SYLLABUS

Course Title : Financial Management

Course Code : MSPS 22
Course Credit :4
Course Objective :
CO 1. Demonstrate the importance of the finance function and
differentiate profit and wealth maximisation. State the overview and
changing scenario of Indian financial system
CO 2. Identify the various sources of long term and short-term finance
and international finance
CO 3. Discuss capital budgeting and time value of money; apply
discounted and non-discounted techniques to appraise the project.
Examine significance and methods to compute cost of capital.
CO 4. Outline the concept, its determinants and theories of capital
structure. Explain dividend policies and apply appropriate theory to
dividend
CO 5. Explain working capital management, its types for formulating
policies and the factors affecting. Illustrate the management of
cash by using Miller and Orr model.

BLOCK I: Financial Management

Finance functions – Its Nature and Scope- objectives; -Profit vs. Wealth
maximization-Role of financial manager in decision making - Significance of
financial management – Changing scenario of financial management in
India- Overview of Indian financial system.

BLOCK II: Sources of Finance

Sources of long term finance-Equity Shares, Preference shares,
Debentures, borrowing from lending institutions: short term finance: money
market, Gilt edged securities- International sources -GDR( Global
Depository Receipts) and ADR (American Depository Receipts)

BLOCK III: Capital Budgeting & Cost of Capital

Capital budgeting- Concept- objectives Significance- -- Methods/
techniques: PB, ARR,NPV and IRR- risk analysis in capital budgeting -
CAPM methods- Capital rationing. Cost of capital - Concept- objectives
Significance-computation of cast of capital- Cost of debt, Equity, Preference
share Capital, Retained earnings, Weighted average cost of Capital
(WACC) .(Simple Problems).

BLOCK IV: Capital Structure & Dividend Policies

Capital Structure- Determinants-Optimal Capital Structure- Capital Structure
theories- Net income approach- Net operating income approach - MM
approach – Dividend policies:-- Types – Dividend theories - Valuation under
Gordon and Walther Theory - Dividend irrelevance - MM theory - Factors
affecting dividend decisions.(simple problems)

BLOCK V: Working Capital Management

Working Capital Management-Definition -Types-Working Capital for Policies
- Factors affecting working Capital requirements - Management of cash –
optimum level of cash - stochastic models, Miller and Orr model-
Management of receivables -Print policies, Period, Terms - Collection
Policies-Inventory Management-Inventory Level- Inventory Management
Techniques.
References:
1. Brigham & Ehrhardt, (2015), Financial Management Text and cases,
latest Edition, Cengage Learning, India
2. Chandra & Iyer, (2012), Financial Management, latest Edition, IBH,
India
3. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
4. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
5. Pandey IM, (2014),Financial Management, 10th Edition, Vikas, India
6. Prasanna Chandra, (2012), Financial Management Theory and
Practice, 8th Edition. TMH , India
7. Preeti Singh, (2015), Financial Management, Latest Edition, Ane
books PVT Ltd., Chennai.
8. Rajiv Srivastava, Anil Mishra , (2012), Financial Management, latest
Edition, Oxford University Press, New Delhi
9. Shashi [Link], [Link] , (2012), Financial Management,
latest Edition, Kalyani Publishers, Chennai
 10. Tulsian P.C.,C.A. Bharat Tulsian , (2019), Financial Management,
latest Edition, [Link] Publications, New Delhi.
Web Resources
1. [Link]
maximization/
2. [Link]
3. [Link]
4. [Link]
5. [Link]
6. [Link]
7. [Link]
Course Outcome :
CLO 1. Comprehend importance of financial management and the
contrast between profit and wealth maximistaion. Recognize the
significance of financial system in India and relate it with
changing scenario
CLO 2. Examine the various sources of finance, international finance
and their pros & cons
CLO 3. Recognize the concept of capital budgeting and recommend
whether and why an investment should be accepted or rejected.
Apply appropriate methods to compute cost of capital.
CLO 4. Summarise concept and theories of capital structure. Analyse
dividend policies and theory to evaluate dividend
CLO 5. Review the working capital management, the measures of
managing cash and receivables by using Miller and Orr model
 CONTENT

BLOCK 1 INTRODUCTION TO FINANCIAL MANAGEMENT

UNIT 1 INTRODUCTION TO FINANCIAL MANAGEMENT 2

1.1 Introduction 3

1.2 Finance: Definition and Meaning 3

1.3 Importance of Financial Management 4

1.4 Functions of Financial Management 5

UNIT 2 NATURE, SCOPE, OBJECTIVES AND 9

SIGNIFICANCE OF FINANCIAL MANAGEMENT

2.1 Nature and Scope of Financial Management 10

2.2 Objectives of Financial Management 14

2.3 Profit Maximization 14

2.4 Wealth Maximisation 16

2.5 Significance of financial Management 17

UNIT 3 ROLE OF A FINANCIAL MANAGER 20

3.1 Role of Financial Manager in Decision Making 21

UNIT 4 FINANCIAL MANAGEMENT IN INDIA& OVERVIEW 28

OF INDIAN FINANCIAL SYSTEM

4.1 Changing Scenario of Financial Management in India 29

4.2 Overview of Indian Financial System 29

4.3 Comparison Between Money Market and Capital 32

Market

4.4 Money Market Instruments 33

4.5 Financial Services 33

BLOCK 2 SOURCE OF FINANCE

UNIT 5 LONG TERM SOURCE OF FINANCE 38

5.1 Long Term Source of Finance 39

5.2 Preference Shares 42

5.3 Debentures 45

UNIT 6 BORROWINGS FROM LENDING INSTITUTIONS 51

6.1 Borrowings from Lending Institutions 52

UNIT 7 SHORT TERM SOURCE OF FINANCE 56

7.1 Introduction to Short Term Finance 57

7.2 Types / Sources of Short Term Financing 57

7.3 Money Market 58

7.4 Gilt-Edged Securities 60

UNIT 8 INTERNATIONAL SOURCE OF FINANCE 63

8.1 Introduction to International Financing 63

8.2 Various International Financing Sources 64

BLOCK 3 CAPITAL BUDGETING & COST OF CAPITAL

UNIT 9 INTRODUCTION TO CAPITAL BUDGETING- 70

CONCEPT- OBJECTIVES, SIGNIFICANCE

9.1 Introduction to capital budgeting 71

9.2 Capital Budgeting: Definition and Meaning 72

9.3 Why Capital Budgeting is Important 73

9.4 Objectives, Process of Capital Budgeting 75

9.5 Process of Capital Budgeting 75

9.6 Cash Flow vs Accounting Profit 76

9.7 Kinds of Capital Budgeting Decisions 79

UNIT 10 METHODS OF CAPITAL BUDGETING AND RISK 82

ANALYSIS

10.1 Methods/ techniques of capital Budgeting 83

10.2 Risk analysis in capital budgeting 112

10.3 CAPM methods- Capital rationing 116

UNIT 11 INTRODUCTION TO COST OF CAPITAL - CONCEPT- 121

OBJECTIVES, SIGNIFICANCE

11.1 Introduction to cost of capital 122

11.2 Importance of the Cost of Capital 124

11.3 Significance of the Cost of Capital 126

11.4 Components of cost of capital 127

11.5 Classification of Cost 128

UNIT 12 COST OF CAPITAL 131

12.1 Classification of cost of capital 132

12.2 Assumptions about Parametric and Non-parametric 133

Tests

12.3 Overall cost of capital or Weighted average cost of 140

capital (Ko)

BLOCK 4 CAPITAL STRUCTURE AND DIVIDEND THEORIES

UNIT 13 INTRODUCTION TO CAPITAL STRUCTURE 148

13.1 Introduction to Capital Structure 149

13.2 Capitalization, Capital Structure and Financial 151
Structure, Patterns

13.3 Capital structure 153

13.4 Optimal Capital Structure 156

UNIT 14 CAPITAL STRUCTURE THEORIES 163

14.1 Theories of Capital Structure 164

UNIT 15 DIVIDEND POLICY 176

15.1 Dividend: Concept, Definition, Meaning 177

15.2 Dividend Decision 178

15.3 Dividend Policy 179

15.4 Significance of Dividend Policy 183

15.5 Types of Dividend 184

15.6 Different form of dividend 184

15.7 Determinants of Dividend Policy 185

UNIT 16 DIVIDEND THEORIES 192

16.1 Dividend Theories 193

16.2 MM Hypothesis 202

BLOCK 5 WORKING CAPITAL MANAGEMENT

UNIT 17 WORKING CAPITAL MANAGEMENT 212

17.1 Introduction to Working capital 213

17.2 Working capital management 217

17.3 Types of Working Capital 219

17.4 Importance of Adequate Working Capital 221

17.5 Excess working capital 224

17.6 Inadequate working capital 225

17.7 Working capital Policy 225

17.8 Working Capital Cycle 229

UNIT 18 CASH MANAGEMENT 236

18.1 Introduction to Cash Management 237

18.2 Determination of Optimum Cash Balance 239

18.3 Basic Strategies Of Cash Management 245

18.4 Cash Management: Techniques 246

UNIT 19 RECEIVABLES MANAGEMENT 251

19.1 Introduction to Management of Receivables 252

19.2 Cost association with accounts receivables 257

19.3 Benefits from credit sales 257

19.4 Decision areas in Receivables Management 258

19.5 Factors Considering the Receivable Size 262

UNIT 20 INVENTORY MANAGEMENT 266

20.1 Introduction to Inventory Management 267

20.2 Inventory control systems 272

20.3 Economic order quantity 278

Plagiarism 284
 BLOCK 1

INTRODUCTION TO FINANCIAL
MANAGEMENT
Unit 1: Introduction to Financial Management
Unit 2: Nature, Scope, Objectives &Significance
of Financial Management
Unit 3: Role of a Finance Manager
Unit 4: Financial Management in India&
Overview of Indian Financial System

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Unit 1

INTRODUCTION TO FINANCIAL
MANAGEMENT
STRUCTURE

Overview
Learning Objectives
1.1 Introduction

1.2 Finance: Definition and Meaning

1.3 Importance of Financial Management
1.3.1 Why a Business Needs Finance

1.3.2 Importance of financial management in a business

1.4 Functions of Financial Management
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your Progress
OVERVIEW
Finance is the lifeline of any business. However, finances, like most
other resources, are always limited. On the other hand, wants are
always unlimited. Therefore, it is important for a business to manage its
finances efficiently.
Financial Management plays a critical role in the financial success of a
business. Therefore, an organization should consider financial
management a key component of the general management of the
organization. Financial management includes the tactical and strategic
goals related to the financial resources of the business. In these
competitive days financial management has to face many challenges
and the financial managers have to take innovative decisions for leading
the concern towards success.
Financial Management means planning, organizing, directing and
controlling the financial activities such as procurement and utilization of

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funds of the enterprise. It means applying general management
principles to financial resources of the enterprise.
LEARNING OBJECTIVES

After reading this unit, you should be able to;

• define the concept of finance
• explain the importance of financial management.

1.1 INTRODUCTION
Finance holds the key to all human activity. It is the guide for regulating
investment decisions and expenditure, and endeavours to squeeze the
most out of every available rupee. Without adequate finance, no
enterprise can possibly accomplish its objectives.
There is, in fact, no part of any corporate plan which can be expressed
in non-financial terms. We may be able to stipulate different sets of
objectives for private sector and public sector undertakings; but these
objectives will have to be explained to investors, employees, customers
and other members of society; for that purpose, it would always be
desirable to state and interpret them in financial terms.
Finance plays a part in every economic transaction in which there is a
present or future payment of money.
1.2 FINANCE: DEFINITION AND MEANING
“Financial management is the activity concerned with planning, raising,
controlling and administering of funds used in the business.” – Guthman
and Dougal
“Financial management is that area of business management devoted to
a judicious use of capital and a careful selection of the source of capital
in order to enable a spending unit to move in the direction of reaching
the goals.” – J.F. Brandley
“Financial management is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for
efficient operations.”- Massie
Management
Management means managing the resources like finance, Information,
technology, human resources called management.
Financial management
It is primarily concerned with Proper Management of Funds and the
Financial Resource. It refers to the planning and controlling the firm's

3
financial resource. Simply it refers to managing the firm financial
resources.
Financial Management deals with procurement of funds and their
effective utilization in the business.
Financing is a functional area of business the main objective of financial
management is proper Planning of financial Resource and proper control
over Financial Resource.
Meaning of Financial Management
Financial Management means planning, organizing, directing and
controlling the financial activities such as procurement and utilization of
funds of the enterprise. It means applying general management
principles to financial resources of the enterprise.

Figure 1.1 Management Functional Area

1.3 IMPORTANCE OF FINANCIAL MANAGEMENT
Being financially independent is one of the primary objectives when
starting a business. Business owners must consider the potential
consequences of their management decisions on profits, cash flows and
on the financial condition of the company. The activities of every aspect
of a business have an impact on the company’s financial performance
and must be evaluated and controlled by the business owner. Most
companies experience losses and negative cash flows during their start-
up period. Financial management is extremely important during this
time. Managers must make sure that they have enough cash on hand to
pay employees and suppliers even though they have more money going
out than coming in during the early months of the business. This means
the owners must make financial projections of these negative cash flows

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so he has some idea of how much capital will be needed to fund the
business until it becomes profitable.
As a business grows and matures, it will need more cash to finance its
growth. Planning and budgeting for these financial needs is crucial.
Deciding whether to fund expansion internally or borrow from outside
lenders is a decision made by financial managers. Financial
management is finding the proper source of funds at the lowest cost,
controlling the company’s cost of capital and not letting the balance
sheet become too highly leveraged with debt with an adverse effect of its
credit rating.
1.3.1 Why a Business Needs Finance
a) Helps establish a business: Without money, you cannot get labour,
land and so on with the finance function you can determine what is
required to start your business and plan for it.
b) Helps to run a business: To remain in business you must cater to
the day to day operating costs such as paying salaries, buying
stationery, raw material; the finance function ensures you always
have adequate funds to cater to this.
c) To Expand, Modernize, diversify: A business needs to grow
otherwise it may become redundant in no time. With the finance you
can determine and acquire the funds required to do so.
d) Purchase Assets: You need money to purchase assets. This can be
tangible assets like furniture, buildings or intangible like trademarks,
patents, etc. to get this you need finances.

1.3.2 Importance of financial management in a business

a) Helps organisations in financial planning
b) Assists organisations in the planning and acquisition of funds
c) Helps organisations in effectively utilising and allocating the
funds received or acquired
d) Assists organisations in making critical financial decisions
e) Helps in improving the profitability of organisations
f) Increases the overall value of the firms or organisations
g) Provides economic stability
h) Encourages employees to save money, which helps them in
personal financial planning
1.4 FUNCTIONS OF FINANCIAL MANAGEMENT
(a) Estimation of capital requirements: A finance manager has to
make estimation with regards to capital requirements of the
company. This will depend upon expected costs and profits and

5
 future programmes and policies of a concern. Estimations have
to be made in an adequate manner which increases earning
capacity of enterprise.
(b) Determination of capital composition: Once the estimation
has been made, the capital structure have to be decided. This
involves short- term and long- term debt equity analysis. This will
depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from
outside parties.
(c) Choice of sources of funds: For additional funds to be
procured, a company has many choices like-
(ii) Issue of shares and debentures
(iii) Loans to be taken from banks and financial institutions
(iv) Public deposits to be drawn like in form of bonds.
(v) Choice of factor will depend on relative merits and
demerits of each source and period of financing.
(d) Investment of funds: The finance manager has to decide to
allocate funds into profitable ventures so that there is safety on
investment and regular returns is possible.
(e) Disposal of surplus: The net profits decision has to be made by
the finance manager. This can be done in two ways:
• Dividend declaration - It includes identifying the rate of
dividends and other benefits like bonus.
• Retained profits - The volume has to be decided which will
depend upon expansion, innovation, and diversification plans
of the company.
(f) Management of cash: Finance manager has to make decisions
with regards to cash management. Cash is required for many
purposes like payment of wages and salaries, payment of
electricity and water bills, payment to creditors, meeting current
liabilities, maintenances of enough stock, purchase of raw
materials, etc.
(g) Financial controls: The finance manager has not only to plan,
procure and utilize the funds but he also has to exercise control
over finances. This can be done through many techniques like
ratio analysis, financial forecasting, cost and profit control, etc.
LET US SUM UP
In this unit, we have discussed the definitions of finance. The importance
of financial management is also given and the functions of the Financial
Management were also explained. The reason why Financial

6
Management is important for a Business and in what way that helps the
business was also discussed.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Financial Management is primarily concerned with proper
__________ and the financial resource.
a) Planning b) Management of funds
c) Controlling d) Technology
2. Most company’s experiences loses and negative cash flows during
their _________ period.
a) Start-up b) Growing
c) Planning d) Decision making

3. Finance function always ensures that the business always have

adequate funds to cater to the day to day _________ cost.
a) Accounting b) Transport
c) Fixed d) Operating
4. A___________ manager has to make an estimation with regards to
capital requirements of the company.
a) HR b) Production
c) Finance d) Operations
5____________are the cumulative net earnings or profits of a company
after accounting for dividend payments.
a) retained earnings b) Investment of funds
c) Disposal of surplus d) Management of cash
GLOSSARY
Management : Management means managing the
resources like finance, Information,
technology, human resources called
management.
: It is primarily concerned with Proper
Financial management
Management of Funds and the Financial
Resource. It refers to the planning and
controlling the firm's financial resource.

7
 : An investment fund provides a broader
Investment of funds
selection of investment opportunities,
greater management expertise.

: Financial controls are the procedures,

Financial controls
policies, and means by which an
organization monitors and controls the
direction, allocation, and usage of its
financial resources
: retained earnings are the cumulative net
Retained profits
earnings or profits of a company after
accounting for dividend payments

SUGGESTED READINGS
1. Erich [Link] (1992)Techniques of Financial Analysis, Jaico
Publishing House.
2. James C van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India.
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
management/#:~:text=In%20simple%20terms%2C%20financial%2
0management,all%20transactions%20in%20a%20business.
7. [Link]
introduction-guide/
8. [Link]
[Link]
ANSWERS TO CHECK YOUR PROGRESS
1) b 2) a 3) d 4) c 5) a

8
Unit 2

NATURE, SCOPE, OBJECTIVES AND

SIGNIFICANCE OF FINANCIAL
MANAGEMENT
STRUCTURE
Overview
Learning Objectives
2.1 Nature and Scope of Financial Management

2.1.1 Nature of Financial Management

2.1.2 Scope of Financial Management
2.1.3 Financial Management Relationship with Other
Functional Area
2.2 Objectives of Financial Management
2.3 Profit Maximization
2.4 Wealth Maximisation
2.4.1 Implications of Wealth Maximization
2.4.2 Criticisms of Wealth Maximization
2.5 Significance of financial Management
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answer to Check Your Progress
OVERVIEW
Finance function is the most important of all business functions. It
remains a focus of all activities. It is not possible to substitute or
eliminate this function because the business will close down in the
absence of finance. The need for money is continuous. It starts with the
setting up of an enterprise and remains at all times. The development
and expansion of business rather needs more commitment for funds.
The funds will have to be raised from various sources. The

9
management should have an idea of using the money profitably. It may
be easy to raise funds but it may be difficult to repay them. The inflows
and outflows of funds should be properly matched.

The maximisation of the value of the firm is the ultimate objective of the
finance function. It is the hand-maid to this primary objective. The
finance function is the process of acquiring and utilizing funds by a
business.
Money is formally the most rational means of orienting economic activity.
Money will have to be procured procure and funds will have to be raised.
One of the earliest incidents in the establishment of most organization is
the procurement of money contributions. Money contributions may vary
in many ways. There are number of ways of procuring funds, and
decisions on this matter are based on a wide range of economic, legal
and organizational considerations.
There is another dimension to the finance function. It is an effective
utilization of funds. Commitments to funds are well justified, if there are
careful and worthwhile plans for their productive utilization.
The finance function has to be related to the profitability of an enterprise,
and is generally considered to be the basis of the profits needed by it.
Profit planning is an important aspect of the finance function, because
the entire structure of business finance hinges on profit planning.

It is generally believed that decisions on the issue of securities,

debentures, loans, etc. are very significant because they directly involve
different interests in an organization.
The term finance function is used for activities regardless of their level in
the hierarchy at which action is taken; recording a transaction in financial
terms. Finance function is very sensitive to the time dimension.
LEARNING OBJECTIVES
After completing this unit, you should be able to;
• describe the nature and scope of financial management
• explain the objectives of financial management
• discuss the significance of financial management.
2.1 NATURE AND SCOPE OF FINANCIAL MANAGEMENT
Finance management is a long-term decision-making process which
involves lot of planning, allocation of funds, discipline and much more.
Let us understand the nature of financial management with reference of
this discipline.

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2.1.1 Nature of Financial Management
i) Risk and Returns Evaluation: Nature of financial management
basically involves decision where risk and return are linked with
investment. Generally high-risk investment yield high returns on
investments. So, role of financial manager is to effectively
calculate the level of risk company is involve and take the
appropriate decision which can satisfy shareholders, investors or
founder of the company.
ii) Capital Requirement Estimation: Using financial management to
forecast working capital and fixed capital requirements for
conducting business operations, it is possible to plan ahead of
time for money. It is necessary to have a proper balance between
debt and equity in order to keep the cost of capital as low as
possible. Financial management determines the appropriate
allocation of various securities (common equity, preferred equity
and debt).
iii) Wealth Management: The finance manager keeps track of all
cash movements (both inflow and outflow) and guarantees that the
company does not experience a cash shortage or surplus.
iv) Valuation of Company: Primary nature of financial management
focus towards valuation of company. That is the reason where all
the financial decisions is directly linked with optimizing /
maximization the value of a company. Finance functionality like
investment, distribution of profit earnings, rising of capital, etc. are
the part of management activities.
v) Improve Company’s Stock / Shareholder Value: Increase the
amount of return to shareholders by lowering the cost of
operations and increasing earnings, according to the company’s
mission statement. The finance manager’s primary focus should
be to increase revenue by obtaining cash from a variety of sources
and investing.
vi) Source of Funds: In every organization, the source of funding is a
critical decision to make. There are long-term, medium-term and
short-term source of funds. Every organization should thoroughly
research and evaluate various sources of money (e.g., stocks,
bonds, debentures, and so on) before selecting the most
appropriate sources of funds with the least amount of risk.

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 vii) Selective Investment: Before committing the funds, it is
necessary to thoroughly examine and assess the investment
proposal’s risk and return characteristics. Appropriate decision
needs to be made for selecting right type of investment options.
viii) Control Management: The implementation of financial controls
assists the firm in maintaining its real costs of operation within
reasonable bounds and generating the projected profits.
2.1.2 Scope of Financial Management
Key scope of financial management is divided in three categories.

I. Financing Decision: Financing Decisions focuses on the

accountabilities and stockholders’ equity side of the
firm’s balance sheet, for example decision to issue bonds is a
kind of financing decision. The main aim of financing decision is
to cover expenses and investments. The decision involves
generating capitals by various methods, from different sources, in
relative proportion and considering opportunity costs, with
respect to time of flotation of securities, etc.

FINANCIAL MANAGEMENT

FINANCING INVESTMENT DIVIDEND

DECISION DECISION DECISION

Figure 2.1 Scope of Financial Management

II. Investment Decision: Evaluating the risk involved, measuring
the cost of fund and estimating expected benefits from a project
comes under investment decision. It is one of the important
scopes of financial management. The two major components of
investment decision are – Capital budgeting and liquidity. Capital
budgeting is commonly known as the investment appraisal. It
deals with the allocation of capital and funds in such a manner
that they will yield earnings in future. Capital budgeting
determines the long term investment which includes replacement

12
 and renovation of old assets. It is all about maintaining an
appropriate balance between fixed and current assets in order to
maximize profitability and to maintain desired liquidity in the firm
for its smooth functioning.
III. Dividend Decision: The Dividend Decision plays a crucial role in
today’s corporate era. It determines the amount of taxation that
stockholders pay. A good dividend policy helps to achieve the
objective of wealth maximization. Distributing the entire profit in
the form of dividends or distributing only a certain percentage of
it is decided by dividend policy. It is known as deciding the
optimum dividend pay-out ratio i.e. proportion of net profits to be
paid out to shareholders. Stability of cash dividends and stock
sets the parameter which determines the number of investment
opportunities. Expansion of an economic activity depends on
effectiveness of dividend decisions and scope of financial
management.
2.1.3 Financial Management Relationship with other Functional
Areas
a) Financial Management and Production Department: The financial
management and the production department are interrelated. The
production department of any firm is concerned with the production
cycle, skilled and unskilled labour, storage of finished goods,
capacity utilisation, etc. and the cost of production assumes a
substantial portion of the total cost.

The production department has to take various decisions like

replacing machinery, installation of safety devices, etc. and all the
decisions have financial implications.
b) Financial Management and Material Department: The financial
management and the material department are also interrelated.
Material department covers the areas such as storage, maintenance
and supply of materials and stores, procurement [Link] finance
manager and material manager in a firm may come together while
determining Economic Order Quantity, safety level, storing place
requirement, stores personnel requirement, etc. The costs of all
these aspects are to be evaluated so the finance manager may come
forward to help the material manager.
c) Financial Management and Personnel Department: The
personnel department is entrusted with the responsibility of
recruitment, training and placement of the staff. This department is
also concerned with the welfare of the employees and their families.

13
 This department works with finance manager to evaluate employees’
welfare, revision of their pay scale, incentive schemes, etc.
d) Financial Management and Marketing Department: The
marketing department is concerned with the selling of goods and
services to the customers. It is entrusted with framing marketing,
selling, advertising and other related policies to achieve the sales
target. It is also required to frame policies to maintain and increase
the market share, to create a brand name etc. For all this finance is
required, so the finance manager has to play an active role for
interacting with the marketing department.
2.2 OBJECTIVES OF FINANCIAL MANAGEMENT
Financial management is concerned with procurement and use of funds.
Its main aim is to use business funds in such a way that the firm’s value /
earnings are maximized. Financial management provides a frame work
for selecting a proper course of action and deciding a viable commercial
strategy. The main objective of a business is to maximize the owner’s
economic welfare. This objective can be achieved by,
1. Profit Maximization and
2. Wealth Maximization.
2.3 PROFIT MAXIMIZATION
Profit earning is the main aim of every economic activity. A business
being an economic institution must earn profit to cover its costs and
provide funds for growth. No business can survive without earning
profit. Profit is a measure of efficiency of a business enterprise. Profits
also serve as a protection against risks which cannot be ensured.
The accumulated profits enable a business to face risks like fall in
prices, competition from other units, adverse government policies etc.
Thus, profit maximization is considered as the main objective of
business. The following arguments are advanced in favour of profit
maximization as the objective of business:
a) When profit-earning is the aim of business then profit maximization
should be the obvious objective.
b) Profitability is a barometer for measuring efficiency and economic
prosperity of a business enterprise.
c) Economic and business conditions do not remain same at all times.
There may be adverse business conditions like recession,
depression, severe competition etc. A business will be able to
survive under unfavourable situation, only if it has some past

14
 earnings to rely upon. Therefore, a business should try to earn more
and more when situation is favourable.
d) Profits are the main sources of finance for the growth of a business.
So, a business should aim at maximization of profits for enabling its
growth and development.
e) Profitability is essential for fulfilling social goals also. A firm by
pursuing the objective of profit maximization also maximizes socio-
economic welfare.
However, profit maximization objective has been criticized on many
grounds. They are:
A firm pursuing the objective of profit maximization starts exploiting
workers and the consumers. Hence, it is immoral and leads to a number
of corrupt practices.
It is also argued that profit maximization should be the objective in the
conditions of perfect competition and in the wake of imperfect
competition today, it cannot be the legitimate objective of a firm
One has to reconcile the conflicting interests of all the parties connected
with the firm. Thus, profit maximization as an objective of financial
management has been considered inadequate. Even as an operational
criterion for maximizing owner’s economic welfare, profit maximization
has been rejected because of the following drawbacks;

The term ‘profit’ is vague and it cannot be precisely defined. It means

different things for different people. Should we consider short-term
profits or long-term profits? Does it mean total profits or earnings per
share? Even if, we take the meaning of profits as earnings per share and
maximize the earnings per share, it does not necessarily mean increase
in the market value of share and the owner’s economic welfare.
Profit maximization objective ignores the time value of money and does
not consider the magnitude and timing of earnings. It treats all earnings
as equal when they occur in different periods. It ignores the fact that
cash received today is more important than the same amount of cash
received after, three years.
It does not take into consideration the risk of the prospective earnings
stream. Some projects are more risky than other.
The effect of dividend policy on the market price of shares is also not
considered in the objective of profit maximization.

15
2.4 WEALTH MAXIMIZATION
Wealth maximization is the appropriate objective of an enterprise. When
the firm maximizes the stockholder’s wealth, the individual stockholder
can use this wealth to maximize his individual utility. It means that by
maximizing stockholder’s wealth the firm is operating consistently
towards maximizing stockholder’s utility.

A stockholder’s current wealth in the firm is the product of the number of

shares owned, multiplied with the current stock price per share.
This objective helps in increasing the value of shares in the market. The
share’s market price serves as a performance index or report card of its
progress. It also indicates how well management is doing on behalf of
the shareholder.

However, the maximization of the market price of the shares should be

in the long run. Every financial decision should be based on cost-benefit
analysis. If the benefit is more than the cost, the decision will help in
maximizing the wealth.
2.4.1 Implications of Wealth Maximization
There is a rationale in applying wealth maximizing policy as an operating
financial management policy. It serves the interests of suppliers of
loaned capital, employees, management and society. Besides
shareholders, there are short-term and long-term suppliers of funds who
have financial interests in the concern. Short-term lenders are primarily
interested in liquidity position so that they get their payments in time.
The long-term lenders get a fixed rate of interest from the earnings and
also have a priority over shareholders in return of their funds.
Wealth maximization objective not only serves shareholder’s interests by
increasing the value of holdings but ensures security to lenders also.
The economic interest of society is served if various resources are put to
economical and efficient use.
2.4.2 Criticisms of Wealth Maximization

The wealth maximization objective has also been criticized by certain

financial theorists mainly on following accounts,
i. It is a prescriptive idea. The objective is not descriptive of what
the firms actually do.
ii. The objective of wealth maximization is not necessarily socially
desirable.
iii. There is some controversy as to whether the objective is to
maximize the stockholders wealth or the wealth of the firm which

16
 includes other financial claimholders such as debenture holders,
preferred stockholders, etc.,
iv. The objective of wealth maximization may also face difficulties
when ownership and management are separated as is the case
in most of the large corporate form of organizations.
In spite of all the criticism, we are of the opinion that wealth
maximization is the most appropriate objective of a firm and the side
costs in the form of conflicts between the stockholders and debenture
holders, firm and society and stock holders and managers can be
minimized.
2.5 SIGNIFICANCE OF FINANCIAL MANAGEMENT
The significance of financial Management can be discussed under the
following heads:
a. Success of Promotion Depends on Financial Management: One
of the most important reasons of failures of business promotions is a
defective financial plan. If the plan adopted fails to provide sufficient
capital to meet the requirement of fixed and fluctuating capital an
particularly, the latter, or it fails to assume the obligations by the
corporations without establishing earning power, the business cannot
be carried on successfully. Hence sound financial plan is very
necessary for the success of business enterprise.

b. Smooth Running of an Enterprise: Sound financial planning is

necessary for the smooth running of an enterprise. Money is to an
enterprise, what oil is to an engine. As finance is required at each
stage of an enterprise, i.e., promotion, incorporation, development,
expansion and administration of day-to-day working etc., proper
administration of finance is very necessary.
The financial management assist the top management in its decision-
making process by suggesting the best possible alternative out of the
various alternatives of the problem available. Hence, financial
management helps the management at different level in taking financial
decisions.
LET US SUM UP
In this unit, we have discussed about the nature and scope of financial
management. We have discussed about the financial management
relationship with other functional areas. We have also discussed about
the objectives and significance of financial management.

17
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. High risk investment yield ________ returns on investment.

a) High b) Low
c) Moderate d) Very low
2. The main objective of a business is to __________ the owner's
economic welfare.
a) Control b) Reduce
c) Maximize d) Stable

3._________ is the main source of finance for the growth of a business.

a) Profit b) Resources
c) Risk d) Experience
4. __________helps in increasing the value of share in the market.
a) Profit maximization b) Wealth maximization
c) Financing decisions d) Dividend decisions
5. __________is concerned with the quantum of profits to be distributed
among shareholders.
a) Investment Decisionb) Profit

c) Financing decisions d) Dividend decisions

GLOSSARY

Financing Decision : Financing Decision is focused on the

borrowing and allocation of funds required
for the investment decisions of the firm.

Investment Decision : Investment decisions concerned with the

allocation of funds into different investment
opportunities for the purpose of earning the
highest possible return.

Dividend Decision : The dividend decision is concerned with the

quantum of profits to be distributed among
shareholders.

Profit Maximisation : Profit maximization is the approach or

process which increases the profit or

18
 Earnings per Share (EPS) of the business.

Wealth Maximisation : Wealth maximization is the concept of

increasing the value of a business in order
to increase the value of the shares held by
its stockholders

SUGGESTED READINGS
1 Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2 James C van Horne, Sanjay Dhamija, (2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3 Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4 Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5 Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House
6 [Link]
management/.
7 [Link]
maximization/
8 [Link]
significance-of-financial-management/10642
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) c 3) a 4) a 5) d

19
Unit 3

ROLE OF A FINANCIAL MANAGER

STRUCTURE

Overview
Learning Objectives
3.1 Role of Financial Manager in Decision Making

3.1.1 Functions of a Financial Manager

3.1.2 Capital Investment Decision
3.1.3 Types of Financial Managers
3.1.4 Important Skills for Financial Managers
Let us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
Financial managers perform data analysis and advise senior managers
on profit-maximizing ideas. Financial managers are responsible for the
financial health of an organization. They produce financial reports, direct
investment activities, and develop strategies and plans for the long-term
financial goals of their organization.

Financial Managers typically:

a) Prepare financial statements, business activity reports and
forecasts.
b) Monitor financial details to ensure that legal requirements are
met.
c) Supervise employees who do financial reporting and budgeting.
d) Review company financial reports and seek ways to reduce
costs.
e) Analyse market trends to find opportunities for expansion or for
acquiring other companies.
f) Help management make financial decisions.

20
The role of the financial manager, particularly in business, is changing in
response to technological advances that have significantly reduced the
amount of time it takes to produce financial reports. Financial managers
main responsibility used to be monitoring a company’s finances, but they
now do more data analysis and advise senior managers on ideas to
maximize profits. They often work on teams, acting as business advisors
to top executives.
Financial managers also do tasks that are specific to their organization
or industry. For example, government financial managers must be
experts on government appropriations and budgeting processes, and
healthcare financial managers must know about issues in healthcare
finance. Moreover, financial managers must be aware of special tax laws
and regulations that affect their industry.
LEARNING OBJECTIVES
After completing this unit, you should be able to;
• explain the various roles played by financial managers.
3.1 ROLE OF FINANCIAL MANAGER IN DECISION MAKING
According to the Inter-American Investment Corporation (IIC), the role of
the Financial Managers in the decision-making process can be divided
into four main areas:
1. Investments: In the investments area, the Financial Manager is
responsible for defining the optimal size of the company. In this
regard, it is important to have a market study in place and be clear
on the objectives that the company needs to meet. It is important to
have properly studied the demand, technology and equipment,
financing methods and human resources available. In second place,
the director must analyse whether the resources adapt to the optimal
size desired for the company. If they don’t, it is necessary to define
the types of assets that the company must acquire, or otherwise sell
or get rid of, in order to achieve efficient management.
2. Financing: Defining a financing strategy is essential to the continuity
of the business over the long term. Access to financing is closely
related with maintaining a constant inflow of capital since the savings
margin will not allow operations to continue for much longer without
the support of additional liquidity. The Financial Manager must define
several aspects of the financing strategy. For example, study the
sources willing to offer credit to the organization, and define the best
financing options for operations. The Financial Manager can also
design a mixed financing strategy for efficient financial management:

21
 this is called the company’s “financing mix”. Sometimes the company
can benefit from a combination of short- and long-term financing to
meet investment and financial strategy objectives.
3. Asset Management: Asset management is one of the main aspects
for a company to adequately meet its obligations and in turn to
position itself to meet the objectives or growth targets that have been
laid out. In other words, the Financial Manager must stipulate and
assure that the existing assets are managed in the most efficient way
possible. Generally, this manager must prioritize current asset
management before fixed asset management. Current assets are
those that will become effective in the near future, such as accounts
receivable or inventories. By contrast, fixed assets lack liquidity since
they are needed for permanent operations. This includes offices,
warehouses, machinery, vehicles, etc.
4. Dividend Policy: One of the most important financial decisions that
a Financial Manager must make is related to the company’s dividend
policy. It concerns how much of the company’s earnings will be paid
out to shareholders. Specifically, it is necessary to determine if
generated earnings will be reinvested in the company to improve
operations or if they will be distributed among shareholders. It is also
possible to choose a mixed policy in this regard, distributing a part
among shareholders and investing the rest in the company.
However, if the dividends distributed are too high, the company may
encounter limitations to expand or improve the management of its
operations. It is important to consider that in order to have growth
perspectives over the long-term, short-term reinvestments are
necessary.
3.1.1 Functions of a Financial Manager
Financial activities of a firm are one of the most important and complex
activities of a firm. Therefore, in order to take care of these activities a
financial manager performs all the requisite financial activities.
A financial manager is a person who takes care of all the important
financial functions of an organization. The person in charge should
maintain a far sightedness in order to ensure that the funds are utilized
in the most efficient manner. His actions directly affect the Profitability,
growth and goodwill of the firm.
(a) Raising of Funds
In order to meet the obligation of the business it is important to have
enough cash and liquidity. A firm can raise funds by the way of equity
and debt. It is the responsibility of a financial manager to decide the ratio

22
between debt and equity. It is important to maintain a good balance
between equity and debt.
(b) Allocation of Funds

Once the funds are raised through different channels the next important
function is to allocate the funds. The funds should be allocated in such a
manner that they are optimally used. In order to allocate funds in the
best possible manner the following point must be considered
• The size of the firm and its growth capability
• Status of assets whether they are long-term or short-term
• Mode by which the funds are raised
These financial decisions directly and indirectly influence other
managerial activities. Hence formation of a good asset mix and proper
allocation of funds is one of the most important activities.
(c) Profit Planning
Profit earning is one of the prime functions of any business organization.
Profit earning is important for survival and sustenance of any
organization. Profit planning refers to proper usage of the profit
generated by the firm.
Profit arises due to many factors such as pricing, industry competition,
state of the economy, mechanism of demand and supply, cost and
output. A healthy mix of variable and fixed factors of production can lead
to an increase in the profitability of the firm.
Fixed costs are incurred by the use of fixed factors of production such as
land and machinery. In order to maintain a tandem, it is important to
continuously value the depreciation cost of fixed cost of production. An
opportunity cost must be calculated in order to replace those factors of
production which has gone thrown wear and tear. If this is not noted then
this fixed cost can cause huge fluctuations in profit.
(d) Understanding Capital Markets
Shares of a company are traded on stock exchange and there is a
continuous sale and purchase of securities. Hence a clear
understanding of capital market is an important function of a financial
manager. When securities are traded on stock market there involves a
huge amount of risk involved. Therefore, a financial manger understands
and calculates the risk involved in this trading of shares and debentures.
It's on the discretion of a financial manager as to how to distribute the
profits. Many investors do not like the firm to distribute the profits

23
amongst shareholders as dividend instead invest in the business itself to
enhance growth. The practices of a financial manager directly impact the
operation in capital market.

3.1.2 Capital Investment Decisions

Capital investment decisions are long-term corporate finance decisions
relating to fixed assets and capital structure. Decisions are based on
several inter-related criteria. Corporate management seeks to maximize
the value of the firm by investing in projects which yield a positive net
present value when valued using an appropriate discount rate in
consideration of risk. These projects must also be financed
appropriately. If no such opportunities exist, maximizing shareholder
value dictates that management must return excess cash to
shareholders (i.e., distribution via dividends). Capital investment
decisions thus comprise an investment decision, a financing decision,
and a dividend decision.
Management must allocate limited resources between competing
opportunities (projects) in a process known as capital budgeting. Making
this investment decision requires estimating the value of each
opportunity or project, which is a function of the size, timing and
predictability of future cash flows.
Achieving the goals of corporate finance requires that any corporate
investment be financed appropriately. The sources of financing are,
generically, capital self-generated by the firm and capital from external
funders, obtained by issuing new debt or equity.
3.1.3 Types of Financial Managers
There are distinct types of financial managers, each focusing on a
particular area of management.
Controllers direct the preparation of financial reports that summarize and
forecast the organization’s financial position, such as income
statements, balance sheets, and analyses of future earnings or
expenses. Controllers also are in charge of preparing special reports
required by governmental agencies that regulate businesses. Often,
controllers oversee the accounting, audit, and budget departments.
Treasurers and finance officers direct their organization’s budgets to
meet its financial goals and oversee the investment of funds. They carry
out strategies to raise capital and also develop financial plans for
mergers and acquisitions.

24
Credit managers oversee the firm’s credit business. They set credit-
rating criteria, determine credit ceilings, and monitor the collections of
past-due accounts. Cash managers monitor and control the flow of cash
that comes in and goes out of the company to meet the company’s
business and investment needs. Risk managers control financial risk by
using hedging and other strategies to limit or offset the probability of a
financial loss or a company’s exposure to financial uncertainty.
Insurance managers decide how best to limit a company’s losses by
obtaining insurance against risks such as the need to make disability
payments for an employee who gets hurt on the job or costs imposed by
a lawsuit against the company.
3.1.4 Important Skills for Financial Managers

(a) Analytical skills:Financial managers increasingly assist

executives in making decisions that affect the organization, a
task for which they need analytical ability.
(b) Communication: Excellent communication skills are essential
because financial managers must explain and justify complex
financial transactions.
(c) Attention to detail: In preparing and analysing reports such as
balance sheets and income statements, financial managers must
pay attention to detail.

(d) Math skills: Financial managers must be skilled in math,

including algebra. An understanding of international finance and
complex financial documents also is important.
(e) Organizational skills: Financial managers deal with a range of
information and documents. They must stay organized to do their
jobs effectively.
LET US SUM UP
We have discussed the role of a financial manager in decision making.
Many types of financial manager exist in a business, each focusing on a
particular area of a business. The financial manager is the one who
makes investment decisions. We have also discussed the important
skills needed for financial managers.

25
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. Financial managers are responsible for the ___________ health of an
organisation.
a) Employees b) Managers
c) financial d) Owners

2. Who develop strategies and plans for the long-term financial goals of
the organisation__________?
a) financialmanager b) Operations

c) HR manager d) Production manager

3. ________refers to proper usage of the profit generated by the firm.
a) Capital planning b) Profit planning

c) Budget planning d) Investment planning

4. _______ is in charge of preparing special reports required by
governmental agencies that regulate businesses.
a) Treasures b) Credit managers
c) Cash managers d) Controllers
5._________ is defined as setting a number of actions that need to be
taken in order to achieve a targeted amount of profit.
a) Capital planning b) Profit planning
c) Budget planning d) Investment planning
GLOSSARY
:
Raising of Funds Obtaining funding for the firm's
operations and investments and
seeking the best balance
between debt and equity
:
Asset Management Asset management refers to the
process of developing, operating,
maintaining, and selling assets in
a cost-effective manner.
Capital market is where
Capital Markets :
individuals and firms borrow
funds using shares, bonds,

26
 debentures and debt instruments,
etc. Example: Stock Exchange
Profit planning can be defined as
Profit Planning :
setting a number of actions that
need to be taken in order to
achieve a targeted amount of
profit.
: Capital investment decisions
Capital Investment Decisions
involve the judgments made by a
management team in regard to
how funds will be spent to
procure capital assets.

SUGGESTED READINGS
1 Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2 James C Van Horne, Sanjay Dhamija, (2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3 Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4 Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5 Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6 [Link]
[Link]
7 [Link]
required-for-finance-manager
8 [Link]
functions-of-a-financial-manager-management/27972
ANSWERS TO CHECK YOUR PROGRESS
1) c 2) a 3) b 4) d 5) b

27
Unit 4

FINANCIAL MANAGEMENT IN INDIA&

OVERVIEW OF INDIAN FINANCIAL
SYSTEM
STRUCTURE

Overview
Learning Objectives
4.1 Changing Scenario of Financial Management in India
4.2 Overview of Indian Financial System
4.2.1 Components of Indian Financial System
4.2.2 Financial Institution wise classification

4.2.3 Components of Money market: RBI is a Regulator of

Money Market
4.4 Money Market Instruments

4.4.1 Types of Money market instruments

4.4.2 Capital Market instruments
4.5 Financial Services

4.5.1 Fund Based & Fee Based Financial Services

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
The financial system of a country mainly aims at managing and
governing the mechanism of production, distribution, exchange and
holding of financial assets or instruments of all kinds.
The services that are provided to a person by the various Financial
Institutions including banks, insurance companies, pensions, funds, etc.

28
constitute the financial system. Given below are the features of the
Indian Financial system:
a) It plays a vital role in the economic development of the country
as it encourages both savings and investment
b) It helps in mobilising and allocating one’s savings
c) It facilitates the expansion of financial institutions and markets

d) Plays a key role in capital formation

e) It helps form a link between the investor and the one saving
f) It is also concerned with the Provision of funds

LEARNING OBJECTIVES
After completing this unit, you should be able to
• define the components of Indian Financial System

• discuss the financial instruments

• explain the available financial services
4.1 CHANGINGSCENARIO OF FINANCIAL MANAGEMENT IN INDIA
Modern financial management has come a long way from traditional
corporate finance. As the economy is opening up and global resources
are being tapped, the opportunities available to a finance manager have
no limits. Financial management is passing through an era of
experimentation and excitement as a large part of finance activities are
carried out today. A few instances of these are mentioned as below:
Interest rate freed from regulation treasury operation therefore has to be
more sophisticated as interest rates are fluctuating. The rupee has
become fully convertible. Optimum debt equity mix is possible.
Maintaining share prices is crucial. The dividend policies and bonus
policies formed by finance managers have a direct bearing on the share
prices. Share buy backs and reverse hook building. Raising resources
globally through ADRS/GDRS Risk Management due to introduction of
option and future trading. Free pricing and book building for IPOs,
seasoned equity offering.
4.2 OVERVIEW OF INDIAN FINANCIAL SYSTEM
The financial system of a country is an important tool for economic
development of the country as it helps in the creation of wealth by linking
savings with investments. It facilitates the flow of funds from the

29
households (savers) to business firms (investors) to aid in wealth
creation and development of both the parties.
The financial system includes a complex of institutions and mechanism
which affects the generation of savings and their transfer to those who
will invest. It may be said to be made of all those channels through
which savings become available for investments.

4.2.1 Components/ Constituents of Indian Financial System:

The following are the four main components of Indian Financial system.
i) Financial institutions
ii) Financial Markets
iii) Financial Instruments/Assets/Securities
iv) Financial Services.

A financial system (within the scope of finance) is a system that allows

the exchange of funds between lenders, investors, and borrowers

Financial System

Financial Financial Fiancial Financial

Institutions Markets Instruments services

[Link] Market
[Link] [Link]
[Link] Maret
[Link] [Link] Banking
Instruments
[Link] [Link]
[Link]-Banking [Link]
[Link] [Link]
[Link] [Link] term [Link] Rating
[Link]
[Link]. [Link] [Link] House
[Link] [Link]
[Link] Term
Houses
[Link] Market

[Link] Market
[Link] Market

Figure 4.1 Overview of Indian Financial System

30
(a) Financial institutions:
A financial intermediary is an entity that acts as the middleman between
two parties in a financial transaction, such as a commercial bank,
investment banks, mutual funds and pension funds.
Financial institutions are the intermediarieswho facilitate smooth
functioning of the financial system by making investors and borrowers
meet. They mobilize savings of the surplus units and allocate them in
productive activities promising a better rate of return. Financial
institutions also provide services to entities seeking advice on various
issues ranging from restructuring to diversification plans. They provide
whole range of services to the entities who want to raise funds from the
markets elsewhere. Financial institutions act as financial intermediaries
because they act as middlemen between savers and borrowers. Were
these financial institutions may be of Banking or Non-Banking
institutions.
(b) Financial Markets:
Financial market is classified into Capital market and Money Market
Components of Capital market: SEBI is a Market Regulator of Capital
Market
Market wise classification
a) Stock Market
b) Debt Market
c) Forex Market
d) Insurance Market
e) Commodity Market
f) Derivative Market
g) Futures Market
4.2.2 Financial Institution wiseclassification
All Development Bank, (IFCI, IDBI, EXIM, NABARD, SIDBI). Non-
banking Finance Companies (Mutual Fund, companies, Leasing
companies, Hire purchasing Companies, Venture Capital Companies,)
4.2.3 Components of Money market: RBI isa Regulator of Money
Market
• Commercial Bank.
• Co-operative Bank,
• Regional Rural bank

31
4.3 COMPARISON BETWEEN MONEY MARKET AND CAPITAL
MARKET

Basis
Money Market Capital Market
for Comparison
Meaning A segment of the A section of financial
financial market where market where long-
lending and borrowing of term securities is
short-term securities are issued and traded.
done.
Nature of Market Informal Formal
Financial Treasury Bills, Shares, Debentures,
instruments Commercial Papers, Bonds, Retained
Certificate of Deposit, Earnings, Asset
Trade Credit etc. Securitization, Euro
Issues etc.
Institutions Central bank, Commercial banks,
Commercial bank, non- Stock exchange, non-
financial institutions, bill banking institutions
brokers, acceptance like insurance
houses, and so on. companies etc.
Risk Factor Low Comparatively High
Liquidity High Low
Purpose To fulfill short term credit To fulfill long term
needs of the business. credit needs of the
business.
Time Horizon Within a year More than a year
Merit Increases liquidity of Mobilization of
funds in the economy. Savings in the
economy.
Return on Less Comparatively High
Investment
Form of Finance Trade finance – trade Corporate Finance-
Credit, Bank Over Draft, Term Loan, Leasing
Bills Discounting Finance
Leader of the RBI SEBI
Market

Finance is a prerequisite for modern business and financial institutions

play a vital role in economic system. It's through financial markets the
financial system of an economy works.

