MB 0045

MB 0045 Financial Management Contents
Unit 1 Financial Management Unit 2 Financial Planning Unit 3 Time Value of Money Unit 4 Valuation of Bonds and Shares Unit 5 Cost of Capital Unit 6 Leverage Unit 7 Capital Structure Unit 8 Capital Budgeting
Edition: Spring 2010 BKID B1134 4 Jan. 2010
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1 18 41 61 87 106 129 146
Unit 9 Risk Analysis in Capital Budgeting Unit 10 Capital Rationing Unit 11 Working Capital Management Unit 12 Cash Management Unit 13 Inventory Management Unit 14 Receivables Management Unit 15 Dividend Decision References
186 213 232 252 271 289 308 331
Dean Directorate of Distance Education Sikkim Manipal University Board of Studies Chairman HOD Management & Commerce SMU DDE Additional Registrar SMU DDE Controller of Examination SMU DDE Dr. T. V. Narasimha Rao Adjunct Faculty & Advisor SMU DDE Prof. K. V. Varambally Director Manipal Institute of Management Manipal Content Preparation Team Content Writing Prof. V. Narayanan Dean, M.S. Ramaiah Institute Management, Bangalore Edition: Spring 2010 This book is a distance education module comprising of collection of learning material for our students. All rights reserved. No part of this work may be reproduced in any form by any means without permission in writing from Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim. Printed and Published on behalf of Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim by Mr. Rajkumar Mascreen, GM, Manipal Universal Learning Pvt. Ltd., Manipal 576 104. Printed at Manipal Press Limited, Manipal.
Mr. Pankaj Khanna Director HR, Fidelity Mutual Fund Mr. Shankar Jagannathan Former Group Treasurer Wipro Technologies Limited Mr. Abraham Mathew Chief Financial Officer Infosys BPO, Bangalore Ms. Sadhna Dash Ex-Senior Manager, HR Microsoft India Corporation (Pvt.) Ltd.
Content Editing Peer Review By Dr. T.V. Narasimha Rao Adjunct Faculty & Advisor SMU, DDE, Bangalore 560 008
SUBJECT INTRODUCTION
Financial management deals with the management of financial resources of a business firm. It discusses the goals of financial management and emphasises on shareholder value maximisation. Financial management mainly comprises of all managerial actions relating to the three major decision areas such as Investment, Financing and Dividends and working capital management. This courseware comprises 15 units: Unit 1: Financial Management This unit explains the meaning and scope of financial management. It examines the goal of corporate financial management. Unit 2: Financial Planning This unit gives a brief account of the meaning and need for financial planning. Unit 3: Time Value of Money This unit introduces the concepts of time value of money, compounding and discounting of cash flows. Unit 4: Valuation of Bonds and Shares This unit explains the principles behind the valuations of bonds and equity shares. Unit 5: Cost of Capital This unit describes the concept of cost of capital and the computation of the weighted average cost of capital. Unit 6: Leverage This unit describes the concepts of operating, financial and combined leverage and gives the procedure for computing the different types of leverage. Unit 7: Capital Structure This unit introduces the concept of capital structure and the importance thereof. It also discusses the various theories of capital structure.
Unit 8: Capital Budgeting This unit explains the meaning and significance of capital budgeting decisions. It gives a detailed account of various investment appraisal techniques. Unit 9: Risk Analysis in Capital Budgeting This unit gives the meaning of risk, types and sources of risk in capital budgeting decisions. It also analyses the various approaches for handling the risk factor in investment decisions. Unit 10: Capital Rationing This unit explains the meaning of capital rationing. It also examines the steps involved in capital rationing process. Unit 11: Working Capital Management This unit gives the meaning of various concepts of working capital. It gives a detailed account of the factors that influence the working capital requirements of a firm. Unit 12: Cash Management Cash is an important component of working capital. It needs to be managed efficiently so as to avoid either excess cash balances or cash shortages. This unit looks at different cash management tools. Unit 13: Inventory Management This unit describes briefly the various forms of inventory that a firm keeps. A brief description and pricing of inventory along with the determination of stock levels are also explained. Unit 14: Receivables Management This unit gives the meaning of receivables management. Costs of maintaining receivables, formulation of credit policy and determination of an optimal credit period are discussed. Unit 15: Dividend Decision Dividends are payments made by firm to its shareholders. Dividends form a part of the returns expected by the shareholders. This unit explains the dividend policy matters of a business firm and the different types of dividends.
Financial Management
Unit 1
Unit 1
Structure:
1.1 Introduction Learning objectives 1.2 Meanings and Definitions 1.3 Goals of Financial Management Profit maximisation Wealth maximisation Wealth maximisation vs. Profit maximisation 1.4 Finance Functions Financing decisions Investment decisions Dividend decisions Liquidity decision Organisation of Finance Function 1.5 Interface between Finance and Other Business Functions Finance and accounting Finance and marketing Finance and production (operations) Finance and HR 1.6 Summary 1.7 Terminal Questions 1.8 Answers to SAQs and TQs
1.1 Introduction
Financial Management of a firm is concerned with procurement and effective utilisation of funds for the benefit of its stakeholders. It embraces all those managerial activities that are required to procure funds at the least cost and their effective deployment. The most admired Indian companies are Reliance and Infosys. They have been rated well by the financial analysts on many crucial aspects that enabled them to create value for its share holders. They employ the best technology, produce good quality goods or render services at the least cost and continuously contribute to the shareholders wealth. The three core elements of financial management are:
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a. Financial Planning Financial Planning is to ensure the availability of capital investments to acquire the real assets. Real assets are land and buildings, plants and equipments. Capital investments are required for establishing and running the business smoothly. b. Financial Control Financial Control involves managing the costs and expenses of a business. For example, it includes taking decisions on the routine aspects of day to day management of collecting money due from the firms customers and making payments to the suppliers of various resources. c. Financial Decisions Decision needs to be taken on the sources from which the funds required for the capital investments could be obtained. There are two sources of funds - debt and equity. In what proportion the funds are to be obtained from these sources is to be decided for formulating the financing plan. In this unit, you will learn about these core elements of financial management. 1.1.1 Learning objectives After studying this unit, you should be able to understand: The meaning of Business Finance The objectives of Financial Management The various interfaces between finance and other managerial functions of a firm
1.2 Meaning and Definitions

Financial Management is the art and science of managing money. Regulatory and economic environments have undergone drastic changes due to liberalisation and globalisation of Indian economy. This has changed the profile of Indian finance managers. Indian financial managers have transformed themselves from licensed raj managers to well-informed dynamic proactive managers capable of taking decisions of complex nature. Traditionally, financial management was considered a branch of knowledge with focus on the procurement of funds. Instruments of financing, formation,
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merger and restructuring of firms and legal and institutional frame work occupied the prime place in this traditional approach. The modern approach transformed the field of study from the traditional narrow approach to the most analytical nature. The core of modern approach evolved around the procurement of the least cost funds and its effective utilisation for maximisation of share holders wealth. Self Assessment Questions Fill in the blanks: 1. What has changed the profile of Indian finance managers? 2. Finance management is considered a branch of knowledge with focus on the __________.
1.3 Goals of Financial Management

Financial Management means maximisation of economic welfare of its shareholders. Maximisation of economic welfare means maximisation of wealth of its shareholders. Shareholders wealth maximisation is reflected in the market value of the firms shares. Experts believe that, the goal of the financial management is attained when it maximises its value. There are two versions of the goals of financial management of the firm Profit Maximisation and Wealth Maximisation (see figure 1.1).
GOALS
Profit Maximisation
Wealth Maximisation
Figure 1.1: Goals of financial management
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1.3.1 Profit Maximisation Profit maximisation is based on the cardinal rule of efficiency. Its goal is to maximise the returns, with the best output and price levels. A firms performance is evaluated in terms of profitability. Allocation of resources and investors perception of the companys performance can be traced to the goal of profit maximisation. Profit maximisation has been criticised on many accounts: 1. The concept of profit lacks clarity. What does profit mean? o o Is it profit after tax or before tax? Is it operating profit or net profit available to share holders?
Differences in interpretation on the concept of profit expose the weakness of profit maximisation. 2. Profit maximisation ignores time value of money. It does not differentiate between profits of current year with the profit to be earned in later years. 3. The concept of profit maximisation fails to consider the fluctuations in profits earned from year to year. Fluctuations may be attributed to the business risk of the firm. 4. The concept of profit maximisation apprehends to be either accounting profit or economic normal profit or economic supernormal profit. Profit maximisation fails to meet the standards stipulated in an operational and a feasible criterion for maximising shareholders wealth, because of the deficiencies explained above. 1.3.2 Wealth Maximisation Wealth maximisation means maximising the net wealth of a companys shareholders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance managers as it overcomes the limitations of profit maximisation. The following arguments are in support of the superiority of wealth maximisation over profit maximisation Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements.
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Wealth maximisation considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented.
Let us now look at some of the key definitions: Positive net present value can be defined as the excess of present value of cash inflows of any decision implemented over the present value of cash out flows Time value factor is known as the time preference rate, that is, the sum of risk free rate and risk premium. Risk free rate is the rate that an investor can earn on any government security for the duration under consideration Risk premium is the consideration for the risk perceived by the investor in investing in that asset or security. Required rate of return is the return that the investors want for making investment in that sector. Caselet X Ltd is a listed company engaged in the business of FMCG (Fast Moving consumer goods). Listed implies that the companys shares are allowed to be traded officially on the portals of the stock exchange. The Board of Directors of X Ltd took a decision in one of its Board meetings to enter into the business of power generation. When the company informed the stock exchange at the conclusion of the meeting of the decision taken, the stock market reacted unfavourably. The result was that the next days closing of quotation was 30 % less than that of the previous day. Why did the market react unfavourably? Investors in FMCG company might have thought that the risk profile of the new business that the company wants to take up is higher compared to risk profile of the existing FMCG business of X ltd. when they want a higher return, market value of the companys shares decline. 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.
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1.3.3 Wealth maximisation vs. Profit maximisation Let us now see how wealth maximisation is superior to profit maximisation. Wealth maximisation is based on cash flow. It is not based on the accounting profit. Through the process of discounting, wealth maximisation takes care of the quality of cash flows. Distant cash flows are uncertain. Converting distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associated with cash flows. These risks are adequately considered when present values of cash flows are taken to arrive at the net present value of any project. Corporates play a key role in todays competitive business scenario. In an organisation, shareholders typically own the company but the management of the company rests with the board of directors. Directors are elected by shareholders. Company management procures funds for expansion and diversification of capital markets.
In the liberalised set up, the society expects corporates to tap the capital markets effectively for their capital requirements. Therefore, to keep the investors happy throughout the performance of value of shares in the market, management of the company must meet the wealth maximisation criterion. When a firm follows wealth maximisation goal, it achieves maximisation of market value of share. A firm can practice wealth maximisation goal only when it produces quality goods at low cost. On this account, society gains because of the societal welfare. Maximisation of wealth demands on the part of corporates to develop new products or render new services in the most effective and efficient manner. This helps the consumers as it brings to the market the products and services that consumer needs. Another notable feature of the firms committed to the maximisation of wealth is that to achieve this goal, they are forced to render efficient service to their customers with courtesy. This enhances consumer welfare and benefit to the society. From the point of evaluation of performance of listed firms, the most remarkable measure is that of performance of the company in the share
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market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholders wealth maximisation could be considered a superior goal compared to profit maximisation. Since listing ensures liquidity to the shares held by the investors, shareholders can reap the benefits arising from the performance of company only when they sell their shares. Therefore, it is clear that maximisation of market value of shares will lead to maximisation of the net wealth of shareholders
Therefore, we can conclude that maximisation of wealth is the appropriate goal of financial management in todays context. Self Assessment Questions Fill in the blanks: 3. Under perfect competition, allocation of resources shall be based on the goal of ________. 4. _______ is based on cash flows. 5. _________ consider rime value of money. 6. What are the main goals of financial management?
1.4 Finance Functions

Finance functions deal with the functions performed by the finance manager. They are closely related to financial decisions. In the course of performing these functions, finance manager takes several decisions (see figure1.2): Finance decisions Investment decisions Liquidity decisions Dividend decisions Organisation of a finance function
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Figure 1.2: Finance manager decisions
1.4.1 Finance decisions Financing decisions relate to the acquisition of funds at the least cost. Cost has two dimensions: Explicit Cost Implicit cost Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the security. Implicit cost is not a visible cost but it may seriously affect the companys operations especially when it is exposed to business and financial risk In India, if a company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high degree of business risk. In all financing decisions, a firm has to determine the proportion of equity and debt. The composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India.
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Caselet The interest rate on loan taken is 12%, tax rate applicable to the company is 50%, and 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 the actual cost is 12% with a tax rate of 50%, the effective cost becomes 6%. Therefore, the debt is cheap. But, every instalment of debt brings along with it corresponding insolvency risk. Another thing notable in connection to this is that the firm cannot avoid its obligation to pay interests and loan instalments to its lenders and debentures. An investor in a companys shares has two objectives for investing: Income from capital appreciation (capital gains on sale of shares at market price) Income from dividends It is the ability of the company to give both these incomes to its shareholders that determines the market price of the companys 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.
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Solved Problem Dividend = 12% on paid up value Tax rate applicable to the company = 30% Dividend tax = 10% Compute the profit that the company must earn before tax, When a company pays Rs.12 on paid up capital of Rs.100 as dividend Solution 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 Rs.12 + Rs.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 Pre tax profit required to declare and (1 Tax rate) pay the dividend
13.2 13.2 Rs.19 approximat e 1 0.3 0.7
Therefore, to declare a dividend of 12%, a company has to earn a pre-tax profit of 19%. On the other hand, to pay an interest of 12%, the company has to earn only 8.4%. This leads to the conclusion that for every Rs.100 procured through debt, it costs 8.4%, whereas the same amount procured in the form of equity (share capital) costs 19 %. This confirms the established theory that equity is costly but debt is a cheap and risky source of funds to the corporate. Financing decision involves the consideration of managerial control, flexibility and legal aspects and regulatory and managerial elements. 1.4.2 Investment decisions To survive and grow, all organisations have to be innovative. Innovation demands managerial proactive actions. Proactive organisations continuously search for innovative ways of performing the activities of the organisation. Innovation is wider in nature. It could be: expansion through entering into new markets
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adding new products to its product mix performing value added activities to enhance customer satisfaction adopting new technology that would drastically reduce the cost of production rendering services or mass production at low cost or restructuring the organisation to improve productivity These innovations change the profile of an organisation. These decisions are strategic because they are risky. However, if executed successfully with a clear plan of action, investment decisions generate super normal growth to the organisation. A firm may become bankrupt, if the management fails to execute the decisions taken. Therefore, such decisions have to be taken after taking into account all the facts affecting the decisions and their execution. There are two critical issues to be considered in these decisions. Evaluation of expected profitability of the new investments. Rate of return required on the project.
The Rate of Return required by an investor is normally known as the hurdle rate or the cut-off rate or the opportunity cost of capital. Investments in buildings and machineries are to be conceived and executed by a firm to enter into any business or to expand its business. The process involved is called Capital Budgeting. Capital Budgeting decisions demand considerable time, attention and energy of the management. They are strategic in nature as the success or failure of an organisation is directly attributable to the execution of Capital Budgeting decisions taken. Investment decisions are also known as Capital Budgeting Decisions and hence lead to investments in real assets. 1.4.3 Dividend decisions Dividends are pay-outs to shareholders. Dividends are paid to keep the shareholders happy. Dividend decision is a major decision made by a finance manager. It is based on formulation of dividend policy. Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend and on the market value of its shares.
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Optimum dividend policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend. In the formulation of dividend policy, the management of a company will have to consider the relevance of its policy on bonus shares. Dividend policy influences the dividend yield on shares. Dividend yield is an important determinant of an investors attitude towards the security (stock) in his portfolio management decisions. The following issues need adequate consideration in deciding on dividend policy: Preferences of share holders Do they want cash dividend or capital gains? Current financial requirements of the company Legal constraints on paying dividends Striking an optimum balance between desires of share holders and the companys funds requirements 1.4.4 Liquidity decision Liquidity decisions deals with Working Capital Management. It is concerned with the day-to-day financial operations that involve current assets and current liabilities. The important elements of liquidity decisions are: Formulation of inventory policy Policies on receivable management Formulation of cash management strategies Policies on utilisation of spontaneous finance effectively
1.4.5 Organisation of finance function Financial decisions are strategic in character and therefore, an efficient organisational structure is required to administer the same. Finance is like blood that flows throughout the organisation. In all organisations, CFOs play an important role in ensuring proper reporting based on substance of the stake holders of the company. Finance functions are organised directly under the control of board of directors, because of the crucial role these functions play. For the survival of the firm, there is a need to ensure both long term and short term financial solvency.
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Weak functional performance by financial department will weaken production, marketing and HR activities of the company. The result would be the organisation becoming anaemic. Once anaemic, unless crucial and effective remedial measures are taken up, it will pave way for corporate bankruptcy. Under the CFO, normally two senior officers manage the treasurer and controller functions. A Treasurer performs the following functions. Obtaining finance Liaison with term lending and other financial institutions Managing working capital Managing investment in real assets
A Controller performs the following functions. Accounting and auditing Management control systems Taxation and insurance Budgeting and performance evaluation Maintaining assets intact to ensure higher productivity of operating capital employed in the organisation
In India, CFOs have a legal obligation under various regulatory provisions to certify the correctness of various financial statements and information reported to the stake holders in the annual report. Listing norms, regulations on corporate governance and other notifications of Govt. of India have adequately recognised the role of finance function in the corporate set up in India.
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Self Assessment Questions Fill in the blanks: 7. 8. 9. 10. 11. ________ lead to investment in real assets. _____ relate to the acquisition of funds at the least cost. Formulation of inventory policy is an important element of _______. Obtaining finance is an important function of _________. What are the two critical issues to be considered under investment decisions? 12. Define rate of return. 13. The most important decision made by a finance manager is ________.
1.5 Interface between Finance and other Business Functions

1.5.1 Finance and accounting From the hierarchy of the finance function of an organisation, the controller reports to the CFO. Accounting is one of the functions that a controller discharges. Accounting and finance are closely related. For computation of Return on Investment, earnings per share and for various ratios of financial analysis, the data base will be accounting information. Without a proper accounting system, an organisation cannot administer the effective function of financial management. The purpose of accounting is to report the financial performance of the business for the period under consideration. All the financial decisions are futuristic based on cash flow analysis. All the financial decisions consider quality of cash flows as an important element of decisions. Since financial decisions are futuristic, it is taken and put into effect, under conditions of uncertainty. Assuming the condition of uncertainty and incorporating the effect on decision making, results in use of various statistical models. In the selection of the statistical models, element of subjectivity creeps in. 1.5.2 Finance and marketing Marketing decisions generally have financial implications. Selections of channels of distribution, deciding on advertisement policy and remunerating the salesmen, have financial implications. In fact, the recent behaviour of rupee against US dollar (appreciation of rupee against US dollar), affected
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the cash flow positions of export oriented textile units and BPOs and other software companies. It is generally believed that the currency in which marketing manager invoices the exports, decides the cash flow consequences of the organisation, if and only if the company is mainly dependent on exports. Marketing cost analysis, a function of finance managers, is the best example of application of principles of finance on the performance of marketing functions by a business unit. Formulation of policy on credit management cannot be done unless the integration of marketing with finance is achieved. Deciding on credit terms to achieve a particular level of sales has financial implications because sanctioning liberal credit may result in huge and bad debt. On the other hand, conservative credit terms may depress the sales. Relation between Inventory and Sales: Co-ordination of stores administration with that of marketing management is required to ensure customer satisfaction and good will. But investment in inventory requires the financial clearance because funds are locked in and the funds so blocked have opportunity cost of capital. 1.5.3 Finance and production (operations) Finance and operations management are closely related. Decisions on plant layout, technology selection, productions or operations, process plant size, removing imbalance in the flow of input material in the production or operation process and batch size are all operation management decisions. Their formulation and execution cannot be done unless they are evaluated from the financial angle. The capital budgeting decisions are closely related to production and operation management. These decisions make or mar a business unit. Failure to understand the implications of the latest technological trend on capacity expansions has cost even blue chip companies. Many textile units in India became sick because they did not provide sufficient finance for modernisation of plant and machinery. Inventory management is crucial to successful operation management. But management of inventory involves quite a lot of financial variables. 1.5.4 Finance and HR Attracting and retaining the best man power in the industry cannot be done unless they are paid salary at competitive rates. If an organisation formulates and implements a policy for attracting the competent man power,
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it has to pay the most competitive salary packages to them. However, by attracting competent man power, capital and productivity of an organisation improves. Caselet 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 investors 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 organisation, the higher the value of the human capital and consequently the higher the productivity of the organisation. Indian Software and IT enabled services have been globally acclaimed only because of the man power they possess. But it has a cost factor -. the best remuneration to the staff.
1.6 Summary
Financial Management is concerned with the procurement of the least cost funds and its effective utilisation for maximisation of the net wealth of the firm. There exists a close relation between the maximisation of net wealth of shareholders and the maximisation of the net wealth of the company. The broad areas of decision are capital budgeting, financing, dividend and working capital. Dividend decision demands the managerial attention to strike a balance between the investors expectation and the organisations growth.
1.7 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. 4. Examine the relationship between finance and accounting. 5. Examine the relationship between finance and marketing.
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1.8 Answers to SAQs and TQs

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Effective utilisation Liberalisation and globalisation of Indian economy Procurement of funds. Profit maximisation. Wealth maximisation Wealth maximisation Investment decisions. Financing decisions Liquidity Treasurers The two critical issues are evaluation of expected profitability of the new investment rate of return required on the project 12. Rate of return is normally defined as the hurdle rate or cut-off rate or opportunity cost of the capital 13. Dividend decision Answers to Terminal Questions 1. 2. 3. 4. 5. Refer 1.3 Refer 1.4.1 Refer 1.5 Refer 1.5.1 Refer 1.5.2
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Unit 2
Financial Planning
Structure: 2.1 Introduction Learning Objectives Objectives of financial planning Benefits that accrue to a firm out of financial planning Guidelines for financial planning 2.2 Steps in Financial Planning Forecast of income statement Forecast of balance sheet Computerised financial planning system 2.3 Factors affecting Financial Plan 2.4 Estimation of Financial Requirements of a Firm 2.5 Capitalisation Cost theory Earnings theory Over-capitalisation Under-capitalisation 2.6 Summary 2.7 Terminal Questions 2.8 Answers to SAQs and TQs
2.1 Introduction
Liberalisation and globalisation policies initiated by the government have changed the dimension of business environment. Therefore, for survival and growth, a firm has to execute planned strategies systematically. To execute any strategic plan, resources are required. Resources may be manpower, plant and machinery, building, technology or any intangible asset. To acquire all these assets, financial resources are essentially required. Therefore the finance manager of a company must have both long-range and short-range financial plans. Integration of both these plans is required for the effective utilisation of all the resources of the firm.
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The long-range plans must include: Funds required for executing the planned course of action Funds available at the disposal of the company Determination of funds to be procured from outside sources 2.1.1 Learning objectives After studying this unit you should be able to: Explain the steps involved in financial planning. Explain the factors effecting financial planning. List out the cases of over-capitation. Explain the effects of under-capitation. 2.1.2 Objectives of financial planning Let us start with defining financial planning as an essential objective. Financial planning is a process by which funds required for each course of action is decided. A financial plan has to consider capital structure, capital expenditure and cash flow. Decisions on the composition of debt and equity must be taken. Financial planning or financial plan indicates: The quantum of funds required to execute business plans Composition of debt and equity, keeping in view the risk profile of the existing business, new business to be taken up and the dynamics of capital market conditions Formulation of policies, giving effect to the financial plans under consideration 2.1.3 Benefits of financial planning Financial planning also helps firms in the following ways. A financial plan is at the core of value creation process. A successful value creation process can effectively meet the bench-marks of investors expectations. Financial planning ensures effective utilisation of the funds. To manage shortage of funds, planning helps the firms to obtain funds at the right time, in the right quantity and at the least cost as per the requirements of finance emerging opportunities. Surplus is deployed through well
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planned treasury management. Ultimately, the productivity of assets is enhanced. Effective financial planning provides firms the flexibility to change the composition of funds that constitute its capital structure in accordance with the changing conditions of the capital market. Financial planning helps in formulation of policies and instituting procedures for elimination of wastages in the process of execution of strategic plans. Financial planning helps in reducing the operating capital of a firm. Operating capital refers to the ratio of capital employed to the sales generated. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets will help the firm in reducing its operating capital. Operating capital = Capital employed / Sales generated A study of annual reports of Dell computers will throw light on how Dell strategically minimised the operating capital required to support sales. Such companies are admired by investing community.
2.1.4 Guidelines for financial planning The following are the guidelines of a financial plan: Never ignore the coordinal principle that fixed asset requirements be met from the long term sources. Make maximum use of spontaneous source of finance to achieve highest productivity of resources. Maintain the operating capital intact by providing adequate out of the current periods earnings. Give due attention to the physical capital maintenance or operating capability. Never ignore the need for financial capital maintenance in units of constant purchasing power. Employ current cost principle wherever required. Give due weight age to cost and risk in using debt and equity. Keeping the need of finance for expansion of business, formulate plough back policy of earnings. Exercise thorough control over overheads.
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Seasonal peak requirements to be met from short term borrowings from banks.
2.2 Steps in Financial Planning

There are six steps involved in financial planning which are as shown in figure 2.1
Figure 2.1: Steps in financial planning
Establish corporate objectives The first step in financial planning is to establish corporate objectives. Corporate objectives can be grouped into qualitative and quantitative. For example, a companys mission statement may specify create economic value added. However this qualitative statement has to be stated in quantitative terms such as a 25 % ROE or a 12 % earnings growth rates. Since business enterprises operate in a dynamic environment, there is a need to formulate both short run and long run objectives.
Formulate strategies The next stage in financial planning is to formulate strategies for attaining the defined objectives. Operating plans helps achieve the purpose. Operating plans are framed with a time horizon. It can be a five year plan or a ten year plan.
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Delegate responsibilities Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management bench-marks, profit targets is to be fixed on respective executives. Forecast financial variables The next step is to forecast the various financial variables such as sales, assets required, flow of funds and costs to be incurred. These variables are to be translated into financial statements. Financial statements help the finance manager to monitor the deviations of actual from the forecasts and take effective remedial measures. This ensures that the defined targets are achieved without any overrun of time and cost.
Develop plans This step involves developing a detailed plan of funds required for the plan period under various heads of expenditure. From the plan, a forecast of funds that can be obtained from internal as well as external sources during the time horizon is developed. Legal constrains in obtaining funds on the basis of covenants of borrowings is given due weight-age. There is also a need to collaborate the firms business risk with risk implications of a particular source of funds. A control mechanism for allocation of funds and their effective use is also developed in this stage. Create flexible economic environment While formulating the plans, certain assumptions are made about the economic environment. The environment, however, keeps changing with the implementation of plans. To manage such situations, there is a need to incorporate an inbuilt mechanism which would scale up or scale down the operations accordingly.
2.2.1 Income Statement There are three methods of preparing income statement: Percent of sales method or constant ratio method Expense method Combination of both these two
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Percent of sales method This approach is based on the assumptions that each element of cost bears some constant relationship with the sales revenue. Caselet Raw material cost is 40% of sales revenue for the year ended 31.03.2007. However, 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 look good in most of the situations. If in case, 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 government policies, wage agreements and technological innovation totally invalidate this approach on a long run basis. Budgeted expense method Expenses for the planning period are budgeted on the basis of anticipated behaviour of various items of cost and revenue. This demands effective database for reasonable budgeting of expenses. Combination of both these methods The combination of both these methods is used because some expenses can be budgeted by the management taking into account the expected business environment while some other expenses could be based on their relationship with the sales revenue expected to be earned. 2.2.2 Balance sheet The following steps discuss the forecasting of the balance sheet. Compute the sales revenue, having a close relationship with the items of certain assets and liabilities, based on the forecast of sales and the historical database of their relationship Determine the equity and debt mix on the basis of funds requirements and the companys policy on capital structure
Page No. 23
Unit 2
Case Study The following details have been extracted from the books of X Ltd Table 2.1: Income statement 2006 Sales less returns Gross Profit Selling Expenses Administration Deprecation Operating Profit Non operating income EBIT (Earnings Before Interest & Tax) Interest Profit before tax Tax Profit after tax Dividend Retained earnings Table 2.2: Balance sheet Liabilities Shareholders fund Share capital Equity Preference Reserves and surplus Secured loans 120 50 122 100 120 50 224 120 Current assets, Loans and Advances Cash at bank Receivables 10 80 12 128 Investments 2006 2007 Assets Fixed assets Less depreciation 2006 400 100 300 50 2007 510 120 390 50 1000 300 100 40 60 100 20 120 15 105 30 75 38 37 2007 1300 520 120 45 75 280 40 320 18 302 100 202 100 102
Unsecured loans
50
60
Page No. 24
Unit 2
Current liabilities Trade creditors Provisions Tax Proposed dividend 10 38 700 60 100 984 210 250
Inventories Loans and Advances Miscellaneous expenditure
200 50 10
300 80 24
700
984
Forecast the income statement and balance sheet for the year 2008 based on the following assumptions: Sales for the year 2008 will increase by 30% over the sales value for 2007. Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2007. Depreciation is charged at 25% of fixed assets. Fixed assets will increase by Rs.100 million Investments will increase by Rs.100 million Current assets and current liabilities are to be decided based on their relationship with the sales in the year 2007 Miscellaneous expenditure will increase by Rs.19 million Secured loans in 2008 will be based on its relationship with the sales in the year 2007 Additional funds required, if any, will be met by bank borrowings Tax rates will be 30 % Dividends will be 50 % of the profit after tax Non operating income will increase by 10% There will be no change in the total amount of administration expenses to be spent in the year 2008 There is no change in equity and preference capital in 2008 Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007 The forecast of the income statement and the balance sheet for the year 2008 has been briefly explained in table 2.3 and in the table 2.4
Page No. 25
Unit 2
Table 2.3: Income statement Particulars Sales Cost of sales Gross profit Selling expenses Administration Depreciation Operating profit Non-operating income Earnings Before Interest and Taxes (EBIT) Interest Basis Increase by 30% Increase by 30% Sales-cost of sales 30% increase No change % given C - (D + E + F) Increase by 10% 1.1 x 40 Working 1300 x 1.3 780 x 1.3 1690-1014 120 x 1.3 Amount (Rs.) 1690 1014 676 156 45
390 100 4
123 (Rounded off) 352 44 396
18 of Sales 1300
18 1690 1300
Profit before tax Tax Profit after tax Dividends Retained earnings Table 2.4: Balance sheet Particulars Assets Fixed Assets Add: Addition Given Basis Working
23 (Decimal ignored) 373 112 261 130 131 Amount (Rs.) 510 100 610
Depreciation 1. Net fixed assets 2. Investments 3. Current Assets & Loans & advances Sikkim Manipal University
120 + 123
243 367 150
Page No. 26
Unit 2
Cash at bank Receivables Inventories Loans & Advances 4. Miscellaneous Expenditure Total Liabilities 1. Share Capital Equity Preference 2. Reserves & Surplus
12 1300 128 1300 300 1300 80 1300

Given
12 1690 1300 128 1690 1300 300 1690 1300 80 1690 1300
24 + 19
16 (Rounded off) 166 390 104 43 1236
120 50 Increase by current years retained earnings 355
3. Secured Loan Bank borrowings
60 1300
60 1690 1300
78 40 (Difference Balancing figure)
4. Unsecured Loan 5. Current Liabilities & Provision Trade creditors Provision for tax Proposed Dividend Total Liabilities
60
60
250 1300 60 1300

Current year given
250 1690 1300 60 1690 1300
325 78 130 1236
Page No. 27
Unit 2
2.2.3 Computerised financial planning system All corporate forecasts use computerised forecasting models. Additional funds required to finance the increase in sales could be ascertained using a mathematical relationship based on the following: Additional Funds Required = Required Increase in Assets Spontaneous increase in Liabilities Increase in Retained Earnings (This formula has been recommended by Eugene F. Brigham and Michael C. Earnhardt in their book Financial Management Theory and Practice, 10th edition, published on 31st July 1998) Prof. Prasanna Chandra, in his book Financial Management,(6th editionmanohar publishers and distributors) has given a comprehensive formula for ascertaining the external financial requirements.
EFR =
A ( s) L ( s) ms (1-d) (1m + SR) S S
Here A ( s) = Expected increase in assets, both fixed assets and current S assets, required for the expected increase in sales in the next year. L ( s) = Expected spontaneous finance available for the expected S increase in sales. MS1 (1-d) = It is the product of profit margin, expected sales for the next year and the retention ratio. Retention ratio = 1 payout ratio Payout ratio refers to the ratio of the dividend paid to the earnings per share. 1m = Expected change in the level of investments and miscellaneous expenditure. SR = It is the firms repayment liability on term loans and debenture for the next year.
Page No. 28
Unit 2
The formula described above has certain features: Ratios of assets and spontaneous liabilities to sales remain constant over the planning period Dividend payout and profit margin for the next year can be reasonably planned in advance Since external funds requirements involve borrowings from financial institution, the formula rightly incorporates the managements liability on repayments Solved Problem X Ltd. has given the following forecasts: Sales in 2008 will increase from Rs. 1000 to Rs. 2000 in 2007. The balance sheet of the company as on December 31, 2007 gives the details as shown below:
Table 2.5: Balance sheet Liabilities Share Capital Equity (Shares of Rs.10 each) Reserves & Surplus Long term loan Creditors for expenses outstanding Trade creditors Bills Payable 100 250 400 50 50 150 1000 1000 Rs. Assets Net Fixed Assets Inventories Cash Bills Receivable Rs. 500 200 100 200
Taking into account the following information, the external funds requirements for the year 2008 has to be ascertained: The companys utilisation of fixed assets in 2007 was 50 % of capacity but its current assets were at their proper levels. Current assets increase at the same rate as sales. Companys after-tax profit margin is expected to be 5%, and its payout ratio will be 60 %. Creditors for expenses are closely related to sales (Adapted from IGNOU MBA).
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Solution Preliminary workings A = Current assets = Cash + Bills Receivables + Inventories = 100 + 200 +200 = 500 A 500 ( s) 1000 Rs. 500 S 1000 L = Trade creditors + Bills payable + Expenses outstanding = 50 + 150 + 50 = Rs. 250 L 250 ( s) 1000 Rs. 250 S 1000 M (Profit Margin) = 5 / 100 = 0.05 S1 = Rs.2000 1-d = 1 0.6 = 0.4 or 40 % 1m = NIL SR = NIL A ( s) L s - ms1 (1-d) (1m + SR) Therefore: EFR S S = 500 250 (0.05 x 2000 x 0.4) (0 + 0) = 500 250 40 - (0 + 0) = Rs. 210 Therefore external fund requirements for 2008 will be Rs. 210. This additional fund requirement will be procured by the firm, based on its policy on capital structure.
Self Assessment Questions Fill in the blanks 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.
Page No. 30
Unit 2
2.3 Factors affecting Finanical Plan

The various other factors affecting financial plan are listed down in figure 2.2
Figure 2.2: Factors affecting financial plan
Nature of the industry The very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or labour intensive industry. This will have a major impact on the total assets that a firm owns. Size of the company The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates
Status of the company in the industry A well established company enjoys a good market share, for its products normally commands investors confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment
Page No. 31
Unit 2
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 firms capability to manage the risk exposure. The capital structure of a company The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders. Matching the sources with utilisation The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed asset investments are to be financed by long term sources, which is a cardinal principle of financial planning. Flexibility The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalisation of capital market. Government policy SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs (Govt. of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint.
Page No. 32
Unit 2
Self Assessment Questions Fill in the blanks: 4. ______ has a major impact on the total assets that the firm owns. 5. Sources of finance could be grouped into ______ and _____. 6. ___________ 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. 7. _____ refers to the ability to _____ whenever needed.
2.4 Estimations of Financial requirements of a Firm

