HARAMAYA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

Financial Management II (AcFn3042)

Distance Education Program Module

Course Writers:
Gemedo Tibeso (MSc in Accounting and Finance)
Nesru Kasim (MSc in Accounting and Finance)

Content Editor: Ashu Girma (MSc in Accounting and Finance)

Language Editor: Sofia Edris (Asst. Professor)
Pedagogical Editor: Tadesse Hailu Afework (PhD)
February, 2024

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Table of Content
Chapter One.............................................................................................................................................................................
Capital Structure Policy and Leverage....................................................................................................................................
Introduction..............................................................................................................................................................................
1.1. The Capital Structure Question....................................................................................................2
1.2. Factors Affecting Capital Structure Decisions............................................................................2
1.3. Business and Financial Risks........................................................................................................5
1.3.2. Financial risk and Financial Leverage..................................................................................9
1.4. Optimum Capital Structure..........................................................................................................11
1.5. The Major theories of Capital structure......................................................................................12
1.5.1. Net Income (NI) theory......................................................................................................12
1.5.2. Net operating income (NOI) Theory.................................................................................16
1.5.3. Traditional theory...............................................................................................................19
1.5.4. Modigliani and Miller Approach.........................................................................................21
1.5.5. Trade-off theory (Static Trade-off Hypothesis)...................................................................23
Summary................................................................................................................................................................................
Review Questions.................................................................................................................................................................
Chapter Two..........................................................................................................................................................................
Dividend Policy and Theory..................................................................................................................................................
2.1. Meaning and Types of Dividends................................................................................................27
2.2. Dividend Decision and Dividend Theories..................................................................................28
2.2.1. The Irrelevance Concept of Dividend..................................................................................29
2.2.2. The Relevance Concept of Dividend...................................................................................37
2.3. Types of Dividend Policy............................................................................................................43
2.3.1. Determinants of Dividend Policy.........................................................................................45
2.4. The Dividend Payment Procedure...............................................................................................48
2.5. Stock Dividends and Stock Split..................................................................................................49
2.5.1. Stock Dividends...................................................................................................................49
2.5.2. Stock Split............................................................................................................................50
2.6. Stock Repurchases.......................................................................................................................50
Summary................................................................................................................................................................................

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Review Exercises...................................................................................................................................................................
Chapter Three........................................................................................................................................................................
Financial Forecasting.............................................................................................................................................................
Introduction..............................................................................................................................................55
3.1. Meaning and Purpose of Financial Forecasting...........................................................................55
3.2. Dimensions of Financial Planning...............................................................................................56
3.3. Forecasting growth rates and outside financing...........................................................................57
Summary................................................................................................................................................................................
Review Exercises...................................................................................................................................................................
Chapter Four..........................................................................................................................................................................
Managing Current Assets......................................................................................................................................................
Introduction............................................................................................................................................................................
4.1. Working Capital Terminologies..................................................................................................78
4.1.1. Importance or Advantages of Adequate Working Capital...................................................79
4.1.2. The Need for Working Capital.............................................................................................80
4.1.3. Characteristics of Working Capital......................................................................................82
4.1.4. Types of working capital.....................................................................................................84
4.1.5. Alternative Current Assets Investment Policy.....................................................................90
4.2. Cash Management........................................................................................................................91
4.2.1. Motives for Holding Cash (Reasons for Holding Cash)......................................................92
4.2.2. Objectives of cash Management..........................................................................................94
4.2.3. Estimating Cash Balances....................................................................................................96
4.2.4. Cash Management Techniques..........................................................................................104
4.3. Receivables Management..........................................................................................................108
4.3.1. Meaning of Receivables.....................................................................................................109
4.3.2. Factors Influencing the Size of Receivables......................................................................109
4.3.3. Meaning and Objectives of Receivables Management......................................................111
4.4. INVENTORY MANAGEMENT..............................................................................................119
4.4.1. Meaning and Nature of inventory......................................................................................120
4.4.2. Purpose/Benefits of Holding Inventors..............................................................................121
4.4.3. Objective of Inventory Management.................................................................................122
4.4.4. Tools and Techniques of inventory Management..............................................................123

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 4.4.5. Risk in Inventory Management..........................................................................................131
Summary..............................................................................................................................................................................
Review Exercises.................................................................................................................................................................
Chapter 5..............................................................................................................................................................................
Financing Current Assets.....................................................................................................................................................
Introduction..........................................................................................................................................................................
5.1. Sources of short-term financing.................................................................................................137
5.2. Alternative CA Financing Policies/Strategies...........................................................................138
5.2.1. Perfect Hedge (Maturity matching) Policy........................................................................138
5.2.2. Conservative Hedge Policy................................................................................................139
5.2.3. Aggressive Hedge Policy...................................................................................................141
Summary..............................................................................................................................................................................
Review Exercises.................................................................................................................................................................
Answer Key For Review Exercises.....................................................................................................................................

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Chapter One

Capital Structure Policy and Leverage

Learning Objectives
After studying this chapter, you should be able to:
 Understand operating, financial, and total leverage and the relationships among them
 Understand factors that influence capital structure decisions
 Explain theories of capital structure
 Determine the optimum capital structure

Introduction

The most crucial component of starting a business is capital. It acts as the foundation of the
company. Debt and Equity are the two primary types of capital sources for a business. Capital
structure is defined as the combination of equity and debt that is put into use by a company in
order to finance the overall operations of the company and for its growth. Capital structure
policy dives into how a company finances itself, specifically the mix of debt and equity used.
Leverage, on the other hand, refers to the extent to which a company uses borrowed funds (debt)
in its capital structure. Leverage results from the use of fixed-cost assets or funds to magnify
returns to the firm’s owners. Generally, increases in leverage result in increased return and risk,
whereas decreases in leverage result in decreased return and risk. The amount of leverage in the
firm’s capital structure the mix of long-term debt and equity maintained by the firm can
significantly affect its value by affecting return and risk. Unlike some causes of risk,
management has almost complete control over the risk introduced through the use of leverage.
Because of its effect on value, the financial manager must understand how to measure and
evaluate leverage, particularly when making capital structure decisions. There are two types of
leverages (operating leverage and financial leverage). Operating leverage is concerned with the
relationship between the firm’s sales revenue and its earnings before interest and taxes, or EBIT.
(EBIT is a descriptive label for operating profits.) Financial leverage is concerned with the
relationship between the firm’s EBIT and its common stock earnings per share (EPS).

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1.1. The Capital Structure Question

Dear Learners! In the course Financial Management I, when calculating the weighted average
cost of capital for use in capital budgeting, it was assumed that the firm had a specific target
capital structure. However, the optimal capital structure may change over time, changes in
capital structure affect the riskiness and cost of each type of capital, and all this can change the
weighted average cost of capital. Moreover, a change in the cost of capital can affect capital
budgeting decisions and, ultimately, the firm’s stock price. The capital structure question is a
question of how should a firm go about choosing its debt/equity ratio. Is there an optimum
capital structure that maximizes firm’s value? Capital structure and cost of capital relationships.
The value of the firm is maximized when the WACC is minimized. WACC is the discount rate
that is appropriate for the firm’s overall cash flows and values and discount rate move in
opposite directions, minimizing the WACC will maximize the value of the firm’s cash flows.

1.2. Factors Affecting Capital Structure Decisions

1. EBIT-EPS Analysis
2. Cost of capital
3. Cash flow analysis
4. Control
5. Timing and flexibility
6. Nature and Size of the Firm
7. Industry Standard
1. EBIT-EPS Analysis: It is needless to say that if we want to examine the effect of
leverage, we are to analyze the relationship between the EBIT (Earnings before interest
and Tax) and EPS (earnings per share). Practically, it requires the comparison of various
alternative methods of financing under various alternative assumptions relating to Earnings
Before Interest and Taxes.
Financial leverage or trading on equity arises when fixed assets are financed from debt
capital, (including preference shares). When the same gives a return which is greater

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 than the cost of debt capital, the excess will increase the EPS (Earnings per share) and the
same is also applicable in case of preference share capital.
2. Cost of Capital: While explaining cost of capital we have mentioned that usually cost of
equity (Ke) is greater than the cost of debt (Kd) due to the most significant advantages of
income-tax among others. Actually, financing decision should be based on overall cost
of capital (i.e., after considering both equity and debt). In other words, their combination
will be in such a way so that, either it minimizes the overall cost of capital or maximizes the
market value of the firm.
If debt financing is increased there will be a corresponding reduction in the overall cost of
capital till the rate of return exceeds the explicit cost of financing. But if debt financing is
continuously increased, the same will increase the cost of equity and debt capital as well
which invites more financial risk and consequently increases the weighted average cost of
capital up to a certain level of debt-equity mix. It can further be stated that if debt-
financing is continuously taken by a firm to minimize the overall cost of capital, the debt
after attaining a certain limit, will become costly as well as risky sources of finance.
Thus, if the degree of leverage increases, the creditors desires a high rate of interest for
increased risk and if the debt reaches at a particular point, they will not provide any loan
further Moreover, the position of the shareholders becomes risky due to such excessive debt
for which cost of equity is increased gradually. So, combination of debt and equity will be in
such a manner so that the market value per share increases and minimizes the average cost of
capital of a firm.
3. Cash Flow Analysis: In order to meet the service fixed charge of a firm, analysis of cash
flow is very important it indicates the ability of the firm to meet its various commitments
including the service fixed charges which includes fixed operating charges and interest on
debt capital. Thus, the analysis of the cash flow ability of the firm to service fixed charges
is no doubt an important tool while analyzing financial risk in addition to EBIT-EPS analysis
in capital structure planning.
It has already been mentioned earlier that if the amount of debt capital increases, there is
a corresponding increase in the amount of uncertainty which a firm must have to face to
meet its obligation in the form of fixed charges. Because, if a firm borrows more than its

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 capacity and if it fails to meet its maturing, obligation at a future date, the creditors will
acquire the assets of the firm for their unsatisfied claim which brings financial
insolvency.
If there is greater and stable expected future cash flow; a firm should go for a higher degree
of debt which can be used as a source of finance. Similarly, if the expected future cash flows
are unstable and smaller, a firm should avoid any fixed-charge securities which will be
considered a very risky proposition.
4. Control: We know that the equity shareholders being the owner of the firm can exercise
control over the affairs of the firm. They have also the voting right. They do not have
any voting rights for the appointment of board of directors as well, other lenders and
creditors also, like debenture holders and preference shareholders, do not have any ‘say’ in
the management of the company. i.e., they cannot actually take part in the management as
the entire body is being controlled by the equity holders or the owners of the company.
the firm should select an appropriate debt-equity mix after considering its overall
profitability.
5. Timing and Flexibility: After determining an appropriate capital structure, a firm has to
face this problem relating to timing of security issues. For procuring additional funds, a
firm has to face the question of appropriate mix of debt and equity and what should be the
timing of issuing such securities in order to maintain strict proportion of debt and equity,
although it is not an easy task. At the same time, which one will be issued at first i.e.,
whether debt at first and equity at last or vice-versa, that also should be decided.
If the existing rate of interest on debt capital is high and there is the possibility of coming
down the rate of such interest, the management will go for issuing equity shares now and
will postpone debt issue. On the contrary, if the market for company’s equity issues are
depressed but that is chance is near future to improve for the same, naturally, the
management must go for debt issues now and will postpone the equity issues. The same
may be issued at a later date when there will be a favorable condition for the company,
i.e., the market for company’s equity shares will go up. It is needless to mention again
that if the alternative stated above, is chosen, a certain amount of flexibility must be
sacrificed. The trade-off is between preserving financial flexibility and dilution in

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 earnings per share. If the price of the stock is high, however, and expected to fall, the firm
can achieve both the flexibility and minimum dilution by issuing stock now.
6. Nature and Size of the Firm: The nature and size of the firm have a significant role while
procuring funds from various sources. For example, it is very difficult for a small firm to
raise funds from long term sources even if its credit status is good. The same is available for
it at a comparatively high rate of interest with inconvenient repayment terms as well.
7. Industry Standard: Evaluation of capital structure of other similar risk-class firm is
absolutely needed when designing the capital structure of a firm and also the industrial
position. Because if a firm follows a different capital structure than that of the similar firm
in the same industry, it may have to face a lot of problems e.g., investors may not accept. It
is needless to say that lenders and creditors together with the investment analysts evaluate
always the firm according to the industry standard.

1.3. Business and Financial Risks

Dear learners! So far, we mentioned factors that influence capital structure decision. Now, let
us discuss about business risk and financial risk. Business risk is defined as the equity risk that
comes from the nature of the firm’s operating activities. Business risk depends on the systematic
risk of the firm’s asset. The basic risk inherent in the operations of a firm is called business
risk. Business risk can be viewed as the variability of a firm’s Earnings Before Interest and
Taxes (EBIT).

Financial Risk on the other hand is the risk arising due to the use of debt financing in the
capital structure. Financial risk is a debt causes financial risk because it imposes a fixed cost in
the form of interest payments. It can be defined as the risk of not being able to pay off the
debt.

1.3.1. Operating Leverage and Business Risks

Business risk in a stand-alone sense is a function of the uncertainty inherent in projections of a

firm’s return on invested capital (ROIC). If a firm uses no debt, then its interest payments will be
zero, its capital will be all equity, and its ROIC will equal its return on equity, ROE. The

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 business risk of a leverage-free firm can be measured by the standard deviation of its ROE,
δROE.

Illustration: consider the following information for ABC Company which has no debt capital.

PLAN A PLAN B

Operating Operating
Units Birr Operating Profits Net Operating Profits
Demand Probability Sold Sales Costs (EBIT) Income ROE Costs (EBIT) Net Income ROE

Br. Br. (Br.20,000 (Br.12,000 - (Br.

Terrible 0.05 0 0 20,000 ) ) 6 .0% Br. 60,000 60,000) (Br.36,000) -18%

Poor 0.20 40,000 80,000 80,000 0 0 0.0% 100,000 (20,000) (12,000) -6%

Normal 0.50 100,000 200,000 170,000 30,000 18,000 9.0% 160,000 40,000 24,000 12%

18.0
Good 0.20 160,000 320,000 260,000 60,000 36,000 % 220,000 100,000 60,000 30%

Wonderful 0.05 200,000 400,000 320,000 80,000 48,000 24.0% 260,000 140,000 84,000 42%

Expected Value 100,000 200,000 170,000 30,000 18,000 9.0% 160,000 40,000 24,000 12%

7.41 14.82
Standard Deviation 24,698 % 49,396 %

Coefficient of Variance 0.82 0.82 1.23 1.23

Dear learners! As you can see from the above table, the coefficient of variance for plan B is
greater than that of plan A. this indicates that plan B has more business risk than plan A.

Operating leverage refers to magnifying gains and losses in earnings before interest and taxes
(EBIT) by changes that occur in sales. This magnification occurs because in employing assets
the firm incurs certain fixed costs, costs unrelated to the sales volume created by the assets.
Operating costs can be divided into variable and fixed costs. As sales changes, variable costs
change proportionally. This means the variable cost ratio to sales is constant. This is true over

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some relevant range of sales. Variable cost includes material, direct labor, repair and
maintenance expenses. In the long run all costs are variable. Fixed costs include depreciation,
indirect labor cost, overhead costs. Although operating leverage doesn’t directly measure
business risk, the higher degree of operating leverage indicates higher business risk and vice
versa.

Degree of Operating Leverage (DOL)

Degree of operating leverage is computed as:

%Chnge∈ EBIT
Degree of Opereting Leverage=
%Change∈Out Put
Or
¿ Cast
Degree of Opereting Leverage=1+
EBIT
Illustration:
P= 10 birr
V= 4 birr
F= 30,000 birr
Level of output (Q) is 8,000 and increase to 10,000 units.
Required:
Determine DOL?
Solution:
EBIT= Q(P-V)-F
=8000(10-4)-30,000 = 18,000
EBIT= 10,000(10-4)-30,000=30,000
Percentage change in EBIT= (30,000-18,000)/18,000=66.67%
Percentage change in our puts = (10,000-8,000)/8,000=25%
% 66.67 %
Degree of Opereting Leverage= =2.67
% 25 %
Or
30,000
Degree of Opereting Leverage=1+ =2.67
18,000
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 or
Q ( p−v )
Degree of Opereting Leverage=
Q ( p−v ) −¿ Cost

8,000 (10−4 )
Degree of Opereting Leverage= =2.67
8,000 ( 10−4 ) −30,000
The coefficient of operating leverage of 2.67 is interpreted as a 1% change in output form the
current base levels, there will be a 2.67% change in EBIT in the same direction as the output
(sales) change. If output (sales) increases by 10%, EBIT will increase by 26.7% (10x 2.67%).
Similarly, if output (sales) decreases by 10%, EBIT will decrease by 26.7%. Other things equal,
the higher the fixed costs relative to variable costs, the higher the operating leverage.

Exercise:
A firm has a base level of 150,000 units of sales. The sales price per unit is Br10.00 and variable
costs per unit are Br6.50. Total annual operating fixed costs are Br155,000, and the annual
interest expense is Br90,000. What is this firm’s degree of operating leverage (DOL)?
Solution
Q ( p−v )
Degree of Opereting Leverage=
Q ( p−v ) −¿ Cost

150,000 ( 10−6.5 )
Degree of Opereting Leverage= =1.4
150,000 (10−6.5 )−150,000
Business risk depends on a number of factors, the more important of which are listed below:
 Demand variability. The more stable the demand for a firm’s products, other things held
constant, the lower its business risk.
 Sales price variability. Firms whose products are sold in highly volatile markets are exposed
to more business risk than similar firms whose output prices are more stable.
 Input cost variability. Firms whose input costs are highly uncertain are exposed to a high
degree of business risk.
 Ability to adjust output prices for changes in input costs. Some firms are better able than
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 others to raise their own output prices when input costs rise. The greater the ability to adjust
output prices to reflect cost conditions, the lower the degree of business risk.
 Ability to develop new products in a timely, cost-effective manner. Firms in such high-tech
industries as drugs and computers depend on a constant stream of new products. The faster
its products become obsolete, the greater a firm’s business risks.
 Foreign risk exposure. Firms that generate a high percentage of their earnings overseas are
subject to earnings declines due to exchange rate fluctuations. Also, if a firm operates in a
politically unstable area, it may be subject to political risks.
The extent to which costs are fixed: operating leverage. If a high percentage of costs are fixed,
hence do not decline when demand falls, then the firm is exposed to a relatively high degree of
business risk. Each of these factors is determined partly by the firm’s industry characteristics, but
each of them is also controllable to some extent by management.
1.3.2. Financial risk and Financial Leverage
Operating leverage refers to the fact that a lower ratio of variable cost per unit to price per
unit causes profit to vary more with a change in the level of output than it would if this ratio was
higher. Financial leverage refers to the fact that a higher ratio of debt to equity causes
profitability to vary more when earnings on assets changes than it would if this ratio was
lower. Financial leverage is created by financing with sources o f c a p i t a l that have fixed
costs.

The major sources of fixed charges financing are debt (requiring interest payment) and preferred
stock require dividend payment and leases which require lease payments. These financing fixed
costs affect the firm’s earning per share (EPS) in the same way that operating fixed costs affect
EBIT. The more fixed charge financing the firm uses, the more financial leverage it will have.

Degree of Financial leverage

Degree of financial leverage is defined as the percentage change in EPS divided by the
percentage change in EBIT.

%Change ∈EPS
Degree of Financial Leverage=
%Change∈ EBIT

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 Or
EBIT
Degree of Financial Leverage=
D
EBIT−I −L−
1−T

EPS=(EBIT −I )(1−T )−D ¿ ¿

N
Where:
EPS is earning per share
EBIT is earning before interest and tax
I is interest payment
T is tax rate
D is dividend for preferred stock holders
N is number of shares of common stock outstanding
L is lease payment
Unlike interest and lease payments, preferred dividends are not tax deductible.
Therefore, dividend payment has to be adjusted by dividing with (1-T) to make it on
equivalent basis.
Example

A firm has a base level of 500,000 units of sales and increase to 600,000 units. The sales price
per unit is Br10.00 and variable costs per unit are Br6.50. Total annual operating fixed costs
are Br1,250,000, and the annual interest expense is Br100,000. The firm paid 80,000 for
preferred stock holders and has 60,000 outstanding shares of common stock. The firm tax rate
is 40%.

1. What is the firm’ earning per share?

2. What is the firm’s degree of financial leverage (DFL)?
Solution:
1.
( EBIT −I )( 1−T )− D
EPS=
N

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 EBIT =Q ( p−v )−¿ Cost
EBIT =500,000 ( 10−6.5 )−1,250,000=500,000
( 500,000−100,000 ) (1−0.4 )−80,000
EPS= =2.67
60,000
If sales increase from 500,000 to 600,000 units the resulting EBIT and EPS are as
follows:
EBIT =600,000 ( 10−6.5 )−1,250,000=850,000

( 850,000−100,000 ) ( 1−0.4 )−80,000

EPS= =6.17
60,000
%Change ∈EPS
2 Degree of Financial Leverage=
%Change∈ EBIT
EPS 1−EPSo
%Change∈ EPS=
EPSo
6.17−2.67 3.5 = 1.1309
%Change∈ EPS= %Change∈ EPS=
2.67 2.67

EBIT 1−EBITo 850,000−500,000 =0.7

%Change∈ EPS= %Change∈ EPS=
EBITo 500,000
1.1309
Degree of Financial Leverage= =1.62
0.7

1.4. Optimum Capital Structure

It is the capital structure at that level of debt – equity proportion, where the market value per
share is maximum and the cost of capital is minimum. Particular mix of debt and equity which
maximizes the value of the firm, is known as optimum capital structure.

Example: In considering the most desirable capital structure of a company, a financial manager
has estimated the following.

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Required: determine the optimal debt - equity mix or optimal capital structure by the calculation
of overall cost of capital.