4.3.1 The main functions of financial markets are

a) To facilitate creation and allocation of credit and liquidity;
b) To serve as intermediaries for mobilization of savings;

32
 c) To assist process of balanced economic growth;
d) To provide financial convenience
4.3.2 Financial Instruments.

Financial instruments in the Indian financial system may be categorized

into Money Market instruments and capital Market instruments
4.4 MONEY MARKET INSTRUMENTS

The instruments which deal in the money market are of short-term

nature. Their maturity period usually varies between 14 and 364 days.
4.4.1 Money market instruments are:

i) Treasury Bills
ii) Bills of Exchange or Trade bills
iii) Finance bills or insurance promissory notes
iv) Commercial Paper
v) Certificates of Deposits
4.4.2 Capital Market instruments
The instruments which deal in Capital market are of long-term nature.
There are various types of securities such as:
i) Equity shares
ii) Preference shares
iii) Debentures
iv) Gilt-edged securities
v) Zero coupon bonds
vi) Deep discount bonds
vii) Option bonds
viii) Derivative securities - options, futures etc.,
4.5 FINANCIAL SERVICES
It refers to services provided by the financial market; financial service is
a part of financial system.
Efficiency of emerging financial system largely depends upon the quality
and variety of financial services provided by financial intermediaries. The
term financial services can be defined as "activities, benefits and
satisfaction connected with sale of money that offers to users and
customers, financial related value".

33
 4.5.1 Fund Based & Fee Based Financial Services

Fund/Assets Based Fee Based

financial services Financial services
• Leasing • Merchant Banking services
• Hire purchasing • Corporate advisory services
• Venture Capital • Bank Guarantee
• Bills discounting • Credit Rating
• House Financing • Stock broking
• Insurance services • Issues Management
• Factoring • Mergers &Acquisitions
• Forfeiting • Portfolio Management services (PMS)
• Consumer credit • Underwriting
• Mutual Funds

LET US SUM UP

We have discussed the changing scenario of financial management in

India. There are four main components in the Indian Financial System in
which each of the components is discussed briefly. All the financial
instruments are also were discussed. An overview of Indian Financial
System is given.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. __________________ plays a key role in capital formation
a) Indian Financial System b) Business
c) Planning d) Capital
2. One of the components of Indian Financial System is ______
a) Cost b) Financial Market
c) Working capital d) Budgeting
3. Financial market is classified into Capital market and ______ market
a) Money b) Stock
c) Bond d) Commodities
4. Which one is money market instrument_________?

a) Equity shares b) Preference shares

c) Debentures d) Treasury bills

34
5. A section of financial market where long-term securities are issued
and traded ________
a) Money Market b) Capital market

c) Commodities market d) Financial Market

GLOSSARY

Money Market : A segment of the financial market

where lending and borrowing of short-
term securities are done.

Capital Market : A section of financial market where

long-term securities is issued and
traded.

Financial : A financial intermediary is an entity that

acts as the middleman between two
Institutions
parties in a financial transaction, such
as a commercial bank, investment
banks, mutual funds and pension
funds.

Money : The instruments which deal in the

money market are of short-term nature.
Market Instruments
Their maturity period usually varies
between 14 and 364 days.

Capital : Shares, Debentures, Bonds, Retained

Earnings, Asset Securitization, Euro
Market Instruments
Issues etc.

SUGGESTED READINGS
1 Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2 James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3 Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4 Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5 Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.

35
 6 [Link]
challenges-for-nirmala-sitharaman
7 [Link]
market-instruments/
8 [Link]
[Link]

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) a 4) d 5) b

36
 BLOCK
BLOCK 2
2

SOURCES OF FINANCE

Unit 5: Long Term Source of Finance

Unit 6: Borrowing from Lending Institutions
Unit 7: Short Term Source of Finance

Unit 8: International Source of Finance

37
Unit 5

LONG TERM SOURCE OF FINANCE

STRUCTURE

Overview
Learning Objectives
5.1 Long Term Source of Finance

5.1.1 Equity Shares

5.1.2 Feature of Characteristics of Equity Shares
5.1.3 Advantages of Equity Shares
5.1.4 Disadvantages of Equity Shares
5.1.5 Rights Issue of Equity Shares
5.2 Preference Shares

5.2.1 Features of Preference Shares

5.2.2 Advantages of Preference Shares
5.2.3 Disadvantages of Preference Shares

5.2.4 Types of Preference Shares

5.3 Debentures
5.3.1 Features of Debentures

5.3.2 Advantages of Debentures

5.3.3 Disadvantages of Debentures
5.3.4 Types of Debentures

Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to check your progress
OVERVIEW

In our present-day economy, finance is defined as the provision of

money at the time when it is required. Finance is the life blood of every
business concern. Without adequate finance, no enterprise can possibly

38
accomplish its objectives. The various sources of finance have been
classified in many ways. Long-term funds are required to create
production facilities through purchase of fixed assets. Funds are also
needed for short-term purposes for the purchase of raw materials,
payment of wages and other day-to-day expenses. This unit will focus
on the various sources of finance. It has been structured to cover all
aspects related to the different sources of finance.
LEARNINGOBJECTIVES
After completing this unit, you should be able to;

• classify the sources of finance.

• describe the characteristics of long term sources of finance.
5.1 LONG-TERM SOURCES OF FINANCE

The various sources of raising long-term funds include issue of shares,

debentures, ploughing back of profits and loans from financial
institutions, etc.
5.1.1 Equity Shares
Equity shares are regarded as corner-stone of the financial structure of a
company without which the company cannot be founded. Management
procures debt and preference share capital against the strength of these
shares.
Equity shares, also known as ordinary shares or common shares,
represent the owner’s capital in a company. The holders of these shares
are the real owners of the company. They have a control over the
working of the company. Equity Shareholders are paid dividend after
paying it to the preference shareholders.
5.1.2 Feature of Characteristics of Equity Shares
Equity shares have a number of features which distinguish them from
other shares and securities. The following are the most significant
features of equity shares.
i) Maturity: Equity shares provide permanent capital to the company
and cannot be redeemed during the life time of the company. The
shareholders can demand their capital only in the event of liquidation
and that too when funds are left after covering all prior claims.
Shareholders can however sell shares during the life of the company.
ii) Claim on Income: Equity shareholders have a residual claim on the
income of a company. They have a claim on income left after paying
dividend to preference shareholders. The rate of dividend on these

39
shares is not fixed; it depends upon the earnings available after paying
dividend on preference shares.
iii) Claim on Assets: Equity shareholders have a residual claim on
ownership of company’s assets. In the event of liquidation of a company,
the assets are utilized first to meet the claims of creditors and preference
shareholders but everything left, thereafter, belongs to the equity
shareholders.
iv) Control: Equity shareholders have unchallenged voice in
management. Whatever control the stockholders retain is exercised
primarily through the voting privilege. Every equity shareholder has the
right to vote on every resolution placed before the general body of
shareholders and his voting right on a poll is in proportion to his share of
the paid-up capital of the company. Although a company is managed by
the Board of Directors who control and direct the affairs of the
organization, supreme control is endowed with the equity shareholders.
It is they who have power to elect the directors of the enterprise and
remove any or all of them if they so wish
v) Pre-emptive Right: The pre-emptive right entitles a shareholder to
maintain his proportionate share of ownership in the company. The law
grants shareholders the right to purchase new shares in the same
proportion as their current ownership. The company in under legal
compulsion to offer new issues to the existing equity stockholders before
placing them in the market for public subscription. Such a right of the
equity shareholders to purchase newly issued equity stock is termed as
‘pre-emptive right’ and sale of equity stock the existing stockholders as a
matter of privilege is referred to as a matter or ‘right offering’. Section 81
of the companies Act, 1956 has conferred pre-emptive right to equity
stockholders. The number of shares that a stockholder will be entitled to
purchase is determined by the number of shares already owned in
relation to the total shares outstanding. Thus, for instance, if ‘A’ owns
100 shares of a company having 1000 shares of equity stock
outstanding he will be entitled to purchase one-tenth of all new shares of
equity stock. This is why, equity stockholders are sometimes called pro-
rata owners.
vi) Limited Liability: Equity shareholders are the real owners of the
company; their liability is limited to the value of share they have
purchased. If Shareholders has already fully paid the share price, he
cannot be held liable further, for any losses of the company even at the
time of liquidation.

40
 5.1.3 Advantages of Equity Shares
i) Equity stock is the most potent source of financing that provides
substantially large amount of funds without involving the company
and the management in any fixed obligations. Further, the manager is
under no statutory obligation to distribute earnings as dividends.
ii) Equity stock facilitates the company to reap the benefits of leverage
by taking recourse to debt which is the cheapest source of finance.
Creditors are desirous of investing in debentures of a company with a
considerable amount of equity capital because it provides a cushion
to absorb any loss.
iii) Equity share capital provides a considerable amount of
manoeuvrability in the financial structure of the company. A company
with equity share capital is under no commitments to its suppliers of
capital and can adjust its sources of funds in response to major
changes in need of funds. It also enhances the bargaining power of
the company when dealing with a prospective supplier of funds which
is not possible in case a company is top heavy with debt.
iv) Thus a new and growing company seeking large funds for its
expansion programmes secures ample resources at cheaper cost
and without any inconvenience and obligations.
5.1.4 Disadvantages of Equity Shares

i) As equity capital cannot be redeemed, there is a danger of over

capitalization.
ii) If only equity shares are issued, the company cannot take the
advantages of trading on equity.
iii) During prosperous periods higher dividends have to be paid
leading to increase in the value of shares in the market and
peculation.
iv) Investors who desire to invest in safe securities with a fixed
income have no attraction for such shares.
5.1.5 Rights Issue of Equity Shares
A rights issue involves selling of ordinary shares to the existing
shareholders of the company. The law in India requires that the new
ordinary shares must be first issued to the existing shareholders on a
pro rata basis. This pre-emptive right can be forfeited by shareholders
through a special resolution. Obviously, this will dilute their ownership.
Terms and Procedures
A company can make rights offering to its shareholders after meeting the
requirements specified by the securities and exchange Board of India

41
(SEBI). Those shareholders who renounce their rights are not entitled
for additional shares. Shares becoming available on account of non-
exercise of rights are allotted to shareholders who have applied for
additional shares can be sold in the open market. In India along with the
letter of rights, four forms may be sent. Form A is intended for accepting
the rights and applying for additional shares. Form B is meant for the
purpose of foregoing the rights in favour of another person. Form c has
to be used by the person in whose favour the rights have been
renounced for making application. Form D is for the purpose of
requesting for the split forms.
a) When the rights are offered for raising funds, three issues are
involved the number of rights needed to buy a new share,
b) theoretical value of a right, and
c) Effect of rights offerings on the value of the ordinary shares
outstanding. We shall consider an example to discuss these
issues.
5.2 PREFERENCE SHARES
Preference shares refer to that kind of security which is accorded
preferential treatment over equity shares in respect of distribution of
earnings and assets of the firm. The extent of the rights and
preferences are generally stated clearly in a firm’s Articles of
Association.
5.2.1 Features of Preference Shares
The following are the most significant features of preference shares.
i) Maturity: Preference shares resemble equity shares in respect of
maturity. These are perpetual (irredeemable) and the company is not
required to repay the amount during its life time. It is only at the time of
liquidation that a company has to repay the preference shareholder after
meeting the claim of creditors but before paying back the equity
shareholders.
ii) Claims on Income: A fixed rate of dividend is payable on preference
shares. Preference shareholders have prior claim on income (dividend)
over equity shareholders. Whenever the company has decided to
distribute profits, the dividend is first paid to the preference
shareholders. However the claim of the preferred stockholders unlike
equity stockholders is fixed for all time to come and does not change in
correspondence with variation in level of earnings. They have no right to
share in extra earnings. Occasionally, however a participating feature is
inserted in the preferred stock which gives the stockholder a right to

42
 participate in the balance of profits in an agreed proportion along with
equity stockholders whose claims are first met on reasonable grounds.
Stocks”. In this case, the stockholders get two kinds of dividends one
fixed and the other changing - depending on the magnitude of excess
profits. It may be noted that in the absence of any specific right to
participate in the surplus profits, preference shares are presumed to be
non-participating.
iii) Claims on Assets: Preference shares have a preference in the
repayment of capital at the time of liquidation of a company. Their claims
on assets are superior to those of equity shareholder. Incase of the
dissolution of the company they will receive their portion of the proceeds
of dissolution before equity shareholders.

iv) Control: Ordinarily, preferred stockholders do not have direct right to

participate in the management through voting for directors and on other
matters. However, under the Companies Act 1956 (Sec.87) a
preference shareholder has been given the right to vote on resolutions
which directly affect the rights attached to his preference shares and in
this connection any resolution for winding up the company or for the
repayment or reduction of this share capital is to be regarded as directly
affecting the rights attached to preference shares.
v) Hybrid form of Security: Preference share capital, in the real sense,
represents a hybrid form of security as it includes some features of
equity and other of debt financing.
5.2.2 Advantages of Preference Shares
i) Riskless leverage advantage: Preference share provides financial
leverage advantages since preference dividend is a fixed obligation.
ii) Dividend post probability: Preference share provides some
financial flexibility to the company since it can postpone payment of
dividend.
iii) Fixed Dividend: The Preference dividend payments are restricted to
the stated amount. Thus, preference shareholders do not participate
in excess profits as do the equity shareholders.
iv) Limited voting Rights: Preference shareholders do not have voting
rights except in case dividend arrears exist. Thus, the control of
ordinary shareholders is presented.
5.2.3 Disadvantages of Preference Shares
i) Non – deductibility of dividends: The primary disadvantage of
preference share is that preference dividend is not tax deductible.
Thus, it is costlier than debenture.

43
ii) Commitment to pay dividend: Although preference dividend can be
omitted, they may have to be paid because of their cumulative nature.
Non- payment of preference dividends can adversely affect the image
of a company, since equity holders cannot be paid any dividends
unless preference shareholders are paid dividends.
5.2.4 Types of Preference Shares

Preference shares are of the following types:

i) Cumulative Preference Shares: These shares have a right to claim
dividend for those years also for which there are no profits. Whenever
there are divisible profits, cumulative preference shares are paid
dividend for all the previous years in which divided could not be
declared.

ii) Non-Cumulative Preference Shares: The holders of these shares

have no claim for the arrears of dividend. They are paid a dividend if
there are sufficient profits. They cannot claim arrears of dividend in
subsequent years.
iii) Redeemable Preference Shares: Normally, the capital of a
company is repaid only at the time of liquidation. Neither the company
can return the share capital nor can the shareholders demand its
repayment. The company, however, can issue redeemable preference
shares if Articles of Association allow such an issue. The company has
right to return redeemable preference share capital after a certain
period. The Companies Act had provided certain restrictions on the
return of this capital. The shares to be redeemed should be fully paid up.
The company should redeem this share either out of profits or out of
fresh issue of capital. The object of these restrictions is that the
resources of the company are not depleted.
iv) Irredeemable Preference Shares: Those shares which cannot be
redeemed unless the company is liquidated are known as irredeemable
preference shares.
v) Participating preference shares: The holders of these shares
participate in the surplus profits of the company. They are first paid a
fixed rate of dividend and then a reasonable rate of dividend is paid on
equity shares. If some profits remain after paying both these dividends,
then preference shareholders participate in the surplus profits. The
mode for dividing surplus between preference and equity shareholders is
given in the Articles of Association.

44
vi) Non-Participating Preference Shares: The shares on which only a
fixed rate of dividend is paid are known as non –participating preference
shares. These shares do not carry the additional right of sharing of
profits of the company.
vii) Convertible Preference Shares: The holders of these shares may
be given a right to convert their holdings into equity shares after a
specific period. These are called convertible preference shares. The
right of conversion must be authorized by the Articles of Association.
viii) Non-Convertible Preference Shares: The shares which cannot be
converted into equity shares are known as non-convertible preference
shares. Preferred stock also helps the management to keep controlling
power of the current stockholders intact. At a time when the economy is
enveloped in uncertainty and the stock market is caught in a whirlwind of
slump and the management finds that investors have a strong desire to
hold investments promising higher yield as compared with fixed interest
debt and greater certainty of return and added protection
in relation to equity stock, preference share is the most suitable form of
security to attract capital. Such a tendency gets reinforced when equity
prices are declining.
5.3 DEBENTURES
A company may raise long-term finance through public borrowings.
These loans are raised by the issue of debentures. A debenture is an
acknowledgement of a debt. A debenture holder is creditor of the
company. A fixed rate of interest is paid on debenture. The debentures
are generally given a floating charge over the assets of the company.
Debenture is one of the most commonly used financing instruments by
which a firm can procure long-term funds from the capital market.
5.3.1 Features of Debentures
The salient characteristics of debentures are as below
i) Maturity: Although debentures provide long-term funds to a company,
they mature after a specific period. The debentures are to be repaid at a
definite time as stipulated in the issue. The company must pay back the
principal amount on these debentures on the given date otherwise the
debenture holders may force winding up of the company as creditors.
ii) Claims on Income: A fixed rate of interest is payable on debentures.
Unlike shares, a company has a legal obligation to pay the interest on
due dates irrespective of its level of earnings. Even if a company makes
no earnings or incurs loss, it is under an obligation to pay interest to its

45
debenture holders. Default in payment of interest may entail the
company in extreme predicament and bondholders may even approach
the court of law for foreclosure. For protecting their claim to income and
assuring regularity of receipt of that income they may even put
restrictions on dividend payments to residual owners and for
maintenance of adequate liquidity.

iii) Claims on Assets: Even in respect of claim on assets, debenture

holders have priority of claim on assets of the company. They have to
be paid first before making any payment to the preference or equity
shareholders in the event of liquidation of the company. To ensure
against risk of loss of principal money, bondholders prefer to have loan
secured by a lien on specific assets. As pointed out above, bonds that
are secured by a lien on specific assets of the company are called
‘secured Bonds’ and those that do not have specific assets pledged to
secure payment of interest and principal are termed ‘Unsecured Bonds’.
In the event of reorganisation or liquidation, assets pledged to secured
bonds will be used to satisfy creditors’ claims. Since no particular asset
is earmarked in case of unsecured debenture, holders of such
debentures will rank s general creditors of the company at the time of
winding up and their claims will be satisfied accordingly.
iv) Control: Since, debenture holders are creditors of the company and
not its owners; they do not have any control over the management of the
company. They have to right to vote for the election of directors and for
the determination of important managerial policies. They may, however,
indirectly influence managerial decision through protective convenes in
indenture. For instance, to protect their interest, bond indenture may
provide for maintenance of minimum liquidity ratio and for building up
stipulated number of reserves before making dividend payments to
stockholders. Undoubtedly, debenture holders cannot interfere in
managerial activities so long as the company is working
in accordance with the terms of the indenture and there are no
managerial lapses. In the event of default to pay interest or principal
money, the bondholders will, in effect, take control of the company.

v) Call feature: Issue of debentures sometimes provide a call feature

which entitles the company to redeem its debentures at a certain price
before the maturity date.
5.3.2 Advantages of Debentures
i) Less Costly: It involves less cost to the firm than the equity financing
because (a) investors consider debentures as a relatively less risky

46
 investment alternative and therefore, require a lower rate of return
and (b) interest payments are tax deductible.
ii) No ownership dilution: Debentures holders do not have voting
rights; therefore, debenture issue does not cause dilution of
ownership.
iii) Fixed payment of interest: Debenture holders do not participate in
extra-ordinary earnings of the company. Thus, the payments are
limited to interest.
iv) Reduced real obligation: During periods of high inflation, debenture
issue benefits the company. Its obligation of paying interest and
principal which are fixed decline in real terms.
5.3.3 Disadvantages of Debentures

i) Obligatory payments: Debenture results in legal obligation of

paying interest and principal, which, if not paid, can force the
company into liquidation.
ii) Financial Risk: It increases the firm’s financial leverage, which
may be particularly disadvantageous to those firms which have
fluctuating sales and earnings.
iii) Cash outflows: Debentures must be paid on maturity, and
therefore, at some points, it involves substantial cash outflows.
iv) Restricted covenants: Debenture indenture may contain
restrictive covenants which may limit the company’s operating
flexibility in future.
5.3.4 Types of Debentures

i) Simple, Naked or Unsecured Debentures: These debentures are

not given any security on assets. They have no priority as compared to
other creditors. They are treated along with unsecured creditors at the
time of winding up of the company.
ii) Secured or Mortgaged Debentures: These debentures are given
security on assets of the company. In case of default in the payment of
interest or principal amount, debenture holders can sell the assets in
order to satisfy their claims.
iii) Bearer Debentures: These debentures are transferable. They are
just like negotiable instruments. The debentures are handed over to the
purchaser without any registration deed. The bearer can get interest
from the company when it becomes due.
iv) Registered Debentures: As compared to the bearer debentures
which are transferred by mere delivery, registered debentures require a
procedure to follow for their transfer. Both the transfer and the

47
transferee are expected to sign a transfer voucher. The form is sent to
the company along with the registration fees. The name of the
purchaser is entered in the register. The coupons for the interest are
sent only to the persons in whose names the debentures are registered.
v) Redeemable Debentures: These debentures are to be redeemed on
the expiry of a certain period. The interest on the debentures is paid
periodically but the principal amount is returned after a fixed period. The
time for redeeming the debentures is fixed at the time of their issue.
vi) Irredeemable Debentures: Such debentures are not redeemable
during the life time of the company. They are payable either on winding
up of the company or at the time of any default on the part of the
company.

vii) Convertible Debentures: Sometimes convertible debentures are

issued by a company and the debenture holders are given an option to
exchange the debentures into equity shares after the lapse of a specified
period.
viii) Zero Interest Bonds/Debentures: Zero interest bond is an
instrument recently introduced in India by some companies. It is usually
a convertible debenture which yields no interest. The company does not
pay any interest on such debentures. They have no right to vote for the
election of directors and for the determination of important managerial
policies. They may, however, indirectly influence managerial decision
through protective covenants in indenture. For instance, to protect their
interest, bond indenture may provide for maintenance of minimum
liquidity ratio and for building up stipulated number of reserves before
making dividend payments to stockholders. Undoubtedly, debenture
holders cannot interfere in managerial activities so long as the company
is working in accordance with the terms of the indenture and there are
no managerial lapses. In the event of default to pay interest or principal
money, the bondholders will, if effect, take control of the company.
LET US SUM UP
In this unit, we have discussed the long-term sources of finance, in
which Equity shares, Preference shares and Debenture were explained
in detail. The Characteristics of Equity shares are explained. The
features of Preference shares are also explained along with the types of
Preference shares. The different types of Debentures were also
explained in detail.

48
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. __________ is the life blood of every business concern.

a) Shares b) Bonds
c) Finance d) Treasury bills
2. __________ provides permanent capital to the company and cannot
be redeemed during the life time of the company.
a) Equity shares b) Preference shares
c) Debentures d) Dividend

3. Which is not a type of Preference share?

a) Redeemable Preference share
b) Cumulative Preference share
c) Convertible Preference share
d) Secured Preference share
4. A company may raise long term finance through ___________
borrowings
a) Partners b) Public
c) Employees d) Bank
5.A portion of a company's profit paid to shareholders is called as
________.
a) Shares b) Equity shares
c) Debentures d) Dividend
GLOSSARY

Shares : A share is a percentage of ownership

in a company or a financial asset.

Equity shares : An equity share, normally known as

ordinary share is a part ownership
where each member is a fractional
owner and initiates the maximum
entrepreneurial liability related to a
trading concern. These types of
shareholders in any organization
possess the right to vote.

49
Preference shares : Preference shares commonly known as
preferred stocks; are those shares that
enable shareholders to receive
dividends announced by the company
before receiving to the equity
shareholders

Debentures : Debenture is a medium- to long-term

debt instrument used by large
companies to borrow money, at a fixed
rate of interest.

Dividend : A portion of a company's profit paid to

shareholders. Public companies that
pay dividends usually do so on a fixed
schedule although they can issue them
at any time. Unscheduled dividend
payments are known as special
dividends or extra dividends

SUGGESTED READINGS
1 Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2 James C van Horne, Sanjay Dhamija, (2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3 Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4 Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5 Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6 [Link]
7 [Link]
8 [Link]
uses/
ANSWERS TO CHECK YOUR PROGRESS
1) c 2) a 3) d 4) b 5) d

50
Unit 6

BORROWINGS FROM LENDING

INSTITUTIONS
STRUCTURE

Overview
Learning Objectives
6.1 Borrowings from Lending Institutions

6.1.1 Industrial Finance Corporation of India (IFCI)

6.1.2 Industrial Credit and Investment Corporation of
India (ICICI)

6.1.3 Industrial Development Bank of India (IDBI)

6.1.4 Life Insurance corporation of India (LIC)
6.1.5 General Insurance Corporation (GIC)
6.1.6 Unit Trust of India (UTI)
6.1.7 Industrial Reconstruction Bank of India (IRBT)
6.1.8 State Financial Corporation’s (SFC)
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your Progress
OVERVIEW
Borrowing is often a fact of adult life. Almost everyone needs to take out
a loan at some point. Maybe it’s for a new home. Maybe it’s for college
tuition. Maybe it’s to start a business. Whatever the reason you have to
borrow money, professional financing options are many and varied
nowadays. They range from traditional financial institutions, like banks,
credit unions, and financing companies, to Internet Age creations, like
peer-to-peer lending (P2P); from public agencies to your own personal
plan. A variety of financing options exist for consumers. General-
purpose lenders include banks, credit unions, and financing companies.
Peer-to-peer (P2P) lending is a digital option for putting together lenders

51
and borrowers. Credit cards can work for short term loans, margin
accounts for buying securities.
LEARNINGOBJECTIVES

After completing this unit, you should be able to;

• describe the lending financial institutions
• classify the different institutions for borrowing.

6.1 BORROWINGS FROM LENDING INSTITUTIONS

6.1.1 Industrial Finance Corporation of India (IFCI)
IFCI is the first All-India term lending institution. It was set up in 1948
with the primary objective of providing medium and long-term credit to
industry. The sources of funds for IFCI are paid-up capital, reserves,
repayment of loans, market borrowings, loans from the Government of
India, advances from the Industrial Development Bank of India, and
foreign lines of credit from KfW (west Germany) BFCE (France), ODA
(UK) and others.
6.1.2 Industrial Credit and Investment Corporation of India (ICICI)
ICICI was founded in 1955. It is owned and financed mainly by the
private sector. It provides assistance to units in the private sector,
particularly to meet their foreign exchange requirements. It provides
assistance to units in the private sector, mainly in the form of rupee and
foreign exchange loans. The resources of ICICI consist of paid-up
capital, reserves, repayments of loans, and borrowings from the
Government of India, advances from the Industrial Development Bank of
India, market borrowings, and foreign lines of credit from the World
Bank, USAID, KfW, UK Government, and others. ICICI has made
important contributions to capital marker and industrial development by
setting up institutions like CRISIL, SCICI, TDICI, and ICICI Bank.
6.1.3 Industrial Development Bank of India (IDBI)
IDBI was established in 1964 as a subsidiary of the RBI. IDBI finances
industry directly and also provides the principal support to State financial
corporations and State Industrial Development Corporations and
commercial banks in their financing of industries, through refinancing
and bill rediscounting facilities.
The resources of IDBI consist of paid-up capital, reserves, repayment of
loans, market borrowings both within and outside the country, temporary
credit from the Reserve Bank of India, foreign lines of credit from the
World Bank, ADB and others IDBI set up a subsidiary called the Small

52
Industries Development Bank of India (SIDBI) to serve as the chief
refinancing institution for the small sector.
6.1.4 Life Insurance corporation of India (LIC)

LIC came into being in 1956 after the nationalisation and merger of
about 250 independent life insurance societies. The primary activity of
LIC is to carry on life insurance business, but it has gradually developed
into an important all India financial institution which provides substantial
support to industry.
6.1.5General Insurance Corporation (GIC)

GI provides substantial assistance to industrial projects by way of term

loans, subscription to equity capital and debentures, and underwriting of
securities. General Insurance Corporation (GIC, hereafter) was founded
when the management of general insurance business in India was taken
over by the government in 1971 and subsequently nationalised in 1973.
It is headquartered in Bombay. GIC is essentially a holding company
that has four fully-owned subsidiary companies in its fold.
6.1.6Unit Trust of India (UTI)
UTI was set up in 1964 with the principal objective of mobilizing public
saving and channelling them into productive corporative investments.
UTI raises its resources primarily through the sale of small domination
units.

6.1.7 Industrial Reconstruction Bank of India (IRBT)

IRBT is primarily an agency to help the reconstruction and rehabilitation
of industrial units which have closed down or which face the risk of
closure.
6.1.8 State Financial Corporation’s (SFC)
SFC setup under the State Financial Corporations Act, 1951, renders
assistance to medium and small-scale industries in their respective
states. Their shareholders are the respective state governments and
IDBI. They also help artisans, village (rural), and tiny units. The
financial resources of SFCs consist of paid-up capital, reserves, market
borrowings, refinance form IDBI and borrowings from the Reserve Bank
of India.
LET US SUM UP
We have discussed in the part about the lending institutions, it was set
up with the primary objective of providing medium and long-term credit

53
to an industry. Many lending institutions and their borrowers have been
discussed.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. IFCI was set up in _______.
a) 1948 b) 1955

c) 1956 d) 1964
2.________ agency helps in reconstruction and rehabilitation of
industrial units which have closed down.

a) IDBI b) IFCI
c) IRBT d) SFC
3. IDBI was established in _______.

a) 1948 b) 1955
c) 1956 d) 1964
4. General Insurance Corporation (GIC) was taken over by government
in _______.
a) 1964 b) 1971
c) 1972 d) 1980

5. SFC provides assistance to Medium and ________ scale industries in

their respective states.
a) large b) Micro
c) small d) Very large
GLOSSARY

Industrial Finance : FCI Ltd (IFCI) was set up as a

Corporation of India (IFCI) Statutory Corporation (“The Industrial
Finance Corporation of India”) in 1948
for providing medium- and long-term
finance to industry.

Industrial Development : IDBI finances industry directly and

Bank of India (IDBI) also provides the principal support to
State financial corporations and State
Industrial Development Corporations
and commercial banks in their
financing of industries, through

54
 refinancing and bill rediscounting
facilities.

Life Insurance : The primary activity of LIC is to carry

corporation of India (LIC) on life insurance business, but it has
gradually developed into an important
all India financial institution which
provides substantial support to
industry.

Unit Trust of India (UTI) : UTI’s principal objective is mobilizing

public saving and channelling them
into productive corporative
investments. UTI raises its resources
primarily through the sale of small
domination units.

Industrial Reconstruction : IRBT is primarily an agency to help

Bank of India (IRBT) the reconstruction and rehabilitation
of industrial units which have closed
down or which face the risk of
closure.

SUGGESTED READINGS
1 Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2 James C Van Horne, Sanjay Dhamija, (2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3 Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4 Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5 Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6 [Link]
investment-corporation-of-india-icici/23506
7 [Link]
bank-of-india-act-1984
8 [Link]
management/financial-institutions/uti/
ANSWERS TO CHECK YOUR PROGRESS
1) c 2) a 3) b 4) d 5) b

55
Unit 7

SHORT TERM SOURCE OF FINANCE

STRUCTURE

Overview
Learning Objectives
7.1 Introduction to Short Term Finance

7.2 Types / Sources of Short-Term Financing

7.2.1 Trade Credit
7.2.2 Short Term / Working Capital Loan
7.2.3 Business Line of Credit
7.2.4 Invoice Discounting
7.2.5 Factoring

7.3 Money Market

7.4 Gilt-Edged Securities
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your Progress

OVERVIEW
Short term financing means the financing of business from short term
sources which are for a period of less than one year and the same helps
the company in generating cash for working of the business and for
operating expenses which is usually for a smaller amount and it involves
generating cash by online loans, lines of credit, invoice financing.
It is also referred to as working capital financing and is used for
inventory, receivables, etc. In most cases, this type of financing is
required in the business process because of their uneven cash flow into
the business or due to their seasonal business cycle.
The main agenda of opting for short term finance for a business is to get
funds for working capital so that the cycle runs efficiently and the fund

56
does not become the hurdle in the day to day business. If the person is
unable to repay the loan then it will affect its credit score as well.
LEARNINGOBJECTIVES

After completing this unit, you should be able to;

• explain the sources of short term finance
• discuss the components and functions of Money Market
• tell the advantages and disadvantages of short term finance.
7.1 INTRODUCTION TO SHORT TERM FINANCE
Short term finance refers to financing needs for a small period normally
less than a year. In businesses, it is also known as working capital
financing. This type of financing is normally needed because of uneven
flow of cash into the business, the seasonal pattern of business, etc. In
most cases, it is used to finance all types of inventories, accounts
receivables etc. At times, only specific one-time orders of business are
financed.
The most important difference between long term and short-term finance
is the time period and the purpose. Short term finance is for less than 1
year and long term could be for 10, 15 years. Short term finance is used
for working capital requirement, however long-term finance is for big
finance requirements.
7.2 TYPES / SOURCES OF SHORT-TERM FINANCING

As we understood, why we need short-term financing, there are various

sources of short-term financing for a business. Each type of short-term
finance has different characteristics and can be used in different
situations.
7.2.1 Trade Credit
This is the floating time allowed the business to pay for the goods or
services which they have purchased or received. The general floating
time allowed to pay is 28 days. This helps the businesses in managing
their cash flows more efficiently and help in dealing with their
finances. Trade credit is a good way of financing the inventories which
means how many numbers of days the vendor will be allowed before its
payment is due. The trade-credit is offered by the vendor as an
inducement in continuing business and that is why it costs nothing.
7.2.2 Short Term/ Working Capital Loan
Banks or other financial institutions extend loans for a shorter period
after studying the business nature, its working capital cycle, past

57
records, etc. Once the loan is sanctioned and disbursed by the bank or
other financial institutions it can be repaid in small instalments or can be
paid in full at the end of loan tenure depending on the agreed terms of
loans between both the parties. It is often advised to finance the
permanent working capital needs through these loans.
7.2.3 Business Line of Credit

A business line of credit, a type of short-term financing, is most

appropriate for temporary working capital needs. In this type of
financing, an amount is approved by the issuing bank or financial
institution. Within the limit of this amount, the business can make
payment and keep depositing once payment from customers is received.
It works like a revolving credit and best part of this is the interest is
charged on the utilized amount only and not on the approved amount.
The business has the flexibility to deposit unused amount to save on
interest cost. This way it becomes a very cost-effective financing option.
7.2.4 Invoice Discounting
Invoice discounting is another source of short-term finance where the
receivable invoices can be discounted with the financial institutes or
banks or any third party. Discounting invoices means the bank will pay
you the money at the time of discounting and collects the money from
your customer when the bill becomes due.

7.2.5 Factoring
Factoring is also a similar arrangement like invoice discounting where
the accounts receivables of a business are sold to a third party at a price
which is lower to the realizable value of the accounts receivable. This
purchasing party is commonly known as a factor. These factoring
services are provided by both banks and other financial institutions.
There are many types of factoring like with recourse or without recourse
etc.
7.3 MONEY MARKET

The money market refers to trading in very short-term debt investments.

At the wholesale level, it involves large-volume trades between
institutions and traders. At the retail level, it includes money market
mutual funds bought by individual investors and money market
accounts opened by bank customers.
In all of these cases, the money market is characterized by a high
degree of safety and relatively low rates of return.

58
The money market is one of the pillars of the global financial system. It
involves overnight swaps of vast amounts of money between banks and
the U.S. government. The majority of money market transactions are
wholesale transactions that take place between financial institutions and
companies.
Institutions that participate in the money market include banks that lend
to one another and to large companies in the Eurocurrency and time
deposit markets; companies that raise money by selling commercial
paper into the market, which can be bought by other companies or
funds; and investors who purchase bank CDs as a safe place to park
money in the short term. Some of those wholesale transactions
eventually make their way into the hands of consumers as components
of money market mutual funds and other investments.
The money market instruments in India mainly comprise as follows:
a) Call/Notice Money Market: Call and notice money are money dealt
for one to 14 days. The period of term money ranges from 14 days to 90
days. This is sometimes determined by the market forces. This market is
of vital importance to bank and financial institutions because of the
avenue it provides for investing funds and meeting the deficit.
b) Repos: Repo is a money market instrument, which enables
collateralized short-term borrowing and lending through sale/purchase
operations in debt instruments. Under a repo transaction, a holder of
securities sells them to an investor with an agreement to re-purchase at
a pre-determined date and rate.
c) Commercial Paper: Commercial paper is unsecured promissory
notes of short-term maturity of highly rated companies, issued to meet
working capital requirements. The commercial paper is subject to credit
rating by any of the recognized credit rating agencies in India.
d) Certificates of Deposits (CD): Certificates of deposits are essentially
securitised short-term deposit issued by banks during periods of tight
liquidity, at relatively high interest Rates. But the transaction cost of
certificates of deposits is often lower as compared with that of retail
deposits.
e) Commercial Bills Market or Bills of Exchange: Commercial bills
are important instruments used to facilitate credit sales. Commercial bills
can be discounted with banks and the banks, when they are in need of
funds, may rediscount them in the money market.

59
f) Treasury Bills: Treasury bills are promissory notes issued by the
central government to raise short term funds to bridge short term
mismatches between receipts and expenditures.

7.4 GILT-EDGED SECURITIES

Gilt-edged securities are high-grade bonds issued by certain national
governments and private organizations. In the past, these instruments
referred to the certificates issued by the Bank of England (BOE) on
behalf of the Majesty's Treasury, so named because the paper they
were printed on customarily featured gilded (golden) edges.

By nature, a gilt-edged denotes a high-quality item whose value

remains fairly constant over time. As an investment vehicle, this
equates to high-grade securities with relatively low yields compared to
riskier, below-investment-grade securities. For that reason, gilt-edge
securities were once solely issued by blue-chip companies and national
governments with proven track records of turning profits. Aside from
conventional gilts, the British government issues index-linked gilts that
offer semi-annual coupon payments adjusted for inflation. Government
bonds in the U.K., India, and several other commonwealth countries are
still known as gilts. Gilt-edged securities are high-grade investment
bonds offered by governments and large corporations as a method of
borrowing funds. The issuing institutions typically boast strong track
records of consistent earnings that can cover dividend or interest
payments. In many ways, these are the next safest bonds to U.S.
Treasury securities.

The United Kingdom and other Commonwealth nations still rely on

these securities; in much the same way the U.S. uses Treasury bonds
to raise revenue. Conventional gilt issued by the U.K. government pays
the holder a fixed cash payment biannually until maturity, at which point
the principal is returned in full. The coupon payment reflects the market
interest rate at the time of issuance and indicates the cash payment that
the holder will receive each year.
Similar to Treasury securities, the duration of gilt-edged assets can
range from a few years up to 30 years. After the 2008 recession, large
quantities of gilts were created and repurchased by the Bank of
England in its campaign to jump-start economic relief efforts.
LET US SUM UP
We have discussed about short term source of finance. Short Term
Loans are very helpful not only for businesses but also for individuals.
For business, this resolves the problem of sudden cash flow and in the

60
same line; it resolves the problem of an emergency fund for the
individual. The consequences of non-payment of the instalment of short-
term loans can be very dangerous as not only it will affect the credit
score but will increase the financial burden and hurdle in day-to-day
business operation. It is advisable to properly go through the projected
business and cash flow before opting for finance.

CHECK YOUR PROGRESS

Choose the Correct Answer:
1. Short term source of finance is for a period of less than__________.

a) 6 months b) 14 days
c) 1 year d) 2 years
2. Treasury bills are promissory notes issued by the _________.

a) State government b) Central government

c) RBI d) IDBI
3. The period of term money in money market ranges from __________.
a) 14-28 days b) 14-38 days
c) 14-60 days d) 14-90 days
4. The duration of gilt-edged assets is from few years up to ______.

a) 30 years b) 38 years
c) 28 years d) 25 years
5. _________are promissory notes issued by the central government to
raise short term funds to bridge short term mismatches between receipts
and expenditures.
a) Trade Credit b) Commercial Bills
c) Treasury Bills d) Certificates of Deposits
GLOSSARY
Factoring : Factoring is also a similar
arrangement like invoice
discounting where the accounts
receivables of a business are
sold to a third party at a price
which is lower to the realizable
value of the accounts receivable

Repo : Repo is a money market

61
 instrument, which enables
collateralized short-term
borrowing and lending through
sale/purchase operations in debt
instruments

Treasury Bills : Treasury bills are promissory

notes issued by the central
government to raise short term
funds to bridge short term
mismatches between receipts
and expenditures.

Gilt-Edged Securities : Gilt-edged securities are high-

grade investment bonds offered
by governments and large
corporations as a method of
borrowing funds.

Trade Credit : Trade credit is a way of financing

the inventories which means how
many numbers of days the
vendor will be allowed before its
payment is due.

SUGGESTED READINGS
1 Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2 James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3 Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4 Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5 Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6 [Link]
7 [Link]
term-sources-of-finance/31757
8 [Link]
ANSWERS TO CHECK YOUR PROGRESS
1) c 2) b 3) d 4) a 5) c

62
Unit 8

INTERNATIONAL SOURCE OF FINANCE

STRUCTURE

Overview
Learning Objectives
8.1 Introduction to International Financing

8.2 Various International Financing Sources

8.2.1 Export Credit Schemes
8.2.2 Commercial Bank
8.2.3 International Agencies and Development Banks
8.2.4 Euro issues
8.2.5 International Capital Market

Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to check your Progress
OVERVIEW

International Financing is also known as International Macroeconomics as

it deals with finance on a global level. There are various sources for
organizations to raise funds. To raise funds internationally is one of them.
With economies and the operations of the business organizations going
global, Indian companies have an access to funds in the global capital
market.
LEARNINGOBJECTIVES
After completing this unit, you should be able to;
• explain the importance of international finance
• discuss the various sources of international finance.
8.1 INTRODUCTION TO INTERNATIONAL FINANCING
International finance helps organizations engage in cross-border
transactions with foreign business partners, such as customers, investors,
suppliers and lenders.

63
8.2 VARIOUS INTERNATIONAL FINANCING SOURCES

The major sources available to an Indian firm for raising foreign currency
finance are;
8.2.1 Export Credit Schemes: Export credit agencies have been
established by the governments of major industrialised countries for
financing exports of capital goods and related technical services. These
agencies follow certain consensus guidelines; the interest rate
applicable for export credits to Indian companies for various maturities is
regulated. Two kinds of export credit are provided: buyer’s credit and
supplier’s credit.
i) Buyer’s Credit: Under this arrangement, credit is provided directly
to the Indian buyer for purchase of capital goods and/or technical
services from the overseas exporter.
ii)Supplier’s Credit: this is a credit provided to the overseas
exporters so that they can make available medium-term finance to
Indian importers.
8.2.2 Commercial Banks
Global commercial banks all over provide loans in foreign currency to
companies. The different types of loans and services provided by banks
vary from country to country. One example of this is Standard Chartered
emerged as a major source of foreign currency loans to the
Indian industry. It is the most used source of international financing.
Subject to certain terms and conditions, the Government of India permits
Indian firms to resort to external commercial borrowings for the import of
plant and machinery. The key steps involved in raising such borrowings
are as follows:
◼ Secure the permission of the Capital Goods
Committee/Projects Approval Board.
◼ Obtain an offer from a bank.
◼ Get the approval of the Department of Economic Affairs (DEA),
Ministry of Finance, for the offer.
◼ Arrange for the documentation of the loan.
◼ Secure the approval of the Reserve Bank of India.
◼ Deposit the loan document with the DEA.
◼ Draw the loan.
In recent years, the government has adopted a very cautious approach
to external commercial borrowings. Borrowings of maturities less than

64
three years are more or less ruled out and the government controls the
access to syndicated loan markets by a queue system within the overall
annual ceiling on total borrowing specified by the government. Certain
sectors such as power projects are given preference over others in
accessing the loan markets.
8.2.3International Agencies and Development Banks

Many development banks and international agencies have come forth over
the years for the purpose of international financing. These bodies are set
up by the Governments of developed countries of the world at national,
regional and international levels for funding various projects. The more
industrious among them include International Finance Corporation (IFC),
EXIM Bank and Asian Development Bank.

8.2.4Euro issues:following the economic liberalisation, Indian

companies started exploring the market again. Unlike the earlier period
when syndicated credits were the predominant form of raising external
finance, companies began looking at bonds and euro equities
collectively referred to as “Euro issues”.

Eurobonds and Foreign Bonds

A company can also raise funds by issuing Eurobonds and foreign
bonds to investors in other countries. Eurobonds are bonds sold
outside the country in whose currency they are denominated. They
are directly by borrowers to the investors. Eurobond market is a free
market without any regulation.
A foreign bond is different from a Eurobond. A foreign bond is issued
by a company in a domestic capital market of a foreign country. It is
denominated in the currency of the country where it is issued, and is
subjected to the laws and regulations of that country.
8.2.5 International Capital Markets
Emerging organizations including multinational companies depend upon
fairly large loans in rupees as well as in foreign currency. The financial
instruments used for this purpose are:
(a) American Depository Receipts (ADR’s)
This a tool often used for international financing. As the name suggests,
depository receipts issued by a company in the USA are known as
American Depository Receipts. ADRs can be bought and sold in American
markets like regular stocks.

65
(b) Global Depository Receipts (GDR’s)
In the Indian context, a GDR is an instrument issued abroad by an Indian
company to raise funds in some foreign currency and is listed and traded
on a foreign stock exchange. A holder of GDR can at any time convert it
into the number of shares it represents. The holders of GDRs do not carry
any voting rights but only dividends and capital appreciation. Many
renowned Indian companies such as Infosys, Reliance, Wipro, and ICICI
have raised money through issue of GDRs.
LET US SUM UP
We have discussed about the international source of finance and various
sources available. Commercial banks, international agencies and
developmental banks and international capital market are the
international sources discussed here.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. _______________ finance helps organizations engage in cross-border
transaction with foreign business partners.
a) international b) Domestic
c) short term d) Long term
2. Global ____________ banks all over provide loans in foreign currency
to Companies.
a) IFCI b) IDBI

c) Commercial d) IRBT
3. Depository receipts issued by company in the USA are known as ____.
a) Global Depository receipts
b) American Depository receipts
c) Bill of exchange
d) Treasury bills

4. _____________ is an instrument issued abroad by an Indian company

to raise funds in some foreign currency.
a) Treasury bills b) ADR
c) Bill of exchange d) GDR
5. A _________is a bank certificate issued in more than one country for
shares in a foreign company.
a) American Depository Receipt

66
 b) Bill of exchange
c) Global Depository Receipts (GDR’s)
d) International Capital Receipts

GLOSSARY
Commercial Banks : The term commercial bank refers
to a financial institution that accepts
deposits, offers checking account
services, makes various loans, and
offers basic financial products like
certificates of deposit (CDs) and
savings accounts to individuals and
small businesses.

: The term American depositary

American
receipt (ADR) refers to a negotiable
Depository Receipts
certificate issued by a U.S.
depositary bank representing a
specified number of shares usually
one share of a foreign company's
stock.
: A global depositary receipt (GDR) is
Global Depository Receipts
a bank certificate issued in more
(GDR’s)
than one country for shares in a
foreign company
: A multilateral development bank
International Agencies and
(MDB) is an international financial
Development Banks
institution chartered by two or more
countries for the purpose of
encouraging economic development
in poorer nations.
: International financial market is the
International Capital
worldwide marketplace in which
Markets
buyers and sellers trade financial
assets, such as stocks, bonds,
currencies, and derivatives.

SUGGESTED READINGS
1 Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.

