organization. Innovation is wider in nature. It could be expansion through

entering into new markets, adding new products to its product mix, performing value added

activities to enhance the customer satisfaction, or adopting new technology that would drastically

reduce the cost of production or rendering services or mass production at low cost or

restructuring the organization to improve productivity. All these will change the profile of an

organization. These decisions are strategic because, they are risky but if executed successfully

with a clear plan of action, they generate super normal growth to the organization.

If the management errs in any phase of taking these decisions and executing them, the firm may

become bankrupt. Therefore, such decisions will have to be taken after taking into account all

facts affecting the decisions and their execution.

Two critical issues to be considered in these decisions are:

1. Evaluation of expected profitability of the new investments.

2. Rate of return required on the project.

The rate of return required by investor is normally known by hurdle rate or cutoff rate or

opportunity cost of capital.

After a firm takes a decision to enter into any business or expand it’s existing business, plans to

invest in buildings, machineries etc. are conceived and executed. The process involved is called

Capital Budgeting. Capital Budgeting decisions demand considerable time, attention and energy

of the management. They are strategic in nature as the success or failure of an organization is

directly attributable to the execution of capital budgeting decisions taken.

Investment decisions are also known as Capital Budgeting Decisions. Capital Budgeting

decisions lead to investment in real assets

Dividends are payouts to shareholders. Dividends are paid to keep the shareholders happy.

Dividend policy formulation requires the decision of the management as to how much of the

profits earned will be paid as dividend. A growing firm may retain a large portion of profits as

retained earnings to meet its needs of financing capital projects. Here, the finance manager has

to strike a balance between the expectation of shareholders on dividend payment and the need to

provide for funds out of the profits to meet the organization’s growth.

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1.4.2 Financing Decisions: Financing decisions relate to the acquisition of funds at the least cost. Here cost has two

dimensions viz explicit cost and implicit cost.

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

etc.

Implicit cost is not a visible cost but it may seriously affect the company’s operations especially

when it is exposed to business and financial risk. For example, implicit cost is the failure of the

organization to pay to its lenders or debenture holders loan installments on due date on account

of fluctuations in cash flow attributable to the firms business risk. In India if the company is

unable to pay its debts, creditors of the company may use legal means to sue the company for

winding up. This risk is normally known as risk of insolvency. A company which employs debt as

a means of financing normally faces this risk especially when its operations are exposed to high

degree of business risk.

In all financing decisions a firm has to determine the proportion of equity and debt. The

composition of debt and equity is called the capital structure of the firm.

Debt is cheap because interest payable on loan is allowed as deductions in computing taxable

income on which the company is liable to pay income tax to the Government of India. For

example, if the interest rate on loan taken is 12 %, tax rate applicable to the company is 50 %,

then when the company pays Rs.12 as interest to the lender, taxable income of the company will

be reduced by Rs.12.

In other words when actual cost is 12% with the tax rate of 50 % the effective cost becomes 6%

therefore, debt is cheap. But, every installment of debt brings along with it corresponding

insolvency risk.

Another thing notable in this connection is that the firm cannot avoid its obligation to pay interest

and loan installments to its lenders and debentures.

On the other hand, a company does not have any obligation to pay dividend to its shareholders.

A company enjoys absolute freedom not to declare dividend even if its profitability and cash

positions are comfortable. However, shareholders are one of the stakeholders of the company.

They are in reality the owners of the company. Therefore well managed companies cannot ignore

the claim of shareholders for dividend. Dividend yield is an important determinant for stock

prices. Dividend yield refers to dividend paid with reference to the market price of the shares of

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

1. Income from Capital appreciation (i.e. Capital gains on sale of shares at market price)

2. Income from dividends.


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It is the ability of the company to give both these incomes to its shareholders that determines the

market price of the company’s shares.

The most important goal of financial management is maximisation of net wealth of the

shareholders. Therefore, management of every company should strive hard to ensure that its

shareholders enjoy both dividend income and capital gains as per the expectation of the market.

But, dividend is declared out of the profit earned by the company after paying income tax to the

Govt of India.

For example, let us assume the following facts:

Dividend = 12 % on paid up value

Tax rate applicable to the company = 30 %

Dividend tax = 10 %

When a Company pays Rs.12 on paid up Capital of Rs.100 as dividend, the profit that the

company must earn before tax is:

Since payment of dividend by an Indian Company attracts dividend tax, the company when it

pays Rs.12 to shareholders, must pay to the Govt of India

10 % of Rs.12 = Rs.1.2 as dividend tax. Therefore dividend and dividend tax sum up to 12 + 1.2

= Rs.13.2

Since this is paid out of the post tax profit, in this question, the company must earn:

Post – tax dividend paid

1 – Tax rate applicable to the company = pre tax profit required to declare and pay the dividend

13.2 13.2

1 – 0.3 0.7

Therefore, to declare a dividend of 12 % Company has to earn a pre tax profit of 19 %. On the

other hand, to pay an interest of 12 % Company has to earn only 8.4 %. This leads to the

conclusion that for every Rs.100 procured through debt, it costs 8.4 % where as the same amount

procured in the form of equity (share capital) costs

19 %. This confirms the established theory that equity is costly but debt is a cheap but risky

source of funds to the corporates.

The challenge before the finance manager is to arrive at a combination of debt and equity for

financing decisions which would attain an optimal structure of capital. An optimal structure is one

that arrives at the least cost structure, keeping in mind the financial risk involved and the ability of

the company to manage the business risk. Besides, financing decision involves the consideration

of managerial control, flexibility and legal aspects. As such it involves quite a lot of regulatory and

managerial elements in financing decisions.

= = = Rs 19 approximate


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1.4.3 Dividend Decisions Dividend yield is an important determinant of an investor’s attitude towards the security (stock) in

his portfolio management decisions. But dividend yield is the result of dividend decision.

Dividend decision is a major decision made by a finance manager. It is the decision on

formulation of dividend policy. Since the goal of financial management is maximisation of wealth

of shareholders, dividend policy formulation demands the managerial attention on the impact of

its policy on dividend on the market value of the shares. Optimum dividend policy requires

decision on dividend payment rates so as to maximize the market value of shares. The payout

ratio means what portion of earnings per share is given to the shareholders in the form of cash

dividend. In the formulation of dividend policy, management of a company must consider the

relevance of its policy on bonus shares.

Dividend policy influences the dividend yield on shares. Since company’s ratings in the Capital

market have a major impact on its ability to procure funds by issuing securities in the capital

markets, dividend policy, a determinant of dividend yield has to be formulated having regard to all

the crucial elements in building up the corporate image. The following need adequate

consideration in deciding on dividend policy:

1. Preferences of share holders Do they want cash dividend or Capital gains?

2. Current financial requirements of the company

3. Legal constraints on paying dividends.

4. Striking an optimum balance between desires of share holders and the company’s funds

requirements.

1.4.4 Liquidity Decision Liquidity decisions are concerned with Working Capital Management. It is concerned with the

day to –day financial operations that involve current assets and current liabilities.

The important element of liquidity decisions are:

1) Formulation of inventory policy

2) Policies on receivable management.

3) Formulation of cash management strategies

4) Policies on utilization of spontaneous finance effectively.

1.4.5 Organization Of Finance Function Financial decisions are strategic in character and therefore, an efficient organizational structure

is required to administer the same. Finance is like blood that flows through out the organization.


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In all organizations CFOs play an important role in ensuring proper reporting based on

substance to the stake holders of the company. Because of the crucial role these functions play,

finance functions are organized directly under the control of Board of Directors. For the survival

of the firm, there is a need to ensure both long term and short term financial solvency. Failure to

achieve this will have its impact on all other activities of the firm.

Weak functional performance by financial department will weaken production, marketing and HR

activities of the company. The result would be the organization becoming anemic. Once

anemic, unless crucial and effective remedial measures are taken up it will pave way for

corporate bankruptcy.

CFO reports to the Board of Directors. Under CFO, normally two senior officers manage the

treasurer and controller functions.

A Treasurer performs the following function :

1. Obtaining finance.

2. Liasoning with term lending and other financial institutions.

3. Managing working capital.

4. Managing investment in real assets.

A Controller performs:

1. Accounting and Auditing

2. Management control systems

3. Taxation and insurance

4. Budgeting and performance evaluation

5. Maintaining assets intact to ensure higher productivity of operating capital employed in the

organization.

In India CFOs have a legal obligation under various regulatory provisions to certify the

correctness of various financial statements information reported to the stake holders in the annual

reports. Listing norms, regulations on corporate governance and other notifications of Govt of

India have adequately recognized the role of finance function in the corporate set up in India.

Self Assessment Questions 3 1. ____________ lead to investment in real assets.

2. _______________ relate to the acquisition of funds at the least cost.

3. Formulation of inventory policy is an important element of ___________.

4. Obtaining finance is an important function of _________.


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1.5 Interface Between Finance And Other Business Functions

1.5.1 Finance And Accounting Looking at the hierarchy of the finance function of an organization, the controller reports to CFO.

Accounting is one of the functions that a controller discharges. Accounting and finance are closely

related. For computation of Return on Investment, earnings per share and of various ratios for

financial analysis the data base will be accounting information. Without a proper accounting

system, an organization cannot administer effectively function of financial management. The

purpose of accounting is to report the financial performance of the business for the period under

consideration. It is historical in character. But financial management uses the historical

accounting information for decision making. All the financial decisions are futuristic based on

cash flow analysis. All the financial decisions consider quality of cash flows as an important

element of decisions. Since financial decisions are futuristic, it is taken and put into effect under

conditions of uncertainty.

Assuming the degree of uncertainty and incorporating their effect on decision making involve use

of various statistical models. In the selection of these models, element of subjectivity creeps in.

1.5.2 Finance And Marketing Many marketing decisions have financial implications. Selections of channels of distribution,

deciding on advertisement policy, remunerating the salesmen etc have financial implications. In

fact, the recent behaviour of rupee against us $ (appreciation of rupee against US dollar), affected

the cash flow positions of export oriented textile units and BPO’s and other software companies.

It is generally believed that the currency in which marketing manager invoices the exports decides

the cash flow consequences of the organization if the company is mainly dependent on exports.

Marketing cost analysis, a function of finance managers is the best example of application of

principles of finance on the performance of marketing functions by a business unit. Formulation

of policy on credit management cannot be done unless the integration of marketing with finance is

achieved. Deciding on credit terms to achieve a particular level of sales has financial implication

because sanctioning liberal credit may result in huge bad debt, on the other hand a conservative

credit terms may depress the sales. Credit terms also affect the investment in receivable, an area

of working capital management. There is a close relation between inventory and sales. Co

ordination of stores administration with that of marketing management is required to ensure

customer satisfaction and good will. But investment in inventory requires the financial clearance

because funds are locked in and the funds so blocked have opportunity cost of capital.


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1.5.3 Finance And Productions (Operations) Finance and operations management are closely related. Decisions on plant layout, technology

selection, productions / operations, process plant size, removing imbalance in the flow of input

material in the production / operation process and batch size are all operations management

decisions but their formulation and execution cannot be done unless evaluated from the financial

angle. The capital budgeting decisions are closely related to production and operations

management. These decisions make or mar a business unit. We have examples to substantiate

this. Failure to understand the implications of the latest technological trend on capacity

expansions has cost even blue chip companies. Many textile units in India became sick because

they did not provide sufficient finance for modernization of plant and machinery. Inventory

management is crucial to successful operation management. But management of inventory

involves quite a lot of financial variables.

1.5.4 Finance And HR Attracting and retaining the best man power in the industry cannot be done unless they are paid

salary at competitive rates. If an organization formulates & implements a policy for attracting the

competent man power it has to pay the most competitive salary packages to them. But it

improves organizational capital and productivity. Infosys does not have physical assets similar to

that of Indian Railways. But if both were to come to capital market with a public issue of equity,

Infosys would command better investor’s acceptance than the Indian Railways. This is because

the value of human resources plays an important role in valuing a firm. The better the quality of

man power in an organization, the higher the value of the human capital and consequently the

higher the productivity of the organization.

Indian Software and IT enabled services have been globally acclaimed only because of the man

power they possess. But it has a cost factor i.e. the best remuneration to the staff.

1.6Summary Financial Management is concerned with the procurement of the least cost funds and its’

effective utilization for maximization of the net wealth of the firm. There exists a close relation

between the maximization of net wealth of shareholders and the maximization of the net wealth

of the company. The broad areas of decision are capital budgeting, financing, dividend and

working capital. Dividend decision demands the managerial attention to strike a balance

between the investor’s expectation and the organizations’ growth.


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Terminal Questions

1. What are the objectives of financial management?

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

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

Answers To Self Assessment Questions’s Self Assessment Questions 1:

1. Effective utilization

Self Assessment Questions 2

1. Profit maximisation.

2. Wealth maximisation

3. Wealth maximisation

Self Assessment Questions 3 1. Investment decisions.

2. Financing decisions

3. Liquidity

4. Treasures

Answer for Terminal Questions 1. Refer 1.3

2. Refer 1.4.1

3. Refer 1.5


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Unit 2 Financial Planning

Structure

2.1. Introduction

2.2. Steps in financial planning

2.3. Factors affecting financial plan

2.4. Estimation of financial requirements of a firm.

2.5. Capitalizations

2.1.1 Cost Theory

2.1.2 Earnings theory:

2.1.3 Overcapitalization

2.1.4 Undercapitalization

2.6 Summary

Terminal Questions

Answer to SAQs and TQs

2.1 Introduction Liberalization and globalization policies initiated by the Government have changed the dimension

of business environment. It has changed the dimension of competition that a firm faces today.

Therefore for survival and growth a firm has to execute planned strategy systematically.

To execute any strategic plan, resources are required. Resources may be manpower, plant and

machinery, building, technology or any intangible asset.

To acquire all these assets financial resources are essentially required. Therefore, finance

manager of a company must have both longrange and shortrange financial plans. Integration of

both these plans is required for the effective utilization of all the resources of the firm.

The longrange plan must consider (1) Funds required to execute the planned course of action.

(2) Funds available at the disposal of the company. (3) Determination of funds to be procured

from outside sources.


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After studying this unit you should

1. Explain the steps involved in financial planning. 2. Explain the factors affecting the financial planning. 3. List out the causes of over capitation 4. Explain the effects of under capitation.

Objectives of Financial Planning Financial Planning is a process by which funds required for each course of action is decided. It

must consider expected business Scenario and develop appropriate courses of action. A

financial plan has to consider Capital Structure, Capital expenditure and cash flow. In this

connection decisions on the composition of debt and equity must be taken.

Financial planning generates financial plan. Financial plan indicates:

1. The quantum of funds required to execute business plans.

2. Composition of debt and equity, keeping in view the risk profile of the existing business, new

business to be taken up and the dynamics of capital market conditions.

3. Formulation of policies for giving effect to the financial plans under consideration.

A financial plan is at the core of value creation process. A successful value creation process can

effectively meet the bench marks of investor’s expectations.

Benefits that accrue to a firm out of the financial planning

1. Effective utilization of funds: Shortage is managed by a plan that ensures flow of cash at the

least cost. Surplus is deployed through well planned treasury management. Ultimately the

productivity of assets is enhanced.

2. Flexibility in capital structure is given adequate consideration. Here flexibility means the firms

ability to change the composition of funds that constitute its capital structure in accordance

with the changing conditions of capital market. Flexibility refers to the ability of a firm to obtain

funds at the right time, in the right quantity and at the least cost as per requirements to

finance emerging opportunities.

3. Formulation of policies and instituting procedures for elimination of all types of wastages in

the process of execution of strategic plans.

4. Maintaining the operating capability of the firm through the evolution of scientific replacement

schemes for plant and machinery and other fixed assets. This will help the firm in reducing its


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operating capital. Operating capital refers to the ratio of capital employed to sales generated.

A perusal of annual reports of Dell computers will throw light on how Dell strategically

minimized the operating capital required to support sales. Such companies are admired by

investing community.

5. Integration of long range plans with the shortage plans.

Guidelines for financial planning 1. Never ignore the coordinal principle that fixed asset requirements be met from the long term

sources.

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

resources.

3. Maintain the operating capital intact by providing adequately out of the current periods

earnings. Due attention to be given to physical capital maintenance or operating capability.

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

5. Employ current cost principle wherever required.

6. Give due weightage to cost and risk in using debt and equity.

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

earnings.

8. Exercise thorough control over overheads.

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

2.2 Steps In Financial Planning 1. Establish Corporate Objectives: Corporate objectives could be grouped into qualitative and

quantitative. For example, a company’s mission statement may specify “create economic –

value added.” But this qualitative statement has to be stated in quantitative terms such as a

25 % ROE or a 12 % earnings growth rates. Since business enterprises operate in a dynamic

environment, there is a need to formulate both short run and long run objectives.

2. Next stage is formulation of strategies for attaining the objectives set. In this connection

corporates develop operating plans. Operating plans are framed with a time horizon. It could

be a five year plan or a ten year plan.

3. Once the plans are formulated, responsibility for achieving sales target, operating targets,

cost management bench marks, profit targets etc is fixed on respective executives.

4. Forecast the various financial variables such as sales, assets required, flow of funds, cost to

be incurred and then translate the same into financial statements. Such forecasts help the


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finance manager to monitor the deviations of actual from the forecasts and take effective

remedial measures to ensure that targets set are achieved without any time overrun and cost

overrun.

5. Develop a detailed plan for funds required for the plan period under various heads of

expenditure.

6. From the funds required plan, develop a forecast of funds that can be obtained from internal

as well as external sources during the time horizon for which plans are developed. In this

connection legal constrains in obtaining funds on the basis of covenants of borrowings should

be given due weightage. There is also a need to collaborate the firm’s business risk with risk

implications of a particular source of funds.

7. Develop a control mechanism for allocation of funds and their effective use.

8. At the time of formulating the plans certain assumptions need to be made about the economic

environment. But when plans are implemented economic environment may change. To

manage such situations, there is a need to incorporate an inbuilt mechanism which would

scale up or scale down the operations accordingly.

Forecast of Income Statement and Balance Sheet

There are three methods of preparing income statement:

1. Percent of sales method or constant ratio method

2. Expense method

3. Combination of both these two

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

For example, Raw material cost is 40 % of sales revenue of the year ended 31.03.2007. But this

method assumes that the ratio of raw material cost to sales will continue to be the same in 2008

also. Such an assumption may not hold good in most of the situations. For example, Raw

material cost increases by 10 % in 2008 but selling price of finished goods increases only by 5 %.

In this case raw material cost will be 44 / 105 of the sales revenue in 2008. This can be solved to

some extent by taking average for same representative years. However, inflation, change in Govt

policies, wage agreements, technological innovation totally invalidate this approach on a long run

basis.


19

2. Budgeted Expense Method: Expenses for the planning period are budgeted on the basis of

anticipated behaviour of various items of cost and revenue. This demands effective data

base for reasonable budgeting of expenses.

3. Combination of both these methods is used because some expenses can be budgeted by the

management taking into account the expected business environment and some other

expenses could be based on their relationship with the sales revenue expected to be earned.

Forecast of Balance Sheet

1. Items of certain assets and liabilities which have a close relationship with the sales revenue

could be computed based on the forecast of sales and the historical data base of their

relationship with the sales.

2. Determine the equity and debt mix on the basis of funds requirements and the company’s

policy on Capital structure.

Example : The following details have been extracted from the books of X Ltd

Income Statement (Rs. In millions)

2006 2007

Sales less returns 1000 1300

Gross Profit 300 520

Selling Expenses 100 120

Administration 40 45

Deprecation 60 75

Operating Profit 100 280

Non operating income 20 40

EBIT (Earnings before interest & Tax 120 320

Interest 15 18

Profit before tax 105 302

Tax 30 100

Profit after tax 75 202

Dividend 38 100

Retained earnings 37 102

Balance Sheet (Rs. In million)


20

Liabilities 2006 2007 Assets 2006 2007

Share holders fund Fixed Assets 400 510

Share Capital Less: Depreciation 100 120

Equity 120 120 300 390

Preference 50 50 Investments 50 50

Reserves & Surplus 122 224

Secured Loans 100 120 Current Assets, loans & Advances

Unsecured loans 50 60 Cash at Bank 10 12

Receivables 80 128

Current Liabilities Inventories 200 300

Trade Crs 210 250 Loans & Advances 50 80

Provisions Miscellaneous

expenditure 10 24

Tax 10 60

Proposed Dividend 38 100

760 984 700 984

Forecast the income statement and balance sheet for the year 2008 based on the following

assumptions.

1. Sales for the year 2008 will increase by 30% over the sales value for 2007.

2. Use percent of sales method to forecast the values for various items of income statement

using the percentage for the year 2007.

3. Depreciation is to charged at 25 % of fixed assets.

4. Fixed assets will increase by Rs.100 million.

5. Investments will increase by Rs.100 million.

6. Current assets and Current liabilities are to be decided based on their relationship to sales in

the year 2007.

7. Miscellaneous expenditure will increase by Rs.19 million.

8. Secured loans in 2008 will be based on its relationship to sales in the year 2007.

9. Additional funds required, if any, will be met by bank borrowings.

10. Tax rates will be 30 %.


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11. Dividends will be 50 % of profit after tax.

12. Non operating income will increase by 10%.

13. There will be no change in the total amount of administration expenses to be spent in the year

2008

14. There is no change in equity and preference capital in 2008.

15. Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007.

Income Statement for the Year 2008 (Rs. In million)

(Forecast)

Particulars Basis Working Amount (Rs.)

a. Sales Increase by 30 % 1300 x 1.3 1690

b. Cost of Sales Increase by 30 % 780 x 1.3 1014

c. Gross profit Sales–Cost of sales 1690 1014 676

d. Selling expenses 30 % increase 120 x 1.3 156

e. Administration No change 45

f. Depreciation % given 390 + 100

4

123 (Rounded off)

g. Operating Profit C (D + E + F) 352

h. Non operating Income Increase by 10 % 1.1 x 40 44

i. Earnings Before

Interest & Taxes (EBIT)

396

j. Interest 18 of sales

1300

18 x 1690

1300

23 (Decimal ignored)

k. Profit before tax 373

l. Tax 112

m. Profit after tax 261

n. Dividends 130

o. Retained earnings 131

Balance Sheet for the year 2008 (Rs. In million) (Forecast)


22

Particulars Basis Working Amount (Rs.)

Assets

Fixed Assets Given 510

Add: Addition 100

610

Depreciation 120 + 123 243

1. Net fixed assets 367

2. Investments 150

3. Current Assets & Loans

& advances

Cash at bank 12

1300

12 x 1690

1300 16 (Rounded off)

Receivables 128

1300

128 x 1690

1300 166

Inventories 300

1300

300 x 1690

1300 390

Loans & Advances 80

1300

80 x 1690

1300 104

4. Miscellaneous

Expenditure Given 24 + 19 43

Total 1236

Liabilities

1. Share Capital

Equity 120

Preference 50

2. Reserves & Surplus Increase by current

year’s retained

earnings

355

3. Secured Loan 60

1300

60 x 1690

1300 78

Bank borrowings 40 (Difference –

Balancing figure)


23

4. Unsecured Loan 60 60

5. Current Liabilities &

Provision

Trade creditors 250

1300

250 x 1690

1300 325

Provision for tax 60

1300

60 x 1690

1300 78

Proposed Dividend Current year given 130

Total Liabilities 1236

Computerised Financial Planning Systems All corporate forecasts use Computerised forecasting models.

Additional funds required to finance the increase in sales could be ascertained using a

mathematical relationship based on the following:

Additional funds = Required increase Spontaneous Increase in

Required in assets increase in retained

liabilities earnings

(This formula has been recommended by Engene.F.Brighaom and Michael C Ehrharte in their

book financial management – Theory and Practice, 10 th edition.

Prof. Prasanna Chandra, in his book Financial Management, has given a comprehensive formula

for ascertaining the external financing requirements:

EFR = A (∆s) – L (∆s) – ms (1d) – (∆1m + SR)

S S

Here

A = Expected increase in assets, both fixed and current required for the

S expected increase in sales in the next year.

L = Expected Spontaneous financing available for the expected increase in

S sales

MS1 (1d) = It is the product of

Profit margin x Expected sales for the next year x Retention Ratio

X ∆s

X ∆s


24

Here, retention ratio is 1 – payout ratio. Payout ratio refers to the ratio of dividend paid to

earnings per share

∆1m = Expected change in the level of investments and miscellaneous expenditure

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

This formula has certain features:

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

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

3. Since external funds requirements involve borrowings from financial institution, the formula

rightly incorporates the management’s liability on repayments.

Example

A Ltd has given the following forecasts:

“Sales in 2008 will increase to Rs.2000 from Rs.1000 in 2007”

The balance sheet of the company as on December 31, 2007 gives the following details:

Liabilities Rs Assets Rs

Share Capital Net Fixed Assets 500

Equity (Shares of Rs.10 each) 100 Inventories 200

Reserves & Surplus 250 Cash 100

Long term loan 400 Bills Receivable 200

Crs for expenses outstanding 50

Trade creditors 50

Bills Payable 150

1000 1000

Ascertain the external funds requirements for the year 2008, taking into account the following

information:

1. The Company’s utilization of fixed assets in 2007 was 50 % of capacity but its current assets

were at their proper levels.

2. Current assets increase at the same rate as sales.

3. Company’s aftertax profit margin is expected to be 5%, and its payout ratio will be 60 %.

4. Creditors for expenses are closely related to sales ( Adapted from IGNOU MBA)

Answers Preliminary workings

A = Current assets = Cash + Bills Receivables + Inventories


25

= 100 + 200 +200 = 500

A = 500 = Rs.500

S 1000

L = Trade creditors + Bills payable + Expenses outstanding

= 50 + 150 + 50 = Rs.250

L = 250 = Rs.250

S 1000

M (Profit Margin)= 5 / 100 = 0.05

S1 = Rs.200

1d = 1 – 0.6 = 0.4 or 40 %

∆1m = NIL

SR = NIL

Therefore:

) 1 ( ) 1 ( ) ( 1 SR m d mS S x

S L

S s A EFR + ∆ − − − ∆ −

∆ =

= 500 – 250 – (0.05 x 200 x 0.4) – (0 + 0)

= 500 – 250 – 40 (0 + 0)

= Rs.210

Therefore, external funds requirements (additional funds required) for 2008 will be Rs.210.

This additional funds requirements will be procured by the firm based on its policy on capital

structure.

Self Assessment Questions 1 1. Corporate objectives could be group into ________ and ________.

2. Control mechanism is developed for _____________ and their effective use.

3. Seasonal peak requirements to be met from ___________________ from banks.

4. Exercise through _________ over overheads.

2.3 Factors Affecting Financial Plan

1. Nature of the industry: Here, we must consider whether it is a capital intensive or labour

intensive industry. This will have a major impact on the total assets that the firm owns.

2. Size of the Company: The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long

X ∆s X 1000

X ∆s X 1000


26

term sources at competitive terms. On the other hand, large companies like Reliance enjoy

the privilege of obtaining funds both short term and long term at attractive rates.

3. Status of the company in the industry: A well established company enjoying a good market share, for its products normally commands investors’ confidence. Such a company

can tap the capital market for raising funds in competitive terms for implementing new projects

to exploit the new opportunities emerging from changing business environment.

4. Sources of finance available: Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital

structure that would achieve the least cost capital structure. A large firm with a diversified

product mix may manage higher quantum of debt because the firm may manage higher

financial risk with a lower business risk. Selection of sources of finance is closely linked to the

firm’s capacity to manage the risk exposure.

5. The Capital structure of a company is influenced by the desire of the existing management

(promoters) of the company to retain control over the affairs of the company. The promoters

who do not like to lose their grip over the affairs of the company normally obtain extra funds

for growth by issuing preference shares and debentures to outsiders.

6. Matching the sources with utilization: The prudent policy of any good financial plan is to

match the term of the source with the term of investment. To finance fluctuating working

capital needs the firm resorts to short terms finance. All fixed assets financed investments are

to be financial by long term sources. It is a cardinal principle of financial planning.

7. Flexibility: The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure when ever need arises. If the capital structure of a

company is flexible, it will not face any difficulty in changing the sources of funds. This factor

has become a significant one today because of the globalization of capital market.

8. Government Policy: SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of

corporate affairs (Govt of India) influence the financial plans of corporates today.

Management of public issues of shares demands the compliances with many statues in India.

They are to be complied with a time constraint.

Self Assessment Questions 2: 1. ___________ has a major impact on the total assets that the firm owns.

2. Sources of finance could be grouped into __ and _______________.


27

3. ___________ of any good financial plan is to match the term of the source with the term of

the source with the term of the investment.

4. ________________ refers the ability to ______________________ whenever need arises.

2.4 Estimation Of Financial Requirements Of a Firm.

The estimation of capital requirements of a firm involves a complex process. Even with expertise,

managements of successful firms could not arrive at the optimum capital composition in terms of

the quantum and the sources. Capital requirements of a firm could be grouped into fixed capital

and working capital. The long term requirements such as investment in fixed assets will have to

be met out of funds obtained on long term basis. Variable working capital requirements which

fluctuate from season to season will have to be financed only by short term sources. Any

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

Self Assessment Question 3:

1. Capital requirement of a firm could be grouped into ________ and __________.

2. Variable working capital will have to be financed only by _______________.

2.5 Capitalizations Meaning: Capitalization of a firm refers the composition of its longterm funds. It refers to the

capital structure of the firm. It has two components viz debt and equity.

After estimating the financial requirements of a firm, then the next decision that the management

has to take is to arrive at the value at which the company has to be capitalized.

There are two theories of Capitalization for new companies:

1. Cost theory and 2. Earnings theory

2.5.1 Cost Theory: Under this approach, the total amount of capitalization for a new company is the sum of the

following:

1. Cost of fixed assets.

2. Cost of establishing the business.

3. Amount of working capital required


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Merits of cost approach:

1. It helps promoters to estimate the amount of capital required for incorporation of company

conducting market surveys, preparing detailed project report, procuring funds, procuring

assets both fixed and current, trial production run and successfully producing, positioning and

marketing of its products or rendering of services.

2. If done systematically it will lay foundation for successful initiation of the working of the firm. Demerits 1. If the firm establishes its production facilities at inflated prices, productivity of the firm will be

less than that of the industry.

2. Net worth of a company is decided by the investors by the earnings of a company. Earnings

capacity based net worth helps a firm to arrive at the total capital in terms of industry specified

yardstick ( i,e, operating capital based on bench marks in that industry) cost theory fails in

this respect.

2.5.2 Earnings Theory: Earnings are forecast and capitalized at a rate of return which is representative of the industry. It

involves two steps.

1. Estimation of the average annual future earnings.

2. Normal earning rate of the industry to which the company belongs.

Merits 1. It is superior to cost theory because there are, the least chances of neither under not over

capitalization.

2. Comparison of earnings approach with that of cost approach will make the management to be

cautious in negotiating the technology and cost of procuring and establishing the new

business.

Demerits 1. The major challenge that a new firm faces is in deciding on capitalization and its division

thereof into various procurement sources.

2. Arriving at capitalization rate is equally a formidable task because the investors’ perception of

established companies cannot be really representative of what investors perceive of the

earning power of new company.


29

Because of the problem, most of the new companies are forced to adopt the cost theory of

capitalization.

Ideally every company should have normal capitalization. But it is an utopian way of thinking.

Changing business environment, role of international forces and dynamics of capital market

conditions force us to think in terms of what is optimal today need not be so tomorrow. Even with

these constraints, management of every firm should continuously monitor the firms capital

structure to ensure to avoid the bad consequences of over and under capitalization.

2.5.3 Overcapitalization A company is said to be overcapitalized, when its total capital (both equity and debt) exceeds the

true value of its assets. It is wrong to identify overcapitalization with excess of capital because

most of the overcapitalized firms suffer from the problems of liquidity. The correct indicator of

overcapitalization is the earnings capacity of the firm. If the earnings of the firm are less then that

of the market expectation, it will not be in a position to pay dividends to its shareholders as per

their expectations. It is a sign of overcapitalization. It is also possible that a company has more

funds than its requirements based on current operation levels, and yet have low earnings.

Overcapitalization may be on account of any of the following:

1. Acquiring assets at inflated rates

2. Acquiring unproductive assets.

3. High initial cost of establishing the firm

4. Companies which establish their new business during boom condition are forced to pay more

for acquiring assets, causing a situation of overcapitalization once the boom conditions

subside.

5. Total funds requirements have been over estimated.

6. Unpredictable circumstances (like change in import –export policy, change in market rates of

interest, changes in international economic and political environment) reduce substantially the

earning capacity of the firm. For example, rupee appreciation against U.S.dollar has affected

earning capacity of firms engaged mainly in export business because they invoice their sales

in US dollar.

7. Inadequate provision for depreciation adversely affects the earning capacity of a company ,

leading to overcapitalization of the firm.

8. Existence of idle funds.


30

Effects of over capitalization

1. Decline in the earnings of the company.

2. Fall in dividend rates.

3. Market value of company’s share falls, and company loses investors confidence.

4. Company may collapse at any time because of anemic financial conditions – it will affect its

employees, society, consumers and its shareholders. Employees will lose jobs. If the

company is engaged in the production and marketing of certain essential goods and services

to the society, the collapse of the company will cause social damage.

Remedies for Overcapitalization: Restructuring the firm is to be executed to avoid the situation of company becoming sick.

It involves

1. Reduction of debt burden.

2. Negotiation with term lending institutions for reduction in interest obligation.

3. Redemption of preference shares through a scheme of capital reduction.

4. Reducing the face value and paidup value of equity shares.

5. Initiating merger with well managed profit making companies interested in taking over ailing

company.

2.5.4 Undercapitalization Undercapitalization is just the reverse of overcapitalization. A company is considered to be

undercapitalized when its actual capitalization is lower than its proper capitalization as warranted

by its earning capacity.

Symptoms of undercapitalization 1. Actual capitalization is less than that warranted by its earning capacity.

2. Its rate of earnings is exceptionally high in relation to the return enjoyed by similar situated

companies in the same industry.

Causes of undercapitalization

1. Under estimation of future earnings at the time of promotion of the company.

2. Abnormal increase in earnings from new economic and business environment.

3. Under estimation of total funds requirements.


31

4. Maintaining very high efficiency through improved means of production of goods or rendering

of services.

5. Companies which are set up during recession start making higher earning capacity as soon

as the recession is over.

6. Use of low capitalization rate.

7. Companies which follow conservative dividend policy will achieve a process of gradually rising

profits.

8. Purchase of assets at exceptionally low prices during recession.

Effects of undercapitalization 1. Encouragement to competition: undercapitalization encourages competition by creating a

feeling that the line of business is lucrative.

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

3. High profits will attract higher amount of taxes.

4. High profits will make the workers demand higher wages. Such a feeling on the part of

employees leads to labour unrest.

5. High margin of profit may create among consumers an impression that the company is

charging high prices for its products.

6. High margin of profits and the consequent dissatisfaction among its employees and

consumer, may invite governmental enquiry into the pricing mechanism of the company.

Remedies 1. Splitting up of the shares – This will reduce the dividend per share.

2. Issue of bonus shares: This will reduce both the dividend per share and earnings per share.

Both overcapitalization and undercapitalization are detrimental to the interests of the society.

Self Assessment Question 4 1. ______________ of a firm refers to the composition of its long –term funds.

2. Two theories of capitalization for new companies are ________ and earnings theory.

3. A company is said to be ___________, when its total capital exceeds the true value of its

assets.

4. A company is considered to be ________________ when its actual capitalization is lower than

its proper capitalization as warranted by its earning capacity.


32

2.6 Summary Financial planning deals with the planning, execution and monitoring of the procurement and

utilization of funds. Financial planning process gives birth to financial plan. It could be thought of

a blueprint explaining the proposed strategy and its execution. There are many financial planning

models. All these models forecast the future operations and then translate them into income

statements and balance sheets. It will also help the finance managers to ascertain the funds to

be procured from outside sources. The essence of all these is to achieve a least cost capital

structure which would match with the risk exposure of the company. Failure to follow the principle

of financial planning may lead a new firm to over or undercapitalization when the economic

environment undergoes a change. Ideally every firm should aim at optimum capitalization. Other

wise it may face a situation of over or undercapitalization. Both are detrimental to the interests of

the society. There are two theories of capitalization viz cost theory and earnings theory.

Terminal Questions

1. Explain the steps involved in Financial Planning.

2. Explain the factors affecting Financial Plan

3. List out the causes of Over – Capitalization.

4. Explain the effects of Under – Capitalization.

Answers To Self Assessment Questions Self Assessment Questions 1 1. Qualitative, Quantitative.

2. Allocation of funds

3. Short term borrowings

Self Assessment Question 2

1. Nature of the industry

2. Debt, Equity

3. The product policy

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



33

1. Fixed capital, working capital.

2. Short term sources

Self Assessment Question 4 1. Capitalization

2. Cost theory

3. Over Capitalized

4. Under capitalized

Answer to Terminal Questions 1. Refer to unit 2.2

2. Refer to unit 2.3

3. Refer to unit 2.5.3



34

Unit 3 Time Value of Money

Structure

3.1 Introduction

3.2 Time Preference Rate and Required Rate of Return

3.2.1 Compounding Technique

3.2.2 Discounting Technique

3.2.3 Future Value of a Single Flow (Lump sum):

3.2.4 Future Value of Series of Cash Flows

3.2.5 Future Value of an Annuity

3.2.5.1 Sinking Fund

3.3 Present Value

3.3.1 Discounting or Present Value of a Single Flow

3.3.2 Present Value of a Series of Cash Flows

3.3.2.1 Present Value of Perpetuity

3.3.2.2 Capital Recovery Factor

3.4 Summary

Solved Problems

Terminal Questions


3.1 Introduction The main objective of this unit is to enable you to learn the time value of money. In the previous unit,

we have learnt that wealth maximization is the primary objective of financial management and that is

more important than profit maximization for its superiority in the sense that it is futureoriented. A

decision taken today will have farfetching implications. For example, a firm investing in fixed assets

will reap the benefits of such investment for a number of years. If such assets are procured through

bank borrowings or term loans from financial institutions, these involve an obligation to pay interest

and return of principal. Decisions are made by comparing the cash inflows (benefits/returns) and

cash outflows (outlays). Since these two components occur at different time periods, there should be


35

a comparison. In order to have a logical and meaningful comparison between cash flows that accrue

over different intervals of time, it is necessary to convert the amounts to a common point of time. This

unit is devoted for a discussion of the techniques of doing so.



1. Explain the time value of money. 2. Understand the valuation concepts. 3. Calculate the present and future values of lump sum and annuity flows.

Rationale: “Time Value of Money” is the value of a unit of money at different time intervals. The

value of money received today is more than its value received at a later date. In other words, the

value of money changes over a period of time. Since a rupee received today has more value, rational

investors would prefer current receipts to future receipts. That is why this phenomenon is also

referred to as “Time Preference of Money”. Some important factors contributing to this are:

Investment opportunities: Preference for consumption Risk

These factors remind us of the famous English saying “A bird in hand is worth two in the bush”.

Why should money have time value?

Some of the reasons are:

Money can be employed productively to generate real returns. For example, if we spend Rs. 500 on

materials and Rs. 300 on labour and Rs. 200 on other expenses and the finished product is sold for

Rs. 1100, we can say that the investment of Rs. 1000 has fetched us a return of 10%.

Secondly, during periods of inflation, a rupee has a higher purchasing power than a rupee in future.

Thirdly, we all live under conditions of risk and uncertainty. As future is characterized by uncertainty, individuals prefer current consumption to future consumption. Most people have


36

subjective preference for present consumption either because of their current preferences or

because of inflationary pressures.

3.2 Future Value: Time Preference Rate and Required Rate of Return

The time preference for money is generally expressed by an interest rate. This rate will be positive

even in the absence of any risk. It is called the riskfree rate. For example, if an individual’s time

preference is 8%, it implies that he is willing to forego Rs. 100 today to receive Rs. 108 after a period

of one year. Thus he considers Rs. 100 and Rs. 108 are equivalent in value. But in reality this is not

the only factor he considers. There is an amount of risk involved in such investment. He therefore

requires another rate for compensating him with this which is called the risk premium. Required rate of return=Risk free rate + Risk Premium

There are two methods by which time value of money can be calculated – compounding and

discounting.