Solution:
Calculation of Overall Cost of Capital

Here optimal capital structure is one, with 90 % equity and 10 % debt since K is less 9.6

1.5. The Major theories of Capital structure

1. Net income (NI) theory

2. Net operating income (NPI) theory
3. Traditional theory
4. Modigliani-Miller (M-M) Theory
5. Other views of capital structure like pecking order theory, trade-off theory

1.5.1. Net Income (NI) theory

Net income approach suggested by the Durand. According to this approach, the capital structure
decision is relevant to the valuation of the firm. In other words, a change in the capital structure
leads to a corresponding change in the overall cost of capital as well as the total value of the
firm. According to this approach, use more debt finance to reduce the overall cost of capital and
increase the value of firm. Weighted Average Cost of Capital (WACC) is the weighted average
costs of equity and debts, where the weights are the amount of capital raised from each source.
WACC =( RRR∗Amount of Equity )+ ( Cost of Debt∗Amount of Debt Capital )

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Where:
WACC- weighted average cost of capital
RRR- required rate of return
According to Net Income Approach, a change in the financial leverage of a firm will lead to a
corresponding change in the Weighted Average Cost of Capital (WACC) and the company’s
value. The Net Income Approach suggests that with the increase in leverage (proportion of debt),
the WACC decreases, and the firm’s value increases. On the other hand, if there is a decrease in
the leverage, the WACC increases, thereby decreasing the firm’s value.
Earning After Tax
Value of Equity=
Cost of Equity

Particulars Amount

Earning Before Interest and Tax (EBIT) xxx

Interest Expense (Cost of Debt* Amount of Debt) (xxx)

Earning Before Tax (EBT) xxx

Tax is assumed to be zero 0

Earning After Tax (EAT) xxx

Shareholders’ Earning xxx

Market Value of Equity xxx

Market Value of Debt xxx

Value of the Firm=Market Value of Equity + Market Value of Debt xxx

EBIT xxx
WACC =
Vaue of the Firm

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Assumptions of Net Income Theory:
 The increase in debt will not affect the confidence levels of the investors.
 There are only two sources of finance; debt and equity.
 There are no sources of finance like Preference Share Capital and Retained Earnings.
 All companies have a uniform dividend payout ratio; it is 100%.
 There is no flotation cost, no transaction cost, and corporate dividend tax.
 The capital market is perfect; it means information about all companies is available to all
investors, and there are no chances of overpricing or underpricing of security. Further, it
means that all investors are rational. So, all investors want to maximize their return by
minimizing risk.
 All sources of finance are for infinity. There are no redeemable sources of finance.
Example:
The following information taken from ABC Company

Earnings before Interest Tax (EBIT) = 100,000

Bonds (Debt part) = 300,000

Cost of Bonds issued (Debt) = 10%

Cost of Equity = 14%

Required: Calculate Firm Value

Solution:

Earnings before Interest Tax (EBIT) = 100,000

Less: Interest cost (10% of 300,000) = 30,000

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 Earnings (since tax is assumed to be absent) = 70,000

Shareholders’ Earnings = 70,000

Market value of Equity (70,000/14%) = 500,000

Market value of Debt = 300,000

Total Market value = 800,000

Overall cost of capital (WACC) = EBIT/(Total value of the firm)

= 100,000/800,000

= 12.5%

Now, assume that the proportion of debt increases from 300,000 to 400,000, and everything else
remains the same.

Earnings before Interest Tax (EBIT) = 100,000

Less: Interest cost (10% of 400,000) = 40,000

Earnings (since tax is assumed to be absent) = 60,000

Shareholders’ Earnings = 60,000

Market value of Equity (60,000/14%) = 428,571 (Rounded)

Market value of Debt = 400,000

Total Market value = 828,571

Overall cost of capital = EBIT/(Total value of the firm)

= 100,000/828,571

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 = 12% (Rounded)

As observed, in the above case of ABC Company, with an increase in debt proportion, the total
market value of the company increases, and the cost of capital decreases. The reason for this
conclusion is the assumption of the NI approach that irrespective of debt financing in capital
structure, the cost of equity will remain the same. Further, the cost of debt is always lower than
the cost of equity, so with the increase in debt finance, WACC reduces, and the firm’s value
increases.
1.5.2. Net operating income (NOI) Theory
This theory is also known as “Irrelevant Theory”. Net Operating Income Approach to capital
structure believes that the value of a firm is not affected by the change of debt component in
the capital structure. It assumes that the benefit that a firm derives by infusion of debt is
negated by the simultaneous increase in the required rate of return by the equity shareholders.
With an increase in debt, the risk associated with the firm, mainly bankruptcy risk, also
increases, and such a risk perception increases the expectations of the equity shareholders.
Net Operating Income Approach suggests that the change in debt of the firm/company or the
change in leverage fails to affect the total value of the firm/company. As per this approach, the
WACC and the total value of a company are independent of the company’s capital structure
decision or financial leverage.

As per this approach, the market value is dependent on the operating income and the associated
business risk of the firm. Both these factors cannot be impacted by financial leverage. Financial
leverage can only impact the share of income earned by debt holders and equity holders but
cannot impact the operating incomes of the firm. Therefore, a change in the debt-to-equity ratio
cannot change the firm’s value. The increase in the debt component of a company, the company
is faced with higher risk. To compensate for that, the equity shareholders expect more returns.
Thus, with an increase in financial leverage, the cost of equity increases.

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Graphical Representation of Net Operating Income Theory of Capital Structure

Assumptions / Features of Net Operating Income Approach

 The overall capitalization rate remains constant irrespective of the degree of leverage. At
a given level of EBIT, the value of the firm would be “EBIT/Overall capitalization rate.
 Value of equity is the difference between total firm value and less value of debt, i.e.,
Value of Equity = Total Value of the Firm – Value of Debt.

17 | P a g e
  WACC (Weightage Average Cost of Capital) remains constant, and with the increase in
debt, the cost of equity increases. An increase in debt in the capital structure results in
increased risk for shareholders. As compensation for investing in the highly leveraged
company, the shareholders expect higher returns resulting in a higher cost of equity
capital.

Example:

The following information taken from ABC Company

Earnings before Interest Tax (EBIT) = 100,000

Bonds (Debt part) = 300,000

Cost of Bonds issued (Debt) = 10%

WACC = 12.5%

Required: Calculate Firm Value

Solution:

Earnings before Interest Tax (EBIT) = 100,000

WACC = 12.5%

Market value of the company = EBIT/WACC= 100,000/12.5% =800,000

Total Debt = 300,000

Total Equity = Total market value – total debt

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 =800,000-300,000= 500,000

EBIT-interest on debt= 100,000-(300,000*0.1)

Shareholders’ earnings =
=100,000-30,000= 70,000

Cost of equity = 70,000/500,000= 0.14 or 14%

Now, assume that the proportion of debt increases from 300,000 to 400,000, and everything else
remains the same.

Earnings before Interest Tax (EBIT) = 100,000

WACC = 12.5%

Market value of the company = EBIT/WACC=100,000/12.5%= 800,000

Total Debt = 400,000

Total market value – total debt

Total Equity =
800,000-400,000= 400,000

EBIT-interest on debt= 100,000-

Shareholders’ earnings = (400,000*0.1)
=100,000-40,000= 60,000

Cost of equity = 60,000/400,000= 0.15 or 15%

Dear learners, as observed in the case of the Net Operating Income approach, with the increase in
debt proportion, the total market value of the company remains unchanged, but the cost of equity
increases.

1.5.3. Traditional theory

It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and equity
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capital can increase the value of the firm by reducing overall cost of capital up to certain
level of debt. Traditional approach states that the Ko decreases only within the responsible

limit of financial leverage and when reaching the minimum level, it starts increasing with
financial leverage.

The traditional approach to capital structure suggests an optimal debt to equity ratio where the
overall cost of capital is the minimum and the firm’s market value is the maximum. On either
side of this point, changes in the financing mix can bring positive change to the firm’s value.
Before this point, the marginal cost of debt is less than the cost of equity, and after this point,
vice-versa.

Graphical Representation of Traditional Theory of Capital Structure

Assumptions

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 Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:

• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.

Example
Consider ABC company with the following data.

Particulars Case 1 Case 2 Case 3 Case 4 Case 5

Weight of debt 10% 30% 50% 70% 90%

Weight of
90% 70% 50% 30% 10%
equity

Cost of debt 10% 11% 12% 14% 16%

Cost of equity 17% 18% 19% 21% 23%

WACC 16.3% 15.9% 15.5% 16.1% 16.7%

From case 1 to case 3, the company increases its financial leverage, and as a result, the debt
increases from 10% to 50%, and equity decreases from 90% to 50%. The cost of debt and equity
also rises, as stated in the table above, because of the company’s higher exposure to risk. The
new WACC is decreased from 16.3% to 15.5%.
Dear learners, as you can observe from the above table, with the increase in the company’s
financial leverage, the overall cost of capital reduces, despite the individual increases in the cost

21 | P a g e
of debt and equity, respectively. The reason is that debt is a cheaper source of finance.
Now, look at the situation in case 3 to case 5, the company increases its financial leverage
further, and as a result, the debt is increased from 50% to 90% and equity from 50% to 10%. The
cost of debt and equity rises further. The new WACC is increased from 15.5% to 16.7%. As
observed, with the increase in the company’s financial leverage, the overall cost of capital
increases.
1.5.4. Modigliani and Miller Approach
Modigliani and Miller approach states that the financing decision of a firm does not affect the
market value of a firm in a perfect capital market. In other words, MM approach maintains that
the average cost of capital does not change with change in the debt weighted equity mix or
capital structures of the firm. The Modigliani and Miller Approach further state that the
operating income affects the firm’s market value, apart from the risk involved in the
investment. The theory states that the firm’s value is not dependent on the choice of capital
structure or financing decisions of the firm. Valuation of a firm is irrelevant to a company’s
capital structure. Whether a firm is high on leverage or has a lower debt component in the
financing mix has no bearing on the value of a firm.
Assumptions of Modigliani and Miller Approach
• There is a perfect capital market.
• There are no retained earnings.
• There are no corporate taxes.
• The investors act rationally.
• The dividend payout ratio is 100%.
• The business consists of the same level of business risk.
Modigliani and Miller Approach: Two Propositions without Taxes
Proposition 1
With the above assumptions of “no taxes,” the capital structure does not influence the valuation
of a firm. In other words, leveraging the company does not increase the company’s market
value. It also suggests that debt holders in the company and equity shareholders have the same
priority, i.e., earnings are equally split amongst them.
Proposition 2

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This says that financial leverage is directly proportional to the cost of equity. With an increase
in the debt component, the equity shareholders perceive a higher risk to the company. Hence, in
return, the shareholders expect a higher return, thereby increasing the cost of equity. A key
distinction here is that Proposition 2 assumes that debt shareholders have the upper hand as far
as the claim on earnings is concerned. Thus, the cost of debt reduces.
Value of the firm can be calculated with the help of the following formula:
EBIT (1-t)
V=
Ko
Where:
V- is value of firm
EBIT- is earning before interest and tax
K0- is the overall cost of capital or weighted average cost of capital
t - is tax rate
Example
There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not use any
debt in its financing, while B has Br. 2,50,000, 6% Debentures in its financing. Both the
firms have earnings before interest and tax of Br. 75,000 and the equity capitalization rate is
10%. Assuming the corporation tax is 50%, calculate the value of the firm.
Solution:
The market value of firm A which does not use any debt.
EBIT 75,000
Value of Firm A= (1-t)=Value of Firm A= (1-0) Value of Firm A=¿
Ko 0.1
750,0000
The market value of firm B which uses debt financing of Br. 250,000
Value of B=Value of A + ( tax rate∗Amount of Debt )
Value ofFirm B=750,000+ ( 0.5∗250,000 )
Value ofFirm B=750,000+ 125,000
Value ofFirm B=875,000

1.5.5. Trade-off theory (Static Trade-off Hypothesis)

The trade-off theory of capital structure is a financial theory that suggests that a company
23 | P a g e
should balance the costs and benefits of various sources of financing, such as debt and equity,
in order to achieve an optimal capital structure. The optimal capital structure is the mix of debt
and equity that maximizes the firm's value.
Benefits of debt:
Interest tax shield: Companies can deduct interest payments on debt from their taxable
income, which reduces their tax liability. This is a significant benefit, as it can effectively lower
the cost of debt financing.
Financial flexibility: Debt can provide companies with financial flexibility, as it allows them to
raise additional capital without issuing new equity. This can be useful for funding growth or
acquisitions.

Financial distress: As a company's debt level increases, it becomes more likely to experience
financial distress. This can lead to a number of negative consequences, such as defaults, loan
restructurings, and even bankruptcy.
Agency costs: Debt financing can create agency costs, as debt holders have different interests
than equity holders. For example, debt holders may pressure managers to focus on short-term
profits at the expense of long-term growth.
The optimal capital structure is the point where the marginal benefit of an additional dollar of
debt equals the marginal cost of that debt. In other words, it is the point where the company is
maximizing its value from the use of debt.
The trade-off theory is a widely used framework for analyzing capital structure decisions.
However, it is important to note that it is not a perfect model. There are a number of other
factors that can affect a company's optimal capital structure, such as its industry, business risk,
and growth prospects.
Assumptions of the trade-off theory:
 Companies are rational and seek to maximize their value.
 The capital markets are efficient and frictionless.
 Companies have access to a variety of debt and equity financing options.

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  The costs and benefits of debt and equity financing are well-defined and
understood.

Summary

Capital structure is defined as the combination of equity and debt that is put into use by a
company in order to finance the overall operations of the company and for its growth. Capital
structure policy dives into how a company finances itself, specifically the mix of debt and
equity used. Leverage, on the other hand, refers to the extent to which a company uses
borrowed funds (debt) in its capital structure. There are two kinds of leverage in finance:
operating leverage and financial leverage. Operating leverage refers to magnifying gains and
losses in earnings before interest and taxes (EBIT) by changes that occur in sales. Financial
leverage refers to the fact that a higher ratio of debt to equity causes profitability to vary more
when earnings on assets changes than it would if this ratio was lower. The optimum capital
structure is the composition of debt and equity capital that maximizes the firm value. The value
of the firm is maximized when the WACC is minimized. Theories of capital structure include
net income (NI) theory, net operating income (NPI) theory, traditional theory and Modigliani-
Miller (M-M) theory. According to Net Income Approach, a change in the financial leverage of
a firm will lead to a corresponding change in the Weighted Average Cost of Capital (WACC)
and the company’s value. Net Operating Income Approach suggests that the change in debt of
the firm/company or the change in leverage fails to affect the total value of the firm/company.
The traditional approach to capital structure suggests an optimal debt to equity ratio where the
overall cost of capital is the minimum and the firm’s market value is the maximum. The
Modigliani-Miller (M-M) theory states that the firm’s value is not dependent on the choice of
capital structure or financing decisions of the firm. Valuation of a firm is irrelevant to a
company’s capital structure.
Review Questions

1. Whenever a firm borrows money, it is using financial leverage.

A. True B. False

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2. which capital structure theory argue that debt financing initially increases the value of
the firm; however excess debt financing beyond a particular point reduces the value of the
firm?
A. NOI approach C. The traditional approach
B. the net income approaches D. Modgliani and miller
3. Capital structure and leverage decision come under the ambit of
A. Investing decision C. financing decision
B. distribution decision D. dividend decision
4. The capital structure of a company is comprised of:
A. Short-term debt only.
B. Long-term debt only.
C. A mix of debt and equity financing.
D. Retained earnings and operating profits.
5. Companies with high debt-to-equity ratios are generally considered to be:
A. More financially stable.
B. Less risky for investors.
C. More vulnerable to financial distress.
D. All of the above.
6. Companies with high financial leverage tend to be:
A. More stable and less risky
B. Less stable and more risky
C. More profitable overall
D. Not affected by economic conditions
7. A firm has a base level of 175,000 units of sales. The sales price per unit is Br 12.00 and
variable costs per unit are Br 7. Total annual operating fixed costs are Br 150,000, and the
annual interest expense is Br 100,000. What is this firm’s degree of operating leverage
(DOL)?
A. 1.21 C. 1.30
B. 1.40 D. 1.15
8. The optimal capital structure refers to the:
A. Highest possible debt-to-equity ratio

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 B. Capital structure that minimizes the weighted average cost of capital (WACC)
C. Capital structure with the most equity financing
D. Capital structure with the lowest cost of debt
9. If a company issues new debt, it can expect the:
A. Cost of equity to decrease C. WACC to remain unchanged
B. Cost of equity to increase D. Debt-to-equity ratio to improve
10. A company has Earnings before Interest Tax (EBIT)100,000, debt capital 300,000 cost of
debt 10%, cost of equity 14%. What is the weighted average cost of capital WACC?
A. 12.5% C. 10%
B. 14% D. 12%

Chapter Two

Dividend Policy and Theory

Learning Objectives
After studying this chapter, you should be able to:
 Understand dividend and types of dividends
 Explain dividend theories
 Distinguish relevancy and irrelevancy of dividend on value of firms
 Explain dividend policy
 Understand factors influencing dividend policy

Introduction
The financial manager must take careful decisions on how the profit should be distributed
among shareholders. It is very important and crucial part of the business concern, because
these decisions are directly related with the value of the business concern and shareholder’s
wealth. Like financing decision and investment decision, dividend decision is also a major part
of the financial manager. When the business concerns decide dividend policy, they have to
consider certain factors such as retained earnings and the nature of shareholder of the business

27 | P a g e
concern.
2.1. Meaning and Types of Dividends

Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit of a business concern, which is distributed among its
shareholders.
According to the Institute of Chartered Accountant of India, dividend is defined as “a
distribution to shareholders out of profits or reserves available for this purpose”.
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Dividends are classified into:
a) Cash dividend
b) Stock dividend
c) Bond dividend
d) Property dividend

Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to rising of more finance. Under this
type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue is
given only to the existing shareholders of the business concern.
Bond Dividend
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Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will be distributed
under the exceptional circumstance.
2.2. Dividend Decision and Dividend Theories

Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long-term growth. Hence, dividend
decision plays very important part in the financial management. Dividend decision consists of
two important concepts which are based on the relationship between dividend decision and value
of the firm.

Dividend Decision and Valuation of Firms

The value of the firm can be maximized if the shareholders wealth is maximized. There are
conflicting views regarding the impact of dividend decision on valuation of the firm. According
to one school of thought, dividend decision does not affect shareholders wealth and hence the
valuation of firm. On other hand, according to other school of thought dividend decision
materially affects the shareholders wealth and also valuation of the firm. We have discussed
below the views of two schools of thought under two groups:
1. The Irrelevance Concept of Dividend or Theory of Irrelevance.
2. The Relevance Concept of Dividend a Theory of Relevance.

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 2.2.1. The Irrelevance Concept of Dividend
The other school of thought on dividend policy and valuation of the firm argues that what a firm
pays as dividends to shareholders is irrelevant and the shareholders are indifferent about
receiving current dividend in future. The advocates of this school of thought argue that dividend
policy has no effect on market price of share. Two theories have been discussed here to focus on
irrelevance of dividend policy for valuation of the firm which are as follows:
1. Residual’s Theory of Dividend
According to this theory, dividend decision has no effect on the wealth of shareholders or the
prices of the shares and hence it is irrelevant so far as valuation of firm is concerned. This theory
regards dividend decision merely as a part of financing decision because earnings available may
be retained in the business for re-investment. But if the funds are not required in the business
they may be distributed as dividends. Thus, the decision to pay dividend or retain the earnings
may be taken as residual decision.
This theory assumes that investors do not differentiate between dividends and retentions by
firm. Their basic desire is to earn higher return on their investment. In case the firm has
profitable opportunities giving higher rate of return than cost of retained earnings, the investors
would be content with the firm retaining the earnings to finance the same. However, if the firm is
not in a position to find profitable investment opportunities, the investors would prefer to receive
the earnings in the form of dividends. Thus, a firm should retain earnings if it has profitable
investment opportunities otherwise it should pay them as dividends.
Under the Residuals theory, the firm would treat the dividend decision in three steps:
I. Determining the level of capital expenditures which is determined by the investment
opportunities.
II. Using the optimal financing mix, find out the amount of equity financing need to support the
capital expenditure in step (i) above
III. As the cost of retained earnings kris less than the cost of new equity capital, the retained
earnings would be used to meet the equity portions financing in step (ii) above. If available
profits are more than this need, then the surplus may be distributed as dividends of
shareholder. As far as the required equity financing is in excess of the amount of profits
available, no dividends would be paid to the shareholders.

30 | P a g e
Hence, in residual theory the dividend policy is influenced by (i) the company’s investment
opportunities and (ii) the availability of internally generated funds, where dividends are paid only
after all acceptable investment proposals have been financed. The dividend policy is totally
passive in nature and has no direct influence on the market price of the share.
2. Modigliani and Miller Approach (MM Model)
Modigliani and Miller have expressed in the most comprehensive manner in support of theory of
irrelevance. They maintain that dividend policy has no effect on market prices of shares and the
value of firm is determined by earning capacity of the firm or its investment policy. As observed
by M.M, “Under conditions of perfect capital markets, rational investors, absence of tax
discrimination between dividend income and capital appreciation, given the firm’s investment
policy, its dividend policy may have no influence on the market price of shares”. Even, the
splitting of earnings between retentions and dividends does not affect value of firm.

Assumptions of MM Hypothesis

(1) There are perfect capital markets.

(2) Investors behave rationally.
(3) Information about company is available to all without any cost.
(4) There are no floatation and transaction costs.
(5) The firm has a rigid investment policy.
(6) No investor is large enough to affect the market price of shares.
(7) There are either no taxes or there are no differences in tax rates applicable to
dividends and capital gains.
The Argument of MM
The argument given by MM in support of their hypothesis is that whatever increase in value of
the firm results from payment of dividend, will be exactly off set by achieve in market price of
shares because of external financing and there will be no change in total wealth of the
shareholders. For example, if a company, having investment opportunities distributes all its
earnings among the shareholders, it will have to raise additional funds from external sources.
This will result in increase in number of shares or payment of interest charges, resulting in fall in
earnings per share in future. Thus whatever a shareholder gains on account of dividend payment
31 | P a g e
is neutralized completely by the fall in the market price of shares due to decline in expected
future earnings per share. To be more specific, the market price of share in beginning of period is
equal to present value of dividends paid at end of period plus the market price of shares at end of
period plus the market price of shares at end of the period. This can be put in form of following
formula: -
P0 = D1 + P1
1 + Ke
where
PO = Market price per share at beginning of period.
D1 = Dividend to be received at end of period.
P1 = Market price per share at end of period.
Ke = Cost of equity capital.
P1 can be calculated with the help of the following formula.
P1 = Po (1+Ke) – D1

Example:
A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at Br100
each. The firm is expecting to pay a dividend of Br5 per share at the end of the current financial
year. The company's expected net earnings are Br250,000 and the new proposed investment
requires Br500,000. Prove that using MM model, the payment of dividend does not affect the
value of the firm.
Solution:
1. Value of the firm when dividends are paid:

i. Price per share at the end of year 1:

P0 = 1/(1+ke)*(D1+P1)
Br100 = 1/(1+0.10)*(Br5+P1)
P1 = Br105
ii. Amount required to be raised from the issue of new shares:
∆nP1 = I–(E–nD1)
=>Br500,000 – (Br250,000 - Br125,000)
=> Br375,000
32 | P a g e
 iii. Number of additional shares to be issued:
∆n = Br375,000 / 105 => 3571.42857 shares (unrounded)
iv. Value of the firm:

=>(25,000 + 3571.42857) (105) -

Br500,000 + Br250,000
(1 + 0.10)
=> Br2,500,000
2. Value of the firm when dividends are not paid:

i. Price per share at the end of year 1:

P0 = 1/(1 + ke)* (D1 +P1)
Br100 = 1/(1 + 0.10)* (Br0 + P1)
P1 = Br110
ii. Amount required to be raised from the issue of new shares:
=> Br500,000 – (Br250,000 -0) = Br250,000
iii. Number of additional shares to be issued:
=> Br250,000/Br110 = 2272.7273 shares (unrounded)
iv. Value of the firm:

=>(25,000 + 2272.7273) (110) -

Br500,000 + Br250,000
(1 + 0.10)
=> Br2,500,000

Thus, according to MM model, the value of the firm remains the same whether dividends are
paid or not. This example proves that the shareholders are indifferent between the retention of
profits and the payment of dividend.
The MM Hypothesis can be explained in another form also presuming that investment required
by the firm on account of payment of dividends is financed out of the new issue of equity shares.