67
 2 James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3 Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4 Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5 Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6 [Link]
[Link]#:~:text=International%20finance%20is%20the%20stud
y,the%20importance%20of%20international%20finance.
7 [Link]
gdr/[Link]
8 [Link]
[Link]

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) b 4) d 5) c

68
 BLOCK 3

CAPITAL BUDGETING & COST OF CAPITAL

Unit 9: Introduction to Capital budgeting- Concept-

Objectives Significance
Unit 10: Methods of Capital Budgeting-Risk analysis in
Capital budgeting

Unit 11: Cost of capital - Concept- objectives Significance

Unit 12: Computation of cast of capital

69
Unit 9

INTRODUCTION TO CAPITAL
BUDGETING, CONCEPT, OBJECTIVES
AND SIGNIFICANCE
STRUCTURE
Overview
Learning Objectives
9.1 Introduction to capital budgeting

9.2 Capital Budgeting: Definition and Meaning

9.2.1 Features of Capital Budgeting Decisions
9.3 Why Capital Budgeting is Important
9.3.1 Need for Capital Budgeting
9.3.2 Significance of Capital Budgeting
9.3.3 Importance of Capital Budgeting
9.4 Objectives, Process of Capital Budgeting
9.5 Process of Capital Budgeting
9.6 Cash Flow vs Accounting Profit
9.7 Kinds of Capital Budgeting Decisions
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your Progress
OVERVIEW
Capital Budgeting is the process of making investment decision in
capital expenditures. Capital budgeting decisions pertain to long term
assets which by definition refer to assets which are in operation, and
yield a return over a period of time. Capital budgeting decisions are of
paramount importance in financial decision making.

70
LEARNING OBJECTIVES
After completing this unit, you should be able to;
• define the concept of capital budgeting.
• discuss the need and significance of capital budgeting.
• distinguish between cash flow and accounting profit.

9.1 INTRODUCTION TO CAPITAL BUDGETING

Financial decision-makers within a company or organization use capital
budgeting to make well-informed decisions. It is used for evaluating
potential expenditures or investments that are significant in amount. It
involves the decision to invest the current funds for the addition,
disposition, modification, or replacement of fixed assets. Capital
budgeting, also known as an investment appraisal, is a financial
management tool you can ensure it is adding the expected value and
continue to measure the progress of the project. It determines the
number of years it takes for a project’s cash flow to pay back the initial
cash investment, an assessment of risk, and various other factors
Capital budgeting is an important financial management tool because
when you need to assess and rank the value of projects or investments
that require a large capital investment to determine whether they are
worth pursuing. For example, investors can use capital budgeting to
analyse investment options and decide which ones are worth investing
in.
Capital budgeting is the long -term investment decision. It is probably the
most crucial financial decision of a firm. It relates to the selection of an
assent or investment proposal. Capital budgeting is the process of
making investment decisions in long term assets. It is the process of
deciding whether or not to invest in a particular project as all the
investment possibilities may not be rewarding. Thus, the manager has to
choose a project that gives a rate of return more than the cost financing
such a project. That is why he has to value a project in terms of cost and
benefit.
Capital budgeting is the process that a business uses to determine
which proposed fixed asset purchases it should accept, and which
should be [Link] budgeting is the process of making
investment decision in long-term assets or courses of action. Capital
expenditure incurred today is expected to bring its benefits over a period
of time. These expenditures are related to the acquisition & improvement
of fixes assets. Every business entity has to continuously incur expenses
on certain resources or assets which help it not only to produce but also

71
grow. This expenditure has to be made on raw materials, labour, fuel
and power, spares and stores as well as certain essential maintenance
expenses. These expenses are the routine and recurring expenses
which help an enterprise to continuously produce at the current level of
output. However, enterprises also want to expand their productive
capacities or to set up new ventures for which also they have to incur
expenses which are not routine or regular. These expenses are
occasional and are made when an enterprise sees a new opportunity
and wants to exploit it in the foreseeable future. These expenses are on
fixed assets like land, building, machinery, equipment etc. They are
called ‘capital expenditure’.
9.2 CAPITAL BUDGETING: DEFINITION AND MEANING

The investment decisions are commonly known as capital budgeting or

capital expenditure decisions. Capital budgeting means planning for
capital expenditure in acquisition of capital assets such as new building,
new machinery or a new project as a whole. It refers to long term
planning for proposed capital outlays and their financing.
Charles [Link] has defined capital budgeting as, capital budgeting
is long term planning for making and financing proposed capital outlays.
Richard and Green law have referred to capital budgeting as acquiring
inputs with long-run return. In the words of Lynch, capital budgeting
consists in planning development of available capital for the purpose of
maximizing the long-term profitability of the concern capital expenditure
decisions and the process of this decision making is called ‘capital
budgeting
Capital budgeting means planning for capital expenditure in acquisition
of capital assets such as new building, new machinery or a new project
as a whole. It refers to long term planning for proposed capital outlays
and their financing. Capital budgeting is the planning process used to
determine which of an organization’s long-term investments are worth
pursuing. Capital budgeting, which is also called investment appraisal, is
the planning process used to determine whether an organization’s long-
term investments, major capital, or expenditures are worth pursuing
According to the definition of Charles T. Hrongreen, “Capital Budgeting
is a long-term planning for making and financing proposed capital
outlays.”

72
9.2.1 Features of Capital Budgeting Decisions
The features of capital budgeting are briefly explained below:
i) Huge Funds: Capital budgeting involves the investment of funds
currently for getting benefits in the future.
ii) High Degree of Risk: To take decisions that involve a huge
financial burden can be risky for the company.

iii) Affects Future Competitive Strengths: The future benefits are

spread over several years. Sensible investing can improve its
competitiveness, whereas a wrong investment may lead to business
failure.
iv) Difficult Decision: When the future is dependent on capital
budgeting decisions, it becomes difficult for the management to
grab the most appropriate investment opportunity.
v) Estimation of Large Profits: Each project involves a huge amount
of funds with the perspective of earning desirable profits in the long
term.
vi) Long Term Effect: The effect of the decisions taken will be visible
in the future or the long term.
vii) Affects Cost Structure: For instance, it may increase the fixed cost
such as insurance charges, interest, depreciation, rent, etc.
viii) Irreversible Decision: Capital expenditure decisions are
irreversible since it involves a high-value asset which may not be
sold at the same price once purchased.
9.3 WHY CAPITAL BUDGETING IS IMPORTANT
Capital budgeting is important because it creates accountability and
measurability. The capital budgeting process is a measurable way for
businesses to determine the long-term economic and financial
profitability of any investment project. A capital budgeting decision is
both a financial commitment and an investment.
9.3.1 Need for Capital Budgeting
The need for Capital budgeting arises due to the following reasons:
a) Capital budgeting is necessary because large sums of money are
involved for acquiring fixed assets.
b) Large sums of money involved on capital assets are permanently
blocked. Capital investment decisions once taken cannot be

73
 reversed easily without heavy loss. This necessitates capital
budgeting.
c) Funds invested in capital projects or fixed assets are recovered
over a long period. Therefore, there is risk and uncertainty in the
recovery of funds. So, it necessitates capital budgeting.
d) Capital investment decisions require an assessment of future
events, which are uncertain. This necessitates capital budgeting.
e) Excessive capital investment would increase the operating cost of
the firm. So, careful planning of the capital budgeting is quite
necessary.
9.3.2 Significance of Capital Budgeting
a) Capital budgeting decisions are of paramount importance in the
financial decision-making process of an organization.
b) Capital budgeting is an essential tool in financial management
c) Capital budgeting provides a wide scope for financial managers to
evaluate different projects in terms of their viability to be taken up
for investments
d) It helps in exposing the risk and uncertainty of different projects
e) It helps in keeping a check on over or under investments
f) The management is provided with an effective control on cost of
capital expenditure projects

g) Ultimately the fate of a business is decided on how optimally the

available resources are used
9.3.3 Importance of Capital Budgeting
1) Long term investments involve risks: Capital expenditures are long
term investments which involve more financial risks. That is why proper
planning through capital budgeting is needed.
2) Huge investments and irreversible ones: As the investments are
huge but the funds are limited, proper planning through capital
expenditure is a pre-requisite. Also, the capital investment decisions are
irreversible in nature, i.e., once a permanent asset is purchased its
disposal shall incur losses.
3)Long run in the business: Capital budgeting reduces the costs as
well as brings changes in the profitability of the company. It helps avoid
over or under investments. Proper planning and analysis of the projects
helps in the long run.

74
It provides the following benefits
i) Capital budgeting decisions affect the profitability of a firm.
ii) Capital budgeting decisions determine the destiny of the company.
A few wrong decisions affect the survival of firms.
iii) Capital budgeting decisions affect a company’s future cost
structures.

iv) Capital budgeting decisions provide a basis for long term financial
planning.
v) Capital budgeting is helpful for taking proper decisions on Capital
expenditure.
vi) Majority of the firms have scarce capital resources. Therefore,
proper Capital budgeting decisions are helpful in allocating such
scarce means in an economical way, keeping in mind the objective
of the company.
9.4 OBJECTIVES OF CAPITAL BUDGETING
To know more about the necessity of capital budgeting for the
companies, let us go through the following objectives:
i) Control of Capital Expenditure: Estimating the cost of
investment provides a base to the management for controlling
and managing the required capital expenditure accordingly.
ii) Selection of Profitable Projects: The company has to select
the most suitable project out of the multiple options available to it.
For this, it has to keep in mind the various factors such as
availability of funds, project’s profitability, the rate of return, etc.
iii) Identifying the Right Source of Funds: Locating and selecting
the most appropriate source of funds required to make a long-
term capital investment is the ultimate aim of capital budgeting.
The management needs to consider and compare the cost of
borrowing with the expected return on investment for this
purpose.

9.5 PROCESS OF CAPITAL BUDGETING

i) Project identification and generation: The company has
various options for capital employment on a long-term basis. In
the initial stage, the management needs to analyse the strengths
and weaknesses of every project for foreseeing the potential of
each option.

75
 ii) Evaluating and Assembling Investment Proposals: In the
next step, the management assembles and compiles all the
investment proposals on the grounds of cost, risk involvement,
future profits, return on investment, etc.
iii) Project Selection: Once the proposal has been finalized, the
different alternatives for raising or acquiring funds have to be
explored by the finance team. This is called preparing the capital
budget. The average cost of funds has to be reduced. A detailed
procedure for periodical reports and tracking the project for the
lifetime needs to be streamlined in the initial phase itself. The
final approvals are based on profitability, Economic constituents,
viability, and market conditions.

iv) Implementation: After the apportioning of the long-term

investment, the company comes into action for the execution of
its decision. To avoid complications and excess time
consumption, the management should lay out a detailed plan of
the project in advance.
v) Performance review: The final stage of capital budgeting
involves the comparison of actual results with the standard ones.
The management needs to measure and correlate the actual
performance with that of the estimated one to figure out the
deviation and take corrective actions for the same. Capital
budgeting is a predominant function of management. Right
decisions taken can lead the business to great heights. However,
a single wrong decision can inch the business closer to shut
down due to the number of funds involved and the tenure of
these projects.
9.6 CASH FLOW VS ACCOUNTING PROFIT
Capital budgeting is concerned with the investment decisions which yield
return over a period of time in future. The foremost requirement to
evaluate any capital investment proposal is to estimate the future
benefits accruing from the investment proposal. Theoretically, two
alternative criteria are available to qualify the benefits:
a. Accounting Profit
b. Cash Flows
The difference in these measures of future profitability is primarily due to
the presence of certain non-cash expenditures in the profit and loss
account. Depreciation provides a classic example of such expenditure.
Therefore, the accounting figure of profit is to be adjusted for all such

76
types of expenditures to determine the actual cash inflow. The cash flow
approach of measuring future benefits of a project is superior to the
accounting approach as cash flows are theoretically better measures of
the net economic benefits of costs associated with a proposed project.
In the first place, while considering an investment proposal, a firm is
interested in estimating its economic value. This economic value is
determined by the economic outflows (costs) and inflows (benefits)
related with the investment project. Only cash flows represent the cash
transactions. The firm must pay for the purchase of an asset with cash.
This cash outlay represents a foregone measure the future net benefits
in cash terms. On the other hand, under the accounting practices, the
cost of the investment is allocated over its economic useful life in the
nature of depreciation rather than at the time when costs are actually
incurred. The accounting treatment clearly does not reflect the original
need for cash at the time of inflows and outflows in later years. Only
cash flows reflect the actual cash transactions associated with the
project. Since investment analysis is concerned with finding out whether
future economic inflows are sufficiently large to warrant the initial
investment, only the cash flow method is appropriate for investment
decision analysis.
Secondly, the use of cash flows avoids accounting ambiguities. There
are various ways to value inventory, allocate costs, calculate
depreciation and amortise various other expenses. Obviously, one set
of cash flows associated with the project. Clearly, the cash flow
approach to project evaluation is better than the net income flow
approach (accounting approach).
Thirdly, the cash flow approach takes cognisance of the time value of
money whereas the accounting approach ignores it. Under the usual
accounting practice, revenue is recognised as being generated when the
product is sold, not when the cash is collected from the sale; revenue
may remain a paper figure for months or years before payment of the
invoice is received. Expenditure, too, is recognised as being made
when incurred and not when the actual payment is made. Depreciation
is deducted from the gross revenues to determine the before-tax
earnings. Such a procedure ignores the increased flow of funds
potentially available for other uses. In other words, accounting profits
which are quite useful as performance measures often are less useful as
decision criteria. Therefore, from the viewpoint of capital expenditure
management, the cash flow approach can be said to be the basis of
estimating future benefits from investment proposals.

77
A Comparison of Cash flow and Accounting Profit Approaches

Accounting approach Cash flow approach

towards benefits towards benefits
Revenues 1,000 Revenues
1,000

Less: Less: Expenses 500

Expenses 500
Cash 250 750
Expenses
Depreciation EBT 500
Earnings 250 Less: Taxes @ 125 25
before tax 50%

Less: Taxes 125

@ 50%
Net 125 Cash Flow
earnings 375
after taxes

The table shows that the accounting profits amounting to Rs.125 are
less than the cash flow Rs.375. This difference can be attributed to
the depreciation charge of Rs.250. The cash available with the firm is
Rs.375. This can be utilized for further investment. The accounting
approach indicates that only Rs.125 is available and hence gives only
a partial picture of the tangible benefits available.
Investment Evaluation Criteria
The investment decision rules may be referred to as capital budgeting
techniques, or investment criteria. A sound appraisal technique should
be used to measure the economic worth of an investment project. The
essential property of a sound technique is that it should maximise the
shareholders’ worth. The following other characteristics should also be
possessed by a sound investment evaluation criterion:
a) It should consider all cash flows to determine the true profitability of
the project.
b) It should provide for an objective and unambiguous way of
separating good projects from bad projects.
c) It should help ranking of projects according to their true profitability.
d) It should recognise the fact that bigger cash flows are preferable to
smaller ones and early has flows is preferable to later ones.
e) It should help to choose among mutually exclusive projects that
project which maximises the shareholders’ wealth.

78
f) It should be a criterion which is applicable to any conceivable
investment project independent of others.
9.7 KINDS OF CAPITAL BUDGETING DECISIONS

Capital budgeting refers to the total process of generating, evaluating,

selecting and following upon capital expenditures alternatives. The firm
allocates or budgets financial resources to new investment proposals.
Basically, the firm may be confronted with three types of capital
budgeting decisions;
i. Accept – Reject Decision
ii. Mutually Exclusive Choice Decision
iii. Capital Rationing Decision
a) Accept – Reject Decisions: This is a fundamental decision in capital
budgeting. If the project is accepted, the firm invests in it; if the proposal
is rejected, the firm does not invest in it. In general, all those proposals
which yield a rate of return greater than a certain required rate of return
or cost of capital are accepted and the rest are rejected. By applying
this criterion, all independent projects are accepted.
b) Mutually Exclusive Project Decision: Mutually exclusive projects
are projects which compete with other projects in such a way that the
acceptance of one will exclude the acceptance of the other projects.
The alternatives are mutually exclusive and only one may be chosen.

c) Capital Rationing Decision: In a situation where the firm has

unlimited funds, capital budgeting becomes a very simple process in that
all independent investment proposal yielding return greater than some
pre-determined level are accepted. A large number of investment
proposals compete for these limited funds. The firm must, therefore,
ration them. The firm allocates funds to projects in a manner that it
maximizes long run returns. Thus, capital rationing refers to the situation
in which the firm has more acceptable investment, requiring greater
amount of finance than is available with the firm. Ranking of the
investment proposals accepted under the accept-reject decisions.
Capital rationing employs ranking of the acceptable investment projects.
The projects can be ranked on the basis of a predetermined criterion
such as the rate of return. The projects are ranked in the descending
order of the rate of return.
LET US SUM UP
Capital budgeting is budgeting for capital projects. It is significant
because it deals with right kind of evaluation of projects. The exercise

79
involves ascertaining / estimating cash inflows and outflows, matching
the cash inflows. The overall objective of capital budgeting is to
maximise the profitability of a firm or the return on investment. This
objective can be achieved either by increasing the revenues or by
reducing costs.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Capital budgeting is the process___________.
a) Which help to make master budget of the organization?

b) By which the firm decides how much capital to invest in business

c) By which the firm decides which long-term investments to make.
d) Undertaken to analyse how make available various finance to the
business.
2. A project is accepted when__________.
a) Net present value is greater than zero
b) internal rate of return will be greater than cost of capital
c) profitability index will be greater than unity
d) any of the above

3. Which of the following method of capital budgeting ignores the time

value of money?
a) Discounted payback period b) net present value
c) internal rate of return d) none of the above
4. As per discounted payback period method, a project with _________
a) more discounted payback period will be selected
b) Higher NPV will be preferred
c) Low NPV will be preferred
d) Less discounted payback period will be selected.
5._________ is the discount rate that should be used in capital
budgeting.
a) Cost of capital (Ko) b) Risk-free rate (Rf)
c) Risk premium (Rm) d) Beta rate (β)

80
GLOSSARY
: Capital budgeting is long term
Capital Budgeting
planning for making and financing
proposed capital outlays.
: This is a fundamental decision in
Accept – Reject Decisions
capital budgeting. If the project is
accepted, the firm invests in it; if the
proposal is rejected, the firm does
not invest in it.
: Mutually exclusive projects are
Mutually exclusive projects
projects which compete with other
projects in such a way that the
acceptance of one will exclude the
acceptance of the other projects.
: Capital rationing employs ranking of
Capital rationing
the acceptable investment projects.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija, (2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
7. [Link]
profit#:~:text=The%20Difference%20Between%20Cash%20Flow
,and%20out%20of%20a%20business.
8. [Link]
budgeting/capital-budgeting-decision-kinds-and-planning-
period/66506
ANSWERS TO CHECK YOUR PROGRESS
1) c 2) d 3) d 4) d 5) a

81
Unit 10

METHODS OF CAPITAL BUDGETING

AND RISK ANALYSIS
STRUCTURE

Overview
Learning Objectives
10.1 Methods/ techniques of capital Budgeting

10.1.1 Traditional Methods (Non-Discounting Methods)

10.1.2 Modern Methods (Discounted cash flow methods)
10.2 Risk analysis in capital budgeting

10.2.1 Techniques of risk analysis in capital budgeting

10.3 CAPM methods- Capital rationing
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your Progress
OVERVIEW
This unit is devoted to a discussion of the principles and techniques of
capital budgeting. The principles and techniques of capital budgeting
focus on the concept, importance and method of appraisal of capital
budgeting. This unit discusses the risk and uncertainty associated with
capital budgeting. The importance of the risk dimension in capital
budgeting can hardly is overstressed. A decision tree is a pictorial
representation in tree form which indicates the magnitude, profitability
and inter-relationship of all possible outcomes. One measure which
expresses risk in more precise term is sensitivity analysis. This unit will
focus on the analysis of risk and uncertainty. It has been structured to
cover all issues related to the decision-tree, sensitivity analysis,
simulation, capital rationing and CAPM.

82
LEARNING OBJECTIVES
After completing this unit, you should be able to;
• discuss various methods of capital budgeting
• describe the risk analysis in capital budgeting
• describe CAPM.
10.1 METHODS OF CAPITAL BUDGETING

The capital budgeting appraisal methods or techniques for evaluation of

investment proposals will help the company to decide the desirability of
an investment proposal, depending upon their relative income
generating capacity and rank them in order of their desirability. These
methods provide the company a set of norms on the basis of which
either it has to accept or reject the investment proposal. Therefore, a
sound appraisal method should enable the company to measure the real
worth of the investment proposal. The various commonly used Capital
Budgeting Methods are:

Methods of Capital
Budgeting

Traditional Methods Modern Methods

or or
Non Discounted Cash Discounted Cash
Flow Flow

Average Internal Probability

Pay-back Net Present
Rate of Rate of Index
period Value(NPV)
Return(ARR) Return (IRR) Method (PI)

Figure 10.1 Capital Budgeting Methods

10.1.1 Traditional Methods (Non-Discounting Methods)
These methods are based on the principles to determine the desirability
of an investment project on the basis of its useful life and expected
returns. These methods depend upon the accounting information
available from the books of accounts of the company. These will not take
into account the concept of “time value of money” which is a significant
factor to determine the desirability of a project in terms of present value.
On-DCF methods do not account for the time value of money; they
assume the value of the dollar will remain constant over the economic
life of a capital investment. The payback period, or PBP, is the only non-

83
DCF method that uses cash flow estimations. PBP is the duration it
takes to recover the initial capital of an investment. Investments with
short PBP are preferred over investments with longer PBP. However,
this method has major shortcomings, because it does not show the
timing of cash flows and the time value of money.
This technique has two methods. They include:

a) Payback period
The payback period method is the simplest way to budget for a new
project. It measures the amount of time it will take to earn enough cash
inflows from your project to recover what you invested. When using this
method, a shorter payback period makes a project more appealing
because it means you will recover your investment cost in a shorter
amount of time. The payback period method is popular for those people
who have a limited amount of funds to invest in a project and need to
recover their initial investment cost before they can start another project.
For example, you are using the payback period method to help your
company choose between a project that has an initial investment cost of
Rs. 50,000 with a payback period of 10 years and one that has an initial
investment cost of Rs. 70,000 with a payback period of eight years.
Using the payback period method, you would likely recommend the
project with a payback period of eight years.

b) Average rate of return (ARR)

The accounting rate of return (ARR) method is also known as the return
on investment (ROI) method. It uses accounting information obtained
from financial statements to measure the profitability of a possible
investment. Some companies prefer the ARR method since it considers
the project’s earnings over its entire economic life.
10.1.2 Modern Methods(Discounted cash flow methods)
Discounted methods are also known as “time-adjusted techniques.”
They consider the time value of money while evaluating the costs and
benefits of a project. The cash flows associated with the project are
discounted at the cost of capital. These methods also take into account
all benefits and costs occurring during the project’s life cycle.
Discounted cash flow, or DCF, methods account for the time value of
money when determining the viability of projects. This time value is the
change in the purchasing power of the dollar over time. The DCF
methods also indicate the opportunity cost -- that is, the consequences
of forgoing alternative investments to make the chosen investment. The

84
main types of DCF methods are net present value, internal rate of
returns and the profitability index.
a) Net present value (NPV)

Net present value, or NPV, is the difference between an investment’s

present value of cash inflows and its present value of cash outflows. The
cash flow estimates are determined using a market-based discount rate,
also known as a hurdle rate, which accounts for the time value of
money. NPV expresses the wealth generation impact of an investment in
dollar terms. The rule of thumb is to accept capital investments with
positive cash flows and reject the ones with negative cash flows. This is
because a positive NPV confirms that the investment’s cash flow will
sufficiently compensate its costs, the cost of financing and the
underlying cash flow risks.
The net present value capital budgeting method measures how
profitable you can expect a project to be. When using this method, any
project with a positive net present value is acceptable, while any project
with a negative net present value is not acceptable. The NPV method is
one of the most popular capital budgeting methods because it helps you
to choose the most profitable projects or investments.
You can use the net present value method to select only one project or
investment or several projects to invest in at the same time. For
example, a company is considering three different projects but only has
enough capital to invest in one. They may use the net present value
method to choose the one project that is likely to be the most profitable.
Likewise, an investor who is considering eight investment portfolio
options but only has enough capital to fund three of the options may use
the net present value method to choose the three portfolio options they
expect to be the most profitable.
b) Internal rate of return (IRR)
Internal rate of return, or IRR, is the rate at which an investment is
expected to generate earnings during its useful life. IRR is actually the
discount rate that pushes the NPV to zero. This is more or less the
discount rate at which the present value of cash outflows equals the
present value of cash inflows. Accept a capital investment if the IRR is
greater than the cost of capital, and reject it if the IRR is lower than the
cost of capital.
The internal rate of return method measures the return percentage you
can expect to receive from a specific project. When using this method,

85
the more the rate of return percentage exceeds the project's initial
capital investment percentage, the more appealing the project becomes.
It is common for a company to use the IRR method to choose between
conflicting project options.
For example, a company can use this method to compare the internal
rate of return of expanding operations in an existing facility to the internal
rate of return of expanding operations by building and opening a new
one. The two project options are conflicting because the company needs
only one site to expand operations. In this scenario, the company would
choose the project that has a greater IRR percentage that exceeds the
cost of investment percentage.
c) Profitability index (PI)

The profitability index, or PI, is the ratio of an investment’s NPV. It shows

the ratio of the present value of cash inflows to the present value of cash
outflows. This method facilitates the ranking of investments, especially
when dealing with mutually exclusive investments or rationed capital
resources. Accept a capital investment when the PI is greater than 1,
and reject it when the PI is less than 1.
Profitability index (PI) is one of the essential capital budgeting
techniques. This technique is also known as “profit investment ratio
(PIR),” “benefit-cost ratio (BCR)” and “value investment ratio (VIR).” The
index signifies a relationship between the investment of the project and
the payoff of the project. It is mainly used for ranking projects.
According to the rank of the project, a suitable project is chosen for
investment. For example, a company must choose between two
projects. One has a PI greater than one while the other has a PI less
than one. Using an accept-reject rule, or basically either one or the
other, the company chooses the project with the greater PI.
Investment Evaluation Criteria
The investment decision rules may be referred to as capital budgeting
techniques, or investment criteria. A sound appraisal technique should
be used to measure the economic worth of an investment project. The
essential property of a sound technique is that it should maximise the
shareholders’ worth. The following other characteristics should also be
possessed by a sound investment evaluation criterion:
a) It should consider all cash flows to determine the true profitability of
the project.

86
b) It should provide for an objective and unambiguous way of
separating good projects from bad projects.
c) It should help ranking of projects according to their true profitability.
d) It should recognise the fact that bigger cash flows are preferable to
smaller ones and early has flows is preferable to later ones.
e) It should help to choose among mutually exclusive projects that
project which maximises the shareholders’ wealth.
f) It should be a criterion which is applicable to any conceivable
investment project independent of others.

Methods of Appraisal
The methods of appraising capital expenditure proposals can be
classified into two broad categories.

a) Traditional Method or Non-discounted Cash Flow Technique.

b) Time Adjusted or Discounted cash flow Technique.
Problems
Non-Discounted Cash Flow Technique
a) Pay Back Period Method
The payback sometimes called as payment or pay off period method
represents the period in which the total investment in permanent assets
payback itself. This method is based on the principle that every capital
expenditure pays itself back within a certain period out of the additional
earnings generated from the capital assets.
Under this method, various investments are ranked according to the
length of their payback periods in such a manner that the investment
with a shorter pay-back period is preferred to the one which has longer
payback period.
The payback period can be ascertained in the following manner:
a) Calculate annual net earnings (profits) before depreciation and
after taxes; these are called annual cash inflows.
b) Divide the initial outlay (cost) of the project by the annual cash
inflow, where the project generates constant cash inflows
c) Thus, where the project generates constant annual cash inflows
where the annual cash inflows (profit before depreciation and
after taxes) are unequal, the payback period can be found by
adding up the cash inflows until the total is equal to the initial
cash outlay of the project or original cost of the asset.

87
Example 1
A Project cost Rs.1, 00,000 and yields an annual cash inflow of
Rs.20,000 for 8 years. Calculate payback period.

Solution
𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Payback Period =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰𝐬
1,00,000
= = 5 years.
20,000

Example 2

Calculate payback period from the following information

Year Cash flow

(Rs.)

0 - 1,00,000

1 12,000

2 15,000

3 20,000

4 18,000

5 30,000

6 10,000

Solution

Year Cash flow Cumulative Cash flow

(Rs. P.) (Rs.P.)
1 12,000 12,000
2 15,000 27,000
3 20,000 47,000
4 18,000 65,000
5 30,000 95,000
6 10,000 1,05,000

At the end of 5th year, we get Rs.95, 000 and 6th year Rs.1,05,000. Our
investment is Rs.1, 00,000. Therefore, payback period lies between 5th
and 6th year.
5000
Payback Period =5years+⌈ × 12⌉ = 5 years 6 months.
10,000

88
Example 3
A Project costs Rs.5,00,000 and yields annually a profit of Rs.80,000
after depreciation @12% p.a. but before tax of 50%. Calculate the
payback period.
Solution

Rs.

Profit before tax 80,000

Less: tax @ 50%(80,000x0.5) 40,000

Profit after tax 40,000

Add:Depreciation @ 12% on Rs.5,00,000 60,000

Profit before depreciation but after tax 1,00,000

5,00,000
Payback Period = = 5 years
1,00,000
Example 4

There are two projects X and Y. Each project requires an investment of

Rs.20,000. You are required to rank these projects according to the
payback period method from the following information.
(Net profit before depreciation and after tax)
Year Project X Project Y
1 1,000 2,000
2 2,000 4,000
3 4,000 6,000
4 5,000 8,000
5 8,000 --------
Solution

Project X Cumulative Project Y Cumulative

Year Cashflow
Cash flow Cash flow Cashflow
(Rs.)
(Rs.) (Rs.) (Rs.)

1 1000 1000 2000 2000

2 2000 3000 4000 6000

3 3000 7000 6000 12000

89
4 4000 12000 8000 20000

5 50000 20000

Payback period for Project X = 5 years

Payback period for Project Y = 4 years

Hence, Project Y should be preferred or ranked first.
Accept- Reject Criterion

a) If the actual payback period is less than the pre-determined

payback, the project would be accepted; if not, it would be
rejected.
b) The project having the shortest payback may be assigned rank
one, followed in that order so that the project with the longest
payback would be ranked last.

Advantages of Payback Method

a) The main advantages of this method is that it is simple to
understand and easy to calculate.
b) It saves cost, it requires lesser time and labour as compared to
other methods of capital budgeting
c) In this method, as a project with a shorter – payback period is
preferred to the one having a larger payback period, it reduces
the loss.
d) Due to its short-term approach, this method is particularly suited
to a firm which has shortage of cash or whose liquidity position is
not particularly good.
Disadvantages of Payback Method
a) It does not take into account the cash inflow earned after the
payback period and hence the true profitability of the projects
cannot be correctly assessed.
b) This method ignores the time value of money
c) It does not take into consideration the cost of capital which is very
important factor in making sound investment decisions.
d) Payback period method does not measure the true profitability of
the project.
b) Average Rate of Return (ARR)
The average rate of return method of evaluating proposed capital
expenditure is also known as the accounting rate of return method. It is
based upon accounting information rather than cash flow.

90
 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐚𝐧𝐧𝐮𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱𝐞𝐬
ARR =𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐨𝐯𝐞𝐫 𝐭𝐡𝐞 𝐥𝐢𝐟𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐩𝐫𝐨𝐣𝐞𝐜𝐭 × 𝟏𝟎𝟎

The average profits after taxes are determined by adding up the after-tax
profits expected for each year of the projects’ life and dividing the result
by the number of years. The average investment is determined by
dividing the net investment by two.

Average Investment = Networking capital + Salvage value +1/2 (Initial

Cost of machine – Salvage value)

For instance, given information

Initial investment Rs.11, 000

(Purchase of machine)

Salvage value 1,000

Working capital 2,000

Service life 5 years

And that the straight-line method of depreciation is adopted the average

investment is
= Rs.2, 000 + 1,000 + 1/2(11,000 – 1,000) = Rs.8, 000
Example 5
Determine the average rate of return from the following data of two
Machine X and Y.
Machine X Machine Y
Cost Rs.56,125 Rs.56,125
Annual estimated income after
Depreciation and tax:

I year 3,375.00 11,375.00

II year 5,375.00 9,375.00
III year 7,375.00 7, 375.00
IV year 9,375.00 5, 375.00
V year 11,375.00 3,375.00
36,875.00 36,875.00

Estimated life in years5 5

Estimated salvage value 3,000 3,000

91
Average income tax rate 55% 55%
Depreciation has been charged on straight line basis.
Solution
Average income
ARR= × 100
Average investment

𝑅𝑠.36,875
Average income of machine X =
5
= Rs.7, 375
Average investment = Salvage value +1/2 (Cost of machine –Salvage
value)
= 3000 + 1/2(56125-3000)
= Rs.29, 562.50
𝑅𝑠.7375
ARR for Machine X and Y = × 100
𝑅𝑠.29562.50
= 24.9%
Example 6
A project required an investment of Rs.5,00,000 and has a scrap value
of Rs.20,000 after five years. It is expected to yield profits after
depreciation and taxes during the five years amounting to Rs.40,000,
60,000, 70,000, 50,000 and Rs.20,000. Calculate ARR on the
investment.
Solution
40,000+60,000+70,000+50,000+20,000
Average Profits =
5
2,40,000
=
5
= Rs.48, 000

Average Investment = 1/2 (Cost – Salvage value)

= 1/2 (5,00,000-20,000)
= 1/2 (4,80,000)
= Rs.2,40,000
48,000
ARR = × 100
2,40,000

= 20%

92
Accept- Reject criterion
According to the ARR as an accept–reject criterion, the actual ARR
would compare with a predetermined or a minimum required rate of
return or cut-off rate. A project would qualify to be accepted if the actual
ARR is higher than the minimum desired ARR. Otherwise; it is liable to
be rejected. Alternatively, the ranking method can be used to select or
reject proposals. Project having higher ARR would be preferred to
projects which have lower ARR.
Advantages of ARR Method

a) It is very simple to understand and easy to operate.

b) It uses the entire earnings of a project in calculating rate of return and
not only the earnings up to the payback period and hence gives a better
view of profitability as compared to pay back period method.
c) As this method is based upon accounting concept of profit, it can be
readily calculated from the financial data.
Disadvantages of ARR Method
a) This method also like payback period method ignores the time value
of money.
b) It does not take into consideration the cash flows which are more
important than accounting profits.
c) This method cannot be applied to a situation where investment in a
project is to be made in parts.
C)Time-Adjusted or Discounted Cash Flow Technique
The distinguishing characteristics of the discounted cash flow capital
budgeting techniques is that they take into consideration the time value
of money while evaluating the costs and benefits of a project. All these
methods require cash flow to be discounted at a certain rate popularly
called the cost of capital. Here, it would be sufficient to define cost of
capital (k) as the minimum discount rate that must be earned on a
project that leaves the firm’s market value unchanged.
The second commendable feature of these techniques is that they take
into consideration all benefits and costs occurring during the entire life of
the project. The Present value or the discounted cash flow procedure
recognizes that cash flow streams at different time periods differ in value
and can be compared only when they are expressed in terms of
common denominator. In this method all cash flows are expressed in
terms of their present value.

93
 How to calculate PV Factor
𝟏
PV factor =
(𝟏+𝟒)𝒏

d) Net Present Value Method (NPV)

The first discounted cash flow or present value technique is the NPV.
NPV may be defined as the summation of the present values of the cash
proceeds (CFAT) in each year minus the summation of the present
value of the net cash out flows in each year.
The formula for the net present value can be written as follows:
𝐶1 𝐶2 𝐶3 𝐶𝑛
NPV=( + + + ) − 𝐶𝑜
(1+𝐾) (1+𝐾)2 (1+𝐾)3 (1+𝐾)𝑛
𝐶𝑡
= ∈𝑤
𝑡=1 −Co
(1+𝑘)𝑡

Where C1, C2… represents net cash inflows in year 1,2……, k is the
opportunity cost of capital, Co is the initial cost of the investment and n is
the expected life of the investment. It should be noted that the cost of
capital, k is assumed to be known and is constant.
Accept–Reject Criterion
The decision rule for a project under NPV is to accept the project of the
NPV is positive and reject if it is negative. Symbolically,
i) NPV >0, Accept the Project
ii) NPV <0, Reject the Project
Zero NPT implies that the firm is indifferent to accepting or rejecting the
project. However, in practice it is rare if ever such a project will be
accepted, as such a situation simply implies that only the original
investment has been recovered.
As a decision criterion, this method can also be used to make a choice
between mutually exclusive projects. On the basis of the NPV method,
the various proposals would be ranked in order of the net present
values. The project with the highest NPV would be assigned the first
rank, followed by others in the descending order. If, in our example, a
choice is to be made between machine A and machine B on the basis of
the NPV method, machine B having larger NPV would be preferred to
machine A.
Example 7
Initial Investment Rs. 50,000
Estimated life 5 years

94
 Discount rate 10%
The profits before depreciation and after taxes (CFAT) are as follows:

Year CFAT(Rs) PV@10%

1 14,000 0.909

2 16,000 0.826

3 18,000 0.751

4 20,000 0.683

5 25,000 0.621

Calculate NPV.

Solution
Calculation of Net Present Value

Year CFAT PV of Re. 1 @ 10% Present

Value

1 14000 0.909 12726

2 16000 0.826 13216

3 18000 0.751 13518

4 20000 0.683 13660

5 25000 0.621 15525

Total Present Value 68645

Net Present Value = Total Present Value - Present Value of initial

Investment

= Rs 68,645 – 50,000
= Rs 18,645.
Example 8

From the following information calculate the NPV of the two projects
and suggest which of the two projects should be accepted assuming a
discount rate of 10%.

95
 Project X Project Y

Initial Investment Rs. 20,000 Rs. 30,000

Estimated Life 5 years 5 years

Scrap Value Rs. 1000 Rs. 2000

The Profits before depreciation and after taxes (cash flows) are as
follows.

Year Project X (Rs. P.) Project Y (Rs. P.)

1 5,000.00 20,000.00

2 10,000.00 10,000.00

3 10,000.00 5,000.00

4 3,000.00 3,000.00

5 2,000.00 2,000.00

Solution
Calculation of NPV for Project X

Year CFAT PV Factor @ 10% Present Value

1 5000.00 0.909 4545.00

2 10000.00 0.826 8260.00

3 10000.00 0.751 7510.00

4 3000.00 0.683 2049.00

5 2000.00 0.621 1242.00

5(scrap) 2000.00 0.621 621.00

Total Present Value 24227.00

NPV = Total PV- PV of Investment

= Rs. 24227- 20,000
= Rs. 4227

96
 Calculation of NPV for Project Y

Year CFAT PV Factor @ Present Value

10%
1 20000.00 0.909 18180.00
2 10000.00 0.826 8260.00
3 5000.00 0.751 3755.00
4 3000.00 0.683 2041.00
5 2000.00 0.621 1242.00
6 2000.00 0.621 1242.00
Total Present Value 34728.00

NPV = Total Present Value –Present value of Investment

= Rs. 34728-30000
= Rs. 4,728.

We find that NPV of Project Y is higher than the NPV of Project X and
hence it is suggested that Project Y should be selected.
Advantages of NPV

a) It recognizes the time value of money and is suitable to be applied

in a situation with uniform cash outflows and uneven cash inflows
or cash flows at different periods of time.
b) It takes into account the earnings over the entire life of the project
and the time profitability of the investment proposal can be
evaluated.
c) It takes into consideration the objective of maximum profitability.
Disadvantages of NPV
a) As compared to the traditional methods, the net present value
method is more difficult to understand and operate.
b) It may not give good results while comparing projects with unequal
lives as the project having higher net present value but realized in
longer life span may not be as desirable as project having
something lesser net present value achieved in a much shorter
span of life of the asset.
c) In the same way as above, it may not give good results while
comparing projects with unequal investment of funds.
d) It is not easy to determine as appropriate discount rate.

e) Internal Rate of Return Method (IRR)

The second discounted cash flow (DCF) or time-adjusted method
for appraising capital investment decisions is the internal rate of return

97
(IRR) method. This technique is also known as yield on investment,
marginal efficiency of capital, marginal productivity of capital, rate of
return, and time-adjusted rate of return and so on. Like the present
value method, the IRR method also considers the time value of money
by discounting the cash streams. The basis of the discount factor,
however, is different in both cases. In the case of the net present value
method, the discount rate is the required rate of return and being a
predetermined rate, usually the cost of capital; its determinants are
external to the proposal under consideration. The IRR, on the other
hand, is based on facts which are internal to the proposal. In other
words, while arriving at the required rate of return for finding out present
values the cash flows-inflows as well as outflows-are not considered.
But the IRR depends entirely on the initial outlay and the cash proceeds
of the project which is being evaluated for acceptance or rejection. It is,
therefore, appropriately referred to as internal rate of return.

The internal rate of return is usually the rate of return that a project
earns. It is defined as the discount rate (r) which equates the aggregate
present value of the net cash inflows (CFAT) with the aggregate present
value of cash outflows of a project. In other words, it is that rate which
gives the project NPV of zero.
This technique is also known as yield an investment, marginal efficiency
of capital, marginal productivity of capital, rate of return, time-adjusted
rate of return.
It can be determined with the help of the following Mathematical formula;

Were,
C = Initial outlay at time zero
A1,A2,……An= Further net cash flows at different periods.

2, 3,……….n = no of years
r = rate of discount of internal rate of return.

Example 9
Calculate the IRR; consider the cash flows of a project.

Year 0 1 2 3 4

Cash flow -1,00,000 30,000 30,000 40,000 45,000

Solution

98
The internal rate of return is the value of r which satisfies the following
equation.
30,000 30,000 40,000 45,000
10,00,000 = + 2
+ 3
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)4
The calculation of r involves a process of trial and error. We try different
values of r till we find that the right-hand size of the above equation is
equal to 1, 00,000.
Let us, to begin with, try r=15 percent. This makes the right-hand side
equal to:
30,000 30,000 40,000 45,000
= + + +
(1.15) (1.15)2 (1.15)3 (1.15)4

=Rs.1, 00,802
This value is slightly higher than our target value, 1,00,000. So, we
increase the value of r from 15 percent to 16 percent. (In general, a
higher r lowers and lower r increases the right- hand side value) the
right-hand side becomes:
30,000 30,000 40,000 45,000
= + + +
(1.16) (1.16)2 (1.16)3 (1.16)4
= Rs.98, 641
Since this value is now less than 1, 00,000. We conclude that the value
of r lies between 15 percent and 16 percent.
Accept –Reject Decision
The use of the IRR, as a criterion to accept capital investment decisions,
involves a comparison of the actual IRR with the required rate of return
also known as the cut-off rate or hurdle rate.
The Project would qualify to be accepted if the IRR(r) exceeds the cut-off
rate (k). If the IRR and the required rate of return are equal, the firm is
indifferent as to whether to accept or reject the project.
Advantages of IRR method

a) It takes into account the time value of money and can be usefully
applied in situations with even as well as uneven cash flow at
different periods of time.
b) It considers the profitability of the project for its entire economic
life and hence enables evaluation of time profitability.
c) The determination of cost of capital is not a pre-requisite for the
use of this method and hence it is better than net –present value
method where the cost of capital cannot be determined easily.

99
 d) It provides for uniform ranking of various proposals due to the
percentage rate of return.
e) This method is also compatible with the objective of maximum
profitability and is considered to be a more reliable technique of
capital budgeting.
Disadvantages

a) It is difficult to understand and is the most difficult method of

evaluation of investment proposals.
b) This method of based upon the assumption that the earnings are
reinvested at the internal rate of return for the remaining life of
the project , which is not a justified assumption particularly when
the average rate of return earned by the firm is not close to the
internal rate of return.
c) The results of NPV method and IRR method may differ when the
projects under evaluation differ in their size, life and timings of
cash flows.
NPV versus IRR
The net present value and the internal rate of return methods are two
closely related investment criteria. Both are time-adjusted methods of
measuring investment worth. In case of independent projects, two
methods lead to same decisions. However, under certain situations (to
be discussed later in this section), a conflict arises between them. It is
under these cases that a choice between the two criteria has to be
made.
Equivalence: Case of Conventional Independent Projects
It is important to distinguish between conventional and non-conventional
investments in discussing the comparison between NPV and IRR
methods. A conventional investment can be defined as one whose cash
flows take the pattern of an initial cash outlay followed by cash inflows.
Conventional projects, have only one change in sign of cash flows; for
example, - + + +. A non-conventional investment, on the other hand, is
one whose cash outflows are not restricted to the initial period, but are
interspersed with cash inflows throughout the life of the project. Non-
conventional projects have more than one changes in signs of cash
flows; for example, - + + + - +.
In case of conventional investments which are economically
independent of each other, NPV and IRR methods result in same
accept-or-reject decision if the firm is not constrained for funds in
accepting all profitable projects. Same projects would be indicated

100
profitable by both methods. The logic is simple to understand. As has
been explained earlier, all projects with positive net present values
would be accepted if the NPV method is used, or projects with internal
rates of return higher than the required rate of return would be accepted
if the IRR method is followed. The last or marginal investment project
acceptable under the NPV method is the one which has zero net present
value; while using the IRR method, this project will have an internal rate
of return equal to the required rate of return. It can be easily shown that
projects with positive net present values would also have internal rates
of return higher than the required rate of return and the marginal project
will have zero present value only when its internal rate of return is
equalto the required rate of return.

We know that NPV is:

𝐶𝑡
NPV =∈nt=1 − 𝐶0 --------------------------(1)
(1+𝑘)𝑡

and IRR is defined to be that rate r which satisfies the following

equation:
𝐶𝑡
NPV =∈nt=1 − 𝐶 0 =0-----------------------------(4)
(1+𝑘)𝑡

Subtracting Equation (4) from Equation (1), we get

n 𝐶𝑡 𝐶𝑡
NPV=∈t=1 [ 𝑡 − ]
(1+𝑘) (1+𝑘)𝑡
As we know that Ct, k, r and t are positive, NPV can be positive (NPV>0)
only if r>k. NPV would be zero if and only if r = k and it would be
negative
(NPV < 0) if r < k. Thus, we find that NPV and IRR methods are
equivalent as regards the acceptance or rejection of independent
conventional investments.
NPV
a2

a1 IRR

0 r1 r2 r3
a3
Discount Rate

Figure10.2 Equivalency of NPV and IRR

101
This argument is also substantiated by the above figure where oa2
represents the highest net present value for the project at zero discount
rate; at this point NPV is simply the difference between cash inflows and
cash outflows. At r2, discount rate, the net present value is zero and
therefore, by definition, r2 is the internal rate of return of the project. For
discount rate (say r3) greater than IRR, the net present value would be
negative. Conversely, for discount rate (say r1) lower than IRR, the net
present value of the project will be positive. Thus, if the required rate of
return is r1, the project will be accepted under both methods since the
net present value, oa1, is greater than zero and internal rate, r2,
exceeds the required rate, r1. Project could also be accepted if the
required rate is r2 as net present value is zero and the required rate and
internal rare are equal. But the project would be rejected under either
method if the required rate is r3 as the net present value is negative and
the internal rate of return is lower than the required rate of return (i.e. r2<
r3).We have shown that the NPV and IRR methods yield the same
accept-or-reject rule in case of independent conventional investments.
However, in real business situations there are alternative ways of
achieving an objective and, thus, accepting one alternative will mean
excluding the other. AS defined earlier, investment projects are said to
be mutually exclusive when only one investment could be accepted and
others would have to be excluded. For example, in order to distribute its
products a company may decide either to establish its own sales
organisation or engage outside distributors. The more profitable out of
the two alternatives shall be selected. This type of exclusiveness may
be referred to as technical exclusiveness. On the other hand, two
independent projects may also be mutually exclusive if a financial
constraint is imposed. If limited funds are available to accept either
Project A or Project B, this would be an example of financial
exclusiveness or capital rationing. The NPV and IRR methods can give
conflicting raking to mutually exclusive projects. In the case of
independent projects raking is not important since all profitable projects
will be accepted. Ranking of projects, however, becomes crucial in the
case of mutually exclusive projects. Since the NPV and IRR rules can
give conflicting ranking to projects, one cannot remain indifferent as to
the choice of the rule.
The NPV and IRR rules will give conflicting ranking to the projects under
the following conditions.
a) The cash flow pattern of the projects may differ. That is, the cash
flows of one project may increase over time, while those of others
may decrease or vice-versa

102
 b) The cash outlays (initial investments) of the projects may differ
c) The projects may have different expected lives.
f) Profitability Index Method (PI)

Profitability index (PI) or Benefit-Cost Ratio (B/C Ratio) yet another

time-adjusted capital budgeting technique is profitability index (PI) or
benefit-cost ration (B/C). It is similar to the NPV approach. The
profitability index approach measures the present value of returns per
rupee invested, while the NPV is based on the difference between the
present value of future cash inflows and the present value of cash
outlays. A major shortcoming of the NPV method is that, being an
absolute measure, it is not a reliable method to evaluate projects
requiring different initial investments. The PI method provides a solution
to this kind of problem. It is, in other words, a relative measure. It may
be defined as the ratio which is obtained dividing the present value of
future cash inflows by the present value of cash outlays. Symbolically,
Present value cash inflows
PI =
Present value of cash outflows
This method is also known as the B/C ratio because the numerator
measures benefits and the denominator costs. A more appropriate
description would be present value index.
Accept-Reject criterion
Using the B/C ratio or the PI, a project will qualify for acceptance if its
PI exceeds one. When PI equals 1; the firm is indifferent to the project.
When PI is greater than, equal to or less than 1, the net present value is
greater than, equal to or less than zero respectively. In other words, the
NPV will be positive when the PI is greater than 1; will be negative when
the PI is less than one. Thus, the NPV and PI approaches give the
same results regarding the investment proposals.