3.2.1 Compounding Technique: Under this method of compounding, the future values of all cash inflows at the end of the time horizon at a particular rate of interest are found. Interest is compounded

when the amount earned on an initial deposit becomes part of the principal at the end of the first

compounding period. If Mr. A invests Rs. 1000 in a bank which offers him 5% interest compounded

annually, he has Rs. 1050 in his account at the end of the first year. The total of the interest and

principal Rs. 1050 constitutes the principal for the next year. He thus earns Rs. 1102.50 for the

second year. This becomes the principal for the third year. This compounding procedure will continue

for an indefinite number of years. The compounding of interest can be calculated by the following

equation:

A=P (1+i ) n

Where A = Amount at the end of the period

P = Principal at the end of the period

i =rate of interest

n = number of years

The amount of money in the account at the end of various years is calculated as under, using the

equation:


37

Amount at the end of year 1=Rs. 1000 (1+0.05)==Rs. 1050

Amount at the end of year 2=Rs. 1050 (1+0.05)==Rs. 1102.50

Amount at the end of year 3=Rs. 1102.50 (1+0.05)==Rs. 1157.63

Year 1 2 3 Beginning amount Rs. 1000 Rs. 1050 Rs. 1102.50 Interest rate 5% 5% 5% Amount of interest 50 52.50 55.13 Beginning principal

1000 Rs. 1050 Rs. 1102.50

Ending principal Rs. 1050 Rs. 1102.50 Rs. 1157.63

The amount at the end of year 2 can be ascertained by substituting Rs. 1000 (1+0.05) for R.

1050, that is, Rs. 1000(1+0.05) (1+0.05)= Rs. 1102.50.

Similarly, the amount at the end of year 3 can be ascertained by substituting Rs. Rs. 1000(1+0.05)

(1+0.05) (1+0.05) =Rs. 1157.63.

Thus by substituting the actual figures for the investment or Rs. 1000 in the formula A=P (1+i ) n , we

arrive at the result shown above in Table.

3.2.2 Discounting Technique: Under the method of discounting, we find the time value of money now, that is, at time 0 on the time line. It is concerned with determining the present value of a future

amount. This is in contrast to the compounding approach where we convert present amounts into

future amounts; in discounting approach we convert the future value to present sums. For example, if

Mr. A requires to have Rs. 1050 at the end of year 1, given the rate of interest as 5%, he would like

to know how much he should invest today to earn this amount. If P is the unknown amount and using

the equation we get P (1+0.5)=1050. Solving the equation, we get P=Rs. 1050/1.05=Rs. 1000.

Thus Rs. 1000 would be the required principal investment to have Rs. 1050 at the end of year 1 at

5% interest rate. In other words, the present value of Rs. 1050 received one year from now, rate of

interest 5%, is Rs. 1000. The present value of money is the reciprocal of the compounding value.

Mathematically, we have P=A 1/(1+i) n in which P is the present value for the future sum to be

received, A is the sum to be received in future, i is the interest rate and n is the number of years.


38

3.2.3 Future Value of a Single Flow (lump sum): The process of calculating future value will become very cumbersome if they have to be calculated over long maturity periods of 10 or 20 years.

A generalized procedure for calculating the future value of a single cash flow compounded annually

is as follows: FVn = PV(1+i) n

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

PV = Initial cash flow

I = Annual rate of interest

N = Life of investment

The expression (1+i) n represents the future value of the initial investment of Re. 1 at the end of n

number of years at the interest rate i, referred to as the Future Value Interest Factor (FVIF). To help

ease in calculations, the various combinations of “I” and “n” can be referred to in the table. To

calculate the future value of any investment, the corresponding value of (1+i) n from the table is

multiplied with the initial investment.

Example: The fixed deposit scheme of a bank offers the following interest rates:

Period of deposit Rate per annum <45 days 9% 46 days to 179 days 10% 180 days to 365 days 10.5% 365 days and above 11%

How much does an investment of R. 10000 invested today grow to in 3 years?

Solution: FVn=PV(1+i) n or PV*FVIF(11%, 3y)

=10000*1.368 (from the tables)

=Rs. 13680

Doubling period: A very common question arising in the minds of an investor is “how long will it take

for the amount invested to double for a given rate of interest”. There are 2 ways of answering this

question. One is called ‘rule of 72’. This rule states that the period within which the amount doubles

is obtained by dividing 72 by the rate of interest. For instance, if the given rate of interest is 10%, the

doubling period is 72/10, that is, 7.2 years.


39

A much accurate way of calculating doubling period is the ‘rule of 69’, which is expressed as

0.35+69/interest rate. Going by the same example given above, we get the number of years as 7.25

years 0.35 + 69/10 (0.35 +6.9).

Increased frequency of compounding

It has been assumed that the compounding is done annually. If a scheme is offered where

compounding is done more frequently, let us see its effect on interest earned. For example, if we

have deposited Rs. 10000 in a bank which offers 10% interest per annum compounded semi

annually, the interest earned will be as follows:

Amount invested Rs. 10000

Interest earned for first 6 months

10000*10%*1/2 (for 6 months) Rs. 500

Amount at the end of 6 months Rs. 10500

Interest earned for second 6 months

10500*10%*1/2 Rs. 525

Amount at the end of the year Rs. 11025

If in the above case compounding is done only once a year the interest earned will be 10000*10%

which is equal to Rs. 1000 and we will have Rs. 11000 at the end of first year. We find that we get

more interest if compounding is done on a more frequent basis. The generalized formula for shorter

compounding periods is: FVn=PV (1+i/m) m*n

Where, FVn= Future value after n years

PV= Cash flow today

i= Nominal interest rate per annum

m= No. of times compounding is done during a year

n= No. of years for which compounding is done.

Example: Under the Andhra Bank’s Cash Multiplier Scheme, deposits can be made for periods

ranging from 3 months to 5 years. Every quarter, interest is added to the principal. The applicable

rate of interest is 9% for deposits less than 23 months and 10% for periods more than 24 months.

What will the amount of Rs. 1000 today be after 2 years?


40

Solution:

FVn= PV (1+i/m) m*n

1000 (1+0.10/4) 4*2

1000 (1+0.10/4) 8

Rs. 1218

Effective vs. nominal rate of interest: We have just learnt that interest accumulation by frequent

compounding is much more than the annual compounding. This means that the rate of interest given

to us, that is, 10% is the nominal rate of interest per annum. If the compounding is done more

frequently, say semiannually, the principal amount grows at 10.25% per annum. 0.25% is known as

the “Effective Rate of Interest”. The general relationship between the effective and nominal rates of

interest is as follows: r = (1+i/m) m 1

Where,

r= Effective rate of interest

i= Nominal rate of interest

m= Frequency of compounding per year.

Example: Calculate the effective rate of interest if the nominal rate of interest is 12% and interest is

compounded quarterly.

Solution:r = (1+i/m) m 1

r = (1+0.12/4) 4 1

r=0.126 or 12.6% p.a.

3.2.4 Future Value Of Series Of Cash Flows We have considered only single payment made once and its accumulation effect. An investor may be

interested in investing money in installments and wish to know the value of his savings after n years.

For example, Mr. Madan invests Rs. 500, Rs. 1000, Rs. 1500, Rs.2000 and Rs. 2500 at the end of

each year for 5 years. Calculate the value at the end of 5 years compounded annually if the rate of

interest is 5% p.a.


41

Solution:

End of year

Amount invested

Number of years

compounded

Compounded interest factor from tables

FV in Rs.

1 Rs. 500 4 1.216 608 2 Rs.

1000 3 1.158 1158

3 Rs. 1500

2 1.103 1654

4 Rs.2000 1 1.050 2100 5 Rs.

2500 0 1.000 2500

Amount at the end of 5 th Year Rs. 8020

3.2.5 Future Value Of An Annuity Annuity refers to the periodic flows of equal amounts. These flows can be either termed as receipts

or payments. For example, if you have subscribed to the Recurring Deposit Scheme of a bank

requiring you to pay Rs. 5000 annually for 10 years, this stream of payouts can be called

“Annuities”. Annuities require calculations based on regular periodic contribution of a fixed sum of

money.

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

under: FVAn = A(1+i) n 1 / i

Where FVAn=Accumulation at the end of n years

i= Rate of interest

n= Time horizon or no. of years

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

The expression (1+i) n 1/ i is called the Future Value Interest Factor for Annuity (FVIFA). This

represents the accumulation of Re. 1 invested at the end of every year for n number of years at i rate

of interest. The tables at the end of this book give us the calculations for different combinations of i

and n. We just have to multiply the relevant value with A and get the accumulation in the formula

given above.


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Example: M. Ram Kumar deposits Rs. 3000 at the end of every year for 5 years into his account for

5 years, interest being 5% compounded annually. Determine the amount of money he will have at the

end of the 5 th year.

End of year

Amount invested

Number of years

compounded

Compounded interest

factor from tables

FV in Rs.

1 Rs. 2000

4 1.216 2432

2 Rs. 2000

3 1.158 2316

3 Rs. 2000

2 1.103 2206

4 Rs.2000 1 1.050 2100 5 Rs.

2000 0 1.000 2000

Amount at the end of 5 th Year Rs. 11054

OR Using formula and the tables we can find that:

=2000 FVIFA(5%, 5y)

=2000*5.526

=Rs. 11052

We notice that we can get the accumulations at the end of n period using the tables. Calculations for

a long time horizon are easily done with the help of reference tables. Annuity tables are widely used

in the field of investment banking as ready reckoners.

Example: Calculate the value of an annuity flow of Rs. 5000 done on a yearly basis for 5 years,

yielding an interest of 8% p.a. Solution:

=5000 FVIFA(8%, 5y)

=5000* 5.867 =Rs. 29335


43

3.2.5.1 Sinking Fund Sinking fund is a fund which is created out of fixed payments each period to accumulate to a future

sum after a specified period. The sinking fund factor is useful in determining the annual amount to be

put in a fund to repay bonds or debentures or to purchase a fixed asset or a property at the end of a

specified period. A=FVA*i / (1+i) n 1 i / (1+i) n 1 is called the Sinking Fund Factor.


1. The important factors contributing to time value of money are __________, ________________

and _______.

2. During periods of inflation, a rupee has a ___________than a rupee in future.

3. As future is characterized by uncertainty, individuals prefer _________consumption to

__________consumption.

4. There are two methods by which time value of money can be calculated by _________ and

_________ techniques.

3.3 Present Value We have so far seen how the compounding technique can be used. They can be used to compare

the cash flows separated by more than one time period, given the interest rate. With this technique,

the amount of present cash can be converted into an amount of cash of equivalent value in future.

Likewise, we may be interested in converting the future cash flows into their present values. The

Present Value PV of a future cash flow is the amount of the current cash that is equivalent to the

investor. The process of determining present value of a future payment or a series of future

payments is known as discounting.


44

3.3.1 Discounting or Present Value of a Single Flow: We can determine the PV of a future cash flow or a stream of future cash flows using the formula: PV = FVn / (1+i) n

Where PV= Present Value

FVn= Amount

i= Interest rate

n= Number of years

Example: If Ms. Sapna expects to have an amount of Rs. 1000 after one year what should be the

amount she has to invest today if the bank is offering 10% interest rate?

Solution: PV = FVn / (1+i) n

=1000/(1+0.10)1 =Rs. 909.09

The same can be calculated with the help of tables.

=1000*PVIF(10%, 1y)

=1000*0.909 =Rs. 909

Example: An investor wants to find out the value of an amount of Rs. 100000 to be received after 15

years. The interest offered by bank is 9%. Calculate the PV of this amount.

Solution:

PV=FVn/(1+i) n or 100000 PVIF(9%, 15y)

=100000*0.275 = Rs. 27500

3.3.2 Present Value of a Series of Cash Flows In a business scenario, the businessman will receive periodic amounts (annuity) for a certain number

of years. An investment done today will fetch him returns spread over a period of time. He would like

to know if it is worthwhile to invest a certain sum now in anticipation of returns he expects over a

certain number of years. He should therefore equate the anticipated future returns to the present sum

he is willing to forego. The PV of a series of cash flows can be represented by the following formula:


45

PV=Ct / (1=i) 1 + Ct / (1=i) 2 + Ct / (1=i) 3 Ct / (1=i) 4 + ………………..+ Ct / (1=i) n

Which reduces to: PVAn = A 1+i) n 1 / i(1+i) n

The expression 1+i) n 1 / i(1+i) n is known as Present Value Interest Factor Annuity (PVIFA). It

represents the PVIFA of Re. 1 for the given values of i and n. The values of PVIFA(I, n) can be found

out using the tables at the end of the book. It should be noted that these values are true only if the

cash flows are equal and the flows occur at the end of every year.

Example:

Calculate the PV of an annuity of Rs. 500 received annually for 4 year, when discounting factor is

10%.

End of year Cash inflows

PV factor PV in Rs.

1 Rs. 500 0.909 454 2 Rs. 500 0.827 413 3 Rs. 500 0.751 375 4 Rs.500 0.683 341

Present Value of an annuity Rs. 1585.

OR by directly looking at the table we can calculate:

=500*PVIFA(10%, 4y)

=500*3.170 =Rs. 1585

Example: Find out the present value of an annuity of Rs. 10000 over 3 years when discounted at

5%.

Solution:

=10000*PVIFA(5%, 3y)

=10000*2.773 =Rs. 27730


46

3.3.2.1 Present Value of Perpetuity An annuity for an infinite time period is perpetuity. It occurs indefinitely. A person may like to find out

the present value of his investment assuming he will receive a constant return year after year. The

PV of perpetuity is calculated as P=A/i

Example: If the principal of a college wants to institute a scholarship of Rs. 5000 to a meritorious

student in finance every year, find out the PV of investment which would yield Rs. 5000 in perpetuity,

discounted at 10%.

Solution: P=A/i

=5000/0.10

=Rs. 50000

This means he should invest Rs. 50000 to get an annual return of Rs. 5000.

Present value of an uneven periodic sum: In some investment decisions of a firm, the returns may

not be constant. In such cases, the PV is calculated as follows:

P = A1/(1+i) + A2/(1+i) 2 + A3/(1+i) 3 + A4/(1+i) 4 +…………………+An/(1+i) n

OR

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

Example: An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000 and R. 4000

respectively at the end of each of 5 years. Find out the present value of this stream of uneven cash

flows, if the investor’s interest rate is 8%.

PV= 10000/(1+0.08)+ 15000/(1+0.08) 2 + 8000/(1+0.08) 3 + 11000/(1+0.08) 4 + 4000/(1+0.08) 5

=Rs. 39276 Or

PV=10000 PVIF(8,1)+ 15000 PVIF(8,2)+ 8000 PVIF(8,3)+ 11000 PVIF(8,4)+

4000 PVIF(8,5)

=10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681 =Rs. 39276


47

3.3.2.2 Capital Recovery Factor Capital recovery is the annuity of an investment for a specified time at a given rate of interest. The

reciprocal of the present value annuity factor is called Capital Recovery Factor. A=PVAn i(1+i) n / (1+i) n 1 i(1+i) n / (1+i) n 1 is known as the Capital Recovery Factor.

Example: A loan of Rs. 100000 is to be repaid in 5 equal annual installments. If the loan carries a

rate of 14% p. a, what is the amount of each installment?

Solution:

Installment*PVIFA(14%, 5)=100000

Installment=100000/3.433=Rs. 29129


1. _________________is created out of fixed payments each period to accumulate to a future sum

after a specified period.

2. The ________________of a future cash flow is the amount of the current cash that is equivalent

to the investor.

3. An annuity for an infinite time period is called ______________.

4. The reciprocal of the present value annuity factor is called _____________.

3.4 Summary Money has time preference. A rupee in hand today is more valuable than a rupee a year later.

Individuals prefer possession of cash now rather than at a future point of time. Therefore cash flows

occurring at different points in time cannot be compared. Interest rate gives money its value and

facilitates comparison of cash flows occurring at different periods of time. Compounding and

discounting are two methods used to calculate the time value of money.

Solved Problems – Time Value of Money

1. What is the future value of a regular annuity of Re.1.00 earning a rate of 12% interest p.a. for 5

years?

Solution: 1*FVIFA(12%, 5y) = 1*6.353 = Rs. 6.353


48

2. If a borrower promises to pay Rs. 20000 eight years from now in return for a loan of Rs. 12550

today, what is the annual interest being offered? Solution: 20000*PVIF(k%, 8y) = Rs. 12550 K is approximately 6%.

3. A loan of Rs. 500000 is to be repaid in 10 equal installments. If the loan carries 12% interest p.a.

what is the value of one installment? Solution: A*PVIFA(12%, 10y) = 500000 So A = 500000/5.650 = Rs. 88492

4. A person deposits Rs. 25000 in a bank that pays 6% interest halfyearly. Calculate the amount at

the end of 3 years.

Solution: 25000*(1+0.06)3*2 = 25000*1.194 = Rs. 29850

5. Find the present value of Rs. 100000 receivable after 10 years if 10% is the time preference for

money.

Solution: 100000*(0.386) = Rs. 38600

Terminal Questions 1. If you deposit Rs. 10000 today in a bank that offers 8% interest, in how many years will this

amount double?

2. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of each year for 20 years.

What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest

given by PF authorities is 9%?

3. A person can save _____________ annually to accumulate Rs. 400000 by the end of 10 years,

if the saving earns 12%.

4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the

annuity assuming he can earn interest on his investment at 10% p.a.

5. Aparna invests Rs. 5000 at the end of each year at 10% interest p.a. What is the amount she

will receive after 4 years?

Answers to Self Assessment Questions Self Assessment Questions 1

1. Investment opportunities, preference for consumption, risk.

2. Higher purchasing power

3. Current and future


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4. Compounding and discounting


1. Sinking fund

2. Present Value PV

3. Perpetuity

4. Capital Recovery Factor.

Answers to Terminal Questions

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

2. 30000*FVIFA(9%, 20Y) = 30000*51.160 = Rs. 1534800 3. A*FVIFA(12%, 10y) = 400000 which is 400000/17.549 = Rs. 22795 4. 20000*PVIFA(105, 5y)=20000*3.791 = Rs. 75820 5. 5000*FVIFA(10%, 5y) = 5000*6.105 = Rs. 23205


50

Unit 4 Valuation Of Bonds And Shares

4.1 Introduction

4.2 Valuation of Bonds

Types of Bonds

4.2.1 Irredeemable or Perpetual Bonds

4.2.2 Redeemable or Bonds with Maturity Period

4.2.3 Zero Coupon Bond

Bondyield Measures

4.2.1 Holding Period Rate of Return

4.2.2 Current Yield

4.2.3 Yield to Maturity (YTM)

4.2.4 Bond Value Theorems

4.3 Valuation of Shares

4.3.1 Valuation of Preference Shares

4.3.2 Valuation of Ordinary Shares

4.4 Summary

Solved Problems

Terminal Questions


4.1 Introduction Valuation is the process of linking risk with returns to determine the worth of an asset. Assets can be

real or financial; securities are called financial assets, physical assets are real assets. The ultimate

goal of any individual investor is maximization of profits. Investment management is a continuous

process requiring constant monitoring. The value of an asset depends on the cash flow it is expected

to provide over the holding period. The fact that as on date there is no method by which prices of

shares and bonds can be accurately predicted should be kept in mind by an investor before he

decides to take an investment decision. The present chapter will help us to know why some


51

securities are priced higher than others. We can design our investment structure by exploiting the

variables to maximize our returns.

Ordinary shares are riskier than bonds or debentures and some shares are more risky than others.

The investor would therefore commit funds on a share only if he is convinced about the rate of return

being commensurate with risk.



1. Know the meaning of value as used in Finance Theory.

2. Understand the mechanics of Bond valuation, and

3. Understand the mechanics of valuation of equity shares.

Concept of Intrinsic value: A security can be evaluated by the series of dividends or interest

payments receivable over a period of time. In other words, a security can be defined as the present

value of the future cash streams – the intrinsic value of an asset is equal to the present value of the

benefits associated with it. The expected returns (cash inflows) are discounted using the required

return commensurate with the risk. Mathematically, it can be represented by: V0=C1/(1+i) 1 + C2/(1+i) 2 + C3/(1+i) 3 + Cn/(1+i) n

= Cn/(1+i) n

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

P0=Present value of the asset

Cn=Expected cash flow at the end of period n

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

n=Expected life of an asset.

Example:

Assuming a discount rate of 10% and the cash flows associated with 2 projects A and B over a 3

year period, determine the value of the assets.


52

Year Cash flows of A(Rs.)

Cash flows of B(Rs)

1 20000 10000 2 20000 20000 3 20000 30000

Solution:

Value of asset A= 20000 PVIFA(10%,3y)

=20000*2.487

=Rs. 49470

Value of asset B=10000PVIF(10%,1) + 20000PVIF(10%,2) + 30000PVIF (10%,3)

=10000*0.909 + 20000*0.826 + 30000*0.751

=9090+16520+22530

=Rs. 48140 Example:

Calculate the value of an asset if the annual cash inflow is Rs. 5000 per year for the next 6 years and

the discount rate is 16%.

Solution: Value of the asset= Cn/(1+i) n

=5000/(1+0.16) 6

Or =5000PVIFA(16%, 6y)

=5000*3.685

=Rs. 18425

4.1.1 Concepts of Value Book value: Book value is an accounting concept. Value is what an asset is worth today in terms of

their potential benefits. Assets are recorded at historical cost and these are depreciated over years.

Book value may include intangible assets at acquisition cost minus amortized value. The book value

of a debt is stated at the outstanding amount. The difference between the book value of assets and

liabilities is equal to the shareholders’ net worth. (Net worth is the sum total of paidup capital and

reserves and surplus). Book value of a share is calculated by dividing the net worth by the number of

shares outstanding.


53

Replacement value is the amount a company is required to spend if it were to replace its existing

assets in the present condition. It is difficult to find cost of assets presently used by the company.

Liquidation value is the amount a company can realize if it sold the assets after the winding up of its

business. It will not include the value of intangibles as the operations of the company will cease to

exist. Liquidation value is generally the minimum value the company might accept if it sold its

business.

Going concern value is the amount a company can realize if it sells its business as an operating

one. This value is higher than the liquidation value.

Market value is the current price at which the asset or security is being sold or bought in the market.

Market value per share is generally higher than the book value per share for profitable and growing

firms.

4.2 Valuation of Bonds Bonds are long term debt instruments issued by government agencies or big corporate houses to

raise large sums of money. Bonds issued by government agencies are secured and those issued by

private sector companies may be secured or unsecured. The rate of interest on bonds is fixed and

they are redeemable after a specific period. Some important terms in bond valuation:

Face value: Also known as par value, this is the value stated on the face of the bond. It represents

the amount that the unit borrows which is to be repaid at the time of maturity, after a certain period of

time. A bond is generally issued at values such as Rs. 100 or Rs. 1000.

Coupon rate is the specified rate of interest in the bond. The interest payable at regular intervals is

the product of the par value and the coupon rate broken down to the relevant time horizon.

Maturity period refers to the number of years after which the par value becomes payable to the

bondholder. Generally, corporate bonds have a maturity period of 710 years and government bonds

2025 years.

Redemption value is the amount the bondholder gets on maturity. A bond may be redeemed at par,

at a premium (bondholder gets more than the par value of the bond) or at a discount (bondholder

gets less than the par value of the bond).


54

Market value is the price at which the bond is traded in the stock exchange. Market price is the price

at which the bonds can be bought and sold and this price may be different from par value and

redemption value.

Types of Bonds

Bonds are of three types: (a) Irredeemable Bonds (also called perpetual bonds) (b) Redeemable

Bonds (i.e., Bonds with finite maturity period) and (c) Zero Coupon Bonds.

4.2.1 Irredeemable Bonds or Perpetual Bonds Bonds which will never mature are known as irredeemable or perpetual bonds. Indian Companies

Acts restricts the issue of such bonds and therefore these are very rarely issued by corporates these

days. In case of these bonds the terminal value or maturity value does not exist because they are not

redeemable. The face value is known; the interest received on such bonds is constant and received

at regular intervals and hence the interest receipts resemble a perpetuity. The present value (the

intrinsic value) is calculated as: V0=I/id

If a company offers to pay Rs. 70 as interest on a bond of Rs. 1000 par value, and the current yield is

8%, the value of the bond is 70/0.08 which is equal to Rs. 875

4.2.2 Redeemable Bonds :

There are two types viz.,bonds with annual interest payments and bonds with semiannual interest

payments.

Bonds with annual interest payments;

Basic Bond Valuation Model:

The holder of a bond receives a fixed annual interest for a specified number of years and a fixed

principal repayment at the time of maturity. The intrinsic value or the present value of bond can be

expressed as: V0 or P0=∑ n t=1 I/(I+kd) n +F/(I+kd) n

Which can also be stated as folloows V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

Where V0= Intrinsic value of the bond


55

P0= Present Value of the bond

I= Annual Interest payable on the bond

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

n= Maturity period of the bond

Kd= Required rate of return

Example: A bond whose face value is Rs. 100 has a coupon rate of 12% and a maturity of 5 years.

The required rate of interest is 10%. What is the value of the bond?

Solution:

Interest payable=100*12%=Rs. 12

Principal repayment is Rs. 100

Required rate of return is 10% V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

Value of the bond=12*PVIFA(10%, 5y) + 100*PVIF(10%, 5y)

= 12*3.791 + 100*0.621

= 45.49+62.1 = Rs. 107.59

Example: Mr. Anant purchases a bond whose face value is Rs. 1000, maturity period 5 years

coupled with a nominal interest rate of 8%. The required rate of return is 10%. What is the price he

should be willing to pay now to purchase the bond?

Solution:

Interest payable=1000*8%=Rs. 80

Principal repayment is Rs. 1000

Required rate of return is 10%

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

Value of the bond=80*PVIFA(10%, 5y) + 1000*PVIF(10%, 5y)

= 80*3.791 + 1000*0.621

= 303.28 + 621 =Rs. 924.28


56

This implies that the company is offering the bond at Rs. 1000 but is worth Rs. 924.28 at the required

rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for the bond

today.

Bond Values with SemiAnnual Interest payment:

In reality, it is quite common to pay interest on bonds semiannually. With the effect of compounding,

the value of bonds with semiannual interest is much more than the ones with annual interest

payments. Hence, the bond valuation equation can be modified as: V0 or P0=∑ n t=1 I/2/(I+id/2) n +F/(I+id/2) 2n

Where V0=Intrinsic value of the bond

P0=Present Value of the bond

I/2=Semiannual Interest payable on the bond

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

2n=Maturity period of the bond expressed in halfyearly periods

kd/2=Required rate of return semiannually.

Example: A bond of Rs. 1000 value carries a coupon rate of 10%, maturity period of 6 years. Interest

is payable semiannually. If the required rate of return is 12%, calculate the value of the bond.

Solution: V0 or P0=∑ n t=1 (I/2)/(I+kd/2) n +F/(I+kd/2) 2n

=(100/2)/(1+0.12/2) 6 + 1000/(1+0.12/2) 6

=50*PVIFA(6%, 12y) + 1000*PVIF(6%, 12y)

=50*8.384 + 1000*0.497

=419.2 + 497

=Rs. 916.20

It is to be kept in mind that the required rate of return is halved (12%/2) and the period doubled (6y*2)

as the interest is paid semiannually.

4.2.3 Valuation of Zero Coupon Bonds. In India Zero coupon bonds are alternatively known as Deep Discount Bonds. For close to a

decade, these bonds became very popular in India because of issuance of such bonds at regular

intervals by IDBI and ICICI. Zerocoupon bonds have no coupon rate, i.e. there is no interest to be


57

paid out. Instead, these bonds are issued at a discount to their face value, and the face value is the

amount payable to the holder of the instrument on maturity. The difference between the discounted

issue price and face value is effective interest earned by the investor. They are called deep discount

bonds because these bonds are long term bonds whose maturity

some time extends up to 25 to 30 years. Example:

River Valley Authority issued Deep Discount Bond of the face value of Rs.1,00,000 payable 25 years

later, at an issue price of Rs.14,600. What is the effective interest rate earned by an investor from

this bond? Solution:

The bond in question is a zero coupon or deep discount bond. It does not carry any coupon rate.

Therefore, the implied interest rate could be computed as follows:

Step 1. Principal invested today is Rs.14600 at a rate of interest of “r”% over 25 years to amount to

Rs.1,00,000.

Step 2. It can be stated as A = P0 (1+r) n

1,00,000 = 14,600 (1+r) 25

Solving for ‘r’, we get 1,00,000/14600 = (1+r) 25

6.849 = (1+r) 25

Reading the compound value (FVIF) table, horizontally along the 25 year line, we find ‘r’ equals 8%.

Therefore, bond gives an effective return of 8% per annum.

4.2.4 Bondyield Measures 4.2.4.1 Current Yield: Current yield measures the rate of return earned on a bond if it is purchased at its current market

price and the coupon interest received. Current Yield = Coupon Interest / Current Market Price

Example: Continuing with the same example above calculate the CY if the current market price is

Rs. 920


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Solution:CY=Coupon Interest / Current Market Price

=80/920 =8.7%

4.2.4.2 Yield to Maturity (YTM) It is the rate earned by an investor who purchases a bond and holds it till its maturity. The YTM is the

discount rate equaling the present values of cash flows to the current market price.

Example: A bond has a face value of Rs. 1000 with a 5 year maturity period. Its current market price

is Rs. 883.4. It carries an interest rate of 6%. What shall be the rate of return on this bond if it is held

till its maturity?

Solution:

V0 or P0=∑ n t=1 I/(I+kd) n +F/(I+kd) n

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

= 60*PVIFA(Kd, 10) + 1000*PVIF(Kd,10)=883.4

We obtain 10% for kd

Example: A bond has a face value of Rs. 1000 with a 9 year maturity period. Its current market price

is Rs. 850. It carries an interest rate of 8%. What shall be the rate of return on this bond if it is held till

its maturity?

Solution:

V0 or P0=∑ n t=1 I/(I+kd) n +F/(I+kd) n

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

=80*PVIFA(Kd%, 9) + 1000*PVIF(Kd%, 9)=850

To find out the value of Kd, trial an error method is to be followed. Let us therefore start the value of

Kd to be 12% and the equation now looks like

=80*PVIFA(12%, 9) + 1000*PVIF(12%, 9)=850

Let us now see if LHS equals RHS at this rate of 12%. Looking at the tables we get LHS as


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80*5.328 + 1000*0.361=Rs. 787.24

Since this value is less than the value required on the RHS, we take a lesser discount rate of 10%. At

10%, the equation is

=80*PVIFA(10%, 9) + 1000*PVIF(10%, 9)=850

Let us now see if LHS equals RHS at this rate of 11%. Looking at the tables we get LHS as

80*5.759 + 1000*0.424=Rs. 884.72

We now understand that Kd clearly lies between 10% and 12%. We shall interpolate to find out the

true value of Kd.

10% + (884.72850)/(884.72787.24)*(12%10%)

10% + (34.72/97.48)*2

10% + 0.71

Therefore Kd=10.71%

An approximation: The following formula may be used to get a rough idea about Kd as Trial and

Error Method is a very tedious procedure and requires lots of time. This formula can be used as a

ready reference formula. YTM=I+(FP)/n / (F+P)/2

Where YTM =Yield to Maturity

I=Annual interest payment

F=Face value of the bond

P=Current market price of the bond

n=Number of years to maturity.

Example: A company issues a bond with a face value of 5000. It is currently trading at Rs. 4500. The

interest rate offered by the company is 12% and the bond has a maturity period of 8 years. What is

YTM?

Solution:

YTM=I+(FP)/n / (F+P)/2

= 600 + (50004500)/8 / (5000+4500)/2

=600 + 62.5 / 4750

= 13.94%


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4.2.5 Bond Value Theorems The following factors affect the bond values: • Relationship between the required rate of interest (Kd) and the discount rate.

• Number of years to maturity.

• YTM

Relationship between the required rate of interest (Kd) and the discount rate: • When Kd is equal to the coupon rate, the intrinsic value of the bond is equal to its face value, that

is, if Kd=coupon rate, then value of bond=face value. • When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face

value, that is, if Kd>coupon rate, then value of bond<face value.

• When Kd is lesser than the coupon rate, the intrinsic value of the bond is greater than its face value, that is, if Kd<coupon rate, then value of bond>face value.

Example: Sugam industries wishes to issue bonds with Rs. 100 as par value, coupon rate 12% an

YTM 5 years. What is the value of the bond if the required rate of return of an investor is 12%, 14%

and 10%

If Kd is 12%, V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

=12*PVIFA(12%, 5) + 100*PVIF(12%, 5)

=12*3.605 + 100*0.567

=43.26 + 56.7 =Rs. 99.96 or Rs. 100


=12*PVIFA(14%, 5) + 100*PVIF(14%, 5)

=12*3.433 + 100*0.519

=41.20 + 51.9

=Rs. 93.1


=12*PVIFA(10%, 5) + 100*PVIF(10%, 5)

=12*3.791 + 100*0.621

=45.49 + 62.1

=Rs. 107.59


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Number of years to maturity

• When Kd is greater than the coupon rate, the discount on the bond declines as maturity

approaches.

• When Kd is less than the coupon rate, the premium on the bond declines as maturity

approaches.

To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a

coupon rate of 11% and a maturity of 7 years.

If Kd is 13%, then, V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

=11*PVIFA(13%, 7) + 100*PVIF(13%, 7)

=11*4.423 + 100*0.425

=48.65 + 42.50

=Rs. 91.15

After 1 year, the maturity period is 6 years, the value of the bond is V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

=11*PVIFA(13%, 6) + 100*PVIF(13%, 6)

= 11* 3.998 + 100*0.480

=43.98 + 48

= Rs. 91.98.

We see that the discount on the bond gradually decreases and value of the bond increases with the

passage of time at Kd being a higher rate than the coupon rate.

Continuing with the same example above, let us see the effect on the bond value if required rate is

8%.


=11*PVIFA(8%, 7) + 100*PVIF(8%, 7)

=11*5.206 + 100*0.583

=57.27 + 58.3

=Rs. 115.57

One year later, Kd at 8%, V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

=11*PVIFA(8%, 6) + 100*PVIF(8%, 6)

=11*4.623 + 100* 0.630


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=50.85 + 63

=Rs. 113.85

For a required rate of return of 8%, the bond value decreases with passage of time and premium on

bond declines as maturity approaches.

YTM: YTM determining the market value of the bond, the bond price will fluctuate to the changes in

market interest rates. A bond’s price moves inversely proportional to its YTM.

4.3 Valuation of Shares A company’s shares may be categorized as (a) Ordinary or Equity shares and (b) Preference shares.

The returns these shareholders get are called dividends. Preference shareholders get a preferential

treatment as to the payment of dividend and repayment of capital in the event of winding up. Such

holders are eligible for a fixed rate of dividends. Some important features of preference and equity

shares.

• Dividends: Rate is fixed for preference shareholders. They can be given cumulative rights, that

is, the dividend can be paid off after accumulation. The dividend rate is not fixed for equity

shareholders. They change with an increase or decrease in profits. During years of big profits, the

management may declare a high dividend. The dividends are not cumulative for equity

shareholders, that is, they cannot be accumulated and distributed in later years. Dividends are

not taxable.

• Claims: In the event of the business closing down, the preference shareholders have a prior

claim on the assets of the company. Their claims shall be settled first and the balance if any will

be paid off to equity shareholders. Equity shareholders are residual claimants to the company’

income and assets.

• Redemption: Preference shares have a maturity date on which day the company pays off the

face value of the share to the holders. Preference shares can be of two types – redeemable and

irredeemable. Irredeemable preference shares are perpetual. Equity shareholders have no

maturity date.

• Conversion: A company can issue convertible preference shares and not vice versa. After a

particular period as mentioned in the share certificate, the preference shares can be converted

into ordinary shares.


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4.3.1 Valuation of Preference Shares: Preference shares, like bonds carry a fixed rate of dividend/return. Symbolically, this can be

expressed as: P0= Dp/1+Kp) n + Pn/(1+Kp) n

OR

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

Where P0=Price of the share

Dp=Dividend on preference share

Kp=Required rate of return on preference share

n=Number of years to maturity

4.4 Valuation of Ordinary Shares People hold common stocks for two reasons – to obtain dividends in a timely manner and to get a

higher amount when sold. Generally, shares are not held in perpetuity. An investor buys the shares,

holds them for some time during which he gets dividends and finally sells it off to get capital gains.

The value of a share which an investor is willing to pay is linked with the cash inflows expected and

risks associated with these inflows. Intrinsic value of a share is associated with the earnings (past)

and profitability (future) of the company, dividends paid and expected and future definite prospects of

the company. It is the economic value of a company considering its characteristics, nature of

business and investment environment.

4.4.1 Dividend Capitalization Model

When a shareholder buys a share, he is actually buying the stream of future dividends. Therefore the

value of an ordinary share is determined by capitalizing the future dividend stream at an appropriate

rate of interest. So under the dividend capitalization approach, the value of an equity share is the

discounted present value of dividends received plus the present value of the resale price expected

when the share is disposed. Two assumptions are made to apply this approach:

• Dividends are paid annually.

• First payment of dividend is made after one year the equity share is bought.


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4.4.1.1Single period valuation model This model holds well when an investor holds an equity share for one year. The price of such a share

will be: P0= D1 + P1

(1+Ke) (1+Ke)

Where P0=Current market price of the share

D1=Expected dividend after one year

P1=Expected price of the share after one year

Ke=Required rate of return on the equity share

Example: Gammon India Ltd.’s share is expected to touch Rs. 450 one year from now. The company

is expected to declare a dividend of Rs. 25 per share. What is the price at which an investor would be

willing to buy if his required rate of return is 15%?

Solution:

P0=D1/(1+Ke) + P1/(1+Ke)

25/(1+0.15) + 450/(1+0.15)

=21.74 + 391.30

=Rs. 413.04 is the price he is willing to pay today

4.4.1.2 Multiperiod valuation model: An equity share can be held or an indefinite period as it has no maturity date, in which case the value of a price at time zero is: P0=D1/(1+Ke) 1 + D2/(1+Ke) 2 + D3/(1+Ke) 3 +……………..+ D∞/(1+Ke) ∞

Or P0=∑ ∞ t=1 Dn

(1+Ke) n

Where P0=Current market price of the share

D1=Expected dividend after one year

P1=Expected price of the share after one year

D∞=Expected dividend at infinite duration

Ke=Required rate of return on the equity share.

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


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

= P0=∑ ∞ t=1 Dn/(1+Ke) n + Pn/(1+Ke) n

We can come across three instances of dividends in companies:

• Constant dividends

• Constant growth of dividends

• Changing growth rates of dividends.

Valuation with constant dividends: If constant dividends are paid year after year, then P0=D1/(1+Ke) 1 + D2/(1+Ke) 2 + D3/(1+Ke) 3 +………..+ D∞/(1+Ke) ∞

Simplifying this we get P=D/Ke

Valuation with constant growth in dividends: Here we assume that dividends tend to increase with time as and when businesses grow over time. If the increase in dividend is at a constant compound rate, then P0=D1/Keg, where g stands for growth rate.

Example: Sagar automobiles ltd.’s share is traded at Rs. 180. The company is expected to grow at 8% per annum and the dividend expected to be paid off is Rs. 8. If the rate of return is expected to be 12%, what is the price of the share one would be expected to pay today?

Solution: P0=D1/Keg =8/0.120.08 =Rs. 200.

Example: Monica labs is expected to pay Rs. 4 as dividend per share next year. The dividends are

expected to grow perpetually@8%. Calculate the share price today if the market capitalization is

12%.