33 | P a g e
In such a case, the number of new shares to be issued can be computed with the help of the
following equation

M × P1 = I – (X – nD1)

Where, M = Number of new share to be issued.

P1 = Price at which new issue is to be made.

I = Amount of investment required.

X = Total net profit of the firm during the period.

nD1= Total dividend paid during the period

Example 2

ABC Ltd. has a capital of Br. 1,000,000 in equity shares of Br. 100 each. The shares are
currently quoted at par. The company proposes to declare a dividend of Br. 10 per share at the
end of the current financial year. The capitalization rate for the risk class to which the company
belongs is 12%.

What will be the Market price of the share at the end of the year, if

i. A dividend is not declared.

ii. A dividend is declared.

iii. Assuming that the company pays the dividend and has net profits of Br. 500,000 and
makes new investments of Br. 1,000,000 during the period, how many new shares must
be issued? Use the MM Model.

Solution

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As per MM Model, the current MP of the share is

(i) If the dividend is not declared

P1 = Br. 112

(ii) If the dividend is declared

112 = 10 + P1

P1 = 112 – 10

P1 = Br. 102

(iii) In case the firm which pays dividend of Br 10 per share,

then the number of new shares to be issued is M.

M×P1 = I – (X – nD1)

M×102 = 1,000,000 – (500,000 – 10,000×10)

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102 m = 1,000,000 – 400,000

M= 5882.35 (or) 5883

The firm should issue 5883 new shares @ Rs. 102 per share to finance its investment proposals.
Further, the value of the firm can be ascertained with the help of the following formula
where,
m = number of shares to be issued.
I = Investment required.
E = Total earnings of the firm during the period.
P1 = Market price per share at the end of the period.
Ke = Cost of equity capital.
n = number of shares outstanding at the beginning of the period.
D1 = Dividend to be paid at the end of the period.
nPO = Value of the firm.
This equation shows that dividends have no effect on the value of the firm when external
financing is used. Given the firm’s investment decision, the firm has two alternatives, it can
retain its earnings to finance the investments or it can distribute the earnings to the shareholders
as dividends and can arise an equal amount externally. If the second alternative is preferred, it
would involve arbitrage process. Arbitrage refers to entering simultaneously into two
transactions which exactly balance or completely offset each other. Payment of dividends is
associated with raising funds through other means of financing. The effect of dividend payment
on shareholder’s wealth will be exactly offset by the effect of raising additional share capital.
When dividends are paid to the shareholder, the market price of the shares will increase. But the
issue of additional block of shares will cause a decline in the terminal value of shares. The
market price before and after the payment of the dividend would be identical. This theory thus
signifies that investors are indifferent about dividends and capital gains. Their principal aim is to
earn higher on investment. If a firm has investment opportunities at hand promising higher rate
of return than cost of capital, investor will be inclined more towards retention. However, if the
36 | P a g e
expected return is likely to be less than what it would cost, they would be least interested in
reinvestment of income. Modigiliani and Miller are of the opinion that value of a firm is
determined by earning potentiality and investment policy and never by dividend decision.

Criticism of MM Approach

MM Hypothesis has been criticized on account of various unrealistic assumptions as given

below.

1. Perfect capital market does not exist in reality.

2. Information about company is not available to all persons.
3. The firms have to incur floatation costs which issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends and capital gains.
5. The firms do not follow rigid investment policy.
6. The investors have to pay brokerage, fees etc. which doing any transaction.
7. Shareholders may prefer current income as compared to further gains.

2.2.2. The Relevance Concept of Dividend

The advocates of this school of thought include Myron Gordon, James Walter and Richardson.
According to them dividends communicate information to the investors about the firm’s
profitability and hence dividend decision becomes relevant. Those firms which pay higher
dividends will have greater value as compared to those which do not pay dividends or have a
lower dividend payout ratio. It holds that dividend decisions affect value of the firm.

We have examined below two theories representing this notion:

(i) Walter’s Approach and (ii) Gordon’s Approach.

(i) Walter’s Approach: Prof. Walter’s model is based on the relationship between the
firms (a) return on investment i.e. r and (b) the cost of capital or required rate of return i.e. k.

37 | P a g e
According to Prof. Walter, If r>k i.e. if the firm earns a higher rate of return on its investment
than the required rate of return, the firm should retain the earnings. Such firms are termed as
growth firm’s and the optimum pay-out would be zero which would maximize value of shares.

In case of declining firms which do not have profitable investments i.e. where r<k, the
shareholder would stand to gain if the firm distributes it earnings. For such firms, the optimum
payout would be 100% and the firms should distribute the entire earnings as dividend.

In case of normal firms where r = k the dividend policy will not affect the market value of shares
as the shareholders will get the same return from the firm as expected by them. For such firms,
there is no optimum dividend payout and value of firm would not change with the change in
dividend rate.

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Assumptions of Walter’s model

1. The firm has a very long life.

2. Earnings and dividends do not change while determining the value.
3. The Internal rate of return (r) and the cost of capital (k) of the firm are constant.
4. The investments of the firm are financed through retained earnings only and the firm does
not use external sources of funds.
Walter’s formula for determining the value of share

P = D + r/ke (E - D)

ke
Where P = Market price per share

D = Dividend per share

r = internal rate of return

E = earnings per share

ke = Cost of equity capital.

Example 3: The following information is available in respect of Axis Ltd.

Earnings per share (EPS or E) Br 10

Cost of Capital, ke, 10%

Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% for
different payouts of 0%, 40%, 80% and 100%.

Answer:

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The market price of the share as per Walter’s Model may be calculated for different
combinations of rates and dividend payout ratios (the earnings per share, E, and the cost of
capital, ke, taken as constant) as follows:
If the rate of return, r= 15% and the dividend payout ratio is 40%, then

P = D + (r/ke) (E-D)
Ke
P = 4 + (0.15/0.1) (10-4)
0.1
= 130

Similarly, if r= 8% and dividend Payout ratio = 80%, then

P = 8 + (0.15/0.1) (10-8)
0.1
P = 96

The expected market price of the share under different combinations of ‘r’ and ke have been
calculated and presented in the table below:

r= 15% 10% 8%

D/P Ratio 0% Br150 Br100 Br80

40% 130 100 88

80% 110 100 96

100% 100 100 100

It may be seen from the table that for a growth firm (r= 15% and r>ke), the market price is
highest at Br 150 when the firm adopts a zero payout and retains the entire earnings. As the
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payout increases gradually from 0% to 100%, the market price tends to decrease from Br 150 to
Br 100 and the firm retains no profit. However if r=ke= 10%, then the price is constant at Br 100
for different payouts ratios. Such a firm does not have any optimum ratio and every payout ratio
is good as any other.

Criticism of Walter’s Model

Walter’s model has been criticized on account of various assumptions made by Prof Walter in
formulating his hypothesis.

1. The basic assumption that investments are financed through retained earnings only is seldom
true in real world. Firms do raise fund by external financing.
2. The internal rate of return i.e. r also does not remain constant. As a matter of fact, with
increased investment the rate of return also changes.
3. The assumption that cost of capital (k) will remain constant also does not hold good. As a
firm’s risk pattern does not remain constant, it is not proper to assume that (k) will always
remain constant.
(ii)Gordon’s Approach
Another theory which contends that dividends are relevant is Gordon’s model. This model which
opinions that dividend policy of a firm affects its value are based on following assumptions:-
1. The firm is an all equity firm. No external financing is used and investment programs are
financed exclusively by retained earnings.
2. r and ke are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g=br) is also
constant.
5. ke>br
Gordon argues that the investors do have a preference for current dividends and there is a direct
relationship between the dividend policy and the market value of share. He has built the model
on basic premise that investors are basically risk averse and they evaluate the future

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dividend/capital gains as a risky and uncertain proposition. Investors are certain of receiving
incomes from dividend than from future capital gains. The incremental risk associated with
capital gains implies a higher required rate of return for discounting the capital gains than for
discounting the current dividends. In other words, an investor values current dividends more
highly than an expected future capital gain.

Hence, the “bird-in-hand” argument of this model suggests that dividend policy is relevant, as
investors prefer current dividends as against the future uncertain capital gains. When investors
are certain about their returns they discount the firm’s earnings at lower rate and therefore
placing a higher value for share and that of firm. So, the investors require a higher rate of return
as retention rate increases and this would adversely affect share [Link]: -

where P = Market price of equity share

E = Earnings per share of firm.

b = Retention Ratio (1 – payout ratio)

r = Rate of Return on Investment of the firm.

Ke = Cost of equity share capital.

br = g i.e. growth rate of firm.

Example 4:

The following information is available in respect of Axis Ltd.

Earnings per share (EPS or E) Br 10

Cost of Capital, ke, 10%

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Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% for
different payouts of 0%, 40%, 80% and 100%.

ANSWER:
The market price of the share as per Gorden’s model may be calculated as follows:
If r=15% and payout ratio is 40%, then the retention ratio, b, is 0.6 (i.e. 1-.4) and the growth rate,
g= br= .09 (i.e.,0 .6*0.15) and the market price of the share is
P = E (1-b)
ke-br
P = 10(1-.6)/0.10-.09
P = Br 400

If r= 8% and payout ratio is 80%, then the retention ratio, b, 0.2 (i.e., 1-.8) and the growth rate,
g=br=.016 (i.e., 0.2*0.08) and the market price of the share is

P = 10(1-.2)//10-.016

P = Br 95

Similarly, the expected market price under different combinations of ‘r’ and dividend payout
ratio have been calculated and shown below:

r= 15% 10% 8%

D/P Ratio 0% 0 0 0

40% Br400 Br100 Br77

80% 114.3 100 95

100% 100 100 100

On the basis of figures given in the table above, it can be seen that if the firm adopts a zero
payout then the investor may not be willing to offer any price. For a growth firm (i.e., r>ke>br),
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the market price decreases when the payout is increased. For a firm having r<ke, the market price
increases when the payout is increased.

If r=ke, the dividend policy is irrelevant and the market price remains constant at Br100 only.
Gordon had also argued that even if r=ke, the dividend payout ratio matters and the investors
being risk averse prefer current dividends which are certain to future capital gains which are
uncertain. The investors will apply a higher capitalization rate i.e., ke to discount the future
capital gains. This will compensate them for the future uncertain capital gain and thus, the
market price of the share of a firm which retains profit will be adversely affected.

2.3. Types of Dividend Policy

A finance manager’s objective for the company’s dividend policy is to maximize owner wealth
while providing adequate financing for the company. When a company’s earnings increase,
management does not automatically raise the dividend. Generally, there is a time lag between
increased earnings and the payment of a higher dividend. Only when management is confident
that the increased earnings would be sustained will they increase the dividend. Once dividends
are increased, they should continue to pay at the higher rate.

Dear Learners! The various types of dividend policies are briefly explained here:

1. Stable dividend-per-share policy. Many companies use a stable dividend-per-share policy

since it is looked upon favorably by investors. Dividend stability implies a low-risk company.
Even in a year that the company shows a loss rather than profit the dividend should be
maintained to avoid negative connotations to current and prospective investors. By continuing to
pay the dividend, the shareholders are more pertinent to view the loss as temporary. Some
stockholders rely on the receipt of stable dividends for income. A stable dividend policy is also
necessary for a company to be placed on a list of securities in which financial institutions
(pension funds, insurance companies) invest. Being on such a list provides greater marketability
for corporate shares.

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2. Constant dividend-payout-ratio (dividend per share/earnings per share) policy. With this
policy a constant percentage of earnings is paid out in dividends. Because net income varies,
dividends paid will also vary using this approach. The problem this policy causes is that if a
company’s earnings drop drastically or there is a loss, the dividends paid will be sharply reduced
or nonexistent. This policy will not maximize market price per share since most stockholders do
not want variability in their dividend receipts.

3. A compromise policy. A compromise between the policies of a stable birr amount and a
percentage amount of dividends is for a company to pay a low birr amount per share plus a
percentage increment in good years. While this policy affords flexibility, it also creates
uncertainty in the minds of investors as to the amount of dividends they are likely to receive.

Stockholders generally do not like such uncertainty. However, the policy may be appropriate
when earnings vary considerably over the years. The percentage, or extra, portion of the dividend
should not be paid regularly; otherwise it becomes meaningless.

4. Residual-dividend policy. When a company’s investment opportunities are not stable,

management may want to consider a fluctuating dividend policy. With this kind of policy the
amount of earnings retained depends upon the availability of investment opportunities in a
particular year. Dividends paid represent the residual amount from earnings after the company’s
investment needs are fulfilled.

Theoretical Position

Theoretically, a company should retain earnings rather than distribute them when the corporate
return exceeds the return investors can obtain on their money elsewhere. Further, if the company
obtains a return on its profits that exceeds the cost of capital, the market price of its stock will be
maximized.

Capital gains arising from the appreciation of the market price of stock have a tax advantage over
dividends. On the other hand, a company should not, theoretically, keep funds for investment if it

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earns less of a return than what the investors can earn elsewhere. If the owners have better
investment opportunities outside the firm, the company should pay a high dividend.

Although theoretical considerations from a financial point of view should be considered when
setting dividend policy, the practicality of the situation is that investors expect to be paid
dividends. Psychological factors come into play which may adversely affect the market price of
the stock of a company that does not pay dividends.

A company’s dividend policy is important for the following reasons:

1. It bears upon investor attitudes: For example, stockholders look unfavorably upon the
corporation when dividends are cut, since they associate the cutback with corporate financial
problems. Further, in setting a dividend policy, management must ascertain and fulfill the
objectives of its owners. Otherwise, the stockholders may sell their shares, which in turn may
bring down the market price of the stock. Stockholder dissatisfaction raises the possibility that
control of the company may be seized by an outside group.

2. It impacts the financing program and capital budget of the firm.

3. It affects the firm’s cash flow position. A company with a poor liquidity position may be
forced to restrict its dividend payments.

4. It lowers stockholders’ equity, since dividends are paid from retained earnings, and so results
in a higher debt-to-equity ratio.

If a company’s cash flows and investment requirements are volatile, the company should not
establish a high regular dividend. It would be better to establish a low regular dividend that can
be met even in years of poor earnings.

2.3.1. Determinants of Dividend Policy

The payment of dividend involves some legal as well as financial considerations. It is difficult to
determine a general dividend policy which can be followed by different firms at different times

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because dividend decision has to be taken considering the special circumstances of an individual
case.

Dear learners! The following are important factors which determine dividend policy of a firm:

1. Legal Restrictions: Legal Provisions relating to dividends as laid down in section, 205, 205A,
206 and 207 of companies Act, 1956 are significant because they lay down a framework within
which dividend policy is formulated. These provisions require that dividend can be paid only out
of current profit or past profits after providing for depreciation. The companies (Transfer of
Profits to Reserves) Rules, 1975 require a company providing more than 10% dividend to
transfer certain percentage of current year’s profit to Reserves.

When Dividend Proposed Amount to be transferred to Reserves most

not be less than
Exceeds 10% but not 12.5% of paid-up 2.5% of current year profit
capital
Exceeds 12.5% but not 15% of paid-up 5% of current year profit
capital
Exceeds 15% but not 20% of paid-up 7.5% of current year profits
capital
Exceeds 20% of paid-up capital 10% of current year profits.
Companies Act, further provides that dividend cannot be paid out of capital, because it will
amount to reduction of capital adversely affecting the security of creditors.

2. Desire and Type of Shareholders: Although, legally, the direction as to whether to declare
dividend or not has been left with BOD, the directors should give importance to desires of
shareholders in declaration of dividends as they are representatives of shareholders. Investors
such as retired persons, widows, and other economically weaker persons view dividends as
source of funds to meet their day-to-day living expenses. To benefit such investors, the
companies should pay regular dividends. On other hand, a wealthy investor in a high-income tax

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bracket may not benefit by high current dividend incomes. Such an investor may be interested in
lower current dividend and high capital gains.

3. Nature of Industry: Nature of Industry to which company is engaged also considerably

affects dividend policy. Certain industries have comparatively steady and stable demand
irrespective of prevailing economic conditions. For example, people used to drink liquor both in
boom as well as in recession. Such firms expect regular earnings and hence follow consistent
dividend policy. On the other hand, if earnings are uncertain, as in the case of luxury goods
conservative policy should be followed. Such firms should retain a substantial part of their
current earnings during boom period in order to provide funds to pay adequate dividends in the
recession periods. Thus, industries with steady demand of their products can follow a higher
dividend payout ratio while cyclical industries should follow a lower payout ratio.

4. Age of Company: It also influences dividend decision of company. A nearly established

concern has to limit payment of dividend and retain substantial part of earnings for financing its
future growth while older companies which have established sufficient reserves can afford to pay
liberal dividends.

5. Future Financial Requirements: If a company has highly profitable investment opportunities

it can convince the shareholders of need for limitation of dividend to increase future earnings and
stabilise its financial position. But when profitable investment appointments do not exist then
company may not be justified in retaining substantial part of its current earnings. Thus, a concern
having few internal investment opportunities should follow high payout ratio as compared to one
having more profitable investment opportunities.

6. Liquid Resources: The dividend policy of a firm is also influenced by availability of liquid
resources. Although, a firm may have sufficient available profit to declare dividends, yet it may
not be desirable to pay dividend if it does not have sufficient liquid resources. Hence liquidity
position of company is an important consideration in paying dividends. If company does not
have liquid resources, it is better to declare stock dividend i.e. issue of bonus shares to existing
shareholders.

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7. Requirements of Institutional Investors: Dividend policy of a company can be affected by
requirements of institutional investors such as financial institutions, banks, insurance
corporations etc. These investors usually favour a policy of regular payment of cash dividends
and stipulate there own terms with regard to payment of dividend on equity shares.

8. Stability of Dividends: Stability of dividend refers to payment of dividend regularly and

shareholders generally, prefer payment of such regular dividends. Some companies follow a
policy of constant dividend per share while others follow a policy of constant payout ratio and
while there are some other who follow a policy of constant low dividend per share plus an extra
dividend in years of high profits. A policy of constant dividend per share is most suitable to
concerns whose earnings are expected to remain stable over a number of years or those who have
built up sufficient reserves to pay dividends in years of low profits. The policy of constant
payout ratio i.e. paying a fixed percentage of net earnings every year may be supported by firm
because it is related to firms ability to pay dividends. The policy of constant low dividend per
share plus some extra dividend in years of high profits is suitable to firms having fluctuating
earnings from year to year.

9. Magnitude and Trend of Earnings: The amount and trend of earnings is an important aspect
of dividend policy. It is rather the starting point of the dividend policy. As dividends can be paid
only out of present or past’s years profits, earnings of a company fix the upper limits on
dividends. The dividends should nearly be paid out of current years earnings only as retained
earnings of the previous years become more or less a part of permanent investment in the
business to earn current profits. The past trend of the company’s earnings should also be kept in
consideration while making dividend decision.

10. Control objectives: When a company pays high dividends out of its earnings, it may result
in dilution of both control and earnings for existing shareholders. As in case of high dividend pay
out ratio the retained earnings are insignificant and company will have to issue new shares to
raise funds to finance its future requirements. The control of the existing shareholders will be
diluted if they cannot buy additional shares issued by the company. Similarly issue of new shares
shall cause increase in number of equity shares and ultimately cause a lower earnings per share

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and their price in the market. Thus under these circumstances to maintain control of the existing
shareholders, it may be desirable to declare lower dividends and retain earnings to finance the
firm’s future requirements.

2.4. The Dividend Payment Procedure

The decision to pay a dividend rest in the hands of the board of directors of the corporation.
When a dividend has been declared, it becomes a debt of the firm and cannot be rescinded easily.
Sometime after it has been declared, a dividend is distributed to all shareholders as of some
specific date.

Dear learners! Now, let see the example of standard dividend payment chronology:

1, Declaration date. This is the date on which the board of directors declares the dividend. On
this date, the payment of the dividend becomes a legal liability of the firm.
2. Date of record. This is the date upon which the stockholder is entitled to receive the dividend.
3. Ex-dividend date. The ex-dividend date is the date when the right to the dividend leaves the
shares. The right to a dividend stays with the stock until 4 days before the date of record. That is,
on the fourth day prior to the record date, the right to the dividend is no longer with the shares,
and the seller, not the buyer of that stock, is the one who will receive the dividend. The market
price of the stock reflects the fact that it has gone ex-dividend and will decrease by
approximately the amount of the dividend. To illustrate, consider that the date of record for the
dividend declared by the Acheme Company is October 20. Hailu sells Jemal his 100 shares of
Acheme Company on October 18. Hailu, not Jemal, will receive the dividend on the shares.
4. Date of payment. This is the date when the company distributes its dividend checks to its
stockholders.

2.5. Stock Dividends and Stock Split

2.5.1. Stock Dividends

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A stock dividend is the issuance of additional shares of stock to stockholders. A stock dividend
may be declared when the cash position of the firm is inadequate and/or when the firm wishes to
prompt more trading of its stock by reducing its market price. With a stock dividend, retained
earnings decrease but common stock and paid-in capital on common stock increase by the same
total amount. A stock dividend, therefore, provides no change in stockholders' wealth. Stock
dividends increase the shares held, but the proportion of the company each stockholder owns
remains the same. In other words, if a stockholder has a 2% interest in the company before a
stock dividend, he or she will continue to have a 2% interest after the stock dividend. For
example, assume Ato Jote owns 200 shares of Newland Corporation. There are 10,000 shares
outstanding; therefore, Ato Jote holds a 2% interest in the company. The company issues a stock
dividend of 10%. Ato Jote will then have 220 shares out of 11,000 shares issued. His
proportionate interest remains at 2% (220/11,000).

2.5.2. Stock Split

A stock split involves issuing a substantial amount of additional shares and reducing the par
value of the stock on a proportional basis. A stock split is often prompted by a desire to reduce
the market price per share, which will make it easier for small investors to purchase shares. To
illustrate, consider the example of Smart Corporation. It has 1,000 shares of Br. 20 par value
common stock outstanding. The total par value is Br. 20,000. A 4-for-1 stock split is issued.
After the split 4,000 shares at Br. 5 par value will be outstanding. The total par value thus
remains at Br. 20,000. Theoretically, the market price per share of the stock should also drop to
one-fourth of what it was before the split.
 The differences between a stock dividend and a stock split are as follows:
1) With a stock dividend, retained earnings are reduced and there is a pro rata distribution of
shares to stockholders. A stock split increases the shares outstanding but does not lower
retained earnings.
2) The par value of stock remains the same with a stock dividend but is proportionally reduced
in a stock split.
 The similarities between a stock dividend and a stock split are:
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 A. Cash is not paid.
B. Shares outstanding increase.
C. Stockholders’ equity remains the same.