The selection of projects with the PI method can also be done on the
basis of ranking. The highest rank will be given to the project with the
highest PI, followed by others in the same order.

Though it is common to define PI as the ratio of the PV of the cash

inflows divided by the PV of cash outflows, the PI may also be measured
on the basis of the net benefits of a project against its current cash
outlay rather than measure its gross benefits against its total cost over
the life of the project. This aspect becomes very important in situations
of capital rationing. In such a situation, the decision rule would be to
accept the project if the PI is positive and reject if it is negative.

103
Advantages and Disadvantages
This method is a slight modification of the NPV method. The NPV has
one major drawback that it is not easy to rank projects on the basis of
this method. Particularly when the costs of the projects differ
significantly.
To evaluate such projects, the PI method is most suitable. The other
advantages and disadvantages of this method are the same as those of
NPV method.

Example 10
Three mutually exclusive projects A, Band C have been proposed.
The projects are expected to each require Rs. 2, 00,000 have an
estimated life of 5 years, 4 years and 3 years respectively and hence no
salvage value. The company’s required rate of return is 10%. The
anticipate cash flows after taxes (CFAT) for the three projects are as
follows

CFAT(Rs)
EAR Projects

A B C
1 50,000 80,000 1,00,000
2 50,000 80,000 1,00,000
3 50,000 80,000 10,000
4 50,000 30,000 ---------
5 1,90,000 -------- --------
Rank each project applying the methods of payback, ARR, NPV, IRRand
PI.
Solution
Calculation of Payback Period

Project A
Year CFAT Cumulative CFAT
1 50,000 50,000
2 50,000 1,00,000
3 50,000 1,50,000
4 50,000 2,00,000

104
 5 1,90,000 3,90,000

Payback Period = 4 years

Project B
Year CFAT Cumulative CFAT
1 80,000 80,000
2 80,000 1,60,000
3 80,000 2,40,000
4 30,000 2,70,000

40,000
Payback Period = 2 years + [ × 12]
80,000

= 2 years 6 months
Project C

Year CFAT Cumulative CFAT

1 1,00,000 1,00,000
2 1,00,000 2,00,000

3 10,000 2,10,000

Payback Period = 2 years

Rank Accordingto Payback Period

Project C should be preferred first

Project B should be preferred second
Project A should be preferred third

Calculation of ARR
Average income
ARR = × 100
Average investment

ARR for Project A

50,000+50,000+50,000+50,000+1,00,000
Average Income =
5
3,90,000
=
5
= 78,000
2,00,000
Average Investment = = 1,00,000
2
78,000
= × 100
1,00,000

105
 =78%
Project B
80,000+80,000+80,000+30,000
Average Income =
4
2,70,000
= = 67,500
4
2,00,000
Average Investment = =1,00,000
2
67,500
=1,00,000 × 100 = 67.5%

Project C
1,00,000+1,00,000+10,000
Average Income =
3
2,00,000
Average Investment = =1,00,000
2
70,000
ARR = 1,00,000
× 100=70%

Rank

Project A should be preferred first

Project C should be preferred second
Project B should be preferred third

Calculation of NPV
Project A

Year CFAT PV Factor @ Present Value

10%
1 50,000 0.909 45,450
2 50,000 0.826 41,300
3 50,000 0.751 37,550
4 50,000 0.683 34,150
5 1,90,000 0.621 1,17,990
Total Present Value 2,76,440

NPV = 2, 75,440 – 2, 00,000= 76,440

Project B
Year CFAT PV Factor @ Present Value
10%
1 80,000 0.909 72,720
2 80,000 0.826 66,080
3 80,000 0.751 60,080

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 4 30,000 0.683 20,490
Total Present Value 2,19,370

NPV = 2, 19,370 – 2, 00,000= 19,370

Project C
Year CFAT PV Factor @ 10% Present Value
1 1,00,000 0.909 90,900
2 1,00,000 0.826 82,600
3 10,000 0.751 7,510
Total Present Value 1,81,010.00

NPV = 1, 18,010 – 2, 00,000

= -18,990

Rank
Project A should be preferred first
Project B should be preferred second
Project C should be preferred third
Calculation of IRR
Project A

PV @ PV@ PV @
Year CFAT PV PV PV
10% 20% 22%

1 50,000 0.909 45450 0.833 41350 0.820 41000

2 50,000 0.826 41300 0.694 34700 0.672 33600

3 50,000 0.751 37550 0.579 28950 0.551 27550
4 50,000 0.683 34150 0.482 24100 0.4751 22550
5 1,90,000 0.621 117990 0.402 76380 0.370 70300

2766440 205780 195000

76440
IRR = 10% + (22%-10%)
276440−195000
76440
= × 12%= 10%+11.26=21.26%
81440
Project B
PV @
Year CFAT PV PV@ 15% PV
10%
1 80,000 0.909 72720 0.870 69600

2 80,000 0.826 66080 0.756 60480

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3 80,000 0.751 60080 0.658 52640
4 30,000 0.683 20490 0.572 17160

219370 199880

19370
IRR = 10% + (15%-10%)
219370−199880
19370
= 10% + × 5%= 10% +4.969 = 14.97%
19490

Project C

PV@ PV@
Year CFAT PV @ 10% PV PV PV
5% 2%

1 1,00,000 0.909 90900 0.952 95200 0.980 98000

2 1,00,000 0.826 82600 0.907 90700 0.961 96100

3 10,000 0.751 75100 0.864 8640 0.942 9420

181010 194540 203520

−18990
IRR = 10% + (20%-12%)
181010−203520
−18990
= 10% + (8%)
−22510
= 10% -60749%=3.251%

Rank
Project A should be preferred first
Project B should be preferred second

Project C should be preferred rejected

Calculation of profitability Index
Project A
PV of CFAT
Profitability Index =
PV of Investment
276440
= =1.38
200000
Project B
219370
PI = =1.09
200000

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Project C
181010
PI = =0.91
200000
Rank
Project A should be preferred first
Project B should be preferred second

Project C should be preferred rejected

Example 11
A company is considering a project consisting of Rs 50,000 life of the
project is 5 years and no salvage value. Tax rate is 55%. The estimated
cash flows before tax (CFBT) are given as follows.
Year CFBT

1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Compute the following
1) Payback Period,
2) ARR,
3) IRR,
4)NPV @ 10% discount rate
5) PI @ 10% discount rate.
Solution
Note 1
CPBT xxxx

(-) Depreciation xxxx

xxxx

(-) Tax xxxx

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 xxxx

(-) Depreciation xxxx

CFBT xxxx

Note 2
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 –𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
Depreciation=
𝐿𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ( 𝑖𝑛 𝑌𝑒𝑎𝑟𝑠)
50,000 –0
=
5
= Rs. 10,000

Net Net
Year CFBT Depreciation Taxes CFAT
profits profits
(1) (2) (3) (5) (7) (6+3)
(2-3) (6) (4-5)

1 10000.00 10000.00 —- —- —- 10000.00

2 11000.00 10000.00 1000.00 550.00 450.00 10450.00

1800.00
3 14000.00 10000.00 4000.00 2200.00 11800.00

4 15000.00 10000.00 5000.00 2750.00 2250.00 12250.00

5 25000.00 10000.00 15000.00 8250.00 6750.00 16750.00

11250.00 61250.00

Payback Period

Year CFAT Cumulative CFAT

1 10000 10000

2 10450 20450

3 11800 32250

4 12250 44500

5 16750 61250

Average Rate of Return (ARR)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑐𝑜𝑚𝑒
ARR = × 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

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 11250
Average income = = 2250
5
50000
Average Investment = = 25000
2
2250
ARR = × 100= 9%
25000

Net Present Value (NPV)

Year CFAT PV @ 10% PV

1 10000.00 0.909 9090.00

2 10450.00 0.826 8632.70

3 11800.00 0.751 8861.80

4 12250.00 0.683 8366.75

5 16750.00 0.621 10401.75

Total PV 45352.00

NPV = 45352 – 50000

= -4648
Internal Rate of Return (IRR)
PV @
Year CFAT PV PV@8% PV PV@6% PV
10 %

1 10000.00 0.909 9090 0.926 9260 0.943 9430

2 10450.00 0.826 8632.70 0.857 8955.65 0.890 9300.5

3 11800.00 0.751 8861.80 0.794 9369.20 0.840 9912.0
4 12250.00 0.683 8366.75 0.735 9003.75 0.792 9702.0
5 16750.00 0.621 10401.75 0.681 11406.75 0.747 12512.25
45352.00 47995.35 50856.75

−4648(6%−10%)
IRR =10% +
45352−50856.75

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 −4648(4%)
=
−5504.75
= 10% -3.38

= 6.62%
Profitability Index @ 10% discount rate
PV of Cash inflow
PI =
PV of cash outflow
47352
=
50000
=0.907= 50000

10.2 RISK ANALYSIS IN CAPITAL BUDGETING

While discussing the capital budgeting techniques we have assumed
that the investment proposals do not involve any risk and cash flows of
the project are known with certainty.
This assumption was taken to simplify the understanding of the capital
budgeting techniques. However, in practice, this assumption is not
correct. In fact, investment projects are exposed to various degrees of
risk.
There can be three types of decision making
a. Decision making under certainty: When cash flows are certain
b. Decision making involving risk: When cash flows involve risk and
probability can be assigned
c. Decision making under uncertainty: When the cash flows are
uncertain and probability cannot be assignedRisk and

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 Uncertainty: Risk is the variability in terms of actual returns
comparing with the estimated returns. Most common techniques of
risk measurement are Standard Deviation and Coefficient of
variations.
Figure 10.2 Techniques of risk analysis
There is a thin difference between risk and uncertainty. In case of risk,

probability distribution of cash flow is known.

When no information is known to formulate probability distribution of
cash flows, there is number of statistical/mathematical techniques of risk
evaluation in capital budgeting

10.2.1 Techniques of Risk Analysis

a) Statistical Techniques
i)Probability Methods: Probability is a measure about the chances that
an event will occur. When an event is certain to occur, probability will be
1 and when there is no chance of happening an event probability will be
0.
Example:

Assumption Cash Flows (Rs) Probability

Best guess 3,00,000 0.3

High guess 2,00,000 0.6

Low guess 1,20,000 0.1

In the above example chances that cash flow will be 3, 00,000, 2,00,00
and 1,00,00 are 30%,60% and 10% respectively.
ii) Variance: Variance is a measurement of the degree of dispersion
between numbers in a data set from its average. In very simple words,
variance is the measurement of difference between the averages of the
data set from every number of the data set Variance measures the
uncertainty of a value from its average. Thus, variance helps an
organization to understand the level of risk it might face on investing in a
project. A variance value of zero would indicate that the cash flows that
would be generated over the life of the project would be same. This
might happen in a case where the company has entered into a contract
of providing services in return of a specific sum. A large variance

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indicates that there will be a large variability between the cash flows of
the different years. This can happen in a case where the project being
undertaken is very innovative and would require a certain time frame to
market the product and enable to develop a customer base and
generate revenues. A small variance would indicate that the cash flows
would be somewhat stable throughout the life of the project. This is
possible in case of products which already have an established market
Standard Deviation: Standard Deviation is a degree of variation of
individual items of a set of data from its average. The square root of
variance is called Standard Deviation. For Capital Budgeting decisions,
Standard Deviation is used to calculate the risk associated with the
estimated cash flows from the project

iii)Coefficient of Variation: The standard deviation is a useful measure

of calculating the risk associated with the estimated cash inflows from an
investment. However, in Capital Budgeting decisions, the management
is several times faced with choosing between many investments’
avenues. Under such situations, it becomes difficult f or the
management to compare the risk associated with different projects using
Standard Deviation as each project has different estimated cash flow
values. In such cases, the Coefficient of Variation becomes useful. The
Coefficient of Variation enables the management to calculate the risk
borne by the concern for every unit of estimated return from a particular
investment.
Simply put, the investment avenue which has a lower ratio of standard
deviation to expected return will provide a better risk – return trade off.
Thus, when a selection has to be made between two projects, the
management would select a project which has a lower Coefficient of
Variation.
b) Conventional Techniques
i) Risk Adjusted Discount Rate
The use of risk adjusted discount rate (RADR) is based on the concept
that investors demand higher returns from the risky projects. The
required rate of return on any investment should include compensation
for delaying consumption plus compensation for inflation equal to risk
free rate of return, plus compensation for any kind of risk taken. If the
risk associated with any investment project is higher than risk involved in
a similar kind of project, discount rate is adjusted upward in order to
compensate this additional risk borne

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A risk adjusted discount rate is a sum of risk-free rate and risk premium.
The Risk Premium depends on the perception of risk by the investor of a
particular investment and risk aversion of the Investor. So, Risks
adjusted discount rate = Risk free rate+ Risk premium Risk Free Rate: It
is the rate of return on Investments that bear no risk For e.g.,
Government securities yield a return of 6 % and bear no risk. In such
case, 6 % is the risk-free rate. Risk Premium: It is the rate of return over
and above the risk -free rate, expected by the Investors as a reward for
bearing extra risk. For high-risk project, the risk premium will be high and
for low-risk projects, the risk premium would be lower.
ii) Certainty Equivalent (CE) Method for Risk Analysis: Certainty
equivalent method –Definition: As per CIMA terminology, “An approach
to dealing with risk in a capital budgeting context. It involves expressing
risky future cash flows in terms of the certain cash flow which would be
considered, by the decision maker, as their equivalent, that is the
decision maker would be indifferent between the risky amount and the
(lower) riskless amount considered to be its equivalent.” The certainty
equivalent is a guaranteed return that the management would accept
rather than accepting a higher but uncertain return. This approach allows
the decision maker to incorporate his or her utility function into the
analysis. In this approach a set of risk less cash flow is generated in
place of the original cash flows.
Certainty Equivalent Coefficients transform expected values of uncertain
flows into their Certainty Equivalents. It is important to note that the
value of Certainty Equivalent Coefficient lies between 0 & 1. Certainty
Equivalent Coefficient 1 indicates that the cash flow is certain or
management is risk neutral. In industrial situation, cash flows are
generally uncertain and managements are usually risk averse under this
method.
c) Other Techniques
i) Sensitivity Analysis Definition of sensitivity analysis: As per CIMA
terminology,” A modelling and risk assessment procedure in which
changes are made to significant variables in order to determine the
effect of these changes on the planned outcome. Particular attention is
thereafter paid to variables identifies as being of special significance”
Sensitivity analysis put in simple terms is a modelling technique which is
used in Capital Budgeting decisions which is used to study the impact of
changes in the variables on the outcome of the project t. In a project,
several variables like weighted average cost of capital, consumer
demand, price of the product, cost price per unit etc. operate

115
simultaneously. The changes in these variables impact the outcome of
the project. It therefore becomes very difficult to assess change in which
variable impacts the project outcome in a significant way. In Sensitivity
Analysis, the project outcome is studied after taking into change in only
one variable. The more sensitive is the NPV, the more critical is that
variable.

So, Sensitivity analysis is a way of finding impact in the project’s NPV (or
IRR) for a given change in one of the variables. A step involved in
Sensitivity Analysis is conducted by following the steps as below:

a. Finding variables, which have an influence on the NPV (or IRR)

of the project
b. Establishing mathematical relationship between the variables.
c. Analysis the effect of the change in each of the variables on the
NPV (or IRR) of the project.
ii) Scenario Analysis: Although sensitivity analysis is probably the most
widely used risk analysis technique, it does have limitations. Therefore,
we need to extend sensitivity analysis to deal with the probability
distributions of the inputs. In addition, it would be useful to vary more
than one variable at a time so we could see the combined effects of
changes in the variables. Scenario analysis provides answer to these
situations of extensions. This analysis brings in the probabilities of
changes in key variables and also allows us to change more than one
variable at a time. This analysis begins with base case or most likely set
of values for the input variables. Then, go for worst case scenario (low
unit sales, low sale price, high variable cost and so on) and best case
scenario. Alternatively scenarios analysis is possible where some factors
are changed positively and some factors are changed negatively. So, in
a nutshell Scenario analysis examines the risk of investment, to analyse
the impact of alternative combinations of variables, on the project’s NPV
(or IRR).
10.3 CAPITAL ASSETS PRICING MODEL (CAPM)
As the name suggests, the CAPM approach to estimate risk adjusted
discount rate is based on Capital Asset Pricing Model. The CAPM is a
theory about how the prices of risky financial assets (securities) are
determined in the Capital Market. In brief, the key insights of the CAPM
are: Investors need be rewarded for systematic risk only because
unsystematic risk can be reduced to zero through diversification of
investment portfolio. A security systematic risk is measured by beta
value. The required rate of return on a security depends on riskless rate

116
of interest, the market risk premium and the security’s beta value. The
basic insights of the CAPM can be mathematically expressed as follows:
Ke = i + (Km - i) 𝜷j
Were,
Ke= the required rate of return on security J
Rf= The riskless rate of interest

Km =the required rate of return on the market portfolio

𝛽j= beta value of security J

So,

Given i = 6%
Km = 12%
𝛽j= 1.2

Ke = i + (Km - i) 𝜷j
Ke= 6+ (12 - 6). (1.2)
= 13.2%
Thus, the required rate of return on a security according to CAPM,
depends on the riskless rate of return (i), the market risk premium (Km -
i), and the beta value ( ) of the security. Computation of is perhaps
the most critical step in the application of CAPM. Let us briefly explain
this statistical value.
A security’s beta can be expressed as:
Where
• 𝜎j = the standard deviation of the expected return on Security j
• 𝜎m =the standard deviation of the expected return on the
marketportfolio
• rjm= the coefficient of correlation between the expected return on
Security j and the market portfolio (m)

Given:
rjm = 0.5
𝜎j = 25

𝜎m = 10
0.5×25
𝛽j = = 1.25
10

117
Thus, beta provides a market related measure of risk of a security and
the CAPM provides a framework of estimating the required rate of return
on a security. Now, by substituting a capital investment project in place
of security in the CAPM framework, you may work out the required rate
of return on an investment project or a similar investment project which
may then be as risk adjusted discount rate for project evaluation.

LET US SUM UP
The analysis of risk and uncertainty is an important element in capital
budgeting decisions. The term risk refers to the variability of the actual
returns from the expected returns of cash flows. The risk involved in
capital budgeting can be measured in absolute as well as relative terms.
The decision tree approach takes into account the impact of all
probabilistic estimates of potential outcomes. Every possible outcome
is weighted in probabilistic terms and then evaluated. Capital rationing
involves choice of combination of available projects in a way to
maximize the total NPV, given the capital budget constraints. Sensitivity
analysis provides information as how sensitive is the outcome to the
estimated change in project parameters. CAPM explains the behaviour
security prices provide a mechanism whereby investors could assess
the impact of a proposed security investment on their overall portfolio
risk and return. We have so far discussed about the various measures of
risk.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. Which of the following is true for a project with a shorter payback
period?
a) The project will have more Net Present Value
b) The project will have less Net Present Value
c) The project carries a greater amount of risk
d) The project carries a lesser amount of risk
[Link] values of the future net incomes discounted by the cost of capital
are called___________.
a) Average capital cost b) Discounted capital cost
c) Net capital cost d) Net present values
3. The decision to accept or reject a capital budgeting project depends
on ________________.
a) An analysis of the cash flows generated by the project

118
 b) Cost of capital that is invested in business/project.
c) Both (A) and (B)
d) Neither (A) nor (B)
4. Internal Rate of Return (IRR) criterion for project acceptance, under
theoretically infinite funds, is: Accept all projects which have –
a) IRR equal to the cost of capital
b) IRR greater than the cost of capital
c) IRR less than the cost of capital
d) None of the above
5. Ranking Projects According to their ability to repay quickly may be useful to
firms________

a) When Experiencing Liquidity Constraints.

b) When Careful Control Over Cash Is Required.
c) To indicate the prospective investors specifying when their funds
are likely to be repaid.
d) All of The Above
GLOSSARY
: Net present value, or NPV, is the
Net present value
difference between an investment’s
present value of cash inflows and its
present value of cash outflows.
: The term payback period refers to
Payback Period
the amount of time it takes to
recover the cost of an investment.
: IRR is a discount rate that makes
Internal Rate of Return
the net present value (NPV) of all
cash flows equal to zero in a
discounted cash flow analysis.

: Modelling technique which is used

Sensitivity Analysis
in Capital Budgeting decisions which
is used to study the impact of
changes in the variables on the
outcome of the project.

: The Capital Asset Pricing Model

Capital Assets Pricing
(CAPM) is a model that describes
Model (CAPM)
the relationship between the

119
 expected return and risk of investing
in a security. It shows that the
expected return on a security is
equal to the risk-free return plus a
risk premium, which is based on the
beta of that security. Below is an
illustration of the CAPM concept.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. (1849) Non-Discounted Cash Flow (DCF) Methods | Topic 2 |
Capital Budgeting - YouTube
7. Discounted Cash Flow (DCF) Techniques: Meaning and Types
([Link])
8. Techniques to Face Risk Factor in Capital Budgeting Decisions |
Financial Management ([Link])

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) d 3) c 4) b 5) d

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Unit 11

INTRODUCTION TO COST OF CAPITAL –

CONCEPT, OBJECTIVES AND
SIGNIFICANCE
STRUCTURE
Overview
Learning Objectives
11.1 Introduction to cost of capital

11.1.1 Cost of capital: Definition and Meaning

11.2 Importance of the Cost of Capital
11.3 Significance of the Cost of Capital
11.4 Components of cost of capital,
11.5 Classification of Cost
11.6 Components of Cost of Capital
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your Progress
OVERVIEW
The concept of cost of capital is a very important in the financial
management. A decision to invest in a particular project depends upon
the cost of capital of the firm or the cut off rate which is the minimum rate
of return expected by the investors. Cost of capital concept can also be
used as a basis for evaluating the performance of a firm and it further
helps management in taking so many financial decisions. This unit will
focus on cost of capital. It has been structured to cover all aspects
related to significance of cost of capital and computation of specific and
overall cost of capital.
LEARNING OBJECTIVES
After completing this unit, you should be able to;
• define cost of capital.

121
 • discuss the concept of cost of capital. meaning of cost of capital
• describe cost of capital is Important
• explain concept, objectives, significances.

11.1 INTRODUCTION TO COST OF CAPITAL

An investor provides long-term funds (i.e., Equity shares, Preference
Shares, retained earnings, Debentures etc.) to a company and quite
naturally he expects a good return on his investment. In order to satisfy
the investor’s expectations, the company should be able to earn enough
revenue.

Thus, to the company, the cost of capital is the minimum rate of return
that the company must earn on its investments to fulfil the expectations
of the investors.

If a company can raise long-term funds from the market at 10%, then
10% can be used as cut-off rate as the management gains only when
the project gives return higher than 10%. Hence 10% is the discount rate
or cut-off rate. In other words, it is the minimum rate of return required
on the investment project to keep the market value per share
unchanged.
In order to maximise the shareholders’ wealth through increased price of
shares, a company has to earn more than the cost of capital. The firm’s
cost of capital can be determined by working out weighted average of
the different costs of raising different sources of capital.
Cost of capital is an integral part of investment decision as it is used to
measure the worth of investment proposal provided by the business
concern. It is used as a discount rate in determining the present value of
future cash flows associated with capital projects. Cost of capital is also
called as cut-off rate, target rate, hurdle rate and required rate of return.
When the firms are using different sources of finance, the finance
manager must take careful decision with regard to the cost of capital;
because it is closely associated with the value of the firm and the
earning capacity of the firm.
Cost of capital is the rate of return that a firm must earn on its project
investments to maintain its market value and attract funds. Cost of
capital is the required rate of return on its investments which belongs to
equity, debt and retained earnings. If a firm fails to earn return at the
expected rate, the market value of the shares will fall and it will result in
the reduction of overall wealth of the shareholders.

122
The cost of capital of a firm is the minimum rate of return expected by its
investors. It is the weighted average cost of various sources of finance
used by a firm. The capital used by a firm may be in the form of debt,
Preference capital, retained earnings and equity shares. The concept of
cost of capital is very important in the financial management. A decision
to invest in a particular project depends upon the cost of capital of the
firm or cut off rate which is the minimum rate of return expected by the
investors. In case a firm is not able to achieve even the cut of rate, the
market value of its shares will fall.

In fact, cost of capital is the minimum rate of return expected by its

investors which will maintain the market value of shares at its present
level. Hence, to achieve the objective of wealth maximization, a firm
must earn a rate of return more than its cost of capital. The cost of
capital of a firm or the minimum rate of return expected by its investors
has a direct relation with the risk involved in the firm. Generally, higher
the risk involved in a firm, higher is the cost of capital.
Cost of capital depends upon:
(a) Demand and supply of capital,
(b) Expected rate of inflation,
(c) Various risk involved, and
(d) Debt-equity ratio of the firm etc.

11.1.2 Cost of Capital: Definition and Meaning

Definitions
The following important definitions are commonly used to understand the
meaning and concept of the cost of capital.
According to the definition of John J. Hampton “Cost of capital is the
rate of return the firm required from investment in order to increase the
value of the firm in the market place”.
According to the definition of Solomon Ezra, “Cost of capital is the
minimum required rate of earnings or the cut-off rate of capital
expenditure”.
According to the definition of James C. Van Horne, Cost of capital is “A
cut-off rate for the allocation of capital to investment of projects. It is the
rate of return on a project that will leave unchanged the market price of
the stock”.

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According to the definition of William and Donaldson, “Cost of capital
may be defined as the rate that must be earned on the net proceeds to
provide the cost elements of the burden at the time they are due”.

Meaning
Cost of Capital is the rate of return the firm expects to earn from its
investment in order to increase the value of the firm in the market place.
In other words, it is the rate of return that the suppliers of capital require
as compensation for their contribution of capital.
Cost of capital is defined as the minimum rate of return that a firm must
earn on its investment for the market value of the firm to remain
unchanged. It is also defined as the rate at which funds can be
borrowed, or it is a rate of return required by those who supply the
capital.
It is also referred cut-off rate, target rate, hurdle rate, minimum required
rate of return, standard return, discount rate.
Simply cost of capital is defined as minimum required rate of return. The
cost of capital is visualized as being composed of several elements.
These elements are the cost of each component of capital. The term
component means the different sources from which funds are raised by
a firm. Each source of funds or each component of capital has its cost.
For e.g., equity capital has a cost, so also preference share capital and
so on. The cost of each source or component is called as specific cost of
capital. When these specific costs are combined to write at overall cost
of capital, it is referred to as the weighted cost of capital.
11.2 IMPORTANCE OF THE COST OF CAPITAL
The concept of cost of capital plays a vital role in decision-making
process of financial management. The financial leverage, capital
structure, dividend policy, working capital management, financial
decision, appraisal of financial performance of top management etc. are
greatly influenced by the cost of capital. Importance of cost of capital
may be stated in the following ways,
1. Maximisation of the Value of the Firm
For the purpose of maximisation of value of the firm, a firm tries to
minimise the average cost of capital. There should be judicious mix of
debt and equity in the capital structure of a firm so that the business
does not to bear undue financial risk.

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2. Capital Budgeting Decisions
Proper estimate of cost of capital is important for a firm in taking capital
budgeting decisions. Generally, cost of capital is the discount rate used
in evaluating the desirability of the investment project. In the internal rate
of return method, the project will be accepted if it has a rate of return
greater than the cost of capital.

In calculating the net present value of the expected future cash flows
from the project, the cost of capital is used as the rate of discounting.
Therefore, cost of capital acts as a standard for allocating the firm’s
investible funds in the most optimum manner. For this reason, cost of
capital is also referred to as cut-off rate, target rate, hurdle rate,
minimum required rate of return etc.

3. Decisions Regarding Leasing

Estimation of cost of capital is necessary in taking leasing decisions of
business concern.
4. Management of Working Capital
In management of working capital, the cost of capital may be used to
calculate the cost of carrying investment in receivables and to evaluate
alternative policies regarding receivables. It is also used in inventory
management also.
5. Dividend Decisions

Cost of capital is significant factor in taking dividend decisions. The

dividend policy of a firm should be formulated according to the nature of
the firm, whether it is a growth firm, normal firm or declining firm.
However, the nature of the firm is determined by comparing the internal
rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k which
indicate growth firm, normal firm and decline firm, respectively.
6. Determination of Capital Structure
Cost of capital influences the capital structure of a firm. In designing
optimum capital structure that is the proportion of debt and equity, due
importance is given to the overall or weighted average cost of capital of
the firm. The objective of the firm should be to choose such a mix of debt
and equity so that the overall cost of capital is minimised.
7. Evaluation of Financial Performance
The concept of cost of capital can be used to evaluate the financial
performance of top management. This can be done by comparing the

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actual profitability of the investment project undertaken by the firm with
the overall cost of capital.
11.3 SIGNIFICANCE OF THE COST OF CAPITAL

Financial experts express conflicting opinions as to the way in which the

cost of capital can be measured. It should be noted that it is a concept of
vital importance in the financial decision-making. It is useful as a
standard for:
a) Evaluating investment decisions
b) Designing a firm’s debt policy

c) Appraising the financial performance of top management

a) Investment evaluation: The primary purpose of measuring the cost
of capital is its use as financial standard for evaluating the investment
projects. In the NPV method an investment project is accepted if it has a
positive NPV. The Projects NPV is calculated by discounting its cash
flows by the cost of capital. In this sense, the cost of capital is the
discount rate used for evaluating the desirability of an investment
project. In the IRR method, the investment project is accepted if it has an
internal rate of return greater than the cost of capital.
An investment project that provides a positive NPV when its cash flows
are discounted by the cost of capital makes net contribution to the
wealth of shareholders. If the project has zero NPV, it means that its
cash flows have yielded a return just equal to the cost of capital, and the
acceptance or rejection of the project will not affect the wealth of
shareholders.
b) Designing debt policy: The debt policy of a firm is significantly
influenced by the cost consideration. In designing the financing policy,
that is, the proportion of debt and equity in the capital structure, the firms
aim at minimizing the overall cost of capital. The cost of a capital can
also be useful in deciding about the methods of financing at a point of
time. For example, cost may be compared in choosing between leasing
and borrowing.
c) Performance appraisal
Further, the cost of capital framework can be used to evaluate the
financial performance of top management. Such an evaluation will
involve a comparison of actual profitability’s of the investment projects
undertaken by the firm with the projected overall cost of capital, and the
appraisal of the actual costs incurred by management in raising the

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required [Link] cost of capital also plays a useful role in divided
decision and investment in current assets.
11.4 CLASSIFICATION OF COST

a) Historical cost and Future cost: Historical costs are book costs
which are related to the past. Future costs are estimated costs for
the future. In financial decision future costs are more relevant than
the historical costs. However, historical costs act as guide for the
estimation of future costs.
b) Specific cost and Composite cost: Specific cost refers to the
cost of a specific source of capital while composite cost is
combined cost of various sources of capital. It is weighted average
cost of capital. In case more than one form of capital is used in the
business, it is the composite cost which should be considered for
decision-making and not the specific cost.
c) Explicit cost and Implicit cost: An explicit cost is the discount
rate which equates the present value of cash inflows with the
present value of cash outflows. The explicit cost of a specific
source of finance may be determined with the help of the following
formula:
Where,Io, is the net cash inflow at zero point of time
Ot is the outflow of cash in periods 1, 2,….. and n

K is the explicit cost of capital.

Implicit cost also known as the opportunity cost is the cost of the
opportunity foregone in order to take up a particular project. For
example, the implicit cost of retained earnings is the rate of return
available to shareholders by investing the funds elsewhere.
d) Average cost and Marginal cost: An average cost refers to the
combined cost of various sources of capital such as debentures,
preference shares and equity shares. It is the weighted average
cost of thevarious sources of finance.

Marginal cost of capital refers to the average cost of capital which

has to be incurred to obtain additional funds required by a firm. In
investment decisions, it is the marginal cost which should be taken
into consideration.
e) Measurement of cost of capital: This is the combined cost of the
specific costs associated with specific sources of financing. The

127
 cost of the different sources of financing represents the
components of the combined cost.
The computation of cost of capital, involves two steps:

a) The computation of the different elements of the cost in

terms of the cost of the different sources of finance.
b) The calculation of the over-all cost by combining of
specific cost into a composite cost.
11.5 COMPONENTS OF COST OF CAPITAL
There are three factors to the cost of capital explained below:

a) Zero Risk Return

It talks about the expected rate of return when a project involves no
financial or business risks.

b) Premium for the Business Risk

Business risk is determined by the capital budgeting decisions that a
firm takes for its investment proposals. So, if a firm selects a project
that has more than normal risk, then it is obvious that the providers
of capital would require or demand a higher rate of return than the
normal rate.

Thus, the premium factor plays an important role here as it

increases the Cost of Capital. But how much premium? It’s up to the
firm’s project selection decision which alienates with the firm’s goal
and objectives and how badly they want the project to increase their
market value.
c) Premium for the Financial Risk
Financial risk is associated with the capital structure pattern of the
firm. Here, the premium finds its way to the picture depending on
the volume of debts the firm owes. The higher the debt capital, the
more is the risk compared to a firm that has relatively low debts.
LET US SUM UP
In this unit we have discussed in detail about cost of capital and its
computation. The cost of capital is an important element in capital
expenditure management. The cost of capital is a discount rate that is
used in determining the present value of future cash flows. The cost of
capital can be explicit or implicit.

128
CHECK YOUR PROGRESS
Choose the Correct Answer:
1._____________ is the minimum required rate of earnings or the cut off
rate of capital expenditure.
a) Cost of capital. b) Working capital

c) Equity capital. d) None of the above.

2. The cost of equity share or debt is known as __________.
a) The specific cost of capital
b) The related cost of capital
c) The burden on the shareholder
d) None of the above
3. The cost of capital is low in case of ____________.
a) Debt capital b) Equity capital
c) Preference capital d) All of the above

4. The cost of preference share capital is calculated by _________.

a) Dividing the price per preference share by the fixed dividend per
share
b) Dividing the book value per preference share by the fixed
dividend per share
c) Dividing the price per preference share by the fixed dividend per
share and then adding the growth rate
d) Dividing the price per preference share by the fixed dividend per
share and then adding the risk premium

5. The cost of equity share capital is greater than the cost of debt
because __________.
a) Equity shares carry a higher risk than debts
b) The face value of equity shares is lower than the face values of
debentures in most cases
c) Equity shares do not provide a fixed dividend rate
d) Equity shares are not easily saleable
GLOSSARY
: Cost of capital is the rate of return
Cost Of Capital
the firm required from investment in
order to increase the value of the
firm in the market place.
: The dividend policy of a firm should
Dividend Decisions
be formulated according to the

129
 nature of the firm, whether it is a
growth firm, normal firm or declining
firm. However, the nature of the firm
is determined by comparing the
internal rate of return (r) and the
cost of capital
: Marginal cost of capital refers to the
Marginal cost
average cost of capital which has to
be incurred to obtain additional
funds required by a firm. In
investment decisions, it is the
marginal cost which should be taken
into consideration
: Business risk is determined by the
Business Risk
capital budgeting decisions that a
firm takes for its investment
proposals.

: Financial risk is associated with the

Financial Risk
capital structure pattern of the firm.
Here, the premium finds its way to
the picture depending on the volume
of debts the firm owes.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. (1849) What is Cost of Capital? - YouTube.
7. Classification of Cost of Capital: 5 Types (With Calculations)
([Link])
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) a 3) a 4) a 5) a

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Unit 12

COST OF CAPITAL
STRUCTURE

Overview
Learning Objectives
12.1 Classification of cost of capital

12.1.1 Explicit and Implicit Cost

12.1.2 Average and Marginal Cost
12.1.3 Historical and Future Cost
12.1.4 Specific and Combine Cost
12.2 Computation of specific costs
12.2.1 Cost of Debt (Kd)

12.2.2 Cost of Preference Shares (kp)

12.2.3 Cost of equity capital (Ke)
12.2.4 Cost of Retained earnings (Kr),

12.3 Overall cost of capital or Weighted average cost of capital (Ko)

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your Progress

OVERVIEW
The concept of cost of capital is a very important in the financial
management. Cost of capital concept can also be used as a basis for
evaluating the performance of a firm and it further helps management in
taking so many financial decisions. This unit will focus on cost of capital.
It has been structured to cover all aspects related to significance of cost
of capital and computation of specific and overall cost of capital.
LEARNING OBJECTIVES
After completing this unit, you should be able to;
• discuss classification of cost of capital

131
 • explain computation of specific costs.
12.1 CLASSIFICATION OF COST OF CAPITAL
Cost of capital may be classified into the following types on the basis of
nature and usage:
a. Explicit and Implicit Cost
b. Average and Marginal Cost
c. Historical and Future Cost
d. Specific and Combined Cost.
12.1.1 Explicit and Implicit Cost

The cost of capital may be explicit or implicit cost on the basis of the
computation of cost of capital.
Explicit cost is the rate that the firm pays to procure financing

Implicit cost is the rate of return associated with the best investment
opportunity for the firm and its shareholders that will be forgone if the
projects presently under consideration by the firm were accepted.
12.1.2 Average and Marginal Cost
Average cost of capital is the weighted average cost of each
component of capital employed by the company. It considers weighted
average cost of all kinds of financing such as equity, debt, retained
earnings etc.
Marginal cost is the weighted average cost of new finance raised by the
company. It is the additional cost of capital when the company goes for
further rising of finance.
12.1.3 Historical and Future Cost
Historical cost is the cost which has already been incurred for financing
a particular project. It is based on the actual cost incurred in the previous
project.
Future cost is the expected cost of financing in the proposed project.
Expected cost is calculated on the basis of previous experience.
12.1.4 Specific and Combine Cost
The cost of each sources of capital such as equity, debt, retained
earnings and loans is called as specific cost of capital. It is very useful to
determine the each and every specific source of capital.

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The composite or combined cost of capital is the combination of all
sources of capital. It is also called as overall cost of capital. It is used to
understand the total cost associated with the total finance of the firm.

12.2 COMPUTATION OF SPECIFIC COSTS

The first step in the measurement of the cost of capital of the firm is the
calculation of the cost of individual sources of raising funds. The specific
costs have to be calculated for
a) Long-term debt (including debentures)
b) Preference shares
c) Equity capital
d) Retained earnings
12.2.1 Cost of Debt (kd)

The cost of funds rose through debt in the form of debentures or loan
from financial institutions can be determined. It is defined as the
minimum rate of interest paid to the debenture holders. The debt can be
either Perpetual or irredeemable debt(Or)Redeemable debt
12.2.2 Cost of Perpetual Debt
The measurement of the cost of perpetual debt is conceptually relatively
easy. It is the rate of return which the lenders expect. The debt carries a
certain rate of interest. The interest rate of the market yield on debt can
be said to represent an approximation of the cost of debt. The bonds
and debentures (debt) can be issued at (1) par (2) Discount and (3)
premium The coupon rate of interest will require adjustment to find out
the true cost of debt.
𝐼
Before tax cost of debt (ki ) =
𝑆𝑉
𝐼
After tax cost of debt (kd) = (1-t)
𝑆𝑉
(Or)
ki(1-t)

Where I= Annual interest payment

SV = Sale proceeds of the debenture / bond
t = Tax rate.

Example 1
A company has 15% perpetual debt of Rs. 1, 00,000. The tax-rate is
50%. Determine the cost of capital (before tax as well as after tax)

133
assuming the debt is issued at 1) par 2)10% discount and 3) 10%
premium.
Solution

1. Debt issued at par

𝐼
Before tax cost of debt (ki ) =
𝑆𝑉
I = 1, 00,000 x 15/100 = 15,000
SV= 1, 00,000
15,000
𝐾𝑖 = =0.15
1,00,000

= 15%.
After tax cost of debt (kd) = ki (1-t)

=15 %( 1-0.5)
=7.5%

2. Issued at 10% discount

𝐼
Before tax cost of debt (ki )=
𝑆𝑉
I= 1,00,000 x 15/100 = 15,000
SV= 1,00,000-1,00,000 x10/100 =90000
15,000
(ki )= = 0.167 =16.7%
90,000
After tax cost of debt (kd)= ki (1-t)

=16.7(1-0.5)
=8.35%
3. Issued at 10% premium
𝐼
Before tax cost of debt (ki )= (ki )=
𝑆𝑉
I= 1, 00,000 x 15/100 = 15,000
SV= 1, 00,000+1, 00,000 x10/100= 1, 10,000
15,000
(ki )= = 13.6%
1,10,000
After tax cost of debt (kd)= ki (1-t)

=13.6 %(1-0.5)=6.8%

134
Cost of Redeemable Debt
In the case of calculation of cost of redeemable debt, account has to be
taken, in addition to interest payments, of the repayment of the principal.
When the amount of principal is repaid in one lump sum at the time of
maturity, the cost of debt would be as follows.
𝑰(𝟏+𝒕)+(𝒇+𝒅+𝒑𝒓− 𝒑𝒊) /𝑵𝒎
𝑲𝒅 =
(𝑹𝑽+𝑺𝑽)/𝟐
Where
I=Annual interest payment
RV=Redeemable value of debt

SV=Net sales proceeds from the issue of debt

Nm=Term of debt

f= Flotation cost
d= Discount on issue of debentures
pi= Premium on issue of debentures

Pr=Premium on redemption of debenture

t=Tax rate

Example: 2
A company issues a new 15% debentures of Rs 1,000 face value to be
redeemable after 10 years. The debenture is expected to be sold at 5 %
discount. It will also involve flotation costs of 5%. The company’s tax
rate is 50% what would the cost of debt be?
Solution
𝐼(1+𝑡)+(𝑓+𝑑+𝑝𝑟− 𝑝𝑖 / 𝑁𝑚
𝐾𝑑 =
(𝑅𝑉+𝑆𝑉)/2

I = 1,000 x 15/100 = 15
t = 50% = 0.5

f = 1000 x 5 /100 = 50
d = 1000 x 5/100 = 50
Nm = 10

RV = Par value – (flotation charge +discount)

= 1000- (50+50) =900
SV=1000

135
 150(1−0.5)+(50+50)/10
𝐾𝑑 =
(900+1000)/2
75+10
= = 8.947%
950
Example: 3
A company issues 15 % debentures of Rs 100 for an amount
aggregating Rs1, 00,000 at 10% premium, redeemable at par after 5
years. The company’s tax rate is 50%. Determine the cost of debt.
Solution
10
𝑅𝑠.15−𝑅𝑠.( ) 𝑅𝑠.13.0
5
𝐾𝑑 = = = 12.4%
(𝑅𝑠.110+𝑅𝑠.100)/2 𝑅𝑠.105
Kd = Ki(1-t)

= 12.4 %( 1-0.5) = 6.2 %

12.2.3 Cost of Preference shares (Kp)

The Computation of the cost of preference shares is conceptually

difficult as compared to the cost of debt. It is true that a fixed dividend
rate is stipulated on preference shares. It is also true that the holders of
such shares have a preferential right as regards payment of dividend as
well as return of principal, as compared to the ordinary shareholders.

It is the minimum rate of dividend expected by the preference

shareholders.
There are two types of preference shares:
1. Irredeemable and
2. Redeemable.
The first category is a kind of perpetual security in that the principal is
not to be returned for a long time to be available till the life of the
company. The redeemable preference shares are issued with a maturity
date so that the principal will be repaid at some future date.

Perpetual Security
The cost of preference shares which has no specific maturity date is
given
𝑑
Kp =
𝑃𝑜 (1−𝑓)

Where
Kp = Cost of preference capital

136
 d = Constant annual dividend payment
Po = Expected sales price of preference shares

f = Flotation costs as a percentage of sales price.

Example: 4
A company issues 14% irredeemable preference shares of the face
value of Rs.100 each. Flotation costs are estimated about 5% of the
expected sale price. What is the Kp, if preference shares are issued at

i) Par value,
ii) 10% Premium and
iii) 5% discount?
Solution
1. Issued at Par
𝑑
Kp =
𝑃𝑜 (1−𝑓)
𝑅𝑠.14 14
= =0.147 = 14.7%
𝑅𝑠.100 (1−0.05) 95

2. Issued at 10% premium

𝑅𝑠.14
Kp =
𝑅𝑠.110 (1−0.05)
14
=0.134 = 13.4%
104.5
3. Issued at 5% discount
𝑅𝑠.14
Kp =
𝑅𝑠.95 (1−0.05)
14
=0.155 = 15.5%
95
Example: 5
A company issues 10% preference shares without a maturity date. The
face value per preference share is Rs.100. But the issue price is RS.95.
What is the cost of preference share? What would be the cost if the
issue price is Rs.105?
Solution
1. Issue price is Rs.95
𝑅𝑠.10
Kp = =0.1053 =10.53%
95

137
2. Issue price is Rs.105
𝑅𝑠.10
Kp = = 0.952 =9.52%
105
12.2.4 Cost of Preference Capital: Redeemable
The explicit cost of preference shares in such a situation is the discount
rate that equates the net proceeds of the sale of preference shares with
the present value of the future dividends and principal repayments. The
appropriate formula to calculate cost is given by
𝒅𝟏 𝒅𝟏
𝑷𝒐 (1-f) = ∑𝒏
𝒕=𝟏 +
(𝟏+𝒌𝒑 ) (𝟏+𝒌𝒑 )𝟐

Where
Po = Expected sale price of preference shares

f = Flotation cost as percentage of Po

d = Dividends paid on preference shares.
Pn = Repayment of preference capital amount.

Example: 6
ABC Ltd has issued 14% preference shares of the face value of Rs100
each to be redeemed after 10 years. Flotation cost is expected to be 5%.
Determine the cost of preference shares (Kp).

Solution
𝑅𝑠.14 100 𝑃𝑛
Rs.95 = ∑10
𝑡=1 + +
(1+𝑘𝑝 )𝑡 (1+𝑘𝑝 )10 (1+𝑘𝑝 )𝑛

It is very apparent that the value if Kp will be between 14% and 15%
as the rate of dividend is 14 %.
Determination of PV at 14% and 15%

Years cash PV factors at Total PV at

outflow

14 % 15% 14 % 15%
Rs. P. Rs. P.

1- 10 Rs.14.00 5.216 5.019 73 70.30

10 Rs.100.00 0.270 0.247 27 24.70
100 95.00

Kp = 15%

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12.2.5 Cost of Equity Capital (Ke)

The cost of equity capital Ke, may be defined as the minimum rate of
return that a firm must earn on the equity financed portion of an
investment project in order to leave unchanged the market price of the
shares.
Dividend Approach
One approach to calculate the cost of equity capital is based on a
dividend valuation model. According to this approach, the cost of equity
capital is calculated on the basis of a required rate of return is terms of
the future dividends to be paid on the shares.
𝑫𝟏 + 𝒈
Ke=
𝑷𝒐

Where
D1 = Expected dividend per share

Po= Current market price per share

g = Growth rate.

Example: 7
The current market price of share is Rs. 90 and the expected dividend
per share is Rs. 4.50. If the dividends are expected to grow at 7%.
Calculate the cost of equity.
Solution
𝐷1 + 𝑔
Ke=
𝑃𝑜
𝑅𝑠.4.50 7
∑10
𝑡=1 + =0.05 +0.07 =0.12 =12%
90 100
Example: 8

The dividend per share of affirms is expected to be Rs. 1 per share next
year and is expected to grow at 6% per year. Determine the cost of
equity capital, assuming the market price per share is Rs. 25.

Solution
𝑫𝟏 + 𝒈
Ke=
𝑷𝒐
1 6
Rs. +
25 100

=0.04 +0.06

=0.10 =10%

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Cost of Equity (Earning Model)
𝑬𝟏
Ke=
𝑷𝒐

Where E1= Expected earnings per share

Po = Current market price per share.

Example: 9

A Firm’s earnings is Rs.1,00,000. The current market price is Rs 100.

Number of equity shares is 10,000. Calculate cost of equity.
Solution
𝑬
Ke= 𝑷𝟏
𝒐

𝑅𝑠.1,00,000
E1= = 10
10,000
10
= 10%
100
12.2.6 Cost of Retained Earnings (Kr)

Retained earnings, as a source of finance for investment proposals,

differ from other sources like debt, preference shares and equities.
There is no obligation, formal or implied, on affirm to pay a return on
retained earnings. Retained earnings may appear to carry no cost since
they represent funds which have not been raised from outside. Cost of
retained earnings may be defined as opportunity cost in terms of
dividends foregone by / with help from the equity shareholders.
Since cost of retained earnings belongs to equity shareholders, cost of
retained earnings equal to cost of equity.
12.3 COMPUTATION OF OVERALL COST OF CAPITAL (KO)

The Computation of the overall cost of capital (represented symbolically

by Ko) involves the following steps.

a. Assuming weights to specific costs.

b. Multiplying the cost of each of the sources by the appropriate
weights.
c. Dividing the total weighted cost by the total weights.
Assignment of weights

The aspects relevant to the selection of appropriate weights are

a. Historical weights versus marginal weights
b. Historical weights can be Book value weights or market value
weights.