The estimation of capital requirements of a firm involves a complex process. Even with expertise, managements of successful firms could not arrive at the optimum capital composition in terms of the quantum and the sources. Capital requirements of a firm could be grouped into fixed capital and working capital. The long term requirements such as investments in fixed assets will have to be met out of funds obtained on long term basis Variable working capital requirements which fluctuate from season to season will have to be financed only by short term sources Any departure from this well accepted norm causes negative impact on firms finances. Self Assessment Questions Fill in the blanks 8. Capital requirement of a firm could be grouped into ____ and _____. 9. Variable working capital will have to be financed only by _______.
2.5 Capitalisation
Capitalisation of a firm refers to the composition of its long term funds and its capital structure. It has two components Debt and Equity.
Page No. 33
Unit 2
After estimating the financial requirements of a firm, the next decision that the management has to take is to arrive at the value at which the company has to be capitalised. There are two theories of capitalisation for the new companies: Cost theory Earnings theory Figure 2.3 displays the two theories.
Figure 2.3: Theories of capitalisation
2.5.1 Cost theory Under this theory, the total amount of capitalisation for a new company is the sum of: Cost of fixed assets Cost of establishing the business Amount of working capital required
Merits of cost approach It helps promoters to estimate the amount of capital required for incorporation of company, conducting market surveys, preparing detailed project report, procuring funds, procuring assets both fixed and current, running a trial production and successfully producing, positioning and marketing its products or rendering of services If done systematically, it will lay foundation for successful initiation of the working of the firm
Page No. 34
Unit 2
Demerits of cost approach If the firm establishes its production facilities at inflated prices, the productivity of the firm will become less than that of the industry. Net worth of a company is decided by the investors and the earnings of a company. Earning capacity based net worth helps a firm to arrive at the total capital in terms of industry specified yardstick (operating capital based on bench marks in that industry), cost theory fails in this respect.
2.5.2 Earnings theory Earnings are forecasted and capitalised at a rate of return, which actually is the representative of the industry. Earnings theory involves two steps: Estimation of the average annual future earnings Estimation of the normal earning rate of the industry to which the company belongs Merits of earnings theory Earnings theory is superior to cost theory because of its lesser chances of being either under or over capitalisation Comparison of earnings approach to that of cost approach will make the management to be cautious in negotiating the technology and the cost of procuring and establishing the new business
Demerits of earnings theory The major challenge that a new firm faces is deciding on capitalisation and its division thereof into various procurement sources Arriving at the capitalisation rate is equally a formidable task because the investors perception of established companies cannot be really unique of what the investors perceive from the earning power of the new company
Page No. 35
Unit 2
Due to this problem, most of the new companies are forced to adopt the cost theory of capitalisation. Ideally every company should have normal capitalisation, which is a utopian way of thinking. Changing business environment, role of international forces and dynamics of capital market conditions force us to think in terms of what is optimal today need not to be so tomorrow. Even with these constraints, management of every firm should continuously monitor its capital structure to ensure and avoid the bad consequences of over and under capitalisation. 2.5.3 Over-capitalisation A company is said to be over-capitalised, when its total capital (both equity and debt) exceeds the true value of its assets. It is wrong to identify over-capitalisation with excess of capital because most of the over-capitalised firms suffer from the problems of liquidity. The correct indicator of over-capitalisation is the earnings capacity of the firm. If the earnings of the firm are less than that of the market expectation, it will not be in a position to pay dividends to its shareholders as per their expectations. This is a sign of over-capitalisation. It is also possible that a company has more funds than its requirements based on current operation levels and yet have low earnings. Over-capitalisation may be considered on the account of: Acquiring assets at inflated rates Acquiring unproductive assets High initial cost of establishing the firm Companies which establish their new business during boom condition are forced to pay more for acquiring assets, causing a situation of overcapitalisation once the boom conditions subside Total funds requirements have been over estimated Unpredictable circumstances (like change in import-export policy, change in market rates of interest and changes in international economic and political environment) reduce substantially the earning capacity of the firm. For example, rupee appreciation against US dollar has affected earning capacity of the firms engaged mainly in the export business because they invoice their sales in US dollar
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Inadequate provision of depreciation, adversely effects the earning capacity of the company, leading to over-capitalisation of the firm Existence of idle funds
Effects of over-capitalisation Decline in earnings of the company Fall in dividend rates Market value of the companys share falls, and the company loses investors confidence Company may collapse at any time because of anaemic financial conditions which affect its employees, society, consumers and its shareholders. Employees will lose jobs. If the company is engaged in the production and marketing of certain essential goods and services to the society, the collapse of the company will cause social damage Remedies of over capitalisation Over-capitalisation often results in a company becoming sick Restructuring the firm helps avoid such a situation. Some of the other remedies of overcapitalisation are: Reduction of debt burden Negotiation with term lending institutions for reduction in interest obligation Redemption of preference shares through a scheme of capital reduction Reducing the face value and paid-up value of equity shares Initiating merger with well managed profit making companies interested in taking over ailing company 2.5.4 Under-capitalisation Under-capitalisation is just the reverse of over-capitalisation. A company is considered to be under-capitalised when its actual capitalisation is lower than the proper capitalisation as warranted by the earning capacity. Symptoms of under-capitalisation The following bullets display the symptoms of under-capitalisation. Actual capitalisation is less than the warranted by its earning capacity Rate of earnings is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry
Unit 2
Causes of under-capitalisation The following bullets display the causes of under-capitalisation. Under estimation of the future earnings at the time of the promotion of the company Abnormal increase in earnings from the new economic and business environments Under estimation of total funds requirement Maintaining very high efficiency through improved means of production of goods or rendering of services Companies which are set-up during the recession period will start making higher earning capacity as soon as the recession is over Purchase of assets at exceptionally low prices during recession Effects of under-capitalisation The following bullets display some of the effects of under-capitalisation. Under-capitalisation encourages competition by creating a feeling that the line of business is lucrative It encourages the management of the company to manipulate the companys share prices High profits will attract higher amount of taxes High profits will make the workers demand higher wages. Such a feeling on the part of the employees leads to labour unrest High margin of profit may create an impression among the consumers that the company is charging high prices for its products High margin of profits and the consequent dissatisfaction among its employees and consumer, may invite governmental enquiry into the pricing mechanism of the company Remedies The following bullets display the remedies of under-capitalisation. Splitting up of the shares, which will reduce the dividend per share Issue of bonus shares, which will reduce both the dividend per share and the earnings per share Both over-capitalisation and under-capitalisation are detrimental to the interests of the society.
Page No. 38
Unit 2
Self Assessment Questions Fill in the blanks 10. _____ of a firm refers to the composition of its long term funds. 11. 12. 13. Two theories of capitalisation for new companies are ______ and earnings theory. A company is said to be ________, when its total capital exceeds the true value of its assets. A company is considered to be _______ when its actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity.
2.6 Summary
Financial planning deals with the planning, execution and the monitoring of the procurement and utilisation of the funds. Financial planning process gives birth to financial plan. It could be thought of as a blue-print explaining the proposed strategy and its execution There are many financial planning models. All these models forecast the future operations and then translate them to income statements and balance sheets. It will also help the finance managers to ascertain the funds to be procured from the outside sources The essence of all these is to achieve a least cost capital structure which would match with the risk exposure of the company Failure to follow the principle of financial planning may lead a new firm of over or under capitalisation, when the economic environment undergoes a change Ideally every firm should aim at optimum capitalisation or it might lead to a situation of over or under capitalisation. Both are detrimental to the interests of the society. There are two theories of capitalisation - cost theory and earnings theory.
Page No. 39
Unit 2

1. 2. 3. 4. Explain the steps involved in Financial Planning Explain the factors affecting Financial Plan List out the causes of over-capitalisation Explain the effects of under-capitalisation

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Qualitative, Quantitative Allocation of funds Short term borrowings Nature of the industry Debt, Equity The product policy Flexibility in capital structure, effect changes in the composites of capital structure Fixed capital, working capital Short term sources Capitalisation Cost theory Over-capitalised Under-capitalised
Answers to Terminal Questions 1. 2. 3. 4. Refer to 2.2 Refer to 2.3 Refer to 2.5.3 Refer to 2.5.4
Page No. 40
Unit 3
Unit 3
Time Value of Money
Structure: 3.1 Introduction Learning objectives Rationale 3.2 Future Value Time preference rate or required rate of return Compounding technique Discounting technique Future value of a single flow Doubling period Increased frequency of compounding Effective vs. Nominal rate of interest Future value of series of cash flows Future value of annuity Sinking fund 3.3 Present Value Discounting or present value of a single flow Present values of a series of cash flows Present values of perpetuity Present value of an uneven periodic sum Capital recovery factor 3.4 Summary 3.5 Solved Problems 3.6 Terminal Questions 3.7 Answers to SAQs and TQs
3.1 Introduction
In the previous unit, you have learnt that wealth maximisation is far more superior to profit maximisation. Wealth maximisation considers time value of money, which translates cash flows occurring at different periods into a comparable value at zero period. For example, a firm investing in fixed assets will reap the benefits of such investments for a number of years. However, if such assets are procured
Unit 3
through bank borrowings or term loans from financial institutions, there is an obligation to pay interest and return of principle. Decisions, therefore, are made by comparing the cash inflows (benefits/returns) and cash outflows (outlays). Since these two components occur at different time periods, there should be a comparison between the two. In order to have a logical and a meaningful comparison between cash flows occurring over different intervals of time, it is necessary to convert the amounts to a common point of time. This unit is devoted to a discussion of techniques of doing so. 3.1.1 Learning objectives After studying this unit, you should be able to: Explain the time value of money Understand the valuation concepts Calculate the present and the future values of lump sums and annuity flows 3.1.2 Rationale Time value of money is the value of a unit of money at different time intervals. The value of the money received today is more than its value received at a later date. In other words, the value of money changes over a period of time. Since a rupee received today has more value, rational investors would prefer current receipts over future receipts. That is why, this phenomena is also referred to as Time preference of money. Some important factors contributing to this are: Investment opportunities Preference for consumption Risk These factors remind us of the famous English saying, A bird in hand is worth two in the bush. The question now is: why should money have time value? Some of the reasons are: Production Money can be employed productively to generate real returns. For example, if we spend Rs. 500 on materials, Rs. 300 on labour and
Unit 3
Rs. 200 on other expenses and the finished product is sold for Rs. 1100, we can say that the investment of Rs. 1000 has fetched us a return of 10%. Inflation During periods of inflation, a rupee has higher purchasing power than a rupee in the future. Risk and uncertainty We all live under conditions of risk and uncertainty. As the future is characterised by uncertainty, individuals prefer current consumption over future consumption. Most people have subjective preference for present consumption either because of their current preferences or because of inflationary pressures.
3.2 Future Value

3.2.1 Time preference rate or required rate of return The time preference for money is generally expressed by an interest rate, which remains positive even in the absence of any risk. It is called the risk free rate. For example, if an individuals time preference is 8%, it implies that he is willing to forego Rs. 100 today to receive Rs. 108 after a period of one year. Thus he considers Rs. 100 and Rs. 108 as equivalent in value. In reality though this is not the only factor he considers. He requires another rate for compensating him for the amount of risk involved in such an investment. This risk is called the risk premium. Required rate of return = Risk free rate + Risk premium There are two methods by which the time value of money can be calculated: Compounding technique Discounting technique 3.2.1.1 Compounding technique In the compounding technique, the future values of all cash inflows at the end of the time horizon at a particular rate of interest are calculated. The amount earned on an initial deposit becomes part of the principal at the end of the first compounding period.
Unit 3
The compounding of interest can be calculated by the following equation:
Where, A = Amount at the end of the period P = Principle at the end of the year i = Rate of interest n = Number of years
Example Mr. A invests Rs. 1,000 in a bank which offers him 5% interest compounded annually. Substituting the actual figures for the investment or Rs. 1000 in the formula
n
, we arrive at the values shown in table 3.1.
Table 3.1: Interest compounded annually Year Beginning amount Interest rate Amount of interest Beginning principal Ending principal 1 Rs.1000 5% 50 Rs.1000 Rs.1050 2 Rs.1050 5% 52.50 Rs.1050 Rs.1102.50 3 Rs.1102.50 5% 55.13 Rs.1102.50 Rs.1157.63
As seen from table 3.1, Mr. A has Rs. 1050 in his account at the end of the first year. The total of the interest and principal amount 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. Let us now see how the values in table 3.1 are arrived at. 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 The amount at the end of the second year can be ascertained by substituting Rs.1000 (1+0.05) for Rs.1050, that is, Rs.1000 (1+0.05) (1+0.05)=Rs.1102.50 Similarly, the amount at the end of the third year can be ascertained by substituting Rs.1000 (1+0.05) for Rs.1102.50, that is, Rs.1000 (1+0.05) (1+0.05) (1+0.05)=Rs.1157.63 Sikkim Manipal University Page No. 44
Unit 3
3.2.1.2 Discounting technique In the discounting technique, the present value of the future amount is determined. Time value of the money at time 0 on the time line is calculated. This technique is in contrast to the compounding approach where we convert the present amounts into future amounts. Solved Problem Mr.A requires Rs.1050 at the end of the first year. Given the rate of interest as 5%,find out how much Mr. A would invest today to earn this amount. Solution If P is the unknown amount, then P (1+0.05) =1050 P=1050/ (1+0.05) =Rs.1000 Thus Rs. 1000 would be the required principal investment to have Rs. 1050 at the end of the first year at 5% interest rate. The present value of the money is the reciprocal of the compounding value. Mathematically, we have
Where 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.
3.2.2 Future value of a single flow (lump sum) The process of calculating future value will become very cumbersome if they have to be calculated over long maturity periods of 10 or 20 years. A generalised procedure of calculating the future value of a single cash flow compounded annually is as follows:
Page No. 45
Unit 3
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. The interest rate i is referred to as the Future Value Interest Factor (FVIF). To help ease the calculations, the various combinations of i and n can be referred to in the table 3.1. To calculate the future value of any investment, the corresponding value of
(1 i)n from the table 3.1 is multiplied with the initial investment.
Solved Problem The fixed deposit scheme of a bank offers the interest rates, as shown in the table 3.2:
Table 3.2: Fixed deposit scheme of a bank Period of deposit <45 days 46 days to 179 days 180 days to 365 days 365 days and above Rate per annum 9% 10% 10.5% 11%
What will be the status of Rs. 10, 000 after three years, if it is invested at this point of time? Solution FVn = PV (1+i)n or PV*FVIF (11%, 3y) = 10000*1.368 (from the tables) = Rs.13, 680 The status of Rs. 10, 000 after three years, if it is invested at this point of time, would be Rs.13, 680. 3.2.2.1 Doubling period A very common question arising in the minds of an investor is how long will it take for the amount invested to double for a given rate of interest. There are 2 ways of answering this question.
Unit 3
1. One is called rule of 72. This rule states that the period within which the amount doubles is obtained by dividing 72 by the rate of interest. For instance, if the given rate of interest is 10%, the doubling period is 72/10, that is, 7.2 years. 2. A much accurate way of calculating doubling period is the rule of 69, which is expressed as 0.35+69/interest rate. Going by the same example given above, we get the number of years as 7.25 years {0.35 + 69/10 (0.35 +6.9)}. 3.2.2.2 Increased frequency of compounding So far we have seen the calculation of the time value of money. It has been assumed that the compounding is done annually. Let us now see the effect on interest earned when compounding is done more frequently - half-yearly or quarterly Example If we have deposited Rs.10, 000 in a bank which offers 10% interest per annum compounded semi-annually, the interest earned is as shown in table 3.3.
Table 3.3: Interest earned Amount invested Interest earned for first 6 months 10000*10%*1/2 (for 6 months) Amount at the end of 6 months Interest earned for second 6 months 105000*10%*1/2 Amount at the end of the year Rs.10,000 Rs.500 Rs.10,500 Rs.525 Rs.11,025
If in the above case, compounding is done only once in 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. Going by the calculations, we see that one gets more interest if compounding is done on a more frequent basis. The generalised formula for shorter compounding periods is:
Page No. 47
Unit 3
Where, FVn = future value after n years PV = cash flow today i = nominal interest rate per annum m = number of times compounding is done during a year n = number of years for which compounding is done Solved Problem Under the ABC Banks 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? Solution 1000 (1+0.10/4)4*2 1000 (1+0.10/4)8 Rs. 1218 The amount of Rs. 1000 after years would be Rs. 1218
3.2.2.3 Effective vs. Nominal rate of interest We have just learnt that interest accumulation by frequent compounding is much more than the annual compounding. This means that the rate of interest given to us, that is 10% is the nominal rate of interest per annum. If the compounding is done more frequently, say semi-annually, the principal amount grows at 10.25% per annum. 0.25% is known as the Effective Rate of Interest. The general relationship between the effective and nominal rates of interest is as follows: Where, r = Effective rate of interest i = Nominal rate of interest m = Frequency of compounding per year.
Page No. 48
Unit 3
Solved Problem Calculate the effective rate of interest if the nominal rate of interest is 12% and interest is compounded quarterly. Solution: r = {(1+0.12/4)4}-1 r=0.126 or 12.6% p.a. The effective rate of interest is 12.6% p.a. 3.2.3 Future value of series of cash flows An investor may be interested in investing money in instalments and wish to know the value of his savings after n years. Let us understand the calculation of the same with the help of a solved problem.
Solved Problem 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. Solution The value at the end of 5 years, compounded annually at a rate of interest of 5% per annum, is calculated in the table 3.4 Table 3.4: Future value of series of cash flows
End of year Amount invested Number of years compounded Compounded interest factors from tables FV in Rs.
1 2 3 4 5
Rs.500 Rs.1000 Rs.1500 Rs.2000
4 3 2 1
1.216 1.158 1.103 1.050
608 1158 1654 2100 2500 Rs.8020
Rs.2500 0 1.000 Amount at the end of the fifth year
The value at the end of the fifth year is Rs. 8020
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3.2.4 Future value of an annuity Annuity refers to the periodic flows of equal amounts. These flows can be either termed as receipts or payments. 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:
Where, FVAn = Accumulation at the end of n years i = Rate of interest n = Time horizon or no. of years A = Amount invested at the end of every year for n years The expression (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. From the tables 3.4 and 3.5, different combinations of i and n can be calculated. We just have to multiply the relevant value with A and get the accumulation in the formula given above.
Page No. 50
Unit 3
Solved Problem Mr. Ram Kumar deposits Rs. 3000 at the end of every year for five years into his account. Interest is being compounded annually at a rate of 5%. Determine the amount of money he will have at the end of the fifth year. Solution The amount of money Mr. Ram Kumar will have at the end of the fifth year is calculated from the table 3.5.
Table 3.5: Computation of future value of annuity
End of year 1 2 3 4 5 Amount invested Rs.2000 Rs.2000 Rs.2000 Rs.2000 Rs.2000 Number of years compounded 4 3 2 1 0 Compounded interest factors from tables 1.216 1.158 1.103 1.050 1.000 FV in Rs.
2432 2316 2206 2100 2000 Rs.11054
Amount at the end of the fifth year
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 beckoners.
Page No. 51
Unit 3
Solved Problem Calculate the value of an annuity flow of Rs.5000 done on a yearly basis of five years, yielding at an interest of 8% p.a. Solution = 5000 FVIFA (8%, 5y) = 5000* 5.867 = Rs. 29335 The value of annuity flow is Rs. 29, 335.
3.2.5 Sinking fund Sinking fund is a fund which is created out of fixed payments each period, to accumulate for a future sum after a specified period. The sinking fund factor is useful in determining the annual amount to be put in a fund, to repay bonds or debentures or to purchase a fixed asset or a property at the end of a specified period.
is called the Sinking Fund Factor. Self Assessment Questions Fill in the blanks 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 characterised by uncertainty, individuals prefer _________ consumption to __________ consumption. 4. There are two methods by which time value of money can be calculated by _________ and _________ techniques.
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Unit 3
3.3 Present Value

Given the interest rate, compounding technique can be used to compare the cash flows separated by more than one time period. With this technique, the amount of present cash can be converted into an amount of cash of equivalent value in future. Likewise, we may be interested in converting the future cash flows into their present values. The Present Value (PV) of a future cash flow is the amount of the current cash that is equivalent to the investor. The process of determining present value of a future payment or a series of future payments is known as discounting. 3.3.1 Discounting or present value of a single flow We can determine the PV of a future cash flow or a stream of future cash flows using the formula: Where, PV = Present Value FVn = Amount i = Interest rate n = Number of years Solved Problem 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 = 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 The amount to be invested today to have an amount of Rs, 1000 after one year is Rs. 909. The amount to be invested today to have an amount of Rs, 1000 after one year is Rs. 909.
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Solved Problem An investor wants to find out the value of an amount of Rs. 10,000 to be received after 15 years. The interest offered by bank is 9%. Calculate the PV of this amount. Solution or 100000 PVIF (9%, 15y) = 100000*0.275 = Rs. 27500 The PV of Rs. 10, 000 is Rs. 27, 500.
3.3.2 Present value of a series of cash flows In a business scenario, the businessman will receive periodic amounts (annuity) for a certain number of years. An investment done today will fetch him returns spread over a period of time. He would like to know if it is worthwhile to invest a certain sum now in anticipation of returns he expects after a certain number of years. He should therefore equate the anticipated future returns to the present sum he is willing to forego. The PV of a series of cash flows can be represented by the following formula:
The above formula or the equation reduces to:
The expression {(1 i)n 1/ i (1 i)n } s known as Present Value Interest Factor Annuity (PVIFA). It represents the PVIFA of Re. 1 for the given values of i and n. The values of PVIFA (i, n) can be found out from the Table 3.6. It should be noted that these values are true only if the cash flows are equal and the flows occur at the end of every year.
Page No. 54
Unit 3
Solved Problem Calculate the PV of an annuity of Rs. 500 received annually for four years, when discounting factor is 10%. Solution The present value of annuity can be calculated from the table 3.6 as shown under:
Table 3.6: Computation of PV of annuity End of year 1 2 3 4 Cash inflows Rs.500 Rs.500 Rs.500 Rs.500 PV factor 0.909 0.827 0.751 0.683 PV in Rs. 454 413 375 341
Present value of an annuity is Rs.1583. OR By directly looking at the table we can calculate: = 500*PVIFA (10%, 4y) = 500*3.170 = Rs. 1585 The present value of annuity is Rs. 1585.
Solved Problem Find out the present value of an annuity of Rs. 10000 over 3 years when discounted at 5%. Solution Present value of annuity = 10000*PVIFA (5%, 3y) = 10000*2.773 = Rs. 27730 Hence, the present value of annuity is Rs. 27, 730.
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3.3.3 Present value of perpetuity An annuity for an infinite time period is perpetuity. It occurs indefinitely. A person may like to find out the present value of his investment assuming he will receive a constant return year after year. The PV of perpetuity is calculated as:
Solved Problem The principal of a college wants to institute a scholarship of Rs. 5000 for a meritorious student every year. Find out the PV of investment which would yield Rs. 5000 in perpetuity, discounted at 10%. Solution = 5000/0.10 = Rs. 50000 This means he should invest Rs. 50000 to get an annual return of Rs. 5000. 3.3.4 Present value of an uneven periodic sum In some investment decisions of a firm, the returns may not be constant. In such cases, the PV is calculated as follows.
Or PV= A1 PVIF (i, 1) + A2 PVIF (i, 2) + A3 PVIF (i, 3) + A4 PVIF (i, 4) +... + An PVIF (i, n)
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Solved Problem An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000 and Rs. 4000 respectively at the end of each of five years. Find out the present value of this stream of uneven cash flows, if the investors interest rate is 8%. Solution 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/ (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 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 The present value of this stream of uneven cash flows is Rs. 39, 276
3.3.5 Capital recovery factor Capital recovery factor is the annuity of an investment for a specified time at a given rate of interest. The reciprocal of the present value annuity factor is called capital recovery factor.
is known as the Capital Recovery Factor.
Page No. 57
Unit 3
Solved Problem A loan of Rs. 100000 is to be repaid in 5 equal annual instalments. If the loan carries a rate of 14% p.a, what is the amount of each instalment? Solution Instalment*PVIFA (14%, 5) = 100000 Instalment=100000/3.433 = Rs. 29128. The amount of each instalment has been calculated.
Self Assessment Questions Fill in the blanks 5. _________________ is created out of fixed payments each period to accumulate for a future sum after a specified period. 6. The ________________ of a future cash flow is the amount of the current cash that is equivalent to the investor. 7. An annuity for an infinite time period is called ______________. 8. 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.
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3.5 Solved Problems

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
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%
A loan of Rs. 500000 is to be repaid in 10 equal instalments. If the loan carries 12% interest p.a. what is the value of one instalment? Solution: A*PVIFA (12%, 10y) = 500000 So A = 500000/5.650 =Rs. 88492
A person deposits Rs. 25000 in a bank that pays 6% interest half-yearly. Calculate the amount at the end of 3 years Solution: 25000*(1+0.06)3*2 = 25000*1.194 = Rs. 29850
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
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1. If you deposit Rs.10000 today in a bank that offers 8% interest, how many years will the amount take to double? 2. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of each year for 20 years. What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest given by PF authorities is 9%? 3. A person can save _____________ annually to accumulate Rs. 400000 by the end of 10 years, if the saving earns 12% 4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the annuity assuming he can earn interest on his investment at 10% per annum 5. Aparna invests Rs. 5000 at the end of each year at 10% interest p.a. What is the amount she will receive after 4 years?

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. Investment opportunities, preference for consumption, risk Higher purchasing power Current and future Compounding and discounting Sinking fund Present Value Perpetuity Capital Recovery Factor
Answers to Terminal Questions 1. 2. 3. 4. 5. (Hint: Use rule of 72 and 69) 30000*FVIFA (9%, 20Y) = 30000*51.160 = Rs. 1534800 A*FVIFA (12%, 10y) = 400000 which is 400000/17.549 = Rs. 22795 20000*PVIFA (105, 5y)=20000*3.791 = Rs. 75820 5000*FVIFA (10%, 4y) = 5000*6.105 = Rs. 23205
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Unit 4
Unit 4
Valuation of Bonds and Shares
Structure: 4.1 Introduction Learning objectives Concept of intrinsic value Concept of book value 4.2 Valuation of Bonds Irredeemable or perpetual bonds Redeemable bonds or bonds with maturity period Bonds with annual interest payments Bond values with semi-annual interest payments Zero coupon bonds Bond-yield measures Current yield Yield to maturity (YTM) Bond value theorems 4.3 Valuation of Shares Valuation of preference shares Valuation of ordinary shares Types of dividends Valuation with constant dividends Valuation with constant growth in dividends Valuation with variable changing growth in dividends Price earnings ratio 4.4 Summary 4.5 Solved Problems 4.6 Terminal Questions 4.7 Answers to SAQs and TQs
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.
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The value of an asset depends on the cash flow it is expected to provide over the holding period. The fact is that, as on date, there is no method by which prices of shares and bonds can be accurately predicted. This fact should be kept in mind by an investor before he decides to take an investment decision. Ordinary shares are riskier than bonds or debentures and some shares are more risky than others. The investor would therefore commit funds on a share only if he is convinced about the rate of return being commensurate with risk. The present unit will help us to know why some securities are priced higher than others. We can design our investment structure by exploiting the variables to maximise our returns. 4.1.1 Learning objectives After studying this unit, you should be able to: Define value in terms of Finance Theory Recall the procedure for calculating the value of bonds Recognise the mechanics of valuation of equity shares 4.1.2 Concept of intrinsic value A security can be evaluated by the series of dividends or interest payments receivable over a period of time. In other words, a security can be defined as the present value of the future cash streams. The intrinsic value of an asset is equal to the present value of the benefits associated with intrinsic value. The expected returns (cash inflows) are discounted using the required return commensurate with the risk. Mathematically, intrinsic value can be represented by:
Where V0= value of the asset at time zero (t=0) Cn= expected cash flow at the end of period n. i = discount rate or the required rate of return on cash flows n = expected life of an asset
Page No. 62
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Solved Problem Determine the value of assets of two projects A and B, with a discount rate of 10% and with a cash flow of Rs.20000 and Rs.10000 as shown in table 4.1
Table 4.1: Cash flows of projects A and B
Year 1 2 3 Solution Value of asset A
Cash flows of A (Rs.) 20000 20000 20000
Cash flows of B (Rs.) 10000 20000 30000
= 20000*PVIFA (10%, 3y) = 20000*2.487 = Rs.49470 Value of asset B = 10000 PVIFA (10%, 1) + 20000 PVIFA (10%, 2) + 30000 PVIFA (10%, 3) = 10000*0.909 + 20000*0.826 + 30000*0.751 = 9090+16520+22530 = Rs.48140
Page No. 63
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Solved Problem 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 an asset = 5000/ (1+0.16)6 = Rs.18425 Or = 5000 PVIFA (16%, 6y) = 5000*3.685 = Rs. 18425
4.1.3 Concept of Book value Book value is an accounting concept. Value is what an asset is worth today in terms of their potential benefits. Assets are recorded at historical cost and these are depreciated over years. Book value may include intangible assets at acquisition cost minus amortised value. The book value of a debt is stated at an outstanding amount. Book value of a share is calculated by dividing the net worth by the number of outstanding shares. Shareholders net worth = Assets Liabilities Net worth = Paid-up capital + Reserves + Surplus The following factors explain the concept of book value more briefly Replacement value is the amount a company is required to spend, if it were to replace its existing assets in the present condition. It is difficult to find cost of assets presently used by the company. Liquidation value is the amount a company can realise if it sold the assets after winding up its business. It will not include the value of intangibles as the operations of the company will cease to exist. Liquidation value is generally the minimum value a company might accept if it sold its business. Going concern value is the amount a company can realise if it sells its business as an operating one. This value is higher than the liquidation value.
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Market value is the current price at which the asset or security is being sold or bought into the market. Market value per share is generally higher than the book value per share for profitable and growing firms Key Points Book value of a share is calculated by dividing the net worth by the number of outstanding shares. Book value may include intangible assets at acquisition cost minus amortised value
4.2 Valuation of Bonds

Bonds are long term debt instruments issued by government agencies or big corporate houses to raise large sums of money. Bonds issued by government agencies are secured and those issued by private sector companies may be secured or unsecured. The rate of interest on bonds is fixed and they are redeemable after a specific period. Let us look at some important terms in bond valuation. Coupon rate is the specified rate of interest in the bond. The interest payable at regular intervals is the product of the par value and the coupon rate broken down to the relevant time horizon. Maturity period refers to the number of years after which the par value becomes payable to the bond-holder. Generally, corporate bonds have a maturity period of 7-10 years and government bonds 20-25 years. Face value, also known as par value, is the value stated on the face of the bond. It represents the amount that the unit borrows which is to be repaid at the time of maturity, after a certain period of time. A bond is generally issued at values such as Rs. 100 or Rs. 1000. Market value is the price at which the bond is traded in the stock exchange. Market price is the price at which the bonds can be bought and sold and this price may be different from par value and redemption value. Redemption value is the amount the bond-holder gets on maturity. A bond may be redeemed at par, at a premium (bond-holder gets more
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than the par value of the bond) or at a discount (bond-holder gets less than the par value of the bond. Types of bonds Bonds are of three types Irredeemable bonds, Redeemable bonds and Zero Coupon Bonds. Figure 4.1 illustrates the three types of bonds.
Figure 4.1: Types of Bonds
4.2.1 Irredeemable bonds or perpetual bonds Bonds which will never mature are known as irredeemable or perpetual bonds. Indian Companies Act restricts the issue of such bonds and therefore these are very rarely issued by corporates these days. In case of these bonds, the terminal value or maturity value does not exist because they are not redeemable. The face value is known; the interest received on such bonds is constant and received at regular intervals and hence, the interest receipt resembles perpetuity. The present value is calculated as:
If a company offers to pay Rs.70 as interest on a bond of Rs.1000 per value, and the current yield is 8%, the value of the bond is 70/0.08 which is equal to Rs. 875. 4.2.2 Redeemable bonds Redeemable bonds are of two types, one with annual interest payments and the other one with semi-annual interest payments. 4.2.2.1 Bonds with annual interest payments The holder of a bond receives a fixed annual interest for a specified number of years and a fixed principal repayment at the time of maturity. The intrinsic value or the present value of bond can be expressed as: V0 or P0=nt=1 I/(I+ Kd)n +F/(I+ Kd)n
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The above expression can also be stated as: V0=I*PVIFA(Kd, n) + F*PVIF(Kd, n) Where V0 = Intrinsic value of the bond P0 = Present Value of the bond I = Annual Interest payable on the bond F = Principal amount (par value) repayable at the maturity time N = Maturity period of the bond Kd = required rate of return Solved Problem 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) Therefore, 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
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Solved Problem Mr. Anant purchases a bond whose face value is Rs.1000, and which has a nominal interest rate of 8%. The maturity period is 5 years. 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
This implies that the company is offering the bond at Rs.1000 but its worth is Rs.924.28 at the required rate of return of 10%. The investor should not pay more than Rs.924.28 for the bond today. 4.2.2.2 Bond values with semi-annual interest payments In reality, it is quite common to pay interest on bonds semi-annually. With the effect of compounding, the value of bonds with semi-annual interest is much more than the ones with annual interest payments. Hence, the bond valuation equation can be modified as: V0 or P0=nt=1 I/2/(I+Kd/2)n +F/(I+Kd/2)2n Where V0 = Intrinsic value of the bond P0 = Present Value of the bond I/2 = Semi-annual Interest payable on the bond F = Principal amount (par value) repayable at the maturity time 2n = Maturity period of the bond expressed in half-yearly periods kd/2 = Required rate of return semi-annually.
Page No. 68
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Solved Problem A bond of Rs. 1000 value carries a coupon rate of 10%, maturity period of 6 years. Interest is payable semi-annually. If the required rate of return is 12%, calculate the value of the bond. Solution V0 or P0 = nt=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*PVIFA (6%, 12y) = 50*8.384 + 1000*0 = 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 semi-annually. 4.2.3 Zero coupon bonds In India Zero coupon bonds are alternatively known as Deep Discount bonds. These bonds became very popular in India, for over a decade, because of issuance of such bonds at regular intervals by IDBI and ICICI. Zero coupon bonds have no coupon rate, that is, there is no interest to be paid out. Instead, these bonds are issued at a discount to their face value, and the face value is the amount payable to the holder of the instrument on maturity. Effective interest earned = Discounted issue price Face value They are called Deep Discount bonds because these bonds are long term bonds whose maturity some time extends up to 25 to 30 years. Reading the compound value (FVIF) table, horizontally along the 25 year line, we find r equals 8%. Therefore, the bond gives an effective return of 8% per annum. 4.2.4 Bond yield measures The bond yield measures are categorised into two parts current yield and the yield to maturity. 4.2.4.1 Current yield
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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 (CY) = Coupon Interest / Current Market Price
Solved Problem Continuing with the same problem, calculate the CY if the current market price is Rs. 920 Solution CY=Coupon Interest / Current Market Price = 80/920 = 8.7%
4.2.4.2 Yield to maturity (YTM) Yield to maturity is the rate earned by an investor who purchases a bond and holds it till its maturity. The YTM is the discount rate equalling the present values of cash flows to the current market price.
Solved Problem A bond has a face value of Rs.1000 with a 5 year maturity period. Its current market price is Rs. 883.40. 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=nt=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% of Kd
Page No. 70
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Solved Problem 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=nt=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 and error method is to be followed. Let us therefore start the value of Kd to be 12%. The equation now looks like this: 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 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% + {(884.72-850)/(884.72-787.24)}*(12%-10%) 10% + (34.72/97.48)*2 10% + 0.71 Therefore Kd =10.71%
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An approximation The trial and error method to obtain the rate of return (Kd) is a very tedious procedure and requires lots of time. The following formula can be used as a ready reference formula.
Where YTM = Yield to Maturity i = Annual interest payment f = Face value of the bond p = Current market price of the bond n = Number of years to maturity Solved Problem 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 = 600 + {(5000-4500)/8} / {(5000+4500)/2} = {600 + 62.5} / 4750 = 13.94%
4.2.5 Bond value theorems The following factors affect the bond value theorems: Relationship between the required rate of interest (Kd) and the discount rate Number of years to maturity Yield to maturity (YTM) The relation between the required rate of interest (Kd) and the discount rate are displayed below. When Kd is equal to the coupon rate, the intrinsic value of the bond is equal to its face value. When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face value.
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When Kd is lesser than the coupon rate, the intrinsic value of the bond is greater than its face value. Solved Problem Sugam Industries wishes to issue bonds with Rs.100 as par value, coupon rate of 12% and YTM of 5 years. What is the value of the bond if the required rate of return of an investor is 12%, 14% and 10%? Solution 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 If Kd is 14%, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) =12*PVIFA (14%, 5) + 100*PVIF (14%, 5) =12*3.433 + 100*0.519 = 41.20 + 51.9 = Rs. 93.1 If Kd is 10%, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) =12*PVIFA (10%, 5) + 100*PVIF (10%, 5) =12*3.791 + 100*0.621 = 45.49 + 62.1 = Rs. 107.59
Number of years of maturity When Kd is greater than the coupon rate, the discount on the bond declines as maturity approaches. When Kd is less than the coupon rate, the premium on the bond declines as the maturity increases.
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Example 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 as Kd is higher than the coupon rate. Continuing with the same problem above, let us see the effect on the bond value if the required rate is 8%. If Kd is 8%, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (8%, 7) + 100*PVIF (8%, 7) = 11*5.206 + 100*0.583 = 57.27 + 58.3 = Rs. 115.57 One year later, with 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 = 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.
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Yield to maturity Yield to maturity (YTM) determines the market value of the bond. The bond price will fluctuate to the changes in market interest rates. A bonds price moves inversely proportional to its YTM.
4.3 Valuation of shares

A companys shares can be categorised into: Ordinary or equity shares Preference shares The returns the shareholders get are called dividends. Preference shareholders get a preferential treatment as to the payment of dividend and repayment of capital in the event of winding up. Such holders are eligible for a fixed rate of dividends. The following are some important features of preference and equity shares: Dividends Rate is fixed for preference shareholders. They can be given cumulative rights, that is, the dividend can be paid off after accumulation. The dividend rate is not fixed for equity shareholders. They change with an increase or decrease in profits. During years of big profits, the management may declare a high dividend. The dividends are not cumulative for equity shareholders, that is, they cannot be accumulated and distributed in later years. Dividends are not taxable. Claims In the event of the business closing down, the preference shareholders have a prior claim on the assets of the company. Their claims shall be settled first and the balance if any will be paid off to equity shareholders. Equity shareholders are residual claimants to the companys income and assets. Redemption Preference shares have a maturity date, on which the company pays off the face value of the shares to the holders. Preference shares can be of two types redeemable and irredeemable. Irredeemable preference shares are perpetual. Equity shareholders have no maturity date.
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Conversion A company can issue convertible preference shares. After a particular period, as mentioned in the share certificate, the preference shares can be converted into ordinary shares.
4.3.1 Valuation of preference shares Preference shares like bonds carry a fixed rate of dividend or return. Symbolically, this can be expressed as: P0= Dp/{1+Kp)n } + Pn/{(1+Kp)n} or P0 = Dp*PVIFA (Kp, n) + Pn *PVIF (Kp, n) Where P0 = Dp = Kp = n = Price of the share Dividend on preference share Required rate of return on preference share Number of years to maturity
4.3.2 Valuation of ordinary shares People hold common stocks to obtain dividends in a timely manner to get a higher amount when sold Generally, shares are not held in perpetuity. An investor buys the shares, holds them for some time during which he gets dividends and finally sells it off to get capital gains. The value of a share which an investor is willing to pay is linked with the cash inflows expected and risks associated with these inflows. Intrinsic value of a share is associated with the earnings (past) and profitability (future) of the company. Dividends pay and expect the future definite prospects of the company. Intrinsic value of the share is the economic value of a company considering its characteristics, nature of business and investment environment. 4.3.2.1 Dividend capitalisation model When a shareholder buys a share, he is actually buying the stream of future dividends. Therefore the value of an ordinary share is determined by capitalising the future dividend stream at an appropriate rate of interest. So under the dividend capitalisation approach, the value of an equity share is the discounted present value of dividends received plus the present value of
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the resale price expected when the share is disposed. Two assumptions are made to apply this approach: Dividends are paid annually. First payment of dividend is made after one year from the day that the equity share is bought. 4.3.2.1.1 Single period valuation model This model holds well when an investor holds an equity share for one year. The price of such a share will be:
D1 P0 ( 1 Ke) P1 ( 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 Solved Problem XYZ India Ltds 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 An investor would be willing to buy the share at Rs/ 413.04
4.3.2.1.2 Multi period valuation model An equity share can be held at an indefinite period as it has no maturity date, in which case the value of a price at time zero is: P0 = D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +..+ D/(1+Ke) Or P0 = t=1 Dn {(1+Ke)n}
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Where P0 = Current market price of the share D1 = expected dividend after one year P1 = expected price of the share after one year D = expected dividend at infinite duration Ke = required rate of return on the equity share. The above equation can also be modified to find the value of an equity share for a finite period. P0 = D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +..+ D/(1+Ke) + Pn/(1+Ke)n P0=t=1 Dn/ {(1+Ke)n} + Pn/(1+Ke)n 4.3.3 Types of Dividends We can come across three types of dividends in companies: Constant dividends Constant growth of dividends Changing growth rates of dividends 4.3.3.1 Valuation with constant dividends If constant dividends are paid year after year, then P0=D1/(1+Ke)1 + D2/(1+Ke)2 + D3/(1+Ke)3 +..+ D/(1+Ke) Simplifying this we get, P=D/Ke
4.3.3.2 Valuation with constant growth in dividends Here we assume that dividends tend to increase with time as and when businesses grow over time. If the increase in dividend is at a constant compound rate, then Where, g stands for growth rate.
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Solved Problem Sagar Automobiles Ltds 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: = 8/0.12-0.08 = Rs. 200 The price of one share today would be Rs. 200.
Solved Problem Monica Labs are 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 capitalisation is 12%. Solution P0 = 4/(0.12-0.08) = Rs. 100 The share price today would be Rs. 100.
4.3.3.3 Valuation with changing growth in dividends Some firms may not have a constant growth rate of dividends indefinitely. There are periods during which the dividends may grow super normally, that is, the growth rate is very high when the demand for the companys products is very high. After a certain period of time, the growth rate may fall to normal levels when the returns fall due to fall in demand for products (with competition setting in or due to availability of substitutes). The price of the equity share of such a firm is determined in the following manner: Expected dividend flows during periods of supernormal growth is to be considered and present value of this is to be computed with the following equation:
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P0=t=1 Dn/(1+Ke)n Value of the share at the end of the initial growth period is calculated as: Pn=(Dn+1)/ (Ke-gn) (constant growth model) This is discounted to the present value and we get: (Dn+1)/ (Ke-gn)*1 / (1+Ke)n
Add both the present value composites to find the value P0 of the share, that is, P0=t=1 Dn/(1+Ke)n + (Dn+1)/(Ke-gn)*1/(1+Ke)n Solved Problem Souparnika Pharmas 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 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
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Step II: Pn = (Dn+1)/(Ke-g) P5 = D6/Ke-gn = D5(1+gn)/Ke-gn = {5(1.25)5(1+0.08)} / (0.15-0.08) = 15.26(1.08) / 0.07 = 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)/(Ke-gn)*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 total sum of paid up equity shares, reserves and surplus. Alternatively, this can also be calculated as the amount per share on the sale of the assets of the company at their exact book value minus all liabilities including preference shares. Example 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 = Rs. 150. BVPS does not give a true investment picture. This relies on historical book values than the companys earning potential.
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Liquidation value The liquidation value per share is calculated as: {(Value realised by liquidating all assets) (Amount to be paid to all the credit and Preference shares)} divided by number of outstanding shares. In the above example, if the assets can be liquidated at Rs.450 Cr., the liquidation value per share is (450Cr-350Cr) / 10 lakh shares which is equal to Rs.1000 per share. 4.3.4 Price Earnings Ratio The price earnings ratio reflects the amount investors are willing to pay for each rupee of earnings. Expected earnings per share = (Expected PAT) (Preference dividend) / Number of outstanding shares. Expected PAT is dependent on a number of factors like sales, gross profit margin, depreciation and interest and tax rate. The price earnings ratio has to consider factors like growth rate, stability of earnings, company size, company management team and dividend pay-out ratio.
Where, 1-b is dividend pay-out ratio r is required rate of return ROE*b is expected growth rate
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Self Assessment Questions Fill in the blanks 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.
4.4 Summary
Valuation is the process which links the risk and return to establish the asset worth. The value of a bond or a share is the discounted value of all their future cash inflows (interest/dividend) over a period of time. The discount rate is the rate of return which the investors expect from the securities. In case of bonds, the stream of cash flows consists of annual interest payment and repayment of principal (which may take place at par, at a premium or at a discount). The cash flows which occur in each year are a fixed amount. Cash flows for preference share are also a fixed amount and these shares may be redeemed at par, at a premium or at a discount. The equity shareholders do not have a fixed rate of return. Their dividend fluctuates with profits. Therefore the risk of holding an equity share is higher than holding a preference share or a bond.
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4.5 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 investors required rate of return is 11%, should he buy this share or not? Solution: P = D1(1+g) / Ke-g = 2.5(1+0.06) / 0.11-0.06 = 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 investors required rate of return is 12%, what should be the price of the bond? Solution: P = Int*PVIFA (12%, 10y) + Redemption value*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 trading 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 + {(F-P)/n} / (F+P)/2 = 60 + {(500-435)/7} / (500+435)/2 = 15.03% The yield to maturity will be 15.03%
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4. The share of Megha Ltd is sold at Rs. 500 a share. The dividend likely to be declared by the company after one year is Rs.25 per share. Hence, the price after one year 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% The return at the end of the year will be 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 The market price of the bond is Rs. 1000.45.