2.6. Stock Repurchases

Dear learners! Companies can repurchase their previously issued stocks for different reasons.
Treasury stock is the term given to previously issued stock that has been purchased by the firm
itself. Corporations purchase their outstanding stock for several reasons:

1. To provide tax-efficient distributions of excess cash to shareholders: Capital gain rates

on sales of stock to the company by the stockholders have been approximately half the
ordinary tax rate for many investors. This advantage has been somewhat diminished by
recent changes in the tax law related to dividends.
2. To increase earnings per share and return on equity: Reducing both shares outstanding
and stockholders’ equity often enhances certain performance ratios. However, strategies to
hype performance measures might increase performance in the short run, but these tactics
add no real long-term value.
3. To provide stock for employee stock compensation contracts or to meet potential
merger needs: Honeywell Inc. reported that it would use part of its purchase of one million
common shares for employee stock compensation contracts. Other companies acquire
shares to have them available for business acquisitions.
4. To thwart takeover attempts or to reduce the number of stockholders: By reducing the
number of shares held by the public, existing owners and managements bar “outsiders”
from gaining control or significant influence. When Ted Turner attempted to acquire CBS,
CBS started a substantial buyback of its stock. Companies may also use stock purchases to
eliminate dissident stockholders.
5. To make a market in the stock. As one company executive noted: “Our Company is
trying to establish a floor for the stock.” Purchasing stock in the marketplace creates a
demand. This may stabilize the stock price or, in fact, increase it.
Some publicly held corporations have chosen to “go private,” that is, to eliminate public
(outside) ownership entirely by purchasing all of their outstanding stock. Companies often
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accomplish such a procedure through a leveraged buyout (LBO), in which the company borrows
money to finance the stock repurchases.
After reacquiring shares, a company may either retire them or hold them in the treasury for
reissue. If not retired, such shares are referred to as treasury stock (treasury shares). Technically,
treasury stock is a corporation’s own stock, reacquired after having been issued and fully paid.
Treasury stock is not an asset. When a company purchases treasury stock, a reduction occurs in
both assets and stockholders’ equity. It is inappropriate to imply that a corporation can own a
part of itself. A corporation may sell treasury stock to obtain funds, but that does not make
treasury stock a balance sheet asset. When a corporation buys back some of its own outstanding
stock, it has not acquired an asset; it reduces net assets.
The possession of treasury stock does not give the corporation the right to vote, to exercise
preemptive rights as a stockholder, to receive cash dividends, or to receive assets upon corporate
liquidation. Treasury stock is essentially the same as unissued capital stock. No one advocates
classifying unissued capital stock as an asset in the balance sheet.

Summary

dividend refers to the business concerns net profits distributed among the shareholders. dividend
decision of the business concern is one of the crucial parts of the financial manager, because it
determines the amount of profit to be distributed among shareholders and amount of profit to be
treated as retained earnings for financing its long-term growth. dividend decision consists of two
important concepts which are based on the relationship between dividend decision and value of
the firm. regarding relationship between dividend and value of a firms, there are two different
theories (relevancy of dividend and irrelevancy of dividend). the irrelevancy of dividend theory
suggests that in a perfect market, a firm's dividend policy has no impact on its overall value. the
relevancy of dividend theory on the other hand, suggests that dividend policy does influence a
firm's value. there are a number of factors that can influence a company's dividend policy, such
as legal restrictions, the desires of shareholders, and the nature of the industry. there are different
dividend policies such as, regular dividend policy, stable dividend policy, constant dividend per
share, constant payout ratio, stable dollar dividend plus extra dividend, irregular dividend policy,
no dividend policy.

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Review Exercises

1. Profit of a company which is distributed among its shareholders for reward of the
shareholder’s investments made by them in the shares of the company.

A. Dividend C. Net income

B. Retained earning D. Gross Profit

2. Assume a company’s management decided to pay the return of shareholders. To do so the

available cash is required for financing new investment opportunities. Due to that new
bonus shares are issued to satisfy shareholders. What form of dividend is followed by this
business?

A. Stock dividend C. Property dividend

B. Bond dividend D. Cash dividend

3. The declaration date is the date on which the:

A. Holders of record are determined for a dividend payment.
B. Stock begins selling without entitlement to an upcoming dividend payment.
C. Board of directors passes a resolution to pay a dividend.
D. Dividend checks are mailed to shareholders.
4. A policy under which a firm pays dividends only after its capital investment needs
are met while maintaining a constant debt/equity ratio is called a:
A. Homemade dividend policy. C. Residual dividend approach.
B. Constant distribution D. Cash dividend policy.

approach. E. Constant dividend growth

model

5. Leslie purchased 100 shares of GT, Inc. stock on Wednesday, July 7th. Marti

purchased 100 shares of GT, Inc. stock on Thursday, July 11 th. GT declared a

dividend on June 20th to shareholders of record on July 12th and payable on

August 1. Which one of the following statements concerning the dividend paid on
August 1 is correct given this information?

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 A. Neither Leslie not Marti is entitled to the dividend.
B. Leslie is entitled to the dividend but Marti is not.

C. Marti is entitled to the dividend but Leslie is not.

D. Both Marti and Leslie are entitled to the dividend.
E. Both Marti and Leslie are entitled to one-half of the dividend amount.
6. Moon World is a technology firm with excellent growth prospects. The firm wishes
to do something to acknowledge the loyalty of the shareholders but needs all of the
available cash to fund the firm's rapid growth. The market price of the stock is
currently trading in the middle of its preferred trading range. The firm could
consider:
A. Issuing a liquidating dividend. D. A reverse stock split.
B. A stock split. E. A special stock dividend
C. Issuing a stock dividend.
7. which one of the following is supporter of bird-in-the hand fallacy dividend policy
A. Myron Gordon. C. Pr. Walter
B. John Linter D. Miller and Modigliani.
E. A special stock dividend
8. Which of the following is correct about relevance concept of dividend?
A. The value the firm depends on the firm’s profitability
B. Dividend decision affects the value the firm
C. The shareholders require higher dividend payout ratio
D. All are correct
9. Which of the following is correct about relevance concept of dividend?
A. The value the firm depends on the firm’s profitability
B. Dividend decision affects the value the firm
C. The shareholders require higher dividend payout ratio
D. All are correct
10. If the company does not have sufficient funds to pay cash dividend, the company
promises to pay the shareholder at a future specific date with the help of issue_____
D. Cash dividend
E. Stock dividend
F. Bond dividend
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 G. None of the above

Chapter Three

Financial Forecasting

Learning Objectives
After studying this chapter, you should be able to:
 Describe meaning and purpose of financial forecasting
 Understand dimension of financial planning
 Describe procedures in financial forecasting
 Understand financial planning model
Introduction

In the first phase of corporate finance, you have had the concept that financial management
involves planning for raising and utilizing funds. Financial managers should be able to plan

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before hand in making investment and financing decisions. So, financial forecasting helps
financial managers to predict events before they occur. This, particularly, is true when they
plan to raise funds externally. Because a firm’s profit is often insufficient to finance assets in
the normal course of business, additional sources of finance should be considered.
Financial forecasting also forces financial managers to develop financial statements
beforehand. These financial statements are called Pro forma financial statements. They include
forecasted sales and forecasted expenses, forecasted assets, forecasted liabilities, and
forecasted stockholders’ equity. Based on these forecasted items, the financial manager is able
to determine the amount of finance to be obtained from external sources.
3.1. Meaning and Purpose of Financial Forecasting

Financial forecasting is one of the four major jobs of a firm’s financial staff, namely
performing financial forecasting and analysis, making investment decisions, and making
financing decisions. It is generally a planning process which involves forecasting of sales,
assets, and financial requirements. In other words, financial forecasting is a process which
involves:
 Evaluation of a firm’s need for increased or reduced productive capacity and
 Evaluation of the firm’s need for additional finance
Generally, financial forecasts are required to run a firm well. Their bases, in almost all
circumstances, are forecasted financial statements. An accurate financial forecast is
very important to any firm in several aspects:
 It helps a firm to predict appropriate demand for its products.
 It helps a firm to project its sales and accordingly to predict its assets properly.
 It contributes significantly to the firm’s profitability.
 It plays a crucial role in the value maximization goal of a firm.
Financial forecasts are also means for forecasted financial statements. By their virtue, a
firm can forecast its income statement, balance sheet and other related statements.
Besides, key ratios can be projected. Once financial statements and ratios have been
forecasted, the financial forecast

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 will be analyzed. Finally, the firm’s management will have an opportunity to make
some decisions beforehand.
So, all in all, financial forecasting is a pre requirement for the investment, financing, as
well as dividend policy decisions of a firm.
3.2. Dimensions of Financial Planning

It is often useful for planning purposes to think of the future as having a short run and a long
run. The short run, in practice, is usually the coming 12 months. We focus our attention on
financial planning over the long run, which is usually taken to be the coming two to five years.
This time period is called the planning horizon, and it is the first dimension of the planning
process that must be established.
In drawing up a financial plan, all of the individual projects and investments the firm will
undertake are combined to determine the total needed investment. In effect, the smaller
investment proposals of each operational unit are added up, and the sum is treated as one big
project. This process is called aggregation. The level of aggregation is the second dimension
of the planning process that needs to be determined.
Once the planning horizon and level of aggregation are established, a financial plan requires
inputs in the form of alternative sets of assumptions about important variables. For example,
suppose a company has two separate divisions: one for consumer products and one for gas
turbine engines. The financial planning process might require each division to prepare three
alternative business plans for the next three years:

1. A worst case: This plan would require making relatively pessimistic assumptions about
the company’s products and the state of the economy. This kind of disaster planning
would emphasize a division’s ability to withstand significant economic adversity, and
it would require details concerning cost cutting and even divestiture and liquidation.
2. A normal case: This plan would require making the most likely assumptions about the
company and the economy.
3. A best case: Each division would be required to work out a case based on optimistic
assumptions. It could involve new products and expansion and would then detail the

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 financing needed to fund the expansion. Not planning for good outcomes can lead to
lost profits.
3.3. Forecasting growth rates and outside financing

Based on our preceding discussion, we see that there is a direct link between growth and external
financing. In this section, we discuss two growth rates that are particularly useful in long-range
planning.

The Internal Growth Rate

The first growth rate of interest is the maximum growth rate that can be achieved with
no external financing of any kind. We will call this the internal growth rate because this is
the rate the firm can maintain with internal financing only. In case, the required increase in
assets is exactly equal to the addition to retained earnings, and EFN is therefore zero. Internal
growth rate can be computed by using the following formula:

Internal growth rate = ROA*b

1 – ROA*b

Here, ROA is the return on assets, and b is the retention ratio.

Illustration: For the Hoffman Company, net income was Br66 and total assets were
Br500. ROA is thus Br66/500 13.2%. Of the Br66 net income, Br44 was retained, so the
plowback ratio, b, is Br44/66 which is 2/3. With these numbers, we can calculate the internal
growth rate:

Thus, the Hoffman Company can expand at a maximum rate of 9.65 percent per year without
external financing.
The Sustainable Growth Rate
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The second growth rate of interest is the maximum growth rate a firm can achieve with no
external equity financing while it maintains a constant debt–equity ratio. This rate is
commonly called the sustainable growth rate because it is the maximum rate of growth a
firm can maintain without increasing its financial leverage. The precise value can be
calculated as follow:

Sustainable growth rate = ROE*b

1 – ROE*b

This is identical to the internal growth rate except that ROE, return on equity, is used instead
of ROA.
Example
For the Hoffman Company, net income was Br66 and total equity was Br250;
ROE is thus Br66/250= 26.4 percent.
The plowback ratio, b, is still 2/3, so we can calculate the sustainable growth rate as follows:

Thus, the Hoffman Company can expand at a maximum rate of 21.36 percent per
year without external equity financing.
Procedures in financial forecasting

The financial forecasting process generally involves the following procedures:

i. Forecasting of sales for the future period
ii. Determining the assets required to meet the sales targets, and
iii. Deciding on how to finance the required assets
The above three procedures are very important in projecting the financial statements and key
financial ratios. However, among the three procedures, the first one, i.e., sales forecast is
the most crucial.
Sales Forecasting

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Sales forecast is a forecast of a firm’s unit and birr sales for some future period. It is generally
based on recent sales trends and forecast of the economic prospects of the nation,
region, industry and other factors. This procedure starts usually by reviewing the sales of the
recent pasts. The whole crucial point of a financial forecasting process lies in an accurate
forecast of sales. If this procedure is off, the firm’s profitably as well as its value will be
negatively affected. So, in forecasting sales, several factors should be considered:
1. The historical sales growth pattern of the firm at both divisional and corporate levels,
2. The level of economic activity in each of the firm’s marketing areas,
3. The firm’s probable market share,
4. The effect of inflation on the firm’s future pricing of products,
5. The effect of advertising campaigns, cash and trade discounts, credit terms, and other
similar factors alike on future sales,
6. Individual products’ sales forecasts at each divisional level.
Forecast of sales is a base for forecasting of the firm’s income statement which in turn
helps to project retained earnings. In forecasting the income statement, assumptions about
the costs, tax rates, interest charges and dividends are required.
Determination of Assets Required

Sales forecasts are also grounds for determination of the firm’s assets requirement. If sales are
to increase, then assets must also grow. The amount each asset account must increase depends
whether the firm was operating at full capacity or not. If higher sales are projected, more cash
will be needed for transactions, higher sales will create higher receivables. Similarly, higher
sales require higher inventory and higher plant and equipment.
Deciding on how to finance the required assets

Finally, the firm will face the question of financing its required assets. Some of the required
finance can be covered by the increased retained earnings. The retained earnings increment
will result from increased sales and profit. Still some other portion of the finance can be
covered by some liabilities which will grow by the same proportion with that of sales. The
remaining finance must be obtained from available external sources.
The forecast of financial requirements, involves again three sub procedures. These are:

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 1. Determining how much money (finance) the firm will need during the forecasted
period. This will be done based on sales and assets forecast.
2. Determining how much of the total required finance, the firm will be able to generate
internally during the same period.
There are two types of finance that will be generated under normal operations. The first is
portion of the net income retained in the firm (retained earnings). The second one is the
increase in the firm’s liabilities as a direct and automatic result of its decision to increase sales.
This finance is called spontaneous finance. For example, if sales are to increase, inventory
must increase. The increase in inventory requires more purchases which in turn causes the
accounts payable to be increased. The accounts payable will increase spontaneously with
the increase in sales. Other examples include accruals like salaries and wages payable and
income tax payable.
3. Determining the additional external financial requirements. Any balance of the total
finance that cannot be met with normally generated funds must be obtained from
external sources. This finance is called the additional funds needed (AFN).
𝑨𝑭𝑵 = Required increase in assets − Required increase in normally generated funds
Additional funds needed (AFN) are funds that a firm must raise externally through
borrowing (bank loans, promissory notes, bonds, etc.) or by issuing new shares of common
stock or preferred stock.
Financial Planning Model

The Pro-Forma Financial Statements Method

The pro-forma financial statements method is simply a method of forecasting financial
requirements based on forecasted financial statements. As a result, this method is also called
the projected financial statements method. Under this method, the asset requirements are first
projected for the fore coming future period. The forecast of assets helps to determine the total
financial requirements. Then, the liabilities and equity that will be generated under normal
operations are projected. Finally, the additional funds needed will be estimated.
The pro-forma financial statements method of determining additional financial requirements
involves the following steps:

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 1. Developing the Pro Forma Income statement
The pro forma income statement provides a projection of the firm’s net income for the
forecasted period. This enables the firm to estimate the amount of retained earnings it will
generate during the period. In developing the projected income statement, first, a forecast of
sales should be established. Second, cost of goods sold should be determined. Third, other
expenses (operating and non-operating) should be computed. Next, the net income should be
determined. Finally, based on the amount of dividends, the amount of addition to retained
earnings should be determined.
2. Constructing the Pro Forma Balance Sheet
Higher sales must be supported by higher asset amounts. Some of the assets increase can be
financed by retained earnings, and spontaneous finance. The remaining balance must be
financed from external sources. In the forecast of the firm’s balance sheet, first, those balance
sheet items that are expected to increase directly with sales are forecasted. Next, the
spontaneously increasing liabilities are forecasted. Then, the liability and equity items that are
not directly affected by sales are set. Next, the value of retained earnings for the forecasted
period is obtained. Finally, the AFN will be raised.
For Example, Blue Nile Share Company is a medium sized firm engaged in manufacturing of
various household. The financial manager is preparing the financial forecast of the following
year. At the end of the year just completed, the condensed balance sheet of the company has
contained the following items.

Assets Liabilities and Equity

Cash Br. 10,000 A/payable Br. 90,000

A/receivable 70,000 Accruals 40,000
Inventories -----------------------150,000 Current liabilities-------------Br.
130,000
Current assets -------------Br. 230,000 Long-term debt---------------------200,000
Net fixed assets -----------------370,000 Common stock--------------------120,000
Retained earnings--------------------150,000
Total assets ------------------Br. 600,000 Total liabilities and equity------Br. 600,000

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During the year just completed, the firm had sales of Br. 1,800,000. In the following year, due
to increased demand to the firm’s products the financial manger estimates that sales will grow
at 10%. There are no preferred stocks outstanding during the year. The firm’s dividend pay-
out ratio is 60%. It is also known that the firm’s assets have been operating at full capacity.
During the same year, Blue Nile’s operating costs were Br. 1,620,000 and are estimated to
increase proportionately with sales. Assume the company’s interest expense will be Br. 40,000
during the next year and its tax rate is 40%.
Required: Determine the additional funds needed (AFN) of Blue Nile Share Company for the
next year using the pro forma financial statements method.

Solution

First, we develop the pro forma income statement

Pro Forma Income Statement

Sales (Br. 1,800,000 x 1.10) Br. 1,980,000

Operating costs (Br. 1,620,000 x 1.10)
1,782,000 Earnings before interest and taxes (EBIT)
………………………………….Br. 198,000
Interest expense

40,000 Earnings before taxes (EBT)

…………………………………………….Br. 158,000
Taxes (Br. 158,000 x 40%)
………………………………………………….63,200
Net income Br. 94,800
Dividends to common stock (Br. 94,800 x 60%) --------------------------------------------Br.

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56,880
Addition to retained earnings (Br. 94,800 – Br. 56,880) -----------------------------------Br.
37,920

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Then, we construct the pro forma balance sheet
Pro Forma Balance Sheet

Assets Liabilities and Equity

Cash (Br. 10,000 x 1.10) ----------------Br. 11,000 A/Payable (Br. 90,000 x 1.10) Br.
99,000
A./receivable (Br. 70,000 x 1.10) ----------77,000 Accruals (Br. 40,000 x 1.10)--44,000
Inventories (Br. 150,000 x 1.10) ----------165,000 Current liabilities ---------Br.
143,000
Current assets ---------------------------Br. 253,000 Long-term debt ………..200,000
Fixed assets (Br. 370,000 x 1.10) ----407,000Common stock----------------------120,000
RE(Br.150,000 + Br. 37,920)=187,920
Total assets -----------------------Br. 660,000Total liabilities and equity Br. 650,920
Blue Nile’s forecasted total assets as shown above are Br. 660,000. However, the forecasted total
liabilities and equity amount to only Br. 650,920. Since the balance sheet must balance, i.e.

A = L + OE, the difference must be covered by additional funds.

Therefore, AFN = Br. 660,000 – Br. 650,920 = Br. 9,080.

The Formula Method
This is a much easier method of determining additional financial requirements than the pro
forma method. The formula method is a shortcut to financial forecasting. However, many
companies use the pro forma method of forecasting their financial requirements because the
output of the formula method is less meaningful. Under the shortcut method, we make the
following assumptions:
1. Each asset maintains a direct proportionate relationship with sales
2. Accounts payable and accruals increase in direct proportion to sales increase.
3. The profit margin and the dividend pay-out ratios are constant.

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The formula that can be used as a shortcut to determine external capital requirements is
given as:

Where
AFN = Additional funds needed
Example
Let’s consider the data presented below to illustrate the determination of external capital needed
and the preparation of pro forma financial statements. Assume that Top Company has prepared
the following Balance Sheet and Income Statement for the year ended December 31, 2020.
Balance Sheet
Assets Liabilities and Stockholders’ Equity
Cash 175,000 Accounts Payable 140,000
As/R 150,000 Accrued liabilities 150,000
Inventory 800,000 Mortgage Notes Payable 1,410,000
Plant Assets, Net 1,500,000 Common Stock 800,000
Retained earnings 125,000
Total 2,625,000 Total 2,625,000

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 Sales 2,500,000
Income
Costs and Expenses except 1,400,000
Statement
depreciation
Depreciation 200,000
Total costs and expenses 1,600,000
Income before taxes 900,000
Taxes (40%) 360,000
Net Income 540,000

Additional Information

 The company plans to have dividend payout ratio of 45%

 Sales are expected to increase by 25% during next year (2021).
 All assets are affected by sales proportionately. Accounts Payable and accrued liabilities
are also affected by sales.
 All expenses are directly proportional to sales
 The firm has been operating at full capacity.
 The company has no preferred stock.
 Assume that additional funds needed would be financed from bond issue and common
stock in 40% and 60% respectively.

a) Increase in sales = 2,500,000 x 25% = Br. 625,000

Projected Sales=Current Sales+ Planned incease∈ sales

Projected Sales=2,500,000+625,000 = 3,125,000

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 ¿ Asset
b) Increase ∈¿ Assets= × Increase ∈Sales
Sales

1,500,000
¿ ×625,000=375,000
2,500,000

If sales increase by 25%, fixed assets will increase by Br 375,000

Current Asset
c) Increase ∈Current Assets= × Increase ∈Sales
Current Sales

1,125,000
Increase ∈Current Assets= ×625,000=281,250
2,500,000

Additional current assets of Br. 281,250 are needed if sales increase by 25%.

Spontaneous Liability
d) Spontaneousely Generated Funds= × Increase ∈Sales
Current Sales

290,000
¿ ×625,000=72,500
2,500,000

e) InternalGenerated Funds=Projected Net income – Projected Cash Dividends

Current Net Income

Projected Net Inocome= × Projected Sales
Current Sales

540,000
¿ ×3,125,000=675,000
2,500,000

Projected Dividend=Projected Net income × Dividend Payout Ratio

¿ 675,000 ×0.45=303,750

InternalGenerated Funds=Projected Net income – Projected Cash Dividends

¿ 675,000 – 303,750=371,250

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 f) Additional Funds (External Capital) Needed

AFN =Increase∈+ Increase∈−Spontaneously + Internally

¿ Assets Current assets Generated Funds Generated Funds

¿ ( 375,000+281,250 )−( 72,500+371,250 )

= 656,250−443,750=212,500

According to the financing policy, the company raises 40% of external capital requirement
from bond issue and the remaining from the issuance of common stock.