140
Example: 10
The following is the capital structure of a firm 14 % equity Rs .4,50,000 ,
13 % retained earnings Rs .1,50,000, 10% preference share Rs
1,00,000 and 4.5 % debt Rs.3,00,[Link] of various sources of finance
is calculated only after tax. You are required to calculate the weighted
average cost of capital.

Solution
Computation ofWeighted Average Cost of Capital
(Book Value Weights)

Amount
Sources of funds Proportion Cost Weighted
Rs. P.
(1) (3) (4) (5)
(2)
Equity Capital 4,50,000.00 45% 14% 0.0630
Retained Earnings 1,50,000.00 15% 13% 0.0195
Preference
1,00,000.00 10 % 10 % 0.0100
ShareCapital
Debt 3,00,000.00 30% 4.5% 0.0135
Total 10,00,000.00 100% 0.1060

Weighted Average Cost of Capital = 10.6 %

Alternative Method
Computation of Weighted Average Cost of Capital

Amount
Sources of funds Cost Weighted
Rs. P.
(1) (3) (4=2*3)
(2)

Equity Capital 4,50,000.00 14% 63,000.00

Retained Earnings 1,50,000.00 13% 19,500.00

Retained Earnings 1,00,000.00 10 % 10,000.00

Debt 3,00,000.00 4.5% 13,500.00

Total 10,00,000.00 1,06,000.00

1,06,000
Weighted Average Cost of Capital= X 100 = 10.6%
10,00,000

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Example: 11
The firms after –tax cost of capital of the specific sources is as
follows:

Cost of debt 8%
Cost Preference Shares 14%
Cost of equity funds 17 %

The firm wishes to raise Rs 5, 00,000 for expansion of its plant. It

estimates that Rs.1, 00,000 will be available as retained earnings and
the balance of the additional funds will be raised as follows:

Long-term debt Rs.3, 00,000

Preference shares 1, 00,000
Using marginal weights, compute the weighted average cost of capital

Solution
Weighted Average Cost of Capital (Marginal Weights)

Sources of Amount
Proportion Cost Weighted
funds Rs. P.
(3) (4) (5)
(1) (2)
Debt 3,00,000.00 60% 8% 24,000.00
Preference
1, 00,000.00 20% 14% 14,000.00
Shares
Retained
1,00,000.00 20 % 17% 17,000.00
Earnings
Total 5,00,000.00 100% 55,000.00
55,000
Weighted Average Cost of Capital = X 100 = 11%
5,00,000

Example: 12
A company has the following capital structure
Common shares Rs.40,00,000.00

6% Preference shares Rs.10, 00,000.00

8% Debt Rs.30,00,000.00
The price of the company share is Rs.20. It is expected the company
will pay next year dividend Rs.2 per share. Which will prove at 7% per
year? Assume 1 50% tax rate. You are required to calculate weighted
average cost of capital.

142
Solution
𝑫𝒆 +𝒈
Ke=
𝑷𝑶
2 7
=Rs. + = 0.17 =17%
20 100
Before tax cost of debt = 8%
After tax cost of debt Kd= Ki(1-t)

= 8 %( 1-0.5) = 4 %
Computation of Weighted Average Cost of Capital
(Alternative Method)

Amount
Sources of funds Cost Weighted
Rs. P.
(1) (3) (4=2*3)
(2)

Equity Capital 40,00,000.00 17% 6,80,000.00

Preference capital 10,00,000.00 6% 60,000.00

Debt 30,00,000.00 4% 1,20,000.00

Total Rs. 80,00,000.00 8,60,000.00

8,60,000
Weighted Average Cost of Capital = X 100
80,00,000

= 10.75%
LET US SUM UP
In this unit we have discussed in detail about cost of capital and its
computation. The cost of capital is an important element in capital
expenditure management. The cost of capital is a discount rate that is
used in determining the present value of future cash flows. The cost of
capital can be explicit or implicit. There are four types of specific costs,
namely cost of debt, cost of preference shares, cost of equity and cost of
retained earnings. The cost of debt is generally lowest among all
sources. The cost of preference capital is a kin to cost of redeemable
debt before tax as preference dividend. The computation of cost of
equity capital is conceptually more difficult. The cost of retrained
earnings is equally difficult to calculate in theoretical terms. The
measurement of the overall cost of capital involves the choice of
appropriate weights. They are historical and marginal weights.

143
CHECK YOUR PROGRESS
Choose the Correct Answer:
[Link] cost of equity share or debt is known as __________.

a) The specific cost of capital

b) The related cost of capital
c) The burden on the shareholder

d) None of the above

2. The cost of capital is low in case of ____________.
a) Debt capital b) Equity capital

c) Preference capital d) All of the above

3. The cost of preference share capital is calculated by _________.
a) Dividing the price per preference share by the fixed dividend per
share
b) Dividing the book value per preference share by the fixed
dividend per share
c) Dividing the price per preference share by the fixed dividend per
share and then adding the growth rate
d) Dividing the price per preference share by the fixed dividend per
share and then adding the risk premium
4. The cost of equity share capital is greater than the cost of debt
because __________.
a) Equity shares carry a higher risk than debts
b) The face value of equity shares is lower than the face values of
debentures in most cases
c) Equity shares do not provide a fixed dividend rate
d) Equity shares are not easily saleable
5. The overall cost of capital is called as ___________.

a) Composite cost of capital b) Combined cost of capital

c) Both (A) and (B) d) Neither (A) nor (B)
GLOSSARY

Explicit cost : Explicit costs are normal

business costs that appear in the
general ledger and directly affect

144
 a company's profitability.

Implicit Cost : An implicit cost is any cost that

has already occurred but not
necessarily shown or reported as
a separate expense. It represents
an opportunity cost that arises
when a company uses internal
resources toward a project
without any explicit compensation
for the utilization of resources.

Marginal cost : Marginal cost of production is the

change in total production cost
that comes from making or
producing one additional unit. To
calculate marginal cost, divide
the change in production costs by
the change in quantity.

Cost of Retained Earnings : The part of revenues that were

not paid but maintained and used
in the company by shareholders
is retained income.

The cost of retained earnings

values thus estimates the return
investors hope to gain from their
equity investments in the
business derived from a valuation
model of capital assets (CAPM).

Weighted Average Cost of : The weighted average cost of

Capital (WACC) capital (WACC) represents a
firm's average cost of capital from
all sources, including common
stock, preferred stock, bonds,
and other forms of debt.

Cost of Debt The cost of debt is the effective

interest rate that a company pays
on its debts, such as bonds and
loans.

145
SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija, (2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
management/cost-of-capital/33354
7. [Link]
calculating-cost-of-capital/
8. WACC Formula, Definition and Uses - Guide to Cost of Capital
([Link])
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) a 3) a 4) a 5) c

146
 BLOCK
BLOCK 44

Capital Structure and Dividend Theories

Unit 13: Introduction to Capital Structure

Unit 14 : Capital structure Theories
Unit 15 : Introduction to Dividends
Unit 16 : Dividend theories

147
Unit 13

INTRODUCTION TO CAPITAL
STRUCTURE
STRUCTURE

Overview
Learning Objectives
13.1 Introduction to Capital Structure

13.1.1 Importance of Capital Structure

13.2 Capitalization, Capital Structure and Financial Structure,
Patterns

13.3 Capital structure

13.3.1 Main features capital structure:
13.4 Optimal Capital Structure
13.4.1 Designing an Optimal Capital Structure
13.4.2 Factors determining Optimal Capital Structure
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your Progress
OVERVIEW
Estimation of capital requirements is necessary, but the formation of a
capital structure is important. The capital structure is made up of debt
and equity securities and refers to the permanent financing of a firm. It is
composed of long-term debt, preference share capital and shareholder’s
funds. Optimal capital structure maximizes the value of the firm and
hence thewealth of its owners and minimizes the company’s cost of
capital. Different kinds of theories have been propounded by different
authors to explain the relationship between capital structure, cost of
capital and value of the firm. This unit will focus on capital structure and
capital structure theories. It has been structured to cover all aspects
related to capital structure and its theories.

148
LEARNING OBJECTIVES
After completing this unit, you would be able to;
• discuss about the capital structure
• describe the optimal capital structure.
• list out the determinants of capital structure.
13.1 INTRODUCTION TO CAPITAL STRUCTURE, CONCEPT
IMPORTANCE
The term capital structure refers to the relationship between the various
long-term sources financing such as equity capital, preference share
capital and debt capital. Deciding the suitable capital structure is the
important decision of the financial management because it is closely
related to the value of the firm.

A company may raise its total capital from various sources such as
shares, debentures and other long-term borrowings. There is no fixed
charge on equity shares but on preference shares and debentures it is
compulsory to pay dividend or interest respectively. Thus debentures
and preference shares create fixed charge.
Capital structure refers to the kinds of securities and the proportionate
amounts that make up capitalization. It is the mix of different long-term
sources such as equity shares, preference shares, debentures, long-
term loans and retained earnings.

Capital structure is that part of financial structure, which represents long-

term sources. The term, ‘capital structure’ is generally defined to include
only long-term debt and total stockholders’ investment. It is the mix of
long-term sources of funds, such as equity shares, reserves and
surpluses, debenture, long-term debt from outside sources and
preference share capital. Capital structure refers to the relationship
between debt and equity the two main forms of capital in a business. In
other words, capital structure refers to the composition of capitalization,
i.e., to the proportion between debt and equity that make up
capitalization.
Capital structure is indicated by the following equation:
Capital Structure = Long-term Debt + Preferred Stock + Net worth (or)
Capital Structure = Total Assets – Current Liabilities
Thus, the capital structure of a firm consists of shareholders’ funds and
debt. The inherent financial stability of an enterprise and risk of
insolvency to which it is exposed are primarily dependent on the source

149
of its funds as well as the type of assets it holds and relative magnitude
of such asset’s categories.
The above definitions have given different meanings of capital structure,
and not about optimal capital structure. The following paragraph gives
the meaning of optimum capital structure.
13.1.1 Importance of Capital Structure

1. Increase in value of the firm

A sound capital structure of a company helps to increase the market
price of shares and securities which, in turn, lead to increase in the value
of the firm.
2. Utilization of available funds
A good capital structure enables a business enterprise to utilise the
available funds fully. A properly designed capital structure ensures the
determination of the financial requirements of the firm and raises the
funds in such proportions from various sources for their best possible
utilisation. A sound capital structure protects the business enterprise
from over-capitalisation and under-capitalisation.
3. Maximization of return
A sound capital structure enables management to increase the profits of
a company in the form of higher return to the equity shareholders i.e.,
increase in earnings per share. This can be done by the mechanism of
trading on equity i.e., it refers to increase in the proportion of debt capital
in the capital structure which is the cheapest source of capital. If the rate
of return on capital employed (i.e., shareholders’ fund + long- term
borrowings) exceeds the fixed rate of interest paid to debt-holders, the
company is said to be trading on equity.
4. Minimisation of cost of capital
A sound capital structure of any business enterprise maximises
shareholders’ wealth through minimisation of the overall cost of capital.
This can also be done by incorporating long-term debt capital in the
capital structure as the cost of debt capital is lower than the cost of
equity or preference share capital since the interest on debt is tax
deductible.
5. Solvency or liquidity position
A sound capital structure never allows a business enterprise to go for
too much raising of debt capital because, at the time of poor earning, the

150
solvency is disturbed for compulsory payment of interest to .the debt-
supplier.
6. Flexibility

A sound capital structure provides a room for expansion or reduction of

debt capital so that, according to changing conditions, adjustment of
capital can be made.

7. Undisturbed controlling
A good capital structure does not allow the equity shareholders control
on business to be diluted.

8. Minimisation of financial risk

If debt component increases in the capital structure of a company, the
financial risk (i.e., payment of fixed interest charges and repayment of
principal amount of debt in time) will also increase. A sound capital
structure protects a business enterprise from such financial risk through
a judicious mix of debt and equity in the capital structure.
13.2 CAPITALIZATION, CAPITAL STRUCTURE AND FINANCING
STRUCTURE
The term capitalization, capital structure and financial structure do not
mean the same.
Capitalization
It refers to the quantitative aspect of the financial planning of an
enterprise. It refers to the total amount of capital raised for its long term
requirement by share, debenture, borrowing etc.
Capital structure
The term capital structure should not be confused with financial structure
and Assets structure. While financial structure consists of short-term
debt, long-term debt and share holders’ fund i.e., the entire left hand
side of the company’s Balance Sheet. But capital structure consists of
long-term debt and shareholders’ fund. So, it may be concluded that the
capital structure of a firm is a part of its financial structure. Some experts
of financial management include short-term debt in the composition of
capital structure. In that case, there is no difference between the two
terms capital structure and financial structure. The important differences
between Capital Structure & Capitalization are as under:

151
[Link] Capital structure Capitalization

1 It refers to proportionate It refers to the total amount of

amount of various sources of all long-term securities issued
funds in the Total capital of the by a company
firm, i.e. the kinds of securities
issued by the firm.

2 Qualitative Aspect Quantitative Aspect

3. The main objective is to The main objective is to

determine the mix of different determine total quantity of long-
kinds of long-term funds term funds

So, capital structure is different from financial structure. It is a part of

financial structure. Capital structure refers to the proportion of long-term
debt and equity in the total capital of a company. On the other hand,
financial structure refers to the net worth or owners’ equity and all
liabilities (long-term as well as short-term). Capital structure refers to the
pattern and the proportion in which the composition of the capitalization
is [Link] structure is the mix of long-term sources and it includes
owned capital, preference share capital and long-term debt capital.
Owned capital is known as variable dividend security, preference share
capital is considered as fixed-dividend security and debentures or bonds
or long-term debts are known as fixed interest-bearing securities.

Financial structure
Financial structure describes the way in which short term and long term
assets are included. Financial structure refers to financial resources and
the composition of percentage of short term and long term sources of
funds. Capital structure is a part of financial structure .The important
differences between Capital structure & financial structure are as under

[Link] Capital Structure Financial Structure

1. Narrow Scope Broader Scope
2. Concerned with long term Concerned with long term funds as
funds well as short term funds
3. Deals with long term funds Deals with total funds of the
of the company company
4. Concerned with the Concerned with the financing of
determination of long term Assets.
capital funds

152
Patterns of Capital Structure
Firm’s capital structure may be arrived at by use of equity share capital
or preference share capital or debt capital (debentures or loans) or
combination of all of them. The use of any one of these sources does
not help come up with an optimum capital structure. Construction of
optimum capital structure is possible only when there is an appropriate
mix of the above sources (debt and equity).
The following are the patterns of capital structure:
a) Complete equity share capital.
b) Different proportions of equity and preference share capital.
c) Different proportions of equity and debenture (debt) capital and.
d) Different proportions of equity, preference and debenture (debt)
capital.
13.3 CAPITAL STRUCTURE
The capital structure is made up of debt and equity securities and refers
to permanent financing of a firm. It is composed of long –term debt,
preference share capital and shareholder’s funds. A decision about the
proportion among equity shares, preference shares and debentures
refers to the capital structure of an enterprise.
Capital structure means the combination of various sources of capital. It
may comprise up of equity, debt, preference share, general reserve,
retained earnings, etc.
In particular, capital structure is the combination of debt and equity.
Capital Structure = Debt + Equity
In theory, capital structure can affect the value of the company by
affecting either its expected earnings or the cost of capital or both. The
capital structure decision can influence the value of the firm through the
earnings available to the shareholders. But the leverage can largely
influence the value of the firm through the cost of capital.
“Capital structure of a company refers to the make-up of its capitalisation
and it includes all long-term capital resources viz., loans, reserves,
shares and bonds.”—Gerstenberg.
“Capital structure is the combination of debt and equity securities that
comprise a firm’s financing of its assets.”—John J. Hampton.
“Capital structure refers to the mix of long-term sources of funds, such
as, debentures, long-term debts, preference share capital and equity
share capital including reserves and surplus.”—I. M. Pandey.

153
According to Gestenberg, “Capital structure of a company refers to
the composition or make-up of its capitalization and it includes all
long-term capital resources viz., loans, reserves, shares and bonds.”

Richard C. Osborn defines capital structure “as the financial plan

according to which all assets of a company are financed. This capital is
supplied by long-term and short-term borrowings, the sale of preferred
and common (equity) stock (shares) and reinvestment of earnings.”
A similar view is also expressed by Walker and Baughn when they opine
that the capital structure is synonymous with total capital; this term refers
to the make-up of the credit side of the balance sheet or the division of
claims among trade creditors, bank creditors, bond-holders, stock-
holders, etc.

13.3.1 The following are main features of an appropriate capital

structure:
1. Financial Leverage
The appropriate capital structure should maximise the return on stocks.
The return can be maximised by having the proper mix of debt and
equity capital in the capital structure of the firm. The debt is the cheapest
source of funds. Thus, by increasing the proportion of debt in the capital
of the firm, return on stocks can be increased.
However, the use of debt in capitalisation will depend on expected
profits of the firm. Financial risk factor is involved in the use of debt in
the total capital of a firm. If profits are low, lower proportion of debt
should be used so that interest burden on the firm does not pose a
threat to the existence of the firm.
If profits are high, a higher level of debt can be used to maximise the
earnings on shares. This will serve the objective of finance manager i.e.,
to maximise the wealth of shareholders.
2. Financial Risk
The capital structure of a firm should provide maximum return to equity
shareholders at the minimum financial risk. As the degree of financial
leverage increases, the financial risk increases in a firm. Financial risk
increases in tandem to increased use of debt in the capital structure of
the firm.
A firm can use debt in a larger proportion in the capital structure of a
firm, if the level of expected profits is high. Otherwise, debt should be
used in small proportion in the capital of a firm. An appropriate capital
structure should strike a balance between financial risk and return.

154
3. Ownership Control
If management wants to keep the control of the firm in a few hands, then
a larger proportion of the capital should be raised by debt capital. The
increasing proportion of debt will not dilute the control of the firm. The
appropriate capital structure should maintain a proper mix of debt and
equity capital so that management of the firm can function in the
democratic way.
4. Flexibility in Raising Funds
The capital structure of a firm should be flexible. It should have some
financial slack. The capital structure should provide a room for
expansion or starting of new projects by raising debt and equity capital
when need arises. An appropriate capital structure of a firm should have
the scope for raising funds as need arises.
Thus, an appropriate capital structure should be such as to maximise the
returns on stock at the minimum level of financial risk. Further, there
should be scope for expansion of business by raising the capital as
when required. The capital structure of a firm should not pose risk to
ownership control.
Illustration
VS International Ltd., has a capital structure (all equity) comprising Rs.5,
00,000 each share of Rs.10. The firm wants to raise an additional Rs.2,
50,000 for expansion programme. The firm has four alternative financial
plans I, II, III and IV. If the firm is able to earn an operating profit at
Rs.80,000 after additional investment and 50 per cent tax rate. Calculate
EPS for all four alternatives and select the preferable financial plan.
Financial plans
i) Raise the entire amount by issue of new equity capital.
ii) Raise 50 per cent as equity capital and 50 per cent as 10 per cent
debt capital.
iii) Raise the entire amount as 12 per cent debentures.
iv) Raise 50 per cent equity capital and 50 per cent preference share
capital at 10 per cent.

155
Solution:

Calculation of EPS under four Financial Plans

Particulars Financial Plans

I II III IV
(Rs.) (Rs.) (Rs.)
(Rs.)
EBIT 80,000 80,000 80,000 80,000
Less: Interest ------- 12,500 30,000 ------
EBT 80,000 67,500 50,000 80,000
Less: Tax 50% 40,000 33,750 25,000 40,000
EAT 40,000 33,750 25,000 40,000
Less: Preference dividend ----- ---- ----- 12,500
Earnings available to 40,000 33,750 25,000 27,500
shareholders
No. of shares (equity) 75,000 62,500 50,000 62,500
outstanding
EPS(Rs.) 0.53 0.54 0.50 0.44

Financial Plan II is preferable since EPS in that plan is high when

compared to others.
13.4 OPTIMAL CAPITAL STRUCTURE
The optimum capital structure may be defined as “that capital structure
or combination of debt and equity that leads to the maximum value of
the firm. “Optimal capital structure ‘maximises the value of the company
and hence the wealth of its owners and minimizes the company’s cost of
capital. Thus, every firm should aim at achieving the optimal capital
structure and then to maintain it.
The following considerations should be kept in mind while maximizing
the value of the firm in achieving the goal of optimum capital structure;
(a) If the return on investment is higher than the fixed cost of funds, the
company should prefer to raise funds having a fixed cost, such as
debentures, loans and preference share capital. It will increase
earnings per share and market value of the firm. Thus, a company
should, make maximum possible use of leverage.
(b) When debt is used as a source of finance, the firm saves a
considerable amount in payment of tax as interest is allowed as a
deductible expense in computation of tax. Hence, the effective cost
of debt is reduced, called tax leverage.

156
 (c) The firm should avoid undue financial risk attached with the use of
increased debt financing. If the shareholders perceive high risk in
using further debt-capital, it will reduce the market price of shares.
(d) The capital structure should be flexible. It should be possible for a
company to adapt its capital structure with minimum cost and delay
if warranted by a changed situation.
(e) The capital structure should involve minimum risk of loss of control
of the company.
13.4.1 Designing an Optimal Capital Structure

1. Maximise the company's wealth An optimal capital structure will

maximise the company's net worth, wealth, and market value. The
wealth of the company is calculated in terms of the present value of
future cash flows. This is discounted by the WACC.
2. Minimise the cost of capital The lower the cost of the capital, the
lower is the risk of insolvency. Companies in industries that have
uncertain future cash flows should keep their cost of financing minimal.
The lower the cost of capital, the higher will be its present value of future
cash flows.
3. Simplicity in structure It should be simple to structure and
understand. A complicated capital structure will only create confusion.
4. Maintain control An optimal capital structure maintains the owners'
rights and control. It is also flexible and gives scope for future borrowing
whenever necessary, without losing control.

Determine Optimum capital structures

Debt as a % of Cost of debt % Cost of equity % .

Capital employed
0 7.0 15.0
10 7.0 15.0
20 7.0 16.0
30 8.0 16.0
40 9.0 18.0
50 10.0 21.0
60 11.0 24.0
The estimates of after tax cost of debt and equity capital for varying of
debt-equity mix are as follows

157
Statement showing optimal capital structure where the overall cost
of capital is minimal

Debt as Equity Cost of Cost of WACC

a% as a % debt % equity %
(1*3)+(2*4)
.

0 100 5.0 12.0 (0*5)+(1*12)=12.00

10 90 5.0 12.0 (0.10*5)+(0.90*120=11.30

20 80 5.0 12.5 =11.00

30 70 5.5 13.0 =10.75

40 60 6.0 14.0 =10.80

50 50 6.5 16.0 =11.25

60 40 7.0 20.0 =12.20

Out of different Debt-equity Mix, the company has the minimum WACC
when the Debt-equity Mix is 30:70 and its WACC is 10.75%. Optimal
capital structure is (Debt- Equity Ratio) 30:70
13.4.2 Factors Determining Capital Structure
I) Internal

a) Cost of capital: The current and future cost of each potential source
of capital should be estimated and compared.
b) Risk: Debt securities increase the risk, while equity securities reduce
it. Risk can be measured to some extent by the use of ratios measuring
gearing and times-interest earned.
c) Dilution of value: A company should not issue any shares which will
have the effect of removing or diluting the value of the shares by the
existing shareholders.
d) Acceptability: A company can borrow only if investors are willing to
lend.
e) Transferability: Many companies put their securities for quotation on
the stock exchange quotations and improve the transferability of shares.
f) Matching Fluctuating Needs Against Short-term: Where needs are
fluctuating, a firm may prefer to borrow short-term loans from
commercial banks.

158
g) Increasing owner’s profit: Profits of the owners can be increased by
relying more and more on debt financing.
h) Surrender operational control: Equity stock may result in a possible
increase of operational control in an enterprise.
i) Future Flexibility: A firm generally maintains a balance to ensure
future flexibility in the capital structure.

II) External

a) General Level of Business Activity: Where the overall level of

business activity is rising, a firm would want to expand its operations.

b) Level of Interest Rates: If interest rates becomes excessive, firms

will delay debt financing.
c) Availability of Funds in the Money Market: The availability of funds
in the money market affects a firm’s ability to offer debt and equity
securities.
d) Tax policy on interest and dividends: The government’s tax policy
on interests and dividends affects the availability of funds though debt
financing. Although each management makes its own decisions on its
capital sources, there are certain general factors which seem to
influence the overall capital structure.
III) General

a) Size of Business and Character of Capital Requirements: New

and
big firms are conservatively financed. But they are likely to issue new
securities to the public. If an enterprise is especially successful, it
grows rapidly and may issue bonds and preferred stock without diluting
equity stock interests.
b) Growth, Age and Size of Firm: The capital structure of firms is
different at the various stages of their development. In the early years of
rapid development, equity capital and short-term growth are the principal
sources.

c) Operational Characteristics: Business differs in their operational

characteristics and their need for funds. Merchandising firms operate on
a small margin of gross profit, mainly with current assets. Public utilities,
on the other hand, have small gross incomes relative to their capital,
and require extensive capital.

159
d) Continuity of Earnings: A firm must have stable earnings in order to
handle recurring fixed charges. The nature of earnings should be the
guiding principle in determining the capital structure of an enterprise.

e) Marketability of Securities: The financial management of a

corporation watches changes in market psychology and considers them
carefully in planning new securities offerings.

f) Government Influence and Corporation Tax: Taxes exercise a

major influence on the capital structures of business. Corporate income-
tax has reduced the net earnings of companies.

LET US SUM UP
In this unit we have discussed in detail about cost of capital and its
computation. The cost of capital is an important element in capital
expenditure management. The cost of capital is a discount rate that is
used in determining the present value of future cash flows. The cost of
capital can be explicit or implicit. There are four types of specific costs,
namely cost of debt, cost of preference shares, cost of equity and cost of
retained earnings. The cost of debt is generally lowest among all
sources. The cost of preference capital is a kin to cost of redeemable
debt before tax as preference dividend. The computation of cost of
equity capital is conceptually more difficult. The cost of retrained
earnings is equally difficult to calculate in theoretical terms.

CHECK YOUR PROGRESS

Choose the Correct Answer:
1. Financial structure refers to ________________.
a) Short-term resources b) All the financial resources
c) Long-term resources d) All of these
2. The mix of debt and equity in a firm is referred to as the firm's
_______.
a) Primary capital b) Capital composition
c) Cost of capital d) Capital structure
3.___________ refers to make-up of a firm's capitalization.
a) Capital structure b) Capital budgeting
c) Equity shares d) Dividend policy

160
4._____________ of different sources of capital influences capital
structure.
a) dividend Policy b) Tax advantage

c) Cost of capital d) Trading on equity

5. The market value of the firm is the result of__________.
a) Dividend decisions
b) Working capital decisions
c) Capital budgeting decisions
d) Trade-off between risk and return

GLOSSARY

Capital Structure : The capital structure is made up of

debt and equity securities and refers to
permanent financing of a firm. It is
composed of long –term debt,
preference share capital and
shareholder’s funds. A decision about
the proportion among equity shares,
preference shares and debentures
refers to the capital structure of an
enterprise.

Optimal Capital Structure : The optimum capital structure may be

defined as “that capital structure or
combination of debt and equity that
leads to the maximum value of the
firm.”

Capitalization : It refers to the quantitative aspect of

the financial planning of an enterprise.
It refers to the total amount of capital
raised for its long-term requirement by
share, debenture, borrowing etc.

Financial structure : Financial structure refers to the mix of

debt and equity that a company uses
to finance its operations.

Financial Leverage : Financial leverage is the use of debt to

buy more assets. The financial
leverage formula is measured as the

161
 ratio of total debt to total assets. As the
proportion of debt to assets increases,
so too does the amount of financial
leverage. Financial leverage is
favorable when the uses to which debt
can be put generate returns greater
than the interest expense associated
with the debt.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
management/capital-structure/33348
7. [Link]
[Link]
8. [Link]

ANSWERS TO CHECK YOUR PROGRESS

1) b 2) d 3) a 4) c 5) d

162
Unit 14

CAPITAL STRUCTURE THEORIES

STRUCTURE

Overview
Learning Objectives
14.1 Theories of Capital Structure

14.1.1 Net Income Approach

14.1.2 Net operating Income Approach
14.1.3 Modigliani-Miller Approach (MM Approach)
14.1.4 Traditional Approach
Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your Progress

OVERVIEW
Estimation of capital requirements is necessary, but the formation of a
capital structure is important. The capital structure is made up of debt
and equity securities and refers to the permanent financing of a firm. It is
composed of long-term debt; preference share capital and shareholder’s
funds. Optimal capital structure maximizes the value of the firm and
hence the wealth of its owners and minimizes the company’s cost of
capital. Different kinds of theories have been propounded by different
authors to explain the relationship between capital structure, cost of
capital and value of the firm. This unit will focus on capital structure and
capital structure theories. It has been structured to cover all aspects
related to capital structure and its theories.

LEARNING OBJECTIVES
After completing this unit, you would be able to;
• describe the various capital structure theories.
• distinguish between various capital structure theories.

163
14.1 THEORIES OF CAPITAL STRUCTURE

ASSUMPTIONS

a) There are only two sources of funds used by a firm : perpetual risk
less debt and ordinary shares.
b) The firm‘s total financing remains constant.
c) Investors have the same subjective probability distributions of
expected future operating earnings for a given firm.
d) The Dividend payment ratio is 100 %.
e) EBIT are not expected to grow.
f) The firm’s business risk is constant.
g) Perpetual life of the firm.
h) The firm’s total assets are given and do not change.
i) The Corporate taxes and personal taxes do not exist.

Definitions and Symbols

The followings are the some symbols and definitions of capital structure
theories based on the above assumptions.
S= Total market value of equity
B= Total market value of debt
V= Total market value of the firm (V=S+B)
I = Total interest payments
NI = Net income available to equity holders.

SOME BASIC DEFINITIONS

1. Cost of debt (Ki) = I/B
Value of debt (B) =I/Ki
D1
2. Cost of equity capital (Ke) = +g
PO

Where D1 = net dividend

Po = Current market price
g = expected growth rate

According to assumption 4 the percentage of retained earnings is zero.

Since
g= br, where is the rate of return on equity shares and b is the retention
rate,
g=0 , the growth rate is zero. So, when g = 0, D1 = E1. Therefore,

164
 E1 E1 E1
Ke = +g= +0=
P0 P0 P0
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
where E1 =
𝑆ℎ𝑎𝑟𝑒𝑠
Ke may be defined on either per share or total basis.
E1
1) Per Share basis P0 =
Ke
EBIT−I
2) Total Basis S =
Ke

Overall cost of capital or weighted average cost of capital

Ko = W1Ki +W2 Ke (where W1and W2 are relative weights)
I+NI EBIT
= (B/V) Ki +(S/V) Ke = =
V V
Hence the total value of the firm is
EBIT
V=
K0

Major Capital Structure Theories are:

a) Net Income Approach (NI)
b) Net Operating Income Approach (NOI)
c) Modigliani –Miller Approach (MM)
d) Traditional Approach
14.1 Net Income Approach (NI)
According to the Net Income (NI) approach suggested by Durand, the
capital structure decision is relevant to the value of the firm. In other
words, a change in capital structure leads to have a change in leverage
and it makes a change in the overall cost of capital as well as the total
value of the firm.
If, therefore, the degree of financial leverage as measured by the ratio of
debt to equity is increased, the weighted average cost of capital will
decline, while the value of the firm as well as the market price of
ordinary shares will increase. Conversely, a decrease in the leverage
will cause an increase in the overall cost of capital and a decline both
in the value of the firm as well as the market price of equity shares.
To prove the above theory, additionally the following three assumption
are made;
i. There are no taxes
ii. Cost of debt is less than cost of equity (Kd<Ke )
iii. The use of debt does not create risk.

165
The implication of the three assumptions underlying the NI approach is
that as the degree of leverage increases, the proportion of an
inexpensive source of funds, i.e. debt in the capital structure increases.
As a result the weighted average cost of capital tends to decline,
leadingto an increase in the total value of the firm. Thus, with the cost of
debt and cost of equity being constant, the increased use of debt
(increase in leverage), will magnify the shareholder’s earnings and,
thereby, the market value of the ordinary shares.
The financial leverage is, according to the NI approach, an important
variable in the capital structure decision of a firm. With a judicious
mixture of debt and equity, a firm can evolve an optimum capital
structure which will be the one at which value of th firm is the highest
and the overall cost of capital is the lowest. At that structure, the market
price per share would be maximum.
This is illustrated in the following example.
A company’s expected annual net operating income (EBIT) is Rs
50,000. The company has Rs 2,00,000, 10% debentures. The equity
capitalization rate (Ke ) of the company is 12.5 %
The value of the firm, according to NI approach is depicted below.
Solution
Value of the firm (NI Approach)

Net operating Income (EBIT) Rs.50,000.00

Less: Interest 10% on 2,00,000(I) 20,000.00
Earnings available to equity holders (NI) 30,000.00
Equity capitalization rate (Ke ) 12.5%
Market value of equity S =(NI/ Ke) Rs.2,40,000.00
Market value of debt (B) 2,00,000.00
Total value of the firm(V=S+B) 4,40,000.00
EBIT
Overall Cost of Capital Ko=
V
50,000
= 0.11363 = 11.36%
4,40,000

Case 1
In order to examine the effect of a change in financing-mix on the firm’s
overall (weighted average) cost of capital and its total value, let us

166
suppose that the firm has decided to raise the amount of debenture
by Rs.1,00,000.

Value of the Firm (NI Approach)

EBIT Rs 50,000.00

Less Interest 10% on Rs 3,00,000 30,000.00

Earning Available to equity holders(NI) 20,000.00

Equity capitalization rate (Ke ) 12.5%

Market value of equity S =(NI/ Ke) Rs 1,60,000.00

Market value of debt (B) 3,00,000.00

Total value of the firm(V=S+B) 4,60,000.00

EBIT
Overall Cost of Capital Ko =
V
50,000
= 0.1087 = 10.87%
4,60,000

When debt increases, overall cost of capital declines and there by EPS
increases and so also the value of the firm.
Case 2
If we decrease the amount of debentures. Let us suppose that the
amount of debt has been reduced by Rs.1,00,000.

Value of the Firm (NI Approach)

EBIT Rs 50,000.00

Less Interest 10% on Rs 1,00,000 10,000.00

Earning Available to equity holders(NI) 40,000.00

Equity capitalization rate (Ke) 12.5%

Market value of equity S =(NI/ Ke) Rs 3,20,000.00

Market value of debt (B) 1,00,000.00

Total value of the firm(V=S+B) 4,20,000.00

EBIT
Overall Cost of Capital Ko=
V

167
50,000
= 0.119 = 11.9%
4,20,000

When debt is decreased overall cost of capital increases and EPS

declines and hence market value of the firm declines.
A change in the capital structure creates a corresponding change in the
value of the firm. In both the cases change in capital structure makes a
change of the firm.
14.1.1 Net Operating Income Approach (NOI)

It is also suggested by Durand. According to this approach capital

structure is irrelevant to the value of the firm. This is opposite to Net
Income approach. That is a change in capital structure does not lead to
have any change inEPS, market price per share and value of the firm.
This approach is proved on the basis of the assumption; Overall cost of
capital (Ko) is constant.

Example
EBIT Rs 50,000, cost of debt 10%, outstanding debt Rs 2,00,000. If the
overall cost of capital is 12.5%. What would be the total value of the firm
and equity capitalization rate?.
Solution

Total value of the firm (NOI Approach)

EBIT Rs.50,000.00

Overall Cost of Capital Ko 12.5%

Total market value of the firm V=EBIT/ Ko Rs 4,00,000.00

Total value of debt (B) 2,00,000.00

Total value of equity(S)=(V-B) 2,00,000.00

EBIT−I
Equity Capitalisation rate (Ke) =
V−B
50,000−20,000
=
4,00,000−2,00,000
30,000
= = 0.15%
2,00,000

168
Case 1
Let us assume that the firm increases the amount of debt from
Rs.2,00,000 to Rs.3,00,000. The value of the firm, equity and the equity
capitalisation rate would be:

EBIT Rs.50,000.00

Overall Cost of Capital Ko 12.5%

Total market value of the firm V=EBIT/ Ko Rs.4,00,000.00

Total value of debt (B) 3,00,000.00

Total value of equity(S)=(V-B) 1,00,000.00

EBIT−I
Equity Capitalisation rate (Ke) =
V−B
50,000−30,000
=
4,00,000−3,00,000
20,000
= = 0.2=20%
1,00,000

The significant feature is that the equity-capitalisation rate, Ke, increases

with the increase in the degree of leverage.
Market Price of Shares
Let us suppose the firm with Rs.2 lakh debt has 2,000 equity shares
(of Rs.100 each) outstanding. The firm has issued additional debt
of Rs.1, 00,000 to repurchase its shares amounting to Rs.1,00,000; it
has to repurchase 1,000 shares of Rs.100 each from the market. It,
then, has 1,000 equity shares outstanding, having total market value of
Rs.1,00, [Link] market price per share, therefore, is Rs.100
Rs.1,00,000  1,000) as before.

Case 2
Let us suppose that the firm retires debt worth Rs.1,00,000, the value of
the firm and the equity capitalisation rate would be:

EBIT Rs.50,000.00

Overall Cost of Capital Ko 12.5%

Total market value of the firm V=EBIT/ Ko Rs.4,00,000.00

Total value of debt (B) 1,00,000.00

169
Total value of equity(S)=(V-B) 3,00,000.00

EBIT−I
Equity Capitalisation rate (Ke) =
V−B
50,000−10,000
=
4,00,000−1,00,000
40,000
= = 13.33%
3,00,000

Ke decreases with the decrease in the degree of leverage.

1,000 equity shares of Rs.100 each to retire debt aggregating Rs.1,
00,000. It will have 3,000 equity shares outstanding, having total market
value of Rs.3,00,000, thus, giving a market price of Rs.100 per share.
Thus, we not that there is no change in the market price per share due
to change in leverage.
14.1.2 Modigliani – Miller (MM) Approach
Modigliani – Miller approach supports to net operating income approach
and its provides behavioral justification to prove that there is no
relationship between capital structure and value of the firm.
There are three basic propositions of the MM approach, namely
a) The overall cost of capital (Ko) and the value of the firm (V) are
independent of its capital structure. The Ko and V are constant
for all degrees of leverage.
b) The second proposition of MM is that the Ke is equal to the
capitalization rate of pure equity stream plus a premium for
financial risk equal to the difference between the pure
equity – capitalization rate (Ke) and Ki times the ratio of debt to
equity.
c) The cut-off rate for investment purposes is completely
independent of the way in which an investment is financed.
Assumption
It has the following assumptions:
a) Perfect Capital Markets
The implication of a capital market is that a) securities are infinitely
divisible; b) investors are free to buy/sell securities; c) investors can
borrow without restrictions on the same terms and conditions as firms
can d) there are no transaction costs e) investors are rational and
behave accordingly.

170
b) All investors have the same expectation of firm’s net operating income
(EBIT) with which to evaluate the value of any firm.
c) Business risk is equal among all firms with similar operating
environment. That means, all firms can be divided into “equivalent risk
class ’or’ homogeneous risk class”.
d) The dividend payout ratio is 100%.

e) There are no taxes.

The basic premise of the MM Approach is that, given the above
assumptions, the total value of a firm must be constant irrespective of
the degree of leverage (debt-equity ratio). Similarly, the cost of capital
as well as the market price of shares must be the same regardless of the
financing-mix.

The justification for the MM hypothesis is the arbitrage process. The

term ‘arbitrage’ refers to an act of buying an asset/security in one market
price of a security in different markets. The MM Approach illustrates the
arbitrage process with reference to valuation in terms of two firms which
are exactly similar in all respects except leverage so that one of them
has debt in its capital structure while the other does not.
The total value of the homogeneous firms which differ only in respect of
leverage cannot be different because of the operation of arbitrage. The
investors of the firm whose value is higher will sell their shares and
instead buy the shares of the firm whose value is lower. Investors will
be able to earn the same return at lower outlay with the same perceived
risk or lower risk. They would, therefore, be better off. The behaviour
of the investors will have the effect of (i) increasing the share prices
(value) of the firm whose shares are being purchased; and (ii) lowering
the share prices (value) of the firm whose shares are being sold. This
will continue till the market process of the two identical firms become
identical. Thus, the switching operation (arbitrage) drives the total value
of two homogeneous firms to identical. This is the point of equilibrium.
The essence of the arbitrage argument of Modigliani and Miller is that
the investors (arbitragers) are able to substitute personal leverage or
home-made leverage for corporate leverage, that is, the use of debt by
the firm itself. Thus, it is unimportant what the capital structure of firm is.
The weighted cost of capital (k0) after the investors exercise their home-
made leverage is constant because investors exactly offset the firm’s
leverage with their own.

171
14.1.3 Traditional Approach
We know that NI approach shows that capital structure is the relevant to
the value of the firm. But NOI approach gives opposite result. Same time
MM hypothesis supports to NOI approach. But traditional approach is a
midway between NI and NOI approach. It is also known as intermediate
approach.

It resembles the NI Approach in arguing that cost of capital and total

value of the firm are not independent of the capital structure. But it does
not subscribe to the view (of NI Approach) that value of a firm will
necessarily increase for all degrees of leverage. In one respect it shares
a feature with the NOI Approach that beyond a certain degree of
leverage, the overall cost increases leading to a decrease in the total
value of the firm. But it differs from the NOI Approach in that it does not
argue that the weighted average cost of capital is constant for all
degrees of leverage.
The crux of this approach is that through a judicious combination of debt
and equity, a firm can increase its value (V) and reduce its cost of capital
(K0) up to a point. However, beyond that point, the use of additional
debt will increase the financial risk of the investors as well as of the
lenders and as a result will cause a rise in the K0. At such a point, the
capital structure is optimum. In other words, at the optimum capital
structure the marginal real cost of debt (both implicit and explicit) will be
equal to the real cost of equity.
Thus, according to the traditional approach, the cost of capital of a firm
as also its valuation is dependent upon the capital structure of the firm
and there is an optimum capital structure in which the firm’s K0 is
minimum and its (V) the maximum.
LET US SUM UP
Capital structure of a company refers to the composition of its
capitalization and it includes all long-term capital resources. The
optimum capital structure may be defined as that capital structure or
combination of debt and equity that leads to the maximum value of the
firm. There are various factors determining capital structure. They are
classified into three major factors viz., Internal, External and General. In
this unit, we have discussed in detail about the capital structure theories.
i.e., NI approach, NOI approach, MM approach and Traditional
approach. The NI approach at one extreme argues that leverage always
affects the cost of capital and the value of the firm. According to NOI
approach capital structure is totally irrelevant to the value of the firm.

172
Modigliani and Miller concur with NOI and provide behavioural support to
its basic proposition. The traditional approach strikes a balance between
these extremes.

CHECK YOUR PROGRESS

Choose the Correct Answer:
1 A critical assumption of the net operating income (NOI) approach to
valuation is____________.
a) Debt and equity levels remain unchanged
b) Dividends increase at a constant rate
c) ko remains constant regardless of changes in leverage
d) Interest expense and taxes are included in the calculation
2. The main factors which affect the capital structure decision of an
entity are___________.
a) Financial Leverage b) Cost of Capital
c) Nature of Assets d) All of these
3. According of MM approach with corporate taxes, the value of levered
entity is ________than the value of unlevered entity.
a) Lower b) Slightly lower

c) Higher d) Normal
4.In_________ approach, the capital structure decision is relevant to the
valuation of the firm.

a) Net income b) Net operating income

c) Traditional d) Miller and Modigliani
5The traditional approach towards the valuation of a company assumes
__________.
a) The overall capitalization rate holds constant with changes in
financial leverage.
b) There is an optimum capital structure.
c) Total risk is not altered by changes in the capital structure.
d) Markets are perfect.
GLOSSARY

Net Income Approach : Capital structure decision is relevant

to the value of the firm. In other
words, a change in capital structure
leads to have a change in leverage

173
 and it makes a change in the overall
cost of capital as well as the total
value of the firm

Net Operating Income : Net operating income approach

Approach says that value of a firm depends on
operating income and associated
business risk. Value of firm will not
be affected by change in debt
components.

Modigliani-Miller Approach : The MM Theory explains the effects

a firm's capital structure may have
on the value of the company for
investment purposes. The definition
states that ''the market value of a
company is calculated using its
earning power and the risk of its
underlying assets and that its value
is independent of the way it finances
investments or distributes
dividends.''

Arbitrage Process : Capital structure arbitrage refers to

a strategy used by companies
where they take advantage of the
existing market mispricing across all
securities to make profits.

Traditional Approach : The traditional theory of capital

structure states that when the
weighted average cost of capital
(WACC) is minimized, and the
market value of assets is
maximized, an optimal structure of
capital exists

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India

174
 3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
structure-theory-net-income-approach
7. [Link]
e/mm-theorem/
8. Traditional Theory of Capital Structure Definition
([Link])

ANSWERS TO CHECK YOUR PROGRESS

1) c 2) d 3) c 4) a 5) b

175
Unit 15

DIVIDEND POLICY
STRUCTURE

Overview
Learning Objectives
15.1 Dividend: Concept, Definition, Meaning

15.2 Dividend Decision

15.3 Dividend Policy
15.3.1 Basic Dividend Policies
15.3.2 Types of Dividend Policies
15.3.3 Essentials of a Sound Dividend Policy
15.4 Significance of Dividend Policy

15.5 Types of Dividends

15.6 Different form of dividend
15.7 Determinants of Dividend Policy

Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to check your Progress
OVERVIEW

Dividend refers to that part of profits of a company which is distributed

by the company among its shareholders. Dividend policy of a firm affects
both the long-term financing and the wealth of shareholders. Thus the
dividend policy is closely linked up with the firm’s investment
and Capital Structure policies. In addition, the level of dividends is a key
factor which leads shareholders and potential investors to determine the
firm’s share value in the market place. Thus it is necessary that the firm
should establish and implement an effective dividend policy. To
understand the mechanics and importance of the dividend decision, one
should understand how retained earnings act as a source of long-term
funds for the firm and also understand the dividend payment procedures
and certain theoretical viewpoints on the importance of dividend policy.

176
This unit focuses on such procedures and on the theories relating to
dividends.
LEARNING OBJECTIVES

After completing this unit, you should be able to;

• explain the nature and meaning of dividend
• describe the objective of dividend policy and the types of dividends
policies generally followed by firms
• classify the dividend theories based on its relevance and
irrelevance
• discuss those theories with the aid of some models developed by
experts in the field
• list out the determinants of dividend policy.

15.1 DIVIDEND: CONCEPT, DEFINITIONAND MEANING

Once a company makes a profit, it must decide on what to do with those
profits. They could continue to retain the profits within the company, or
they could pay out the profits to the owners of the firm in the form of
dividends. The dividend policy decision involves two questions:
1) What fraction of earnings should be paid out, on average, over time?
2) What type of dividend policy should the firm follow? I.e., issues such
as whether it should maintain steady dividend policy or a policy
increasing dividend growth rate etc.

Definition
According to the Institute of Chartered Accountants of India, dividend
is "a distribution to shareholders out of profits or reserves available for
this purpose. “The term dividend refers to that portion of profit (after tax)
which is distributed among the owners / shareholders of the firm”. In
other words, dividend is that part of the net earnings of a corporation that
is distributed to its stockholders. It is a payment made to the equity
shareholders for their investment in the company. Dividend is a reward
to equity shareholders for their investment in the company. It is a basic
right of equity shareholders to get dividend from the earnings of a
company.
Dividend is defined as the distribution of a portion of a company’s
earnings, decided by the board of directors, to a class of its
shareholders.
Dividend is a taxable payment declared by a company’s board of
directors and given to its shareholders out of the company’s current or
retained earnings, usually quarterly. Dividends are usually given as

177
cash (cash dividend), but they can also take the form of stock (stock
dividend) or other property. Dividends provide an incentive to own
stocking stable companies even if they are not experiencing much
growth. Companies are not required to pay dividends. The companies
that offer dividends are most often companies that have progressed
beyond the growth phase, and no longer benefit sufficiently by
reinvesting their profits, so they usually choose to pay them out to their
shareholders also called dividend payout
The term dividend refers to that part of profits of a company which is
distributed by the company among its shareholders. When the entire
profit is given to equity shareholders, dividend payout ratio is 100%. That
is D/P ratio is 100%. When no dividend is given, D/P ratiois 0% or
retention ratio is 100% or retained earnings is 100%. Sometimes a part
may be given as dividend and remaining part may be kept as retained
earnings.