Solution:

P0=D1/Keg

P0=4/(0.120.08)

=Rs. 100

Valuation with variable growth in dividends: Some firms may not have a constant growth rate of

dividends indefinitely. There are periods during which the dividends may grow supernormally, that is,

the growth rate is very high when the demand for the company’s products is very high. After a certain

period of time, the growth rate may fall to normal levels when the returns fall due to fall in demand for


66

products (with competition setting in or due to availability of substitutes). The price of the equity share

of such a firm is determined in the following manner:

• Step 1. Expected dividend flows during periods of supernormal growth is to be considered and

present value of this is to be computed with the following equation: P0=∑ ∞ t=1 Dn/(1+Ke) n

• Value of the share at the end of the initial growth period is calculated as: Pn=(Dn+1)/(Kegn) (constant growth model). This is discounted to the present value and we

get: (Dn+1)/(Kegn)*1 / (1+Ke) n

• Add both the present value composites to find the value P0 of the share, that is, P0=∑ ∞ t=1 Dn/(1+Ke) n + (Dn+1)/(Kegn)*1/(1+Ke) n

Example: Souparnika Pharma’s current dividend is Rs. 5.It expects to have a supernormal growth

period running to 5 years during which the growth rate would be 25%. The company expects normal

growth rate of 8% after the period of supernormal growth period. The investors’ required rate of

return is 15%. Calculate what the value of one share of this company is worth.

Solution: D0=5, n=5y, ga (supernormal growth)=25%, gn (normal growth)=8%, Ke=14% Step I: P0=∑ ∞ t=1 Dn/(1+Ke) n

D1=5 (1.25) 1

D2= 5 (1.25) 2

D3=5 (1.25) 3

D4=5 (1.25) 4

D5=5 (1.25) 5

The present value of this flow of dividends will be:

5(1.25)/(1.15) + 5(1.25) 2 /(1.15) 2 + 5(1.25) 3 /(1.15) 3 + 5(1.25) 4 /(1.15) 4 + 5(1.25) 5 /(1.15) 5

5.43+ 5.92 + 6.42 + 6.98 + 7.63 = 32.38

Step II: Pn=(Dn+1)/(Keg)

P5=D6/Kegn

=D5(1+gn)/Kegn

=5(1.25) 5 (1+0.08) / (0.150.08)

= 15.26(1.08) / 0.07


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= 16.48 / 0.07

= 235.42

The discounted value of this price is 235.42 / (1.15) 5 = Rs. 117.12

Step III: P0=∑ ∞ t=1 Dn/(1+Ke) n + (Dn+1)/(Kegn)*1/(1+Ke) n

The value of the share is Rs. 32.38 + Rs. 117.12 = Rs.149.50

Other approaches to equity valuation

In addition to the dividend valuation approaches discussed in the previous section, there are other

approaches to valuation of shares based on “Ratio Approach”.

Book value approach: The book value per share (BVPS) is the net worth of the company divided by the number of outstanding equity shares. Net worth is represented by the sum total of paid up equity

shares, reserves and surplus. Alternatively, this can also be calculated as the amount per share on

the sale of the assets of the company at their exact book value minus all liabilities including

preference shares.

Example:

A One Ltd. has total assets worth Rs. 500 Cr., liabilities worth Rs. 300 Cr., and preference shares

worth Rs. 50 Cr. and equity shares numbering 10 lakhs The BVPS is Rs. 150 Cr/10 lakhs = R. 150

BVPS does not give a true investment picture. This relies on historical book values than the

company’s earning potential.

Liquidation value: The liquidation value per share is calculated as: (Value realized by liquidating all assets) – (Amount to be paid to all Crs and Pre SH) divided by Number of outstanding shares.

In the above example, if the assets can be liquidated at Rs. 450 Cr., the liquidation value per share is

(450Cr350Cr) / 10 lakh shares which is equal to Rs. 1000 per share.

4.4.2 Price Earnings Ratio: The priceearnings ratio reflects the amount investors are willing to pay for each rupee of earnings.

Expected earning per share = (Expected PAT) – (Preference dividend) / Number of outstanding shares. Expected PAT is dependent on a number of factors like sales, gross profit


68

margin, depreciation and interest and tax rate. The P/E ratio is also to consider factors like growth

rate, stability of earnings, company size, company management team and dividend payout ratio. P/E ratio = (1b) / r(ROE*b)

Where 1b is dividend pay out ratio

r is required rate of return

ROE*b is expected growth rate.


1. ______________________ is the minimum value the company accepts if it sold its business.

2. ______________per share is generally higher than the book value per share for profitable and

growing firms.

3. Bonds issued by ____________are secured and those issued by private sector companies may

be _________ or ___________.

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

5. When Kd is lesser than the coupon rate, the value of the bond is _________than its face value.

6. ___________of a share is associated with the earnings (past) and profitability (future) of the

company, dividends paid and expected and future definite prospects of the company.

7. The _______________is the net worth of the company divided by the number of outstanding

equity shares.

4.5 Summary Valuation is the process which links the risk and return to establish the asset worth. The value of a

bond or a share is the discounted value of all their future cash inflows (interest/dividend) over a

period of time. The discount rate is the rate of return which the investors expect from the securities.

In case of bonds, the stream of cash flows consists of annual interest payment and repayment of

principal (which may take place at par, at a premium or at a discount). The cash flows which occur in

each year is a fixed amount.

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

at a premium or at a discount.

The equity shareholders do not have a fixed rate of return. Their dividend fluctuates with profits.

Therefore the risk of holding an equity share is higher than holding a preference share or a bond.


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Solved problems

1. The current price of a Ashok Leyland share is Rs. 30. The company is expected to pay a dividend

of Rs. 2.50 per share which goes up annually at 6%. If an investor’s required rate of return is

11%, should he buy this share or not? Advise.

Solution: P = D1(1+g) / Keg = 2.5(1+0.06) / 0.110.06 = Rs. 53. The investor should certainly

buy this share at the current price of Rs. 30 as the valuation model says the share is worth Rs.

53.

2. A bond with a face value of Rs. 100 provides an annual return of 8% and pays Rs. 125 at the

time of maturity, which is 10 years from now. If the investor’s required rate of return is 12%, what

should be the price of the bond?

Solution: P = Int*PVIFA(12%, 10y) + Redemption price*PVIF(12%, 10y)

= 8*PVIFA(12%, 10y) + 125*PVIF(12%, 10y)

= 8*5.65 + 125*0.322

= 45.2 + 40.25 = Rs. 85.45

The price of the bond should be Rs. 85.45

3. The bond of Silicon Enterprises with a par value of Rs. 500 is currently traded at Rs. 435. The

coupon rate is 12% with a maturity period of 7 years. What will be the yield to maturity? Solution: r = I + (FP)/n / (F+P)/2

= 60 + (500435)/7 / (500+435)/2

= 15.03%

4. The share of Megha Ltd is sold at Rs. 500 a share. The dividend likely to be declared by the

company is Rs. 25 per share after one year and the price one year hence is expected to be Rs.

550. What is the return at the end of the year on the basis of likely dividend and price per share?

Solution: Holding period return = (D1 + Price gain/loss) / purchase price

= (25 + 50) / 500 = 15%

5. A bond of face value of Rs. 1000 and a maturity of 3 years pays 15% interest annually. What is

the market price of the bond if YTM is also 15%?

Solution: P = Int*PVIFA(15%, 3y) + Redemption value*PVIF(15%, 3y)

P = 150*2.283 + 1000*0.658

P = 342.45 + 658 = Rs. 1000.45


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1. A perpetual share pays an annual dividend of Rs. 15 on a face value of Rs. 100 and the rate of

return required by investors on such investments is 20%. What should be the market price of the

preference share?

Solution: Expected yield = Expected income /current market price

Expected yield = 15/0.2 = Rs. 75

Terminal Questions 1. What should be price of a bond which has a par value of Rs.1000 carrying a coupon rate of 8%

and having a maturity period of 9 years? The required rate of return of the investor is 12%.

2. A bond of Rs. 1000 value carries a coupon rate of 10% and has a maturity period of 6 years.

Interest is payable semiannually. If the required rate of return is 12%, calculate the value of the

bond.

3. A bond whose par value is Rs. 500 bearing a coupon rate of 10% and has a maturity of 3 years.

The required rate of return is 8%. What should be the price of the bond?

4. If the current year’s dividend is Rs. 24, growth rate of a company is 10% and the required return

on the stock is 16%, what is the intrinsic value of the stock?

5. If a stock is purchased for Rs. 120 and held for one year during which time Rs. 15 dividend per

share is paid and the price decreases to Rs. 115, what is the nominal return on the share?

Answers to Self Assessment Questions


1. Liquidation value

2. Market value

3. Government agencies, secured or unsecured

4. Yield to Maturity

5. Greater

6. Intrinsic value

7. Book value per share (BVPS)


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Answers to Terminal Questions

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

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

80*5.328 + 1000*0.361

426.24 + 361 = Rs. 787.24

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

50*8.384 + 1000*0.497 Rs. 916.2

3. P = Int*PVIFA(8%, 3y) + Redemption price*PVIF(6%+12y)

50*2.577 + 500*0.794

128.85 + 397 = Rs. 525.85

4. Intrinsic value = 24 (1+0.1) / 0.160.1 = Rs. 440

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

15 + (5) / 120 = 8.33%


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Unit 5 Cost of Capital Structure

5.1 Introduction

5.2 Design of an Ideal Capital Structure

5.3 Cost of Different Sources of Finance

5.3.1 Cost of Debentures

5.3.2 Cost of Term Loans

5.3.3 Cost of Preference Capital

5.3.4 Cost of Equity capital

5.3.5 Cost of Retained Earnings

5.3.5.1 Capital Asset Pricing Model Approach

5.3.5.2 Earnings Price Ratio Approach

5.4 Weighted Average Cost of Capital

5.5 Summary

Solved Problems

Terminal Questions


5.1 Introduction Capital structure is the mix of longterm sources of funds like debentures, loans, preference shares,

equity shares and retained earnings in different ratios. It is always advisable for companies to plan

their capital structure. Decisions taken by not assessing things in a correct manner may jeopardize

the very existence of the company. Firms may prosper in the shortrun by not indulging in proper

planning but ultimately may face problems in future. With unplanned capital structure, they may also

fail to economize the use of their funds and adapt to the changing conditions.


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1. Define cost of capital. 2. Bring out the importance of cost of capital. 3. Explain how to design an ideal capital structure. 4. Compute Weighted Average Cost of Capital.

5.2 Designing an Ideal Capital Structure It requires a number of factors to be considered such as:

• Return: The capital structure of a company should be most advantageous. It should generate

maximum returns to the shareholders for a considerable period of time and such returns should

keep increasing.

• Risk: As already discussed in the previous chapter on leverage, use of excessive debt funds may

threaten the company’s survival. Debt does increase equity holders’ returns and this can be done

till such time that no risk is involved.

• Flexibility: The company should be able to adapt itself to situations warranting changed

circumstances with minimum cost and delay.

• Capacity: The capital structure of the company should be within the debt capacity. Debt capacity

depends on the ability for funds to be generated. Revenues earned should be sufficient enough

to pay creditors’ interests, principal and also to shareholders to some extent.

• Control: An ideal capital structure should involve minimum risk of loss of control to the company.

Dilution of control by indulging in excessive debt financing is undesirable.

With the above points on ideal capital structure, raising funds at the appropriate time to finance firm’s

investment activities is an important activity of the Finance Manager. Golden opportunities may be

lost for delaying decisions to this effect. A combination of debt and equity is used to fund the

activities. What should be the proportion of debt and equity? This depends on the costs associated

with raising various sources of funds. The cost of capital is the minimum rate of return a company

must earn to meet the expenses of the various categories of investors who have made investment in

the form of loans, debentures, equity and preference shares. A company no being able to meet these

demands may face the risk of investors taking back their investments thus leading to bankruptcy.


74

Loans and debentures come with a predetermined interest rate, preference shares also have a fixed

rate of dividend while equity holders expect a minimum return of dividend based on their risk

perception and the company’s past performance in terms of payout of dividends.

The following graph on riskreturn relationship of various securities summarizes the above

discussion.

Error!

5.3 Cost of Different Sources of Finance The various sources of finance and their costs are explained below:

5.3.1 Cost of debentures The cost of debenture is the discount rate which equates the net proceeds from issue of debentures

to the expected cash outflows—interest and principal repayments.

Kd= I(1—T) + (F—P)/n

(F+P)/2

Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,

T is the corporate tax rate,

F is the redemption price per debenture,

P is the net amount realized per debenture,

Risk free security

Govt bonds

Debt

Preference share

Equity share

RiskReturn relationship of various securities

Required rate of return


75

n is maturity period.

Example:

Lakshmi Enterprise wants to have an issue of nonconvertible debentures for Rs. 10 Cr. Each

debenture is of a par value of Rs. 100 having an interest rate of 15%. Interest is payable annually

and they are redeemable after 8 years at a premium of 5%. The company is planning to issue the

NCD at a discount of 3% to help in quick subscription. If the corporate tax rate is 50%, what is the

cost of debenture to the company? Solution:

Kd = I(1—T) + (F—P)/n

(F+P)/2

15(1—0.5) + (105—97)/8

(105+97)/2

= 7.5 + 1

101

= 0.084 or 8.4%

5.3.2 Cost of Term Loans Term loans are loans taken from banks or financial institutions for a specified number of years at a

predetermined interest rate. The cost of term loans is equal to the interest rate multiplied by 1—tax

rate. The interest is multiplied by 1—tax rate as interest on term loans is also taxed. Kt=I(1—T)

Where I is interest,

T is tax rate.

Example:

Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9% interest. What is the cost of term

loan?

Solution

Kt=I(1—T) = 9(1—0.4) = 5.4%


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5.3.2 Cost of Preference Capital The cost of preference share Kp is the discount rate which equates the proceeds from preference

capital issue to the dividend and principal repayments which is expressed as:

Kp = D + (F—P)/n

(F+P)/2

Where Kp is the cost of preference capital,

D is the preference dividend per share payable,

F is the redemption price,

P is the net proceeds per share,

n is the maturity period.

Example:

C2C Ltd. has recently come out with a preference share issue to the tune of Rs. 100 lakhs. Each

preference share has a face value of 100 and a dividend of 12% payable. The shares are

redeemable after 10 years at a premium of Rs. 4 per share. The company hopes to realize Rs. 98

per share now. Calculate the cost of preference capital.

Solution

Kp = D + (F—P)/n

(F+P)/2

= 12 + (10498)/10

(104+98)/2

= 12.6

101 Kp = 0.1247 or 12.47%

5.3.4 Cost of Equity Capital Equity shareholders do not have a fixed rate of return on their investment. There is no legal

requirement (unlike in the case of loans or debentures where the rates are governed by the deed) to

pay regular dividends to them. Measuring the rate of return to equity holders is a difficult and

complex exercise. There are many approaches for estimating return the dividend forecast

approach, capital asset pricing approach, realized yield approach, etc. According to dividend forecast


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approach, the intrinsic value of an equity share is the sum of present values of dividends associated

with it. Ke=(D1/Pe) + g

This equation is modified from the equation Pe=D1/Keg. Dividends cannot be accurately forecast

as they may sometimes be nil or have a constant growth or sometime supernormal growth periods.

Is Equity Capital free of cost?

Some people are of the opinion that equity capital is free of cost for the reason that a company is not

legally bound to pay dividends and also the rate of equity dividend is not fixed like preference

dividends. This is not a correct view as equity shareholders buy shares with the expectation of

dividends and capital appreciation. Dividends enhance the market value of shares and therefore

equity capital is not free of cost.

Example:

Suraj Metals are expected to declare a dividend of Rs. 5 per share and the growth rate in dividends

is expected to grow @ 10% p.a. The price of one share is currently at Rs. 110 in the market. What is

the cost of equity capital to the company?

Solution Ke=(D1/Pe) + g

=(5/110) + 010 =0.1454 or 14.54%

5.3.5 Cost of Retained Earnings A company’s earnings can be reinvested in full to fuel the everincreasing demand of company’s fund

requirements or they may be paid off to equity holders in full or they may be partly held back and

invested and partly paid off. These decisions are taken keeping in mind the company’s growth

stages. High growth companies may reinvest the entire earnings to grow more, companies with no

growth opportunities return the funds earned to their owners and companies with constant growth

invest a little and return the rest. Shareholders of companies with high growth prospects utilizing

funds for reinvestment activities have to be compensated for parting with their earnings. Therefore

the cost of retained earnings is the same as the cost of shareholder’s expected return from the firm’s

ordinary shares. That is, Kr=Ke


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5.3.5.1 Capital Asset Pricing Model Approach This model establishes a relationship between the required rate of return of a security and its

systematic risks expressed as β. According to this model, Ke = Rf + β (Rm—Rf)

Where Ke is the rate of return on share,

Rf is the risk free rate of return,

Β is the beta of security,

Rm is return on market portfolio.

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

• Investors are riskaverse.

• Investors make their investment decisions on a singleperiod horizon.

• Transaction costs are low and therefore can be ignored. This translates to assets being bought

and sold in any quantity desired. The only considerations mattering are the price and amount of

money at the investor’s disposal.

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

Example:

What is the rate of return for a company if its β is 1.5, risk free rate of return is 8% and the market

rate or return is 20%

Solution Ke = Rf + β (Rm—Rf)

= 0.08 + 1.5(0.20.08)

= 0.08 + 0.18

= 0.26 or 26%

5.3.5.2 Earnings Price Ratio Approach According to this approach, the cost of equity can be calculated as: Ke = E1/P where E1 is expected EPS one year hence and P is the current market price per share.

E1 is calculated by multiplying the present EPS with (1 + Growth rate). Cost of Retained Earnings and Cost of External Equity


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As we have just learnt that if retained earnings are reinvested in business for growth activities the

shareholders expect the same amount of returns and therefore Ke=Kr. But it should be borne in mind

by the policy makers that floating a new issue and people subscribing to it will involve huge amounts

of money towards floatation costs which need not be incurred if retained earnings are utilized

towards funding activities. Using the dividend capitalization model, the following model can be used

for calculating cost of external equity. Ke=D1/P0(1—f) + g

Where Ke is the cost of external equity,

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

P0 is the current market price per share,

g is the constant growth rate of dividends,

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

The following formula can be used as an approximation: K’e=ke/(1—f)

Where K’e is the cost of external equity,

ke is the rate of return required by equity holders,

f is the floatation cost.

Example:

Alpha Ltd. requires Rs. 400 Cr to expand its activities in the southern zone of India. The company’s

CFO is planning to get Rs. 250 Cr through a fresh issue of equity shares to the general public and for

the balance amount he proposes to use ½ of the reserves which are currently to the tune of Rs. 300

Cr. The equity investors’ expectations of returns are 16%. The cost of procuring external equity is

4%. What is the cost of external equity?

Solution

We know that Ke=Kr, that is Kr is 16%

Cost of external equity is K’e=ke/(1—f) 0.16/(1—0.04) = 0.1667 or 16.67%


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5.4 Weighted Average Cost of Capital In the previous section we have calculated the cost of each component in the overall capital of the

company. The term cost of capital refers to the overall composite cost of cap or the weighted

average cost of each specific type of fund. The purpose of using weighted average is to consider

each component in proportion of their contribution to the total fund available. Use of weighted

average is preferable to simple average method for the reason that firms do not procure funds

equally from various sources and therefore simple average method is not used. The following steps

are involved to calculate the WACC. Step I: Calculate the cost of each specific source of fund, that of debt, equity, preference capital and

term loans. Step II: Determine the weights associated with each source. Step III Multiply the cost of each source by the appropriate weights. Step IV: WACC = WeKe + WrKr + WpKp + WdKd + WtKt

Assignment of weights

Weights can be assigned based on any of the below mentioned methods:

(1) The book values of the sources of funds in the capital structure, (2) Present market

value of the funds in the capital structure and (3) in the proportion of financing planned for the

capital budget to be adopted for the next period.

As per the book value approach, weights assigned would be equal to each source’s proportion in the

overall funds. The book value method is preferable. The market value approach uses the market

values of each source and the disadvantage in this method is that these values change very

frequently. Example:

Prakash Packers Ltd. has the following capital structure:

Rs. in lakhs

Equity capital (Rs. 10 par value) 200 14% Preference share capital Rs. 100 each

100

Retained earnings 100 12% debentures (Rs. 100 each) 300 11% Term loan from ICICI bank 50 Total 750


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The market price per equity share is Rs. 32. The company is expected to declare a dividend per

share of Rs. 2 per share and there will be a growth of 10% in the dividends for the next 5 years. The

preference shares are redeemable at a premium of Rs. 5 per share after 8 years and are currently

traded at Rs. 84 in the market. Debenture redemption will take place after 7 years at a premium of

Rs. 5 per debenture and their current market price is Rs. 90 per unit. The corporate tax rate is 40%.

Calculate the WACC.

Solution

Step I is to determine the cost of each component. Ke =( D1/P0) + g

= (2/32) + 0.1 = 0.1625 or 16.25%

Kp = [D + (F—P)/n] / F+P)/2

= [14 + (105—84)/8] / (105+84)/2

=16.625/94.5

= 0.1759 or 17.59%

Kr=Ke which is 16.25% Kd = [I(1—T) + (F—P)/n] / F+P)/2

= [12(1—0.4) + (105—90)/7] / (105+97)/2

= [7.2 + 2.14] / 101 = 0.092 or 9.2%

Kt = I(1—T)

=0.11(1—0.4) = 0.066 or 6.6%

Step II is to calculate the weights of each source.

We = 200/750 = 0.267

Wp = 100/750 = 0.133

Wr = 100/750 = 0.133

Wd = 300/750 = 0.4

Wt = 50/750 = 0.06


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Step III Multiply the costs of various sources of finance with corresponding weights and WACC

calculated by adding all these components.

WACC = WeKe + WpKp +WrKr + WdKd + WtKt

= (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) + (0.06*0.066)

= 0.043 + 0.023 + 0.022 + 0.034 + 0.004

= 0.1256 or 12.56%

Example:

Johnson Cool Air Ltd would like to know the WACC. The following information is made available to

you in this regard.

The after tax cost of capital are:

• Cost of debt 9%

• Cost of preference shares 15%

• Cost of equity funds 18%

The capital structure is as follows:

• Debt Rs. 600000

• Preference capital Rs. 400000

• Equity capital Rs. 1000000

Solution

Fund source Amount Ratio Cost Weighted cost

Debt Rs. 600000 0.3 0.09 0.027

Preference capital

Rs. 400000 0.2 0.15 0.03

Equity capital Rs. 1000000

0.5 0.18 0.09

Total Rs. 2000000

1.0 0.147

WACC is 14.7%


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Example:

Manikyam Plastics Ltd. wants to enter into the arena of plastic moulds next year for which it requires

Rs. 20 Cr. to purchase new equipment. The CFO has made available the following details based on

which you are required to compute the weighted marginal cost of capital.

• The amount required will be raised in equal proportions by way of debt and equity (new issue and

retained earnings put together account for 50%).

• The company expects to earn Rs. 4 Cr as profits by the end of year of which it will retain 50% and

pay off the rest to the shareholders.

• The debt will be raised equally from two sources—loans from IOB costing 14% and from the IDBI

costing 15%.

• The current market price per equity share is Rs. 24 and dividend pay out one year hence will be

Rs. 2.40.

Solution

Source of funds Weights After tax cost

Weighted cost

Equity capital 0.4 0.1 0.04 Retained earnings 0.1 0.1 0.01 14% loan from IOB 0.25 0.07 0.0175 15% IDBI loan 0.25 0.075 0.01875 Total 0.0863 or 8.63%

Ke =( D1/P0) + g

= (2.40/24) = 0.1 or 10% Kt = I(1—T)

= 0.14(1—0.5) = 0.07 or 7% Kt = I(1—T)

= 0.15(1—0.5) = 0.075 or 7.5%

Example:

Canara Paints has paid a dividend of 40% on its share of Rs. 10 in the current year. The dividends

are growing @ 6% p.a. The cost of equity capital is 16%. The Company’s top Finance Managers of

various zones recently met to take stock of the competitors’ growth and dividend policies and came

out with the following suggestions to maximize the wealth of the shareholders. As the CFO of the


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company you are required to analyze each suggestion and take a suitable course keeping the

shareholders’ interests in mind.

Alternative 1: Increase the dividend growth rate to 7% and lower Ke to 15%

Alternative 2: Increase the dividend growth rate to 7% and increase Ke to 17%

Alternative 3: Lower the dividend growth rate to 4% and lower Ke to 15%

Alternative 4: Lower the dividend growth rate to 4% and increase Ke to 17%

Alternative 5: increase the dividend growth rate to 7% and lower Ke to 14%

Solution We all know that P0 = D1/(Ke—g)

Present case = 4/(0.160.06) = Rs 40

Alternative 1 = 4.28/(0.15—0.07) = Rs. 53.5

Alternative 2 = 4.28/(0.17—0.07) = Rs. 42.8

Alternative 3 = 4.16/(0.15—0.04) = Rs. 37.8

Alternative 4 = 4.16/(0.17—0.04) = Rs. 32

Alternative 5 = 4.28/(0.14—0.07) = Rs. 61.14

Recommendation: The last alternative is likely to fetch the maximum price per equity share thereby

increasing their wealth.


1. _________is the mix of longterm sources of funds like debentures, loans, preference shares,

equity shares and retained earnings in different ratios.

2. The capital structure of a company should generate __________to the shareholders.

3. The capital structure of the company should be within the__________.

4. An ideal capital structure should involve ___________to the company.

5. ________________do not have a fixed rate of return on their investment.

6. According to Dividend Forecast Approach, the intrinsic value of an equity share is the sum of

______________associated with it.


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5.5 Summary Any organization requires funds to run its business. These funds may be acquired from shortterm or

longterm sources. Longterm funds are raised from two important sources—capital (owners’ funds)

and debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not

desirable as debtholders attach many conditions which may not be possible for the companies to

adhere to. It is therefore desirable to have a combination of both debt and equity which is called the

‘optimum capital structure’. Optimum capital structure refers to the mix of different sources of long

term funds in the total capital of the company.

Cost of capital is the minimum required rate of return needed to justify the use of capital. A company

obtains resources from various sources – issue of debentures, availing term loans from banks and

financial institutions, issue of preference and equity shares or it may even withhold a portion or

complete profits earned to be utilized for further activities. Retained earnings are the only internal

source to fund the company’s future plans.

Weighted Average Cost of Capital is the overall cost of all sources of finance.

The debentures carry a fixed rate of interest. Interest qualifies for tax deduction in determining tax

liability. Therefore the effective cost of debt is less than the actual interest payment made by the firm.

The cost of term loan is computed keeping in mind the tax liability.

The cost of preference share is similar to debenture interest. Unlike debenture interest, dividends do

not qualify for tax deductions.

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

The cost of retained earnings is the same as the cost of equity funds.

Solved Problems

1. Deepak steel has issued nonconvertible debentures for Rs. 5 Cr. Each debenture is of a par

value of Rs. 100 carrying a coupon rate of 14%. Interest is payable annually and they are

redeemable after 7 years at a premium of 5%. The company issued the NCD at a discount of

3%. What is the cost of debenture to the company? Tax rate is 40%.


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Solution

Kd = I(1—T) + (F—P)/n

(F+P)/2

14(1—0.4) + (105—97)/7

(105+97)/2

= 8.4 + 1.14 = 0.094 or 9.4% 101

2. Supersonic industries Ltd. has entered into an agreement with Indian Overseas Bank for a loan of Rs. 10 Cr with an interest rate of 10%. What is the cost of the loan if the tax rate is 45%? Solution Kt=I(1—T) = 10(1—0.45) = 5.5%

3. Prime group issued preference shares with a maturity premium of 10% and a coupon rate of 9%. The shares have a face a value of Rs. 100. and are redeemable after 8 years. The company is planning to issue these shares at a discount of 3% now. Calculate the cost of preference capital.

Solution Kp = D + (F—P)/n

(F+P)/2 = 9 + (11097) / 8 = 9 + 1.625 = 10.27%

(110 + 97) / 2 103.5

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

Equity Rs. 10 lakhs, cost of capital 18%

Debt Rs. 5 lakhs, cost of debt 13%

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

is 40%.

2. Bharat Chemicals has the following capital structure:

Rs. 10 face value equity shares Rs. 400000 Term loan @ 13% Rs.150000 9% Preference shares of Rs. 100, currently traded at Rs. 95 with 6 years maturity period

Rs. 100000

Total Rs. 650000


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The company is expected to declare a dividend of Rs. 5 next year and the growth rate of

dividends is expected to be 8%. Equity shares are currently traded at Rs. 27 in the market.

Assume tax rate of 50%. What is WACC?

3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is

Rs. 60 lakhs. The cost of equity and debt are 15% and 12%. What is the WACC?

4. A company has 3 divisions – X, Y and Z. Each division has a capital structure with debt,

preference shares and equity shares in the ratio 3:4:3 respectively. The company is planning to

raise debt, preference shares and equity for all the 3 divisions together. Further, it is planning to

take a bank loan @ 12% interest. The preference shares have a face value of Rs. 100, dividend

@ 12%, 6 years maturity and currently priced at Rs. 88. Calculate the cost of preference shares

and debt if taxes applicable are 45%

5. Tanishk Industries issues partially convertible debentures of face value of is Rs. 100 each and

realizes Rs. 96 per share. The debentures are redeemable after 9 years at a premium of 4%,

taxes applicable are 40%. What is the cost of debt?

5.8 Answers to Self Assessment Questions Self Assessment Questions 1

1. Capital structure

2. Maximum returns

3. Debt capacity

4. Minimum risk of loss of control

5. Equity shareholders

6. Present values of dividends

Answers to Terminal Questions:

1, 2, 3 : WACC = WeKe + WpKp +WrKr + WdKd + WtKt

4. Hint: Apply the formula Kp = D + (F—P)/n

(F+P)/2

5. Hint: Apply the formula Kd = I(1—T) + (F—P)/n

(F+P)/2


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Unit 6 Leverage

Structure

6.1 Introduction

6.2 Operating Leverage

6.2.1 Application of Operating Leverage

6.3 Financial Leverage

6.3.1 Uses of Financial Leverage

6.4 Combined Leverage

6.4.1 Uses of Combined Leverage

6.5 Summary

Solved Problems

Terminal Questions


6.1 Introduction A company uses different sources of financing to fund its activities. These sources can be classified

as those which carry a fixed rate of return and those whose returns vary. The fixed sources of

finance have a bearing on the return on shareholders. Borrowing funds as loans have an impact on

the return on shareholders and this is greatly affected by the magnitude of borrowing in the capital

structure of a firm. Leverage is the influence of power to achieve something. The use of an asset or

source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage.

Leverage is the influence of an independent financial variable on a dependent variable. It studies

how the dependent variable responds to a particular change in independent variable.

There are two types of leverage – operating leverage and financial leverage. Leverage

associated with the asset purchase activities is known as operating leverage, while those associated

with financing activities is called as financial leverage.


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1. Explain the meaning of leverage. 2. Mention the different types of leverage. 3. Discuss the advantages of leverage.

6.2 Operating Leverage Operating leverage arises due to the presence of fixed operating expenses in the firm’s income

flows. A company’s operating costs can be categorized into three main sections:

• Fixed costs are those which do not vary with an increase in production or sales activities for a

particular period of time. These are incurred irrespective of the income and volume of sales and

generally cannot be reduced.

• Variable costs are those which vary in direct proportion to output and sales. An increase or

decrease in production or sales activity will have a direct effect on such types of costs incurred.

• Semivariable costs are those which are partly fixed and partly variable in nature. These costs

are typically of fixed nature up to a certain level beyond which they vary with the firm’s activities.

The operating leverage is the firm’s ability to use fixed operating costs to increase the effects of

changes in sales on its earnings before interest and taxes. Operating leverage occurs any time a firm

has fixed costs. The percentage change in profits with a change in volume of sales is more than the

percentage change in volume. Example:

A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per unit and fixed expenses

amount to R. 5000 p.a. Show the various levels of EBIT that result from sale of 1000 units, 2000

units and 3000 units. Solution

Sales in units 1000 2000 3000 Sales revenue Rs. 10000 20000 30000 Variable cost 5000 10000 15000 Contribution 5000 10000 15000 Fixed cost 5000 5000 5000


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EBIT 000 5000 10000 If we take 2000 units as the normal course of sales, the results can be summed as under:

• A 50% increase in sales from 2000 units to 3000 units results in a 100% increase in EBIT.

• A 50% decrease in sales from 2000 units to 1000 units results in a 100% decrease in EBIT.

The illustration clearly tells us that when a firm has fixed operating expenses, an increase in sales

results in a more proportionate increase in EBIT and vice versa. The former is a favourable operating

leverage and the latter is unfavourable.

Another way of explaining this phenomenon is examining the effect of the degree of operating

leverage DOL. The DOL is a more precise measurement. It examines the effect of the change in the

quantity produced on EBIT.

DOL=% change in EBIT / % change in output To put in a different way, (ΔEBIT/EBIT)

(ΔQ/Q)

EBIT is Q(S—V)—F where Q is quantity, S is sales, V is variable cost and F is fixed cost. Substituting this we get, Q(S—V)

Q(S—V)—F Example:

Calculate the DOL of Guptha enterprises.

Quantity produced and sold – 1000 units

Variable cost – Rs. 100 per unit’

Selling price per unit – Rs. 300 per unit

Fixed expenses – Rs. 20000 Solution DOL=Q(S—V)

Q(S—V)—F

=1000(300—200)

1000(300—200)—20000

=100000/80000 DOL=1.25

If the company does not incur any fixed operating costs, there is no operating leverage.


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Example:

Sales in units 1000 Sales revenue Rs. 10000 Variable cost 5000 Contribution 5000 Fixed cost 0 EBIT 5000

Solution: DOL=Q(S—V)

Q(S—V)—F

1000(5000) / 1000(5000) – 0

=5000000/5000000 =DOL=1

As operating leverage can be favourable or unfavourable, high risks are attached to higher degrees

of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the

operating risks of the company and hence a higher degree of operating leverage. Higher operating

risks can be taken when income levels of companies are rising and should not be ventured into when

revenues move southwards.

6.2.1 Application of Operating Leverage Measurement of business risk: Risk refers to the uncertain conditions in which a company

performs. Greater the DOL, more sensitive is the EBIT to a given change in unit sales. A high DOL is

a measure of high business risk and vice versa.

Production planning: A change in production method increases or decreases DOL. A firm can

change its cost structure by mechanizing its operations, thereby reducing its variable costs and

increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only

if the company is confident of achieving a higher amount of sales thereby increasing its earnings.


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6.3 Financial Leverage Financial leverage as opposed to operating leverage relates to the financing activities of a firm and

measures the effect of EBIT on EPS of the company. A company’s sources of funds fall under two

categories – those which carry a fixed financial charge – debentures, bonds and preference shares

and those which do not carry any fixed charge – equity shares. Debentures and bonds carry a fixed

rate of interest and have to be paid off irrespective of the firm’s revenues. Though dividends are not

contractual obligations, dividend on preference shares is a fixed charge and should be paid off before

equity shareholders are paid any. The equity holders are entitled to only the residual income of the

firm after all prior obligations are met.

Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results

from the presence of fixed financial charges in the company’s income stream. Such expenses have

nothing to do with the firm’s performance and earnings and should be paid off regardless of the

amount of EBIT. It is the firm’s ability to use fixed financial charges to increase the effects of changes

in EBIT on the EPS. It is the use of funds obtained at fixed costs to increase the returns to

shareholders. A company earning more by the use of assets funded by fixed sources is said to be

having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning

sufficiently to cover the cost of funds. Financial leverage is also referred to as “Trading on Equity”.

Example:

The EBIT of a firm is expected to be Rs. 10000. The firm has to pay interest @ 5% on debentures

worth Rs. 25000. It also has preference shares worth Rs. 15000 carrying a dividend of 8%. How

does EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may be taken as 40% and number of

outstanding shares as 1000. Solution:

EBIT 10000 5000 15000 Interest on deb. 1250 1250 1250 EBT 8750 3750 13750 Tax 40% 3500 1500 5500 EAT 5250 2250 8250 Preference div. 1200 1200 1200 Earnings available to equity holders

4050 1050 7050


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EPS 4.05 1.05 7.05 Interpretation:

• A 50 % increase in EBIT from Rs. 10000 to Rs. 15000 results in 74% increase in EPS.

• A 50 % decrease in EBIT from Rs. 10000 to Rs. 5000 results in 74% decrease in EPS.

This example shows that the presence of fixed interest source funds leads to a more than

proportional change in EPS. The presence of such fixed sources implies the presence of financial

leverage. This can be expressed in a different way. The degree of financial leverage DFL is a more

precise measurement. It examines the effect of the fixed sources of funds on EPS. DFL=%change in EPS

%change in EBIT DFL=ΔEPS/EPS

ΔEBIT/EBIT Or DFL = EBIT

EBIT—I—Dp/(1T)

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

Kusuma Cements Ltd. has an EBIT of Rs. 500000 at 5000 units production and sales. The capital

structure is as follows:

Capital structure Amount Rs. Paid up capital 500000 equity shares of Rs. 10 each

5000000

12% Debentures 400000 10% Preference shares of Rs. 100 each 400000

Total 5800000

Corporate tax rate may be taken at 40%

Solution:

EBIT 500000

Less Interest on debentures 48000

EBT 452000


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DFL= EBIT EBIT—I—Dp/(1T) 500000

(500000—48000—40000/(1—0.40) DFL=1.30

6.3.1 Use of Financial Leverage Studying DFL at various levels makes financial decisionmaking on the use of fixed sources of funds

for funding activities easy. One can assess the impact of change in EBIT on EPS.

Like operating leverage, the risks are high at high degrees of financial leverage. High financial costs

are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the

necessary financial commitments. A firm not capable of honouring its financial commitments may be

forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these

circumstances. On the one hand trading on equity improves considerably by the use of borrowed

funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the

business. All these factors should be considered while formulating the firm’s mix of sources of funds.

One main goal of financial planning is devise a capital structure in order to provide a high return to

equity holders. But at the same time, this should not be done with heavy debt financing which drives

the company on to the brink of winding up.

Impact of financial leverage:

Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them

further to fuel their expansion activities. On being forced to continue lending, they may do so with

their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the

market rates or no further mortgage of securities. Financial leverage is considered to be favourable

till such time that the rate of return exceeds the rate of return obtained when no debt is used. This

can be explained with the help of the following example:

Following are the balance sheets of 2 firms A and B


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Balance sheet of A Balance sheet of B Equity capita l

10000 0

Assets 10000 0

Equity capital

40000 Assets 10000 0

Debt @15%

60000

Total 10000 0

Total 10000 0

Total 10000 0

Total 10000 0

Both the companies earn an income before interest and tax of Rs. 40000. Calculate the DFL and

interpret the results thereof.

DFL= ) T 1 /( Dp I EBIT

EBIT − − −

Company A = 1 0 0 40000

4000 =

− −

Company B = 29 . 1 0 9000 40000

4000 =

− −

The company not using debt to finance its assets has a higher DFL. Financial leverage does not exist

when there is no fixed charge financing.

6.4 Total or Combined Leverage The combination of operating and financial leverage is called combined leverage. Operating leverage affects the firm’s operating profit EBIT and financial leverage affects PAT or the EPS. These cause wide fluctuation in EPS. A company having a high level of operating or financial leverage will find a drastic change in its EPS even for a small change in sales volume. Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes in EPS due to leverages is more pronounced. The combined effect is quite significant for the earnings available to ordinary shareholders. Combined leverage is the product of DOL and DFL.

DTL = ) T 1 /( Dp I F ) V S ( Q

) V S ( Q − − − − −

−

Example: Calculate the DTL of M/s Pooja Enterprises Ltd. given the following information. Quantity sold 10000 units


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Variable cost per unit Rs. 100 per unit Selling price per unit Rs. 500 per unit Fixed expenses Rs. 1000000 Number of equity shares 100000 Debt Rs. 1000000 @ 20% interest Preference shares 10000 shares of Rs. 100 each @ 10% dividend Tax rate 50%

DTL = ) T 1 /( Dp I F ) V S ( Q

) V S ( Q − − − − −

−

5 . 0 / 100000 200000 1000000 ) 100 500 ( 10000 ) 100 500 ( 10000

− − − − −

DTL=1.54

Cross verification:

DOL= F ) V S ( Q

) V S ( Q − −

−

1000000 ) 100 500 ( 10000 ) 100 500 ( 10000

− − −

=

DOL=1.33

DFL= ) T 1 /( Dp I EBIT

EBIT − − −

5 . 0 / 100000 200000 3000000 3000000

− −

DFL=1.15 DTL=DOL*DFL 1.33*1.15=1.54

6.4.1 Uses of DTL DTL measures the total risk of the company as it is a combined measure of both operating and

financial risk. It measures the variability of EPS.