Accordingly,

– Additional Bond issue = 212,500 X 0.40 = 85,000

– Additional Common stock = 212,500 X 0.60 = 127,500

Based on the above computations and the original data, the following pro forma financial
statements could be prepared:

Projected Income statement items:

Sales 3,125,000

Costs and expenses except depreciation (1,400,000 x1.25) 1,750,000

Deprecation (200,000 x 1.25) 250,000

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 Top Company

Pro Forma Income Statement

For the Year Ended December 31, 2021

Sales ……………………………………………………………… 3,125,000

Less: Costs and Expenses except depreciation ………….. 1,750,000

Depreciation ………………………………………….. 250,000

Total costs and expenses ……………………………………………… 2,000,000

Income Before Taxes ……………………………………………… 1,125,000

Less: Income Taxes (40%) ……………………………………….. 450,000

Net income ………………………………………………………… 675,000

Projected Balance Sheet items:

Cash (175,000 x1.25)………………………………………………….218,750
Accounts receivable (150,000 x 1.25) ………………………………..187,500
Inventory (800,000 x 1.25)……………………………………………1,000,000
Fixed Assets (1,500,000 x 1.25)………………………………………1,875,000
Accounts Payable (140,000 x 1.25)…………………………………..175,000
Accrued liabilities (150,000 x 1.25)…………………………………..187,500
Mortgage notes payable ……………………………………………...1,410,000
Bonds Payable………………………………………………………...85,000
Common Stock (800,000 + 127,500)…………………………….927,500

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 Retained Earnings:

Beginning Retained Earnings 125,000

Add: Projected Net Income 675,000

Subtotal………………….. 800,000

Ded: Dividend ……………….. 303,750

Retained Earning, December 31, 2021 496,250

Top Company

Pro Forma Balance Sheet

December 31, 2021

Assets:

Current Assets:

Cash……………………………………………………….218,750

Accounts receivable………………………………………187,500

Inventory………………………………………………….1,000,000

Total current assets………………………………………..1,406,250

Fixed Assets………………………………………………1,875,000

Total Assets………………………………………………3,281,250

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 Liabilities & Stockholders’ Equity:

Current Liabilities:

Accounts Payable 175,000

Accrued liabilities 187,500

Total current Liabilities 362,500

Long-term debts:

Mortgage notes payable 1,410,000

Bonds Payable 85,000 1,495,000

Total Liabilities 1,857,500

Stockholders’ Equity:

Common Stock 927,500

Retained Earnings 496,250 1,423,750

Total Liabilities and Stockholders’ Equity 3,281,250

Note that any excess fund may be used for short-term investment purpose or for
repayment of liabilities, especially long-term liabilities.

Additional Funds Needed Model

The second financial planning model is the Additional Funds Needed model. This model is used
to compute external fund requirement and in turn used to prepare pro forma financial statements.

The model is shown below:

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 AFN =Required Asset Increase−Spontanous Liability Increse−increase∈ Retained Earning

A L
AFN =( × ∆ S)−( × ∆ S)−¿
S S

Where:

A = Assets that are tied directly to sales

S0 = Current sales

∆ S = Change in sales

L = Liabilities that increase spontaneously

M = Net Profit margin=Current Net Income/Current Sales

S1= Projected sales

D = Dividend payout ratio

Using Top Company data, Additional Funds Needed is computed as follows

A L
AFN =( × ∆ S)−( × ∆ S)−¿
S S

2,625,000 290,000
AFN =( × 625,000)−( ×625,000)−¿
2,500,000 2,500,000

AFN= 656,250.00 - 72,500.00 -371,250.00 = 212,500

Factors that affect additional financial requirements

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The external financial requirements of a firm during any given period are affected by several
factors.
1. Financial Planning: Refers to the growth rates of sales a firm has projected. Sales
growth rates and additional funds needed are positively related. At low growth rates
of a sale, a firm needs small or no external financing. The firm might even generate
surplus funds at low growth rates. As the growth rates increase, the AFN will also
increase. So other factors being constant, the higher the sales growth rates, the higher
the AFN.
2. Capital Intensity: This is the amount of assets required to support each birr of sales.
In the formula, this is designated as A/S. Generally, firms with higher capital intensity
ratios are with greater capital requirements. Highly capital-intensive firms generally
require more external funds than labor intensive firms.
3. Profit Margin: Profit margin is the net income per each birr of net sales. It is evident
from the very formula of computing AFN that external capital requirements and
net profit margin are related in opposite directions. Other factors held constant, the
higher the profit margin, the lower the external funds requirements.
4. Dividends policy: Dividend policy refers to the percentage of a firm’s net earnings
paid out as cash dividends. It is reflected in the firm’s payout ratio. The higher the
dividend payout ratio, the smaller the addition to retrained earnings, and hence the
greater the requirements for external finance.

Summary

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Financial forecasting involves predicting a company's financial future by analyzing past
performance data like revenue, cash flow, expenses, and sales. This process enables financial
managers to anticipate upcoming events and make well-informed decisions regarding
investments and financing. There are two key aspects to financial planning: the planning
horizon, which is the timeframe for creating a financial plan (typically one to five years), and
the level of aggregation, which determines the level of detail included in the plan. Financial
forecasts are usually developed through three main steps: forecasting sales, determining the
assets needed to achieve sales targets, and deciding how to finance these assets. The sales
forecast is particularly crucial as it directly impacts a company's profitability and overall value.
When calculating a company's additional funds needed (AFN), two primary methods are
commonly used: the pro-forma financial statements method and the formula method. The pro-
forma method is more detailed and informative, while the formula method offers a quicker but
less comprehensive approach. Various factors, such as financial planning, capital intensity,
profit margin, and dividend policy, can influence a company's external financial requirements.
By considering these factors and employing effective financial forecasting techniques,
businesses can better prepare for future financial challenges and opportunities.

Review Exercises
1) Financial forecasting helps financial managers to:
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 A. Predict appropriate demand for products
B. Project sales and asset needs
C. Make better investment decisions
D. All of the above
2) What are the three main procedures involved in financial forecasting?
A. Sales forecasting, asset determination, and financing decisions
B. Sales forecasting, asset valuation, and liability management
C. Sales forecasting, asset determination, and financing strategy
D. Sales budgeting, asset allocation, and capital budgeting
3) What is the main purpose of a financial forecast?
A. To comply with government regulations
B. To predict future profitability
C. To secure external financing
D. To value the company for acquisition
4) The two types of financial statements used in financial forecasting are:
A. Income statement and cash flow statement
B. Income statement and balance sheet
C. Balance sheet and cash flow statement
D. Retained earnings statement and stockholders' equity statement
5) The short-run planning period in financial forecasting typically refers to:
A. The next two to five years C. Beyond the next five years
B. The coming 12 months D. It depends on the industry

6) What is the process of combining individual investment proposals into a single plan for
analysis called?
A. Aggregation C. Diversification
B. Consolidation D. Integration
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 7) The three main types of alternative sets of assumptions used in financial planning are:
A. Worst case, normal case, and best-case
B. Short-term, mid-term, and long-term
C. Internal, external, and combined
D. All of the above
8) The internal growth rate refers to the maximum growth rate achievable with:
A. No change in debt-to-equity ratio
B. No external financing of any kind
C. Only short-term financing
D. A constant dividend payout ratio
9) The sustainable growth rate refers to the maximum growth rate achievable with:
A. No change in total assets
B. No external equity financing
C. A constant return on equity (ROE)
D. A declining profit margin
10) What factors are used to calculate the sustainable growth rate?
A. Return on Assets (ROA) and retention ratio (b)
B. Return on Equity (ROE) and retention ratio (b)
C. Net profit margin and plowback ratio
D. Debt-to-equity ratio and current ratio
11) The process of estimating a firm's sales for a future period is called:
A. Sales budgeting C. Sales forecasting
B. Sales targeting D. Demand estimation
12) What factors should be considered when forecasting sales?
A. Historical sales trends and economic outlook
B. Production capacity and marketing strategies
C. Interest rates and foreign exchange rates
D. All of the above
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 13) If higher sales are projected, what will likely happen to a firm's asset requirements?
A. They will decrease
B. They will remain constant
C. They will increase
D. It depends on the type of asset

Chapter Four

Managing Current Assets

Learning Objectives

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After studying this chapter, you should be able to:

 Define working capital

 Describe current assets and current liabilities
 Describe importance of working capital
 Identify principles of working capital management
 Explain current asset investment policies
 Describe cash and liquidity management
 Describe receivable management
 Describe inventory management

Introduction

The term Current Assets refer to those assets which in the ordinary course of business can be, or
will be, converted into cash within one year without undergoing a reduction in value and without
disrupting the operations of the firm. Current Liabilities are those liabilities which are intended,
at their inception, to be paid in the ordinary course of business, within a year, out of the current
assets or earnings of the concern. In the management of working capital two characteristics of
current assets must be borne in mind: (i) Short life span, and (ii) swift transformation into other
asset form.
Current assets have a short life span. Cash balance may be held idle for a week or two, account
receivables may have a life span of 30 to 60 days, and inventories may be held for 30 to 100
days. The life span of current assets depends upon the time required in the activities of
procurement, production, sales and collection and degree of coincide (synchronization) among
them.

Each current asset is swiftly transformed into another asset forms: cash is used for acquiring raw
material; raw materials are transformed into finished goods ( this transformation may involve
several stages of work-in-progress); finished goods, generally sold on credit, are converted into

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accounts receivables; and finally accounts receivables, on realization generate cash. The
following figure shows the cycle of transformation.

The goal of the working capital management is to manage the firm’s current assets and liabilities
in such a way that a satisfactory level of working capital is maintained. This is so because if the
firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and
may even be forced into bankruptcy. The current assets should be large enough to cover its
current liabilities in order to ensure a reasonably margin of safety. Each of the current assets
must be managed efficiently in order to maintain the liquidity of the firm while not keeping too
high level of any one of them. Each of the short-term sources of financing must be continuously
managed to ensure that they are obtained and used in the best possible way. The interaction
between current assets and current liabilities is, therefore, the main theme of the theory of
working capital management.

4.1. Working Capital Terminologies

Dear learners! Have you ever heard of the term working capital? Here in this part, we will
discuss about working capital in detail. There are two concepts of working capital: “Gross” and
“Net”.
The term Gross Working Capital also referred to as working capital means a firm’s investment
in assets that are expected to be converted to cash within one year (i.e. current assets).
Gross Working Capital = Total of Current Assets
When a firm is originally established there is a need for two types of investment, fixed asset
investments (land, building, machinery, vehicles, office equipment etc.) and working capital
investment. The working capital investment is meant for payments for raw material purchases,
payment for labor and to meet other expenditures in an attempt to produce goods (services) for
sale.

The term Net Working Capital (NWC) can be defined in two ways (i) the most common
definition of NWC is the difference between current assets and current liabilities; and (ii)
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alternative definition of NWC is that portion of current assets which is financed with long-term
funds.

NWC = Current Assets – Current Liabilities

NWC is commonly defined as the difference b/n CA s and CLs. Efficient working capital requires
that firms should operate with some amount of NWC, the exact amount varying from firm to
firm and depending, among other things, on the nature of industry. The theoretical justification
for the use of NWC to measure liquidity is based on the basis that the greater the margin by
which the current assets cover the short-term obligations, the more is the ability to pay
obligations when they become due for payment. The NWC is necessary because the cash
outflows and inflows do not coincide. In other words, it is the non-synchronous nature of cash
flows that makes NWC necessary. The cash inflows are, however, difficult to predict, therefore,
NWC is necessary. The more predictable the cash inflows are, the less NWC will be required and
vise-versa.

NWC can alternatively be defined as that part of the current assets which are financed with
long-term funds. Since current liabilities represent sources of short-term funds, as long as current
assets exceed the current liabilities, the excess must be finance with long-term funds.

4.1.1. Importance or Advantages of Adequate Working Capital

Working capital is the life blood and nerve center of a business. Hence, it is very essential to
maintain smooth running of a business. No business can run successfully without an adequate
amount of working capital. The main advantages of maintaining adequate amount of working
capital are as follows:

1) Solvency of the Business: Adequate working capital helps in maintaining solvency of

business by providing uninterrupted flow of production.

2) Goodwill: Sufficient working capital enables a business concern to make prompt

payments and hence helps in creating and maintaining goodwill.
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 3) Easy Loans: A concern having adequate working capital, high solvency and good credit
standing can arrange loans from banks and others on easy and favourable terms.

4) Cash Discounts: Adequate working capital also enables a concern to avail cash discounts
on purchases and hence it reduces cost.

5) Regular Supply of Raw Material: Sufficient working capital ensure regular supply of raw
materials and continuous production.

6) Regular payment of salaries, wages and other day to daycommitments: A company

which has ample working capital can make regular payment of salaries, wages and other
day to day commitments which raises morale of its employees, increases their efficiency,
reduces costs and wastages.

7) Ability to face crisis: Adequate working capital enables a concern to face business crisis
in emergencies such as depression.

8) Quick and regular return on investments: Every investor wants a quick and regular return
on his investments. Sufficiency of working capital enables a concern to pay quick and
regular dividends to is investor as there may not be much pressure to plough back profits
which gains the confidence of investors and creates a favorable market to raise additional
funds in future.

9) Exploitation of Favorable market conditions: Only concerns with adequate working

capital can exploit favorable market conditions such as purchasing its requirements in
bulk when the prices are lower and by holding its inventories for higher prices.

10) High Morale: Adequacy of working capital creates an environment of security,

confidence, high morale and creates overall efficiency in a business.

4.1.2. The Need for Working Capital

The need for working capital arises due to time gap between production and realisation of cash
from sales. There is an operating cycle involved in sales and realisation of cash. There are time

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gaps in purchase of raw materials and production, production and sales, and sales and realization
of cash. Thus, working capital is needed for following purposes.

1. For purchase of raw materials, components and spares.

2. To pay wages and salaries.

3. To incur day-to-day expenses and overhead costs such as fuel, power etc.

4. To meet selling costs as packing, advertisement

5. To provide credit facilities to customers.

6. To maintain inventories of raw materials, work in progress, stores and spares and finished
stock.

Greater size of business unit large will be requirements of working capital. The amount of
working capital needed goes on increasing with growth and expansion of business till it attains
maturity. At maturity the amount of working capital needed is called normal working capital.
Operating and Cash Conversion Cycle
The need for working capital or current assets cannot be overemphasized. Given the objective of
financial decision making which is to maximize the shareholders’ wealth, it is necessary to
generate sufficient profits. The extent to which profits can be earned will naturally depend,
among other things, upon the magnitude (size) of the sales. A successful sales program is, in
other words, necessary for earning profits by any business enterprise. However, sales do not
convert into cash instantly; there is invariably a time-lag b/n the sales of goods and the receipt of
cash. There is, therefore, a need for working capital in the form of CA s to deal with the problem
arising out of the lack of immediate realization of cash against good sold. Therefore, sufficient
working capital is necessary to sustain sales activity. Technically, this is referred to as the
“Operating Cycle”.

The Operating Cycle can be said to be at the heart of the need for working capital. The
continuing flow from cash to suppliers, to inventory, to accounts receivable and back into cash is

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what is called the Operating Cycle.

Phase 3
RECEIVABLES

CASH
Phase - 2

INVENTORY
Phase - 1

The Operating cycle consists of three phases. In the phase – 1, cash gets converted into
inventory. This includes purchase of raw materials, conversion of raw material into WIP,
finished goods and finally the transfer of goods to stock at the end of the manufacturing process.
In the case of trading organizations, this phase is shorter as there would be no manufacturing
activity and cash is directly converted into inventory. The phase is, of course, totally absent in
the case of service organizations.

In phase – 2 of the cycle the inventory is converted into receivables as credit sales are made to
customers. Firms which do not sell on credit obviously not have phase – 2 of the operating cycle.

The last, phase, phase – 3, represents the stage of when receivables are collected. This is phase
completes the operating cycle. This, the firm has moved from the cash to inventory, to
receivables and to cash again.

4.1.3. Characteristics of Working Capital

A) Circulating Capital

Working capital, once invested, is constantly circulating from one component to other
component of working capital. Cash is used to buy RMs, pay labor and overhead costs. Then the
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result of production becomes outputs and hence changed to finished goods inventories. The
finished goods will be sold either for cash or on account. The A/R is then changed back to cash.
This circulation goes on until the life of a project (see figure). Note that the working capital
changes with the stage of life cycle of product or condition of operation. Stable operation
necessitates constant working capital.

The cycle is shown in the following figure.

Working Capital as a Circulating Capital

WIP

Finished goods (or service)

Input (Raw Material)

Cash sales

Sales on account

Cash A/R

b) Liquidity

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Each component of working capital has different degrees of liquidity. Cash is the most liquid
asset. Next is the marketable security (it is sometimes called near cash asset). A/R is more liquid
than inventories in the sense that inventories may first be converted to receivables before it is
converted to cash.

c) Risk

Each component of working capital has its own risk. For example, accounts receivable may be
uncollectible or becomes bad debt. The raw materials may be damaged, finished goods may be
unsalable.

d) Profitability

Generally, excess working capital may reduce profit as the money is tied up in current assets,
entailing high cost (interest or opportunity cost).

Policy A Policy B
Current Assets 2000
1200
Fixed Assets 5000 5000
Total Assets 7000
6200
Current Liabilities 1000 1000
EBIT 2000
2000
Indicators:
Risk (Current ratio) 2.00 1.20
Profitability (EBIT/TA) 0.29
0.32

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Policy A with high volume of current asset is less profitable and less risky, while
policy B with low investment in current asset is more profitable but also riskier since the current
assets to current liability ratio is too low leaving the firm with little safety margin.

4.1.4. Types of working capital

Permanent and Temporary Working Capital

The operating cycle creates the need for the current assets (working capital). However, the need
does not come to an end after the cycle is completed. It continues to exist. To explain this
continuing need of current assets (working capital) a distinction should be drawn b/n
“Permanent and Temporary WC”.

To carry on business, a certain minimum level of working capital is necessary on a continuous

and uninterrupted basis. For all practical purposes, this requirement has to be met permanently as
with other fixed assets. This requirement is referred to as “Permanent or Fixed WC”.

Any amount over and above the permanent level of working capital is “temporary, fluctuating
or variable WC”. This is related to cyclical WC that does not have long term impact, changing
with sales and business cycles. The basic distinction b/n permanent and temporary WC is
illustrated in the above figure.

Permanent and Temporary WC

Y-axis

Amount of
WC Temporary WC

Permanent working capital

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 0 Time X - axis

The above figure shows that the permanent level is fairly constant, while temporary WC
is fluctuating – increasing and decreasing in accordance with seasonal demands. In the
case of an expanding firm, the permanent WC line may not be horizontal. This is because
the demand for permanent current assets might be increase (or decreasing) to support a
rising level of activity. In that case the line would be a rising one as shown in the
following figure

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 Determinants of Working Capital Management

A firm should plan its operations in such a way that it should have neither too much nor too little
working capital. The total working capital requirement is determined by a wide variety of
factors. These factors, however, affect different enterprise differently.

a) Nature of Business

The working capital requirement of a firm is closely related to the nature of its business. A
service firm, like electricity undertaking or a transport corporation, which has a short operating
cycle and which sells predominantly on cash basis, has modest (low) working capital
requirement. On the other hand, a manufacturing concern likes a machine tools unit, which has
long operating cycle and which sells largely on credit, has a very substantial working capital
requirement.

b) Length of Operating Cycle

The longer the operating cycle the more the working capital requirement will be. Hence, more
working capital is needed:

 The more time the inventories (RMs or FGs) are stocked.

 The more the manufacturing cycle (i.e. the more the time it takes to convert the raw
materials to final output).
 The more time it takes to collect receivables (liberal credit policy).
c) Seasonality of Operations

Firms which have marked seasonality in their operations usually have highly fluctuating working
capital requirements. To illustrate, consider a firm manufacturing rain coats. The sale of rain
coats reaches a peak during the rainy season and drops sharply during the winter period, and
almost no sales in summer season. The working capital need of such a firm is likely to increase
considerably in rainy months and decrease significantly during winter period. On the other hand,

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a firm manufacturing a product like lamps, which have fairly even sales round the year, tends to
have stable working capital needs.

d) Production Policy

A marked by pronounced seasonal fluctuation in its sales may pursue a production policy which
may reduce the sharp variations in working capital requirements. For example, a manufacturer of
rain coats may maintain a steady production throughout the year rather than intensify the
production activity during the peak business. Such a production policy may dampen the
fluctuations in working capital requirements.

e) Market Conditions

The degree of competition prevailing in the market place has an important bearing on working
capital needs. When competition is keen, a large inventory of finished goods is required to
promptly serve customers who may not inclined to wait because other manufacturer are ready to
meet their needs. Further, generous(liberal) credit terms may have to be offered to attract
customers in a highly competitive market. Thus, working capital needs tend to be high because
of greater investment in finished goods inventory and A/R.

f) Conditions of Supply

The inventory of raw material, spare parts, and stores depends on the conditions of supply. If the
supply is prompt and adequate, the firm can manage with small inventory. However, the supply
is unpredictable and scant then the firm, to ensure continuity of production, would have to
acquire stocks as and when they are available and carry larger inventory on an average. A similar
policy may have to follow when the raw material is available only seasonally and production
operations are carried out round the year.

g) Credit Policy
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The credit policy related to sales and purchases also affect the working capital. The credit policy
influences the requirements of working capital in two ways:
(1) through credit terms granted by the firm to its customers; (2) credit terms available to the
firm from its suppliers. The credit terms granted to customers have a bearing on the magnitude of
working capital by determining the level of receivables. The credit sales results in higher
receivables; higher receivables mean more working capital. On the other hand, if liberal credit
terms are available from the supplier of goods, the need for working capital is high. The working
capital requirements of a business are thus, affected by the terms of purchase and sale, and the
role given to credit by a company in its dealing with suppliers and customers.

h) Inflation

Inflation affects the value of cash and other elements of cash. More WC is required during high
inflation rate affecting price of inputs.

Excess or Inadequate Working Capital

Every business concern should have adequate working capital to run its business operations. It
should have neither excess working capital nor inadequate working capital. Both excess as well
as short working capital positions are bad for any business.

Disadvantages of Excessive Working Capital

1. Excessive working capital means idle funds which earn no profits for business and hence
business cannot earn a proper rate of return.

2. When there is a redundant working capital it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.

3. It may result into overall inefficiency in organization.

4. Due to low rate of return on investments, the value of shares may also fall.

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 5. The redundant working capital gives rise to speculative transaction.

6. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.

Disadvantages of Inadequate working capital

1. A concern which has inadequate working capital cannot pay its short-term liabilities in
time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts.
3. It becomes difficult for firm to exploit favorable market conditions and undertake
profitable projects due to lack of working capital.
4. The rate of return on investments also falls with shortage of working capital.
5. The firm cannot pay day-to-day expenses of its operations and it created inefficiencies,
increases costs and reduces the profits of business.

4.1.5. Alternative Current Assets Investment Policy

An investment working capital policy decision is concerned with the level of investment in
current assets. Under a relaxed/flexible policy, the investment in current assets is high. This
means that the firm maintains huge balance of cash and marketable securities, carries large
amount of inventories, and grants generous terms of credit to customers which leads to high level
of receivables.

Under a restricted/aggressive policy, the investment in current assets is low. This means that
firm keeps a small balance of cash marketable securities, manages with small amount of
inventories, and offers terms of credit which leads to a low level of receivables. A restricted
currents asset investment policy generally provides the highest expected return on investment
(ROI). But it entails the greatest risk. The reverse is true under a relaxed policy.

Moderate policy is a policy that is b/n the relaxed and restricted policy. It falls in between the
two extremes in terms of expected risk and return.