It is the reward of the shareholders for investments made by them in the

shares of the company. The investors are interested in earnings the
maximum return on their investments and to maximize their wealth. A
company, on the other hand, needs to provide funds to finance its long-
term growth.
If company pays out as dividend most of what it earns then for business
requirements and further expansion it will have to depend upon outsider
resources such as issue of debt or new shares. Dividend decision of a
firm, thus affects both the long-term financing and the wealth of
shareholders.
As a result, the firm’s decision to pay dividends must be reached in such
a manner so as to equitably apportion the distributed profits and retained
earnings. The company should, therefore, distribute a reasonable
amount as dividend to its members and retain the rest for its growth and
survival.
15.2 DIVIDEND DECISION
The Dividend Decision is one of the crucial decisions made by the
finance manager relating to the payouts to the shareholders. The payout
is the proportion of Earning per Share given to the shareholders in the
form of dividends.
The companies can pay either dividend to the shareholders or retain the
earnings within the firm. The amount to be disbursed depends on the
preference of the shareholders and the investment opportunities
prevailing within the firm.

178
The optimal dividend decision is when the wealth of shareholders
increases with the increase in the value of shares of the company.
Therefore, the finance department must consider all the decisions viz.
Investment, Financing and Dividend while computing the payouts.
Dividend decision is the core of the financial management; since it
affects capital structure decision and, in turn, investment decision of that
firm. The most significant aspect of the dividend policy is to determine
the amount of earnings to be distributed to the shareholders and the
amount to be retained in the firm. Retained earnings are the most
important internal sources of financing the growth of the firm. On the
other hand, dividends are considered desirable from the shareholders
point of view, as they tend to increase their current wealth. Dividends
constitute the use of the firm’s funds. A firm intending to pay dividends
also needs the funds to finance its investment opportunities will have to
use the external sources of financing namely, issue of new common
shares/ stocks or issue of debt. Dividend policy of the firm thus, has its
effects on both the long-term financing and wealth of the shareholders.
Dividend decisions are an important aspect of corporate financial policy
since they can have an effect on the availability as well as the cost of
capital. Dividend decision determines the division of earnings between
payments to shareholders and retained earnings. The Dividend
Decision, in corporate finance, is a decision made by the directors of a
company about the amount and timing of any cash payments made to
the company’s stockholders. The dividend decision, which consider the
amount of funds retained by the company and the amounts to be
distributed to the shareholders, is closely linked to both investment and
financing decisions. For example, the company with few projects should
return the unused funds to shareholder by the way of paying more
dividends. A company with several suitable projects that maintains high
dividends will have to fund from external sources.
15.3 DIVIDEND POLICY
Dividend policy is the guideline for dividend distribution drafted by the
board of directors of the company. The policy includes parameters for
sharing profits with the shareholders. It also includes how often and in
which form the dividends are to be distributed.
A dividend policy can be defined as the dividend distribution
guidelines provided by the board of directors of a company. It sets the
parameter for delivering returns to the equity shareholders, on the
capital invested by them in the business. While taking such decisions,
the company has to maintain proper balance between its debt and equity

179
composition. A dividend is nothing but the return declared to the equity
shareholders through the distribution of a portion of
profits earned by the organization.

One of the major decision areas of financial management in which the

shareholders are also actively interested is the formulation of dividend
policy. This decision involves the choice between distributing the
earnings between the shareholders and retention by the company of
such earnings. Since the principal objective of corporate financial
management is to maximize the shareholders’ wealth or the market
value of shares, the choice would be influenced by its effect on this
objective. A vital question that would arise at this stage whether dividend
policy pursued by a company has bearing on the market value of its
equity shares. There is no clear-cut answer to this question. In fact, it is
one of the most controversial and unresolved issues in corporate
finance. On this issue the opinions of the academicians are sharply
divided into two schools of thought. One school of thought considers the
extent of earnings distributed as dividends among equity shareholders
as relevant to the market value of equity shares. The other school of
thought argues that dividend policy is not a factor of enhancing the
market value of equity shares.
15.3.1 Basic Dividend Policies

In real life, a firm may practice any dividend policy based on the basic
dividend policies. A dividend policy that a firm follows depends on a
number of factors. Each firm must formulate its own dividend policy as
per its needs. A few basic dividend policies which firms generally pursue
are mentioned below:
a) Constant Rate of Dividend: As per this policy, the firm pays a
dividend at a fixed rate on the paid-up share capital. If this policy is
pursued, the shareholders are more or less sure on the earnings on their
investment. This policy of paying dividend at a constant rate will not
create any problem in those years in which the company is making
steady profit. But paying dividend at a constant rate may face the trouble
in the year when the company fails to earn the steady profit. Therefore,
some of the experts opine that the rate of dividend should be maintained
at a lower level if thus policy is followed.
b) Constant Percentage of Earnings: A firm may pay dividend at a
constant rate on earnings. Since payment of dividend depends on the
current earnings, the payment of dividend will rise in the year the firm is
earning higher profit and the dividend payment will be lower in the year
in which the profit falls. Since fluctuations in profits lead to fluctuations in

180
dividends, the principle adversely affects the price of the shares. As a
result, the firm will find it difficult to raise capital from the external source.
c)Stable Rupee Dividend Plus Extra Dividend: Under this policy, a
firm pays fixed dividend to the shareholders. In the year the firm is
earning higher profits it pays extra dividend over and above the regular
dividend. When the normal condition returns, the firm begins to pay
normal dividend by cutting down the extra dividend. The dividend policy
divides the net profits or earnings after taxes into two parts:
i. Earnings to be distributed as dividend
ii. Earnings retained in the business
Since dividends are distributed out of the profits, there exists an inverse
relationship between dividends distributed and retained earnings in the
business. If larger net profits are distributed as dividends, retained
earnings would be less and on the contrary, if lesser profits are
distributed as dividends, the retained earnings would be larger.
The retained earnings are the most easily accessible significant source
of finance for the firm. A firm which declares larger dividends will have to
use external sources of financing to finance its investment opportunities.
Thus, a firm will have to choose between the portion of profits distributed
as dividends and the portion ploughed back into the business. The
choice is called the dividend policy and it will have its effect on both the
long-term financing and the wealth of shareholders.
15.3.2 Types of Dividend Policies
An organization considers many factors before deciding its dividend
policy.
a) Stable Dividend Policy: Refers to the policy in which an
organization pays regular dividends to its shareholders. The stable
dividend policy is also known as constant-payout-ratio.
b) Long-Term Dividend Policy: Refers to the policy in which dividend
is paid to the shareholders in the long run. If an organization follows
long-term dividend policy, then it would not distribute dividend
among its shareholders regularly and consistently, even in case of
huge profit.
c) The organization retains the earnings to be used in future for its
growth and expansion programs. Investors looking for short-term
gains do not favor the long-term dividend policy. This policy is
preferred by those shareholders who have interest in long-
term capital gains.

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d) Regular and Extra Dividend Policy: Refers to the dividend policy,
which pays a fixed amount of dividend on a regular basis, and an
additional amount of dividend, if the organization earns abnormal
profit This policy encourages the prospective investors to invest in
the organization and helps in raising capital in the future.
e) Irregular Dividend Policy: Refers to the policy in which the
dividend payout ratio keeps on fluctuating. In the irregular dividend
policy, dividend per share depends on profit of the organization. If
the profit is high, the organization would pay a high dividend per
share.
f) However, if the profit is low, the organization would pay less or no
dividend to the shareholders. The irregular dividend policy is
favorable for an organization, which has unstable income. Although,
shareholders do not approve this policy very much, as it does not
provide any certain income.
g) Regular Stock Dividend Policy: Refers to the policy in which an
organization gives dividend in the form of stock instead of cash. If an
organization needs liquidity, then it may adopt regular stock dividend
policy and issue bonus shares to its shareholders.
h) However, regular stock dividend policy is not considered a very
good strategy because it adversely affects share prices and credit
standing of the organization. Moreover, shareholders are more
interested in getting cash instead of shares.

15.3.3 Essentials of a Sound Dividend Policy

Following are the essentials of a sound dividend policy of a company

a) Stability: Stability in dividend distribution implies regularity in
payment of dividend. If a company pays a high dividend in a year
but fails to pay any dividend next year, then it cannot be said as
good. On the other hand, if a company pays a dividend each year
even though at a medium rate, its shareholders will remain satisfied
and its shares will not be subjected to high speculation.
b) Gradually Rising Dividends: The management of the company
should always try to make some increase in the dividend rate each
year, though this increase will depend on the increase in income of
the company. If there are huge profits in any year than in that year
the company should distribute additional or special dividends.
c) Distribution of Cash Dividend: Dividends should be paid in cash.
But, if the amounts of reserves and funds in the company become
very high, then stock dividend may also be declared. But the

182
 distribution of stock dividend should remain within reasonable limits
otherwise the company may become victim of over-capitalization.
d) Moderate Start: In the beginning years of a company’s
incorporation, dividends should be declared at lower rates for some
years so that the company’s financial position may become sound.
Afterwards with the growth and progress of the company, dividend
rates may be increased gradually.
e) Other Factors: Dividends should be paid out of earned profits only.
If there is carry forward of past losses, then dividend should not be
declared till these are set off. Though, the dividend is usually paid
only once in a year in order to keep the shareholders in high spirits,
interim dividends should also be declared.

15.4 SIGNIFICANCE OF DIVIDEND POLICY

Theoretically, the objective of the dividend policy should be to maximise
the shareholder’s return so that the value of his investment is
maximised. Shareholder’s return is composed of – the dividends and the
capital gains. Dividend policy has a direct impact on these two
components of return.
The term dividend policy involves two ratios namely the Payout ratio and
the Retention ratio. The Payout ratio is the dividend which is calculated
as the percentage of the earnings, for example, the total earnings are
Rs. 1,00,000 and the company distributes or pays 20% of its earnings to
the shareholders then the Payout ratio is 20% and the Retention ratio is
calculated as 100% minus the payout ratio, i.e., in the above example
the Retention ratio is 100% – 20% = 80%.
A company could adopt a high payout policy or a low payout policy. A
high payout policy means more current dividends and less retained
earnings, which may consequently result in slower growth and lower
market price per share.
A low payout policy means fewer current dividends and more retained
earnings, which may result in higher growth, higher capital gains and
higher market price per share. Capital gains are future earnings while
dividends are current earnings.
Paying dividends involves outflow of cash. The cash available for the
payment of dividends is affected by the firm’s investment and financing
decisions. If a company decides to incur large capital expenditure, it
would have less cash available for the payment of dividends. Thus, the
investment decision affects the dividend decision

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15.5 TYPES OF DIVIDENDS
1. Interim Dividend: It is the dividend which is paid to the shareholders
before the preparation of final accounts. Alternatively, it can be stated as
dividend payment between two annual general meetings of the
company. Interim dividend can be paid only when the board of directors
is authorized by the articles of association to do so. A shareholders
meeting is not necessary for declaration of interim dividend. At the
middle of the financial year a company is in a position to estimate the
profitability for the year. Based on the estimate, the company pays the
interim dividend.
2. Final Dividend: After the determination of divisible profit at the end of
the financial year, the dividend declared as per provisions of the articles
of association of the company is known as final dividend. The articles of
association impart full authority to the directors to declare dividend. It is
the discretion of the directors whether to declare dividend or not and if
dividend is declared the rate at which such dividend is to be paid. The
shareholders have no power to declare dividend or to fix up the rate
unless the board has any such recommendation.
15.6 DIFFERENT FORM OF DIVIDEND
Dividends can be classified in various forms. Dividends paid in the
ordinary course of business are known as Profit dividends, while
dividends paid out of capital are known as Liquidation dividends.
A company may pay dividend in different forms as follows:
1. Equity Dividend: The dividend paid on equity shares is called Equity
Dividend. The rate of equity dividend is set (recommended) by the board
of directors of a business firm and approved by their shareholders.
2. Preference Dividend: Preference dividend is paid on Preference
Shares. At the time of issue of such shares, the rate of dividend is
mentioned which remains fixed in nature. This dividend on preference
shares is paid before equity dividend. The board of directors of a
business firm does not put any recommendation towards preference
dividend viz. rate, payment mode etc.
3. Interim Dividend: Interim dividend is paid by a company for the
current year before the accounts for that period have been closed. Such
dividend is paid when the company has heavy earnings during the year.
4. Regular Dividend: Payment of dividend at the usual rate is termed as
regular dividend. The investors such as retired persons, widows and
other economically weaker people prefer to get regular dividends

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5. Cash Dividend: A cash dividend is a usual method of paying
dividends. Payment of dividend in cash results in outflow of funds and
reduces the company’s net worth, though the shareholders get an
opportunity to invest the cash in any manner they desire. This is why the
ordinary shareholders prefer to receive dividends in cash.
But the firm must have adequate liquid resources at its disposal or
provide for such resources so that its liquidity position is not adversely
affected on account of cash dividends.
6. Stock Dividend: Stock dividend means the issue of bonus shares to
the existing shareholders. If a company does not have liquid resources it
is better to declare stock dividend. Stock dividend amounts to
capitalization of earnings and distribution of profits among the existing
shareholders without affecting the cash position of the firm.
7. Scrip or Bond Dividend: A scrip dividend promises to pay the
shareholders at a future specific date. In case a company does not have
sufficient funds to pay dividends in cash, it may issue notes or bonds for
amounts due to the shareholders. The objective of scrip dividend is to
postpone the immediate payment of cash. A scrip dividend bears
interest and is accepted as a collateral security
8. Property Dividend: Property dividends are paid in the form of some
assets other than cash. They are distributed under exceptional
circumstances and are not popular in India.
9. Composite Dividend: When dividend is paid partly in cash and partly
in the form of property then it is known as composite dividend.
10. Optional Dividend: Instead of paying a composite dividend, if the
company gives option to its shareholders either for cash dividend or for
property dividend then it is called option dividend.
11. Extra or Special Dividend: Special dividend is an abnormal and
non-recurring form of dividend, when the management of a company
does not want to make frequent changes in the regular rate of dividend
but company is having good number of profits or undistributed reserves
then they can declare extra or special dividend.
15.7 DETERMINANTS OF DIVIDEND POLICY
The following are the factors which determine the dividend policy of a
firm.
a) Dividend Payout Ratio
b) Stability of Dividends

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c) Legal, contractual and internal constraints and Restrictions.
d) Owner’s Considerations
e) Capital market Considerations

f) Inflation
a) Dividend Payout Ratio: Dividend Policy, involves the decision to
payout earnings or to retain them for reinvestment in the firm. The
retained earnings constitute a source of financing. The payment of
dividends results in the reduction of cash and, therefore, in total assets.
The optimum dividend policy should strike that balance between current
dividends and future growth which maximizes the price of the firm’s
shares. The D/P ratio of a firm should be determined with reference to
two basic objectives. Maximizing the wealth of the firm’s owner’s and
providing sufficient funds to finance growth.
b) Stability of Dividends: The term dividend stability refers to the
consistency or lack of variability in the stream of dividends. In more
precise terms it means that a certain minimum amount of dividend is
paid out regularly. The stability of dividends can take any of the following
three forms.
i) Constant dividend per share
ii) Constant /stable D/P ratio
iii) Constant dividend per share plus extra dividend

i) Constant dividend per share

According to this form of stable dividend policy, a company follows a
policy of paying a certain fixed amount per share as dividend. For
instance, on a share of face value of Rs 10, a firm may pay a fixed
amount of, say Rs 2.50 dividend. This amount would be paid year
after year, irrespective of the level of earnings.
The rel5ationship between the earnings per share (EPS) and
dividends per share (DPS) with a constant dividend policy
per share is shown in the following figure.
It can, thus, be seen that while the earnings may fluctuate from year
to year, the dividend per share is constant. To be able to pursue such
a policy, a firm whose earnings are not stable would have tom
make provisions in years when earnings are higher for payment
of dividends in lean years.

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ii) Constant Payout ratio
Another form of stable dividend policy is constant payout ratio.
The term payout ratio refers, to the ratio of dividend to earnings are
percentage share of earnings used to pay dividend. With constant
payout ratio, a firm pays a constant percentage of net earnings as
dividend to the shareholders. To illustrate, if a firm has policy of 50%
payout ratio, its dividends will range between Rs.5 and zero per share
on the assumption that the EPS are Rs.10 per share and zero per share.
The relationship between the EPS and DPS under the policy of constant
payout ratio is shown in the following figure.
iii) Stable rupee dividend plus extra dividend
Under this policy, firm usually pays a fixed dividend to the shareholders
and in years of marked prosperity, additional or extra dividend is paid
over and above the regular dividend.
c) Legal, Contractual and Internal Constraints and Restrictions
Legal Requirements
Legal rules do not require a dividend declaration but they specify the
conditions under which dividends must not be paid. Such conditions
pertain to a) capital impairment b) net profits c) insolvency and d) illegal
accumulation of excess profits.
i) Capital Impairment Rules

Legal enactments limit the amount of cash dividends the firm may pay.
The firm cannot pay dividends out of its paid-up capital, otherwise these
would be a reduction in the capital adversely affecting the security of its
lenders.
ii) Net Profits
The net profits requirement is essentially a corollary of the capital
impairment requirements, in that, it restricts the dividend to be paid out
of the firm’s current profits plus past accumulated retained earnings.
The firm cannot pay cash dividends greater than the amount of current
profits plus the accumulated balance of retained earnings.
iii) Insolvency
A firm is said to be insolvent in two situations; first, when its liabilities
exceed the assets; and second, when it is unable to pay its bills. If the
firm is currently insolvent in either sense it is prohibited from paying
dividends.

187
iv) Illegal Accumulation
The incentive for retained earnings is that shareholders are required to
pay income taxes on dividends when receive, but they are not taxed on
capital gains unless the shares are actually sold. A firm may deliberately
retain a large portion of its earnings so as to either defer income-tax
payments by the shareholders or to provide them with opportunities for
capital gains. In such situations, the firm may be forced to pay
dividends.
Contractual Requirements

Important restriction on the payment of dividend may be accepted by a

company when obtaining external capital either by a loan agreement,
a debenture indenture, a preference share agreement, or a lease
contract. Such restrictions may cause the firm to restrict the payment of
cash dividends until a certain level of earnings has been achieved or
limit the amount of dividends paid to a certain amount or percentage of
earnings.
Internal Constraints
Once the payment of dividend is permissible on legal and contractual
ground, the next step is to ascertain whether the firm has sufficient
excess cash funds to pay cash dividends. It may well be possible that
the firm’s earnings are substantial, but the firm may be short of funds.
This situation is common for i) growing companies ii) companies which
have to retire past loans as their maturity year has come; iii) preference
shares are to be redeemable.
d) Owner’s Considerations: The dividend policy is also to be affected
by the owner’s considerations of
i) the tax status of the shareholders
ii) their opportunities of investment
iii) the dilution of owners
i) Taxes

The firm’s dividend policy may be dictated by the income-tax status of its
shareholders. If a firm has a large percentage of owners who are in high
tax – brackets, its dividend policy should seek to have higher retentions.
ii) Owner’s Opportunities
The firm should not retain funds if the rate of return earned by its would
be less than the one which could have been earned by the investors
themselves from external investments of funds. The firm should

188
evaluate the rate of return obtainable from external investments in firm
belonging to the same risk class. If evaluation shows that the owners
have better opportunities outside, the firm should opt for a higher D/p
ratio.
iii) The Dilution of Ownership
Dilution in earnings results because low retentions may necessitate the
issue of new equity shares in future, causing an increase in the number
of equities shares outstanding and ultimately lowering earnings per
share and their price in the market.

e) Capital Market Considerations: Yet another factor that can strongly

affect dividend policy is that extent to which the firm has access to
capital markets. In case the firm has easy access to the capital markets,
either because it is financially strong or large in size, it can follow a
liberal dividend policy.
f) Inflation: Finally, inflation is another factor which affects the firm’s
dividend decision. Dividend payout tends to be low during periods of
inflation.
LET US SUM UP
In this unit we have discussed in detail dividend policies. Dividend refers
to that portion of a firm’s net earnings which are paid out to the
shareholders. It is the reward of the shareholders for investment made
by them in the shares of the company. Dividend can be classified into
various forms like cash dividend, bond dividend, property dividend and
stock dividend. Various types of dividend policies are adopted by firms.
CHECK YOUR PROGRESS
Choose the Correct Answer:
[Link] policy determines___
a) What portion of earnings will be paid out to stockholders
b) What portion will be retained in the business to finance long-term
growth.
c) Only (A) not (B)
d) Both (A) and (B)
2. The information content of dividends refers to________.
a) Non-payment of dividends by corporations.
b) Dividend changes as indicators of a firm’s future.
c) a stable and continuous dividend
d) a dividend paid as a percent of current earnings.

189
3. The factors involved in setting a dividend policy include all of the
following except__________.
a) restrictive covenants in a bond indenture
b) growth prospects
c) the legal prohibition on paying dividends which exceed current
earnings.
d) capital impairment restrictions.
[Link] dividend policy must be formulated considering two basic
objectives, namely_________

a) delaying the tax liability of the stockholder and information

content.
b) maximizing shareholder wealth and delaying the tax liability of
the stockholder
c) maximizing shareholder wealth and providing for sufficient
financing
d) maintaining liquidity and minimizing the weighted average cost of
capital.
5The problem with the regular dividend policy from the firm’s perspective
is that________.
a) it bores the shareholders
b) if the firm’s earnings drop, so does the dividend payment
c) even when earnings are low, the company must pay a fixed
dividend
d) it increases the shareholders’ uncertainty.

GLOSSARY

Dividend Policy : Dividend policy is the guideline

for dividend distribution drafted
by the board of directors of the
company. The policy includes
parameters for sharing profits
with the shareholders.
Stock Dividend : Stock dividend means the issue
of bonus shares to the existing
shareholders. If a company does
not have liquid resources it is
better to declare stock dividend.
Interim Dividend : Interim dividend is paid by a
company for the current year

190
 before the accounts for that
period have been closed. Such
dividend is paid when the
company has heavy earnings
during the year.
Equity Dividend : The dividend paid on equity
shares is called Equity Dividend.
The rate of equity dividend is set
(recommended) by the board of
directors of a business firm and
approved by their shareholders
Dividend Decision : The Dividend Decision is one of
the crucial decisions made by the
finance manager relating to the
payouts to the shareholders. The
payout is the proportion of
Earning per Share given to the
shareholders in the form of
dividends.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
nd/
7. [Link]
management/dividend-policy/33373
8. [Link]
9-factors-affecting-the-dividend-policy-of-a-company/74187
ANSWERS TO CHECK YOUR PROGRESS
1) d 2) b 3) c 4) c 5)c

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Unit 16

DIVIDEND THEORIES
STRUCTURE

Overview
Learning Objectives
16.1 Dividend Theories

16.1.1 Walter’s Model

16.1.2 Gordon’s Model
16.2 MM Hypothesis
Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to check your Progress
16.1 DIVIDEND THEORIES

The value of the firm can be maximized if the shareholder’s wealth is

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

There are some theories that consider dividend decisions to be an

active variable in determining the value of a firm. The dividend decision
is therefore, relevant. We critically examine below two theories
representing this notion:

192
i) Walter’s model
ii) Gordon’s model.
16.1.1 Walter’s Model

Professor James E. Walter model supports the doctrine that dividends

are relevant. The investment policy of a firm cannot be separated from
its dividend. Policy and both are, according to Walter interlinked. The
choice of an appropriate dividend policy affects the value of an
enterprise.

Assumptions

i) All Financing is done through retained earnings: External sources

of funds like debt or new equity capital are not used.
ii) The firm’s business risk does not change.
iii) All earnings are either distributed as dividends or re-invested
internal immediately.
iv) EPS and dividend are constant
v) The firm has perpetual or very long life.
Walter proves that dividend policy is relevant to the value of the firm.
He considers 2 variables.
i) Return on investment or Internal rate of return which is equal to r.
ii) Cost of Capital or the required rate of return (k)
When r>k, that is actual return on investment is more than the required
rate of return, company can earn more than the expectation of the
shareholders. In this case the entire earnings should be retained and
D/P ratio is 0%. This firms are called growth firms. Since company earns
more than expectations, even though we do not give dividend, value of
the firm will increase.
When r <k, it is better to issue the entire earnings as dividends. That
is D/P ratio is 100%. Investors can earn higher returns by investing
some funds elsewhere; as a result, market price per share is maximized.
When r=k, it is left to the financial manager to retain or to distribute
the earnings. D/P ratio lies in between 0 to 100%
Walter’s Formula for determining the value of a share
Walter has given the following formula to ascertain the market price of a
share:
r( E−D)
D+
Ke
P=
Ke

193
Where
P = prevailing market price of a share
D = Dividend per share

E = Earnings per share

r = rate of return on the firm’s investment
Ke= Capitalisation rate

Equation reveals that the market price per share is the sum of the
present value of two sources of income: (i) the present value of the
infinite stream of constant dividends, D/Ke(ii) the present value of the
infinite stream of capital gains, [r(E-D)/Ke]/Ke. When the firm retains a
perpetual sum of (E-D) at r rate of return, its present value will be: r(E-
D)/Ke. This quantity can be known as a capital gain which occurs when
earnings are retained within the firm. If these retained earnings occur
every year, the present value of an infinite number of capital gains, r (E-
D)/Kewill be equal to:
[r (E-D)/Ke]/Ke
Consider example 1,
The following information is available in respect of a firm,

Capitalisation rate (Ke) = 10%

Earnings per share = Rs.50
Assume rate of return on investment:
i) 12% ii) 8% iii) 10%
Show the effect of dividend policy on market price of shares applying
Walter’s formula when payout ratio is a) 0% b) 20% c) 40% d) 80%
and e) 100%
Solution
Dividend policy and Value of Shares (Walter’s Model)

i) When r - 12% (r>Ke)

a) D/P ratio 0% (Dividend per share is zero)
0.12
0+ (50−0)
0.10
P=
0.10
= Rs.600.

194
b) D/P ratio 20% (Dividend per share is Rs.10)
0.12
10+ (50−10)
0.10
P=
0.10
= Rs.580.
c) D/P ratio 40% (Dividend per share is Rs.20)
0.12
20+ (50−20)
0.10
P=
0.10
= Rs.560.
d) D/P ratio 80% (Dividend per share is Rs.40)
0.12
40+ (50−40)
0.10
P=
0.10
= Rs.520.
e) D/P ratio100% (Dividend per share is Rs.50)
0.12
50+ (50−50)
0.10
P=
0.10
= Rs.500.
ii) When r = 8% (r<Ke)

a) D/P ratio 0% (Dividend per share is zero)

0.08
0+ (50−0)
0.10
P=
0.10
= Rs.400.
b) D/P ratio 20% (Dividend per share is Rs.10)
0.08
10+ (50−10)
0.10
P=
0.10
= Rs.420
c) D/P ratio 40% (Dividend per share is Rs.20)
0.08
20+ (50−20)
0.10
P=
0.10
= Rs.440
d) D/P ratio 80% (Dividend per share is Rs.40)
0.08
40+ (50−40)
0.10
P=
0.10
= Rs.480

195
e) D/P ratio100% (Dividend per share isRs.50)
0.08
50+ (50−50)
0.10
P=
0.10
= Rs.500
iii) When r = 10% (r = Ke)

a) D/P ratio 0% (Dividend per share is zero)

0.10
0+ (50−0)
0.10
P=
0.10
= Rs.500

b) D/P ratio 20% (Dividend per share is Rs.10)

0.10
10+ (50−10)
0.10
P=
0.10
= Rs.500
c) D/P ratio 40% (Dividend per share is Rs.20)
0.10
20+ (50−20)
0.10
P=
0.10
= Rs.500
d) D/P ratio 80% (Dividend per share is Rs.40)
0.10
40+ (50−40)
0.10
P=
0.10
= Rs.500
e) D/P ratio100% (Dividend per share isRs.50)
0.10
50+ (50−50)
0.10
P=
0.10
= Rs.500
From the what we have so far discussed, we can draw the conclusion
that when,
i) r>K, the company should retain the profits, i.e. when r = 12%
and Ke= 10%
ii) r<K, the payout should be high; i.e. when r = 8% and Ke= 10%

iii) r=K, the dividend pay-out does not affect the price of the share
i.e. when r = 10% and Ke= 10%

196
Thus, dividend policy in Walter’s model is a financing decision. When
dividend policy is treated as a financing decision, the payment of cash
dividends is a passive residual.

Limitations of Walter’s Model

a) It assumes that the firm’s investment are financed exclusively be

retained earnings; no external financing is used. The model would
be only applicable to all equity firms.
b) The model assumes that r is constant. This is not a realistic
assumption because when increased investments are made by the
firm, r also changes.
c) As regards the assumption of constant Ke, the risk complexion of
the firm has a direct bearing it. By assuming Ke to be constant,
Walter’s model ignores the effect of risk on the value of the firm.
Following are the details regarding three companies A ltd, B ltd, C Ltd
A Ltd B Ltd C ltd
R 18% 20% 8%
Ke 15% 20% 10%
EPS Rs. 30 40 20
Calculate the value of equity shares of each of these companies applying
Walter’s formula when dividend payment ratio is:
(a) 30%, (b) 60%, (c) 100%
Comment on the results drawn
Calculation of Market price by using Walters’ Method.
Formula
r( E−D)
D+
Ke
P=
Ke

Company A Company B Company C

When Payout ratio is =30% Rs. 228 Rs.200 Rs. 172

When Payout ratio is =60% Rs. 216 Rs. 200 Rs. 184

When Payout ratio is =100% Rs. 200 Rs. 200 Rs. 200

Comments
a) Company A is a growing firm( r is greater than K. if the payout is
increases share prices declines it is better to retain the entire Profit with
the firm, so, the ideal payout is 0%

197
b) Company B is a Normal firm( r = K. Dividend payout does not affect
the value of the Equity share of the firm.
c) Company C is a declining firm( r is Less than K. if the pay out is
increases share prices increases it is better to distribute all the Profit to
the shareholders of the firm, , so, the ideal payout is 100%
16.1.2 Gordon’s Model

Another theory which contends that dividends are relevant is the

Gordon’s Model. Gordon’s Model is based on the following assumptions:
a) The firm is an all-equity firm, it has no debt
b) No external financing is used and investment programmes are
financed exclusively by retained earnings.
c) r and Ke are constant. The internal rate of return, the cost of
capital remains constant.
d) The firm and its stream of earnings are perpetual.
e) The retention ratio, once decided upon, is constant.
f) The growth rate, (g = br ) is also constant.
g) Ke >br i.e. Cost of capital is greater than the growth rate.
h) Corporate taxes do not exist.
Gordon also proved that dividend is relevant to the value of the firm.
Gordon’s argument is a two-fold assumption:
a) Investors are risk- averse, and
b) They put a premium on a certain return and discount uncertain
returns.
The investors are rational. Accordingly, they want to avoid risk. The
term risk refers to the possibility of not getting a return on investment.
The payment of current dividend is certain and future dividend is
uncertain. Both with respect to the amount as well as the timing. The
rational investors can reasonably be expected to prefer current dividend.
In other words, they would discount future dividends, i.e. they would
place less importance on it as compared to current dividend. The
retained earnings are evaluated by the investors as a risky promise. In
case the earnings are retained, therefore, the market price of the shares
would be adversely affected.
The above argument underlying Gordon’s model of dividend relevance is
also described as a bird-in-the hand argument. That bird in hand is
better than two in the bush is based on the logic that what is available
at present is preferable to what may be available in the future. Basing

198
his model on this argument, Gordon argues that the future is uncertain
and more distant the future, the more uncertain it is likely to be.
According to Gordon, the market value of a share is equal to the present
value of future streams of dividends. Thus, Solving this equation, we
get a simplified version of Gordon’s model can be symbolically
expressed by substituting E(1-b) for D and br for g
𝑬(𝟏−𝒃)
P =𝑲
𝒆−𝒃𝒓

Where P= Price of shares

E = Earnings per Share

b = Retention ratio
1-b = D/P ratio
Ke = Capitalisation rate

br = g = Growth rate in r
This value shows the relationship of expected earnings, EPS1, dividend
policy, b, internal profitability, r, and the all-equity firm’s cost of capital,
ke, in the determination of the value of the share. It is particularly useful
for studying the effects of dividend policy on the value of the share.

Consider example 2,
The following information is available in respect of the rate of return
on investments(r), the capitalization rate (Ke ) and earnings per share
(E) or Hypothetical Ltd.
R = (i) 12% (ii) 11% (iii) 10%
Ke = 11%

E = Rs 20
Determine the value of its shares, assuming the following:
D/P ratio (1-b) Retention ratio (b)
(a) 10% 90%
(b) 20% 80%
(c) 30% 70%
(d) 40% 60%

Solution

199
Dividend Policy and Value of shares of Hypothetical Ltd
(Gordon’s Model)
i) When r > Ke

a) D/P ratio 10%

Retention ratio 90%
br(g)=.9 x .12= 0.108
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟗) 𝑹𝒔.𝟐
P= =𝟎.𝟎𝟎𝟐 = Rs.1,000
𝟎.𝟏𝟏−𝟎.𝟏𝟎𝟖

b) D/P ratio 20%

Retention ratio 80%

br(g)=.8 x .12= 0.096

𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟖) 𝑹𝒔.𝟒
P= =𝟎.𝟎𝟏𝟒 = Rs.285.71
𝟎.𝟏𝟏−𝟎.𝟎𝟗𝟔

c) D/P ratio 30%

Retention ratio 70%
br(g)=.7 x .12= 0.084
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟕) 𝑹𝒔.𝟔
P= = = Rs.230.76
𝟎.𝟏𝟏−𝟎.𝟎𝟖𝟒 𝟎.𝟎𝟐𝟔

d) D/P ratio 40%

Retention ratio 60%
br(g)=.6 x .12= 0.072
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟔) 𝑹𝒔.𝟖
P= =𝟎.𝟎𝟑𝟖 = Rs.210.52
𝟎.𝟏𝟏−𝟎.𝟎𝟕𝟐

Dividend Policy and Value of shares of Hypothetical Ltd

(Gordon’s Model)
ii) When r= Ke

a) D/P ratio 10%

Retention ratio 90%

br(g)=.9 x .11= 0.099
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟗) 𝑹𝒔.𝟐
P= =𝟎.𝟎𝟏𝟏 = Rs.181.82
𝟎.𝟏𝟏−𝟎.𝟎𝟗𝟗

b) D/P ratio 20%

Retention ratio 80%

200
br(g)=.8 x .11= 0.088
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟖) 𝑹𝒔.𝟒
P= =𝟎.𝟎𝟐𝟐 = Rs.181.82
𝟎.𝟏𝟏−𝟎.𝟎𝟖𝟖

c) D/P ratio 30%

Retention ratio 70%
br(g)=.7 x .11= 0.077
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟕) 𝑹𝒔.𝟔
P= =𝟎.𝟎𝟑𝟑 = Rs.181.82
𝟎.𝟏𝟏−𝟎.𝟎𝟕𝟕

d) D/P ratio 40%

Retention ratio 60%

br(g)=.6 x .11= 0.066
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟔) 𝑹𝒔.𝟖
P= =𝟎.𝟎𝟒𝟒 = Rs.181.82
𝟎.𝟏𝟏−𝟎.𝟎𝟔𝟔

Dividend Policy and Value of shares of Hypothetical Ltd

(Gordon’s Model)
iii) When r< Ke

a) D/P ratio 10%

Retention ratio 90%

br(g)=.9 x .10= 0.090
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟗) 𝑹𝒔.𝟐
P= = = Rs.100
𝟎.𝟏𝟏−𝟎.𝟎𝟗𝟎 𝟎.𝟎𝟐

b) D/P ratio 20%

Retention ratio 80% br(g)=.8 x .10= 0.080

𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟖) 𝑹𝒔.𝟒
P= = = Rs.133.33
𝟎.𝟏𝟏−𝟎.𝟎𝟖𝟎 𝟎.𝟎𝟑

c) D/P ratio 30%

Retention ratio 70% br(g)=.7 x .10= 0.070
𝐑𝐬.𝟐𝟎(𝟏−𝟎.𝟕) 𝐑𝐬.𝟔
P= = = Rs.150
𝟎.𝟏𝟏−𝟎.𝟎𝟕𝟎 𝟎.𝟎𝟒

d) D/P ratio 40%

Retention ratio 60% br(g)=.6 x .10= 0.060
𝑹𝒔.𝟐𝟎(𝟏−𝟎.𝟔) 𝑹𝒔.𝟖
P= = = Rs.160
𝟎.𝟏𝟏−𝟎.𝟎𝟔𝟎 𝟎.𝟎𝟓

The value of shares of Hypothetical Ltd. For different D/P and retention
ratios for the three alternatives of r.

201
Gordon, thus, contends that the dividend decision has a bearing on the
market price of the share. In situations where > Ke, the market price of
the share is favorably affected with more retentions. The reverse holds
true when r < Ke , i.e., more retentions lead to decline market price of
the share. Retentions do not affect the market price of the share when r
= Ke.

Gordon’s model’s conclusions about dividend policy are similar to that of

Walter’s model. This similarity is due to the similarities of assumptions
which underlie both the models. Thus, the Gordon model suffers from
the same limitations as the Walter model.

IRRELEVANCE THEORY
16.2 MM HYPOTHESIS
The most comprehensive argument in support of the irrelevance of
dividends is provided by the MM hypothesis. MM maintain that dividend
policy has no effect on the share prices of the firm and is, therefore, of
no consequence. According to them, it is the investment policy through
which the firm can increase its earnings and thereby the value of the
firm.
Assumptions
The MM hypothesis of irrelevance of dividends is based on the following
critical assumptions.
a) Perfect capital markets in which all investors are rational. Information
is available to all free of cost, there are no transaction cash; securities
are infinitely divisible; no investors is large enough to influence the
market price of securities; there are no flotation costs.

b) There are no taxes.

c) A firm has a given investment policy which does not change. The
operational implication of this assumption is that financing of new
investment out of retained earnings will not change the business risk
complexion of the firm and, therefore, no change in the required risk
of return.

d) There is a perfect certainty by every investor as to future investments

and profits of the firm. In other words, investors are able to forecast
future prices and dividends with certainty. This assumption is dropped
by MM latter.

202
MM Hypothesis Process
The crux of the MM position on the irrelevance of dividend is the
arbitrage argument. The arbitrage process involves a switching and
balancing operation. In other words, arbitrage refers to entering
simultaneously into two transactions which exactly balance or
completely offset each other. The two transactions here are the acts of
paying out dividends and raising external funds-either through the sale
of new shares or raising additional loans-to finance investment
programmes.

When company needs additional capital, let us assume, it can raise the
capital in 2 ways.
a) It can retain its earnings to finance the investment programme.
b) Distribute the earnings to the shareholders as dividend and raise
an equal amount externally through the sale of new shares.
If the firm selects the second alternative, arbitrage process is involved, in
that payment of dividends is associated with raising funds through other
means of financing. The effect of dividend payment on shareholders’
wealth will be exactly offset by the effect of raising additional share
capital. When dividends are paid to the shareholders, the market price
of the shares will decrease. What is gained by the investors as a result
of increased dividends will be neutralized completely by the reductions in
the terminal value of the shares. The market price before and after the
payment of dividend would be identical. The investors, according to
Modigliani and Miller, would, therefore, be indifferent between dividend
and retention of earnings. Since the shareholders are indifferent, the
wealth would not be affected by current and future dividend decisions of
the firm. It would depend entirely upon the expected future earnings of
the firm.
There would be no difference to the validity of the MM premise, if
external funds are raised in the form of debt instead of equity capital.
This is because of their indifference between debt and equity with
respect to leverage.
Those investors are indifferent between dividend and retained earnings
imply that the dividend decision is irrelevant.
With dividends being irrelevant, a firm’s cost of capital would be
independent of its D/P ratio. Finally, the arbitrage process will ensure
that under conditions of uncertainty also the dividend policy would be
irrelevant.

203
When two firms are similar in respect of business risk, prospective future
earnings and investment policies, the market price of their shares must
be the same. This, MM argues, is because of the rational behaviour of
investors who are assumed to prefer more wealth to less wealth.
Differences in current and future dividend policies cannot affect the
market value of the two firms as the present value of prospective
dividends plus terminal value is the same.
MM Hypothesis Proof

MM provide the proof in support of their argument in the following

manner:
Step 1

The market price of a share in the beginning of the period is equal to the
present value of dividends paid at the end of the period plus the market
price of the share at the end of the period. Symbolically
Where Po = theprevailing market price of a share
1
P0= (𝐷1 + 𝑃1 )
(1+𝐾𝑒)

Ke= the cost of equity capital

D1 = the dividend to be received at the end of period one
P1= the market price of a share at the end of period one

Step 2
Assuming no external financing, the total capitalized value of the firm
would be simply the number of shares (a) times the price of each
share (Po). Thus, we have:
1
nP0 = (nD1+nP1)------------(2)
(1+Ke)

Step 3
If the firm’s internal sources of financing its investment opportunities fall
short of the funds required, and n is the number of new shares issued
at the end of the year 1 at price of P1, Eq.2 can be written as:
1
nP0 = (nD1+ n)P1-+ nP1 ------------(3)
(1+Ke)

Where n = The number of shares outstanding at the beginning of the

period.
n = the change in the number of shares outstanding during the
period.

204
Step 4
If the firm were to finance to all investment proposals, the total amount of
new shares issued would be given by
nP1 = I - (E – nD1)

nP1 = I - E + nD1 ---------------------------

(4)
Where nP1 =The amount obtained from the sale of new shares to
finance capital budget
I = The total amount requirement of capital budget
E = Earnings of the firm during the period
nD1 = Total dividends paid
(E – nD1) = Retained earnings.

Step 5
If we substitute Eq. 4 into Eq. 3 we derive Eq. 5.
1
nP0 = [nD1 + (n + ∆n)P1 − (1 − E + nD1) ]
(1+Ke)

Solving Eq. 5, we have

Since dividends are not found in eq.(6) MM concludes that dividends
do not count and that dividend policy has no effect on the share price.
Consider Example 3
A Company belongs to a risk class for which the appropriate
capitalization rate is 10%. It currently has outstanding 25,000 shares
selling at Rs 100 each. The firm is contemplating the declaration of a
dividend of Rs 5 per share at the end of the current financial year. The
company expects to have a net income of Rs 2,50,000 and has a
proposal for making new investments of Rs 5,00,000. Show that under
the MM assumption the payment of dividend does not affect the value of
the firm.
Solution
a) The value of the firm, when dividends are paid

(i) Price per share at the end of year 1

1
P0= (1+𝐾 (𝐷1 + 𝑃1 )
𝑒)

1
100=(1+0.1)(5+P1)

Rs 110 = Rs 5 + P1

205
 P1 = 110 -5 =105.

(ii) Amount required to be raised from the issue of new shares

∆n P1 = I – (E- n P1 )

= Rs 5,00,000 – (Rs 2,50,000 – Rs 1,25,000)

= Rs 3,75,000
(iii) Number of additional shares to be issued
Rs 3,75,000
∆n= = Rs.3571.43 shares
105

(iv) Value of the firm

(𝑛+∆𝑛)𝑃1 −𝐼+𝐸
nP0=
(1+𝐾𝑒 )
25,000+ 75,000
(105) − (5,00,000 − 2,50,000)
1 21
60,000(105)−2,50,000
21

= 30,00,000 -2,50,000 = 27,50,000

b) The value of the firm when dividends are not paid
(i) Price per share at the end of year 1
1
P0= (𝐷1 + 𝑃1 )
(1+𝐾𝑒)
1
100= (5+P1)
(1+0.1)

P1 = Rs 110.

(ii) Amount required to be raised from the issue of new shares

n P1 = (Rs 5,00,000 – 2,50,000)

= Rs 2, 50,000
(iii) Number of new shares to be issue.
(𝑛+∆𝑛)𝑃1 −𝐼+𝐸
nP0=
(1+𝐾𝑒 )
25,000+ 25,000
= (110) − (5,00,000 − 2,50,000)
1 21
30,00,000+
(105) -2,50,000
21

= 30,00,000 -2,50,000
= 27,50,000
Thus, whether dividends are paid or not, value of the firm remains the
same.

206
Criticism of MM Approach
i) Perfect capital market does not exist in reality
ii) Information about the company is not available to the entire person

iii) The firm have to incur floatation costs while issuing securities.
iv) Taxes do exit and there is normally different tax treatment for
dividends and capital going.

v) The firm do not follow a rigid investment policy

vi) The investors have to pay brokerage, fees etc. while doing any
transaction

vii) Shareholders may prefer current incomes as compared to further

gains.
The empirical evidence regarding the effect of dividends on the market
price of shares is only suggestive. Yet, it is indicative of the fact that
companies behave as if dividends are relevant. The MM hypothesis,
therefore, is untenable.
Problem 1
Hero Motor Corp belongs to a risk class of which the appropriate
capitalization rate is 10% , it currently has 1,00,000 shares quoting
Rs.100 each. It pay Rs.6 Dividend per share use [Link]
Find out
1. What will be the price of the share when dividend is paid and dividend
is not paid.
2. It has Net income of Rs. 10,00,000. It plans to make now investment
of Rs. 20,00,000,It pays dividend, How many new shares must be
issued.
17.M. M model
P1=Po(1+Ke)-D1

When Dividend is paid When Dividend is paid

P1=Po(1+Ke)-D1 P1=Po(1+Ke)-D1
=P1=100(1+0.10)-6 =P1=100(1+0.10)-0
=Rs=104 =Rs=110

Profit
Rs 10,00,000
Less dividends=1,00,000*6= 600000

207
Available profit after Dividend
Rs4,00,000
Funds Requirements
Rs20,00,000
Balance of amounts to be raised by
shares=16,00,000,
16,00,000/104=15385 shares are to
be issued to raise required funds for
financing Expansion activities

LET US SUM UP

In this unit we have discussed in dividend theories. Various type of

dividend policies is adopted by firms. Dividend theories are classified
into two aspects which support i) the relevance of dividends and ii) The
irrelevance of dividends. According to one view, represented by Walter,
Gordon and others the D/P ratio is relevant, and it certainly affects the
market price of shares. The other view led by Modigliani and Miller,
takes a diametrically opposite position and argues that dividends are
passive residual, solely determined by the available investment
opportunities. A firm should try to follow the optimum dividend policy,
defined as one which maximizes the shareholder’s wealth in the long
run. We have finally concluded by discussing about the factors which
determine the dividend policy of a concern.

CHECK YOUR PROGRESS

Choose the Correct Answer:
1._________ is the expected cash dividend that is normally paid to
Shareholders.
a) Stock split. b) Stock dividend.
c) Extra dividend. d) Regular dividend
2. The most important and common form of dividend is _____________.
a) Stock dividend. b) Cash dividend.
c) Bond dividend. d) Scrip’s dividend.
3.__________ is a payment of additional shares to shareholders in lieu
of cash.
a) Stock split. b) Stock dividend.
c) Extra dividend. d) Regular dividend.

208
4. Which one of the following is the relevance theory?
a) Gorden. b) Walter.
c) Residual. d).Both (a) and (b).

5. In Walter model formula D stands for ____________.

a) Dividend per share. b) Direct dividend.
c) Direct earnings. d) None of these.

GLOSSARY

Dividend Payout Ratio : The dividend payout ratio shows how

much of a company's earnings after
tax (EAT) are paid to shareholders. It
is calculated by dividing dividends
paid by earnings after tax and
multiplying the result by 100.

MM Hypothesis : According to Miller and Modigliani

Hypothesis or MM Approach,
dividend policy has no effect on the
price of the shares of the firm and
believes that it is the investment
policy that increases the firm's share
value.

Gordon’s Model : he Gordon growth model (GGM)

assumes that a company exists
forever and that there is a constant
growth in dividends when valuing a
company's stock. The GGM works by
taking an infinite series of dividends
per share and discounting them back
into the present using the required
rate of return.

Equity Dividend : Equity income primarily refers to

income from stock dividends, which
are cash payments from companies
to their shareholders as a reward for
investing in their stock.

Dividend Decision : The Dividend Decision is one of the

209
 crucial decisions made by the
finance manager relating to the
payouts to the shareholders. The
payout is the proportion of Earning
per Share given to the shareholders
in the form of dividends.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
walters-model-gordons-model-and-modigliani-and-millers-
hypothesis/29462
7. What Is the Modigliani-Miller (M&M) Theorem, and How Is It
Used? ([Link])
ANSWERS TO CHECK YOUR PROGRESS
1) b 2) a 3) b 4) d 5) a

210
 BLOCK 5

WORKING CAPITAL MANAGEMENT

Unit 17: Working Capital Management

Unit 18: Cash Management
Unit 19: Receivable Management

Unit 20: Inventory Management

211
Unit 17

WORKING CAPITAL MANAGEMENT

STRUCTURE
Overview
Learning Objectives
17.1 Introduction to Working capital
17.1.1 Concept of Working Capital
17.1.2 Components of working capital
17.1.3 Need or Objectives of Working Capital
17.2 Working capital management
17.2.1 Objectives of working capital management
17.3 Types of Working Capital
17.3.1 Basics of periodicity
17.3.2 Basics of concept
17.4 Importance of Adequate Working Capital
17.4.1 Measuring the efficiency of the working capital
17.4.2 Adequate Working Capital or Optimum Working Capital
17.4.3 Importance or Advantages of Adequate
17.5 Excess working capital
17.5.1 Disadvantages of Redundant or Excessive Working
Capital
17.6 Inadequate working capital
17.6.1 Disadvantages of Inadequate working capital
17.7 Working capital Policy
17.7.1 Factors Determining Working Capital
17.8 Working Capital Cycle
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your Progress

212
OVERVIEW
Working capital management is an integral part of overall corporate
management. Every business need funds for short term purposes for
the purchase of raw materials, payment of wages and other day-to-day
expenses. These funds are known as working capital. There are two
concepts of working capital. They are Gross working capital and Net
working capital. Working capital may be fixed working capital or variable
working capital. Working capital is the excess of current assets over the
current liabilities of a business. Cash is one of the important constituent
of working capital which is a current asset. It is needed at all times to
keep the business going. A firm has to maintain a minimum amount of
cash for setting the dues in time. The cash is needed to purchase raw
materials, pay creditors, day to day expenses, dividend; etc. Cash
budget is the most important tool in the cash management. A number of
mathematical models have also been developed to determine the
optimal cash balance. This unit will focus on the idea about working
capital management and cash management. It has been structured to
cover all issues related to the working capital management and cash
management.
LEARNING OBJECTIVES
After completing this unit, you should be able to;

• define the concept of working capital.