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1. ________________arises due to the presence of fixed operating expenses in the firm’s income

flows.

2. EBIT is calculated as _____________.

3. Higher operating risks can be taken when _____________of companies are rising.

4. Dividend on __________is a fixed charge.

5. Financial leverage is also referred to as ____________.

6.5 Summary Leverage is the use of influence to attain something else. The advantage a company has with its

current status is used to gain some other benefit. There are three measures of leverage – operating

leverage, financial leverage and total or combined leverage. Operating leverage examines the effect

of change in quantity produced upon EBIT and is useful to measure business risk and production

planning. Financial leverage measures the effect of change in EBIT on the EPS of the company. It

also refers to the debtequity mix of a firm. Total leverage is the combination of operating and

financial leverages.

Solved Problems

1. The following information has been collected from the annual report of Garden Silks. What is the

degree of financial leverage?

Total sales Rs. 1400000

Contribution ratio 25%

Fixed expenses Rs. 150000

Outstanding bank loan Rs. 400000 @ 12.5%

Applicable tax rate 40% Solution: DFL = EBIT / (EBITI) = 200000/20000050000 = 1.33

EBIT = Sales*25% less fixed expenses

1400000*25% = 350000150000 = 200000

2. X and Y have provided the following information. Which firm do you consider risky?


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X Ltd. Y Ltd. Sales in units 40000 40000 Price per unit 60 60 Variable cost p.u 20 25 Fixed financing cost

Rs. 100000 Rs. 50000

Fixed financing cost

Rs. 300000 Rs. 200000

Solution: DOL = Q(SV) / Q(SV)F

Company X: 40000(6020) / 40000(6020)400000

1600000/1200000 = 1.33

Company Y: 40000(6025) / 40000(6025)250000

1400000/1100000= 1.22

3. Calculate EPS with the following information.

EBIT Rs. 1180000

Interest Rs. 220000

No. of shares outstanding 40000

Tax rate applicable 40% Solution: EBIT 1180000

Less Int 220000

EBT 960000

Tax 40% 384000

EAT 576000

EPS = EAT/no of shares outstanding

576000/40000 = Rs. 14.4

4. The leverages of three firms are given below. Which one of the combinations should be chosen

for the combined leverage to be maximum and what are the inferences?

A B C

Operating leverage 1.14 1.23 1.33

Financial leverage 1.27 1.3 1.33


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Solution: We should calculate the combined leverage to draw inferences. Combined leverage of

A is 1.14*1.27 = 1.45,

Combined leverage of B is 1.23*1.3 = 1.60,

Combined leverage of C is 1.33*1.33 = 1.77

We find that the combined leverage is highest for firm C and this suggests that this firm is working

under very high risky situation.

Terminal Questions 1. Mishra Ltd. provides the following information. What is the degree of operating leverage?

Output 100000 Units

Fixed costs Rs. 15000

Variable cost per unit Rs. 0.50

Interest on borrowed funds Rs. 10000

Selling price per unit Rs. 1.50

2. X Ltd. provides the following information. What is the degree of financial leverage?

Output 25000 units

Fixed costs Rs. 25000

Variable cost Rs. 2.50 per unit

Interest on borrowed funds Rs. 15000

Selling price Rs. 8 per unit

3. The following information is available in respect of 2 firms. Comment on their relative

performance through leverage

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


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4. ABC Ltd. provides the following information. Calculate the DFL.

Output 200000 units

Fixed costs Rs.3500

Variable cost Rs. 0.05 per unit

Interest on borrowed funds Nil

Selling price per unit 0.20


1. Operating leverage

2. Q(S—V)—F

3. Income levels

4. Preference shares

5. Trading on Equity


1. Hint DOL = F ) V S ( Q

) V S ( Q − −

−

2. Hint DFL = ) T 1 /( Dp I EBIT

EBIT − − −

3. Hint calculate DFL


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Unit 7 Capital Structure

Structure

7.1 Introduction

7.2 Features of Ideal Capital Structure

7.3 Factors Affecting Capital Structure

7.4 Theories of Capital Structure

7.4.1 Net Income Approach

7.4.2 Net Operating Income Approach

7.4.3 Traditional Approach

7.4.4 Miller and Modigliani Approach

7.4.4.1 Criticism of Miller and Modigliani Approach

7.5 Summary

Terminal Questions


7.1 Introduction The capital structure of a company refers to the mix of longterm finances used by the firm. In short, it

is the financing plan of the company. With the objective of maximizing the value of the equity shares,

the choice should be that pattern of using debt and equity in a proportion that will lead towards

achievement of the firm’s objective. The capital structure should add value to the firm. Financing mix

decisions are investment decisions and have no impact on the operating earnings of the firm. Such

decisions influence the firm’s value through the earnings available to the shareholders.

The value of a firm is dependent on its expected future earnings and the required rate of return. The

objective of any company is to have an ideal mix of permanent sources of funds in a manner that will

maximize the company’s market price. The proper mix of funds is referred to as Optimal Capital

Structure.

The capital structure decisions include debtequity mix and dividend decisions. Both these have an

effect on the EPS.


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1. Explain the features of ideal capital structure. 2. Name the factors affecting the capital structure. 3. Mention the various theories of capital structure.

7.2 Features of an Ideal Capital Structure

• Profitability: The firm should make maximum use of leverage at minimum cost.

• Flexibility: It should be flexible enough to adapt to changing conditions. It should be in a position

to raise funds at the shortest possible time and also repay the moneys it borrowed, if they appear

to be expensive. This is possible only if the company’s lenders have not put forth any conditions

like restricting the company from taking further loans, no restrictions placed on the assets usage

or laying a restriction on early repayments. In other words, the finance authorities should have the

power to take decisions on the basis of the circumstances warrant.

• Control: The structure should have minimum dilution of control.

• Solvency: Use of excessive debt threatens the very existence of the company. Additional debt

involves huge repayments. Loans with high interest rates are to be avoided however attractive

some investment proposals look. Some companies resort to issue of equity shares to repay their

debt for equity holders do not have a fixed rate of dividend.

7.3 Factors Affecting Capital Structure Leverage: The use of fixed charges sources of funds such as preference shares, loans from banks

and financial institutions and debentures in the capital structure is known as “trading on equity” or

“financial leverage”. Creditors insist on a debt equity ratio of 2:1 for medium sized and large sized

companies, while they insist on 3:1 ratio for SSI. Debt equity ratio is an indicator of the relative

contribution of creditors and owners. The debt component includes both long term and short term

debt and this is represented as Debt/Equity. A debt equity ratio of 2:1 indicates that for every 1 unit of

equity, the company can raise 2 units of debt. By normal standards, 2:1 is considered a healthy ratio,

but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 1.5:1 is

considered good for a manufacturing company while a ratio of 3:1 is good for heavy engineering


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companies. It is generally perceived that lower the ratio, higher is the element of uncertainty in the

minds of lenders.

Increased use of leverage increases commitments of the company, the outflows being in the nature

of higher interest and principal repayments, thereby increasing the risk of the equity shareholders.

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

• Cost of capital – High cost funds should be avoided however attractive an investment

proposition may look like, for the profits earned may be eaten away by interest repayments.

• Cash flow projections of the company – Decisions should be taken in the light of cash flows

projected for the next 35 years. The company officials should not get carried away at the

immediate results expected. Consistent lesser profits are any way preferable than high profits in

the beginning and not being able to get any after 2 years.

• Size of the company

• Dilution of control – The top management should have the entire flexibility to take appropriate

decisions at the right time. The capital structure planned should be one in this direction.

• Floatation costs – A company desiring to increase its capital by way of debt or equity will

definitely incur floatation costs. Effectively, the amount of money raised by any issue will be lower

than the amount expected because of the presence of floatation costs. Such costs should be

compared with the profits and right decisions taken.

7.4 Theories of Capital Structure As we are aware, equity and debt are the two important sources of longterm sources of finance of a

firm. The proportion of debt and equity in a firm’s capital structure has to be independently decided

case to case. A proposal though not being favourable to lenders may be taken up if they are

convinced with the earning potential and longterm benefits. Many theories have been propounded to

understand the relationship between financial leverage and firm value.

Assumptions

The following are some common assumptions made:

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

• There are no taxes – both corporate and personal.


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• The firm’s dividend payout ratio is 100%, that is, the firm pays off the entire earnings to its equity

holders and retained earnings are zero.

• The investment decisions of a company are constant, that is, the firm does not invest any further

in its assets.

• The operating profits EBIT are not expected to increase or decline.

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

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

costs.

• The life of the firm is indefinite.

Based on the above, we derive the following:

1. Debt capital being constant, Kd is the cost of debt which is the discount rate at which discounted

future constant interest payments are equal to the market value of debt, that is, Kd = I/B where, I

refers to total interest payments and B is the total market value of debt.

Therefore value of the debt B = I/Kd 2. Cost of equity capital Ke = (D1/P0) + g where D1 is dividend after one year, P0 is the current

market price and g is the expected growth rate.

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

where NI is the net income to equity holders and S is market value of equity shares.

4. The net operating income being constant, overall cost of capital is represented as K0 = W1K1 + W2K2. That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S market value of

equity and V total market value of the firm (B+S). The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, ( K1 being the debt component and Ke being the equity component) which can be expressed as K0 = I + NI/V or EBIT/V or in other words, net operating income/market value of firm.

7.4.1 Net Income Approach This theory is suggested by Durand and he is of the view that capital structure decision is relevant to

the valuation of the firm. Any change in the financial leverage will have a corresponding change in

the overall cost of capital and also the total value of the firm. As the ratio of debt to equity increases,

the WACC declines and market value of firm increases. The NI approach is based on 3 assumptions


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– no taxes, cost of debt less than cost of equity and use of debt does not change the risk perception

of investors.

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

The following graphical representation of net income approach may help us understand this better.

Example:

Given below are two firms A and B, which are identical in all aspects except the degree of

leverage employed by them. What is the average cost of capital of both firms?

Firm A Firm B Net operating income EBIT Rs. 100000 Rs. 100000 Interest on debentures I Nil Rs. 25000 Equity earnings E Rs. 100000 Rs. 80000 Cost of equity Ke 15% 15% Cost of debentures Kd 10% 10% Market value of equity S = E/Ke Rs. 666667 Rs. 533333 Market value of debt B Nil Rs. 250000 Total value of firm V Rs. 666667 Rs. 783333

Average Cost of capital of firm A is:

10% * 0/Rs. 666667 + 15% * 666667/666667 which is 15%

K0

Ke

Kd Percentage cost

Leverage B/S


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Average Cost of capital of firm B is: 10% * 25000/783333 + 15% * 533333/783333 which is 10.53% Interpretation: The use of debt has caused the total value of the firm to increase and the overall cost

of capital to decrease.

7.4.2 Net Operating Income Approach This theory is again propounded by Durand and is totally opposite of the Net Income Approach. He

says any change in leverage will not lead to any change in the total value of the firm, market price of

shares and overall cost of capital. The overall capitalization rate is the same for all degrees of

leverage. We know that: K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

As per the NOI approach the overall capitalization rate remains constant for all degrees of leverage.

The market values the firm as a whole and the split in the capitalization rates between debt and

equity is not very significant.

The increase in the ratio of debt in the capital structure increases the financial risk of equity

shareholders and to compensate this, they expect a higher return on their investments. Thus the cost

of equity is Ke = Ko +[ (Ko – Kd)(B/S)]

Cost of debt: The cost of debt has two parts – explicit cost and implicit cost. Explicit cost is the given rate of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can mean that the increasing proportion of debt does not affect the financial risk of lenders and they do not charge higher interest. Implicit cost is increase in Ke attributable to Kd. Thus the advantage of use of debt is completely neutralized by the implicit cost resulting in Ke and Kd being the same. Graphically this is represented as:


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Example:

Given below are two firms X and Y which are similar in all aspects except the degree of leverage

employed.

Firm A Firm B Net operating income EBIT Rs. 10000 Rs. 10000 Overall capitalization rate Ko 18% 18% Total market value V = EBIT/Ko 55555 55555 Interest on debt I Rs. 1000 Rs. 2000 Debt capitalization rate Kd 11% 11% Market value of debt B= I/Kd Rs. 9091 Rs. 18181 Market value of equity S=V—B Rs. 46464 Rs. 37374 Leverage B/S 0.1956 0.2140 The equity capitalization rates are Firm A = 9000/46464 which is 19.36% Firm B = 8000/37374 which is 21.40%

The equity capitalization rates can also be calculated with the formula Ke = Ko +[ (Ko – Kd)(B/S)] Firm A = 0.18 + [(0.18 – 0.11)(0.1956)] = 19.36% Firm B = 0.18 + [(0.18 – 0.11)(0.4865)] = 21.40%

Kd

Ko

Ke

Leverage B/S

Percentage cost


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7.4.3 Traditional Approach: The Traditional Approach has the following propositions: • Kd remains constant until a certain degree of leverage and thereafter rises at an increasing rate. • Ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very

sharply.

• As a sequence to the above 2 propositions, Ko decreases till a certain level, remains constant for moderate increases in leverage and rises beyond a certain point.

Graphically, we can represent these as under:

7.4.4 Miller and Modigliani Approach Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a

reasonable limit and Ko being constant at all degrees of leverage. They state that the relationship

between leverage and cost of capital is elucidated as in NOI approach. The assumptions for their

analysis are:

• Perfect capital markets: Securities can be freely traded, that is, investors are free to buy and

sell securities (both shares and debt instruments), there are no hindrances on the borrowings, no

presence of transaction costs, securities infinitely divisible, availability of all required information

at all times.

• Investors behave rationally, that is, they choose that combination of risk and return that is most

advantageous to them.

Ke

Ko

Kd

Percentage cost

Leverage B/S


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• Homogeneity of investors risk perception, that is, all investors have the same perception of

business risk and returns.

• Taxes: There is no corporate or personal income tax.

• Dividend payout is 100%, that is, the firms do not retain earnings for future activities.

Basic propositions: The following three propositions can be derived based on the above

assumptions: Proposition I: The market value of the firm is equal to the total market value of equity and total

market value of debt and is independent of the degree of leverage. It can be expressed as: Expected NOI

Expected overall capitalization rate V + (S+D) which is equal to O/Ko which is equal to NOI/Ko V + (S+D) = O/Ko = NOI/Ko

Where V is the market value of the firm,

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

D is the market value of the debt,

O is the net operating income,

Ko is the capitalization rate of the risk class of the firm.

Error!

Ke

Leverage D/V

Cost of capital

Ko


110

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

mechanism. Arbitrage is the process of buying a security at lower price in one market and selling it in

another market at a higher price bringing about equilibrium. This is a balancing act. Miller and

Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in

return buy shares of the firm whose value is lower. They will earn the same return at lower outlay and

lower perceived risk. Such behaviours are expected to increase the share prices whose shares are

being purchased and lowering the share prices of those share which are being sold. This switching

operation will continue till the market prices of identical firms become identical.

Proposition II: The expected yield on equity is equal to discount rate (capitalization rate) applicable

plus a premium. Ke = Ko +[(Ko—Kd)D/S] Proposition III: The average cost of capital is not affected by the financing decisions as investment

and financing decisions are independent.

7.4.4.1 Criticisms of MM Proposition Risk perception: The assumption that risks are similar is wrong and the risk perceptions of investors

are personal and corporate leverage is different. The presence of limited liability of firms in contrast

to unlimited liability of individuals puts firms and investors on a different footing. All investors lose if a

levered firm becomes bankrupt but an investor loses not only his shares in a company but would also

be liable to repay the money he borrowed. Arbitrage process is one way of reducing risks. It is more

risky to create personal leverage and invest in unlevered firm than investing in levered firms.

Convenience: Investors find personal leverage inconvenient. This is so because it is the firm’s

responsibility to observe corporate formalities and procedures whereas it is the investor’s

responsibility to take care of personal leverage. Investors prefer the former rather than taking on the

responsibility and thus the perfect substitutability is subject to question.

Transaction costs: Another cost that interferes in the system of balancing with arbitrage process is

the presence of transaction costs. Due to the presence of such costs in buying and selling securities,

it is necessary to invest a higher amount to earn the same amount of return.

Taxes: When personal taxes are considered along with corporate taxes, the Miller and Modigliani

approach fails to explain the financing decision and firm’s value.


111

Agency costs: A firm requiring loan approach creditors and creditors may sometimes impose

protective covenants to protect their positions. Such restriction may be in the nature of obtaining prior

approval of creditors for further loans, appointment of key persons, restriction on dividend payouts,

limiting further issue of capital, limiting new investments or expansion schemes etc.


1. Financing mix decisions are _______________and have no impact on the _____________of the

firm.

2. The value of a firm is dependent on its _____________and the ________.

3. _________ and _______are two important sources of longterm sources of finance of a firm.

4. As the ratio of debt to equity increases, the ________declines and _____________of firm

increases.

5. As per the NOI approach the ____________remains constant for all degrees of leverage.

6. ________is the process of buying a security at lower price in one market and selling it in another

market at a higher price bringing about _______.

7.5 Summary According to the NI Approach, overall cost of capital continuously decreases as and when debt goes

up in the capital structure. Optimal capital structure exists when the firm borrows maximum.

NOI Approach believes that capital structure is not relevant. Ko is dependent business risk which is

assumed to be constant.

Traditional Approach tells us that Ko decreases with leverage in the beginning, reaches its maximum

point and further increases.

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

Terminal Questions

1. What are the assumptions of MM approach?

2. The following data are available in respect of 2 firms. What is the average cost of capital?

Firm A Firm B

Net operating income Rs. 500000 Rs. 500000

Interest on debt Nil Rs. 50000

Equity earnings Rs. 500000 Rs. 450000


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Cost of equity capital 15% 15%

Cost of debt Nil 10%

Market value of equity shares Rs. 2000000 Rs.1400000

Market value of debt Nil Rs. 400000

Total value of firm Rs. 2000000 Rs. 1800000

3. Two companies are identical in all respects in all aspects except the debt equity profile. Company

X has 14% debentures worth Rs. 2500000 whereas company Y does not have any debt. Both

companies earn 20% before interest and taxes on their total assets of Rs. 5000000. Assuming a

tax rate of 40%, and cost of equity capital to be 22%, what is the value of the company X and Y

using Net operating income approach?

4. The market value of debt and equity of a firm are Rs. 10 cr and Rs. 20 Cr. respectively and their

respective costs are 12% and 14%. The overall capital is 13%. Assuming the company has a

100% dividend payout ratio and there are no taxes, calculate the net operating income of the

firm.

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

worth Rs. 50 lakhs, calculate the WACC.

Answers to Self Assessment Questions Self Assessment Questions

1. Investment decisions, operating earnings

2. Expected future earnings, required rate of return

3. Equity; debt

4. WACC; market value

5. Overall capitalization rate

6. Arbitrage; equilibrium


1. Refer to 6.4.4 2, 3, 4. K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

5. WACC = WeKe + WpKp +WrKr + WdKd + WtKt

Hint: We=0.4 ; Wd=0.533 ; W t=0.067


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Unit 8 Capital Budgeting

Structure

8.1. Introduction

8.2. Importance of Capital budgeting

8.3. Complexities involved in Capital budgeting decisions

8.4. Phases of Capital expenditure decisions

8.5. Identification of investment opportunities

8.6. Rationale of Capital budgeting proposals

8.7. Capital Budgeting process

8.7.1 Technical appraisal

8.7.2 Economic Appraisal

8.8. Investment Evaluation

8.9. Appraisal criteria

8.9.1 Traditional techniques

8.9.2 Discounted pay back period

8.10. Summary

Terminal Questions


8.1 Introduction HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over Bank of Madurai. The

motive behind all these mergers is to grow because in this era of globalization the need of the

hour is to grow as big as possible. In all these, one could observe that the desire of the

management to create value for shareholders is the motivating force.

Another way of growing is through branch expansion, expanding the product mix and reducing

cost through improved technology for deeper penetration into the market for the company’s

products. For example, a bank which is urban based, for expansion takes over a bank with rural

network. Here urban based bank can open more urban branches only when it meets the Reserve

Bank of India guideline of having a minimum number of rural branches. This is the motive for the

merger of urban based bank of ICICI with the rural based Bank of Madurai.


114

In this competitive arena proactive organization makes attempts to convert challenges into

opportunities. Indian economy is growing at 9%. It has far reaching implications. New lines of

business such as retailing, investment advisory services and private banking are emerging. All

these involve investment decisions. These investment decisions that corporates take to reap the

benefits arising out of the emerging business opportunities are known as Capital Budgeting

decisions. Capital budgeting decisions involve evaluation of specific investment proposals. Here

the word capital refers to the operating assets used in production of goods or rendering of

services. Budgeting involves formulating a plan of the expected cash flows during the future

period. When we combine Capital with budget we get Capital budget. Capital budget is a blue

print of planned investments in operating assets. Therefore, Capital budgeting is the process of

evaluating the profitability of the projects under consideration and deciding on the proposal to be

included in the Capital budget for implementation. Capital budgeting decisions involve investment

of current funds in anticipation of cash flows occurring over a series of years in future. All these

decisions are Strategic because they change the profile of the organizations. Successful

organizations have created wealth for their shareholders through Capital budgeting decisions.

Investment of current funds in longterm assets for generation of cash flows in future over a series

of years characterizes the nature of Capital Budgeting decisions.



1. Explain the concept of capital budgeting.

2. Bring out the importance of capital budgeting.

3. Examine the complexity of capital budgeting procedures.

4. Discuss the various techniques of appraisal methods.

5. Evaluate capital budgeting decision

8.2 Importance of Capital budgeting Capital budgeting decisions are the most important decisions in Corporate financial management.

These decisions make or mar a business organization. These decisions commit a firm to invest

its current funds in the operating assets (i,e longterm assets) with the hope of employing them

most efficiently to generate a series of cash flows in future.

These decisions could be grouped into


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1. Replacement decisions: These decisions may be decision to replace the equipments for

maintenance of current level of business or decisions aiming at cost reductions.

2. Decisions on expenditure for increasing the present operating level or expansion through

improved network of distribution.

3. Decisions for products of new goods or rendering of new services.

4. Decisions on penetrating into new geographical area.

5. Decisions to comply with the regulatory structure affecting the operations of the company.

Investments in assets to comply with the conditions imposed by Environmental Protection Act

come under this category.

6. Decisions on investment to build township for providing residential accommodation to

employees working in a manufacturing plant.

There are many reasons that make the Capital budgeting decisions the most crucial for finance

managers

1. These decisions involve large outlay of funds now in anticipation of cash flows in future. For

example, investment in plant and machinery. The economic life of such assets has long

periods. The projections of cash flows anticipated involve forecasts of many financial

variables. The most crucial variable is the sales forecast.

a. For example, Metal Box spent large sums of money on expansion of its production

facilities based on its own sales forecast. During this period, huge investments in R & D in

packaging industry brought about new packaging medium totally replacing metal as an

important component of packing boxes. At the end of the expansion Metal Box Ltd found

itself that the market for its metal boxes had declined drastically. The end result is that

Metal Box became a sick company from the position it enjoyed earlier prior to the

execution of expansion as a blue chip. Employees lost their jobs. It affected the standard

of lining and cash flow position of its employees.

This highlights the element of risk involved in these type of decisions.

b. Equally we have empirical evidence of companies which took decisions on expansion

through the addition of new products and adoption of the latest technology creating wealth

for shareholders. The best example is the Reliance group.

c. Any serious error in forecasting Sales and hence the amount of capital expenditure can

significantly affect the firm. An upward bias may lead to a situation of the firm creating idle

capacity, laying the path for the cancer of sickness.


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d. Any downward bias in forecasting may lead the firm to a situation of losing its market to its

competitors. Both are risky fraught with grave consequences.

2. A long term investment of funds some times may change the risk profile of the firm. A FMCG

company with its core competencies in the business decided to enter into a new business of

power generation. This decision will totally alter the risk profile of the business of the

company. Investor’s perception of risk of the new business to be taken up by the company

will change his required rate of return to invest in the company. In this connection it is to be

noted that the power pricing is a politically sensitive area affecting the profitability of the

organization. Therefore, Capital budgeting decisions change the risk dimensions of the

company and hence the required rate of return that the investors want.

3. Most of the Capital budgeting decisions involve huge outlay. The funds requirements during

the phase of execution must be synchronized with the flow of funds. Failure to achieve the

required coordination between the inflow and outflow may cause time over run and cost over

run. These two problems of time over run and cost over run have to be prevented from

occurring in the beginning of execution of the project. Quite a lot empirical examples are

there in public sector in India in support of this argument that cost over run and time over run

can make a company’s operations unproductive. But the major challenge that the

management of a firm faces in managing the uncertain future cash inflows and out flows

associated with the plan and execution of Capital budgeting decisions.

4. Capital budgeting decisions involve assessment of market for company’s products and

services, deciding on the scale of operations, selection of relevant technology and finally

procurement of costly equipment. If a firm were to realize after committing itself considerable

sums of money in the process of implementing the Capital budgeting decisions taken that the

decision to diversify or expand would become a wealth destroyer to the company, then the

firm would have experienced a situation of inability to sell the equipments bought. Loss

incurred by the firm on account of this would be heavy if the firm were to scrap the

equipments bought specifically for implementing the decision taken. Sometimes these

equipments will be specialized costly equipments. Therefore, Capital budgeting decisions are

irreversible.

5. The most difficult aspect of Capital budgeting decisions is the influence of time. A firm incurs

Capital expenditure to build up capacity in anticipation of the expected boom in the demand

for its products. The timing of the Capital expenditure decision must match with the expected

boom in demand for company’s products. If it plans in advance it may effectively manage the


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timing and the quality of asset acquisition. But many firms suffer from its inability to forecast

the future operations and formulate strategic decision to acquire the required assets in

advance at the competitive rates.

6. All Capital budgeting decisions have three strategic elements. These three elements are

cost, quality and timing. Decisions must be taken at the right time which would enable the

firm to procure the assets at the least cost for producing the products of required quality for

customer. Any lapse on the part of the firm in understanding the effect of these elements on

implementation of Capital expenditure decision taken will strategically affect the firm’s

profitability.

7. Liberalization and globalization gave birth to economic institutions like World Trade

organization. General Electrical can expand its market into India snatching the share already

enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of G E to sell its

products in India at a rate less than the rate at which Indian Companies sell cannot be

ignored. Therefore, the growth and survival of any firm in today’s business environment

demands a firm to be proactive. Proactive firms cannot avoid the risk of taking challenging

Capital budgeting decisions for growth.

Therefore, Capital budgeting decisions for growth have become an essential characteristics of

successful firms today.

8. The social, political, economic and technological forces generate high level of uncertainty in

future cash flows streams associated with Capital budgeting decisions. These factors make

these decisions highly complex.

9. Capital expenditure decisions are very expensive. To implement these decisions firm’s will

have to tap the Capital market for funds. The composition of debt and equity must be optimal

keeping in view the expectation of investors and risk profile of the selected project.


1. ______________ make or mar a business.

2. _____ decisions involve large outlay of funds now in anticipation of cash inflows in future.

3. Social, political, economic and technological forces make capital budgeting decisions

________________.

4. ________ are very expensive.


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8.3 Complexities involved in Capital budgeting decisions Capital expenditure decision involves forecasting of future operating cash flows. Such forecasting

suffers from uncertainty because the future is highly uncertain. Forecasting the future cash flows

demands the necessity to make certain assumptions about the behaviour of costs and revenues

in future. Fast changing environment makes the technology considered for implementation many

times obsolete. For example, the arrival of mobile revolution totally made the pager technology

obsolete. The firm’s which invested in pagers faced the problem of pagers losing its relevance as

a means of communication. The firms with the ability to adapt the new knowhow in mobile

technology could survive the effect of this phase of technological obsolescence. Others who

could not manage the effect of change in technology had a natural death and so most Capital

expenditure decisions are irreversible. Estimation of future cash flows of Capital budgeting

decisions is really complex and difficult commitment of funds on long term basis along with the

associated problem of irreversibility of decisions and difficulty in estimating cash flows makes

Capital expenditure decisions complex in nature.

Self Assessment Questions 2 1. Capital expenditure decisions are ____________.

2. Forecasting of future operating cash flows suffers from ____ because the future is

____________________.

8.4 Phases of Capital expenditure decisions: The following steps are involved in Capital budgeting decisions:

1. Identification of investment opportunities.

2. Evaluation of each investment proposal.

3. Examine the investments required for each investment proposal.

4. Prepare the statements of Costs and benefits of investment proposals.

5. Estimate and compare the net present values of the investment proposals that have been

cleared by the management on the basis of screening criteria.

6. Examine the government policies and regulatory guidelines to be observed for execution of

each investment proposal screened and cleared based on the criteria stipulated by the

management.

7. Budgeting for capital expenditure for approval by the management.

8. Implementation.

9. Post_ completion audit.


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1. Postcompletion audit is _____ in the phases of capital budgeting decisions.

2. Identification of investment opportunities is the ______ in the phases of capital budgeting

decisions.

8.5 Identification of investment opportunities: A firm is in a position to identify investment proposal only when it is responsive to the ideas for

capital projects emerging from various levels of the organization. The proposal may be adding

new products to the company’s product line, expansion of capacity to meet the emerging market

at demand for company’s products to meet the emerging market demand for company’s product

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

For example, a sales manager may come with a proposal to produce a new product as per the

requirements of company’s consumers. Marketing manager, based on the sales managers

proposal may conduct a market survey to determine the expected demand for the new product

under consideration. Once the marketing manager is convinced of the market potential for

proposed new product the proposal goes to the engineers to examine the same with all aspects

of production process. Then the proposal goes to the cost accountant to translate the entire

gamut of the proposal into costs and revenues in terms of incremental cash flows both outflows

and inflows. The costbenefit statement generated by cost accountant shall include all

incremental costs and benefits that the firm will incur and derive on commercialization of the

proposal under consideration. Therefore, generation of ideas with the feasibility to convert the

same into investment proposals occupies a crucial place in the Capital budgeting decisions.

Proactive organizations encourage a continuous flow of investment proposals from all levels in

the organization.

In this connection following deserves to be considered:

1. Market Characteristics: Analysing the demand and supply conditions of the market for the

company’s product could be a fertile source of potential investment proposals.

2. Various reports submitted by production engineers coupled with the information obtained

through market surveys on customer’s perception of company’s product could be a potential

investment proposal to redefine the company’s products in terms of customer’s expectations.

3. Companies which invest in Research and Development constantly get exposure to the benefit

of adapting the new technology quite relevant to keep the firm competitive in the most

dynamic business environment. Reports emerging from R & D section could be a potential

source of investment proposal.


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4. Economic growth of the country and the emerging middle class endowed with purchasing

power could generate new business opportunities to existing firms. These new business

opportunities could be potential investment ideas.

5. Public awareness of their rights compels many firm’s to initiate projects from environmental

protection angle. If ignored, the firm may have to face the public wrath through PILs

entertained at the Supreme court and High courts.

Therefore, project ideas that would improve the competitiveness of the firm by constantly

improving the production process with the sole objective of cost reduction and costumer

welfare are accepted by wellmanaged firms.

Therefore, generation of ideas for capital projects and screening the same can be considered

the most crucial phase of Capital budgeting decisions.


1. Analyzing the demand and supply conditions of the market for the company’s products could

be________ of potential investment proposal.

2. Generation of ideas for capital budgets and screening the same can be considered

__________ of capital budgetary decisions.

8.6 Rationale of Capital budgeting proposals: The investors and stake holders expect a firm to function efficiently to satisfy their expectations .

Through the stake holder’s expectation of the performance of the company may clash among

themselves, the one that touches all these stakeholder’s expectation could be visualized in terms

of the firms obligation to reduce the operating costs on a continuous basis and increasing its

revenues. These twin obligations of a firm form the basis of all Capital budgeting decisions.

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

1. Decisions on cost reduction programmes.

2. Decisions on revenue generation through expansion of installed capacity.

Self Assessment Questions 5 1. _________ decisions could be grouped into two categories.

2. ____________ and revenue generation are the two important categries of capital budgeting.

8.7 Capital Budgeting process: Once the screening of proposals for potential involvement is over the next. The company should take up the following aspects of Capital Budgeting process.


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1. Commercial: A proposal should be commercially viable. The following aspects are

examined to ascertain the commercial viability of any investment proposal.

a. Market for the product

b. Availability of raw materials

c. Sources of raw materials

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

selection.

2. Infrastructural facilities such as roads, communications facilities, financial services such as

banking, public transport services.

Among the aspects mentioned above the crucial one is the need to ascertain the demand for

the product or services. It is done by market appraisal. In appraisal of market for the new

product, the following details are compiled and analyzed.

a. Consumption trends.

b. Competition and players in the market

c. Availability of substitutes

d. Purchasing power of consumers

e. Regulations stipulated by Government on pricing the proposed products or services

f. Production constraints: Relevant forecasting technologies are employed to get a realistic

picture of the potential demand for the proposed product or service. Many projects fail to

achieve the planned targets on profitability and cash flows if the firm could not succeed in

forecasting the demand for the product on a realistic basis.

8.7.1 Technical appraisal: This appraisal is done to ensure that all technical aspects of the implementation of the project are considered.

The technical examination of the project considers the following:

a. Selection of process know how

b. Decision on determination of plant capacity

c. Selection of plant and equipment and scale of operation

d. Plant design and layout

e. General layout and maternal flow

f. Construction schedule

8.7.2 Economic Appraisal: This appraisal examines the project from the social point of

view. It is also known as social cost benefit analysis. It examines:


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g. The impact of the project on the environment

h. The impact of the project on the income distribution in the society.

i. The impact of the project on fulfillment of certain social objective like generation of

employment, attainment of self sufficiency etc.

j. Will it materially alter the level of savings and investment in the society?

3. Financial appraisal: This appraisal is to examine the financial viability of the project. It assesses the risk and returns at various stages of project execution. Besides, it examines

whether the risk adjusted return from the project exceeds the cost of financing the project.

The following aspects are examined in the process of evaluating a project in financially terms.

a. Cost of the project

b. Investment outlay

c. Means of financing and the cost of capital

d. Expected profitability

e. Expected incremental cash flows from the project

f. Breakeven point

g. Cash break even point

h. Risk dimensions of the project

i. Will the project materially alter the risk profile of the company ?

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

k. Tax holiday benefits, if any


1. ______________ examines the project from the social point view.

2. All technical aspects of the implementation of the project are considered in _____.

3. ___ of a project is examined by financial appraisal.

4. Among the elements that are to be examined under commernal appraised the most crucial

one is the _________________.

8.8 Investment Evaluation: following steps are involved in the evaluation of any investment proposal:

1. Estimates of Cash flows both inflows and outflows occurring at different stages of project life

cycle.

2. Examination of the risk profile of the project to be taken up and arriving at the required rate of

return


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3. Formulating the decision criteria.

Estimation of Cash flows: Estimating the cash flows associated with the project under

consideration is the most difficult and crucial step in the evaluation of an investment proposal. It

is the result of the team work of many professionals in an organization.

1. Capital outlays are estimated by engineering departments after examining all aspects of

production process.

2. Marketing department on the basis of market survey forecasts the expected sales revenue

during the period of accrual of benefits from project executions.

3. Operating costs are estimated by cost accountants and production engineers

4. Incremental cash flows and cash out flow statement is prepared by the cost accountant on the

basis of the details generated in the above steps. The ability of the firm to forecast the cash

flows with reasonable accuracy lies at the root of the success of the implementation of any

capital expenditure decision.

Investment (Capital budgeting) decision required the estimation of incremental cash flow

stream over the life of the investment. Incremental cash flows are estimated on after tax

basis.

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

1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is determined after considering any post tax cash inflows if any, In replacement decisions existing old machinery

is disposed of and a new machinery incorporating the latest technology is installed in its

place. On disposal of existing old machinery the firm has a cash inflow. This cash inflow has

to be computed on post tax basis. The net cash out flow (total cash required for investment in

capital assets minus post tax cash inflow on disposal of the old machinery being replaced by

a new one) therefore is the incremental cash outflow. Additional net working capital required

on implementation of new project is to be added to initial investment.

2. Operating Cash inflows: Operating Cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over

the life of the project. Here also incremental inflows and outflows attributable to operating

activities are considered. Any savings in cost on installation of a new machinery in the place

of the old machinery will have to be accounted to on post tax basis. In this connection

incremental cash flows refer to the change in cash flows on implementation of a new proposal

over the existing positions.


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3. Terminal Cash inflows: At the end of the economic life of the project, the operating assets

installed now will be disposed off. It is normally known as salvage value of equipments. This

terminal cash inflows is computed on post tax basis.

Prof. Prasanna Chandra in his book Financial Management has identified certain basic

principles of cash flow estimation. The knowledge of these principles will help a student in

understanding the basis of computing incremental cash flows.

These principles, as given by Prof. Prasanna Chandra are:

a. Separation principle

b. Incremental principle

c. Post tax principle

d. Consistency principle

a. Separation principle: The essence of this principle is the necessity to treat investment element of the project separately (i,e independently) from that of financing element. The

financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of

return expected on implementation of the project is compared with the cost of capital. Therefore,

we compute separately cost of funds for execution of project through the financing mode. The

rate of return expected on implementation if the project is arrived at by the investment profile of

the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows.

The following formulae is used to calculate profit after tax.

Incremental PAT = Incremental EBIT ( 1t )

(Incremental) (Incremental)

EBIT = Earnings (Profit) before interest and taxes.

t = tax rate

EBIT infact represents incremental earnings before interest and tax

When depreciation charges on computing incremental post tax profit is added back to incremental

profit after tax, we get incremental operating cash inflow.

b. Incremental principle: Incremental principle says that the cash flows of a project are to

be considered in incremental terms. Incremental cash flows are the changes in the firms

total cash flows arising directly from the implementation of the project.

The following are to be kept in mind in determining incremental cash flows.

1. Ignore Sunk costs: A sunk cost means an outlay already incurred. It is not a relevant cost

for the project decisions to be taken now. It is ignored when the decisions on project now

under consideration is to be taken.


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2. Opportunity Costs: If the firm already owns an asset or resource which could be used in the

execution of the project under consideration the asset or resource has an opportunity cost.

The opportunity of cost of such resources will have to be taken into account in the evaluation

of the project for acceptance or rejection. For example, the firm wants to open a branch in

Chennai for expansion of its market in Tamil Nadu. The firm already owns a building in

Chennai. The building in Chennai is let out to some other firm on an annual rent of Rs.1

Crore. The firm takes a decision to open a brands at Chennai. For opening the branch at

Chennai the firm uses the building it owns by sacrificing the rental income which it receives

now. The opportunity cost of the building at Chennai is Rs.1 crores. This will have to be

considered in arriving at the operating cash flows associated with the decision to open a

branch at Chennai.

3. Need to take into account all incident effect: Effects of a project on the working of other parts of a firm also known as externalities must be taken into account. For example,

expansion or establishment of a branch at a new place may increase the profitability of

existing branches because the branch at the new place has a complementary relationship

with the other existing branches or reduce the profitability of existing branches because the

branch at the new place competes with the business of other existing branches or takes away

some business activities from the existing branches.

Cannibalization: Another problem that a firm faces on introduction of a new product is the

reduction in the sale of an existing product. This is called cannibalization. The most challenging

task is the handling of problems of cannibalization. Depending on the company’s position with

that of the competitors in the market, appropriate strategy has to follow. Correspondingly the

cost of cannibalization will have to be treated either as revelent cost of the decision or ignored.

Product cannibalization will affect the company’s sales if the firm is marketing its products in a

market characterized by severe competition, without any entry barriers.

In this case costs are not relevant for decision. On the other hand if the firm’s sales are not

affected by competitor’s activities due to certain unique protection that it enjoys on account of

brand positioning or patent protection the costs of cannibalization cannot be ignored in taking

decisions

c.Post Tax Principle: all cash flows should be computed on post tax basis d. Consistency principle: cash flows and discount rates used in project evaluation need to consistent with the investor group and inflation.