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 Alternative current assets investment policies

Determining the optimal level of current assets involves a trade-off between costs that rise with
currents assets and costs that fall with current assets. The former are referred to as “carrying
cost” and later as “shortage costs”. Carrying costs are mainly in the form of the cost of financing
a higher level of current assets. Shortage costs are mainly in the form of disruption in production
schedule, loss of sales, and loss of customer goodwill.

4.2. Cash Management

Cash management is one of the key areas of working capital management. Apart from the fact
that it is the most liquid current asset, cash is the common denominator to which all current assets
can be reduced because the other major liquid asset, that is, receivable, and inventory get
eventually converted into cash. This underlines the significance of the cash management.
The term “cash” with reference to cash management is used in two senses. In a narrow sense, it is
used broadly to cover currency and generally accepted equivalents of cash, such checks, drafts (an
order by one bank telling another bank, usually in another country, to pay money to someone) and
demand deposits (Checking accounts that pay no interest and can be withdrawn upon demand) in
banks. The broad view of cash also includes near-cash assets, such as marketable securities and
time deposits (a deposit of money for a fixed period, during which it cannot be withdrawn) in
banks.

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The main characteristics of these are that they can be readily sold and converted into cash. They
serve as a short- term investment outlay for excess cash and are also useful for meeting planned
outflow of funds. Here the term cash management is employed in the broader sense.
The following are some activities that are increases or decreases the cash balance

Activities that increases cash balance Activities that decrease cash balance
(Cash Inflow) (Cash outflow)

 Increasing long- term debt  Decreasing long- term debt

 Increasing equity(selling some stocks)  Decreasing equity
 Increasing current liabilities  Decreasing current liabilities
 Decreasing current assets other than  Increasing current assets other than
cash cash(buying some inventories etc)
 Decreasing fixed assets (selling assets)  Increasing fixed assets (purchase
Building, Furniture etc.)

4.2.1. Motives for Holding Cash (Reasons for Holding Cash)

Dear students! Do you have any idea about the motives for holding cash? If so, foreword your
points in writing before you decide to go through the following discussions.

There are three primary motives (Reasons) for maintaining cash balance:
1. Transaction Motive;
2. Precautionary Motive
3. Speculative Motive

Transaction Motive: An important reason for maintaining cash balance is the Transaction
Motive. This refers to the holding of cash to meet routine cash requirements to finance the
transactions which a firm carries on in the ordinary course of business. A firm enters into a
variety of transactions to accomplish it objectives which have to be paid for in the form cash. For
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example, cash payments have to be made for purchase, wages, operating expenses, financial
charges like interest, taxes, dividends, and so on. Similarly, there is a regular inflow of cash to
the firm from the sales operations returns on outside investment, and so on. These receipts and
payments constitute a continuous two-way flow of cash.
Motive and such motive refers to be holding of cash to meet anticipate obligations whose
timing is not perfectly synchronized with cash receipts.

Precautionary Motive: In addition to the non-coincide of anticipated cash receipt and payments
in the ordinary course of business, a firm may have to pay cash for purposes which cannot be
predicted or anticipated. The unexpected cash need at short may be result of:
Flood, strikes and failure of important customer;
Bills may be presented for settlement earlier than expected;
Unexpected slowdown in collection of accounts receivable;
Cancellation of some order for goods as the customer is not satisfied; &
Sharp increase in cost of raw materials.
The cash balance held in reserve for such random and unforeseen fluctuations in cash flows
are called as precautionary balances. In other words, precautionary motive of holding cash
implies the need to hold cash to meet unpredictable obligations.
Speculative Motive: It refers to the desire of a firm to take advantage of opportunities which
represent themselves at unexpected moments and which are typically outside the normal course
of business. While the precautionary motive is defensive in nature in that
firms must make provision to tide over unexpected contingencies, the speculative motive
represents appositive and aggressive approach. Firms aim to exploit profitable opportunities and
keep cash in reserve to do so. The speculative motive help to take advantage of:
An opportunity to purchase raw materials at reduced price on payment of immediate cash.
A chance to speculate on interest rate movements by buying securities when
interest rates are expected to decline.
Delay purchase of raw materials on the anticipation of decline in prices and

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Make purchase at favorable prices.
Of the three primary motive of holding cash balance, the most important one is the Transaction
Motive. Business firms normally do not speculate and need not have speculative balances. The
requirement of precautionary balance can be met out of short- term borrowings.

Benefit of Holding Adequate (Sufficient) Cash Balance

The important advantages of holding adequate cash balances are:
It prevents insolvency or bankruptcy arising out of the inability of a firm to meet its obligations.
The relationship with the bank is not strained (worried).
It helps in developing good relations with trade creditors and supplier of raw material, as prompt
payment may help their own cash management.
A cash discount can be availed, if its payment is made within the due date.
It leads to a strong credit rating which enables the firm to purchase goods on favorable terms and
to maintain its line of credit with banks and other sources of credit.
To take an advantage of favorable business opportunities that may be available periodically and
finally. The firm can meet unanticipated cash expenditure with a minimum of strain. Keeping
large cash balance, however, implies a high cost.

4.2.2. Objectives of cash Management

The basic objectives of cash management are two-fold:

a) Meeting payment
b) Minimizing Funds Committed to Cash Balance

Meeting payment: In the normal course of business, firms have to make payments of cash on a
continuous and regular basis to suppliers of goods, employees and so on. At the same time, there
is a constant inflow of cash through collections from accounts receivables. A basic objective of
cash management is to meet the payment schedule, that is, to have sufficient cash to meet the

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cash disbursement needs of a firm.
Minimizing Funds Committed to Cash Balance: The second objective of cash management is
to minimize cash balances. In minimizing cash balance, two conflicting aspects have to
reconcile. A high level of cash balances will, as shown above, ensure prompt payment together
with all the advantages. But it also implies that large funds will remain idle, as cash is non-
earning asset and the firm will have to fore go profits. A low level of cash balance, on the other
hand, may mean failure to meet the payment schedule. The aim of cash management, therefore,
should to have an optimal amount of cash balances.

Investment of Surplus Funds

There are, sometimes surplus funds with the companies which are required after sometime.
These funds can be employed in liquid and risk-free securities to earn some income. There are
number of avenues where these funds can be invested. The selection of securities or method of
investment is very important. Some of these methods are discussed herewith:

Treasury Bills: The treasury bills or T-Bills are the bills issued by the Reserve Bank of India for
different maturity periods. These bills are highly safe investment and are easily marketable.
These treasury bills usually have a very low level of yield and that too in the form of difference
purchase price and selling price as there is no interest payable on these bills.

Bank Deposits: All the commercial banks are offerings short term deposits schemes at varying
rate of interest depending upon the deposit period. A firm having excess cash can make deposit
for even short period of few days only. These deposits provide full safety, facility of pre-mature
retirement and a comfortable return.

Inter-Corporate Deposits: A firm having excess cash can make deposit with other firms also.
When company makes a deposit with another company, such deposit is known as inter corporate
deposits. These deposits are usually for a period of three months to one year. Higher rate of
interest is an important characteristic of these deposits.

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Bill Discounting: A firm having excess cash can also discount the bills of other firms in the
same way as the commercial banks do. On the bill maturity date, the firm will get the money.
However, the bill discounting as a marketable security is subject to 2 constraints (i) the safety of
this investment depends upon the credit rating of the acceptor of the bill, and (ii) usually the pre
mature retirement of bills is not available.

4.2.3. Estimating Cash Balances

The key purpose of cash management is to hold optimal balance of cash that is just enough to
meet the demand for cash. Cash balance more than the optimum level will cost the firm’s
profitability, whereas cash balance that is below the optimum level will result in poor liquidity.
Thus, the crux of cash management is to determine the level of cash which will provide
sufficient liquidity without adversely affecting profitability. Management’s goal should be to
maintain levels of transactional cash balances and marketable securities investments that
contribute to improving the value of the firm. If levels of cash are too high, the profitability of
the firm will be lower than if more optimal balance were maintained.

To determine the appropriate transactional cash balances firms can use either subjective
approaches or quantitative models.
Subjective Approaches
Since this approach is subjective in nature it relies on the firm’s experience. If the subjective
approach to maintain cash balance is equal to 10 percent of the following months sales and the
forecast amount of sales for the following month is, for example, birr 800,000, the firm would
maintain a birr 80,000 (i.e. 0.10  800,000) transaction cash balance.
Quantitative Models

Two quantitative models that management can use to determine the optimum cash balances are
the Baumol model and the Miller-Orr model.

1. Baumol Model
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William J. Baumol for the first time adopted the inventory economic order quantity model for
cash management in 1952. The model is popularly known as the Baumol’s model.

The Baumol model is a simple approach that provides for cost-efficient transactional cash
balances by determining optimal cash conversion quantity, that is, the optimal amount of cash
that should be transferred from marketable securities to cash each time a conversion is made. It
assumes that the demand for cash can be predicted with certainty and determines the optimum
cash balance or economic conversion quantity (ECQ). It treats cash as inventory item, the future
demand of which for settling transactions can be predicted with certainty. Baumol’s cash
management model helps in determining a firm’s optimum cash balance under certainty. A
portfolio of marketable securities acts as a reservoir for replenishing cash balances. The firm
manages this cash on the basis of the cost of converting marketable securities into cash
(transaction cost) and the cost of holding cash rather than marketable securities (opportunity
cost).

Most firms try to minimize the sum of the cost of holding cash and the cost of converting
marketable securities to cash. As per the model, cash and inventory management problems are
one and the same.

There are certain assumptions that are made in the model. They are as follows:

i) The firm is able to forecast its cash requirements with certainty and receive a specific
amount at regular intervals.
ii) The firm’s cash payments occur uniformly over a period of time, i.e., a steady rate of
cash outflows.
iii) The opportunity cost of holding cash is known and does not change over time.
iv) The firm will incur the same transactional cost whenever it converts securities to cash.

Let us assume that the firm sells securities and starts with a cash balance of C birr. When the
firm spends cash, its cash balance starts decreasing and reaches zero. The firm again gets back its

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money by selling marketable securities. As the cash balance decreases gradually, the average
cash balance will be: C*/2. This can be shown in the following figure:

Baumol Model for cash balance

Opportunity Cost: is the interest earnings per birr given up during a specified time period as a
result of holding funds in a non-interest earning cash account rather than having them invested in
interest earning marketable securities. This cost is the cost of holding cash instead of investing
the cash in marketable securities. Thus, the firm incurs a holding cost for maintaining the cash
balance. It is known as opportunity cost, the return inevitable on the marketable securities. If the
opportunity cost is k, then the firm’s holding cost for maintaining an average cash balance is as
follows.

Holding Cost = k(C*/2)

Where: k = the opportunity (in decimal form)
C*= the optimal amount of conversion (optimum cash balance)
C*/2 = the average cash balance

Transaction Cost (Conversion Cost): whenever the firm converts its marketable securities to
cash, it incurs a cost known as transaction cost. This includes the fixed cost of placing and

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receiving an order for cash in the amount of the optimal cash balance (C*). It includes the cost of
communicating the necessity to transfer funds from marketable securities to the cash account,
associated paper work costs, and the cost of any follow up action. The conversion cost is stated
as birr per conversion.

Total Funds Required ( T )

Total Number of Transaction=
Optimum Cash Balance ¿ ¿

The assumption here is that the cost per transaction is constant. If the cost per transaction is c,
then the total transaction cost will be:

Transaction cost = (Cost per transaction) *(Total of transaction) = c*(T/C*)

The optimal cash balance (C*) is the balance that will minimize the total cost of managing cash.
This optimum balance is the amount that will be converted from marketable securities as the
balance of cash at hand is depleted. Thus, this optimum cash balance is also known as the
economic conversion quantity (ECQ), i.e., the optimum amount to be transferred from
marketable securities to cash whenever conversion or cash is to be made.

Total cost: is the sum of the total conversion and total opportunity costs.

Total cost = Holding cost + Transaction cost

Total cos t= k (C*/2) + c (T/C*)

Optimum Level of Cash Balance

As the demand for cash, ‘C’ increases, the holding cost will also increase and the transaction cost
will reduce because of a decline in the number of transactions. Hence, it can be said that there is
a relationship b/n the holding cost and the transaction cost.

The optimum cash balance, C* is obtained when the total cost is minimum. When we solve the
total cost equation shown above to determine the level of C* where total cost is minimum, we
get the following equation for C*:
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 C* =2 x c x T Where: C* = the optimal amount of conversion
k T = the total cash needed during the year.
c = cost per conversion.
k = the opportunity cost of holding cash

balance

With the increase in the cost per transaction and total funds required, the optimum cash balance
will increase. However, with an increase in the opportunity cost, it will decrease.
Example: the management of Hake Sport, a small distributor of sporting goods, anticipates
Br1, 500,000 cash outlays (demand) during the coming year. A recent study indicates that it costs
Br. 30 to convert marketable securities to cash. The marketable securities portfolio currently
earns an 8% annual rate or return.

Required: Compute

a) The optimum cash conversion balance (C*)

b) The number of conversions
c) The average cash balance
d) The total cost

Solution:

a. C*= 2xConversion cost x demand for cash

Opportunity cost (in decimal form)

= 2x30x1,500,000
0.08
= Br.33, 541

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 b. The number of conversions during the year to replenish the account
= T/C*
= 1,500,000/33,541 = 45
c. The average cash balance
= C*/2 = Br.33,541/2 = Br.16,770.50
d. The cost of managing the cash is:
Total cost = k (C*/2) + c (T/C*)
=(0.08 x 16,770.50) + (Br.30 x 45) = Br.2,692
2. The Miller-Orr Model

The Miller-Orr (MO) model is considered by many as more realistic model for cash management
as compared to Baumol’s model since it allows the fluctuation in cash balance from time to time.
It is an improvement of Baumol’s model in some aspect but with its own new features as well.
The model was developed by Merton Miller and Daniel Orr in the early 1960 S, hence the name
Miller-Orr model.

The MO model overcomes Baumol’s shortcoming and allows for daily cash flow variation. It
assumes that firm’s cash flows vary randomly over a planning period with normal distribution of
zero mean and a given standard deviation.

As shown in the following figure, the MO model provides for two control limits – the upper
control limit and the lower control limit as well as a return point. If the firm’s cash flows
fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come
back to a normal level of cash balance (the return point). Similarly, when the firm’s cash flows
wander and hit the lower limit, it sells sufficient marketable securities to bring the cash balance
back to the normal level (the return point).

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 The firm sets the lower control limit as per its requirement of maintaining minimum cash
balance. The difference between the upper limit and the lower limit depends on the following
factors:

 The transaction cost (c)

 The interest rate, (k)
 The standard deviation () of net cash flows.

The formula for determining the distance between upper and lower control limits (called Z) is
as follows:

Z=
{ 4 × Daily opportunity cost ( ¿ decimal form )}
3 ×Transaction cost × variance of daily cash flow 1
3

Z= { 4K }
3 ×C × σ 2 1
3

Note: 1) Z will be larger if transaction cost is higher or cash flows show greater fluctuation

3) The gap b/n the two limits will come closer as the interest rate increases, i.e., Z is inversely
related to the interest rate.

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  Upper Limit = Lower Limit + 3Z
 Return Point = Lower Limit + Z. This is the optimum (target) cash balance.
 Average Cash Balance = Lower Limit + 4/3Z

The MO model is more realistic since it allows variation in cash balance within lower and upper
limits. The financial manager can set the lower limit according to the firm’s liquidity
requirement. The past data of the cash flow behavior can be used to determine the standard
deviation of net cash flows. Once the upper limit and lower limits are set, managerial attention is
needed only if the cash balance deviate from the limits. The action under these situations are
anticipated and planned in the beginning.

Example: Continuing with the prior example, the management of Hake Sport sets the minimum
cash balance of Br.1,000. The cost that converts marketable securities (MS S) to cash is Br.30; the
firm’s MSS portfolio earns an 8%annual return. The variance of Hake Sport’s daily net cash
flows is estimated to be Br. 27,000.

Required: Compute

a) the distance b/n the Upper and the Lower Limits (Z)
b) the Upper limit
c) average cash balance and the target cash balance.

Solution:

a. Z= { 4×k }
3 ×C × σ 2 1
3

Z= {3 ×304××27,000
k } 13
b. Upper Limit = Lower Limit + 3Z

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 =Br.1,000+(3x1,399)
= Br.5,197
c. Average Cash Balance = Lower Limit + 4/3Z
=Br.1,000+4/3 x 1,399
= Br. 2865.33
d. Target Cash Balance (Return point) = Lower Limit + Z
= Br.1,000 + 1,399
=Br.2,399

4.2.4. Cash Management Techniques

To minimize the firm’s financial requirements; financial managers attempt to speed collections
and delay disbursements.

Float

Dear students! Have you heard anything about float? What do you think about it? Try to
forward your own answer in writing.

Float is the difference between the bank balance (also called available balance) and the book
balance of an account holder. In the broader sense, float refers to funds that have been dispatched
by a payer (the firm or individual making payment) but are not yet in a form that can be spent by
the payee (the firm or individual receiving payment). Float also exists when a payee has received
funds in a spendable form but these funds have not been withdrawn from the account of the
payer. Delays in the collection –payment system resulting from the transportation and processing
of checks are responsible for float. With electronic payment system float will disappear.
However, financial managers must continue to understand and take advantage of float until that
time.

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Types of Floats

There are two types of floats. They are discussed below.

1. Collection float: results from the delay between the time when a payer or customer
deducts a payment from its checking account ledger and the time when the payee or
vendor actually receives these funds in a spendable form. Thus, collection float is
experienced by the payee and is a delay in the receipt of funds. Checks received by the
firm create collection float. Collection float increases
book balances but does not immediately change bank balances.

Example-Suppose XY CO. receives a check from a customer for Br 100,000 on Oct. 8. Assume
that the company has Br. 200,000 deposited in its bank and a zero float. The company deposits
and increases its book balance by Br.100,000 to Br.300,000. However, the additional cash is not
available to XY Company until its bank has presented the check to the customer’s bank and
received Br.100,000. This will occur, say, on October 14. In the meantime, the cash position at
XY Co. will reflect a collection float of Br.100,000.

Before October8, XY’s position is:

Float= firm’s bank balance-firm’s book balance

0 =Br.200,000 – Br.200,000

From October 8 to October 14; XY’s position is:

Collection float =firm’s bank balance – firm’s book balance
=200,000-300,000
= -100,000

2. Disbursement float: results from the lapse between the time when a firm deducts a
payment from its account ledger (disburse it) and the time when funds are actually
withdrawn from its account. Disbursement float is experienced by the payer and is a
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 delay in the actual withdrawal of funds. Checks written by the firm generate
disbursement float, causing a decrease in its book balance
but no change (until sometime in the future) in its bank balance.

Example –ABC Co. currently has Br. 100,000 on deposit with its bank. On June 8, it bought
some raw materials and pays with a check for Br.100,000. The company’s book balance is
immediately reduced by Br.100,000 as a result. ABC’s bank, however, will not find out about
this check until it is presented to ABC’s bank for payment, say, on June 14. Until the check is
presented, the firm’s bank balance is greater than its book balance by Br.100,000.

That is, before June 8, there was no float.

From June 8 to June 14, disbursement float = Firm’s bank bal. – Firm’s book bal.
=100,000-0
= 100,000

In general, a firm’s disbursement or payment activities generate disbursement float and its
collection activities generate collection float. The net effect, i.e., the sum of disbursement float
and collection float is the net float. The net float at a point in time is the overall d/c b/n the firm’s
available balance and its book balance. If the net float is positive, then the firm’s disbursement
float exceeds its collection float and its available balance exceeds its book balance. If the
available balance is less than the book balance, then the firm has a net collection float.

Components of Float

Both collection float and disbursement float have the same three basic components:

1. Mail float: the delay b/n the time when a payer places payment in the mail and the time
when it is received by the payee. Mail float refers to the money tied up in the mailing
process.

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 2. Processing float: the delay between the receipt of a check by the payee and the deposit
of it in the firm’s account. Processing float refers to funds received by the firm but not yet
deposited at its bank.
3. Clearing float: the delay b/n the deposit of a check by the payee and the actual
availability of the funds. This component of float is attributable to the time required for a
check to clear the banking system.

Speeding up Cash Collections

The firm’s objective is not only to stimulate customers to pay their accounts as promptly as
possible but also to convert their payments into a spendable form as quickly as possible- in other
words, to minimize collection float. Some of the techniques to speeding up collections are:

1. Lockboxes. A lockbox is simply a post office address handled by the firm’s bank. In a
lockbox system, the firm bills its customers with instructions to mail payments to a post
office box in a designed city. The firm authorizes a local bank (called a lockbox bank) to
collect checks from the box and process them through the bank’s clearing system,
notifying the firm of the payments. At time of deposit, the clearing process begins,
resulting in lower processing float because the checks are being deposited before the
firm’s accounting department processes the payments. This collection procedure in which
payers send their payments to a nearby post office box that is emptied by the firm’s bank
several times daily, and the bank deposits the payment checks in the firm’s account,
reduces collection float by shortening processing float as well as mail and clearing float.
2. Concentration banking system. In this system, the firm collects payments itself,
through flied sales offices or the like. Like lockboxes, this system has the advantage of
placing collection centers close to the customers, thereby reducing mail float. Payments
received by the sales offices are recorded and then deposited at a local (called a
depository bank). These are more likely to be banks since field officers are often in small

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 cities. Funds collected and deposited in depository banks are transferred to the firm’s
concentration banks. This reduces collection float by shortening mail and clearing float.
3. Direct send: a collection procedure in which the payee presents payment checks directly
to the banks on which they are drawn, thus reducing clearing float.
4. Preauthorized checks. Are checks written against a customer’s checking account for a
previously agreed upon amount by the firm to whom it is payable. Because the check has
been legally authorized by the customer, it does not require the customer’s signature. The
payee merely issues and then deposits the preauthorized check in its account. The check
then clears through the banking system just as if it were written by the customer and
received and deposited by the firm.
5. Wire transfer. Transfer of money electronically could minimize or even eliminate floats.

4.3. Receivables Management

A sound managerial control requires proper management of liquid assets and inventory. These
assets are a part of working capital of the business. An efficient use of financial resources is
necessary to avoid financial distress. Receivables result from credit sales. A concern is required
to allow credit sales in order to expand its sales volume. It is not always possible to sell goods on
cash basis only. Sometimes, other concerns in that line might have established a practice of
selling goods on credit basis. Under these circumstances, it is not possible to avoid credit sales
without adversely affecting sales. The increase in sales is also essential to increase profitability.
After a certain level of sales the increase in sales will not proportionately increase production
costs. The increase in sales will bring in more profits.

Thus, receivables constitute a significant portion of current assets of a firm. But, for investment
in receivables, a firm has to incur certain costs. Further, there is a risk of bad debts also. It is,
therefore, very necessary to have a proper control and management of receivables.