• classify working capital into different types.
• describe the working capital policy.
• list out the determinants of working capital.
17.1 WORKING CAPITAL: CONCEPT, MEANING
Working Capital is one of the most important components of business.
Businesses cannot think of functioning without sufficient working capital
to meet their day-to-day needs. Insufficient working capital amounts to a
shortage of resources. Whereas excessive working capital results in
increased cost for the business.
Thus, it is important to have an optimum quantity of working capital to
run a business. This means working capital should neither be more nor
less than the amount actually required by the business. Furthermore,
you must evaluate the return on the number of funds invested in the
business in the form of working capital. Such a return should be at least
equal to the return earned by the business in case it invested funds in
other avenues.

213
Many times, businesses fail not because of a lack of profits but because
of insufficient funds required to run its day-to-day operations. Thus,
working capital management plays an important part. This is because it
greatly impacts the liquidity and profitability of the business. So you need
to ascertain the amount of working capital needed and the sources of
financing such a capital. This is to ensure that the working capital
available is sufficient to meet the short term obligations of your business.
Working capital represents the net current assets available for day-to-
day operating activities. It is defined as current assets less current
liabilities and, in exam questions, the components are usually inventory
and trade receivables, trade payables and bank overdraft.
Many businesses that appear profitable are forced to cease trading due
to an inability to meet short-term obligations when they fall due.
Successful management of working capital is essential to remaining in
business.
Businesses require adequate capital to succeed in business
environment. There are two types of capital required by business; fixed
capital and working capital. Businesses require investment in asset,
which has to be utilized over a longer period of times. These long-term
investments are considered as fixed capital, e.g. plant, machinery, etc.
Another type of finance required is short term in nature. This short term
finance or capital is required to undertake day to day operation. Such
short capital is called current capital or working capital.
Working capital refers to company’s investment in short term asset such
as cash, inventory, short term marketable securities and account
receivable.
Information technology is playing a big part in today’s working capital
management. Several aspects of working capital management like the
cash management, inventory management, account receivables/payable
management, etc. are managed through enterprise resource planning
modules.
Working capital is defined as the excess of current assets over current
liabilities. It forms a part of the aggregate capital of the business. Now, a
business needs working capital to fund its short term obligations.
Typically, firms with an optimum level of working capital indicate
efficiency in managing its operations. This further enables the firm to pay
for its short-term dues and day-to-day operational expenses.

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Therefore, working capital is a measure of business’ liquidity position,
operational efficiency, and short-term financial soundness.
Hence, working capital can be put into the following equation:

Working Capital = Current Assets – Current Liabilities

So, let’s have a look at what forms current assets and current liabilities
of a business in order to understand the above equation.

17.1.1 Concept of working capital

There are two concepts of working capital
a) Gross working capital

b) Net working capital

In the broad sense, the term working capital refers to the Gross working
capital and represents the amount of funds invested in current assets.
Thus, the gross working capital is the capital invested in total current
assets of the enterprise.
Current assets are those assets which, in the ordinary course of
business can be converted into cash within a short period of normally
one accounting year.
In a narrow sense, the term working capital refers to the net working
capital. Net working capital is the excess of current assets over current
liabilities or say,
Net working capital =Current Assets – Current liabilities.

Networking capital may be positive or negative. When current assets

exceed to the current liabilities the working capital is positive and the
negative working capital results when the current liabilities are more than
current assets.
Current liabilities are those liabilities which are intended to be paid in the
ordinary course of business within a short period of normally one
accounting year. Both gross and net concepts of working capital are
important aspects of the working capital management. The net concepts
of working capital may be suitable only for proprietary form of
organization. But the gross concepts very suitable to the company form
of organization where there is a divorce between ownership,
management and control.

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17.1.2 Components of working capital
a) Current Assets
Current Assets are the assets of the business that can be easily
converted into cash within a year or normal operating cycle of the
business, whichever is greater. These assets typically include:
i) Cash and cash equivalents
ii) Inventory
iii) Accounts Receivable
iv) Marketable Securities
v) Prepaid Expenses
vi) Other Liquid Assets
b) Current Liabilities

Current Liabilities are the obligations of the business that are due within
one operating cycle or a year, whichever is greater. Such liabilities are
paid off by either using the current assets of the business or by creating
other current liabilities.
Therefore, Current Liabilities include:
i) Accounts Payable
ii) Notes Payable
iii) Current Portion of Long-Term Debt
iv) Accrued Liabilities

v) Unearned Revenues
17.1.2 Need or Objectives of Working Capital
Working capital is the life blood and nerve center of a business. No
business can run successfully without an adequate amount of working
capital. The main advantages of adequate amount of working capital are
as follows;
i) Solvency of the business: Adequate working capital helps in
maintaining solvency of the business by providing uninterrupted
flow of production.
ii) Goodwill: Sufficient working capital enables a business concern
to make prompt payments and hence helps in creating and
maintaining goodwill.
iii) Easy Loans: A concern maintaining adequate working capital,
high solvency and good credit standing can arrange loans from
banks and others on easy and favourable terms.

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 iv) Cash Discount: Adequate working capital also enables a
concern to avail cash discounts on the purchases and hence it
reduces costs.
v) Regular supply of raw materials: Sufficient working capital
ensures regular supply of raw materials and continuous
production.
vi) Regular payment of day-to-day commitments: Adequate
working capital enables payment of salaries, wages and other
day-to-day expenses in right time.
vii) Exploitation of favourable market conditions: Only concerns
with adequate working capital can exploit favourable market
conditions. Such as purchasing its requirements in bulk when the
prices are lower and by holding its inventories for higher prices.
viii) Ability to face crisis: Adequate working capital enables a
concern to face business crisis in emergencies such as
depression because during such periods, generally, there is
much pressure on working capital.
ix) Quick and Regular return on investment: 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 its investors as there may not be much pressure to
plough back profits.
x) High Morale: Adequacy of working capital creates an
environment of security, confidence, high morale and creates
overall efficiency in a business.
17.2 WORKING CAPITAL MANAGEMENT
Working capital management requires great care due to potential
interactions between its components. For example, extending the credit
period offered to customers can lead to additional sales. However, the
company’s cash position will fall due to the longer wait for customers to
pay, potentially leading to the need for a bank overdraft. Interest on the
overdraft may even exceed the profit arising from the additional sales,
particularly if there is also an increase in the incidence of bad debts.

Working capital management is central to the effective management of a

business because:
i) current assets comprise the majority of the total assets of some
companies
ii) shareholder wealth is more closely related to cash generation
than accounting profits

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 iii) Failure to control working capital, and hence to manage liquidity,
is a major cause of corporate collapse.
17.2.1 Objectives of working capital management

Working capital is an essential metric for businesses to pay attention to,

as it represents the amount of capital, they have on hand to make
payments, cover unexpected costs, and ensure business runs as usual.
However, working capital management isn’t that simple, and there can
be multiple objectives of a working capital management program,
including:

One of the two key objectives of working capital management is to

ensure liquidity. A business with insufficient working capital will be
unable to meet obligations as they fall due, leading to late payments to
employees, suppliers and other providers of credit. Late payments can
result in lost employee loyalty, lost supplier discounts and a damaged
credit rating. Non-payment (default) can lead to the compulsory
liquidation of assets to repay creditors.
The other key objective is profitability. Funds tied up in working capital
tend to earn little, or no, return. Hence, a company with a high level of
working capital may fail to achieve the return on capital employed
(Operating profit ÷ (Total equity and long-term liabilities)) expected by its
investors. Therefore, when determining the appropriate level of working
capital there is a trade-off between liquidity and profitability:

a) Meeting obligations. Working capital management should always

ensure that the business has enough liquidity to meet its short-term
obligations, often by collecting payment from customers sooner or by
extending supplier payment terms. Unexpected costs can also be
considered obligations, so these need to be factored into the approach
to working capital management, too.

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b) Growing the business. With that said, it’s also important to use your
short-term assets effectively, whether that means supporting global
expansion or investing in R&D. If your company’s assets are tied up in
inventory or accounts payable, the business may not be as profitable as
it could be. In other words, too cautious an approach to working capital
management is suboptimal.

c) Optimizing capital performance. Another working capital

management objective is to optimize the efficiency of capital usage –
whether by minimizing capital costs or maximizing capital returns. The
former can be achieved by reclaiming capital that is currently tied up to
reduce the need for borrowing, while the latter involves ensuring the ROI
of spare capital outweighs the average cost of financing it

17.3 TYPES OF WORKING CAPITAL

WORKING CAPITAL

Basics of time Basics of Concept

Temporary/
Permanent / Fixed Net Working
Variable Working Capital
Working Capital
Capital

Seasonal
Reserve Margin Gross Working
Variable
Working Capital Capital
Working Capital

Regular Working Special Variable

Capital Working Capital

Figure 17.1 Working Capital

17.3.1 Basics of time
a) Permanent /Fixed Working Capital: It is that portion of the working
capital that remains permanently tied up in current assets to undertake
business activity uninterruptedly. In other words, permanent working
capital is the least amount of current assets needed to carry out
business effortlessly. Thus, it is also known as fixed working capital. The
amount of fixed working capital required by a business depends upon
the size and the growth of the business. For instance, minimum cash or
stock required by a firm to undertake the operational activities of the

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business. Now, permanent working capital can be further subdivided into
two categories:
i) Regular Working Capital: This is defined as the least amount of
capital required by a business to fund its day-to-day operations of a
business. Examples include payment of salaries and wages and
overhead expenses for the processing of raw materials.

ii) Reserve Margin Working Capital: Apart from day-to-day activities,

a business may need some amount of capital for unforeseen
circumstances. Reserve Margin Working Capital is nothing but the
amount of capital kept aside apart from the regular working capital.
These pools of funds are kept separately for unforeseen
circumstances such as strikes, natural calamities, etc.,

b) Temporary/ Variable Working Capital

This can be defined as the working capital invested for a temporary
period of time in the business. For this reason, it is also called as
fluctuating working capital. Such a capital varies with respect to the
change in the size of the business or changes in the assets of the
business.
Further, variable working capital is subdivided into two categories
i) Seasonal Variable Working Capital
This refers to the increased amount of working capital a business needs
during the peak season of the year. A business may even have to
borrow funds to meet its working capital needs. Such a working capital
specifically meets the demands of business having a seasonal nature.
ii) Special Variable Working Capital
Supplementary working capital may also be required by a business to
undertake exceptional operations or unforeseen circumstances. The
capital required for such circumstances is termed as special variable
working capital. Funds needed to finance marketing campaigns,
unforeseen events like accidental fires, floods, etc

17.3.2 Basics of Concept

a) Gross Working Capital
This refers to the aggregate amount of funds invested in the current
assets of the business. In other words, Gross Working Capital is the total
of the current assets of the business. These include:
i) Cash
ii) Accounts Receivable

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 iii) Inventory
iv) Marketable Securities and
v) Short-Term Investments

Gross Working Capital used alone neither shows the complete picture of
the short-term financial soundness. Nor does it showcase the
operational efficiency of the business. Current assets should be
compared with the current liabilities to get a better understanding of a
business’s operational efficiency. That is, how efficiently a business
utilizes its short-term assets to meet its day-to-day cash requirements.

b) Net Working Capital

Net Working Capital is the amount by which current assets exceed the
current liabilities of a business. Thus, the working capital equation is
defined as the difference between current assets and current liabilities.
Where current assets refer to the sum of cash, accounts receivable, raw
material and finished goods inventory. Whereas, current liabilities
include accounts payable.
The amount of working capital in a business is the indicator of liquidity,
operational efficiency and short-term financial soundness of the
business. Businesses having adequate working capital typically have the
ability to invest and grow.
On the other hand, businesses having insufficient working capital have
higher odds of going bankrupt. This is because of their inability to pay for
their short-term obligations, thus making it difficult for them to grow.
17.4 IMPORTANCE OF ADEQUATE WORKING CAPITAL
Management of working capital is an essential task of the finance
manager. He has to ensure that the amount of working capital available
is neither too large nor too small for its requirements. The various
studies conducted by the Bureau of Public Enterprises have shown that
one of the reasons for the poor performance of public sector
undertakings in our country has been the large amount of funds locked
up in working capital. This results in over capitalization. Over
capitalization implies that a company has too large funds for its
requirements, resulting in a low rate of return, a situation which implies a
less than optimal use of resources.
17.4.1 Measuring the efficiency of the working capital
The efficiency of the working capital can be easily measured by various
ratios. The cycle of working capital and its corresponding ratios are
generally compared to the benchmarks of other industries and peers of

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the company. Some of the general measures which are generally used
while estimating the working capital management efficiency often include
the current ratios, inventory outstanding days, payables outstanding
days, sales outstanding days, etc. For the small-scale operations in the
small business, the money flow is always in a tight supply and the
investment in this area of the working capital might be an issue.

Some of the small companies are mostly unable to fund these operating
cycles with payable accounts and so, need to depend on this cash which
is mostly generated by various internal income sources such as the
owner, etc. if one is able to manage the working capital efficiently, these
small businesses would be easily able to free up their cash for paying
debts or for the reinvestments.

17.4.2 Adequate Working Capital or Optimum Working Capital

Adequate working capital means an amount of working capital sufficient
to meet day to day operation activities of the business concern under
normal situations. No business can run successfully without an adequate
amount of working capital. If an enterprise has an adequate working
capital, it is able to carry on its affairs without any financial stringency
and economically. It will also be ready to face losses and unforeseen
emergencies without inviting any disaster.
17.4.3 Importance or Advantages of Adequate

The following are the advantages of adequate working capital.

[Link] of the Business: Adequate working capital ensures
uninterrupted flow of production. The finished goods can be sold thereby
increase in sales turnover and results in the sufficient cash in hand. In
this way, solvency of the business is maintained.
2. Cash Discount: If proper cash balance is maintained, the business
can avail of the cash discount facilities offered to it by the suppliers
[Link]: Whenever the solvency of the business is maintained, the
business concern can make the. payments within the stipulated time
very easily. If so, the good will of the business concern is created and
maintained in the days to come.
[Link]: An able businessman can determine the extent of working
capital requirements i.e. adequate working capital. In this context, the
liquidity of the business concern is maintained with the help of adequate
working capital.
[Link] Loan: If a business concern maintains high solvency of business
and goodwill banks and financial institutions are ready to extent credit

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facility i.e. loan on favourable terms. In this way, the business concern
gets the loan very easily.
[Link] unseen Contingencies: It provides funds for unseen
emergencies so that a business can successfully meet the
contingencies. The impact of contingencies on the business operation
can be reduced at the maximum.

[Link] Supply of Raw Materials: Adequate working capital ensures

regular supply of raw material for continuous flow of production.
[Link] Morale: The executives cannot use the available funds
according to their wishes. If so, misuse of funds is highlighted through
the business operation. The uses of funds increase efficiency of
employees and results in the higher income. In this way, high morale is
maintained among the employees.
[Link] Payment of Commitments: The wages and salaries and
other day to day operating expenses should be paid within the stipulated
time. It is possible only because of maintaining adequate working
capital. The regular payment of commitments increases the efficiency of
employees and reduces wastage, costs and enhances production and
profits.
[Link] Relations with Banks and Financial Institutions: A business
concern can repay its loan with interest within the due date by having
adequate working capital. This type of practice ensures good relations
with banks and financial institutions.
[Link] of favourable Market Conditions: Market condition is
in such a way that trade discount and low price are available for bulk
purchase. These type of favourable market conditions can be availed
only if adequate working capital is maintained.
[Link] Fixed Assets Productivity: Generally, fixed assets are
acquired for increasing earning capacity of the business concern.
Therefore, the fixed assets should be used properly. The fixed assets
can be used properly for increasing productivity with the help of
adequate working capital.
[Link] to Face Crisis: Adequate working capital enables a business
concern to face the crisis during emergency period such as depression.
Most of the business concern has no adequate working capital during
depression period. If one business concern has adequate working
capital, the specified business concern can reap more benefits.

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[Link] and Innovation Programme: No research programme,
innovation and technical developments are possible to be undertaken
without sufficient amount of working capital.

[Link] and Regular Return on Investments: Investor would always

look for a way to earn quick bucks. They also expect regular returns on
their investments. A company can pay the dividends to its shareholders
i.e. investors very quickly and regularly by maintaining sufficient amount
of working capital. This type of practice helps in obtaining confidence
among the shareholders.

[Link] Facilitated: The expansion of any type of business

programme requires additional funds. Adequate working capital
facilitates the business concern for the successful implementation of the
expansion programme.
[Link] Profitability: There should be a right proportion of fixed
assets and current assets. The maintenance of adequate working capital
ensures the right proportion of fixed assets and current assets. If so,
there is a chance of being increased profitability of the business
concern.
17.5 EXCESS WORKING CAPITAL
Excess working capital means that the working capital of a company is
higher than the norm. Working capital means the amount of current
assets that exceed the current liabilities of a company.
17.5.1 Disadvantages of Redundant or Excessive Working Capital:
a) Excessive Working Capital means idle funds which earn no profits
for the business and hence the business cannot earn a proper rate
of return on its investments.
b) 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.
c) Excessive working capital implies excessive debtors and defective
credit policy which may cause higher incidence of bad debts.
d) It may result into overall inefficiency in the organisation.
e) When there is excessive working capital, relations with banks and
other financial institutions may not be maintained. Due to low rate of
return on investments, the value of shares may also fall.
f) The redundant working capital gives rise to speculative transactions.

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17.6 INADEQUATE WORKING CAPITAL
Inadequate working capital means shortage of working capital to meet
the day-to-day operating activities of the business concern. In other
words, the quantum of inadequate working capital is the difference
between actual working capital and adequate working capital.
17.6.1 Disadvantages of Inadequate working capital:

The following are the dangers, limitations or disadvantages of

inadequate working.
a) The growth of the business concern will be stagnated. The reason
is that the business concern is not in a position to take up a
profitable venture due to unavailability of working capital funds.
b) It affects the goodwill of the company.
c) The objectives of the business concern cannot be achieved.
Moreover, average rate of return cannot be earned by the company
d) The short-term liabilities cannot be met in time.
e) Fixed assets cannot be used properly due to inadequate working
capital.
f) The market opportunities like cash discount and trade discount
cannot be availed by the business concern.
g) Sometimes, business opportunities are not utilized due to non-
availability of adequate working capital.

h) Production capacity is not used fully. It results in the low level of

production. This leads to failure to meet the regular demands.
Hence, the customers may switch over to some other products.
i) It directly affects the liquidity position of the business firm.
j) Whenever the goodwill of the company is affected, the credit
worthiness of the company is decreased to some extent among the
banks and financial institutions.
17.7 WORKING CAPITAL POLICY
Two important issues in formulating the working capital policy are:
a) What should be the ratio of current assets to sales?
b) What should be the ratio of short-term financing to long-term
financing?

225
Current Assets in Relation to sales
If the firm can forecast accurately its level and pattern of sales, inventing
usage rates, level and pattern of production, production cycle time, split
between cash sales and credit sales, collection period, and other factors
which impinge on working capital components, the investment in current
assets can be defined uniquely. In the face of uncertainty, the outlay on
current assets would consist of a base component meant to meet normal
requirement and a safety component meant to cope with unusual
demands and requirements. The safety component depends on how
conservative or aggressive is the current asset policy of the firm.
If the firm pursues a very conservative current asset policy it would carry
a high level of current assets in relation to sales. If the firm adopts a
moderate current asset policy, it would carry a moderate level of current
assets in relation to sales. Finally, if the firm follows a highly aggressive
current asset policy, it would carry low level current assets in relations to
sales. The relationship between current assets and sales under
these different current asset policies in shown in the following figure.

Conservative

Moderate
Current Assets

Aggressive

Sales

Fig. Various Current Asset Policies

Figure 17- Working Capital Policy
A conservative current asset policy tends to reduce risk. The surplus
current asset under this policy enable the firm to cope rather easily
with variations in sales, production plans, and procurement time.
An aggressive current asset policy, seeking to minimise the investment
in current assets, exposes the firm to greater risk. The firm maybe
unable to cope with unanticipated charges in the market place and
operating conditions.

Ratio of Short-Term Financing To Long-Term Financing

Current assets of a firm are supported by spontaneous current liabilities
(trade creditors and provisions), short-term bank financing, and long-
term sources of finance (debentures and equity, in the main).

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The two broad policy alternatives, in this respect, are:
(a) a conservative current asset financing policy
(b) an aggressive current asset financing policy.

A conservative current asset financing policy relies less on short-term

bank financing and more on long-term sources like debentures. Indeed,
a highly conservative current asset financing policy would seek to
replace even long-term debt by equity. An aggressive current asset
financing policy, on the other hand, relies heavily on short-term bank
finance and seeks to reduce dependence on long-term financing.

An aggressive current –asset financing policy, relying more on short-

term bank financing, tends to have the opposite effects. It exposes the
firm to a higher degree of risk, but reduces the average cost of financing.

Choosing the Working Capital Policy

The overall working capital policy, adopted by the firm may broadly
be conservative, moderate, or aggressive. A conservative overall
working capital policy means that the firm chooses a conservative
current asset policy along with a conservative current asset financing
policy. A moderate overall working capital policy reflects a combination
of a conservative current asset policy and an aggressive current asset
financing policy or a combination of an aggressive current asset policy
and a conservative Current asset financing policy.

An aggressive overall working capital policy consists of an aggressive

current asset policy and an aggressive current asset financing policy.
17.7.1 Factors Determining Working Capital
i) Nature and Size of Business
The working capital need of a business depends a great deal on its
nature and size. Let’s consider various types of businesses to
understand how the nature of business impacts its working capital
requirements. When it comes to trading firms, they require less amount
of money to be invested in fixed assets. However, a huge pool of funds
needs to be invested in the form of working capital. On the other hand,
retail stores must keep a large quantity of inventory to meet the
diversified and continuous needs of its customers. Similarly, the need for
working capital in manufacturing firms varies between small to a
substantial amount. This working capital amount depends upon the type
of business a firm is into. Likewise, public utility firms require less
working capital but invest heavily in fixed assets. This is because they
have cash sales only and supply services over products. Hence, they

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have fewer funds blocked in current assets such as debtors and
inventories.
Finally, the size of the business also impacts the working capital needs
of the business. Firms with large scale operations need more working
capital as compared to smaller firms.
ii) Business Cycle

Business cycle too has a significant impact on the working capital needs
of a business. During the boom phase of the business cycle, businesses
typically tend to expand thus requiring additional working capital. These
periods of increased business activity require additional funds to meet
the time lag between collection and sales. Further, funds are also
needed to purchase additional raw material needed to produce
additional goods for increased sales.
Not only that, the peak period leads to the increased prices of raw
material and increased wages. Thus, additional funds are needed to
provide for such operational expenses.
In contrast, there is lesser demand leading to both the decline of
production and sale of goods during periods of depression. Thus, less
amount of working capital is required by the business to carry out its
operational activities.
iii) Production Cycle

Production cycle, also known as the operating cycle, is the time

difference between the conversions of raw materials into final products.
This too impacts the working capital requirements of a business to a
greater extent.
Businesses with longer production cycles need more working capital to
fund its operational activities. Therefore, firms adopt various measures
to reduce their production cycle in order to minimize their working capital
requirements.
iv)Seasonal Fluctuations

There are certain businesses that are seasonal in nature. This means
there is a high demand for their goods during a specific period of the
year. In such cases, inventory of raw material needs to be purchased
during a specific period of time. This is done so that goods are produced
and are offered for sale when they are needed.

Thus, the need for inventory increases during this period as compared to
the other periods of the year. Therefore, businesses need additional

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funds to purchase inventories during the specific time of the year. As a
result, the seasonality of business impacts the working capital
requirements of the business.

v) Operational Efficiency
Various businesses operate on different operational efficiencies. Thus,
the operational efficiency of a business depends upon various factors.
These include:
a) Short production cycles that involve less time to convert raw
material into finished goods

b) Achieving sales quickly

c) The shorter debt collection period
Thus, businesses with increased operational efficiency are required to
invest a lesser amount of funds in working capital. In contrast,
businesses that has lesser operational efficiency need more funds to be
invested in working capital.
17.8 WORKING CAPITAL CYCLE / OPERATING CYCLE
Working Capital Cycle or popularly known as operating cycle, is the
length of time between the outflow and inflow of cash during the
business operation. It is the time taken by the firm, for the payment of
materials, wages and other expenses, entering into stock and realizing
cash from the sale of the finished good.

Working Capital Cycle is Time required for converting, Raw materials in

to work –in-progress, work- in progress in to finished goods, Finished
goods into Receivable, Receivable into cash
In short, the working capital cycle is the average time required to invest
cash in assets and reconverting it into cash by selling the assets
produced.
The working capital cycle may vary from enterprise to enterprise
depending on various factors, such as nature and size of business,
production policies, manufacturing process, fluctuations in trade cycle,
credit policy, terms and conditions for purchase and sales, etc.

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 Figure 17.2 - Working Capital Cycle / Operating Cycle
Problem1
Prepare an estimate of working capital, from the following,

Expected level of production for the year 15600 units

Cost per unit

Raw material Rs.90

Direct Labour Rs.40

Overheads Rs.75

Selling Price per unit Rs.265

Raw materials in stock on an average for one month

Materials are in process on an average for 2 weeks

Finished goods in stock on an average for 4 weeks

Period of credit allowed from debtors 8 weeks

Lag in payment of wages:1.5 weeks (one and half weeks)

Period of credit allowed by creditors: 4 weeks

Lag in payment of Overheads :4 weeks (all sales are on credit)

Cash in hand and at Bank Rs.60,000

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It is assumed that production is carried on evenly throughout the year.
Solution
WORKING CAPITAL STATEMENT

Particulars Amount Amount

Current assets:

Stock:

Raw material 15000x90x4/52 1,08,000

Work in Progress

Raw material 15000x90x2/52=54,000

Labour 15000x20x2/52=12,000

Overheads 15600x37.50x2/52=22,500 88,500

Finished goods 2,46,000

4,42,500

Cash in hand 60,000

Debtors 15,600x205x8/52 4,92,000

Total current assets 9,94,500

(-) Current liabilities

Creditors 15,600x90x4/52=1,08,000

Outstanding wages 15,600x40x1.5/52=18,000

Outstanding 15,600x75x4/52=90,000
sales: overheads

Total current Liabilities 2,16,000

Working capital 9,94,500-2,16,000 7,78,500

(Total Current Assets –
Total Current Liabilities)

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Problem.2
Calculate estimated working capital from the following particulars.

Annual expenses:

a) Wages 52,000
b) Stores & Materials 9600
c) Office salaries 12,480
d) Rent 2000
e) Other exp 9600

Average amount of stock to be maintained:

Stock of finished goods 1000

Stock of materials & stores 1600

Expenses paid in advance:

Quarterly advances 1600

Annual sales:
Home market 62,400
Foreign market 15,600

Lag in payment of all expenses

a) Wages 52,000

b) Stores & Materials 9600

c) Office salaries 12,480
d) Rent 2000
e) other exp. 9600

Credit allowed to customer:

For home market 6 weeks
Foreign market 1.5 weeks

Expenses paid in advance:

Quarterly advances 1600

Annual sales:
Home market 62,400
Foreign market 15,600

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Solution
STATEMENT OF WORKING CAPITAL REQUIREMENT

Current Assets Amount Amount

Stocks:
Stock of finished goods 1,000
Stock of materials & stores 1,600 2,600
Debtors:
For home market 62,400x6/52=7200
For foreign market 15,600x1.5/52=450 7,650
Prepaid expenses 1,600x3/12 400
Total current assets 10,650
(-) Current Liability:
Creditors 9,600x1.5/12 1,200
(Stores and materials)
Outstanding expenses:
Wages 5,200x1.5/52 1,500
Office salaries 12,480x.5/12 520
Rent 2,000x6/12 1,000
Other expenses 9,600x1.5/12 1,200
Total outstanding expenses 4,220
Total current liabilities 5,420
Working capital 10,650-5,420 5,230
(Total Current Assets –
Total Current Liabilities)

LET US SUM UP
Management of working capital is an essential task of the finance
manager. He has to ensure that the amount of working capital available
is neither too large nor too small for its needs. A large amount of working
capital would mean that the company has idle funds. Since funds have a
cost, the company has to pay huge amount as interest on such funds. If
the firm has inadequate working capital, such firm runs the risk of
insolvency. Paucity of working capital may lead to a situation where the
firm may not be able to meet its liabilities. Working capital is required for
smooth functioning of the business of an entity as lack of this may
interrupt the ordinary activities. Hence, the working capital needs
adequate attention and efficient management.

233
CHECK YOUR PROGRESS

Choose the Correct Answers:

1. Working capital is also known as________ capital.
a) current asset b) Operating
c) Projecting d) Operation capital
2. Working capital is calculated as ________.
a) Core current assets less core current liabilities
b) Current assets less current liabilities
c) Core current assets less current liabilities
d) Liquid assets less current liabilities
3. Permanent working capital ___________.

a) Varies with seasonal needs.

b) Includes fixed assets.
c) Is the amount of current assets required to meet a firm's long-
term minimum needs
d) Includes accounts payable.
4. Operating cycle is also called as _________.
a) Working cycle b) Business cycle
c) Current asset cycle d) Working capital cycle
5. Working capital management consisting of _____________.

a) Receivable management b) Inventory management

c) Cash management d) All of the above
GLOSSARY

Current Assets : Current assets are all the assets of a

company that are expected to be sold or
used as a result of standard business
operations over the next year.
Current assets include cash, cash
equivalents, accounts receivable, stock
inventory, marketable securities, pre-paid
liabilities, and other liquid assets.

Current Liabilities : Current liabilities are a company's debts

or obligations that are due to be paid to
creditors within one year.

234
Working Capital : Working capital refers to the amount
which the company requires with the
purpose of financing the day to day
operation

Operating Cycle : The operating cycle is the average period

of time required for a business to make an
initial outlay of cash to produce goods, sell
the goods, and receive cash from
customers in exchange for the goods

Adequate Working : Adequate working capital means an

Capital amount of working capital sufficient to
meet day to day operation activities of the
business concern under normal situations.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
[Link]
7. [Link]
financing/objectives-of-working-capital-management
8. [Link]
working-capital-meaning-types-factors/

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) b 3) c 4) d 5) d

235
Unit 18

CASH MANAGEMENT
STRUCTURE

Overview
Learning Objectives
18.1 Introduction to Cash Management: Concept, Importance

18.1.1 Motives for Holding Cash

18.1.2 Factors Determining Cash Needs
18.2 Determination of Optimum Cash Balance
18.2.1 Cash Budget
18.2.2 Cash Management Models
18.3 Basic Strategies of Cash Management

18.4 Cash Management: Techniques

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your Progress

OVERVIEW
Cash is the lifeblood of a business, and a business needs to generate
enough cash from its activities so that it can meet its expenses and have
enough left over to repay investors and grow the business. While a
company can fudge its earnings, its cash flow provides an idea about its
real health. Cash Management refers to the day-to-day administration of
managing cash inflows and outflows. Because of the multitude of cash
transactions on a daily basis, they must be managed. The ultimate goal
of cash management is to maximize liquidity and minimize the cost of
funds. A company has to generate adequate cash flow from its business
in order to survive, meaning it is able to cover its expenses, repay
investors, and expand the business. In addition to generating cash from
its activities, a business also needs to manage its cash situation so that
it holds the right amount of cash to meet its immediate and long-term
needs. Cash management is a broad area having to do with the

236
collection, concentration, and disbursement of cash including measuring
the level of liquidity, managing the cash balance, and short-term
investments. Efficient cash management means more than just
preventing bankruptcy. It improves the profitability and reduces the risk
the firm is exposed to.
18.1 CASH MANAGEMENT

Cash management as the word suggests is the optimum utilization of

cash to ensure maximum liquidity and maximum profitability. It refers to
the proper collection, disbursement, and investment of cash. For a small
business, proper utilization of cash ensures solvency. Hence, cash
management is a vital business function; it is a function that manages
the collection and utilization of cash. Management needs to ensure that
there is adequate cash to meet the current obligations while making sure
that there are no idle funds. This is very important as businesses depend
on the recovery of receivables. If a debt turns bad (irrecoverable debt) it
can jeopardize the cash flow. Therefore, cash management is also about
being cautious and making enough provision for contingencies like bad
Debts, Economic Slowdown, Etc.
18.1.1 Motives for Holding Cash
There are four primary motives for maintaining cash balances:
i) Transaction Motive
ii) Precautionary Motive
iii) Speculative Motive
iv) Compensating Motive
a) Transaction Motive: An important reason for maintaining cash
balances is the transaction motive. This refers to the holding of cash, to
meet routine cash requirements to finance the transaction which a firm
carries on in the ordinary course of business. A firm enters into a variety
of transaction to accomplish its objectives which have to be paid for in
the form of cash. For e.g.: cash payments have to be made for
purchase, wages, operating expenses, financial charges, like interest,
taxes, dividends and so on.
b) Precautionary Motive: In addition to the non-synchronisation of
anticipated cash inflows and outflows on the ordinary course of
business, affirm may have to pay cash for purposes which cannot be
predicted or anticipated. The unexpected cash needs at short notice
may be the result of

237
 (i) Floods, strikes and failure of important customers.
(ii) Bills may be presented for settlement earlier than expected.
(iii) Unexpected slowdown in collection of accounts receivable
(iv) Sharp increase in cost of raw materials.
Precautionary motive of holding cash implies the need to hold cash to
meet unpredictable obligations. Thus, precautionary cash balance serve
as to provide a cushion to meet unexpected contingencies.
c) Speculative Motive: It refers to the desire of a firm to take
advantages of opportunities which present themselves at unexpected
moments and which are typically outside the normal course of business.
The speculative motive helps to take advantages of
(i) An opportunity to purchase raw materials at a reduced price on
payment of immediate cash.
(ii) A chance to speculative on interest rate movements by buying
securities when interest rates are expected to decline.
(iii) Delay purchases of raw materials on the anticipation of decline
in prices.
(iv) To make purchases at favourable prices.
d) Compensation Motive: Yet another motive to hold cash balances is
to compensate banks for providing certain services and loans. Banks
provide a variety of services to business firms, such as clearance of
cheque, supply of credit information, transfer of funds, etc. While for
some of the services banks charge a commission or fee, for others they
seek indirect compensation. Compensating balances are also required
by some loan agreements between a bank and its customers.
18.1.2 Factors Determining Cash Needs
a) Synchronisation of cash flows: The need for maintaining cash
balances arises from the non-synchronisation of the inflows and outflows
of cash; if the receipts and payments of cash perfectly coincide or
balance each other, there would be no need for cash balance.

b) Short costs: Another general factor to be considered in determining

cash needs is the cost associated with a short fall in the firm’s cash
needs. The cash presented in the cash budget would reveal periods of
cash shortages. In addition, there may be some unexpected short falls.
Expenses incurred as a result of short fall are called short costs. It
includes
(i) Transaction costs
(ii) Borrowing costs

238
 (iii) Loss of trade-discount
(iv) Cost associated with deterioration of the firm’s credit rating
(v) Penalty rates by banks to meet a short fall in compensating
balances.
c) Excess Cash Balance Costs: Another consideration in determining
cash needs are the cost associated with maintaining excess / idle cash.
The cost of having excessively large cash balances is known as excess
cash balance cost. If large funds are idle, the implication is that the firm
has
missed opportunities to invest those funds and has thereby cost interest
which it would otherwise have earned.
d) Procurement and Management: These are the costs associated
with establishing and operating cash management staff and activities.
They are generally fixed and are mainly accounted for by salary,
storage, handling of securities, etc.
18.2 DETERMINATION OF OPTIMUM CASH BALANCE
A firm has to maintain a minimum amount of cash for setting the dues in
time. The cash is needed to purchase raw materials, pay creditors, day
to day expenses, dividend, etc. Some cash will be needed for
transaction needs and amounts may be kept as safety stock. An
appropriate amount of cash balance to be maintained should be
determined on the basis of past experience and future expectations. If a
firm maintains less cash balance, then its liquidity position will be weak.
If higher cash balance is maintained then an opportunity to earn is lost.
Thus, a firm should maintain an optimum cash balance, neither a small
nor a large cash balance. There are basically two approaches to
determine an optimal cash balance, namely
a) Cash budget and
b) Minimizing cost models.
18.2.1 Cash Budget
Cash budget is the most important tool in cash management. A cash
budget is an estimate of cash receipts and disbursements of cash during
a future period of time. It is a forecast of expected cash intake and
outlay. It is a device to plan and control the use of cash. It is a
statement showing the estimated cash inflows and cash outflows over
the planning horizon. In other words, the net cash position (surplus or
deficiency) of a firm as it moves from one budgeting sub period to
another is highlighted by the cash budget. The various purposes of cash
budget are: (i) to coordinate the timings of cash needs. (ii) it pinpoints

239
the period(s) when there is likely to be excess cash; (iii) it enables a firm
which has sufficient cash to take advantage of cash discounts on its
accounts payable, to pay obligations when due, to formulate dividend
policy, to plan financing of capital expansion and to help unify the
production schedule during the year so that the firm can smooth out
costly seasonal fluctuations; finally, (iv) it helps to arrange needed funds
on the most favourable terms and prevents the accumulation of excess
funds.
Preparation of Cash Budget

The preparation of a cash budget involves various steps. The first

element of a cash budget is the selection of the period of time to be
covered by the budget. It is referred to as a the planning horizon. The
planning horizon means the time span and the sub periods within that
time span over which the cash flows are to be projected. As a general
rule, the period selected should be neither too long nor two short. As a
general rule, the period selected should be neither too long nor two
short. The second element of the cash budget is the selection of the
factors that have a bearing on cash flows.
The cash receipts from various sources are anticipated. The estimated
cash collections for sales, debts, bills receivables, interests, dividends
and other incomes and sale of investments and other assets will be
taken into account. The amount to be spent on purchase of materials,
payment to creditors and meeting various other revenue and capital
expenditure needs should be considered. Cash forecasts will include all
possible sources from which cash will be received and the channels in
which payments are to made so that a consolidated cash position is
determined. The preparation of cash budget has been explained in the
following example.
To include the steps involved in preparation of cash budget.
Example
From the following forecast of income and expenditure, prepare a cash
budget for the months January to April, 2003.

240
 Sales Purc. Manf. Admn. Selling
Wages
Months (Credit) (Credit) Exps. Exps. Exps.
Rs.
Rs. Rs. Rs. Rs. Rs.

2002

Nov. 30,000 15,000 3,000 1,150 1,060 50

Dec. 35,000 20,000 3,200 1,225 1,040 550

2003

Jan. 25,000 15,000 2,500 990 1,100 600

Feb. 30,000 20,000 3,000 1,050 1,150 620

March 35,000 22,500 2,400 1,100 1,220 570

April 40,000 25,000 2,600 1,200 1,180 710

Additional information is as follows:

i) The customers are allowed a credit period of 2 months.
ii) A dividend of Rs.10,000 is payable in April.
iii) Capital expenditure to be incurred: Plant purchased on
15thJanuary for Rs. 5,000; a Building has been purchased on
1st March and payments are to be made in monthly
instalments of Rs.2, 000 each.
iv) The creditors are allowing a credit of 2 months
v) Wages are paid on 1st of next month
vi) Lag in payment of other expenses is one month
vii) Balance of cash in hand on 1st January, 2003 is Rs.15,000.
Solution
Cash Budget

For months from January to April, 2003

Details January February March April

Rs. Rs. Rs. Rs.

Receipts
Opening Balance of Cash 15,000 18,985 28,795 30,975
Cash realized from Debtors 30,000 35,000 25,000 30,000

241
Cash available (A) 45,000 53,985 53,795 60,975
Payments
Payments to customers 15,000 20,000 15,000 20,000
Wages 3,200 2,500 3,000 2,400
Manufacturing Expenses 1,225 990 1,050 1,100
Administrative Expenses 1,040 1,100 1,150 1,220
Selling Expenses 550 600 620 570
Payment of Dividend 10,000
Purchase of Plant 5,000
Instalments of Building Loan 2,000 2,000
Total Payments (B) 26,015 25,190 22,820 37,290
Closing Balance 18,985 28,795 30,975 23,685
(A) - (B)

18.2.2 Cash Management Models

A number of mathematical models have also been developed to
determine the optimal cash balance as a) Operating Cycle Model; b)
Inventory Model; c) Stochastic Model; and d) Probability Model.
However, the inventory model developed by William [Link] and
stochastic model of [Link] Daniel Orr are mainly used to
determine the optimum balance of cash.
a) William [Link]’s Model
William [Link] developed a model which is usually used in inventory
management but has its application in determining the optimal cash
balance. The Baumol Model is similar to the Economic Order Quantity
(EOQ) Model. Mathematically it is: The basic objective of the Baumol
model is to determine the minimum cost amount of cash conversion and
the lost opportunity cost. It is a model that provides for cost efficient
transactional balances and assumes that the demand for cash can be
predicated with certainty and determines the optimal conversion size.
When the cash balance touches the upper control limit (h), marketable
securities are purchased to the extent of hzto return back to normal level
of cash balance of z. In the same manner when the cash balance
touches lower control limit (o), the firm will sell the marketable securities
to the extent of oz to again return to the normal level of cash balance.
The firm sets the lower control limit as per its requirement of maintaining
minimum cash balance. At what distance the upper control limit will be

242
 set? The difference between the upper limit and the lower limit depends
on the following factors:
a) transaction cost (c)
b) interest rate (i)
c) Standard deviation 𝜎of net cash flows.

The Baumol model is based upon the following assumptions:

i)
The cash needs of the firm are known with certainty
ii)
The cash disbursements of the firm occurs uniformly over a period of
iii)
time and is known with certainty
iv)The opportunity cost of holding cash is known and it remains
constant.
v) The transaction cost of converting securities into cash is known and
remains constant.
The Baumol model can also be represented algebraically

2𝐴𝐹
Where C=√
𝑂

C = Optimum balance
A= Annual cash disbursements or monthly disbursements
F = Fixed cost per transaction
O = Opportunity cost of holding cash.

Example

Advani chemical limited estimates its total cash requirements as Rs.2

crores next year. The company’s opportunity cost of funds is 15% per
Annum. The Company to incur Rs.150 per transaction when it converts
its short-term securities to cash. Determine the optimum cash balance.

243
Solution
2𝐴𝐹
C=√
𝑂
2(150)(2,00,000)
C=√ =Rs 2,00,000
0.15

Miller-Orr Model (MO Model)

Baumol’s model is based on the basic assumption that the size and
timing of cash flows are known with certainty. This usually does not
happen in practice. The cash flows of a firm are neither uniform nor
certain. The Miller and Orr model overcomes the shortcomings of
Baumol model. M.H. Miller and Daniel Orr expanded on the Baumol
model and developed stochastic model for firms with uncertain cash
inflows and cash outflows. The Miller and Orr(MO) Model provides two
control limits the upper control limit and the lower control limit along with
a return point as shown in the figure below.

The formula for determining the distance between upper and lower
control limits (called Z) is as follows:
(Upper Limit - Lower Limit)
3 Transaction Cost x Cash Flow Variance
Z= ×
4 Interest Rate
3 𝑐𝜎 2 1/3
Z=( × )
4 𝑖
We can notice from eq. (8) that the upper and lower limits will be far off
from each other (i.e. Z will be larger) if transaction cost is higher or cash
flows show greater fluctuations. The limits will come closer as the
interest increases. Z is inversely related to the interest rate. It is
noticeable that the upper control limit is three times above the lower
control limit and the return point lies between the upper and the lower
limits. Thus,

Upper Limit = Lower Limit + 3Z

Return Point = Lower Limit + Z

244
The Net effect is that the firms hold the average cash balance equal to:
Average Cash Balance = Lower Limit + 4/3Z
This model was suggested by Miller Orr. This model is to determine the
optimum cash balance level which minimises the cost of management of
cash. Miller-Orr Model can be
Example:

A Company has a policy of maintaining a minimum cash balance of

Rs.1,00,000. The standard deviation is daily cash balance is Rs.10,000.
The interest rate on Daily basis is 0.01%. The transaction cost for each
sale or purchase of securities is Rs.50. Compute the upper Control limit
and the return point as per the Miller –Orr Model
Solution:

Spread between the upper and lower cash balance (z)

3 Transaction Cost x Cash Flow Variance
Z= ×
4 Interest Rate

33 50 × (10000)2
√ ×
4 0.001

=Rs.1,00,415

Thus, the upper control limit of cash balance is

= Rs.1,00,000 + 1,00,415 = Rs. 2,00,415
And, the return point is
𝑆𝑝𝑟𝑒𝑎𝑑
=Lower Limit+
3
1,00,415
=Rs.1,00,000+
3
18.3 BASIC STRATEGIES OF CASH MANAGEMENT

The cash management strategies are intended to minimize the operating

cash balance requirement. The basic strategies that can be employed
to do the needful are:

a) Stretching Accounts Payable

b) Efficient Inventory – Production Management
c) Speedy collection of Accounts Receivable
d) Combined Cash Management Strategies
a) Stretching Accounts Payable: One basic strategy of efficient cash
management is to stretch the accounts payable. In other words, a firm

245
should pay its accounts payable as late as possible without damaging its
credit
standing.

b) Efficient Inventory – Production Management: Another strategy is

to increase the inventory turn-over rate, avoiding stock-outs, shortage of
stock. This can be done in the following ways:

(i) Increasing the raw materials turn-over by using more efficient

inventory control technique
(ii) Decreasing the production cycle through better production
planning, scheduling and control techniques; it will lead to an
increase in the work-in-process inventory turn-over.
(iii) Increasing the finished goods turnover through better forecasting of
demand and a better planning of production.
c) Speedy Collection of Accounts Receivable: Yet another strategy
for efficient cash management is to collect accounts receivable as
quickly as possible without losing future sales because of high pressure
collection technique. The average collection period receivables can be
reduced by changes in (1) credit terms, (2) credit standards, and (3)
collection policies.
d) Combined Cash Management Strategies: We have shown the
effect
of individual strategies on the efficiency of cash management. Each one
of them has a favourable effect on the operating cash requirement.
18.4 CASH MANAGEMENT: TECHNIQUES
a) Speedy Cash Collection: There are two broad approaches to do
this. In the first place, the customers should be encouraged to pay as
quickly as possible. Secondly, the payment from customers should be
converted into cash without any delay.
b) Prompt Payment by Customers: One way to ensure prompt
payment by customers is prompt billing. What the customer has to pay,
the period of payment, etc. should be notified accurately and in advance.
The use of mechanical devices for billing along with the enclosure of a
self-addressed return envelope will speed up payment by customers.
The other important technique to encourage prompt payment by
customer, is the practice of offering trade discounts.
c) Early Conversion of payment in to Cash: Once the customer
makes the payment by writing a cheque in favour of the firm, the
collection can be expedited by prompt encashment of the cheque. It will

246
be recalled that there is a lag between the time a cheque is prepared
and mailed by the customer and the time the funds are included in the
cash reservoir of the firm. Within this time interval, three steps are
involved,
i) Transit or Mailing Time: The time taken by the post offices to
transfer the cheque from the customers to the firm. This delay or
lag is referred to as postal float.
ii) Time taken in processing the cheque within the firm before they are
deposited in the banks, termed as lethargy.
iii) Collection time within the bank. The time taken by the bank in
collecting the payment from the customer’s bank. This is called
bank float.