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In capital budgeting, the cash flows applicable to all investors (i.e equity, preference share

holders and debt holders) and weighted average cost of capital are considered. Nominal cash

flows and nominal discounts are considered in capital budgeting decision. Example (illustration) A firm considering replacement of its existing machine by a new machine. The new machine will

cost Rs 1,60,000 and have a life of five years. The new machine will yield annual cash revenue

of Rs 2,50,000 and incur annual cash expenses of Rs 1,30,000. The estimated salvage of the

new machine at the end of its economic life is Rs 8,000. The existing machine has a book value

of Rs 40,000 and can be sold for Rs 20,000. The existing machine, if used for the next five years

is expected to generate annual cash revenue of Rs 2,00,000 and to involve annual cash

expenses of Rs 1,40,000. If sold after five years, the salvage value of the existing machine will

be negligible.

The company pays tax at 30%. It writes off depreciation act 25% on the written down value. The

company’s lost of capital is 20%

Compute the incremental cash flows of replacement decisions.

Solution:

Initial Investment:

Gross investment for the new machine (1,60,000)

Less: Cash received from the sale of

Existing machine 20,000

Net cash out lay (1,40,000)

Annual Cash flows from operations

Incremental cash flows from revenue 50,000

Incremental decrease in expenditure (10,000)

Incremental Depreciation Schedule

Year Depreciation (New Machine (Rs.)

Depreciation (Old Machine)

Incremental Depreciation (Rs.)

1 45,000 10,000 35,000

2 33,750 7,500 26,250

3 25,312 5,625 19,687


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4 18,984 4,219 14,765

5 14,238 3,164 11,074

Depreciation is calculated as under

Book Value 40,000

Add: Cost of new machine 1,60,000

2,00,000

Less: Sale proceeds of Old Machine 20,000

1,80,000

Depreciation for I year 25 % 45,000

1,35,000

Depreciation for II year 25% 33,750

1,01,250

Depreciation for III year 25% 25,312

75,938

Depreciation for IV year 25% 18,984

56,954

Depreciation for V year 25% 14,238

Book value after 5 years 42,716

Statement of incremental Cash flows

Particulars Year

0 Rs 1 Rs 2 Rs 3 Rs 4 Rs 5 Rs

1. Investment in new

machine

(1,60,000)

2. After tax salvage value

of old machine

20,000

3. Net Cash Out lay (1,40,000)


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4. Increase in revenue 50,000 50,000 50,000 50,000 50,000

5. Decrease in expenses 10,000 10,000 10,000 10,000 10,000

6. Increase in depreciation 35,000 26,250 19,687 14,765 11,074

7. Increase in EBIT 25,000 33,750 40,313 45,235 48,926

8. EBIT (1 – T) 17,500 23,625 28,219 31,665 34,248

9. Incremental Cash flows

from operation (8 + 6)

52,500 49,875 47,906 46,430 45,322

10. Salvage value of new

machine

8,000

11. Incremental Cash

flows

(1,40,000)

negative

52,500 49,875 47,906 46,430 53,322

The following points to be kept in deciding on the appraisal technique:

1. Appraisal technique should measure the economic worth of the project.

2. Wealth maximization of share holders shall be the guiding principle.

3. It shall consider all cash flows over the entire life of the project to ascertain the profitability of

the project.

4. It shall rank the projects on a scientific basis.

5. It should ensure an accepted criterion when faced with the need to select from among the

projects which are mutually exclusive so as to make a correct choice.

6. It should recognize the fact that initial higher cash flows are to be preferred to smaller ones.

7. Earlier cash flows are preferred to that occurring later.

Self Assessment Questions 7 1. Formulating _ is the third step in the evaluation of investment proposal.

2. A _____________ is not a relevant cost for the project decision.

3. Effect of a project on the working of other parts of a firm is know as ________.

4. The essence of separation principle is the necessity to treat ________ of a project separately

from that of ________.

5. Payback period ________ time value of money.

6. IRR gives a rate of return that reflects the __ the project.


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8.9 Appraisal Criteria: The methods of appraising an investment proposal can be grouped into

1. Traditional methods.

2. Modern methods.

Traditional Method are:

i. Payback method.

ii. Accounting Rate of Return.

Modern techniques are:

a. Net present value.

b. Internal Rate of Rate.

c. Modified internal rate of return.

d. Profitability index.

8.9.1 Traditional Techniques: a. Payback method: payback period is defined as the length of time required to recover the

initial cash out lay.

Example: The following details are available in respect of the cash flows of two projects A & B

Year Project A Project B

Cash flows (Rs.) Cash flows (Rs.)

0 (4,00,000) (5,00,000)

1 2,00,000 1,00,000

2 1,75,000 2,00,000

3 25,000 3,00,000

4 2,00,000 4,00,000

5 1,50,000 2,00,000

Compute pay back period for A and B Solution:

Year Project A Project B

Cash flows (Rs.) Cumulative

Cash flows

Cash flows (Rs.) Cumulative

Cash flows

1 2,00,000 2,00,000 1,00,000 1,00,000

2 1,75,000 3,75,000 2,00,000 3,00,000


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3 25,000 4,00,000 3,00,000 6,00,000

4 2,00,000 6,00,000 4,00,000 10,00,000

5 1,50,000 7,50,000 2,00,000 12,00,000

From the cumulative cash flows column project A recovers the initial cash outlay of Rs

4,00,000 at the end of the third year. Therefore, payback period of project A is 3 years.

From the cumulative cash flow column the initial cash outlay of Rs 5,00,000 lies between

2 nd year and 3 rd year in respect of project B. Therefore, payback period for project B is:

5,00,000 3,00,000

3,00,000

= 2.67 years

Evaluation of payback period: Merits:

1. Simple in concept and application.

2. Since emphasis is on recovery of initial cash outlay it is the best method for evaluation of

projects with very high uncertainty.

3. With respect to accept or reject criterion pay back method favors a project which is less than

or equal to the standard pay back set by the management. In this process early cash flows

get due recognition than later cash flows. Therefore, pay back period could be used as a tool

to deal with the ranking of projects on the basis of risk criterion.

4. For firms with shortage funds this is preferred because it measures liquidity of the project. Demerits:

1. It ignores time value of money.

2. It does not consider the cash flows that occur after the pay back period.

3. It does not measure the profitability of the project.

4. It does not throw any light on the firm’s liquidity position but just tells about the ability of the

project to return the cash out lay originally made.

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

maximization goal of the firm. Accept or reject criterion:

a. If projects are mutually exclusive, select the project which has the least pay back period.

b. In respect of other projects, select the project which have pay back period less than or equal

to the standard pay back stipulated by the management. Illustration:

2 +


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Following details are available

Pay back period:

Project A = 3 years

Project B = 2.5 years

Standard set up by management = 3 years

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

If projects are not mutually exclusive, accept both the project because both have pay back period

less than or equal to original to the standard pay back period set by the management

Pay back period formula

Year Prior to full recovery + Balance of initial out lay to be recovered

Of initial out lay at the beginning of the year in which full

Recovery takes place

Cash in flow of the year in which full recovery

takes place

8.9.2 Discounted Pay Back Period: The length in years required to recover the initial cash out lay on the present value basis is called

the discounted pay back period. The opportunity cost of capital is used for calculating present

values of cash inflows.

Discounted pay back period for a project will be always higher than simple pay back period

because the calculation of discounted pay back period is based on discounted cash flows.

For example:

Year Project A Cash flows

PV factor at 10 %

PV of Cash flows

Cumulative positive Cash flows

0 (4,00,000) 1 (4,00,000)

1 2,00,000 0.909 1,81,800 1,81,800

2 1,75,000 0.826 1,44,550 3,26,350

3 25,000 0.751 18,775 3,45,125

4 2,00,000 0.683 1,36,600 4,81,725

5 1,50,000 0.621 93,150 5,74,875

Discounted Pay back period:


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4,00,000 3,45,125

1,36,600 = 3.4 years

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

statements:

Average income

Average investment

Average of post tax operating profits

Average investment

Average investment =

Book value of the investment + Book value of investment at the end of

In the beginning the life of the project or investment

2 Illustration: The following particular refer to two projects :

X Y

Cost 40,000 60,000

Estimated life 5 years 5 years

Salvage value Rs.3,000 Rs.3,000

Estimate income

After tax

Rs Rs

1 3,000 10,000

2 4,000 8,000

3 7,000 2,000

4 6,000 6,000

5 8,000 5,000

Total 28,000 31,000

Average 5,600 6,200

3 +

ARR =

=


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Average investment 21,500 31,500

ARR 5,600 6,200

21,500 31,500

= 26 % 19.7%

Merits of Accounting rate of return: 1. It is based on accounting information.

2. Simple to understand.

3. It considers the profits of entire economic life of the project.

4. Since it is based on accounting information the business executives familiar with the

accounting information under stand this technique. Demerits:

1. It is based on accounting income and not based on cash flows, as the cash flow approach is

considered superior to accounting information based approach.

2. It does not consider the time value of money.

3. Different investment proposals which require different amounts of investment may have the

same accounting rate of return. The ARR fails to differentiate projects on the basis of the

amount required for investment.

4. ARR is based on the investment required for the project. There are many approaches for the

calculation of denominator of average investment. Existence of more than one basis for

arriving at the denominator of average investment may result in adoption of many arbitary

bases.

Because of this the reliability of ARR as a technique of appraisal is reduced when two projects

with the same ARR but with differing investment amounts are to be evaluated. Accept or reject criterion:

Any project which has an ARR more the minimum rate fixed by the management is accepted. If

actual ARR is less than the cuff rate (minimum rate specified by the management ) then that

project is rejected). When projects are to be ranked for deciding on the allocation of capital on

account of the need for capital rationing, project with higher ARR are preferred to the ones with

lower ARR.


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Discounted cash flow method:

Discounted cash flow method or time adjusted technique is an improvement over the traditional

techniques. In evaluation of the projects the need to give weight age to the timing of return is

effectively considered in all DCF methods. DCF methods are cash flow based and take the

cognizance of both the interest factors and cash flow after the pay back period.

DCF technique involves the following. 1. Estimation of cash flows, both inflows and outflows of a project over the entire life of the

project.

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

3. Sum of the present value of cash outflows is deducted from the sum of present value of cash

inflows to arrive at net present value of cash flows, the most popular techniques of DCF

methods.

DCF methods are of 3 types:

1. The net present value.

2. The internal rate of return.

3. Profitability index.

The net present value: NPV method recognizes the time value of money. It correctly admits that cash flows occurring at

different time periods differ in value. Therefore, there is the need to find out the present values of

all cash flows.

NPV method is the most widely used technique among the DCF methods.

Steps involved in NPV method:

1. Forecast the cash flows, both inflows and outflows of the projects to be taken up for

execution.

2. Decisions on discount factor or interest factor. The appropriate discount rate is the firms cost

of capital or required rate of return expected by the investors.

3. Compute the present value of cash inflows and outflows using the discount factor selected.

4. NPV is calculated by subtracting the PV of cash outflows from the present value of cash

inflows.

Accept or reject criterion:

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

rejected.


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Accept or reject criterion can be summarized as given below:

1. NPV > Zero = accept

2. NPV < Zero = reject

NPV method can be used to select between mutually exclusive projects by examining whether

incremental investment generates a positive net present value.

Merits of NPV method: 1. It takes into account the time value of money.

2. It considers cash flows occurring over the entire life of the project.

3. NPV method is consistent the goal of maximizing the net wealth of the company.

4. It analyses the merits of relative capital investments.

5. Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project generates

profits from the investment made for it. Demerits:

1. Forecasting of cash flows in difficult as it involves dealing with the effect of elements of

uncertainties on operating activities of the firm.

2. To decide on the discounting factor, there is the need to assess the investor’s required rate of

return But it is not possible to compute the discount rate precisely.

3. There are practical problems associated with the evaluation of projects with unequal lives or

under funds constraints.

For ranking of projects under NPV approach the project with the highest positive NPV is

preferred to that with lower NPV.

Example: A project t costs Rs.25000 and is expected to generate cash in flows as Year Cash in flows

1 10,000

2 8,000

3 9,000

4 6,000

5 7,000

The cost of capital is 12 %. The present value factors are:

Year PV factor at 12 %

1 0.893

2 0.797

3 0.712


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4 0.636

5 0.567

Compute the NPV of the project

Solution:

Year Cash flows PV factor at 12

%

PV of Cash

flows

1 10,000 0.893 8,930

2 8,000 0.797 6,376

3 9,000 0.712 6,408

4 6,000 0.636 3,816

5 7,000 0.567 3,969

29,499

Sum of the present value of cash inflows

Less: Sum of the present value of cash outflows 25,500

NPV 4,499

The project generates a positive NPV of Rs.4499. Therefore, project should be accepted.

Problem: A company is evaluating two alternatives for distribution within the plant. Two

alternatives are

1. C system with a high initial cost but low annual operating costs.

2. F system which costs less but have considerably higher operating costs.

The decision to construct the plant has already been made, and the choice here will have no

effect on the overall revenues of the project. The cost of capital of the plant is 12% and the

projects expected net costs are listed below: Year Expected Net Cash Costs

C Systems F Systems

0 (3,00,000) (1,20,000)

1 (66,000) (96,000)

2 (66,000) (96,000)

3 (66,000) (96,000)

4 (66,000) (96,000)

5 (66,000) (96,000)


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What is the present value of costs of each alternative?

Which method should be chosen.? Solution: Computation of present value

Year

C Systems F Systems Incremental

1 (66,000) (96,000) 30,000

2 (66,000) (96,000) 30,000

3 (66,000) (96,000) 30,000

4 (66,000) (96,000) 30,000

5 (66,000) (96,000) 30,000

Present value of incremental savings = 30,0000 x PV IFA (12%, 5)

= 30,000 x 3.605 = 1,08,150

Incremental cash out lay = 1,80,000

(71,850)

Since the present value of incremental net cash inflows of C system over F system is negative. C

system is not recommended.

Therefore, F system is recommended . Properties of the NPV

1. NPVs are additive. If two projects A and B have NPV (A) and NPV (B) then by additive rule

the net present value of the combined investment is NPV (A + B)

2. Intermediate cash inflows are reinvested at a rate of return equal to the cost of capital. Demerits of NPV:

1. NPV expresses the absolute positive or negative present value of net cash flows. Therefore,

it fails to capture the scale of investment.

2. In the application of NPV rule in the evaluation of mutually exclusive projects with different

lives, bias occurs in favour of the long term projects.

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

of cash flows.

IRR is also called yield on investment, managerial efficiency of capital, marginal productivity of

capital, rate of return, time adjusted rate of return. IRR is the rate of return that a project earns.


138

Evaluation of IRR: 1. IRR takes into account the time value of money

2. IRR calculates the rate of return of the project, taking into account the cash flows over the

entire life of the project.

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

4. It is consistent with the goal of financial management i,e maximization of net wealth of share

holders

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

6. To calculate the NPV the discount rate normally used is cost of capital. But to calculate IRR,

there is no need to calculate and employ the cost of capital for discounting because the

project is evaluated at the rate of return generated by the project. The rate of return is internal

to the project.

Demerits: 1. IRR does not satisfy the additive principle.

2. Multiple rates of return or absence of a unique rate of return in certain projects will affect the

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

3. In project evaluation, the projects with the highest IRR are given preference to the ones with

low internal rates.

Application of this criterion to mutually exclusive projects may lead under certain situations to

acceptance of projects of low profitability at the cost of high profitability projects.

4. IRR computation is quite tedious.

Accept or Reject Criterion: If the project’s internal rate of return is greater than the firm’s cost of capital, accept the proposal.

Otherwise reject the proposal.

IRR can be determined by solving the following equation for r =

Ct where t = 1 to n

(1 + r) t

CF0 = Investment

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

Ct where t = 1 to n

(1 + r) t

CF0 = ∑

∑


139

Example: A project requires an initial out lay of Rs.1,00,000. It is expected to generate the

following cash inflows: Year Cash inflows 1 50,000

2 50,000

3 30,000

4 40,000

What is the IRR of the project?

Step I

Compute the average of annual cash inflows Year Cash inflows 1 50,000

2 50,000

3 30,000

4 40,000

Total 1,70,000

Average = 1,70,000 = Rs.42,500

4

Step II: Divide the initial investment by the average of annual cash inflows:

= 1,00,000 = 2.35

42,500

Step III: From the PVIFA table for 4 years, the annuity factor very near 2.35 is 25%. Therefore

the first initial rate is 25%


%

PV of Cash

flows

1 50,000 0.800 40,000

2 50,000 0.640 32,000

3 30,000 0.512 15,360

4 40,000 0.410 16,400

Total 1,03,760

Since the initial investment of Rs.1,00,000 is less than the computed value at 25% of Rs.1,03,760

the next trial rate is 26%.


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%

PV of Cash

flows

1 50,000 0.7937 39,685

2 50,000 0.6299 31,495

3 30,000 0.4999 14,997

4 40,000 0.3968 15,872

Total 1,02,049

The next trial rate is 27%

Year Cash flows PV factor at 27 %

PV of Cash flows

1 50,000 0.7874 39,370

2 50,000 0.6200 31,000

3 30,000 0.4882 14,646

4 40,000 0.3844 15,376

Total 1,00,392

The next trial rate is 28%

Year Cash flows PV factor at 26 %

PV of Cash flows

1 50,000 0.7813 39,065

2 50,000 0.6104 30,520

3 30,000 0.4768 14,3047

4 40,000 0.3725 14,900

Total 98,789

Since initial investment of Rs.1,00,000 lies between 98789 (28 %) and 1,00,392 (27%) the IRR by

interpolation.

1,00,392 1,00,000

1,00,392 – 98,789

.

392

1603

27 + X 1

27 + X 1


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= 27 + 0.2445

= 27 .2445 = 27.24 %

Modified Internal Rate of Return:

MIRR is a distinct improvement over the IRR. Managers find IRR intuitively more appealing than

the rupees of NPV because IRR is expressed on a percentage rates of return. MIRR modifies

IRR. MIRR is a better indicator of relative profitability of the projects.

MIRR is defined as

PV of Costs = PV of terminal value

TV

(1 + MIRR) n

PVC = PV of costs

To calculate PVC, the discount rate used is the cost of capital.

To calculate the terminal value, the future value factor is based on the cost of capital

Then obtain MIRR on solving the following equation.

TV

(1 + MIRR) n

Superiority of MIRR over IRR 1. MIRR assumes that cash flows from the project are reinvested at the cost of capital. The

IRR assumes that the cash flows from the project are reinvested at the projects own IRR.

Since reinvestment at the cost of capital is considered realistic and correct, the MIRR

measures the project’s true profitability

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

Illustration:

Year 0 1 2 3 4 5 6

Cash flows (100) (100) 30 60 90 120 130

(Rs in million)

Cost of Capital is 12 %

Present value of cost = 100 + 100

1.12

= 100 + 89.29 = 189.29

PVC =

PV of Costs =


142

Terminal value of cash flows:

= 30 (1.12) 4 + 60 (1.12) 3 + 90 (1.12) 2 + 120 (1.12) + 130

= 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130

= 47.205 + 84.294 + 112.896 + 134.4 + 130

= 508.80

MIRR is obtained on solving the following equation

508.80

(1 + MIRR) 6

508.80

189.29

(1 + MIRR) 6 = 2.6879

MIRR = 17.9 % Profitability Index: it is also known as Benefit cost ratio.

Profitability index is the ratio of the present value of cash inflows to initial cash outlay.The

discount factor based on the required rate of return is used to discount the cash in flows.

Present value of cash inflows

Initial Cash outlay

Accept or Reject Criterion:

1. Accept the project if PI is greater than 1

2. Reject the project if PI is less than 1

If profitability index is 1 then the management may accept the project because the sum of the

present value of cash inflows is equal to the sum of present value of cash outflows. It neither

adds nor reduces the existing wealth of the company.

Merits of PI: 1. It takes into account the time value of money

2. It is consistent with the principle of maximization of share holders wealth.

3. It measures the relative profitability.

Demerits:

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

189.29 =

(1 + MIRR) 6 =

PI =


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2. A conflict may arise between NPV and profitability index if a choice between mutually

exclusive projects has to be made.

Example

X Y

PV of Cash inflows 4,00,000 2,00,000

Initial cash outlay 2,00,000 80,000

NPV 2,00,000 1,20,000

Profitability Index 2 2.5

As per NPV method project X should be accepted. As per profitability index project Y should be

accepted. This leads to a conflicting situation. The NPV method is to be preferred to profitability

index because the NPV represents the net increase in the firm’s wealth.

Example: A firm is considering an investment proposal which requires an intial cash outlay of Rs

8 lakh now and Rs 2 lakh at the end of the third year. It is expected to generate cash flows as

under: Year Cash inflows

1 3,50,000

2 8,00,000

3 2,50,000

Apply the discount rate of 12% calculate profitability index Solution: Present Value of Cash out flows

Year PV factor at 12 %

Cash out flows PV of Cash flows

1 Rs.8 lakhs Rs.8 lakhs

2

3 0.712 2 lakhs 1.424 lakhs

Total 9.424 lakhs


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Present Value of Cash inflows

Year PVIF (12%) Cash inflows PV of Cash flows

1 0.893 3,50,000 3.1255 lakhs

2 0.797 8,00,000 6.376 lakhs

4 0.636 2,50,000 1.5900 lakhs

Total 11.0915 lakhs

PI = Total of present value of cash inflows

Total of present value of cash outflows

= 11.0915 = 1.177

9.424

For every Re.1 invested the project is expected to give a cash inflow of Rs.1.177 i,e for every

rupee invested a profit of Rs.0.177 is obtained.

8.10 Summary Capital investment proposals involve current outlay of funds in the expectation of a stream of

cash in flow in future. Various techniques are available for evaluating investment projects. They

are grouped into traditional and modern techniques. The major traditional techniques are payback

period and accounting rate of return. The important discounting criteria are net present value,

internal rate of return and profitability index. A major deficiency of payback period is that it does

not take into account the time value of money. DCF techniques overcome this limitation. Each

method has both positive and negative aspect. The most popular method for large project is the

internal rate of return. Payback period and accounting rate of return are popular for evaluating

small projects.

Terminal Questions 1. Examine the importance of capital budgeting.

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

budgeting process.

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

4. Summaries the features of DCF techniques.


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Answer for Self Assessment Questions

Self Assessment Questions 1 1. Capital budgeting

2. Capital budgeting

3. Highly complex

4. Capital budgeting decisions


1. Irreversible.

2. Uncertainty, highly uncertain.

Self Assessment Questions 3 1. Final step.

2. First step Self Assessment Questions 4 1. A fertile source

2. The most crucial phase

Self Assessment Questions 5 1. Capital budgeting

2. Cost reduction.

Self Assessment Questions 6 1. Economic appraisal

2. Technical appraisal

3. Financial viability

4. Demand for the product or service.

Self Assessment Questions 7 1. Decision criteria

2. Sunk cost

3. Externalities.

4. Investment element.

5. Ignores.


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6. Profitability of

Answer for Terminal Questions. 1. Refer to unit 8.2





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Unit 9 Risk Analysis in Capital Budgeting

Structure

9.1 Introduction

9.2 Types and sources of Risk in capital Budgeting

9.3 Risk Adjusted Discount Rate

9.4 Certainty Equivalent

9.5 Sensitivity Analysis

9.6 Probability Distribution Approach:

9.7 Decision – tree approach

9.8 Summary:

Terminal Questions


9.1 Introduction In the previous chapter on capital budgeting the project appraisal techniques were applied on the

assumption that the project will generate a given set of cash flows.

It is quite obvious that one of the limitations of DCF techniques is the difficulty in estimating cash

flows with certain degree of certainty. Certain projects when taken up by the firm will change the

business risk complexion of the firm.

This business risk complexion of the firm influences the required rate of return of the investors.

Suppliers of capital to the firm tend to be risk averse and the acceptance of a project that changes

the risk profile of the firm may change their perception of required rates of return for investing in

firm’s project.

Generally the projects that generate high returns are risky. This will naturally alter the business

risk of the firm. Because of this high risk perception associated with the new project a firm is

forced to asses the impact of the risk on the firm’s cash flows and the discount factor to be

employed in the process of evaluation.

Definition of Risk: Risk may be defined as the variation of actual cash flows from the expected

cash flows. The term risk in capital budgeting decisions may be defined as the variability that is

likely to occur in future between the estimated and the actual returns. Risk exists on account of

the inability of the firm to make perfect forecasts of cash flows.


148

Risk arises in project evaluation because the firm cannot predict the occurrence of possible future

events with certainty and hence, cannot make any correct forecast about the cash flows. The

uncertain economic conditions are the sources of uncertainty in the cash flows.

For example, a company wants to produce and market a new product to their prospective

customers. The demand is affected by the general economic conditions. Demand may be very

high if the country experiences higher economic growth. On the other hand economic events like

weakening of US dollar, sub prime crises may trigger economic slow down. This may create a

pessimistic demand drastically bringing down the estimate of cash flows.

Risk is associated with the variability of future returns of a project. The greater the variability of

the expected returns, the riskier the project.

Every business decision involves risk. Risk arises out of the uncertain conditions under which a

firm has to operate its activities. Because of the inability of firms to forecast accurately cash flows

of future operations the firms face the risks of operations. The capital budgeting proposals are

not based on perfect forecast of costs and revenues because the assumptions about the future

behaviour of costs and revenue may change. Decisions have to be made in advance assuming

certain future economic conditions.

There are Many factors that affect forecasts of investment, cost and revenue.

1) The business is affected by changes in political situations, monetary policies, taxation, interest

rates, policies of the central bank of the country on lending by banks etc.

2) Industry specific factors influence the demand for the products of the industry to which the

firm belongs.

3) Company specific factors like change in management, wage negotiations with the workers,

strikes or lockouts affect company’s cost and revenue positions.

Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management.

The best business decisions may not yield the desired results because the uncertain conditions

likely to emerge in future can materially alter the fortunes of the company.

Every change gives birth to new challenges. New challenges are the source of new

opportunities. A proactive firm will convert every problem into successful enterprise opportunities.

A firm which avoids new opportunities for the inherent risk associated with it, will stagnate and

degenerate. Successful firms have empirical history of successful management of risks.

Therefore, analysing the risks of the project to reduce the element of uncertainty in execution has

become an essential aspect of today’s corporate project management.


149



1. Define risk in capital budgeting.

2. Examine the importance of risk analysis in capital budgeting.

3. Methods of incorporating the risk factor in capital budgeting decision.

4. Understand the types and sources of risk in capital budgeting descision

9.2 Types and sources of Risk in capital Budgeting Risks in a project are many. It is possible to identify three separate and distinct types of risk in

any project.

1) Stand – alone risk: it is measured by the variability of expected returns of the project.

2) Portfolio risk: A firm can be viewed as portfolio of projects having as certain degree of risk.

When new project added to the existing portfolio of project the risk profile the firm will alter.

The degree of the change in the risk depend on the covariance of return from the new project

and the return from the existing portfolio of the projects. If the return from the new project is

negatively correlated with the return from portfolio, the risk of the firm will be further diversified

away.

3) Market or beta risk: It is measured by the effect of the project on the beta of the firm. The

market risk for a project is difficult to estimate.

Stand alone risk is the risk of a project when the project is considered in isolation. Corporate

risk is the projects risks to the risk of the firm. Market risk is systematic risk. The market risk

is the most important risk because of the direct influence it has on stock prices.

Sources of risk: The sources of risks are

1. Project – specific risk

2. Competitive or Competition risk

3. Industry – specific risk

4. International risk

5. Market risk

1. Project – specific risk: The sources of this risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flows or discount rate

may lead to a situation of actual cash flows realised being less than that projected.

2. Competitive risk or Competition risk: unanticipated actions of a firm’s competitors will

materially affect the cash flows expected from a project. Because of this the actual cash

flows from a project will be less than that of the forecast.


150

3. Industry – specific: industry – specific risks are those that affect all the firms in the industry.

It could be again grouped into technological risk, commodity risk and legal risk. All these risks

will affect the earnings and cash flows of the project. The changes in technology affect all the

firms not capable of adapting themselves to emerging new technology.

The best example is the case of firms manufacturing motor cycles with two strokes engines.

When technological innovations replaced the two stroke engines by the four stroke engines those

firms which could not adapt to new technology had to shut down their operations.

Commodity risk is the risk arising from the effect of price – changes on goods produced and

marketed.

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

belongs. The best example is the imposition of service tax on apartments by the Government of

India when the total number of apartments built by a firm engaged in that industry exceeds a

prescribed limit. Similarly changes in Import – Export policy of the Government of India have led

to the closure of some firms or sickness of some firms.

4. International Risk: these types of risks are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets. For

example, rupee – dollar crisis affected the software and BPOs because it drastically reduced

their profitability. Another best example is that of the textile units in Tirupur in Tamilnadu,

exporting their major part of the garments produced. Rupee gaining and dollar Weakening

reduced their competitiveness in the global markets. The surging Crude oil prices coupled

with the governments delay in taking decision on pricing of petro products eroded the

profitability of oil marketing Companies in public sector like Hindustan Petroleum Corporation

Limited. Another example is the impact of US sub prime crisis on certain segments of Indian

economy.

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

5. Market Risk: Factors like inflation, changes in interest rates, and changing general economic

conditions affect all firms and all industries.

Firms cannot diversify this risk in the normal course of business.

Techniques used for incorporation of risk factor in capital budgeting decisions

There are many techniques of incorporation of risk perceived in the evaluation of capital

budgeting proposals. They differ in their approach and methodology so far as incorporation of

risk in the evaluation process is concerned.

Conventional techniques Pay Back Period


151

The oldest and commonly used method of recognising risk associated with a capital budgeting

proposal is pay back period. Under this method, shorter pay back period is given preference to

longer ones. Firms establish guidelines for acceptance or rejections of projects based on

standards of pay back periods.

Payback period prefers projects of short – term pay backs to that of long – term pay backs. The

emphasis is on the liquidity of the firm through recovery of capital. Traditionally Indian business

community employs this technique in evaluating projects with very high level of uncertainty. The

changing trends in fashion make the fashion business, one of high risk and therefore, pay back

period has been endorsed by tradition in India to take decisions on acceptance or rejection of

such projects. The usual risk in business is more concerned with the fore cast of cash flows. It is

the down side risk of lower cash flows arising from lower sales and higher costs of operation that

matters in formulating standards of pay back.

Pay back period ignores time value of many (cash flows). For example, the following details are

available in respect of two projects.

Particulars Project A (Rs) Project B (Rs) Initial cash outlay 10 lakhs 10 lakhs Cash flows Year 1 5 lakhs 2 lakhs Year 2 3 lakhs 2 lakhs Year 3 1 lakhs 3 lakhs Year 4 1 lakhs 3 lakhs

Both the projects have a pay back period of 4 years. The project B is riskier than the Project A

because Project A recovers 80% of initial cash outlay in the first two years of its operation where

as Project B generates higher Cash inflows only in the latter half of the payback period. This

undermines the utility of payback period as a technique of incorporating risk in project evaluation.

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

consideration.

Self Assessment Questions 2 1. _____________ is measured by the variability of expected returns of the project.

2. Market risk is measured by the effect of the project on the ____ of the firm.

3. Firms cannot ____ market risk in the normal course of business.

4. Impact of U.S sub prime crisis on certain segments of Indian economy is and example of

_______________________.


152

9.3 Risk Adjusted Discount Rate The basis of this approach is that there should be adequate reward in the form of return to firms

which decide to execute risky business projects. Man by nature is riskaverse and tries to avoid

risk. To motivate firms to take up risky projects returns expected from the project shall have to be

adequate, keeping in view the expectations of the investors. Therefore risk premium need to be

incorporated in discount rate in the evaluation of risky project proposals.

Therefore the discount rate for appraisal of projects has two components.

Those components are

1. Risk – free rate and risk premium

Risk Adjusted Discount rate = Risk free rate + Risk premium

Risk free rate is computed based on the return on government securities.

Risk premium is the additional return that investors require as compensation for assuming the

additional risk associated with the project to be taken up for execution.

The more uncertain the returns of the project the higher the risk. Higher the risk greater the

premium. Therefore, risk adjusted Discount rate is a composite rate of risk free rate and risk

premium of the project.

Example: An investment will have an initial outlay of Rs 100,000. It is expected to generate cash

inflows as under:

Year Cash in flows 1 40,000 2 50,000 3 15,000 4 30,000

Risk free rate of interest is 10%. Risk premium is 10% (the risk characterising the project)

(a) compute the NPV using risk free rate

(b) Compute NPV using risk – adjusted discount rate

Solutions = (a) using risk – free rate

Year Cash flows (inflows) Rs PV Factor at 10% PV of Cash flows (in flows)

1 40,000 0.909 36,360

2 50,000 0.826 41,300

3 15,000 0.751 11,265

4 30,000 0.683 20,490

PV of cash in flows 1,09,415


153

PV of Cash outflows 1,00,000

NPV 9,415

(b) Using risk – adjusted discount rate

Year Cash in flows Rs PV factor at 20% PV of cash inflows

1 40,000 0.833 33,320

2 50,000 0.694 34,700

3 15,000 0.579 8,685

4 30,000 0.482 14,460

PV of Cash in flows 91,165

PV of Cash out flows 100,000

NPV (8,835)

The project would be acceptable when no allowance is made for risk.

But it will not be acceptable if risk premium is added to the risk free rate. It moves from positive

NPV to negative NPV.

If the firm were to use the internal rate of return, then the project would be accepted when IRR is

greater than the risk – adjusted discount rate.

Evaluation of Risk – adjusted discount rate: Advantages:

1. It is simple and easy to understand.

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

3. It satisfies the businessmen who are risk – averse.

Limitations: 1. There are no objective bases of arriving at the risk premium. In this process the premium

rates computed become arbitrary.

2. The assumption that investors are risk – averse may not be true in respect of certain investors

who are willing to take risks. To such investors, as the level of risk increases, the discount

rate would be reduced.

3. Cash flows are not adapted to incorporate the risk adjustment for net cash in flows.


1. Risk premium is the __________________ that the investors require as compensation for


154

assumption of additional risks of project.

2. RADR is the sum of ______________ and ______________.

3. Higher the risk __________________ the premium.

4. Man by nature is riskaverse and tries to avoid risk.

9.4 Certainty Equivalent: Under this method the risking uncertain, expected future cash flows are converted into cash flows

with certainty. Here we multiply uncertain future cash flows by the certainty – equivalent

coefficient to convert uncertain cash flows into certain cash flows. The certainty equivalent

coefficient is also known as the risk – adjustment factor. Risk adjustment factor is normally

denoted by αt (Alpha). It is the ratio of certain net cash flow to risky net cash flow

= Certainty Equivalent = Certain Cash flow

Risky Cash flow

The discount factor to be used is the risk free rate of interest. Certainty equivalent coefficient is

between 0 and 1. This risk – adjustment factor varies inversely with risk. If risk is high a lower

value is used for risk adjustment. If risk is low a higher coefficient of certainty equivalent is used

Illustration (Example) A project costs Rs 50,000. It is expected to generate cash inflows as under

Year Cash in flows Certainty Equivalent

1 32,000 0.9

2 27,000 0.6

3 20,000 0.5

4 10,000 0.3

Risk – free discount rate is 10% compute NPV

Answer:

Year Uncertain cash in flows

C E Certain cash flows

PV Factor at 10%

PV of certain cash inflows

1 32,000 0.9 28,800 0.909 26,179

2 27,000 0.6 16,200 0.826 13,381

3 20,000 0.5 10,000 0.751 7,510

4 10,000 0.3 3,000 0.683 2,049


155

PV of certain cash in

flows

49,119

Initial cash out lay 50,000

NPV (881) negative

The project has a negative NPV.

Therefore, it is rejected.

If IRR is used the rate of discount at which NPV is equal to zero is computed and then compared

with the minimum (required) risk free rate. If IRR is greater than specified minimum risk free rate,

the project is accepted, other wise rejected.

Evaluation: It recognises risk. Recognition of risk by risk – adjustment factor facilitates the conversion of risky

cash flows into certain cash flows. But there are chances of being inconsistent in the procedure

employed from one project to another.

When forecasts pass through many layers of management, original forecasts may become highly

conservative.

Because of high conservation in this process only good projects are likely to be cleared when this

method is employed.

Certainty – equivalent approach is considered to be theoretically superior to the risk – adjusted

discount rate.

Self Assessment Questions 3 1. CE coefficient is the _______ .

2. Discount factors to be used under CE approach is _____________.

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

4. ___________ is considered to be superior to RADR

9.5 Sensitivity Analysis: There are many variables like sales, cost of sales, investments, tax rates etc which affect the

NPV and IRR of a project. Analysing the change in the project’s NPV or IRR on account of a

given change in one of the variables is called Sensitivity Analysis. It is a technique that shows the

change in NPV given a change in one of the variables that determine cash flows of a project. It

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

NPV.


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The reliability of the NPV depends on the reliability of cash flows. If fore casts go wrong on

account of changes in assumed economic environments, reliability of NPV & IRR is lost.

Therefore, forecasts are made under different economic conditions viz pessimistic, expected and

optimistic. NPV is arrived at for all the three assumptions.

Following steps are involved in Sensitivity analysis:

1. Identification of variables that influence the NPV & IRR of the project.

2. Examining and defining the mathematical relationship between the variables.

3. Analysis of the effect of the change in each of the variables on the NPV of the project.

Example: A company has two mutually exclusive projects under consideration viz project A &

project B.

Each project requires an initial cash outlay of Rs 3,00,000 and has an effective life of 10 years.

The company’s cost of capital is 12%. The following fore cast of cash flows are made by the

management.

Economic Project A Project B

Environment Annual cash inflows Annual cash in flows

Pessimistic 65,000 25,000

Expected 75,000 75,000

Optimistic 90,000 1,00,000

What is the NPV of the project?

Which project should the management consider?

Given PVIFA = 5.650

Answer / Solutions

NPV of project A

Economic Project PVIFA PV of cash in flows NPV

Environment cash inflows at 12% 10

years

Pessimistic 65,000 5.650 3,67,250 67,250

Expected 75,000 5.650 4,23,750 1,23,750

Optimistic 90,000 5.650 5,08,500 2,08,500


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NPV of Project B

Pessimistic 25,000 5.650 1,41,250 (1,58,750)

Expected 75,000 5.650 4,23,750 1,23,750

Optimistic 1,00,000 5.650 5,65,000 2,65,000

Decision 1. Under pessimistic conditions project A gives a positive NPV of Rs 67,250 and Project B has a

negative NPV of Rs 1,58,750 Project A is accepted.

2. Under expected conditions, both gave some positive NPV of Rs 1,23,000. Any one of two

may be accepted.

3. Under optimistic conditions Project B has a higher NPV of Rs 2,65,000 compared to that of

A’s NPV of Rs 2,08,500.

4. Difference between optimistic and pessimistic NPV for Project A is Rs 1,41,250 and for

Project B the difference is Rs 4,23,750.

5. Project B is risky compared to Project A because the NPV range is of large differences.

Statistical Techniques: Statistical techniques use analytical tools for assessing risks of investments.


1. _____________ analysis the changes in the project NPV on account of a given change in one

of the input variables of the project.

2. Examining and defining the mathematical relation between the variable of the NPV is

_________________________.

3. Forecasts under sensitivity analysis are made under __________.

9.6 Probability Distribution Approach: When we incorporate the chances of occurrences of various economic environments computed

NPV becomes more reliable. The chances of occurrences are expressed in the form of

probability. Probability is the likelihood of occurrence of a particular economic environment. After

assigning probabilities to future cash flows expected net present value is computed.

Illustration: A company has identified a project with an initial cash outlay of Rs 50,000. The following distribution of cash flow is given below for the life of the project of 3 years.