1. What should be the price of a bond which has a par value of Rs.1000 carrying a coupon rate of 8% and having a maturity period of 9 years? The required rate of return of the investor is 12%. 2. A bond of Rs. 1000 value carries a coupon rate of 10% and has a maturity period of 6 years. Interest is payable semi-annually. If the required rate of return is 12%, calculate the value of the bond. 3. A bond whose par value is Rs. 500 bearing a coupon rate of 10% and has a maturity of 3 years. The required rate of return is 8%. What should be the price of the bond? 4. If the current years 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?
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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. 2. 3. 4. 5. 6. 7. Liquidation value Market value Government agencies, secured or unsecured Yield to Maturity Greater Intrinsic value Book value per share (BVPS)
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 (6% + 12y) 50*8.384 + 1000*0.497 = Rs. 916.2 3. P = Int*PVIFA (8%, 3y) + Redemption Price*PVIF (8%, 3y) 50*2.577 + 500*0.794 397 = Rs. 525.85 4. Intrinsic value = 24 {(1+0.1)} / 0.16-0.1 = Rs. 440 5. Holding period return = (D1 + Price gain/loss) / purchase price {15 + (-5)} / 120 = 8.33%
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Unit 5
Structure: 5.1 Introduction Learning objectives 5.2 Design of an Ideal Capital Structure 5.3 Cost of Different Sources of Finance Cost of debentures Cost of term loans Cost of preference capital Cost of equity capital Cost of retained earnings Capital asset pricing model approach Earnings price ratio approach 5.4 Weighted Average Cost of Capital Assignment of weights 5.5 Summary 5.6 Solved Problems 5.7 Terminal Questions 5.8 Answers to SAQs and TQs
Cost of Capital
5.1 Introduction
Capital structure is the mix of long-term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios. It is always advisable for companies to plan their capital structure. Decisions taken by not assessing things in a correct manner may jeopardise the very existence of the company. Firms may prosper in the short-run by not indulging in proper planning but ultimately may face problems in future. With unplanned capital structure, they may also fail to economise the use of their funds and adapt to the changing conditions.
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5.1.1 Learning objectives After studying this unit, you should be able to, Define cost of capital. Bring out the importance of cost of capital. Explain how to design an ideal capital structure. Compute Weighted Average Cost of Capital.
5.2 Design of an Ideal Capital Structure

The design of an ideal capital structure requires five factors to be considered (see in figure 5.1)
Figure 5.1: Design of an ideal capital structure
Return The capital structure of a company should be most advantageous. It should generate maximum returns to the shareholders for a considerable period of time and such returns should keep increasing. Risk Debt does increase equity holders returns and this can be done till such time that no risk is involved. Use of excessive debt funds may threaten the companys survival. Flexibility The company should be able to adapt itself to situations warranting changed circumstances with minimum cost and delay. Capacity The capital structure of the company should be within the debt capacity. Debt capacity depends on the ability for funds to be generated. Revenues earned should be sufficient enough to pay creditors interests, principal and also to shareholders to some extent.
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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 firms investment activities is an important activity of the Finance Manager. Golden opportunities may be lost for delaying decisions to this effect. A combination of debt and equity is used to fund the activities. What should be the proportion of debt and equity? This depends on the costs associated with raising various sources of funds. The cost of capital is the minimum rate of return of a company, which must earn to meet the expenses of the various categories of investors who have made investment in the form of loans, debentures and equity and preference shares. A company now being able to meet these demands may face the risk of investors taking back their investments thus leading to bankruptcy. Loans and debentures come with a pre-determined interest rate. Preference shares also have a fixed rate of dividend while equity holders expect a minimum return of dividend, based on their risk perception and the companys past performance in terms of pay-out dividends. The following graph on risk-return relationship of various securities summarises the above discussion.
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Required rate of return
Equity share Preference share Debt Govt bonds Risk free security
Risk-Return relationship of various securities
Figure 5.2: Risk return relationship
5.3 Cost of Different Sources of Finance

The various sources of finance and their costs are explained in this section. 5.3.1 Cost of debentures The cost of debenture is the discount rate which equates the net proceeds from issue of debentures to the expected cash outflows. The expected cash outflows relate to the interest and principal repayments. Kd =
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 realised per debenture, n is maturity period.
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Solved Problem Lakshmi Enterprise wants to have an issue of non-convertible 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 0r 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 pre-determined interest rate. The cost of term loans is equal to the interest rate multiplied by 1-tax rate. The interest is multiplied by 1-tax rate as interest on term loans is also taxed. Kt = I (1T) Where I is interest, T is tax rate Solved Problem Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9% interest. What is the cost of term loan if the tax rate is 40%? Solution: Kt = I (1T) = 9(10.4) = 5.4% The cost of term loan is 5.4%
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5.3.3 Cost of Preference Capital The cost of preference share Kp is the discount rate which equates the proceeds from preference capital issue to the dividend and principal repayments. It is expressed as: Kp = (D + {(F P) / n} / ((F + P) / 2) Where Kp is the cost of preference capital, D is the preference dividend per share payable, F is the redemption price, P is the net proceeds per share, n is the maturity period. Solved Problem 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 realise Rs. 98 per share now. Calculate the cost of preference capital. Solution:
Kp
D ( F P ) / n (F P ) / 2
12 (104 98 ) / 10 (104 98 ) / 2
12.6 101
Kp = 0.1247 or 12.47% The cost of preference capital now will be 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.
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Measuring the rate of return to equity holders is a difficult and complex exercise. There are many approaches for estimating return the dividend forecast approach, capital asset pricing approach, realised yield approach etc. According to dividend forecast approach, the intrinsic value of an equity share is the sum of present values of dividends associated with it. Ke = (D1/Pe) + g This equation is modified from the equation, Pe= {D1/Ke-g}. Dividends cannot be accurately forecasted as they may sometimes be nil or have a constant growth or sometime have supernormal growth periods. Is Equity Capital free of cost? Some people are of the opinion that equity capital is free of cost as a company is not legally bound to pay dividends and also as the rate of equity dividend is not fixed like preference dividends. This is not a correct view as equity shareholders buy shares with the expectation of dividends and capital appreciation. Dividends enhance the market value of shares and therefore equity capital is not free of cost. Solved Problem 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) + 0.10 = 0.1454 or 14.54% Cost of equity capital is 14,54% 5.3.5 Cost of Retained Earnings A companys earnings can be reinvested in full to fuel the ever-increasing demand of companys fund requirements or they may be paid off to equity
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holders in full or they may be partly held back and invested and partly paid off. These decisions are taken keeping in mind the companys growth stages. High growth companies may reinvest the entire earnings to grow more, companies with no growth opportunities return the funds earned to their owners and companies with constant growth invest a little and return the rest. Shareholders of companies with high growth prospects utilising funds for reinvestment activities have to be compensated for parting with their earnings. Therefore the cost of retained earnings is the same as the cost of shareholders expected return from the firms ordinary shares. So, Kr = Ke 5.3.6 Capital Asset Pricing Model Approach This model establishes a relationship between the required rate of return of a security and its systematic risks expressed as . According to this model, Ke = Rf + (Rm Rf) Where Ke is the rate of return on share, Rf is the risk free rate of return, is the beta of security, Rm is return on market portfolio The CAPM model is based on some assumptions, some of which are: Investors are risk-averse. Investors make their investment decisions on a single-period horizon. Transaction costs are low and therefore can be ignored. This translates to assets being bought and sold in any quantity desired. The only considerations that matter are the price and amount of money at the investors disposal. All investors agree on the nature of return and risk associated with each investment.
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Solved Problem What is the rate of return for a company if its is 1.5, risk free rate of return is 8% and the market rate or return is 20% Solution: Ke = Rf + (Rm Rf) = 0.08 + 1.5(0.2-0.08) = 0.08 + 0.18 = 0.26 or 26% The rate of return is 26% 5.3.7 Earnings Price Ratio Approach Under the case of earnings price ratio approach, the cost of equity can be calculated as: Ke = E1/P Where E1 = expected EPS per one year P = current market price per share E1 is calculated by multiplying the present EPS with (1 + Growth rate). Cost of Retained Earnings and Cost of External Equity As we have just learnt that if retained earnings are reinvested in business for growth activities, the shareholders expect the same amount of returns and therefore Ke=Kr However, it should be borne in mind by the policy makers that floating of a new issue and people subscribing to the new issue will involve huge amounts of money towards floating costs which need not be incurred if retained earnings are utilised towards funding activities. From the dividend capitalisation model, the following model can be used for calculating cost of external equity. Ke = {D1/P0(1f)} + 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
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The following formula can be used as an approximation: Ke = Ke/(1f) Where Ke is the cost of external equity, Ke is the rate of return required by equity holders, f is the floatation cost. Solved Problem Alpha Ltd. requires Rs. 400 Cr to expand its activities in the southern zone of India. The companys 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 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 Ke = Ke/(1f) 0.16/(1 0.04) = 0.1667 or 16.67% Hence, cost of external equity is 16.67%
Key Point Dividends cannot be accurately forecasted as they might sometimes become nil or have a constant growth or sometimes have supernormal growth periods.
5.4 Weighted Average Cost of Capital

In the previous section, we have calculated the cost of each component in the overall capital of the company. The term cost of capital refers to the overall composite cost of capital or the weighted average cost of each specific type of fund. The purpose of using weighted average is to consider each component in proportion of their contribution to the total fund available.
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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 = W e Ke + W r Kr + W p Kp + W d Kd + W t Kt Assignment of weights Weights can be assigned based on any of the following methods The book value of the sources of the funds in capital structure Present market value of funds in the capital structure and Adoption of finance planned for capital budget for the next period As per the book value approach, weights assigned would be equal to each sources 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.
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Solved Problem The capital structure of Prakash Packers ltd. is as shown in table 5.1
Table 5.1 : Capital structure in lakhs Equity capital (Rs. 10 par value) 14% Preference share capital Rs. 100 each Retained earnings 12% debentures (Rs. 100 each) 11% Term loan from ICICI bank Total 200 100 100 300 50 750
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 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 + {(FP)/n}] / {F+P)/2} = [14 + (10584)/8] / (105+84)/2 =16.625/94.5 = 0.1759 or 17.59% Kr = Ke which is 16.25% Kd = [I(1T) + {(FP)/n}] / {F+P)/2} = [12(10.4) + (10590)/7] / (105+90)/2 = [7.2 + 2.14] / 97.5 = 0.096 or 9.6% Kt = I(1T) = 0.11(10.4) = 0.066 or 6.6%
Unit 5
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 Step III Multiply the costs of various sources of finance with corresponding weights and WACC is calculated by adding all these components WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt = (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 + 0.0384 + 0.004 = 0.1304 or 13.04% The value of WACC is 13.04%
Solved Problem 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.6,00,000 Preference capital Rs. 4,00,000 Equity capital Rs. 10,00,000
Page No. 99
Unit 5
Solution WACC is calculated from the table 5.2

Table 5.2: WACC Fund source Debt Preference capital Equity capital Total Amount Rs. 600000 Rs. 400000 Rs. 1000000 Rs. 2000000 Ratio 0.3 0.2 0.5 1.0 Cost 0.09 0.15 0.18 Weighted cost 0.027 0.03 0.09 0.147
WACC is 14.7%.
Solved Problem 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 5%) The company expects to earn Rs.4Cr. as profits by the end of the year after which it will retain 50% and pay-off 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 the dividend pay-out one year hence will be Rs.2.40. Solution Computation of weighted marginal cost of capital is as shown in table 5.3
Table 5.3 Weighted cost of capital Source of funds Equity capital Retained earnings 14% loan from IOB 15% IDBI loan Weights 0.4 0.1 0.25 0.25 Total After tax cost 0.1 0.1 0.07 0.075 Weighted cost 0.04 0.01 0.0175 0.01875 0.0863 or 8.63%
Ke =( D1/P0) + g
Unit 5
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% The weighted cost of capital is 7.5% Solved Problem 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 companys 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 maximise the wealth of the shareholders. As the CFO of the company, you are required to analyse 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/(0.16-0.06) = 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 the wealth.
Page No. 101
Unit 5
Self Assessment Question Fill in the blanks: 1. ________ is the mix of long-term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios. 2. The capital structure of the 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.
5.5 Summary
Any organisation requires funds to run its business. These funds may be acquired from short-term or long-term sources. Long-term funds are raised from two important sources capital (owners funds) and debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not desirable as debt-holders attach many conditions which may not be possible for the companies to adhere to. It is therefore desirable to have a combination of both debt and equity which is called the optimum capital structure. Optimum capital structure refers to the mix of different sources of long term funds in the total capital of the company. Cost of capital is the minimum required rate of return needed to justify the use of capital. A company obtains resources from various sources issue of debentures, availing term loans from banks and financial institutions, issue of preference and equity shares or it may even withhold a portion or complete profits earned to be utilised for further activities. Retained earnings are the only internal source to fund the companys 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.
Unit 5
The cost of term loan is computed keeping in mind the tax liability. The cost of preference share is similar to debenture interest. Unlike debenture interest, dividends do not qualify for tax deductions. The calculation of cost of equity is slightly different as the returns to equity are not constant. The cost of retained earnings is the same as the cost of equity funds.
5.6 Solved Problems

1. Deepak Steel has issued non-convertible 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%. Solution:
Kd I(1 T ) ( F P ) / n (F P ) / 2
14 (1 0.4 ) (105 97 ) / 7 8.4 1.14 = 0.094 or 9.4% (105 97 ) / 2 101

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
(110 97 ) / 8 9 .1.625 10.27% (110 97 ) / 2 103.5

Page No. 103
Unit 5

1. The following data is available in respect of a company : Equity Rs.10lakhs,cost of capital 18% Debt Rs.5lakhs,cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40% 2. Bharat chemicals has the following capital structure as shown in table 5.4
Table 5.4: Capital structure Rs. 10 face value equity shares Term loan @ 13% 9% Preference shares of Rs. 100, currently traded at Rs. 95 with 6 years maturity period Total Rs. 400000 Rs.150000 Rs. 100000 Rs. 650000
The company is expected to declare a dividend of Rs. 5 next year and the growth rate of dividends is expected to be 8%. Equity shares are currently traded at Rs. 27 in the market. Assume tax rate of 50%. What is WACC? 3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is Rs. 60 lakhs. The cost of equity and debt are 15% and 12%. What is the WACC? 4. A company has 3 divisions X, Y and Z. Each division has a capital structure with debt, preference shares and equity shares in the ratio 3:4:3 respectively. The company is planning to raise debt, preference shares and equity for all the 3 divisions together. Further, it is planning to take a bank loan at the rate of 12% interest. The preference shares have a face value of Rs. 100, dividend at the rate of 12%, 6 years maturity and currently priced at Rs. 88. Calculate the cost of preference shares and debt if taxes applicable are 45% 5. Tanishk Industries issues partially convertible debentures of face value of Rs. 100 each and retains Rs. 96 per share. The debentures are redeemable after 9 years at a premium of 4%, taxes applicable are 40%. What is the cost of debt?
Unit 5

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. Capital structure Maximum returns Debt capacity Minimum risk of loss of control Equity shareholders Present values of dividends
Answers to Terminal Questions 1. Hint: Use the equation WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt 2. Hint: Use the equation WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt 3. Hint: Use the equation WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt 4. Hint: Apply the formula Kp D 5. Hint: Apply the formula Kd
(F P ) / n
F P ) / 2
1(1 T ) ( F P ) / n (F P ) / 2
Page No. 105
Unit 6
Unit 6
Structure: 6.1 Introduction Learning objectives 6.2 Operating Leverage Application of operating leverage 6.3 Financial Leverage Uses of financial leverage 6.4 Combined Leverage Uses of DTL 6.5 Summary 6.6 Solved Problems 6.7 Terminal Questions 6.8 Answers to SAQs and TQs
Leverage
6.1 Introduction
A company uses different sources of financing to fund its activities. These sources can be classified as those which carry a fixed rate of return and those whose returns vary. The fixed sources of finance have a bearing on the return on shareholders. Borrowing funds as loans have an impact on the return on shareholders and this is greatly affected by the magnitude of borrowing in the capital structure of a firm. Leverage is the influence of power to achieve something. The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies how the dependent variable responds to a particular change in independent variable. There are three types of leverage as shown in the following diagram 6.1 operating, financial and combined.
Page No. 106
Unit 6
Figure 6.1: Types of leverage
Operating leverage is associated with the asset purchase activities, while financial leverage is associated with the financial activities. However, combined leverage is the combination of operating leverage and the financial leverage. 6.1.1 Learning objectives After studying this unit, you should be able to: Explain the meaning of leverage Mention the different types of leverage Discuss the advantages of leverage
6.2 Operating Leverage

Operating leverage arises due to the presence of fixed operating expenses in the firms income flows. A companys operating costs can be categorised into three main sections as shown in figure 6.2 fixed costs, variable costs and semi-variable costs.
Figure 6.2: Classification of operating costs
Fixed costs Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced.
Page No. 107
Unit 6
For example, consider that a firm named XYZ enterprises is planning to start a new business. The main aspects that the firm should concentrate at are salaries to the employees, rents, insurance of the firm and the accountancy costs. All these aspects relate to or are referred to as fixed costs. Variable costs Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activities will have a direct effect on such types of costs incurred. For example, we have discussed about fixed costs in the above context. Now, the firm has to concentrate on some other features like cost of labour, amount of raw material and the administrative expenses. All these features relate to or are referred to as Variable costs, as these costs are not fixed and keep changing depending upon the conditions. Semi-variable costs Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firms activities. For example, after considering both the fixed costs and the variable costs, the firm should concentrate on some-other features like production cost and the wages paid to the workers which act at some point of time as fixed costs and can also shift to variable costs. These features relate to or are referred to as Semi-variable costs. The operating leverage is the firms ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume.
Page No. 108
Unit 6
Solved Problem A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per unit and fixed expenses amount to Rs. 5000 p.a. Show the various levels of EBIT that result from sale of 1000 units, 2000 units and 3000 units. Solution The various levels of EBIT that result from sale of 1000 units, 2000 units and 3000 units is as shown under in table 6.1
Table 6.1: Various levels of EBIT
Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost EBIT
1000 10000 5000 5000 5000 000
2000 20000 10000 10000 5000 5000
3000 30000 15000 15000 5000 10000
If we take 2000 units as the normal course of sales, the results can be summed as : 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 earnings before interest and taxes (EBIT) and vice versa. The former is a favourable operating leverage and the latter is unfavourable. Another way of explaining this phenomenon is examining the effect of the degree of operating leverage (DOL). The DOL is a more precise measurement. It examines the effect of the change in the quantity produced on earnings before interest and taxes (EBIT). DOL = % change in EBIT / % change in output
Page No. 109
Unit 6
To put in a different way, (EBIT/EBIT) / (Q/Q) EBIT is Q(SV)F Where Q is quantity S is sales V is variable cost F is fixed cost Substituting this we get, {Q(SV)} / {Q(SV)F} Solved Problem Calculate the degree of leverage (DOL) of Guptha Enterprises based on the information provided in the table 6.2
Table 6.2: Information of Guptha enterprises
Quality produced and sold Variable cost Selling price per unit Fixed expenses Solution
1000 units Rs.200 per unit Rs. 300 per unit Rs.20, 000
DOL = {Q(SV)} / {Q(SV)F} = {1000(300200)}/{1000(300200)20000} = 100000/80000 DOL = 1.25 The degree of operating leverage of Guptha enterprises is 1.25. If the company does not incur any fixed operating costs, there is no operating leverage.
Page No. 110
Unit 6
Solved Problem Calculate the degree of leverage (DOL) of Utopia Enterprises based on the information provided in the table 6.3
Table 6.3: Information of Utopia Enterprises
Quality produced and sold Variable cost Selling price per unit Fixed expenses Solution
2000 units Rs.300 per unit Rs. 400 per unit Rs.25, 000
DOL = {Q(SV)} / {Q(SV)F} = {2000(400300)}/{2000(400300)25000} = 200000/175000 DOL = 1.14 The degree of operating leverage of Utopia Enterprises is 1.14.
Solved Problem The table 6.4 shows the statistics of a firm and its sales requirements. Compute the degree of operating leverage (DOL) according to the values given in the table.
Table 6.4: Statistics of a firm Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost EBIT 1000 10000 5000 5000 0 5000
Solution DOL= {Q(SV)} / {Q(SV)F} {1000(5000)} / {1000(5000) 0} = 5000000/5000000 = DOL=1 The degree of operating leverage according to the values given in the table is 1.
Unit 6
Solution DOL= {Q(SV)} / {Q(SV)F} {1000(5000)} / {1000(5000) 0} = 5000000/5000000 = DOL=1 The degree of operating leverage according to the values given in the table is 1.
Solved Problem The table 6.5 given below shows the statistics of a firm and its sales requirements. Compute the degree of operating leverage (DOL) according to the values given in the table.
Table 6.5: Statistics of a firm
Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost EBIT Solution
2000 20000 10000 6000 0 6000
DOL= {Q(SV)} / {Q(SV)F} {2000(10000)} / {2000(10000) 0} = 2000000/2000000 = DOL=1 The degree of operating leverage according to the values given in the table is 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.
Unit 6
6.2.1 Application of Operating Leverage The applications of operating leverage are as follows: Business risk measurement Production planning Measurement of business risk Risk refers to the uncertain conditions in which a company performs. A business risk is measured using the degree of operating leverage (DOL) and the formula of DOL is: DOL = {Q(SV)} / {Q(SV)F} Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given change in unit sales. A high DOL is a measure of high business risk and vice versa. Production planning A change in production method increases or decreases DOL. A firm can change its cost structure by mechanising its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only if the company is confident of achieving a higher amount of sales thereby increasing its earnings.
6.3 Financial Leverage

Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. A companys sources of funds fall under two categories Those which carry a fixed financial charges like debentures, bonds and preference shares and Those which do not carry any fixed charges like equity shares Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firms 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.
Unit 6
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 companys income stream. Such expenses have nothing to do with the firms performance and earnings and should be paid off regardless of the amount of earnings before income and tax (EBIT). It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as Trading on Equity.
Page No. 114
Unit 6
Solved Problem The EBIT of a firm is expected to be Rs. 10000. The firm has to pay interest at a rate of 5% on debentures of 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 The various changes of EPS if EBIT is Rs. 15,000, Rs. 10,000 and Rs. 5,000 is shown under in table 6.6
Table 6.6: Various changes of EPS
EBIT Interest on debt EBT Tax 40% EAT Preference div. Earnings available to equity holders EPS
10000 1250 8750 3500 5250 1200 4050 4.05
5000 1250 3750 1500 2250 1200 1050 1.05
15000 1250 13750 5500 8250 1200 7050 7.05
Interpretation A 50 % increase in EBIT from Rs.10,000 to Rs.15,000 results in 74% increase in EPS A 50 % decrease in EBIT from Rs.10,000 to Rs.5,000 results in 74% decrease in EPS This example shows that the presence of fixed interest source funds leads to a value more than that occurs due to proportional change in EPS. The presence of such fixed sources implies the presence of financial leverage. This can be expressed in a different way. The degree of financial leverage (DFL) is a more precise measurement. It examines the effect of the fixed sources of funds on EPS. DFL=%change in EPS %change in EBIT
Unit 6
DFL={EPS/EPS} {EBIT/EBIT} Or DFL = EBIT {EBITI{Dp/(1-T)}} I is Interest, Dp is dividend on preference shares, T is tax rate. Solved Problem Kusuma Cements Ltd. has an EBIT of Rs. 5,00,000 at 5000 units of production and sales. The capital structure of the company is briefly described in table 6.7
Table 6.7: Capital structure of the company
Capital structure Paid up capital 500000 equity shares of Rs. 10 each 12% Debentures 10% Preference shares of Rs. 100 each Total Corporate tax rate may be taken at 40% Solution EBIT Less Interest on debentures EBT 500000 48000 452000
Amount Rs. 5000000 400000 400000 5800000
DFL= EBIT {EBITI{Dp/(1-T)}} 500000/(50000048000{40000/(10.40)} DFL=1.30 The degree of financial leverage of Kusuma Cements Ltd. is found to be 1.30.
Page No. 116
Unit 6
Solved Problem XYZ Enterprises Ltd. has an EBIT of Rs. 2,00,000 at 4000 units of production and sales. The capital structure of the company is briefly described in table 6.8
Table 6.8: Capital structure
Capital structure Paid up capital 200000 equity shares of Rs. 10 each 10% Debentures 5% Preference shares of Rs. 100 each Total Corporate tax rate may be taken at 50% Solution EBIT Less Interest on debentures EBT 200000 50000 150000
Amount Rs. 2000000 500000 500000 3000000
DFL= EBIT {EBITI{Dp/(1-T)}} 200000/(20000050000{25000/(10.50)} DFL=2.0 The degree of financial leverage of XYZ Enterprises is found to be 2.0.
6.3.1 Use of Financial Leverage Studying the degree of financial leverage (DFL) at various levels makes financial decision-making, on the use of fixed sources of funds, for funding activities easy. One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS). Like operating leverage, the risks are high at high degrees of financial leverage (DFL). High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments.
Unit 6
A firm which is not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances. On one side the trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firms mix of sources of funds. One main goal of financial planning is to devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up. Impact of financial leverage Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities. Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used.
Page No. 118
Unit 6
Solved Problem The following table 6.9 displays the balance sheets of two firms firm A and firm B.
Table 6.9: Balance sheets of firms A and B Balance sheet of A Equity capital 100000 Assets 100000 Equity capital Debt @ 15% Total 100000 Total 100000 Total Balance sheet of B 40000 60000 100000 Total 100000 Assets 100000
Both the companies earn an income before interest and tax of Rs. 40000. Calculate the DFL and interpret the results thereof. Solution DFL=
EBIT {EBIT I {Dp /(1 T )}}
40000 1 40000 0 0 40000 Company B = 1.29 40000 9000 0

Company A = The degree of financial leverage of the companies A and B are 1 and 1.29. The company not using debt to finance its assets has a higher DFL compared to that of a company using it. Financial leverage does not exist when there is no fixed charge financing.
6.4 Total or combined leverage

The combination of operating and financial leverage is called combined leverage. Operating leverage affects the firms operating profit EBIT and financial leverage affects PAT or the EPS. These cause wide fluctuations in EPS. A company having a high level of operating or financial leverage will find a drastic change in its EPS even for a small change in sales volume. Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes in EPS due to leverages is more pronounced.
Unit 6
The combined effect is quite significant for the earnings available to ordinary shareholders. Combined leverage is the product of degree of operating leverage (DOL) and degree of financial leverage (DFL). DTL =
Q(S V ) Q(S V ) F I {Dp /(1 T )}
Solved Problem Calculate the DTL of Pooja Enterprises Ltd., given the information regarding the expenses, shares and sales of the company in table 6.10
Table 6.10: Details of Pooja Enterprises Ltd.
Quantity sold Variable cost per unit Selling price per unit Fixed expenses Number of equity shares Debt Preference shares dividend Tax rate Solution DTL =
10,000 units Rs.100 per unit Rs.500 per unit Rs.10,00,000 1,00,000 Rs.10,00,000 @ 20% interest 10,000 shares of Rs.100 each @ 10% 50%
Q(S V ) Q(S V ) F I {Dp /(1 T )}
10000 (500 100 ) 10000 (500 100 ) 1000000 200000 {100000 / 0.5}
DTL=1.54 Cross verification: DOL =
{Q(S V )} {Q(S V ) F}
10000 (500 100 ) 10000 (500 100 ) 1000000
DOL=1.33
Page No. 120
Unit 6
DFL=
EBIT EBIT I {Dp /(1 T )}}
3000000 3000000 200000 {100000 / 0.5}

DFL=1.15 DTL=DOL*DFL 1.33*1.15=1.54 Hence the degree of total leverage of Pooja Enterprises Ltd. is 1.54.
Solved Problem Calculate the degree of total leverage of Utopia Enterprises Ltd., given the following information regarding the expenses, shares and sales of the company in table 6.11.
Table 6.11: Details of Utopia Enterprises Ltd. Quantity sold Variable cost per unit Selling price per unit Fixed expenses Number of equity shares Debt Preference shares dividend Tax rate 20,000 units Rs.200 per unit Rs.600 per unit Rs.20,00,000 1,50,000 Rs.20,00,000 @ 20% interest 20,000 shares of Rs.200 each @ 10% 40%
Page No. 121
Unit 6
Solution DTL =
Q(S V ) Q(S V ) F I {Dp /(1 T )}
20000 (600 200) 20000 (600 200) 2000000 400000 {400000 / 0.6}
DTL=1.62 Cross verification:
20000(600 200) 20000(600 200) 2000000

DOL=1.33
DFL=
DOL=
{Q(S V )} {Q(S V ) F}
20000(600 200) 20000(600 200) 2000000
DOL=1.33 DFL=
5000000 5000000 400000 {400000 / 0.5}

DFL=1.20 DTL=DOL*DFL 1.33*1.20=1.60 Hence the degree of total leverage of Utopia enterprises Ltd. is 1.60
Page No. 122
Unit 6
Solved Problem Calculate the degree of total leverage of CMA Enterprises Ltd., given the following information regarding the expenses, shares and sales of the company in table 6.12
Table 6.12: Details of CMA Enterprises Ltd. Quantity sold Variable cost per unit Selling price per unit Fixed expenses Number of equity shares Debt Preference shares dividend Tax rate 30,000 units Rs.300 per unit Rs.700 per unit Rs.30,00,000 2,00,000 Rs.30,00,000 @ 30% interest 30,000 shares of Rs.200 each @ 20% 30%
Solution DTL =
Q(S V ) Q(S V ) F I {Dp /(1 T )}
30000 (700 300) 30000 (700 300) 3000000 900000 {1200000 / 0.7}
DTL=1.88 Cross verification: DOL=
{Q(S V )} {Q(S V ) F}
30000(700 300) 30000(700 300) 3000000
DOL=1.33 EBIT DFL= EBIT I {Dp /(1 T )}}
6000000 6000000 900000 {1200000 / 0.7}

DFL=1.77 DTL=DOL*DFL 1.33*1.77=2.35 Hence the degree of total leverage of CMA enterprises Ltd. is 2.35
Unit 6
6.4.1 Uses of degree of total leverage (DTL) Degree of total leverage (DTL) measures the total risk of the company as DTL is a combined measure of both operating and financial risk Degree of total leverage (DTL) measures the variability of EPS Self Assessment Questions Fill in the blanks: 1. __________ arises due to the presence of fixed operating expenses in the firms 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. Operating leverage is categorised into _____, ____ and _______. 7. The three types of leverage a company faces are ______, ________ and __________.
6.5 Summary
Leverage is the use of influence to attain something else. The advantage a company has, with the current status of the leverage can be used to gain other benefits. There are three measures of leverage operating leverage, financial leverage and total or combined leverage. Operating leverage examines the effect of change in quantity produced upon EBIT and is useful to measure business risk and production planning. Financial leverage measures the effect of change in EBIT on the EPS of the company. It also refers to the debt-equity mix of a firm. Total leverage is the combination of operating and financial leverages.
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6.6 Solved Problems

1. The information, shown in table 6.13, has been collected from the annual report of Garden Silks. What is the degree of financial leverage?
Table 6.13: Annual report of Garden silks
Total sales Contribution ratio Fixed expenses Outstanding bank loan Applicable tax rate Solution
Rs.14,00,000 25% Rs.1,50,000 Rs.4,00,000 @ 12.5% 40%
DFL = EBIT / (EBIT-I) = 200000/200000-50000 = 1.33 EBIT = Sales*25% less fixed expenses 1400000*25% = 350000-150000 = 200000 2. Suppose X and Y have provided the information regarding the sales and the cost of their expense in table 6.14. Which firm do you consider to be risky?
Table 6.14: Information of X and Y
Sales in units Price per unit Variable cost p.a. Fixed financing cost Fixed financing cost Solution:
X Ltd. 40000 60 20 Rs. 100000 Rs. 300000
Y Ltd. 40000 60 25 Rs. 50000 Rs. 200000
DOL = Q(S-V) / Q(S-V)-F Company X: 40000(60-20) / 40000(60-20)-400000 1600000/1200000 = 1.33 Company Y: 40000(60-25) / 40000(60-25)-250000 1400000/1100000= 1.22
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3. Calculate EPS with the following information shown in table 6.15.