The early conversion of payments into cash, as a technique to speed up

collection of accounts receivable, is done to reduce the time lag between
posting of the cheque by the customers and the realization of money by
the firm. The postal float, lethargy and bank float are collectively
referred to as deposit float.
d) Concentration Banking: In this system of decentralized collection of
accounts receivable, large firms which have a large number of branches
at different places, select some of these which are strategically located
as collection centres for receiving payments from customers. Under this
arrangement the customers are required to send their payments to the
collection centre covering the area in which they live and these are
deposited in the local account of the concerned collection centre, after
meeting local expenses, if any.
e) Lock-Box System: Under this arrangement, firms hire a post office
box at important collection centres. The customers are required to remit
payments to the lock-box. The local banks of the firm, at the respective
places, are authorized to open the box and pick up the remittances
(cheques) received from the customers.
f) Slowing Disbursements: Apart from speedy collection of accounts
receivable, the operating cash requirement can be reduced by slow
disbursement of accounts payable. There are several techniques to
delay payment of accounts payable,
i) Avoidance of early payments
ii) Centralised disbursements
iii) Floats
iv) Accruals

247
g) Avoidance of early payments: One way to delay payments is to
avoid early payments. According to the terms of credit, a firm is required
to make a payment within a stipulated period.

h) Centralized Disbursements: Another method to slow down

disbursements is to have centralized disbursements. All the payments
should be made by the head office from a centralised disbursement
account. Such an arrangement would enable a firm to delay payments
and conserve cash for several reasons.
i) Float: A very important technique of slow disbursements is float. The
term float refers to the amount of money tied up in cheques that have
been written, but have yet to be collected and encashed. Alternatively,
float represents the difference between the bank balance and book
balance of cash of a firm.
j) Accruals: Finally, a potential tool for stretching account payable is
accruals which are defined as current liabilities that represent a service
or goods received by a firm but not yet paid for. The longer the period
after which payment is made, the greater the amount of free financing
and the smaller the amount of cash balances required.
LET US SUM UP

In this unit, we have discussed in detail about Cash Management. Cash

management is one of the key areas of working capital management.
There are four motives for holding cash: Transaction motive,
Precautionary motive, Speculative motive and Compensating motive.
There are two approaches to derive an optimal cash balance: minimizing
cash cost models and Cash budget. The important models are Baumol
Model, Miller – Orr Model. Cash budget is probably the most important
tool in cash management. The cash management strategies are
intended to minimize the operating cash balance requirement.
CHECK YOUR PROGRESS
Choose the Correct Answers:

[Link] management is related to ___________.

a) Receivable management b) Inventory management
c) Cash management d) All of the above

248
2. Optimum utilization of cash to ensure maximum liquidity and
maximum profitability ________.
a) Cash management b) Inventory management

c) Receivable management d) All of the above

3. ________is an estimate of cash receipts and disbursements of cash
during a future period of time Varies with seasonal needs.

a) Fixed Budget b) Cash Budget

c) Flexible Budget d) Master Budget
4.___________refers to the desire of a firm to take advantages of
opportunities which present themselves at unexpected moments and
which are typically outside the normal course of business.
a) Transaction Motive b) Precautionary Motive

c) Speculative Motive d) Compensating Motive

5. ___________refers to the holding of cash, to meet routine cash
requirements to finance the transaction which a firm carries on in the
ordinary course of business.
a) Transaction Motive b) Precautionary Motive
c) Speculative Motive d) Compensating Motive
GLOSSARY

Cash management : Cash management is a vital business

function; it is a function that manages
the collection and utilization of cash.
Management needs to ensure that
there is adequate cash to meet the
current obligations while making sure
that there are no idle funds.

Cash Budget : Is an estimate of cash receipts and

disbursements of cash during a future
period of time Varies with seasonal
needs.

Transaction Motive : Refers to the holding of cash, to meet

routine cash requirements to finance
the transaction which a firm carries on
in the ordinary course of business.

249
Speculative Motive : Refers to the desire of a firm to take
advantages of opportunities which
present themselves at unexpected
moments and which are typically
outside the normal course of business

Precautionary Motive : A desire to hold cash in order to be

able to deal effectively with unexpected
events that require cash outlay.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
management/cash-management/33389
7. [Link]
management/2-models-of-cash-management-with-calculations-
working-capital/68120
8. Cash: Nature and Motives for Holding It | Working Capital
([Link])
ANSWERS TO CHECK YOUR PROGRESS
1) c 2) a 3) b 4) c 5) a

250
Unit 19

RECEIVABLES MANAGEMENT
STRUCTURE

Overview
Learning Objectives
19.1Introduction to Management of Receivables

19.1.1 Objectives or Features of Receivable Management

19.1.2 Nature of Receivable Management
19.1.3 Importance and Function of Receivable Management
19.1.4 Scope of Receivable Management
19.2 Cost association with accounts receivables
19.3 Benefits from credit sales

19.4 Decision areas in Receivables Management

19.4.1 Credit Policies
19.4.2 Credit Terms

19.4.3 Collection Policies

19.5 Factors Considering the Receivable Size
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your Progress

OVERVIEW
Receivables management is the process of making decisions relating to
investment in trade debtors. Receivable is necessary to increase the
sales and the profits of a firm. The objective of receivables management
is to take a sound decision as regards investment is debtors. There are
three crucial decision areas in receivables management: Credit policies,
Credit terms and Collection policies. Every enterprise needs inventory
for smooth running of its activities. The investment in inventories
constitutes the most significant part of current assets, in most of the
undertakings. A firm should maintain an optimum level of inventory. This

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unit will focus on all issues related receivables and inventory
management.
LEARNING OBJECTIVES

After completing this unit, you should be able to;

• explain the meaning of receivables management.
• discuss the costs and benefits associated with extension of trade
credit.
• describe the decision areas in receivables management.
• define the meaning of inventory management.
• list out the objectives of inventory management.
• enumerate the inventory control techniques.
19.1 INTRODUCTION TO MANAGEMENT OF RECEIVABLES

Receivable management is a process of managing the account

receivables within a business organisation. Account receivables simply
mean credit extended by the company to its customers and are treated
as liquid assets. It involves taking decisions regarding the investment to
be made in trade debtors by organisation. Deciding the proper amount
be lent by the company to its customers in the form of credit sales is
quite important. It affects the overall cash availability for undertaking
various operations. Receivable management business ensures that a
sufficient amount of cash is always maintained within the business so
that operations can continue uninterrupted. It helps in deciding the
optimum proportion of credit sales. The overall process of receivable
management involves properly recording all credit sales invoices,
sending notices on due date to collection department, recording all
collections, calculation of outstanding interest on late payments etc.
Receivable management aims at raising the sales volumes and profit of
the business by managing and providing credit facilities to customers. A
proper receivable management process aims at monitoring and
avoidance of occurrence of any overdue payment and non-payment. It is
an effective way of improving the financial and liquidity position of the
company. Credit facilities are important for attracting and retaining
customers and this makes management of credit facilities by business
crucial. Objectives of receivable management are as follows:
The term receivable is defined as debt owed to the concern by
customers arising from sale of goods or services in the ordinary course
of business. Receivables are also one of the major parts of the current
assets of the business concerns. It arises only due to credit sales to
customers; hence, it is also known as Account Receivables or Bills

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Receivables. Management of account receivable is defined as the
process of making decision resulting to the investment of funds in these
assets which will result in maximizing the overall return on the
investment of the firm.
The objective of receivable management is to promote sales and profit
until that point is reached where the return on investment in further
funding receivables is less than the cost of funds raised to finance that
additional credit.
The receivables represent an important component of current assets of
a firm. The term receivables is defined a” debt owed to the firm by
customers arising from sale of goods or services in the ordinary course
of business. When a firm makes an ordinary sale of goods or services
and does not receive payment the firm grants trade credit and creates
accounts receivable which would be collected in the future.
Receivables management is also called trade credit management. Thus,
accounts receivable represents an extension of credit to customers,
allowing them a reasonable period of time in which to pay for the goods
which they have received.
The objective 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 cost. The specific costs and benefits which are
relevant to the determination of the objectives of receivables
management are examined below.
19.1.1Objectives or Features of Receivable Management
1. Monitor and Improve Cash Flow: Receivable management
monitors and control all cash movements of organisations. It
maintains a systematic record of all sales transactions. Receivable
management helps business in deciding appropriate investment in
trade debtors. It aims that a sufficient amount of cash needed for
day-to-day activities is maintained at business. Credit facilities are
extended by doing proper analysis and planning to ensure optimum
cash flow in a business organisation.
2. Minimises bad debt losses: Bad debts are harmful to
organisations and may lead to heavy losses. Receivable
management takes all necessary steps to avoid bad debts in
business transactions. It designs and implement schedules for
collection of outstanding amounts timely and informs the collection

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 department on due dates. Customers are notified for amount
standing against them and charges interest on delay in payments.
3. Avoids invoice disputes; Receivable management has an
efficient role in avoiding any disputes arising in business. Disputes
adversely affect the relationship between customers and business
organisations. Complete and fair record of all transactions with
customers is maintained on a daily basis. There is no chance of
confusion and dispute arising as all sales transactions are
accurately maintained. Automated receivable management systems
present full evidence in a short time in case of dispute arising for
resolving them.
4. Boost up sales volume: Receivable management increase the
sales and the profitability of the organisation. By extending the
credit facilities to their customers business are able to boost up their
sales volume. More and more customers are able to do
transactions with the business by purchasing products on a credit
basis. Receivable management helps business in managing and
deciding their investment in credit sales. This leads to increase in
the number of sales and profit level.
5. Improve customer satisfaction: Customer satisfaction and
retention are key goals of every business. By lending credit, it
supports financially weaken customers who can’t purchase
business products fully on a cash basis. This strengthens the
relationship between customer and organisation. Customers are
happy with the services of their business partners. Receivable
management help in organising better credit facilities for their
customers.
6. Helps in facing competition: Receivable management helps in
facing stiff competition in the market. Several competitors existing in
market offers different credit options to attract more and more
customers. Receivable management process analysis all
information about market and helps the business in farming its
credit lending policies. Customers are provided better services by
extending credit at convenient rates. Appropriate amount and rates
of credit transactions can be easily decided through receivable
management process. All credit and payment terms are decided for
every customer as per their needs.

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19.1.2 Nature of Receivable Management
1. Regulate Cash Flow: Receivable management regulates all cash
flows in an organization. It controls all inflow and outflow of funds
and ensure that an efficient amount of cash is always available.
Proper management of receivables enables organizations in
efficient functioning at all the times.

2. Credit Analysis: It performs proper analysis of customer

credentials for determining their credit ratings. Monitoring and
scanning of customers before provide them any credit facility helps
in minimizing the credit risk.
3. Decide Credit Policy: Receivable management decides the credit
policy and standards as per which credit facility should be
extended to customers. A company may have a lenient credit
policy where customer credit-worthiness is not at all considered or
a stringent policy where credit-worthiness is considered for
providing credit.
4. Credit Collection: Receivable management focuses on efficient
and timely collection of business payments from its customers. It
works towards reducing the time gap in between the moments
when bills are raised and payment is collected.
5. Maintain Up-to-date Records: Receivable management
maintains a systematic record of all business transactions on a
regular basis. All transactions are maintained fairly in the form of
proper billing and invoices which helps in avoiding any confusion or
settling of disputes arising later.
19.1.3 Importance and Function of Receivable Management
1. Evaluates Customer Credit Ratings: Receivable management
evaluates its customers borrowing capacity and repaying ability
for determining their credit ratings. It approves any credit facility
to its customers after analysing their information both
qualitatively and quantitatively. Proper investigation of client
details helps in reducing the credit risk.
2. Minimizes investment in Receivables: It reduces investment in
receivable by ensuring optimum funds are available within
organization at all the times. Receivable management decides
proper credit limit and credit period for avoiding any bankruptcy
situations. Attempts are made to collect account receivable as
soon as they become due for payment which reduces the overall
investment in receivables.

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 3. Optimize Sales: Efficient receivable management assist
business in raising their sales volume. Business is able to attract
more and more customers by providing them credit facilities.
They are able to properly decide and monitor credit facilities with
the help of a receivable management.
4. Reduce risk of bad Debts: It takes all steps to avoid any
instances of bad debts. Receivable management notify all
customers for the payment as soon as the amount gets due. It
charges interest on delay payments and aims at optimum
collection of all payment timely. Implementation of proper
schedule and monitoring of collection process results in
minimizing the risk of bad debts.

5. Maintain Efficient Cash: Maintaining efficient cash is crucial for

the survival of every organization. Receivables management
properly records all cash inflows and outflows of a business. All
credit facilities are extended after analyzing the capability of
organization and due payments is collected timely. This results in
steady cash flow within the organization.
6. Lower cost of Credit: Receivable management helps business
in lowering its cost of credit by limiting the credit amount and
credit period for its customers. It performs all processes such as
acquiring credit information of clients and collecting all due
payments in an efficient way which lower the overall cost
associated with credit facilities.
19.1.4 Scope of Receivable Management
a) Formulation of Credit Policy: Receivable management is the one
which formulates and implements an effective credit policy in an
organization. Credit policies are decided as per the capabilities of
an organization. A company may either follow a liberal policy or
stringent credit policy for providing credit facilities to its customers.
b) Credit Evaluation: Credit evaluation involves examining the credit
worthiness of customer before approving any credit amount.
Proper investigation of customer’s information lowers the risk of
bad debts. Receivable management acquire all credentials of client
for determining their borrowing capacity and repaying ability.
c) Credit Control: Receivable management implement a proper
structure for monitoring all credit functions of business. It records
credit sales with proper documents on a daily basis. Invoices are
raised immediately after goods get dispatch and amount is
collected soon as they become due for payment.

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 d) Maximize Profit: It plays an efficient role in maximizing the profit of
organizations. Receivable management helps in boosting the sales
volume by providing credit facilities to customers. More and more
people are able to purchase goods on credit which maximizes the
overall profit level.
e) Better Competition: Efficient account receivable management
helps business in facing the strong competition in market. It
enables in providing credit facilities to customers as per their needs
and capabilities. Receivable management analyses the credit
strategies adopted by competitors and according frame policy for
an organization. It attracts more and more customers by offering
them credit facilities at convenient rates.

19.2 COST ASSOCIATION WITH ACCOUNTS RECEIVABLES

The costs associated with the extension of credit and accounts
receivables are identified as follows:
1. Collection Cost: This cost incurred in collecting the receivables
from the customers to who credit sales has been made.
2. Capital Cost: This is the cost on the use of additional capital to
support credit sales which alternatively could have been
employed elsewhere.
3. Administrative Cost: This is an additional administrative cost for
maintaining account receivable in the form of salaries to the staff
kept for maintaining accounting records relating to customers,
cost of investigation etc.
4. Default Cost: Default costs are the over dues that cannot be
recovered. Business concern may not be able to recover the over
dues because of the inability of the customers
19.3 BENEFITS FROM CREDIT SALES
Apart from the cost, another factor that has a bearing on accounts
receivable management is the benefit emanating from credit sales. The
benefits are the increased sales and profits anticipated because of a
more liberal policy. When firms extend trade credit, they intend to
increase the sales level. The impact of a liberal policy of trade credit is
likely to have two forms.
i) It is oriented to sales expansion. In other words, a firm may
grant trade credit either to increase sales to existing customers
or attract new customers.

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 ii) The firm may extend credit to protect its current sales against
emerging competition. Here the motive is sales-retention. As a
result of increased sales the profits of the firm will increase.

19.4 DECISION AREAS IN RECEIVABLES MANAGEMENT

The three crucial decision areas in receivables management are;
19.4.1 Credit Policies

The credit policy of a firm provides the framework to determine Whether

or not to extend credit to a customer and how much credit to extend. The
credit policy decision of a firm has two broad dimensions:

a) Credit standards
The term credit standards represent the basic criteria for the extension
of credit to customers. The quantitative basis of establishing credit
standards are factors such as credit ratings, credit references, average
payments period and certain financial ratio. The trade – off with
reference to credit standards covers
i) The Collection cost
ii) The average collection period
iii) Level of bad debt losses, and
iv) Level of sales.
These factors should be considered while deciding whether to relax
credit standards or not. If standards are relaxed, it means more credit
will be extended while if standards are tightened, less credit will be
extended.
i) Collection Costs: The implications of relaxed credit standards are
more credit, a larger credit department to service accounts and relaxed
matters, increase in collection costs. The effect of tightening of credit
standards will be exactly opposite. These costs are likely to be semi-
variable as up to a certain point the existing staff will be able to carry on
the increased workload, but, beyond that additional staff would be
required.

ii) Investment in Receivables or the Average Collection Period: The

investments in accounts receivable involves a capital cost as funds have
to be arranged by the firm to finance them till customers make
payments. The higher the average accounts receivable, the higher the
capital or carrying cost. A change in the credit standards – relaxation or
tightening- leads to change in the level of accounts receivable either a)
through a change in sales, or b) through a change in collections.

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iii) Bad Debt Expenses: Another factor which is expected to be affected
by changes in credit standards is bad debt expenses (default expenses).
They can be expected to increase with relaxation in credit standards and
decrease as credit standards became more restrictive.
iv) Sales Volume: Changing credit standards can also be expected to
change the volume of sales. As standards are relaxed, sales are
expected to increase; conversely, a tightening is expected to cause a
decline in sales.
b) Credit Analysis

The second aspect of credit policies of a firm is credit analysis and

investigation. Two basic steps are involved in the credit investigation
process:

i) Obtaining credit information: The sources of information, broadly

speaking, are internal, and external.
Firms require their customers to fill various forms and documents giving
details about financial operations. They are also required to furnish
trade references with whom the firms can have contacts to judge the
suitability of the customers for credit. This type of information is
obtained from internal sources of credit information. Another internal
source of credit information is deriving from the records of the firms
contemplating an extension of credit.

The second source of credit information is external. The availability of

information from this source to assess the credit-worthiness of
customers depends upon the development of institutional facilities and
industry practices. Depending upon the availability, the following
external sources may be employed to collect information.
• Financial Statements
• Bank References
• Trade References
• Specialist credit bureau reports

ii) Analysis of credit information: Once the credit information has

been collected from different sources, it should be analysed to determine
the credit-worthiness of the applicant. Although there is not established
procedure to analyse the information, the firm should devise one suit its
needs. The analysis should cover two aspects: Quantitative, and
Qualitative.
The assessment of the quantitative aspects is based on the factual
information available from the financial statements, the past records of

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the firm, and so on. Another step in analysing the credit information is
through a ratio analysis of the liquidity, profitability and debt capacity of
the applicant. The quantitative assessment should be supplemented by
a qualitative interpretation of the applicant’s credit-worthiness. The
subjective judgment would cover aspects relating to the quality of
management.

19.4.2 Credit Terms

The second decision area in accounts receivable management is the
credit terms. After the credit standards have been established and the
credit worthiness of the customers has been assessed, the management
of a firm must determine the terms and conditions on which trade credit
will be made available. The stipulations under which goods are sold on
credit are referred to as credit terms. Credit terms specify the
repayment terms of receivables.
Credit terms have three components.
a) Credit period, in terms of the duration of time for which trade
credit is extended, during this period the overdue amount must
be paid by the customer.
b) Cash discount, if any, which the customer can take advantage of
the overdue amount, will be reduced by this amount.
c) Cash discount period, which refers to the duration during which
the discount can be availed of.
These terms are usually written in abbreviations, 2/10 net 30. The three
numerals are;
a) 2 signifies the rate of cash discount(2%), which will be available to
the customers if they pay the overdue within the stipulated time
b) 10 represent the time duration (10 days) within which a customer
must pay to be entitled to the discount.
c) 30 means the maximum period for which credit is available and the
amount must be paid in any case before the expiry of 30 days.
In other words, the abbreviation 2/10 net 30 means that the customer is
entitled to 2 per cent cash discount (discount rate) if he pays within 10
days (discount period) after the beginning of the credit period (30 days).
If, however, he does not want to take advantage of the discount, he may
pay within 30 days. If the payment is not made within a maximum period
of 30 days, the customer would be deemed to have defaulted.

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The credit terms, like the credit standards, affect the profitability as well
as the cost of a firm. A firm should determine the credit terms on the
basis of cost-benefit trade-off.

The cash discount has implications for the sales volume, average
collection period/average investment in receivables, bad debt expenses
and profit per unit.

The implications of increasing or initiating cash discount are as

follows:
The sale volume will increase. The grant of discount implies reduced
prices. If the demand for products is elastic, reduction in prices will
result in higher sales volume.
Since the customers, to take advantage of the discount, would like to
pay within the discount period, the average collection period would be
reduced. The reduction in the collection period would lead to a reduction
in the investment in receivables as also cause a fall in bad debt
expenses. As a result, profits would increase.
The discount would have a negative effect on the profits. This is
because the decrease in prices would affect the profit margin per unit of
sale.
19.4.3 Collection Policies
The third area involved in the accounts receivable management is
collection policies. They refer to the procedures followed to collect
accounts receivable. When, after the expiry of the credit period, they
become due. These policies cover two aspects
i) Degree of collection Effort: The credit policies of a firm may be
categorised into (i) strict /tight and (ii) lenient. The collection policy would
be tight if very rigorous procedures are followed. A tight collection policy
has implications which involve benefits as well costs. The management
has to consider the trade- off between them. A lenient collection effort
also affects the cost-benefit trade-off. The effect of tightening the
collection policy would be as follows.
In the first place, the bad debt expenses would decline. Moreover, the
average collection period will be reduced. As a result of these two
effects, the firm will benefit and its profit will increase.
ii) Types of Collection Efforts: The second aspect of collection
policies relates to the steps that should be taken to collect over dues
from the customers. A well-established collection policy should have
clear-cut guidelines as to the sequences of collection efforts.

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The efforts should in the beginning be polite, but, with the passage of
time it should become gradually more strict and stern.
The steps usually taken are;

a) Letters, including reminders, to expedite payment.

b) Telephone calls for personal contact
c) Help of collection agencies; and
d) Legal action
The firm should take recourse to very stringent measures, like legal
action, only after all other avenues have been fully exhausted. They not
only involve a cost but also affect the relationship with the customers.
The aim should be to collect as early as possible; genuine difficulties of
the customers should be given due consideration.

19.5 FACTORS CONSIDERING THE RECEIVABLE SIZE

Receivables size of the business concern depends upon various factors.
Some of the important factors are as follows:
1. Sales Level: Sales level is one of the important factors which
determines the size of receivable of the firm. If the firm wants to
increase the sales level, they have to liberalise their credit policy and
terms and conditions. When the firms maintain more sales, there will
be a possibility of large size of receivable.
2. Credit Policy: Credit policy is the determination of credit standards
and analysis. It may vary from firm to firm or even some times
product to product in the same industry. Liberal credit policy leads to
increase the sales volume and also increases the size of receivable.
Stringent credit policy reduces the size of the receivable.
3. Credit Terms: Credit terms specify the repayment terms required of
credit receivables, depend upon the credit terms, size of the
receivables may increase or decrease. Hence, credit term is one of
the factors which affect the size of receivable.
4. Credit Period: It is the time for which trade credit is extended to
customer in the case of credit sales.
5. Normally it is expressed in terms of ‘Net days’.
6. Cash Discount: Cash discount is the incentive to the customers to
make early payment of the due date. A
7. special discount will be provided to the customer for his payment
before the due date.
8. Management of Receivable: It is also one of the factors which
affect the size of receivable in the firm. When the management

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 involves systematic approaches to the receivable, the firm can
reduce the size of receivable.
LET US SUM UP

Accounts receivable represent an extension of credit to customers,

allowing them to reasonable period of time, in which to pay for the goods
which they have received. The objectives of receivables associated with
the extension of credit. The management of receivables associated with
the extension of credit. The management of receivables involves crucial
decision in three areas credit policies, 2) credit terms and 3) collection
determine whether or not to extend credit to customer and how much
credit to extend the term credit to customers. The credit terms specify
the repayment terms, comprising credit period, cash discount, if any, and
cash discount period. Collection policies refer to the procedure followed
to collect accounts receivables. When they become due. The term
inventory refers to assets which will be sold in future is the normal
course of business operations. The objectives of inventory management
consist of two counter-balancing parts, namely, to minimize investments
in inventory. The costs of holding inventory are ordering cost and
carrying cost. The major benefits of holding inventory are in the area of
purchasing, production and sales.
CHECK YOUR PROGRESS

Choose the Correct Answers:

[Link] management is related to ___________.
a) Receivable management b) Inventory management
c) Cash management d) All of the above
2. Optimum utilization of cash to ensure maximum liquidity and
maximum profitability ________.
a) Cash management b) Inventory management
c) Receivable management d) All of the above
3. ________is an estimate of cash receipts and disbursements of cash
during a future period of time Varies with seasonal needs.
a) Fixed Budget b) Cash Budget
c) Flexible Budget d) Master Budget
4.___________refers to the desire of a firm to take advantages of
opportunities which present themselves at unexpected moments and
which are typically outside the normal course of business.

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 a) Transaction Motive b) Precautionary Motive
c) Speculative Motive d) Compensating Motive
5. ___________refers to the holding of cash, to meet routine cash
requirements to finance the transaction which a firm carries on in the
ordinary course of business.
a) Transaction Motive b) Precautionary Motive
c) Speculative Motive d) Compensating Motive
GLOSSARY

Credit Terms : Credit terms are the payment terms

mentioned on the invoice at the time
of buying goods. It is an agreement
between the buyer and seller about
the timings and payment to be made
for the goods bought on credit. It is
also known as payment terms

Receivable Management : Management of receivables refers to

planning and controlling of debt
owed to the customer on account of
credit sales.

Credit Policies : A credit policy contains guidelines

that structure the amount of credit
granted to customers, as well as
how collections are to be conducted
for delinquent accounts

Float : The term float refers to the amount

of money tied up in cheques that
have been written, but have yet to
be collected and en cashed.
Alternatively, float represents the
difference between the bank
balance and book balance of cash
of a firm.

Capital Cost : A cost incurred on the purchase of

land, buildings, construction and
equipment to be used in the
production of goods or the rendering
of services

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SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija,(2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014),Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. Receivable Management: Meaning, Objectives, Importance |
Tally Solutions
7. [Link]
management/management-of-receivables/33400
8. [Link]
determination-evaluation-of-credit-policy/
ANSWERS TO CHECK YOUR PROGRESS
1) c 2) a 3) b 4) c 5) a

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Unit 20

INVENTORY MANAGEMENT
STRUCTURE

Overview
Learning Objectives
20.1 Introduction to Inventory Management

20.1.1 Inventories classification

20.1.2 Objectives of Inventory Management
20.1.3 Benefits of Holding Inventory
20.1.4Costs associated with inventory
20.2 Inventory control systems
20.2.1 Tools and Techniques of Inventory Management

20.3 Economic order quantity

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your Progress

OVERVIEW
Effective inventory management enables businesses to balance the
amount of inventory they have coming in and going out. The better a
business controls its inventory, the more money it can save in business
operations. A business that has too much stock has overstock.
Overstocked businesses have money tied up in inventory, limiting cash
flow and potentially creating a budget deficit. This overstocked inventory,
which is also called dead stock, will often sit in storage, unable to be
sold, and eat into a business's profit margin. But if a business doesn't
have enough inventories, it can negatively affect customer service. Lack
of inventory means that a business may lose sales. Telling customers
they don't have something, and continually backordering items, can
cause customers to take their business elsewhere. An inventory
management system can help businesses strike the balance between
being under- and overstocked for optimal efficiency and profitability.

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LEARNING OBJECTIVES
After reading this unit, you should be able to;
• define the term inventory
• describe How does inventories are classified
• list out the major reasons for holding inventories
• describe invent management
• discuss the objectives of inventory management.
• discuss the importance of inventories Management
• discuss various stock levels.
• describe various inventory control models
• calculate EOQ, and tell its assumption and solve typical
problems

20.1 INTRODUCTION TO INVENTORY MANAGEMENT: CONCEPT,

MEANING
Every enterprise needs inventory for smooth running of its activities. It
serves as a link between production and distribution processes. 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.
Inventory management helps companies identify which and how much
stock to order at what time. It tracks inventory from purchase to the sale
of goods. The practice identifies and responds to trends to ensure
there’s always enough stock to fulfil customer orders and proper warning
of a shortage. Once sold, inventory becomes revenue. Before it sells,
inventory (although reported as an asset on the balance sheet) ties up
cash. Therefore, too much stock costs money and reduces cash flow.
One measurement of good inventory management is inventory turnover.
An accounting measurement, inventory turnover reflects how often stock
is sold in a period. A business does not want more stock than sales.
Poor inventory turnover can lead to dead stock, or unsold stock.
Inventory management is vital to a company’s health because it helps
make sure there is rarely too much or too little stock on hand, limiting the
risk of stock outs and inaccurate records Inventory Management.
Inventory Management makes sure that the core processes of a
business keep running efficiently by optimizing the availability of
inventory. It has to minimize the investment in inventory to enhance

267
firm's profitability. Managing inventory in a cost-efficient way helps you
optimize your profits. Inventory turnover ratio measures how efficiently
you sell through your inventory

Inventory
Inventory, as a current asset, differ from other current assets because
only financial managers are not involved. Rather, all functional areas ,i.e.
finance, marketing, production, and purchasing, are involved. Inventory
management, like the management of other current assets, should be
related to the over-all objective of the firm. Inventory is a non-
capitalized asset, a physical resource that a firm holds in stock either for
sale or for the purpose of converting it into finished goods inputs for
production important current assets The term inventory refers to the
stockpile of the product a firm is offering for sale and the components
that make up product. In other words, inventory is composed of assets
that will be sold in future in the normal course of business operations.
201.1 Inventories Classification
Types of inventories
a) Raw materials are purchased items received which have not
entered the production process. : A material in its unprocessed,
natural state considered usable for manufacture. It is a Basic input
that are converted into finished product through the manufacturing
process
b) Work-in-process (WIP)- (semi-finished / partially completed
partially in completed) is raw materials that have entered the
manufacturing process and are being worked on or waiting to be
worked on Semi-manufactured products, goods partially worked on
but not fully completed. It is a Semi-manufactured products need
some more works before they become finished goods for sale
c) Finished goods are the finished products /Completely
manufactured products ready for sale
20.1.2 Objectives of Inventory Management
The main objective of inventory management is to maintain inventory at
appropriate level to avoid excessive or shortage of inventory because
both the cases are undesirable for business. Thus, management is
faced with the following conflicting objectives: The right stock, at the right
levels, in the right place, at the right time, and at the right cost.
The main objectives of inventory management are operational and
financial.

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a) 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.

b) 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: The following are the objectives of inventory
management.
i) 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.
ii) To avoid both over-stocking and under-stocking of inventory.
iii) To maintain investments in inventories at the optimum level as
required by the operational and sales activities.
iv) To keep material cost under control.
v) To eliminate duplication in ordering or replenishing stock.
vi) To minimise losses through deterioration, pilferage, wastages
and damages.
vii) To ensure perpetual inventory control
viii) To ensure right quality goods at reasonable prices.
ix) To facilitate furnishing of data for short term and long-term
planning and control of inventory.
c) Inventory policy Inventory policy is also essential to maintain a
proper balance of different types of inventories in storage.
Insufficient stock can cause a manufacturing halt. A sound inventory
policy will ensure a business has enough raw materials to smoothly
run the manufacturing and supply of finished products. Inventory
policy also plays a crucial role to avoid over-accumulation
20.1.3 Benefits of Holding Inventory
The major benefits of holding inventory are the basic functions of
inventory. The basic function of inventories is to act as a buffer to
decouple or uncouple the various activities of a firm so that all do not
have to be pursued at exactly the same rate.
The key activities are;
a) Benefits in purchasing: If the purchasing of raw materials and
other goods is not tied to production/sales, a firm can purchase
independently to ensure the most efficient purchase, several
advantages would become available. In the first place, a firm can
purchase larger quantities than is warranted by usage in

269
 production or the sales level. This will enable it to avail of
discount that is available on bulk purchases. It will lower the
ordering cost as fewer acquisition would be made. Second, firms
can purchase goods before anticipated or announced price
increases. This will lead to a decline in the cost of production.
b) Benefits in production: Production can be carried on at a rate
higher or lower than the sales rate. This would be of special
advantage to firms with seasonal sales pattern. In their case, the
sales rate will be higher than the production rate during a part of
the year (peak season) and lower during, the off-season. The
choice before the firm is either to produce at a level to meet the
actual demand.
c) Benefits in sales: The maintenance of inventory also helps a
firm to enhance its sales efforts. If there are no inventories of
finished goods, the level of sales will depend upon the level of
current production. A firm will not be able to meet demand
instantaneously. There will be a lag depending upon the
production process. If the firm has inventory, actual sales will not
have to depend on lengthy manufacturing process. Thus,
inventory serves to bridge the gap between current production
and actual sales.
20.1.4 Costs associated with inventory
1. Material cost (Costof Direct materials)
Opportunity cost -Opportunity cost is the estimated return of investments
you don't make compared to the expected return of investments you do
make. It's an important factor to consider when allocating time or
resources like Inventory to any type of Business/ projects
2. Ordering cost
a)Cost of Placing an order with a vendor/ supplier of materials)
i) Preparing a Purchasing order,
ii) Processing payments
iii) Receiving and inspecting materials
b) Ordering from the plant
i) Machine set up
ii) Start- up scrap generated from getting a production run started

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3. Carrying cost
a) Cost connected directly with materials
i) Obsolescence
ii) Deterioration
iii) Pilferage
b) financial cost

i) Taxes, Insurances
ii) Cost of capital – interest on loan for acquire and maintain the
inventories

c) Capital cost
i) Interest on money invested in inventory
ii) Interest on money invested in land and building and control
equipment
d) Storage space costs
i) Rent on warehouse
ii) Insurance on storage building
iii) Depreciation on warehouse installation
iv) Cost of maintenance and repairs
v) Utility charges- like heat, light, water
vi) Salaries to security and maintenance personnel
e) Inventory service costs

i) Labour cost in handling and maintaining stocks

ii) Clerical expenses in keeping records
iii) Employee benefits for warehouse and admin personnel
f) Handling equipment costs
i) Taxes & insurances on Equipment
ii) Depreciation on equipment’s
iii) Fuel Expenses
iv) Cost of maintenance & Repairs
g) Inventory Risk cost
i) Obsolescence of inventory
ii) Insurance on inventory
iii) Physical deterioration of inventory
iv) Losses from Pilfereage

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4. Stock out cost
i) Back ordering
ii) Lost sales

5. Capacity Costs
i) Overtime payments when capacity is too small
ii) Lay- off and idle time when capacity is too large

20.2 INVENTORY CONTROL SYSTEMS

In any scheme of inventory control, following things have to be studied
i) Stock levels
ii) Determination of safety stock
iii) System of ordering for inventory
iv) Preparation of inventory reports.

a) Stock levels
Carrying 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 that a firm
should maintain an optimum level of inventory.

Minimum level - This represents the quantity which must be maintained

in hand at all times. If stocks are less than the minimum level the work
will stop due to shortage of materials.

Minimum stock level = Re-ordering level - (Normal

consumption x Normal Re-order Period)
Re-ordering level - Re-ordering level or ordering level is fixed between
minimum level and maximum level. The rate of consumption, number of
days required replenishing the stocks, 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.
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.

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Maximum stock level = Re-ordering Quantity – (Minimum
consumption x Minimum Re-order Period)
Danger level - It is the level beyond which materials should not fall in
any case. If danger level is arises then immediate steps should be taken
to replenish the stocks even if more cost is incurred in arranging the
materials. If materials are not arranged immediately there is a possibility
of stoppage of work.
Danger level = Average Consumption x Maximum re-order period
for emergency purchases

Average stock level - The average stock level is calculated as such:

Average stock Level = Minimum stock level + ½ of Re-order
Quantity.

b) Determination of safety stocks

Safety stock is a buffer to meet same unanticipated increase in usage.
The usage of inventory cannot be perfectly forecasted. 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. In order
to protect against the stock out arising out of usage fluctuations firms
usually maintain some margin of safety or safety stock.
c) Ordering systems of Inventory
The basic problem of inventory is to decide the re-order point. The re-
order point is determined with the help of these things:
i) Average consumption rate
ii) Duration of lead time
iii) Economic order quantity
There are three prevalent system of ordering and a concern can choose
any one of these.
i) Fixed order quantity system generally known as EOQ system.
ii) Fixed period order system or periodic re-ordering system or
periodic review system.
iii) Single order and scheduled part delivery system.
d) Inventory Reports
This is usually done by preparing periodical inventory reports. These
reports should contain all information necessary for managerial action.

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On the basis of these reports management takes corrective action
wherever necessary.
20.2.1 Tools and Techniques of Inventory Management

Inventory management is an essential part of every business. With an

effective inventory management system in place, the business can
significantly reduce its various costs like warehousing cost, inventory
carrying cost, ordering cost, cost of obsolescence, etc. It improves the
supply chain of the business identify categories of stock that may require
different management and controls. By using these categorization
methods, you can rank inventory items by their cost and turnover
a) XYZ analysis
XYZ analysis is a framework to classify products based on their
variability of demand.
X-items = regular demand
Y-items = strong variability in demand
Z-items = very irregular and difficult to predict demand
For example, it makes sense to treat AX items that are valuable and
have a constant demand differently to AZ items with erratic demand. If
demand is steady and easy to predict (X items), your safety stock levels
can be much lower than products where demand is much more volatile
(Z items).

b) ABC Analysis
This analysis categorizes items based on their annual consumption
value. Sometimes, Inventory Managers can use Pareto’s Principle for
classification. Pareto’s Principle classifies the important items in a
certain group that usually constitute a small portion of the total items in
the group. Then, the majority of the items, as a whole, will seem to be of
minor significance.
Here is how ABC Analysis looks like:
A: 10% of total inventories contributing to 70% of total consumption
value.
B: 20% of total inventories, which account for about 20% of the total
consumption value.
C: 70% of total inventories, which account for only 10% of the total
consumption value.

274
This can then be further supplemented by XYZ Analysis, which helps
forecast the difficulty of selling a particular item. X is used as a symbol
for those that are easier to sell, whereas Z classifies the most difficult
items to sell.
Here is how ABC Analysis looks like:
A: 10% of total inventories contributing to 70% of total consumption
value.
B: 20% of total inventories, which account for about 20% of the total
consumption value.

C: 70% of total inventories, which account for only 10% of the total
consumption value.

Distribution of ABC class

Number of items Total amount required

10％ 70％

20％ 20％

70％ 10％

100％ 100％

Line 1

120

100
Value of items (%)

80 C
B
60
40

20 A
0
10
20
30
40
50
60
70
80
90
100

No of items (%)

c) FSN Analysis
This analysis classifies inventory based on quantity, the rate of
consumption and frequency of issues and uses. Here is the basic
depiction of FSN Analysis:
F stands for Fast moving, S for Slow moving and N for Non-moving
items.

275
 i) Fast Moving (F) – Items that are frequently issued/used
ii) Slow Moving (S) – Items that are issued/used less for a certain
period
iii) Non-Moving (N) – Items that are not issued/used for more than a
certain duration
d) VED Analysis

This is an analysis whose classification is dependent on the user’s

experience and perception. This analysis classifies inventory according
to the relative importance of certain items to other items, like in spare
parts. In VED Analysis, the items are classified into three categories
which are:
i) Vital – inventory that consistently needs to be kept in stock.

ii) Essential – keeping a minimum stock of this inventory is enough.

iii) Desirable – operations can run with or without this, optional.
e) HML Analysis
HML Analysis classifies inventory based on how much a product
costs/its unit price. The classification is as follows:
i) High Cost (H) – Item with a high unit value.
ii) Medium Cost (M) – Item with a medium unit value.
iii) Low Cost (L) – Item with a low unit value.
f) SDE Analysis

This analysis classifies inventory based on how freely available an item

or scarce an item is, or the length of its lead time. This is how the
inventory is classified:
i) Scarce (S) – Imported items and require longer lead time.
ii) Difficult (D) – Items which require more than a fortnight to be
available, but less than 6 months lead time.
iii) Easily available (E) – Items which are easily available
Problem:
1) From the following information, calculate minimum stock level,
maximum stock level and re-ordering level:
i) Maximum Consumption = 200 units per day
ii) Minimum Consumption = 120 units per day
iii) Normal Consumption =160 units per day

276
 iv) Reorder period = 10-15 days
v) Reorder quantity = 1,600 units
vi) Normal reorder period = 10 days.

Solution:
Reordering Level = Maximum Consumption x Maximum Reorder
period

= 200 units X 15 = 3,000 units

Minimum Stock Value = Reordering Level – (Normal Consumption x
Nominal Reordering Period)

= 3,000 – (160 X 10) = 3,000 – 1,600 = 1,400 units

Maximum Stock Level = Reordering Level + Reorder Quantity –
(Minimum Consumption x Reorder period)

= 3,000 + 1,600 – (120 X 10)

= 3,000 + 1,600 – 1,200 = 2,400 units.
2) Two components A & B are used as follows:

Normal Usage 120 per week each

Minimum Usage 60 per week each

Maximum Usage 180 per week each

Re-ordering quantity A- 2000;

B-3200

Re-ordered period A- 6 to 10 weeks

B-4 to 8 weeks

For each component, calculate:

a) Re-ordering level
b) Minimum level
c) Maximum level
d) Average stock level
Also on the difference in the levels for the two components, comment
briefly.

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Solution:
(a)Re-ordering level = Maximum usage* maximum re-order period
A = 180*10 = 1800 units

B = 180*8 = 1440 units

Inference:
Re-order level of B is lower because against 10 weeks of re-order period
for A, re-order period for B is 8 weeks.
(b)Minimum level = Re-ordering level-(Normal usage*Normal re-
order period)

Normal Re-order period is to be taken as the average re-order period

A = 1800-(120*8) = 840 units
B = 1440-(120*6) = 720 units.

Inference:
Because of its lower re-ordering level, minimum level for B is lower.
(c)Maximum level = Re-ordering level +Re-ordering quantity-
(Minimum usage*minimum re-order period)
A = 1800+2000-(60*6) = 3440 units
B = 1440+3200-(60*4) = 4400 units.

Inference:
Because of its higher re-order quantity, maximum level for B is higher.
(d) Average stock level= (Minimum level+ Maximum level)/2
A = (840+3440)/2 = 2140 units
B = (720+4400)/2 = 2560 units.
20.3 ECONOMIC ORDER QUANTITY (EOQ)
Economic order quantity is an inventory control model is used to
determine the optimum order size that will help in minimizing the
ordering costs and the carrying costs. All other costs are assumed to be
constant. The average level of inventory is order quantity/2. The driving
factor for this model is the need to minimize the ordering costs and the
carrying costs. EOQ also gives solutions to other problems like:
a) How frequently to buy?
b) When to buy?

278
 c) What should be the reserve stock?
EOQ Model is also based on certain assumptions
a) Only one product is involved

b) Annual demand is known and constant

c) Lead time known and constant
d) Each order is received in a single delivery

e) Quantity discounts are not possible

Problem 1:
XYZ Ltd consumes 4000 units of a particular items every year, the cost
per item ascertained to be Rs.240/ the price of the unit Rs.10/ PU the
inventory carrying cost of the company is 30% so determine the EOQ.
√2 𝐴𝐵
E O Q=
𝐶𝑠
√2 𝑋 4000 𝑋 240
=
10 𝑋 30%
√19,20,000
=
3
= 800 Units
Annual Usage
Optimum no of orders for year =
EOQ
4000
=
800
= 5 Order

A B C D

Order Size 400 500 800 1000

No. of Order to Buy 10 times 8 times 5 times 4 times

Order Cost Rs.240/ Order 2400 1920 1200 960

Carrying Cost 30% ofavg. 600 750 1200 1500

Inventory10 x 30%Rs.3

TOTAL COST 3000 2670 2400 2460

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Problem 2:
A firm estimate a demand for a material for next year is 2500 units. The
acquisition cost are Rs.400 and carrying cost Rs.50/ per unit. The safety
stock is set at 25% of EOQ. The daily usage is 10 units and
a) Find EOQ
b) Safety Stock
c) Re-order point
Reorder point= 𝐋𝐞𝐚𝐝 𝐓𝐢𝐦𝐞 𝐝𝐞𝐦𝐚𝐧𝐝 + Safety Stock
Lead Time Demand= Avg. Lead Time (Day/Month) ×Average units sold
√𝟐 𝑨𝑩
1. EOQ=
𝑪𝒔
√2 𝑋 2500 𝑋 400
=
50
√20,00,000
=
50
= 200 units
2. Safety Stock
[𝐦𝐚𝐱𝐢𝐦𝐮𝐦𝐝𝐚𝐢𝐥𝐲𝐮𝐬𝐞𝐱𝐦𝐚𝐱𝐢𝐦𝐮𝐦𝐥𝐞𝐚𝐝𝐭𝐢𝐦𝐞] – [𝐚𝐯𝐞𝐫𝐚𝐠𝐞𝐝𝐚𝐢𝐥𝐲𝐮𝐬𝐞𝐱𝐚𝐯𝐞𝐫𝐚𝐠𝐞𝐥𝐞𝐚𝐝𝐭𝐢𝐦𝐞]
= 𝐬𝐚𝐟𝐞𝐭𝐲𝐬𝐭𝐨𝐜𝐤.

25% of the EOQ

200 x 25%
= 50 units
3. Re Order Point
= Lead Time Demand + Safety Stock
= 100 + 50 = 150
4. Lead Time Demand
= Average Lead Time (Days) X Average Units Sold
= 10 x 10 Units = 100

Problem 3
X Ltd has a demand for a particular parts at 10,000 units per year. The
cost per unit is [Link] cost Rs.36 to place an order to process delivery.
The inventory carrying cost is estimated as 9% of the unit cost.
Determine
(1) EOQ
(2) Optimum No. of orders per year
(3) Total procurement cost
(4) Minimum total cost of inventory p.a.

280
(i) E O Q
√2 𝐴𝐵
=
𝐶𝑠
√2 𝑋 10000 𝑋 36
=
2 x 9/100
√720000
= 0.18

=√40,00,000
= 2000 Units
(ii) Optimum No. of orders per year

= Annual usage/ EOQ

= 10,000/2000 = 5 Order
(iii) Total procurement cost

= Annual Demand X Cost per Unit

10,000 x 2 = 20,000
(iv)Minimum Total cost of Inventory

Purchasing cost Rs.20, 000

Ordering Cost Rs.180
Carrying Cost 5 x 36=180
E O Q at an average rate Rs.180
2000 x ½ x ( 2 x 9/100 )
Total Inventory Cost 20,360

LET US SUM UP

Inventory serves a useful purpose in the supply chain. That said, firms
can help minimize the need for inventory by carefully managing those
factors that drive inventory levels up. The term inventory refers to assets
which will be sold in future is the normal course of business operations.
The objectives of inventory management consist of two counter-
balancing parts, namely, to minimize investments in inventory. The costs
of holding inventory are ordering cost and carrying cost. The major
benefits of holding inventory are in the area of purchasing, production
and sales. The economic order quantity (EOQ) is the order quantity that
minimizes total holding and ordering costs for the year. Even if all the
assumptions don’t hold exactly, the EOQ gives us a good indication of
whether or not current order quantities are reasonable the reorder point
formula allows us to determine the safety stock (SS) needed to achieve

281
a certain cycle service level. In general, the longer the lead times are,
and the greater the variability of demand and lead times.
CHECK YOUR PROGRESS

Choose the Correct Answers:

1. Buffer stock’s is the level of stock _____________.
a) Half of the actual stock
b) At which the ordering process should start
c) Minimum stock level below which actual stock should not fall
d) Maximum stock in inventory

2. The minimum stock level is calculated as ____________.

a) Reorder level – (Normal consumption x Normal delivery time)
b) Reorder level + (Normal consumption x Normal delivery time)
c) (Reorder level + Normal consumption) x Normal delivery time
d) (Reorder level + Normal consumption) / Normal delivery time
3. Re-ordering level is calculated as___________.
a) Maximum consumption rate x Maximum re-order period
b) Minimum consumption rate x Minimum re-order period
c) Maximum consumption rate x Minimum re-order period
d) Minimum consumption rate x Maximum re-order period
4 In the ABC Analysis system the B category stands for____________.
a) Outstanding importance in value
b) Comparatively unimportant in value
c) Comparatively important in value
d) Average importance in value
5. Which among the following costs is the expense of storing inventory
for a specified period of time?
a) Purchasing cost b) Carrying cost
c) financial cost d) Storing cost
GLOSSARY

Economic Order Quantity : Economic order quantity is an

(EOQ) inventory control model is used to
determine the optimum order size
that will help in minimizing the
ordering costs and the carrying
costs.

282
VED Analysis : VED Analysis is a popular
inventory management strategy
that classifies material according to
their criticality for the business into
three categories of Vital, Essential
and Desirable.

ABC Analysis : ABC analysis is an inventory

management technique that
determines the value of inventory
items based on their importance to
the business.

Reorder level : Reorder level (or reorder point) is

the inventory level at which a
company would place a new order
or start a new manufacturing run.

Buffer stock’s : Buffer stock refers to a reserve of

a commodity that is used to offset
price fluctuations and unforeseen
emergencies.

SUGGESTED READINGS
1. Erich [Link] (1992) Techniques of Financial Analysis, Jaico
Publishing House.
2. James C Van Horne, Sanjay Dhamija, (2012), “Financial
Management and Policy” latest Edition, Pearson Education, India
3. Khan. M.Y., P K Jain (2012), “Financial Management-Text and
Problems”, 6th Edition, TMH, India
4. Pandey IM, (2014), Financial Management, 10th Edition, Vikas,
India
5. Srivastava R.M. (1998) Financial Management and Policy,
Himalaya Publishing House.
6. [Link]
management
7. [Link]
8. What Is an Inventory Control System? | BigCommerce
9. 9 Inventory types: From raw materials to finished goods - Article
([Link])
ANSWERS TO CHECK YOUR PROGRESS
1) c 2) a 3) a 4) d 5) b

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