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Year 1 Year 2 Year 3

Cash in flow Probability Cash in flow Probability Cash in flow Probability

15,000 0.2 20,000 0.3 25,000 0.4

18,000 0.1 15,000 0.2 20,000 0.3

35,000 0.4 15,000 0.2 20,000 0.3

32,000 0.3 30,000 0.2 45,000 0.1

Discount rate is 10%

Year 1

= 15,000 x 0.2 + 18,000 x 0.1 + 35,000 x 0.4 + 32,000 x 0.300

3,000 + 1,800 + 14,000 + 9,600 = 28,400

Year 2

20,000 x 0.3 + 15,000 x 0.2 + 30,000 x 0.3 + 30,000 x 0.2

= 6,000 + 3,000 + 9,000 + 6,000 = 24,000

Year 3

25,000 x 0.4 + 20,000 x 0.3 + 40,000 x 0.2 + 5,000 x 0.1 =

10,000 + 6,000 + 8,000 + 4,500 == 28,500

Year Expected cash inflows PV factor at 10% PV of expected cash in flows

1 28,400 0.909 25,816

2 24,000 0.826 19,824

3 28,500 0.751 21,403

PV of expected cash in flows 67,043

PV of initial cash out lay 50,000

Expected NPV 17,043

Variance: A study of dispersion of cash flows of projects will help the management in assessing the risk

associated with the investment proposal. Dispersion is computed by variance or standard

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

Square root of variance is standard deviation.

Example: Following details are available in respect of a project which requires an initial cost of Rs 5,00,000.


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Year Economic Conditions Cash flows Probability

1 High growth 2,00,000 0.3

Average growth 1,50,000 0.6

No growth 40,000 0.1

2 High growth 3,00,00 0.3


No growth 5,00,000 0.2

3 High growth 4,00,000 0.2


No growth 30,000 0.2

Discount rate is 10% Solution: Year 1

Economic Condition Cash in flow Probability Expected value of Cash in flow

1 2 3

High growth 2,00,000 0.3 60,000

Average growth 1,50,000 0.6 90,000

No growth 40,000 0.1 4,000

Expected Value 1,54,000

Year 2


High growth 3,00,000 0.3 90,000

Average growth 2,00,000 0.5 1,00,000

No growth 50,000 0.2 10,000

Expected Value 2,00,000

Year 3


High growth 4,00,000 0.2 80,000

Average growth 2,50,000 0.6 1,50,000

No growth 30,000 0.2 6,000


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Expected Value of

Cash inflows

2,36,000

1,54,000 2,00,000 2,36,000

1.10 (110) 2 (1.10) 3

= 1,40,000 + 1, 65, 289 + 1, 77, 310 – 5,00,000 = (17,401) negative NPV

Standard Deviation for I year

Cash in flow C

Expected Value E

(C – E) 2 (C – E) 2 x prob

2,00,000 1,54,000 (46,000) 2 (46,000) 2 x 0.3 = 634800 000

1,50,000 1,54,000 ( 4000) 2 ( 4,000) 2 x 0.3 = 9600 000

40,000 1,54,000 ( 1,14,000) 2 ( 1,14,000) 2 x 0.3 = 12996 00 000

Total 1944 000 000

Standard deviation of Cash flows for I year = 44091

For 2 nd year

Cash in flow C

Expected Value E

(C – E) 2 (C – E) 2 x prob

3,00,000 2,00,000 (1,00,000) 2 (1,00,000) 2 x 0.3 = 3000 000 000

2,00,000 2,00,000 (0) 2 (0) 2 x 0.5 = 0

50,000 2,00,000 ( 1,50,000) 2 ( 1,50,000) 2 x 0.2 = 45 00 000 000

Total 7500 00 000

Variance of Cash flows for 2 nd year = 7500 000 000

Standard Deviation of cash flows for 2 nd year = 8660

For the third year

Cash in flow

C

Expected Value

E

(C – E) 2 (C – E) 2 x prob

4,00,000 2,36,000 (1,64,000) 2 (1,64,000) 2 x 0.2 = 53792 00 000

2,50,000 2,36,000 (14,000) 2 (14,000) 2 x 0.6 = 1176 00 000

30,000 2,36,000 ( 2,00,000) 2 ( 2,00,000) 2 x 0.2 = 8000 000 000

Total 13496800 000

Expected NPV = + + 5,00,000


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Variance of Cash flows for 3 rd year = 13496800 000

Standard Deviation of cash flows for 3 rd year = 116175

Standard Deviation of NPV

√(44091) 2 (8660) 2 (116175) 2

√(1.10) 2 (1.10) 4 (1.10) 6

= √1606625026 + 51223004 + 7618496131

= √9276344161

= 96314

Here the assumption is that there is no relationship between cash flows from one period to

another. Under this assumption the standard deviation of NPV is Rs 96,314.

On the other hand, if cash flows are perfectly correlated, cash flows of all years have

linear correlation to one another, then

44091 8660 116175

1.10 (1.10) 2 (1.10) 3

= 40083 + 7157 + 87284 = 134524

The standard deviation of NPV when cash flows are perfectly correlated will be higher

than that under the situation of independent cash flows.

Self Assessment Questions. 5 1. Probability distribution approach incorporates the probability of occurrences of various

economic environment, to make the NPV ________.

2. _______ is likelihood of occurrence of a particular economic environment.

9.7 Decision – tree approach: Many project decisions are complex investment decisions. Such complex investment decisions

involve a sequence of decisions over time. Decisions tree can handle the sequential decisions of

complex investment proposals. The decision of taking up an investment project is broken into

different stages. At each stage the proposal is examined to decide whether to go ahead or not.

The multi – stages approach can be handled effectively with the help of decision trees. A

decision tree presents graphically the relationship between a present decision and future events,

future decisions and the consequences of such decisions.

σNPV = + +

σNPV = + +


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Example

R & D section of a company has developed an electric moped. The firm is ready for pilot

production and test marketing. This will cost Rs 20 million and take six months. Management

believes that there is a 70% chance that the pilot production and test marketing will be successful.

If successful the company can build a plant costing Rs 200 million.

The plant will generate annual cash in flow of Rs 50 million for 20 years if the demand is high or

an annual cash inflow or 20 million if the demand is low.

High demand has a probability of 0.6 and low demand has a probability of 0.4. Cost of capital is

12%.

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

adapted).

Working Notes: From right hand side of the decision tree

I step: Computation of Expected Monetary Value at point C2. Here EMV represents expected

NPV.

Cash in flow Probability Expected value of cash inflows

50 0.6 30

20 0.4 8

EMV 38

Present Value of EMV = Expected value of cash inflow x PVIFA (12% 20)

38 x 7.469 = Rs 283.82 million

D

C1

D3

C2

D2

D11 Carry out pilot Production And Market test (20 million)

D12 Do Nothing

C11 Success

C12 failure Probability 0.3

D31 Stop

D22 Stop

D21 Investment Rs.200 million

High Demand Probability 0.6 C21

C22 Low Demand Probability 0.4

Annual Cash inflow Rs.50 million

Annual Cash inflow Rs.20 million

0.7


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Step 2:

Computation of EMV at decision point D2.

Decision taken Consequences The resulting EMV at this level

D2 Invest Rs 200 million 283.82 – 200 83.82 million

D22 Stop 0

Here the decision criterion is “select the EMV with the highest value”.

Stage 3:

Therefore EMV with Rs 83.82 million will be considered therefore; we select the decision taken at

D2,

Stage 4:

Computation of EMV at the point C,

EMV Probability Expected Value

83.82 0.7 58.67

0 0.3 0

EMV at this stage 58.67

Step 5:

Compute EMV at decisions point D,

Decision taken Consequences The resulting Em at this level

D11 carry out pilot

production and market test

Invest

20 million

58.67 – 20 = Rs 38.67 Million

D12 Do nothing 0 0

EMV at this stage 38.67 Million

(Apply the EMV criterion) i.e

select the EMV with the

highest value

Therefore optimal strategy is

1. Carry out pilot production and market test.

2. If the result of pilot production and market test is successful, go ahead with the investment

decision of Rs 200 million in establishing a plant.

3. If the result of pilot production and market test is future, stop.


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Evaluation of Decision tree approach:

1. It portrays inter – related, sequential and critical multi dimensional elements of major project

decisions.

2. Adequate attention is given to the critical aspects in an investment decision which spread over

a time sequence.

3. Complex projects involve huge out lay and hence risky. There is the need to define and

evaluate scientifically the complex managerial problems arising out of the sequence of

interrelated decisions with consequential outcomes of high risk. It is effectively answered by

decision tree approach.

4. Structuring a complex project decision with many sequential investment decisions demands

effective project risk management. This is possible only with the help of an analytical tool like

decision tree approach.

5. Able to eliminate unprofitable outcomes and helps in arriving at optimum decision stages in

time sequence.

Self Assessment Questions 6 1. Decision tree can handle the _____________ of complex investment proposals.

2. _____ portrays interrelated, sequential and critical multi dimensional elements of major project

decisions.

3. Adequate attention is given to the ______ in an investment decision under decision tree

approach’s.

4. ____________ are effectively handled by decision tree approach’s .

9.8 Summary Risk in project evaluation arises on account of the inability of the firm to predict the performance

of the firm with certainty. Risk in capital budgeting decision may be defined as the variability of

actual returns from the expected. There are many factors that affect forecasts of investment,

costs and revenues of a project. It is possible to identify three type of risk in any project, viz stand

alone risk, corporate risk and market risk. The sources of risks are:

a. Project

b. Competition

c. Industry

d. International factors and

e. Market


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The techniques for incorporation of risk factor in capital budgeting decision could be grouped into

conventional techniques and statistical techniques.

Terminal Questions 1. Define risk. Examine the need for assessing the risks in a project.

2. Examine the type and sources of risk in capital budgeting .

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

budgeting.

4. Examine the steps involved in sensitivity analysis.

5. Examine the features of Decisiontree approaches.

Answer for Self Assessment Questions Self Assessment Questions 1

1. Standalone risk.

2. Beta

3. Diversify

4. International risk

Self Assessment Question 2 1. Additional return

2. Risk free rate, risk premium.

3. Greater.


1. Risk adjustment factor

2. Risk free rate of interest.

3. Conservation.

4. CE

Self Assessment Question 4 1. Sensitivity analysis

2. One of the steps of sensitivity analysis

3. Different economic conditions


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1. More reliable

2. Probability


1. Sequential decisions

2. Decision tree.

3. Critical aspects

4. Complex projects.

Answer for Terminal Questions 1. Refer to units 9.1

2. Refer to units 9. 2

3. Refer to units 9.3




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Unit 10 Capital Rationing

Structure

10.1 Introduction

10.2 Meaning of Capital Rationing

10.3 Steps involved in Capital Rationing

10.4 Summary

Terminal Questions


10.1 Introduction: Capital budgeting decisions involve huge outlay of funds. Funds available for projects may be

limited. Therefore, a firm has to prioritize the projects on the basis of availability of funds and

economic compulsion of the firm. It is not possible for a company to take up all the projects at a

time. There is the need to rank them on the basis of strategic compulsion and funds availability.

Since companies will have to choose one from among many competing investment proposal the

need to develop criteria for Capital rationing cannot be ignored. The companies may have many

profitable and viable proposals but cannot execute because of shortage of funds. Another

constraint is that the firms may not be able to generate additional funds for the execution of all the

projects. When a firm imposes constraints on the total size of firm’s capital budget, it is requires

Capital Rationing. When Capital is rationed there is a need to develop a method of selecting the

projects that could be executed with the company’s resources yet give the highest possible net

present value.



1. Explain the meaning of capital rationing.

2. Explain the need for capital rationing.

3. Explain the process of capital rationing.

4. Explain the various approaches to capital rationing.


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10.2 Meaning of Capital Rationing: Because of the limited financial resources, firms may have to make a choice from among

profitable investment opportunities. Capital rationing refers to a situation in which the firm is under

a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a

situation may be due to external factors or due to the need to impose internal constraints, keeping

in view of the need to exercise better financial control.

Why Capital Rationing Reasons for Capital Rationing:

Capital Rationing may be due to

a. External factors b. Internal constraints imposed by management

External Capital Rationing: External Capital Rationing is due to the imperfections of capital markets Imperfection may be caused by:

a. Deficiencies in market information

b. Rigidities that hamper the force flow of Capital between firms.

When capital markets are not favourable to the company the firm cannot tap the capital market for

executing new projects even though the projects have positive net present values. The following

reasons attribute to the external capital rationing:

1. Inability of the firm to procure required funds from Capital market because the firm does not

command the required investor’s confidence.

2. National and international economic factors may make the market highly volatile and instable.

3. Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the

market for funds.

4. High Cost of issue of Securities I,e High floatation cost. Smaller firms smaller firms may have

to incur high costs of issue of securities. This discourages small firms from tapping the capital

markets for funds.

Internal Capital Rationing: Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative

policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount

that they can commit on new projects.

Another internal restriction for Capital budgeting decision may be imposed by a firm based on the

need to generate a minimum rate of return. Under this criterion only projects capable of


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generating the management’s expectation on the rate of return will be cleared. Generally internal

capital rationing is used by a firm as a means of financial control.

Self Assessment Questions 1 1. When a firm imposes constraints on the total size of its capital budget, it is known as

_____________.

2. Internal capital rationing is used by a firm as a ______________________.

3. Rigidities that affect the free flow of capital between firms cause _________________.

4. Inability of a firm to satisfy the regularity norms for issue of equity shares for tapping the market

for funds causes __________________.

10.3 Steps involved in Capital Rationing Steps involved in Capital Rationing are:

1. Ranking of different investment proposals

2. Selection of the most profitable investment proposal

Ranking of different investment proposals The various investment proposals should be ranked on the basis of their profitability. Ranking is

done on the basis of NPV, Profitability index or IRR in the descending order. Profitability index as the basis of Capital Rationing The following details are available:

Cash Inflows

Project Initial Cash outlay Year 1 Year 2 Year 3

A 1,00,000 60,000 50,000 40,000

B 50,000 20,000 40,000 20,000

C 50,000 20,000 30,000 30,000

Cost of Capital is 15 %

Computation of NPV

Year Cash in flows PV factor at 15% PV of Cash in

flows

1 60,000 0.870 52,200

2 50,000 0.756 37,800

3 40,000 0.658 26,320


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PV of Cash inflow 1,16,320

Initial Cash out lay 1,00,000

NPV 16,320

PV of Cash inflows

PV of Cash outflows

1,16,320

1,00,000

Project B

Year Cash in flows PV factor at 15% PV of Cash in flows

1 20,000 0.870 17,400

2 40,000 0.756 30,240

3 20,000 0.658 13,160

PV of Cash inflow 60,800

Initial Cash out lay 50,000

NPV 10,800

Profitability index = 60,800 = 1.216

50,000 Project C

Year Cash in flows PV factor at 15% PV of Cash in flows

1 20,000 0.870 17,400

2 30,000 0.756 22,680

3 30,000 0.658 19,740

PV of Cash inflow 59,820

Initial Cash out lay 50,000

NPV 9,820

Profitability index =

= = 1.1632


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Profitability index = 59,820 = 1.1964

50,000 Ranking of Projects

Project NPV Profitability Index

Absolute Rank Absolute Rank

A 16320 1 1.1632 3

B 10800 2 1.216 1

C 9820 3 1.1964 2

If the firm has sufficient funds and no capital rationing restriction, then all the projects can be

accepted because all of them have positive NPVs.

Let us assume that the firm is forced to resort to capital rationing because the total funds

available for execution of project is only Rs.1,00,000.

In this case on the basis of NPV Criterion, project A will be cleared. It incurs an initial cash outlay

of Rs.1,00,000. After allocating Rs.1,00,000 to project A, left over funds is nil. Therefore, on the

basis of NPV criterion other projects i,e B & C cannot be taken up for execution by the firm. It will

increase the net wealth of the firm by Rs.16,320.

On the other hand on the basis of profitability index, project B and C can be executed with

Rs.1,00,000 because both of them incur individually an initial cash outlay of Rs.50,000.

Therefore, with the execution of projects B and C, increase in net wealth of the firm will be 10800

+ 9820 = Rs20620

The objective is to maximize NPV per rupee of Capital and projects should be ranked on the

basis of the profitability index. Funds should be allocated on the basis ranks assigned by

profitability index.

Evaluation: 1. PI rule of selecting projects under Capital rationing may not yield satisfactory result because

of project indivisibility. When projects involving high investment is accepted many small

projects will have to be excluded. But the sum of the NPVs of small projects to be accepted

may be higher than the NPV of single large project.

2. It also suffers from the multiperiod Capital constraints.

Programming approach: There are many programming techniques to Capital rationing. Among

them are:


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1. Linear Programming: LP approach to Capital rationing tries to achieve maximum NPV subject

to many constraints. Here the objective function is maximisation of sum of the NPVs of the

projects.

Here the constraints matrix incorporates all the restrictions associated with Capital rationing

imposed by the firm.

2. Integer Programming: LP may give an optimal mix of projects in which there may be need to

accept fraction of a project. Accepting fraction of a project is not feasible. Therefore,

optimum may not be attainable. The actual implementation of projects may be suboptimal.

When projects are not divisible, integer programming can be employed to avoid the chances of

accepting fraction of projects.

The advantage of programming approach is that it provides information on dual variables. It also

gives information on shadow prices of budget constraints. Dual variables provide information for

decision on transfer of funds from one year to another year

The demerits of programming approach is that

a. Costly to use when large, indivisible projects are being examined.

b. They are deterministic models. But variables of Capital budgeting are subject to change

making the assumption of deterministic highly invalid.


1. The two steps involved in capital rationing are __________ and __________________.

2. Project indivisibility can lead to sub optimal result when ____________ is used for capital

rationing.

3. Objective function under linear programining approach is ___________.

4. When project are not divisible ______________ can be employed to avoid the changes of

accepting fraction of a project.

10.4 Summary Often firms are forced to ration the funds among the eligible projects that the firm wants to take

up. The inability of the firm in finding adequate funds for execution of the projects could be due to

many factors. It may be due to external factors or internal constraints imposed by the

management. External capital rationing occurs mainly because of imperfections in capital

markets. Internal capital rationing is caused by restrictions imposed by the managements.


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Terminal Questions

1. Examine the need for capital rationing.

2. Examine the reasons for external capital rationing.

3. Internal capital rationing is uses by firms for exercising financial control” How does a firm

achieve this ?

4. Brief explain the process of capital rationing.

Answer to Self Assessment Questions


1. Capital rationing.

2. Means of financial control.

3. External capital rationing.

4. External capital rationing.

Self Assessment Questions 2 1. Ranking the project, selection of the most profitable investment proposal

2. Profitability index

3. Maximisation of sum of NPVs of the projects.

4. Integer programming

Answer for Terminal Questions 1. Refer to unit 10.1





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Unit 11 Working Capital Management

Structure

11.1 Introduction

11.2 Components of Current Assets and Current Liabilities

11.3 Concepts of Working Capital

11.4 Objective of Working Capital Management

11.5 Need for working Capital

11.6 Operating Cycle

11.7 Determinants of Working Capital

11.8 Estimation of Working Capital

11.9 Summary

Terminal Questions


11.1 Introduction Sound working Capital Management has become a necessity in an era of information technology

for a company to succeed. The best example to support this argument is the performance of Dell

computers as reported in one of the recent Fortune article.

A perusal of the article will give us an insight into how Dell could use technology for improving the

performance of components of working capital.

1. Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and

dealers.

2. Outsourcing an operations if the firm’s core competence does not permit the performance of

the operation effectively.

3. Train the employees to accept change.

4. Introduction of internet business

5. Releasing Capital by reduction in investment in inventory for improving the profitability of

operating capital.

A financial manger spends a large part of his time in managing working capital.

There are two important elements of working capital management.


175

1. Decisions on the amount of current assets to be held by a firm for efficient operations of its

business.

2. Decisions on financing working capital requirement.

Inadequacy or mismanagement of Working Capital is the leading cause of many business

failures. Working Capital is that portion of asset of a business which are used in current

operations. They are used in the operating cycle of the firm. It is defined as the excess of

Current Assets over Current Liabilities and provisions.



1. Explain the meaning, definition and concepts of Working Capital

2. State the objectives of Working Capital management.

3. Bring out the importance of Working Capital management.

4. Explain the process of estimation of Working Capital.

11.2 Components of Current Assets and Current Liabilities 11.2.1 Current Assets are:

1) Inventories 2) Sundry Debtors 3) Bills Receivables

4) Cash and Bank Balances 5) Short term investments

6) Advances such as advances for purchase of raw materials, components and

consumable stores, prepaid expenses etc.

11.2.2 Current Liabilities are:

1) Sundry Creditors 2) Bills Payable 3) Creditors for outstanding expenses

4) Provision for tax 5) Other provisions against the liabilities payable within a period of

12 months.

Working Capital Management is concerned with managing the different components of current

assets and current liabilities. A firm must have adequate Working Capital neither excess nor

shortage. Maintaining adequate Working Capital at the satisfactory level is crucial for maintaining

the competitiveness of a firm.

Any lapse of a firm on this account may lead a firm to the state of insolvency.


176


1. Maintaining adequate working capital at the satisfactory level is crucial for

______________the _____________of a firm.

2. Prepaid expenses are ____________.

3. Provision for tax is ______________.

4. A firm must ___________________ neither excess nor shortage.

11.3 Concepts of Working Capital There are two important concepts of Working Capital – gross and net

Gross Working Capital: Gross Working Capital refers to the amounts invested in the various

components of current assets. This concept has the following practical relevance.

a. Management of current assets is the crucial aspect of Working Capital Management.

b. It is an important component of operating capital. Therefore, for improving the profitability on

its investment a finance manager of a company must give top priority to efficient management

of current assets.

c. The need to plan and monitor the utilization of funds of a firm demands working capital

management as applied to current assets.

d. It helps in the fixation of various areas of financial responsibility.

Net Working Capital Net Working Capital is the excess of current assets over current liabilities and provisions. Net

Working Capital is positive. when current assets exceed current liabilities and negative when

current liabilities exceed current assets. This concept has the following practical relevance.

1. It indicates the ability of the firm to effectively use the spontaneous finance in managing the

firm’s Working Capital requirements.

2. A firm’s short term solvency is measured through the net Working Capital position it

commands.

Permanent Working Capital Permanent Working Capital is the minimum amount of investment required to be made in current

assets at all times to carry on the day to day operation of firm’s business. This minimum level of

current asset has been given the name of core current assets by the Tandon Committee. It is

also known as fixed Working Capital.


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Temporary Working Capital

It is also known as Variable Working Capital or fluctuating Working Capital. The firm’s working

capital requirements vary depending upon the seasonal and cyclical changes in demands for a

firm’s products. The extra Working Capital required as per the changing production and sales

levels of a firm is known as Temporary Working Capital.

Self Assessment Question 2 1. _______________ refers to the amounts invested in current assets.

2. To _______ and monitor the ________________________________ to (current assets) is to

be given top priority.

3. When current assets exceed current liabilities the net working capital is _____.

4. Permanent working is called ____ working capital.

11.4 Objective of Working Capital Management The basic objective of financial management is maximizing the net wealth of shareholders. A firm

must earn sufficient returns from its operations to ensure the realization of this objective. There

exists a positive correlation between sales and firm’s return on its investment. The amount of

earnings that a firm earns depends upon the volume of sales achieved. There is the need to

ensure adequate investment in current assets, keeping pace with accelerating sales volume.

Firms make sales on credit. There is always a time gap between sale of goods on credit and the

realization of proceeds of sales from the firm’s customers. Finance manger of a firm is required

to finance the operation during this time gap. Therefore, objective of Working Capital

Management is to ensure smooth functioning of the normal business operations of a firm. The

firm has to decide on the amount of Working Capital to be employed.

The firm may have a conservative policy of holding large quantum of current assets to ensure

larger market share and to prevent the competitors from snatching any market for their products.

But such a policy will affect the firm’s return on its investment. The firm will have higher than the

required amount of investment in current asset. This excess funds locked in current assets will

reduce the firm’s profitability on operating capital.

On the other hand a firm may have an aggressive policy of depending on spontaneous finance to

the maximum extent. Credit obtained by a firm from its suppliers is known as spontaneous

finance. Here a firm will try to reduce its investments in current assets as much as possible but

without affecting the firm’s ability to meet working capital needs for sales growth targets. Such a

policy will ensure higher return on its investment as the firm will not be locking in any excess


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funds in current assets. However, any error in forecasting can affect the operations of the firm

unfavorably if the error is fraught with the down side risk. There is also another risk of firm losing

on maintaining its liquidity position.

Objective of working capital management is achieving a trade – off between liquidity and

profitability of operations for the smooth conduct of normal business operations of the firm.

Self Assessments Questions 3 1. Objective of working capital management is achieving a trade off between ______ and

________.

2. Credit obtained by firm from its suppliers is know as _________.

3. An aggressive policy of working capital management means depending on

____________________ to the maximum extent.

4. To prevent the competitors from snatching any market for their products the firm may have a

________________ policy of holding __________ of current assets.

11.5 Need for working Capital The need for working capital arises on account of two reasons:

a. To finance operations during the time gap between sale of goods on credit and realization

of money from customer’s of the firm.

b. To finance investments in current assets for achieving the growth target in sales.

Therefore finance the operations in operating cycle of a firm working capital is required.


1. To finance the operations in _______ of a firm working capital is required.

2. To finance operations during the time gap between ______ and ____________ working capital

is required.

11.6 Operating Cycle Operating cycle of a firm has the following elements.

1. Acquisition of resources from suppliers.

2. Making payments to suppliers.

3. Conversion of raw materials into finished products.

4. Sale of finished products to customers.

5. Collection of cash from customers for the goods sold.


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The time gap between acquisition of resources and collection of cash from customers is known as

the operating cycle. These five phases occur on a continuous basis. There is no synchronization

between the activities in operating cycle. Cash out flows occur before the occurrences of cash

inflows in operating cycle cash out flows are certain. On the other hand cash in flows are

uncertain because of uncertainty associated. With effecting sales as per the sales forecast and

ultimate timely collection of amount due from the customers to whom the firm has sold its goods.

Since cash inflows do not match with cash out flows, firm has to invest in various current assets

to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess

the operating cycle time of its operation for providing adequately for its working capital

requirements.

Operating cycle = IC period + RC period

IC period = Inventory conversion period

RC period = Receivables conversion period

Inventory conversion period is the average length of time required to produce and sell the

product.

1. Inventory Conversion period = Average Inventory x 365

Annual cost of goods sold

2. Receivables conversion period = Average Accounts Receivables x 365

Annual Sales

Accounts payables period is also known as payables deferral period.

3. Accounts payables period = Average creditors

(Payables deferral period) purchases per day

Purchases per day = Total Purchases for year

365

Receivables conversion period is the average length of time required to convert the firm’s

receivables into cash.

4. Cash Conversion Cycle: Is the length of time between the firm’s actual cash expenditure

and its own cash receipt. The cash conversion cycle is the average length of time a rupee

is tied up in current assets.

Cash Conversion Cycle is


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CCC = ICP + RCP – PDP

CCC = Cash Conversion Cycle

ICP = Inventory Conversion Period

RCP = Receivables Conversion Period

PDP = Payables deferral period

Example: The following details are available for XYZ Ltd for the year ended 31.03.08

Sales 80,000 Inventory

Cost of goods 56,000 31.03.07 9,000

31.03.08 12,000

Accounts Receivables

31.03.07 12,000

31.03.08 16,000

Accounts Payable

31.03.07 7,000

31.03.08 10,000

What is the length of the operating cycle?

What is the cash cycle?

Assume 365 days in the year (MBA Adopted)

Answer

Operating Cycle = Inventory Conversion Period + Accounts Receivables conversion Period

Inventory Conversion Period

Average Inventory ( 9000 + 12000 ) / 2

Annual Cost of goods sold 56000

10500 x 365

56000

Average Accounts Receivables

Annual sales

( 12000 + 16000 ) / 2 x 365

80000

X 365 X 365

= 68.4 days

X 365 Receivables Conversion Period =

= 63.9 days


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Average Accounts Payables

Annual Cost of goods sold

( 7000 + 10000 ) / 2 x 365

56000

8500 x 365

56000

Operating Cycle = ICP + RCP

= 68.4 + 63.9 = 132.3 days

Cash Conversion cycle

= OC – PDP

= 132.3 – 55.4 = 76.9 days

The Cash conversion cycle shows the time interval over which additional non spontaneous

sources of working capital financing must be obtained to carry out firm’s activities. An increase in

the length of operating cycle, without a corresponding increase in payables deferral period,

increases the cash conversion cycle. Any increase in cash conversion cycle leads to additional

working capital needs of the firm.

Self Assessment Question 5 1. The time gap between acquisition of resources from suppliers and collection of cash from

customers is known as ______.

2. __________ is the average length of time required to produce and sell the product.

3. ______________ is the average lenth of time required to concept the firms receivables into

cash.

4. _______________ is conversion cycle is the length of time between firm’s actual cash

expenditure and its own receipt.

11.7 Determinants of Working Capital A large number of factors influence Working Capital needs of a firm. The basic objective of a

firm’s Working Capital management is to ensure that the firm has adequate working capital for its

operations, neither too much not too little. Investing heavily in current assets will drain the firm’s

earnings and inadequate investment in current assets will reduce the firm’s credibility as it affects

X 365 Receivables Conversion Period =

= 63.9 days

= 55.4days


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the firm’s liquidity. Therefore, the need to strike a balance between liquidity and profitability

cannot be ignored. The following factors determine a firm’s working capital requirements.

1. Nature of business: Working Capital requirements are basically influenced by the nature of

business of the firm. Trading organizations are forced to carry large stocks of finished goods,

accounts receivables and accounts payables. Public utilities require lesser investment in

working capital.

2. Size of Business Operation: Size is measured in terms of a scale of operation. A firm with

large scale of operation normally requires more Working Capital than a firm with a low scale of

operation.

3. Manufacturing Cycle: Capital intensive industries with longer manufacturing process will

have higher requirements of Working Capital because of the need to run their sophisticated

and long production process.

4. Products Policy: Production schedule of a firm influences the investments in inventories. A

firm, exposed to seasonal changes in demand when following a steady production policy will

have to face the costs and risks associated with inventory accumulation during the offseason

periods. On the other hand a firm with a variable production policy will be facing different

dimensions of management of working capital. Such a firm may have to effectively handle

problem of production planning and control associated with utilization of installed plant

capacity under conditions of varying volumes of production of products of seasonal demand.

5. Volume of sales: There is a positive direct correlation between the volume of sales and the

size of working capital of a firm.

6. Term of Purchase and Sales: A firm which allows liberal credit to its customers will need

more working capital than that of a firm with strict credit policy. A firm which enjoys liberal

credit facilities from its suppliers requires lower amount of working capital when compared to a

firm which does not have such a facility.

7. Operating efficiency: The firm with high efficiency in operation can bring down the total

investment in working capital to lower levels. Here effective utilization of resources helps the

firm in bringing down the investment in working capital.

8. Price level changes: Inflation affects the working capital levels in a firm. To maintain the

operating efficiency under an inflationary set up a firm should examine the maintenance of

working capital position under constant price level. The financial capital maintenance

demands a firm to maintain higher amount of working capital keeping pace with rising price

levels. Under inflationary conditions same levels of inventory will require increased


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investment. The ability of a firm to revise its products prices with rising price levels will decide

the additional investment to be made to maintain the working capital intact.

9. Business Cycle: During boom, sales rise as business expands. Depression is marked by a

decline in sale. During boom, expansion of business can be achieved only by augmenting

investment in various assets that constitute working capital of a firm. When there a decline in

business on account of depression in economy, inventory glut forces a firm to maintain

working capital at a level far in excess of the requirements under normal conditions.

10. Processing technology: Longer the manufacturing cycle the larger the investment in

working capital when raw material passes through several stages in the production process

work in process inventory will increase correspondingly.

11. Fluctuations in the supply of raw materials: Companies which use raw materials available

only from one or two sources are forced to maintain buffer stock of raw materials to meet the

requirements of uncertainty in lead time

Such firms normally carry more inventory than it would have, had the materials been available

in normal market conditions.


1. Capital intensive industries required ___ amount of working capital .

2. There is a _______________ between volume of sales and the size of working capital of a

firm.

3. Under inflationing conditions same level of inventory will require ____________ investment in

working capital

4. Longer the manufacturing cycle the _ the investment in working capital.

11.8 Estimation of Working Capital The best approach to estimate is based on operating cycle. Therefore, the two components of

working capital are current assets and current liabilities. This approach is based on the

assumption that production and sales occur on a continuous basis and all costs occur

accordingly. Estimation of Current Assets.

1. Raw materials inventory: Average investment in raw material is estimated.

2. Average investment in workinprogress inventory is estimated.

3. Average investment in finished goods inventory is estimated.


Sikkim Manipal University 184

4. Average investment in receivables (i,e both in debtors and bills receivables) is estimated

based on credit policy that the firm wishes to pursue.

5. Based on the firm’s attitude towards risk, access to borrowing sources, past experience and

nature of business, firms decide on the policy of maintaining the minimum cash balances.

Estimation of Current Liabilities: 1. Trade Creditors: Based on production budget, raw material consumption, credit period

enjoyed from suppliers average amount of financing available to the firm is estimated.

2. Direct wages: Based on production budget, direct labour cost per unit, average timelag in

payment of wages estimation is made on total wages to be paid on an average basis.

3. Overheads: Based on production budget, overhead cost per unit and average timelag in

payment of overhead an estimation on an average basis of the amount outstanding to be paid

to creditors for overhead.

Example: A Proforma cost sheet of a company provides the following data

Costs per Unit

Raw Material 52.00

Direct Labout 19.50

Overheads 39.00

Total Cost 110.50

Profit 19.50

Selling Price 130.00

The following additional information is available:

a. Average raw material in stock: One month

b. Average materials in process: Half a month

c. Credit allowed by Suppliers: One month

d. Credit allowed to debtors: Two months

e. Time lag in payment of wages: one and a half weeks

f. Time lag in payment of overheads one month

g. Onefourth of sales on cash basis

h. Cash balance expected to be maintained is Rs.1,20,000

You are required to prepare a statement showing the working capital required to finance a level of

activity of 70,000 units of output. You may assume that production is carried on evenly through


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out the year and wages and overheads occur similarly. Assume 360 days in a year (MBA

adapted)

Solution:

Estimation of Working Capital

a. Investment in inventory

1. Raw material

RMC = 70000 x 52

360 360

2. Work – in process inventory

COP = 70000 x 110.5

360 360

3. Finished goods inventory

COS = 70000 x 110.5 x 30 644583.33

360 360 1270208.33

b. Investment in debtors

Cost of Credit Sales 52500 x 110.5

360 360

c. Cash balance 120000

d. Total current Asset (A + B + C) 2357083.33

e. Current Liabilities

1. Creditors

Purchase of raw materials x PDP

360

70000 x 52 x30 = 303333.33

360

2. Wages

70000 x 19.5 x 10 = 37916.67

360

3. Overheads

70000 x 39 x 30 = 227500.00

360

X RMCP X 30 = 303333.33

X WIPCP X 15 = 322291.67

X FGCP =

X DCP X 60 = 966875.00


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f. Total Current Liabilities 568750.00

g. Net working Capital (D – F) 1788958.33

Examples 2 : The following annual figures relate to XYZ :

Sales (at two months credit) 36 00 000

Materials consumed

(Suppliers extend two months credit) 9 00 000

Wages Paid (monthly in arrears) 720 000

Manufacturing expenses outstanding

at the end of the year 80 000

(Cash expenses are paid one

month in arrears)

Total administrative expenses

paid, as above 240 000

Sales promotion expenses,

Paid quarterly in advance 120 000

The company sells its products on gross profit of 25% counting depreciation as part of the cost of

production. It keeps one month’s stock each of raw materials and finished goods, and a cash

balance of Rs.100 000.

Assume a 20 percent safety margin. Calculate the working capital requirements of the company

on cash cost basis. Ignore work in process.

[CA Final Adapted]

Solution

Working Notes :

Computation of manufacturing expenses

Sales 36 00 000

Less: gross profit at 25% 9 00 000

Total manufacturing cost 27 00 000

Less: Materials 9 00 000

Wages 7 20 000 16 20 000

Manufacturing expenses 1080000


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Cash manufacturing expenses 960000

Depreciation : Total manufacturing expenses – Cash manufacturing expenses

10 80 000 – 960000 = Rs.120000

Total cash cost

Total manufacturing cost 27 00 000

Less: Depreciation 120000

Cash manufacturing cost 2580000

Total manufacturing expenses 240000

Sales Promotion expenses 120000

Total cash cost 2940000

Statement of working capital required current assets:

Raw Materials stock

Material Cost 90000 x 1 = 75000

12 12

Finished goods stock

Cash manufacturing cost x 1

12

2580 000 x ½ = 215000

Debtors:

Total cash cost of sales x 2 /12

= 2940000 x 2 / 12 = 490000

Sales promotion expenses 30000

= 120000 x 1/4

Cash required 100000

(A) Total Assets 910000

Current Liabilities

Sundry Creditors

Material Cost 90000 x 2 = 150000

12 12

X 1

X 2


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Wages outstanding = 720000 x 1/12 = 60000

Manufacturing expenses outstanding = 80000

Total administrative expenses

Outstanding 240000 / 12 = 20000

(B) Total current Liabilities 310000

Working Capital

A – B 600000

Add 20% safety margin 120000

Working Capital required 720000

Self Assessment Questions 7 1. ________________ is used to estimate working capital requirements of a firm.

2. Operating cycle approach is based on the assumption that production and sales occur on a

_____________.

11.9 Summary All companies are required to maintain a minimum level of current assets at all point of time. This

level is called core or permanent working. Capital of the company. Working capital management

is concerned with the determination of optimum level of working capital and its effective utilization.

To assets the working capital required for a form to conduct its operations smoothly, firm use

operating cycle concept and compute each component of working capital.

Terminal Questions

1. Examine the Components of working capital. 2. Explain the concepts of working capital 3. What are the objectives of working capital management ?

4. Briefly explain the various elements of operating cycle.

Answer for Self Assessment Questions Self Assessment Questions 1

1. Maintaining, Competitiveness.

2. Current assets.

3. Current Liabilities

4. Adequate working capital


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1. Gross working capital

2. Plan, utilization of funds of a firm working capital management as applied.

3. Positive

4. Fixed

Self Assessment Questions 3 1. Liquidity, Profitability.

2. Spontaneous finance.

3. Spontaneous finance.

4. Conservative, Large quantum. Self Assessment Questions 4 1. Operating cycle

2. Sales of goods on credit, realization of money from customers.

Self Assessment Questions 5 1. Operating cycle

2. Inventory conversion period

3. Receivables conversion period

4. Cash Conversion cycle Self Assessment Questions 6 1. Higher

2. Positive direct correlation.

3. Increased

4. Larger Self Assessment Questions 7

1. Operating cycle

2. Continuous bases

Answer for Terminal Questions 1. Refer to unit 11.2





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Unit 12 Cash Management

Structure

12.1 Introduction

12.1.1 Meaning of Cash

12.2 Meaning and importance of cash management

12.3 Motives for holding cash balances

12.4 Objectives of Cash Management

12.5 Determining the Cash Needs– Models for Determining Optimal Cash

12.5.1 Baumol Model

12.5.2 MillerOrr model

12.5.3 Cash Planning

12.5.4 Cash Forecasting and Budgeting

12.6 Summary

Terminal Questions

Answers to TQs and SAQs.

12.1 Introduction Cash is the most important current asset for a business operation. It is the energy that drives

business activities and also the ultimate output expected by the owners. The firm should keep

sufficient cash at all times. Excessive cash will not contribute to the firm’s profits and shortage of

cash will disrupt its manufacturing operations.

12.1.1 Meaning of Cash The term ‘cash’ can be used in two senses – in a narrow sense it means the currency and other cash

equivalents such as cheques, drafts and demand deposits in banks. In a broader sense, it includes

nearcash assets like marketable securities and time deposits in banks. The distinguishing nature of

this kind of asset is that they can be converted into cash very quickly. Cash in its own form is an idle

asset. Unless employed in some form or another, it does not earn any revenue.


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1. Meaning of cash and near cash assets 2. The importance of cash management in a firm 3. The different models of determining the optimal cash balances 4. Techniques for forecasting the cash inflows and outflows.