Table 6.15: Information of a firm
EBIT Interest No. of outstanding shares Tax rate applicable
Rs.11,80,000 Rs.2,20,000 40,000 40%
Solution: Earnings per share is calculated using the table 6.16

Table 6.16 Earnings per share
EBIT Less interest Tax @ 40% EAT
Rs.11,80,000 Rs.9,60,000 Rs.3,84,000 Rs.5,76,000
EPS = EAT/no of shares outstanding 576000/40000 = Rs. 14.4 4. The leverages of three firms is as shown in table 6.17 given below. Which one of the combinations should be chosen for the combined leverage to be maximum and what are the inferences?
Table 6.17: Leverages of three firms
A Operating leverage Financial leverage 1.14 1.27
B 1.23 1.3
C 1.33 1.33
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.
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1. Mishra Ltd. provides the information as shown in the table 6.11. What is the degree of operating leverage?
Table 6.18: Details of Mishra Ltd.
Output Fixed costs Variable cost per unit Interests on borrowed funds Selling price per unit
25,000 units Rs.15,000 Rs. 0.50 Rs.15,000 Rs. 1.50
2. X Ltd. provides the following information as shown in table 6.19. What is the degree of financial leverage?
Table 6.19: Details of X Ltd.
Output Fixed costs Variable cost Interest on borrowed funds Selling price
25,000 units Rs. 25,000 Rs. 2.50 per unit Rs.15,000 Rs. 8 per unit
3. The information available in table 6.20 describes the sales, costs and interests of two firms. Comment on their relative performance through leverage?
Table 6.20: Sales and costs of two firms A and B
A Ltd. (Rs. In lakhs) Sales Variable cost Fixed cost EBIT Interest 1000 300 250 450 50
B Ltd. (Rs. In lakhs) 1500 600 400 500 100
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4. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL.
Table 6.21: Details of ABC Ltd.
Output Fixed costs Variable cost Interest on borrowed funds Selling price per unit
20,000 units Rs.3,500 Rs.0.05 per unit Nil 0.20

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. Operating leverage Q(SV)F Income levels Preference shares Trading on Equity Fixed costs, variable costs and semi-variable costs. Operating leverage, financial leverage and combined leverage.
Answers to Terminal Questions 1. Hint DOL = 2. Hint DFL =
{Q(S V )} {Q(S V ) F}
EBIT {EBIT I {Dp /(1 T )}}
3. Hint calculate DFL 4. Hint calculate DFL =
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Unit 7
Unit 7
Structure: 7.1 Introduction Learning Objectives 7.2 Features of Ideal Capital Structure 7.3 Factors affecting Capital Structure 7.4 Theories of Capital Structure Net income approach Net operating income approach Traditional approach Miller and Modigliani approach Basic proposition Criticisms of MM proposition 7.5 Summary 7.6 Terminal Questions 7.7 Answers to SAQs and TQs
Capital Structure
7.1 Introduction
The capital structure of a company refers to the mix of long-term finances used by the firm. In short, it is the financing plan of the company. With the objective of maximising the value of the equity shares, the choice should be that pattern of using of debt and equity in a proportion which will lead towards achievement of the firms 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 firms value through the earnings available to the shareholders. The value of a firm is dependent on its expected future earnings and the required rate of return. The objective of any company is to have an ideal mix of permanent sources of funds in a manner that it will maximise the companys market price. The proper mix of funds is referred to as optimal capital structure. The capital structure decisions include debt-equity mix and dividend decisions. Both these have an effect on the EPS.
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7.1.1 Learning Objectives After studying this unit, you should be able to: Explain the features of ideal capital structure. Name the factors affecting the capital structure. Mention the various theories of capital structure.
7.2 Features of an Ideal Capital Structure

The features of an ideal capital structure are (see figure 7.1) profitability, flexibility, control and solvency.
Figure 7.1: Features of an ideal capital structure
Profitability The firm should make maximum use of leverage at a minimum cost. Flexibility An ideal capital structure should be flexible enough to adapt to changing conditions. It should be in a position to raise funds at the shortest possible time and also repay the money it borrowed, if they appear to be expensive. This is possible only if the companys 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
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companies resort to issue of equity shares to repay their debt for equity holders do not have a fixed rate of dividend
7.3 Factors affecting Capital Structures

The major factor affecting the capital structure is leverage. There are a few different other factors effecting them also. All the factors are explained briefly here. Leverage The use of fixed charges sources of funds such as preference shares, loans from banks and financial institutions and debentures in the capital structure is known as trading on equity or financial leverage. Creditors insist on a debt equity ratio of 2:1 for medium sized and large sized companies, while they insist on 3:1 ratio for SSI. Debt equity ratio is an indicator of the relative contribution of creditors and owners. The debt component includes both long term and short term debt and this is represented as debt/equity. A debt equity ratio of 2:1 indicates that for every 1 unit of equity, the company can raise 2 units of debt. By normal standards, 2:1 is considered as a healthy ratio, but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 5:1 is considered good for a manufacturing company while a ratio of 3:1 is good for heavy engineering companies. Debt equity ratio is generally perceived as that lower the ratio, higher is the element of uncertainty in the minds of lenders. Increased use of leverage increases commitments of the company, the outflows being in the nature of higher interest and principal repayments, thereby increasing the risk of the equity shareholders. The other factors to be considered before deciding on an ideal capital structure are: Cost of capital High cost funds should be avoided. However attractive an investment proposition may look like, the profits earned may be eaten away by interest repayments. Cash flow projections of the company Decisions should be taken in the light of cash flows projected for the next 3-5 years. The company officials should not get carried away at the immediate results expected.
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Consistent lesser profits are any way preferable than high profits in the beginning and not being able to get any after 2 years. Dilution of control The top management should have the flexibility to take appropriate decisions at the right time. The capital structure planned should be one in this direction. Floatation costs A company desiring to increase its capital by way of debt or equity will definitely incur floatation costs. Effectively, the amount of money raised by any issue will be lower than the amount expected because of the presence of floatation costs. Such costs should be compared with the profits and right decisions taken.
7.4 Theories of Capital Structure

As we are aware, equity and debt are the two important sources of longterm sources of finance of a firm. The proportion of debt and equity in a firms capital structure has to be independently decided case to case. A proposal, though not being favourable to lenders, may be taken up if they are convinced with the earning potential and long-term benefits. Many theories have been propounded to understand the relationship between financial leverage and firm value. Assumptions The following are some common assumptions made: The firm has only two sources of funds debt and ordinary shares. There are no taxes both corporate and personal The firms dividend pay-out ratio is 100%, that is, the firm pays off the entire earnings to its equity holders and retained earnings are zero The investment decisions of a company are constant, that is, the firm does not invest any further in its assets The operating profits EBIT are not expected to increase or decrease All investors shall have identical subjective probability distribution of the future expected EBIT A firm can change its capital structure at a short notice without the occurrence of transaction costs The life of the firm is indefinite
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Unit 7
Based on the assumptions regarding the capital structure, we derive the following formulae. Debt capital being constant, Kd is the cost of debt which is the discount rate at which the discounted future constant interest payments are equal to the market value of debt, that is, Kd = I/B where, I refers to total interest payments and B is the total market value of debt. Therefore value of the debt B = I/Kd Cost of equity capital Ke = (D1/P0) + g where D1 is dividend after one year, P0 is the current market price and g is the expected growth rate. Retained earnings being zero, g = br where r is the rate of return on equity shares and b is the retention rate, therefore g is zero. Now we know Ke = E1/P0 + g and g being zero, so Ke = NI/S where NI is the net income to equity holders and S is market value of equity shares. The net operating income being constant, overall cost of capital is represented as K0 = W1 K1 + W2 K2. That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S is the market value of equity and V is the total market value of the firm and can be given as (B+S). The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1 being the debt component and Ke being the equity component) which can be expressed as K0 = I + NI/V or EBIT/V or in other words, net operating income/market value of firm. 7.4.1 Net income approach Net income approach is suggested by Durand and he is of the view that capital structure decision is relevant to the valuation of the firm. Any change in the financial leverage will have a corresponding change in the overall cost of capital and also the total value of the firm. As the ratio of debt to equity increases, the WACC declines and market value of firm increases. The NI approach is based on 3 assumptions no taxes, cost of debt less than cost of equity and use of debt does not change the risk perception of investors. We know that, K0 = [B/(B+S)]Kd + [S/(B+S)]Ke The following graphical representation of net income approach may help us understand this better (see figure 7.2).
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Figure 7.2: Net income approach Solved Problem Given below are two firms A and B, which are identical in all aspects except the degree of leverage employed by them, clearly shown in the table 7.1. What is the average cost of capital of both firms? Table 7.1: Details of firms A and B Firm A Net operating income EBIT Interest on debentures I Equity earnings E Cost of equity Ke Cost of debentures Kd Market value of equity S = E/Ke Market value of debt B Total value of firm V Rs. 1, 00, 000 Nil Rs. 1, 00, 000 15% 10% Rs. 6, 66, 667 Nil Rs. 6, 66, 667 Firm B Rs. 1, 00, 000 Rs. 25, 000 Rs. 75, 000 15% 10% Rs. 50, 000 Rs. 2, 50, 000 Rs. 7, 50, 000
Solution Average cost of capital of firm A is: 10% * 0/Rs. 666667 + 15% * 666667/666667 which is 15% Average cost of capital of firm B is: 10% * 25000/783333 + 15% * 533333/783333 which is 13.4% Interpretation: The use of debt has caused the total value of the firm to increase and the overall cost of capital to decrease.
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Solved Problem The net income approach may be illustrated with a numerical illustration. Consider two firms X and Y, which are identical in all respects except in the degree of leverage employed by them. Table 7.2 shows the financial data of these firms
Table 7.2: Details of firms X and Y
Firm X Net operating income Interest on debentures i Equity earnings E Cost of equity Ke Cost of debentures Kd Market value of equity S = E/Ke Market value of debt B Total value of firm V Rs.50, 000 Nil Rs.50, 000 13% 10% Rs.2, 66, 667 Nil Rs.2, 66, 667 Firm Y Rs.50, 000 Rs.10, 000 Rs.45, 000 13% 10% Rs.1, 00, 000 Rs.1, 50, 000 Rs.5, 00, 000
Solution Average cost of capital of firm X is: 10% * 0/2,66,667 + 13% * 2,66,667/2,66,667 = 13% Average cost of capital of firm Y is: 10% * 1,50,000/5,00,000 + 13% * 1,00,000/1,50,000 = 11.67% 7.4.2 Net operating income approach (NOI) Net operating income approach is propounded by Durand and is totally opposite of the Net Income Approach. Durand says that any change in leverage will not lead to any change in the total value of the firm, market price of shares and overall cost of capital. The overall capitalisation rate is the same for all degrees of leverage. We know that: K0 = [B/(B+S)]Kd + [S/(B+S)]Ke As per the NOI approach the overall capitalisation rate remains constant for all degrees of leverage. The market values the firm as a whole and the split in the capitalisation rates between debt and equity is not very significant. The increase in the ratio of debt in the capital structure increases the financial risk of equity shareholders and to compensate this, they expect a higher return on their investments. Thus the cost of equity is Ke = K0 +[ (K0 Kd)(B/S)]
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Cost of debt The cost of debt has two parts as shown in the figure 7.3
Figure 7.3: Cost of debt
Explicit cost can be considered as the given rate of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can result to a conclusion that the increasing proportion of debt does not affect the financial risk of lenders and they do not charge higher interest. Implicit cost is nothing but increase in Ke attributable to Kd. Thus the advantage of use of debt is completely neutralised by the implicit cost resulting in Ke and Kd being the same. Graphical representation of the debts is shown in figure 7.4:
Ke
Percentage cost
K0
Kd
Leverage B/S Figure 7.4: Graphical representation of debts
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Solved Problem Given below in table 7.3 are figures of two firms X and Y, which are similar in all aspects except the degree of leverage employed. Calculate the equity capitalisation rates of the firms.
Table 7.3: Details of firms X and Y
Firm X Net operating income EBIT Overall capitalisation rate K0 Total market value V = EBIT/K0 Interest on debt I Debt capitalisation rate Kd Market value of debt B= I/Kd Market value of equity S=VB Leverage B/S Rs. 10000 18% 55555 Rs. 1000 11% Rs. 9091 Rs. 46464 0.1956 Firm Y Rs. 10000 18% 55555 Rs. 2000 11% Rs. 18181 Rs. 37374 0.2140
Solution The equity capitalisation rates are Firm Pri = 9000/46464 which is 19.36% Firm Sud = 8000/37374 which is 21.40% The equity capitalisation rates can also be calculated with the formula Ke = K0 +[ (K0 Kd)(B/S)] Firm Pri = 0.18 + [(0.18 0.11)(0.1956)] = 19.36% Firm Sud = 0.18 + [(0.18 0.11)(0.4865)] = 21.40%
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Solved Problem Consider two firms MA and CMA, which are similar in all respects other than the degree of leverage employed by them. Table 7.4 shows the financial data of both these firms. Calculate the equity capitalisation rates of the firms.
Table 7.4: Details of firms MA and CMA Firms MA Net operating income EBIT Overall capitalisation rate K0 Total market value V = EBIT/K0 Interest on debt i Debt capitalisation rate Kd Market value of debt B = i/Kd Market value of equity S = V-B Leverage B/S Rs.1, 500 13% Rs.11, 538 Rs.55, 128 0.21 Rs.3, 000 13% Rs.23, 077 Rs.43, 589 0.53 Rs.20, 000 19% 66, 666 Firms CMA Rs.20, 000 19% 66, 666
Solution The equity capitalisation rates are Firm MA = 11538/55128 which is 21% Firm CMA = 23077/43589 which is 53% The equity capitalisation rates can also be calculated with the formula Ke = K0 +[ (K0 Kd)(B/S)] Firm MA = 0.19 + [(0.19 0.13)(0.21)] = 0.2026 = 20.26% Firm CMA = 0.19 + [(0.19 0.13)(0.53)] = 0.2218 = 22.18%
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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 there-after rises at an increasing rate Ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very sharply As a sequence to the above 2 propositions, K0 decreases till a certain level, remains constant for moderate increases in leverage and rises beyond a certain point Graphical representation based on the propositions made on the traditional approach is as shown in figure 7.5
Figure 7.5: Propositions of traditional approach
7.4.4 Miller and Modigliani Approach Miller and Modigliani criticise that the cost of equity remains unaffected by leverage up to a reasonable limit and K0 remains constant at all degrees of leverage. They state that the relationship between leverage and cost of capital is elucidated as in net operating income(NOI) approach. The assumptions regarding Miller and Modigliani (MM) approach are (see figure 7.6): Perfect capital markets, Rational behaviour, Homogeneity, Taxes and Dividend Pay-out.
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Figure 7.6: Analysis of Miller and Modigliani approach
Perfect capital markets: Securities can be freely traded, that is, investors are free to buy and sell securities (both shares and debt instruments), there are no hindrances on the borrowings, no presence of transaction costs, securities are infinitely divisible, availability of all required information at all times. Investors behave rationally: They choose the combination of risk and return which is most advantageous to them. Homogeneity of investors risk perception: All investors have the same perception of business risk and returns. Taxes: There is no corporate or personal income tax. Dividend pay-out is 100%: The firms do not retain earnings for future activities. 7.4.4.1 Basic propositions Three propositions can be derived based on the assumptions made on Miller and Modigliani approach: Proposition I: The market value of the firm is equal to the total market value of equity and total market value of debt and is independent of the degree of leverage. Therefore, the market value of the firm can be expressed as: Expected NOI
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Expected overall capitalisation rate V + (S+D) which is equal to O/K0 which is equal to NOI/K0 V + (S+D) = O/K0 = NOI/K0 Where V is the market value of the firm, S is the market value of the firms equity, D is the market value of the debt, O is the net operating income, K0 is the capitalisation rate of the risk class of the firm The graphical representation of proposition 1 is as shown in figure 7.7
Figure 7.7: Representation of Proposition 1
The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage mechanism. Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about equilibrium. This is a balancing act. Miller and Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in return buy shares of the firm whose value is lower. They will earn the same return at lower outlay and lower perceived risk.
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Such behaviours are expected to increase the share prices whose shares are being purchased and lowering the share prices of those share which are being sold. This switching operation will continue till the market prices of identical firms become identical. Proposition II: The expected yield on equity is equal to discount rate (capitalisation rate) applicable plus a premium. Ke = K0 +[(K0Kd)D/S] Proposition III: The average cost of capital is not affected by the financing decisions as investment and financing decisions are independent. 7.4.4.2 Criticisms of MM Proposition There were kind of many criticisms over MM propositions which are described briefly and shown below in the form of a diagram as figure 7.8
Figure 7.8: Criticisms of MM proposition
Risk perception The assumptions that risks are similar is wrong. The risk perceptions of investors are personal and corporate leverage is different. The presence of limited liability of firms in contrast to unlimited liability of individuals puts firms and investors on a different footing. All investors lose if a levered firm becomes bankrupt but an investor loses not only his shares in a company but would also be liable to repay the money he borrowed. Arbitrage process is one way of reducing risks. It is more risky to create personal leverage and invest in unlevered firm than investing in levered firms. Convenience Investors find personal leverage inconvenient. This is so because it is the firms responsibility to observe corporate formalities and procedures whereas it is the investors responsibility to take care of personal leverage. Investors prefer the former rather than taking on the responsibility and thus the perfect substitutability is subjected to question.
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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 firms value. Agency costs A firm requiring loan approaches creditors and creditors may sometimes impose protective covenants to protect their positions. Such restriction may be in the nature of obtaining prior approval of creditors for further loans, appointment of key persons, restriction on dividend pay-outs, limiting further issue of capital, limiting new investments or expansion schemes etc. Self Assessment Questions Fill in the blanks: 1. Financing decisions are ________ and have no impact on the _______ of the firm. 2. The value of the firm is dependent on its _____ and the ________. 3. ______ and _________ are two important sources of long-term sources of finance of a firm. 4. As the ratio of debt to equity increases, the ________ declines and ______ of the 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 a lower in one market and selling it in another market at a higher price bringing about ____. 7. The criticisms over Miller and Modigliani approach are ______, __________, _________, _________, _________. 8. Define Arbitrage. 9. The features of an ideal capital structure are _______, __________, ________, __________. 10. The Miller and Modigliani approach fails to explain ______ decisions and _____ value.
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7.5 Summary
According to the NOI approach, overall cost of capital continuously decreases as and when debt goes up in the capital structure. Optimal capital structure exists when the firm borrows maximum. NOI approach believes that capital structure is not relevant. K0 is dependent business risk which is assumed to be constant. Traditional approach tells us that K0 decreases with leverage in the beginning, reaches its maximum point and further increases. Miller and Modigliani Approach also believes that capital structure is not relevant.

1. What are the assumptions of MM approach? 2. The following data, shown under in table 7.5, are available in respect of 2 firms. What is the average cost of capital?
Table 7.5: Data of a company Firm A Net operating income Interest on debt Equity earnings Cost of equity capital Cost of debt Market value of equity shares Market value of debt Total value of firm Rs.5,00,000 Nil Rs.5,00,000 15% Nil Rs.20,00,000 Nil Rs.20,00,000 Firm B Rs.5,00,000 Rs.50,000 Rs.4,50,000 15% 10% Rs.14,00,000 Rs.4,00,000 Rs.18,00,000
3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? 4. The market values of debt and equity of a firm are Rs. 10 Cr. and Rs. 20 Cr. respectively and their respective costs are 12% and 14%. The
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overall capital is 13.33%. Assuming that the company has a 100% dividend pay-out ratio and there are no taxes, calculate the net operating income of the firm. 5. If a company has equity worth Rs. 300 lakhs, debentures worth Rs. 400 lakhs and term loan worth Rs. 50 lakhs, calculate the WACC.

Answers to Self Assessment Questions Investment decisions, operating earnings Expected future earnings, required rate of return Equity debt WACC, market value Overall capitalisation rate Arbitrage, equilibrium Risk perception, convenience, transaction costs, taxes and Agency costs. 8. Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about equilibrium. Thus arbitrage process is a balancing act. 9. Profitability, flexibility, control and solvency. 10. Financing, firms Answers to Terminal Questions 1. 2. 3. 4. 5. Refer to 6.44 Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt Hint : we =0.4; W d = 0.533; wt = 0.067 1. 2. 3. 4. 5. 6. 7.
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Unit 8
Unit 8
Capital Budgeting
Structure: 8.1 Introduction Learning objectives 8.2 Importance of Capital Budgeting 8.3 Complexities involved in Capital Budgeting Decisions 8.4 Phases of Capital Expenditure Decisions 8.5 Identification of Investment Opportunities 8.6 Rationale of Capital Budgeting Proposals 8.7 Capital Budgeting Process Technical appraisal Economic appraisal Financial appraisal 8.8 Investment Evaluation Estimation of cash flows 8.9 Appraisal Criteria Traditional techniques Pay back method Accounting rate of return Discounted pay-back period Discounted cash flow period 8.10 Summary 8.11 Terminal Questions 8.12 Answers to SAQs and TQs
8.1 Introduction
Indian economy is growing at 9% per annum. New lines of business such as retailing investment, investment advisory services and private banking are emerging. All such businesses involve investment decisions. These investment decisions that corporates take are known as capital budgeting decisions. Such decisions help corporates reap the benefits arising out of the emerging business opportunities. Capital budgeting decisions involve evaluation of specific investment proposals. Here the word capital refers to the operating assets used in
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production of goods or rendering of services. Budgeting involves formulating a plan of the expected cash flows during the future period. Capital budgeting is a blue-print of planned investments in operating assets. Therefore, capital budgeting is the process of evaluating the profitability of the projects under consideration and deciding on the proposal to be included in the capital budget for implementation. Capital budgeting decisions involve investment of current funds in anticipation of cash flows occurring over a series of years in future. All these decisions are strategic because they change the profile of the organisations. Successful organisations have created wealth for their shareholders through capital budgeting decisions. Investment of current funds in long term assets for generation of cash flows in future over a series of years characterises the nature of capital budgeting decisions. HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over Bank of Madurai. The motive behind all these mergers is to grow because in this era of globalisation the need of the hour is to grow as big as possible. In all these, one could observe the desire of the management to create value for shareholders as a motivating force. Another way of growing is through branch expansion, expanding the product mix and reducing cost through improved technology for deeper penetration into the market for the companys products. Example A bank which is urban based, for expansion takes over a bank with rural network because, 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 of the merger of urban based bank of ICICI with the rural based Bank of Madurai. Investment of current funds in long-term assets for generation of cash flows in future over a series of years characterises the nature of capital budgeting decisions.
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8.1.1 Learning objectives After studying this unit, you should be able to: Explain the concept of capital budgeting. Recoil the importance of capital budgeting. Examine the complexity of capital budgeting procedures. Discuss the various techniques of appraisal methods Evaluate capital budgeting decision.
8.2 Importance of Capital Budgeting

Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organisation. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into: Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant The reasons that make the capital budgeting decisions most crucial for finance managers are: These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.
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o For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes has declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions. o Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for share-holders. The best example is the Reliance Group. o Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness. o Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors. Long time investments of the funds sometimes may change the risk profile of the firm.
Example A FMCG company decides to enter into a new business of power generation. This decision will totally alter the risk profile of the business of the company. Investors perception of risk of the new business to be taken up by the company will change its 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 organisation. Therefore, capital budgeting decisions change the risk dimensions of the company and hence the required rate of return that the investors want.
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Most of the capital budgeting decisions involve huge outlay. The funds required during the phase of execution must be synchronised with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a companys operation unproductive.
Capital budgeting decisions involve assessment of market for companys product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment. If a firm were to realise after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialised costly equipments. Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are: o cost o quality o timing Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken, will strategically affect the firms profitability.
Liberalisation and globalisation gave birth to economic institutions like world trade organisations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric company. Ability of GE to sell its products in India at
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a rate less than the rate at which Indian companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth. The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex. Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project.
Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today. Self Assessment Questions Fill in the blanks: 1. _______ make or mar a business. 2. _______ decisions involve large outlay of funds in anticipation of cash inflows in future. 3. Social, political, economical and technological forces make capital budgeting decisions ___________. 4. __________ are very expensive.
8.3 Complexities involved in Capital Budgeting Decisions

Capital expenditure decision involves forecasting of future operating cash flows. Forecasting the future cash flows demands certain assumptions about the behaviour of costs and revenues in future.
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Example The arrival of mobile revolution made the pager technology obsolete. The firms 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 know-how 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. However, there are complexities involved in capital budgeting decisions They are: Estimation of future cash flows Commitment of funds on long-term basis Problem of irreversibility of decisions Self Assessment Questions Fill in the blanks: 5. Capital expenditure decisions are _________. 6. Forecasting of future operating cash flows from ____________ because the future is________.
8.4 Phases of Capital Expenditure Decisions

There are various phases involved in capital budgeting decisions. Identification of investment opportunities. Evaluation of each investment proposal Examination of the investments required for each investment proposal Preparation of the statements of costs and benefits of investment proposals Estimation and comparison of the net present values of the investment proposals that have been cleared by the management on the basis of screening criteria Examination of the government policies and regulatory guidelines, for execution of each investment proposal screened and cleared based on the criteria stipulated by the management
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Budgeting for capital expenditure for approval by the management Implementation Post-completion audit
Self Assessment Questions Fill in the blanks: 7. Post-completion audit is ________ in the phases of capital budgeting decisions. 8. 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 of capital projects emerging from various levels of the organisation. The proposal may be to: Add new products to the companys product line, Expand capacity to meet the emerging market at demand for companys products Add new technology based process of manufacture that will reduce the cost of production. Caselet A sales manager may come with a proposal to produce a new product as per the requirements of companys 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 cost-benefit statement generated by cost accountant shall include all incremental costs and benefits that the firm will incur and derive on commercialisation of the proposal under consideration.
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Therefore, generation of ideas with the feasibility to convert the same into investment proposals occupies a crucial place in the capital budgeting decisions. Proactive organisations encourage a continuous flow of investment proposals from all levels in the organisation. In this connection following points deserve to be considered: Analysing the demand and supply conditions of the market for the companys product could be a fertile source of potential investment proposals. Market surveys on customers perception of companys product could be a potential investment proposal to redefine the companys products in terms of customers expectations. Companies which invest in Research and Development constantly get exposure to the benefit of adapting the new technology quite relevant to keep the firm competitive in the most dynamic business environment. Reports emerging from R & D section could be a potential source of investment proposal. Economic growth of the country and the emerging middle class endowed with purchasing power could generate new business opportunities in existing firms. These new business opportunities could be potential investment ideas. Public awareness of their rights compels many firms to initiate projects from environmental protection angle. If ignored, the firm may have to face the public wrath through PILs entertained at the Supreme Court and High courts. Therefore project ideas that would improve the competitiveness of the firm by constantly improving the production process with the sole objective of cost reduction and customer welfare, are accepted by well managed firms. Self Assessment Questions Fill in the blanks: 9. Analysing the demand and supply conditions of the market for the companys products could be _______ of potential investment proposal. 10. Generation of ideas for capital budgets and screening the same can be considered _______ of capital budgetary decisions.
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8.6 Rationale of Capital Budgeting Proposals

The investors and the stake-holders expect a firm to function efficiently to satisfy their expectations. The stake-holders expectation and the performance of the company may clash among themselves, the one that touches all these stake-holders expectation could be visualised in terms of firms obligation to reduce the operating costs on a continuous basis and increasing its revenues. Therefore, capital budgeting decisions could be grouped into two categories: Decisions on cost reduction programmes Decisions on revenue generation through expansion of installed capacity Self Assessment Questions Fill in the blanks: 11. __________ decisions could be grouped into two categories. 12. ________ and revenue generation are the two important categories of capital budgeting.
8.7 Capital Budgeting Process

Once the screening of proposals for potential involvement is over, the company should take up the following aspects of capital budgeting process: A proposal should be commercially viable. The following aspects are examined to ascertain the commercial viability of any investment proposal o Market for the product o Availability of raw materials o Sources of raw materials o The elements that influence the location of a plant i.e. the factors to be considered in the site selection Infrastructural facilities such as roads, communication facilities, financial services such as banking and public transport services Ascertaining the demand for the product or services is crucial. It is done by market appraisal. In appraisal of market for the new product, the following details are compiled and analysed. Consumption trends
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Competition and players in the market Availability of substitutes Purchasing power of consumers Regulations stipulated by Government on pricing the proposed products or services Production constraints
Relevant forecasting technologies are employed to get a realistic picture of the potential demand for the proposed product or service. Many projects fail to achieve the planned targets on profitability and cash flows if the firm could not succeed in forecasting the demand for the product on a realistic basis. Capital budgeting process involves three steps (see figure 8.1) Financial appraisal, Technical appraisal and Economic appraisal.
Figure 8.1: Capital budgeting process
8.7.1 Technical appraisal Technical appraisal ensures implementation of all the technical aspects of the project. The technical aspects of the project are: Selection of process know-how Decision on determination of plant capacity Selection of plant, equipment and scale of operation Plant design and layout General layout and material flow Construction schedule 8.7.2 Economic appraisal Economic appraisal examines the project from the social point of view. Hence, is referred to as social cost benefit analysis. It examines: The impact of the project on the environment The impact of the project on the income distribution in the society The impact of the project on fulfilment of certain social objective like generation of employment and attainment of self sufficiency
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Will the project materially alter the level of savings and investment in the society?
8.7.3 Financial appraisal Financial appraisal is to examine the financial viability of the project. Under this appraisal, the risk and returns at various stages of project execution are assessed. Besides, it examines whether the risk adjusted return from the project exceeds the cost of financing the project. Financial appraisal technique examines: Cost of the project Investment outlay Means of financing and the cost of capital Expected profitability Expected incremental cash flows from the project Break-even point Cash break-even point Risk dimensions of the project Will the project materially alter the risk profile of the company ? If the project is financed by debt, expected Debt Service Coverage Ratio Tax holiday benefits, if any. Self Assessment Questions Fill in the blanks: 13. ________ examines the project from the social point of view. 14. All technical aspects of the implementation of the project are considered in __________ 15. _________ of a project is examined by financial appraisal. 16. Among the elements that are to be examined under commercial appraisal, the most crucial one is the ______.
8.8 Investment Evaluation

Steps involved in the evaluation of any investment proposal are: Estimation of cash flows both inflows and outflows occurring at different stages of project life cycle
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Examination of the risk profile of the project to be taken up and arriving at the required rate of return Formulation of the decision criteria
8.8.1 Estimation of cash flows Estimating the cash flows associated with the project under consideration is the most difficult and crucial step in the evaluation of an investment proposal. Estimation is the result of the team work of many professionals in an organisation. Capital outlays are estimated by engineering departments after examining all aspects of production process Marketing department on the basis of market survey forecasts the expected sales revenue during the period of accrual of benefits from project executions Operating costs are estimated by cost accountants and production engineers Incremental cash flows and cash out flow statement is prepared by the cost accountant on the basis of the details generated in the above steps The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the success of the implementation of any capital expenditure decision. 8.8.2 Estimation of incremental cash flows Investment (capital budgeting) decision requires the estimation of incremental cash flow stream over the life of the investment. Incremental cash flows are estimated on tax basis. Incremental cash flows stream of a capital expenditure decision has three components. Initial cash outlay (Initial investment) Initial cash outlay to be incurred is determined after considering any post tax cash inflows. In replacement decisions existing old machinery is disposed of and a new machinery incorporating the latest technology is installed in its place. On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis. The net cash out flow (total cash required for investment in capital assets minus post tax cash
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inflow on disposal of the old machinery being replaced by a new one) therefore is the incremental cash outflow. Additional net working capital required on implementation of new project is to be added to initial investment. Operating cash inflows Operating cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here also incremental inflows and outflows attributable to operating activities are considered. Any savings in cost on installation of a new machinery in the place of the old machinery will have to be accounted on post tax basis. In this connection incremental cash flows refer to the change in cash flows on implementation of a new proposal over the existing positions. Terminal cash inflows At the end of the economic life of the project, the operating assets installed will be disposed off. It is normally known as salvage value of equipments. This terminal cash inflows are computed on post tax basis.
Prof. Prasanna Chandra in his book Financial Management (Tata McGraw Hill, published in 2007) has identified certain basic principles of cash flow estimation. The knowledge of these principles will help a student in understanding the basics of computing incremental cash flows. The basic principles of cash flow estimation, by Prof. Prasanna Chandra, are (see figure 8.2) Separation principle, Increment principle, Post-tax principle and Consistency principle.
Figure 8.2: Principles of Prof. Prasanna Chandra
Separation principle The essence of this principle is the necessity to treat investment element of the project separately (i.e. independently) from that of financing element.
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The financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of return expected on implementation of the project. Therefore, we compute separately cost of funds for execution of project through the financing mode. The rate of return expected on implementation if the project is arrived at by the investment profile of the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows. The following formula is used to calculate profit after tax Incremental PAT = Incremental EBIT ( 1-t ) (Incremental) (Incremental) EBIT = earnings (profit) before interest and taxes t = tax rate Incremental principle Incremental principle says that the cash flows of a project are to be considered in incremental terms. Incremental cash flows are the changes in the firms total cash flows arising directly from the implementation of the project. Keep the following in mind while determining incremental cash flows. Ignore sunk costs Sunk costs are costs that cannot be recovered once they have been incurred. Therefore, sunk costs are ignored when the decisions on project under consideration is to be taken. Opportunity costs If the firm already owns an asset or a resource which could be used in the execution of the project under consideration, the asset or resource has an opportunity cost. The opportunity cost of such resources will have to be taken into account in the evaluation of the project for acceptance or rejection.
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Caselet A 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. For opening the branch at Chennai the firm uses its own building by sacrificing the rental income which it has been receiving. The opportunity cost of the building at Chennai is Rs. 1 crore. This will have to be considered in arriving at the operating cash flows associated with the decision to open a branch at Chennai. 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. Caselet 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. Cannibalisation Another problem that a firm faces on introduction of a new product is the reduction in the sale of an existing product. This is called cannibalisation. The most challenging task is the handling the problems of cannibalisation. Depending on the companys position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored. Depending on the companys position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored. Product cannibalisation will affect the companys sales if the firm is marketing its products in a market characterised by severe competition, without any entry barriers. In this case costs are not relevant for decision.
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However, if the firms sales are not affected by competitors activities due to certain unique protection that it enjoys on account of brand positioning or patent protection, the costs of cannibalisation cannot be ignored in taking decisions. Post tax principle All cash flows should be computed on post tax basis Consistency principle Cash flows and discount rates used in project evaluation need to be consistent with the investor group and inflation. Solved Problem A firm is 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 involves 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 at 25% on the written down value. The companys cost of capital is 20%. Compute the incremental cash flows of replacement decisions. Solution Table 8.1 gives the initial investments and annual cash flows from projects.
Table 8.1: Initial investments and annual cash flows Initial investment Gross investment for new machine Less: cash received from the sale of existing machine Net cash outlay Annual cash flows from operations Incremental cash flows from revenue Incremental decrease in expenditure 50, 000 10, 000 1, 60, 000 20, 000 1, 40, 000
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Table 8.2 shows the incremental depreciation schedule:

Table 8.2: Incremental depreciation schedule Year 1 2 3 4 5 Depreciation (new machine) 45, 000 33, 750 25, 312 18, 984 14, 238 Depreciation (old machine) 10,000 7,500 5,625 4,219 3,164 Incremental depreciation (Rs.) 35,000 26,250 19,687 14,765 11,074
Table 8.3 shows the calculation of depreciation:

Table 8.3: Calculation of depreciation Book value Add: cost of new machine Less: sale proceeds of old machine Depreciation for 1 year 25% Depreciation for 2 year 25% Depreciation for 3 year 25% Depreciation for 4 year 25% Depreciation for 5 year 25% Book value after 5 years 40, 000 1, 60, 000 2, 00, 000 20, 000 1, 80, 000 45, 000 1, 35, 000 33, 750 1, 01, 250 25, 312 75, 938 18, 894 56, 954 14, 238 42, 716
The computation of the incremental cash flows of replacement decisions is briefly described in table 8.4.
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Table 8.4: Statement of incremental cash flows

Particulars 0 Rs 1. Investment in new machine 2. After tax salvage value of old machine 3. Net Cash Out lay 4. Increase in revenue 5. Decrease in expenses 6. Increase in depreciation 7. Increase in EBIT 8. EBIT (1 T) 9. Incremental Cash flows from operation (8 + 6) 10. Salvage value of new machine 11. Incremental Cash flows (1,40,000) negative 52,500 49,875 47,906 46,430 (1,60,000) 20,000 1 Rs Year 2 Rs 3 Rs 4 Rs 5 Rs
(1,40,000) 50,000 10,000 35,000 25,000 17,500 52,500 50,000 10,000 26,250 33,750 23,625 49,875 50,000 10,000 19,687 40,313 28,219 47,906 50,000 10,000 14,765 45,235 31,665 46,430 50,000 10,000 11,074 48,926 34,248 45,322
8,000 53,322
Self Assessment Questions Fill in the blanks: 17. ______ is the third step in the evaluation of investment proposal. 18. A ________ is not a relevant cost for the project decision. 19. Effect of a project on the working of other parts of a firm is known as __________. 20. The essence of separation principle is the necessity to treat _____ of a project separately from that of ________. 21. Pay-back period __________ time value of money. 22. 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 methods are: o Payback method o Accounting rate of return Modern techniques are: o Net present value o Internal rate of return o Modified internal rate of return o Profitability index 8.9.1 Traditional techniques Traditional methods are of two types payback method and accounting rate of return. 8.9.1.1 Payback method Payback period is defined as the length of time required to recover the initial cash out lay. Solved Problem The following details shown in table 8.5, are in respect of the cash flows of two projects A and B.
Table 8.5: Cash flows of A and B Year 0 1 2 3 4 5 Project A cash flows (Rs.) 4,00,000 2,00,000 1,75,000 25,000 2,00,000 1,50,000 Project B cash flows (Rs.) 5,00,000 1,00,000 2,00,000 3,00,000 4,00,000 2,00,000
Compute pay-back period for A and B.
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Solution The cash flows and the cumulative cash flows of the projects A and B are shown under in table 8.6
Table 8.6 Cash flows and cumulative cash flows of A and B Year Project A Cash flows (Rs.) 1 2 3 4 5 2,00,000 1,75,000 25,000 2,00,000 1,50,000 Cumulative Cash flows 2,00,000 3,75,000 4,00,000 6,00,000 7,50,000 Project B Cash flows (Rs.) 1,00,000 2,00,000 3,00,000 4,00,000 2,00,000 Cumulative Cash flows 1,00,000 3,00,000 6,00,000 10,00,000 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 2nd year and 3rd year in respect of project B. Therefore, payback period for project B is:
2 5,00,000 3,00,000 3,00,000
= 2.67 years Pay-back period for project B is 2.67 years
8.9.1.1.1 Evaluation of payback period: Merits Simple in concept and application Emphasis is on recovery of initial cash outlay. Pay-back period is the best method for evaluation of projects with very high uncertainty
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With respect to accept or reject criterion, pay back method favours a project which is less than or equal to the standard pay back set by the management. In this process early cash flows get due recognition than later cash flows. Therefore, pay-back period could be used as a tool to deal with the ranking of projects on the basis of risk criterion For firms with short-age funds this is preferred because it measures liquidity of the project Demerits
Pay-back period ignores time value of money. It does not consider the cash flows that occur after the pay-back period. It does not measure the profitability of the project. It does not throw any light on the firms liquidity position but just tells about the ability of the project to return the cash out lay originally made. Project selected on the basis of pay back criterion may be in conflict with the wealth maximisation goal of the firm.
Accept or reject criteria If projects are mutually exclusive, select the project which has the least pay-back period In respect of other projects, select the project which have pay-back period less than or equal to the standard pay back stipulated by the management Illustration Pay-back period: Project A = 3 years Project B = 2.5 years Standard set up by management = 3 years If projects are mutually exclusive, accept project B which has the least pay-back period. If projects are not mutually exclusive, accept both the projects because both have pay-back period less than or equal to the standard pay-back period set by the management
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Pay-back 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
Re cov ery takes place Cash in flow of the year in w hich full recovery takes place
8.9.1.2 Accounting rate of return Accounting rate of return (ARR) measures the profitability of investment (project) using information taken from financial statements: ARR = Average income / Average investment ARR = Average of post tax operating profit / Average investment 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 Solved Problem The following particulars shown in table 8.7 refers to two projects:
Table 8.7: Particulars of two projects Cost Estimated life Salvage value X 40,0005 years Rs. 3,000 Table 8.8: After tax 1 2 3 4 5 Total Sikkim Manipal University Rs. 3,000 4,000 7,000 6,000 8,000 28,000 Rs. 10,000 8,000 2,000 6,000 5,000 31,000 Page No. 168 Y 60,000 5 years Rs. 3,000
Estimate income
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Average 5,600 Average investment 21,500