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4.3.1. Meaning of Receivables
Receivables represent amounts owed to the firm as a result of sale of goods or services in the
ordinary course of business. These are claims of the firm against its customers and form part of
its current assets. Receivables are also known as accounts receivables, trade receivables,
customer receivables or book debts. The receivables are carried for the customers. The period of
credit and extent of receivables depends upon the credit policy followed by the firm. The purpose
of maintaining or investing in receivables is to meet competition, and to increase the sales and
profits.

Costs of Maintaining Receivables

The allowing of credit to customers means giving funds for the customer’s use. The concern
incurs the following cost on maintaining receivables:

(1) Cost of Financing Receivables: When goods and services are provided on credit then
concern’s capital is allowed to be used by the customers. The receivables are financed from the
funds supplied by shareholders for long term financing and through retained earnings. The
concern incurs some cost for collecting funds which finance receivables.

(2) Cost of Collection: A proper collection of receivables is essential for receivables

management. The customers who do not pay the money during a stipulated credit period are sent
reminders for early payments. Some persons may have to be sent for collection these amounts.
All these costs are known as collection costs which a concern is generally required to incur.

(3) Bad Debts: Some customers may fail to pay the amounts due towards them. The amounts
which the customers fail to pay are known as bad debts. Though a concern may be able to
reduced bad debts through efficient collection machinery but one cannot altogether rule out this
cost.

4.3.2. Factors Influencing the Size of Receivables

Besides sales, a number of other factors also influence the size of receivables. The following
factors directly and indirectly affect the size of receivables.
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 1. Size of Credit Sales: The volume of credit sales is the first factor which increases or
decreases the size of receivables. If a concern sells only on cash basis as in the case of
Bata Shoe Company, then there will be no receivables. The higher the part of credit sales
out of total sales, figures of receivables will also be more or vice versa.

2. Credit Policies: A firm with conservative credit policy will have a low size of receivables
while a firm with liberal credit policy will be increasing this figure. If collections are
prompt then even if credit is liberally extended the size of receivables will remain under
control. In case receivables remain outstanding for a longer period, there is always a
possibility of bad debts.

3. Terms of Trade: The size of receivables also depends upon the terms of trade. The period
of credit allowed and rates of discount given are linked with receivables. If credit period
allowed is more then receivables will also be more. Sometimes trade policies of
competitors have to be followed otherwise it becomes difficult to expand the sales.

4. Expansion Plans: When a concern wants to expand its activities, it will have to enter new
markets. To attract customers, it will give incentives in the form of credit facilities. The
period of credit can be reduced when the firm is able to get permanent customers. In the
early stages of expansion more credit becomes essential and size of receivables will be
more.

5. Relation with Profits: The credit policy is followed with a view to increase sales. When
sales increase beyond a certain level the additional costs incurred are less than the
increase in revenues. It will be beneficial to increase sales beyond the point because it
will bring more profits. The increase in profits will be followed by an increase in the size
of receivables or vice-versa.

6. Credit Collection Efforts: The collection of credit should be streamlined. The customers
should be sent periodical reminders if they fail to pay in time. On the other hand, if
adequate attention is not paid towards credit collection then the concern can land itself in

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 a serious financial problem. An efficient credit collection machinery will reduce the size
of receivables.

7. Habits of Customers: The paying habits of customers also have bearing on the size of
receivables. The customers may be in the habit of delaying payments even though they
are financially sound. The concern should remain in touch with such customers and
should make them realize the urgency of their needs.

4.3.3. Meaning and Objectives of Receivables Management

Receivables management is the process of making decisions relating to investment in trade
debtors. We have already stated that certain investment in receivables is necessary to increase the
sales and the profits of a firm. But at the same time investment in this asset involves cost
considerations also. Further, there is always a risk of bad debts too. Thus, the objective of
receivables management is to take a sound decision as regards investment in debtors. In the
words of Bolton, S.E., the objectives of receivables management is “to promote sales and profits
until that point is reached where the return on investment in further funding of receivables is less
than the cost of funds raised to finance that additional credit.”

[Link]. Dimensions of Receivables Management

Receivables management involves the careful consideration of the following aspects:

1. Forming of credit policy.

2. Executing the credit policy.

3. Formulating and executing collection policy.

1. Forming of Credit Policy- For efficient management of receivables, a concern must adopt a
credit policy. A credit policy is related to decisions such as credit standards, length of credit
period, cash discount and discount period, etc.

(a) Quality of Trade Accounts of Credit Standards: The volume of sales will be influenced by the
credit policy of a concern. By liberalizing credit policy, the volume of sales can be increased

114 | P a g e
resulting into increased profits. The increased volume of sales is associated with certain risks too.
It will result in enhanced costs and risks of bad debts and delayed receipts. The increase in
number of customers will increase the clerical work of maintaining the additional accounts and
collecting of information about the credit worthiness of customers. There may be more bad debt
losses due to extension of credit to less worthy customers. These customers may also take more
time than normally allowed in making the payments resulting into tying up of additional capital
in receivables. On the other hand, extending credit to only credit worthy customers will save
costs like bad debt losses, collection costs, investigation costs, etc. The restriction of credit to
such customers only will certainly reduce sales volume, thus resulting in reduced profits.

A finance manager has to match the increased revenue with additional costs. The credit should
be liberalized only to the level where incremental revenue matches the additional costs. The
quality of trade accounts should be decided so that credit facilities are extended only up to that
level. The optimum level of investment in receivables should be where there is a tradeoff
between the costs and profitability. On the other hand, a tight credit policy increases the liquidity
of the firm. On the other hand, a tight credit policy increases the liquidity of the firm. Thus,
optimum level of investment in receivables is achieved at a point where there is a tradeoff
between cost, profitability and liquidity.

(b) Length of Credit Period: Credit terms or length of credit period means the period allowed to
the customers for making the payment. The customers paying well in time may also be allowed
certain cash discount. A concern fixes its own terms of credit depending upon its customers and
the volume of sales. The competitive pressure from other firms compels to follow similar credit
terms, otherwise customers may feel inclined to purchase from a firm which allows more days
for paying credit purchases. Sometimes more credit time is allowed to increase sales to existing
customers and also to attract new customers. The length of credit period and quantum of discount
allowed determine the magnitude of investment in receivables.

(c) Cash Discount: Cash discount is allowed to expedite the collection of receivables. The
concern will be able to use the additional funds received from expedited collections due to cash
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discount. The discount allowed involves cost. The discount should be allowed only if its cost is
less than the earnings from additional funds. If the funds cannot be profitably employed then
discount should not be allowed.

(d)Discount Period: The collection of receivables is influenced by the period allowed for
availing the discount. The additional period allowed for this facility may prompt some more
customers to avail discount and make payments. This will mean additional funds released from
receivables which may be alternatively used. At the same time the extending of discount period
will result in late collection of funds because those who were getting discount and making
payments as per earlier schedule will also delay their payments.

2. Executing Credit Policy

After formulating the credit policy, its proper execution is very important. The evaluation of
credit applications and finding out the credit worthiness of customers should be undertaken.

(a) Collecting Credit information: The first step in implementing credit policy will be to gather
credit information about the customers. This information should be adequate enough so that
proper analysis about the financial position of the customers is possible. This type of
investigation can be undertaken only up to a certain limit because it will involve cost.

The sources from which credit information will be available should be ascertained. The
information may be available from financial statements, credit rating agencies, reports from
banks, firm’s records etc. Financial reports of the customer for a number of years will be helpful
in determining the financial position and profitability position. The balance sheet will help in
finding out the short term and long-term position of the concern. The income statements will
show the profitability position of concern. The liquidity position and current assets movement
will help in finding out the current financial position. A proper analysis of financial statements
will be helpful in determining the credit worthiness of customers. There are credit rating
agencies which can supply information about various concerns. These agencies regularly collect

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information about business units from various sources and keep this information upto date. The
information is kept in confidence and may be used when required.

Credit information may be available with banks too. The banks have their credit departments to
analyses the financial position of a customer.

In case of old customers, business own records may help to know their credit worthiness. The
frequency of payments, cash discounts availed, interest paid on over due payments etc. may help
to form an opinion about the quality of credit.

(b) Credit Analysis: After gathering the required information, the finance manager should
analyze it to find out the credit worthiness of potential customers and also to see whether they
satisfy the standards of the concern or not. The credit analysis will determine the degree of risk
associated with the account, the capacity of the customer borrow and his ability and willingness
to pay.

(c) Credit Decision: After analyzing the credit worthiness of the customer, the finance manager
has to take a decision whether the credit is to be extended and if yes then up to what level. He
will match the creditworthiness of the customer with the credit standards of the company. If
customer’s creditworthiness is above the credit standards, then there is no problem in taking a
decision. It is only in the marginal case that such decisions are difficult to be made. In such cases
the benefit of extending the credit should be compared to the likely bad debt losses and then
decision should be taken. In case the customers are below the company credit standards then they
should not be outrightly refused. Rather they should be offered some alternative facilities. A
customer may be offered to pay on delivery of goods, invoices may be sent through bank. Such a
course help in retaining the customers at present and their dealings may help in reviewing their
requests at a later date.

(d) Financing Investments in Receivables and Factoring: Accounts receivables block a part of
working capital. Efforts should be made that funds are not tied up in receivables for longer
periods. The finance manager should make efforts to get receivables financed so that working

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capital needs are met in time. The quality of receivables will determine the amount of loan. The
banks will accept receivable of dependable parties only. Another method of getting funds against
receivables is their outright sale to the bank. The bank will credit the amount to the party after
deducting discount and will collect the money from the customers later. Here too, the bank will
insist on quality receivables only. Besides banks, there may be other agencies which can buy
receivables and pay cash for them. This facility is known as factoring. The factoring may be with
or without recourse. It is without recourse then any bad debt loss is taken up by the factor but if it
is with recourse then bad debts losses will be recovered from the seller.

Factoring is collection and finance service designed to improve he cash flow position of the
sellers by converting sales invoices into ready cash. The procedure of factoring can be explained
as follows:

1. Under an agreement between the selling firm and factor firm, the latter makes an
appraisal of the credit worthiness of potential customers and may also set the credit limit
and term of credit for different customers.

2. The sales documents will contain the instructions to make payment directly to factor who
is responsible for collection.

3. When the payment is received by the factor on the due date the factor shall deduct its
fees, charges etc and credit the balance to the firm’s accounts.

4. In some cases, if agreed the factor firm may also provide advance finance to selling firm
for which it may charge from selling firm. In a way this tantamount to bill discounting by
the factor firm. However, factoring is something more than mere bill discounting, as the
former includes analysis of the credit worthiness of the customer also. The factor may
pay whole or a substantial portion of sales vale to the selling firm immediately on sales
being affected. The balance if any, may be paid on normal due date.

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Benefits and Cost of Factoring

Firm availing factoring services may have the following benefits:

 Better Cash Flows

 Better Assets Management

 Better Working Capital Management

 Better Administration

 Better Evaluation

 Better Risk Management

However, the factoring involves some monetary and non-monetary costs as follows:

Monetary Costs

a. The factor firm charges substantial fees and commission for collection of receivables.
These charges sometimes may be too much in view of amount involved.

b. The advance fiancé provided by factor firm would be available at a higher interest costs
than usual rate of interest.

Non-Monetary Costs

a. The factor firm doing the evaluation of credit worthiness of the customer will be
primarily concerned with the minimization of risk of delays and defaults. In the process it
may over look sales growth aspect.

b. A factor is in fact a third party to the customer who may not feel comfortable while
dealing with it.

c. The factoring of receivables may be considered as a symptom of financial weakness.

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3. Formulating and Executing Collection Policy

The collection of amounts due to the customers is very important. The collection policy the
termed as strict and lenient. A strict policy of collection will involve more efforts on collection.
Such a policy has both positive and negative effects. This policy will enable early collection of
dues and will reduce bad debt losses. The money collected will be used for other purposes and
the profits of the concern will go up. On the other hand, a rigorous collection policy will involve
increased collection costs. It may also reduce the volume of sales. A lenient policy may increase
the debt collection period and more bad debt losses. A customer not clearing the dues for long
may not repeat his order because he will have to pay earlier dues first, thus causing.

The objective is to collect the dues and not to annoy the customer. The steps should be like (i)
sending a reminder for payments (ii) Personal request through telephone etc. (iii) Personal visits
to the customers (iv) Taking help of collecting agencies and lastly (v) Taking legal action. The
last step should be taken only after exhausting all other means because it will have a bad impact
on relations with customers.

Illustration: ABC Company is making sales of Br.1, 600,000 and it extends a credit of 90 days to
its customers. However, in order to overcome the financial difficulties, it is considering to
change the credit policy. The proposed terms of credit and expected sales are given hereunder:

Policy Terms Sales

I 75 days Br.1,500,000

II 60 days Br. 1,450,000

III 45 days Br. 1,425,000

IV 30 days Br. 1,350,000

V 15 days Br.1,300,000

The firm has variable cost of 80% and fixed cost of Br.100,000. The cost of capital is 15%.
Evaluate different policies and which policy should be adopted
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 Solution:

figures in Br.

Particulars Present I II III IV V

Sales 1,600,000 1,500,000 1,450,000 1,425,000 1,350,000 1,300,000

Variable cost 1,280,000 1,200,000 1,160,000 1,140,000 1,080,000 1,040,000

-Fixed Cost 100,000 100,000 100,000 100,000 100,000 100,000

Profit (A) 220,000 200,000 190,000 185,000 170,000 160,000

Total Cost 1,380,000 1,300,000 1,260,000 1,240,000 1,180,000 1,140,000

Average Receivable (at cost) 345,000 270,833 210,000 155,000 98,333 47,500
(B)

(Cost/360*credit period
51,750 40,625 31,500 23,250 14,750 7,125
Cost of debtors @ 15% (B)
168,250 159,350 158,500 161,750 155,250 152,875
Net profit (A – B)

Illustration: Traders whose current sales are Br.1, 500,000 per annum and average collection
period is 30 days wants to pursue a more liberal credit policy to improve sales. A study made by
consultant firm reveals the following information.

Credit Policy increase in collection period Increase in sales

A 15 days Br.60,000

B 30 days 90,000

C 45 days 150,000

D 60 days 180,000

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 E 90 days 200,000

The selling price per unit is Br.5. Average Cost per unit is Br.4 and variable cost per unit is
Br.2.75 per unit. The required rate of return on additional investments is 20 percent. Assume 360
days a year and also assume that there are no bad debts. Which of the above policies would you
recommend for adoption?

Solution:

Particulars Present A B C D E
Credit period 30 days 45 days 60 days 75 days 90 days 120 days
No. of units @ Br.5 300,000 312,000 318,000 330,000 336,000 340,000
Sales 1,500,000 1,560,000 1,590,000 1,650,000 1,680,000 1,700,000
Variable cost@ 2.75 825,000 858,000 874,500 907,500 924,000 935,000
Fixed Cost 375,000 375,000 375,000 375,000 375,000 375,000
Total Cost 1,200,000 1,233,000 1,249,500 1,282,500 1,299,000 1,310,000
Profit (A) 300,000 327,000 340,500 367,500 381,000 390,000
Average debtors(at cost)
Cost/360* credit period 100,000 154,125 208,250 267,188 324,750 436,667
Cost of investment@ 20% 20,000 30,825 41,650 53,437 64,950 87,333
(B) 280,000 296,175 298,850 314,063 316,050 302,667
Net Profit (A-B)

4.4. INVENTORY MANAGEMENT

Every enterprise needs inventory for smooth running of its activities. It serves as a link between
production and distribution processes. There is, generally, a time lag between the recognition of
need and its fulfillment. The greater the time lag, the higher the requirements for inventory.
The investment in inventories constitutes the most significant part of current assets/working
capital in most of the undertakings. Thus, it is very essential to have proper control and
management of inventories. The purpose of inventory management is to ensure availability of
materials in sufficient quantity as and when required and also to minimize investment in
inventories.

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4.4.1. Meaning and Nature of inventory

In accounting language, it may mean stock of finished goods only. In a manufacturing concern, it
may include raw materials, work in process and stores, etc. Inventory includes the following
things:

(a) Raw Material: Raw material form a major input into the organization. They are required to
carry out production activities uninterruptedly. The quantity of raw materials required will be
determined by the rate of consumption and the time required for replenishing the supplies. The
factors like the availability of raw materials and government regulations etc. too affect the stock
of raw materials.

(b) Work in Progress: The work-in-progress is that stage of stocks which are in between raw
materials and finished goods. The raw materials enter the process of manufacture but they are yet
to attain a final shape of finished goods. The quantum of work in progress depends upon the time
taken in the manufacturing process. The greater the time taken in manufacturing, the more will
be the amount of work in progress.

(c) Consumables: These are the materials which are needed to smoothen the process of
production. These materials do not directly enter production but they act as catalysts, etc.
Consumables may be classified according to their consumption and criticality.

(d) Finished goods: These are the goods which are ready for the consumers. The stock of
finished goods provides a buffer between production and market. The purpose of maintaining
inventory is to ensure proper supply of goods to customers.

(e) Spares: Spares also form a part of inventory. The consumption pattern of raw materials,
consumables, finished goods are different from that of spares. The stocking policies of spares are
different from industry to industry. Some industries like transport will require more spares than
the other concerns. The costly spare parts like engines, maintenance spares etc. are not discarded
after use, rather they are kept in ready position for further use.

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4.4.2. Purpose/Benefits of Holding Inventors

There are three main purposes or motives of holding inventories:

1. The Transaction Motive which facilitates continuous production and timely execution of
sales orders.

2. The Precautionary Motive which necessitates the holding of inventories for meeting the
unpredictable changes in demand and supplies of materials.

3. The Speculative Motive which induces to keep inventories for taking advantage of price
fluctuations, saving in re-ordering costs and quantity discounts, etc.

Risk and Costs of Holding Inventors

The holding of inventories involves blocking of a firm’s funds and incurrence of capital and
other costs. It also exposes the firm to certain risks. The various costs and risks involved in
holding inventories are as below:

1. Capital costs: Maintaining of inventories results in blocking of the firm’s financial

resources. The firm has, therefore, to arrange for additional funds to meet the cost of
inventories. The funds may be arranged from own resources or from outsiders. But in
both cases, the firm incurs a cost. In the former case, there is an opportunity cost of
investment while in later case the firm has to pay interest to outsiders.

2. Cost of Ordering: The costs of ordering include the cost of acquisition of inventories. It is
the cost of preparation and execution of an order, including cost of paper work and
communicating with supplier. There is always minimum cot involve whenever an order
for replenishment of good is placed. The total annual cost of ordering is equal to cost per
order multiplied by the number of order placed in a year.

3. Cost of Stock-outs: A stock out is a situation when the firm is not having units of an item
in store but there is demand for that either from the customers or the production
department. The stock out refer to demand for an item whose inventory level is reduced
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 to zero and insufficient level. There is always a cost of stock out in the sense that the firm
faces a situation of lost sales or back orders. Stock out are quite often expensive.

4. Storage and Handling Costs. Holding of inventories also involves costs on storage as well
as handling of materials. The storage costs include the rental of the godown, insurance
charge etc.

5. Risk of Price Decline. There is always a risk of reduction in the prices of inventories by
the suppliers in holding inventories. This may be due to increased market supplies,
competition or general depression in the market.

6. Risk of Obsolescence. The inventories may become obsolete due to improved

technology, changes in requirements, change in customer’s tastes etc.

7. Risk Deterioration in Quality: The quality of the materials may also deteriorate while the
inventories are kept in stores.

4.4.3. Objective of Inventory Management

The main objectives of inventory management are operational and financial. The operational
objectives mean that the materials and spares should be available in sufficient quantity so that
work is not disrupted for want of inventory. The financial objective means that investments in
inventories should not remain idle and minimum working capital should be locked in it.

The following are the objectives of inventory management:

a) To ensure continuous supply of materials spares and finished goods so that production
should not suffer at any time and the customers demand should also be met.

b) To avoid both over-stocking and under-stocking of inventory.

c) To keep material cost under control so that they contribute in reducing cost of production
and overall costs.

d) To minimize losses through deterioration, pilferage, wastages and damages.

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 e) To ensure perpetual inventory control so that materials shown in stock ledgers should be
actually lying in the stores.

f) To ensure right quality goods at reasonable prices.

g) To maintain investments in inventories at the optimum level as required by the

operational and sales activities.

h) To eliminate duplication in ordering or replenishing stocks. This is possible with help of

centralizing purchases.

i) To facilitate furnishing of data for short term and long-term planning and control of
inventory.

j) To design proper organization of inventory. A clear-cut accountability should be fixed at

various levels of management.

4.4.4. Tools and Techniques of inventory Management

Effective Inventory management requires an effective control system for inventories. A proper
inventory control not only helps in solving the acute problem of liquidity but also increases
profits and causes substantial reduction in the working capital of the concern.

The following are the important tools and techniques of inventory management and control:

1. Determination of Stock Levels.

2. Determination of Safety Stocks.

3. Determination of Economic Order Quantity

4. A.B.C. Analysis

5. VED Analysis

6. Inventory Turnover Ratios

7. Aging Schedule of Inventories

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 8. Just in Time Inventory

1. Determination of Stock Levels

Carrying of too much and too little of inventories is detrimental to the firm. If the inventory level
is too little, the firm will face frequent stock-outs involving heavy ordering cost and if the
inventory level is too high it will be unnecessary tie-up of capital. Therefore, an efficient
inventory management requires that a firm should maintain an optimum level of inventory where
inventory costs are the minimum and at the same time there is not stock-out which may result in
loss of sale or stoppage of production. Various stock levels are discussed as such.

(a) Minimum Level: This represents the quantity which must be maintained in hand at all times.
If stocks are less than the minimum level then the work will stop due to shortage of materials.
Following factors are taken into account while fixing minimum stock level:

i. Lead Time: A purchasing firm requires some time to process the order and time is also
required by supplying firm to execute the order. The time taken in processing the order
and then executing it is known as lead time.
ii. Rate of Consumption: It is the average consumption of materials in the factory. The
rate of consumption will be decided on the basis pas experiences and production plans.
iii. Nature of Material: The nature of material also affects the minimum level. If material
is required only against special orders of customer, then minimum stock will not be
required for such materials.

Minimum stock level = Re-ordering level-(Normal consumption x Normal Re-order period).

(b) Re-ordering Level: When the quantity of materials reaches at a certain figure then fresh order
is sent to get materials again. The order is sent before the materials reach minimum stock level.
Reordering level is fixed between minimum and maximum level. The rate of consumption,

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number of days required to replenish the stock and maximum quantity of material required on
any day are taken into account while fixing reordering level.

Re-ordering Level = Maximum Consumption x Maximum Re-order period.

(c) Maximum Level: It is the quantity of materials beyond which a firm should not exceed its
stocks. If the quantity exceeds maximum level limit then it will be overstocking. A firm should
avoid overstocking because it will result in high material costs.

Maximum Stock Level = Re-ordering Level+ Re-ordering Quantity-(Minimum Consumption x

Minimum Re-ordering period).

(d) Danger Level: It is the level beyond which materials should not fall in any case. If danger
level arises then immediate steps should be taken to replenish the stock even if more cost is
incurred in arranging the materials. If materials are not arranged immediately there is possibility
of stoppage of work.

Danger Level = Average Consumption x Maximum reorder period for emergency purchases.