12.2 Meaning and importance of Cash Management

Cash management is concerned with (a) management of cash flows into and out of the firm, (b) cash

management within the firm and (c) management of cash balances held by the firm – deficit financing

or investing surplus cash. Cash management tries to accomplish at a minimum cost the various tasks

of cash collection, payment of outstandings and arranging for deficit funding or surplus investment. It

is very difficult to predict cash flows accurately. Generally, there is no correlation between inflows

and outflows. At some points of time, cash inflows may be lower than outflows because of the

seasonal nature of product sale thus prompting the firm to resort to borrowings and sometimes

outflows may be lesser than inflows resulting in surplus cash. There is always an element of

uncertainty about the inflows and outflows. The firm should therefore evolve strategies to manage

cash in the best possible way. These can be broadly summarized as:

• Cash planning: Cash flows should be appropriately planned to avoid excessive or shortage of

cash. Cash budgets can be prepared to aid this activity

• Managing cash flows: The flow of cash should be properly managed. Steps to speed up cash

collection and inflows should be implemented while cash outflows should be slowed down.

• Optimum cash level: The firm should decide on the appropriate level of cash balance. Balance

should be struck between excess cash and cash deficient stage.

• Investing surplus cash: The surplus cash should be properly invested to earn profits. Many

investment avenues to invest surplus cash are available in the market such as, bank short term

deposits, TBills, inter corporate lending etc.


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The ideal cash management system will depend on a number of issues like, firm’s product,

competition, collection program, delay in payments, availability of cash at low rates of interests and

investment opportunities available.

12.3 Motives of Holding Cash There are four motives of holding cash. They are: Transaction motive: This refers to a firm holding cash to meet its routine expenses which are

incurred in the ordinary course of business. A firm will need finances to meet a plethora of payments

like wages, salaries, rent, selling expenses, taxes, interests, etc. The necessity to hold cash will not

arise if there were a perfect coordination between the inflows and outflows. These two never

coincide. At times, receipts may exceed outflows and at other times, payments outrun inflows. For

such periods when payments exceed inflows the firm should maintain sufficient balances to be able

to make the required payments. For transactions motive, a firm may invest its cash in marketable

securities. Generally, they purchase such securities whose maturity will coincide with payment

obligations.

Precautionary motive: This refers to the need to hold cash to meet some exigencies which cannot

be foreseen. Such unexpected needs may arise due to sudden slowdown in collection of accounts

receivable, cancellation of an order by a customer, sharp increase in prices of raw materials and

skilled labour etc. The moneys held to meet such unforeseen fluctuations in cash flows are called

precautionary balances. The amount of precautionary balance also depends on the firm’s ability to

raise additional money at a short notice. The greater the creditworthiness of the firm in the market,

the lesser is the need for such balances. Generally, such cash balances are invested in highly liquid

and low risk marketable securities.

Speculative motive: This relates to holding cash to take advantage of unexpected changes in

business scenario which are not normal in the usual course of firm’s dealings. It may also result in

investing in profitbacked opportunities as the firm comes across. The firm may hold cash to benefit

from a falling price scenario or getting a quantity discount when paid in cash or delay purchases of

raw materials in anticipation of decline in prices. By and large, business firms do not hold cash for

speculative purposes and even if it is done, it is done only with small amounts of cash. Speculation

may sometimes also boomerang in which case the firms lose a lot.


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Compensating motive: This is yet another motive to hold cash to compensate banks for providing

certain services and loans. Banks provide a variety of services like cheque collection, transfer of

funds through DD, MT, etc. To avail all these purposes, the customers need to maintain a minimum

balance in their account at all times. The balance so maintained cannot be utilized for any other

purpose. Such balances are called compensating balances. Compensating balances can take any

of the following two forms – (a) maintaining an absolute minimum, say for example, a minimum of Rs.

25000 in current account or (b) maintaining an average minimum balance of Rs. 25000 over the

month. A firm is more affected by the first restriction than the second restriction.

12.4 Objectives of Cash Management: There are two major objectives for cash management in a firm (a) meeting payments schedule and

(b) minimizing funds held in the form of cash balances.

Meeting payments schedule: In the normal course of functioning, a firm will have to make many

payments by cash to its employees, suppliers, infrastructure bills, etc. It will also receive cash

through sales of its products and collection of receivables. Both these do not happen simultaneously.

A basic objective of cash management is therefore to meet the payment schedule in time. Timely

payments will help the firm to maintain its creditworthiness in the market and to foster good and

cordial relationships with creditors and suppliers. Creditors give a cash discount if payments are

made in time and the firm can avail this discount as well. Trade credit refers to the credit extended

by the supplier of goods and services in the normal course of business transactions. Generally, cash

is not paid immediately for purchases but after an agreed period of time. There is deferral of payment

and is a source of finance. Trade credit does not involve explicit interest charges, but there is an

implicit cost involved. If the credit terms are, say, 2/10, net 30, it means the company will get a cash

discount of 2% for prompt payment made within 10 days or else the entire payment is to be made

within 30 days. Since the net amount is due within 30 days, not availing discount means paying an

extra 2% for 20day period.

The other advantage of meeting the payments in time is that it prevents bankruptcy that arises out of

the firm’s inability to honour its commitments. At the same time, care should be taken not to keep

large cash reserves as it involves high cost.


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Minimize funds committed to cash balances: Trying to achieve the second objective is very

difficult. A high level of cash balances will help the firm to meet its first objective discussed above, but

keeping excess reserves is also not desirable as funds in its original form is idle cash and a non

earning asset. It is not profitable for firms to keep huge balances. A low level of cash balances may

mean failure to meet the payment schedule. The aim of cash management is therefore to have an

optimal level of cash by bringing about a proper synchronization of inflows and outflows and check

the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of

mismatches between inflows and outflows.

The efficiency of cash management can be augmented by controlling a few important factors

described below:

Prompt billing and mailing: There is a time lag between the dispatch of goods and preparation of

invoice. Reduction of this gap will bring in early remittances.

Collection of cheques and remittances of cash: It is generally found that there is a delay in the

receipt of cheques and their deposits into banks. The delay can be reduced by speeding up the

process of collection and depositing cash or other instruments from customers. The concept of ‘float’

helps firms to a certain extent in cash management. Float arises because of the practice of banks not

crediting firm’s account in its books when a cheque is deposited by it and not debit firm’s account in

its books when a cheque is issued by it until the cheque is cleared and cash is realized or paid

respectively. A firm issues and receives cheques on a regular basis. It can take advantage of the

concept of float. Whenever cheques are deposited with the bank, credit balance increases in the

firm’s books but not in bank’s books until the cheque is cleared and money realized. This refers to ‘collection float’, that is, the amount of cheques deposited into a bank and clearance awaited. Likewise the firm may take benefit of ‘payment float’. The difference between payment float and collection float is called as ‘net float’. When net float is positive, the balance in the firm’s books is less than the bank’s books; when net float is negative; the firm’s book balance is higher than in the

bank’s books.

12.5 Determining the Cash Needs – Models for Determining Optimal Cash One of the prime responsibilities of a Finance Manager is to maintain an appropriate balance

between cash and marketable securities. The amount of cash balance will depend on riskreturn


195

tradeoff. A firm with less cash balances has a weak liquidity position but may be earning profits by

investing its surplus cash and on the other hand it loses on the profits by holding too much cash. A

balance has to be maintained between these aspects at all times. So how much is optimum cash?

This section explains the models for determining the appropriate balance. Two important models are

studied here – Baumol model and MillerOrr model.

12.5.1 Baumol Model The Baumol model helps in determining the minimum cost amount of cash that a manager can obtain by converting securities into cash. It is an approach to establish a firm’s optimum cash balance under certainty. As such, firms attempt to minimize the sum of the cost of holding cash and the cost of converting marketable securities to cash. The Baumol model is based on the following assumptions:

• The firm is able to forecast its cash requirements in an accurate way.

• The firm’s payouts are uniform over a period of time.

• The opportunity cost of holding cash is known and does not change with time. • The firm will incur the same transaction cost for all conversions of securities into cash.

A company will sell securities and realizes cash and this cash is used to make payments. As the cash balance comes down and reaches a point, the Finance Manager replenishes its cash balance by selling marketable securities available with it and this pattern continues. Cash balances are refilled and brought back to normal levels by the acts of sale of securities. The average cash balance is C/2. The firm buys securities as and when they have abovenormal cash balances. This pattern is

explained below: Error!

Baumol’s Model 0 T1 T3 T2

C/2

C

Time

Cash balance

Average


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The total cost associated with cash management has two elements—(a) cost of conversion of

marketable securities into cash and (b) the opportunity cost.

The firm incurs a holding cost for keeping cash balance which is the opportunity cost. Opportunity

cost is the benefit foregone on the next best alternative for the current action. Holding cost is k(C/2).

The firm also incurs a transaction cost whenever it converts its marketable securities into cash. Total

number of transactions during the year will be the total funds requirement, T, divided by the cash

balance, C, i.e. T/C. If per transaction cost is c, then the total transaction cost is c(T/C).

The total annual cost of the demand for cash is k(C/2) + c(T/C).

Error!

The optimum cash balance C* is obtained when the total cost is minimum which is expressed as C* = √2cT/k where C* is the optimum cash balance, c is the cost per transaction, T is the total cash

needed during the year and k is the opportunity cost of holding cash balance. The optimum cash

balance will increase with increase in the per transaction cost and total funds required and decrease

with the opportunity cost.

Example:

A firm’s annual cost requirement is Rs. 20000000. The opportunity cost of capital is 15% per annum.

Rs. 150 is the per transaction cost for the firm when it converts is shortterm securities to cash. Find

Cash balance

Transaction cost

Holding cost

Total cost

Cost

C*

Baumol’s Cutoff Model


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out the optimum cash balance. What is the annual cost of the demand for the optimum cash

balance?

Solution

C* = √2cT/k = √ [2(150)(20000000)] / 0.15 = Rs. 200000 The annual cost is 150(20000000/200000) + 0.15 (200000/2) = Rs. 30000. Example:

Mysore Lamps Ltd. requires Rs. 30 lakhs to meet its quarterly cash requirements. The annual return

on its marketable securities which are of the tune of Rs. 30 lakhs is 20%. The conversion of the

securities into cash necessitates a fixed cost of Rs. 3000 per transaction. Compute the optimum

conversion amount.

Solution C* = √2cT/k = √[2*3000*3000000] / 0.05 @ = Rs. 600000

@ is 20% / 4 as 20% is annual return and fund requirement is done on a quarterly basis.

12.5.2 MillerOrr model MillerOrr came out with another model due to the limitation of the Baumol model. Baumol model

assumes that cash flow does not fluctuate. In the real world, rarely do we come across firms which

have their cash needs as constant. Keeping other factors such as expansion, modernization,

diversification constant, firms face situations wherein they need additional cash to maintain their

present position because of the effect of inflationary pressures. The firms therefore cannot forecast

their fund requirements accurately. The MillerOrr model overcomes this shortcoming and considers

daily cash fluctuations. The MO model assumes that cash balances randomly fluctuate between an

upper bound (upper control limit) and a lower bound (lower control limit). When cash balances hit the

upper limit, the firm has too much cash and it is time to buy enough marketable securities to bring

back to the optimal bound. When cash balances touch zero level, the level is brought up by selling

securities into cash. Return point lies between the upper and lower limits. Symbolically, this can be

expressed as Z = 3√3/4*(cσ 2 /i) where Z is the optimal cash balance, c is the transaction cost, σ 2 is

the standard deviation of the net cash flows and i is the interest rate. MO model also suggests the

optimum upper boundary b as three times the optimal cash balance and lower limit, i.e. upper limit b=lower limit + 3Z and return point=lower limit + Z. This is shown graphically as follows:


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Error!

MillerOrr Model Example:

Mehta industries have a policy of maintaining Rs. 500000 minimum cash balance. The

standard deviation of the company’s daily cash flows is Rs. 200000. The interest rate is 14%. The

company has to spend Rs. 150 per transaction. Calculate the upper and lower limits and the return

point as per MO model.

Solution

Z = 3√3/4*(cσ 2 /i) 3√3/4*(150*200000 2 ) / 0.14/365 = Rs. 227226 The Upper control limit = lower limit + 3Z = 500000 + 3*227226 = Rs. 1181678 Return point = lower limit + Z = 500000 + 227226 = Rs. 727226 Average cash balance = lower limit + 4/3Z = 500000 + 4/3*227226 = Rs. 802968

12.5.3 Cash Planning Cash planning is a technique to plan and control the use of cash. It helps in developing a projected

cash statement from the expected inflows and outflows of cash. Forecasts are based on the past

performance and future anticipation of events. Cash planning can be done a daily, weekly or on a

monthly basis. Generally, monthly forecasts are commonly prepared by firms.

Upper limit

Lower limit

Return point

Cash balance

Time


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12.5.4 Cash Forecasting and Budgeting Cash budget is a device to plan for and control cash receipts and payments. It gives a summary of

cash flows over a period of time. The Finance Manager can plan the future cash requirements of a

firm based on the cash budgets. The first element of a cash budget is the selection of the time period

which is referred to as the planning horizon. Selecting the appropriate time period is based on the

factors exclusive to the firms. Some firms may prefer to prepare weekly budget while others may

work out monthly estimates while some others may be preparing quarterly or yearly budgets. Firms

should keep in mind that the period selected should be neither too long nor too short. Too long a

period, estimates will not be accurate and too short a period requires periodic changes. Yearly

budgets can be prepared by such companies whose business is very stable and they do not expect

major changes affecting the company’s flow of cash.

The second element that has a bearing on cash budget preparation is the selection of factors that

have a bearing on cash flows. Only items of cash nature are to be selected while noncash items

such as depreciation and amortization are excluded.

Cash budgets are prepared under three methods:

1. Receipts and Payments method

2. Income and Expenditure method

3. Balance Sheet method

We shall be discussing only the receipts and payments method of preparing cash budgets.

Example :

Given below is the prepared a cash budget of M/s. Panduranga Sheet Metals Ltd. for the 6 months

ending 30 th June 2007. It has an opening cash balance of Rs. 60000 on 1 st Jan 2007.

Month Sales Purchases Wages Production overheads

Selling overheads

Jan 60000 24000 10000 6000 5000

Feb 70000 27000 11000 6300 5500

March 82000 32000 10000 6400 6200

April 85000 35000 10500 6600 6500

May 96000 38800 11000 6400 7200

June 110000 41600 12500 6500 7500


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The company has a policy of selling its goods 50% on cash basis and the rest on credit terms.

Debtors are given a month’s time period to pay their dues. Purchases are to be paid off two months

from the date of purchase. The company has a time lag in the payment of wages of ½ a month and

the overheads are paid after a month. The company is also planning to invest in a machine which will

be useful for packing purposes, the cost being Rs. 45000, payable in 3 equal installments

starting bimonthly from April. It also expects to make a loan application to a bank for Rs. 50000 and

the loan will be granted in the month of July. The company has to pay advance income tax of Rs.

20000 in the month of April. Salesmen are eligible for a commission of 4% on total sales effected by

them and this is payable one month after the date of sale.

Solution

Jan Feb March April May June Opening cash balance

60000 85000 126100 153000 118850 150100

Cash receipts: Cash sales 30000 35000 41000 42500 48000 55000 Credit sales 30000 35000 41000 42500 48000 Total cash available

90000 150000 202100 236500 209350 253100

Cash payments Materials 24000 27000 32000 35000 Wages 5000 10500 10500 10250 10750 11750 Production overheads

6000 6300 6400 6600 6400

Selling overheads

5000 5500 6200 6500 7200

Sales commission

2400 2800 3280 3400 3840

Purchase of asset

15000 15000

Payment of advance IT

20000

Total cash payments

5000 23900 49100 117650 59250 79190

Closing cash balances

85000 126100 153000 118850 150100 173930


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Working note: Wages calculation

Jan Feb Mar Apr May Jun 10000 11000 10000 10500 11000 12500 5000 5500feb 5000mar 5250apr 5500may 6250jun

5000mar 5500feb 5000mar 5250apr 5500may 5000 10500 10500 10250 10750 11750


1. Management of cash balances can be done by ____________ and _________.

2. The four motives for holding cash are ___________, _______________, ____________ and

____________.

3. The greater the creditworthiness of the firm in the market lesser is the need for ___________

balances.

4. __________refers to the credit extended by the supplier of goods and services in the normal

course of business transactions.

5. When cheques are deposited in a bank, credit balance increases in the firm’s books but not in

bank’s books until the cheque is cleared and money realized. This is called as

________________.

6. According to Baumol model, the total cost associated with cash management has two elements

______________ and ____________.

7. The MO model assumes that cash balances randomly fluctuate between a ____________and a

__________________.

12.6 Summary All companies are required to maintain a minimum level of current assets at all points of time. Cash management is concerned with determination of relevant levels of cash balances and near cash assets and their efficient use.

The need for holding cash arises due to a variety of motives – transaction motive, speculation

motive, precautionary motive and compensating motive. The objective of cash management is to

make shortterm forecasts of cash inflows and outflows, investing surplus cash and finding means to

arrange for cash deficits. Cash budgets help Finance Manager to forecast the cash requirements.


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Terminal Questions

1. Miraj Engineering Co. has forecast its sales for the 3 months ending Dec. as follows:

Oct. Rs. 500000 Nov Rs. 600000 Dec. Rs. 650000

The goods are sold on cash and credit basis 50% each. Credit sales are realized in the month

following the sale. Purchases amount to 50% of the month’s sales and are paid in the following

month. Wages and administrative expenses per month amount to Rs. 150000 and Rs. 80000

respectively and are paid in the following month. On 1 st Dec. the company has purchased a

testing equipment worth Rs. 20000 payable on 15 th Nov. On 31 st Dec. a cash deposit with a bank

will mature for Rs. 150000. The opening cash balance on 1 st Nov. is Rs. 100000. What is the

closing balance in Nov. and Dec.?

2. Michael Industries Ltd. requests you to help them in preparing a cash budget for the period

ending Dec. 2007.

Rs. in lakhs

Particulars May June July Aug Sep Oct Nov Dec Jan Sales 15 20 22 3 34 25 25 15 15 Materials 7 20 22 29 15 15 8 8 Nil Rent – – 0.50 0.5 0.5 0.50 0.5 0.5 – Salaries – – 1.5 2 2.5 1.5 1 1 – Misc charges

– – 0.15 0.2. 0.2 0.4. 0.3. 0.2 –

Taxes – – – – – 4 – – – Purchase of asset

– – – – – – 10 – –

Credit terms: Customers are allowed 1 month time.

Suppliers of materials are paid after 2 months.

The company pays salaries after a gap of 15 days.

Rent is paid after a gap of 1 month.

The company has an opening balance of Rs. 200000 on 1 st June.

Prepare a cash budget and find out what is the closing cash balance on 31 st Dec.


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1. Deficit financing or investing surplus cash

2. Transaction, speculative, precautionary and compensating

3. Precautionary

4. Trade credit

5. Collection float

6. Cost of conversion of marketable securities into cash and opportunity cost.

7. Upper bound (upper control limit) and lower bound (lower control limit).

Answer to Terminal Questions

1. Prepare a Cash Budget for November and December. Refer to the Example 12.5.4

2. Prepare a cash budget as shown in Example 12.5.4.


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Unit 13 Inventory Management

Structure

13.1 Introduction

13.2 Costs associated with inventories are

13.3 Inventory management Techniques

13.3.1 Determination of Stock Levels

13.3.2 Pricing of inventories

13.4 Summary

Terminal Questions


13.1 Introduction Inventories are the most significant part of current aspects of most of the firms in India. Since

they constitute an important element of total current assets held by a firm the need to manage

inventories efficiently and effectively for ensuring optimal investment in inventory cannot be

ignored. Any lapse on the part of management of a firm in managing inventories may cause the

failure of the firm. The major objectives of inventory management are:

a. Maximum satisfaction to customer.

b. Minimum investment in inventory.

c. Achieving low cost plant operation.

These objectives conflict each other. Therefore, a scientific approach is required to arrive at an

optimal solution for earning maximum profit on investment in inventories.

Decisions on inventories involve many departments:

a. Raw material policies are decided by purchasing and production departments;

b. Production department plays an important role in work – in – process inventory, policy and

c. Finished goods inventory policy is shaped by production and marketing departments.

But the decisions of these departments have financial implications. Therefore, as an executive

entrusted with the responsibility of managing finance of the company, the financial manager of the

firm has to ensure that monitoring and controlling inventories of the firm are executed in a

scientific manner for attaining the goal of wealth maximization of the firm.


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1. Explain the meaning of inventory management. 2. State the objectives of inventory management. 3. Bring out the importance of inventory management.

4. State the purpose of inventory. 5. Discuss the techniques of inventory control.

Role of inventory in working Capital: Inventories constitute an important component of a firm’s working capital. The following features

of inventory highlight the significance of inventory in working capital management.

1. Characteristics of inventory as current assets. Current assets are those assets which are expected to be realized in cash or sold or consumed

during the normal operating cycle of the business. Various forms of inventory in any

manufacturing unit are:

a. Raw materials to be converted into finished goods through the process of production.

b. Work – in – process inventories are semi finished products in the process of being converted

into finished good.

c. Finished goods inventories are completely manufactured products that can be sold

immediately.

The first two are inventories concerned with production and the third is meant for smooth

performance of marketing function of the firm.

Nature of business influences the levels of inventory that a firm has to maintain in these three

kinds. A manufacturing unit will have to maintain high levels of inventory in all the three forms. A

retail firm will be maintaining very high level of finished goods inventory only.

The three kinds of inventories listed above are direct inventories. There is an another form of

indirect inventories. These indirect inventories are those item which are necessary for

manufacturing but do not become part of the finished goods. They are lubricants, grease, oil,

petrol, office material maintenance material etc.

The Inventories are held for the following reasons.

1. Smooth production: to ensure smooth production as per the requirements of marketing

department, inventories are procured and sold.


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2. To achieve Competitive edge: Most of the retail and industrial organizations carry inventory

to ensure prompt delivery to customers. No firm likes to lose customers on account of the

item being out of stock.

3. To reap the benefits of buying in large volume. Sometimes buying in large volumes may give

the firm quantity discounts. This quantity discounts may be substantial that the firm will take

benefit of it.

4. Hedge against uncertain lead times: Lead time is the time required to procure fresh supplies

of inventory. Uncertainty due to supplier taking more than the normal lead time will affect the

production schedule and the execution of the orders of customers as per the orders received

from customers. To avoid all these problems arising from uncertainty in procurement of fresh

supplies of inventories, the firms maintain higher levels of inventories for certain items of

inventory.

2. Level of liquidity: Inventories are meant for consumption or sale. Both excess and shortage

of inventory affect of the firm’s.Profitability .

Though inventories are called current assets, in calculating absolute liquidity of a firm inventories

are excluded because it may have slow moving or dormant items of inventory which cannot be

easily disposed of. Therefore level and composition of inventory significantly influence the

quantum of working capital and hence profitability of the firm.

3. Liquidity Lags: Inventories have three types of lags. a. Creation lag: Raw materials are purchased on credit and consumed to produce

finished goods. There is always a lag in payment to suppliers from whom raw

materials are procured. This is called spontaneous finance. The amount of

spontaneous finance that a firm is capable of enjoying influences the quantum of

working capital of a firm.

b. Storage lag: The goods manufactured or held for sale cannot be converted into

cash immediately. Before dispatching the goods to customers on sale, there is

always a time lag. During this time lag goods are stored in warehouse. Many

expenses of storage will be recurring in nature and cannot be avoided. The level

of expenditure that a firm incurs on this account is influenced by the inventory

levels of the firm. This influences the working capital management of a firm.

c. Sale Lag: Firms sell their products on credit. There is some time lag between sale

of finished goods and collection of dues from customers. Firms which are

aggressive in capturing markets for their products maintain high levels of inventory

and allow its customers liberal credit period. This will increase its investment in


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receivables. This increase in investment in receivables will have its effect on

working capital of the firm.

Purpose of inventory:

The purpose of holding inventory is achieving efficiency through cost reduction and increased

sales volume. The following are the purpose of holding inventories.

1. Sales : Customers place orders for goods only when they need it. But when customers approach the firm with orders the firms must have adequate inventory of finished goods to

execute it. This is possible only when firms maintain ready stock of finished goods in

anticipation of orders from customers. If a firm suffers from complaints from customers of

constantly the product being out of stock, customers may migrate to other producers. It

will affect the firm’s customer’s base, customer loyalty and market share.

2. To avail quantity discounts: Suppliers give discounts for bulk purchases. Such

discounts decrease the cost per unit of inventory purchased. Such cost reduction

increase firm’s profits. Firms may go in for orders of large quantity to avail themselves of

the benefit of quantity discounts. 3. Reducing ordering Costs and time

Every time a firm places an order it incurs cost of procuring it. It also involves a lead time

in procurement. In some cases the uncertainty in supply due to certain administrative

problems of the supplier of the product will affect the production schedules of the

organization. Therefore, firms maintain higher levels of inventory to avoid the risks of

lengthening the lead time in procurement. Therefore, to save on time and costs firms may

place orders for large quantities. 4. Reduce risk of production stoppages

Manufacturing firms require a lot of raw materials and spares and tools for production and

maintenance of machines. Non availability of any vital item can stop the production

process. Production stoppage has serious consequences. Loss of customers on account

of the failure to execute their orders will affect the firm’s profitability. To avoid such

situations, firms maintain inventories as hedge against production stoppages.

Therefore, it can be concluded that the motives for holding inventories are

1. Transaction motive: for making available inventories to facilitate smooth

production and sales.

2. Precautionary motive: For guarding against the risk of unexpected changes in

demand and supply.


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3. Speculative motive: To take benefit out of the changes in prices firms increase

or decrease the inventory levels.

13.2 Costs associated with inventories are: 1. Material costs: These are the costs of purchasing the goods and related costs such as

transportation and handling costs associated with it.

2. Ordering Cost: The expenses incurred to place orders with suppliers and replenish

the inventory of raw material are called ordering costs. They include costs of the

following.

a. Requisitioning

b. Purchase ordering or setup

c. Transportation

d. Receiving, inspecting and receiving at the ware house. These costs increase

in proportion to the number of orders placed. Firms maintaining large inventory

levels, place a few orders and incur less ordering costs.

3. Carrying Costs: costs incurred for maintaining the inventory in ware house are called

carrying costs. They include interest on capital locked up in inventory, storage,

insurance, taxes, obsolescence, deterioration spoilage, salaries of ware house staff

and expenses on maintenance of ware house building. The greater the inventory held

the higher the carrying costs.

4. Shortage costs or stock out costs: These are the costs associated with either a delay

in meeting the demand or inability to meet the demand at all due to shortage of stock.

These costs include.

a. Loss of profit on account sales lost caused by the stock out.

b. Loss of future sales customers migrate to other dealers.

c. Loss of customer goodwill and

d. Extra costs associated with urgent replenishment purchases.

Measurement of shortage cost attributable to the firm’s failure to meet customers demand is

difficult because it is intangible in nature and it affects the operation of the firm now and in future. Self Assessment Questions 1 1. Lead time is the time required to _______________.

2. Both excess and shortage of inventory affect the firm’s ____________.

3. Precautionary motive of holding inventory is for guarding against the risk of

_____________________ and supply.

4. Costs incurred for maintaining the inventory in warehouse are called ______.


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13.3 Inventory management Techniques There are many techniques of management of inventory. Some of them are:

Economic Order Quantity:

EOQ refers to the optimal order size that will result in the lowest ordering and carrying costs for

an item of inventory based on its expected usage.

EOQ model answers the following key quantum of inventory management.

a. What should be the quantity ordered for each replenishment of stock?

b. How many orders are to be paced in a year to ensure effective inventory Management?

EOQ is defined as the order quantity that minimizes the total cost associated with inventory

management.

It is based on the following assumptions:

1. Constant or uniform demand. The demand or usage is even throughout the period.

2. Known demand or usage: Demand or usage for a given period is known i.e deterministic.

3. Constant Unit price: Per unit price of material does not change and is constant irrespective of

the order size.

4. Constant Carrying Costs

The cost of carrying is a fixed percentage of the average value of inventory.

5. Constant ordering cost

Cost per order is constant whatever be the size of the order.

6. Inventories can be replenished immediately as the stock level reaches exactly equal to zero.

Consequently there is no shortage of inventory.

7.

Carrying Costs

Ordering Costs

Cost

Total Cost

Q

x


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Economic order Quantity

√2DK

√Kc

D = Annual usage or demand

Q x = Economic order Quantity

K = ordering cost per order

kc = pc = price per unit x percent carrying cost = carrying cost of inventory per unit per annum.

Example: Annual consumption of raw materials is 40,000 units. Cost per unit Rs 16

Carrying cost is 15% per annum.

Cost of placing an order = Rs 480

Solution:

√2 x 40000 x 480

√16 x 0.15

Example: A company has gathered the following information:

Annual demand 30,000 units

Ordering cost per order = Rs 20 (Fixed)

Carrying cost = Rs 10 per unit per annum

Purchase cost per unit i.e price per unit = Rs 32 per unit

Determine EOQ, total number of orders in a year and the time – gap between two orders. Solution:

√2DK √2 x 30000 x 20

√Kc 10

= 346 units

K = Rs.20

Kc = Rs.10

D = 30000

The total number of orders in a year = 30,000

346

= 87 orders

Q x =

EOQ = = 4000 units

Q x = =


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Time gap between two orders = 365 = 4 days

87

1. ABC System: the inventory of an industrial firm generally comprises of thousands of items

with diverse prices, large lead time and procurement problems. It is not possible to exercise

the same degree of control over all these items. Items of high value require maximum

attention while items of low value do not require same degree of control. The firm has to be

selective in its approach to control its investment in various items of inventory. Such an

approach is known as selective inventory control. ABC system belongs to selective inventory

control.

ABC analysis classifies all the inventory items in an organization into three categories.

A: Items are of high value but small in number. A items require strict control.

B: Items of moderate value and size which require reasonable attention of the

management..

C: Items represent relatively small value items and require simple control.

Since this method concentrates attention on the basis of the relative importance of various

items of inventory it is also known as control by importance and exception. As the items

are classified in order of their relative importance in terms of value, it is also known as

proportional value Analysis. Advantages of ABC analysis: 2. It ensures closer controls on costly elements in which firm’s greater part of resources are

invested.

3. By maintaining stocks at optimum level it reduces the clerical costs of inventory control.

4. Facilitates inventory control and control over usage of materials, leading to effective cost

control.

Limitations:

1. A never ending problem in inventory management is adequately handling thousands of low

value of c items. ABC analysis fails to answer this problem.

2. If ABC analysis is not periodically reviewed and updated, it defeats the basic purpose of ABC

approach.


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13.3.1 Determination of Stock Levels Most of the industries are subject to seasonal fluctuations and sales during different months of the

year are usually different. If, however, production during every month is geared to sales demand

of the month, facilities have to installed to cater to for the production required to meet the

maximum demand. During the slack season, a large portion of the installed facilities will remain

idle with consequent uneconomic production cost. To remove this disadvantage, attempt has to

be made to obtain a stabilized production programme throughout the year. During the slack

season, there will be accumulation of finished products which will be gradually cleared as sales

progressively increase. Depending upon various factors of production, storing and cost, a normal

capacity will be determined. To meet the pressure of sales during the peak season, however,

higher capacity may have to be sued for temporary periods. Similarly, during the slack season, to

avoid loss due to excessive accumulation, capacity usage may have to be scaled down.

Accordingly, there will be a maximum capacity and minimum capacity, only consumption of raw

material will accordingly vary depending upon the capacity usage.

Again, the delivery period or lead time for procuring the materials may fluctuate. Accordingly,

there will be maximum and minimum delivery period and the average of these two is taken as the

normal delivery period. Maximum Level:

Maximum level is that level above which stock of inventory should never rise. Maximum level is

fixed after taking in to account the following factors:

1. Requirement and availability of capital

2. Availability of storage space and cost of storing.

3. Keeping the quality of inventory intact

4. Price fluctuations

5. Risk of obsolescence, and

6. Restrictions, if any, imposed by the government.

Maximum Level = Ordering level – (MRC x MDP) + standard ordering quantity.

Where, MRC = minimum rate of consumption

MDP= minimum lead time. Minimum Level: Minimum level is that level below which stock of inventory should not normally fall.

Minimum level = OL – (NRC x NLT)


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Where,

OL = ordering level

NRC = Normal rate of consumption

NLT = Normal Lead Time. Ordering Level:

Ordering level is that level at which action for replenishment of inventory is initiated.

OL = MRC X MLT

Where,

MRC = Maximum rate of consumption

MLT = Maximum lead time.

3. Average stock level Average stock level can be computed in two ways

1. minimum level + maximum level

2

2. Minimum level + 1 /2 of reorder quantity.

Average stock level indicates the average investment in that item of inventory. It in of quite

relevant from the point of view of working capital management.

Managerial significance of fixation of Inventory level : 1. It ensure the smooth productions of the finished goods by making available the raw material

of right quality in right quantity at the right time.

2. It optimizes the investment in inventories. In this process, management can avoid both

overstocking and shortage of each and every essential and vital item of inventory.

3. It can help the management in identifying the dormant and slow moving items of inventory.

This brings about better coordination between materials management and production

management on the one hand and between stores manager and marketing manager on the

other.

Re – order Point: “When to order” is another aspect of inventory management. This is answered by re – order

point. The re – order point is that inventory level at which an order should be placed to replenish

the inventory.


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To arrive at the re – order point under certainty the two key required details are:

1. Lead time

2. Average usage

lead time refers to the average time required to replenish the inventory after placing orders

for inventory

Re – order point = lead time x Average usage

Under certainty, re – order point refers to that inventory level which will meet the consumption

needs during the lead time.

Safety Stock: Since it is difficult to predict in advance usage and lead time accurately, provision

is made for handling the uncertainty in consumption due to changes in usage rate and lead time.

The firm maintains a safety stock to manage the stock – out arising out of this uncertainty.

When safety stock is maintained, (When Variation is only in usage rate)

Re – order point = lead time x Average usage + Safety stock

Safety stock = [(maximum usage rate) – (Average usage rate)] x lead time. Or Safety stock when the variation in both lead time and usage rate are to be incorporated.

Safety stock = (Maximum possible usage) – (Normal usage)

Maximum possible usage = Maximum daily usage x Maximum lead time

Normal usage = Average daily usage x Average lead time

Example: A manufacturing company has an expected usage of 50,000 units of certain product

during the next year. Re cost of processing an order is Rs 20 and the carrying cost per unit per

annum is Rs 0.50. Lead time for an order is five days and the company will keep a reserve of two

days usage. Calculate 1. EOQ 2. Re – order point. Assume 250 days in a year

Solution:

√2DK √2 x 50000 x 20

√Kc 0.50

= 2000 units

Re order point Daily usage = 50000 = 200 units

250

Safety stock = 2 x 200 400 units.

EOQ = =


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Re – order point (lead time x Average usage) + safety stock

(5 x 200) + 400 = 1,400 units

13.3.2 Pricing of inventories There are different ways of pricing inventories used in production. If the items in inventory are

homogenous (identical except for in significant differences) it is not necessary to use specific

identification method. The convenient price is using a cost flow assumption referred to as a flow

assumption.

When flow assumption is used it means that the firm makes an assumption as to the sequence in

which units are released from the stores to the production department.

The flow assumptions selected by a company need not correspond to the actual physical

movement of raw materials. When units of raw material are identical, it does not matter which

units are issued from the stores to the production department.

The method selected should match the costs with the revenue to ensure that the profits are

uncertain in a manner that reflects the conditions actually prevalent.

1. First in, first out (FIFO): It assumes that the raw materials (goods) received first are used first.

The same sequence is followed in pricing the material requisitions.

2. LIFO (last in, first out): The consignment last received is first used and if this is not sufficient

for the requisitions received from production department then the use is made from the

immediate previous consignment and so on. The requisitions are priced accordingly. This

method is considered to be suitable under inflationary conditions. Under this method the cost

of production reflects the current market trend. The closing inventory of raw material will be

valued on a conservative basis under the inflationary conditions.

3. Weighted average: Material issues are priced, at the weighted average cost of materials in

stock. This method considers various consignments in stock along with their unit’s prices for

pricing the material issues from stores.

4. other methods are:

a. Replacement price method: This method prices the issues at the value at which it can be

procured from the market.

b. Standard price method: under this method the materials are priced at standard price.

Standard price is decided based on market conditions and efficiency parameters. The

difference between the purchase price and the standard price is analyzed through variance

analysis.


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1. ABC system belongs to ______.

2. ______________ are of high value but small in number.

3. ABC system is known as _____________ because the items are classified in order of their

relative importance in terms of value.

4. _________ is defined as the order quantity that minimizes the total cost of inventory

management.

13.4 Summary Inventories form part of current assets of firm. Objectives of inventory management are.

a. Maximum customer satisfaction

b. Optimum investment in inventory and

c. Operation of the plant at the least cost structure. Inventories could be grouped into direct

inventories are raw materials, workin process inventories and finished goods inventory.

Indirect inventories are those items which are necessary for production process but do not

become part of the finished goods. There are many reasons attributable to holding of

inventory by the managements.

Terminal Questions 1. Examine the reasons for holding inventories by a firm.

2. Discuss the techniques of inventory control.

3. Discuss the relevance and factors that influence the determination of stock level.

4. Explain the various cost of inventory decision.

Answer for Self Assessment Questions

Self Assessment Questions 1 1. Obtain fresh supplies of inventory

2. Profitability

3. Unexpected changes in demand, supply

4. Carrying costs

Self Assessment Questions 2 1. Selective inventory control.

2. A items

3. Proportional value analysis


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4. EOQ.

Answer for Terminal Questions

1. Refer to unit 13.1 2. Refer to 13.3

3. Refer to 13.3.3

4. Refer to 13.2


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Unit 14 Receivables Management

Structure

14.1 Introduction

14.2 Costs associated with maintaining receivables

14.3 Credit policy variables

14.4 Evaluation of credit policy

14.5 Summary

Terminal Questions

14.6 Answer to SAQs and TQs

14.1 Introduction:

Firms sell goods on credit to increase the volume of sales. In the present era of intense

competition, business firms, to improve their sales, offer to their customers relaxed

conditions of payment. When goods are sold on credit, finished goods get converted into

receivables. Trade credit is a marketing tool that functions as a bridge for the movement

of goods from the firm’s wear house to its customers. When a firm sells goods on credit

receivables are created. The receivables arising out of trade credit have three features.

1. It involves an element of risk. Therefore, before sanctioning credit, careful analysis of

the risk involved needs to be done;

2. It is based on economic value. Buyer gets economic value in goods immediately on

sale, while the seller will receive an equivalent value later on and

3. It has an element of futurity. The buyer makes payment in a future period.

Amounts due from customers, when goods are sold on credit, are called trade debits or

receivables. Receivables form part of current assets. They constitute a significant

portion of the total current assets of the buyers next to inventories.

Receivables are asset – accounts representing amounts owing to the firm as a result of

sale of goods/services in the ordinary course of business.

Objectives: The main objective of selling goods on credit is to promote sales for

increasing the profits of the firm. Customers will always prefer to buy on credit to buying


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on cash basis. They always go to a supplier who gives credit. All firms therefore grant

credit to their customers to increase sales, profits and to meet competition.



1.Understand the meaning of receivables management.

2. What are the costs associated with maintaining receivable ?

3. Understand the credit policy variables.

4. Understand the process of evaluation of credit policy.

Meaning of Receivables Management:

Receivables are a direct result of credit sales are resorted to, by a firm to push up its

sales which ultimately result in pushing up the profits earned by the firm. At the same

time, selling goods on credit results in blocking of funds in accounts receivables.

Additional funds are, therefore, required for the operating needs of the business which

involve extra costs in terms of interest. Moreover, increase in receivables also increases

the chances of bad debts. Thus, creation of accounts receivables is beneficial as well as

dangerous to the firm.

The financial manager needs to follow a policy of using cash funds economically to the

extent possible in extending receivables without adversely affecting the chances of

increasing sales and making more profits. Management of accounts receivables may,

therefore, be defined as, the process of making decision relating to the investment of

funds in receivables which will result in maximising the overall return on the investment of

the firm.

Thus, the objective of receivables management is to promote sales and projects until the

level where the return on investment in further finding of receivables is less then the cost

of funds raised to finance that additional credit.