ARR 5,600 6,200 21,500 31,500
6,200 31,500
= 26 % 19.7%
Merits of accounting rate of return It is based on accounting information Simple to understand It considers the profits of entire economic life of the project Since it is based on accounting information, the business executives familiar with the accounting information understand it Demerits of accounting rate of return ARR is based on accounting income not on cash flows, as the cash flow approach is considered superior to accounting information based approach ARR does not consider the time value of money Different investment proposals which require different amounts of investment may have the same accounting rate of return. The ARR fails to differentiate projects on the basis of the amount required for investment ARR is based on the investment required for the project. There are many approaches for the calculation of denominator of average investment. Existence of more than one basis for arriving at the denominator of average investment may result in adoption of many arbitrary bases
Due to this the reliability of ARR as a technique of appraisal is reduced when two projects with the same ARR but with differing investment amounts are to be evaluated.
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Accept or reject criteria In any project which has an excess ARR, the minimum rate fixed by the management is accepted. If actual ARR is less than the cut-off rate (minimum rate specified by the management ) then that project is rejected. When projects are to be ranked for deciding on the allocation of capital on account of the need for capital rationing, project with higher ARR are preferred to the ones with lower ARR. 8.9.2 Discounted pay-back period The length in years required to recover the initial cash out lay on the present value basis is called the discounted pay-back period. The opportunity cost of capital is used for calculating present values of the cash inflows. Discounted pay-back period for a project will be always higher than simple pay-back period because the calculation of discounted pay-back period is based on discounted cash flows. Solved Problem Table 8.9 shows the cash flows of project A for different years at a rate of 10% p.a.
Table 8.9: Cash flows of project A Year 0 1 2 3 4 5 Project A Cash flows (4,00,000) 2,00,000 1,75,000 25,000 2,00,000 1,50,000 PV factor at 10% 1 0.909 0.826 0.751 0.683 0.621 PV of Cash flows (4,00,000) 1,81,800 1,44,550 18,775 1,36,600 93,150 Cumulative positive Cash flows 1,81,800 3,26,350 3,45,125 4,81,725 5,74,875
Discounted pay-back period

3 4,00,000 3, 45,125 1,36,600 3.4 years
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8.9.3 Discounted cash flow method Discounted cash flow method or time adjusted technique is an improvement over the traditional techniques. In evaluation of the projects the need to give weight-age to the timing of return is effectively considered in all DCF methods. DCF methods are cash flow based and take the cognisance of both the interest factors and cash flow after the pay-back period. DCF technique involves: Estimation of cash flows, both inflows and outflows of a project over the entire life of the project Discounting the cash flows by an appropriate interest factor (discount factor) Deducting the sum of the present value of cash outflows from the sum of present value of cash inflows to arrive at net present value of cash flows The most popular techniques of DCF methods are: The net present value The internal rate of return Profitability index Net present value Net present value (NPV) method recognises the time value of money. It correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is the need to find out the present values of all cash flows. NPV method is the most widely used technique among the DCF methods. Steps involved in NPV method involve: Forecasting the cash flows, both inflows and outflows of the projects to be taken up for execution Decisions on discount factor or interest factor. The appropriate discount rate is the firms cost of capital or required rate of return expected by the investors Computation of the present value of cash inflows and outflows using the discount factor selected Calculation of NPV by subtracting the PV of cash outflows from the present value of cash inflows.
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Accept or reject criteria If NPV is positive, the project should be accepted. If NPV is negative the project should be rejected. Accept or reject criterion can be summarised as given below: NPV > Zero = accept NPV < Zero = reject NPV method can be used to select between mutually exclusive projects by examining whether incremental investment generates a positive net present value. Merits of NPV method It takes into account the time value of money. It considers cash flows occurring over the entire life of the project. NPV method is consistent with the goal of maximising the net wealth of the company. It analyses the merits of relative capital investments. Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project generates profits from the investment made for it. Demerits of NPV method Forecasting of cash flows is difficult as it involves dealing with the effect of elements of uncertainties on operating activities of the firm. To decide on the discounting factor, there is the need to assess the investors required rate of return. But it is not possible to compute the discount rate precisely. There are practical problems associated with the evaluation of projects with unequal lives or under funds constraints
For ranking of projects under NPV approach, the project with the highest positive NPV is preferred to that with a lower NPV.
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Solved Problem A project costs Rs.25000 and is expected to generate cash inflows as shown in table 8.10
Table 8.10: Cash inflows Year 1 2 3 4 5 Cash inflows 10,000 8,000 9,000 6,000 7,000
The cost of capital is 12%. The present value factors are as shown in the table 8.11.
Table 8.11: Present value factors Year 1 2 3 4 5 PV factor at 12% 0.893 0.797 0.712 0.636 0.567
Compute the NPV of the project Solution The present value of the cash flows are computed based on the information given in tables 8.8 and 8.9, at a rate of interest of 12% per annum, in the table 8.12 shown under:
Table 8.12: PV of cash flows Year 1 2 3 4 5 Cash flows 10,000 8,000 9,000 6,000 7,000 PV factor at 12% 0.893 0.797 0.712 0.636 0.567 PV of cash flows 8,930 6,376 6,408 3,816 3,969
Sum of the present value of cash inflows = 29,499 Sum of the present value of the cash outflows = 25,500 NPV = 4,499 The project generates a positive NPV of Rs. 4,499. Therefore, project should be accepted.
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Solved Problem A company is evaluating two alternatives for distribution within the plant. Two alternatives are C system with a high initial cost but low annual operating costs. 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 cash costs are listed in table 8.13.
Table 8.13: Expected net cash Year 0 1 2 3 4 5 Expected net cash costs C systems 3,00,000 66,000 66,000 66,000 66,000 66,000 F systems 1,20,000 96,000 96,000 96,000 96,000 96,000
What is the present value of costs of each alternative? Which method should be chosen ? Solution Computation of present value is done in table 8.14
Table 8.13: Expected net cash Year 0 1 2 3 4 5 Expected net cash costs C systems 3,00,000 66,000 66,000 66,000 66,000 66,000 F systems 1,20,000 96,000 96,000 96,000 96,000 96,000
What is the present value of costs of each alternative? Which method should Sikkim Manipal University be chosen?
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Solution Computation of present value is done in table 8.14

Table 8.14: Computation of PV Year 1 2 3 4 5 C systems 66,000 66,000 66,000 66,000 66,000 F systems 96,000 96,000 96,000 96,000 96,000 Incremental 30,000 30,000 30,000 30,000 30,000
Present value of incremental savings = 30,0000 x PV IFA (12%, 5)= 30,000 x 3.605 = 1,08,150 Incremental cash outlay =
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 NPVs are additive. If two projects A and B have NPV (A) and NPV (B) then by additive rule the net present value of the combined investment is NPV (A + B) Intermediate cash inflows are reinvested at a rate of return equal to the cost of capital. Internal rate of return (IRR) Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the NPV of any project equal to zero. IRR is the rate of interest which equates the PV of cash inflows with the PV of cash outflows. IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns.
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Merits of IRR IRR takes into account the time value of money IRR calculates the rate of return of the project, taking into account the cash flows over the entire life of the project. It gives a rate of return that reflects the profitability of the project. It is consistent with the goal of financial management i.e. maximisation of net wealth of share holders IRR can be compared with the firms cost of capital. To calculate the NPV the discount rate normally used is cost of capital. But to calculate IRR, there is no need to calculate and employ the cost of capital for discounting because the project is evaluated at the rate of return generated by the project. The rate of return is internal to the project.
Demerits of IRR IRR does not satisfy the additive principle. Multiple rate of returns or absence of a unique rate of return in certain projects will affect the utility of this technique as a tool of decision making in project evaluation. In project evaluation, the projects with the highest IRR are given preference to the ones with low internal rates. Application of this criterion to mutually exclusive projects may lead under certain situations to acceptance of projects of low profitability at the cost of high profitability projects. IRR computation is quite tedious.
Accept or reject criteria If the projects internal rate of return is greater than the firms cost of capital, accept the proposal, otherwise reject the proposal.
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IRR can be determined by solving the following equation for r = CF 0

Ct (1 r ) t
where t = 1 to n
CF0 = Investment Sum of the present values of cash inflows at the rate of interest of r :CF 0 Ct (1 r ) t
where t = 1 to n
Solved Problem A project requires an initial outlay of Rs. 1,00,000. It is expected to generate the following cash inflows shown in table 8.15
Table 8.15: Cash inflows Year 1 2 3 4 Cash inflows 50,000 50,000 30,000 40,000
What is the IRR of the project? Solution Step 1 The average of annual cash inflows is computed as shown under in table 8.16
Table 8.16:Average of cash inflows Year 1 2 3 4 Total Cash inflows 50,000 50,000 30,000 40,000 1,70,000
Average
1,70,000 4
Rs . 42,500
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Step 2 Divide the initial investment by the average of annual cash inflows 1,00,000 2.35 42,500 Step 3 From the PVIFA table for 4 years, the annuity factor very near 2.35 is 25%. Therefore the first initial rate is 25% as shown in table 8.17
Table 8.17: Trial rate at 25% Year 1 2 3 4 Cash flows 50,000 50,000 30,000 40,000 PV factor at 25 % 0.800 0.640 0.512 0.410 Total PV of Cash flows 40,000 32,000 15,360 16,400 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%. Hence the changes in the calculations are as shown in table 8.18
Table 8.18: Trial rate at 26% Year 1 2 3 4 Cash flows 50,000 50,000 30,000 40,000 PV factor at 26 % 0.7937 0.6299 0.4999 0.3968 Total PV of Cash flows 39,685 31,495 14,997 15,872 1,02,049
The next trial rate is 27%, the changes are as shown under in table 8.19.
Table 8.19: Trial rate at 27% Year 1 2 3 4 Cash flows 50,000 50,000 30,000 40,000 PV factor at 27 % 0.7874 0.6200 0.4882 0.3844 Total Sikkim Manipal University PV of Cash flows 39,370 31,000 14,646 15,376 1,00,392 Page No. 178
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The next trial rate is 28%, the changes are as shown under in table 8.20
Table 8.20: Trial rate at 28% Year 1 2 3 4 Cash flows 50,000 50,000 30,000 40,000 PV factor at 26 % 0.7813 0.6104 0.4768 0.3725 Total PV of Cash flows 39,065 30,520 14,3047 14,900 98,789
Since initial investment of Rs.1,00,000 lies between 98789 (28 %) and 1,00,392 (27%) the IRR by interpolation.
27 1,00,392 1,00,000 1,00,392 98,789 1
27
392 1 1603
= 27 + 0.2445 = 27.2445 = 27.24 %
Modified Internal Rate of Return (MIRR) Modified internal rate of return (MIRR) is a distinct improvement over the IRR. Managers find IRR intuitively more appealing than the rupees of NPV because IRR is expressed on a percentage rate of return. MIRR modifies IRR. MIRR is a better indicator of relative profitability of the projects. MIRR is defined as PV of Costs = PV of terminal value
PVC
TV (1 MIRR ) n
PVC = PV of costs
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To calculate PVC, the discount rate used is the cost of capital. To calculate the terminal value, the future value factor is based on the cost of capital MIRR is obtained on solving the following equation. PV of costs = TV/ (1 + MRR)n Superiority of MIRR over IRR MIRR assumes that cash flows from the project are reinvested at the cost of capital. The IRR assumes that the cash flows from the project are reinvested at the projects own IRR. Since reinvestment at the cost of capital is considered realistic and correct, the MIRR measures the projects true profitability MIRR does not have the problem of multiple rates which we come across in IRR Solved Problem The cash flows for respective years at a cost of capital of 12% is as shown in table 8.21.
Table 8.21: Cost of capital
Year Cash flows (Rs. in millions) 0 (100) 1 (100) 2 30 3 60 4 90 5 120 6 130
Present value of cost = 100 +
100
1.12 = 100 + 89.29 = 189.29
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
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MIRR is obtained on solving the following equation:
189.29
508.80 (1 MIRR ) 6
(1 MIRR ) 6
508.80 189.29
(1 + MIRR)6 = 2.6879 MIRR = 17.9 % Modified internal rate of return = 17.9% Profitability Index Profitability index is also known as benefit cost ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows. P1= Present value of cash inflows / initial cash outlay Accept or reject criteria Accept the project if PI is greater than 1 Reject the project if PI is less than 1 If profitability index is 1 then the management may accept the project because the sum of the present value of cash inflows is equal to the sum of present value of cash outflows. It neither adds nor reduces the existing wealth of the company.
Merits of PI It takes into account the time value of money It is consistent with the principle of maximisation of share holders wealth It measures the relative profitability
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Demerits of PI Estimation of cash flows and discount rate cannot be done accurately with certainty A conflict may arise between NPV and profitability index if a choice between mutually exclusive projects has to be made.
Solved Problem A firm is considering an investment proposal which requires an initial cash outlay of Rs 8lakhs now and Rs 2lakhs at the end of the third year. It is expected to generate cash flows as shown in table 8.22
Table 8.22 Cash inflows Year 1 2 3 Cash inflows 3,50,000 8,00,000 2,50,000
Apply the discount rate of 12% and calculate profitability index
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Solution
Table 8.23: Present value of cash outflows Year 1 2 3 0.712 2lakhs Total Table 8.24: Present value of cash inflows Year 1 2 4 PVIF (12%) 0.893 0.797 0.636 Cash inflows 3,50,000 8,00,000 2,50,000 Total PV of Cash flows 3.1255 lakhs 6.376 lakhs 1.5900 lakhs 11.0915 lakhs 1.424lakhs 9.424lakhs PV factor at 12 % Cash out flows Rs.8lakhs PV of Cash flows Rs.8lakhs
PI
Total of present value of cashinf low s Total of present value of cashoutflow s

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 expectation of a stream of cash inflow in future. Various techniques available for evaluating investment projects. They are grouped traditional and modern techniques. The major traditional techniques payback period and accounting rate of return. the are into are
The important discounting criteria are net present value, internal rate of return and profitability index. A major deficiency of payback period is that it does not take into account the time value of money. DCF techniques overcome this limitation. Each method has both positive and negative aspects. The most popular method for large project is the internal rate of return. Payback period and accounting rate of return are popular for evaluating small projects.
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1. Examine the importance of capital budgeting. 2. Briefly examine the significance of identification of investment opportunities in capital budgeting process. 3. Critically examine the pay-back period as a technique of approval of projects. 4. Summarise the features of DCF techniques.

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. Capital budgeting Capital budgeting Highly complex Capital budgeting decisions Irreversible Uncertainty, highly uncertain. Final step First step A fertile source The most crucial phase Capital budgeting Cost reduction Economic appraisal Technical appraisal Financial viability Demand for the product or service. Decision criteria Sunk cost Externalities Investment element; Financing element Ignores Profitability of
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Answers to Terminal Questions 1. 2. 3. 4. Refer to 8.2 Refer to 8.5 Refer to 8.8.1 Refer to 8.8.2
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Unit 9
Risk Analysis in Capital Budgeting
Structure: 9.1 Introduction Learning objectives 9.2 Types and Sources of Risk in Capital Budgeting Sources of risk Conventional techniques 9.3 Risk Adjusted Discount Rate Evaluation of risk adjusted discount rate 9.4 Certainty Equivalent Evaluation of certainty equivalent 9.5 Sensitivity Analysis 9.6 Probability Distribution Approach Variance 9.7 Decision Tree Approach Evaluation of decision tree approach 9.8 Summary 9.9 Terminal Questions 9.10 Answers to SAQs and TQs
9.1 Introduction
Capital budgeting decisions typically involve forecasting the future operating cash flows. Forecasting involves making certain assumptions about the future behaviour of costs and revenues. Such forecasting, however, suffers from uncertainty because the future is highly uncertain. Assumptions made about the future behaviour of costs and revenues may change and can significantly alter the fortunes of a company. The process is thereby inherently risky. Analysing the risks to reduce the element of uncertainty has therefore become an essential aspect of todays corporate project management. This unit will help you understand the various types of risks involved in capital budgeting decisions. In this unit, you will study how sensitivity analysis is used to determine the most critical uncertainties in the
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estimation. You will also study the pitfalls of using uncertain single-point estimates for the cash flows associated with the project. This unit will help the capital budget decision-makers to avoid costly mistakes. 9.1.1 Learning Objectives After studying this unit, you should be able to: Define risk in capital budgeting Examine the importance of risk analysis in capital budgeting Determine the methods of incorporating the risk factor in capital budgeting decision Understand the types and sources of risk in capital budgeting decision 9.1.2 Definition of Risk Before we start to discuss about risk analysis in capital budgeting, let us first understand what risk in capital budgeting means. Risk in capital budgeting may be defined as the variation of actual cash flows from the expected cash flows. Every business decision involves risk. Risk exists on account of the inability of a firm to make perfect forecasts of cash flows. The inability can be attributed to factors that affect forecasts of investment, cost and revenue. Some of these are as follows: The business is affected by changes in political situations, monetary policies, taxation, interest rates and policies of the central bank of the country on lending by banks Industry specific factors influence the demand for the products of the industry to which the firm belongs Company specific factors like change in management, wage negotiations with the workers, strikes or lockouts affect companys cost and revenue positions Let us see a case explaining why making a perfect forecast of cash flows is difficult.
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Caselet A company wants to produce and market a new product to their prospective customers and 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 and sub-prime crises may trigger economic slow-down. This may create a pessimistic demand drastically bringing down the estimate of cash flows.
9.2 Types and Sources of Risk in Capital Budgeting

Having understood what risk in capital budgeting means, let us now understand the types of risk and their sources. Capital budgeting involves four types of risks in a project stand-alone risk, portfolio risk, market risk and corporate risk (see figure 9.1)
Figure 9.1: Types of risks
Stand-alone risk Stand alone risk of a project is considered when the project is in isolation. Stand-alone risk is measured by the variability of expected returns of the project.
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Portfolio risk A firm can be viewed as portfolio of projects having a certain degree of risk. When new project is added to the existing portfolio of project, the risk profile of the firm will alter. The degree of the change in the risk depends on: The co-variance of return from the new project The return from the existing portfolio of the projects If the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be further diversified. Market risk Market risk is defined as the measure of the unpredictability of a given stock value. However, market risk is also referred to as systematic risk. The market risk has a direct influence on stock prices. Market risk is measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to estimate. Corporate risk Corporate risk focuses on the analysis of the risk that might influence the project in terms of entire cash flow of the firms. Corporate risk is the projects risks of the firm. 9.2.1 Sources of risk The five different sources of risk are: Project specific risk Competitive or Competition risk Industry specific risk International risk Market risk Project-specific risk Project-specific risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash flows realised being less than the projected. Competitive or Competition risk Unanticipated actions of a firms competitors will materially affect the cash flows expected from a project. As a result of this, the actual cash flows from a project will be less than that of the forecast.
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Industry-specific risk Industry-specific risks are those that affect all the industrial firms. Industryspecific risk could be again grouped into technological risk, commodity risk and legal risk. All these risks will affect the earnings and cash flows of the project. Technological risk The changes in technology affect all the firms not capable of adapting themselves in emerging into a new technology. Example The best example is the case of firms manufacturing motor cycles with two stroke 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 Commodity risk is the risk arising from the effect of price-changes on goods produced and marketed. Legal risk Legal risk arises from changes in laws and regulations applicable to the industry to which the firm belongs. Example 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.
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.
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Let us now look at the firms facing such kind of risk: The rupee-dollar crisis affected the software and BPOs because it drastically reduced their profitability. Another example is that of the textile units in Tirupur in Tamil Nadu, which exports the major part of the garments produced. Rupee gaining and dollar weakening reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments delay in taking decision on pricing of petro products, eroded the profitability of oil marketing companies in public sector like Hindustan Petroleum Corporation Limited. Another example is the impact of US sub-prime crisis on certain segments of Indian economy. The changes in international political scenario also affected the operations of certain firms. Market risk Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and all industries. Firms cannot diversify this risk in the normal course of business. There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology as far as incorporation of risk in the evaluation process is concerned. 9.2.2 Techniques for incorporation of risk factor in capital budgeting The techniques for incorporation of risk factor in capital budgeting decisions could be grouped into conventional and statistical techniques. In this chapter, we are going to discuss mainly the conventional techniques pay-back period. Pay-back period The oldest and the most commonly used method of recognising risk associated with a capital budgeting proposal is pay-back period. Pay-back period is defined as the length of time required to recover the initial cash out-lay. Pay-back period ignores time value of money (cash flows).
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Pay-back period prefers projects of short term pay backs to that of longterm pay backs. The emphasis is on the liquidity of the firm through recovery of capital. Traditionally, Indian business community employs this technique in evaluating projects with very high level of uncertainty. The changing trends in fashion, makes the fashion business risky and therefore, pay-back period has been endorsed as a tradition in India to take decisions on acceptance or rejection of such projects. The usual risk in business is more concerned with the forecast of cash flows. It is the down side risk of lower cash flows arising from lower sales and higher costs of operation that matters in formulating standards of pay back. Caselet Table 9.1 gives the details related to two projects:
Table 9.1: Details of two projects
Particulars Initial cash outlay Cash flows Year 1 Year 2 Year 3 Year 4
Project A (Rs.) 10lakhs 5 lakhs 3 lakhs 1 lakh 1 lakh
Project B (Rs.) 10 lakhs 2 akhs 2 lakhs 3 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 whereas 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.
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Self Assessment Questions Fill in the blanks: 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 the example of _______________________
9.3 Adjusted Discount Rate

The basic principle of risk adjusted discount rate is that there should be adequate reward in the form of return to the firms which decide to execute risky business projects. Man by nature is risk-averse and tries to avoid risk. To motivate firms to take up risky projects, returns expected from the project shall have to be adequate, keeping in view the expectations of the investors. Therefore risk premium need to be incorporated in discount rate during the evaluation of risky project proposals. Risk adjusted discount rate is more briefly described as: Risk Adjusted Discount rate = Risk free rate + Risk premium Risk free rate is computed based on the returns on government securities. Risk premium is the additional returns that the investors require for assuming the additional risk associated with the project to be taken up for execution.
The more the uncertainty in the returns of the project, higher is the risk. Higher the risk, greater is the premium
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Solved Problem An investment will have an initial outlay of Rs 100,000. It is expected to generate cash inflows as shown in table 9.2.
Table 9.2: Cash inflows
Year
1 2
Cash in flows 40000 50000 15000 30000
3 4
If the risk free rate and the risk premium is 10%, a) Compute the NPV using the risk free rate b) Compute NPV using risk-adjusted discount rate Solution a) NPV can be computed using risk free rate from the table 9.3.
Table 9.3 NPV using Risk free rate
Year 1 2 3 4
Cash flows (inflows) Rs. 40000 50000 15000 30000 PV of cash inflows
PV of cash outflows NPV
PV factor at 10% 0.909 0.826 0.751 0.683
PV of cash flows (inflows) 36,360 41,300 11,265 20,490 1,09,415
1,00,000 9,415
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b) NPV can be computed using risk-adjusted discount from the table 9.4.
Table 9.4: NPV using Risk-adjusted discount rate Year Cash inflows Rs. 40000 1 2 3 4 50000 15000 30000 PV of Cash in flows PV of cash outflows NPV 0.694 0.579 0.482 34,700 8,685 14,460 91,165 100, 000 (8, 835) PV factor at 20% 0.833 PV of cash inflows 33,320
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. By doing so, it moves from positive NPV to negative NPV. If the firm were to use the internal rate of return (IRR), then the project would be accepted, when IRR is greater than the risk-adjusted discount rate.
9.3.1 Evaluation of risk-adjusted discount rate The advantages and limitations occurring during the evaluation of riskadjusted discount rate are listed as follows:
Merits of risk adjusted discount rate Risk adjusted discount rate is simple and easy to understand Risk premium takes care of the risk element in future cash flows Risk adjusted discount rate satisfies the businessmen who are risk averse
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Demerits of risk adjusted discount rate There are no objective bases of arriving at the risk premium. In this process the premium rates computed become arbitrary. The assumption that investors are risk-averse may not be true in respect of certain investors who are willing to take risks. To such investors, as the level of risk increases, the discount rate would be reduced Cash flows are not adapted to incorporate the risk adjustment for net cash inflows
Self Assessment Questions Fill in the blanks: 5. Risk premium is the __________________ that the investors require as compensation for assumption of additional risks of project. 6. RADR is the sum of ______________ and ______________. 7. Higher the risk __________________ the premium.
9.4 Certainty Equivalent

Under the method of certainty equivalent, risking is found to be uncertain and unexpected future cash flows are converted into cash flows with certainty. Here we multiply uncertain future cash flows by the certaintyequivalent coefficient to convert uncertain cash flows into certain cash flows. The certainty equivalent coefficient is also known as the riskadjustment factor. Risk adjustment factor is normally denoted by (Alpha). Risk adjustment factor is the ratio of certain net cash flow to risky net cash flow.
Certainty equivalent =
Certain Cash flow Risky Cash flow
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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. Solved Problem A project costs Rs. 50,000. It is expected to generate cash inflows as shown in table 9.5.
Table 9.5: Generation of cash inflows
Year 1 2 3 4
Cash inflows 32000 27000 20000 10000
Certainty equivalent 0.9 0.6 0.5 0.3
If the risk free rate is 10%, compute NPV. Solution

Table 9.6: Computation of NPV Year Uncertain cash inflows 32000 27000 20000 10000 CE Certain cash flows 28800 16200 10000 3000 PV factor at 10% 0.909 0.826 0.751 0.683 PV of certain cash inflows 26179 13381 7510 2049 49119 50000 (881) negative
1 2 3 4
0.9 0.6 0.5 0.3 PV of certain cash inflows Initial cash out-lay NPV
The project has negative NPV, therefore it is rejected.
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If internal rate of return (IRR) is used, the rate of discount at which NPV is equal to zero is computed and then compared with the minimum (required) risk free rate. If IRR is greater than specified minimum risk free rate, the project is accepted, otherwise rejected. 9.4.1 Evaluation of certainty equivalent Evaluation of certainty equivalent recognises risk. Recognition of risk by riskadjustment factor facilitates the conversion of risky cash flows into certain cash flows. But there are chances of inconsistency in the procedure employed from one project to another. When forecasts pass through many layers of management, original forecasts may become highly conservative. Due to high conservation in this process, good projects are likely to be cleared when this method is employed. Certainty-equivalent approach is considered to be theoretically superior to the risk-adjusted discount rate. Self Assessment Questions Fill in the blanks: 8. CE coefficient is the _______ . 9. Discount factor to be used under CE approach is _________. 10. Because of high ______________ CE clears only good projects. 11. ___________ is considered to be superior to RADR.
9.5 Sensitivity Analysis

There are many variables like sales, cost of sales, investments and tax rates which affect the NPV and IRR of a project. Analysing the change in the projects NPV or IRR on account of a given change in one of the variables is called Sensitivity Analysis. Sensitivity analysis measures the sensitivity of NPV of a project in respect to a change in one of the input variables of NPV. The reliability of the NPV depends on the reliability of cash flows. If forecasts go wrong on account of changes in assumed economic environments, reliability of NPV & IRR is lost. Therefore, forecasts are made
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under different economic conditions like pessimistic, expected and optimistic. NPV is arrived at for all the three assumptions. Following steps are involved in sensitivity analysis: Identification of variables that influence the NPV & IRR of the project. Examining and defining the mathematical relationship between the variables. Analysis of the effect of the change in each of the variables on the NPV of the project. Solved Problem A company has two mutually exclusive projects under considerationproject A and project B. Each project requires an initial cash outlay of Rs.300000 and has an effective life of 10 years. The companys cost of capital is 12%. The forecast of cash flows made by the management is as shown in the table 9.7. What is the NPV of the project?
Table 9.7: Details of project A and B Economic Environment Pessimistic Expected Optimistic Project A Annual cash inflows 65, 000 75, 000 90, 000 Project B Annual cash inflows 25, 000 75, 000 1, 00, 000
Which project should the management consider? Given PVIFA = 5.650. Solution
Table 9.8: NPV of project A is as shown in table 9.6 Economic Project PVIFA PV of cash inflows NPV
Environment Pessimistic Expected Optimistic
Cash inflows 65000 75000 90000
At 12% for 10 years 5.650 5.650 5.650 367250 423750 508500 67250 123750 208500
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Table 9.9: NPV of project B
Pessimistic Expected Optimistic
25000 75000 100000
5.650 5.650 5.650
141250 423750 565000
158750 123750 265000
Solution 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. Thus, Project A is accepted Under expected conditions, both gave some positive NPV of Rs. 1, 23, 000. Any one of two may be accepted Under optimistic conditions Project B have a higher NPV of Rs 2, 65, 000 compared to that of As NPV of Rs 2, 08, 500 Difference between optimistic and pessimistic NPV for Project A is Rs. 1, 41,250 and for Project B the difference is Rs 4, 23, 750 Project B is risky compared to Project A, because the NPV range is of large difference Self Assessment Questions Fill in the blanks: 12. ________ analyse the changes in the project NPV on account of a given change in one of the input variables of the project 13. Examining and defining the mathematical relation between the variable of the NPV is _________________________ 14. Forecasts under sensitivity analysis are made under __________
9.6 Probability distribution approach

Net present value becomes more reliable when we incorporate the chances of occurrences of various economic environments. The chances of occurrences are expressed in the form of probability.
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Probability is the likelihood of occurrence of a particular economic environment. After assigning probabilities to future cash flows, expected net present value is computed. Solved Problem A company has identified a project with an initial cash outlay of Rs. 50, 000. The following distribution of cash flow as shown in table 9.10 gives the life of the project for three years.
Table 9.10: Life of the project for three years Year 1 Cash inflow 15, 000 18, 000 35, 000 32, 000 Probability 0.2 0.1 0.4 0.3 Cash inflow 20, 000 15, 000 15, 000 30, 000 Year 2 Probability 0.3 0.2 0.2 0.2 Cash inflow 25, 000 20, 000 20, 000 45, 000 Year 3 Probability 0.4 0.3 0.3 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
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Table 9.11 gives the complete illustration of the entire procedure

Table 9.11: Illustration of entire procedure Year 1 2 3 Expected cash inflows 28,400 24,00 28,500 PV of expected cash inflows PV of initial cash out-lay Expected NPV PV factor at 10% 0.909 0.826 0.751 PV of expected cash inflows 25,816 19,824 21,403 67,043 50,000 17,043
9.6.1 Variance A study of dispersion of cash flows of projects will help the management in assessing the risk associated with the investment proposal. Dispersion is computed by variance or standard deviation. Variance measures the deviation of each possible cash flow from the expected. Square root of variance is standard deviation.
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Solved Problem The details shown in the table 9.12 are related to a project which requires an initial cost of Rs. 50, 000.
Table 9.12: Details of a project Year 1 Economic conditions High growth Average growth No growth 2 High growth Average growth No growth 3 High growth Average growth No growth Cash flows 2,00,000 1,50,000 40,000 3,00,00 2,00,000 5,00,000 4,00,000 2,50,000 30,000 Probability 0.3 0.6 0.1 0.3 0.5 0.2 0.2 0.6 0.2
Discount rate is 10% Determine the NPV and the standard deviation for the respective years. Solution
Table 9.13: NPV for the first year Economic condition High growth Average growth No growth Cash inflow 2,00,000 1,50,000 40,000 Probability 0.3 0.6 0.1 Expected value Expected value of cash inflow 60000 90000 4000 1,54,000
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Table 9.14: NPV for the second year Economic condition High growth Average growth No growth Cash inflow 3,00,000 2,00,000 50,000 Probability 0.3 0.5 0.2 Expected value Table 9.15: NPV for the third year Economic condition High growth Average growth No growth Cash inflow 4,00,000 2,50,000 30,000 Profitability 0.2 0.6 0.2 Expected value Expected value of cash inflow 80,000 1,50,000 6,000 2,36,000 Expected value of cash inflow 90,000 1,00,000 10,000 2,00,000
Expected NPV =
154,000 2,00,000 2,36,000 , 5,00,000 1.10 (1.10) 2 (1.10)3
= 1, 40,000 + 1, 65, 289 + 1, 77, 310 5, 00,000= (17,401) negative NPV

Table 9.16: Standard deviation for the first year Cash inflow C 2,00,000 1,50,000 Expected value E 1,54,000 1,54,000 (C-E)
2
(C-E) probability
(46,000) (-4000)
(46000) 0.3=634,800,000 (-4000) 0.3=4,800,000

2
40,000
1,54,000
(-1,14,000)2 Total
(-1,14,000)2 0.3=3,898,800,000 4,538,400,000
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Standard deviation of cash flows for one year= 67,368

Table 9.17: Standard deviation for the second year Cash inflow C 30,000 20,000 50,000 Expected value E 2,00,000 2,00,000 2,00,000 (C-E)
2
(C-E) probability
(1,00,000) (0)
2
(1,00,000) 0.3=3,000,000,000 (0) 0.5=0

2
(-1,50,000) Total
(-1,50,000) 0.2=4,500,000,000 7,500,000,000
Variance of cash flows for 2nd year = 7,500,000,000 Standard deviation of cash flow for 2nd year = 86,603
Table 9.18: Standard deviation for third year Cash inflow C 4,00,000 2,50,000 30,000 Expected value E 2,36,000 2,36,000 2,36,000 (C-E)
2
(C-E) probability
(1,64,000) (14,000)
2
(1,64,000) 0.2=5,379,200,000 (14,000) 0.6=117,600,000

2
(-2,00,000) Total
(-2,00,000) 0.2=8,000,000,000 13496800000
Variance of cash flows for the 3rd year=13496800000 Standard deviation of cash flows for the third year=116175 Standard Deviation of NPV
NPV
( 44091) 2 (1.10) 2
(8660 ) 2 (1.10) 4
(11.6175 ) 2 (1.10 ) 6
1606625026 51223004 7618496131

9276344161
= 96314
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Variance of cash flows for the 3rd year=13496800000 Standard deviation of cash flows for the third year=116175 Standard Deviation of NPV
NPV
( 44091) 2 (1.10) 2
(8660 ) 2 (1.10) 4
(11.6175 ) 2 (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
NPV 44091 8660 116175 2 1.10 (1.10) (1.10)3
= 40083 + 7157 + 87284 = 134524 The standard deviation of NPV when cash flows are perfectly correlated will be higher than under the situation of independent cash flows. Self Assessment Questions Fill in the blanks: 15. Probability distribution approach incorporates the probability of occurrences of various economic environment, to make the NPV ________. 16. _______ is likelihood of occurrence of a particular economic environment.
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9.7 Decision tree approach

Many project decisions are complex investment decisions. Such complex investment decisions involve a sequence of decisions over time. Decisions tree can handle the sequential decisions of complex investment proposals. The decision of taking up an investment project is broken into different stages. At each stage the proposal is examined to decide whether to go ahead or not. The multi stages approach can be handled effectively with the help of decision trees. A decision tree presents graphically the relationship between Present decision and future events Future decisions and the consequences of such decisions Case Study 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 takes six months. Management believes that there is a 70% chance that the pilot production and test marketing will be successful. If a successful company can build a plant costing Rs 200 million. The plant will generate annual cash inflow of Rs 50 million for 20 years if the demand is high or an annual cash inflow of 20 million if the demand is low. High demand has a probability of 0.6 and low demand has a probability of 0.4 with a cost of capital of 12%. Suggest the optimal course of action using decision tree analysis (Bangalore University MBA, adapted).
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D11 pilot
Carry out D21 Investment Rs.200 million C

2
High Demand Probability 0.6 C21 Annual Cash inflow Rs.50 million Annual Cash inflow Rs.20 million D22 Stop D3 C22 Low Demand Probability 0.4
Production C11 And Market Success test (20 million) 0 . C 7 D 1

C12
D2
D12 Nothing
Do 0.3
failure Probability
D31 Stop
Working Notes: From right hand side of the decision tree Step 1: Computation of Expected Monetary Value at point C2. Here EMV represents expected NPV.
Table 9.19: Computation of expected monetary value at point C2 Cash in flow 50 20 Probability 0.6 0.4 EMV Expected value of cash inflows 38 8 38
Present Value of EMV = Expected value of cash inflow x PVIFA (12% 20) 38 x 7.469 = Rs 283.82 million Step 2
Table 9.20: Computation of EMV at decision point D2 Decision taken D2 D 22 Consequences Invest Rs.200 million Stop The resulting EMV at this level 283.82-200=83.82 million 0
Here the decision criterion is select the EMV with the highest value. Step 3 Therefore EMV with Rs.83.82 million will be considered therefore; we select the decision taken at D2,
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Table 9.20 Computation of EMV at decision point D2 Decision taken D2 D 22 Consequences Invest Rs.200 million Stop The resulting EMV at this level 283.82-200=83.82 million 0
Here the decision criterion is select the EMV with the highest value. Step 3 Therefore EMV with Rs.83.82 million will be considered therefore; we select the decision taken at D2, Step 4
Table 9.21: Computation of EMV at point C EMV 83.82 0 Probability 0.7 0.3 Expected value 58.67 0
Step 5
Table 9.22: Computation of EMV at point D Decision taken D 11 carry out pilot production and market test D 12 Do nothing Consequences Invest 20 million The resulting EMV at this level 58.67-20= Rs.38.67 million 0 38.67 million (Apply the EMV criterion) i.e. select the EMV with the highest value
0 EMV at this stage
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Their optimal strategy is: Carry out pilot production and market test 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 If the result of pilot production and market test is a failure, stop the investment and production
9.7.1 Evaluation of Decision tree approach The evaluation of decision tree approach leads to the following assumptions Decision tree approach portrays inter related, sequential and critical multi dimensional elements of major project decisions Adequate attention is given to the critical aspects in an investment decision which spread over a time sequence Complex projects involve huge out lay and hence are risky. There is the need to define and evaluate scientifically the complex managerial problems arising out of the sequence of interrelated decisions with consequential outcomes of high risk. It is effectively answered by decision tree approach Structuring a complex project decision with many sequential investment decisions demands effective project risk management. This is possible only with the help of an analytical tool like decision tree approach Ability to eliminate unprofitable outcomes helps in arriving at optimum decision stages in time sequence Self Assessment Questions Fill in the blanks: 17. Decision tree can handle the _____________ of complex investment proposals 18. _____ portrays inter-related, sequential and critical multi dimensional elements of major project decisions 19. Adequate attention is given to the ______ in an investment decision under decision-tree approach 20. ____________ are effectively handled by decision-tree approach
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9.8 Summary
Risk in project evaluation arises on account of the inability of the firm to predict the performance of the firm with certainty. Risk in capital budgeting decision may be defined as the variability of actual returns from the expected. There are many factors that affect forecasts of investment, costs and revenues of a project. It is possible to identify three types of risk in any project-stand-alone risk, corporate risk and market risk. The sources of risks are: Project Competition Industry International factors and Market The techniques for incorporation of risk factor in capital budgeting decision could be grouped into conventional techniques and statistical techniques.