(e) Average Stock Level

The average stock level is calculated as such:

Average Stock level = Minimum Stock Level +½ of re-order quantity

2. Determination of Safety Stocks

Safety stock is a buffer to meet some unanticipated increase in usage. It fluctuates over a period
of time. The demand for materials may fluctuate and delivery of inventory may also be delayed
and in such a situation the firm can face a problem of stock-out. The stock-out can prove costly
by affecting the smooth working of the concern. In order to protect against the stock out arising
out of usage fluctuations, firms usually maintain some margin of safety or safety stocks. Two
costs are involved in the determination of this stock i.e. opportunity cost of stock-outs and the
carrying costs. The stock out of raw materials cause production disruption resulting in higher
cost of production. Similarly, the stock out of finished goods result into failure of firm in
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competition, as firm cannot provide proper customer service. If a firm maintains low level of
safety frequent stock out will occur resulting in large opportunity coast. On the other hand larger
quantity of safety stock involves higher carrying costs.

3. Economic Order Quantity (EOQ)

A decision about how much to order has great significance in inventory management. The
quantity to be purchased should neither be small nor big because costs of buying and carrying
materials are very high. Economic order quantity is the size of the lot to be purchased which is
economically viable. This is the quantity of materials which can be purchased at minimum costs.
Generally, economic order quantity is the point at which inventory carrying costs are equal to
order costs. In determining economic order quantity it is assumed that cost of a managing
inventory is made of solely of two parts i.e. ordering costs and carrying costs.

(A). Ordering Costs: These are costs that are associated with the purchasing or ordering of
materials. These costs include:

 Inspection costs of incoming materials.

 Cost of stationery, typing, postage, telephone charges etc.

 Expenses incurred on transportation of goods purchased.

These costs are also known as buying costs and will arise only when some purchases are
made.

(B) Carrying Costs: These are costs for holding the inventories. These costs will not be incurred
if inventories are not carried. These costs include:

 The cost of capital invested in inventories. An interest will be paid on the amount of
capital locked up in inventories.

 Cost of storage which could have been used for other purposes.

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  Insurance Cost

 Cost of spoilage in handling of materials

Assumptions of EOQ: While calculating EOQ the following assumptions are made.

i. The supply of goods is satisfactory. The goods can be purchased whenever these are
needed.

ii. The quality to be purchased by the concern is certain.

iii. The prices of goods are stable. It results to stabilize carrying costs.

Economic order quantity can be calculated with the help of the following formula:

Total inventory cost (TC) = ordering cost + carrying cost + material cost

EOQ= Q =
√ 2 x Z x Co
Cc x C
or EOQ= Q =
√
2 x Z x Co
I

Where; Z = annual demand

Q = quantity to be ordered
C = cost per unit
Co = cost per order
Cc = carrying cost on average inventory per year (%)

I=carrying costs per unit of inventory= Cc x C

Z
Ordering cost = x Co where; Z/Q = total number of orders
Q

Illustration: The finance department of a Corporation provides the following information:

 The carrying costs per unit of inventory are Br. 10

 The fixed costs per order are Br. 20]
 The number of units required is 30,000 per year.

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 Determine the economic order quantity (EOQ) total number of orders in a year and the
time gap between orders.

Solution: The economic order quantity may be found as follow

EOQ= Q =
√ 2 x Z x CO
I

Z = 30,000 Co = Br.2I = Br.10

Now, EOQ = ( 2 x 30,000x 20) / 10 )1/2 = 346 units

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So, the EOQ is 346 units and the number of orders in a year would be 30,000/346 = 86.7 or 87
orders. The time gap between two orders would be 365/87 = 4.2 or 4 days.

A-B-C Analysis

Under A-B-C analysis, the materials are divided into three categories viz, A, B and C. Past
experience has shown that almost 10 per cent of the items contribute to 70 percent of value of
consumption and this category is called ‘A’ Category. About 20 per cent of value of
consumption and this category is called ‘A’ Category. About 20 per cent of the items contribute
about 20 per cent of value of consumption and this is known as category ‘B’ materials. Category
‘C’ covers about 70 per cent of items of materials which contribute only 10 per cent of value of
consumption. There may be some variation in different organizations and an adjustment can be
made in these percentages.

The information is shown in the following diagram:

Class No. of Items (%) Value of Items (%)

A 10 70

B 20 20

C 70 10

A-B-C analysis helps to concentrate more efforts on category A since greatest monetary
advantage will come by controlling these items. An attention should be paid in estimating
requirements, purchasing, maintaining safety stocks and properly storing of ‘A’ category
materials. These items are kept under a constant review so that substantial material cost may be
controlled. The control of ‘C’ items may be relaxed and these stocks may be purchased for the
year. A little more attention should be given towards ‘B’ category items and their purchase
should be undertaken a quarterly or half-yearly intervals.

VED Analysis

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 The VED analysis is used generally for spare parts. The requirements and urgency of spare parts
is different from that of materials. A-B-C analysis may not be properly used for spare parts.
Spare parts are classified as Vital (V), Essential (E) and Desirable (D) The vital spares are a must
for running the concern smoothly and these must be stored adequately. The non-availability of
vital spares will cause havoc in the concern. The E types of spares are also necessary but their
stocks may be kept at low figures. The stocking of D type of spares may be avoided at times. If
the lead time of these spares is less, then stocking of these spares can be avoided.

Inventory Turnover Ratios

Inventory turnover ratios are calculated to indicate whether inventories have been used
efficiently or not. The purpose is to ensure the blocking of only required minimum funds in
inventory. The Inventory Turnover Ratio also known as stock velocity is normally calculated as
sales/average inventory or cost of goods sold/average inventory cost.

Inventory Turnover Ratio = sales /average inventory

= cost of goods sold/average inventory cost.

and, Inventory Conversion Period.

Aging Schedule of Inventories

Classification of inventories according to the period (age) of their holding also helps in
identifying slow moving inventories thereby helping in effective control and management of
inventories. The following tables show aging of inventories of a firm.

AGING SCHEDULE OF INVENTORIES

Item Name/Code Age Classification Date of Amount (Br.) %age to

Acquisition total

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 011 0-15 days June 25, 2022 30,000 15

002 16-30 days June 10, 2022 60,000 30

003 31-45 days May 20, 2022 50,000 25

004 46-60 days May 5, 2022 40,000 20

005 61 and April 12, 2022 20,000 10

above 2,00,000 100
Just in Time Inventory (JIT)

JIT is a modern approach to inventory management and goal is essentially to minimize such
inventories and thereby maximizing the turnover. In JIT, affirm keeps only enough inventory on
hand to meet immediate production needs. The JIT system reduces inventory carrying costs by
requiring that the raw materials are procured just in time to be placed into production.
Additionally, the work in process inventory is minimized by eliminating the inventory buffers
between different production departments. If JIT is to be implemented successfully there must be
high degree of coordination and cooperation between the suppliers and manufacturers and among
different production centers.

4.4.5. Risk in Inventory Management

The main risk in inventory management is that market value of inventory may fall below what
firm paid for it, thereby causing inventory losses. The sources of market value of risk depend on
type of inventory. Purchased inventory of manufactured goods is subject to losses due to changes
in technology. Such changes may sharply reduced final prices of goods when they are sold or
may even make the goods unsaleable. There are also substantial risks in inventories of goods
dependent on current styles. The ready-made industry is particularly susceptible to risk of
changing consumer tastes. Agricultural commodities are a type of inventory subject to risks due
to unpredictable changes in production and demand.

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Moreover, all inventories are exposed to losses due to spoilage, shrinkage, theft or other risks of
this sort. Insurance is available to cover many of these risks and if purchased is one of the costs
of holding inventory. Hence, the financial manager must be aware of the degree of risk involve
infirm investment in inventories. The manager must take those risks into account in evaluating
the appropriate level of investment.

Summary

Working capital refers to the current assets a business needs to operate day-to-day. Current assets
are those that can be converted to cash within a year. Examples include cash, inventory, and
accounts receivable. Current liabilities are debts a company owes that are due within a year.
Examples include accounts payable and accrued expenses. A company needs working capital to
cover its current liabilities and ensure smooth operations. There are two main concepts of
working capital: gross (total current assets) and net (current assets minus current liabilities).
Maintaining an adequate level of working capital is essential for a business's solvency, goodwill,
ability to secure loans, and ability to take advantage of discounts and opportunities. The need for
working capital arises from the time gap between production and cash collection from sales.
Working capital has four characteristics: circulating capital, liquidity, risk, and profitability.
There are two types of working capital: permanent and temporary. Permanent working capital is
the minimum level needed for ongoing operations, while temporary working capital fluctuates
with sales and business cycles. Several factors affect a company's working capital requirements,
including the nature of the business, operating cycle, seasonality of operations, production
policy, market conditions, conditions of supply, credit policy, and inflation. Both excess and
inadequate working capital can harm a business. Excess working capital means idle funds that
aren't generating profits, while inadequate working capital can lead to insolvency. Working
capital management involves managing current assets, current liabilities, and the relationship
between them. The goal is to maintain an optimal level of working capital that is neither too high
nor too low. There are four principles of working capital management: risk variation, cost of
capital, equity position, and maturity of payment. Companies can choose from relaxed,
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restricted, or moderate current asset investment policies, each with different risk-return profiles.
Estimating working capital requirements is crucial. There are different approaches, such as using
a percentage of sales or total assets, or basing it on the operating cycle. Companies hold cash for
three main reasons: transaction motive (for routine business needs), precautionary motive (for
unexpected needs), and speculative motive (to take advantage of opportunities). The objectives
of cash management are to meet payment obligations and minimize idle cash balances. Surplus
cash can be invested in liquid, risk-free securities to earn income. The objective of receivables
management is to find a balance between sales growth, cost of funds, and risk of bad debts.
Dimensions of receivables management includes forming credit policy, executing credit policy,
factoring, formulating and executing collection policy. Proper inventory management is
necessary for smooth operations and to minimize investment in inventory. Inventory include raw
materials, work in process, finished goods, consumables, and spares. Purposes of holding
inventory are transaction motive, precautionary motive, and speculative motive.

Review Exercises
1. A firm has an average age of inventory of 101 days, an average collection period of 49
days, and an average payment period of 60 days. The firm's cash conversion cycle is
A. 150 days C. 112 days
B. 90 days D. 8 days
2. A firm can reduce its cash conversion cycle by
A. Increasing the average age of inventory
B. Increasing the average collection period.
C. Decreasing the average payment period.
D. Increasing the average payment period.
3. A firm has an operating cycle of 170 days, an average payment period of 50 days, and an
average age of inventory of 145 days. The firm's average collection period is days.
A. 25 C. 120
B. 75 D. 95

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 4. The capital which is required for day-to-day operations of the business
A. Floating Capital C. Permanent Capital
B. Fixed Capital D. Working Capital
5. Which of the following is used to improve the efficiency of the business operation and to
get good profits by the business concern:
A. Inadequate working capital is good
B. Excess working capital is good
C. A&B
D. Optimum level of working capital is good
6. Which of the following is not correct
A. A strict credit policy a firm has the relative lower amount of working capital that
the firm is to maintain.
B. The larger the production cycle is require more working capital
C. The need for working capital decline in boom economic condition
D. Manufacturing companies require more working capital than service giving
companies
7. The working capital management policy which aims to minimize risk by maintaining a
higher-level working capital is
A. Aggressive working capital (lean or mean) policy
B. Moderate working capital policy
C. Conservative working capital policy (fat cat) policy
D. None
8. Firms need to maintain working capital due to one of the following reasons
A. To have a smooth operation and to sustain their activities
B. Due to the existence of time-gap between sales of goods and services and the
receipt of cash
C. To deal with problems arising out of immediate realization of cash against goods
sold
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 D. All
9. A problem in managing receivable may be indicated by:
A. A declining average collection period
B. Increasing percentage of overdue accounts
C. Extending days’ sales outstanding
D. All except ‘A’
E. None of the above
10. A system of inventory management that discourages the use of safety stock and that
requires coordination between a firm and its suppliers to ensure delivery of the right
quality material at the right time is called:
A. Computerized system D. Material Requirement Planning
B. Just-in-time E. None of the above
C. Economic Order Quantity

11. According to Baumol Model, optimum cash level is that level of cash where:

A. The carrying costs and transaction costs are the maximum.

B. The carrying costs beyond to holding cost
C. The carrying costs and transaction costs are the minimum.
D. The holding cost beyond to carrying costs
12. Keeping inventories for taking advantage of price fluctuations, saving in re-ordering costs
and quantity discounts is known as:
A. Transaction motive C. Speculative motive
B. Precautionary motive D. Transformational motive
13. The holding of inventories for meeting the unpredictable changes in demand and supplies of
materials is known as:
A. Transaction motive C. Precautionary motive
B. Transformational motive D. Speculative motive

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 14. Which one of the following is a reason for adoption of just-in time technique of inventory
management?
A. Avoidance of storage wastages C. Maximization of profit
B. Minimization of cost of capital D. All of the above

15. Inventory management of an organization aims to avoid excessive and inadequate levels of
inventories due to:
A. Excessive physical existing inventories do not earn profit
B. Shortage of inventories may lead to stock outs and interruption of operation
C. Idle investments on inventories have opportunity cost
D. All of the above
16. Which one of the following factors which affects the size of receivable.
A. Expansion Plans C. Terms of Trade
B. Relation with Profits D. All of the above

17. Buffer to meet some unanticipated increase/Fluctuation in usage of inventory.

A. Economic order Quantity C. Safety stock

B. Optimum Quantity D. Danger level

18. Level of inventory in which fresh order is sent to get materials again.
A. Economic order Quantity C. Re-ordering Level
B. Danger level D. Minimum Level
19. The process of making decisions relating to investment in trade debtors
A. Inventory management C. Receivable management
B. Cash management D. All of the above
20. The costs of receivable management include all of the following, except

A. Bad debts B. Carrying cost

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 C. Cost of collection D. Cost of financing

Chapter 5

Financing Current Assets

Learning Objectives
After studying this chapter, you should be able to:
 Explain sources of short-term financing
 Differentiate alternative short term financing policies
 Explain advantage and disadvantages of alternative short term financing policies
 Analyze the impact of financing decisions on financial ratios

Introduction
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Financing current assets is crucial for businesses to maintain smooth operations. These
assets, like inventory, receivables, and prepaid expenses, fuel the day-to-day activities and
require a constant influx of funds. Financing current assets is an essential strategic decision
for businesses. Understanding different approaches, considering costs and benefits, and
adhering to the matching principle are crucial for making informed choices. Effective
management of current assets and their financing significantly impacts a company's
financial health and operational efficiency.
5.1. Sources of short-term financing

Working capital can be financed from different sources:

a) Spontaneous current liabilities: this source of working capital financing mainly
emanated from operational activities between a credit customer and a supplier. The
customer finances his purchases through a credit that he obtains from the supplier. Other
spontaneous liabilities include accrued wages, accrued taxes, etc.
b) Short – term financing sources: the sources include bank loans, private loans, and
commercial papers.
c) Long – term loans: this usually involves bank loans on long term basis.
d) Equity Capital: this is usually the major source of initial WC investment. It is the money
put in the firm by the owner or investor.

In assessing the suitability of the above sources, one needs to evaluate the risk and the costs
involved, in relation to the returns from each of the sources. Spontaneous liabilities usually do
not involve costs. The short- and long-term sources have explicit cost (interest) while equity
capital has implicit costs (opportunity costs).

5.2. Alternative CA Financing Policies/Strategies

There are three basic option of financing WC, i.e., options of matching-expected cash inflows
from assets with outflows from their respective sources of financing.

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 5.2.1. Perfect Hedge (Maturity matching) Policy
It is a strategy of financing temporary current assets from short term sources and permanent
current assets and fixed assets from long term sources of funds. This strategy is considered sound
because temporary obligations are paid from the sale of temporary current assets i.e. the
temporary obligations are used to finance the acquisition of current assets (a self-liquidating
principle).
For example, a purchase policy of 2/10, n/30 may be matched with a sales policy of 2/10, n/30.

5.2.2. Conservative Hedge Policy

This strategy finances all the fixed assets, all permanent current assets and significant portion of
temporary current assets with a long-term source. The short-term source of finance is used to
finance just little of temporary CAS. This policy is conservative because it makes sure that most
of its current assets are acquired from a stable long-term source. The advantage is that such long-
term sources may be obtained when credit terms are favorable and at times of credit restraint the

142 | P a g e
firm will have already enough funds and will have less risk. Excess funds at firms may be
invested in marketable securities.

The distinct features of this approach are:

 Liquidity is greater
 Risk is minimized
 The cost of financing is relatively more as interest has to be paid even on seasonal
requirements for entire period.

Birr Temporary CAS Short term financing

Permanent CA S Long term financing

Fixed Assets

Trade-off between the Hedging and Conservative Approaches

The hedging approach implies low cost, high profit and high risk while the conservative
approach leads to high cost, low profits and low risk. Both the approaches are the two extremes
and neither of them serves the purpose of efficient working capital management. A tradeoff
between the two will then be an acceptable approach. The level of trade off may differ from case
to case depending upon the perception of risk by the persons involved in financial decision
making. However, one way of determining the tradeoff is by finding the average of maximum
and the minimum requirements of current assets. The average requirements so calculated may be
financed out of long-term funds and excess over the average from short-term funds.

Hedging Vs Conservative Approach

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 Hedging Approach Conservative Approach
1. The cost of financing is reduced. 1. The cost of financing is higher
2. The investment in net working 2. Large Investment is blocked in temporary
capital is nil. working capital.
3. Frequent efforts are required to 3. The firm does not face frequent financing
arrange funds. problems.

4. The risk is increased as firm is 4. It is less risky and firm is able to absorb
vulnerable to sudden shocks. shocks.

5.2.3. Aggressive Hedge Policy

In aggressive hedge policy, all fixed assets and portion of permanent assets are financed from
long term sources. All temporary current assets and a portion of permanent current assets are
financed from the short-term sources. It is a dangerous strategy in the sense that it may create a
problem of liquidity crisis and sometimes it may lead to a bankruptcy.

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Which policy is better?

This depends on how individuals view risks in relation to return on equity. Basically, higher
returns involve higher risk or conversely, for taking higher risk, there should be compensating
higher return. In the same manner, lower risks are associated with lower returns. Relating this to
the hedging policy, one should realize that conservative hedge policy has less risk and less return
on equity and aggressive hedge policy has higher risk and higher return.

The following illustration shows that the risk of conservative policy as measured in current ratio
is less than that of aggressive policy. But aggressive policy has higher return on equity.

The Effect of Conservative and Aggressive Financing

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 Assets
Current Assets 1,000
Fixed Assets 1,000
Total Assets 2,000
Financing Options Conservative Aggressive
Short term loan (12%) 200 1000
Long term loan (15%) 900 100
Equity 900 900
Total 2,000
2,000
Summary of operation:
EBIT 1,000 1,000
less: Interest
Short term (24) (120)
Long term (135)(15)
EBT 841.00 865.00
less: Tax(50%) 420.50 432.50
Net Income 420.50
432.50
Financial Indicators:
Risk: current ratio 5 times 1 times
Return: ROE 46.7% 48.06%

Summary

Sources of Short-Term Financing Include:

Spontaneous liabilities: Arise from trade credit offered by suppliers.

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Short-term financing: Includes bank loans, commercial paper, etc., which typically involve
interest costs.

Long-term loans: Provide financing over extended periods but also come with interest costs.

Equity capital: Investment from owners and doesn't involve explicit costs, but there's an
opportunity cost of using the funds elsewhere.

Alternative Financing Policies:

Perfect Hedge (Matching) Policy: Matches the maturity of financing sources with the use of
funds. Temporary current assets are financed with short-term sources, and long-term needs are
financed with long-term sources. This is considered a balanced approach.

Conservative Hedge Policy: Finances most assets with long-term sources, leading to greater
liquidity but potentially higher financing costs.

Aggressive Hedge Policy: Finances temporary current assets with short-term sources,
maximizing profitability but also increasing the risk of liquidity shortfalls.

Choosing the best policy involves a risk-return trade-off. A conservative approach minimizes
risk but comes with lower returns, while an aggressive approach offers potentially higher returns
but with greater risk. Companies should consider their risk tolerance and financial situation when
selecting a financing policy.

Review Exercises

1. In which Current Assets Investment Policy, the investment in current assets is high.

A. Flexible policy C. Aggressive policy

B. Restricted policy D. Moderate policy

2. In which current asset Financing Policies states that financing all the fixed assets, all
permanent current assets and significant portion of temporary current assets with a long-
term source.

A. Conservative Hedge Policy B. Perfect Hedge Policy

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 C. Aggressive Hedge Policy D. Maturity matching Policy

3. Which one of the following statements is incorrect about conservative and aggressive
financing strategy of working capital?
A. Conservative hedge policy has less risk.
B. Conservative hedge policy has less return.
C. Aggressive hedge policy has higher risk.
D. Aggressive hedge policy has less return.
4. Which of the following illustrates the use of a hedging (or matching) approach to
financing?
A. Short-term assets financed with long-term liabilities.
B. Permanent working capital financed with long-term liabilities.
C. Short-term assets financed with equity.
D. All assets financed with a 50 percent equity; 50 percent long-term
5. Compared to the conservative approach, the aggressive approach might have:
A. A lower current ratio but potentially higher return
B. A higher current ratio and lower profitability
C. Similar risk and return profiles
D. No significant differences
6. When comparing risk and return, the conservative approach typically offers:

A. Higher risk and higher return C. Higher risk and lower return
B. Lower risk and lower return D. Lower risk and higher return

7. Which approach is associated with a higher investment in temporary working capital?

A. Hedging approach C. Aggressive approach

B. Conservative approach D. None of the above

8. The aggressive hedge policy is generally considered as:

A. The safest approach for all companies.
B. A balanced approach offering moderate risk and return.
C. A potentially risky strategy with liquidity concerns.
D. Ideal for maximizing return on equity regardless of risk.

9. The source of working capital financing which mainly emanated from operational activities
between a credit customer and a supplier is:
A. Spontaneous current liabilities

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 B. Short term loans
C. Equity capital
D. All of the above
10. Compared to the conservative approach, the aggressive approach might have:
A. A lower current ratio and potentially higher return.
B. A higher current ratio and lower profitability.
C. Similar risk and return profiles.
D. No significant differences in financial ratios.

Answer Key for Review Exercises

Chapter One

1. B 2. C
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 3. C 7. A
4. C 8. B
5. C 9. B
6. B 10. A

Chapter Two

1. A 6. C
2. A 7. D
3. C 8. B
4. C 9. B
5. B 10. C

Chapter Three

1. D 8. B
2. C 9. B
3. B 10. B
4. B 11. C
5. B 12. D
6. A 13. C
7. A

Chapter Four

1. A 8. D 15. D
2. D 9. D 16. D
3. B 10. B 17. C
4. D 11. C 18. C
5. D 12. C 19. C
6. C 13. C 20. B
7. C 14. D

Chapter Five

1. A 3. D
2. A 4. B

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 5. A 8. C
6. B 9. A
7. B 10. A

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