14.2 Costs associated with maintaining receivables: Costs of maintaining receivables are: 1) Capital costs: A firm when sells goods credit achieves higher sales. Selling goods

on credit has consequences of blocking the firm’s resources in receivables as there is


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a time lag between a credit sale and cash receipt from customers. To the extent the

funds are held up in receivables, the firm has to arrange for additional funds to meet

its own obligation of monthly as well as daily recurring expenditure. Additional funds

may have to be raised either out of profits or from outside. In both the cases, the firm

incurs a cost. In the former case there is the opportunity cost of the income the firm

could have earned had the same been invested in same other profitable avenue. In

the latter case of obtaining funds from outside, the firm has to pay interest on the loan

taken. Therefore, sanctioning credit to customers on sale of goods on credit has a

capital cost.

2) Administration Cost: When a firm sells goods on credit it has to incur two types of

administration cost viz

a. Credit investigation and supervision costs and

b. Collection Costs.

Before sanctioning credit to any customer the firm has to investigate the credit rating of

the customer to ensure that credit given will recovered on time. Therefore, administration

costs have to be incurred in this process.

Costs incurred in collecting receivables are administrative in nature. These include

additional expenses on staff for administering the process of collection of receivables

from customers.

3. Delinquency Costs: The firm incurs this cost when the customer fails to pay the

amount to it on the expiry of credit period. These costs take the form of sending

remainders and legal charges.

Bad – Debts or Default cost:

When the firm is unable to recover the amount due from its customers, it results in bad

debts. When a firm relaxes its credit policy, selling to customers with relatively low credit

rating occurs. In this process a firm may make credit sales to its customers who do not

pay at all.

Therefore, the assessing the effect of a change in credit policy of a firm involves

examination of

a. Opportunity Cost of lost contribution

b. Credit administration Cost


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c. Collection Costs

d. Delinquency Cost

e. Bad – debt loses


1. Costs of maintaining receivables are ________________, _________ cost and

_______.

2. A period of “Net 30” means that it allows to its customers 30 days of credit with ____

for ___________.

3. Selling goods on credit has consequences of blocking the firm’s resources in

receivables as there is a time lag between ___________________ and ____________.

4. When a firm sells goods on credit it has to incur two types of administration cost viz

_____ and _________________ .

14.3 Credit policy Variables

1. Credit standards.

2. Credit period.

3. Cash discounts and

4. Collection programme.

1. Credit standards: The term credit standards refer to the criteria for extending credit to

customers. The bases for setting credit standards are.

a. Credit rating.

b. References

c. Average payment period

d. Ratio analysis

There is always a benefit to the company with the extension of credit to its customers but

with the associated risks of delayed payments or non – payment, funds blocked in

receivables etc. The firm may have light credit standards. It may sell on cash basis and

extend credit only to financial strong customers. Such strict credit standards will bring

down bad – debt losses and reduce the cost of credit administration. But the firm may

not be able to increase its sales. The profit on lost sales may be more than the costs


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saved by the firm. The firm should evaluate the trade – off between cost and benefit of

any credit standards.

2. Credit period: credit period refers to the length of time allowed to its customers by a

firm to make payment for the purchases made by customers of the firm. It is generally

expressed in days like 15 days or 20 days. Generally, firms give cash discount if

payments are made within the specified period.

If a firm follows a credit period of ‘net 20’ it means that it allows to its customers 20 days

of credit with no inducement for early payments. Increasing the credit period will bring in

additional sales from existing customers and new sales from new customers. Reducing

the credit period will lower sales, decrease investments in receivables and reduce the

bad debt loss. Increasing the credit period increases sales increases investment in

receivables and increases the incidence of bad debt loss.

The effects of increasing the credit period on profits of the firm are similar to that of

relaxing the credit standards. 3. Cash discount Firms offer cash discounts to induce their customers to make prompt

payments. Cash discounts have implications on sales volume, average collection period,

investment in receivables, incidence of bad debts and profits. A cash discount of 2/10 net

20 means that a cash discount of 2% is offered if the payment is made by the tenth day;

other wise full payment will have to made by 20 th day.

4 Collection programme

The success of a collection programme depends on the collection policy pursued by the

firm. The objective of a collection policy is to achieve. Timely collection of receivables,

there by releasing funds locked in receivables and minimizes the incidence of bad debts.

The collection programmes consists of the following.

1. Monitoring the receivables

2. Reminding customers about due date of payment

3. On line interaction through electronic media to customers about the payments due

around the due date.

4. Initiating legal action to recover the amount from overdue customers as the last resort

to recover the dues from defaulted customers.


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Collection policy formulated shall not lead to bad relationship with customers

Self Assessment Question 2 1. Credit period is a ______________.

2. _______ refer to the criteria for extending credit to customers.

3. _________ refers to the length of time allowed to its customers by a firm to make

payment for purchase made by customers of the firm.

4. A cash discount of 2 / 10 net 20 means that a ____________ is offered if the payment

is made __________________

14.4 Evaluation of Credit Policy: Optimum credit policy is one which would maximize

the value of the firm. Value of a firm is maximized when the incremental rate of return on

an investment is equal to the incremental cost of funds used to finance the investment.

Therefore, credit policy of a firm can be regarded as a trade – off between higher profits

from increased sales and the incremental cost of having large investment in receivables.

The credit policy to be adopted by a firm is influenced by the strategies pursued by its

competitors. If competitors are granting 15 days credit and if the firm decides to extend

the credit period to 30 days, the firm will be flooded with customers demand for

company’s products.

Credit policy variables of a firm are 1. Credit Standard

The effect of relaxing the credit standards on profit can be estimated as under:

Change in profit = P

Increase in sales = S

Contribution = c = 1 – V

Where V = Variable cost to sales

Bad – Debts on new sales = S x bn K = post tax cost of capital

Increase in receivables investment = I

Therefore


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Change in profit = (Additional contribution on increase in sales – Bad Debts on new

sales) (1 – tax rate) – cost of incremental investment. (1 – tax rate) – cost of capital x

Incremental investment in receivables.

Increase in profit i.e change in profit = [Incremental contribution – Bad debts on new

sales]

Example: Following details are available in respect of x ltd:

Current sales = Rs 100 million

The company is considering relaxation of its credit policy. Such relaxation would

increase the sales by Rs 15 million on which bad debt losses would be 10%. The

contribution margin ratio for the firm is 20%. Average collection period is 40 days. Post –

tax cost of funds is 10%. Tax rate applicable to the firm is 30%. Assume 360 days in a

year.

Examine the effect of relaxing the credit policy on the profitability of the organization.

(MBA) adopted. Solution:

Incremental contribution = 1,50,00,000 x 0.20 = Rs 30,00,000

Bad debts on new sales = 1,50,00,000 x 0.10 = Rs 15,00,000

Cost of capital is 10%

Incremental investment in receivables =

Investment in sales

No. of days in the year

15 000 000

360

Cost of Incremental Investment

10

100

Therefore change in profit is calculated as under

Incremental Contribution = 3 000 000

Less: Bad debts on new sales = 15 00 000

= X Average Collection Period X Variable Cost to Sales ratio

= X 40 X 0.8 = Rs.13,33,333

= x 13,33,333


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Less: Income tax at 30% = 4 50 000

10 50 000

Less: Opportunity cost of

Incremental investment in

Receivables 13,33,333

Increase in profit 9 16 667

Since the impact of change in credit standards on profit is positive the change in credit

standards may be considered.

2. Credit period

The effect of changing the credit period on profits of the firm can be computed as under :

Change in profit = (Incremental contribution – Bad debts on new sales) (1 – tax rate) –

cost of incremental investment in receivables. Example:

A company is currently allowing its customers, 30 days of credit. Its present sales are Rs

100 million. The firm’s cost of capital is 10% and the ratio of variables cost to sales is

0.80. The company is considering extending its credit period to 60 days. Such an

extension will increase the sales of the firm by Rs 100 million. Bad debts on additional

sales would be 8%. Tax rate is 30%. Assume 360 days in a year.

(MBA) adopted.

Solution:

Incremental contribution = 10,000,000 x 0.2 = Rs 2,000,000

Bad debts on new sales = 10,000,000 x 0.8 = Rs 8,000,000

Existing investment in receivables =

30

360

Expected investment in receivables after increasing the credit period to 60 days:

Expected investment in receivables on current sales =

1 00 000 000

360

1 00 000 000 x Rs.8 333 333

= X 60 = Rs.16 666 667


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Additional investment in receivable on new sales

60

360

Expected total investment in receivables on increasing the period of credit = 1 80 00 000

Incremental investment in receivables = 1 80 00 000 – 8 333 333 = Rs.9666667

Opportunity cost of Incremental investment in receivables =

0.10 x 9666667 = Rs.966667

Statement showing the effect of increasing the credit period from 30 days to 60 days as

firm’s project

Incremental Contribution 2 00 000

Less: Bad debts on new sales 8 00 000

12 00 000

Less: Income tax at 30 % 3 60 000

8 40 000

Less: Opportunity cost of incremental

Investment in receivables 9 66 667

Change in profit (126667) negative

Since the impact of increasing the credit period on profits of the firm is negative, the

proposed change in credit period is not desirable. 2. Cash Discount

For assessing the effect of cash discount the following formula can be used.

Change in profit = (Incremental contribution – increase in discount cost) (1 – t) +

opportunity cost of savings in receivables investment. Example

Present credit terms of a company are 1/10 net 30. Its sales are Rs 100 million, average

collection period is 20 days, variable cost to sales ratio is 0.8, and cost of capital is 10%.

The proportion of sales on which customers currently take discount is 0.5.

1 00 000 000 x X 0.80 = Rs.13 33 333


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The company is considering relaxing its discount terms to 2/10, net 30

Such a relaxation is expected to increase sales by Rs 10 million, reduce Average

collection period to 14 days, increase discount sales to 0.8. Tax rate is 0.30.

Examine the effect of relaxing the discount policy on profits of the organisation

Assume 360 days in a year (MBA adopted).

Solution

Incremental Contribution = 10 000 000 x 0.2 = Rs.2 000 000

Increase in discount

Discount cost before liberalising discount terms =

0.5 x 1 00 000 000 x 0.01 = Rs.5 00 000

Discount cost after liberalisation of discount terms =

0.8 x 110 000 000 x 0.002 = Rs.1760 000

Increase in discount cost = Rs.1260 000

Computation of savings in receivables investment

1 00 000 000 10 000 000

360 360

1 00 000 000

60

= 1666667 – 311111 = Rs.1355556

Opportunity cost (savings of reduction in investment in receivables

= 0.1 x 135556 = Rs.135556

Statement showing the effect of change in discount policy as profit of the company

Increase in Contribution 2 000 000

Less: increase in discount cost 12 60 000

7 40 000

Less: Tax at 30 % 2 22 000

5 18 000

Add: Benefit of savings due to

Reduction in investment in

= 20 – 14 – 0.8 x X 14

= 311 111


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Receivables profit 135556

653556

It is desirable to change the discount policy as it will improve the profitability of the firm.

4.Collection policy

For computation of the effect of new collection programme can be evaluated with the help

of following formula .

Change in profit = (Incremental contribution – Increase in bad debts) (1 – tax rate) – cost

of increase in investment in receivables. Example

A company is considering relaxing its collection effort. Its present sales are Rs 50 million,

ACP = 20 days, variable cost to sales ratio = 0.8, cost of capital 10%. Its bad debt ratio is

0.05.

The relaxation in collection programme is expected to increase sales by Rs 5 million,

increase ACP to 40 days and bad debts ratio to 0.56. Tax rate is 30%.

Examine the effect of change in collection programme on firm’s profits. Assume 360

days in a year. (MBA adopted and also ACS) Solution

Increase in Contribution = 5 000 000 x 0.2 = Rs.1 000 000

Increase in bad debts

Bad debts on existing sales = 50 000 000 x 0.05 = 250 00 00

Bad debts on total sales after increase in sales =

55 000 000 x 0.56 = 33 00 000

Increase in bad debts = Rs.8 00 000

Incremental investment in receivables

50 000 000 (40 – 20) 5 000 000 x 40 x 0.8

360 360

= 2777778 + 444444 = Rs.3222222

Opportunity cost of incremental investment in receivables =

0.1 x 3222222 = Rs.322222

= +


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Statement showing the impact of new collection programme on profits of the organisation

Incremental Contribution 1 000 000

Less: Increase in bad debts 8 00 000

2 00 000

Less: Income tax at 30% 60 000

1,40,000

Less: Opportunity cost of increase

In investment in receivables 3,22,222

Profit (182222) loss

Since the change will lead to decrease in profit (i,e a loss of Rs.182222) it is not desirable

to relax the collection programme of the firm


1. Credit policy of a firm can be regarded as a tradeoff between ___________ and

_______.

2. Optimum credit policy maximises the __________.

3. Value of a firm is maximised when the incremental rate of return on investment in

receivable is ________________ to the incremental cost of funds used to finance that

investment.

4. Credit policy to be adopted by a firm is influenced by strategies pursued by its

competitions.

14.5 Summary

Receivables are a direct result of credit sales. Management of accounts receivables is

the process of making decision relating to investment of funds in receivable which will

result in maximising the overall return on the investment of the firm. Cost of maintaining

receivables are capital costs, administration costs and delinquency costs. Credit policy

variables are credit standards, credit period, cash discounts and collection programme.

Optimum credit policy is that which Maximises the value of the firm.


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Terminal Questions

1. Examine the meaning of receivable management.

2. Examine the costs of maintaining receivables.

3. Examine the variables of credit policy.

4. What are the features of optimum credit policy

Answer for self Assessment Questions Self Assessment Questions 1

1. Capital costs, administration, Delinquency costs.

2. No inducement for early payments

3. Credit sale, Cash receipt from customers.

4. Credit investigation and supervision cost, collection costs Self Assessment Questions 2

1. Credit policy variable.

2. Credit standards

3. Credit period

4. Cash discount of 2% , on the tenth day. Self Assessment Questions 3

1. Higher profits from increased sales, incremental cost of having large investment in

receivable.

2. Value of the firm.

3. Equal

Answer for Terminal Questions






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Unit 15 Dividend Decision

Structure

15.1 Introduction

15.2 Traditional Approach

15.3 Dividend Relevance Model

15.3.1 Walter Model

15.3.2 Gordon’s Dividend Capitalization Model

15.4 Dividend Irrelevance Theory: Miller and Modigliani Model

15.5 Stability of Dividends

15.6 Forms of Dividends

15.7 Stock Split

15.8 Summary

Terminal Questions


15.1 Introduction

Dividends are that portion of a firm’s net earnings paid to the shareholders. Preference shareholders

are entitled to a fixed rate of dividend irrespective of the firm’s earnings. Equity holders’ dividends

fluctuate year after year. It depends on what portion of earnings is to be retained by the firm and what

portion is to be paid off. As dividends are distributed out of net profits, the firm’s decisions on retained

earnings have a bearing on the amount to be distributed. Retained earnings constitute an important

source of financing investment requirements of a firm. However, such opportunities should have

enough growth potential and sufficient profitability. There is an inverse relationship between these

two – larger retentions, lesser dividends and vice versa. Thus two constituents of net profits are

always competitive and conflicting.

Dividend policy has a direct influence on the two components of shareholders’ return – dividends and

capital gains. A low payout and high retention may have the effect of accelerating earnings growth.

Investors of growth companies realize their money in the form of capital gains. Dividend yield will

be low for such companies. The influence of dividend policy on future capital gains is to happen in


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distant future and therefore by all means uncertain. Share prices are a reflection of many factors

including dividends. Some investors prefer current dividends to future gains as prophesied by an

English saying – A bird in hand is worth two in the bush. Given all these constraints, it is a major

decision of financial management.

Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient

investment opportunities will retain the entire earnings to fund its growth avenues. Conversely, if no

such avenues are forthcoming, the firm will payout its entire earnings. So there exists a relationship

between return on investments r and the cost of capital k. So long as r exceeds k, a firm shall have

good investment opportunities. That is, if the firm can earn a return r higher than its cost of capital k,

it will retain its entire earnings and if this source is not sufficient, it will go in for additional sources in

the form of additional financing like equity issue, debenture issue or term loans. Thus, the dividend

decision is a tradeoff between retained earnings and financing decisions.

Different theories have been given by various people on dividend policy. We have the traditional

theory and new sets of theories based on the relationship between dividend policy and firm value.

The modern theories can be grouped as – (a) theories that consider dividend decision as an active

variable in determining the value of the firm and (b) theories that do not consider dividend decision as

an active variable in determining the value of the firm.



1. Explain the importance of dividends to investors. 2. Discuss the effect of declaring dividends on share prices. 3. Mention the advantages of a stable dividend policy. 4. List out the various forms of dividend. 5. Give reasons for stock split.

15.2 Traditional Approach

This approach is given by B. Graham and D. L. Dodd. They clearly emphasize the relationship

between the dividends and the stock market. According to them, the stock value responds positively


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to high dividends and negatively to low dividends, that is, the share values of those companies rises

considerably which pay high dividends and the prices fall in the event of low dividends paid.

Symbolically, P = [m (D+E/3)]

Where P is the market price,

M is the multiplier,

D is dividend per share,

E is Earnings per share.

Drawbacks of the Traditional Approach: As per this approach, there is a direct relationship

between P/E ratios and dividend payout ratio. High dividend payout ratio will increase the P/E ratio

and low dividend payout ratio will decrease the P/E ratio. This may not always be true. A company’s

share prices may rise in spite of low dividends due to other factors.

15.3 Dividend Relevance Model

Under this section we examine two theories – Walter Model and Gordon Model.

15.3.1 Walter Model

Prof. James E. Walter considers dividend payouts are relevant and have a bearing on the share

prices of the firm. He further states, investment policies of a firm cannot be separated from its

dividend policy and both are interlinked. The choice of an appropriate dividend policy affects the

value of the firm. His model clearly establishes a relationship between the firm’s rate of return r, its

cost of capital k, to give a dividend policy that maximizes shareholders’ wealth. The firm would have

the optimum dividend policy that will enhance the value of the firm. This can be studied with the

relationship between r and k. If r>k, the firm’s earnings can be retained as the firm has better and

profitable investment opportunities and the firm can earn more than what the shareholders could by

reinvesting, if earnings are distributed. Firms which have r>k are called ‘growth firms’ and such firms

should have a zero payout ratio.

If return on investment r is less than cost of capital k, the firm should have a 100% payout ratio as

the investors have better investment opportunities than the firm. Such a policy will maximize the firm

value.


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If a firm has a ROI r equal to its cost of capital k, the firm’s dividend policy will have no impact on the

firm’s value. The dividend payouts can range between zero and 100% and the firm value will remain

constant in all cases. Such firms are called ‘normal firms’.

Walter’s Model is based on certain assumptions:

• Financing: All financing is done through retained earnings.Retained earnings is the only source

of finance available and the firm does not use any external source of funds like debt or new

equity.

• Constant rate of return and cost of capital: The firm’s r and k remain constant and it follows

that any additional investment made by the firm will not change the risk and return profile.

• 100% payout or retention: All earnings are either completely distributed or reinvested entirely

immediately.

• Constant EPS and DPS: The earnings and dividends do not change and are assumed to be

constant forever.

• Life: The firm has a perpetual life.

Walter’s formula to determine the market price is as follows:

P = Ke

] Ke / ) D E ( r [ Ke D −

+

Where P is the market price per share,

D is the dividend per share,

Ke is the cost of capital,

g is the growth rate of earnings,

E is Earnings per share,

r is IRR. Example:

The following information relates to Alpha Ltd. Show the effect of the dividend policy on the market

price of its shares using the Walter’s Model

Equity capitalization rate Ke 11%

Earnings per share Rs. 10

ROI (r) may be assumed as follows: 15%, 11% and 8%

Show the effect of the dividend policies on the share value of the firm for three different levels of r,

taking the DP ratios as zero, 25%, 50%, 75% and 100%


235

Solution

Ke 11%, EPS 10, r 15%, DPS=0

P = Ke

)] D E ( Ke / r [ Ke D −

+

Case I r>k (r=15%, K=11%)

a. DP = 0 11 . 0

)] 0 10 ( 11 . 0 / 15 . 0 [ 0 − + = 13.64/0.11 = Rs. 123.97

b. DP = 25% 11 . 0

)] 5 . 2 10 ( 11 . 0 / 15 . 0 [ 5 . 2 − + = 12.73/0.11 = Rs. 115.73

c. DP = 50% 11 . 0

)] 5 10 ( 11 . 0 / 15 . 0 [ 5 − + = 11.82/0.11 = Rs. 107.44

d. DP = 75% 11 . 0

)] 5 . 7 10 ( 11 . 0 / 15 . 0 [ 5 . 7 − + = 10.91/0.11 = Rs. 99.17

e. DP = 100% 11 . 0

)] 10 10 ( 11 . 0 / 15 . 0 [ 10 − + = 10/0.11 = Rs. 90.91

Case II r = k (r = 11%, K = 11%)

a. DP = 0 11 . 0

)] 0 10 ( 11 . 0 / 11 . 0 [ 0 − + = 10/0.11 = Rs. 90.91

b. DP = 25% 11 . 0

)] 5 . 2 10 ( 11 . 0 / 11 . 0 [ 5 . 2 − + = 10/0.11 = Rs. 90.91

c. DP = 50% 11 . 0

)] 5 10 ( 11 . 0 / 11 . 0 [ 5 − + = 10/0.11 = Rs. 90.91

d. DP = 75% 11 . 0

)] 5 . 7 10 ( 11 . 0 / 11 . 0 [ 5 . 7 − + = 10/0.11 = Rs. 90.91

e. DP = 100% 11 . 0

)] 10 10 ( 11 . 0 / 11 . 0 [ 10 − + = 10/0.11 = Rs. 90.91

Case III r<k (r=11%, K=8%)

f. DP = 0 08 . 0

)] 0 10 ( 08 . 0 / 11 . 0 [ 0 − + = 13.75/0.08 = Rs. 171.88

g. DP = 25% 08 . 0

)] 5 . 2 10 ( 08 . 0 / 11 . 0 [ 5 . 2 − + = 12.81/0.08 = Rs. 160.13


236

h. DP = 50% 08 . 0

)] 5 10 ( 08 . 0 / 11 . 0 [ 5 − + = 11.88/0.08 = Rs. 107.95

i. DP = 75% 08 . 0

)] 5 . 7 10 ( 08 . 0 / 11 . 0 [ 5 . 7 − + = 10.94/0.08 = Rs. 99.43

j. DP= 100% 08 . 0

)] 10 10 ( 08 . 0 / 11 . 0 [ 10 − + = 10/0.08 = Rs. 90.91

Interpretation: The above workings can be summarized as follows:

1. When r>k, that is, in growth firms, the value of shares is inversely related to DP ratio, as the DP

increases, market value of shares decline. Market value of share is highest when DP is zero and

least when DP is 100%.

2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected

whether the firm retains the profits or distributes them.

3. In the third situation, when r<k, in declining firms, the market price of a share increases as the DP

increases. There is a positive correlation between the two.

Limitations

Walter has assumed that investments are exclusively financed by retained earnings and no external

financing is used. This model is applicable only to allequity firms. Secondly r is assumed to be

constant which again is not a realistic assumption. Finally, Ke is also assumed to be constant and

this ignores the business risk of the firm which has a direct impact on the firm value.

15.3.2 Gordon’s Dividend Capitalization Model

Gordon also contends that dividends are relevant to the share prices of a firm. Myron Gordon uses

the Dividend Capitalization Model to study the effect of the firm’s dividend policy on the stock price.

Assumptions

• All equity firm: The firm is an all equity firm with no debt.

• No external financing is used and only retained earnings are used to finance any expansion

schemes.

• Constant return r

• Constant cost of capital Ke

• The life of the firm is indefinite.

• Constant retention ratio: The retention ratio g=br is constant forever.


237

• Cost of capital greater than br, that is Ke>br

Gordon’s model assumes investors are rational and riskaverse. They prefer certain returns to

uncertain returns and therefore give a premium to the constant returns and discount uncertain

returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they

discount future dividends. Retained earnings are evaluated by the shareholders as risky and

therefore the market price of the shares would be adversely affected. Gordon explains his theory with

preference for current income. Investors prefer to pay higher price for stocks which fetch them

current dividend income. Gordon’s model can be symbolically expressed as:

br Ke ) b 1 ( E P

− −

=

Where P is the price of the share,

E is Earnings Per Share,

b is Retention raio,

(1 – b) is dividend payout ratio,

Ke is cost of equity capital,

br is growth rate in the rate of return on investment.

Example:

Given Ke as 11%, E is Rs. 10, calculate the stock value of Mahindra Tech. for (a) r=12%, (b) r=11%

and (c) r=10% for various levels of DP ratios given under:

DP ratio (1 – b) Retention ratio A 10% 90% B 20% 80% C 30% 70% D 40% 60% E 50% 50%

Solution Case I r>k ( r=12%, K=11%)

P = E(1—b) Ke—br


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a. DP 10%, b 90%

10(1—0.9) equals 1/.002 = Rs. 500

0.11(0.9*0.12)

b. DP 20%, b 80%

10(1—0.8) equals 2/.014 = Rs. 142.86

0.11(0.8*0.12)

c. DP 30%, b 70%

10(1—0.7) equals 3/.026 = Rs. 115.38

0.11(0.7*0.12)

d. DP 40%, b 60%

10(1—0.6) equals 4/.038 = Rs. 105.26

0.11(0.6*0.12)

e. DP 50%, b 50%

10(1—0.5) equals 5/.05 = Rs. 100

0.11(0.5*0.12)

Case II r=k ( r=11%, K=11%) P = E(1—b)

Ke—br

a. DP 10%, b 90%

10(1—0.9) equals 1/.011 = Rs. 90.91

0.11(0.9*0.11)

b. DP 20%, b 80%

10(1—0.8) equals 2/.022 = Rs. 90.91

0.11(0.8*0.11)

c. DP 30%, b 70%

10(1—0.7) equals 3/.033 = Rs. 90.91

0.11(0.7*0.11)

d. DP 40%, b 60%

10(1—0.6) equals 4/.044 = Rs. 90.91

0.11(0.6*0.11)


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e. DP 50%, b 50%

10(1—0.5) equals 5/.55 = Rs. 90.91

0.11(0.5*0.11)

Case III r<k ( r=10%, K=11%) P = E(1—b)

Ke—br

a. DP 10%, b 90%

10(1—0.9) equals 1/.02 = Rs. 50

0.11(0.9*0.1)

b. DP 20%, b 80%

10(1—0.8) equals 2/.03 = Rs. 66.67

0.11(0.8*0.1)

c. DP 30%, b 70%

10(1—0.7) equals 3/.04 = Rs. 75

0.11(0.7*0.1)

d. DP 40%, b 60%

10(1—0.6) equals 4/.05 = Rs. 80

0.11(0.6*0.1)

e. DP 50%, b 50%

10(1—0.5) equals 5/.06 = Rs. 83.33

0.11(0.5*0.1)

Interpretation: Gordon is of the opinion that dividend decision does have a bearing on the market

price of the share.

1. When r>k, the firm’s value decreases with an increase in payout ratio. Market value of share is

highest when DP is least and retention highest.

2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected

whether the firm retains the profits or distributes them.

3. When r<k, market value of share increases with an increase in DP ratio.


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15.4 Miller and Modigliani Model

The MM hypothesis seeks to explain that a firm’s dividend policy is irrelevant and has no effect on

the share prices of the firm. This model advocates that it is the investment policy through which the

firm can increase its share value and hence this should be given more importance.

Assumptions

• Existence of perfect capital markets: All investors are rational and have access to all

information free of cost. There are no floatation or transaction costs, securities are infinitely

divisible and no single investor is large enough to influence the share value.

• No taxes: There are no taxes, implying there is no difference between capital gains and

dividends.

• Constant investment policy: The investment policy of the company does not change. The

implication is that there is no change in the business risk position and the rate of return.

• No Risk – Certainty about future investments, dividends and profits of the firm. This

assumption was, however, dropped at a later stage.

Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as

the crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two

transactions which are entered into simultaneously. The two transactions are paying out dividends

and raising external funds to finance additional investment programs. If the firm pays out dividend, it

will have to raise capital by selling new shares for financing activities. The arbitrage process will

neutralize the increase in share value (due to dividends) with the issue of new shares. This makes

the investor indifferent to dividend earnings and capital gains as the share value is more dependent

on the future earnings of the firm than on its current dividend policy.

Symbolically, the model is given as: Step I: The market price of a share in the beginning is equal to the PV of dividends paid and market

price at the end of the period. P0 = 1 * (D1 + P1)

(1+Ke)

Where P0 is the current market price,

P1 is market price at the end of period 1,

D1 is dividends to be paid at the end of period 1,

Ke is the cost of equity capital.


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Step II: Assuming there is no external financing, the value of the firm is: nP0 = = 1 * (nD1 + nP1)

(1+Ke)

Where n is number of shares outstanding. Step III: If the firm’s internal sources of financing its investment opportunities fall short of funds

required, new shares are issued at the end of year 1 at price P1. The capitalized value of the

dividends to be received during the period plus the value of the number of shares outstanding is less

than the value of new shares. nP0 = = 1 * (nD1 + (n + n1)P1 – n1p1)

(1+Ke)

Firms will have to raise additional capital to fund their investment requirements after utilizing their

retained earnings, that is, n1P1 = I—(E—nD1) which can be written as n1P1 = I—E + nD1

Where I is total investment required,

nD1 is total dividends paid,

E is earnings during the period,

(E—nD1) is retained earnings. Step IV: The value of share is thus: nP0 = = 1 * (nD1 + (n + n1)P1 –I + E—nD1)

(1+Ke) Example:

A company has a capitalization rate of 10%. It currently has outstanding shares worth 25000 shares

selling currently at Rs. 100 each. The firm expects to have a net income of Rs. 400000 for the current

financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also

requires Rs. 600000 to fund its investment requirement. Show that under MM model, the dividend

payment does not affect the value of the firm.

Solution Case I: When dividends are paid: Step I: P0 = 1 * (D1 + P1)

(1+Ke)


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100 = 1/(1+0.1) * (4 + P1) P1 = Rs. 106 Step II: n1P1 = I—(E—nD1), nD1 is 25000*4 n1P1 = 600000—(400000—100000)=Rs. 300000 Step III: Number of additional shares to be issued 300000/106 = 2831 shares Step IV: The firm value nP0 = = (n + n1)P1 –I + E

(1+Ke) (25000 + 2831)*106—600000 + 400000 equals Rs. 2500000

(1+0.1)

Case II: When dividends are not paid: Step I: P0 = 1 * (D1 + P1)

(1+Ke)

100 = 1/(1+0.1) * (0 + P1) P1 = Rs. 110 Step II: n1P1 = I—(E—nD1), nD1 is 25000*4 n1P1 = 600000—(400000—0)=Rs. 200000 Step III: Number of additional shares to be issued 200000/110 = 1819 shares Step IV: The firm value nP0 = = (n + n1)P1 –I + E

(1+Ke) (25000 + 1819)*110—600000 + 400000 equals Rs. 2500000

(1+0.1)

Thus, the value of the firm remains the same in both the cases whether or not dividends are

declared.

Critical Analysis of MM Hypothesis: Floatation costs: Miller and Modigliani have assumed the absence of floatation costs. Floatation

costs refer to the cost involved in raising capital from the market, that is, the costs incurred towards

underwriting commission, brokerage and other costs. These costs ordinarily account to around 10%


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15% of the total issue and they cannot be ignored given the enormity of these costs. The presence of

these costs affects the balancing nature of retained earnings and external financing. External

financing is definitely costlier than retained earnings. For instance, if a share is issued worth Rs. 100

and floatation costs are 12%, the net proceeds are only Rs. 88.

Transaction costs: This is another assumption made by MM that there are no transaction costs like brokerage involved in capital market. These are the costs associated with sale of securities by investors. This theory implies that if the company does not pay dividends, the investors desirous of current income sell part of their holdings without any cost incurred. This is very unrealistic as the sale of securities involves cost, investors wishing to get current income should sell higher number of shares to get the income they are to receive.

Underpricing of shares: If the company has to raise funds from the market, it should sell shares at a price lesser than the prevailing market price to attract new shareholders. This follows that at lower prices, the firm should sell more shares to replace the dividend amount.

Market conditions: If the market conditions are bad and the firm has some lucrative opportunities, it is not worthapproaching new investors at this juncture, given the presence of floatation costs. In such cases, the firms should depend on retained earnings and low payout ratio to fuel such opportunities.

15.5 Stability of Dividends Stability of dividends is the consistency in the stream of dividend payments. It is the payment

of certain amount of minimum dividend to the shareholders. The steadiness is a sign of good health of the firm and may take any of the following forms – (a) constant dividend per share, (b) constant DP ratio and (c) constant dividend per share plus extra dividend.

Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount of

dividend per share year after year. For example, a firm may have a policy of paying 25% dividend per

share on its paidup capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year

irrespective of its earnings. Generally, a firm following such a policy will continue payments even if it

incurs losses. In such years when there is a loss, the amount accumulated in the dividend

equalization reserve is utilized. As and when the firm starts earning a higher amount of revenue it will

consider payment of higher dividends and in future it is expected to maintain the higher level.


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Constant DP ratio: With this type of DP policy, the firm pays a constant percentage of net earnings

to the shareholders. For example, if the firm fixes its DP ratio as 25% of its earnings, it implies that

shareholders get 25% of earnings as dividend year after year. In such years where profits are high,

they get higher amount.

Constant dividend per share plus extra dividend: Under this policy, a firm usually pays a fixed

dividend ordinarily and in years of good profits, additional or extra dividend is paid over and above

the regular dividend.

The stability of dividends is desirable because of the following advantages:

• Build confidence amongst investors: A stable dividend policy helps to build confidence and

remove uncertainty in the minds of investors. A constant dividend policy will not have any

fluctuations suggesting to the investors that the firm’s future is bright. In contrast, shareholders of

a firm having an unstable DP will not be certain about their future in such a firm.

• Investors’ desire for current income: A firm has different categories of investors – old and

retired persons, pensioners, youngsters, salaried class, housewives, etc. Of these, people like

retired persons prefer current income. Their living expenses are fairly stable from one period to

another. Sharp changes in current income, that is, dividends, may necessitate sale of shares.

Stable dividend policy avoids sale of securities and inconvenience to investors.

• Information about firm’s profitability: Investors use dividend policy as a measure of evaluating

the firm’s profitability. Dividend decision is a sign of firm’s prosperity and hence firm should have

a stable DP.

• Institutional investors’ requirements: Institutional investors like LIC, GIC and MF prefer to

invest in companies which have a record of stable DP. A company having erratic DP is not

preferred by these institutions. Thus to attract these organizations having large quantities of

investible funds, firms follow a stable DP.

• Raise additional finance: Shares of a company with stable and regular dividend payments

appear as quality investment rather than a speculation. Investors of such companies are known

for their loyalty and whenever the firm comes with new issues, they are more responsive and

receptive. Thus raising additional funds becomes easy.

• Stability in market price of shares: The market price of shares varies with the stability in

dividend rates. Such shares will not have wide fluctuations in the market prices which is good for

investors.


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Self Assessment Questions I

1. ____________constitute an important source of financing investment requirements of a firm.

2. Dividend policy has a direct influence on the two components of shareholders’ return__________

and ____________.

3. ______________considers dividend payouts are relevant and have a bearing on the share

prices of the firm.

4. If a firm has a ROI r equal to its cost of capital k, it is called a ___________

5. ________ model explains that consumers prefer certain returns to uncertain returns and

therefore give a premium to the constant returns and discount uncertain returns.

6. The __________process refers to setting off or balancing two transactions which are entered into

simultaneously.

7. __________ costs refer to the cost involved in raising capital from the market.

8. ______________are the costs associated with sale of securities by investors.

15.6 Forms of Dividends

Dividends are that potion of earnings available to shareholders. Generally, dividends are distributed

in cash, but sometimes they may also declare dividends in other forms which are discussed below:

• Cash dividends: Most companies pay dividends in cash. The investors also, especially the old

and retired investors depend on this form of payment for want of current income.

• Scrip dividend: In this form of dividends, equity shareholders are issued transferable promissory

notes with shorter maturity periods which may or may not have interest bearing. This form is

adopted if the firm has earned profits and it will take some time to convert its assets into cash

(having more of current sales than cash sales). Payment of dividend in this form is done only if

the firm is suffering from weak liquidity position.

• Bond dividend: Scrip and bond dividend are the same except that they differ in terms of

maturity. Bond dividends carry longer maturity period and bear interest, whereas scrip dividends

carry shorter maturity and may or may not carry interest.

• Stock dividend (Bonus shares): Stock dividend, as known is USA or bonus shares in India, is

the distribution of additional shares to the shareholders at no additional cost. This has the effect

of increasing the number of outstanding shares of the firm. The reserves and surplus (retained

earnings) are capitalized to give effect to bonus issue. This decision has the effect of


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recapitalization, that is, transfer from reserves to share capital not changing the total net worth.

The investors are allotted shares in proportion to their present shareholding. Declaration of bonus

shares has a favourable psychological effect on investors. They associate it with prosperity.

15.7 Stock Split

A stock split is a method to increase the number of outstanding shares by proportionately reducing

the face value of a share. A stock split affects only the par value and does not have any effect on the

total amount outstanding in share capital. The reasons for splitting shares are:

• To make shares attractive: The prime reason for effecting a stock split is to reduce the market

price of a share to make it more attractive to investors. Shares of some companies enter into

higher trading zone making it out of reach to small investors. Splitting the shares will place them

in more popular trading range thus providing marketability and motivating small investors to buy

them.

• Indication of higher future profits: Share split is generally considered a method of

management communication to investors that the company is expecting high profits in future.

• Higher dividend to shareholders: When shares are split, the company does not resort to

reducing the cash dividends. If the company follows a system of stable dividend per share, the

investors would surely get higher dividends with stock split.

15.8 Summary

Dividends are the earnings of the company distributed to shareholders. Payment of dividend is not

mandatory, but most companies see to it that dividends are paid on a regular basis to maintain the

image of the company. As payment of dividend is not compulsory, the question which arises in the

minds of policy makers is “Should dividends be paid, if yes, what should be the quantum of

payment?” Various theories have come out with various suggestions on the payment of dividend. B.

Graham and D. L. Dodd are of the view that there is a close relationship between the dividends and

the stock market. The stock value responds positively to high dividends and vice versa.

Prof. James E. Walter considers dividend payouts are necessary but if the firm’s ROI is high,

earnings can be retained as the firm has better and profitable investment opportunities.


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Gordon also contends that dividends are significant to determine the share prices of a firm.

Shareholders prefer certain returns (current) to uncertain returns (future) and therefore give a

premium to the constant returns and discount uncertain returns.

Miller and Modigliani explain that a firm’s dividend policy is irrelevant and has no effect on the share

prices of the firm. They are of the view that it is the investment policy through which the firm can

increase its share value and hence this should be given more importance.

Dividends can be paid out in various forms such as cash dividend, scrip dividend, bond dividend and

bonus shares.

Terminal Questions

1. Write a short note on the different types of dividend.

2. What is stock split? What are its advantages?

3. The following information is available in respect of a company.

Equity capitalization 15%

EPS Rs. 25

Dividend payout ratio25%

ROI 12%

What is the price of the share as per Walter Model?

4. Considering the following information, what is the price of the share as per Gordon’s Model?

Net sales Rs. 120 lakhs

Net profit margin 12.5%

Outstanding preference shares Rs. 50 lakhs @ 12% dividend

No. of equity shares 250000

Cost of equity shares 12%

Retention ratio 40%

ROI 16%

5. If the EPS is Rs.5, dividend payout ratio is 50%, cost of equity is 20%, growth rate in the ROI is

15%, what is the value of the stock as per Gordon’s Dividend Equalization Model?

6. Nile Ltd. makes the following information available. What is the value of the stock as per Gordon

Model?


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Ke 14%, EPS Rs. 20, D/P ratio 35% Retention ratio 65%, ROI 16%

7. What is the stock price as per Gordon Model if DP ratio is 60% in the above case?


1. Retained earnings

2. Dividends and capital gains

3. Prof. James E. Walter

4. Normal firm

5. Gordon

6. Arbitrage

7. Floatation costs

8. Transaction costs


1. Refer to10.6

2. Refer to10.7

3. Hint: Apply the formulaWalter’s formula to determine the market price P = D + [r(E—D)/Ke]

Ke Ke 4, 5, 6, 7 : Hint: Apply the Gordon formula of P = E(1—b)

Ke—br

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