1. Define risk. Examine the need for assessing the risks in a project. 2. Examine the type and sources of risk in capital budgeting . 3. Examine risk adjusted discount rate as a technique of incorporating risk factor in capital budgeting. 4. Examine the steps involved in sensitivity analysis. 5. Examine the features of Decision-tree approaches.

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. Stand-alone risk. Beta Diversify International risk Additional return Risk free rate, risk premium Greater Risk - adjustment factor
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9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.
Risk free rate of interest Conservation CE Sensitivity analysis One of the steps of sensitivity analysis Different economic conditions More reliable Probability Sequential decisions Decision tree Critical aspects Complex projects
Answers to Terminal Questions 1. 2. 3. 4. 5. Refer to 9.1 Refer to 9. 2 Refer to 9.3 Refer to 9.5 Refer to 9.7
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Unit 10
Capital Rationing
Structure: 10.1 Introduction Learning Objectives 10.2 Meaning of Capital Rationing 10.3 Types of Capital Rationing 10.4 Steps Involved in Capital Rationing 10.5 Various Approaches to Capital Rationing 10.6 Summary 10.7 Example of Capital Rationing 10.8 Terminal Questions 10.9 Answers to SAQs and TQs
10.1 Introduction
Capital budgeting decisions involve huge outlay of funds. Funds available for projects may be limited. Therefore, a firm has to prioritise the projects on the basis of availability of funds and economic compulsion of the firm. It is not possible for a company to take up all the projects at a time. There is the need to rank them on the basis of strategic compulsion and funds availability. Since companies will have to choose one from among many competing investment proposals, the need to develop criteria for capital rationing cannot be ignored. The companies may have many profitable and viable proposals but cannot execute them because of shortage of funds. Another constraint is that the firms may not be able to generate additional funds for the execution of all the projects. When a firm imposes constraints on the total size of the firms capital budget, it requires capital rationing. When capital is rationed, there is a need to develop a method of selecting the projects that could be executed with the companys resources yet giving the highest possible net present value. 10.1.1 Learning Objectives After studying this unit, you should be able to: Describe the meaning of capital rationing
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Recognise the need for capital rationing Explain the process of capital rationing Describe the various approaches to capital rationing
10.2 Meaning of Capital Rationing

Firms may have to make a choice from among profitable investment opportunities, because of the limited financial resources. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control. Capital rationing may be needed due to: External factors Internal constraints imposed by management
Figure 10.1: Reasons for capital rationing
External capital rationing External capital rationing is due to the imperfections of capital market. Imperfections are caused mainly due to: Deficiencies in market information Rigidities that hamper the force flow of capital between firms When capital markets are not favourable to the company, the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing: The inability of the firm to procure required funds from capital market because the firm does not command the required investors confidence
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National and international economic factors may make the market highly volatile and unstable Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds High cost of issue of securities i.e. high floatation costs. Smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital market for funds
Internal capital rationing Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects. Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the managements expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control. The various factors relating to the internal constraints imposed by the management are (see figure 10.2) Private owned company, Divisional constraints, Human resource limitations, Dilution and Debt constraints.
Figure 10.2: Internal constraints Sikkim Manipal University Page No. 215
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Private owned company Under internal constraint, the management of the firms might decide that expansion of the company might be a problem and not worth taking. This kind of condition arises only when the management of a firm fears losing the control in the company. Divisional constraints Another constraint might lead to the allocation of fixed amount for each division in a firm by the upper management. This procedure can also be considered as an overall corporate strategy. These situations arise mainly from the point of view of a department. The cost of capital or the cost structure of the management, the budget constraints imposed by the senior officials or decisions coming from the head-office and wholly owned subsidiary decisions relate to the internal constraints. Human Resource limitations The management of the firm or the company should see that excessive labour is being used for the project. Lack of proper man-power can become an internal constraint. Dilution Dilution refers to the dilution of the company. This constraint occurs mainly when a reluctance in the issuing of further equity takes place, due to the fear of management losing the control over the company. Debt constraints Debt constraints also constitute to the internal constraints in capital rationing. This constraint occurs mainly due to the issue of earlier debt which prohibits the issue of debts in the firm up-to a certain level.
These are the methods by which various factors are effecting the capital rationing of a particular firm or a management. Let us now look at the different types of capital rationing in the following topic.
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Self Assessment Questions Fill in the blanks: 1. When a firm imposes constraints on the total size of its capital budget, it is known as _____________. 2. Internal capital rationing is used by a firm as a ____________________. 3. Rigidities that affect the free flow of capital between firms cause _________________. 4. Inability of a firm to satisfy the regularity norms for issue of equity shares for tapping the market for funds causes __________________. 5. The various internal constraints for capital rationing are _____, ________, ____, _____ and ________. 6. Lack of ____ will become a huge failure and also an essential effect of internal constraint. 7. The reasons for capital rationing are _______ and ________.
10.3 Types of Capital Rationing

Now let us discuss the various types of capital rationing effecting the management of a firm. There are basically two types of capital rationing (see figure 10.3): Hard capital rationing Soft capital rationing
Figure 10.3: Types of capital rationing
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Hard capital rationing Hard capital rationing is defined as the capital rationing that under no circumstances can be violated. Hard capital rationing also refers to the companies acting external to the firms, which will not supply enough amount of investment capital, though having positive NPV projects. Hard capital rationing does not occur under perfect market. Soft capital rationing Soft capital rationing is defined as the circumstances under which the constraints on spending can be violated. Soft capital rationing refers to or arises with the internal, management-imposed limits on investment expenditure.
10.4 Steps involved in Capital Rationing

In the above topic we have discussed about the different types of capital rationing. Now let us look at the different steps involved in capital rationing. The following are the steps involved in capital rationing (see figure 10 .4). Ranking of different investment proposals Selection of the most profitable investment proposal
Figure 10.4: Steps involved in capital rationing
Ranking of different investment proposals means the various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the descending order. Net present value method recognises the time value of money. Net present value correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is a need to find out the present
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values of all the cash flows. NPV can be represented with the following formula. Net present value = present value of cash inflows - present value of cash outflows Profitability index is also known as benefit cash ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows.
Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the net present value of any project equal to zero. Internal rate of return is the rate of interest which equates the present value (PV) of cash inflows with the present value of cash outflows. IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns. IRR can be determined by solving the following equation for r = CF0
Ct (1 r ) t
where t = 1 to n
CF0 = Investment Profitability Index as the Basis of Capital Rationing Let us now discuss a Caselet regarding the concept of profitability index as the basis of capital rationing. The profitability index is calculated in the following Caselet based on the capital rationing factors per annum and the ranking is given according to the most preferable investment proposal.
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Solved Problem The details shown in table 10.1 describes the cash inflows of three projects. Compute the NPV and profitability index of all the three projects and rank them as the basis of capital rationing:
Table 10.1: Details of the projects Cash Inflows Project A B C Initial Cash outlay 1,00,000 50,000 50,000 Year 1 60,000 20,000 20,000 Year 2 50,000 40,000 30,000 Year 3 40,000 20,000 30,000
Cost of Capital is 15 % Solution Computation of NPV is as shown in table 10.2

Table 10.2: Computation of NPV Year 1 2 3 Cash in flows 60,000 50,000 40,000 PV factor at 15% 0.870 0.756 0.658 PV of Cash inflow Initial Cash out lay NPV PV of Cash in flows 52,200 37,800 26,320 1,16,320 1,00,000 16,320
Profitability index =
PV of Cash inf low s PV of Cash outflow s

116,320 , 1.1632 100,000 ,
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Table 10.3: Project B Year 1 2 3 Cash in flows 20,000 40,000 20,000 PV factor at 15% 0.870 0.756 0.658 PV of cash inflow Initial cash out-lay NPV PV of Cash inflows 17,400 30,240 13,160 60,800 50,000 10,800
60,800 1.216 50,000

Table 10.4: Project C
Year 1 2 3
Cash inflows 20,000 30,000 30,000
PV factor at 15% 0.870 0.756 0.658 PV of Cash inflow Initial Cash out lay NPV
PV of Cash inflows 17,400 22,680 19,740 59,820 50,000 9,820
59,820 1.1964 50,000
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Table 10.5: Ranking of Projects Project Absolute A B C 16320 10800 9820 NPV Rank 1 2 3 Profitability Index Absolute 1.1632 1.216 1.1964 Rank 3 1 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 and 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 maximise NPV per rupee of capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis of ranks assigned by profitability index. Let us consider another caselet discussing about the profitability index as the basis of capital rationing.
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Solved Problem The details shown in table 10.6 describes the cash inflows of three projects. Compute the NPV and profitability index of all the three projects and rank them as the basis of capital rationing.
Table 10.6: Details of a firm Cash Inflows Project A B C Initial Cash outlay 1,00,000 60,000 30,000 Year 1 50,000 30,000 10,000 Year 2 40,000 50,000 20,000 Year 3 30,000 10,000 20,000
Cost of Capital is 15 % Solution

Table 10.7: Computation of NPV Year 1 2 3 Cash in flows 70,000 40,000 30,000 PV factor at 15% 0.870 0.756 0.658 PV of Cash inflow Initial Cash out lay NPV PV of Cash in flows 60,870 30,250 19,730 1,10,850 1,00,000 10,850
PV of Cash inf low s PV of Cash outflow s

110,850 , 1.1085 100,000 ,
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Table 10.8: Project B Year 1 2 3 Cash inflows 30,000 50,000 10,000 PV factor at 15% 0.870 0.756 0.658 PV of cash inflow Initial cash out-lay NPV PV of Cash inflows 26,100 37,800 6,580 70,480 60,000 10,480
70,480 1.175 60,000

Table 10.9: Project C PV factor at 15% 0.870 0.756 0.658 PV of Cash inflow Initial Cash out lay NPV PV of Cash inflows 8,700 15,120 13,150 36,970 30,000 6,970
Year 1 2 3
Cash inflows 10,000 20,000 20,000
36,970 1.232 30,000

Table 10.10: Ranking of Projects NPV Profitability Index Rank 1 2 3 Absolute 1.1085 1.175 1.232 Rank 3 2 1
Project Absolute A B C 10850 10480 6970
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.
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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 and C cannot be taken up for execution by the firm. It will increase the net wealth of the firm by Rs.10,850. 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.60,000 and Rs.30,000. Therefore, with the execution of projects B and C, increase in net wealth of the firm will be 10480 + 6970 = Rs17450. The objective in the above explained caselet is to maximise NPV per rupee of capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis of ranks assigned by profitability index. Selection of the most profitable investment proposal After ranking the different investment proposals based on their net present value, profitability index and the internal rate of return, the selection of the most profitable investment proposal is to be done. The selection is done mainly in a view to select the investment proposal which earns more profits than compared to the other proposals. The basic features to be taken under consideration during the selection of the most profitable investment proposal are: The proposal should have the potentiality of making large anticipated profits The proposal should involve high degree of risk The proposal should involve a relatively long time-period between the initial outlay and the anticipated return
Evaluation of the selection procedure PI rule of selecting projects under capital rationing may not yield satisfactory result because of project indivisibility. When projects involving high investment is accepted many small projects will have to be excluded. But the sum of the NPVs of small projects to be accepted may be higher than the NPV of a single large project
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Capital rationing also suffers from the multi-period capital constraints
10.5 Various Approaches to Capital Rationing

There are various approaches to analyse capital rationing, but here we will mainly deal with the programming approach. Programming approach There are many programming techniques of capital rationing. Among them are Linear programming and Integer programming (see figure 10.5)
Figure 10.5: Programming approach
Linear programming Linear programming (LP) approach to capital rationing tries to achieve maximum NPV subject to many constraints. Here the objective function is maximisation of sum of the NPVs of the projects. Here the constraints matrix incorporates all the restrictions associated with capital rationing imposed by the firm. Caselet Let us consider a wine production problem and try to solve using linear programming approach. A firm, has decided to produce two types of wine (X and Y), to sell to the local shops. Now the firm should know the profit figures for each type. The firm should know the requirements of each type of wine in terms of their ingredients, namely, grapes, sugar and extract. When the firm gets to know the constraints on these ingredients, it should be in a position to know the best way to proceed. In this way the firm should obtain information on how to use the resources to maximise profit.
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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. Merits of programming approach Programming approach provides information on dual variables Programming approach also gives information on shadow prices of budget constraints Dual variables provide information for decision on transfer of funds from one year to another year Demerits of programming approach They are costly to use when large, indivisible projects are being examined They are deterministic models The variables of capital budgeting are subjected to change, making the assumption of deterministic highly invalid
Self Assessment Questions Fill in the blanks: 8. The two steps involved in capital rationing are __________ and __________________. 9. Project indivisibility can lead to sub optimal result when ____________ is used for capital rationing. 10. Objective function under linear programming approach is ___________. 11. When project are not divisible ______________ can be employed to avoid the changes of accepting fraction of a project. 12. The programming techniques of capital rationing are ______ and ____________. 13. The selection is done mainly in the view that which investment proposal earns __________than compared to the other proposals. 14. The proposal should have the potentiality of making large ____________.
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10.6 Summary
Often, firms are forced to ration the funds among the eligible projects that the firm wants to take up. The inability of the firm in finding adequate funds for execution of the projects could be due to many factors. It may be due to external factors or internal constraints imposed by the management. External capital rationing occurs mainly because of imperfections in capital markets. Internal capital rationing is caused by restrictions imposed by the managements.
10.7 Example of Capital Rationing

Financing public hospitals Capital rationing technique is an essential requirement in the case of public hospitals. Funding public hospitals is essentially required to meet the requirements of the residents and to provide efficient treatment to the residents. Funding public hospitals also meets the requirements of hospitals like getting latest equipments for better treatment of the residents. Furthermore, the number of alternatives available is small enough that each alternative can be thoroughly investigated and traditional capital markets can be used to acquire the necessary requirements or the resources. Many of these conditions do not apply to the public hospitals. The government introduces many policies or funds in respect to the development of public hospitals, but very rarely these policies get implemented. New projects, when finished, must compete with the existing facilities for a limited supply of operating funds. So the commission should look for the technique to screen the proposals submitted by the hospitals get approved, while the unneeded proposals could be rejected. Over 8,000,000 residents come under or relate to the public hospitals. Over 200 active treatment and chronic hospitals of all types (proprietary, voluntary and religiously affiliated) except long time psychiatric hospitals fall under its sphere of influence in a manner analogous to a franchise system. No readily available output measure adequately reflects the operation of this social welfare system.
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The government introduces many policies or funds in respect to the development of public hospitals, but very rarely these policies get implemented. New projects, when finished, must compete with the existing facilities for a limited supply of operating funds. So the commission should look for the technique to screen the proposals submitted by the hospitals get approved, while the unneeded proposals could be rejected.
Criteria of a Finance Manager We generally know from various units discussed under finance management that rate of return on the intermediate cash flows is equal to the riskadjusted discount rate. However in many situations the two rates are different. In this unit we have discussed that Net present value and the Profitability index are used in ranking of the proposed projects, but this technique is found incorrect in many situations. Another problem is that in the present business scenario, finance managers would prefer to use internal rate of return for ranking the proposed projects, although ranking by Net present value is theoretically superior. The reason behind the finance manager considering Internal rate of return rather than the Net present value, may be that the rate of return gives the finance manager a clear idea about the proposal than compared to the net present value. For example, we consider NPV in dollars whereas rate of return in percentages. The value in percentages gives more clear idea to the finance manager rather than the value in dollars. Theoretically, a company should be able to obtain the financing for all the acceptable projects (NPV>0). However, in reality all companies practice capital rationing. The objective of capital rationing is to maximise NPV per rupee of capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis of ranks assigned by profitability index. Obviously when one project is allowed by the budget, the NPV criterion is appropriate. However, when two or more projects are allowed, the NPV criterion might fail to serve that purpose because it does-not consider the investment size at the same time.
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For example, when the company is in the business of a single line of products (e.g., computer hardware) and the project is to expand the production and sales (in the same market) of the line of products, then risk adjusted discount rate (RADR) will be equal to normal rate of return (k), as the risks are the same. Thus the financing of the project and future projects is consistent with the target capital structure of the company. The actual rate of return on the project may be different from the Risk adjusted discount rate (RADR), as the expansion of business may be more efficient or less efficient than the current business. Concerning r and RADR, r is the actual rate (not required rate) of return on the cash flows. Even if the reinvestment has the same risk as the project, r is not necessarily equal to RADR. Thus a finance manager considers all the situations and scenario and depends only on the Internal rate of return in ranking the projects rather than going for Net present value and Profitability index.

1. Examine the need for capital rationing 2. Examine the reasons for external capital rationing 3. Internal capital rationing is used by firms for exercising financial control How does a firm achieve this? 4. Brief explain the process of capital rationing

Answers to Self Assessment Questions 1. 2. 3. 4. 5. Capital rationing Means of financial control External capital rationing External capital rationing Private owned company, Divisional constraints, Human resource limitations, Dilution and Debt constraints 6. Lack of man-power
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7. External constraints and internal constraints imposed by the management 8. Ranking the project, selection of the most profitable investment proposal 9. Profitability index 10. Maximisation of sum of NPVs of the projects 11. Integer programming 12. Linear programming and integer programming 13. More profits 14. Anticipated profits Answers to Terminal Questions 1. 2. 3. 4. Refer to 10.1 Refer to 10.1 Refer to 10.1 Refer to 10.3
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Unit 11
Unit 11
Working Capital Management
Structure: 11.1 Introduction Learning Objectives 11.2 Components of Current Assets and Current Liabilities 11.3 Concepts of Working Capital Gross working capital Net working capital 11.4 Objective of Working Capital Management 11.5 Need for Working Capital 11.6 Operating Cycle 11.7 Determinants of Working Capital 11.8 Estimation of Working Capital Estimation of current assets Estimation of current liabilities 11.9 Summary 11.10 Terminal Questions 11.11 Answers to SAQs and TQs
11.1 Introduction
Working capital is defined as the excess of current assets over current liabilities and provisions. It is that portion of asset of a business which is used frequently in current operations and in the operating cycle of the firm. Inadequacy or mismanagement of working capital is the leading cause of many business failures. A financial manger, therefore, spends a larger part of his time in managing working capital. There are two important elements to be considered under the working capital management: Decisions on the amount of current assets to be held by a firm for efficient operations of its business Decisions on financing working capital requirement
The need for proper management of working capital management is even more important in the modern era of information technology. In support of the above argument, let us consider the performance of Dell computers as reported in one of the recent Fortune articles. A perusal of the article will
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give you an insight into how Dell could use the technology for improving the performance of components of working capital. Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and dealers Outsourcing on operations, if the firms competence does not permit the performance of the operation effectively Training the employees to accept change Introducing to internet business Releasing capital by reduction in investment in inventory for improving the profitability of operating capital
11.1.1 Learning Objectives After studying this unit, you should be able to: Explain the meaning, definition and various concepts of working capital State the objectives of working capital management Recognise the importance of working capital management Estimate the process of working capital
11.2 Components of Current Assets and Current Liabilities

Working capital management is concerned with managing the different components of current assets and current liabilities. The following are the components of current assets: Inventories Sundry debtors Bills receivables Cash and bank balances Short-term investments Advances such as advances for purchase of raw materials, components and consumable stores and pre-paid expenses
The components of current liabilities are: Sundry creditors Bills payable Creditors for out-standing expenses
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Provision for tax Other provisions against the liabilities payable within a period of 12 months
A firm must have adequate working capital, neither excess nor inadequate. Maintaining adequate working capital is crucial for maintaining the competitiveness of a firm. Any lapse of a firm on this account may lead a firm to the state of insolvency. Self Assessment Questions Fill in the blanks: 1. Maintaining adequate working capital at the satisfactory level is very crucial for ___________ and _______ of a firm. 2. Pre-paid expenses are __________. 3. Provision for tax is____________. 4. A firm must have _________ neither excess nor shortage. 5. List any two components of current assets. 6. List any two components of current liabilities.
11.3 Concepts of Working Capital

The four most important concepts of working capital are (see figure 11.1) Gross working capital, Net working capital, Temporary working capital and Permanent working capital.
Figure 11.1: Concepts of working capital
Gross working capital Gross Working Capital refers to the amounts invested in various components of current assets. This concept has the following practical relevance.
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Management of current assets is the crucial aspect of working capital management Gross working capital helps in the fixation of various areas of financial responsibility Gross working capital is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets The need to plan and monitor the utilisation of funds of a firm demands working capital management, as applied to current assets
Net working capital Net working capital is the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance. Net working capital indicates the ability of the firm to effectively use the spontaneous finance in managing the firms working capital requirements A firms 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 firms business. This minimum level of current assets has been given the name of core current assets by the Tandon Committee. Permanent working capital is also known as fixed working capital. Temporary Working Capital Temporary working capital is also known as variable working capital or fluctuating working capital. The firms working capital requirements vary depending upon the seasonal and cyclical changes in demand for a firms products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital.
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Self Assessment Questions Fill in the blanks: 7. _______________ refers to the amounts invested in current assets. 8. To _______ and monitor the utilisation of funds of a firm ________________________ is to be given top priority.
9. When current assets exceed current liabilities the net working capital is _____. 10. Permanent working is called ____ working capital.
11.4 Objective of Working Capital Management

The objective of financial management is maximising the net wealth of the shareholders. A firm must earn sufficient returns from its operations to ensure the realisation of this objective. There exists a positive co-relation between sales and firms return on its investment. The amount of earnings that a firm earns depends upon the volume of sales achieved. There is the need to ensure adequate investment in current assets, keeping pace with accelerating sales volume. Firms make sales on credit. There is always a time gap between sale of goods on credit and the realisation of earnings of sales from the firms customers. Finance manger of a firm is required to finance the operation during this time gap. Therefore, objective of working capital management is to ensure smooth functioning of the normal business operations of a firm. The firm has to decide on the amount of working capital to be employed. The firm may have a conservative policy of holding large quantum of current assets to ensure larger market share and to prevent the competitors from snatching any market for their products. However such a policy will affect the firms returns on its investment. The firm will have returns higher than the required amount of investment in current assets. This excess funds locked in current assets will reduce the firms profitability on operating capital.
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On the other hand a firm may have an aggressive policy of depending on spontaneous finance to the maximum extent. Credit obtained by a firm from its suppliers is known as spontaneous finance. Here a firm will try to reduce its investments in current assets as much as possible but checks that they are not affecting the firms ability to meet working capital needs for sales growth targets. Such a policy will ensure higher return on its investment as the firm will not be locking in any excess funds in current assets. However, any error in forecasting can affect the operations of the firm unfavourably if the error is fraught with the down side risk. There is also another risk of firm losing on maintaining its liquidity position. Objective of working capital management is achieving a tradeoff between liquidity and profitability of operations for the smooth conduct of normal business operations of the firm. Self Assessment Questions Fill in the blanks: 11. Objective of working capital management is achieving a trade-off between _________ and _____________. 12. Credit obtained by a firm from its suppliers is known as _______. 13. An aggressive policy of working capital management means depending on _________ to the maximum extent. 14. To prevent the competitors from snatching any market for their products the firm may have ___________ a policy of holding _______ of current assets.
11.5 Need for Working Capital

The need for working capital arises on account of two reasons: To finance operations during the time gap between sale of goods on credit and realisation of money from customers of the firm To finance investments in current assets for achieving the growth target in sales Therefore to finance the operations in operating cycle of a firm, working capital is required. In the next section, we will know more about the operating cycle of the firm.
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Self Assessment Questions Fill in the blanks: 15. 16. To finance the operations in _______ of a firm working capital is required. To finance operations during the time gap between _______ and ________ time gap is required.
11.6 Operating Cycle

The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle Operating cycle of a firm involves the following elements. Acquisition of resources from suppliers Making payments to suppliers Conversion of raw materials into finished products Sale of finished products to customers Collection of cash from customers for the goods sold The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle. Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods. Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements. Operating cycle = IC period + RC period IC period = Inventory conversion period RC period = Receivables conversion period
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Inventory conversion period is the average length of time required to produce and sell the product. Inventory Conversion period =
Average Inventory 365 Annual Cost of goods sold
Receivables conversion period is the average length of time required to convert the firms receivables into cash. Receivables conversion period =
Average Accounts Re ceivables 365 Annual Sales
Accounts payables period is also known as payables deferral period. Average Creditors Accounts payables period = Purchases per day (Payables deferral period) Purchases per day =
Total Purchases for year 365
Cash conversion cycle is the length of time between the firms actual cash expenditure and its own cash receipt. The cash conversion cycle is the average length of time a rupee is tied up in current assets. Cash Conversion Cycle is CCC = ICP + RCP PDP CCC = Cash Conversion Cycle ICP = Inventory Conversion Period RCP = Receivables Conversion Period PDP = Payables deferral period
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Solved Problem The following details shown in table 11.1 gives the complete details of sales and costs of the goods produced by XYZ ltd for the year 31.03.08.
Table 11.1: Sales and costs produced by XYZ ltd. Sales Cost of goods 80,000 56,000 Inventory 31.03.07 31.03.08 Accounts Receivables 31.03.07 31.03.08 Accounts Payable 31.03.07 31.03.08 7,000 10,000 12,000 16,000 9,000 12,000
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 From the above formula we need to first calculate the individual conversion periods. Inventory conversion period
Average Inventory 365 Annual Cost of goods sold
(9000 12000 ) / 2 365 56000
10500 365 68.4 days 56000 Receivables Conversion Period Average Accounts Re ceivables 365 = Annual Sales
( 12000 16000 ) / 2365 63.9 days 80000

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Payables Conversion Period Average Accounts Payables = 365 Annual Cost of goods sold
(7000 10000 ) / 2 365 56000 8500 365 55.4 days 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 firms 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 Questions Fill in the blanks: 17. 18. 19. 20. The time gap between acquisition of resources from suppliers and collection of cash from customers is known as ______. ___________ is the average length of time required to produce and sell the product. __________ is the average length of time required to convert the firms receivables into cash. _________ conversion cycle is the length of time between firms actual cash expenditure and its own receipt.
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11.7 Determinants of Working Capital

A large number of factors influence working capital needs of a firm. The basic objective of a firms working capital management is to ensure that the firm has adequate working capital for its operations, neither too much nor too little. Investing heavily in current assets will drain the firms earnings and inadequate investment in current assets will reduce the firms credibility as it affects the firms liquidity. Therefore, the need to strike a balance between liquidity and profitability cannot be ignored. The following factors determine a firms working capital requirements (see figure 11.2) Nature of business: Working Capital requirements are basically influenced by the nature of business of the firm. Trading organisations are forced to carry large stocks of finished goods, accounts receivables and accounts payables. Public utilities require lesser investment in working capital. Size of business operation: Size is measured in terms of a scales of operations. A firm with large scale of operation normally requires more working capital than a firm with a low scale of operation. Manufacturing cycle: Capital intensive industries with longer manufacturing process will have higher requirements of working capital because of the need to run their sophisticated and long production process.
Figure 11.2: Factors determining working capital Sikkim Manipal University Page No. 242
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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 has to effectively handle the problem of production planning and control associated with utilisation of installed plant capacity under conditions of varying volumes of production of products of seasonal demand. Volume of sales: There is a positive direct correlation between the volume of sales and the size of working capital of a firm. Term of purchase and sales: A firm which allows liberal credit to its customers will need more working capital than that of a firm with strict credit policy. A firm which enjoys liberal credit facilities from its suppliers requires lower amount of working capital when compared to a firm which does not have such a facility. Operating efficiency: The firm with high efficiency in operation can bring down the total investment in working capital to lower levels. Here effective utilisation of resources helps the firm in bringing down the investment in working capital. Price level changes: Inflation affects the working capital levels in a firm. To maintain the operating efficiency under an inflationary set up, a firm should examine the maintenance of working capital position under constant price level. The financial capital maintenance demands a firm to maintain higher amount of working capital keeping pace with rising price levels. Under inflationary conditions same levels of inventory will require increased investment. The ability of a firm to revise its products prices with rising price levels will decide the additional investment to be made to maintain the working capital intact. Business Cycle: During boom, sales rise as business expands. Depression is marked by a decline in sale. During boom, expansion of business can be achieved only by augmenting investment in various assets that constitute working capital of a firm. When there is a decline in business on account of depression in economy, inventory glut forces
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a firm to maintain working capital at a level far in excess of the requirements under normal conditions. Processing technology: Longer the manufacturing cycle, the larger is the investment in working capital. When raw material passes through several stages in the production, process work in process inventory will increase correspondingly. Fluctuations in the supply of raw materials: Companies which use raw materials available only from one or two sources are forced to maintain buffer stock of raw materials to meet the requirements of uncertainty in lead time Such firms normally carry more inventory than it would have had the materials been available in normal market conditions.
Self Assessment Questions Fill in the blanks: 21. Capital intensive industries require _________ amount of working capital. 22. There is a __________ between volume of sales and the size of a working capital of a firm. 23. Under inflationary conditions same level of inventory will require __________ investment in working capital. 24. Longer the manufacturing cycle, ________ the investment in working capital.
11.8 Estimation of Working Capital

The approach to estimate a working capital is based on an operation cycle. Operation cycle comprises of two important components of working capital (see figure 11.3) Current assets and Current liabilities
Figure 11.3: Components of working capital Sikkim Manipal University Page No. 244
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Estimation of working capital is based on the assumption that production and sales occur on a continuous basis and all costs occur accordingly. Estimation of Current Assets Current assets are estimated based on the following assumptions: Average investment in raw material is estimated Average investment in work-in-progress inventory is estimated Average investment in finished goods inventory is estimated Average investment in receivables (both in debtors and bills receivables) is estimated based on credit policy that the firm wishes to pursue Based on the firms attitude towards risk, access to borrowing sources, past experience and nature of business, firms decide on the policy of maintaining the minimum cash balances Estimation of Current Liabilities Current liabilities are estimated based on the following factors Trade creditors, Direct wages and Overheads (see figure 11.4).
Figure 11.4: Estimation of current liabilities
Trade creditors The average amount of financing available to the firm is estimated based on the production budget, raw material consumption and the credit period enjoyed from suppliers. Direct wages Estimation is made on total wages, to be paid on average basis, based on production budget, direct labour cost per unit and average time-lag in payment of wages.
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Overheads Estimation on an average basis of the outstanding amount to be paid to the creditors for overhead is estimated based on production budget, overhead cost per unit and average time-lag in payment of overhead. Solved Problem A pro-forma cost sheet of a company provides the following details as shown in table 11.2.
Table 11.2: Pro-forma sheet Raw material Direct labour Overheads Total cost Profit Selling price 52.00 19.50 39.00 110.50 19.50 130.00
The following additional information is also available: Average raw material in stock: One month Average materials in process: Half a month Credit allowed by Suppliers: One month Credit allowed to debtors: Two months Time lag in payment of wages: one and a half weeks Time lag in payment of overheads: one month One-fourth of sales on cash basis 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-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 52 RMCP 30 303333 .33 360 360
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2. Work in process inventory

COP 70000 110.5 WIIPCP 15 322291 .67 360 360
3. Finished goods inventory
COS 70000 110.5 30 FGCP 644583.33 360 360

b. Investment in debtors
Cost of Credit Sales 52500 110.5 DCP 60 966875 .00 360 360
c. Cash balance d. Total current Asset (A + B + C) e. Current Liabilities 1. Creditors Purchase of raw materials PDP 360 5230 70000 303333 .33 360 2. Wages
120000 2357083.33
70000
19.5 10 37916.67 360

39 30 227500.00 360
3. Overheads
70000
Total Current Liabilities = 568750.00 Net working Capital (D F) = 1788958.33
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Solved Problem The following annual figures as shown in table 11.3, are regarding the sales and production of the company XYZ ltd.
Table 11.3: Annual figures of XYZ ltd Sales (at two months credit) Materials consumed (suppliers extend two months credit) Wages paid (monthly in arrears) Manufacturing expenses outstanding at the end of the year(cash expenses are paid one month in arrears) Total administrative expenses paid, as above Sales promotion expenses, paid quarterly in advance Rs. 36,00,000 Rs. 9,00,000 Rs. 7,20,000 Rs. 80,000 Rs. 2,40,000 Rs.1,20,000
The company sells its products on gross profit of 25% counting depreciation as part of the cost of production. It keeps one months 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. Solution The computation of manufacturing expenses is as shown in the table 11.4
Table 11.4: Computation of manufacturing expenses Sales Less: gross profit at 25% Total manufacturing cost Less: materials Less: wages Manufacturing expenses Cash manufacturing expenses Rs.36,00,000 Rs.9,00,000 Rs.27,00,000 Rs.9,00,000 Rs.7,20,000 Rs.10,80,000 Rs.9,60,000
Depreciation Total manufacturing expenses Cash manufacturing expenses 10,80,000 9,60,000 = Rs.1,20,000
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The total cash cost is determined and shown in the following table 11.5
Table 11.5: Total cash cost Total manufacturing cost Less: depreciation Cash manufacturing cost Total manufacturing expenses Sales promotion expenses Total cash cost Rs.27,00,000 Rs.1,20,000 Rs.25,80,000 Rs.2,40,000 Rs.1,20,000 Rs.29,40,000
Statement of working capital required: Current assets: Raw Materials stock

Material Cost 90000 1 1 75000 12 12 Finished goods stock 1 Cash manufacturing cost 12 2580 000 x = 215000
Debtors Total cash cost of sales x 2 /12 = 2940000 x 2 / 12 = 490000 Sales promotion expenses = 120000 x 1/4= 30,000 Cash required = 100000 Total Assets = 910000 Current Liabilities Sundry Creditors
Material Cost 12 2 90000 2 150000 12
Wages outstanding = 720000 x 1/12 = 60000 Manufacturing expenses outstanding = 80000
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Total administrative expenses: Outstanding = 240000 / 12 =20000 Total current Liabilities = 310000 Working Capital A B = 600000 Add 20% safety margin = 120000 Working Capital required = 720000 Self Assessment Questions Fill in the blanks: 25. 26. 27. ______ is used to estimate working capital requirements of a firm. Operating cycle approach is based on the assumption that production and sales occur on a ___________. The factors involved in the estimation of the current liabilities are _____, _________ and _________.
11.9 Summary
All companies are required to maintain a minimum level of current assets at all point of time. This level is called core or permanent working capital of the company. Working capital management is concerned with the determination of optimum level of working capital and its effective utilisation. To assess the working capital required for a form to conduct its operations smoothly, firms use operating cycle concept and compute each component of working capital.

1. Examine the components of working capital. 2. Explain the concepts of working capital 3. What are the objectives of working capital management ? 4. Briefly explain the various elements of operating cycle
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Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. Maintaining, Competitiveness. Current assets. Current Liabilities Adequate working capital Inventories Sundry debtors Gross working capital Plan, working capital management as applied. Positive Fixed Liquidity, Profitability. Spontaneous finance. Spontaneous finance. Conservative, Large quantum. Operating cycle Sale of goods on credit, realisation of money from customers. Operating cycle Inventory conversion period Receivables conversion period Cash Conversion cycle Higher Positive direct correlation. Increased Larger Operating cycle Continuous bases Trade creditors, Direct wages and Overheads
Answers to Terminal Questions 1. 2. 3. 4. Refer to 11.2 Refer to 11.3 Refer to 11.4 Refer to 11.6
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Unit 12
Cash Management
Structure: 12.1 Introduction Learning objectives Meaning of cash 12.2 Meaning and Importance of Cash Management 12.3 Motives for Holding Cash 12.4 Objectives of Cash Management 12.5 Models for Determining Optimal Cash Needs Baumol model Miller-Orr model Cash planning Cash forecasting and budgeting 12.6 Summary 12.7 Terminal Questions 12.8 Answers to SAQs and TQs
12.1 Introduction
Cash is the most important current asset for a business operation. It is the energy that drives business activities and also gives the ultimate output expected by the owners. The firm should keep sufficient cash at all times. Excessive cash will not contribute to the firms profits and shortage of cash will disrupt its manufacturing operations. 12.1.1 Learning objectives After studying this unit, you should be able to understand: Meaning of cash and near cash assets The importance of cash management in a firm The different models of determining the optimal cash balances Techniques for forecasting the cash inflows and outflows 12.1.2 Meaning of cash Now, before getting into various other concepts of cash management, let us first discuss about the meaning of the cash and the near cash assets.
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Cash can be classified into or can be used in two senses (see figure 12.1) Narrow sense and Broader sense.
Figure 12.1: Classification of cash
In a narrow sense, it means the currency and other cash equivalents such as cheques, drafts and demand deposits in banks. In a broader sense, it includes near-cash assets like marketable securities and time deposits in banks.
The distinguishing nature of this kind of asset is that they can be converted into cash very quickly. Cash in its own form is an idle asset. Unless employed in some form or another, it does not earn any revenue.
12.2 Meaning and Importance of Cash Management

Cash management is concerned with the following requirements: Management of cash flows in and out of the firm Cash management within the firm Management of cash balances held by the firm deficit financing or investing surplus cash. Cash management tries to accomplish at a minimum cost the various tasks of cash collection, payment of out-standings and arranging for deficit funding or surplus investment. It is very difficult to predict cash flows accurately. Generally, there is no co-relation between inflows and outflows. At some point of time, cash inflows may be lower than outflows because of the seasonal nature of product sale thus prompting the firm to resort to
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borrowings and sometimes outflows may be lesser than inflows resulting in surplus cash. There is always an element of uncertainty about the inflows and outflows. The firm should therefore evolve strategies to manage cash in the best possible way. The management of cash can be categorised into: Cash planning: Cash flows should be appropriately planned to avoid excessive or shortage of cash. Cash budgets can be prepared to aid this activity Managing cash flows: The flow of cash should be properly managed. Steps to speed up cash collection and inflows should be implemented while cash outflows should be slowed down Optimum cash level: The firm should decide on the appropriate level of cash balance. Balance should be struck between excess cash and cash deficient stage Investing surplus cash: The surplus cash should be properly invested to earn profits. Many investment avenues to invest surplus cash are available in the market such as, bank short term deposits, T-Bills and inter corporate lending.
The ideal cash management system will depend on a number of issues like, firms product, competition, collection program, delay in payments, availability of cash at low rates of interests and investment opportunities available.
12.3 Motives of Holding Cash

The main motives behind holding cash are Transaction motive Precautionary motive Speculative motive Compensating motive
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Figure 12.2 displays the various motives.
Figure 12.2: Motives of holding cash
Transaction motive Transaction motive refers to a firm holding some cash to meet its routine expenses which are incurred in the ordinary course of business. A firm will need finances to meet an excess of payments like wages, salaries, rent, selling expenses, taxes and interests. The necessity to hold cash will not arise if there were a perfect co-ordination between the inflows and outflows. These two never coincide. At times, receipts may exceed outflows and at other times, payments outrun inflows. For such periods when payments exceed inflows, the firm should maintain sufficient balances to be able to make the required payments. For transactions motive, a firm may invest its cash in marketable securities. Generally, they purchase such securities whose maturity will coincide with payment obligations. Precautionary motive Precautionary motive refers to the need to hold cash to meet some exigencies which cannot be foreseen. Such unexpected needs may arise due to sudden slow-down in collection of accounts receivable, cancellation of an order by a customer, sharp increase in prices of raw materials and skilled labour. The money held to meet such unforeseen fluctuations in cash flows are called precautionary balances. The amount of precautionary balance also depends on the firms 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.
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Speculative motive Speculative motive relates to holding cash to take advantage of unexpected changes in business scenario which are not normal in the usual course of firms dealings. Speculative motive 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. Compensating motive Compensating motive is yet another motive to hold cash to compensate banks for providing certain services and loans. Banks provide a variety of services like cheque collection, transfer of funds through DD and MT. To avail all these purposes, the customers need to maintain a minimum balance in their accounts at all times. The balance so maintained cannot be utilised for any other purpose. Such balances are called compensating balance. Compensating balances can restrict to any of the following forms Maintaining an absolute minimum, say for example, a minimum of Rs. 25000 in current account or Maintaining an average minimum balance of Rs. 25000 over the month.
A firm is more affected by the first restriction than the second restriction.
12.4 Objectives of Cash Management

The major objectives of cash management in a firm are: Meeting payments schedule Minimising funds held in the form of cash balances Meeting payments schedule In the normal course of functioning, a firm will have to make many payments by cash to its employees, suppliers and infrastructure bills. Firms will also
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receive cash through sales of its products and collection of receivables. Both these do not happen simultaneously. A basic objective of cash management is therefore to meet the payment schedule in time. Timely payments will help the firm to maintain its creditworthiness in the market and to foster good and cordial relationships with creditors and suppliers. Creditors give a cash discount if payments are made in time and the firm can avail this discount as well. Trade credit refers to the credit extended by the supplier of goods and services in the normal course of business transactions. Generally, cash is not paid immediately for purchases but after an agreed period of time. There is deferral of payment and is a source of finance. Trade credit does not involve explicit interest charges, but there is an implicit cost involved. If the credit terms are, say, 2/10, net 30, it means the company will get a cash discount of 2% for prompt payment made within 10 days or else the entire payment is to be made within 30 days. Since the net amount is due within 30 days, not availing discount means paying an extra 2% for 20-day period. The other advantage of meeting the payments in time is that it prevents bankruptcy that arises out of the firms inability to honour its commitments. At the same time, care should be taken not to keep large cash reserves as it involves high cost. Minimise funds committed to cash balances Trying to achieve the second objective is very difficult. A high level of cash balances will help the firm to meet its first objective discussed above, but keeping excess reserves is also not desirable as funds in its original form is idle cash and a non-earning asset. It is not profitable for firms to keep huge balances. A low level of cash balances may mean failure to meet the payment schedule. The aim of cash management is therefore to have an optimal level of cash by bringing about a proper synchronisation of inflows and outflows and to check the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of mismatches between inflows
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and outflows. The efficiency of cash management can be augmented by controlling a few important factors: Prompt billing and mailing There is a time lag between the dispatch of goods and preparation of invoice. Reduction of this gap will bring in early remittances. Collection of cheques and remittances of cash Generally, we find a delay in the receipt of cheques and their deposits into banks. The delay can be reduced by speeding up the process of collection and depositing cash or other instruments from customers. Floatation cost The concept of float helps firms to a certain extent in cash management. Float arises because of the practice of banks not crediting firms account in its books when a cheque is deposited by it and not debit firms account in its books when a cheque is issued by it until the cheque is cleared and cash is realised or paid respectively.
A firm issues and receives cheques on a regular basis. It can take advantage of the concept of float. Whenever cheques are deposited in the bank, credit balance increases in the firms books but not in banks books until the cheque is cleared and money is realised. This refers to collection float, that is, the amount of cheques deposited into a bank and clearance awaited. Likewise the firm may take benefit of payment float. Net float = Payment float Collection float When net float is positive, the balance in the firms books is less than the banks books; when net float is negative; the firms book balance is higher than in the banks books.
12.5 Models for Determining Optimal Cash Needs

One of the prime responsibilities of a finance manager is to maintain an appropriate balance between cash and marketable securities. The amount of cash balance will depend on risk-return trade-off. A firm with less cash balances has a weak liquidity position but earns profits by investing its
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surplus cash, while on the other hand it loses profits by holding too much cash. A balance has to be maintained between these aspects at all times. So how much is optimum cash? This section explains the models for determining the appropriate balance. Two important models which determine the optimal cash needs are studied here: Baumol model Miller-Orr model. 12.5.1 Baumol Model The Baumol model helps in determining the minimum amount of cash that a manager can obtain by converting securities into cash. Baumol model is an approach to establish a firms optimum cash balance under certainty. As such, firms attempt to minimise the sum of the cost of holding cash and the cost of converting marketable securities to cash. The Baumol model is based on the following assumptions. The firm is able to forecast its cash requirements in an accurate way The firms pay-outs are uniform over a period of time The opportunity cost of holding cash is known and does not change with time The firm will incur the same transaction cost for all conversions of securities into cash A company sells securities and realises cash and this cash is used to make payments. As the cash balance comes down and reaches a point, the finance manager replenishes its cash balance by selling marketable securities available with it and this pattern continues. Cash balances are refilled and brought back to normal levels by the acts of sale of securities. The average cash balance is C/2. The firm buys securities as and when they have above-normal cash balances. This pattern is explained in figure 12.3.
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Cash balance
C/2
Average
T1
T2 Time
T3
Figure 12.3: Baumol model
Baumol cut-off model The total cost associated with cash management has two elements: Cost of conversion of marketable securities into cash and Opportunity cost The firm incurs a holding cost for keeping cash balance which is the opportunity cost. Opportunity cost is the benefit foregone on the next best alternative for the current action. Holding cost is k(C/2). The firm also incurs a transaction cost whenever it converts its marketable securities into cash. Total number of transactions during the year will be the total funds requirement, T, divided by the cash balance, C, i.e. T/C. If per transaction cost is c, then the total transaction cost is c(T/C). The total annual cost of the demand for cash is k(C/2) + c(T/C).
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Total cost
Cost
Holding cost
Transaction cost
Cash balance
C* Baumol Cut-off Model
Figure 12.4: Baumol cut-off model
The optimum cash balance C* is obtained when the total cost is minimum which is expressed as C* = 2cT/k where C* is the optimum cash balance, c is the cost per transaction, T is the total cash needed during the year and k is the opportunity cost of holding cash balance. The optimum cash balance will increase with increase in the per transaction cost and total funds required and decrease with the opportunity cost.
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Solved Problem A firms annual cost requirement is Rs. 200,00,000. The opportunity cost of capital is 15% per annum. Rs.150 is the per transaction cost of the firm when it converts its short-term securities to cash. Find 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 Rs. 200, 000 150(20000000/200000) + 0.15 (200000/2) = Rs. 30000 Annual cost of the demand = Rs. 30000
Solved Problem 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%. During the conversion of the securities into cash necessities, a fixed cost of Rs. 3000 per transaction is maintained. Compute the optimum conversion amount. Solution C* = 2cT/k = [2*3000*3000000] / 0.05@ = Rs. 600000 The optimum conversion amount is Rs. 600, 000 The rate of return is 20%/4 as 20% is annual return and 4 signifies that the fund requirement is done on a quarterly basis. 12.5.2 Miller-Orr model Miller-Orr came out with another model due to the limitation of the Baumol model. Baumol model assumes that cash flow does not fluctuate. In the real world, rarely do we come across firms which have their constant cash needs. Keeping other factors such as expansion, modernisation and diversification constant, firms face situations wherein they need additional cash to maintain their present position because of the effect of inflationary pressures. The firms therefore cannot forecast their fund requirements accurately.
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The Miller-Orr (MO) model overcomes these shortcomings and considers daily cash fluctuations. The MO model assumes that cash balances randomly fluctuate between an upper bound (upper control limit) and a lower bound (lower control limit). When cash balances hit the upper limit, the firm has too much cash and it is time to buy enough marketable securities to bring back to the optimal bound. When cash balances touch zero level, the level is brought up by selling securities into cash. Return point lies between the upper and lower limits. Symbolically, this can be expressed as Z = 33/4*(c2/i) where Z is the optimal cash balance, c is the transaction cost, 2 is the standard deviation of the net cash flows and i is the interest rate. MO model also suggests that the optimum upper boundary b is three times the optimal cash balance plus the lower limit, i.e. upper limit b = lower limit + 3Z and return point = lower limit + Z. The above explanations are more briefly explained or described using a graphical representation in figure 12.5.
Upper limit Cash balance
Return point
Lower limit Time
Figure 12.5: Miller-Orr model Sikkim Manipal University Page No. 263
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Solved Problem Mehta Industries have a policy of maintaining Rs. 5,00,000 minimum cash balance. The standard deviation of the companys daily cash flows is Rs. 2,00,000. 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 = 33/4*(c2/i) 33/4*(150*2000002) / 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. Cash planning helps in developing a projected cash statement from the expected inflows and outflows of cash. Forecasts are based on the past performance and future anticipation of events. Cash planning can be done based on a daily, weekly or on a monthly basis. Generally, monthly forecasts are commonly prepared by firms. Cash budget is a device which is used to plan and control cash receipts and payments. It gives a summary of cash flows over a period of time The Finance Manager can plan the future cash requirements of a firm based on the cash budgets. The first element of a cash budget is the selection of the time period which is referred to as the planning horizon. Selecting the appropriate time period is based on the factors exclusive to the firms. Some firms may prefer to prepare weekly budget while others may work out on monthly estimates while some others may be preparing quarterly or yearly budgets. Firms should keep in mind that the period selected should be neither too long nor too short.
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Over too long a period, estimates will not be accurate and too short a period requires periodic changes. Yearly budgets can be prepared by such companies whose business is very stable and who do not expect major changes affecting the companys flow of cash. The second element that has a bearing on cash budget preparation is the selection of factors that have a bearing on cash flows. Only items of cash nature are to be selected while non-cash items such as depreciation and amortisation are excluded. Cash budgets are prepared based on the following three methods: Receipts and Payments method Income and Expenditure method Balance Sheet method We shall be discussing only the receipts and payments method of preparing cash budgets.
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Case Study The information in table 12.1 gives the cash budget of M/s. Panduranga Sheet Metals Ltd. for the 6 months, ending on 30th June 2007. The company has an opening cash balance of Rs. 60000 on 1st Jan 2007.
Table 12.1: Cash budget of Panduranga Sheet Metals Month Jan Feb March April May June Sales 60000 70000 82000 85000 96000 110000 Purchases 24000 27000 32000 35000 38800 41600 Wages 10000 11000 10000 10500 11000 12500 Production overheads 6000 6300 6400 6600 6400 6500 Selling overheads 5000 5500 6200 6500 7200 7500
The company has a policy of selling its goods at 50% on cash basis and the rest on credit terms. Debtors are given a months 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 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.45,000, payable in 3 equal instalments starting bi-monthly from April. It also expects to make a loan application to a bank for Rs. 50,000 and the loan will be granted in the month of July. The company has to pay advance income tax of Rs.20,000 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.
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Solution The cash balances, the cash payments and the closing cash balances of the company are described clearly in the table 12.2 below:
Table 12.2: Details of the company Jan Opening cash balance Cash receipts: Cash sales Credit sales Total cash available Cash payments Materials Wages Production overheads Selling overheads Sales commission Purchase of asset Payment of advance IT Total cash payments Closing cash balances 5000 85000 23900 126100 49100 153000 5000 10500 6000 5000 2400 24000 10500 6300 5500 2800 27000 10250 6400 6200 3280 15000 20000 117650 59250 79190 32000 10750 6600 6500 3400 35000 11750 6400 7200 3840 15000 90000 30000 35000 30000 150000 41000 35000 202100 42500 41000 48000 42500 55000 48000 60000 Feb 85000 March 126100 April May June
153000 118850 150100
236500 209350 253100
118850 150100 173930
Working note: The wages are calculated in table 12.3
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Table 12.3: Wages Jan 10000 5000 Feb 11000 5500-feb 5000-mar 5000 10500 Mar 10000 5000-mar 5500-feb 10500 Apr 10500 5250-apr 5000-mar 10250 May 11000 5500-may 5250-apr 10750 Jun 12500 6250-jun 5500-may 11750
Self Assessment Questions Fill in the blanks: 1. Management of cash balances can be done by ____________ and _________. 2. The four motives for holding cash are ______________________, ____________ , ____________ and ____________. 3. The greater the creditworthiness of the firm in the market lesser is the need for ___________ balances. 4. __________refers to the credit extended by the supplier of goods and services in the normal course of business transactions. 5. When cheques are deposited in a bank, credit balance increases in the firms books but not in banks books until the cheque is cleared and money realised. This is called as ________________. 6. According to Baumol model, the total cost associated with cash management has two elements __________ and __________. 7. The MO model assumes that cash balances randomly fluctuate between a ____________and a __________________.
12.6 Summary
All companies are required to maintain a minimum level of current assets at all points of time. Cash management is concerned with determination of relevant levels of cash balances, near cash assets and their efficient use. The need for holding cash arises due to a variety of motives transaction motive, speculation motive, precautionary motive and compensating motive. The objective of cash management is to make short-term forecasts of cash
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inflows and outflows, investing surplus cash and finding means to arrange for cash deficits. Cash budgets help Finance Manager to forecast the cash requirements.

1. Miraj Engineering Co. has forecasted its sales for 3 months ending on Dec. as follows: Oct. Rs. 500000 Nov. Rs. 600000 Dec. Rs. 650000 The goods are sold on cash and credit basis at a rate of 50% each. Credit sales are realised in the month following the sale. Purchases amount to 50% of the months sales and are paid in the following month. Wages and administrative expenses per month amount to Rs. 1,50,000 and Rs. 80,000 respectively and are paid in the following month. On 1st Dec. the company has purchased a testing equipment worth Rs. 20,000 payable on 15th Nov. On 31st Dec. a cash deposit with a bank will mature for Rs. 1,50,000. The opening cash balance on 1st Nov. is Rs. 1,00,000. What is the closing balance in Nov. and Dec.? 2. Michael Industries Ltd. requests you to help them in preparing a cash budget for the period ending on Dec. 2007 based on the information given in table 12.4.
Table 12.4: Cash budget Particulars Sales Materials Rent Salaries Misc charges Taxes Purchase of asset May 15 7 June 20 20 July 22 22 0.50 1.5 0.15 Aug 3 29 0.5 2 0.2. Sep 34 15 0.5 2.5 0.2 Oct 25 15 0.50 1.5 0.4. 4 Nov 25 8 0.5 1 0.3. 10 Dec 15 8 0.5 1 0.2 Jan 15 Nil
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Credit terms: Customers are allowed 1 month time. Suppliers of materials are paid after 2 months. The company pays salaries after a gap of 15 days. Rent is paid after a gap of 1 month. The company has an opening balance of Rs. 2,00,000 on 1st June. Prepare a cash budget and find out what is the closing cash balance on 31st Dec.
12.8 Answers to SAQs an TQs

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. Deficit financing or investing surplus cash Transaction, speculative, precautionary and compensating Precautionary Trade credit Collection float Cost of conversion of marketable securities into cash and opportunity cost. 7. Upper bound (upper control limit) and lower bound (lower control limit). Answers 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
Structure: 13.1
Inventory Management
13.2 13.3
13.4 13.5 13.6
Introduction Learning objectives Role of inventory in working capital Costs Associated with inventories Inventory Management Techniques Economic order quantity ABC system Determination of stock levels Pricing of inventories Summary Terminal Questions Answers to SAQs and TQs
13.1 Introduction
Inventories are the most significant part of current assets of most of the firms in India. Since they constitute an important element of the total current assets held by a firm, the need to manage inventories efficiently and effectively for ensuring optimal investment in inventory cannot be ignored. Any lapse on the part of a management of a firm in managing inventories may cause the failure of the firm. The major objectives of inventory management are: Maximum satisfaction to customer Minimum investment in inventory Achieving low cost plant operation These objectives conflict each other. Therefore, a scientific approach is required to arrive at an optimal solution for earning maximum profit on investment in inventories. Decisions on inventories involve many departments: Raw material policies are decided by purchasing and production departments Production department plays an important role in work in process inventory, policy
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Finished goods inventory policy is shaped by production and marketing departments.
But the decisions of these departments have financial implications. Therefore, as an executive entrusted with the responsibility of managing finance of the company, the financial manager of the firm has to ensure that monitoring and controlling inventories of the firm are executed in a scientific manner for attaining the goal of wealth maximisation of the firm. 13.1.1 Learning objectives: After studying this unit, you should be able to: Explain the meaning of inventory management State the objectives of inventory management Recall the importance of inventory management State the purpose of inventory Discuss the techniques of inventory control 13.1.2 Role of inventory in working capital Inventories constitute an important component of a firms working capital. The various features of inventory (see figure 13.1) Inventory as current assets, Level of liquidity and Liquidity lags, highlight the significance of inventory in working capital management.
Figure 13.1: Features of inventory
Characteristics of inventory as current assets Current assets are those assets which are expected to be realised in cash or sold or consumed during the normal operating cycle of the business. Various forms of inventory in any manufacturing unit are: Process of production, where the raw materials are to be converted into finished goods Work in process inventories are semi finished products in the process of being converted into finished good
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Finished goods inventories are completely manufactured products that can be sold immediately.
The first two are inventories concerned with production and the third is meant for smooth performance of marketing function of the firm. Nature of business influences the levels of inventory that a firm has to maintain in these three kinds. A manufacturing unit will have to maintain high levels of inventory in all the three forms. A retail firm will be maintaining very high level of finished goods inventory only. The three kinds of inventories listed above are direct inventories. There is another form of inventories called indirect inventories. These indirect inventories are those items which are necessary for manufacturing but do not become part of the finished goods. The indirect inventories are: Lubricants Grease Oil Petrol Office maintenance material The inventories are held for the following four reasons: i. Smooth production To ensure smooth production as per the requirements of marketing department, inventories are procured and sold. ii. Competitive edge To achieve competitive edge most of the retail and industrial organisations carry inventory to ensure prompt delivery to customers. No firm wants to lose their customers on account of their item being out of stock. iii. Benefits of buying in large volume Sometimes buying in large volumes may give the firm quantity discounts. This quantity discounts may be substantial that the firm will take the benefit of it. iv. Hedge against uncertain lead times Lead time is the time required to procure fresh supplies of inventory. Uncertainty due to supplier taking more than the normal lead time will
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affect the production schedule and the execution of the orders of customers as per the orders received from customers. To avoid all these problems arising from uncertainty in procurement of fresh supplies of inventories, the firms maintain higher levels of inventories for certain items of inventory. Levels of liquidity Inventories are meant for consumption or sale. Both excess and shortage of inventory affect the firms profitability. Though inventories are called current assets, in calculating absolute liquidity of a firm inventories are excluded because it may have slow moving or dormant items of inventory which cannot be easily disposed of. Therefore level and composition of inventory significantly influence the quantum of working capital and hence profitability of the firm. Liquidity lags Inventories have three types of liquidity lags (see figure 13.2) Creation lag, Storage lag and Sale lag.
Figure 13.2: Liquidity lags
Creation lag Raw materials are purchased on credit and consumed to produce finished goods. There is always a lag in payment to suppliers from whom raw materials are procured. This is called spontaneous finance. Spontaneous finance is that amount of a firm which is capable of enjoying the influences of the quantum of working capital of the firm. Storage lag The goods manufactured or held for sale cannot be converted into cash immediately. Before dispatching the goods to the customers on sale, there is always a time lag. During this time lag goods are stored in warehouse.
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Many expenses of storage will be recurring in nature and cannot be avoided. The level of expenditure that a firm incurs on this account is influenced by the inventory levels of the firm. This influences the working capital management of a firm. Sale lag Firms sell their products on credit. There is some time lag between sale of finished goods and collection of dues from customers. Firms which are aggressive in capturing markets for their products maintain high levels of inventory and allow its customers liberal credit period. This will increase its investment in receivables. This increase in investment in receivables will have its effect on working capital of the firm. Purpose of inventory The purpose of holding inventory is to achieve efficiency through cost reduction and increased sales volume. Figure 13.3 displays various purposes involved in holding inventories:
Figure 13.3: Purpose for holding inventory
Sales Customers place orders for goods only when they need it. But when customers approach the firm with orders the firms must have adequate inventory of finished goods to execute it. This is possible only when firms maintain ready stock of finished goods in anticipation of orders from the customers. If a firm suffers from constant customer complaints about the product being out of stock, customers may migrate to other producers. This will affect the firms customers base, customer loyalty and market share.
To avail quantity discounts Suppliers give discounts for bulk purchases. Such discounts decrease the cost per unit of inventory purchased. Such cost reduction increase
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firms profits. Firms may go in for orders of large quantity to avail themselves of the benefit of quantity discounts. Reduce risk of production stoppages Manufacturing firms require a lot of raw materials and spares and tools for production and maintenance of machines. Non availability of any vital item can stop the production process. Production stoppage has serious consequences. Loss of customers on account of the failure to execute their orders will affect the firms profitability. To avoid such situations, firms maintain inventories as hedge against production stoppages Reducing ordering costs and time Every time a firm places an order it incurs cost of procuring it. It also involves a lead time in procurement. In some cases the uncertainty in supply due to certain administrative problems of the supplier of the product will affect the production schedules of the organisation. Therefore, firms maintain higher levels of inventory to avoid the risks of lengthening the lead time in procurement.
Therefore, to save on time and costs, firms may place orders for large quantities. Therefore, it can be concluded that the motives for holding inventories are Transaction motive: For making available inventories to facilitate smooth production and sales Precautionary motive: For guarding against the risk of unexpected changes in demand and supply Speculative motive: To take benefit out of the changes in prices, firms increase or decrease in the inventory levels
13.2 Costs Associated with Inventories

Figure 13.4 shows the various types of costs associated with the inventories:
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Figure 13.4: Costs associated with inventories
Material cost Material costs are the costs of purchasing the goods and related costs such as transportation and handling costs are associated with it. Ordering cost The expenses incurred to place orders with suppliers and replenish the inventory of raw materials are called ordering costs. They include the costs of the following: a. Requisitioning b. Purchase ordering or set-up c. Transportation d. Receiving, inspecting and receiving at the ware house. These costs increase in proportion to the number of orders placed. Firms maintaining large inventory levels, place a few orders and incur less ordering costs Carrying costs Costs incurred for maintaining the inventory in warehouses are called carrying costs. They include interest on capital locked up in inventory, storage, insurance, taxes, obsolescence, deterioration spoilage, salaries of warehouse staff and expenses on maintenance of warehouse building. The greater the inventory held, the higher the carrying costs.
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Shortage costs or stock-out costs These are the costs associated with either a delay in meeting the demand or inability to meet the demand at all due to shortage of stock. These costs include: Loss of profit on account of sales and loss caused by the stock out Loss of future sales as customers migrate to other dealers Loss of customer goodwill Extra costs associated with urgent replenishment purchases Measurement of shortage cost attributable to the firms failure to meet the customers demand is difficult because it is intangible in nature and it affects the operation of the firm now and then in future. Self Assessment Questions Fill in the blanks: 1. Lead time is the time required to ____________ 2. Both excess and shortage of inventory affect the firms _____ 3. Precautionary motive of holding inventory is for guarding against the risk of _______ and supply 4. Costs incurred for maintaining the inventory in warehouse are called __________. 5. The purposes involved in holding inventory are ___, ____, ___ and ___.
13.3 Inventory Management Techniques

There are many techniques of management of inventory. Some of them are as shown in the figure 13.5
Figure 13.5: Inventory management techniques
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Economic order quantity (EOQ) Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage. EOQ model answers the following key quantum of inventory management. What should be the quantity ordered for each replenishment of stock? How many orders are to be placed in a year to ensure effective inventory management? EOQ is defined as the order quantity that minimises the total cost associated with inventory management. EOQ is based on the following assumptions, as shown in figure 13.6:
Figure 13.6: Assumptions
Constant or uniform demand: The demand or usage is even through-out the period Known demand or usage: Demand or usage for a given period is known i.e. deterministic Constant unit price: Per unit price of material does not change and is constant irrespective of the order size Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory Constant ordering cost: Cost per order is constant whatever be the size of the order
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Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory. Economic order quantity is represented using the following formula:
Qx =
2 DK Kc
Figure 13.7: Economic order quantity
Where D = Annual usage or demand Qx = Economic order quantity K = ordering cost per order kc = pc = price per unit x percent carrying cost = carrying cost of inventory per unit per annum. Solved Problem Annual consumption of raw materials is 40,000 units. Cost per unit is Rs.16 along with a carrying cost of 15% per annum. The cost of placing an order is given as Rs.480. Find out the EOQ of the raw materials. Solution
EOQ = 2 40000 480 16 0.15 = 4000 units
EOQ of the raw materials = 400 units
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Solved Problem Annual demand of a company is 30,000 units. The ordering cost per order is Rs. 20(fixed) along with a carrying cost of Rs. 10 per unit per annum. The purchase cost per unit i.e. price per unit is Rs. 32 per unit. Determine EOQ, total number of orders in a year and the time-gap between two orders Solution
Qx = 2 DK Kc = 2 30000 20 10
= 346 units K = Rs.20 Kc = Rs.10 D = 30,000 The total number of orders in a year =
30,000 346 = 87 orders
Time gap between two orders =
365 = 4 days 87
ABC system The inventory of an industrial firm generally comprises of thousands of items with diverse prices, large lead time and procurement problems. It is not possible to exercise the same degree of control over all these items. Items of high value require maximum attention while items of low value do not require same degree of control. The firm has to be selective in its approach to control its investment in various items of inventory. Such an approach is known as selective inventory control. ABC system belongs to selective inventory control. ABC analysis classifies all the inventory items in an organisation into three categories. Items are of high value but small in number. All items require strict control
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Items of moderate value and size which require reasonable attention of the management Items represent relatively small value items and require simple control
Since this method concentrates attention on the basis of the relative importance of various items of inventory, it is also known as control by importance and exception. As the items are classified in order of their relative importance in terms of value, it is also known as proportional value analysis. Advantages of ABC analysis ABC analysis ensures closer controls on costly elements in which firms greater part of resources are invested By maintaining stocks at optimum level it reduces the clerical costs of inventory control Facilitates inventory control over usage of materials, leading to effective cost control Limitations A never ending problem in inventory management is adequately handling thousands of low value of C items. ABC analysis fails to answer this problem If ABC analysis is not periodically reviewed and updated, it defeats the basic purpose of ABC approach 13.3.1 Determination of stock levels Most of the industries which are subjected to seasonal fluctuations and sales during different months of the year are usually different. If, however, production during every month is geared to sales demand of the month, facilities have to be installed to cater for the production required to meet the maximum demand. During the slack season, a large portion of the installed facilities will remain idle with consequent uneconomic production cost. To remove this disadvantage, attempt has to be made to obtain a stabilised production programme throughout the year. During the slack season, there will be accumulation of finished products which will be gradually cleared as sales progressively increase. Depending upon various factors of production, storing and cost, a normal capacity will
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be determined. To meet the pressure of sales during the peak season, however, higher capacity may have to be used for temporary periods. Similarly, during the slack season, to avoid loss due to excessive accumulation, capacity usage may have to be scaled down. Accordingly, there will be a maximum capacity and minimum capacity, consumption of raw material will accordingly vary depending upon the capacity usage. Again, the delivery period or lead time for procuring the materials may fluctuate. Accordingly, there will be maximum and minimum delivery period and the average of these two is taken as the normal delivery period. Maximum level Maximum level is that level above which stock of inventory should never rise. Maximum level is fixed after taking in to account the following factors. Requirement and availability of capital Availability of storage space and cost of storing Keeping the quality of inventory intact Price fluctuations Risk of obsolescence Restrictions, if any, imposed by the government Maximum Level = Ordering level (MRC x MDP) + standard ordering quantity Where, MRC = minimum rate of consumption MDP = minimum lead time Minimum Level Minimum level is that level below which stock of inventory should not normally fall. Minimum level = OL (NRC x NLT) Where, OL = ordering level NRC = Normal rate of consumption NLT = Normal lead time
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Ordering Level Ordering level is that level at which action for replenishment of inventory is initiated. OL = MRC X MLT Where, MRC = Maximum rate of consumption MLT = Maximum lead time Average stock level Average stock level can be computed in two ways 1.
minimum level + maximum level 2
2. Minimum level + 1 /2 of re-order quantity Average stock level indicates the average investment in that item of inventory. It is quite relevant from the point of view of working capital management. Managerial significance of fixation of Inventory level Inventory level ensures the smooth productions of the finished goods by making available the raw material of right quality in right quantity at the right time. Inventory level optimises the investment in inventories. In this process, management can avoid both overstocking and shortage of each and every essential and vital item of inventory. Inventory level can help the management in identifying the dormant and slow moving items of inventory. This brings about better co-ordination between materials management and production management on one hand and between stores manager and marketing manager on the other. Re-order Point When to order is another aspect of inventory management. This is answered by re-order point. The re-order point is that inventory level at which an order should be placed to replenish the inventory. To arrive at the re-order point under certainty, the two key required details are: Lead time Average usage
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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
Solved Problem A manufacturing company has an expected usage of 50,000 units of a 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 EOQ and. Re order point. Assume 250 days in a year
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Solution
EOQ 2 DK Kc 2 50000 20 0.50
= 2000 units Re-order point
50000 250 = 200 units Safety stock = 2 x 200 = 400 units. Re-order point (lead time x Average usage) + safety stock (5 x 200) + 400 = 1,400 units
Daily usage = 13.3.2 Pricing of inventories There are different ways of pricing inventories used in production. If the items in inventory are homogenous (identical except for insignificant differences) it is not necessary to use specific identification method. The convenient price is using a cost flow assumption referred to as a flow assumption. When flow assumption is used, it means that the firm makes an assumption as to the sequence in which units are released from the stores to the production department. The flow assumptions selected by a company need not correspond to the actual physical movement of raw materials. When units of raw material are identical, it does not matter which units are issued from the stores to the production department. The method selected should match the costs with the revenue to ensure that the profits are uncertain in a manner that reflects the conditions actually prevalent. First in, first out (FIFO): FIFO assumes that the raw materials (goods) received first are used first. The same sequence is followed in pricing the material requisitions. Last in, first out (LIFO): The consignment last received is first used and if this is not sufficient for the requisitions received from production department then the use is made from the immediate previous
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consignment and so on. The requisitions are priced accordingly. This method is considered to be suitable under inflationary conditions. Under this method, the cost of production reflects the current market trend. The closing inventory of raw material will be valued on a conservative basis under the inflationary conditions. Weighted average: Material issues are priced at the weighted average of cost of materials in stock. This method considers various consignments in stock along with their units prices for pricing the material issues from stores.
Other methods are a. Replacement price method Replacement price method prices the issues at the value at which it can be procured from the market. b. Standard price method Under the standard price method the materials are priced at standard price. Standard price is decided based on market conditions and efficiency parameters. The difference between the purchase price and the standard price is analysed through variance analysis. Self Assessment Questions Fill in the blanks: 6. ABC system belongs to ______. 7. ______________ are of high value but small in number. 8. ABC system is known as _____________ because the items are classified in order of their relative importance in terms of value. 9. _________ is defined as the order quantity that minimises the total cost of inventory management. 10. Define Re-order point. 11. Define Lead time.
13.4 Summary
Inventories form part of current assets of firm. Objectives of inventory management are. Maximum customer satisfaction Optimum investment in inventory
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Operation of the plant at the least cost structure
Inventories could be grouped into direct inventories as 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.

Examine the reasons for holding inventories by a firm. 1. Discuss the techniques of inventory control. 2. Discuss the relevance and factors that influence the determination of stock level. 3. Explain the various cost of inventory decision.

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Obtain fresh supplies of inventory Profitability Unexpected changes in demand Carrying costs Sales, To avail quantity discounts, Reduce risk of production stoppages and Reducing ordering costs and time Selective inventory control. ABC items Proportional value analysis Economic order quantity (EOQ) The re-order point is that inventory level at which an order should be placed to replenish the inventory. Lead time refers to the average time required to replenish the inventory after placing orders for inventory.
Answers to Terminal Questions 1. 2. 3. 4. Refer to 13.1 Refer to 13.3 Refer to 13.3.3 Refer to 13.2
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Unit 14
Receivable Management
Structure: 14.1 Introduction Learning Objectives Meaning of receivable management 14.2 Costs Associated with Maintaining Receivables 14.3 Credit Policy Variables 14.4 Evaluation of Credit Policy 14.5 Summary 14.6 Terminal Questions 14.7 Answers 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 relaxed conditions of payment to their customers. When goods are sold on credit, finished goods get converted into receivables. Trade credit is a marketing tool that functions as a bridge for the movement of goods from the firms warehouse to its customers. When a firm sells goods on credit, receivables are created. The receivables arising out of trade credit have three features: Receivables out of trade credit involves an element of risk. Therefore, before sanctioning credit, careful analysis of the risk involved needs to be done Receivables out of trade credit are based on economic value. Buyer gets economic value in goods immediately on sale, while the seller will receive an equivalent value later on Receivables out of trade credit have an element of futurity. The buyer makes payment in a future period
Amounts due from customers, when goods are sold on credit, are called trade debits or receivables. Receivables form part of current assets. They constitute a significant portion of the total current assets of the buyers next to inventories.
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Receivables are asset accounts representing amounts owing to the firm as a result of sale of goods/services in the ordinary course of business. The main objective of selling goods on credit is to promote sales for increasing the profits of the firms. Customers will always prefer to buy on credit rather than buying on cash basis. They always go to a supplier who gives credit. All firms therefore grant credit to their customers to increase sales, profit and to beat competition. 14.1.1 Learning objectives After studying this unit, you should be able to: Understand the meaning of receivables management Recognise the costs associated with maintaining receivable Understand the credit policy variables Understand the process of evaluation of credit policy 14.1.2 Meaning of receivables management Receivables are a direct result of credit. Sales are resorted by a firm, to push up its sales which ultimately result in pushing up the profits earned by the firm. At the same time, selling goods on credit results in blocking of funds in accounts receivables. Additional funds are, therefore, required for the operating needs of the business which involve extra costs in terms of interest. Moreover, increase in receivables also increases the chances of bad debts. Thus, creation of accounts receivables is beneficial as well as dangerous to the firm. The financial manager needs to follow a policy of using cash funds economically to the extent possible, in extending receivables without adversely affecting the chances of increasing sales and making more profits. Management of accounts receivables may, therefore, be defined as, the process of making decision relating to the investment of funds in receivables which will result in maximising the overall return on the investment of the firm. Thus, the objective of receivables management is to promote sales and projects until the level where the return on investment in further finding of receivables is less than the cost of funds raised to finance that additional credit.
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14.2 Costs Associated with Maintaining Receivables

There are four different varieties of costs associated with maintaining receivables (see figure 14.1): capital cost, administration cost, delinquency cost and bad-debts or default cost.
Figure 14.1: Costs associated with maintaining receivables
Capital cost When firm sells goods, credit on that good achieves higher sales. Selling goods on credit has consequences of blocking the firms resources in receivables as there is a time lag between a credit sale and cash receipt from customers. To the extent the funds are held up in receivables, the firm has to arrange for additional funds to meet its own obligation of monthly as well as daily recurring expenditure. Additional funds may have to be raised either out of profits or from outside. In both the cases, the firm incurs a cost. In the former case there is the opportunity cost of the income the firm could have earned had the same been invested in some other profitable avenue. In the latter case of obtaining funds from outside, the firm has to pay interest on the loan taken. Therefore, sanctioning credit to customers on sale of goods on credit has a capital cost.
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Administration cost When a firm sells goods on credit it has to incur two types of administration costs: Credit investigation and supervision costs Collection Costs. Before sanctioning credit to any customer, the firm has to investigate the credit rating of the customer to ensure that credit given will be recovered on time. Therefore, administration costs have to be incurred in this process. Costs incurred in collecting receivables are administrative in nature. These include additional expenses on staff for administering the process of collection of receivables from customers. Delinquency cost The firm incurs this cost when the customer fails to pay the amount to it on the expiry of credit period. These costs take the form of sending remainders and legal charges. Bad-debts or Default costs When the firm is unable to recover the amount due from its customers, it results in bad debts. When a firm relaxes its credit policy, selling to customers with relatively low credit rating occurs. In this process a firm may make credit sales to its customers who do not pay at all. Therefore, assessing the effect of a change in credit policy of a firm involves examination of Opportunity Cost of lost contribution Credit administration Cost Collection Costs Delinquency Cost Bad debt loses
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Self Assessment Questions Fill in the blanks: 1. Costs of maintaining receivables are _____________, _________ cost and _______. 2. A period of Net 30 means that it allows to its customers 30 days of credit with ____ for ___________. 3. Selling goods on credit has consequences of blocking the firms resources in receivables as there is a time lag between _____________ and ____________. 4. When a firm sells goods on credit it has to incur two types of administration cost _____ and _________________. 5. The four different varieties of costs associated with maintaining receivables are _________, ________, _____ and ____. 6. Define receivable management 7. Define receivables.
14.3 Credit Policy Variables

The following are the four varieties of credit policy variables (see figure 14.2): Credit standards Credit period Cash discounts and Collection programme
Figure 14.2: Credit policy variables
Credit standards The term credit standards refer to the criteria for extending credit to customers. The bases for setting credit standards are: o Credit ratings o References
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o Average payment period o Ratio analysis There is always a benefit to the company with the extension of credit to its customers, but with the associated risks of delayed payments or non-payment, the funds get blocked in receivables. The firm may have light credit standards. The firm may sell on cash basis and extend credit only to financially strong customers. Such strict credit standards will bring down bad debt losses and reduce the cost of credit administration. However, the firm will not be able to increase its sales. The profit on lost sales may be more than the costs saved by the firm. The firm should evaluate the trade-off between cost and benefit of any credit standards. Credit period Credit period refers to the length of time allowed to its customers by a firm to make payment, for the purchases made by customers of the firm. Credit period is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if payments are made within the specified period. If a firm follows a credit period of net 20 it means that it allows its customers 20 days of credit with no inducement for early payments. Increasing the credit period will bring in additional sales from existing customers and new sales from new customers. Reducing the credit period will lower sales, decrease investments in receivables and reduce the bad debt loss. Increasing the credit period increases sales, increases investment in receivables and increases the incidence of bad debt loss. The effects of increasing the credit period on the profits of the firms are similar to that of relaxing the credit standards. Cash discount Firms offer cash discounts to induce their customers to make prompt payments. Cash discounts have implications on sales volume, average collection period, investment in receivables, incidence of bad debts and profits.
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A cash discount of 2/10 net 20 means that a cash discount of 2% is offered if the payment is made by the tenth day; otherwise full payment will have to be made by 20th day. Collection programme The success of a collection programme depends on the collection policy pursued by the firm. The objective of a collection policy is to achieve a timely collection of receivables. Releasing funds locked in receivables and minimising the incidence of bad debts are the other objectives of the collection policy. The collection programmes consists of the following. o Monitoring the receivables o Reminding customers about due date of payment o On line interaction through electronic media to customers about the payments due around the due date o Initiating legal action to recover the amount from overdue customers as the last resort to recover the dues from defaulted customers o Collection policy formulated shall not lead to bad relationship with the customers
Self Assessment Question Fill in the blanks: 8. Credit period is a ______________. 9. _______ refer to the criteria for extending credit to customers. 10. _________ refers to the length of time allowed to its customers by a firm to make payment for purchase made by customers of the firm. 11. A cash discount of 2 / 10 net 20 means that a ____________ is offered if the payment is made __________________ 12. The four varieties of credit policy variables are ____, ______, _____ and _____.
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14.4 Evaluation of Credit Policy

Optimum credit policy is one which would maximise the value of the firm. Value of a firm is maximised when the incremental rate of return on an investment is equal to the incremental cost of funds used to finance the investment. Therefore, credit policy of a firm can be regarded as Trade off between higher profits from increased sales and The incremental cost of having large investment in receivables The credit policy to be adopted by a firm is influenced by the strategies pursued by its competitors. If competitors are granting 15 days credit and if the firm decides to extend the credit period to 30 days, the firm will be flooded with customers demand for companys products. Individual evaluation of all the four credit policy variables of a firm are as shown: Credit Standard The effect of relaxing the credit standards on profit can be estimated as under: 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 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]
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Solved Problem The details shown in table 14.1 are regarding the statistics of the company X Ltd.
Table 14.1: Statistics of X Ltd Current sales Rs.100 million Increase in sales Rs.15 million Bad-debt losses 10% Contribution margin ratio 20% Average collection period 40 days Post-tax cost of funds 10% Tax-rate 30%
Examine the effect of relaxing the credit policy on the profitability of the organisation. (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 Average Collection period Variable cos t to Sales ratio No. of days in the year
15,000,000 40 0.8 Rs.13,33,333 360 10 Cost of Incremental Investment 13,33,333 100
Therefore, change in profit is calculated using the table 14.2

Table 14.2: Change in profit Incremental contribution Less: bad-debts on new sales Less: Income tax at 30% Less: Opportunity cost of incremental investment in receivables 30,00,000 15,00,000 4,50,000 10,50,000 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.
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Solved Problem The details shown in table 14.3 are regarding the statistics of the company Y Ltd.
Table 14.3: Statistics of Y Ltd.
Current sales Increase in sales Bad-debt losses Contribution margin ratio Average collection period Post-tax cost of funds Tax-rate
Rs.200 million Rs.20 million 15% 25% 50 days 15% 40%
Examine the effect of relaxing the credit policy on the profitability of the organisation. (MBA) adopted. Solution Incremental contribution = 2,00,00,000 x 0.25 = Rs 50,00,000 Bad debts on new sales = 2,00,00,000 x 0.15 = Rs 30,00,000 Cost of capital is 10% Incremental investment in receivables =
Investment in Sales No. of days in the year Average Collectionperiod Variablecos t to Sales ratio
20,000,000 50 0.75 Rs.2,083,333 360 10 2,083,333 100
Cost of Incremental Investment
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Therefore change in profit is calculated using the table 14.4

Table 14.4: Change in profit Incremental contribution Less: bad-debts on new sales Less: Income tax at 40% 50,00,000 30,00,000 12,00,000 18,00,000 Less: Opportunity cost of incremental investment in receivables Increase in profit 2,083,333 (2791666.7) positive
Since the impact of change in credit standards on profit is positive, the change in credit standards may be considered. Credit period The effect of changing the credit period on profits of the firm can be computed as shown: Change in profit = (Incremental contribution Bad debts on new sales) (1 tax rate) cost of incremental investment in receivables.
Solved Problem A company is currently allowing its customers, 30 days of credit. Its present sales are Rs 100 million. The firms cost of capital is 10% and the ratio of variables cost to sales is 0.80. The company is considering extending its credit period to 60 days. Such an extension will increase the sales of the firm by Rs 100 million. Bad debts on additional sales would be 8%. Tax rate is 30%. Assume 360 days in a year. Examine the effect of relaxing the credit policy on the profitability of the organisation (MBA) adopted.
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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 =
100,000,000 , 30 Rs.8,333,333 360
Expected investment in receivables after increasing the credit period to 60 days: Expected investment in receivables on current sales =
100,000,000 , 60 Rs.16,666,667 360 60 100,000,000 , 0.80 Rs.13,33,333 360
Additional investment in receivable on new sales = Rs. 13,33,333 Expected total investment in receivables on increasing the period of credit = 1 80 00 000 Incremental investment in receivables = 18000000 8333333 = 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 firms project (see table 14.5)
Table 14.5: Effect of increase in credit period Incremental contribution Less: Bad debts on new sales Less: Income tax at 30% Less: Opportunity cost of incremental in receivables Change in profit 2,00,000 8,00,000 12,00,000 3,60,000 8,40,000 9,66,667 (1,26,667) 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.
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Solved Problem A company is currently allowing its customers, 30 days of credit. Its present sales are Rs 150 million. The firms cost of capital is 10% and the ratio of variables cost to sales is 0.60. The company is considering extending its credit period to 60 days. Such an extension will increase the sales of the firm by Rs 200 million. Bad debts on additional sales would be 10%. Tax rate is 50%. Assume 360 days in a year. Examine the effect of relaxing the credit policy. Solution Incremental contribution = 150,000,000 x 0.4 = Rs 60,000,000 Bad debts on new sales = 150,000,000 x 0.1 = Rs 150,000,000 Existing investment in receivables = 30 150,000,000 Rs.12,500,000 360 Expected investment in receivables after increasing the credit period to 60 days: Expected investment in receivables on current sales = 200,000,000 60 Rs.400,000,000 360 Additional investment in receivable on new sales 60 200,000,000 0.10 Rs.3,333,333 360 Additional investment in receivable on new sales = Rs. 3,333,333 Expected total investment in receivables on increasing the period of credit = 403,333,333 Incremental investment in receivables = 403,333,333 12,500,000 = Rs. 390,833,333 Opportunity cost of Incremental investment in receivables = 0.10 x 390,833,333 = Rs.39,083,333
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Statement showing the effect of increasing the credit period from 30 days to 60 days as firms project (see table 14.6)
Table 14.6: Effect of increase in credit period Incremental contribution Less: Bad debts on new sales Less: Income tax at 30% Less: Opportunity cost of incremental in receivables Change in profit 60,000,000 150,000,000 75,000,000 75,000,000 39,083,333 (9,083,333) 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. Cash discount For assessing the effect of cash discount the following formula can be used. Change in profit = (Incremental contribution increase in discount cost) (1 - t) + opportunity cost of savings in receivables investment Solved Problem Present credit terms of a company are 1/10 net 30. Its sales are Rs 100 million, average collection period is 20 days, variable cost to sales ratio is 0.8, and cost of capital is 10%. The proportion of sales on which customers currently take discount is 0.5. The company is considering relaxing its discount terms to 2/10, net 30. Such a relaxation is expected to increase sales by Rs 10 million, reduce Average collection period to 14 days, increase discount sales to 0.8. Tax rate is 0.30. Examine the effect of relaxing the discount policy on profits of the organisation Assume 360 days in a year (MBA adopted).
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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
100,000,000 , 20 14 0.8 10,000,000 14 360 360 100,000,000 , 311,111 60
= 1666667 311111 = Rs.1355556 Computation of savings in receivables investment

100,000,000 , 20 14 0.8 10,000,000 14 360 360 100,000,000 , 311,111 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
Table 14.7: Effect of change in discount policy Incremental contribution Less: increase in discount tax Less: Tax at 30% Add: Benefit of savings due to reduction in investment in receivable profit 2,00,000 12,60,000 7,40,000 2,22,000 5,18,000 9,66,667 (1,26,667) negative
It is desirable to change the discount policy as it will improve the profitability of the firm.
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Collection policy Computation of the effect of new collection programme can be evaluated with the help of the following formula. Change in profit = (Incremental contribution Increase in bad debts) (1 tax rate) cost of increase in investment in receivables.
Solved Problem 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 firms 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 = 25, 00, 000 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 40 0.8 360 360
= 2777778 + 444444 = Rs.3222222 Opportunity cost of incremental investment in receivables = 0.1x 3222222 = Rs.322222
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Statement showing the impact of new collection programme on profits of the organisation
Table 14.8: Impact of new collection Incremental contribution Less: increase in bad debts 1,00,000 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 Profit/loss 3,22,222 (1,82,222) negative
Since the change will lead to decrease in profit (a loss of Rs.182222) it is not desirable to relax the collection programme of the firm. Self Assessment Questions Fill in the blanks: 13. 14. 15. Credit policy of a firm can be regarded as a trade-off between ___________ and _______. Optimum credit policy maximises the __________. 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. Credit policy to be adopted by a firm is influenced by strategies pursued by its competitors. (True/False).
16.
14.5 Summary
Receivables are a direct result of credit sales. Management of accounts receivables is the process of making decision relating to investment of funds in receivable which will result in maximising the overall return on the investment of the firm. Cost of maintaining receivables are of three types -
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capital costs, administration costs and delinquency costs. Credit policy variables are credit standards, credit period, cash discounts and collection programme. Optimum credit policy is that which maximises the value of the firm.

1. 2. 3. 4. Examine the meaning of receivable management. Examine the costs of maintaining receivables. Examine the variables of credit policy. What are the features of optimum credit policy?

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. Capital costs, administration, Delinquency costs No inducement for early payments Credit sale, Cash receipt from customers Credit investigation and supervision cost, collection costs Capital cost, administration cost, delinquency cost and bad-debts or default cost Management of accounts receivables may be defined as the process of making decision relating to the investment of funds in receivables that will result in maximising the overall return on the firms investment Receivables are asset-accounts representing amounts owing to the firm as a result of sale of goods/services Credit policy variable Credit standards Credit period Cash discount of 2% , on the tenth day Credit standards, credit periods, cash discounts and collection programme Higher profits from increased sales, incremental cost of having large investment in receivable. Value of the firm. Equal True
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7. 8. 9. 10. 11. 12. 13. 14. 15. 16.
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Answers to Terminal Questions 1. 2. 3. 4. Refer to 14.1 Refer to 14.2 Refer to 14.3 Refer to 14.4
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Unit 15
Structure: 15.1
Dividend Decisions
Introduction Learning objectives 15.2 Traditional Approach 15.3 Dividend Relevance Model Walter Model Gordons Dividend Capitalisation Model 15.4 Miller and Modigliani Model 15.5 Stability of Dividends 15.6 Forms of Dividends 15.7 Stock Split 15.8 Summary 15.9 Terminal Questions 15.10 Answers to SAQs and TQs 15.11 References
15.1 Introduction
Dividends are that portion of a firms net earnings which are paid to the shareholders. Preference shareholders are entitled to a fixed rate of dividend irrespective of the firms earnings. Equity holders dividends fluctuate year after year. Dividend decisions depend on what portion of earnings is to be retained by the firm and what portion is to be paid off. As dividends are distributed out of net profits, the firms decisions on retained earnings have a bearing on the amount to be distributed. Retained earnings constitute an important source of financing investment requirements of a firm. However, such opportunities should have enough growth potential and sufficient profitability. There is an inverse relationship between these two larger the retentions, lesser the dividends and vice versa. The constituents of net profits dividends and retentions, are always competitive and conflicting. Dividend policy has a direct influence on the two components of shareholders return dividends and capital gains. A low payout and high retention may have the effect of accelerating earnings growth.
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Investors of growth companies realise their money in the form of capital gains. Dividend yield will be low for such companies. The influence of dividend policy on future capital gains is to happen in distant future and therefore by all means uncertain. Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient investment opportunities will retain the entire earnings to fund its growth avenues. Conversely, if no such avenues are forthcoming, the firm will pay-out its entire earnings. So there exists a relationship between return on investments r and the cost of capital k. So as long as r exceeds k, a firm shall have good investment opportunities. That is, if the firm can earn a return r higher than its cost of capital k, it will retain its entire earnings and if this source is not sufficient, it will go in for additional sources in the form of additional financing like equity issue, debenture issue or term loans. Thus, the dividend decision is a trade-off between retained earnings and financing decisions. Different theories have been given by various people on dividend policy. We have the traditional theory and new sets of theories based on the relationship between dividend policy and firm value. The modern theories can be grouped as: Theories that consider dividend decision as an active variable in determining the value of the firm and Theories that do not consider dividend decision as an active variable in determining the value of the firm 15.1.1 Learning objectives After studying this unit, you should be able to: Explain the importance of dividends to investors Discuss the effect of declaring dividends on share prices Mention the advantages of a stable dividend policy List out the various forms of dividend Give reasons for stock split
15.2 Traditional approach

Traditional approach is given by B. Graham and D. L. Dodd (3rd edition, McGraw Hill, Newyork, 1951). They clearly emphasise the relationship
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between the dividends and the stock market. According to them, the stock value responds positively to high dividends and negatively to low dividends, that is, the share values of those companies rises considerably which pay high dividends and the prices fall in the event of low dividends paid. Symbolically, P = [m (D+E/3)] Where P is the market price, m is the multiplier, D is dividend per share, E is Earnings per share. Drawbacks of traditional approach As per this approach, there is a direct relationship between P/E ratios and dividend pay-out ratio. High dividend pay-out ratio will increase the P/E ratio and low dividend pay-out ratio will decrease the P/E ratio. This may not always be true. A companys share prices may rise in spite of low dividends due to other factors.
15.3 Dividend Relevance Model

Under this section we examine two theories: Walter Model Gordon Model 15.3.1 Walter model Prof. James E. Walter considers dividend pay-outs are relevant and have a bearing on the share prices of the firm. He further states that investment policies of a firm cannot be separated from its dividend policy and both are inter-linked. The choice of an appropriate dividend policy affects the value of the firm. Walter model clearly establishes a relationship between the firms rate of return r and its cost of capital k to give a dividend policy that maximises shareholders wealth. The firm would have the optimum dividend policy that will enhance the value of the firm. Walter model can be studied with the relationship between r and k. If r>k, the firms earnings can be retained as the firm has better and profitable investment opportunities and the firm can earn more than what
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the shareholders could by re-investing, if earnings are distributed. Firms which have r>k are called growth firms and such firms should have a zero pay-out ratio. If r<k, the firm should have a 100% pay-out ratio as the investors have better investment opportunities than the firm. Such a policy will maximise the firm value. If r = k, the firms dividend policy will have no impact on the firms value. The dividend pay-outs can range between zero and 100% and the firm value will remain constant in all cases. Such firms are called normal firms.
Walters model is based on the following assumptions (see figure 15.1)
Figure 15.1: Assumptions regarding Walters Model
Financing All financing is done through retained earnings. Retained earnings is the only source of finance available and the firm does not use any external source of funds like debt or equity Constant rate of return and cost of capital The firms r and k remain constant and it follows that any additional investment made by the firm will not change the risk and return profile 100% pay-out or retention All earnings are either completely distributed or re-invested immediately Constant EPS and DPS The earnings and dividends do not change and are assumed to be constant forever
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Life The firm has a perpetual life Walters formula to determine the market price is as follows: P=
D [r(E D) / Ke] Ke Ke
Where P is the market price per share D is the dividend per share Ke is the cost of capital g is the growth rate of earnings E is Earnings per share r is IRR Case Study The following information relates to Alpha Ltd. Show the effect of the dividend policy on the market price of its shares using the Walters Model Equity capitalisation rate Ke is 11% Earnings per share is given as Rs. 10 ROI (r) may be assumed as follows: 15%, 11% and 8% Show the effect of the dividend policies on the share value of the firm for three different levels of r, taking the DP ratios as zero, 25%, 50%, 75% and 100% Solution Ke 11%, EPS 10, r 15%, DPS=0 [r / Ke (E D)] D P= Ke Ke Case I r >k (r = 15%, Ke = 11%) a. DP = 0
0 [0.15 / 0.11(10 0)] = 13.64/0.11 = Rs. 123.97 0.11
b. DP = 25%
2.5 [0.15 / 0.11(10 2.5)] = 12.73/0.11 = Rs. 115.73 0.11

5 [0.15 / 0.11(10 5)] = 11.82/0.11 = Rs. 107.44 0.11
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c. DP = 50%
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d. DP = 75%
7.5 [0.15 / 0.11(10 7.5)] = 10.91/0.11 = Rs. 99.17 0.11
e. DP = 100%
10 [0.15 / 0.11(10 10)] = 10/0.11 = Rs. 90.91 0.11
Case II r = k (r = 11%, Ke = 11%) a. DP = 0 b. c. d. e.
0 [0.11/ 0.11(10 0)] = 10/0.11 = Rs. 90.91 0.11 2.5 [0.11/ 0.11(10 2.5)] DP = 25% = 10/0.11 = Rs. 90.91 0.11 5 [0.11/ 0.11(10 5)] DP = 50% = 10/0.11 = Rs. 90.91 0.11 7.5 [0.11/ 0.11(10 7.5)] DP = 75% = 10/0.11 = Rs. 90.91 0.11 10 [0.11/ 0.11(10 10)] DP = 100% = 10/0.11 = Rs. 90.91 0.11
Case III r<k (r = 8%, K = 11%)
0 [0.11/ 0.08 (10 0)] = 13.75/0.08 = Rs. 171.88 0.08 2.5 [0.11/ 0.08 (10 2.5)] b. DP = 25% = 12.81/0.08 = Rs. 160.13 0.08 5 [0.11/ 0.08 (10 5)] c. DP = 50% = 11.88/0.08 = Rs. 107.95 0.08 7.5 [0.11/ 0.08 (10 7.5)] d. DP = 75% = 10.94/0.08 = Rs. 99.43 0.08 10 [0.11/ 0.08 (10 10)] e. DP= 100% = 10/0.08 = Rs. 90.91 0.08 Interpretation The above workings can be summarised as follows:
a. DP = 0 When r>k, that is, in growth firms, the value of shares is inversely related to dividend policy (DP) ratio, as the DP increases, market value of shares decline. Market value of share is highest when DP is zero and least when DP is 100%.
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When r=k, the market value of share is constant irrespective of the DP ratio. The market value of the share is not affected, though the firm retains the profits or distributes them. In the third situation, when r<k, in declining firms, the market price of a share increases as the DP increases. There is a positive correlation between the two.
Limitations of Walters Model Walter has assumed that investments are exclusively financed by retained earnings and no external financing is used Walters model is applicable only to all-equity firms. Also, r is assumed to be constant which again is not a realistic assumption Finally, Ke is also assumed to be constant and this ignores the business risk of the firm which has a direct impact on the firm value 15.3.2 Gordons Dividend Capitalisation Model Myron Gordon also contends that dividends are relevant to the share prices of a firm. Gordon uses the dividend capitalisation model to study the effect of the firms dividend policy on the stock price. The following are some assumptions regarding Gordons dividend capitalisation model: The firm is an all equity firm with no debt No external financing is used and only retained earnings are used to finance any expansion schemes Constant return r Constant cost of capital Ke The life of the firm is indefinite The retention ratio g = br is constant forever Cost of capital is greater than br, that is Ke > br
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Gordons model assumes investors are rational and risk-averse. Investors prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount to uncertain returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they discount future dividends. Retained earnings are evaluated by the shareholders as risky and therefore the market price of the shares would be adversely affected. Gordon explains his theory with preference to the current income. Investors prefer to pay higher price for stocks which fetch them current dividend income. Gordons model can be symbolically expressed as:
Where P is the price of the share, E is Earnings per share, b is Retention ratio, (1 b) is dividend payout ratio, Ke is cost of equity capital, br is growth rate in the rate of return on investment
Case Study Given Ke as 11%, E as Rs. 10, calculate the stock value of Mahindra Tech. for (a) r=12%, (b) r=11% and (c) r=10% for various levels of DP ratios given under:
Table 15.1: Various levels of DP ratio
DP ratio (1 b) A B C D E 10% 20% 30% 40% 50%
Retention ratio 90% 80% 70% 60% 50%
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Solution Case I r >k (r = 12%, K = 11%) P= a. DP 10%, b 90%

10 (1 0.9) 0.11 (0.8 * 0.12)
E (1 b ) Ke br
equals 1/.002 = Rs. 500
b. DP 20%, b 80%
10 (1 0.8) 0.11 (0.8 * 0.12)
equals 2/.014 = Rs. 142.86
c. DP 30%, b 70%
10 (1 0.7) 0.11 (0.7 * 0.12
equals 3/.026 = Rs. 115.38
d. DP 40%, b 60%
10 (1 0.6) 0.11 (0.6 * 0.12)
equals 4/.038 = Rs. 105.26
e. DP 50%, b 50%
10 (1 0.5) 0.11 (0.5 * 0.12)
equals 5/.05 = Rs. 100
Case II r = k ( r = 11%, K = 11%) P= a. DP 10%, b 90%

10 (1 0.8) 0.11 (0.9 * 0.11)
E (1 b) Ke br
equals 1/.011 = Rs. 90.91
b. DP 20%, b 80%
10 (1 0.8) 0.11 (0.6 * 0.11)
equals 2/.022 = Rs. 90.91
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c. DP 30%, b 70%
10 (1 0.7) 0.11 (0.7 * 0.11)
equals 3/.033 = Rs. 90.91
d. DP 40%, b 60%
10 (1 0.6) 0.11 (0.6 * 0.11)
equals 4/.044 = Rs. 90.91
e. DP 50%, b 50%
10 (1 0.5) 0.11 (0.5 * 0.11)
equals 5/.55 = Rs. 90.91
Case III r<k ( r=10%, K=11%) P= a. DP 10%, b 90%

10 (1 0.9) equals 1/.02 = Rs. 50 0.11 (0.9 * 0.1) E (1 b) Ke br
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.
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When r > k, the firms value decreases with an increase in pay-out ratio. Market value of share is highest when dividend policy (DP) is least and retention highest When r = k, the market value of share is constant irrespective of the DP ratio. It is not affected whether the firm retains the profits or distributes them
When r < k, market value of share increases with an increase in DP ratio
15.4 Miller and Modigliani Model

The Miller and Modigliani (MM) hypothesis seeks to explain that a firms dividend policy is irrelevant and has no effect on the share prices of the firm. This model advocates that it is the investment policy through which the firm can increase its share value and hence this should be given more importance. The following are certain assumptions regarding Miller and Modigliani model: Existence of perfect capital markets: All investors are rational and have access to all information, free of cost. There are no floatation or transaction costs, securities are infinitely divisible and no single investor is large enough to influence the share value No taxes: There are no taxes, implying there is no difference between capital gains and dividends Constant investment policy: The investment policy of the company does not change. The implication is that there is no change in the business risk position and the rate of return Certainty about future investments, dividends and profits of the firm had no risk. This assumption was, however, dropped at a later stage Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as the crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two transactions which are entered into investment programmes simultaneously.
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The two transactions which the arbitrate process refers to are: paying out dividends and raising external funds to finance additional investment programs If the firm pays out dividend, it will have to raise capital by selling new shares for financing activities. The arbitrage process will neutralise the increase in share value (due to dividends) with the issue of new shares. This makes the investor indifferent to dividend earnings and capital gains as the share value is more dependent on the future earnings of the firm than on its current dividend policy. Symbolically, the model is given as Step I: The market price of a share in the beginning is equal to the PV of dividends paid and market price at the end of the period. 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 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 out-standing shares Step III: If the firms internal sources of financing its investment opportunities fall short of funds required, new shares are issued at the end of year 1 at price P1. The capitalised value of the dividends to be received during the period plus the value of the number of shares outstanding is less than the value of new shares. nP0 =
1 * (nD1 + (n + n1)P1 n1 P1) (1 + Ke)
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Firms will have to raise additional capital to fund their investment requirements after utilising their retained earnings, that is, n1 P1 = I (E nD1) which can be written as n1 P1 = I E + nD1 Where I is total investment required, nD1 is total dividends paid, E is earnings during the period, (E nD1) is retained earnings. Step IV: The value of share is thus: nP0 =
1 * (nD1 + (n + n1) P1 I + E nD1) (1 Ke)
Case Study A company has a capitalisation rate of 10%. It currently has outstanding shares worth 25,000 selling currently at Rs. 100 each. The firm expects to have a net income of Rs. 400000 for the current financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also requires Rs. 600000 to fund its investment requirement. Show that under MM model, the dividend payment does not affect the value of the firm. Solution: Case I: When dividends are paid: Step I: P0 =
1 * (D1 + P1) (1 Ke)
100 = 1/(1+0.1) * (4 + P1) P1 = Rs. 106 Step II: n1 P1 = I (E nD1), nD1 is 25000*4 n1 P1 = 600000 (400000 100000) = Rs. 300000 Step III: Number of additional shares to be issued 300000/106 = 2831 shares
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Step IV: The firm value nP0 = =

(n n1) P1- I E (1 Ke)
(25000 2831) * 106600000 400000 equals Rs. 2500000 (1 Ke )

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 2831) * 106600000 400000 equals Rs. 2500000 (1 0.1)

Thus, the value of the firm remains the same in both the cases whether dividends are declared or not. Critical Analysis of MM Hypothesis The analysis of MM hypothesis considers the following costs (see figure 15.2) transaction cost, floatation cost, under-pricing of shares,
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Figure 15.2: Analysis of MM hypothesis
Floatation cost Miller and Modigliani have assumed the absence of floatation costs. Floatation costs refer to the cost involved in raising capital from the market, that is, the costs incurred towards underwriting commission, brokerage and other costs. Floatation costs ordinarily account for around 10%-15% of the total issue and they cannot be ignored given the enormity of these costs. The presence of these costs affects the balancing nature of retained earnings and external financing. External financing is definitely costlier than retained earnings. For instance, if a share is issued worth Rs. 100 and floatation costs are 12%, then the net proceeds are only Rs. 88.
Transaction cost This is another assumption made by MM which implies that there are no transaction costs like brokerage involved in capital market. These are the costs associated with sale of securities by investors. This theory implies that if the company does not pay dividends, the investors desirous of current income sell part of their holdings without any cost incurred. This is very unrealistic as the sale of securities involves cost; investors wishing to get current income should sell higher number of shares to get the income they are to receive.
Under-pricing of shares If the company has to raise funds from the market, it should sell shares at a price lesser than the prevailing market price to attract new shareholders. This follows that at lower prices, the firm should sell more shares to replace the dividend amount.
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Market conditions If the market conditions are bad and the firm has some lucrative opportunities, it is not worth-approaching new investors at this juncture, given the presence of floatation costs. In such cases, the firms should depend on retained earnings and low pay-out ratio to fuel such opportunities.
15.5 Stability of Dividends

Stability of dividends is the consistency in the stream of dividend payments. This method relates to the payment of certain amount of minimum dividend to the shareholders. The steadiness is a sign of good health of the firm and may take any of the following forms constant dividend per share constant DP ratio constant dividend per share plus extra dividend Constant dividend per share As per this form of dividend policy, a firm pays a fixed amount of dividend per share year after year. 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 equalisation reserve is utilised. As and when the firm starts earning a higher amount of revenue it will consider payment of higher dividends and in future it is expected to maintain the higher level. Constant DP ratio With this type of DP policy, the firm pays a constant percentage of net earnings to the shareholders. 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.
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Constant dividend per share plus extra dividend Under this policy, a firm usually pays a fixed dividend ordinarily and in years of good profits, additional or extra dividend is paid over and above the regular dividend. The stability of dividends is desirable due to the following advantages: Building confidence amongst investors A stable dividend policy helps to build confidence and remove uncertainty in investors. A constant dividend policy will not have any fluctuations thereby suggesting to the investors that the firms 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 o old and retired persons o pensioners o youngsters o salaried class o housewives Of these, people like retired persons prefer current income. Their living expenses are fairly stable from one period to another. Sharp changes in current income, that is, dividends, may necessitate sale of shares. Stable dividend policy avoids sale of securities and inconvenience to investors. Information about firms profitability Investors use dividend policy as a measure of evaluating the firms profitability. Dividend decision is a sign of firms prosperity and hence a firm should have a stable DP. Institutional investors requirements Institutional investors like LIC, GIC and MF prefer to invest in companies with a record of stable DP. A company having erratic DP is not preferred by these institutions. Thus to attract these organisations which have large quantities of investible funds, firms follow a stable DP. Raise additional finance Shares of a company with stable and regular dividend payments appear as quality investment rather than a speculation. Investors of such companies are known for their loyalty and whenever the firm comes with
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new issues, they are more responsive and receptive. Thus raising additional funds becomes easy. Stability in market The market price of shares varies with the stability in dividend rates. Such shares will not have wide fluctuations in the market prices which is good for investors.
Self Assessment Questions Fill in the blanks: 1. ____________ constitute an important source of financing investment requirements of a firm 2. Dividend policy has a direct influence on the two components of shareholders return __________ and ____________ 3. ______________ considers dividend pay-outs are relevant and have a bearing on the share prices of the firm. 4. 5. 6. ____________ constitute an important source of financing investment requirements of a firm Dividend policy has a direct influence on the two components of shareholders return __________ and ____________ ______________ considers dividend pay-outs are relevant and have a bearing on the share prices of the firm to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns The __________ process refers to setting off or balancing two transactions which are entered into simultaneously ______ costs refer to the cost involved in raising capital from the market ______ are the costs associated with sale of securities by investors.
7. 8. 9.
15.6 Forms of Dividends

Dividends are portions of earnings available to the shareholders. Generally, dividends are distributed in cash, but sometimes they may also declare dividends in other forms which are discussed below (see figure 15.3):
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Figure 15.3: Forms of dividend
Cash dividends Most companies pay dividends in cash. The investors also, especially the old and retired investors depend on this form of payment for want of current income. Scrip dividend In this form of dividends, equity shareholders are issued transferable promissory notes with shorter maturity periods which may or may not have interest bearing. This form is adopted if the firm has earned profits and it will take some time to convert its assets into cash (having more of current sales than cash sales). Payment of dividend in this form is done only if the firm is suffering from weak liquidity position. Bond dividend Scrip and bond dividend are the same except that they differ in terms of maturity. Bond dividends carry longer maturity periods and bear interest, whereas scrip dividends carry shorter maturity periods and may or may not carry interest. Stock dividend (bonus shares) Stock dividend, as known is USA or bonus shares in India, is the distribution of additional shares to the shareholders at no additional cost. This has the effect of increasing the number of outstanding shares of the firm. The reserves and surplus (retained earnings) are capitalised to give effect to bonus issue. This decision has the effect of recapitalisation, that is, transfer from reserves to share capital and not changing the total net worth. The investors are allotted shares in proportion to their present
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shareholding. Declaration of bonus shares has a favourable psychological effect on investors. They associate it with prosperity
15.7 Stock Split

Before going into the concept of stock split, let us start with its definition. A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share. A stock split affects only the par value and does not have any effect on the total outstanding amount in share capital. The reasons for splitting shares are: To make shares attractive The prime reason for effecting a stock split is to reduce the market price of a share to make it more attractive to investors. Shares of some companies enter into higher trading zone making it out of reach to small investors. Splitting the shares will place them in more popular trading range thus providing marketability and motivating small investors to buy them. Indication of higher future profits Share split is generally considered a method of management communication to investors that the company is expecting high profits in future. Higher dividend to shareholders When shares are split, the company does not resort to reducing the cash dividends. If the company follows a system of stable dividend per share, the investors would surely get higher dividends with stock split.
15.8 Summary
Dividends are the earnings of the company distributed to shareholders. Payment of dividend is not mandatory, but most companies see to it that dividends are paid on a regular basis to maintain the image of the company. As payment of dividend is not compulsory, the question which arises in the minds of policy makers is- Should dividends be paid, if yes, what should be the quantum of payment?
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Various theories have come out with various suggestions on the payment of dividend. B. Graham and D. L. Dodd are of the view that there is a close relationship between the dividends and the stock market. The stock value responds positively to high dividends and vice versa. Prof. James E. Walter considers dividend pay-outs are necessary but if the firms ROI (rate of interest)is high, earnings can be retained as the firm has better and profitable investment opportunities. Gordon also contends that dividends are significant to determine the share prices of a firm. Shareholders prefer certain returns (current) to uncertain returns (future) and therefore give a premium to the constant returns and discount to uncertain returns. Miller and Modigliani explain that a firms dividend policy is irrelevant and has no effect on the share prices of the firm. They are of the view that it is the investment policy through which the firm can increase its share value and hence this should be given more importance. Dividends can be paid out in various forms such as cash dividend, scrip dividend, bond dividend and bonus shares.

1. Write a short note on the different types of dividend. 2. What is stock split? What are its advantages? 3. The following information (shown in table 15.1) is available in respect of a company. Calculate the price of the share as per Walter model.
Table 15.1: Information of a company
Equity capitalisation Earnings per share Dividend pay-out ratio Rate of interest (ROI)
15% Rs.25 25% 12%
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4. Considering the following information, what is the price of the share as per Gordons Model?
Table 15.2: Details of the company
Net sales Net profit margin No. of equity shares Cost of equity shares Retention ratio Rate of interest (ROI)
Rs.120 lakhs 12.5% 25, 000 12% 40% 16%
Outstanding preference shares Rs.50 lakhs@ 12% dividend
5. If the EPS is Rs.5, dividend pay-out ratio is 50%, cost of equity is 20%, growth rate in the ROI is 15%, what is the value of the stock as per Gordons Dividend Equalisation Model? 6. Nile Ltd. makes the following information available. What is the value of the stock as per Gordon Model? Ke 14%, EPS Rs. 20, D/P ratio 35% Retention ratio 65%, ROI 16% 7. What is the stock price as per Gordon Model if DP ratio is 60% in the above case?

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. Retained earnings Dividends and capital gains Prof. James E. Walter Normal firm Gordon Arbitrage Floatation costs Transaction costs
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Answers to Terminal Questions 1. Refer to 15.6 2. Refer to 15.7 3. Hint: Apply the formula Walters formula to determine the market price P =
[r(E - D) / Ke] D + Ke Ke
4. Hint: Apply the Gordon formula of P = 5. Hint: Apply the Gordon formula of P = 6. Hint: Apply the Gordon formula of P = 7. Hint: Apply the Gordon formula of P =
E (1 - b) . Ke - br E (1 - b) . Ke - br E (1 - b) . Ke - br E (1 - b) . Ke - br
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15.11 References
Financial Management by Khan Jain, 4th edition, 2005 Financial Management by I. M. Pandey, 9th edition, 2005 Financial Management by Prasanna Chandra, 6th edition, 2005 Financial Management by Shashi Gupta and Neeti Gupta, 2nd edition, 2008 5. Financial Management by Rustogi, first edition, 2010. 1. 2. 3. 4.
___________________
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MB 0045 Financial Management Contents

1 18 41 61 87 106 129 146

186 213 232 252 271 289 308 331

1.2 Meaning and Definitions

1.3 Goals of Financial Management

Figure 1.1: Goals of financial management

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1.4 Finance Functions

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Figure 1.2: Finance manager decisions

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13.2 13.2 Rs.19 approximat e 1 0.3 0.7

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1.5 Interface between Finance and other Business Functions

1.7 Terminal Questions

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1.8 Answers to SAQs and TQs

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2.2 Steps in Financial Planning

Figure 2.1: Steps in financial planning

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Inventories Loans and Advances Miscellaneous expenditure

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123 (Rounded off) 352 44 396

243 367 150

12 1300 128 1300 300 1300 80 1300

16 (Rounded off) 166 390 104 43 1236

120 50 Increase by current years retained earnings 355

3. Secured Loan Bank borrowings

78 40 (Difference Balancing figure)

250 1300 60 1300

250 1690 1300 60 1690 1300

325 78 130 1236

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A ( s) L ( s) ms (1-d) (1m + SR) S S

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2.3 Factors affecting Finanical Plan

Figure 2.2: Factors affecting financial plan

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2.4 Estimations of Financial requirements of a Firm

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Figure 2.3: Theories of capitalisation

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2.7 Terminal Questions

2.8 Answers to SAQs and TQs

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Time Value of Money

3.2 Future Value

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